Concepts in Federal Taxation 2017 24th Edition Murphy Test Bank Download

Chapter 5
Concepts in Federal Taxation 2017 24th Edition

Murphy
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1. In order for a taxpayer to reduce taxable income with a deduction, the tax law must allow it, and it must meet all
statutory requirements.
a. True
b. False
ANSWER: True
2. In order to take a business deduction, the taxpayer engaged in a business must be able to establish a business purpose
for each expenditure.
a. True
b. False
ANSWER: True
3. An individual should be indifferent whether an expense is deducted for or deducted from adjusted gross income.
a. True
b. False
ANSWER: False
4. Evelyn can avoid the 2 percent limitation on her investment expenses by having her partnership pay them.
a. True
b. False
ANSWER: False
5. An expense that is incurred for the production of rent will be deducted for adjusted gross income.
a. True
b. False
ANSWER: True
6. For a taxpayer to be engaged in a trade or business, the activity must meet all of the following tests: it must produce a
profit every year; must be continuous and regular activity; and must be the taxpayer's livelihood not their hobby.
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a. True
b. False
ANSWER: False
7. A necessary expense is one that is appropriate and helpful to the taxpayer’s income activity.
a. True
b. False
ANSWER: True
8. Pamela owns the building where her plumbing supply business is located. This year she put on vinyl siding to replace
the weathered wood siding on her building. The cost of the new siding can be expensed in the current year.
a. True
b. False
ANSWER: False
9. Bowen is planning to quit his job as a plumber and open a paint store. He has incurred expenses of $8,000 dealing with
the opening of the store and will be able to deduct all of these expenses.
a. True
b. False
ANSWER: True
10. Morgan, a banker, is an amateur photographer who takes pictures at weddings and parties. He earned $1,000 but
incurred $1,200 in related expenses. Since he takes a standard deduction, he will have to include the $1,000 in income but
will not get any benefit from the expenses.
a. True
b. False
ANSWER: True
11. Andy lives in New York and rents his house for two weeks during the U.S. Open Tennis tournament for $3,500. He
must include the rent in his income.
a. True
b. False
ANSWER: False
12. John decides rather than work late in the office, he does all of his work in an office at home. His employer approves of
this arrangement. Since John uses his home office on a regular and exclusive basis, he will be eligible to take a home
office deduction even though it was not required as a condition of employment.
a. True
b. False
ANSWER: False
13. A taxpayer can take a deduction for a portion of his phone bill if he is eligible for the home office deduction.
a. True
b. False
ANSWER: False

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14. Ona is a professional musician. She prepared her music teacher’s tax return in exchange for music lessons. Since she
is a cash basis taxpayer, she cannot take a deduction for the music lessons.
a. True
b. False
ANSWER: False
15. Devery, Inc. sells high tech machine parts that are fully warranted against defects. Based on prior years experience
they can expect to incur $20,000 of warranty expense on current sales. They are on the accrual basis, and the warranty
expense is based on a reasonable estimate, so Devery can deduct the $20,000.
a. True
b. False
ANSWER: False
16. Teresa, Terri, and Tricia operate Sassy Solutions, an exclusive boutique. Based on advice from Teresa's sister, a CPA,
the three form a partnership. Teresa owns 50% and Terri and Tricia each own 25%. For the year, Sassy Solutions reports
the following:
Sales revenues $600,000
Business expenses (320,000)
Investment expenses (4,000)
Short-term capital gains 26,000
Long-term capital losses (14,000)
Taxable income $288,000
For tax purposes, what amount will Sassy Solutions report to Teresa as her ordinary income from the partnership?
a. $144,000
b. $146,000
c. $148,000
d. $138,000
e. $140,000
ANSWER: e
17. Tom, Dick, and Harry operate Quality Stores. Based on advice from Tom's sister, a CPA, the three form a partnership.
Tom owns 50%; Dick and Harry each own 25%. For the year, Quality Stores reports the following:
Business expenses (440,000)
Investment expenses (4,000)
Short-term capital gains 26,000
Long-term capital losses (14,000)
By how much will Tom’s adjusted gross income increase because of the above?
a. $178,000
b. $180,000
c. $183,000
d. $184,000
e. $186,000
ANSWER: e

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18. To be deductible, the dominant motive for incurring an expense must be
a. the relationship to a business activity.
b. to reduce income taxes.
c. tax avoidance.
d. the intent to earn a profit.
e. personal.
ANSWER: d
19. Which of the following is an example of a business purpose as dominant motive?

I. Darren is a full-time plumber and a part-time Amway salesman. He is taking his family to
Disney World and plans to take his Amway products with him so that he may deduct most
of his cost of the trip.
II. Larry is a full-time plumber. He is taking his family with him to a convention in Orlando
featuring the latest in plumbing products and techniques. He plans to deduct most of his
cost of the trip.
a. Only statement I is correct.

b. Only statement II is correct.
c. Both statements are correct.
d. Neither statement is correct.
ANSWER: b
20. The Business Purpose Concept means

I. that the economic purpose of the transaction must exceed the tax avoidance motive.
II. that the taxpayer's dominant motive for an expenditure is to reduce taxation.

ANSWER: a
21. The legislative grace concept dictates that deductible business expenses be grouped into certain categories that include
I. Personal expenses.
II. Trade or business expenses.
III. Expenses for the production of income.
a. Statements I and II are correct.

b. Statements I and III are correct.
c. Statements I, II, and III are correct.
d. Statements II and III is correct.
ANSWER: d
22. Business expenses include

I. expenditures that have a business purpose
II. expenditures that are incurred for the production of income.

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ANSWER: c
23. A business expense includes

I. an expenditure that satisfies the dominant profit-motive requirement.
II. an expenditure that is incurred in a trade or business activity.

ANSWER: c
24. Sheila extensively buys and sells securities. The IRS has determined upon examination that she is not in a trade or
business concerning the securities' transactions and therefore, Shelia must be
a. a broker.
b. an active trader.
c. an active investor.
d. a securities' dealer.
ANSWER: c
25. Sarah extensively buys and sells securities . The IRS has determined upon examination that she is in a trade or
business concerning the securities' transactions and therefore, Sarah is
a. a day trader.
b. an active trader.
c. an active investor.
d. a securities' dealer.
ANSWER: b
26. Which of the following is/are trade or business expenses?

I. Mahlon incurs expenses related to investing in stocks and bonds. Mahlon is a Sociology
professor at State University but spends 10-15 hours per week on his investments. Almost
2/3 of Mahlon's annual income comes from his investments as dividends and interest.
II. Shaheen has expenses related to managing her portfolio of securities. The short-term
trading of her securities generates most of her annual income. She has no other job.

ANSWER: b
27. Which of the following is/are trade or business expenses?

I. Solly incurs legal expenses related to real estate he leases to Bucko Burger Hamburger
Haven for a parking lot. Solly does little but negotiate the lease every year..
II. Susan owns several rental apartments. She negotiates new rental contracts, arranges for
repairs and maintenance, and handles all leasing activities.
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ANSWER: b
28. Which of the following people is currently engaged in a trade or business?

I. Barry spends 4 hours a day 5 days a week managing his investment portfolio. He watches
the market and buys and sells securities when he thinks the market is right. His investment
strategy is to realize income from dividends and long-term gains from holding investments
for appreciation in value.
II. Jennifer is a full-time realtor, and she owns a house that she rents to Barry and his family
for $900 a month. Jennifer provides for the repairs and maintenance of the house, and she
stops by monthly to collect the rent and visit with Barry and his family.

ANSWER: b
29. Which of the following people are currently engaged in a trade or business?
I. Willie devotes 45 hours per week to betting on horse races. Although he intends to win
large sums, he has failed to win the big one. He considers his betting activities his job and
relies on his meager winnings to support his family.
II. Daryl owns 214 home sites in and around Orlando, Florida. He bought these vacant lots
several years ago in hoping that they would appreciate in value so he could sell them at a
profit. Because of the recreational activities in the area, the building lots are worth several
times his original cost. He is getting the lots ready to sell this year.

ANSWER: a
30. Which of the following individuals is involved in a trade or business?

I. Lil owns a farm near Lafayette, Indiana. She leases the property to Cal, who operates the
farm for himself. Lil receives 10% of Cal’s net income as part of the lease agreement but
has no responsibilities for the farming operation.
II. Lorraine owns a warehouse located in Brooklyn NY. She paid $250,000 for the real estate
several years ago. It is now appraised at over $1,000,000, but she still uses the building
only to store her painting collection.


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ANSWER: d
31. Marian, a schoolteacher in Duluth, Minnesota, owns a rental house in Scottsdale, Arizona. She travels to Arizona
during spring break to inspect her property and discuss property improvements with the tenant and property manager.
Marian's brother, Brian, lives in Scottsdale. She stays at his house during her week in Arizona and borrows his car to
travel across town for her day of meetings. Her trip accomplishes several objectives: a visit with her brother, a trip away
from Wisconsin's winter weather, and a review of her investment property. The expenses of traveling to Scottsdale
I. have a dominant business purpose.
II. are deductible as expenses for the production of income.

ANSWER: d
32. Bonnie's sister, Diane, wants to open a restaurant. Because Diane is short of funds, Bonnie purchases the building and
leases it to Diane. No agreement is signed, and Bonnie tells Diane not to worry about paying rent until the cash flow can
support it. Also, Bonnie promises not to sell the property to anyone other than Diane.
I. Any expenditures Bonnie makes regarding the building would be classified as production
of income expenses.
II. The building rental has the characteristics of a gift.
III. The dominant motive in acquiring the building is to earn an economic benefit (profit).
IV. Bonnie's property tax expenses related to the property are deductible.
a. Only statement II is correct.

b. Only statement III is correct.
c. Statements I, II, and IV are correct.
d. Statements II and IV are correct.
e. Statements I, II, III, and IV are correct.
ANSWER: d
33. Shaheen owns 2 rental properties. She hires her 21 year old son, who is a junior at State College, to obtain tenants,
negotiate leases, make arrangements for repairs, and pay expenses related to the properties.
I. Shaheen's sale of the properties will result in a capital gain or loss.
II. Shaheen's sale of the properties at a loss results in a current-year loss deduction of no more
than $3,000.

ANSWER: c
34. Pedro owns 5 rental properties. He contracts with East Lake Properties, Inc., to manage the real estate. East Lake
obtains tenants, negotiates leases, makes necessary repairs, pays expenses related to the properties, and remits monthly net
receipts to Pedro.
I. Pedro's sale of the properties at a gain will result in a capital gain.
II. Pedro's sale of the properties at a loss results in an ordinary loss on his tax return.

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ANSWER: a
35. In the current year, Paul acquires a car for $16,000. He uses the car in his advertising business and for personal
purposes. His records indicate the car is used 60% for business and that the total operating expenses, including
depreciation, are $4,700. Paul expects to use the car for 5 years in his business. What amount can Paul deduct as the
operating costs of the car?
a. $- 0 -
b. $2,400
c. $2,820
d. $4,700
e. $12,000
ANSWER: c
36. During 2016, Myca sells her car for $5,000. She acquired the car in 2012 for $11,000 and has used it 60% for business
and 40% for personal use. She deducted $5,280 in depreciation. What is the taxable gain or loss from the sale of the car
attributable to her business use?
a. $3,680 gain
b. $432 gain
c. $720 loss
d. $2,280 loss
e. $1,680 gain
ANSWER: e
37. Charlotte traveled to Annapolis to attend a three-day business conference. After her meetings concluded, she stays 2
additional days sightseeing. Charlotte's airfare is $400 and pays $110 per night for lodging, $60 a day for meals, and $20 a
day for incidentals. How much of Charlotte's costs can be deducted as a business expense?
a. $- 0 -
b. $400
c. $880
d. $970
e. $1,200
ANSWER: c
38. Three requirements must be met in order to deduct a trade or business expense. Also, deductible trade or business
expenses may not be which of the following:
I. a capital expenditure.
II. reasonable in amount.
III. a payment that frustrates public policy.
IV. an expense related to tax-exempt income.

c. Statements III and IV are correct.
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d. Statements I, II, and III are correct.
e. Statements I, III, and IV are correct.
ANSWER: e
39. An ordinary expense

I. is normal, common, and accepted under the circumstances of the business community.
II. is an expense commonly incurred in an income-producing activity.

ANSWER: c
40. An ordinary expense

I. is an expense commonly incurred in an income-producing activity.
II. is an expenditure that provides future benefits to an income-producing activity.

ANSWER: a
41. All of the following are a required test for the deduction of a business expense except?
a. GAAP approved.
b. Ordinary.
c. Necessary.
d. Business purpose.
e. Reasonable in amount.
ANSWER: a
42. Portia, a CPA, operates a financial and tax planning service. During the months of February, March, and April of
every year, she hires graduate tax students from The University of Chicago as interns. This year she hires 4 interns. One is
her brother, Sidney. She pays all interns except Sidney $20 per hour for help with tax return preparation and tax research.
Sidney receives $25 an hour. She cannot deduct the full amount of Sidney's hourly wages because the expense is not
a. appropriate.
b. ordinary.
c. necessary.
d. reasonable.
ANSWER: d
43. Which of the following payments are currently deductible?

I. Sweeney Corporation pays tuition to an MBA program for Phyllis, the controller.
Amber's Construction Company pays the tuition for Karl's son. Karl is a local building
II.
inspector and has no other relationship with the company.

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ANSWER: a
44. Which of the following payments are currently deductible?

I. Steve is a self-employed attorney. He pays another attorney $14,000 to represent him in a
lawsuit that alleged that he was liable in a personal auto accident.
II. Connie has an investment portfolio in excess of $600,000. She pays Chris $1,000 to do an
analysis of her investments and make recommendations on restructuring the portfolio.

ANSWER: b
45. Which of the following is a currently deductible trade or business expense.

a. $ 5,000 trustee fees paid to a bank to manage tax-exempt securities.
b. $ 12,000 fee paid to a marketing firm for a market analysis for a new business.
c. $15,000 fee paid to a TV station to advertise a new product.
d. $20,000 to an attorney to defend title to a new patent.
e. All of the above are currently deductible expenses.
ANSWER: c
46. Which of the following is/are currently deductible trade or business expenses?
I. Membership dues to an environmental lobbying group.
II. Cost of acquiring a new business automobile.

ANSWER: d
47. Which of the following is/are currently deductible trade or business expenses?
I. Personal property taxes on a hot air balloon operated as a hobby.
II. Interest paid on the mortgage note on a business warehouse.

ANSWER: b
48. Which of the following requirements does not have to be met for a business or investment expense to be deductible:
a. Be ordinary and necessary.

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b. Be reasonable in amount.
c. Be recurring.
d. Be the taxpayer's own expense.
e. All of the above must be met.
ANSWER: c
49. Which of the following is not deductible?

a. Expenses related to earning dividends on a portfolio of "blue chip" stocks.
b. Expenses related to interest income from municipal bonds.
c. Legal expenses related to rental real estate property.
d. Medical expenses of the taxpayer's dependent child.
ANSWER: b
50. Kelly buys a new Lexus for $48,750 in the current year to use in her commercial real estate business. Kelly cannot
deduct the cost of the automobile in the current year, because
a. it is unreasonable in amount.
b. it is not a regularly recurring item.
c. it is a capital expenditure.
d. it is not necessary
ANSWER: c
51. Angel owns a gourmet Mexican restaurant. His head chef, Carmen, is arrested for a parole violation. Because Angel
needs Carmen back to work as soon as possible, Angel pays her bail of $250, attorney's fees of $300, and a court fine of
$200.
I. A business purpose exists for the payments.
II. If Carmen were required to repay the expenditures, it would constitute a loan and not be
deductible for Angel.
III. If Angel does not require Carmen to repay the amounts paid on Carmen's behalf, the
payments constitute compensation and Angel gets a deduction for the expenses paid.

b. Statements I and III are correct.
c. Statements I and II are correct.
d. Statements I, II and III are correct.
ANSWER: d
52. Which of the following expenditures are not deductible because they are personal in nature?
I. Premiums paid on liability insurance for the taxpayer.
II. Education costs that improves the taxpayer's skills in his/her trade or business.

ANSWER: a
53. Which of the following expenditures are not deductible because they are personal in nature?
I. Legal costs to acquire a personal residence.
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II. Losses resulting from the sale of personal residences.

ANSWER: c
54. Diana bought 1,500 shares of Dalton Protection, Inc., common stock for $10 per share. She paid her broker a $300
commission to close the purchase. The following year, Diana sold 1,000 of the shares for $17 per share and paid a
commission of $175 on the sale. What is Diana's capital gain on the sale of the stock?
a. $1,525
b. $2,000
c. $6,625
d. $6,825
e. $7,000
ANSWER: c
55. Wanda owns and operates a restaurant on the north side of Cleveland. She is considering opening a second restaurant
on the south side of town and incurs $13,600 of investigation expenses. In July of the current year, Wanda decides not to
open a second restaurant. How much of the investigation expenses can Wanda deduct in the current year?
a. $- 0 -
b. $5,000
c. $5,120
d. $5,600
e. $13,600
ANSWER: e
56. Kim owns and operates a restaurant on the north side of Indianapolis. She is considering opening a day care center on
the south side of town and incurs $10,400 of investigation expenses. In July of the current year, Kim opens the day care
center. How much of the investigation expenses can Kim deduct in the current year?
a. $- 0 -
b. $5,000
c. $1,540
d. $5,180
e. $10,400
ANSWER: d
57. Davis owns and operates a convenience store on the north side of the city. He has always wanted to operate a sports
bar. When he hears of a new shopping center development in the south part of the city, he contacts the developer and
begins negotiations to open his dream enterprise.
I. If negotiations are successful and Davis incurs $40,000 in start-up costs to open his new
business, he can deduct up to $5,000 of the start-up costs and must capitalize the costs of
investigation and start-up exceeding $5,000.
II. If Davis decides not to open his bar and restaurant, the investigation expenses are fully
deductible.

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ANSWER: a
58. Henry owns a hardware store in Indianapolis. He has decided to expand his business interests and is considering
opening a golf store in a neighboring town. He has incurred $12,000 of expenses investigating whether to open the new
golf store. In July of the current year he finds the perfect location and opens the golf store on October 1. What amount of
the investigation expenses can he deduct in the current year?
a. $- 0 -
b. $600
c. $5,117
d. $5,540
e. $12,000
ANSWER: c
59. Paul owns a lumber yard in Portland. He has decided to expand his business interests and is considering opening a golf
course in Seattle. He has incurred $51,000 of expenses investigating whether to open the new golf course. In January of
the current year he finds the perfect location and opens the golf course on July 1. What amount of the investigation
expenses can he deduct in the current year?
a. $- 0 -
b. $5,100
c. $5,567
d. $6,533
e. $51,000
ANSWER: c
60. Jackie recently retired from the U.S. Coast Guard after 30 years of service. She would like to open a boat shop to
operate in her retirement years. Jackie incurs $3,800 of expenses while investigating sites for her shop and while checking
out boat franchises. What are the tax effects of the expenses Jackie incurs?
I. If Jackie enters the boat business, she can deduct the costs only by capitalizing them and
amortizing them over 180 months.
II. They are not deductible if Jackie does not enter the ski and boat business.

ANSWER: b
61. Which of the following can be deducted as a trade or business expense?

a. Lobbying expenses to influence taxpayers.
b. Political contribution to elect a local Congressman.
c. Illegal bribes to government
d. Rent paid on a office to run an illegal gambling operation.
e. None of the above can be deducted.
ANSWER: d
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62. Oscar drives a taxi on weekends. In maximizing the amount of fares he earns, he occasionally gets tickets for
speeding. Oscar figures that as long as he keeps his traffic violations under $100 over a weekend, he can more than offset
those costs with additional fares. What is/are the tax effect(s) of Oscar's speeding ticket costs?
a. The costs are deductible because they are ordinary and necessary expenses directly related to the business.
b. The costs are deductible because they have a business purpose and the business is not illegal.
c. The costs are not deductible because the business activity is illegal.
d. The costs are not deductible because they are due to violations of law.
ANSWER: d
63. Which of the following expenditures or losses incurred in the context of a trade or business activity is deductible at the
time it is incurred?
a. Aaron owns a local restaurant. He pays the local health inspector a fee of $125 per week, as provided by city
regulation.
b. Beth owns a local delivery company and pays $750 in parking fines during the year with respect to her
delivery vehicles. These fines were unavoidable in the context of her business activity.
c. Brad hires the son of the police chief as the night watchman at his business. The son is paid at the same
weekly rate as other night watchmen in the area, but he does not show up for work on a regular basis.
d. Dotty owns a local nightclub that features live music. She pays $4,600 to purchase a full page ad in the local
newspaper urging citizens to vote against a noise ordinance in the next election that will force her out of
business if passed.
ANSWER: a
64. Bruce operates an illegal drug business. Which of the following is deductible?
a. Commissions paid to dealers.
b. Rent for a warehouse.
c. Bribes paid to local police.
d. Cost of drugs sold.
e. Interest on debt to finance the purchase of inventory.
ANSWER: d
65. Michael operates an illegal cock fighting business. Which of the following expenses is currently deductible?
a. Fines paid to the local authorities.
b. Bribes paid to local police.
c. Rent expense on the enterprise's building.
d. Expenditures to acquire bar and kitchen equipment.
e. None of these expenses are currently deductible.
ANSWER: c
66. Chelsea operates an illegal gambling enterprise out of her restaurant. Considering only the following expenses, what
amount can Samantha deduct?
Building rent $34,000
Secretarial services 12,000
Payments to off-duty policemen to provide security 20,000
Lease payments for cars given to health inspectors 18,000
a. $- 0 -
b. $46,000
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c. $66,000
d. $72,000
e. $84,000
ANSWER: c
67. Which of the following expenses is/are deductible?

I. Transportation and lodging expenses of $4,000 to influence state legislation that may
affect the taxpayer's business.
II. A $4,000 contribution to the mayor’s campaign fund.

ANSWER: d
68. Which of the following expenses is/are deductible?

I. Transportation and lodging expenses of $3,000 incurred to monitor state legislation that
may affect the taxpayer's business.
II. Lobby expenses of $300 during the year to influence local town legislators to support pro-
business legislation.

ANSWER: c
69. Which of the following payments are deductible?

I. Wilcox pays $1,000 to run an add in the program of the state Independent Party
convention
II. Wilcox is in the construction business. In January, he sends his chief financial officer to
Washington, D.C., to monitor current legislation affecting the real estate industry.
Expenses totaled $2,100.
III. In March, Wilcox personally travels to Washington, D.C., to testify before the banking
subcommittee on the effects of proposed legislation on the construction industry. Expenses
totaled $2,300.

c. Only statement III is correct.
d. Statements II and III are correct.
e. Statements I and II are correct.
ANSWER: b
70. Which of the following production of income expenses would be deductible:

I. Interest expense on loan to acquire U.S. Treasury notes.
II. Interest expense on loan to acquire IBM Corporate bonds.

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ANSWER: c
71. Clay incurs $5,000 of investment expenses related to purchasing Renco Company stock and New Orleans municipal
bonds. He receives $6,000 of dividends on the stock and $14,000 of interest on the bonds. The amount of investment
expense Clay can deduct is:
a. $- 0 -
b. $1,500
c. $2,500
d. $3,500
e. $5,000
ANSWER: b
72. Walter pays a financial adviser $2,100 to help him manage his investment portfolio during the current year. Walter
receives $5,000 in interest from investments in General Motors and Xerox bonds, and $2,500 in interest from investments
in City of San Francisco bonds. How much may Walter deduct for the current year?
a. $- 0 -
b. $ 700
c. $1,050
d. $1,400
e. $4,200
ANSWER: d
73. Jennifer pays the following expenses for her dependent 30-year old daughter while the daughter was ill during the
current year:
Real estate taxes on daughter's house $3,000
Utilities on daughter’s house 1,000
Interest on the daughter's home mortgage 8,000
Interest on daughter's car 800
Daughter's medical expenses 6,000
How much of the above expenditures may Jennifer use in computing her itemized deductions?
a. $- 0 -
b. $6,000
c. $9,000
d. $14,800
e. $17,000
ANSWER: b
74. During the current year, Paul came down with a serious illness. Paul's uncle paid many of Paul's expenses during the
period of rehabilitation. For tax purposes, how are Paul's mortgage interest and real estate property taxes handled?
I. Paul can deduct both items.
II. Paul's uncle can deduct both items.
III. Neither Paul nor his uncle can deduct the expenses.

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d. Statements I and II are correct.
ANSWER: c
75. Sadie is a full time nurse and a part time painter. Her painting qualifies as a hobby. Her gross income from painting is
$7,000. Her expenses include $800 of interest on inventory loans, $5,200 of expenses in conducting business activities,
and $2,000 of depreciation of equipment. Which of the following statements about Sadie's hobby activity is/are correct?
I. Sadie will not recognize any taxable income as a result of her hobby.
II. Sadie can deduct the interest of $800 plus $6,200 of other hobby expenses for the year.
III. Sadie will lose at least $1,000 of her depreciation deduction for the current year.
If Sadie uses the standard deduction she will not receive any tax benefit from the hobby
IV.
expenses.
a. Statements I and II are correct.

b. Statements II and III are correct.
c. Statements III and IV are correct.
e. Statements II, III, and IV are correct.
ANSWER: e
76. Several factors are used to determine whether an activity is classified as a hobby or as a business. Which of the
following are factors that aid in this determination?
I. The financial status of the taxpayer
II. The expectation that the assets involved in the activity will increase in value.
III. The taxpayer's success in similar activities.
IV. The amount of personal pleasure and enjoyment that accrues to the taxpayer.
a. Only statements II, III, and IV are correct.

b. Only statement III is correct.
c. Statements I, II, and III are correct.
d. Only statement IV is correct.
ANSWER: e
77. Which of the following factors absolutely must be present for an activity to be considered a trade or business for tax
purposes?
a. The activity is profitable most of the time.
b. Taxpayer has experience in the activity.
c. Taxpayer has a mailing address and phone number for his business that is different from his personal address
and phone number.
d. Taxpayer has a profit motive for engaging in the activity.
e. All of the above factors must be present to have a trade or business activity.
ANSWER: d
78. Which of the following factors are used to aid in determining whether an activity that earns income is profit motivated
and should be treated as a business or is subject to the hobby loss rules?
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I. The amounts of occasional profits, if any.
II. Taxpayer’s success in similar activities.

ANSWER: c
79. Which of the following factors are used to aid in determining whether an activity that earns income is profit motivated
and should be treated as a business or is subject to the hobby loss rules?
I. The taxpayer's financial status.
II. Elements of personal pleasure derived from the activity.

ANSWER: c
80. Virginia, a practicing CPA, receives $11,000 from the sale of rare orchids that she grows. Her expenses of operating
this hobby activity follow:
Property taxes on the structures $4,500
Seeds, fertilizer, and bug sprays. 8,000
Depreciation on the structures 5,000
How much of the expenses that Virginia incurs can be deducted as hobby expenses?
a. $- 0 -
b. $4,500
c. $11,000
d. $12,500
e. $17,500
ANSWER: c
81. Mario paints landscape portraits, and he treats the activity as a hobby. During the current year, Mario incurred the
following expenses while earning $2,500 from sales of paintings:
Paints and supplies $2,200
Utilities expenses for his studio 1,000
Advertising 300
Insurance on his studio and equipment 700
Mario uses the standard deduction and never itemizes his deductions. How should Mario report all of the items related to
his hobby on his tax return?
a. Hobby losses are not allowed so he couldn’t deduct anything whether or not he itemizes anyway.
b. Report a $400 loss as a deduction for AGI.
c. Include $2,500 in gross income and deduct $2,500 for AGI.
d. Include $2,500 in gross income and deduct nothing for AGI.
e. Include $2,500 in gross income and deduct $1,700 for studio expenses.
ANSWER: d
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82. Michelle is a bank president and a weekend artist. She regularly sells her paintings at flea markets and spends an
average of 9 hours a week painting or selling. Although she made about $6,000 last year from sales of artwork, she tells
her friends she would do it for free. For the current tax year, she incurs expenses of $800 primarily for admission fees to
flee markets and art fairs. The $800 is
I. deductible for AGI as a business expense.
II. a miscellaneous itemized deduction.
III. is deductible only because she has revenue from the activity.
a. Only statement III is correct.

b. Only statement I is correct.
c. Statements I and II are correct.
e. Statements I, II, and III are correct.
ANSWER: d
83. Mike and Pam own a cabin near Teluride, Colorado. In the current year the cabin was rented for 8 days to friends.
Mike and Pam used the cabin a total of 82 days during the same year. After allocating the expenses between personal and
rental use, the following rental loss was determined:
Rental income $700
Property taxes (250)
Mortgage interest (300)
Repairs and maintenance (100)
Utilities (150)
Rental loss $(100)
How should Mike and Pam report the rental income and expenses for last year?
a. Report the $100 loss for AGI.
b. Include the $700 in gross income, but no deductions are allowed.
c. Only expenses up to the amount of $700 rental income may be deducted.
d. Report the interest ($300) and taxes ($250) as itemized deductions and the other expenses for AGI.
e. No reporting for the rental activity is necessary.
ANSWER: e
84. Tom and RoseMary own a cabin near Stowe, Vermont. During the current year the cabin is rented for 31 days for
$1,800. Tom and RoseMary used the cabin a total of 12 days during the year. After making the appropriate allocation of
expenses between personal and rental use, the following rental loss was determined:
Rental income $1700
Utilities (300)
Depreciation (200)
Rental loss $(300)
How should Tom and RoseMary report the rental income and expenses for the current year?
a. Include the $1,700 in gross income, but no deductions are allowed.
b. Report the $300 loss for AGI.
c. Only expenses up to the amount of $1,700 rental income may be deducted in the current year.
d. Report the interest ($950) and taxes ($150) as itemized deductions and the other expenses for AGI.
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e. No reporting for the rental activity should be reported.
ANSWER: b
85. Claire and Harry own a house on Hilton Head Island. During the year, Claire and Harry rent the house for 30 days to
friends from Texas for $2,000. Claire and Harry use the house a total of 60 days during the year. After making the
appropriate allocation of expenses between personal and rental use, the following rental loss was determined:
Rental income $2,000
Utilities (300)
Depreciation (400)
Rental loss $(100)
How should Claire and Harry report the rental income and expenses for the forthcoming year?
I. Report the $100 loss for AGI.
II. Only expenses up to the amount of $2,000 rental income may be deducted for the year.
III. Include the $2,000 in gross income, but no deductions are allowed.
IV. Nothing needs to be reported.

c. Statements II and III are correct.
d. Statements III and IV are correct.
e. Statements I and III are correct.
ANSWER: b
86. Marlene is a single taxpayer with an adjusted gross income of $140,000. In addition to her personal residence,
Marlene owns a ski cabin in Vail. She uses the cabin for 40 days during the current year and rents it out to unrelated
parties for 80 days, receiving rent of $10,000. Marlene's costs before any allocation related to the cabin are as follows:
Mortgage interest and property taxes $9,000
Utilities, maintenance, and repairs 4,500
Depreciation 6,000
Based on the above information, what is her allowable depreciation deduction?
a. $- 0 -
b. $1,000
c. $3,000
d. $4,000
e. $6,000
ANSWER: b
87. Jack and Cheryl own a cabin near Copper Mountain, Colorado. During the year, Jack and Cheryl rent the cabin for 30
days to friends for $1,800. Jack and Cheryl use the cabin a total of 60 days during the year. After making the appropriate
allocation of planned expenses between personal and rental use, the following rental loss was determined:
Utilities (300)

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Depreciation (400)
Rental loss $(300)
How should Jack and Cheryl report the rental income and expenses for the forthcoming year?
I. Only expenses up to the amount of $1,800 rental income may be deducted for the year.
II. Only depreciation in the amount of $100 may be deducted.
III. The amount of the disallowed depreciation deduction ($300) can be carried forward.
IV. Nothing needs to be reported.

b. Statements II and III are correct.
c. Statements I, II and III are correct.
d. Statements III and IV are correct.
e. Statements I, II, III, and IV.
ANSWER: c
88. James rents his vacation home for 30 days during the year and lives in it personally for 10 days. He receives rents of
$4,000 and incurs the following expenses before allocation:
Property taxes $2,000
Utilities 800
Depreciation 4,200
What is James' income or loss from the rental property?
a. $- 0 -
b. $1,000 loss
c. $1,250 loss
d. $1,000 income
e. $1,200 income
ANSWER: c
89. Girardo owns a condominium in Key West. During the year, Girardo uses the condo a total of 22 days. The condo is
also rented to vacationers for a total of 78 days and generates rental income of $24,000. Girardo incurs the following
expenses before allocation:
Mortgage interest $8,000
Property taxes 3,600
Utilities 4,000
Insurance 2,400
Depreciation 22,000
The amount of depreciation that Girardo may deduct with respect to the rental property is
a. $7,300
b. $9,960
c. $14,040
d. $17,160
e. $22,000
ANSWER: b
90. Karen owns a vacation home in Door County, Wisconsin. During the year, she rents it out for two weeks and uses it
personally for three weeks. Her expenses directly related to renting out the property were utilities $300, and maid service
$150. The portion of taxes allocable to the rental activity is $600 and revenue from the rental is $1,000. Karen will
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a. report no income and deduct $50.
b. report no income and deduct no rental expenses related to the vacation home.
c. report income of $1,000 and deduct $450 of expenses for adjusted gross income.
d. report income of $1,000 and $150 of expenses from adjusted gross income.
e. report income of $1,000 and deduct $1,000 of expenses for adjusted gross income.
ANSWER: b
91. Landis is a single taxpayer with an adjusted gross income of $280,000. In addition to his personal residence, Landis
owns a vacation home in Beaver Creek, Colorado. He uses the vacation home for 21 days during the current year and
rents it out to unrelated parties for 63 days. After making the appropriate allocation between rental and personal use, the
following rental loss is determined:
Mortgage interest and property taxes (3,200)
Utilities, maintenance, and repairs (6,000)
Depreciation (8,000)
Rental loss $(3,200)
What is the correct reporting of the rental income and expenses?
I. Because the rental shows a loss, Landis reports no income and deducts the mortgage
interest and property taxes as an itemized deduction.
II. Landis must report the $14,000 in rental income but he can deduct only $14,000 of the
expenses.
III. Landis's depreciation deduction is limited to $4,800.
IV. Because the vacation home is a qualified second residence, Landis can deduct the $1,600
loss for adjusted gross income.
a. Only statement II is correct.

b. Only statement IV is correct.
c. Only statement I is correct.
e. Statements II and IV are correct.
ANSWER: d
92. Elise is a self-employed business consultant who operates her business out of an office in her home. The home office
passes the qualifying tests for deducting office in the home expenses. For the current tax year, Elise earns $90,000 from
her business activities. She incurs $82,000 in supplies, travel expenses, wage expense, etc. Elise's mortgage interest and
real estate taxes allocable to the home office space were determined to be $9,000. Also, other expenses including
insurance, repairs and maintenance, utilities, and depreciation allocable to the home office space total $11,000. How much
of the other expenses (insurance, repairs, etc.) can Elise deduct?
a. $- 0 -
b. $2,000
c. $8,000
d. $9,000
e. $11,000
ANSWER: a
93. Frank is a self-employed architect who maintains a qualifying office in his home. Frank has $80,000 gross income
from his practice and incurs $72,000 in salaries, supplies, computer services, etc. Frank's mortgage interest and real estate

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taxes allocable to the office total $3,000. Other expenses total $9,000 and consist of depreciation, utilities, insurance, and
maintenance. Frank's total office in home deductions are
a. $3,000
b. $5,000
c. $8,000
d. $9,000
e. $12,000
ANSWER: c
94. Jim operates a business out of his home. One room in his home is used for business and qualifies as a home office.
Which of the following allocable expenditures can Jim use in computing his home office expense deduction?
I. Jim pays his housekeeper $25 a week to sweep, dust and straighten-up his office.
II. Jim’s fire and casualty insurance premiums on his home are $800.

ANSWER: c
95. In which of the following independent situations is the taxpayer entitled to deduct expenses related to the home office?
I. A real estate agent employed by a local real estate agency owns several rental properties.
She regularly and exclusively uses a second bedroom in her home solely as an office for
bookkeeping and other activities related to management of the rental properties. She has
no other place to perform these functions.
II. An attorney employed by a large law firm frequently brings work home from the office.
She uses a study in her home for doing this work as well as managing her investment
portfolio.

ANSWER: a
96. Safina is a high school teacher. She has set aside one room in her home exclusively as a home office where she grades
papers, prepares for class, etc. No revenues are generated from her activities. Depreciation and maintenance are $800 on
the home office space. How much of the expenses are deductible by Safina?
a. $- 0 -
b. $200
c. $400
d. $500
e. $800
ANSWER: a
97. Generally income tax accounting methods are designed to result in

I. a proper application of the wherewithal-to-pay concept.
II. a proper matching of expenses to the revenues being generated.
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ANSWER: a

I. a tax based on the amount of cash available in the current period to pay taxes.
II. a denial of a current deduction for costs that will not have to be paid in the near future.

ANSWER: c

I. a proper matching of expenses to the revenues being generated.
II. a denial of a current deduction for costs that will not have to be paid in the near future.

ANSWER: b
100. William, a single taxpayer, has $3,500 state income tax withheld from his paychecks in 2015. When he filed his 2015
state income tax return on April 15, 2016, he calculated and received a $600 refund. The $600 refund was received on
May 27, 2016. What are the federal tax effects of the state income tax events of 2015 and 2016?
If his itemized deductions including state income taxes total $6,000 in 2015, William
I.
includes $300 in gross income for 2016,
If he did not itemize his deductions in 2015, none of the refund is included in 2016 gross
II.
income.

ANSWER: c
101. Jenny, an individual cash basis taxpayer, has $6,000 of state income taxes withheld from her salary during 2016.
When she filed her 2015 state income tax return during April 2016, she paid an additional $500 in state income taxes.
When she filed her 2016 state income tax return in April 2017, she received a $200 refund. What is her state income tax
deduction for 2016 for federal income tax purposes?
a. $500
b. $5,800
c. $6,000
d. $6,300
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e. $6,500
ANSWER: e
102. Harold, a cash basis taxpayer, borrows $65,000 for his business on a 2-year note from First City Bank on December
1, 2016. To close on the loan agreement, Harold is required to prepay interest of $4,800 on December 1. How much
interest can Harold deduct in 2016?
a. $- 0 -
b. $200
c. $400
d. $2,400
e. $4,800
ANSWER: b
103. Amy borrowed $25,000 for her business from a local bank two years ago. To increase her deductions for 2016, she
pays December interest of $400 and prepays January and February interest totaling $800 on December 30, 2016. The
maturity date of the note is November 30, 2017. How much of the interest that she paid in December is deductible in
2016?
I. If she is a cash-basis taxpayer, Amy's interest deduction is $1,200.
II. If she is an accrual-basis taxpayer, Amy's interest deduction is $400.

ANSWER: b
104. Janine, a cash-basis taxpayer, borrowed $15,000 for her business from a local bank three years ago. To increase her
deductions for 2016, she pays December interest of $150 and prepays January and February interest totaling $300. The
maturity date of the note is November 30, 2017. How much of the interest is deductible in 2016?
a. $-0-
b. $150
c. $300
d. $450
ANSWER: b
105. Electronic City sells various electronic products. With each of its products, Electronic City offers customers the
option of purchasing a repair contract. Under the contracts, Electronic City will make repairs anytime during the term of
the contract. Electronic City estimates that repair costs related to this year's sales will be $39,000. During the current year,
Electronic City incurs repair costs of $37,000 related to prior year's contracts and $4,000 on contracts sold this year.
I. If Electronic City accounts for the contracts using the accrual method of accounting, its
repair cost deduction is $39,000.
II. If Electronic City accounts for the contracts using the cash method of accounting, its repair
cost deduction is $41,000.

Chapter 5
ANSWER: b
106. Christy purchases $1,000-worth of supplies from a local vendor. The supplies are delivered on March 29, 2016. The
supplies are fully used up by year end. Because of unusual circumstances, a bill for the supplies arrives from the vendor
on January 10, 2017, and is promptly paid. When can Christy deduct the expenses?
I. In 2016, if she is an accrual basis taxpayer.
II. In 2017, if she is a cash basis taxpayer.

ANSWER: c
107. Sergio purchases $3,000-worth of supplies from a local vendor. The supplies are delivered on April 1, 2016. The
supplies are fully used up on December 31, 2016. Because of unusual circumstances, a bill for the supplies arrives from
the vendor on February 1, 2017, and is promptly paid. When can Sergio deduct the expenses?
I. In 2016, if he is an accrual basis taxpayer.
II. In 2016, if he is a cash basis taxpayer.

ANSWER: a
108. In which of the following circumstances would a cash basis taxpayer be required to account for an item of income or
deduction under the accrual method of accounting?
a. Alice receives advance payment for services that she will perform and complete by the end of the following
tax year.
b. Ben paid his business property taxes at year-end even though they were not due until the end of January.
c. Cheryl received six months of pre-paid rent on her rental property just before the end of the year.
d. Donald prepaid a one-year service contract on his copy machine just before year-end.
e. A cash basis taxpayer will not be required to use the accrual basis method of accounting in any of the above
circumstances.
ANSWER: e
109. The all-events test requires that

I. All events have occurred that determine a liability exists
II The due date for payment of the liability has been established
III. The amount of a liability is determined with reasonable accuracy.

b. Statement I and II are correct.
c. Statement I and III are correct
e. Only statement III is correct
ANSWER: c
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110. If someone provides a taxpayer with either property or services, economic performance occurs when
a. The taxpayer actually uses the property.
b. The property or services are actually provided.
c. The liability to pay for the property or services exists.
d. The taxpayer pays the other person for the property or services.
ANSWER: b
111. Twin City Manufacturing Corporation is an accrual basis taxpayer. Twin City Manufacturing provides medical
insurance for its employees through a self-insured reimbursement plan. Twin City Manufacturing pays $100 per month
per employee into the plan fund. The fund is then used to reimburse employees' medical expenses. During the current
year, Twin City Manufacturing Corp. pays $12,000 into the fund and pays medical reimbursement claims of $10,600.
I. If Twin City Manufacturing is an accrual basis taxpayer it can deduct $12,000.
II. If Twin City Manufacturing is a cash basis taxpayer it can deduct $10,600.

ANSWER: b
112. An accrual basis taxpayer may deduct expenses in the year in which certain tests are met. These tests include
I. when services or property are provided to the taxpayer or when the taxpayer uses the
property.
II. when the "all-events test" is met.
III. when "economic performance" has occurred.
IV. when all events have occurred to determine that a liability exists and the amount of the
liability can be determined with reasonable accuracy.

c. Statements I and IV are correct.
ANSWER: e
113. If a taxpayer owes interest, economic performance occurs

I. with the passage of time.
II. when the all-events test is met.
III. when payments are made by the taxpayer.

e. Statements I, II, and III are correct.
ANSWER: a
114. Angela is an accrual basis taxpayer. On September 1 of the current year, she prepays the annual premium of $4,800
for a one-year fire insurance policy on the contents of her business warehouse. The expense is not material for either
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financial or tax purposes. The prepayment is necessary to activate the insurance coverage and maintain annual renewals.
How much may Angela deduct in the current year?
a. $- 0 -
b. $ 400
c. $1,600
d. $2,400
e. $4,800
ANSWER: e
115. An exception to the economic performance test allows the deduction of year-end accruals if
I. The liability exists and the amount of the liability can be reasonably estimated.
II. Economic performance occurs within the shorter of 8 1/2 months after the close of the tax
year or a reasonable time after the close of the tax year

ANSWER: c
116. An exception to the economic performance test allows the deduction of year-end accruals if
I. Either the expense is not material for both tax and financial purposes or the accrual results
in a better matching of revenue and expenses.
II. The taxpayer consistently treats the item as incurred in the year the all events test is met.

ANSWER: c
117. Due to a shortage of cash, East Coast Entertainment Company, an accrual basis taxpayer, could not pay its November
2016 utility bill on time. In February of 2017, East Coast Entertainment pays the utility bill.
I. East Coast can deduct the expense on either its 2016 or 2017 tax return.
II. East Coast cannot deduct the utility expense in 2016 because it is paid in 2017.

ANSWER: d
118. Indicate which of the following statements is/are correct:

I. An accrual basis taxpayer who gives a creditor his note payable in payment of a claim may
deduct the related expense when the note is given.
II. When a cash basis taxpayer uses a credit card to pay for an expense it can deduct the
expense when the expense is charged to the credit card..

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ANSWER: c
119. Indicate which of the following statements is/are correct:

I. A cash basis taxpayer may deduct prepaid rent if it will be used-up within one year of
prepayment and the payment is required to be made.
II. An accrual basis taxpayer must satisfy an all-events test and an economic performance test
to claim a deduction.

ANSWER: c
120. Richard, a cash basis taxpayer, is an 80% owner and president of WLFI TV. WLFI TV is an S corporation and uses
the accrual method of accounting. On December 1, 2016, WLFI TV accrues a bonus of $50,000 to Richard. The bonus is
payable on January 31, 2017. In what year does Richard report the income and WLFI TV take the deduction?
Richard WLFI TV
a. 2017 2016
b. 2017 2017
c. 2016 2016
d. 2016 2017
ANSWER: b
121. Harold is a 90% owner of National Homes Construction, an accrual basis S corporation. On December 30, 2015,
National Homes accrues a $100,000 bonus to Harold, payable on February 15, 2016.
I. If Harold is an accrual basis taxpayer, National Homes deducts the bonus in 2015 and
Harold reports the income in 2016.
II. If Harold is a cash basis taxpayer, National Homes deducts the bonus in 2015 and Harold
reports the income in 2016.

ANSWER: d
122. For its financial accounting records Addison Company uses the allowance method to account for bad debts and
estimates the balance in the "Allowance for Bad Debts" account using the aging method. For tax purposes, the allowance
method cannot be used. The rationale for not allowing this method is
a. The arm’s length transaction concept has not been met.
b. The all-events test has not been met.
c. The Business Purpose Concept has not been met.
d. Lack of constructive payment.
ANSWER: b
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123. Income tax accounting methods and financial accounting methods differ in many ways. Which of the following tax
law provisions are likely to create permanent differences between taxable income and financial (or book) income of a
single entity?
I. Treatment of payment of penalties and fines.
II. Disallowance of 50% of the cost of business meals and entertainment.

ANSWER: c
124. Income tax accounting methods and financial accounting methods differ in many ways. Which of the following tax
law provisions are likely to create permanent differences between taxable income and financial (or book) income of an
entity?
I. The cost of certain property is allowed to be deducted in the year of acquisition rather than
through regular depreciation methods.
II. Tax depreciation is computed over a statutory life rather than the asset's useful life.

ANSWER: d
125. Dustin, Dan, and Dennis operate Heritage Hills dry cleaners as an S corporation. Dustin owns 50% of the business,
Dan 30%, and Dennis 20%. For the current year, Heritage Hills reports the following:
Trade and business expenses (185,000)
Charitable contributions (5,000)
Short-term capital losses (4,000)
Long-term capital gains 12,000
How must Heritage Hills report its results to each of the owners?
ANSWER: Because capital gains and losses, and charitable contributions are subject to special rules, these items cannot
be used to calculate ordinary taxable income. Instead, these items must be reported separately by the S
corporation. The long-term capital gains along with the short-term capital losses are reported separately and
netted with the individuals other capital gains and losses.
The ordinary taxable income of the S corporation is $215,000 ($400,000 sales - $185,000 trade and business
expenses). The taxable income and the separately reported information is allocated to Dustin, Dan, and Dennis
based on their percentage of ownership. Heritage Hills reports the following amounts to each shareholder:
100% 50% 30% 20%

Total Dustin Dan Dennis
Taxable ordinary
$215,000 $107,500 $64,500 $43,000
income
Long-term capital
12,000 6,000 3,600 2,400
gain
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Short-term capital
(4,000) (2,000) (1,200) (800)
loss
Charitable
5,000 2,500 1,500 1,000
contributions
126. List the criteria necessary for an expenditure to be deductible as a trade or business expense or an expense for the
production of income.
ANSWER: To be deductible an expenditure must be
- ordinary
- necessary
- reasonable in amount
- not personal
- not a capital expenditure
- not a payment that frustrates public policy
- not related to tax-exempt income
- not another person's expense
127. Discuss whether the following persons are currently engaged in a trade or business:
a. Darlene has expenses related to managing her portfolio of securities. The trading of the
securities generates most of her annual income. She generally does not hold securities long-
term. She buys and sells continuously. She has no other job.
b. Mark incurs expenses related to investing in stocks and bonds. Mark is a Sociology
professor at Indiana University but spends 10-15 hours per week on his investments.
Approximately 70% of Mark's annual income come from his investments as dividends and
interest.
c. Paul leases real estate to Floyd's Barber Shop for a parking lot. The only expense he incurs is
legal expense regarding the lease, which he renegotiates annually.
d. Mandy owns several rental apartments. She arranges for repairs and maintenance, pays for
the expenses related to the properties, and handles all leasing activities.
ANSWER: a. Yes. This is her primary income-generating activity. She has no other job. She is actively
engaged in the activity through her management of her securities portfolio.
b. No. Although almost 70% of his income comes from the investments, this is not Mark's
primary activity. This is not his livelihood. He is primarily an employee of Local
University. Most of his time is spent engaged in his duties as a professor.
c. No. Leasing the property is not a trade or business for Paul. Paul is not actively involved
with the lease activity. He does nothing other than sign the lease.
d. Yes. Mandy actively manages the property. She performs all of the necessary duties to
manage the enterprise.
128. Discuss whether the following persons are currently engaged in a trade or business:
a. Katerina owns 35 home sites in and around Orlando. She bought these vacant lots several
years ago in hopes to developing them into a subdivision. She begins to develop the lots in
the current year.

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b. John spends 2 hours a day, 5 days a week, managing his investment portfolio. He watches
the market and buys and sells securities when he thinks the market is right. His investment
strategy is to realize dividends, interest, and long-term gains from holding the investments.
c. Bill lives in Miami and works full-time betting on dog races. Although he intends to win
large sums, he has failed to win the big one. He considers his betting activities his job and
relies on his meager winnings to support his family. He is devoted to the races and has
rarely missed a day betting in over 3 years.
ANSWER: a. Yes. Katerina is actively engaged in developing the lots for resale.
b. No. John is an investor. He realizes income from holding the securities long-term. He is not
an active trader or dealer in securities.
c. Yes. Bill is actively engaged in the gambling endeavor. He works at it full-time, and
supports his family with the winnings.
129. Larry is a history teacher. He subscribes to several periodicals about teaching history and judging history fairs. This
year Larry spends $285 on subscriptions to various periodicals. Discuss the deductibility of the expenditures for tax
purposes.
ANSWER: Larry is an employee. Therefore, he provides a service to his employer. The expenditure is incurred within
Larry's trade or business of being an employee and is ordinary, necessary, and reasonable to his employment.
The expense as an unreimbursed business expense, deductible as a miscellaneous itemized deduction.

However, students may not be aware of this type of deduction. The discussion about miscellaneous itemized
deductions occurs in Chapter 8.
130. Discuss whether the following expenditures meet the ordinary, necessary, and reasonable requirements for
deductibility.
a. Mortimer owns a shoe store. Every August Mortimer has a "Back-to-School" sale. To
promote that event Mortimer spends $2,000 on newspaper and radio advertising.
Generally, this event generates about $85,000 in sales. These sales revenues are about
twice the level of sales in other months.
b. Wilma bought a small manufacturing business that had been declared bankrupt. To retain
the current sales force, she pays some of the obligations owed to these people by the
former owners. Wilma has no legal obligation to pay these debts.
c. Ned owns a large sporting goods store. Nick's 17-year-old son, Tony, works in the store
when time permits. Nick pays Tony $10 per hour because he has worked in the store
several years. Other high school age individuals also work at the store and perform
functions requiring less experience than Tony. They are paid $8 per hour.
d. Art is a self-employed CPA. Last month he attended an AICPA Continuing Education

course that cost him $750. In addition to the course registration fee, Art incurred $800 in
travel expenses to attend the course.
e. Elvira is a stockholder in over 100 different corporations. However, she does not own
more than 10 shares of stock in any one company. She enjoys attending annual
stockholder meetings and often gives her "two cents worth" about issues affecting the
companies' operations. In the past year Elvira spent $7,540 to attend the stockholder
meetings to help protect her investments.

Chapter 5
ANSWER: a. The advertising is ordinary because it is common to advertise big events. It is necessary
because it helps to promote the sale. It is reasonable because the amount is a relatively small
percentage of the revenues he expects from the sale, and because of the relative high level of
August sales when compared to other months. Therefore, the $2,000 is deductible.
b. The payments are necessary in that they are appropriate and helpful. The payments are likely
reasonable in that the obligations are created in the normal course of business. Accordingly,
the amounts could be deemed normal and not excessive. However, the payments are not
ordinary. It is not common to pay the debts of others. Also, the payments are in the nature of
capital expenditures to build a positive reputation.
c. The amount of Tony's pay is reasonable because of his previous experience and not just
because he is the owner’s son. Ned will be allowed to deduct the entire $10 per hour for the
time Tony works. The $8 per hour paid to the other students is not only reasonable, but it is
also ordinary and necessary.
d. All of the costs of attending the course are ordinary, necessary, and reasonable. The purpose
of the expenditures is directly related to Art's business. The expenditures are deductible as
education expenses.
e. The $7,540 expenditure to attend the meetings is not considered ordinary because a prudent
businessperson in the same situation would not make such a large expenditure on small
investments. Also, it is quite likely that the $7,540 is greater than her investment in the
stock. Therefore, the amount spent is not reasonable.
131. Using the tests for deductibility discussed in Chapter 5, explain why the following expenses are not deductible.
a. Mel is a sprint car racer. He does repair and maintenance on his cars in the garage at his
home. After repairing the cars, he tests them on city streets. He received 15 citations
(totaling $2,900) for speeding, running stop signs, and reckless driving.
b. Albert, a carpenter, pays his 10-year-old son $150 a week to empty waste cans in his work
shop. Albert's son works each evening and two hours on Saturday morning.
c. Sharon contributes $25 to a local organization that is campaigning against a foreign trade
bill. The legislation would damage Sharon's business.
d. Marline borrows $5,000 and pays $500 in interest. The loan is used to purchase bonds
issued by the City of Lafayette School District.
e. Christine is the wife of a physician, and she is an experienced horseman. She has raised
horses for ten years and occasionally shows them for prize money. She also boards horses
for monthly fees. She enjoys her horse activity but has never made a profit in any year.
Her horses are appraised at $200,000.
ANSWER: a. The citations are violations of public policy. Fines are not deductible.
b. The pay is not reasonable. Someone, other than a related party, would not receive $150 for
emptying waste cans. The reasonable portion of the pay is deductible.
c. Lobbying and expenditures to influence public opinion about legislation are not deductible.
Technically, these expenditures are deemed to lack the ordinary and necessary requirements
for deducting business expenses.

Chapter 5
d. The interest expense is incurred to earn tax-exempt income and is not deductible. Allowing
the deduction violates the Ability-to-Pay Concept.
e. Christine is an experienced horseman, she carries on the trade regularly, and her horses are
appraised at a substantial amount. She is in a trade or business.
132. Using the general tests for deductibility, explain why the following expenses are not fully deductible.
a. Irene spends $1,600 on a trip to Florida to investigate opening up a consulting firm. Irene
currently works for a consulting firm.
b. Augie and his wife divorce during the current year. Augie pays $3,000 in legal fees related
to the divorce.
c. Peter owns a hardware store. During the current year, he pays $328,000 to acquire a new
warehouse.
d. Paul contributes $25 to a fund to be used for advertising to persuade voters to vote against a
candidate running for Congress.
ANSWER: a. Because Irene is already in the consulting trade, she may be able to deduct the trip as a
business expense. But she will have to substantiate that the trip was primarily for the
business trip, and was not mainly personal pleasure.
b. The primary purpose of the legal fees is personal. Only those personal expenditures that are
specifically allowed by the tax law are deductible. There is no provision that allows the
deduction of personal legal fees.
c. The warehouse is a capital expenditure. Therefore, the $328,000 cost is capitalized and
deducted over the tax life of the warehouse using the appropriate depreciation method
under the tax regulations.
d. Expenditures that frustrate public policy are disallowed. Political contributions and
amounts paid to influence public opinion are specifically disallowed.
133. Using the tests for deductibility discussed in Chapter 5, explain why the following expenses may not be fully
deductible in the current year
a. Janet pays $900 in interest on debt she incurred to purchase municipal bonds. The bonds pay
$1,500 of interest in the current year.
b. Andrew owns a retail-clothing store. Andrew has the opportunity to obtain a franchise to
operate a discount sporting goods store. He spends $5,000 investigating the possibility of
opening a sporting goods store in a neighboring town.
c. Jane owns a fitness center. She employs the star basketball player at Local University as an
aerobics instructor. Because of his reputation, she pays him $20 an hour. Jane pays her other
aerobics instructors $10 an hour.
d. Alvin makes a vacation trip to Florida, and while there spends two days investigating the
feasibility of opening up a new office of his optometry practice.
ANSWER: a. Expenses paid to produce tax-exempt income are not deductible. Because the interest on the
municipal bonds is excluded from gross income, Janet cannot deduct the interest on the loan
to purchase the bonds.

Chapter 5
b. Capital expenditures are not deductible. Because the sporting goods store is not in the same
line of business as Andrew's clothing store, the $5,000 is a start-up cost. If Andrew opens
the sporting goods store, the $5,000 is currently deductible. If Andrew does not open the
sporting goods store, the $5,000 is a personal, nondeductible expenditure.
c. Deductible expenses must be reasonable in amount. If the extra $10 an hour that Jane pays
the basketball star is not reasonable under the circumstances, then she cannot deduct the
extra $10 an hour.
d. Personal expenses are not deductible. So Alvin will be unable to deduct most of his travel
expenses.
134. The Wilson Corporation incurs the following expenses. Explain whether the following expenses should be
capitalized or deducted in the current period.
a. Paid $2,500 to blacktop a gravel parking lot.
b. Paid $1,900 for new tires on the truck.
c. Paid $3,000 for a new fire and security alarm system for the factory.
Paid $6,250 to paint the interior and exterior of the office and factory building that it just
d.
acquired.
e. Paid $1,200 for a new compressor for the factory's central air conditioning system.
ANSWER: Repair and maintenance expenditures are currently deductible as an expense. These expenditures do not
extend the asset's useful life or add to its value. Repairs and maintenance expenditures keep the asset in normal
operating condition. The repairs and maintenance listed above include (b) new tires for the truck; and (e)
repairing the air conditioning.
Capital expenditures that provide benefits to more than one accounting period are not currently deductible.
Blacktopping the parking lot (a) increases the value of the property and the use of the newly surfaced parking
lot benefit several accounting periods. The alarm system (c) increases the value of the building and the alarm
system will be used for several accounting periods. Painting the office and building should be capitalized
because the building is a new acquisition, and it is really part of the acquisition cost.
135. Using the tests for deductibility discussed in Chapter 5, explain why the following expenses may not be fully
deductible in the current year.
a. Antonio is the owner of a restaurant. His business has been growing, and Antonio
determines that he needed to add more seating capacity. He builds a patio garden section
onto the back of the restaurant at a cost of $70,000.
b. Tina owns a construction company. Because she is behind schedule on a project, she pays
a city building inspector $500 to get him to come out and do his inspection a week before
he had scheduled the inspection.
c. Claude is a graduate of State University and an avid supporter of the school's athletic
program. During the summer he employed State's star running back in his pool cleaning
business. He paid the football player $15 an hour, although other employees doing similar
work are only paid $10 per hour.
d. Melody owns a chain of coffeehouses. When she opened a coffeehouse in a new city this
year, she spent $20,000 advertising the new store. Even though this is much more than she

Chapter 5
typically spends on advertising, she felt that it was reasonable because the new
coffeehouse has the potential to be a very profitable venture for many years.
ANSWER: a. The addition of the patio garden section is a capital expenditure. The expenditure has a
usefulness that extends substantially beyond the end of the year of the expenditure. The
patio garden represents expanded capacity and cannot be deducted in the current period. It
must be capitalized and depreciation over its tax life.
b. Payments that frustrate public policy are not deductible. The payment to the building
inspector is an illegal bribe and therefore, it is not deductible.
c. To deduct compensation, the amount of the compensation must be reasonable in amount.

The running back is paid $5 ($15 - $10) more per hour than other employees doing
comparable work. Since their is no indication that the extra payment is for a skill related to
the job, the $5 per hour payment would not be deductible. However, Claude can deduct
the $10 per hour that is considered reasonable.
d. Even though the special advertising is large relative to her normal advertising and does
benefit future periods, it is not a capital expenditure. Such promotional advertising is an
ordinary and necessary expense of opening a new store (all businesses normally make
larger expenditures upon the opening of a new store). Although the amount is large, it
would not be unreasonable under the circumstances. Melody can deduct the entire $20,000
as a current period expense.
136. Explain the rationale for disallowing the deduction for interest expense attributable to money borrowed to acquire
tax-exempt municipal bonds.
ANSWER: Municipal bond interest is excluded from gross income. A double benefit would result if the current rules did
not exist. For example, a taxpayer in the 35% tax bracket could borrow funds at 7%, invest the money in
municipal bonds at 5%, and realize a profit simply because the interest expense is deductible. The after-tax
interest cost to a taxpayer in the 35% tax bracket is 4.55% [7% ⋅ (1 - tax rate of .35)].
137. Cornelius owns a condominium in Orlando. During the year, Cornelius uses the condo a total of 25 days. The condo
is also rented to vacationers for a total of 75 days and generates rental income of $9,000. Cornelius incurs the following
expenses:
Utilities 2,000
Insurance 1,200
Depreciation 10,000
Determine Cornelius's deduction related to the condominium. Indicate the amount of each expense that can be deducted
and how it would be deducted.
ANSWER: The rental is a vacation home because Cornelius' personal use of the condominium is greater than 14 days.
Cornelius' allowable deductions are limited to the $9,000 in rental income. Further, the interest and property
taxes must be allocated first and the depreciation last in determining the make-up of the maximum $9,000
deduction. Mortgage interest and property taxes allocated to Cornelius' personal use of the condominium are
deductible as itemized deductions. The costs are allocated based on number of days as rental to the total days
used.
Allocated expenses:
Interest & taxes $5,800 ⋅ 75/100 (4,350)
Balance of income $4,650
Utilities & Insurance $3,200 ⋅ 75/100 (2,400)
Balance of income $2,250
Chapter 5
Depreciation $10,000 ⋅ 75/100 = $7,500
(2,250)
Limited to:
Income from rental $-0-
Cornelius can also deduct the $1,450 ($5,800 - $4,350) in interest and taxes not allocated to the rental as an
itemized deduction. The $5,250 ($7,500 - $2,250) of depreciation not deducted in the current year can be
carried forward to offset rental income in future years.
138. Wilson owns a condominium in Gatlinburg, Tennessee. During the current year, she incurs the following expenses
before allocation related to the property:
Utilities 1,000
Maintenance fees 1,300
Repairs 800
Depreciation 6,000
a. For each of the following scenarios indicate whether Wilson would treat the condominium
for income tax purposes as personal use property, a rental or a vacation home.
Rental Rental Personal Personal, rental,

Case
Income Days Use Days or vacation
A $10,000 300 0
B 7,000 60 10
C 15,000 60 20
D 2,000 10 40
E 11,000 280 20
b. Consider Case C. Determine Wilson’s deductions related to the condominium. Indicate the
amount of each expense that can be deducted and how it would be deducted.
ANSWER: a.
Rental Rental Personal Personal, rental, or
Case
Income Days Use Days vacation
A $10,000 300 0 Rental
B 7,000 60 10 Rental
C 15,000 60 20 Vacation
D 2,000 10 40 Personal Use
E 11,000 280 20 Rental
b.

Chapter 5
Income $15,000
Expenses
Mortgage Interest [(60 ⎟
7,500
80) ⋅ $10,000]
Taxes [(60 ⎟ 80) ⋅ $4,000] 3,000
Utilities [(60 ⎟ 80) ⋅
750
$1,000]
Maintenance [(60 ⎟ 80) ⋅
975
$1,300]
Repairs [(60 ⎟ 80) ⋅ $800] 600
Depreciation [(60 ⎟ 80) ⋅
2,175 $15,000
$6,000 = $4,500] Limited to
Wilson can deduct $15,000 in allocated rental expenses, enough to offset the $15,000 of income. Since the
personal usage is greater than 14 days, the rental portion cannot generate a loss. The $15,000 consists of
$10,500 of interest and taxes, $2,325 of other deductions and the remaining $2,175 is from depreciation. If
Wilson itemizes, he can deduct $2,500 of mortgage interest and $1,000 of property taxes. In addition, the
$2,325 ($4,500 - $2,175) of depreciation not deducted in the current year can be carried forward to offset
rental income in future years.
Match each statement with the correct term below.

a. Specifically disallowed.
b. Appropriate and helpful.
c. Considered a trade or business.
d. Not considered a trade or business.
e. Problems with this generally arise with related parties.
f. This is met when services or property are provided to the taxpayer.
g. Normal, common, and accepted but not necessarily regularly recurring.
h. This is met when the existence and the amount of a liability have been established.
139. Active Trader

ANSWER: c
140. Active Investor

ANSWER: d
141. All-events Test

ANSWER: h
142. Economic Performance

ANSWER: f
143. Necessary Expense

ANSWER: b
144. Ordinary Expense

ANSWER: g
145. Personal Expense

Chapter 5
ANSWER: a
146. Reasonable Expense

ANSWER: e
Match the proper deduction method with the correct expenditures.

a. Capitalized and amortized over a number of accounting periods
b. Expensed in the period incurred
c. Not deductible
d. Can be capitalized and amortized or deductible depending on the amount of the expenditure
147. Betterment
ANSWER: a
148. Covenant not to compete for 4 years

ANSWER: a
149. Fire and casualty insurance premium on business warehouse

ANSWER: b
150. Hobby loss

ANSWER: c
151. Illegal gambling operation expenses

ANSWER: b
152. Investment expenditures related to earning interest from municipal bonds

ANSWER: c
153. Federal lobbying expenditures

ANSWER: c
154. Organization costs

ANSWER: d
155. Political contributions

ANSWER: c
156. Premiums the insured taxpayer pays for life insurance

ANSWER: c
157. Repair-and-maintenance expenditures

ANSWER: b
158. Start-up costs over $5,000.

ANSWER: d
Match each statement with the correct term below.

Chapter 5
a. Automobile used 75% for business.
b. Investment expenses on municipal bonds.
c. Cost of investigating a new trade or business that the taxpayer enters.
d. Can be separated into two classifications.
e. Safety-deposit box for taxable investments.
f. Expenditure to influence legislation.
g. Cost of a new roof for office building.
h. Relates to an income producing activity mainly carried on for recreation or personal enjoyment.
i. Deductibility depends on income and amount of personal and rental use.
j. Deductibility depends on whether the area is used exclusively for trade or business activities.
159. Amortizable or deductible expense

ANSWER: c
160. Capital expenditure

ANSWER: g
161. Hobby expense

ANSWER: h
162. Home office deduction

ANSWER: j
163. Lobbying expense

ANSWER: f
164. Mixed-use asset

ANSWER: a
165. Non-deductible expense

ANSWER: b
166. Production-of-income expense

ANSWER: e
167. Profit motivated business expenses

ANSWER: d
168. Vacation home expense

ANSWER: i

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Chapter 5

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19. Which of the following is an example of a business purpose as dominant motive?

a. Only statement I is correct.

20. The Business Purpose Concept means

a. Only statement I is correct.

a. Statements I and II are correct.

22. Business expenses include

a. Only statement I is correct.

23. A business expense includes

a. Only statement I is correct.

26. Which of the following is/are trade or business expenses?

a. Only statement I is correct.

27. Which of the following is/are trade or business expenses?

a. Only statement I is correct.

28. Which of the following people is currently engaged in a trade or business?

a. Only statement I is correct.

a. Only statement I is correct.

30. Which of the following individuals is involved in a trade or business?

a. Only statement I is correct.

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a. Only statement I is correct.

a. Only statement II is correct.

a. Only statement I is correct.

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a. Only statement I is correct.

39. An ordinary expense

a. Only statement I is correct.

40. An ordinary expense

a. Only statement I is correct.

43. Which of the following payments are currently deductible?

a. Only statement I is correct.

44. Which of the following payments are currently deductible?

a. Only statement I is correct.

45. Which of the following is a currently deductible trade or business expense.

a. Only statement I is correct.

a. Only statement I is correct.

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49. Which of the following is not deductible?

a. Only statement I is correct.

a. Only statement I is correct.

a. Only statement I is correct.

a. Only statement I is correct.

a. Only statement I is correct.

61. Which of the following can be deducted as a trade or business expense?

67. Which of the following expenses is/are deductible?

a. Only statement I is correct.

68. Which of the following expenses is/are deductible?

a. Only statement I is correct.

69. Which of the following payments are deductible?

a. Only statement I is correct.

70. Which of the following production of income expenses would be deductible:

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a. Statements I and II are correct.

a. Only statements II, III, and IV are correct.

a. Only statement I is correct.

a. Only statement I is correct.

a. Only statement III is correct.

a. Only statement I is correct.