2010 regulation released mcqs_with explanations

2010 AICPA Newly Released Questions – Regulation

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 explanation.

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.

1 © 2010 DeVry/Becker Educational Development Corp. All rights reserved.


1. What defense must an accountant establish to be absolved from civil liability under Section 18 of the Securities Exchange Act of 1934 for false or misleading statements made in reports or documents filed under the Act? a. Lack of gross negligence. b. Exercise of due care. c. Good faith and lack of knowledge of the statement's falsity. d. Lack of privity with an injured party. Solution: Choice "c" is correct. Section 18 of the Securities Exchange Act of 1934 imposes civil liability on persons who intentionally make false statements in a registration statement or any other document required to be filed under the act. Since the act proscribes only intentional misconduct, lack of intent to deceive is a defense. Good faith and lack of knowledge of the statement's falsity would show that the false or misleading statement was not made with an intent to deceive.

Choice "a" is incorrect. Lack of gross negligence sets the bar too high for the defense. Gross negligence can be proved through reckless conduct. Under section 18, liability cannot be imposed merely because the CPA acted recklessly.

Choice "b" is incorrect. Due care is the standard for negligence. It is a much higher standard of care than is required under section 18. Under section 18, a CPA need not prove that he or she was careful; only that he or she did not intentionally deceive.

Choice "d" is incorrect. Privity (e.g., a contractual relationship) is not a requirement of a section 18 cause of action. Therefore, lack of privity is not a defense.



2. On December 1, Gem orally contracted with Mason for Mason to manage Gem's restaurant for one year starting the following January 1. They agreed that Gem would pay Mason $40,000 and that Mason would be allowed to continue to work for Gem if "everything worked out." On June 1, Mason quit to take a better paying job, alleging that the contract violated the statute of frauds. What will be the outcome of a suit by Gem for breach of contract? a. Gem will win because the contract was executory. b. Gem will win because the contract was for services not goods. c. Gem will lose because the contract could not be performed within one year. d. Gem will lose because the contract required payment of more than $500. Solution: Choice "c" is correct. As a general rule, under the statute of frauds, a contract that cannot be performed within one year from the time of its making is unenforceable absent proof of its material terms in a writing signed by the party being sued. Here, the contract by its terms could not be performed within a year from the time it was made and Gem cannot prove the material terms of the contract through a writing signed by Mason. Therefore, Gem would lose its breach of contract action.

Choice "a" is incorrect. The statute of frauds requires proof of the material terms of certain contracts to be evidenced by a writing signed by the party being sued. There is an exception to the statute if the contract has been executed. Since the contract here is executory, the exception does not apply, so Gem will lose (not be able to enforce the contract) rather than win because the contract is executory.

Choice "b" is incorrect. The statute of frauds applies to contract other than contracts for the sale of goods. It applies to a service contract if by its terms it cannot be performed within a year. Thus, the fact that the contract here is for services rather than goods is not a reason for Gem to win the law suit to enforce the agreement with Mason. Gem will lose because the statute of frauds applies and Gem does not have a writing signed by Mason that sets out the material terms of the agreement.

Choice "d" is incorrect. The $500 threshold is not relevant to the contract here. That threshold applies to contracts for the sale of goods. The contract here is for services. What matters for service contracts is whether or not they can be performed within a year of their making. If they cannot, such as the contract here, they are within the statute of frauds regardless of the price involved.



3. Which of the following bonds are an obligation of a surety? a. Convertible bonds. b. Debenture bonds. c. Municipal bonds. d. Official bonds. Solution: Choice "d" is correct. An official bond is a type of surety bond. Many states require public officials to obtain bonds from a surety for faithful performance of their duties. Such bonds obligate a surety for all losses that the public official causes by negligence or nonperformance of required duties.

Choice "a" is incorrect. A convertible bond is a corporate bond that may be converted into stock. It has nothing to do with the obligations of a surety.

Choice "b" is incorrect. A debenture bond is simply an unsecured corporate bond. It has nothing to do with the obligations of a surety.

Choice "c" is incorrect. A municipal bond is a bond issued by a city or other local government. It has nothing to do with the obligations of a surety.



4. According to the Securities Act of 1933, which of the following statements is correct regarding an issuer of securities? a. All securities issuers must provide potential investors with a prospectus containing specified

information. b. An issuer is permitted to advertise an initial offering of securities only through distribution of the

prospectus. c. All securities issuers must register the securities offering with the Securities and Exchange

Commission (SEC). d. If an issuer sells a security and fails to meet certain disclosure requirements, the purchaser may sell it

back to the issuer and recover the price paid. Solution: Choice "d" is correct. A purchaser has a right to rescind under section 12 of the 1933 Act if the issuer fails to meet disclosure requirements.

Choice "a" is incorrect. Under rule 506 of Regulation D, if only accredited investors invest, no prospectus need be given.

Choice "b" is incorrect. Red herring prospectuses, tombstone ads, and oral offers also are permitted.

Choice "c" is incorrect. Certain issuers (e.g., charities, banks) need to register.



5. A calendar-year individual filed an income tax return on April 1. This return can be amended no later than: a. Four months and 15 days after the end of the calendar year. b. Ten months and 15 days after the end of the calendar year. c. Three years, three months, and 15 days after the end of the calendar year. d. Three years after the return was filed. Solution: Rule: An individual may file an amended tax return (Form 1040X) within three (3) years of the date the original return was filed or within two (2) years of the date the tax was paid, whichever is later. An original return filed early is considered filed on the due date of the return.

Choice "c" is correct. In this question, the return was filed early (April 1), so the return is considered filed on April 15. There is no information on when the tax was paid, but it can be reasonably assumed that the tax was properly paid on April 1 with the return. So the latter of the two dates is three years. The question that arises is "three years from when," and here the question falls somewhat short.

Three of the answers to this question are worded in terms of "the" calendar year. These answers have to mean the prior calendar year. Three years from April 15 (when the return was considered to be filed) would be three years, three months, and 15 days from the end of the prior calendar year.

Choice "a" is incorrect. The date is not four months and 15 days after the end of the (prior) calendar year. This answer ignores the three years. It appears to be trying to trick candidates into thinking that April is four months. However, that would mean that the last day that an amended return could be filed was the date of the filing of the original return.

Choice "b" is incorrect. The date is not ten months and 15 days after the end of the (prior) calendar year.

Choice "d" is incorrect. The date is not three years after the (original) return was filed. This answer looks good at first glance, but note that the return was actually filed on April 1. The Rule above considers an original return filed early to be filed on the due date of the return. However, the answer says "after the return was filed" and not "after the return was considered to be filed."



6. In the absence of an election to adopt an annual accounting period, the required tax year for a partnership is: a. A tax year that results in the greatest aggregate deferral of income. b. A calendar year. c. A tax year of one or more partners with a more than 50% interest in profits and capital. d. A tax year of a principal partner having a 10% or greater interest. Solution: Rule: Per IRC Section 706(b), a partnership tax year must have the same taxable year as the common taxable year of the partners that, in the aggregate, have interest greater than 50%, which is determined based on the "testing day," the first day of the partnership's tax year (not considering the majority interest rule). Note: After a change is made to the "majority-interest" tax year end, the partnership does not have to change to another tax year for two years following the year of change. Exceptions to the rule exist. (1) If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership). (2) If the partnership is still unable to determine a tax year using the general rule or the first exception, then the tax year that causes the least aggregate deferral of income to the partners must be adopted.

Choice "c" is correct. In the absence of election to adoption of an annual accounting period, the required tax year for a partnership would be the tax year of one or more partners who have an aggregate of more than 50% interest in profits and capital, per the majority interest rule. This is the BEST answer to the question.

Choice "a" is incorrect. If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership). If the partnership is still unable to determine a tax year using the general rule or the first exception, then the tax year that causes the least (not the greatest) aggregate deferral of income to the partners must be adopted.

Choice "b" is incorrect. A partnership may be able to avoid the rules above if it has a business purpose for selecting a different tax year and if this can be established with the IRS. In this case, a calendar year (assuming it is not already required because it coincides with the general rule or the exceptions identified above) may be used. Of course, while this answer may be correct in some circumstances, it is not the BEST answer to the question.

Choice "d" is incorrect. If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership). Note that this is the second-best answer, but it only applies if answer option "c" is not available.



7. In the current year Tatum exchanged farmland for an office building. The farmland had a basis of $250,000, a fair market value (FMV) of $400,000, and was encumbered by a $120,000 mortgage. The office building had an FMV of $350,000 and was encumbered by a $70,000 mortgage. Each party assumed the other's mortgage. What is the amount of Tatum's recognized gain? a. $0 b. $ 50,000 c. $100,000 d. $150,000 Solution: Rule: Per IRC Section 1031, non-recognition treatment is accorded to a like-kind exchange of property used in a trade or business. "Like-kind" exchanges include exchanges of business property for business property, where like-kind is interpreted very broadly and refers to the nature or character of the property and not to its grade or quality.

Choice "b" is correct. The exchange in this question qualifies for Section 1031 treatment since the exchange appears to be business property for business property. However, the boot involved in the exchange (the mortgages) must be taken into account to determine the recognition or non-recognition of the gain realized on the exchange. In this transaction, the total consideration received by Tatum is the FMV of the property received of $350,000 plus the mortgage of $120,000 that was assumed by the other party, for a total of $470,000. The adjusted basis of the property given up was $250,000, and there is also $70,000 of mortgage given up by the other party (and assumed by Tatum), for a total of $320,000. The realized gain is thus $470,000 – $320,000 = $150,000. The recognized gain will be the lesser of realized gain or net boot received. The $120,000 of mortgage given up (and assumed by the other party) is treated as boot received, and the $70,000 of mortgage assumed is treated as boot given up. The net is $50,000 of boot received. The $50,000 of boot received is the recognized gain. The treatment is somewhat the same as if cash/boot had been received in the transaction.

Choice "a" is incorrect. Gain is recognized due to the net boot received.

Choice "c" is incorrect. The $100,000 is the amount of realized gain being deferred, not the recognized gain.

Choice "d" is incorrect. The $150,000 is the realized gain. However, it is not the recognized gain.



8. Danielson invested $2,000,000 in DEC, a qualified small business corporation. Six years later, Danielson sold all of the DEC stock for $16,000,000, and purchased an office building with the proceeds. Danielson had not previously excluded any gain on the sale of small business stock. What is Danielson's taxable gain after the exclusion? a. $0 b. $6,000,000 c. $7,000,000 d. $9,000,000 Solution: Rule: Per IRC Section 1202, a non-corporate taxpayer can exclude from gross income (and thus taxable income) 50% of any gain from the sale of exchange of qualified small business stock held for more than 5 years. There are all sorts of special rules including special rules for property acquired between 2009 and 2011, but the rule stated is the general rule.

Choice "c" is correct. DEC is a qualified small business corporation and the stock has been held by Danielson for more than 5 years. Danielson is not a corporation. The realized gain on the sale of the stock is $14,000,000 ($16,000,000 – $2,000,000). The amount of this gain that is excluded from gross income is 50% of the $14,000,000, or $7,000,000. That means that $7,000,000 of the gain is taxable.

Choice "a" is incorrect. A percentage (normally 50%) of the gain from the sale of qualified small business corporation stock can be excluded from gross income by a non-corporate taxpayer.

Choice "b" is incorrect, per the above explanation.

Choice "d" is incorrect, per the above explanation.



9. Robbe, a cash basis single taxpayer, reported $50,000 of adjusted gross income last year and claimed itemized deductions of $5,500, consisting solely of $5,500 of state income taxes paid last year. Robbe's itemized deduction amount, which exceeded the standard deduction available to single taxpayers for last year by $1,150, was fully deductible and it was not subject to any limitations or phase-outs. In the current year, Robbe received a $1,500 state tax refund relating to the prior year. What is the proper treatment of the state tax refund? a. Include none of the refund in income in the current year. b. Include $1,150 in income in the current year. c. Include $1,500 in income in the current year. d. Amend the prior-year's return and reduce the claimed itemized deductions for that year. Solution: Rule: IRC Section 111 provides that gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax previously imposed (the tax benefit rule).

Choice "b" is correct. Under the tax benefit rule, an itemized deduction recovered in a subsequent year is included in income in the year recovered. In this question, only $1,150 of the state income taxes was actually deducted as an itemized deduction last year. The recovery is thus limited in the amount actually deducted (and not to the entire amount of the state tax refund).

Choice "a" is incorrect. The amount deducted, not $0, is included in income in the current year.

Choice "c" is incorrect. The amount originally deducted, not necessarily the entire amount of the refund, is included in income in the current year.

Choice "d" is incorrect. The amount deducted is included in income in the current year. There is no necessity to amend the prior year's return.



10. Lane, a single taxpayer, received $160,000 in salary, $15,000 in income from an S Corporation in which Lane does not materially participate, and a $35,000 passive loss from a real estate rental activity in which Lane materially participated. Lane's modified adjusted gross income was $165,000. What amount of the real estate rental activity loss was deductible? a. $0 b. $15,000 c. $25,000 d. $35,000 Solution: Rule: Passive activity is any activity in which the taxpayer does not materially participate. A net passive activity loss generally may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains). In other words, passive losses may generally only offset passive income for a tax year—the remaining net loss is generally "suspended" and carried forward to a year when it may be used to offset passive income (or when the final disposition of the property occurs). However, there is an exception (the "mom and pop exception," as we refer to it in the textbooks) to this general rule. Taxpayers who own more than 10% of the rental activity, have modified AGI under $100,000, and have active participation (managing the property qualifies), may deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 - $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000.

Choice "b" is correct. Per the above rule, unless an exception exists (and it does not in this case, as Lane's modified adjusted gross income is in excess of $150,000), passive losses may only offset passive income for a tax year (i.e., no "net loss" may exist). In this case, Lane has a $20,000 net loss from passive activity [$15,000 S Corporation income (passive, in this case because the facts state Lane does not materially participate) minus the $35,000 rental real estate loss]. Thus, only $15,000 of the passive loss from real estate rental activity may be used to offset the $15,000 income from the S Corporation. The remaining $20,000 passive activity loss is carried forward to be used in future years.

Choice "a" is incorrect. Per the above rule, passive losses may generally only offset passive income for a tax year. Lane has passive income of $15,000 in the year; thus, passive loss up to $15,000 may be deducted from passive income.

Choice "c" is incorrect. This answer option is an attempt to confuse the candidate into using the "mom and pop" exception, which applies when taxpayers who actively participate, own more than 10% of the rental activity, and have modified AGI under $100,000 are able to deduct up to $25,000 annually of net passive losses attributable to real estate. There is a phase-out provision for modified AGI from $100,000 - $150,000, and the deduction is completely phased-out for modified AGI in excess of $150,000. In this case, the facts state that Lane's modified adjusted gross income is $165,000; thus, Lane does not qualify to use the exception.

Choice "d" is incorrect. This answer option assumes that the full amount of the rental real estate loss is deductible against the passive income from the S Corporation, and, thus, against Lane's other taxable income. As indicated in the rule above, unless an exception applies (it does not in this case), a net passive activity loss may not be deducted against other types of income (e.g., wages, other ordinary or active income, portfolio income (interest and dividends), or capital gains). Thus, the full $35,000 rental real estate loss is not deductible in the year by Lane.



11. Which of the following disqualifies an individual from the earned income credit? a. The taxpayer's qualifying child is a 17-year-old grandchild. b. The taxpayer has earned income of $5,000. c. The taxpayer's five-year-old child lived in the taxpayer's home for only eight months. d. The taxpayer has a filing status of married filing separately. Solution: Rules: Earned income tax credit is a refundable tax credit. It is designed to encourage low-income workers (i.e., those with earned income) to offset the burden of U.S. tax. A claimant can have one qualifying child or two or more qualifying children for this credit. There is a maximum credit available for this purpose. Further:

• The taxpayer must meet certain earned low-income thresholds.

• The taxpayer must not have more than the specified amount of disqualified income.

• The taxpayer must be over age 25 and less than 65 if there are no qualifying children.

• If married, the taxpayer must generally file a joint return with his/her spouse (i.e., the married filing separate status disqualifies a taxpayer from claiming the earned income credit).

• A qualifying child can be up to and including age 18 at the end of the tax year, provided the child shared a residence with the taxpayer for 6 months or more.

• The taxpayer must be related to the qualifying child (or children) through blood, marriage, or law.

• The child must be either in the same generation or a later generation of the taxpayer.

• A foster child qualifies if officially placed with the taxpayer by an agency.

Choice "d" is correct. Per the above rules, the filing status of married filing separately disqualifies a taxpayer from claiming the earned income credit.

Choice "a" is incorrect. If the taxpayer's qualifying child is a 17-year-old grandchild, the requirement of age and relation is satisfied, and the taxpayer may qualify to claim the EIC.

Choice "b" is incorrect. The taxpayer earning an income of $5,000 meets the earned low-income requirements; thus, it does not disqualify him or her from claiming the EIC.

Choice "c" is incorrect. The taxpayer's five year old child lived in the taxpayer's home for eight months. The above rules indicate that the otherwise qualifying child must live with the taxpayer for six or more months; thus, this fact does not disqualify the taxpayer from claiming the EIC.



12. Which of the following can be an advantage of a limited liability company over an S corporation? a. Double taxation of profits is avoided. b. Owners receive limited liability protection. c. Appreciated property can be distributed tax-free to an owner. d. Incentive stock options can be used to compensate owners. Solution: Rule: IRC Section 311 controls the taxability of corporate distributions. An S corporation (and a C corporation) recognizes a gain on any distribution of appreciated property (a property dividend) in the same manner as if the asset had been sold to the shareholder at its fair market value.

Choice "c" is correct. An S corporation cannot distribute appreciated property to its shareholders without gain. In general, a partnership can distribute appreciated property tax-free to its partners (in general, a non liquidating distribution to a partner is nontaxable). Since a limited liability company (LLC) is taxed like a partnership (an LLC properly structured and with two or more owners is taxed like a limited partnership with no general partners), a limited liability company can distribute appreciated property to its owners tax-free.

Choice "a" is incorrect. A limited liability company is a hybrid business entity that combines the corporate characteristic of limited liability for the owners with the tax characteristics of a partnership. With a partnership, there is no double taxation of profits. Neither is there with a limited liability company. There is no advantage for a limited liability company over an S corporation here.

Choice "b" is incorrect. Owners receive limited liability protection with both an S corporation and a limited liability company so there is no advantage for a limited liability company over an S corporation here.

Choice "d" is incorrect. Incentive stock options can be used to compensate owners with both an S corporation and a limited liability company. There is no entity restriction for these stock options, other than that they can be granted only by corporations. There is no advantage for a limited liability company over an S corporation here.



13. Quigley, Roberk, and Storm form a corporation. Quigley exchanges $25,000 of legal fees for 30 shares of stock. Roberk exchanges land with a basis of $10,000 and a fair market value of $100,000 for 60 shares of stock. Storm exchanges $10,000 cash for 10 shares of stock. What amount of income should each shareholder recognize? Quigley Roberk Storm a. $0 $0 $0 b. $25,000 $90,000 $0 c. $25,000 $90,000 $10,000 d. $0 $90,000 $0 Solution: Rule: IRC Section 351 controls the taxation of transfers to controlled corporations. No gain or loss is recognized to the transferors/shareholders on the property transferred if certain conditions are satisfied.

Choice "b" is correct. The transaction in this question does not satisfy the conditions of Section 351, and gain or loss can be recognized for each of the shareholders. For Section 351 to apply, the shareholders contributing property, including cash, must own, immediately after the transaction, at least 80% of the voting stock and at least 80% of the nonvoting stock of the corporation. A shareholder who contributes only services (Quigley in this question) is not counted as part of the control group. Thus, only Roberk and Storm are counted, and they together own only 70 shares out of the 100 shares (70%). The $25,000 of legal fees to Quigley is compensation for services rendered and is recognized as income by Quigley. A gain of $90,000 (the fair market value of the land of $100,000 – its adjusted basis of $10,000) is recognized to Roberk. Storm bought shares for cash and has no gain.

Choice "a" is incorrect. This is what would happen if Section 351 applies to all of the transferors/shareholders.

Choice "c" is incorrect. Storm recognizes no gain of any kind since he/she merely bought shares for cash.

Choice "d" is incorrect. Quigley recognizes gain since transferors who contribute only services are not counted as part of the control group for Section 351 purposes. Gain is recognized by transferors who are not part of the control group.



14. Tap, a calendar-year S corporation, reported the following items of income and expense in the current year:

Revenue $44,000 Operating expenses 20,000 Long-term capital loss 6,000 Charitable contributions 1,000 Interest expense 4,000

What is the amount of Tap's ordinary income? a. $13,000 b. $19,000 c. $20,000 d. $24,000 Solution: Rule: IRC Section 1366 controls the pass-through of S corporation income items to shareholders. In general, items are divided into separately stated items (items that could potentially affect the tax liability of the shareholders) and non-separately stated items. Non-separately stated items are lumped together and constitute the S corporation's ordinary income. Separately stated items are passed through to the shareholders (in a manner similar to partnerships) and retain their tax attributes to the shareholders.

Choice "c" is correct. Tap's ordinary income is calculated as follows:

Revenue $44,000 Operating expenses (20,000) Interest expense (4,000) Ordinary income $20,000

The long-term capital loss and the charitable contributions are not included in Tap's ordinary income. They are separately stated items and thus are passed through to the shareholders and retain their tax attributes.

Choice "a" is incorrect. The $13,000 would include both the long-term capital loss and the charitable contributions.

Choice "b" is incorrect. The $19,000 would include the long-term capital loss but not the charitable contributions.

Choice "d" is incorrect. The $24,000 would not include the interest expense.



15. During the current year, a trust reports the following information:

Dividends $10,000 Interest from corporate bonds 12,000 Tax-exempt interest from state bonds 4,000 Capital gain (allocated to corpus) 2,000 Trustee fee (allocated to corpus) 6,000

What is the trust's accounting income? a. $22,000 b. $26,000 c. $28,000 d. $34,000 Solution: Choice "b" is correct. The accounting income of the trust (normally just called income in Subchapter J of the IRC) is calculated as follows:

Dividends $10,000 Interest from corporate bonds 12,000 Tax-exempt interest from state bonds 4,000 Accounting income $26,000

The capital gain and trustee fee are not included in the trust's income since they are both allocated to corpus.

Choice "a" is incorrect. The $22,000 would not include the tax-exempt interest.

Choice "c" is incorrect. The $28,000 would include the capital gain, which is allocated to corpus.

Choice "d" is incorrect. The $34,000 would include the capital gain and the trustee fee, both of which are allocated to corpus.



16. Mackenzie is the grantor of a trust over which Mackenzie has retained a discretionary power to receive income. Kelly, Mackenzie's child, receives all taxable income from the trust unless Mackenzie exercises the discretionary power. To whom is the income earned by the trust taxable? a. To the trust to the extent it remains in the trust. b. To Mackenzie because he has retained a discretionary power. c. To Kelly as the beneficiary of the trust. d. To Kelly and Mackenzie in proportion to the distributions paid to them from the trust. Solution: Rule: IRC Sections 671-679 control the taxation of grantor trusts when the grantor of the trust retains the beneficial enjoyment or substantial control over the trust property or income. In that case, the grantor is taxed on the trust income. The trust is disregarded for income tax purposes. The grantor is taxed on the income if he/she retains (1) the beneficial enjoyment of the corpus or (2) the power to dispose of the trust income without the approval or consent of any adverse party.

Choice "b" is correct. Income earned by the grantor trust is taxable to the grantor (Mackenzie) since he/she retained discretionary power to receive the taxable income from the trust. The fact that the discretionary power may not actually be exercised is irrelevant.

Choice "a" is incorrect. Income earned by a grantor trust is taxable even if it is not distributed by the trust.

Choice "c" is incorrect. Income earned by a grantor trust is taxable to the grantor of the trust, not to the beneficiary, basically to the extent that the grantor has retained discretionary power to receive the taxable income from the trust.

Choice "d" is incorrect. Income earned by a grantor trust is not allocated to the grantor (Mackenzie) and the beneficiary (Kelly) of the trust based on the amount of distributions paid to the parties.



17. Lawson, a CPA, discovers material noncompliance with a specific Internal Revenue Code (IRC) requirement in the prior-year return of a new client. Which of the following actions should Lawson take? a. Wait for the statute of limitations to expire. b. Discuss the requirements of the IRC with the client and recommend that client amend the return. c. Contact the IRS and discuss courses of action. d. Contact the prior CPA and discuss the client's exposure. Solution: Choice "b" is correct. The CPA should notify the client concerning the noncompliance and recommend the proper course of action.

Choice "a" is incorrect. The CPA is required to notify and discuss the situation with the client.

Choice "c" is incorrect. The CPA must discuss the situation with the client and is barred from contacting the IRS without the client's permission.




18. Able, CPA, was engaged by Wedge Corp. to audit Wedge's financial statements. Wedge intended to use the audit report to obtain a $10 million loan from Care Bank. Able and Wedge's president agreed that Able would give an unqualified opinion on Wedge's financial statements in the audit report even though there were material misstatements in the financial statements. Care refused to make the loan. Wedge then gave the audit report to Ranch to encourage Ranch to purchase $10 million worth of Wedge common stock. Ranch reviewed the audit report and relied on it to purchase the stock. After the purchase, Able's agreement with Wedge's president was revealed. As a result, Wedge stock lost half its value and Ranch sued Able for fraud. What will be the result of Ranch's suit? a. Ranch will win because Able intentionally gave an unqualified opinion on Wedge's materially

misstated financial statements. b. Ranch will win because Able is strictly liable for errors made in auditing Wedge's financial statements. c. Ranch will lose because Ranch is not a foreseen user of Able's audit report. d. Ranch will lose because Ranch is not in privity with Able. Solution: Choice "a" is correct. This question is about to whom a CPA owes a duty. A CPA's duties are broadest with regard to fraud. A duty to refrain from fraud is owed to anyone who can make out the elements of a fraud case (misrepresentation, intent to deceive, reliance, intent to induce reliance, and damages). Because Able intentionally made the false statement and Ranch was harmed as a result, Ranch can hold Able liable for his damages.

Choice "b" is incorrect. A CPA is not strictly liable for misstatements in financial statements; the CPA must be at least negligent in order to have any liability in most cases.

Choice "c" is incorrect. It does not matter whether or not Ranch was a foreseen user of the audit report because the action here is for fraud. If the action were for negligence, foreseeability would limit Able's liability.

Choice "d" is incorrect. It does not matter whether or not Ranch was in privity of contract with Able. A CPA's liability for fraud (or even for negligence in most states) is not limited to those with whom the CPA is in privity.



19. Which of the following terms best describes the relationship between a corporation and the CPA it hires to audit corporate books? a. Employer and employee. b. Employer and independent contractor. c. Master and servant. d. Employer and principal. Solution: Choice "b" is correct. An employer/independent contractor relationship arises when an employer hires someone to do a job but does not have control over the manner in which the work is performed. In performing and audit, a CPA must have independence with regard to how the audit is performed. Thus, an employer/independent contractor relationship arises.

Choice "a" is incorrect. An employer has control over the manner in which an employee performs his work. An employer does not have control over the methods that a CPA uses to perform an audit. Thus, the CPA is an independent contractor rather than an employee.

Choice "c" is incorrect. Master/servant is older terminology for employer/employee. Thus, this choice is wrong for the same reason that choice b is wrong.

Choice "d" is incorrect. An employer is a principal. In an agency, there must be both a principal and an agent. There cannot be a principal/principal relationship.



20. Card communicated an offer to sell Card's stereo to Bend for $250. Which of the following statements is correct regarding the effect of the communication of the offer? a. Bend should immediately accept or reject the offer to avoid liability to Card. b. Card is not obligated to sell the stereo to Bend until Bend accepts the offer. c. Card is required to mitigate any loss Card would sustain in the event Bend rejects the offer. d. Bend may not reject the offer for a reasonable period of time. Solution: Choice "b" is correct. In order to form a contract, there must be at least an offer, an acceptance, and consideration. Card's communication is an offer. The stereo and the $250 would be the consideration for the contract here. But, Card will not be bound until Bend accepts the offer.

Choice "a" is incorrect. As a general rule, silence cannot constitute an acceptance, and Bend cannot be liable on a contract until it is accepted. If Bend remains silent, no contract is formed and Bend has no liability.

Choice "c" is incorrect. Card owes no contractual duties to Bend until Bend has accepted Card's offer. Thus, there is no duty to mitigate here.

Choice "d" is incorrect. An offeree may reject an offer at any time.



21. Worker's compensation benefits are available to which of the following parties? a. Only those employees injured while working on workplace premises. b. Only those employees injured while working within the scope of employment. c. All agents injured while commuting to and from work. d. All agents injured while using the employer's automobile for personal use. Solution: Choice "b" is correct. Worker's compensation benefits are available if the employee is injured within the scope of employment.

Choice "a" is incorrect. The injury need not occur on workplace premises; it need only occur within the scope of employment. Thus, if an employee is injured off-site but while working for an employer, the employee is covered.

Choice "c" is incorrect. This choice is wrong for two reasons: worker's compensation covers only employees ("agent" is broader) and, in most cases, commuting to and from work is not within the scope of employment.

Choice "d" is incorrect. This choice also is wrong for two reasons: again, not all agents are employees and so not all agents are covered, and use of one's automobile for personal purposes is not within the scope of employment.



22. Under the Negotiable Instruments Article of the UCC, which of the following statements is correct regarding a check? a. A check is a promise to pay money. b. A check is an order to pay money. c. A check does not need to be payable on demand. d. A check does not need to be drawn on a bank. Solution: Choice "b" is correct. A check is a type of draft with two particular characteristics, namely drawn on a bank and payable on demand. A draft is order paper (a drawer orders the drawee to pay money to a payee or to bearer).

Choice "a" is incorrect. As indicated above, a draft (including checks) is not a promise to pay (two-party paper), but rather it is an order to pay.

Choice "c" is incorrect. A check must be payable on demand. An instrument that has all of the other attributes of a check but that is not payable on demand is a time draft.

Choice "d" is incorrect. A check must be drawn on a bank. An instrument that has all of the other attributes of a check but that is not drawn on a bank is simply a draft.



23. A tax preparer has advised a company to take a position on its tax return. The tax preparer believes that there is a 75% possibility that the position will be sustained if audited by the IRS. If the position is not sustained, an accuracy-related penalty and a late-payment penalty would apply. What is the tax preparer's responsibility regarding disclosure of the penalty to the company? a. The tax preparer is responsible for disclosing both penalties to the company. b. The tax preparer is responsible for disclosing only the accuracy-related penalty to the company. c. The tax preparer is responsible for disclosing only the late-payment penalty to the company. d. The tax preparer has no responsibility for disclosing any potential penalties to the company, because

the position will probably be sustained on audit. Solution: Choice "a" is correct. This position passes the realistic possibility standard, and it is proper for the tax preparer to recommend it to the client. However, the tax preparer is required to notify the client of all possible penalties in the event that the position is not sustained.

Choice "b" is incorrect, per the above rule.

Choice "c" is incorrect, per the above rule.

Choice "d" is incorrect, per the above rule.



24. Terry, a taxpayer, purchased stock for $12,000. Later, Terry sold the stock to a relative for $8,000. What amount is the relative's gain or loss? a. $2,000 loss. b. $0. c. $2,000 gain. d. $4,000 gain. Solution: Rule: IRC Section 267 controls the nonrecognition of realized losses on sales or exchanges of property to related parties. The most common related parties for individual taxpayers are members of a family (although there are certainly many other examples).

Choice "b" is correct. The loss realized on the transaction by Terry is $4,000 ($8,000 – $12,000).This transaction appears to qualify under Section 267. "Relative" is not defined in the question. Section 267 limits "family" to brothers and sisters, spouse, ancestor, and lineal descendants. However, the definition of relative is really irrelevant if the question is read closely. The question wants to know the relative's gain or loss, not Terry's gain or loss. Since all the relative did to this point was to buy the stock, the relative has no gain or loss.

Choice "a" is incorrect, per the above explanation.

Choice "c" is incorrect, per the above explanation.




25. Winkler, a CPA, provided accounting services to a client, Thompson. On December 15 of the same year, Thompson gave Winkler 100 shares of Foster Corp. as compensation for services. The adjusted basis of the stock was $4,000, and its fair market value at the time of transfer was $5,000. Two months later, Winkler sold the stock on February 15 for $7,500. What is the amount that Winkler should recognize as gain on the sale of stock? a. $0 b. $1,000 c. $2,500 d. $5,000 Solution: Choice "c" is correct. The adjusted basis of the stock to Winkler was the $5,000 fair market value at the time of transfer (that same amount will be considered compensation in the form of property). The proceeds from the sale were $7,500. The gain on the sale of the stock was thus $2,500. The $4,000 adjusted basis of the stock to Thompson is irrelevant. Note that there is no "gift" here even though the word "gave" was used in the question.

Choice "a" is incorrect. There is gain on the sale, effectively in the amount of the increase in fair market value between the date of the transfer and the date of the sale.

Choice "b" is incorrect. The $1,000 appears to be the difference between Thompson's basis and the fair market value of the stock on the date of the transfer to Winkler. This might be the gain to Thompson, but the question asks about Winkler.

Choice "d" is incorrect. The $5,000 fair market value of the stock on the date of the transfer is not the amount of the gain on the sale.



26. Which of the following should be included when determining adjusted gross income? a. Alimony received. b. Compensation for injuries or sickness. c. Rental value of parsonages. d. Tuition scholarship. Solution: Rule: IRC Sections 71, 62, and 215 control the taxation of alimony. Payments for the support of a spouse (alimony) are income to the spouse receiving the payments and are deductible to arrive at adjusted gross income (AGI) by the spouse making the payments. To be alimony:

1. Payments must be legally required pursuant to a written divorce or separation agreement, 2. Payments must be in cash or its equivalent. 3. Payments cannot extend beyond the death of the payee-spouse, 4. Payments cannot be made to members of the same household. 5. Payments must not be designated as anything other than alimony, and 6. The spouses may not file a joint tax return.

Choice "a" is correct. Alimony received is definitely considered part of income and of adjusted gross income.

Choice "b" is incorrect. Compensation for injuries or sickness is excluded from income and thus adjusted gross income.

Choice "c" is incorrect. The rental value of parsonages (furnished by churches or synagogues) is excluded from the income of a minister and thus that minister's adjusted gross income.

Choice "d" is incorrect. A scholarship for tuition is excluded from income and thus adjusted gross income. There are certainly limits or restrictions such as the student has to be a degree-seeking student and amounts must actually be spent on tuition, fees, books, and supplies, but, as a general statement, the amount is excluded.



27. An individual starts paying student loan interest in the current year. How many years may the individual deduct a portion of the student loan interest? a. Current year only. b. Five years. c. Ten years. d. Duration of time that interest is paid. Solution: Rule: IRC Section 221 allows the deduction of student loan interest (above-the-line for AGI) paid on qualified education loans up to a maximum of $2,500 for the tax year. There is a phase-out for the deduction in 2010, and there are some minor restrictions such as a married couple must file joint returns to take the deduction.

Choice "d" is correct. There is no limitation of the number of years that the interest may be deducted, other than that the interest may be deducted only when paid.

Choice "a" is incorrect, per the above rule.

Choice "b" is incorrect, per the above rule.

Choice "c" is incorrect, per the above rule.



28. A taxpayer's spouse dies in August of the current year. Which of the following is the taxpayer's filing status for the current year? a. Single. b. Qualified widow(er). c. Head of household. d. Married filing jointly. Solution: Choice "d" is correct. The joint return rates apply for two years following the death of a spouse, if the surviving spouse does not remarry and maintains a household for a dependent child. There is nothing in this question that says whether or not the surviving spouse maintains a household for a dependent child. However, since the question is asking about the current year, the surviving spouse is considered to be married (and thus able to file as married filing jointly) for the entire current year even if the spouse dies earlier in the year (in this case in August).

Choice "a" is incorrect. The filing status is not single for the current year.

Choice "b" is incorrect. The filing status is not qualified widow(er) for the current year.

Choice "c" is incorrect. The filing status is not head of household for the current year.



29. Which of the following entities must pay taxes for federal income tax purposes? a. General partnership. b. Limited partnership. c. Joint venture. d. C corporation. Solution: Choice "d" is correct. A C corporation (a regular corporation) must pay federal income tax. A C corporation is not a pass-through entity like the other entities listed.

Choice "a" is incorrect. A general partnership is a pass-through entity and does not pay federal income tax.

Choice "b" is incorrect. A limited partnership is a pass-through entity and does not pay federal income tax.

Choice "c" is incorrect. A joint venture is a pass-through entity (a joint venture is similar to and is treated as a partnership) and does not pay federal income tax. A joint venture is a combination of two or more (tax) persons who jointly seek a profit from some business venture without designating themselves as an actual partnership or corporation.



30. Quail, Inc. manufactures consumer products and sells them to distributors. Quail advertises its products to increase sales and enhance the value of its trade name. What is the appropriate tax treatment for the advertising costs? a. Amortize the costs over 15 years. b. Amortize the costs over 36 months. c. Amortize the costs over 60 months. d. Deduct the costs currently as ordinary and necessary business expenses. Solution: Rule: IRC Section 162 controls the deductibility of trade or business expenses. There is nothing special about advertising costs, except for certain foreign advertising costs. Any business expenses have to be reasonable and related to the taxpayer's business activities.

Choice "d" is correct. Advertising costs which are in the nature of selling expenses (which these expenses appear to be) are deductible if they are reasonable and are related to the taxpayer's business activities.

Choice "a" is incorrect. Advertising costs are expensed, not amortized over 15 years (180 months). Amortization over such a period is for goodwill and covenants not to compete, for example.

Choice "b" is incorrect. Advertising costs are expensed, not amortized over 36 months.

Choice "c" is incorrect. Advertising costs are expensed, not amortized over 60 months.



31. On June 30, Gold and Silver are calendar-year C corporations. The corporations have merged, with Gold as a subsidiary of Silver. Silver owns 85% of Gold's voting stock and fair market value (FMV). Which of the following tax return filings would be appropriate for the two companies? a. Two separate returns, because Silver owns at least 80% of both the voting stock and FMV of Gold. b. Two separate returns, because the merger took place before the close of the second quarter. c. A consolidated return, because Silver owns at least 80% of both the voting stock and FMV of Gold. d. A consolidated return, because the merger took place before the close of the second quarter. Solution: Rule: IRC Sections 1501 and 1504 allow certain combinations of corporations (an affiliated group) to file a consolidated income tax return. An affiliated group is one or more chains of corporations connected through stock ownership with a common parent if that parent directly owns stock possessing at least 80% of the total voting power of at least one of the other corporations and having a value equal to at least 80% of the total value of the stock of the corporation.

Choice "c" is correct. Since Silver owns 85% of the voting stock and fair market value of Gold, they can file a consolidated return.

Choice "a" is incorrect. A consolidated return, not two separate returns, is appropriate with the 85% ownership.

Choice "b" is incorrect. A consolidated return, not two separate returns, is appropriate with the 85% ownership. The timing of the merger has nothing to do with the decision.

Choice "d" is incorrect. A consolidated return is appropriate with the 85% ownership. The timing of the merger has nothing to do with the decision.



32. Stone Corp. has been an S corporation since inception. In each of Year 1, Year 2, and Year 3, Stone made distributions in excess of each shareholder's basis. Which of the following statements is correct concerning these three years? a. In Year 1 and Year 2 only, the excess distributions are taxed as capital gain. b. In Year 1 only, the excess distributions are tax free. c. In Year 3 only, the excess distributions are taxed as capital gain. d. In all three years, the excess distributions are taxed as capital gains. Solution: Rule: Per IRC Section 1368, the amount of any distribution to an S corporation shareholder is equal to the cash plus the fair market value of any other property distributed. How the distribution is taxed depends on whether the S corporation has C corporation accumulated earnings and profits (E&P). If the S corporation has never been a C corporation or if it has no C corporation accumulated E&P, the distribution is a tax-free recovery of capital to the extent it does not exceed the shareholder's adjusted basis in the stock of the S corporation. When the amount of the distribution exceeds the shareholder's adjusted basis of the stock, the excess is treated as a gain from the sale or exchange of property (normally a long-term capital gain).

Choice "d" is correct. In each of the years, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains.

Choice "a" is incorrect. In each of the years, and not just the first and second years, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains; they are not tax free.

Choice "b" is incorrect. In each of the years, and not just the first year, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains.

Choice "c" is incorrect. In each of the years, and not just the third year, Stone made distributions in excess of each shareholder's basis. These distributions will normally be taxed as capital gains.



33. Brown, a 50% partner in Brown & White, received a distribution of $12,500 in the current year. The partnership's income for the year was $25,000. What is the character of the payment that Brown received? a. Partial liquidation. b. Liquidating distribution. c. Disproportionate distribution. d. Current distribution. Solution: Rule: IRC Section 731 controls the taxability of partnership distributions. A partner who receives a distribution from a partnership realizes gain only to the extent that he receives cash in excess of the adjusted basis of his interest in the partnership immediately before the distribution.

Choice "d" is correct. This distribution is a current distribution (a distribution other than in liquidation of an entire partnership interest). Brown is a 50% partner and he/she received ½ of the partnership's income in cash.

Choice "a" is incorrect. There is nothing in the question that indicates that the distribution is a liquidating distribution, partial or not. In fact, it is definitely not a liquidating distribution since it was covered by the partnership's income.

Choice "b" is incorrect. There is nothing in the question that indicates that the distribution is a liquidating distribution of any kind. In fact, it is definitely not a liquidating distribution since it was covered by the partnership's income.

Choice "c" is incorrect. This distribution is not a disproportionate distribution since Brown is a 50% partner and he/she received ½ of the partnership's income.



34. Under the Revised Uniform Limited Partnership Act, which of the following is true regarding limited partnerships?

a. A limited partnership has no general partners. b. General partnerships may not be converted to limited liability partnerships because they must be

terminated first. c. The limited partners may not participate in the management of the company. d. Official formation is not necessary for a limited partnership other than two or more people carrying on

as co-owners of a business for profit. Solution: Choice "c" is correct. A limited partner has no right to participate in management. The right to manage the limited partnership is vested in the general partner(s).

Choice "a" is incorrect. A limited partnership must have at least one general partner (who has all management rights and unlimited personal liability for obligations of the partnership) and at least one limited partner (who has no management rights or personal liability for partnership obligations).

Choice "b" is incorrect. Most business entities maybe converted into other business entities. Limited partnerships are not exempt from this general rule.

Choice "d" is incorrect. A limited partnership maybe formed only by filing a certificate of limited partnership with the state.



35. Terry recently started a new business and is trying to decide what type of entity to form. Terry is part owner and is active in running the business. What type of entity would best protect Terry, as one of the owners, from personal liability? a. General partnership. b. Limited partnership. c. Joint venture. d. Limited liability company. Solution: Choice "d" is correct. The owners of a limited liability company don't have personal liability for obligations of the company. Moreover, they can actively participate in management without becoming personally liable for company obligations. Owners of all of the other business entities mentioned are personally liable for obligations of the business.

Choice "a" is incorrect. All partners of a general partnership are personally liable for the obligations of the partnership.

Choice "b" is incorrect. In a limited partnership, only general partners may take part in management. General partners in a limited partnership are personally liable for the obligations of the partnership.

Choice "c" is incorrect. A joint venture is like a partnership for a single undertaking. Joint ventures are personally liable for obligations of the joint venture.



36. Which of the following is a characteristic of a C corporation? a. Includes most privately held businesses. b. Pays taxes on profits after paying dividends to shareholders. c. Subject to double taxation on profits if dividends are paid. d. Must have only one class of stock. Solution: Choice "c" is correct. C corporations are subject to double taxation if dividends are paid. Profits are taxed at the corporate level, and if the corporation pays dividends, the dividends are taxable income for the recipient.

Choice "a" is incorrect. Sole proprietorships and partnerships are more common.

Choice "b" is incorrect. C corporation pays taxes on profits regardless of whether the profits are distributed to shareholders.

Choice "d" is incorrect. C corporations are not limited to only one class of stock. They can have as many classes of stock as described in its articles of incorporation.



37. Which of the following is considered a corporate equity security? a. A shareholder's preemptive right. b. A shareholder's appraisal right. c. A callable bond. d. A share of callable preferred stock. Solution: Choice "d" is correct. An equity security represents an ownership interest in a corporation. All types of stock are considered equity securities.

Choice "a" is incorrect. A preemptive right is the right to purchase newly issued shares of stock in order to maintain proportionate ownership. The right is a contract right and not an actual ownership interest in the corporation.

Choice "b" is incorrect. An appraisal right is the right to demand that the corporation repurchase a shareholder's stock at fair value after a fundamental change (e.g., a merger, consolidation, or the sale of substantially all of the corporation's assets) has been approved by the corporation. It's not an ownership interest in the corporation.

Choice "c" is incorrect. All bonds represent debt owed by the corporation to the bondholder. They don't qualify as ownership interests.



38. Which of the following statements generally is correct regarding a general partner in a general partnership as compared to a general partner in a limited partnership? a. A general partner in a general partnership has greater rights and powers than a general partner in a

limited partnership. b. A general partner in a general partnership has greater liability than a general partner in a limited

partnership. c. A general partner in a general partnership and a general partner in a limited partnership have the

same rights and powers. d. A general partner in a general partnership has rights and powers provided by articles of partnership,

while a general partner in a limited partnership has rights and powers provided by statute. Solution: Choice "c" is correct. A general partner in a general partnership and a general partner in a limited partnership have the same right to manage the partnership and both are personally liable for all obligations of the partnership.

Choices "a" and "b" are incorrect. They both indicate differences between general partners in the two types of partnerships.

Choice "d" is incorrect. A general partners rights and powers are not necessarily limited to those provided in articles of partnership, because general partnerships are not required to have articles of partnership.



39. Which of the following disqualifies an entity from an S corporation election?

a. Seventy-seven individual shareholders (including four married couples). b. An estate shareholder. c. A 501(c)(3) exempt organization shareholder. d. A nonresident alien shareholder. Solution: Choice "d" is correct. An S corporation cannot have any foreign shareholders.

Choice "a" is incorrect. An S corporation may have up to 100 shareholders.

Choice "b" is incorrect. An estate maybe a shareholder in an S corporation.

Choice "c" is incorrect. A charitable (501(c)(3)) organization maybe a shareholder in an S corporation.



40. Davis, an inventor, developed a new product, but lacked money to get the product to the marketplace. Before creating a corporation to raise capital, Davis leased office space and equipment, entered into contracts with third parties, and identified investors. Who has liability for pre-incorporation debts?

a. Davis is liable until the corporation assumed the debts in novation. b. Davis is liable until the articles of incorporation were filed. c. If this corporation is never formed, Davis is not liable. d. If this corporation is never formed, the unpaid third parties must write off the debt because no

corporate entity existed at the time debt was incurred. Solution: Choice "a" is correct. Davis acted as a promoter (a person who procures capital and other commitments for a corporation to be formed). Promoters are personally liable for contracts that they enter into on behalf of the corporation to be formed. They remain liable on the contracts even after the corporation is formed unless the parties enter into a novation (i.e., an agreement among the parties to substitute the corporation for the promoter).

Choice "b" is incorrect. A promoter remains liable on contracts he enters into on behalf of a corporation, even if the corporation is formed by filing articles of incorporation. The corporation does not become liable on the contracts merely because articles were filed.

Choices "c" and "d" are incorrect. Promoters remain liable on contracts they enter into on behalf of corporations even if the corporations are never formed.



41. Frey Corp. has 1,000 shares of issued and outstanding common stock. Frey's articles of incorporation permit a stockholder who owns 5% or more of the outstanding stock or who has owned the stock for longer than six months to inspect Frey's books and records. Ace, who has owned 25 shares of Frey stock for four months, wants to inspect the books and records. Under the Revised Model Business Corporation Act, which of the following statements is correct regarding Ace's right to inspect the books and records?

a. Ace must wait two months before being allowed to inspect the books and records. b. Ace must purchase an additional 25 shares of Frey stock before being allowed to inspect the books

and records. c. Ace may, after giving five days written notice, inspect the books and records to determine the value of

Frey stock. d. Ace may, after giving five days written notice, inspect the books and records to provide a list of Frey

stockholders to Ace's broker. Solution: Choice "c" is correct. The Revised Model Business Corporation Act (RMBCA) provides that any shareholder may inspect a corporation's books and records on five days notice for a proper purpose, and this right may not be limited or abolished by the articles or bylaws. Thus, Ace may inspect on five days notice.

Choice "a" is incorrect. Despite the fact that Ace would have to wait two more months according to the bylaws (because Ace does not own 5% of the outstanding stock of Frey), he only must wait five days. The RMBCA provides that a shareholder's inspection rights may not be limited or abolished in the articles or bylaws.

Choice "b" is incorrect. Under the RMBCA, Ace need only provide five days notice and demonstrate a proper purpose to inspect. There is no requirement in the RMBCA that Ace own at least 5% of the outstanding stock. The provision in the articles requiring 5% ownership would be unenforceable because the RMBCA provides that the articles cannot limit or abolish a shareholder's inspection rights.

Choice "d" is incorrect. Even if Ace had a right to inspect, inspection must be for a proper purpose. Taking names for a mailing list for a purpose not unrelated to operation of the corporation is not a proper purpose.



42. Which of the following corporate shareholder rights is enforceable by means of a derivative suit?

a. Compelling payment of properly declared dividends. b. Enforcing access to corporate records. c. Recovering damages from a third party. d. Protecting preemptive rights. Solution: Choice "c" is correct. A derivative action is used when a corporation fails to enforce a right that it has against a third party; the shareholder brings suit on behalf of the corporation. A suit against a third party to enforce the corporation's rights against the third party is an example of a corporate shareholder right enforceable by derivative suit.

Choices "a", "b", and "d" are incorrect. All of the other choices are incorrect because they involve suits directly against the corporation rather than against a third party.



43. Toby invested $25,000 in a limited partnership with Connor and Blair. Toby was a general partner in the limited partnership. The partnership failed to pay Kelly $45,000 for services on behalf of the partnership. Which of the following statements is generally correct regarding Toby's liability under the Revised Uniform Limited Partnership Act? a. Toby was liable for $25,000 because this was a limited partnership. b. Toby was liable for zero because this was a partnership debt, not a personal debt. c. Toby was liable for $45,000 because Toby was a general partner. d. Toby was liable for $15,000 because this was a limited partnership. Solution: Choice "c" is correct. Toby was a general partner. General partners in a limited partnership are personally liable for all obligations of the partnership. If the partnership does not pay Kelley, Toby will be liable for the amount owed.

Choices "a", "b", and "d" are incorrect, based on the above explanation.



AICPA Released Simulation

Directions



Situation

Alaska, Inc. is an accrual-basis C corporation that was incorporated on January 1, year 1. At the end of year 2, the corporation is considering converting to an S corporation. Alaska is required to determine its accumulated earnings and profits prior to conversion. The company has already calculated book net income, taxable income, and prior-year accumulated earnings and profits, and is now attempting to calculate the company’s current earnings and profits.



E and P Determination

For purposes of this task, assume that all items of income and expense have been properly reported by Alaska on Form 1120, U.S. Corporation Income Tax Return, for the appropriate years. Starting with taxable income as a benchmark, indicate the effect of each of the following items in the calculation of current-year earnings and profits by placing a check in the correct column next to each item. Be sure a column is checked for each item.

Definition of Corporate Earnings and Profits:

Although similar in many respects and in concept, corporate earnings and profits (E&P) are not exactly the same as retained earnings. Earnings and profits is calculated according to the rules of federal income taxation, and retained earnings is calculated according to Generally Accepted Accounting Principles (GAAP). For example, while non-taxable dividends reduce retained earnings, they have no effect on E&P. The calculation of E&P is critical to the tax impact of corporate distributions, and the calculation of E&P (both the current and prior accumulated amounts) is required in the preparation of the corporate income tax return. [Note that the adjustments applied to the starting amount of corporate taxable income can be always positive, always negative, or either positive or negative. Note also that those differences may be temporary or permanent in nature, and they follow the rules discussed in the textbook in the section that presents the corporate Schedule M-1.]

The determination of E&P is also critical to evaluating the ability of the corporation to pay dividends. Thus, any items that have not been reflected in the corpoartion’s taxable income but may have an impact on the corporation’s ability to pay dividends must be included in the calculation of E&P.



Current Earnings and Profits General Calculation

Corporate taxable income [postive or negative taxable income]

Common E&P Adjustments [negative or positive]

*: Always a negative adjustment / ^: Always a positive adjustment

Federal income tax expense*

Non-deductible penalties, fines, political contributions, etc.*

Officer life insurance premiums [corporation is the beneficiary]*

Expenses for production of tax-exempt income*

Non-deductible charitable contributions*

Non-deductible capital losses*

Losses and gains that have different effects on taxable income vs. E&P

Changes in the cash surrender value of certain life insurance policies

Excess depreciation for E&P over that for regular income tax

Installment income method adjustments

Completed contract income vs. %-of-completion income adjustments

Amortization of intangible drilling costs adjustments

Refunds of federal income tax paid^

Tax-exempt income^

NOL deductions^

Life insurance proceeds where corporation is the beneficiary^

Dividends received deduction used to calculate regular taxable income^

Carryovers of capital losses that impacted taxable income^

Carryovers of charitable contributions that impacted taxable income^

Non-taxable cancellation of debt not used to reduce basis of property^

= Current Earnings and Profits (E&P)



Explanations:

1. Unrealized losses (and unrealized gains) represent changes in value of securities held but not yet sold. These unrealized gains and losses are not recognized for tax purposes. They have no effect on regular taxable income, stockholders’ equity, or E&P.

2. Federal income taxes accrued and paid is an expense item that will reduce stockholders’ equity. Although it is not allowed as a tax deduction, it will reduce E&P (a negative adjustment).

3. For purposes of E&P, a corporation will treat gain from an installment sale as if the installment method were not used. This means that the entire profit will enter E&P in the year of the sale. Therefore, gain on a prior year installment sale recognized in the current year must be subtracted from taxable income (thus reducing E&P). This is because it is included in the current year’s taxable income but was already included in E&P in the original year of the sale.

4. The nondeductible portion of meals and entertainement (50% of the total meals and entertainment expense) is a valid expense that will reduce both stockholder’s equity and E&P. Because this is the portion that was not deductible in determining regular taxable income, it must be subtracted from taxable income in determining E&P.

5. The amount of state income tax expense that relates to the corporate taxable income for the year is the amount that is deducted from regular tax as income tax expense. The difference in the amount paid and the expense is accrued and reported on the balance sheet (i.e., either a taxes receivable or a taxes payable account is created). Thus, the amount of the state refund from a prior year received in the current year is a reduction to the amount reported I the prior year as “taxes receivable” on the balance sheet. Thus, there is no effect on corporate income or E&P.

6. As presented above, the expense related to premiums on life insurance of an officer when the corporation is the beneficiary is not deductible (i.e., it is a negative adjustment for E&P), and the related proceeds from the collection on that type of life insurance policy are not taxable (i.e., they are a postive adjustment for E&P purposes). Under GAAP, changes in the cash surrender value of a life insurance policy run through the income statement and either increase or decrease the ability of the corporation to pay dividends (i.e., they increase or decrease equity). However, just as the premiums are not deductible and the proceeds not taxable, neither are the changes in the cash surrender value of life insurance reportable for tax purposes. Thus, the increase in cash surrender value of life insurance policies owned by the company is not taxable and is not part of taxable income; however, it must be included as a positive adjustment in the calculation of E&P (i.e., an addition to taxable income and an increase to E&P).



Distribution

In year 4, Alaska is still a C corporation. Accumulated earnings and profits at the end of year 3 were $61,000. Current earnings and profits for year 4 are $24,000. During year 4, Alaska made two distributions on the dates indicated in column A of the table below. Allocate the distributions indicated in column B among columns C, D, and E. Round all answers to the nearest dollar.

Distribution dates

Distribution amounts Current E&P

Accumulated E&P at

12/31/year 3 Excess

distribution

3/31/year 4 58,000 15,297 42,703 0

9/30/year 4 33,000 8,703 18,297 6,000

Totals 91,000 24,000 61,000 6,000

Explanation:

Corporate distributions are first applied to current E&P, then to accumulated E&P, then to return of capital, and, then, if any excess remains, it is classified as excess distributions and reported as capital gain distributions (taxable income) by the shareholder. Distributions within the year are allocated based on the ratio of each distribution to the total distribution. Note that the allocation of the excess distribution to return of capital and capital gain distributions depends on the stock basis of the shareholder (refer to the next section of this simulation).

Current E&P

o 3/31/Year 4: $15,297. The $24,000 current E&P is allocated between the two distributions based on the ratio of each distribution to the total distribution, which is $91,000. $15,297 = 24,000 X (58,000 / 91,000).

o 9/30/Year 4: $8,703. The $24,000 current E&P is allocated between the two distributions based on the ratio of each distribution to the total distribution, which is $91,000. $8,703 = 24,000 X (33,000 / 91,000).

Accumulated E&P at 12/31/Year 3 and Excess Distribution

3/31/year 4: $42,703 and $0. The total distribution of $58,000 at 3/31/year 4, is below the total of current and accumulated E&P of $85,000 (24,000 + 61,000). Therefore, there is no excess distribution associated with this. The remaining $42,703 ($58,000



total distribution – $15,297 [calculated above as the distribution from current E&P]) is allocated to accumulated E&P.

9/30/Year 4: $18,297 and $6,000. This distribution represents an excess distribution of $6,000. The total available E&P from above is $85,000, and this distribution of $33,000 results in total distributions for the year in the amount of $91,000 [$58,000 + $33,000]. Thus, $6,000 is a distribution in excess of E&P. The remaining amount of $18,297 ($33,000 total distribution – $8,703 [distribution from current E&P per above] – $6,000 excess distribution) is allocated to accumulated E&P.



Underwood, a 20% shareholder in Alaska, has a stock basis of $700 at the beginning of year 4. Complete the following table to indicate the characterization of the Alaska distributions to Underwood during year 4. Round all answers to the nearest dollar.

Underwood's total

distribution Dividend income

Return of capital Capital gain

18,200 17,000 700 500

Explanations:

Underwood’s Total Distribution: $18,200. Total distributions from above are $91,000. Underwood is a 20% shareholder. Thus, the total distribution is $18,200 ($91,000 X 20%).

Dividend Income: $17,000. According to the first chart, $85,000 of the total distributions of $91,000 represent current and accumulated E&P. The remaining $6,000 is classified as excess distributions. All distributions will be considerd to be taxable dividends to the extent of this ratio. Dividend income is $17,000 ($18,200 X $85,000 / $91,000).

Return of Capital: $700. The remaining excess distribution of $1,200 ($18,200 – $17,000) is considered to be a return of capital to the extent of basis in the stock. The basis is given to be $700, so that amount is return of capital.

Capital Gain: $500. The portion of the excess distribution that exceeds stock basis is taxable as a capital gain. Stock basis is $700, so the capital gain is $500 ($1,200 – $700).



Communication

Alaska’s controller, who has no tax background, was reviewing the corporate income tax return and does not understand why taxable income, as reported on the return, does not agree to net income before tax, as reported on the financial statements. Prepare a memo to the controller explaining the purpose of Schedule M-1, Reconciliation of Income (Loss) per Books with Income per Return, and provide an explanation for two items that would most likely appear on a corporation’s Schedule M-1.

Type your communication in the response area below the horizontal line using the word processor provided.

REMINDER: Your response will be graded for both technical content and writing skills. Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue. Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence. Use a standard business memo or letter format with a clear beginning, middle, and end. Do not convey information in the form of a table, bullet point list, or other abbreviated presentation.



Explanation:

Generally, taxable income will not agree to net income before taxes on the Income Statement. The reason for this is that the financial statements are prepared under the rules of Generally Accepted Accounting Principles (GAAP) and the tax return is prepared using tax law. This can result in differences in revenue, expenses, or both.

A Schedule M-1 is prepared with the Federal Income Tax Return, Form 1120, of the company. This purpose of this schedule is to provide a reconciliation between taxable income on the tax return and book income on the Income Statement. The schedule begins with book income and ends with income for tax purposes.

Let’s look at a couple of common examples that may cause differences between book income and taxable income and, thus, be included on the Schedule M-1.



Depreciation on the income statement is based on GAAP depreciation rules. However, tax depreciation is typically based on the Modified Accelerated Cost Recovery System (MACRS). This will lead to timing differences between book income and taxable income, and the difference will be reported on the Schedule M-1 as either a positive or a negative adjustment, depending on the depreciation schedules for all of the company’s assets.

Another common example is interest revenue from municipal bonds. This interest is reported as revenue and included in the Income Statement under the rules of GAAP. However, this interest is tax-exempt under the Internal Revenue Code and is not included in taxable income. Thus, to reconcile book income to income per the tax return, a negative adjustment (i.e., a subtraction from book income) is necessary to be reported on the Schdeule M-1.

I am hopeful that this information has aided in your understanding of how the GAAP income statement reconciles with the taxable income on the tax return. Should you have any additional questions or require further clarification, please do not hesitate to contact me.

Sincerely,

CPA Exam Candidate




Research/Authoritative Literature

Alaska, Inc. uses MACRS for income tax purposes. However, MACRS is not allowed in determining the company’s current and accumulated earnings and profits. Which code section and subsection provides guidance on the effect of depreciation on earnings and profits?

IRC 312 (k)

Keywords: “Depreciation Effect Earnings and Profits”

2010 regulation released mcqs_with explanations

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