Earn more and reduce your taxes by understanding and having a tax-wise: 

1. Shawn Smith, sole proprietor, had the following transactions during 2022: 

Received rental income                                                                                                                          $7,500

Performed legal services for ATI Corporation in return for 10 shares of stock                                       $24,000

Recovered accounts receivable that had been written off and deducted in 2019 (did not reduce tax)  $20,000

What amount must Mr. Smith include in gross income for 2022?

A. $27,500

B. $31,500

C. $44,000

D. $51,500

Correct: B  

Income is included in the taxable year in which all the events have occurred that fix the right to receive such income and in which the amount can be determined with reasonable accuracy. The rental income is included in gross income. The payment for legal services performed is also included in gross income. The fair market value of the stock is the amount included [Sec. 83(a)]. Under Sec. 111, the recovery of bad debt is excluded from income if the previous deduction did not reduce taxes. Therefore, $31,500 ($7,500 + $24,000) is included in gross income.

2. Supplemental wages are compensation paid in addition to an employee’s regular wages. They do NOT include payments for

A. Vocation pay.

B. Accumulated sick leave.

C. Nondeductible Moving Expenses. 

D. Travel reimbursements are paid at the federal government per diem rate.

Correct: D

Supplemental wages are compensation paid in addition to an employee’s regular wages. They do not include payments for travel reimbursements paid at the federal government per diem rate.

3. Barclay Corporation transferred its own stock to one of its creditors in satisfaction with a $23,000 debt. At the time of the transfer, the stock had a fair market value of $21,000. Barclay is a solvent corporation. As a result of the transfer, Barclay will recognize the income of: 

A. $2,000.

B. $21,000.

C. $0

D. $23,000.

Correct: A

Under Sec. 61(a)(12), taxpayers, including corporations, must recognize gain from the discharge of indebtedness. If a corporation transfers stock to its creditors in satisfaction of indebtedness, it will have income from the discharge of the indebtedness to the extent that the amount or adjusted issue price of the debt satisfied exceeds the value of the distributed stock. Therefore, the amount of gain included in Barclay’s return is $2,000.

4. A farmer sold a 3-year-old raised dairy cow for $600. It cost him $75 for shipping and commissions to sell the cow. He reports this sale as follows on his return: 

A. A loss of $700 on his Schedule F because he believed it cost him $1,300 to raise the dairy cow.

B. A Sec. 1231 gain of $525 reported on Form 4797.

C. A Sec. 1245 gain of $525 reported on Form 4797.

D. A gain of $525 reported on Schedule F as an ordinary farm income.

Correct: B

Capital gain treatment under Sec. 1231 applies to the sale of livestock held for draft, breeding, dairy, or sporting purposes. To qualify for such treatment, cattle must be held for at least 24 months. The gain is equal to the amount realized minus selling expenses and adjusted basis. Publication 225 states that shipping and commissions are added to the basis and reduce the amount of gain reported. Therefore, the farmer’s gain is $525 ($600 – $75).

5. Gross income from a hobby activity of an individual is 

A. Reported as other income on Form 1040.

B. Netted against related expenses, and the excess, if any, is reported as other income on Form 1040.

C. Reported as gross income on Schedule C (Form 1040).

D. Not reported if less than $400.

Correct: A

Income from activities from which a profit is not expected must be included on the tax return. Such activities include hobbies and farm activities operated for recreation and pleasure. Related expenses are not deductible. The income is reported on Schedule 1 of Form 1040.

6. Farmer Judy is a calendar-year taxpayer who uses the cash method of accounting. She normally sells 200 head of sheep a year. Because of a drought, she sold 250 head of sheep in 2021. Farmer Judy realized $50,000 from the sale. The affected area was declared a disaster area eligible for federal assistance on March 12, 2021. How much, if any, income can Farmer Judy postpone to 2022?

A. $12,500.

B. $50,000.

C. $$0, since only sales because of flooding qualify for postponement.

D. $10,000.

Correct: D

The gain from sales caused by drought, flood, or other weather-related conditions can be postponed for 4 years. If, because of the weather-related conditions, a farmer who uses the cash method of accounting sells more livestock (including poultry) than (s)he would have sold under normal business conditions, the farmer may choose to include the gain from the sale of the additional livestock in income next year instead of the current year. Farmer Judy realized a gain of $200 per sheep sold ($50,000 ÷ 250). Because she only sold 50 sheep more than she normally does, she can only defer recognition of $10,000 of the gain (50 × $200).

7. Michael operates his health food store as a sole proprietorship out of a building he owns. Based on the following information regarding 2021, compute his net self-employment income (for SE tax purposes) for 2021.

A. John ships goods on consignment to a vendor. The fair market value of the goods is $10,000.

B. The consignment vendor sells $3,000 of John’s goods and places the proceeds in an escrow account controlled by the vendor. 

C. The lessee erects a carport on the rental property without notifying John. Upon inspection, John estimates the value of the carport is

approximately $2,000.

D. John owns a rental house and the rental agreement directs the lessee to pay the $1,000 monthly rent to Michelle, his ex-wife.  

Correct: D

This involves the assignment of income doctrine, which says that an individual is taxed on the earnings from his or her personal services. Assigning this income to another individual does not permit a person to avoid being taxed on the income. This doctrine includes income from property, so income from property is taxed to the owner of the property. This $1,000 monthly rent is included in John’s income because John owns the property that is earning the income. In order for John to transfer the income to his ex-wife, he must transfer the property.

9. Based on the following information, how much will Cassie have to report as self-employment income?

Cassie’s salary is reasonable for the services she provides to the S corporation.

A. $21,500

B. $300

C. $10,500

D. $44,500

Correct: A

Under Sec. 1402(a) and Reg. 1.1402(a)-1, net earnings from self-employment include the net income from a trade or business, guaranteed payments for services from a partnership, and a partner’s distributive share of income from a partnership (whether the partner is active or not). Directors’ fees are self-employment income. Revenue Ruling 91-19 held that payments received for lost earnings were included in net earnings from self-employment. S corporation earnings required to be included in a shareholder’s gross income are not self-employment income (Rev. Rul. 59-221). A bona fide salary is income from employment, not self-employment. Cassie’s self-employment income is computed as follows:

10. Which of the following would generally be reported as other income for a business?

A. Sales tax collected

B. Proceeds from international sales.

C. Income not reported on a form 1099-MISC.

D. Bad debts recovered. 

Correct: D

If a deduction is claimed for a bad debt on the income tax return and later all or part of it is recovered (collected), all or part of the recovery may have to be reported in gross income. The amount included is limited to the amount actually deducted. However, the amount deducted that did not reduce the tax can be excluded. Report the recovery as “other income” on the appropriate business form or schedule.

11. For self-employment tax purposes, which of the following is NOT considered earnings from self-employment? 

A. Distributive share of income from an operating partnership received by a general partner.

B. Salary received by a corporate officer who is also the sole shareholder.

C. Guaranteed payment received from a partnership by a limited partner for services (s)he has performed.

D. Net profit of a delicatessen operated by a sole proprietor.

Correct: B 

Self-employment income is defined in Sec. 1402 generally as the net income derived by an individual from a trade or business. Wages and salary from a corporation are not self-employment income; they are earnings of an employee regardless of his or her stock ownership.

12. With regard to postponing gains from sales caused by drought conditions, which of the following statements is true?

A. Poultry qualifies if the sale was due to drought conditions.

B. All of the answers are correct 

C. Livestock sold before the area became eligible for federal assistance qualifies as long as the drought that caused the sale also caused the area to be designated as eligible for federal assistance.

D. Livestock not raised or sold in a drought area will qualify if the sale occurred solely because of drought conditions.

Correct: B 

An election can be made to postpone for 1 year reporting the gain from a sale or exchange of all livestock (including poultry) if the sale was due to drought conditions. This election applies to all livestock, whether held for resale or other purposes. It applies even if the livestock was not actually raised or sold in an area inside the drought area, as long as the sale was solely a result of the drought. Sales made before the area becomes eligible for assistance still qualify, as long as the drought that caused the sale subsequently caused the area to be designated as eligible.

13. During the current year, Mrs. R, a cash-basis lawyer, had the following transactions:

What is Mrs. R’s gross income from her business?

A.120,300 

B. $100,000

C. $130,000

D. $110,000

Correct: D  The gain on the sale of a personal automobile and the interest on a personal loan are not income from the taxpayer’s business, although they are items of gross income. The appreciation of the taxpayer’s building is not included in gross income since there has been no event causing the realization of the income, e.g., a sale or exchange. Mrs. R’s only self-employment income consists of $100,000 of cash fees and the $10,000 value of the stock received (Sec. 83), which total $110,000.

14.  In July of Year 1, Mr. Brown, a cash-basis, calendar-year farmer, had his bean crop damaged by a flood. He normally would have reported the income from the crop in Year 2. On November 1, Year 1, he received a $40,000 payment under the Disaster Assistance Act of 1988 due to the damage to his beans. Regarding Mr. Brown’s reporting of the $40,000 for federal income tax purposes, which of the following statements is true?

A. He may elect to postpone reporting the $40,000 to Year 2.

B. $40,000 must be included in his gross income for Year 1.

C. He may note on his Schedule F, Form 1040, that $40,000 from the Disaster Assistance Act will be reported in Year 3.

D. The $40,000 is nontaxable income.

Correct: A  Section 451(d) provides that payments from the Disaster Assistance Act of 1988 for crop loss from drought, flood, or any other natural disaster shall be treated as insurance proceeds. These payments (in the form of insurance proceeds) may be included in income in the year of receipt, or the taxpayer may elect to include the proceeds in income in the year following the year of destruction as damage.

15. Gross income from self-employment includes all but which of the following? 

A.  Income from general partnerships. 

B. Damage awards for lost profits. 

C. Book royalties.

D. Improvements on rental property left by a lessee.

Correct: D Income from self-employment is included in gross income under Sec. 61(a)(1) and (2). Improvements on rental property left by a lessee at the termination of the lease are not included in gross income under Sec. 109. They would be included only if made in lieu of rent. Even if such amounts were included in gross income, they would not be self-employment income.

16. The receipt of agricultural program payments by a farmer for refraining from growing crops should be reported as:

A. Farm income, subject to self-employment tax.

B. Rental income, not subject to self-employment tax.

C. Farm income, not subject to self-employment tax.

D. Miscellaneous income on Form 1040.

Correct: A An agricultural program payment should be reported on the appropriate line of Part I of Schedule F (farm income) (Publication 225). The full amount of the payment should be reported even if it is returned to the government for cancellation. A self-employed individual usually has to pay self-employment tax (Publication 225). Farmers are considered to be self-employed if they operate their own farm on land they own or rent. 

17. Who of the following may use farm income averaging, assuming farm income rules are met?

A. A natural person filing a Form 1040, a partnership, an S corporation, and a C corporation.

B. A natural person filing a Form 1040, a partner in a partnership, an estate, and a trust. 

C. A natural person filing a Form 1040, a partner in a partnership, and a shareholder in a C corporation.

D. A natural person filing a Form 1040, a partner in a partnership, and a shareholder in an S corporation. 

Correct: D Under Sec. 1301, a taxpayer engaged in a farming business in the year of election as an individual, a partner in a partnership, or a shareholder in an S corporation can elect to use farm income averaging. Corporations, partnerships, S corporations, estates, and trusts cannot use farm income averaging.

18. For purposes of estimated tax exceptions for farmers, all of the following are considered gross income from farming EXCEPT

A.  Gross farm rental income.

B. Gross farm income from partnerships, S corporations, estates, and trusts.

C. Gains from the sale of livestock used for breeding, draft, sport, or dairy purposes.

D. Gains from the sale of investment stock (securities).

Correct: D Gross income from farming includes gross farm income, gross farm rental income, and gains from the sale of livestock. Gains from the sale of investment stock are neither farming-related nor included in gross income from farming.

19. Sally, a calendar-year, cash-basis taxpayer, operates a used furniture business in a building she owns. At the end of the current year, her basis in the building is $175,000, and the difference between the building’s $100,000 value and the $150,000 mortgage reflects countrywide declining real property values. Because Sally’s ability to make full payments on the mortgage that was taken out 2 years ago has decreased with demand for her inventory, the lender reduced the principal amount of the mortgage to $120,000 at year-end. Which of the following statements is the best answer regarding the mortgage principal adjustment?

A. Sally must report $30,000 of gross income on her current-year tax return.

B. The $30,000 adjustment is not includible in gross income for the current year.

C. Sally must reduce the property’s basis on the first day of her next tax year.

D. Sally must either report $30,000 of gross income for the current year or reduce the property’s basis next year.

Correct: D Discharge of debt is gross income [Sec. 61(a)(12)]. Sally is not insolvent, so the debt discharged is not excluded under Sec. 108(a)(1)(B). However, under Sec. 108(a)(1)(D), a taxpayer may elect to exclude discharged debt incurred or assumed in connection with the purchase of real property used in a trade or business. The discharged debt may be excluded to the extent the taxpayer reduces his or her basis in the property. The basis reduction is limited to the lesser of (1) the adjusted basis of real estate held by the taxpayer, or (2) excess of the debt principal before discharge over the fair market value of the property which secures the debt. Thus, Sally must either report gross income or reduce the property’s basis in the amount of $30,000 ($150,000 original mortgage – $120,000 new mortgage amount). Basis reduction is made at the beginning of the year following discharge.