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Chapter 1

Introduction to Taxation

 

Note to Instructor: The reference tables in the appendix of the text may be required for a limited number of answers to the questions and problems in this chapter. This is indicated by “REFERENCE TABLES REQUIRED” after the learning objective.

True-False: Insert T for True and F for False before the questions.

 

______ 1. A hidden tax is one that is included with a payment but not specifically identified.

 

ANSWER         True LO 1.1

DIFFICULTY: Easy

 

_____   2. Both sales and use taxes are collected in the state in which the sale takes place.

 

ANSWER         False LO 1.

DIFFICULTY: Easy

 

_____   3. The person giving the gift pays the gift tax.

 

ANSWER         True LO 1.1

DIFFICULTY: Easy

 

_____   4. The value added tax is a type of consumption tax.

 

ANSWER         True LO 1.1

DIFFICULTY: Easy

 

_____   5. The type and degree of connection between a business and a state necessary for a state to impose a tax is referred to as nexus.

 

ANSWER         True LO 1.1

DIFFICULTY: Easy

 

_____   6. The 16^th Amendment to the US Constitution that provided for an income tax was ratified in 1913.

 

ANSWER         True LO 1.1

DIFFICULTY: Easy

 

_____   7. Any current changes to the tax laws are now amendments to the Internal Revenue Code of 2016.

 

ANSWER         False LO 1.1

DIFFICULTY: Easy

 

_____   8. A flat tax generally would be considered a regressive tax.

 

ANSWER         False LO 1.2

DIFFICULTY: Easy

 

_____   9.  Adam Smith’s four canons of taxation are Equity, Certainty, Economy and Convenience.

 

ANSWER         True LO 1.3

DIFFICULTY: Easy

 

_____   10.  Vertical equity asserts that persons in similar circumstances should face similar tax burdens.

 

ANSWER         False LO 1.3

DIFFICULTY: Easy

_____   11. There are three basic taxable entities: the individual, the fiduciary, and the C corporation.

 

ANSWER         True LO 1.4

DIFFICULTY: Easy

 

_____   12. All interest paid to a taxpayer must be included in gross income.

 

ANSWER         False LO 1.4

DIFFICULTY: Moderate

 

_____   13. The lowest tax rate on the tax rate schedules for taxable incomes is the same for individuals and C corporations.

 

ANSWER         False LO 1.4     REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

_____   14. A $100 tax deduction is more valuable to a taxpayer than a $100 tax credit.

 

ANSWER         False LO 1.4

DIFFICULTY: Easy

 

_____   15. Corporations are only allowed to carry their net operating losses forward.

 

ANSWER         False LO 5.

DIFFICULTY: Moderate

 

_____   16. All limited liability companies (LLCs) can file their tax returns as partnerships, or electively, as corporations.

 

ANSWER         False LO 1.5

DIFFICULTY: Moderate

 

_____   17. Partnerships and S corporations are flow-through entities.

 

ANSWER         True LO 1.5

DIFFICULTY: Easy

 

 

 

Short-Answer Questions: Provide a brief written answer to each of the following questions.

 

1. Name and describe two types of taxes other than the income tax. Give example of each.

 

ANSWER         Wealth taxes are those taxes levied on the value of property owned by a taxpayer. Examples include real estate taxes, tangible taxes, intangible taxes, and inventory taxes.

Wealth transfer taxes are those taxes levied on the value of property transferred to another. Examples are the gift, estate, and inheritance taxes. Consumption taxes are taxes levied on the value of goods or services that are purchased for consumption. Examples include sales, use, excise, and value added taxes.

LO 1.1

DIFFICULTY: Easy

 

2. Compare a sales tax to a use tax.

 

ANSWER         A sales tax is levied on a purchase at the point of sale regardless of the state of residence of the purchaser. A use tax is levied on a purchased item brought into a different state for use when a sales tax is not paid by the purchaser in the state where the item was purchased. Normally the sales and use taxes in a specific state are levied at identical rates.

LO 1.1

DIFFICULTY: Moderate.

 

3. Differentiate a wealth tax from a wealth transfer tax and give an example of each.

 

ANSWER:        A wealth tax is a tax levied on the value of a person’s possessions at a specific point in time; common wealth tax would be real estate taxes that are levied on the owner of real property or intangible taxes on stocks. The wealth transfer tax is levied on the value of a person’s possessions that are transferred to another person; the gift and estate taxes are examples of wealth transfer taxes.

 

LO 1.1

DIFFICULTY: Moderate

 

4. Compare progressive, proportional, and regressive taxes.

 

ANSWER         The tax rate in a progressive system of taxation increases at a greater rate than the rate of increase in income. The higher the income, the greater the percentage of taxes paid. The tax rate in a proportional system of taxation increases at the same rate as the rate of increase in income. The percentage of taxes paid would be the same over all income levels. The tax rate in a regressive system of taxation increases at a slower rate than the rate of increase in income. The higher the income, the smaller the percentage of taxes paid.

 

LO 1.2

DIFFICULTY: Moderate

 

5. What are Adam Smith’s four canons of taxation? Briefly describe each.

 

ANSWER         Certainty—a taxpayer knows what the tax consequences of a transaction will be when the transaction is undertaken. Equity—the tax is fair relative to the taxpayer’s level of income and circumstances. Economy—the costs of administering and complying with the tax are small relative to the amount of taxes collected. Convenience—the payment of taxes is simple and easy.

LO 1.3

DIFFICULTY: Easy

6. Explain how horizontal equity differs from vertical equity.

 

ANSWER        Horizontal equity would require taxpayers with similar incomes to pay a like amount of taxes. Vertical equity would require taxpayers with greater (lesser) incomes to pay a greater (lesser) amount of taxes.

LO 1.3

DIFFICULTY: Easy

 

7. What tax provision encourages the fiduciary of and estate or a trust to distribute the income annually to the beneficiaries?

 

ANSWER:        The tax rates applicable to the income that a trust or an estate receives are far more progressive than any other entity; they have not 10 or 35 percent tax rates and the highest tax rate (39.6%) begins at $12,400 of taxable income.

 

LO 1.4

DIFFICULTY: Easy

 

8. Briefly compare a sole proprietorship to a corporation as a business entity.

 

ANSWER         A sole proprietorship has only one owner; a corporation can have one or an unlimited number of owners. The corporation has limited liability; the sole proprietor is responsible for the liabilities of the business. There generally are few if any legal requirements to establish a sole proprietorship; a corporation must be incorporated under the laws of one of the states and have a corporate chapter. The sole proprietor cannot take advantage of employee status and reports all results of operations on his or her own tax return. A shareholder-employee of a corporation is eligible for fringe benefits and the corporation files a completely separate tax return from that of any owner. There are other differences as well, too numerous to mention.

 

LO 1.5

DIFFICULTY: Moderate

 

9. Why are S corporations and partnerships called flow-through entities?

 

ANSWER         S corporations and partnerships are called flow-through entities because they do not pay taxes on their incomes and gains. Instead the revenue and expense items flow through to the entity’s owners and are included in and taxed along with the owners’ other income.

LO 1.5

DIFFICULTY: Easy

 

10. 10. What are the fiduciary entities and how are they created?

 

ANSWER         The two fiduciary entities are the trust and the estate. A trust is created by a grantor who places assets in trust for the benefit of another person. A trustee manages the trust assets. An estate is created anytime a person who owns or has an interest in assets subject to estate taxes dies.

LO 1.5

DIFFICULTY: Easy

 

 

 

 

Problems: Provide numerical solutions for each of the following.

 

1. The Walstore Shoe Market had $1,875,000 of shoe sales and its cost for these shoes was $688,000. In addition, Shoe Market received $5,000 of corporate bond interest and $6,000 interest on State of California bonds. It paid $512,000 in salaries and had $552,000 of other operating expenses. What is Shoe Market’s taxable income? What is its income tax liability?

 

ANSWER   $128,000 taxable income; $33,170 tax

Taxable income = $1,875,000 – $688,000 + $5,000 interest – $512,000 salaries – $552,000 expenses = $128,000. [Interest on state bonds is tax exempt.] Income tax = ($50,000 x .15) + ($25,000 x .25) + ($25,000 x .34) + ($28,000 x .39) = $33,170.

 

LO 1.4               REFERENCE TABLES REQUIRED

DIFFICULTY: Moderate

 

2. Walter is married and files a joint return. If his adjusted gross income is $64,000 and he has $32,850 of deductions in 2016, what is his taxable income? What is his income tax liability?

 

ANSWER   $31,150; taxable income; $3,745 tax

Taxable income = $64,000 – ($32,850 in deductions) = $31,150. Income tax = [($31,150 – $18,550) x .15] + $1,855 = $3,745.

 

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Moderate

 

3. Susie is single, has salary income of $26,000, and $10,350 of deductions in 2016. What is her taxable income? What is her income tax liability?

 

ANSWER  $15,650 taxable income; $1,883.75 tax

Taxable income = $26,000 – 10,350 deduction = $15,650; Income tax = ($9,275 x .10) + [($15,650 – $9,275) x .15] = $927.50 + $956.25 = $1,883.75

 

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Moderate

 

4. Cragen Corporation has gross income of $625,000 and operating expenses of $418,000. What is its taxable income? What is its income tax liability?

 

ANSWER   $207,000 taxable income; $63,980 tax

Taxable income = $625,000 – $418,000 = $207,000. Income tax = ($50,000 x .15) + ($25,000 x .25) + ($25,000 x .34) + ($107,000 x .39) = $63,980

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

5. Chloe and Bill, both single with no dependents, plan to marry either immediately before or immediately after year-end. Chloe’s taxable income for 2016 is $89,000 and Bill’s is $86,000 before the $10,350 total for each of their deductions. Would they have a marriage penalty or a marriage benefit if they married at the end of 2016?

 

ANSWER   Marriage penalty.

As single taxpayers:  Chloe’s taxable income: $89,000 – $10,350 standard deduction = $78,650. Bill’s taxable income: $86,000 – $10,350 deduction = $75,650.  Chloe’s income tax: ($9,275 x .10) + ($28,375 x .15) + ($27,650 x .25) = $15,433.75. Bill’s income tax: ($9,725 x .10) + ($28,375 x .15) + (38,250 x .25) = $14,683.75.  Total tax as single taxpayers: $15,468.75 + $14,718.75 = $30,187.50

As a married couple:  Taxable income: $89,000 + $86,000 – (2 x $4,050) – $12,600 standard deduction = $154,300.  Their income tax: ($18,550 x .10) + ($56,750 x .15) + ($76,600 x .25) + ($2,400 x .28) = $30,189.50.  If they married, they would have a marriage penalty of $72 ($30,189.50, – $30,117.50).

 

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Hard

 

6. Darden Corporation has taxable income of $200,000. If it distributes 25 percent of its after-tax income to its sole shareholder who is in the 25 percent marginal tax bracket, what is the total tax burden on this $200,000 of income?

 

ANSWER   $66,453 total tax is 33.23% of $200,000

Tax on $200,000 = ($50,000 x .15) + $25,000 x .25) + $25,000 x .34) + ($100,000 x .39) = $61,250 corporate tax. ($200,000 – $61,250) x .25 = $34,687.50 distributed to the shareholder.  Individual tax = $34,687.50 x .15 dividend rate = $5,203.13. Total tax = $61,250 + $5,203 = $66,453. The $66,453 total tax is 33.23% of $200,000.

 

LO 1.4 & 1.5                REFERENCE TABLES REQUIRED

DIFFICULTY: Hard

 

7. Harold is a 40 percent partner in HDT Partnership. At the beginning of the year, his partnership interest basis was $20,000. The partnership had net income of $58,000 for the year and it made an $8,000 distribution to Harold. What is Harold’s basis at the end of the year?

 

ANSWER   $35,200

$20,000 + (.40 x $58,000) – $8,000 = $35,200 basis

 

LO 1.5              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

8. Karen, single with $10,350 in deductions, wants to set up a business. She will use either a sole proprietorship or incorporate as a regular corporation. She expects the business to earn $45,000 after all expenses and payments to Karen except for federal taxes. Karen will take $25,000 from the business for living expenses (as a distribution from a sole proprietorship or a salary from a corporation). Considering only income taxes for 2016, should she establish the business as a C corporation or as a sole proprietorship?

 

ANSWER   Karen should incorporate.

As a C corporation: Income tax on corporation = $45,000 x .15 = $6,750. Tax on $25,000 salary: taxable income = $25,000 – $10,350 deduction = $14,650; income tax = ($9,275 x .10) + ($5,375 x .15) = $927.50 + $806.25; total tax = $6,750 + $1,733.75 = $8,483.75.  As a sole proprietorship, Karen would be taxed on $70,000 of income ($45,000 + $25,000 salary).  Taxable income = $70,000 – $10,350 = $59,650; income tax = ($9,275 x .10) + ($28,375 x .15) + ($22,000 x .25) = $10,683.75.  Based on income taxes alone, Karen should incorporate as she will pay $2,200 ($10,683.75 – $8,483.75) less in taxes.

 

LO 1.4 & 1.5                REFERENCE TABLES REQUIRED

DIFFICULTY: Hard

Reference table(s) required for solution (Income tax tables).

 

9. Sylvester, single, has $10,350 in deductions when filing his income tax. His sole proprietorship averages net income of $125,000 annually. He needs $50,000 per year to live on. If he incorporates his business, would he pay more or less in total income taxes if he takes a salary of $50,000 for his living expenses? (Consider only income taxes.)

 

ANSWER

If he incorporates, Sylvester will save $5,718.50 in taxes.

As a sole proprietorship:  Taxable income: $125,000 – $10,350 in deductions = $114,650.

Income tax: [($114,650 – $91,150) x .28] + $18,558.75 = $25,138.75.

As a corporation:  Corporate taxable income: $125,000 – $50,000 salary = $75,000.  Income tax: ($50,000 x .15) + ($25,000 x .25) = $13,750.  Sylvester’s taxable income:  $50,000 – $10,350 = $39,650.

Income tax: [($39,650 – $37,650) x .25)] + $5,183.75 = $5,683.75.  Total tax: $5,683.75 + $13,750 = $19,433.75. If he incorporates, Sylvester will save $5,705 ($25,138.75 – $19,433.75) in taxes.

 

LO 1.4 & 1.5                REFERENCE TABLES REQUIRED

 

Other Objective Questions

 

Identify the following with an E if all or part of the item could be an exclusion from gross income or D if all or part of the item could be a deduction.

 

_____   a. Scholarship                                       _____   f. State income taxes

 

_____   b. Medical expense                                _____   g. Tax exempt interest

 

_____   c. Charitable contribution                     _____   h. Student loan interest

 

_____   d. Life insurance proceeds                     _____   i. Social Security benefits

 

_____   e. Inheritances                                      _____   j. The value of food stamps

 

ANSWER.      a. E      b. D      c. D      d. E      e. E      f. D      g. E      h. D    i. E       j. E

LO 1.4

DIFFICULTY: Moderate

 

 

Multiple Choice: Select the best answer for each of the following questions.

 

1. What is a tax?
2. a voluntary payment to the government for services received
3. a penalty
4. a fine
5. a forced payment to the government

 

ANSWER: d

LO 1.1

DIFFICULTY: Easy

 

2. Which of the following is a tax?
3. Dog license
4. Parking fine
5. Water usage fee
6. Import duty

 

ANSWER: d

LO 1.1

DIFFICULTY: Easy

 

3. Which of the following types of taxes is not levied by the U.S. government?
4. Sales tax
5. Income tax
6. Gift tax
7. Estate tax

 

ANSWER: a

LO 1.1

DIFFICULTY: Easy

 

4. Which of the following types of taxes is a consumption tax?
5. Estate tax
6. Income tax
7. Gift tax
8. Use tax

 

ANSWER: d

LO 1.1

DIFFICULTY: Easy

 

5. William lives in Delaware but works for a company that has offices in both Maryland and Pennsylvania. William spent four months working in Pennsylvania and 8 months working in Maryland.
6. Only Delaware can impose a state income tax on his income.
7. Only Maryland can impose a state income tax on his income as he worked there the longer time period.
8. Only Pennsylvania and Maryland can impose state income taxes on his income.
9. Delaware, Pennsylvania, and Maryland can impose state income taxes on his income.

 

ANSWER: d

LO:  1.1

DIFFICULTY: Moderate

 

6. Which of the following is a type of wealth tax?
7. A tax on a person’s salary
8. A tax on stocks owned by the taxpayer
9. A tax on purchases made at a department store
10. A tax on property given to a grandchild

 

ANSWER: b

LO 1.1

DIFFICULTY: Moderate

 

7. Which type of tax is a real property tax?
8. Income tax
9. Consumption tax
10. Wealth tax
11. Use tax

 

ANSWER: c

LO 1.1

DIFFICULTY: Easy

 

8. When appreciated property is transferred, the gift tax is based on
9. replacement cost of the property
10. fair market value of the property on the date of the gift
11. the donor’s original cost of the property
12. the donor’s original cost increased by half of the appreciation

 

ANSWER: b

LO 1.1

DIFFICULTY: Moderate

 

9. Which of the following types of taxes is levied by almost all states on some or all goods purchased?
10. Sales tax
11. Income tax
12. Property tax
13. Wealth transfer tax

 

ANSWER: a

LO 1.1

DIFFICULTY: Easy

 

10. Which of the following statements is false?
11. Use taxes are assessed on out-of-state purchases used in the purchaser’s state.
12. The estate tax is based on the fair market value of property transferred at the owner’s death.
13. Tariffs are taxes levied on good and materials brought into a country.
14. Gift taxes are imposed on the recipient of the gift.

 

ANSWER: d

LO 1.1

DIFFICULTY: Moderate

 

11. Which of the following types of taxes is not levied by the U.S. government?
12. Excise tax
13. Income tax
14. Value added tax
15. Gift tax

 

ANSWER: c

LO 1.1

DIFFICULTY: Easy

 

12. Kate received $130,000 in salary in 2016. What is her FICA tax if the Medicare rate is 1.45%, the Social Security rate is 6.2% on a maximum of $118,500 in 2016?
13. $7,347
14. $9,065
15. $9,232
16. $9,945

 

ANSWER: c

($130,000 x 1.45%) + ($118,500 x 6.2%) = $9,232

LO 1.1

DIFFICULTY: Moderate

 

13. Alexander received $80,000 in salary in 2016. What is his FICA tax if the Medicare rate is 1.45%, the Social Security rate is 6.2% on the 2016 maximum of $118,500, and the FUTA rate is 6% on a $7,000 maximum?
14. $4,960
15. $6,120
16. $6,540
17. $10,920

 

ANSWER: b

$80,000 x (1.45% + 6.2%) = $6,120. FUTA is a separate tax.

LO 1.1

DIFFICULTY: Moderate

 

14. Ethan received $120,000 in salary in 2016. What is his FICA tax if the Medicare rate is 1.45%, the Social Security rate is 6.2% on the 2016 maximum of $118,500, and the FUTA rate is 6% on a $7,000 maximum?
15. $9,065
16. $9,087
17. $9,485
18. $9,507

 

ANSWER: b

($120,000 x 1.45%) + ($118,500 x 6.2%) = $9,087. FUTA is a separate tax.

LO 1.1

DIFFICULTY: Moderate

 

15. By what right does the U.S. levy an income tax on individuals?
16. The 13^th Amendment to the Constitution
17. Public Law 1913
18. The 16^th Amendment to the Constitution
19. An Act of Congress ratified by the states

 

ANSWER: c

LO 1.1

DIFFICULTY: Easy

 

16. Current changes to the federal tax law are amendments to which of the following?
17. The Internal Revenue Code of 1913
18. The Internal Revenue Code of 1954
19. The Internal Revenue Code of 1986
20. The Internal Revenue Code of 2014

 

ANSWER: c

LO 1.1

DIFFICULTY: Easy

 

17. Which of the following is an objective of taxation?
18. Raise revenue
19. Foster social goals
20. Stimulate the economy
21. All of the above
22. None of the above

 

ANSWER: d

LO 1.1

DIFFICULTY: Easy

 

18. William is single and had salary income from his position as Chief Financial Officer of Zippy Bank of $450,000 (the 39.6 tax bracket). He also had $35,000 in income from the dividends on the stock of his previous employer. What tax rate will apply to William’s dividend income?
19. 15%
20. 20%
21. 35%
22. 39.6%

 

ANSWER:        b

LO:  1.2

DIFFICULTY: Moderate

 

19. John earns $25,000 and pays $2,000 in taxes. Marcy earns $60,000 and pays $4,000 in taxes. How would you characterize this tax system?
20. A flat tax system
21. A proportional system
22. A regressive system
23. A progressive system

 

ANSWER: c

$2,000/$25,000 = .08; $4,000/$60,000 = .0667

LO 1.2

DIFFICULTY: Moderate

 

20. The Mercury Corporation must decide whether to invest in some new machinery for its business. Which tax rate is the most relevant for making this decision?
21. The average tax rate
22. The marginal tax rate
23. The nominal tax rate
24. The effective tax rate

 

ANSWER: b

LO 1.2

DIFFICULTY: Moderate

 

21. Which of the following statements describes the correct relationship between marginal and average tax rates in a progressive tax system?
22. The marginal tax rate is higher than the average tax rate.
23. The average tax rate is higher than the marginal tax rate.
24. The marginal and average tax rates are the same.
25. The average tax rate will always be half of the marginal tax rate.

 

ANSWER: a

LO 1.2

DIFFICULTY: Easy

 

22. Which of the following nominal rates does not apply to a C corporation?
23. 10%
24. 15%
25. 25%
26. 35%

 

ANSWER: a

LO 1.2              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

23. What is the marginal tax rate for a corporation with $110,000 of taxable income?
24. 15%
25. 25%
26. 34%
27. 39%

 

ANSWER: d

LO 1.2              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

24. Which of the following best describes horizontal equity?
25. All taxpayers should pay some taxes on their incomes
26. As income increases, taxes should increase
27. Persons with equal incomes should pay the same amount of taxes
28. A person with capital gains should pay less tax than a person with the same amount of salary income

 

ANSWER: c

LO 1.3

DIFFICULTY: Moderate

 

25. Which of the following best describes vertical equity?
26. All taxpayers should pay some taxes on their incomes
27. As income increases, taxes should increase
28. Persons with equal incomes should pay the same amount of taxes
29. A person with capital gains should pay less tax than a person with the same amount of salary income

 

ANSWER: b

LO 1.3

DIFFICULTY: Moderate

 

26. Which of the following are included in Adam Smith’s characteristics of a good tax?
27. Certainty
28. Economy
29. Convenience
30. All are included
31. None are included

 

ANSWER: d

LO 1.3

DIFFICULTY: Easy

 

27. Two married persons with moderately high incomes will pay more taxes than two single persons with the same income. This is commonly called:
28. vertical equity.
29. horizontal equity.
30. a marriage bonus.
31. a marriage penalty.

 

ANSWER: d

LO 1.3

DIFFICULTY: Easy

 

28. Daniel is a single with taxable income of $40,000. What is his marginal tax rate?
29. 10%
30. 15%
31. 25%
32. 28%

 

ANSWER: c

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

29. Charlotte is a head of household with taxable income of $40,000. What is her marginal tax rate?
30. 10%
31. 15%
32. 25%
33. 28%

 

ANSWER: b

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

30. Ethan and Mia are married and file a joint tax return. Their taxable income is $200,000. What is their marginal tax rate?
31. 35%
32. 33%
33. 28%
34. 25%

 

ANSWER: c

LO 1.4              REFERENCE TABLES REQUIRED

DIFFICULTY: Easy

 

31. What is an individual’s maximum annual deduction for capital losses?
32. $3,000
33. An amount equal to capital gains only
34. An amount equal to capital gains plus $3,000
35. Individuals cannot deduct capital losses

 

ANSWER: c

LO 1.4

DIFFICULTY: Easy

 

32. What is a corporation’s annual deduction for capital losses?
33. $3,000
34. An amount equal to capital gains only
35. An amount equal to capital gains plus $3,000
36. Corporations cannot deduct capital losses

 

ANSWER: b

LO 1.4

DIFFICULTY: Moderate

 

33. Which of the following is never included in computing gross income?
34. Loss on stock sale
35. Social security benefits
36. Unemployment benefits
37. Gifts

 

ANSWER: d

LO 1.4

DIFFICULTY: Easy

 

34. Which of the following is normally not included in gross income?
35. Cash dividend
36. Corporate bond interest income
37. Stock dividend
38. All are included in gross income
39. None are included in gross income

 

ANSWER: c

LO 1.4

DIFFICULTY: Moderate

 

35. What is George’s gross income if he has the following: $78,000 salary, $4,000 dividend income, $2,000 interest income on city of San Francisco bonds, a gain of $14,000 on a stock sale, and a $4,000 operating loss on a small sole proprietorship that he owns?
36. $78,000
37. $84,000
38. $92,000
39. $96,000

 

ANSWER: c

[$78,000 + $4,000 + $14,000 – $4,000 = $92,000] Interest on municipal bonds is tax exempt.

LO 1.4

DIFFICULTY: Moderate

 

Purchase For Continue…. 

 

Chapter 5

Deductions and Completing the Individual Tax Return

 

True-False: Insert T for True and F for False before the questions.

 

_____  1.   The tax model is the formula for how individuals report their tax liability.

 

ANSWER         True     LO 5.1

DIFFICULTY: Easy

 

_____  2.   Contributions to health savings accounts are made with before-tax dollars.

 

ANSWER         True     LO 5.2

DIFFICULTY: Easy

 

_____  3.   The deduction for student loan interest has limits placed on it based on the taxpayer’s AGI.

 

ANSWER        True     LO 5.2

DIFFICULTY: Easy

 

_____  4.   To file as a surviving spouse, a taxpayer must maintain a home for a dependent child for the entire year.

 

ANSWER         True     LO 5.3

DIFFICULTY: Easy

 

_____  5.   Surviving spouse status may be claimed for three years after the year of the spouse’s death.

 

ANSWER         False    LO 5.3

DIFFICULTY: Easy

 

_____  6.   A legally married couple can elect to file as married filing jointly or single individuals.

 

ANSWER         False    LO 5.3

DIFFICULTY: Easy

 

_____  7.   To qualify as head of household, the taxpayer must pay more than half of the costs of a home in which a qualifying person lives for the entire year.

 

ANSWER         False    LO 5.3

DIFFICULTY: Easy

 

_____  8.   An abandoned spouse must only live apart from his or her spouse during the last six months of the tax year.

 

ANSWER         True     LO 5.3

DIFFICULTY: Easy

 

_____  9.   Jan and James’s divorce is final on December 31 of the current year. They must file married filing separately for the tax year.

 

ANSWER         False    LO 5.3

DIFFICULTY: Easy

 

_____  10. The basic and additional standard deductions are both indexed for inflation.

 

ANSWER         True     LO 5.3

DIFFICULTY: Easy

 

_____   11. A taxpayer’s filing status determines the basic standard deduction allowed.

 

ANSWER         True     LO 5.3

DIFFICULTY: Easy

 

_____   12. A married person filing a separate return has the lowest standard deduction amount.

 

ANSWER         False    LO 5.3

DIFFICULTY: Easy

 

_____  13. Beginning in 2017, qualified medical expenses for a 66-year-old single individual must exceed 10 percent of AGI to be deductible for regular income tax purposes.

 

ANSWER         True     LO 5.4

DIFFICULTY: Easy

 

_____  14. Each separate item of miscellaneous itemized deductions must exceed two percent of AGI to be deductible.

 

ANSWER         False    LO 5.4

DIFFICULTY: Easy

 

_____  15.  Real property taxes are deductible for state, local, and foreign real property.

 

 

ANSWER         True     LO 5.4

DIFFICULTY: Easy

 

_____ 16.  Sales taxes levied on the purchase of depreciable business property are deductible as part of depreciation.

 

ANSWER         True     LO 5.4

DIFFICULTY: Easy

 

_____  17.  A personal theft loss can be deducted if it exceeds $100 plus 10 percent of AGI.

 

ANSWER         True     LO 5.4

DIFFICULTY: Easy

 

_____  18.   A homeowner who itemizes his or her deductions can only deduct the property taxes on his or her primary residence and one other residence.

 

ANSWER         False    LO 5.4

DIFFICULTY: Easy

 

_____  19.   The itemized deduction for medical expenses is subject to the phase-out applicable to total itemized deductions based on the taxpayer’s AGI.

 

ANSWER         False    LO 5.4

DIFFICULTY: Easy

 

_____  20.  Single individuals must reduce their personal exemption if their AGI exceeds $259,400.

 

ANSWER         True     LO 5.5

DIFFICULTY: Easy

 

_____  21.  Under a multiple support agreement, Jim may claim an exemption for his mother if he supplies 25 percent, his brother supplies 40 percent, and his sister supplies 8 percent of the support for their mother.

 

ANSWER         True     LO 5.5

DIFFICULTY: Easy

 

_____ 22.  A parent cannot be claimed as a dependent if his or her gross income equals or exceeds the amount of the dependency exemption.

 

ANSWER         True     LO 5.5

DIFFICULTY: Easy

 

_____ 23. A taxpayer’s exemptions and standard deduction are limited by the taxpayer’s AGI if AGI exceeds a certain threshold.

 

ANSWER         False    LO 5.3 & 5.5

DIFFICULTY: Easy

 

_____  24. Taxpayers can apply any excess FICA tax paid to their income tax liability.

 

ANSWER         True     LO 5.6

DIFFICULTY: Easy

 

_____  25. Qualifying low-income wage earners may not only deduct their IRA contributions but they may take a credit for their contribution.

 

ANSWER         True     LO 5.6

DIFFICULTY: Moderate

 

_____  26. The maximum annual lifetime learning credit is $2,000 per taxpayer.

 

ANSWER         True     LO 5.6

DIFFICULTY: Easy

 

 

_____  27. The additional 0.9 percent Medicare surtax applies to earned income of individuals with wages in excess of $200,000 but does not apply to self-employed individuals.

 

ANSWER         False    LO 5.7

DIFFICULTY: Easy

 

 

_____  28  The NII tax is assessed on the greater of net investment income or modified adjusted gross income.

 

ANSWER         False    LO 5.7

DIFFICULTY: Easy

 

_____  29  The tax rate applied to the AMTI for individuals is 2 percent higher than the top individual regular tax rate.

 

ANSWER         False    LO 5.7

DIFFICULTY: Easy

 

_____  30. The alternative minimum tax is a tax determined on a broadened definition of income with no deductions permitted.

 

ANSWER       False LO 1.5

DIFFICULTY: Easy

 

 

Short-Answer Questions: Provide a brief written answer to each of the following questions.

 

1. When should a taxpayer itemize deductions rather than taking the standard deduction?

 

ANSWER         A taxpayer should itemize deductions rather than take the standard deduction when the total of all the itemized deductions after consideration of all limitations is greater than the standard deduction for the filing status of the taxpayer.

LO 5.1

DIFFICULTY: Easy

 

2. What is the purpose of the Health Savings Account?

 

ANSWER         The Health Savings Account allows a person (and family, if applicable) who is covered by a medical insurance plan that has a high deductible ($1,300 minimum for a single person or $2,600 for family coverage in 2016) to put aside an amount equal to the lesser of $3,350 ($6,750 for family coverage) or the annual deductible amount on a before-tax basis to pay the deductible. The threshold of 10% of AGI before medical expenses (for persons under 65) are deductible often prevents a taxpayer from getting the benefit of a tax deduction for high deductible policies. Thus, this allows the taxpayer to pay all or a portion of the deductible with before-tax income.

LO 5.2

DIFFICULTY: Moderate

 

3. What is the standard deduction for a person claimed as a dependent on another person’s return in 2016?

 

ANSWER         The standard deduction for a person claimed as a dependent on another taxpayer’s return is the greater of $1,050 or $350 plus the person’s earned income up to the usual standard deduction for the filing status; for example, up to $6,300 for a single person in 2016.

LO 5.3

DIFFICULTY: Easy

 

4. What is required for a taxpayer to qualify to file as a surviving spouse?

 

ANSWER         To qualify to file as a surviving spouse, a taxpayer’s spouse must have died during either the first or second year prior to the current tax year and he or she must not have remarried. The taxpayer must also provide a home for a dependent child for the entire tax year and pay for more than one-half of the cost of maintaining the home.

LO 5.3

DIFFICULTY: Moderate

 

5. How is the deductibility of itemized deductions limited in determining taxable income?

 

ANSWER         Medical expenses, casualty losses, and most items included in miscellaneous itemized deductions are limited directly to an amount that exceeds a certain percentage of AGI. Charitable contributions cannot exceed a specific percentage of AGI based on the type of contribution. Mortgage interest, home equity interest, and investment interest are limited to the interest on a specific amount of debt. There is a phase-out of up to 80% of the affected itemized deductions over a certain threshold AGI for higher income taxpayers. This latter phase-out primarily affects the charitable contribution, home mortgage, and tax deductions. It does not affect the medical expense, casualty loss and investment interest deductions.

LO 5.4

DIFFICULTY: Moderate

 

6. What limits are placed on the deduction for interest on debt that is secured by a person’s personal residence?

 

ANSWER         A taxpayer may only deduct interest on qualified residence interest. The interest on acquisition indebtedness is limited to debt principal of no more than $1,000,000. Debt on no more than two homes can be combined to reach the $1 million limit. Interest on a home equity loan is limited to debt principal of $100,000.

LO 5.4

DIFFICULTY: Moderate

 

7. What types of insurance premiums are deductible as an itemized deduction?

 

ANSWER         Health insurance premiums for a taxpayer and his or her dependents are deductible if paid with after-tax income. Health insurance includes coverage for doctor, dentist, and hospital bills. All or a portion of a taxpayer’s premium for long-term care insurance is also deductible; the deduction may be limited if the cost exceeds a certain amount related to the taxpayer’s age, however. Nondeductible insurance premiums include disability insurance and other insurance that covers loss of life, limb, or income.

LO 5.4

DIFFICULTY: Moderate

 

8. What is included in investment income? What is the limit on the deduction for investment interest?

 

ANSWER         Investment income includes interest, annuity payments, and net short-term capital gains from the sale of investment property. Long-term gains from investment property and dividends are excluded unless their favorable tax rates are foregone. Investment interest is deductible to the extent of net investment income with any excess carried forward to future years.

LO 5.4

DIFFICULTY: Moderate

 

9. What limits are placed on an individual’s charitable contribution deduction?

 

ANSWER         An individual’s total charitable contribution deduction is limited to 50 percent of AGI.  The deduction for property other than a capital asset is the lesser of the property’s fair market value or basis. The deduction for long-term capital gain property is the property’s fair market value, but the deduction cannot exceed 30 percent of adjusted gross income (unless the alternate valuation of the lesser of fair market value or basis is used); this limit is determined after the contribution of other property.

LO 5.4

DIFFICULTY: Moderate

 

10. Which is more advantageous, a deduction for or a deduction from adjusted gross income? Why?

 

ANSWER         A deduction for adjusted gross income is more valuable than an equal amount of deduction from adjusted gross income because many of the deductions from AGI have some limitation imposed on their deductibility based on AGI. The deductions for AGI generally are not subject to any reduction but they do reduce the amount of AGI before the limitations on deductions from AGI are imposed—meaning the limitations based on AGI are smaller. In addition, deductions for AGI are allowed to be deducted regardless of the taxpayer’s filing status; deductions from AGI are only valuable if they exceed the taxpayer’s standard deduction.

LO 5.1, 5.2  & 5.4

DIFFICULTY: Moderate

 

11. What uses are made of adjusted gross income (AGI) in the individual tax model?

 

ANSWER         The intermediate income concept of adjusted gross income provides a number that can be used as a limit for some itemized deductions, as a threshold minimum for the deduction of other itemized deductions, and as a basis for determining the phase-out of other benefits.

LO 5.1 & 5.4

DIFFICULTY: Easy

 

12. Who are qualifying relatives for a dependency exemption?

 

ANSWER         Qualifying relatives for a dependency exemption include children, grandchildren, and other lineal descendants; parents, grandparents,  and other direct ancestors, sisters and brothers (including stepsisters and stepbrothers), sisters and brothers of the taxpayer’s parents, children of brothers and sisters, and in-laws such as mothers-, fathers-, sisters-, brothers-, sons-, and daughters-in law. (Cousins, aunts, uncles, nieces and nephews not related by blood are not qualified relatives.)

LO 5.5

DIFFICULTY: Moderate

 

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