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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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.
44
AICPA Released Simulation
Directions
45
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.
46
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.
47
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)
48
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).
49
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.
Accumulated
Distribution Distribution Excess
Current E&P E&P at
dates amounts distribution
12/31/year 3
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
50
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.
51
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
Dividend Return of
total Capital gain
income capital
distribution
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).
52
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.
53
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.
54
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
55
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”
56

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2010 AICPA Newly Released Questions – Regulation

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

What is the amount of Tap's ordinary income?

AICPA Released Simulation

Alaska, Inc. is an accrual-basis C corporation that was incorporated on January 1, year

Definition of Corporate Earnings and Profits:

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*

Changes in the cash surrender value of certain life insurance policies

Installment income method adjustments

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

Amortization of intangible drilling costs adjustments

Refunds of federal income tax paid^

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)

1. Unrealized losses (and unrealized gains) represent changes in value of

4. The nondeductible portion of meals and entertainement (50% of the total

6. As presented above, the expense related to premiums on life insurance of an

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

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

9/30/Year 4: $18,297 and $6,000. This distribution represents an excess distribution of

18,200 17,000 700 500

Return of Capital: $700. The remaining excess distribution of $1,200 ($18,200 –

Depreciation on the income statement is based on GAAP depreciation rules. However,

CPA Exam Candidate

IRC 312 (k)

Keywords: “Depreciation Effect Earnings and Profits”

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