2011 AICPA newly released questions – regulation

The capital gain or loss is measured by the difference between the amount realized for the sale and the adjusted basis of the partnership interest.. At the beginning of the current tax

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Following are multiple choice questions and simulations recently released by the

AICPA These questions were released by the AICPA with letter answers only Our editorial board has provided the accompanying explanation

Please note that the AICPA generally releases questions that it does NOT intend to use again These questions and content may or may not be representative of questions you may see on any upcoming exams

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1

Under the position taken by a majority of the courts, to which third parties will an accountant who negligently prepares a client's financial report be liable?

a Only those third parties in privity of contract with the accountant

b All third parties who relied on the report and sustained injury

c Any foreseen or known third party who relied on the report

d Any third party whose reliance on the report was reasonably foreseeable

Solution:

Choice "c" is correct Under the majority position an accountant is liable for negligence only to third parties whom the accountant knows or should foresee will be relying on the accountant's work

Choice "a" is incorrect This choice reflects the minority Utramares position In most states, an

accountant's liability extends beyond those who are in privity (i.e., in a contractual relationship with) the accountant

Choice "b" is incorrect This choice is too broad An accountant is not liable in negligence merely because someone relied on the accountant's work

Choice "d" is incorrect This answer is too broad because it is not enough that a party could have foreseeably relied – the party must have actually relied

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2

A company engaged a CPA to perform the annual audit of its financial statements The audit failed to reveal an embezzlement scheme by one of the employees Which of the following statements best describes the CPA's potential liability for this failure?

a The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability

b The CPA will not be liable if care and skill of an ordinary reasonable person was exercised

c The CPA may be liable for punitive damages if due care was not exercised

d The CPA is liable for any embezzlement losses that occurred before the scheme should have been detected

Solution:

Choice "a" is correct A CPA will be liable in negligence if he or she fails to exercise the care and

prudence that an ordinary CPA would exercise in performing an audit An ordinary CPA would normally adhere to GAAS Thus, proof of adherence to GAAS may prevent liability

Choice "b" is incorrect A CPA must perform an audit with the care and skill that an ordinary CPA would exercise; exercising the care and skill of an ordinary, reasonable person is not enough

Choice "c" is incorrect A CPA may be liable for punitive damages for willful fraud or recklessly

performing an audit While failure to exercise due care is a sufficient basis to impose liability for

negligence, it is not a sufficient basis to impose liability for fraud

Choice "d" is incorrect This choice sets up a strict liability standard – CPAs are liable for any

embezzlement losses that should have been detected The law imposes no such liability A CPA must at least be negligent before liability will be imposed

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3

In which of the following types of action, brought against a CPA who issues an audit report containing an unqualified opinion on materially misstated financial statements, may a plaintiff prevail without proving reliance on the audit report?

a An action for common law fraud

b An action for common law breach of contract

c An action brought under Section 11 of the Securities Act of 1933

d An action brought under Rule 10b-5 of the Securities Exchange Act of 1934

Choice "a" is incorrect The drawer is the person who writes the check

Choice "b" is incorrect A maker is a person who makes a (promissory) note A note is presented to the maker for payment, but a check is not a type of note; it is a type of draft, and drafts are presented to a drawee for payment

Choice "c" is incorrect A holder is someone in legal possession of a check; the holder may be the payee

or some subsequent transferee of the payee In any event, a check is not presented to a holder for payment

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5

Under the Secured Transactions Article of the UCC, which of the following statements is correct regarding

a security interest that has not attached?

a It is effective against the debtor, but not against third parties

b It is effective against both the debtor and third parties

c It is effective against third parties with unsecured claims

d It is not effective against either the debtor or third parties

Solution:

Choice "d" is correct A security interest is not effective against anyone before it attaches to the collateral Thus, all of the other answer choices are incorrect

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6

Which of the following transactions is subject to registration requirements of the Securities Act of 1933?

a The public sale of stock of a trucking company regulated by the Interstate Commerce Commission

b A public sale of municipal bonds issued by a city government

c The issuance of stock by a publicly-traded corporation to its existing shareholders because of a stock split

d The public sale by a corporation of its negotiable 10-year notes

Solution:

Choice "d" is correct No registration exemption is available for sales of long term notes

Choice "a" is incorrect Securities of regulated common carriers are within a securities exemption (on the rationale that the regulating government agency will oversee the securities issuance)

Choice "b" is incorrect The issuance of securities of governmental bodies generally is within a securities exemption

Choice "c" is incorrect Exchanges with existing shareholders are within a transaction exemption if no sales commission is paid in connection with the sale

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7

In the current year, Essex sold land with a basis of $80,000 to Yarrow for $100,000 Yarrow paid $25,000 down and agreed to pay $15,000 per year, plus interest, for the next five years, beginning in the second year Under the installment method, what gain should Essex include in gross income for the year of sale?

Total Gross Profit $ 20,000

Step 2: Gross Profit Percentage :

Gross Profit/Sale on Installment ($20,000/$100,000) = 20%

Step 3: Taxable Gross Profit:

Collections ($25,000) x Gross Profit Percentage (20%) = $5,000

90% of the current year's tax ($50,000 x 90%) = $45,000, or

100% of the previous year's tax ($30,000 x 100%) = $30,000

However, if the taxpayer had adjusted gross income in excess of $150,000 in the prior year, 110% of the prior year's tax liability is used to compute the safe harbor for estimated payments (Previous year's tax

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9

On January 1, Fast, Inc entered into a covenant not to compete with Swift, Inc for a period of five years, with an option by Swift to extend it to seven years What is the amortization period of the covenant for tax purposes?

Choice "a" is incorrect The time certain does not impact the amortization period

Choice "b" is incorrect The option to extend does not impact the amortization period

Choice "d" is incorrect 17 years is longer than required to amortize intangible assets

Choice "a" is incorrect The total gain is $100,000 which is the sales price ($200,000) in excess of cost

($160,000) less depreciation ($60,000) Under Sec 1245, ordinary income is recognized on the gain to the extent of the accumulated depreciation Any gain in excess of the original cost is capital gain Choice "b" is incorrect Under Sec 1245, ordinary income is recognized on the gain to the extent of the accumulated depreciation Any gain in excess of the original cost is capital gain The total gain is

$100,000, but only $60,000 is ordinary income and $40,000 is capital gain income

Choice "d" is incorrect The total gain is $100,000, but only $60,000 is ordinary income and $40,000 is capital gain income

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11

Lobster, Inc incurs the following losses on disposition of business assets during the year:

Loss on the abandonment of office equipment $25,000

Loss on the sale of a building (straight-line

depreciation taken in prior years of $200,000) 250,000

What is the amount and character of the losses to be reported on Lobster's tax return?

a $40,000 Section 1231 loss only

b $40,000 Section 1231 loss, $50,000 long-term capital loss

c $40,000 Section 1231 loss, $250,000 long-term capital loss

d $290,000 Section 1231 loss

Solution:

Choice "d" is correct Section 1231 assets are comprised principally of depreciable personal and real property used in the taxpayer's trade or business and held for over twelve months Trade or business property and capital assets (held over twelve months) that have been involuntarily converted are also included All of the assets listed in this problem are Section 1231 assets Net 1231 losses (Sec 1231 losses less Sec 1231 gains) are treated as ordinary losses

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12

In the current year, a taxpayer reports the following items:

Income from partnership A, in which the taxpayer materially participates 20,000

During the year, the taxpayer disposed of the interest in partnership B, which had a suspended loss carryover of $10,000 from prior years What is the taxpayer's adjusted gross income for the current year?

unused, passive activity losses are fully deductible in the year of disposal:

+ Income from partnership A 20,000

- PAL from partnership B (40,000)

- Loss carryover from partnership B (10,000)

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13

Stone owns 100% of an S corporation and materially participates in its operations The stock basis at the beginning of the year is $5,000 During the year, the corporation makes a distribution of $3,500 and passes through a loss from operations of $2,000 for the year What loss can Stone deduct on Stone's personal tax return?

Choice "b" is correct An S Corporation shareholder's basis is reduced by distributions to the

shareholders as well as loss or expense items However, loss deductions are limited to a shareholder's adjusted basis in S corporation stock plus direct shareholder loans to the corporation Any losses

disallowed may be carried forward indefinitely and will be deductible as the shareholder's basis is

increased

Less: Distributions to Shareholder ($3,500)

Less: Shareholder share of losses ($1,500) Excess $500 carried forward indefinitely

Ending Shareholder Basis 0

Choice "a" is incorrect Losses are deductible only to the extent of the shareholder's basis

Choice "c" is incorrect The shareholder cannot deduct the full loss without a sufficient amount of basis in the S corporation stock

Choice "d" is incorrect The shareholder cannot have a negative basis as a result of distributions and losses

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Farr, an unmarried taxpayer, had $70,000 of adjusted gross income and the following deductions for regular income tax purposes:

Home mortgage interest on a loan to

acquire a principal residence $11,000

Miscellaneous itemized deductions

above the threshold limitation $ 2,000

What are Farr's total allowable itemized deductions for computing alternative minimum taxable income?

Choice "a" is incorrect Mortgage interest is allowed as a deduction for AMT purposes

Choice "b" is incorrect Miscellaneous itemized deductions are not allowed for AMT purposes

Choice "d" is incorrect The $2,000 miscellaneous itemized deductions are an add back for AMT

purposes

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15

Robin, a C corporation, had revenues of $200,000 and operating expenses of $75,000 Robin also received a $20,000 dividend from a domestic corporation and is entitled to a $14,000 dividend-received deduction Robin donated $15,000 to a qualified charitable organization in the current year What is Robin's contribution deduction?

Choice "b" is correct Corporations making contributions to recognized charitable organizations are

allowed a maximum deduction of 10% of their taxable income Taxable income is calculated before the deduction of: (1) any charitable contribution; (2) the dividends received deduction; (3) any net operating

loss carryback; (4) any capital loss carryback; or, (5) U.S production activities deduction

Income before the dividends received deduction $145,000

x 10%

Maximum allowable charitable deduction $14,500

Note: Excess charitable contributions not allowed as a deduction due to the 10% limitation may be carried forward up to five years

Choice "a" is incorrect The full $15,000 would not be allowed due to the 10% limitation illustrated above Choice "c" is incorrect The dividends received are considered in taxable income for purposes of the 10% limitation

Choice "d" is incorrect The 10% limitation is applied before the dividends received deduction

Choice "b" is correct As a general rule, a partner who sells or exchanges his or her partnership interest

has a recognized capital gain or loss The capital gain or loss is measured by the difference between the

amount realized for the sale and the adjusted basis of the partnership interest

An exception to the capital gain treatment is on any gain that represents a partner's share of "hot assets" Any gain that represents a partner's share of hot assets is treated as ordinary income Hot assets are: (1)

Unrealized receivables and, (2) Appreciated inventory

Choice "a" is incorrect Cash is not a hot asset

Choice "c" is incorrect Section 1231 assets are not hot assets

Choice "d" is incorrect Capital assets are not hot assets

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17

George and Martha are equal partners in G&M Partnership At the beginning of the current tax year, the adjusted basis of George's partnership interest was $32,500, which included his share of $40,000 of partnership liabilities During the tax year, the following information applied to G&M:

Partnership liabilities at end of year 24,000

What was the basis of George's partnership interest at year end?

Initial basis in partnership interest $32,500

Share of decreased partnership liabilities at year end (8,000)

Basis of George's partnership interest at year end $13,500

Choice "b" is incorrect Reducing liabilities decreases basis

Choice "c" is incorrect Equal partners would divide partnership activity equally

Choice "d" is incorrect Operating losses are a reduction of basis

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18

As a general partner in Greenland Associates, an individual's share of partnership income for the current tax year is $25,000 ordinary business income and a $10,000 guaranteed payment The individual also received $5,000 in cash distributions from the partnership What income should the individual report from the interest in Greenland?

Withdrawals/distributions are not a taxable event, yet will decrease the partner's basis

Choice "a" is incorrect Cash distributions are not included in income

Choice "b" is incorrect Guaranteed payments are taxable income to the receiving partner

Choice "d" is incorrect Distributions are not income, since the money was taxed when the partnership earned such money, but would reduce the partner's basis

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19

In the current year, when Hoben's tax basis in Lynz Partnership interest was $10,000, Hoben received a

liquidating distribution as follows:

Choice "a" is correct In a complete liquidation, the partner's basis for distributed property is the same as

the adjusted basis of his/her partnership interest, reduced by any money actually received The partner recognizes gain only to the extent that money received exceeds the partner's basis in the partnership Therefore, the partner's basis in the distributed assets as part of the liquidation would be $10,000, with no immediate recognized gain

Choice "b" is incorrect The partner recognizes gain only to the extent that money received exceeds the partner's basis in the partnership

Choice "c" is incorrect The partner recognizes gain only to the extent that money received exceeds the partner's basis in the partnership

Choice "d" is incorrect The partner recognizes gain only to the extent that money received exceeds the partner's basis in the partnership

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Pursuant to Treasury Circular 230, which of the following statements about the return of a client's records

is correct?

a The client's records are to be destroyed upon submission of a tax return

b The practitioner may retain copies of the client's records

c The existence of a dispute over fees generally relieves the practitioner of responsibility to return the client's records

d The practitioner does not need to return any client records that are necessary for the client to comply

with the client's federal tax obligations

Solution:

Choice "b" is correct A tax preparer should retain client records for three years

Choice "a" is incorrect A tax preparer should retain client records for three years

Choice "c" is incorrect Generally, at the request of the client, the practitioner must return all client records An exception is if state law allows the practitioner to retain the records in the case of a fee dispute, the practitioner may do so However, the practitioner must (1) return to the client those records which must be attached to the tax return, and (2) allow the client to review and copy the practitioner-retained client records related to the client's federal tax obligation

Choice "d" is incorrect The general rule is to return all requested records

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21

According to the AICPA Statements on Standards for Tax Services, which of the following factors should

a CPA consider in choosing whether to provide oral or written advice to a client?

a Whether the client will seek a second opinion

b The tax sophistication of the client

c The likelihood that current tax litigation will impact the advice

d The client's business acumen

Choice "c" is incorrect Verbal or written advice should not be determined by tax legislation

Choice "d" is incorrect The client's business acumen should not be considered when deciding to give them verbal as opposed to written advice

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Louis, the volunteer treasurer of a nonprofit organization and a member of its board of directors, compiles

the data and fills out its annual Form 990, Return of Organization Exempt from Income Tax Under the

Internal Revenue Code, Louis is not considered a tax return preparer because:

a He is a member of the board of directors

b The return does not contain a claim for a tax refund

c He is not compensated

d Returns for nonprofit organizations are exempt from the preparer rules

Solution:

Choice "c" is correct The term "tax return preparer" means any person who prepares for compensation,

or who employs one or more persons to prepare for compensation, any tax return required under the IRC

or any claim for refund of tax imposed by the IRC

Choice "a" is incorrect Board status alone does not determine tax preparer status

Choice "b" is incorrect Claim for a refund or underpayment is not a factor in determining tax preparer status

Choice "d" is incorrect There is no such exception that exists