Enrolled Agent > EA - Part 2: Businesses > Unit 3: Business Income > Flashcards

Unit 3: Business Income Flashcards

Identify types of business income and reporting requirements. (46 cards)

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1
Q

What is the general rule for advance payments for services for accrual-basis taxpayers?

A

They are generally taxable in the year received, but accrual-basis taxpayers can elect to defer income using the same figure for financial accounting purposes, with the remainder reported as taxable income in the following year.

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2
Q

Can advance payments for rent, interest, or insurance premiums be deferred?

A

No, these types of prepaid payments must be included as taxable income in the year they are received.

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3
Q

Under what condition can a business postpone reporting income from service agreement contracts?

A

If it regularly sells the property without a service agreement and the service agreement is optional .

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4
Q

What is the rule for advance payments for sales of goods under the accrual method?

A

Advance payments for goods are generally included in income in the year received. However, a business may defer reporting them to the next year if it also defers the income for financial accounting purposes.

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5
Q

What are the two kinds of passive activities?

A
  • Passive business activities: Trade or business activities in which the taxpayer does not materially participate during the year.
  • Rental real estate activities: Generally passive, even if the taxpayer participates, except for bona fide real estate professionals.
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6
Q

What are the seven tests to determine material participation in a business activity?

A
  • Participation in the activity for more than 500 hours during the year.
  • Participation was substantially all the participation in the activity of all individuals for the tax year.
  • Participation for more than 100 hours during the tax year, and no less than any other individual.
  • Significant participation activity with more than 500 hours in all significant activities.
  • Material participation in the activity during any 5 of the preceding 10 taxable years.
  • Personal service activity with material participation for any 3 preceding tax years.
  • Participation on a regular, continuous, and substantial basis during the year.
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7
Q

What is the treatment of passive activity losses for limited partners?

A

Limited partners are generally not treated as materially participating, and thus passive activity losses cannot be deducted against non-passive income.

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8
Q

What is the effect of a spouse’s participation in determining material participation?

A

A taxpayer’s participation in an activity includes their spouse’s participation, even if the spouse does not have an ownership interest, and regardless of whether they file jointly or separately.

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9
Q

What is the definition of nonpassive activities?

A

They are businesses in which the taxpayer works on a regular, continuous, and substantial basis.

Examples include a trade or business activity where the taxpayer materially participates, a working interest in an oil or gas well, and certain rental real estate activities.

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10
Q

Which types of income are NOT considered passive activity income?

A
  • Portfolio income
  • Personal service income
  • Retirement income
  • Income from self-produced intangibles
  • State, local, and foreign income tax refunds
  • Alaska Permanent Fund dividends
  • Cancellation of debt income
  • Income from a covenant not to compete

These types of income are explicitly excluded from passive activity income, affecting how losses can be offset against them.

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11
Q

What are the three main categories of income for the EA exam?

A
  • Active income
  • Passive activity income
  • Portfolio income

It is important not to confuse ‘passive income’ with ‘passive activity income’ as they are distinct categories.

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12
Q

What is the general rule for passive activity loss limitations (PAL rules)?

A

Losses from passive activities that exceed passive income in a given year are generally disallowed for the current year.

Unused losses are suspended and carried over to offset passive activity income in future years.

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13
Q

When can suspended passive losses be claimed in full?

A

Upon the qualifying disposition of a passive activity.

The activity must be sold to an unrelated party in a fully taxable transaction.

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14
Q

What is a ‘former’ passive activity?

A

An activity that was passive in an earlier tax year but is not passive in the current tax year.

Suspended losses from a former passive activity can be offset against income from the activity once the taxpayer materially participates.

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15
Q

What is the purpose of a Section 469 grouping election?

A

It allows taxpayers to treat multiple business activities as a single activity for passive loss restrictions.

This election helps in demonstrating material participation across grouped activities.

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16
Q

Under what conditions can rental activities be grouped with trade or business activities?

A

If they form an “appropriate economic unit” and either:

  • The rental activity is insubstantially related to the trade or business, or
  • Both activities are commonly owned.

The grouping must meet one of the specified conditions to qualify.

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17
Q

What forms are used to report rental income based on the type of services provided?

A
  • Schedule E: Used by taxpayers who are not professional real estate dealers or do not provide substantial services.
  • Schedule C: Used for professional real estate dealers and owners providing substantial services.

The choice of form depends on the nature and extent of services provided in relation to the rental activity.

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18
Q

How should advance rental payments be recognized for tax purposes?

A

Recognized in the year received.

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19
Q

When is a security deposit recognized as income?

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A

If it is forfeited by the tenant, such as when it is kept for unpaid rent or damages. Otherwise, refundable deposits are not included in income when received.

20
Q

What is the special $25,000 loss allowance for real estate rental activities?

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A

A deduction for up to $25,000 of losses against nonpassive income

The taxpayer must actively participate in the rental activity and meet certain income thresholds.

21
Q

How is the $25,000 special rental real estate loss allowance phased out, and what are the MFS rules?

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A

Phaseout: The allowance is reduced by $1 for every $2 of MAGI above $100,000, and is completely phased out at $150,000 MAGI.

MFS: If married filing separately and lived apart all year, the phaseout range is $50,000–$75,000. If you lived with your spouse at any time during the year, the allowance is not allowed.

22
Q

What are the requirements for a taxpayer to be considered ‘actively participating’ in a rental activity?

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A
  • Own at least 10% of the rental property
  • Make management decisions in a significant and bona fide way
23
Q

True or False:

Material participation is the same as active participation.

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A

False

Material participation is a higher standard than active participation.

24
Q

What happens to rental losses that cannot be deducted due to passive activity loss limitations?

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A

Carried forward indefinitely.

25
What is required for a taxpayer to be considered a '**real estate professional**'?
* **More-than-50% Rule** - More than half of the personal services performed in all trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates. * **More-than-750 Hour Rule** - The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which they materially participate.
26
What is the **benefit** of being classified as a “real estate professional” regarding the Net Investment Income Tax (NIIT)?
Rental real estate income is not subject to the 3.8% NIIT if the taxpayer qualifies as a real estate professional and materially participates in the rental activity.
27
How are **dividends** treated for professional stockbrokers and securities dealers?
As business income
28
Which types of court awards and settlements are generally **taxable**?
* Patent or copyright infringement * Breach of contract * Compensation for lost profits * Emotional distress damages * Punitive damages ## Footnote Court awards and settlements for physical injuries or illness are generally not taxable (except for punitive damages which are always taxable)
29
Are punitive damages subject to income tax?
Yes ## Footnote Punitive damages are subject to income tax but are not subject to self-employment tax. Punitive damages are awarded in addition to compensatory damages and are meant to punish the defendant for a willful or malicious act.
30
What is **bartering** in the context of income?
Occurs when a taxpayer exchanges goods or services without exchanging money. ## Footnote The fair market value of goods and services received in a barter exchange must be included in income by each party in the year received.
31
How is income from **canceled debt** generally treated for a business?
If a business-related debt is canceled or forgiven, the business generally includes the amount of the cancellation of debt (COD) in income. ## Footnote A cash-basis business is not required to realize income from a canceled debt to the extent that payment of the debt would have led to a business deduction.
32
Which **types of income** are not considered business income?
Amounts not considered business income include: * Issuances of stock * Most business loans * State and local taxes collected and remitted to governments * Like-kind exchanges of property * Gain from an involuntary conversion reinvested properly. ## Footnote These types of income are either not taxable, partially taxable, or their recognition is delayed.
33
What is a **Section 1031 exchange**?
A transaction that allows for the **deferral of income** on the exchange of business real estate. ## Footnote This is an example of a tax-deferred transaction where the taxation of income is deferred to a later date.
34
How does **IRC Section 451(c)(1)** affect income reporting for guarantee or warranty contracts?
It allows an accrual-basis taxpayer to elect to **defer advance payments** in gross income, recognizing income in the year of receipt only to the extent it is effectively earned, with the remainder recognized in the next tax year.
35
What activities are NOT considered **passive activities**?
* A trade or business activity where the taxpayer has **materially participated**. * A working interest in an oil or gas well without **limited liability**. * Rental real estate activities where the taxpayer materially participated as a **real estate professional**.
36
What is **Form 8582** used for?
To summarize **passive activity** income and losses and compute deductible losses for noncorporate taxpayers.
37
# True or False: A **limited partner** in a rental activity can claim the special loss allowance.
False ## Footnote Limited partners in a rental activity are not allowed to claim the special loss allowance.
38
What is the primary benefit for **real estate professionals** regarding rental property losses?
They can use rental property losses to offset **other income** without being constrained by passive activity loss limits.
39
How is income from a **real estate dealer** typically treated for tax purposes?
Reported on Schedule C and subject to **self-employment tax** ## Footnote Real estate is usually treated as inventory for a real estate developer.
40
What types of **court awards** are generally taxable?
* Patent or copyright infringement * Breach of contract * Compensation for lost profits * Compensatory damages for financial losses * Interest on awards * Emotional distress damages * Punitive damages ## Footnote Punitive damages are always taxable.
41
What must be included in income when engaging in **bartering**?
The **fair market value** of goods and services received in a barter exchange.
42
What is the IRS definition of **fair market value**? | (FMV)
The price at which property would change hands between a buyer and a seller with **reasonable knowledge** of all necessary facts, and neither is forced to buy or sell.
43
When is a cash-basis business not required to recognize **canceled debt** as income?
When the payment of the debt would have led to a **business deduction**. ## Footnote For example, if a business's payment of a canceled debt would have been deductible as a business expense, it does not need to recognize the canceled debt as income.
44
How does the treatment of **canceled debt** differ between cash-basis and accrual-basis businesses?
* Cash-basis: Not required to recognize canceled debt as income if the payment would have been **deductible expense**. * Accrual-basis: Must recognize canceled debt as income since the deduction for the expense would have already been **recorded deduction**.
45
What are some **exclusions** from recognizing canceled debt as income?
* **Bankruptcy or insolvency** (up to the extent of insolvency) * Qualified farm indebtedness * Qualified real property business indebtedness ## Footnote Taxpayers using these exclusions must reduce specified tax attributes by corresponding amounts.
46
Which form must be used to report **reductions in tax attributes** due to discharged indebtedness?
**Form 982**, Reduction of Tax Attributes Due to Discharge of Indebtedness. ## Footnote This form must be attached to the taxpayer's Form 1040.
EA - Part 2: Businesses
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