Taxation of Individuals and Business Entities
Advanced Prep: Master Income Recognition,
Deductions, and Property Transactions Practice
Questions & Detailed Explanations (Part 2)
Subject: Federal Income Taxation – Advanced Conceptual Applications
(Questions 31–60)
Question 31: Under the "All-Events Test" for accrual-basis taxpayers, an expense is deductible
when the fact of the liability is established and the amount can be determined with reasonable
accuracy. What is the additional requirement for the "economic performance" rule regarding
services provided to the taxpayer?
A) The liability must be paid in cash within 30 days.
B) Economic performance occurs only as the services are provided to the taxpayer.
C) The services must be provided by an unrelated party.
D) The liability must be reflected on audited financial statements.
Correct Answer: B) Economic performance occurs only as the services are provided to the
taxpayer.
Explanation: Under Section 461(h), economic performance is a critical hurdle for accrual-basis
deductions. If the taxpayer’s liability arises from services or property provided TO the taxpayer,
economic performance occurs as the services or property are provided. This prevents taxpayers
from deducting future-year liabilities merely because the obligation is fixed.
Question 32: A taxpayer receives $10,000 for a covenant not to compete in connection with the
sale of their business. How is this payment characterized for federal tax purposes?
A) It is treated as an amount realized on the sale of goodwill, qualifying for long-term capital
gain.
B) It is treated as ordinary income.
C) It is treated as a tax-free gift from the purchaser.
D) It is treated as a dividend if the purchaser is a corporation.
Correct Answer: B) It is treated as ordinary income.
,Explanation: Payments received for a covenant not to compete are generally treated as ordinary
income, regardless of whether they are received as a lump sum or in installments. Unlike
goodwill, which may be a capital asset, a covenant not to compete is a promise to refrain from
doing something, making the payment compensation for lost opportunity, which is taxed as
ordinary income.
Question 33: When a taxpayer exchanges real estate held for investment for other real estate
held for investment, and receives "boot" in addition to the property, which of the following is
true regarding the recognized gain?
A) The recognized gain is the lesser of the realized gain or the boot received.
B) The recognized gain is always equal to the boot received.
C) No gain is recognized if the value of the boot is less than 10% of the total exchange.
D) The recognized gain is the entire realized gain, regardless of the boot.
Correct Answer: A) The recognized gain is the lesser of the realized gain or the boot
received.
Explanation: In a Section 1031 like-kind exchange, the presence of boot (non-like-kind property,
such as cash or debt relief) triggers the recognition of gain. However, the taxpayer never
recognizes more gain than was actually realized in the transaction. Therefore, the gain
recognized is the lesser of the realized gain or the fair market value of the boot received.
Question 34: An S corporation has three shareholders, each owning one-third of the stock. The
corporation incurs a $90,000 net loss for the year. What is the maximum loss a shareholder can
deduct on their personal return?
A) $30,000, provided they have sufficient basis in their stock and debt.
B) $90,000, because they are an owner.
C) $0, because losses must be deducted by the corporation.
D) $30,000, regardless of their stock basis.
Correct Answer: A) $30,000, provided they have sufficient basis in their stock and debt.
Explanation: S corporation losses flow through to shareholders pro-rata. However, Section
1366(d) limits the deductibility of these losses to the shareholder's adjusted basis in their S
corporation stock plus any direct loans made to the corporation. If basis is insufficient, the loss
is suspended and carried forward.
, Question 35: Regarding the "Excess Business Loss" limitation under Section 461(l) for non-
corporate taxpayers, how is an "excess business loss" calculated?
A) The amount by which total business deductions exceed business gross income plus a
threshold amount.
B) Any loss exceeding $10,000.
C) Total business income minus standard deductions.
D) The amount by which passive losses exceed active income.
Correct Answer: A) The amount by which total business deductions exceed business gross
income plus a threshold amount.
Explanation: Section 461(l) limits the amount of net business loss that an individual can use to
offset non-business income. The excess business loss is the amount by which total aggregate
business deductions exceed the aggregate business gross income, plus an inflation-indexed
threshold amount. Any disallowed loss is treated as a Net Operating Loss (NOL) carryover to the
following year.
Question 36: Which of the following is true concerning the "qualified dividend" tax rate for
individuals?
A) It is the same as the taxpayer's ordinary marginal tax rate.
B) It is a flat 10% for all taxpayers.
C) It is taxed at preferential capital gains rates (0%, 15%, or 20%), depending on taxable income.
D) It is exempt from all federal income taxes.
Correct Answer: C) It is taxed at preferential capital gains rates (0%, 15%, or 20%),
depending on taxable income.
Explanation: To mitigate double taxation, dividends paid by domestic corporations and certain
foreign corporations to individual shareholders are taxed at the same preferential rates as long-
term capital gains, provided the holding period requirements are met.
Question 37: A taxpayer buys equipment for $100,000. Under bonus depreciation (if currently
applicable), how much can the taxpayer potentially deduct in the year of purchase?
A) The entire $100,000
B) Only the first-year MACRS allowance
Advanced Prep: Master Income Recognition,
Deductions, and Property Transactions Practice
Questions & Detailed Explanations (Part 2)
Subject: Federal Income Taxation – Advanced Conceptual Applications
(Questions 31–60)
Question 31: Under the "All-Events Test" for accrual-basis taxpayers, an expense is deductible
when the fact of the liability is established and the amount can be determined with reasonable
accuracy. What is the additional requirement for the "economic performance" rule regarding
services provided to the taxpayer?
A) The liability must be paid in cash within 30 days.
B) Economic performance occurs only as the services are provided to the taxpayer.
C) The services must be provided by an unrelated party.
D) The liability must be reflected on audited financial statements.
Correct Answer: B) Economic performance occurs only as the services are provided to the
taxpayer.
Explanation: Under Section 461(h), economic performance is a critical hurdle for accrual-basis
deductions. If the taxpayer’s liability arises from services or property provided TO the taxpayer,
economic performance occurs as the services or property are provided. This prevents taxpayers
from deducting future-year liabilities merely because the obligation is fixed.
Question 32: A taxpayer receives $10,000 for a covenant not to compete in connection with the
sale of their business. How is this payment characterized for federal tax purposes?
A) It is treated as an amount realized on the sale of goodwill, qualifying for long-term capital
gain.
B) It is treated as ordinary income.
C) It is treated as a tax-free gift from the purchaser.
D) It is treated as a dividend if the purchaser is a corporation.
Correct Answer: B) It is treated as ordinary income.
,Explanation: Payments received for a covenant not to compete are generally treated as ordinary
income, regardless of whether they are received as a lump sum or in installments. Unlike
goodwill, which may be a capital asset, a covenant not to compete is a promise to refrain from
doing something, making the payment compensation for lost opportunity, which is taxed as
ordinary income.
Question 33: When a taxpayer exchanges real estate held for investment for other real estate
held for investment, and receives "boot" in addition to the property, which of the following is
true regarding the recognized gain?
A) The recognized gain is the lesser of the realized gain or the boot received.
B) The recognized gain is always equal to the boot received.
C) No gain is recognized if the value of the boot is less than 10% of the total exchange.
D) The recognized gain is the entire realized gain, regardless of the boot.
Correct Answer: A) The recognized gain is the lesser of the realized gain or the boot
received.
Explanation: In a Section 1031 like-kind exchange, the presence of boot (non-like-kind property,
such as cash or debt relief) triggers the recognition of gain. However, the taxpayer never
recognizes more gain than was actually realized in the transaction. Therefore, the gain
recognized is the lesser of the realized gain or the fair market value of the boot received.
Question 34: An S corporation has three shareholders, each owning one-third of the stock. The
corporation incurs a $90,000 net loss for the year. What is the maximum loss a shareholder can
deduct on their personal return?
A) $30,000, provided they have sufficient basis in their stock and debt.
B) $90,000, because they are an owner.
C) $0, because losses must be deducted by the corporation.
D) $30,000, regardless of their stock basis.
Correct Answer: A) $30,000, provided they have sufficient basis in their stock and debt.
Explanation: S corporation losses flow through to shareholders pro-rata. However, Section
1366(d) limits the deductibility of these losses to the shareholder's adjusted basis in their S
corporation stock plus any direct loans made to the corporation. If basis is insufficient, the loss
is suspended and carried forward.
, Question 35: Regarding the "Excess Business Loss" limitation under Section 461(l) for non-
corporate taxpayers, how is an "excess business loss" calculated?
A) The amount by which total business deductions exceed business gross income plus a
threshold amount.
B) Any loss exceeding $10,000.
C) Total business income minus standard deductions.
D) The amount by which passive losses exceed active income.
Correct Answer: A) The amount by which total business deductions exceed business gross
income plus a threshold amount.
Explanation: Section 461(l) limits the amount of net business loss that an individual can use to
offset non-business income. The excess business loss is the amount by which total aggregate
business deductions exceed the aggregate business gross income, plus an inflation-indexed
threshold amount. Any disallowed loss is treated as a Net Operating Loss (NOL) carryover to the
following year.
Question 36: Which of the following is true concerning the "qualified dividend" tax rate for
individuals?
A) It is the same as the taxpayer's ordinary marginal tax rate.
B) It is a flat 10% for all taxpayers.
C) It is taxed at preferential capital gains rates (0%, 15%, or 20%), depending on taxable income.
D) It is exempt from all federal income taxes.
Correct Answer: C) It is taxed at preferential capital gains rates (0%, 15%, or 20%),
depending on taxable income.
Explanation: To mitigate double taxation, dividends paid by domestic corporations and certain
foreign corporations to individual shareholders are taxed at the same preferential rates as long-
term capital gains, provided the holding period requirements are met.
Question 37: A taxpayer buys equipment for $100,000. Under bonus depreciation (if currently
applicable), how much can the taxpayer potentially deduct in the year of purchase?
A) The entire $100,000
B) Only the first-year MACRS allowance
