2006 AICPA Newly-Released Regulation Questions

Transcription

1 Following are multiple choice questions recently released by the AICPA. These questions were released by the AICPA with letter answers only. Our editorial board has provided the accompanying explanations. Please note that the AICPA generally releases questions that it does NOT intend to use again. These questions and content may or may not be representative of questions you may see on any upcoming exams.

2 Under the provisions of the Employee Retirement Income Security Act of 1974 (ERISA), which of the following statements is(are) correct regarding employee rights? I. Employers are required to establish either a contributory or noncontributory employee pension plan. II. Employers are required to include employees as pension-plan managers. a. I only. b. II only. c. Both I and II. d. Neither I nor II. Choice "d" is correct. The Employment Retirement Income Security Act (ERISA) does not require employers to have retirement plans or require contributions to existing retirement plans. ERISA does not mandate that employers are required to include employees as pension-plan managers. ERISA does establish standards for funding and investing and imposes fiduciary duties on pension fund managers. Only choice "d" reflects that employers are not required to establish a pension plan and employees do not need to be included as pension-plan managers

3 The Rites are married, file a joint income tax return, and qualify to itemize their deductions in the current year. Their adjusted gross income for the year was $55,000, and during the year they paid the following taxes: Real estate tax on personal residence $2,000 Ad valorem tax on personal automobile 500 Current-year state and city income taxes withheld from paycheck 1,000 What total amount of the expense should the Rites claim as an itemized deduction on their current-year joint income tax return? a. $1,000 b. $2,500 c. $3,000 d. $3,500 Choice "d" is correct. In answering this question, we must assume that the examiners mean to ask, "What total amount of the tax expense should the Rites claim as an itemized deduction?" Obviously, the Rites have more deductions than just those tax deductions above, or they would tax advantage of the standard deduction. In any case, for cash-basis taxpayers, deductible taxes are generally deductible in the year paid, and real estate taxes, income taxes, and personal property taxes (e.g., ad valorem taxes on personal automobile) are allowable deductions. The total amount of deductions for tax expense is calculated as follows: Real estate tax on personal residence $2,000 Ad valorem tax on personal automobile 500 Current-year state and city income taxes withheld 1,000 Total deduction for taxes $3,500 Choice "a" is incorrect. Real estate taxes and personal property taxes are allowable itemized deductions. Choice "b" is incorrect. Current-year state and city income taxes withheld from a paycheck are allowable itemized deductions. Choice "c" is incorrect. Personal property taxes (e.g., ad valorem taxes paid) are allowable itemized deductions

4 Under the Negotiable Instruments Article of the UCC, an instrument will be precluded from being negotiable if the instrument: a. Fails to state the place of payment. b. Is made subject to another agreement. c. Fails to state the underlying consideration. d. Is undated. Choice "b" is correct. Under the Negotiable Instruments Article of the UCC, an instrument is not negotiable if it states that it is "subject to" or "contingent upon" another agreement. Choice "a" is incorrect. A negotiable instrument is not required to state the place of payment. Choice "c" is incorrect. Consideration is not required for an instrument to be negotiable. We frequently make gifts by check. The check can be negotiable even though no consideration is given for the gift. Choice "d" is incorrect. Failure to date an instrument will not destroy negotiability. An undated instrument is counted as being payable on demand

5 Porter was unemployed for part of the year. Porter received $35,000 of wages, $4,000 from a state unemployment compensation plan, and $2,000 from his former employer's company-paid supplemental unemployment benefit plan. What is the amount of Porter's gross income? a. $35,000 b. $37,000 c. $39,000 d. $41,000 RULE: Gross income includes all income unless it is specifically excluded in the tax code. Choice "d" is correct. Wages and all unemployment compensation are not excluded from being taxable; therefore, there are included in the taxpayer's gross income for tax purposes. Wages received $35,000 State unemployment compensation 4,000 Employer's unemployment compensation plan 2,000 $41,000 Choice "a" is incorrect. All forms of unemployment compensation are included as part of gross income. Choice "b" is incorrect. The $4,000 of state unemployment compensation received is included as part of gross income. Choice "c" is incorrect. The $2,000 of his former employer's company-paid supplemental unemployment benefit plan is included as part of gross income

6 Under the ethical standards of the profession, which of the following business relationships would generally not impair an auditor's independence? a. Promoter of a client's securities. b. Member of a client's board of directors. c. Client's general counsel. d. Advisor to a client's board of trustees. Choice "d" is correct. Rule 101 of the Code of Conduct requires that members be independent in fact and appearance in audits and attestation services. Independence is impaired if an auditor is an employee of an audit client or is able to make management decisions on behalf of an audit client. An advisor of an audit client's board of directors is not an employee, nor is the advisor able to make management decisions for the audit client. The advisor does not make decisions, the advisor simply gives advice that the client is free to accept or reject. Choice "a" is incorrect. A promoter of the audit client's securities has a direct relationship with the client. A promoter is a business relationship that would impair independence. Choice "b" is incorrect. A member of the board of directors of the audit client is able to make management decisions for the client. A member of the board is a business relationship that would impair independence. Choice "c" is incorrect. A client's general counsel is an employee. A general counsel is a business relationship that would impair independence

7 Under the Securities Exchange Act of 1934, which of the following penalties could be assessed against a CPA who intentionally violated the provisions of Section 10(b), Rule 10b-5 of the Act? Civil liability of Criminal liability monetary damages of a fine a. Yes Yes b. Yes No c. No Yes d. No No Choice "a" is correct. Violation of Rule 10b-5 of the Securities Exchange Act of 1934 can result in civil damages, an SEC injunctive action and or criminal fines and penalties. Only choice "a" reflects that both civil and criminal liability can be assessed against a CPA who intentionally violates the provisions of Rule 10b-5 of the Securities Exchange Act of

8 All of the following statements regarding compliance with the statute of frauds are correct, except: a. Any necessary writing must be signed by all parties against whom enforcement is sought. b. Contracts involving the sale of goods in an amount greater than $500 must be in writing. c. Contract terms must be contained in only one document. d. Contracts for which it is improbable to assume that performance will be completed within one year must be in writing. Choice "c" is correct. Under the Statute of Frauds, there is no requirement that the terms be stated in a single document. Terms can be stated in more than one document. Choice "a" is incorrect. The Statute of Frauds does require that the party or parties against whom enforcement is sought sign certain specified contracts. Choice "b" is incorrect. Contracts for the sale of goods for $500 or more are one of the specified contracts requiring some kind of writing under the Statute of Frauds. Choice "d" is incorrect. Contracts which by there terms can not be performed within a year are one of the specified contracts requiring some kind of writing under the Statute of Frauds

9 ParentCo, SubOne, and SubTwo have filed consolidated returns since their inception. The members reported the following taxable incomes (losses) for the year. ParentCo $50,000 SubOne ($60,000) SubTwo ($40,000) No member reported a capital gain or loss or charitable contributions. What is the amount of the consolidated net operating loss? a. $0 b. $30,000 c. $50,000 d. $100,000 Choice "c" is correct. Net capital losses are not allowable deductions for corporations. A corporation can only use capital losses to offset capital gains. Further, the deduction for charitable contributions may be limited in some cases, and no charitable contribution deduction is allowed in calculating the NOL. The facts of this question indicate that there are no reported capital gains or losses or charitable contributions for any of the consolidated entities; therefore, we know that we are able to use the total income (loss) identified in the facts to calculate the net operating loss. When entities file consolidated income tax returns, 100% if their net income (losses) is consolidated. The facts do not indicate that any intercompany transactions exist; therefore, there are no elimination entries to make before consolidating the net income (loss). The consolidated net operating loss is calculated as follows: Parent Co. $ 50,000 Sub One (60,000) Sub Two (40,000) NOL $(50,000) Choice "a" is incorrect. A consolidated net loss of $50,000 exists, as calculated above. Choice "b" is incorrect. A consolidated net loss of $50,000 exists, as calculated above. Choice "d" is incorrect. The income from Parent Co. ($50,000) is netted with the losses from the subsidiaries ($100,000) to arrive at the consolidated net operating loss of $50,

10 Which of the following types of mistake will generally make a contract unenforceable and allow it to be rescinded? a. A unilateral mistake of fact. b. A mutual mistake of fact. c. A unilateral mistake of value. d. A mutual mistake of value. Choice "b" is correct. A mutual mistake of a material fact is unenforceable. The adversely affected party can rescind the contract. Choice "a" is incorrect. Generally, a unilateral mistake of fact does not make the contract unenforceable. The mistaken party can only rescind if there was a mistake of a material fact and the other party knew or should have known that a mistake was being made. Choice "c" is incorrect. Only mistakes as to material facts can make a contract unenforceable. Mistakes as to value do not make a contract unenforceable. Thus, a unilateral mistake of value would not make a contract unenforceable. Choice "d" is incorrect. Only mistakes as to material facts can make a contract unenforceable. Mistakes as to value do not make a contract unenforceable. Thus, a mutual mistake of value would not make a contract unenforceable

11 Wallace purchased 500 shares of Kingpin, Inc., 15 years ago for $25,000. Wallace has worked as an owner/employee and owned 40% of the company throughout this time. This year, Kingpin, which is not an S corporation, redeemed 100% of Wallace's stock for $200,000. What is the treatment and amount of income or gain that Wallace should report? a. $0 b. $175,000 long-term capital gain. c. $175,000 ordinary income. d. $200,000 long-term capital gain. Choice "b" is correct. An investment in a capital asset (e.g., stock) results in the income being capital (either a capital loss or a capital gain). Ownership percentage is not a factor in the calculation, and, in this question, nor is the fact that the corporation is not an S corporation. The calculation is simple: Wallace invested $25,000 in the stock and received $200,000 for 100% of his investment 15 years later. The capital gain is $175,000 ($200,000 - $25,000), and it is considered long-term because the stock was held for greater than one year. Choice "a" is incorrect. There is $175,000 of gain on the transaction ($200,000 - $25,000). This type of transaction is not a transaction that is excluded from tax in the tax code. Choice "c" is incorrect. An investment in a capital asset (e.g., stock) results in the income being capital (either a capital loss or a capital gain). Although the calculation of the income is correct (i.e., $175,000), ordinary income is not the proper treatment for this transaction. Choice "d" is incorrect. Although this transaction does result in a long-term capital gain, Wallace has basis in the stock ($25,000), and the gain is calculated as the proceeds from the sale ($200,000) less the basis in the stock

12 Carter purchased 100 shares of stock for $50 per share. Ten years later, Carter died on February 1 and bequeathed the 100 shares of stock to a relative, Boone, when the stock had a market price of $100 per share. One year later, on April 1, the stock split 2 for 1. Boone gave 100 shares of the stock to another of Carter's relatives, Dixon, on June 1 that same year, when the market value of the stock was $150 per share. What was Dixon's basis in the 100 shares of stock when acquired on June 1? a. $5,000 b. $5,100 c. $10,000 d. $15,000 Choice "a" is correct. This question combines the rules of estate taxation and gift taxation. Carter's investment in the stock was $50 per share when he died. Upon Carter's death, the stock received a stepup in basis to the fair market value at the date of death (or six months later, if the alternate lower valuation data was elected). Therefore, the stock's basis was $100 per share when it was transferred to Boone. [Note that no capital gain was reportable for the step-up in basis from $50 to $100; however, Carter's estate included the stock at its fair market value of $100/share for estate tax purposes and likely paid a large amount of estate tax on that.] Further, regardless of how long Carter owned the stock (i.e., it could have only been owned for one day), it was automatically deemed long-term property upon Carter's death. So, Boone had 100 shares of stock at a basis of $100/share when Boone received the inheritance. Then, there was a 2-for-1 stock split on April 1 of the following year. This transaction caused Boone to now have double the amount of shares (or, 200 shares) at half the basis per share (or, $50/share). [Note that the total basis remains unchanged (i.e., $100 x 100 shares = $10,000 and $50 x 200 shares = $10,000).] When Boone gifted the stock to Dixon (note: it would not have mattered if Dixon had not been a relative), the donee (Dixon) received the stock at the carryover basis of the donor (Boone). The 100 shares gifted to Dixon were shares from after the stock split; therefore, they have a basis of $50 per share, or a total basis of $5,000 for the 100 shares. [Note that Boone still has 100 shares at a basis of $50 as well.] Choice "b" is incorrect, per the above discussion. Choice "c" is incorrect, per the above discussion. Choice "d" is incorrect, per the above discussion

13 Which of the following sales should be reported as a capital gain? a. Sale of equipment. b. Real property subdivided and sold by a dealer. c. Sale of inventory. d. Government bonds sold by an individual investor. Choice "d" is correct. Government bonds held by an individual investor are considered capital assets in the hands of the investor. When these types of security investments are sold, the resulting gain or loss is reported as capital. Choice "a" is incorrect. In this case, we must assume that the BEST answer is option "d" (as that option would ALWAYS result in capital gain or loss treatment) and that the examiners are assuming that the equipment is depreciable equipment that has been used in a business for over one year. [If the equipment had been considered a personal asset by the examiners and had sold for a gain, it would also be a capital asset that sold for a capital gain, and there would be two correct answers. Remember that the correct answer is the option that best answers the question.] Depreciable equipment used in a business and held for over one year falls under the category of Section 1245 property. When Section 1245 assets are sold at a gain, all the accumulated depreciation on the asset is recaptured as ordinary income (the same category as the depreciation expense was deducted against), and any remaining gain (typically, in practice, this is not the case, though, as the asset would have had to sell for an amount greater than its purchase price) is capital gain under Code Section [Note that Section 1245 applies only to gains. If the asset had sold for a loss, the loss would have been ordinary under Section 1231.] Choice "b" is incorrect. Real property sold by a dealer is considered inventory and results in ordinary income or ordinary losses upon sale. Inventory is not a capital asset and is not afforded the capital gain benefits. Choice "c" is incorrect. Inventory is not a capital asset and is not afforded the capital gain benefits. The sale of inventory results in ordinary income or loss (e.g., gross profit on sales) being reported on the tax return, as inventory is an asset held for sale in the ordinary course of business

14 A partnership had four partners. Each partner contributed $100,000 cash. The partnership reported income for the year of $80,000 and distributed $10,000 to each partner. What was each partner's basis in the partnership at the end of the current year? a. $170,000 b. $120,000 c. $117,500 d. $110,000 RULE: The basis in a partnership is increased by investment, pro-rata share of income, and liabilities for which the partner is personally liable. The basis of a partnership is decreased by distributions, pro-rata share of losses, and liabilities for which the partner is personally relieved of. Choice "d" is correct. Per the above RULE, each partner's basis in the partnership is $110,000 at the end of the current year, calculated as follows: Contributions $100,000 Pro-rata income allocation 20,000 [$80,000 / 4 partners] Distributions received ( 10,000) Basis at year-end $110,000 Choice "a" is incorrect. The partnership reported income of $80,000, and this amount must be allocated pro-rata to each partner. The mistake made here is that the entire $80,000 was included for each partner as an increase in basis when it should only have been ¼ of that amount (or $20,000). Applying all other facts correctly, this answer was calculated as $100,000 + $80,000 - $10,000 = $170,000. Choice "b" is incorrect. The distribution of $10,000 must be deducted from the basis of each partner. Applying all other facts correctly, this answer was calculated as $100,000 + $20,000 = $120,000. Choice "c" is incorrect. Each partner received a distribution of $10,000. Therefore, the total distributions for the partnership were $40,000. The mistake made here was that the $10,000 distribution was incorrectly assumed to be the total distribution made by the partnership. $10,000 divided by 4 = $2,500. Applying all the other facts correctly, this answer was calculated as $100,000 + $20,000 - $2,500 = $117,

15 An accounting firm was hired by a company to perform an audit. The company needed the audit report in order to obtain a loan from a bank. The bank lent $500,000 to the company based on the auditor's report. Fifteen months later, the company declared bankruptcy and was unable to repay the loan. The bank discovered that the accounting firm failed to discover a material overstatement of assets of the company. Which of the following statements is correct regarding a suit by the bank against the accounting firm? The bank: a. Cannot sue the accounting firm because of the statute of limitations. b. Can sue the accounting firm for the loss of the loan because of negligence. c. Cannot sue the accounting firm because there was no privity of contact. d. Can sue the accounting firm for the loss of the loan because of the rule of privilege. Choice "b" is correct. The bank can certainly sue the accountant for negligence. Whether the bank would be successful or not is another question. The accounting firm may be able to raise the "privity defense." Under this defense, the accounting firm is only liable to clients and to those the accounting firm has reason to know will rely on their work. Whether or not the privity defense is successful, the bank can obviously sue the accounting firm for negligence. The privity defense does not preclude the lawsuit. The defense determines whether or not the lawsuit will be successful. Choice "a" is incorrect. The statute of limitations requires that a lawsuit be brought within a specified period of time. Although states vary as to the time in which lawsuits must be commenced, no state would preclude a lawsuit brought within fifteen months. Choice "c" is incorrect. Lack of privity would not preclude the lawsuit. However, the privity defense might preclude the lawsuit from being successful. Additionally, although the accounting firm only has privity of contract with the client, the firm owes a duty of care to parties the firm has reason to know will rely on their work. Although not clear from the facts, it is likely that the bank can show the accountant had reason to know it would rely on the accountant's work. Choice "d" is incorrect. There is no rule of privilege in the law concerning lawsuits between accountants and banks

16 In evaluating the hierarchy of authority in tax law, which of the following carries the greatest authoritative value for tax planning of transactions? a. Internal Revenue Code. b. IRS regulations. c. Tax court decisions. d. IRS agents' reports. Note: This question is not specifically addressed in your text materials, as the topic has yet to show up on the exam as far as we are aware, and if it ever did, we are confident that our students would be able to respond correctly over 85% of the time without any guidance. The answer is rather obvious. Just by looking at the answer options, you will immediately notice that Option A is presented in title case. This would be a quick sign that it may be the correct response. Further, we suspect that most students would narrow the options down to "a" or "b" by simply using common sense. While we are confident that our students would fare well on this question if it appeared on their exams, we present the following detailed explanation of the answer options. Choice "a" is correct. According to the IRS's website under Tax Code, Regulations and Official Guidance, the "federal tax law begins with the Internal Revenue Code (IRC), [which was] enacted by Congress in Title 26 of the United States Code (26 U.S.C.)." The IRC holds the most authoritative value. Choice "b" is incorrect. According to the IRS's website under Tax Code, Regulations and Official Guidance, the IRS regulations or "Treasury regulations (26 C.F.R.) commonly referred to as Federal tax regulations pick up where the Internal Revenue Code (IRC) leaves off by providing the official interpretation of the IRC by the U.S. Department of Treasury." Regulations give directions on how to apply the law outlined in the Internal Revenue Code. Regulations have the second most force and effect, second only to the IRC. Choice "c" is incorrect. Tax court decisions interpret the Internal Revenue Code. They do not have the authority of the IRC. Choice "d" is incorrect. The reports of IRS agents are used to report on specific taxpayer situations. IRS agents' reports apply the Internal Revenue Code, IRS regulations, and other forms of authoritative literature, but they do not hold the value that the IRC, the IRS regulations, or even tax court decisions have

17 Which of the following items should be included on the Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, of Form 1120, U.S. Corporation Income Tax Return to reconcile book income to taxable income? a. Cash distributions to shareholders. b. Premiums paid on key-person life insurance policy. c. Corporate bond interest. d. Ending balance of retained earnings. Choice "b" is correct. The Schedule M-1 reports the reconciliation of income (loss) per books to income (loss) per the tax return. [Note: It reports both permanent and temporary differences that are discussed in the Financial textbook for deferred taxes.]. Items that are included on this schedule are those that are (1) reported as income for book purposes but not for tax purposes; (2) reported as an expense for book purposes but not for tax purposes; (3) reported as taxable income for tax purposes but not as income for book purposes; and (4) reported as deductible for tax purposes but not as an expense for book purposes. The only option above that falls into one of these four categories is option b. Premiums paid on a keyperson life insurance policy are proper GAAP expenses for book purposes, but they are not allowable deductions for tax purposes. Choice "a" is incorrect. Cash distributions to shareholders are not reported on the income statement for book purposes and are not deductible as an expense for tax purposes. They do not enter into the calculation of income in either case and are not reported on the Schedule M-1. Cash distributions actually are reported on Schedule M-2, which is a reconciliation of unappropriated retained earnings. Choice "c" is incorrect. Corporate bond interest is not reported differently for GAAP and Tax purposes. It is included as income for GAAP purposes and for tax purposes. Therefore, no reconciliation of book income to taxable income is required for this item. Choice "d" is incorrect. The ending balance of retained earnings is not reported on a GAAP income statement, nor is it included as part of taxable income. Therefore, it is not part of the Schedule M-1. Unappropriated retained earnings are reconciled on Schedule M-2 of the Form

18 In which of the following situations may taxpayers file as married filing jointly? a. Taxpayers who were married but lived apart during the year. b. Taxpayers who were married but lived under a legal separation agreement at the end of the year. c. Taxpayers who were divorced during the year. d. Taxpayers who were legally separated but lived together for the entire year. RULE: In order to file a joint return, the parties must be MARRIED at the end of the year. Exception: If the parties are married but are LEGALLY SEPARATED under the laws of the state in which they reside, they cannot file a joint return (they will file either under the single or head of household filing status). Choice "a" is correct. Per the above rule, taxpayers who are married but lived apart during the year are allowed to file a joint return for the year. The fact that they did not live together during the year has no bearing on the issue. Choice "b" is incorrect. Per the above rule, taxpayers who are married but lived under a legal separation agreement at the end of the year may not file a joint return. They will generally file either under the single or head of household filing status. Choice "c" is incorrect. Per the above rule, taxpayers who were divorced during the year may not file a joint return together, as they are not married at the end of the year. [Note, however, that they may become married again in the year and file a joint return with the new spouse.] Choice "d" is incorrect. Per the above rule, taxpayers who were legally separated but lived together for the entire year may not file a joint return. They will generally file either under the single or head of household filing status

19 Which one of the following will result in an accruable expense for an accrual-basis taxpayer? a. An invoice dated prior to year end but the repair completed after year end. b. A repair completed prior to year end but not invoiced. c. A repair completed prior to year end and paid upon completion. d. A signed contract for repair work to be done and the work is to be completed at a later date. RULE: An accruable expense is one is which the services have been received/performed but have not been paid for by the end of the reporting period. Choice "b" is correct. The facts indicate that a repair was completed prior to year end but not yet invoiced. If it has not yet been invoiced, it is assumed that it has also not yet been paid for. Therefore, this is a situation in which the repair expense would be accrued at year end. Services have been performed, but they have not been paid for, as they have not even been invoiced yet. Choice "a" is incorrect. If the repair was completed after year end, then the expense is not accruable, as the benefit of the services hasn't been received as of year end. The fact that the repair was invoiced prior to year end does not impact the situation. Choice "c" is incorrect. If a repair was completed and paid for prior to year end, no accrual is appropriate. On the accrual basis, the expense is taken in the year the repair is completed and the benefit is received. In this case, the account payable was also paid in the same year, but this has no effect on the expense. Choice "d" is incorrect. The facts indicate that the work is to be completed at a date later than year end. Therefore, the expense is not accruable at year end, as the benefit of the repair hasn't been received as of year end. It is reasonable that a signed contract for the repair work exists, but this has no effect on the accrual

20 At a confidential meeting, an audit client informed a CPA about the client's illegal insider-trading actions. A year later, the CPA was subpoenaed to appear in federal court to testify in a criminal trial against the client. The CPA was asked to testify to the meeting between the CPA and the client. After receiving immunity, the CPA should do which of the following? a. Take the Fifth Amendment and not discuss the meeting. b. Site the privileged communications aspect of being a CPA. c. Discuss the entire conversation including the illegal acts. d. Discuss only the items that have a direct connection to those items the CPA worked on for the client in the past. Choice "c" is correct. A CPA can be compelled to disclose confidential client information if he is subpoenaed and the information is relevant to the court case. The CPA's information regarding illegal insider trading would be relevant in a criminal case. Choice "a" is incorrect. The Fifth Amendment only applies to self-incriminating evidence. Here the evidence does not relate to wrongdoing by the CPA, but rather to wrongdoing by the client. Choice "b" is incorrect. The privileged communication rule for accountants does not apply at the federal level. Choice "d" is incorrect. Since there is no privilege communication rule in federal courts, the CPA must reveal all relevant information if subpoenaed

21 Which of the following types of entities is entitled to the net operating loss deduction? a. Partnerships. b. S corporations. c. Trusts and estates. d. Not-for-profit organizations. RULE: A Net Operating Loss (NOL) exists if there is a net loss on the following tax returns: Form 1040, Line 41 for Individuals Form 1041, Line 22 for Estates and Trusts Form 1120, Line 28 for Taxable C Corporations A net operating loss exists on tax returns of taxable entities. Choice "c" is correct. Per the above rule, trusts and estates are entitled to a net operating loss deduction. Trusts and estates can be taxable entities, even though, at times, they may also have pass-through effects. Choice "a" is incorrect. Partnerships are pass-through entities; thus, they do not pay tax at the entity level. Therefore, NOLs are not allowed at the partnership level. [Note: If the partnership has a passthrough loss, however, an NOL may exist, for example, on the personal tax return of an individual partner.] Choice "b" is incorrect. S Corporations are pass-through entities; thus, they do not pay tax at the entity level. Therefore, NOLs are not allowed at the S Corporation level. [Note: If the S Corporation has a pass-through loss; however, an NOL may exist, for example, on the personal tax return of an individual shareholder.] Choice "d" is incorrect. Not-for-profit organizations are not taxable entities (although they may generate some taxable income, called unrelated business taxable income); therefore, they cannot generate net operating losses

22 Jans, an individual, owns 80% and 100% of the total value and voting power of A and B Corps., respectively, which in turn own the following (both value and voting power). Ownership Property A Corp. B Corp. C Corp. 80% - D Corp % All companies are C corporations, except B Corp., which had elected S status since inception. Which of the following statements is correct with respect to the companies' ability to file a consolidated return? a. A, C, and D may file as a group. b. A and C may not file as a group, and B and D may not file as a group. c. A and C may file as a group, and B and D may file as a group. d. A and C may file as a group, but B and D may not file as a group. RULE: Filing a consolidated return is a privilege afforded to affiliated groups of corporations (Code Sections 1501 and 1504(b)), and it can only be filed if all of the affiliated corporations consent to such a filing. An affiliated group has ownership through a common parent. The common parent must directly own at least 80% of the voting power of at least one of the affiliated (includible) corporations and at least 80% of the value of the stock of that corporation, and the other corporations not controlled by the parent must be controlled under the 80% ownership test by an includible corporation. Not all corporations are allowed the privilege of filing a consolidated return. Examples of those that are denied the privilege include: (1) S Corporations, (2) Foreign corporations, (3) Most real estate investment trusts (REITs), (4) Some insurance companies, and (5) Most exempt organizations. Choice "d" is correct. To summarize the facts in the question, the ownership percentage rules are met for all corporations. A, C, and D are all C corporations, and B Corp is an S corporation. Jans owns A and B; A owns C; and B owns D. Per the rules above, S corporations are denied the privilege of filing a consolidated return. Therefore, B Corp. cannot file a consolidated return. A and C may file a consolidated return, as Jans controls A, and A controls C in the required percentages and both are includible corporations. However, the control of D rests with B, an S corporation. Therefore, D cannot be consolidated with A or C, and because B cannot file a consolidated return (as it is an S corporation), D cannot file consolidated with B. Therefore, A and C may file as a group, but B and D may not file as a group. Choice "a" is incorrect. Per the above rules, D cannot file as a group with A and C, as the control of D rests with B, an S corporation that is not deemed an includible corporation. Choice "b" is incorrect. A and C may file a consolidated return, as Jans controls A, and A controls C in the required percentages and both are includible corporations. The control of D rests with B, an S corporation. Therefore, D cannot be consolidated with A or C, and because B cannot file a consolidated return (as it is an S corporation), D cannot file consolidated with B. Therefore, A and C may file as a group, but B and D may not file as a group. Choice "c" is incorrect. A and C may file a consolidated return, as Jans controls A, and A controls C in the required percentages and both are includible corporations. The control of D rests with B, an S corporation. Therefore, D cannot be consolidated with A or C, and because B cannot file a consolidated return (as it is an S corporation), D cannot file consolidated with B. Therefore, A and C may file as a group, but B and D may not file as a group

23 In the current year, an unmarried individual with modified adjusted gross income of $25,000 paid $1,000 interest on a qualified education loan entered into on July 1. How may the individual treat the interest for income tax purposes? a. As a $500 deduction to arrive at AGI for the year. b. As a $1,000 deduction to arrive at AGI for the year. c. As a $1,000 itemized deduction. d. As a nondeductible item of personal interest. RULE: The adjustment for education loan interest (an above-the-line deduction to arrive at AGI) is limited to the amount paid or $2,500 (whichever is lower), and all qualified education loan interest is allowed as part of the adjustment. The adjustment is phased-out for single taxpayers with modified AGI between $50,000 and $65,000 (2005 tax law the amounts are indexed annually for inflation and the 2006 amount is not available at this time). Choice "b" is correct. Per the above rule, the $1,000 of qualified education loan interest paid in the year is reported as a deduction to arrive at AGI for the year. Choice "a" is incorrect. The adjustment for education loan interest (an above-the-line deduction to arrive at AGI) is limited to the amount paid or $2,500 (whichever is lower), and all qualified education loan interest is allowed as part of the adjustment. Therefore, the total amount paid of $1,000 is an allowable adjustment. (The $500 limit likely refers to an older education tax law that is no longer in effect.) Choice "c" is incorrect. Allowable education loan interest paid is deductible as an adjustment, which is an above-the-line deduction to arrive at AGI. It is not reported as the less-advantageous itemized deduction. Choice "d" is incorrect. Allowable education loan interest paid is deductible as an adjustment, which is an above-the-line deduction to arrive at AGI. Only the disallowed portion (in this case there is no disallowed portion) is a nondeductible item of personal interest

24 Page, CPA, has T Corp. and W Corp. as audit clients. T Corp. is a significant supplier of raw materials to W Corp. Page also prepares individual tax returns for Time, the owner of T Corp. and West, the owner of W Corp. When preparing West's return, Page finds information that raises going-concern issues with respect to W Corp. May Page disclose this information to Time? a. Yes, because Page has a fiduciary relationship with Time. b. Yes, because there is no accountant-client privilege between Page and West. c. No, because the information is confidential and may not be disclosed without West's consent. d. No, because the information should only be disclosed in Page's audit report on W Corp.'s financial statements. Choice "c" is correct. Under Rule 301, a member in public practice cannot disclose its client's confidential information without permission from the client. In this case, West is an individual with his/her own confidential relationship with tax preparer Page, CPA. Information discovered during the preparation of West's individual tax return is confidential and cannot be disclosed without West's permission. Additionally, tax preparers are prohibited from disclosure of a client's information without client permission. Choice "a" is incorrect. Page's relationship to Time is not one of the exceptions to the confidentiality rules. Choice "b" is incorrect. Page is a CPA subject to the Professional Rules of Conduct, Rule 301, and West is Page, CPA's client. Choice "d" is incorrect. Page CPA should discuss the going concern with West to determine its significance to the audit of W Corp.'s financial statements and to seek permission to disclose the taxpayer's information. There is potential for a conflict of interest in doing the audit that should be considered

25 Part agreed to act as Young's agent to sell Young's land. Part was instructed to disclose that Part was acting as an agent but not to disclose Young's identity. Part contracted with Rice for Rice to purchase the land. After Rice discovered Young's identity, Young refused to fulfill the contract. Who does Rice have a cause of action against? Part Young a. Yes Yes b. Yes No c. No Yes d. No No Choice "a" is correct. Once an undisclosed principal becomes known to the third party, the third party can elect to hold either the agent or the principal liable for breach of contract. Choice "b" is incorrect, per the above explanation. Choice "c" is incorrect, per the above explanation. Choice "d" is incorrect, per the above explanation

26 Tana's divorce decree requires Tana to make the following transfers to Tana's former spouse during the current year: Alimony payments of $3,000. Child support of $2,000. Property division of stock with a basis of $4,000 and a fair market value of $6,500. What is the amount of Tana's alimony deduction? a. $3,000 b. $7,000 c. $9,500 d. $11,500 RULE: Alimony payments to a former spouse are adjustments to arrive at AGI. Child support payments are NOT alimony and are NOT deductible. Property settlements are NOT alimony and are NOT deductible. Choice "a" is correct. Only the amount of alimony ($3,000) is allowed as Tana's alimony deduction. Choice "b" is incorrect. The basis of property division of stock ($4,000) is NOT alimony and is NOT deductible, but the $3,000 in alimony paid is deductible. Choice "c" is incorrect. The fair market value of property division of stock ($6,500) is NOT alimony and is NOT deductible, but the $3,000 in alimony paid is deductible. Choice "d" is incorrect. The fair market value of property division of stock ($6,500) and the child support ($2,000) are NOT alimony and are NOT deductible, but the $3,000 in alimony paid is deductible

27 Ball borrowed $10,000 from Link. Ball, unable to repay the debt on its due date, fraudulently induced Park to purchase a piece of worthless costume jewelry for $10,000. Ball had Park write a check for that amount naming Link as the payee. Ball gave the check to Link in satisfaction of the debt Ball owed Link. Unaware of Ball's fraud, Link cashed the check. When Park discovered Ball's fraud, Park demanded that Link repay the $10,000. Under the Negotiable Instruments Article of the UCC, will Link be required to repay Park? a. No, because Link is a holder in due course of the check. b. No, because Link is the payee of the check and had no obligation on the check once it is cashed. c. Yes, because Link is subject to Park's defense of fraud in the inducement. d. Yes, because Link, as the payee of the check, takes it subject to all claims. Choice "a" is correct. A Holder in Due Course takes free of personal defenses. Fraudulent inducement is a personal defense. Park should have verified the worth of the jewelry before giving Ball the check. Link is a holder in due course because Link gave the transferor Ball value (the $10,000) without notice of any defenses and in good faith. Choice "b" is incorrect. Even though the check was cashed, payees and endorser's remain secondarily liable. The drawee bank was primarily liable on the instrument. This choice is not the reason why Link is not liable on the instrument to Park. Choice "c" is incorrect, per the above explanation in choice "a". Choice "d" is incorrect. Link is a holder in due course and does not take subject to "all" claims. An HDC does take subject to real defenses

28 Starr, a self-employed individual, purchased a piece of equipment for use in Starr's business. The costs associated with the acquisition of the equipment were: Purchase price $55,000 Delivery charges 725 Installation fees 300 Sales tax 3,400 What is the depreciable basis of the equipment? a. $55,000 b. $58,400 c. $59,125 d. $59,425 Choice "d" is correct. The rules for depreciable basis in tax are generally the same as the GAAP rules for capitalizing an asset. The depreciable basis is the cost associated with the purchase of the asset and with getting the asset ready for its intended use. Further improvements are also capitalized, and the basis is reduced for any accumulated depreciation. In this case, the cost of obtaining the equipment and getting the equipment ready for its intended use includes all the items shown above, as follows: Purchase price $55,000 Delivery charges 725 Installation fees 300 Sales tax 3,400 Total depreciable basis $59,425 Choice "a" is incorrect. The costs of delivery charges, installation, and sales tax are all part of the cost of obtaining the asset and getting the asset ready for its intended use. All of these charges are included in the depreciable basis of the equipment. Choice "b" is incorrect. The costs of delivery charges and installation are both part of the cost of obtaining the asset and getting the asset ready for its intended use. These charges are included in the depreciable basis of the equipment. Choice "c" is incorrect. The cost of installation is part of the cost getting the asset ready for its intended use. This charge is included in the depreciable basis of the equipment

29 Which of the following securities is exempt from registration under the Securities Act of 1933? a. Municipal bonds. b. Securities sold by a discount broker. c. Pre-incorporation stock subscriptions. d. One-year notes issued to raise working capital. Choice "a" is correct. Municipal bonds are securities issued by the government and are generally exempt from registration. Choice "b" is incorrect. Securities issued by discount brokers are required to be registered and do not fall within the exempt securities of section 3 of the 1933 Act. Choice "c" is incorrect. Pre-incorporation stock subscriptions are required to be registered and do not fall within the exempt securities of section 3 of the 1933 Act. Choice "d" is incorrect. One-year notes are securities that are required to be registered and do not fall within the exempt securities of section 3 of the 1933 Act

30 Which of the following statements is the best definition of real property? a. Real property is only land. b. Real property is all tangible property including land. c. Real property is land and intangible property in realized form. d. Real property is land and everything permanently attached to it. Choice "d" is correct. Real property includes land and all items permanently affixed to the land (e.g., buildings, paving, etc.) Choice "a" is incorrect. Real property includes more than just the land (as per the explanation above); it includes all items permanently affixed to land. Choice "b" is incorrect. "All" tangible property could include moveable personal property and is therefore, incorrect. Choice "c" is incorrect. "Intangible property in realized form" is a distracter and a contradiction in terms

31 Which of the following is correct concerning the LIFO method (as compared to the FIFO method) in a period when prices are rising? a. Deferred tax and cost of goods sold are lower. b. Current tax liability and ending inventory are higher. c. Current tax liability is lower and ending inventory is higher. d. Current tax liability is lower and cost of goods sold is higher. NOTE: This question was released by the AICPA as a Regulation question, and while it relates to tax, it is actually more of a question related to financial accounting. Therefore, the reference to the Becker textbooks is to the Financial textbook. Choice "d" is correct. Under LIFO, the last costs inventoried are the first costs transferred to cost of goods sold. Ending inventory, thus, includes the oldest costs. The ending balance of inventory will typically not approximate replacement cost, as it will under FIFO. Further, LIFO generally does not reflect the actual flow of goods in a company because most companies sell their oldest goods first to prevent holding old or obsolete items. This question asks about current and deferred income tax expenses and about current tax liability. Therefore, it is focusing on the effects of LIFO vs. FIFO on the income statement for tax expense. It further asks about the impact on the balance sheet. As discussed above, LIFO tends to match current revenues with current costs because (in a period of rising prices, as in this case) the cost of goods sold under LIFO tends to be higher than the cost of goods sold under FIFO. The ending inventory under LIFO, however, tends to be lower than the ending inventory under FIFO, as the oldest goods are the ones still in inventory under LIFO. So, cost of goods sold is higher under LIFO than under FIFO in a period of rising prices. If the expense is higher on the tax return, then, the related income tax expense is lower. Therefore, the current tax liability would be lower. Choice "a" is incorrect. As discussed above, LIFO tends to match current revenues with current costs because (in a period of rising prices, as in this case) the cost of goods sold under LIFO tends to be higher than the cost of goods sold under FIFO, not lower. Also, the effect on deferred tax really depends on if ending inventory is higher or lower than beginning inventory, so we don't have enough information to evaluate deferred tax liability, asset, or expense. Choice "b" is incorrect. Cost of goods sold is higher under LIFO than under FIFO in a period of rising prices. If the expense is higher on the tax return, then, the related income tax expense. Therefore, the current tax liability would be lower, not higher. Further, as discussed above, under LIFO (in a period of rising prices), ending inventory tends to be lower than under FIFO, not higher. Choice "c" is incorrect. Cost of goods sold is higher under LIFO than under FIFO in a period of rising prices. If the expense is higher on the tax return, then, the related income tax expense. Therefore, the current tax liability would be lower, as the option indicates. However, as discussed above, under LIFO (in a period of rising prices), ending inventory tends to be lower than under FIFO, not higher

32 A calendar-year individual is eligible to contribute to a deductible IRA. The taxpayer obtained a fourmonth extension to file until August 15 but did not file the return until November 1. What is the latest date that an IRA contribution can be made in order to qualify as a deduction on the prior year's return? a. October 15. b. April 15. c. August 15. d. November 1. Choice "b" is correct. For IRAs, the adjustment is allowed for a year ONLY if the contribution is made by the due date of the tax return for individuals (April 15). The due date for filing the tax return under a filing extension is NOT allowed (i.e., filing extensions are NOT considered). Choice "a" is incorrect, per the above explanation. Choice "c" is incorrect, per the above explanation. Choice "d" is incorrect, per the above explanation