REG CPA Exam Review Course

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Hello, and welcome to the Bisk CPA reviews coverage of the regulation section of the CPA exam. My name is Bob Monette. I'll be your instructor for this REG CPA Review course and in this class. We're going to be covering a very heavily tested topic in the regulation exam. And that is the taxation of corporations.

Before we dive into that topic, let me just say a word about the best way to use this class. The important thing is that for you to treat this REG CPA Review course like any other class, try to avoid just sitting back, watching passively take good notes later in the class. When we do problems, I think the important thing.

Is to shut the class down. You do the problems first, come up with your answers before you come back and we go through the problems together. And you'll find that if you do these simple things, you get much more out of this class. So with that in mind, let's talk about the taxation of corporations. And as I I'm sure you know, for federal tax purposes, there are two types of corporations.

There are C corporations and there are S corporations. Now we're going to begin with C corporations and we're going to begin at the very beginning. And that is the formation of a C corporation. And the point, this is section three 51. And the point is that the formation of a C corporation is a tax-free event.

It's tax-free for the shareholders. It's tax-free for the corporation. If it meets this criteria, the shareholders have to contribute property. In other words, boot paid in exchange for stock. So the shareholders have to contribute property boot paid not services. Be careful if, if you exchange services in return for stock.

Well, that's, that's not tax-free. Then the fair market value of the shares would be ordinary gross income for the shareholder. So it can't be services in exchange for stock. No, the shareholders would have to contribute property food paid in exchange for stock, nothing else. And after the transaction, the shareholders alone, 80% or more of the stock.

So after the transaction, the shareholders have to own 80% or more of the stock. If you meet that criteria, the formation of a corporation is tax-free for the shareholders. Tax-free for the corporation. Now be careful of something. You got to be careful. If at formation, a shareholder contributes property that is subject to a mortgage.

And obviously the corporation is going to assume that mortgage that's going to be debt relief to the shareholder. You have to be careful because if the debt relief to the shareholder is greater than the shareholder's basis in that property, that will trigger a taxable gain. Let me say that again. If that formation, the shareholder contributes property, that is subject to a mortgage, and obviously the corporation is going to assume that mortgage and that's going to be debt relief for the shareholder.

You have to be careful because if the debt relief of the shareholder is greater than the shareholder's basis in that property, That will trigger a taxable gain. Let me give you an example. Let's say at formation, a shareholder contributes a building the shareholder's basis in that building 100,000. So that's the shareholders adjusted basis in the building a hundred thousand, the building is subject to an $80,000 mortgage and the shareholder contributes the building in exchange for a thousand shares of stock at formation.

And let's say the fair value of the building is 500,000. Well, right away. If you look at the facts that we're stuck with in this example, there is no taxable gain that's triggered here. Why? Because when the corporation assumes that mortgage of 80,000, yes, that will be debt relief to the shareholder. But the debt relief to the shareholder 80,000 is not greater than the shareholder's basis in that asset.

So there's no taxable gain triggered here.

Now in my example, how would we work out the shareholder's basis in the stock? What is the shareholder's basis in the stock? In my example, and before I start this. I think, you know, the CPA Exam Love's basis REG CPA Exam questions on basis. How many times do I hear that from my students? So many REG CPA Exam questions on basis. So how would we work out in this example, the shareholder's basis in the stock?

Well, notice I would start with the shareholders adjusted basis in the building that was exchanged a hundred thousand notice. I ignore the fair value of the building. That's not used. I would start with whatever the shareholders adjusted basis was. In the asset that was exchanged a hundred thousand, you would add any boot paid, but the shareholder didn't pay any boot you'd subtract any boot received.

Now shareholder did receive boot here. The debt relief, the corporation assume that $80,000 mortgage that's debt relief for the shareholders. So that's boot received. Now you can also add the shareholder can add any taxable gain recognized by the shareholder, but we agreed that there would be no taxable gain because.

The debt relief, 80,000 was not greater than the shareholder's basis in the building a hundred thousand. So there was no taxable gain, but if there was any taxable gain, we could add that as well. But the point is that the shareholder's basis in that stock, in my example would be 20,000 same example.

What's the basis of the building in the hands of the corporation. Well, notice this, if I want to work out the basis of the building. In the hands of the corporation, I start with the a hundred thousand whatever the shareholders basis was in that building transfers over to the corporation. And that becomes the basis of the asset in the hands of the corporation.

The a hundred thousand and the corporation can add any taxable gain recognized by the shareholder. But we agreed. In my example, there was none. So what is the basis of the building and the hands of the corporation? A hundred thousand. Now, let me change the facts a little bit. Same example, let's say that the building was subject to $130,000 mortgage.

If in the same example, the building was subject to $130,000 mortgage. It's a different situation because when the corporation assumes that mortgage, that's going to be debt relief to the shareholder. And now the debt relief to the shareholder 130,000 is greater than the shareholder's basis in that building a hundred thousand now.

What is triggered is a $30,000 taxable gain for the shareholder. Okay. Now the shareholder does have a $30,000 taxable gain. So now in this example, how would I work out the shareholder's basis in the stock? Well, you know, my starting point is a hundred thousand, whatever the shareholder's basis was in that building becomes your starting point to work out the basis in the shares, a hundred thousand, you would add any boot paid, but.

The shareholder didn't pay any boot. You have to attract any boot received. And the shareholder did receive boot here. The debt relief, 130,000. And remember the shareholder can add any taxable gain recognized by the shareholder. And we agree that would be 30,000. So if they ask you in the exam, what is the shareholder's basis in that stock is zero.

It is zero now. Same problem. What is the basis of the building in the hands of the corporation? Well, you start with the shareholders basis in the building, whatever the shareholders basis, wasn't that building transfers over to the corporation. That's your starting point a hundred thousand. And the corporation is allowed to add any taxable gain recognized by the shareholder.

And we agreed that was 30,000. So they ask you in the exam. What is the basis of the building in the hands of the corporation, 130,000. These are the natural REG CPA Exam questions that grow out of this type of problem. I'd like you to try some REG CPA Exam questions on this in your viewers guide. I want you to go to the multiple choice and do the first three mult multiple choice one, two, and three.

And as I said earlier, the best thing to do is shut the class down, get your answers to those three REG CPA Exam questions and then come back and we'll talk them through together.

Welcome back. Let's do this set together. Now, obviously REG CPA Exam questions one, two, and three are a set of multiple choice about formation. It says that burns and limb organized acorn corporation. So. The corporations being organized. This is at formation. The corporation issued voting common stock with a fair market value of 120,000.

They each transferred property in exchange for stock. So burns exchanges, a building with an adjusted basis of 40,000 subject to a $10,000 mortgage in exchange for shares. The building has a fair value of 82,000 owned. 60% of the stock. Limb exchanges land with a basis of five, a fair value of 48,000 for 40% of the stock.

So notice after the exchange, the shareholders own a hundred percent of the stock, they have to own at least 80%. So this is all a tax-free exchange. Now, number one says, what amount of gain did burns recognize on the exchange? Well, I know you see the key information. The corporation is going to assume this mortgage that's on the building.

Of $10,000 that is going to represent debt relief to burns, but notice the debt relief for burns 10,000 is not greater than burns basis in the building. So the answer is a zero. There is no gain indicated here for burns, no taxable gain. That's triggered by this information because the debt relief for burns 10,000 is not greater than burns adjusted basis in that building.

Number two. What was acorn corporation's basis in the building? Well, you know, your starting point is 40,000 because whatever the shareholders basis was in the asset, exchanged that transfers over to the corporation. That becomes the basis of the asset in the hands of the corporation, 40,000. And remember the corporation can add any taxable gain recognized by the shareholder, but we know that zero from the first question.

So the answer is B 40,000. That is the basis of the building in the hands of the corporation. Number three, what was burns basis in the stock? As I mentioned earlier, these are the natural REG CPA Exam questions that grow out of a fact pattern on formation. So that's the final question. What is burns basis in the stock?

Well, you know, your starting point is 40,000 whatever burns basis was in the building that was transferred in exchange for shares. That transfers over that becomes the starting point to work out the basis in the stock, then burns would add any boot paid, but burns didn't pay any boot subtract. Any boot received burns did receive boot the debt relief of 10,000.

And remember burdens could add any taxable gain recognized, but we agree that was zero. So what is burns basis in that stock? 30,000 answer C.

Now I want you to remember that a C corporation is a tax paying entity. It is a tax paying entity and a C corporation has to file a federal income tax return, federal tax form 1120. It's due on the 15th day of the third month of the year. If it's a calendar year, we're talking about it's due on March 15th and because a C corporation is a tax paying entity, a C corporation does have to make estimated tax payments through the year.

They have to make an estimated tax payment on April 15th, June 15th, September 15th and December 15th. Because it's a tax paying entity. They have to make estimated tax payments now for a C corporation to avoid any penalties for underpayment of estimated tax. They have two ways to go. So again, if you're a C corporation and you want to avoid any penalties for underpayment of estimated taxes, because you have to pay estimated taxes, there's two ways to go.

You can either pay a hundred percent of last year's taxes. Again, number one, you could pay a hundred percent of last year's taxes. Now you're not allowed to use last year's method. If in the prior year you didn't have any tax liability. Let's say in the prior year, the corporation has a net operating loss.

So if there is no tax liability the previous year, you're not allowed to use this method, but again, you could pay a hundred percent of last year's tax or a hundred percent of this year's tax. In other words, if you pay a hundred percent of this year's tax, you're using what they call the annualized income method on the, under the annualized income method, you basically estimate your tax liability for the current year.

This is the annualized income method. You estimate your tax liability for the current year divided by four. And that's what's due on April 15th. I'd like you to try some more REG CPA Exam questions, please do four through seven and then come back.

welcome back. Let's try this set of REG CPA Exam questions together. Number four says Jackson corporation, a calendar, your corporation mailed it's year one tax return to the IRS by certified mail. Friday, March 10th, year two. The return that was postmarked March 10th, year two was delivered to the IRS March 20th, year two.

And they want to know when the statute of limitations would begin for this return. Well, you may know that the general rule is that a tax return is deemed to have been filed when it's postmarked. That's the general rule that a tax return is considered to be filed when it's postmarked, but not for statute of limitations purposes.

For statute of limitations purposes, the return is deemed to have been filed on the due date, which for C corporation is March 15th. So the statute of limitations would begin the following day, answer C March 16th. So just remember general rule. Our return is considered to be filed when it's postmark, but not for statute of limitations purposes for statute of limitations purposes.

The return is deemed to have been filed on the due date. In this case, March 15th. So the statute of limitations, which would begin the following day, March 16th, by the way, if the corporation filed an extension that wouldn't change, that the statute of limitations would begin on March 16th. Number five, a civil fraud penalty can be imposed on a corporation that underpays tax by, by what?

Well, you know what fraud is all about. Fraud is intentional. So you're looking for intent a says omitting income as a result of inadequate record keeping. Well, that's not fraud, it's not intentional B failing to report income in a Ray. It erroneously considered not to be part of corporate profits, a likely story, but if it was, it was a failure to report.

There's no indication that was intentional. It's not fraud D. Filing an incomplete return with an appended statement, making it clear that the return is incomplete. Well, that's certainly not fraud. Of course, the answer is C maintaining false records, reporting fictitious transactions. You know, that's fraud, it's intentional.

Number six edge corporation, a calendar year C corporation had a net operating loss, zero tax liability for year one to avoid the penalty. For underpayment of estimated taxes edge could compute its first quarter, year to estimate attacks by using, you know, you cannot use the preceding year method. So you want to know in that second column, they cannot use the preceding year method because they had no tax liability.

The preceding year, it was a net operating loss. So you're not allowed to use the preceding year method. If there was no tax liability for the preceding year, this corporation would have to use the annualized income method. Answer B number seven says a corporations penalty for underpayment of estimated taxes.

You know, answer a, not the deductible. You can't deduct penalties, fines. I'm sure you know that.

Now I want to give you some advice. And I think you'll find this really does help. One of the things that helps, I think a student a lot with the taxation of a C corporation is to memorize and I mean, memorize the basic format. Of a federal tax form, 1120, just you want to memorize the outline of the basic format, the approach in the federal tax form 1120.

Let's take a look at it. Here's how the federal tax form 1120 basically works. If you're a C corporation, you're going to start with your gross income. And then you've got to subtract all the ordinary and necessary business expenses that you incurred to produce the income that you weren't. So you start with gross income, you subtract all the ordinary and necessary business expenses that you incurred to produce the income that you earned.

But notice those deductions do not include a charitable deduction and those deductions do not include. The dividend received deduction. The DRD we'll talk about that later. These deductions are just all the ordinary and necessary business expenses that you incurred to produce the income that you earned.

Those deductions would not include a deductions for charitable contribution or the dividend received deduction. And when you back out those deductions, that gives you what I'm calling sub point a. Now. Because a C corporation is a tax paying entity. A C corporation can take a charitable deduction, but notice the charitable deduction is limited to 10% of sub point a.

So again, a C corporation is a tax paying entity. So a C corporation is allowed to take a deduction for a charitable contribution, but the charitable contribution deduction is limited to 10% of sub point a. What if there's an excess, if there's an excess, if your charitable contribution was greater than 10%, you can carry the excess forward for up to five years.

Now, when I back out the charitable contribution, that gives us a very important line, T I B S D taxable income before special deductions. So now we're down to tib SD taxable income before special deductions. And I'm sure you say there are two special deductions. There is the DRD, the dividend received deduction, which we'll talk about later and any net operating loss carry back or carry forward.

Remember when a corporation, when a C corporation has a net operating loss and in a well IRS. We'll allow the C corporation to carry that loss back up to two years now, why do they want to do that? Why does a C corporation want to carry the net operating loss back two years to get a refund of taxes that were paid in those two years.

Now, if that doesn't eat up the entire loss, if there's any unused loss, the C corporation can, can carry the loss forward for up to 20 years and that'll save the C corporation taxes in the future that, that they'd otherwise have to pay. So this is where you would work in. Any net operating loss, carry back or carry forward.

That's one of the special deductions. And when you back that out, that gives you the taxable income for a C corporation. I'm not exaggerating when I say you should memorize that basic outline because it does help a lot. I'd like you to try some more REG CPA Exam questions, please do eight through 12 and then come back.

Welcome back. Let's go through these REG CPA Exam questions together. Number eight says in year two cable corporation, a calendar year C corporation contributed 80,000 to a qualified charitable organization. And. Notice cable at the bottom of the question, they say, cable also had carry over contributions of 10,000 from a prior year.

And we know that that's fine. When you have excess contributions that you are unable to deduct in a prior year, you can carry them forward for up to five years. So their total potential charitable contribution here is 80,000 plus 10 90,000. But of course there's a limit. A C corporation can only take a charitable deduction up to 10% of sub 0.8.

Now, what is some point at, you know, if you really get that format down, what exactly is sub point a isn't sub-point a taxable income before the charitable contribution. Before the dividend received deduction. And before any net operating loss carryback or carry forward, that's what sub point is. It's a mouthful, but that's what it is.

Isn't it it's taxable income before any charitable contribution before any dividend received deduction before any net operating loss, carry back a carry forward. Now, do we know that because that's the limitation 10% of that line. It says cables year to taxable income before the deduction for charitable contributions was.

820,000, but that was after a dividend received deduction of 40,000 members. Some 0.8 is before charitable contribution before dividend received deduction before net operating loss carry back, carry forward. So that eight 20 was after the dividend received deduction. So we have to add it back. So sub point a would be the 820,000.

Add back the 40,000. Take the 820,000. Add back the 40,000 dividend received deduction, sub point a 860,000. That's sub-point a taxable income before charitable contribution before dividend received deduction before net operating loss, carry back, carry forward. And the deduction that a C corporation can take for charitable contribution is limited to 10% of that line or 86,000 answer B and then the other 4,000.

Excess can be carried forward for up to five years, but the answer is B. You see why it's important to know that format number nine for the calendar year eight Taylor corporation had a net operating loss of 200,000 taxable income for the early, earlier years was as follows. So this is taxable income without any reference to the net operating loss.

For years, three, four, five, six, and seven are given to us. And it says if Taylor makes no special election to wave the net operating loss, carry back. What amount of operating loss will be available in year nine the next year? Well, when a corporation like Taylor has an NOL, a net operating loss, remember IRS will allow that C corporation to carry the loss back up to two years.

And as I said earlier, What you're trying to do with the loss, carry back is get a refund of taxes you paid in those prior two years. So if you look at the schedule they gave us let's, let's focus in on the prior two years, year six and year seven. Notice in year six, they had 30,000 of taxable income year seven.

They had 40,000 of taxable income added up. There was 70,000 of taxable income in those previous two years. So IRS is going to allow Taylor corporation to take 70,000 of the 200,000 net operating loss. Carry it back for those two years, get a refund of taxes. They paid in those two years, but notice that still leaves 130,000 of unused loss that you can carry forward for up to 20 years.

And that'll save you taxes in future years that you'd otherwise have to pay. So when they ask us at the bottom, what is the operating loss that's available in year nine? It's answer B 130,000. That's the loss carry forward. We've used 70,000 of the net operating loss to wipe out the tax liability for the previous two years.

And that leaves us with 130,000 of unused losses. That's the carry forward. That's what we can carry forward to year nine. And again, for up to 20 years to save taxes in future years that we'd otherwise have to pay number 10, if a corporations charitable contribution. Exceeds the limitation for deductability the excess, you know, is the answer C can be carried forward for up to five years.

Number 11 in a C corporation in a C corporations contribution in a C corporations, computation of the maximum allowable deduction for contributions. What percentage limitation should be applied? To the applicable base amount. Well, it's 10%. We're talking about contributions. What is what's the base amount sub point a taxable income before charitable contribution before dividend received deduction before net operating loss, carry back, carry forward.

That is the base amount and you'll limit it to 10% of that base amount for contributions. And the answer is B 12 is Zephyr Inc had the following items of income and expense and. If you look at the bottom, it says in Zephyr's corporate income tax return, what amount would be reported as income before special deductions?

This is why you really have to have this basic format in your head. So let's just, let's just go through the format for Zephyr at the top. That'd be gross income. What's the gross income. Well, that's the sales 500,000 plus the dividend received the dividend income of 25,000 gross income for Zephyr corporation.

525,000. Then you back out all the ordinary and necessary business expenses that were incurred to produce the income earned. All we have here is cost of goods, sold cost of sales two 50. So that gives us a point a 275,000. Then we would back out the charitable contribution. That's limited to 10% of sub point a, but as far as we know the zero and that gives you what you need.

Taxable income before special deductions. The answer is C. 275,000. And of course, once you're down to that point, then you back out the dividend received deduction and the net operating loss, carry back, carry forward to get taxable income. But all they wanted to know was taxable income before special deductions.

And that is 275,000. Make sure you get comfortable with that basic format because it really will help you a lot. Now, getting back to the format. Let's talk about some of these items in a little bit more detail. We know the way the federal tax form 1120 basically works is the C corporation starts with their gross income.

Now just a couple of things to look out for the gross income of a C corporation would include again, just things to look out for gross income for C corporation would include any rent collected in advance. It's taxable now, even though you haven't earned it, but that gross income would include any rent collected in advance.

Any royalties collected in advance, even though it hasn't been earned. No IRS doesn't care about the matching concept. IRS does not care about a cruel accounting. What IRS cares about is money. So if you've got the money rent collected in advanced royalties collected in advance, it's taxable now. Also in gross income, you would find nonrefundable rent deposits.

Oh, they're non-refundable when we're never going to give it back then it's income for us now. So it also gross income would include non-refundable rent deposits, lease cancellation payments. Now gross income would exclude, exclude interest income from municipal bonds. So the gross income would exclude.

Interest income from municipal bonds. Now, remember we said that a corporation can take out a life insurance policy on say an executive of the corporation. I'm sure you're aware of this. A corporation can take out a life insurance policy on say the president of a corporation and the corporation is the beneficiary of the policy.

It's what they call a key person policy.

Well, if the corporation is the beneficiary of the policy, and let's say the president passes away and the corporation collects a million dollars of life insurance proceeds that's that that million dollars of life insurance proceeds would not be included in gross income. Why? Because life insurance proceeds are not taxable.

So gross income would exclude any proceeds from key person, life insurance policies, life insurance proceeds, but just not taxable. So that would not be included in gross income.

Now after your below gross income, you deduct what you deduct all the ordinary and necessary business expenses that were incurred to produce the income that was earned. Right? Well, here's a question that comes up in the CPA Exam a lot. Can a C corporation deduct on their 1120 on expense that they've incurred, but haven't paid for yet.

Can a C corporation on their federal tax form 1120 deduct inexpense. That was incurred, but has not been paid for yet? Well, the answer is yes. If they follow what is called the accrued expense rule, you've got to know the accrued expense rule. the CPA Exam loves it. All right. Here's the accrued expense rule. A C corporation can deduct inexpense in the year.

End curd, even though it hasn't been paid. If number one, the corporation is obligated by the board to pay the expense. So, yeah, so the corporation has to be obligated by the board. Number two, the service has been rendered and number three, the expenses paid within two and a half months from the end of the tax year.

If it's a calendar year, it would have to be paid by March 15th. So as long as you meet that criteria, corporations obligated by the board. The service has been rendered and payment is made within two and a half months from the close of the tax year. If it's a calendar year, we're talking about March 15th, you have to know that accrued expense rule.

Now how about bad debts? Can a C corporation. On their 1120 take a deduction for bad debts. Yes, but the C corporation must be an accrual basis. Taxpayer and notice for federal tax purposes, the C corporation must use the direct write-off method. In other words, for federal tax purposes, a C corporation is not allowed to use the allowance method which we use under generally accepted accounting principles.

But for federal tax purposes, a C corporation is not allowed to use the allowance method or the reserve method. No, if they're an accrual basis, taxpayer, they can take a deduction on their 1120 for bad debt expense, but it has to be the direct write-off method. And you know what? The direct write-off method means.

There's no deduction until the customer defaults. That is the direct write-off method where there's no deduction until the customer defaults. Can a C corporation take a deduction for taxes? Yes. A C corporation can take a deduction for state and local taxes, real estate taxes, payroll taxes. And of course I'm talking about the employer share, not the employee share.

So state local taxes. Yes. Real estate taxes. Yes. Payroll taxes. Yes. But just the employer share. And I know you know this, but just to say it plainly. The C corporation cannot deduct on their 1120 federal income taxes. Federal income taxes are not an allowable deduction. The federal income taxes for the C corporation.

It's a tax paying entity, but that's not a deduction on their 1120.

The C corporation can take a deduction for organization costs, organization costs, you're drafting the corporate charter minutes of meetings. You're paying state incorporation fees. These are organization costs. And a C corporation can take up to a $5,000 deduction in the first year of operations. And then if there's any excess that's amortized over 15 straight line years, or 180 months that's organization costs, C corporation can take a deduction up to $5,000 in the first year of operations.

And then any, any remaining organization costs are amortized straight line over 15 years or 180 months. Now that 5,000 though, does phase out, you know, once your organization costs add up to 50,000, you start to lose your $5,000 first year deduction, dollar for dollar. When the organization costs exceed 50,000.

So once the organization costs get 55,000, you're not going to get that $5,000 deduction. So once you hit that, once you hit 55,000, the organization costs. You're not going to get that $5,000 deduction. The first year of operation, you would just have to amortize the whole thing over 15 straight line years or 180 months also, they might mention, and you might confuse the two.

There's a difference between organization costs and business startup costs. You know, business startup costs, your surveying, the market, your advertising, your grand opening, your.

Training employees before you open, these are businesses startup costs and the same rule applies, but it's a separate thing. There's no startup costs. You can take up to a $5,000 deduction in the year. You begin operations and the rest is amortized over 180 months, 15 years straight line

in tangible assets. What are in tangible assets, you know, copyrights, patents, trademarks, franchises, even Goodwill for federal tax purposes. All intangibles, even Goodwill are amortized straight line over 180 months, 15 straight line years business travel, a hundred percent deductible business travel, a hundred percent deductible meals and entertainment.

50%. Deductible. So business travel, a hundred percent deductible meals and entertainment, 50% deductible. Now there's an exception there for business meals. If they're on the employer's premises for the benefit of the employer, they're not lavish, they're not extravagant business meals can be a hundred percent deductible.

I mean the general rule is meals and entertainment. 50% deductible. That's the general rule. But as I say, the exception and you know, the example of exceptions, if the meal is on the business premises for the convenience of the business, not lavish, not extravagant, not luxurious could be a hundred percent deductible business gifts.

Business gifts are deductible for C corporation up to $25 per recipient per year. That's business gifts, deductible for C corporation, up to $25 per recipient per year, executive compensation. You can deduct executive compensation up to a million dollars unless it's based, unless it's based on performance, you know, some kind of commissions that's different, but you know, if you're a publicly traded company, you're fi you're for highest paid officers, you're limited to.

Deducting a million dollars of executive compensation up to a million, as I say, as long as it's not, performance-based it can't be some sort of commission based on performance. Can a C corporation take a deduction for depreciation? Of course, that's form 45, 62. And you know, they'd probably use the modified accelerated cost recovery system makers.

Sure. You know all about that, but a C corporation does get a deduction for depreciation. Now, what is not deductible?

What is not deductible penalties, fines, bribes kickbacks, a C corporation can not deduct penalties, fines, bribes, kickbacks, political contributions. And as we said, If a corporation takes out a life insurance policy on say the president of the corporation, it's a key person policy. If that president were to die and the corporation collects life insurance proceeds, not taxable.

Well, the premiums that the corporation pays on that policy are non-deductible that makes sense. Right? It's consistent. So any premiums that the C corporation is paying on a key person, policy would not be deductible. How does a C corporation handle capital gains? You know, if you sell or exchange capital assets that results in capital gains and losses, and you have to know what capital assets are.

I always tell my students just remember what capital assets or not remember capital assets or not. Mr. CIA. Let's just go over it. Mr. CII, Mr. CIA M machinery equipment used in a trader business are real property used in the trader business. That's the Mr. Machinery equipment used in a trader business, real property used in a trader business.

That's the Mr. The C copyrights in the hands of the original artist I inventory and a accounts or notes receivable. That's what capital assets are not. And once you know that, then you can always infer what capital assets are. No stock securities partnership interest as a capital asset. But as I started to say, if a C corporation sells or exchanges capital assets, that results in capital gains and losses.

Now remember if a C corporation has capital gains, a C corporation does not get spec special capital gains tax rates. I have to mention that. If a C corporation does have capital gains cause that's possible. A C corporation does not get special cap capital gains tax rates. An individual taxpayer can get a special tax break on capital gains, not a C corporation.

If a C corporation has any capital gains, those capital gains are taxed at whatever the C corporations marginal tax rate would be. What if a C corporation has capital losses? If a C corporation has capital losses. A C corporation can only use capital losses to offset capital gains. So if it's a C corporation has capital losses, a C corporation can only use capital losses to offset capital gains.

If there's an excess, the C corporation can carry the loss back up to three years. And if that doesn't eat up, the loss carried forward up to five years. So a C corporation could only use capital gains to, to. Excuse me. I see corporation can only use capital losses to offset capital gains. And if there's an excess, the C corporation can carry the loss back up to three years.

Now, there's offset capital gains. In prior years, the prior three years to get a refund of taxes paid in those three years. If that doesn't eat up the loss, if there's any unused loss, then you can carry it forward up to five years. That'll save you taxes in future years that you'd otherwise have to pay.

And one little odd point. When a corporation is carrying these capitals losses back three years forward, five years, the capital loss is always carried a short term. Why? Because a C corporation does not get long-term capital gains tax rates. Anyway. So if they ask him the exam, how was it carried? Always a short term, which makes sense.

When you remember that a C corporation does not get special long-term capital gains tax rates. Anyway. Let's do some more REG CPA Exam questions. I'd like you to shut the class down and do REG CPA Exam questions 13 to 23. And you may have noticed that in the viewer's guide, there are no letter answers to the REG CPA Exam questions. No detailed solutions.

Well that's because I don't believe in having that in the viewer's guide because I think it's a problem. I think if there are letter answers in the viewer's guide, detailed solutions, it's just human. You look up the answer right away. And you don't really try to solve it yourself. You just look up the answer and you'll look at it and go, well, that's what I would have done.

Well, that makes that's probably how I would have solved it. And not only that, because you might be fooling yourself, but not only that you'll notice the answer for the next three or four. No. The best thing is to have no idea what the answer is. Shut the class down, get your answers and then come back and we'll talk about the answers.

Welcome back. Let's do these REG CPA Exam questions together. 13 says global corporation is an accrual basis. Calendar year corporation on December 13th, year one, the board of directors declared a 2% of profits bonus to all employees for services rendered during year one, notified them in writing. None of the employees own stock and global, the amount represents reasonable compensation for services rendered was paid on March 10th, year two.

They want to know when this bonus can be deducted, you know what? It's going to be a valid deduction, but when can it be deducted? Can it be deducted in year one and year one? It's been accrued, but it hasn't been paid yet. It's not going to be paid till March 10th, year two. So can this be deducted in year one or does global have to wait till year two?

Well, of course, what they're testing you on here is the accrued expense rule. So let's go through the criteria. Is this expense board authorized. It is have the services been rendered. They have in year one was the expense paid within two and a half months from the close of the year within March by March 15th.

Yes, it was paid March 10th. So even though it was paid in year two global would be able to deduct this in their year, one return. And the answer is B number 14. In the case of a corporation that is not a financial institution, which of the following statements is correct with regard to the deduction for bad debts, a says either the reserve method or the direct charge off method may be used, you know, that's wrong.

Get used the reserve method. You have to use the direct write-off method. B says on approval from IRS, a corporation may change its method from direct charge off to reserve. Can't use the reserve method. See if the reserve method is con it was consistently used in prior years, the corporation may take a deduction for a reasonable addition to the reserve.

You can't use the reserve method. You have to use the direct write-off method. So of course the answer is D a corporation is required to use the direct charge off method rather than the reserve method. It's that simple. The answer is D number 15, which of the following costs are amortizable as organizational expenditures.

While I want you to notice that a professional fees to issue the stock B printing costs to print up the stock certificates, D commissions paid to the underwriter, a, B and D are not organization costs their costs. You incurred to issue the stock and they really. Get deducted from the net amount you realize from selling your stock, they really in effect lower your capital because all those expenses, as I say, effectively, lower the net amount you collect for your shares for the issuance of your stock.

Those three items really reduce capital. They're not organization costs, but answers see legal fees for drafting the corporate charter, the bylaws minutes of meetings. That's what we mean by organizational costs. So the answer is C number 16, Butte corporation, a calendar. Your corporation provides meals for employees for its own convenience.

The employees are present at the meals, which are neither lavish nor extravagant, and the reimbursement is not treated as wages, subject to withholding. What percentage of the meal expense? Can the corporation deduct? Well, we talked about this earlier. Normally the rule is meals. Entertainment for a corporation would be 50% deductible, but this is a hundred percent.

This is an exception. When the meal is on the corporate premises, not extravagant, not luxurious

for the convenience of the employer. Then the business meal can be 100% deductible. They're just hitting on an exception there. Number 17 keg corporation on accrual basis calendar. Your corporation was organized January 2nd year one, and they have the following information. Notice their taxable income before charitable contributions, 500,000 that's sub 0.8.

Isn't it. You're getting used to this format. The format of the 1120 does help you. Doesn't it. Cause that's really sub point a and we know that. A deduction that a C corporation can take for charitable contributions is limited to 10% of sub point a. So what, whatever, however, this works out. They cannot take a deduction for charitable contributions greater than 10% of 500,000 greater than 50,000.

That's the absolute limitation. Now they had kegs matching contribution to employ designated qualified universities. That's a charitable contribution pick up the 10 and then the board of directors authorized the contribution to. A qualified charity authorized December one year one wasn't paid until February, February one, year two.

What's really the accrued expense rule. Again, it's board authorized. It's not really a service, but it's going to be a contribution to a charity it's paid within two and a half months from the close of the year. So even though that wasn't paid until February 1st year to the corporation would be able to deduct it in the air year one, 1120.

So add up 10,000 plus 30,000, the total deduction that. Keg can take for charitable contributions would be 40,000 answer D because it does not exceed the absolute limitation, which is 10% of 500,000, 50,000. So as long as it doesn't exceed that, just take the full amount. 40 2018. Rain corporations operating income for the year ended December 31 year one amounted to a hundred thousand in year one.

A machine owned by rain was completely destroyed in an accident. So what we're dealing with here is a casualty loss. The machines adjusted basis immediately before the casualty 30,000, the machine was not insured. That's a great idea. No insurance had no salvage value in the corporations year, one tax return.

What amount would be deducted for casualty loss. I only wanted to do this question with you to emphasize that if your mind is thinking back to individual taxation, an individual taxpayer on their 10 40 can take a casualty loss, but remember there's a hundred dollars floor per casualty, and you can only deduct a casualty loss greater than 10% of AGI.

Well, a corporation has none of that criteria to worry about. The answer is D a C corporation will take the $30,000 loss as a business loss. So just to point out that difference for a C corporation, this is fully deductible as a business loss of 30,000, no, a hundred dollars floor per casualty temp, greater than 10% of AGI.

None of that applies. It's a corporate taxpayer, so it's just fully deductible as a business loss number 19. Hayes corporation, accrual basis, calendar C corporation began business January one, incurred the following costs. There were underwriters fees to issue the stock. You know, that's not an organization cost that lowers the amount you realize for the sale of your securities.

It really lowers your capital legal fees to draft the corporate charter. Yes, the 16,000 is an organizational cost haze elected to amortize the organization cost. What was the maximum amount of costs that Hayes could deduct for tax purposes in its first calendar year tax return, 5,000 answer date, maybe you can take up to a $5,000 deduction the year you begin operations.

That's why the answer is date. The rest amortized straight line over 15 years or 180 months. Number 20, uh, corporations loss carry back. Or carry over is a not allowable under current law. Of course it's allowable. Is it limited to 3000? No. That's for an individual taxpayer always treated as long-term actually, no, it's always treated as short term.

The answer is D it's always treated the short term because a corporate taxpayer does not get special long-term capital gains tax rates anyway, so it's always carried. As short-term 21 micro a calendar year accrual basis corporation purchased a five-year 8%, a hundred thousand dollars taxable corporate bond at a premium corporation paid 108,005 30 for the bond July one year one.

That was the date. The bond was issued. The bond paid interest. Semi-annually. For Micro's tax return, the bond premium amortization for year one. Should what? Well, number one, statement number one says, should it, should the premium amortization be computed under the constant yield method? In other words, the effect of interest method yes.

For tax purposes, you do use the effective interest method or the constant yield method is the amortization statement. Number two, treat it as an offset to interest income. It is the amortization of a premium effectively lowers for tax purposes. The interest income. So the answer is B both statements are true.

22, Mary fine is the sole stockholder of RAL corporation on a cruel basis. Taxpayer engaged in wholesaling. Rouse retained earnings January one year, one amount of two, a million for the year ended December 31 year one Rouse book income before tax was 300,000 included in the computation of this 300,000 was a $5,000 loss from the sale of in investments in stock to an unaffiliated corporation, the stock had been held two years.

Notice Ralph had no other capital gains or losses in computing, taxable income. Route would deduct a capital loss of what? Well, you know, it's zero because a C corporation can only use capital losses to offset capital gains. A C corporation doesn't get a deduction for capital losses. They can only use capital losses to offset capital gains.

And they said that Ralph had no other capital gains or losses. So there'd be no deduction for that capital loss answer a 23. M corporations, 55,000 of income before income taxes includes 10,000 of life insurance proceeds. The life insurance policy proceeds represent a lump sum payment in full as a result of the depth of the controller.

M corporation was the owner and the beneficiary of the policy. This is a key person policy. And at the bottom, it says in the income tax return, M corporation should report taxable life insurance proceeds up zero answer date, life insurance proceeds are not taxable. The corporation was the beneficiary of the policy and life insurance proceeds are simply not taxable.

All right now, I want to go back to the basic format. Uh, the federal tax form 1120 that I know you're starting to have a real, a real affection for, cause we come back to it so often and it helps you a lot. We know we start with gross income. We back out all the ordinary necessary business expenses to produce the income that was earned.

That gives a sub point a I C corporation can take a deduction for charitable contributions, limited to 10% of some point a and then that gives you the all-important line taxable income before special deductions. Now we've talked about net operating loss, carry back, carry forward, but we haven't yet talked in detail about the DRD.

The dividend received deduction. Let's get into that now. Now here's the bottom line. When one domestic corporation pays another domestic corporation, a dividend. So that's the fact pattern you're looking for when one domestic corporation pays another domestic corporation, a dividend, a certain percent of that dividend.

Will be non-taxable when one domestic corporation pays another domestic corporation, the dividend, a certain percent of that dividend will be non-taxable to the corporation that received the dividend. This is the dividend received deduction. Now there is a holding period requirement here. If it's common stock that we're talking about to qualify for the DRD, the corporation had to own the stock for more than 45 days.

So there is a holding period requirement here. If it's, if it's common stock, if it's a dividend on common stock to qualify for the DRD, the corporation receiving the dividend had owned the stock for more than 45 days. If it's preferred stock, the corporation receiving the dividend had to own the stock for more than 90 days.

In other words, what that shows you is that the DRD, the dividend received deduction was not meant for very temporary investments in stock, just temporary stock holding. That's not what it's for. All right now to calculate the dividend received deduction, because you have to be able to do this in the CPA Exam and to calculate the dividend received deduction.

The first thing you must determine is the DRD percentage. Now, here are the rules, cause you ha you can't do any DRD problem until you nail down the DRD percentage. The rules work like this. If the corporation receiving the dividend. All ones, at least 80% up to a hundred percent of the stock of the corporation paying the dividend.

The DRD percentage is a hundred percent. I'll say it again. If the corporation receiving the dividend owns at least 80% up to 100% of the stock of the corporation, that's paying the dividend. The DRD percentage is a hundred percent. If the corporation receiving the dividend owns at least 20% up to 80%.

So at least 20%, but less than 80%. Of the stock of the corporation that's paying the dividend. The DRD percentage is 80%. And then finally, if the corporation receiving the dividend, all ones less than 20% of the stock of the corporation, that's paying the dividend. The DRD percentage is 70%, but I make my point again, you can't solve any DRD problem unless you have your DRD percentage.

Now, one more point, if the CPA Exam is silent because they do this. If the CPA Exam is silent, if the CPA Exam doesn't say anything about what percent of the stock of the dividend paying company, the dividend receiving company owns. If the CPA Exam is silent, you always assume that the DRD percentage is 70%. Just a rule of thumb.

the CPA Exam says nothing about ownership percentage. You have to assume that the corporation receiving the dividend owns less than 20% of the stock of the corporation. That's paying the dividend. And the DRD percentage is 70%. All right. Now, here is the general rule general rule. Is this your dividend received deduction?

Your DRD is the lesser of two things. Again, your dividend received deduction. Your DRD is the lesser of two things. Either. Number one. The DRD percentage times the taxable income before the DRD or the DRD percentage times the actual dividend you received. Let me say that again. That's the general rule.

You've got to know it. Cold. Your dividend received deduction or DRD is the lesser of those two things. Either the DRD percentage, times the taxable income before the DRD or the DRD percentage times the actual dividend you received. Let me show you some examples. Now listen carefully in all my examples.

I'm going to assume that the corporation receiving the dividend owns less than 20% of the stock of the corporation. That's paying the dividend. In other words, in all my examples, I'm going to assume that the DRD percentage is 70%. Cause I'm going to say again, you can't solve any DRD problem until you nail down the DRD percentage.

And I'm going to assume in all my problems that the DRD percentage is 70%. Let's look at some let's look at some examples. Let's say that a corporation has 500,000 of income from operations and the corporation also received a hundred thousand dollars dividend from a domestic corporation. So obviously total gross income, 600,000.

I'll say that again. I'm assuming that the corporations income from operations 500,000 and the corporation also received a hundred thousand dollars dividend from a domestic corporation. So total gross income, 600,000, and let's assume that all their ordinary and necessary business expenses 400,000. So that gives you that the income before the DRD is 200,000.

So that's we know now the income before the dividend received deduction is 200,000. Now, what is your dividend received deduction? Now, remember your dividend received deduction is the lesser of two things. Either. Number one, Your DRD percentage, which I'm assuming is 70% times the taxable income before the DRD, which is 200,000, that comes out to 140,000 or my DRD percentage, 70% times the actual dividend, I received a hundred thousand that comes out to 70,000.

I look at one 40, I look at 70, I take the lower of the two. This corporations dividend received deduction is 70,000. So the taxable income for this corporation, 130,000.

Let me give you example B once again, let's assume that the corporation's income from operations 500,000, they also received a hundred thousand dollars dividend. From a domestic corporation. So total gross income, 600,000. And we'll assume that the, the ordinary and necessary business expenses 510,000. So now this corporation's income before the DRD 90,000, what is the dividend received deduction while we know the general rule that your dividend received deduction is the lesser of two things, either.

Number one, my DRD percentage, which I'm still assuming is 70%. Times the taxable income before the DRD 90,000, that comes out to 63,000 or my DRD percentage, 70% times the actual dividend, I received a hundred thousand that comes out to 70,000. I take the lower of the two. So in this case example, B the corporations dividend received deduction is 63,000.

So taxable income would be 27,000 example C. Once again, we'll assume that the company has income from operations of 500,000. They also received a hundred thousand dollars dividend from a domestic corporation. So total gross income once again, 600,000. But now we're going to assume that all the ordinary and necessary business expenses to produce the income earned come out to 650,000.

So now there's a loss before the DRD. Uh, 50,000. So what is the DRD? Well, I know the general rule, my DRD generally is the lesser of two things. It's either the DRD percentage, which I'm assuming it's still 70% times the tax wind come before the DRD. That's 50,000. That comes up to 35,000 or my DRD percentage, 70% times the actual dividend, I received a hundred thousand that comes out to 70,000.

Normally I take the lesser of the two. But notice, not in this case, because this is an exception and you have to know it. What's the exception. If there's a net operating loss before the DRD, you ignore the general rule and just take the full DRD again. If there's a net operating loss before the DRD, then you ignore the general rule.

Just take the full DRD percentage, 70% times the actual dividend that you received a hundred thousand. Take the full 70,000. If there's a net operating loss before the DRD, then you ignore the general rule and just take the full DRD. So now they have a net operating loss in total of 120,000, but you got to watch out for that.

If there's a net operating loss before the DRD, you ignore the general rule, just take the full 70,000 DRD. And that gives you a net operating loss of 120,000 example. Dig. Once again, we'll assume that this corporation's income from operations 500,000. This corporation also received a $100,000 dividend from a domestic corporation.

So total gross income, 600,000, all their ordinary and necessary business expenses. 550,005 50. So they do have taxable income before the DRD of 50,000. Right? So what is my dividend received deduction? Well, I know that generally my dividend received deduction is the lesser of two things. It's either my DRD percentage, which I'm still assuming is 70% times the taxable income before the DRD, which is 50,000, that comes up to 35,000 or.

My DRD percentage, 70% times the actual dividend, I received a hundred thousand that comes out to 70,000. Normally I take the lesser of the two, but not in this case. Why? Because notice in this case example, D if I take the full DRD 70,000, it creates a net operating loss, and that's another exception. If taking the full DRD creates a net operating loss.

Then you ignore the general rule and just take the full DRD again. If taking the full DRD in this case, 70,000 creates a net operating loss, then you ignore the general role. Take the full DRD, the full 70,000. So now my net operating loss is 20,000. I know what you want to hear. Example E once again, we'll assume that this corporation's income from operations.

500,000. This corporation also received a a hundred thousand dollars dividend from a domestic corporation. So total gross income, 600,000. And let's assume that all of their ordinary and necessary business deductions 530,000. So they do have income before the DRD of 70,000. Now, what is my general rule set?

My general rule sets that my DRD is the lesser of two things. Either first, my DRD percentage, which I'm still assuming it's 70% times the taxable income before the DRD 70,000, that comes out to 49,000 or my DRD percentage, 70% times the actual dividend, I received a hundred thousand that comes out to 70,000.

Normally I take the lower of the two. So let me ask you a question. If do any exceptions apply here? What am I exceptions? But there's two of them. First, is there a net operating loss before the DRD? No. Right. Remember that's one of the first acts that is the first exception. If there's a net operating loss before the DRD, I ignore the general rule, but there's not a net operating loss before the DRD.

So that doesn't apply. What's my second exception. If I take the full DRD 70,000, will that create a net operating loss? No notice in this case, if I take the full DRD, the 70,000, it just brings me to break even. I have no income or loss. So notice taking the full DRD does not create a net operating loss.

If I take the full DRD 70,000, it just brings me to break even. So there's no exception that applies here. So I just take the lesser of the two, which is I'm just back to my general rule again. So I take the lesser of the two 49,000 and my taxable income will be 21,000. Now the DRD does not apply. Just be careful here.

The dividend received deduction does not apply to S corporations. We'll talk about S corporations later in this class, but a dividend received deduction simply does not apply to S corporations, real estate, investment trusts, REITs, personal service corporations, personal holding companies just simply does not apply.

I'd like you to do 24 25 and 26, and then come back.

Welcome back. Let's do this group of REG CPA Exam questions together in number 24. They say in year one, Avery corporation on a cruel basis, calendar year C corporation received a hundred thousand dollars dividend from an unrelated domestic corporation. And you know, when one domestic corporation pays another domestic corporation, a dividend, that's how you get into the dividend received deduction.

And if you go to the bottom, that's what they want to know. What is Avery's dividend received deduction for year one? When you look at the information, they have a loss from operations of 10,000, they have the. A hundred thousand dollars dividend received from the domestic corporation. So total taxable income before the DRD 90,000.

So how do we work out the dividend received deduction? Well, remember we said earlier in this REG CPA Review course that if you're going to solve any DRD problem, the first thing you have to figure out is the DRD percentage. Is it 70%, 80%, a hundred percent. That depends on what percent of the stock of the dividend paying company.

That the dividend receiving company owns. We don't know that we don't know what percent of the stock of the company paying the dividend that Avery, the dividend receiving company owns. So what did we say in this class, if they're silent, what do we always assume? We always assume that Avery, in this case, my stones, less than 20% of the stock of the corporation is paying the dividend.

You have to assume that the DRD percentage is. 70%. So we know the general rule, the general rule is that the DRD, the dividend received deduction will be the lesser of two things. Either the DRD percentage, 70% times the taxable income before the DRD. That's 90,000 that comes out to 63,000 or the DRD percentage, 70% times the actual dividend, they received a hundred thousand that comes out to 70,000.

Normally we take the lesser of the two, but remember there are exceptions and the reason I'm bringing these up is because I want my students to always think of the exceptions. What's the first exception. First, if there's a net operating loss before the DRD, but there isn't here. There's 90,000 of taxable income before the DRD.

So the first exception where we have to watch out, if there's a net operating loss before the DRD does not apply, but I like you to think of it. What's the second exception. If I take the full DRD 70,000, will it create a net operating loss? No, because the taxable income is 90,000. There's plenty of taxable income here.

So all my point is neither exception applies, but I like you to think of them because they'll try to fool you with the exceptions, but since neither exception applies, I just use the general rule. I take the lesser of the two 63,000. The answer is D that would be the dividend received deduction for Avery corporation, 63,000 number 25, the corporate dividend received deduction.

I bet you went right to it. Answer B is affected by the requirement that there's a certain holding period. Remember if it's common stock to qualify for the DRD, you have to, you have to own the stock for more than 45 days. If it's preferred stock. You have to own the stock for more than 90 days, the dividend received deduction is not meant for very temporary holding of stock.

That's not, that's not its intention. So, you know, the answer is big. There is a holding period requirement here in number 26, Kisco corporation's taxable income before the DRD 70,000. This includes a $10,000 dividend from an unrelated domestic corporation. Given the following tax rates, what would be the income tax before any credits?

They want to know the tax liability while we have to work out the DRD. And once again, you can't do any DRD problem till you nail down the DRD percentage. And once again, it must be 70% because they're silent. We don't know what percent of the stock. Uh, the corporation paying the dividend that Kisco owns.

We don't know that. So we have to assume it's less than 20%. We have to assume that the DRD percentage is 70%. So what's our general rule. Say our general says that. Our dividend received deduction is the lesser of two things. Either the DRD percentage, which we're assuming is 70% times the taxable income before the DRD 70,000, that comes out to 49,000 or my DRD percentage, 70% times the actual dividend that was received 10,000, that comes out to 7,000.

Normally I take the lesser of the two, which of course would be 7,000. Does any exception apply? Is there a net operating loss before the DRD? No there's income of 70001st exception does not apply. How about the second exception? If I take the full DRD 7,000, would that create a net operating loss? No, there's plenty of taxable income.

So my point is neither exception applies, but I like you to think of them. To be careful. So what lie do, just use the general rule. I take the lesser of the two, which is 7,000. So if they're taxable income before the DRD was 70,000, and now we know the dividend received deduction is 7,000. That gives you taxable income

of 63,000. Now they want us to work out the actual tax liability. So we have enough information here. If the actual taxable income is 63,000, we know the first 50,000 is taxed at 15%. So that's a tax liability of 7,500. Then the remaining 13,000 would be taxed at 25%. That comes out to 3002 50. So the total income tax total tax liability here is answer B 10,750.

Now, you know that there are differences between the income that a corporation reports on their income statement on their books. Under generally accepted accounting principles and the income that's reported on the 1120 taxable income. I think we all know that very well. There are differences between the income that's reported on the books, on the income statement under generally accepted accounting principles and the taxable income on the 1120.

And my point is that part of the federal tax form 1120 is to reconcile. Book income under gap to the taxable income on the 1120. This is what schedule M one is about where we reconcile book income under gap to taxable income. And it's very important that you know how to do this. So let me give you an example.

Let's set up a column for book and a column for tax, and let's go through some of the. Common differences that the CPA Exam may throw at you. And you'll find when you, when you look at these, if you've studied for financial already, if you had our class on deferred taxes, then you know that in financial accounting and reporting, it's very important to be able to reconcile from book income, to taxable income.

So we're doing the same thing here, but the difference is in the regulation exam. They're going to give you more tax rules to think about. So let me give you a typical example. We'll set up a call and for book income, I call them for taxable income. Now let's go through some differences. Let's assume that this company had a $6,000 capital loss.

Now, if this company had a $6,000 capital loss, would that be on the books? Would that be on the income statement? Yes. Other gains and losses. The corporation would show that on their income statement under generally accepted accounting principles, other gains, or the losses, the full capital loss would be there.

But remember for federal tax purposes, IRS would disallow that. Why? Because a C corporation can only use capital losses to offset capital gains. So assuming they have no capital gains here, I'm assuming they do not. IRS would disallow that. And if IRS disallows that all by itself, that's going to cause taxable income to be 6,000 higher than book income.

I hope you understand that point. IRS disallows that loss, the effect that has is to cause taxable income to be 6,000 higher than book income. That's a positive adjustment, the taxable income meals and entertainment. Let's assume that this company had. $10,000 of meals and entertainment expenses, would that 10,000, all 10,000 meals and entertainment expense beyond the books?

Yes. All that would be on the books because all IRA, because all gap cares about is that that's an expense. You incurred in the pursuit of profit. It's all gap cares about all 10,000 meals and entertainment expenses would be on the books because that's gap's point of view. That's 10,000 of expense. You incurred in the pursuit of profit.

But remember on the 1120 for federal tax purposes, meals and entertainment are only 50% deductible. So IRS would disallow 50% of that or 5,000. And once again, if IRS disallows a deduction, a deduction, that's going to cause taxable income to be higher than book. We add that that's a positive adjustment now, depreciation.

They always love depreciation. Let's say on their books, they took six that they took $2,000 of depreciation on their books under gap. They took $2,000 depreciation, but let's say on their tax return, they're using makers, the modified, accelerated cost recovery system makers. It's an accelerated method. So let's say on their tax return, they took 6,000 of depreciation six.

Well, If there's $4,000 more depreciation on the tax return over and above what you have on the books all by itself. That's going to cause taxable income to be 4,000 less than book income.

Okay. You understand that one. If this 4,000 extra depreciation on the tax return over and above what you took on the books, then all by itself, that's going to cause taxable income to be 4,000 less than book income. That's going to cause taxable income to be lower than book income, bad debt expense on their books.

They follow gap. They have to, and remember under gap, you have to estimate your bad debt expense for the year under gap, we use the allowance method. We set up a provision on our balance sheet out allowance on our balance sheet for the accounts that we think will go bad. So for gap on our books, we estimate our bad debt expense.

Now the IRS would disallow that because for IRS purposes, you can only take that bad debt expense when the customer defaults, presumably that hasn't happened yet for tax purposes, we have to use the direct write-off method or the direct charge off method. So my point is IRS would disallow that. And once again, if IRS disallows a deduction, that's going to cause taxable income to be five, 500 higher than books.

Taxable income because of that is 500 higher than book, a positive adjustment. Let's say that this corporation paid a thousand dollars of premiums on a key person policy, you know, with the key person policy, the corporation is the beneficiary of the policy. Well, with the thousand dollars premium, beyond the books on the income statement shore, because that's an expense that was incurred in the pursuit of profit, it's all gap cares about that expense would definitely be on the books.

But IRS would disallow it. Wouldn't they, if the corporation is the beneficiary of the policy, if it is a key person, policy, IRS would disallow that and that's going to cause taxable income to be higher than book by 1,001 more. This corporation has $60,000 worth of Goodwill on the balance sheet on the books.

Remember under gap, we do not amortize Goodwill. We do not. We test it for impairment. At least annually. So if the $60,000 of Goodwill on the books, on our books, we do not take amortization. What we do is test that Goodwill for impairment, at least annually. And we're not, we're not told anything about impairment.

So I'm assuming there'd be nothing on the books, but for tax purposes, Goodwill is just another intangible and it's amortized straight line over 15 years. So we take the 60,000 of Goodwill divide by 15 straight line years. That would be. 4,000 of amortization expense on the tax return that you wouldn't have on the books.

And that's going to cause taxable income to be 4,000 less than book income, add it all up. There's a net positive adjustment to taxable income of 4,500 so important. When you go in the regulation exam to be able to reconcile from book income, to taxable income, it is an essential thing to be comfortable about.

Because as you can just imagine, this would make a great simulation and it certainly makes great multiple choice. So let's see what they're like. I'd like you to do 27 to 31 and then come back.

Welcome back. Let's look at these REG CPA Exam questions together in number 27. In year two, Ciro corporations, second year of operation Ciro's book income before federal income taxes, 400,000. And what's included in the book. Income were a couple of items and they want to know at the bottom of the question, what is taxable income?

As I say, it's so important in the CPA Exam to be able to reconcile from book income, to taxable income. All right. So we know the income on the books under gap is. 400,000. And how about the state income tax refunds? Well, you know that the state income tax was deducted on the income statement. The state income tax that was paid was deducted on the income statement under gap as an expense.

And if you now get a refund, the refund is taxable on the income statement, miscellaneous income. So that's in the 400,000. But it would also be on the tax return. There's no difference there, there's no different treatment there that 10,000 would also be taxable on the 1120. So that's not that doesn't create a difference.

How about the meals and entertainment? Well, you know, the meals and entertainment, all 10,000 of the expense would be in the books because that's an expense. You incur it in the pursuit of profit. It's all gap cares about, but IRS would disallow half of that. Because for federal tax purposes on your 1120, a corporation can only deduct 50% of meals and entertainment.

So IRS would disallow 5,000 of that. And as we've said in our discussion, if IRS disallows a deduction of 5,000, 50%, that's going to cause taxable income to be higher than book by 5,000. So taxable income must be 5,000 higher than book income, 405,000. Answer B. Number 28 media corporation is an accrual basis.

Calendar year sequel, operation it's reported book income included 6,000 in municipal bond interest in gum it's expenses included 1500 of interest incurred on indebtedness used to carry municipal bonds and 8,000 and advertising expense. What is the net M one adjustment to reconcile. Book income under gap to taxable income.

What is the net M one adjustment in the form? 1120 to reconcile the taxable income? Well, let's work it out. Just set up in your mind, a little column for taxable income. How about the municipal bond interest income of 6,000? Is that on the books? Of course it is. Why? Because you weren't, it it's all gap cares about.

That would be in the income statement. It would be in the books because that's 6,000 of income that you earned. But it wouldn't be on the tax return because interest income from municipal obligations is just not taxed. So all by itself, that's going to cause taxable income to be 6,000 less than book income.

I hope you see why that is a minus adjustment because that income is not on the tax return. I mean, income interest income from municipal obligations is just not taxed. So all by itself, that's going to cause taxable income to be 6,000 less than book income. Now the interest expense incurred on indebtedness to carry investments.

Well on your books, it's fully deductible. It's fully deductible on the books. It's an expense incurred in the pursuit of profit. So on the income statement on the books under gap as an expense, But IRS would disallow it. Why? Because if the interest expense is on indebtedness, that you've in embeddedness, you've taken on in order to carry a non-taxable investment.

If the indebtedness is being used to carry a non-taxable investment than the interest expense to carry that indebtedness is non-deductible. So IRS would disallow that deduction. And as we keep saying, if IRS. Just allows a deduction that causes taxable income to be higher than book. That's a positive adjustment of 1500.

How about the 8,000 of advertising expense? Is it on the books? Of course, another expense incurred in the pursuit of profit. Is it on the tax return? Yes, it is. It would be there too. Advertising expense is on the 11, 20 as well. So that wouldn't cause any difference. So if you, so if you add it up, what we have here is a net.

$4,500 minus adjustment. The answer is that taxable income must be 4,500 less than book income. It's a 4,500 minus adjustment. Meaning taxable income is 4,500 less than book income. Answer a in number 27, January 2nd tech cooperation and accrual basis. Calendar your C corporation. Purchased all the assets of a sole proprietorship, including 60,000 in Goodwill text book income before and before federal income taxes, 400,000, no deduction for annual amortization of Goodwill was taken in the financial statements.

Of course not. We don't amortize Goodwill in financial reporting. We tested for impairment at least annually, but there was, there's nothing here about an impairment loss of any kind. But there's no amortization taken on the books under gap, none, but on the 1120 for federal tax purposes, Goodwill is amortized like any other intangible, any other intangible Goodwill, Goodwill is no different.

It's going to be amortized over 15 straight line years or 180 months. So divide by 15 straight line years on the tax return, there would be $4,000 of Goodwill amortization, nothing on the books because. Goodwill is not, is no longer advertised for financial accounting and reporting purposes. It's tested for at least annually.

And there's nothing here about an impairment, but there would be 4,000 of Goodwill amortization on the 1120, because Goodwill is amortized like any other intangible. So all by itself, that's going to cause taxable income to be 4,000 less than book income. And what they're asking you here is what is taxable income?

Well, taxable income must be 4,000 less than book income. Answer B 396,000. As I keep saying, you can't go in that exam and not know how to reconcile book income to taxable income.

Number 30 Cape company. Reported book income of 140,000. All right. So there's the income on the books? 140,000 under gap included in that amount was 50,000 for meals and entertainment and 40,000 for federal income taxes. And they want to know what's taxable income. Once again, what the CPA Exam is making you do is reconcile from book income to taxable income.

Let's go through it. We know the income on the books is 140,000. How about the meals and entertainment? What all 50,000 of meals and entertainment expense be in the books? You know, it would. Because all gap cares about is that that's 50,000 in expenses that you incurred in the pursuit of profit, but IRS would disallow half of it because the federal tax purposes on the 1120 a corporation could only deduct 50% of meals and entertainment expense.

So if IRS disallows half of that 25,000, when IRS disallows a deduction, 25,000, that's going to cause taxable income to be higher than books. By 25,000. I hope you see why that's a positive adjustment. How about the 40,000 of federal income tax expense? Is it in the books? Absolutely. It's on the books.

Remember the way a corporation looks at federal income taxes. It's just another expense of doing business. That's all federal that's how generally accepted accounting principles really looks at federal income taxes for the corporation. Just another expense of doing business. So it's on the income statement.

It's in the books, but IRS would just allow it. Because it's not on the 1120, your federal income tax expense is not an allowable deduction on your 1120. And again, if IRS disallows a deduction that causes taxable income to be higher than book by 40,000, if you added up one 40 plus 25 plus 40 taxable income must be 205,000.

Answer a, let me ask you a question. What if they asked you, you know, what are the three most common differences? Between book and tax on, uh, on the schedule. M one, what are the three most common? Well, I would say the three most common on the M one, which would be this one, federal income taxes. I'm just guessing, but I'll bet that's the most common federal income taxes.

Cause it's on the income statement is never on the 1120. So federal income tax, probably the most common. Maker's depreciation got to be in there as another one. That's a very common one straight line depreciation on the books, makers accelerated depreciation on the tax return. And I would say meals and entertainment being just 50% deductible for a corporation.

I would say those are the three most common am. Want adjustments, number 31.

For the calendar year, Kelly corporation had income on the books of 300,000. They say, assuming that no bad debts written off, what is the taxable income for the year? So once again, they're making us reconcile from book income to taxable income. So let's do it. We know the income on the books is 300,000.

How about that dividend received from an unaffiliated domestic corporation? So Kelly, a domestic corporation received a $50,000 dividend from another domestic corporation.

So we know that Kelly would qualify for the dividend received deduction. Do we know what percent of the dividend paying stock comp corporation do we know what percent of the corporation stock that's paying the dividend that Kelly owns? We do not. If they're silent, we assume that the DRD percentage is 70%.

If you take 70% of 50,000, the dividend received deduction would be 35,000, because obviously that would be lower than the DRD percentage times the taxable income before the DRD, which would be well above, you know, 70% of a 300,000 plus would be well above 200,000. And if we take the lower of the two. So the dividend received deduction would just be the DRD percentage.

Again, they're silent. I have to assume it's 70% times the actual dividend received 50,000 would give you 35,000. So Kelly would take a dividend received deduction of 35,000. And how about the bad debt expense? Their bad debt expense represents an increase in the allowance account of 80,000. IRS would disallow that because for federal tax purposes, you cannot use the allowance method.

You have to use the direct write-off method. And they said, No bad debts were written off. That's the direct write-off method that you write off the bad debt expense when a customer defaults, but no bad debts were written off. So IRS would disallow that 80,000 cause that's an estimated bad debt expense.

IRS does not allow you to estimate your bad debt expense. And if IRS disallows a deduction that causes taxable income to be higher than book. So add that 80,000 taxable income for Kelly must be 345,000. That's looking at the book income Kelly would qualify for the dividend received deduction. The lesser of the DRD percentage, which we have to assume is 17 present.

Cause they're silent times the income before the DRD that's well above 300,000. So that would come out to 200,000 plus or the DRD percentage, 70% times the actual dividend received 50,000 take the lesser of the two, which would be 35,000. Kelly would get that deduction. The bad debt expense would be disallowed because it's.

The allowance approach, the reserve approach, an increase to the reserve. No actual bad debts were written off and that's all we can take on our 1120. So IRS disallows that cause it causes taxable income to be higher than book. And that gives us taxable income 345,000. The answer is safe. Those are your  adjustments.

Now if the CPA Exam mentioned schedule M three, it's very similar schedule M three is required for corporations that have total assets of $10 million or more. So schedule M three, very, very similar to M one. Is required, but corporations with total assets of $10 million or more. And as I say, this M schedule M three is very similar to the schedule.

M one, but it's more detailed schedule. M three gives more detail about temporary differences, permanent differences. There are separately reported and also schedule M three reconciles worldwide consolidated book income. Two worldwide consolidated taxable income. So schedule M three, as I say, also reconciles worldwide consolidated book income to worldwide consolidated, taxable income, very similar to the M one.

Now, you know that when you talk about corporations, inevitably, you talk about dividends. the CPA Exam loves dividends. Let's talk about dividends now for federal tax purposes, a dividend by definition. Is a distribution of earnings and profits. That's how a dividend is defined for federal tax purposes. It is a distribution of earnings and profits.

The tricky thing here is that there is current earnings and profits, and there is accumulated earnings and profits. That's what complicates this a little bit, because a C corporation will have current earnings and profits and also. Accumulated earnings and profits retained earnings, essentially. So here are the rules.

If current earnings and profits is positive. In other words, it's a profit, but accumulated earnings and profits say as of January one, like think of accumulated earnings and profits as your retained earnings is negative. It's in deficit. When it comes to a dividend, don't net them. If current earnings and profits is positive, it's a profit, but accumulated earnings and profits, January one is in deficit.

It's negative for a dividend. Don't net them. On the other hand, if current earnings and profits is negative, it's a loss, but accumulated earnings and profits as of January, one is positive for dividend purposes. You net them. Now what if current earnings and profits is positive, it is a profit and accumulated earnings and profits.

As a January. One is also positive when it comes to a dividend, you add them. So if they're both positive, if current earnings and profits is positive and accumulated earnings and profits is positive, if they're both positive that both. In plus the both profits when it comes to a dividend, add them another possibility.

If current earnings and profits is negative, it's a loss, accumulated earnings and profits is negative. It's in deficit and there's a distribution. What's not a dividend. If they're both negative and as a distribution, it's not a dividend because there's no earnings and profits. That distribution must be a return of capital.

Now the only other thing you have to worry about is a property dividend, a property distribution. What if appreciated property is distributed as a dividend?

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hello and welcome to the Bisk CPA review course and our coverage of the regulation section of the CPA exam. My name is Bob Monette. I'll be your instructor for this class. And in this class, we're going to be talking about the federal taxation of. Partnerships, we'll also be talking about some other tax topics as well, but we're going to spend most of this REG CPA Review course talking about the federal taxation of partnerships.

Now very similar to an S-corporation very similar to an S-corporation. A partnership is not a tax paying entity. It is a pass through entity, all the earnings and losses of the partnership pass through to the individual partners. Everything is taxed at the individual partner level. As I say, it's very similar to what S-corporation.

We know that every shareholder in an S-corporation receives a K one, well, each partner in a partnership is going to receive a schedule K one and each individual partner will be taxed based on what's on that K one, each individual partner in the partnership. We'll be taxed on their pro rata share of partnership, income losses, deductions credits all reflected on the individual partners.

K one. So as a partner in the partnership, you're taxed based on what's on that K one. In other words, you're not taxed on distributions. We'll say more about that later, but generally you're not taxed on distribution. You're taxed based on what's on that, on that K one. Now, even though the partnership is not a tax paying entity, the partnership has to file an information return to the IRS that's federal tax form 10 65.

Now let's just think about the basic format of the partnership return. The 10 65 on the 10 65. The partnership will show all their business income. And of course the partnership we'll take a deduction for all the ordinary and necessary business expenses that were incurred to produce the income. But then there's something unique to partnerships.

The partnership on the 10 65 can take a tax deduction for any guaranteed payments to partners. So I want you to notice that. That the partnership on the 10 65 can take a deduction for any guaranteed payments to partners. And that will give you the net business income or the net business loss of the partnership.

Now, as I say, this idea of guaranteed payments to partners, this is unique to partnerships. So let me define it. Guaranteed payments to partners are payments to partners for services or use of capital without any regard to partnership income. Let me say it again. Guaranteed payments to partners are payments to partners for services or use of capital without any regard to partnership income.

It's not a distribution of profits. The payment is guaranteed. All right, Lindsey, let's be clear on this. When a partnership makes guaranteed payments to partners, how is that handled? Well, the partnership gets a tax deduction for any guaranteed payments to partners. The tax deduction on the partnerships, 10 65.

Now the individual partner that received the guaranteed payment that guaranteed payment will be on that partners. K one, and it will be taxed as ordinary gross income. So the partner that received the guaranteed payment, that guarantee payment will be reflected on that. Partner's K one and it'll be taxed as ordinary gross income.

Now I think you may know what's coming next because the taxation. Is always at the individual partner level based on what's on the partner's K one, there's also going to have to be separately stated items of income reflected on the partners. K one. So just think for a second, what has to be separately stated?

Well, capital gains and losses have to be separately. Stated dividend income has to be separately stated charitable contribution. Have to be separately stated again, the taxation is at the individual partner level. So all these items are separately stated on the partner's K one investment interest expense, section 1231 gains and losses, any foreign taxes paid, any tax credits.

All these items have to be separately stated for the simple reason that all the taxation is at the individual partner level. So let's be clear on this. What will be on a partner's K one? If you're a partner in a partnership, what's going to be reflected on a partner's K one. What's going to be on a partner's K one.

First of all, will be any guaranteed payments received by that partner because we know, and he guaranteed payments received by that partner will be on the partners K one, and be taxed as ordinary gross income. Also on the partners, K one will be that partners, prorate a share of the net business income, more than net business loss of the partnership.

And also what's on the K one will be that partners prorate a share up separately, stated items. That's what's on a partner's K one. Now the partnership generally uses a calendar year. Partnership generally uses the tax year that the majority partners use, which will generally be a calendar year. Now a partnership can elect to use a fiscal year.

Other than a calendar year partnership can elect to use a fiscal year. But if the partnership elects to use a fiscal year, that fiscal year cannot result in deferring taxable income for individual partners, more than three months, you have to remember that limitation. So again, generally a partnership we'll use a calendar year.

Generally the partnership we'll use the tax year that the majority partner has bought a partnership can elect to use a fiscal year. Other than a calendar year, but if the partnership elects to use a fiscal year, that fiscal year that they elect can not result in deferring taxable income for individual partners for more than three months.

Let me just illustrate quickly. Let's say a partnership does elect to use a fiscal year. The fiscal year is going to go from October 1st, 2012 to September 30th, 2013. That's the fiscal year they've elected October 1st, 2012 to September 30th, 2013. Now let's say. An individual partner in that partnership, their tax here's a calendar year.

The tax year ends December 31st, 2012. While you see the result that the fiscal year has on taxable income, all the taxable income for the partnership for October, November, and December, 2012 will not be reported until 2013. You see what we're doing? By electing and use that fiscal year. We're deferring three months of taxable income into the following year because of all the taxable income for the partnership for October, November, December of 2012, won't be reported to individual partners on their K ones until 2013.

It gets deferred into the next year. And of course, that partner's return for 2013 is not due until April 15th, 2014. So that's the result that the fiscal year has on taxable income. My point is that's. As far as you can go October, November, December. In other words, if a partnership elected to try to use a fiscal year from July one to June 30th, IRS would shoot it down because if the partnership ALEKS to use a fiscal year from July 1st to June 30th, they would, they would be deferring six months of taxable income into the following year.

Well, you can't defer more than three months of taxable income. Into the following year. Now, the 10 65, the partnership return is due three and a half months from the close of the year. If it is a calendar year, it's due by April 15th.

Now I've talked for a few minutes. And now inevitably, when you're talking about the area of federal taxation, that's something I have to get into. And that is basis. How do you calculate an individual partner's basis in the partnership interest? Don't forget the CPA exam Love's basis. I hear that a lot from my students.

A lot of my students, when I talk to them after the exam, you know, how did it go, Bob? So many REG CPA Exam questions on basis, basis, basis. It's just a critically important area. So when you boil it down, how do you calculate an individual partner's basis in the partnership interest? What are they going to have to memorize this formula?

You're going to start with what the partner invested to acquire the partnership interest. That makes sense. You would start with whatever the partner invested to acquire the partnership interest. Then you would add. All the income items off the partners. K one, notice all the income items on the partner's K one increase the basis.

You would subtract all the losses and deductions on the partners. K one. So any losses on the partners, K one that would lower the basis. Now there's also something that's unique to partnerships. What will also increase basis for the partner will be any increases during the year to that partner share a partnership debt notice we're going to add to basis.

We're going to increase basis by any increases. There were during the year to that partner share of partnership debt, you would subtract any decreases during the year to that partnership, partnership debt. You would also subtract any distributions to that partner. And that would give you the partner's basis in the partnership interest.

You've got to know that formula. Now, as I said, what is unique to partnerships is, is this idea that any increases during the year to that partnership partnership, debt will increase basis any decreases during the year to that partner share of partnership, debt will decrease basis. Let me just quickly illustrate, for example, let's say that back on January one, total partnership liabilities were $200,000.

And the partner is a 25% partner in the partnership. Well, if the partner is a twenty-five percent partner in the partnership, the partner share of partnership debt back on January one was 25% of 200,000 or 50,000. Now let's say by year end, total partnership, liabilities are just a hundred thousand and by year end, now the partner is only a 15% partner in the partnership.

Well at year end, the partner share partnership, that would be 15% of a hundred thousand or 15,000. So during the year, There was a $35,000 decrease in the partner, share a partnership debt that lowers basis that would lower the partner's basis in the partnership interest. That's really treated like a distribution that would be treated like a distribution.

It's it? It is handled as a distribution. It lowers basis now is a taxable generally. No, generally, no, but if that decrease in the partnership part, partnership debt. As I say, it's really treated as a distribution. If it were greater than the partner's basis in the partnership interest, it would be a capital gain, but that's unusual, you know, generally it's not taxed, but it is treated as a distribution.

Now, another point notice we said that any losses deductions on the partner's K one would lower basis. So any partnership, losses or deductions that are reflected on the partners, K one. We'll lower the partner's basis in their partnership interest. Now can the partner deduct those losses, those partnership losses that are reflected on the partners?

K one, could the partner deduct those losses on their 10 40 as a business loss? Yes. Those losses are deductible on the partners, 10 40, but remember you can only deduct losses on your 10 40 to the extent that the partner has basis. You can only deduct losses. Business losses reflected on the K one on your 10 40 to the extent you have basis, but basis can never go below zero basis can not go below zero.

Now faces goes to zero and there were still a more partnership losses. Those losses get held in suspension and the partner could deduct their pro rata share of those losses later if basis becomes available. And of course there also could be. Passive loss limitations as well, you know, to be considered, I'd like you to try the first three REG CPA Exam questions, multiple choice, one, two, and three.

Now it's very important in a class like this. When we get to REG CPA Exam questions and I asked you to do them to shut the class down, do the REG CPA Exam questions come up with your answers. Before you come back and we discuss them together. You'll find you get much more out of the class if you approach it that way. So please do the first three REG CPA Exam questions.

Get your answers and then come back.

Welcome back. Let's look at these three REG CPA Exam questions together. Number one says a guaranteed payment by a partnership to a partner for services rendered may include an agreement to pay. Number one says a salary of 5,000 monthly. Without any regard to partnership income? Yes, that's guaranteed. That's what a guaranteed payment is.

It's a payment to a partner for services in this case, or use of capital without any regard to partnership profit, without any regard to partnership income, the payment is guaranteed. Number two, a 25% interest in partnership profits. That's not a guaranteed payment because if there were no profits, there's no payment.

Payment's gotta be guaranteed. So the answer is a, just the first statement. Reflects a guaranteed payment. Now in two and three, we're talking about flag and miles. Flagging miles are each 50% partners in the debt Corp partnership. Each partner had a $200,000 tax basis in the partnership interest back on January one deck, or is net business income.

Before any guaranteed payments was 45,000 during the year, Decora made a $7,500 guaranteed payment to miles for services rendered. Number two says what total amount from decor is includable in flag's tax return. Well, of course, flag's going to get a K one and what's going to be on flags. K one will be flags pro at a share of the net business income of the partnership.

So what is the net business income? Of the deck partnership? Well, we were told that the business income for the Decora partnership was 45,000, but that was before any guaranteed payments to partners, they did make a 75, $7,500 guaranteed payment to miles. Remember the deck or a partnership would get a tax deduction on the 10 65 for that guaranteed payment.

So back that out, the net business income of the deco partnership. Was 37,500. And because flag is a 50% partner flags prorate, a share of that net business income, 50% of 37 five answer B 18,007 50 would be on flags. K one. Number three says what's miles tax basis in the deco partnership at year end, December 31.

Well, we know a year ago back on January one. Miles tax basis in the deco partnership was 200,000. Now what's going to increase that basis. Remember what's going to increase that basis would be any increases during the year two mile share partnership debt what's going to decrease basis would be any decreases during the year to mild share partnership deck.

But that's not in this problem. There are no changes in partnership debt. What else? Increases basis? All the income items on miles K one. So what's going to be on miles. K one. Well, let me ask you this. Would that be 18,007 50 of net business income on miles K one there's 18,007 50 of net business income on flags.

K one would the 18,007 50 of net business income on miles K one shore miles is a 50% partner. So miles per writer's share of the net business income. 18,007 50 would be on miles. K one. Anything else on miles? K one. Sure. The guaranteed payment. That guaranteed payment. That was the miles that would be on miles K one.

All right. So all the income items on miles K one would be 18,007, 50 plus 70 $526,250. 26,002 50. I didn't come. Items would be on miles K one. And that would increase miles basis. Were there any distributions to miles? Yes, the guaranteed payment. So back that out, there was a distribution of miles. The 7,500.

So back that out. So miles basis in the partnership interest that year end December 31 would be answered C 218,007 50.

Now, what I want to get into next is this, how do we handle a situation? Where a partner exchanges property in return for partnership interest. How do we handle that? If a partner exchanges, property to acquire a partnership interest? Well, basically you follow some rules. If a partner exchanges property in return for partnership interest, here are the rules.

Whatever the partner's basis was in that property becomes the partners initial basis in the partnership interest. Let me say it again. Whatever the partner's basis was in the property becomes the partners initial basis in the partnership interest. Not only that, but whatever the partners basis, wasn't that property transfers over to the partnership becomes the basis of the asset in the hands of the partner ship.

Not only that, but whatever the partner's holding period was in the asset that was exchanged. Becomes the partner's holding period in the partnership interest. In other words, if a partner's holding period in the property that they, that they exchanged, if the partner's holding period in that property was long-term, then the partner's holding period in the partnership interest as long-term in the first second, in the first instance, holding period, just transfers over whatever the partner's holding period wasn't that property becomes.

The holding period and the partnership interests. So if the partner's holding period in that property as long-term, then the partner's holding period and the partnership interest as long-term in the first second in the first instance, let me give you some examples. Let's say that Smith acquires a 30% partnership interest by contributing land.

All right. So we have Smith Smith acquires a 30% partnership interest by contributing land. The land has a, a basis. To Smith, a $5,000, but the land has a fair value of a hundred thousand. So I think, you know, the natural REG CPA Exam questions here first, what would be Smith's basis in the partnership interest 5,000 whatever Smith's basis was in that property that was exchange.

That's going to be the initial basis and the partnership interest 5,000 notice, not the fair value of the property. The a hundred thousand we don't use that. Is there any taxable gain for Smith? No. Even though the fair value of the property is a hundred thousand. There's no taxable gain here for Smith.

What is the basis of the land in the hands of the partnership? 5,000 whatever Smith's spaces was in the land transfers over to the partnership and becomes the basis of the property in the hands of the partnership is another example. Let's say Smith again, acquires a 30% partnership interest by contributing land.

And we're going to assume that the land. Has a basis to Smith of 75,000, 75,000. It has a fair value of a hundred thousand and the land is subject to a $50,000 mortgage. And the partnership is going to assume that mortgage. So with that in mind, what would be Smith's initial basis in the partnership interest?

Well, you know, if I'm going to work out. Smith's basis. And the partnership interest I start with whatever Smith's basis was in the land. In this case, 75,000. Now this problem is more complicated because the land was subject to a $50,000 mortgage. The partnership assume that mortgage and Smith is now a 30% partner.

So it hasn't there been an increase to Smith share partnership debt of 30% of 50,000. Or 15,000 that increases basis because there's been an increase to mid share part of dismissed share partnership debt. When the partnership assumes that mortgage Smith is now a 30% partner. So there's been an increase.

This Ms shared partnership debt of 30% of 50,000, 15,000, that increases the basis. But there was also 50,000 of debt relief for Smith because the partnership assumed the mortgage. Remember debt relief is boot. So the initial basis was. Smith's basis in the land, 75,000, but it would go up 15,000 because of the increase in Smith's share of debt, go down 50,000 because of the debt relief.

Smith's initial basis in the partnership interest 40,000, 40,000. Let me have you think about this, any taxable gain for Smith? No. Do you see why? What was the net debt relief for Smith? The net debt relief. Was 40,000, excuse me, 50,000 minus 15. Right? The net debt relief was the 50,000 debt relief. Minus the increase in debt in the partnership 15, the net debt relief for Smith was 35,000.

And that's not greater than Smith's basis in the land, 75,000. So there's no taxable gain. For Smith, what would be the bait in this example, what would be the basis of the land in the hands of the partnership? 75,000 whatever Smith's basis was in the land transfers over to the partnership becomes the basis of the asset in the hands of the partnership.

Here's another example. Once again, let's assume Smith acquires a 30% partnership interest by contributing land. The land has a fair value of a hundred thousand. Again. Now let's assume the basis of the land to Smith is 25,000 that's Smiths basis in the land 25,000. And let's assume that the land is subject to a $50,000 mortgage, and the partnership is going to assume that mortgage while you know, the basic REG CPA Exam questions that would be asked, first of all, what would be Smith's.

Initial basis in the partnership interests. Well, if I want to work out Smith's initial basis in the partnership interest, I start with whatever Smith's basis was in the land. 25,000, we don't care about the fair value of the land. We start with 25,000, but when the partnership assumes that mortgage of 50,000 Smith is now a 30% partner.

So that would be an increase to Smith's share a partnership debt of 15030% of 50. That increases basis, but there's also 50,000 of debt relief for Smith because the partnership assumed his mortgage that relief his boat. So if they ask you in the exam, what was Smith's initial basis of the partnership interest zero.

Any taxable gain for Smith? Yes. Sure. You see it. What was the net debt relief for Smith? The net net relief for Smith was 50 minus 15, 35,000. And notice the net debt relief that really was boat. The net debt relief. 35,000 is greater than Smith's basis in the land 25,000, so that there would also be a $10,000 taxable gain for Smith because the net debt relief, 50 minus 15, 35,000 is greater than Smith's basis in the land.

Twenty-five then basis in the land, 25,000, there's a $10,000 taxable gain for Smith. What would be the basis of the land in the hands of the partnership? Well, if I want to work out the basis of the land in the hands of the partnership, I start with whatever Smith's basis was in the land. 25,000, just transfers over to the partnership, but IRS will also allow the partnership to add to that basis.

Any taxable gain recognized by the partner. So remember that IRS would let the partnership add to that basis, any taxable gain recognized by the partner. And we agreed that was 10,000. So if they ask you in the exam, what was the base of the land in the hands of the partnership? 25,000 plus 10 30, 5,000.

Very important that you're comfortable with how you handle exchanging property. In return for partnership interest. I'd like you to try some REG CPA Exam questions, please try four to nine. Please do number four to number nine, and then come back.

Welcome back. Let's go through these REG CPA Exam questions together. In four and five, we're talking about Jones and Curry Jones and Curry formed the major partnership. So we're at the formation of a partnership as equal partners. Now Jones contributed cash in return for the partnership interest Curry contributes land in exchange for the partnership interest, the adjusted basis of the land to Curry 30,000.

The fair value of the land. 67,000. 57,000, excuse me. And the land was subject to a $12,000 mortgage and the partnership is going to assume that mortgage number four says what was Curry's initial basis in the partnership interest? Well, if you're going to work out Curry's initial basis in the partnership interest, you'd start with whatever Curry's basis was in that land.

30,000. We don't care about the fair value of the land. The 57,000 no, you'd start with whatever Curry's basis was in the land. 30,000. Now the land is subject to a $12,000 mortgage. The partnership assume that mortgage and Curry is now a 50% partner. So wouldn't there be an increase to kit, to Curry, share a partnership debt.

Uh, 50% of six of 50% of 12,000 or 6,000, that's going to increase Curry's basis, but there was also 12,000 of debt relief for Curry debt relief is boot that lowers basis. So what does Curry's initial basis of the partnership interest? 30 plus six minus 12, answer C 24,000. Number five says what's Joan's initial basis.

In the partnership interest while Jones contributed 45,000 cash, but Jones is now a 50% partner. So when the partnership assumes that $12,000 mortgage that'd be an increase to Jones share partnership debt of 6,000. So that increases basis from 45, up to 51,000, answer a

number six act, me and buck are equal partners in the deer. Partnership actually, it's an LLC, a limited liability company. And, you know, let me say that what we're going through in this class, this is how we handle the federal taxation of a general partnership, a limited partnership, a limited liability partnership, an LLC.

An LLC could elect to be taxed as a corporation, but if they don't elect to be taxed as a corporation that taxed like a partnership, Deere has not elected to be taxed. As a corporation, Acme contributed 7,000 cash and buck contributed a machine where they an adjusted basis of 5,000 and a fair market value of 10,000.

And notice the machine is subject to liability, a debt of 3000. They want to know what is Acme's basis in the, in the LLC? Well, Acme did contribute 7,000 cash, but Acme is now a 50% partner. So when the LLC adopts that liability of 3000, there'd be an increase to Acme share of the LLCs debt. Of 50% of 3000 or 1500, that's going to increase basis from 7,000 opt to answer C 8,500

number seven. Dale was a 50% partner in the DNP partnership. Dale contributed 10,000 cash upon the formation of the partnership. So that's, that's how the basis has started by what was contributed to acquire. What was invested to acquire the partnership interest. The 10,000 at the bottom, they're saying at the end of the year, at the end of the first year of operation, what would be Dale's basis in the partnership interest?

Well, again, we know when it was formed, we would start calculating Dale's basis in the partnership interest with whatever Dale invested to acquire the partnership interest in this case 10,000 cash. Now what happened during the year? Well notice DMP borrowed 10,000 to purchase new equipment. Well, there'd be an increase to Dale's share partnership debt of 50% of that 10,000.

That 5,000 would increase basis has been an increase to Dale shared partnership debt of 50% of 10,000. That borrowing basis would go up by 5,000. During the first year of operations, DNP had 15,000 of net of net taxable income. While 50% of that 7,500 would be on Dale's K one that would increase basis by 7,500.

There's also 2000 of tax exempt. Income. Well, 50% of that tax exempt income would be on Dale's K one that would increase basis by a thousand, by the way, income always retains its character as it passes through to the partners. In other words, if income is tax exempt in the hands of the partnership, it's tax exempt, as it flows to the partner's income, always retains its character as it flows to the partners.

What else? Well, it says there was a $4,000 reduction of debt. Well, there's a $4,000 reduction of debt. Dale is a 50% partner, so there'd be a decrease to Dale, share a partnership debt of 2000 that would lower basis, right. That lowers basis. And there was also a $3,000 distribution to Dale that lowers basis, 3000.

So at year end Dale's basis in the partnership interest answer's C 18,500. Number eight. Okay. Uh, partners at partnership inception, black acquires, a 50% interest in the decorators partnership by contributing property with an adjusted basis of 250,000, they ask black would recognize a gain. If number one, the fair market value of the contributed property exceeded its basis.

That's not true. We basically ignore fair value. So if the fair value of the property that was contributed is higher than black spaces, that's not going to result in a taxable gain, whatever black spaces wasn't, the property is going to become blacks basis in the partnership interest. The fact that the fair value is higher would not result in a game.

How about number two? Would there be a gain if the property is encumbered by a mortgage of a hundred thousand, let's think it through. If the property is encumbered by a a hundred thousand dollar mortgage, the partnership assumed that mortgage. There'd be an increase to black share partnership debt of 50,000, right.

Partnership would assume that mortgage black is a 50% partner. There'll be an increase to black share partnership debt of 50,000, but then also be a a hundred thousand of debt relief for black. So the net debt relief, a hundred minus 50 is 50,000 and that's not greater than blacks based on the property two 50.

So that would not result in a taxable gain either. The answer is D neither statement one or two. Would result in a taxable gain. Number nine, the holding period of a partnership interest acquired in exchange for contributed capital asset begins when answers say it begins when the partner's holding period for the asset began because holding period transfers over whatever the partner's holding period was in the asset, they contributed becomes the holding period for the partnership interests in the first second.

So always remember that if the partner's holding period and the asset that was contributed was longterm than the partner's holding period in the partnership interest is long-term in the first, in the first instance in the first, second holding period, just transfers over. Now another point I wanted to make, you know, so far we've been talking about, you know, exchanging property in return for partnership interest.

We'll be careful if a partner exchanges services. In exchange for partnership interest, that's very different. If a partner exchange services in return for partnership interest, the fair market value that partnership interest will be taxed as ordinary gross income to the partner. So watch out for that.

If a partner exchanges services in return for partnership interests, the fair market value that partnership interest will be taxed to the partner as ordinary gross income.

Now, if you've been through the federal taxation of property, if you've had our class on the federal taxation of property, then you know, if you sell an asset to a related party, You sell an asset to your mother, you sell an asset to your uncle. Anytime you sell an asset to a related party, IRS would disallow any loss from that transaction it's related party transaction, sell an asset to your mother, sell an asset to your grandfather.

IRS is going to disallow any loss Metro transaction, because that is a related party transaction. I think you know that well, don't forget if a more than 50% partner. Sells an asset to the partner ship. Again, if I'm more than 50% partner sells an asset to the partner ship, that is a related party transaction, and IRS would disallow any loss from that transaction.

It's a little tricky. So be careful if a more than 50% partner sells an asset to the partnership that is considered a related party transaction and IRS would disallow any loss from that transaction. Not only that, but. If there's a gain on the transaction, if I'm more than 50% partner sells an asset to the partnership and there's a gain on the transaction capital gain treatment will be disallowed.

If the asset is not a capital asset in the hands of the partnership, let me say it again. Not only a loss is disallowed, but if there's a gain on the transaction, if I'm more than 50% partner sells an asset to the partnership and there's a gain capital gain treatment will be disallowed. If the asset is not a capital asset in the hands of the partnership.

Let me give you an example. Let's say I'm a more than 50% partner in a partnership. And I have a piece of land that I've been holding as an investment. Is that a capital asset for me? I have a piece of land. I've been holding it as an investment that a capital asset for me, it is. How do you know that?

Well, here again, if you've had our class on. The federal taxation of property. You remit, you may remember what capital assets are not. Remember. Capital assets are not. Mr. CIA M machinery equipment used in a trader business are real property used in a trader business. See a copyright in the hands of the original artists.

I inventory a accounts or notes receivable. That's what capital assets are not. Machinery equipment using the trader business real property used in a trader business, a copyright in the hands of the original artist inventory accounts or notes receivable. Remember Mr. CIA, that's what capital assets are not.

So getting back to my point, I have a piece of land I've been holding as an investment. Is that a capital asset for me? Yes. It's not Mr. CIA. It's none of those. Now. Let's say I sell the land to my partnership member. I'm a more than 50% partner in the partnership. And I sell that land to my partnership. My partnership is a partnership of land developers.

What's the land in the hands of the partnership inventory. So it's not a, it's not a capital asset in the hands of the partnership. So even if there's a gain on the transaction, I can't get, I cannot get capital gain tax rates on that. It's going to be taxed as ordinary income. Why? Because the land is not a capital asset in the hands of the partnership.

If it's a partnership with land developers in the hands of the partnership, the land is going to be inventory. So I'm denied capital gain treatment, please do 10, 11, and 12, and then come back.

Welcome back. Let's look at these REG CPA Exam questions. Number 10 K owns an 85% interest in the capital and profits of a more antiques, a partnership. Okay. Is a more than 50% partner, 85% in year two K sold. An Oriental lamp to a more for 6,000 K bought the lamp back in year one for her personal use at a cost of 2000 and had used the lamp continuously in her home until she sold it to a more.

Now notice that lamp is a capital asset to K. In the hands of Kay it's capital asset because it's not Mr. CIA, it's not machinery equipment used in a trader business, real property used in a trader business. It's not a copyright in the hands of the original artists inventory or accounts and notes receivable.

So it's a capital asset in the hands of Kay. And now she sells it to a more and she sells it to a more partnership. Uh, more antiques for 6,000. So there's obviously a $4,000 gain in that transaction, but notice a more is going to use it as inventory to a more antiques. This lamp is inventory. So because it's not a capital asset in the hands of a more, even though it was a capital asset in the hands of Kay, Kay's not gonna be able to get capital gain treatment on this sale.

Capital gain treatment will be denied. Because K is a more than 50% partner in the, in this, uh, more antiques in the hands of, uh, more antiques it's inventory. It's not a capital asset. So what this is going to be for K is answer a 4,000 of ordinary gross income, not answer B it's not a $4,000 capital capital gain.

No, it's 4,000 it's taxed as 4,000 of ordinary gross income. Number 11. On June 1st, Kelly received a 10% interest in rock company. A partnership for services rendered services contributed. This is an exchange of services in return for partnership interests. As we've said, if you exchange services in return for partnership interests, the fair market value of that partnership interest will be taxed to the partner as ordinary gross income.

So Kay gets a 10% partnership interest. The net assets of the partnership are worth a hundred thousand. Not don't go by the 70,000, the basis, the fair market value of the net assets of the partnership on that date. Total a hundred thousand 10% of that is 10,000. The answer is C. That's going to be taxed to Kelly as 10,000 of ordinary gross income.

The fair market value of, of 10% of those net assets. $10,000 gets taxed to Kelly as ordinary gross income. Why? Because it was an exchange of services in return for partnership interest number 12, Ola associates is a limited partnership engaged in real estate development. Hough, a civil engineer build Ola 40,000 for consulting services in full settlement of the invoice.

Huff accepted 15,000 cash. Also serving equipment worth 7,000 and a 3% limited partnership that has a fair value of 10,000. Well, again, because it's an exchange of services for partnership interest, the fair value of the partnership interest 10,000 plus the fair value of the equipment. Plus of course the cash answers see all of it is taxed as ordinary gross income.

What I want to get into next is how we handle distributions of cash property from the partnership to the partners. Well, you've got to remember that there are two types of potential distributions. From partnerships to partners, the first type of distribution is called a non liquidating distribution.

Listen, carefully. First type of distribution you can see in the CPA Exam is a non liquidating distribution. In other words, the partnership is not liquidating. Sometimes they call it a current distribution and it's really very simple. If a partner receives a non liquidating distribution or a current distribution from a partnership for that partner.

That distribution is tax-free all it does. It's tax-free it just lowers their basis in the partnership interest. Remember, as a partner in a partnership, you're not taxed on distributions, you're taxed based on what's on your K one. That's what you're taxed on. Now. Listen carefully. It's important to remember this.

It is impossible. It is literally impossible to have a loss from a current distribution. That's not possible. A loss is impossible from a non liquidating or current distribution. Again, you can never have a loss, but again, as possible, a capital gain is possible. If in a current distribution cash or debt relief received is greater than the partner's basis in the partnership interest, you'd have a capital gain.

Let me say that again. It is literally impossible to have a loss from a current distribution. That's not possible. A capital gain is possible if cash or debt relief received. In a current distribution is greater than the partner's basis in the partnership interest, there would be a capital gain. Let me give you an example.

Let's say that before any distribution, the partner's basis in the partnership interest 25,000. All right. So before there was any distribution, the partner's basis in the partnership interest 25,000 and now let's assume this partner gets a non liquidating, a current distribution of 10,000 cash. And a piece of land.

The land has a fair value of a hundred thousand dollars, but the land has an inside basis in the hands of the partnership. It's what they call an inside basis. The land has a basis of the partnership and inside basis of 8,000. So let's work it out. We know that the partner's basis in the partnership interest before the distribution was 25,000.

Now the first thing you want to deal with is the cash. The cash comes in 10,000. That's tax rate that's tax rate. All that's going to do is lower the partner's basis from 25,000 down to 15,000, but here's what the CPA Exam is going to ask you. The exam's going to ask you what is the partner's basis in that land?

Well, if they ask you, what is the partner's basis in that land? You look at two numbers. Look at two numbers. Look at the inside basis for the land in the partnership. Look at the inside basis for the land in the hands of the partnership. 8,000 look at the partner's remaining basis in the partnership interest 15,000, take the lower of the two.

That's the rule of thumb. Again, you want to look at two numbers. They want to know what is the partner's basis in the property. You look at two numbers, look at the inside basis of the land in the hands of the partnership, 8,000 and also look at the partner's remaining basis in the partnership interest 15,000 take the lower of the two.

Obviously the 8,000 is lower. So the partner's basis in the land will be 8,000. Now that leaves 7,000. What's that what's that remaining 7,000. That's the partner's remaining basis in the partnership interest. Remember this was a non liquidating distribution. The partnership did not liquidate. The partnership goes on and now the is remaining basis in the partnership.

Interest is 7,000. Please do more REG CPA Exam questions, please do 13 to 17 and then come back.

Welcome back. Let's look at these REG CPA Exam questions together. Number 13 Ryan's adjusted basis in the Lux partnership was 18,000 and now Ryan receives a non. Liquidating distribution of 10,000 cash and a piece of land. And they want to know what is Ryan's basis in the land? Well, first of all, you deal with the cash.

The cash comes in. All that does is lower Ryan's basis in the partnership interest from 18,000 down 10 down 8,000 now, because they want to know what is the basis of the land? You look at two numbers, look at Ryan Ryan's remaining basis, and the partnership interests 8,000. And look at the inside basis of the land in the hands of the partnership.

And that's 14,000 take the lower of the two. So lion Ryan's basis in the land would be the 8,000 cause it's lower than that lower than 14. Take the lower of the two. So Ryan's basis in the land would be answer B 8,000. Let me ask you this. What is Ryan's remaining basis in the partnership interests? It's zero, isn't it?

Zero partnership. This was a non liquidating distribution partnership is not liquidate and Ryan's remaining basis. And the partnership interest zero and 14 and 15, they say the adjusted basis of Jodi's partnership interest was 50,000 immediately before Jody received a current distribution, a non liquidating distribution of 20,000 cash.

And also. A piece of property. Well, let's deal with deal with the cash. First cash comes in. All that's going to do is lower the basis that the cash is tax free, that just lowers the basis from 50 down to 30, let's go to number 18. I mean, number 14, number 14 says what amount of gain must Jody report as result of this distribution?

I want you think about something is a gain possible in a current distribution, in a non liquidating distribution. Is a game possible. Yes, it's possible. If cash or debt relief received is greater than your basis, but the cash received here 20,000 was not greater than our basis. So the answer is a, there's no taxable gain.

Now, you know what question 15 is going to be? What is Jody's basis in the property while you look at two numbers, right? You look at the inside basis in the prop for the property in the hands of the partnership. That's. 40,000 look at Jody's remaining basis and the partnership interest 30,000 take the lower of the two.

The answer is B and notice. Now Jody's remaining basis in the partnership. Interest is zero number. The partnership goes on. It's a non liquidating distribution partnership did not liquidate partnership goes on and Jody's remaining basis in the partnership. Interest is zero number 16. Stone's basis. And the ACE partnership was 70,000.

At the time he received a non liquidating distribution of partnership, capital assets. The capital assets had an adjusted basis in the hands of the partnership of 65,000. A fair value of 83,000 ACE had no unrealized receivables or appreciated inventory or properties which have been contributed by the partners.

What was stones gain a loss. From this distribution. I want to ask you something, tell me why you'd be sitting in the CPA Exam and you'd be thinking this you'd be thinking well, I'm not sure what the answer is yet. I got to think about it, but I know it's not safe. Tell me why you're thinking that I'm not sure what the answer is.

I got to really think about that, but I know it's not safe. How do you know it's not safe? Because a loss is impossible. It's impossible. You cannot have a loss from a current distribution. It's not possible. So hopefully not even thinking about answers, say, all right now is a game possible. Yes, a gain is possible if cash or debt relief received is greater than basis, right?

A gain is possible in a current distribution. If cash or debt relief received is greater than your basis. Is there any cash or debt relief received here? No. So they can't be a gain either. And the answer is D has to be zero. Let me ask you this. What Stone's basis in those assets, how would you answer that?

What stones basis in those assets? Well, you look at two numbers, right? Look at the inside basis for the assets, the hands of the partnership, 65,000 look at stones basis. The partnership interest set 70,000 take the lower of the two. So stones basis. In those assets that were distributed 65,000, what's the remaining 5,000.

That would be Stone's remaining basis in the partnership interest partnership goes on. It's a non liquidating distribution partnership did not liquidate. It goes on and Stone's remaining basis in the partnership interest would be 5,000 number 17 Owen's basis in the Regal partnership. Was 18,000 at the time own received a non liquidating distribution of 3000 cash.

Well, that's tax free that just lowers the basis from 18,915,000. Also Owen gets a piece of property, a piece of land with an inside basis in the hands of the partnership of 7,000. And they want to know. What is Owen's remaining basis in Regal after the distribution. All right. As we know, the cash would lower the basis.

It's tax-free lowers the basis from 18 down to 15, what would be all ones basis in the land? You'd look at two numbers. You look at the inside basis for the land and the hands of the partnership, 7,000 all ones remaining basis in the partnership interest 15,000, take the lower of the two. So Owen's basis in the land would be 7,000.

So the remaining basis and the partnership interest would be 8,000. And the answer is

the other type of distribution to partners is called a complete liquidation. In a complete liquidation. The partnership is liquidating. It's going to cease to exist. Now, a couple of things. If you see a complete liquidation, again, a capital gain is possible in a complete liquidation. A capital gain is possible if cash or debt relief received is greater than the basis in the part of your Pinterest.

We know that. So when a complete liquidation, the partnership is liquidating, it's going to cease to exist. The capital gain is possible. If cash or debt relief received is greater than the partner's basis in the partnership interest. But notice this in a complete liquidation, a loss as possible, a loss is possible in a complete liquidation.

If cash or debt relief received is less than the partner's basis in the partnership interest and the partner receives no other property. Let me say that again. A loss is possible. It is possible in a complete liquidation. If cash or debt relief received. Is less than the partner's basis in the partnership interests and the partner receives no other property.

Let me give you an example. Let's say that a partner's basis in the partnership interest was 25,000 before any, before any distribution. So the partners basis and the partnership interest twenty-five thousand before any distribution. And now let's assume in complete liquidation of the partnership, the partner gets 10,000 cash and a piece of land.

The land has a fair value of a hundred thousand and an inside basis enhance the partnership of 8,000. So how do we handle this? Well, we know before the distribution, the partner's basis in the partnership interest was 25,000 cash comes in. That's tax-free, that's just going to lower the basis from 25,000 down to 15.

You know what the CPA Exam is going to ask you. What's the partner's basis in the land while you look at two numbers, right? You look at the inside basis in the hands of the partnership, 8,000, look at the partners remaining basis. The partnership interest 15,000 take the lower of the two. No, you don't. No, you don't take the lower of the two.

This is a complete liquidation. So what any BA so any basis the partner has left in this case, 15,000 by definition must be the basis in the land. Let me say it again. This is a complete liquidation. The partnership has ceased to exist. So whatever basis the partner has remaining in this case, 15,000 by definition must be the basis of the property.

See the difference it's complete liquidation. The partnership has ceased to exist. It's gone. So whatever basis the partner has remaining in this case, 15,000 by definition must be the basis of the land. It's not the lower of the two. So be careful, please do 18 and 19. And then come back,

come back in number 18, they say the adjusted basis of Smith's interest in the Eva partnership. Was 230,000 immediately before receiving the following in complete liquidation of Ava, it's a complete liquidation, a liquidating distribution. So we know that Smith's basis in the partnership interest before the complete liquidation was 230001st, the cash comes in the 150,000 that's tax-free.

That would just lower the basis from 230,000 down, one 50 to 80,000. And that remaining 80,000. Must be the basis of the land because Smith also gets a piece of real estate and this is a complete liquidation. So whatever basis Smith has left by definition must be the basis of the property. So the answer is D because the partnership is gone, it cease to exist.

And number 19, the CSU partnership distributed. To each partner, cash of 4,000 inventory with a basis of 4,000 and a fair value of 6,000. Also a piece of land with an adjusted basis of 5,000 and a fair value of 3000 in a liquidating distribution. The partnership is liquidated. This partner had had a basis in the partnership interest of 12 thousands.

Let's work it out. Partner had a basis in the partnership interest of 12001st, the cash comes in the 4,000 that's tax-free that just lowers the basis from 12,000 down to 8,000. Now the remaining basis in the partnership interest right now is 8,000 after the cash, but we have a couple of assets deal with here.

The first thing you should value. Is any inventory or receivables that always comes first. Again, the first thing you want to value when a case like this is any inventory or receivables, these ordinary income items. So the inventory will be valued first at its basis, 4,000, because that's lower than the remaining basis of the 12,000, the 8,000 remaining basis.

So the inventory would have a basis in the hands of. The partner of 4,000, then the remaining basis is still 4,000 basis remaining. And by definition, that must be the basis in the land. Now, what happens after the distribution? The partner sells the inventory for 5,000. Well, if the inventory sold for 5,000 has a basis of 4,000, that's a thousand of ordinary income.

It's an ordinary income item. It's inventory. Now the land was sold for 3000. Well, The partner's basis in the land is 4,000. This is a capital asset. If it's sold for 3000, there's a capital loss of 1000. And the answer is

now if a partner sells their partnership interests, Is that the sale of a capital asset? You know what I'm asking you is a partnership interest, a capital asset. And I know you're thinking, yes, Bob. It is because it's not Mr. CIA, a partnership interest is not machinery equipment using the trader business real property, using the trader business inventory, you know, a copyright in the hands of the original artist accounts and notes receivable, right?

It's not Mr. CIA. It's not Mr. CIA. That's what capitalized it's are not machinery equipment using the trader business real property using a trader business. A copyright in the hands of the original artists inventory counts, notes receivable. That's what capital assets are not. So a partnership interest is a capital asset.

So if a partner sells their cap, their partnership interest, that's treated as the sale of a capital asset, but there's one thing you have to be careful about. Yes, the sale of the partnership interest is the sale of a capital asset. But if the partnership has any hot assets, hot assets are unrealized receivables or.

I appreciate it inventory again, those are hot assets, hot assets are unrealized receivables or appreciated inventory. They're called hot assets. If the partnership has any hot assets, you've got to take the partner's ownership, percentage times, those hot assets, that part of, of any gain on the sale of the partnership interest would be taxed as ordinary income.

If you take the partners. Ownership percentage times those hot assets, that part of any gain on sale would be taxed as ordinary gross income. It would, you cannot get capital gain treatment on that. Try 2021 and 22, and then come back.

Welcome back. Let's look at number 20, they say December 31 after receipt of his share of partnership, income Clark sold his interest in a limited partnership, but 30,000 cash and relief of all liability. On that date, the adjusted basis of Clark's partnership interest was 40,000. That's made up of his capital account of 15,000 and his share partnership debt of 25,000.

So Clark's basis in the partnership Pinterest 40,000. Now they say the partnership has no unrealized receivables, no substantially appreciated inventory. There's no hot assets. What. Would be Clark's gain or loss from the sale? Well, let's work it out Clark's basis in the partnership interest before the sale, 40,000 now Clark sells his partnership interest for what, for 30,000 cash and also debt relief, 25,000 of debt relief.

So that's a net amount realized by Clark, a 55,030,000 cash, 25,000 of debt relief. So the net amount realized from the sale 55,000, remember debt relief is boot Clark's basis. Departure of interest was 40,000 since there's no hot assets, the answer's D it's a $15,000 capital gain because the sale of a partnership interest is the sale of a capital asset in 21 and 22.

We're talking about the partnership of Alan Baker and Carr are equal partners. And car sells his partnership interest to Dole and outsider for 154,000 cash. And in addition, Dole assumed car share a partnership debt. Number 21 says, what was the total amount realized by car from the sale? Well, car gets 154,000 cash and also debt relief.

Now, if you look at the balance sheet, the only debt is the note payable of 60,000. Carr is a one-third partner. They're equal partners. Car's a one-third partner. So cars share a partnership. Debt would be one third of 60,000 or 20,000. Dole's greet. We assume that debt debt relief is boot. So what is it?

Car get car gets 154,000 cash. 20,000 of debt relief. The total amount car realized from the sale is answer a 174, right thousand 22. What amount of ordinary income? Would car report as a result of the sale? Well, I think they want you to go for a zero because they want you to sit in the CPA Exam and say, it's not ordinary income.

A partnership interest is a capital asset. It's not Mr. CIA. The sale of partnership interest is the sale of a capital assets, capital gain. But if you look at the balance sheet, this hot assets, unrealized receivables, which add up to 420,000 what's car share of that. Car's an equal partner. One third partner, take one third to four 20.

It's 140,000. Now let's work it out. Cargos out, sells the partnership Pinterest for 174,000. Right? That was 154. We know from the last question, car gets 154,000 cash. 20,000 of debt relief car gets 174,000 what's car's basis in the partnership interest. Well notice. The inside basis for cars, capital account 14,000 plus car share partnership debt one third of 60,000, 20,000 cars basis.

And the partnership interest would be 34,000. So car realizes 174,000 for the sale cars basis. The partnership interests would be 34,000. Again, that's 14 plus 20, so there's $140,000 gain on the sale. And as I say, They want you to think? Well, that's $140,000 capital gain because the sale of the partnership interest is the sale of a capital asset.

But you look at those hot assets, the unrealized receivables for 20 times, car's ownership percentage one third, 140,000 of the gain. Or in other words, all of it gets taxed as ordinary gross income. The answer is D and there's no capital gain here because there's 420,000. The pot assets, times cars, ownership, percentage one third.

Cars share of hot assets is 140,000. That was the total gain from the sale, 140,000. And it's all going to be taxed as ordinary gross income. All of it, no capital gain there.

Now, how do you terminate a partnership? The way you terminate a partnership? If 50% or more of partnership interests are sold or exchanged within a 12 month period, the way you terminate a partnership, if 50% or more of partnership interests are solar exchange within a 12 month period part, the partnership is terminated or operations, just cease operations, just seats.

It's another way. Now what's the effect of a termination. Here's the effect of a termination. When there's a termination, there is a deemed. A deemed distribution of assets to the surviving partners and the purchaser. Again, there's going to be a deemed distribution of assets to the surviving partners and the purchaser, and then a re contribution of assets to a brand new partnership.

That's what happens. There's a deemed distribution of assets to the surviving partners and the purchaser, and then a re contribution of assets to a brand new partnership.

In a trust, a trustee takes legal title to property for the benefit of somebody else. The trustee is taking legal title to property for the benefit of beneficiaries. Now a. Testament Terry trust. That is a trust created by Wil that's called a Testament. Terry trust. That's a trust created by will. An inter-vivos trust is a trust created during your lifetime.

That's called an inter-vivos trust. Now, generally speaking, there are two types of trusts. There are simple trusts and there are complex trusts. Make sure you know what a simple trust is. In a simple trust, all income must be distributed every year. Again, in a simple trust, all income must be distributed every year and in a simple trust, all distributions come from current income.

So think about it. If all income must be distributed every year, that means a simple trust is not allowed to accumulate income to accumulate principle. Because all income must be distributed every year. So that tells you that a simple trust is not allowed to accumulate income. We also know that in a simple trust, all distributions come from current income.

So in other words, that tells you a simple trust, cannot distribute principal or Corpus because all distributions come from current income. A simple trust cannot take a charitable contribution. A charitable deduction cannot now just remember. That any trust? That's not a simple trust is a complex trust.

It's really that easy. Any trust that's not as simple. Trust is a complex trust and you already know a lot about it. What's a complex trust. We'll just flip it around in a comp on, in a complex trust. You can distribute principle, not all distributions come from current income, not all distributions. Come with growing income in a complex trust you can distribute principal or Corpus.

In a complex trust. All the income does not have to be distributed every year, so you can accumulate income in a complex trust. So in a complex trust,

all distributions do not have to come from current income. So you can distribute principle in a complex trust. You can't say that all income has to be distributed every year. You can accumulate income. A complex trust can take a charitable contribution. A charitable deduction. So once you know what a simple trust is, just flip it around, you know, what a complex trust is.

And then just remember any trust. That's not a simple trust is a complex trust

now on an annual basis. The trustee of a trust has to file the fiduciary income tax return. Remember a trust is a tax paying entity and on an annual basis, the trustee of a trust has to file the fiduciary income tax returns. Now, not only that, but let's go back to a States for a moment. You know that in an estate.

If all the property in the estate is not distributed to beneficiaries immediately. And the estate continues as a going concern. If all the property in an estate is not distributed to beneficiaries and the estate continues as a going concern, the executor of an estate has to file the fiduciary income tax return, the federal tax form 1041.

So just remember the trustee of a trust on an annual basis. The executor of an estate on an annual basis has to file the fiduciary income tax return, federal tax form 1041. Now an estate has the option to use a calendar or a fiscal year. A trust has to use a calendar year again, and the state has the option.

They can use a calendar or a fiscal year. A trust has to use a calendar year. Now the 1041, the fiduciary income tax return. Is due on the 15th day of the fourth month after the close of the year. If it's a calendar year, we're talking about April 15th now, as I've been saying, uh, trust is a tax paying entity on a state is a tax paying entity.

That's why they're filing the federal, the income tax return for estates and trusts the 1041. Do they have to make estimated tax payments? Yes. A trust is required to. A trust is required to make estimated tax payments on a state is exempt from estimated tax payments for the first two years for the first two years.

So let's get right down to it on the federal fiduciary income tax return on federal tax form 1041. How do you calculate the taxable income of a trust or an estate? Well, you'd start with all the gross income for the trust or the estate. Then you would add any capital gains or subtract any capital losses.

And remember that estates and trusts get an exemption. There is an exemption on a state gets a $600 exemption. A simple trust gets a $300 exemption. A complex trust gets a $100 exemption. So notice. There was an exemption on a state, gets a $600 exemption. A simple trust gets a $300 exemption. A complex trust gets a $100 exemption.

All right, so it start with all the gross income. Add any capital gains subtracting any capital losses you take the exemption. Then the state of the trust would take a deduction for all the expenses to administer the estate, all the expenses to administer the trust. So rent and electricity and internet and postage.

This is where they would take a deduction for any trustee fee, any executor fee, if it is a complex trust or an estate, this is where they would take a charitable deduction. So they'd back out all the deductions for the state of the trust and very important. Both the States and trusts get a distribution deduction.

This is what prevents double taxation, as I've been saying, uh, States and trusts are taxpaying entity on the 1041, but of course the beneficiaries are also taxed, but what prevents double taxation is that both the States and trusts on the 1041, get a distribution deduction, then remember. The beneficiaries of an estate or trust get a K one.

The beneficiaries will be taxed based on what's on the K one, but the state of the trust on the 1041 gets a distribution deduction. Also they can deduct any tax credits and that'll give you the taxable income of the estate of the trust. So with that formula in mind, let's get right down to it. How do you calculate the distribution deduction?

For an estate or a trust, just remember the distribution deduction for an estate or a trust on the 1041 is the lesser of it is the lesser of either the actual distribution to the beneficiaries or DNI distributable, net income. Let me say it again. The distribution deduction that in the state or trust can take on the 1041 is the lesser of.

It's the lesser of either the actual distribution of beneficiaries or DNI, distributable, net income. And I think, you know where we're headed here. You cannot go in that exam and not know how to calculate DNI. How do you calculate distributable net income? You memorize this formula. Now, if you're going to calculate distributable net income, you start with the taxable income for the state of the trust.

Before the distribution deduction. Again, you want to start. With the taxable income for the state of the trust before any distribution deduction, then you would add to that any tax exempt income you're going to add any tax exempt income. Then you would add back the exemption, add back the exemption. Then you would subtract any capital gains allocated the principal allocated to Corpus, and that'll give you DNI.

Start with the taxable income for the state of the trust for the distribution deduction. Add any tax exempt income. Add back the exemption and subtract any capital gains allocated to Corpus allocated to principal. And that'll give you DNI distributable, net income. I'd like you to try some REG CPA Exam questions. I'd like you to try 23 to 28 and then come back.

Welcome back. Let's do this group of REG CPA Exam questions together. And number 23, they say the standard deduction for a trust or an estate on the fiduciary income tax return is I hope he didn't fall for this, uh, States and trusts. On the 1041, don't get a standard deduction. They get an exemption. So the answer is a, they don't, the answer is zero.

They don't get a standard deduction to get an exemption. If you're in a state, you get a $600 exemption. If it's a simple trust, you get a $300 exemption. If it's a complex trust, you get a $100 exemption, but no standard deduction, 24, which of the following. Fiduciary entities are required to use a calendar year.

Well, you want no for on a state on a state has the choice either a calendar year or a fiscal year, but yes, under trusts, generally trusts are required. Use a calendar year, not a charitable, you know, tax exempt. You know, there are some exceptions, there are some exceptions, but generally trusts are required to use.

Uh, calendar year, number 25, a distribution to an estates sole beneficiary for the year one calendar year equaled 15,000. The amount currently required to be distributed by the will were given the estates year. One records. They had 40,000 taxable interest income. And 34,000 expenses attributable to that interest income.

And they want to know what amount of the distribution was taxable to the beneficiary. Now, I don't know if you thought about it, but together let's work out DNI. What would be distributable net income for this estate while remembered workout, distributable, net income. You start with. The taxable income for the estate before the distribution deduction.

And that would be basically the taxable interest, 40,000 minus the expenses attributable to the taxable interest. 34,000. I think we can agree that taxable income before the distribution deduction, 6,040 minus 34. Now, what do we do to work out DNI while we'd add any tax exempt income? They don't have any we'd add back the exemption, but we didn't take it out to add it back.

We didn't, but then we'd add it back. If we did take it out, you'd subtract any capital gains allocated to principal to Corpus. They don't have that. So I think we can agree that DNI would be 6,000. And I think this question. Is a good way to highlight why DNI is so important. Just think about this for a second.

What will this estate take as a distribution deduction on their 1041? Remember the distribution deduction would be the lesser of the lesser of either the actual distribution made to the beneficiary 15,000 or DNI, which is six. So. The amount that the estate would take as a distribution deduction would be the lesser of the two.

And that would be 6,000. Now, remember the beneficiary would get a K one and what's going to be on the beneficiaries. K one, 6,000. You see why DNI is so important. DNI sets the limit on what's taxable to the beneficiary, and it also sets the limit on the distribution deduction for the state of the trust.

Let me say that again. DNI is critical. Because DNI sets the limit on what's taxable to the beneficiary and it sets the limit on the distribution deduction for the estate of the trust. As I say, this beneficiary is going to get okay, one and what's going to be on that. K one is 6,000. So the answer is C when they say what amount of the distribution was taxable to the beneficiary to 6,000 that's what's on the beneficiaries.

K one. But I have a question for you. How much cash did the estate send the beneficiary? 15,000. So what's the other nine. If there's only 6,000 on the beneficiaries, K one. And that's what the beneficiary's taxed on. What's the other 9,000. It must be a distribution of a state property and inherited property.

There is no tax, right? There's no tax on inherited property. You see why DNI is so important, it sets the limit on what's taxable to the beneficiary, and it sets the limit on the distribution deduction for the state of the trust. As I say, this beneficiary got 15,000 that other 9,000, must've been a distribution of a state property and inherited property.

There is no it's not taxed as gross income.

Number 26 raft died in year five, leaving her entire estate to her only child RAF's will gave full discretion to the estate's executor with regard to distributions of income for year six. These States. DNI was 15,000 of which 9,000 was paid. The beneficiary. None of the income was tax exempt. What amount can be claimed on the estates year six fiduciary income tax return, the 1041 for the distribution deduction?

Well, you know, the distribution deduction is the lesser of either the actual distribution made to the beneficiary 9,000 or DNI, which is 15, the lesser of the two answers C. 9,000 number 27, the Simon trust reported DNI of 120,000 for the current year. The trustee is required to distribute 60,000 to Ken and 90,000 to Linde each year.

If the trustee distributes these amounts, what's, includable in Len's gross income. What's going to be on lens K one. Well, the trust requires that Linde get 90,000 and can't get 60,000. Add that up. The required distributions, 150,000 Lynn gets 90. Over one 50 Lynn gets 60% again, 90,000, over 150,000. Linda gets 60% of the required distribution.

So 60% of the DNI, 60% of 120,072,000 answer's C would be on Lynn's K one and be taxable to lend 28. I distribution from a state income that was currently required, was made to the estate sole beneficiary during the year. The maximum amount of the distribution that would be included in the gross income for the beneficiary is limited to what DNI right?

Answer C answer. Say DNI sets the limit on what's taxable to the beneficiary and sets the limit on the distribution deduction for the state of the trust. Please do 29 to 34 and then come back.

Welcome back. Let's look at these REG CPA Exam questions together. And number 29, they ask ordinary and necessary administrative expenses paid by the fiduciary of an estate are deductible, and the answer is C. Those administrative expenses can be taken either on the seven Oh six, the estate tax return or the 1041, the fiduciary income tax return, but not both.

So it's an election that the executor would make the executor. If the executor is not going to take the deduction on the seven Oh six, the state tax return, they, they waive their rights. To take that deduction on the seven Oh six and therefore it would be taken on the 1041. But as I say, it can't be taken on both.

So the answer is C. Now you may have noticed that there are no answers to these REG CPA Exam questions in the viewers guy. I'm sure you've noticed that as we've gone through the class, I don't know if you've looked for answers, but there are no answers in the viewers guide because I don't think there should be. I think it's important that we discuss the REG CPA Exam questions together, that you get your answers first, before we discuss the REG CPA Exam questions, the problem with putting the answers in the viewers guide is, you know, people look back to find the answer and they noticed the answer for the next three.

Don't lie to me. You would do that. And I just don't think it it's good for a student. So the answers are deliberately not in the viewer's guide, so we can go through them together and solve them together. And as I say, you get your answer. Then we can have a discussion and I'm 30 asked her a cash basis.

Taxpayer died on February 3rd year one during year one, the state's executor adopted the calendar year for the estates taxable income for the 1041. The executor is not going to file an extension and they want to know when the 1041 would be due. Well, remember the 1041 is due just like when your tax return is due three and a half months.

From the close of the year, it's a calendar year. So it would be April 15th. And you know, if April 15th falls on a Saturday or a Sunday or legal holiday, then it's due the next business day. So they only answer that makes any sense is big Wednesday, April 17th.

And number 31, if a calendar year S corporation does not file an extension. When is the S corporations return? When is that due? We'll remember the S corporation return and the C corporation returns are due two and a half months from the close of the year. It's a calendar year. So it would be March 15th.

32, which of the following statements regarding a partnership tax year is correct? ACE says a partnership formed on July. One is required to adopt a tax year ending on June 30th. Now you'd be forbidden to. I mean, I have a partnership normally adopts a fiscal year that the majority partner has that's fine, but generally it's a calendar year.

And if you elect to use a fiscal year, there's a limitation to it. And it can't be answer a because if you elected that fiscal year from July one to June 30th, you'd be deferring six months of taxable income for partners in the following year. So of course the answer is B. A partnership may elect to have a tax year other than, than the generally required tax year.

If the deferral period for the tax year elected does not exceed three months, remember S corporations have the same limitation. You know, you with an S corporation, you can use a fiscal year, but that fiscal year cannot result in deferring shareholder's taxable income more than three months in the following year 33.

One of the elections, a new corporation must make is to choose an accounting period, which of the following entities has the most flexibility in choosing an accounting period? Well, I think, you know, it's not B or C S corporations and partnerships are not PA tax-paying entities. They're pass through entities.

The taxation is that the individual partner level for a partnership or an individual shareholder shareholder level for an S-corporation, they're not tax paying entities. So there are limitations on the tax year. You know, generally it's a calendar year. You know, if you're an S-corporation you can use, uh, the, the, the fiscal year that a majority shareholder is using, or if you're going to elect a fiscal year, It can't defer taxable income for shareholders into the following year.

More than three months, partnerships, generally a calendar year, they elect a fiscal year. Can't defer taxable income for partners into the following year. You know, more than three months personal service corporations, you know, pretty much always use a calendar year. They can use a fiscal year, but they've got to demonstrate the IRS.

There's a valid business purpose, but the answer is that C corporations have a lot of flexibility. And their tax year, which of number 34, which of the following types of entities is entitled to an NOL loss deduction and net operating loss deduction. Well,

partnerships S corporations, you know, they're not tax paying entities. They're. Pass through entities. The taxation is all at the individual partner level for partners, for partnerships at the individual shareholder level for S corporations. So, you know, losses for a partnership, you know, pass through to the partners losses for an S-corporation passed through to the shareholders.

But as an entity partnerships and that's corporations, don't get a net operating loss deduction. Not for profit, not for profit organizations. Don't get one. They're not profit-making. And of course the answer is C trusts in the States can get a net operating loss deduction.

Welcome back. Let's look at these REG CPA Exam questions together. Number 35. It says Cox transferred assets into a trust under which smart is entitled to receive the income for the rest of their life. After Smart's death, the remaining assets are to be given to mix the remainder man in year one, the trust received rent of a thousand stock dividends of 6,000 interest on CDs of 3000 municipal bond interest of.

4,000 and the proceeds of 7,000 from the sale of the bonds, both smart and mics are still alive. What amount of the receipts will be allocated to trust principle? So they were making a sorted out from all this income information. What goes to Corpus? What goes to trust principle and what is considered part of income?

For the income beneficiary? Well, the basic rule is, I mean, unless there's, unless there's contrary instructions in the trust document, you know, the trust document always prevails unless there's contrary instructions in the trust document, ordinary receipts go to the income beneficiary. So ordinary receipts, like the rental income, the thousand, the interest on the CDs, the 3000.

The bond interest of 4,000. Those are ordinary receipts. Extrordinary receipts. The stock dividends 6,000. The proceeds from the sale of the bonds. 7,000 answer C 13,000 is allocated to principle.

Number 36. Number 36 is about a trust. That was created by dicks on January 1st, year three. And what Dick's transfers into the trust are corporate bonds with a face amount of 500,000 and an interest rate of 12%. The bonds pay interest semi-annually May 1st and November 1st. And basically they want to know how you'd allocate the interest on the bonds.

To principle and income. Well, just doing some quick calculations here. If you take 12%, it's 12% bonds. If you take 12% of 500,000, that's 60,000 of interest for a full year divided by 12 months, we're talking 5,000 of interest per month. Now the last time interest was paid was November 1st year, too. So on January 1st, year three, when Dick's creates the trust, there's two months of accrued interest for November and December.

And the general rule is that that interest that accrued before the trust was created again, unless they were contrary instructions in the trust document. Generally, the rule is that the interest that was accrued on those bonds before the trust was created, I'm talking about November and December of year to 10,000.

Will be allocated to principal. The answer is C and then the rest of the interest that was received, the interest that was received for

January, February, March, and April of year three. And then may June, July, August, September, and October of year three, those 10 months, 50,000. Would be allocated to income. So the answer is C and notice the question was, assume the trust is valid. How would the amount of interest received in year three, be allocated between principal and income?

So again, in terms of what they received, they received $60,000, right? Two payments. But the first two months, November, December of year two, 5,000 per month, that those months were, that that interest was pertaining to months before the trust was created. And the general rule is that would be allocated to principal.

The rest would be allocated to income.

Talk about tax exempt organizations. Now, when you talk about tax exempt organizations, you're talking about charitable organizations, you know, religious scientific, literary. Civic leagues, labor unions, chambers of commerce, you know, society for the prevention of cruelty to animals. There's a whole huge list of these types of organizations.

And even though these organizations are tax exempt, they are required to file an information return to the IRS. I'm talking about form nine 90. Tax form nine 90. It's an information return that has to be filed to the IRS and form nine 90 is just a simple report of gross income and expenses. The nine 90 also has to identify substantial contributors and the amount they contributed.

So the nine 90 also identifies substantial contributors and what they contributed and identifies managers and all highly. Compensated employees and their salaries. So that's basically though and information return that has to be filed with the IRS because these organizations are tax exempt. Now some organizations are exempt from having to file a nine 90, the big one, religious religious organizations, churches, religious schools, missions, religion, or religious organizations.

Don't have to file the nine 90. Also any organization that has gross receipts of $25,000 less any organization with gross receipts of $25,000 or less exempt from having the file the nine 90. Now, even though these organizations are tax exempt, they do have to pay tax on any unrelated business, taxable income you BTI.

So we build the tax exempt. These organizations would have to pay tax on any unrelated business, taxable income. In other words, this is income. That's unrelated to their main mission.

And if there's any unrelated business, taxable income you BTI, the tax exempt organization has to file tax form nine 90 T. On the 15th day of the third month from the close of the year. So it's calendar year. We're talking about March 15th. Now this you BTI this unrelated business, taxable income will be taxed at corporate rates.

If the tax exempt organization is organized as a corporation, or it'll be taught, it will be taxed at trust rates. If it's organized as a trust. Now having said all that some tax exempt organizations are exempt from unrelated business, taxable income. I mean, there's some income, that's just the, some income that's just exempt from unrelated business, taxable income, for example, amounts under a thousand dollars.

It's diminimous, it's just considered too minimal to worry about. So amounts under a thousand dollars exempt from the UBT tax games of chance. No, it's what they hold a casino night, exempt sales of gifted items, interest in dividend income, rental income and activities of volunteers all exempt from BTI.

So there is some income that is exempt from the BTI tax.

Let's do 37 38 and 39 37 says if an exempt organization is a corporation, the tax on unrelated business, taxable income is of course answer a. Tax the corporate tax rate. If it's organized as a corporation, 38 help Inc. An exempt organization derived income of 15,000 from conducting bingo games, you know, games of chance conducting bingo games is legal in the locality and is confined to exempt organization in health exempt organizations and help state.

Which of the following statements is true regarding this income. The answer is B the entire 15,000 is exempt from the UBT tax games of chance,

39 unincorporated exempt organization, subject to the tax on its current year. You be income, unrelated business income. And of course the answer is B. They have to comply with the provisions having to do with estimated tax payments. I mean, the, even though it's a tax exempt organization, they are going to get taxed on you BTI.

And because they had they're being taxed on that unrelated business, taxable income, they would have to make estimated tax payments. I'd like you to try number 40 and then come back.

Welcome back. Let's do number 40 together. I like question number 40 because it gives you a situation. It happens to be in a state and they say, okay, what would be DNI? They make you work out. Distributable net income. Now, remember if you're going to calculate distributable net income, your starting point is what the taxable income for this estate before the distribution deduction.

That's your starting point. You've got to know the taxable income before the distribution deductions let's work that out. We're going to take their taxable interest 65,000 plus the long-term capital gains. So that's total income there of 70,000. Now it's an estate. So we would back out an exemption on a state, gets a $600 exemption.

We'll back that out. Then we're going to back out all the ordinary necessary deductions. We would back out the administrative expenses. The charitable bequest on a state can take a charitable deduction. So you back out $23,000 of expenses. And that would mean the taxable income before the distribution deduction is 46,446 four.

All right. And you see why I calculated that because that's my starting point. If I'm going to work out DNI, I start with taxable income before the distribution deduction. In this case 46, four are not, how do I get DNI? Well first I would add to that 46 for any tax exempt income. There isn't any, I would add back the exemption, the 600 and then I would subtract any capital gains allocated to Corpus.

And they said that the long-term capital gain, the 5,000 was allocated to Corpus allocated to principal. So I backed that out and DNI is answer B. 42,000. I hope you're getting more and more comfortable with DNI and why it is so significant. Well, that concludes our class on partnerships and other tax topics.

And from all of us at Bisk CPA review, I want to wish you the best of luck on the exam. Keep studying.

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Hello, and welcome to the Bisk CPA review course and our coverage of the regulation section of the CPA exam. My name is Bob Monette. I'll be your instructor for this class. And in this class, we're going to be talking about a very heavily tested topic, and that is the federal taxation of property.

Before we get into the topic. I want to say a word about the best way to use this class. The important thing is to treat this like any other class take good notes. And later when we do problems, it's important that at that point you shut the class down, work on the problems, get all of your answers first before you come back to the class and then we go through the problems together.

You'll find if you do those simple things. You get much more out of this REG CPA Review course and that's what we both want. So with that said, let's get into the federal taxation of property. I want to begin by going over how you would calculate the adjusted basis, the tax bases of a piece of property used in a trader business.

If you're going to calculate the adjusted basis or the tax basis of a piece of property used in a trader business. You're going to start with the cost of acquisition. Then you're going to add to that cost of acquisition, all the costs you incurred to prepare the asset for its business use. You'd also add any costs of improvements.

You'd subtract accumulated depreciation, and that would give you the tax basis or the adjusted basis of a piece of property used in a trader business. So would that formula in mind? Why don't we talk about depreciation

now, as you probably know, since 1986, we have been depreciating property used in a trader business under the modified. Accelerated cost recovery system or makers. And what makers does is divide property used in a trader business, in a different categories. For example, under makers, there's three, your property three or property would be something like a race horse this 10 year property, like a barge there's 15 year property, like sewer treatment plants, 20 year property like sewer pipes.

That's how makers works. It divides property using a trader business into different categories. So with that structure in mind, let's get right down to what you'd likely see in the exam. What you're probably going to see in the CPA Exam is machinery and equipment used in a trader business. What I'm talking about is makers five-year property and makers.

Seven-year property. Let's start with makers. Five-year property makers. Five-year property would be things like computers, automobiles. Trucks machinery equipment. That's makers, five-year property computers, automobiles trucks, machinery equipment, seven year property would be furniture and fixtures. It's primarily what you'd say in the exam.

Now, fundamentally makers is a double declining balance approach and, you know, double declining balance. So well from financial accounting. Double declining balance means literally what it says. It is double the straight line rate times and ever declining balance. So if it's five-year property, we know the straight line rate would be one fifth every year.

Well, makers is going to let you double that to two-fifths same thing with seven-year property. We know the straight line rate would be one seventh. Every year. Makers is going to let you double that. Two two sevens. And of course, salvage, value's never used. Salvage has never used in makers. Now under makers.

We also use what is called the half year convention. Now, what is the half year convention? The half year convention means you're allowed under makers to take one half year's depreciation in the year of acquisition. And one half years depreciation in the year of disposal. That's the half year convention.

We're under makers. You're allowed to take one half year's depreciation in the year of acquisition and one half years depreciation in the year of disposal. So how would that work? Well, if it's five-year property, we know the straight line rate is one fifth. Every year makers is going to let us double that to two-fifths, but in the year of acquisition, we only get a half a year's depreciation or one fifth.

And then the next four years, two fifths, two fifths, two fifths, two fifths. And in the year of disposal, one fifth, same thing with seven-year property. We know the straight line rate would be one seventh. Every year. Makers is going to let us double that to two sevens, but not in the year of acquisition because of the half year convention in the year of acquisition, we don't take two sevens.

We take one seventh, I half a year's depreciation and then two (727) 272-7272 sevens. And then in the year of disposal, one seven, that is the half year convention where you're allowed to take one half years depreciation in the year of acquisition. And one half years depreciation in the year of disposal.

Now you'll notice that in our class here we are using fractions, you know, one fifth and two fifth and one seventh and two sevens. And I do that because I think fractions work very well with multiple choice, but I have to warn you. What they have done is take these fractions and converted them into percentages and come up with maker's tables.

And they're very useful. And in your viewers guide, you'll see the makers tables and they are really great because the maker's tables automatically build in the half year convention. The makers tables automatically switch over to straight line when it's more advantageous, which makers Lexus. Which makers lets you do.

And you want to make sure that, you know, you make up a couple of assets and just play with the maker's tables a little bit. And it's very easy. You basically go to the table. You want what used appreciation you want. Get that factor multiplied by the cost of the asset. And that's your depreciation for the year.

It's very easy to use, but the reason I am assigning for you to do this is because they're very unlikely. To give you makers tables in a multiple choice because it's too much, it's too much information, but in a simulation you'll never know you may be given makers tables in a simulation. And I don't want for you to be in a situation where the first time you've seen these tables is in the actual exam, because it really is possible that you could have a simulation where they give you the maker's table.

So take a look at those makers tables in your viewers guide, make up a couple of assets, just kind of play around with it. So that you have some exposure to the tables. Now also makers uses what is called the mid quarter convention. Now, when we get into the mid-quarter convention, if more than 40%, more than 40% of depreciable assets are acquired by a business in the last quarter of the year, they are required to use the mid-quarter convention.

If more than 40% of depreciable assets are acquired in the last quarter of the year. That's when a business is required to use the mid-quarter convention. Now here's the midpoint of each quarter. The midpoint of each quarter would be two 15, five, 15, eight, 15, and 1115. That's the midpoint of each quarter.

Now let me show you how it works. Let's say that a business purchases and places in the business use a computer on February one, the cost $10,000 also. They purchased and placed into business. Use another computer, the cost $30,000 on December one. So you add up their total asset purchases during the year adds up to 40,000 notice 30,000, over 40,000, 75% of those purchases were in the last quarter of the year.

This business would be required to use the mid-quarter convention. So here's how it works. The computer that was bought on February one in the first quarter. For makers purposes, we're going to treat that computer as if it were purchased at the mid point of the first quarter or two 15. So in other words, under makers, we'd be allowed to take 10 and a half months to appreciation on the first computer because we treat that computer as if it was purchased in place into use.

At the mid point of the first quarter, we'll just do 15. You're allowed under makers to take 10 and a half months to appreciation on the first computer. Now the second computer. That you bought on December one in the last quarter for makers purposes. You're going to treat that computer as if you bought it and placed it into use at the mid point of the last quarter, which is 1115.

So for the second computer, we're allowed under makers to take one and a half months depreciation. That's the mid quarter convention. And you'll see, of course, as we're going through this, that it's going to be important. That you've really got these conventions in your mind and understand them and you're ready for them.

The half year convention and the mid-quarter convention.

Now also with personal property used in a trader business, a business. Under section one 79 is allowed to expense right off the top. Again, this is for personal property used in a trader business under section one 79. A business makes an election they can elect to deduct right off the top up to a maximum of $500,000 right off the top four new or used new or used personal property.

No machinery equipment placed in the business use. And this section one 79 election deduction is made the first year you place the asset into business use. Now I said that the maximum section one 79 election deduction is 500,000. Well that's for 2011, but I should warn you that with all the stimulus legislation.

Floating around Congress, section one 79 is one of those, one of those provisions in the tax code that gets changed a lot. So always be sure that you're up to date before you take the exam. If there's been any recent changes to that section one 79, because with stimulus packages, it's very common for them to change that section one 79, but for 2011, the maximum.

Section one 79 election deduction is 500,000. Now be careful. We said that maximum section one 79 election deduction is 500,000, but taking the section one 79 deduction can never result in a net operating loss. Never. So, so if a business's taxable income before the section one 79, We'll say 182,000, then the maximum section one 79 election deduction that business could take this year is 182,000, not 500,000, because that would throw them into an NOL that would throw the business into a net operating loss.

So, yeah. So you had that, you have that other limitation as well, taking the maximum section one 79 election deduction can never result in a net operating loss. So if a business has taxable income before the section one 79 is $311,000, Well, then the maximum section one 79 election deduction that business can take is 311,000, because it can not result in an NOL.

Let me illustrate how section one 79 works. Let's say that a business purchases, places in the business use for trucks and the Ford trucks combined cost $550,000, 550,000. Now, if the business elects, this is an election, the business makes if the business elects to take the maximum section one 79 election deduction, they'll just write right off the top.

500,000. That's the maximum section one 79. So they'll back out 500,000. So that leaves a basis of 50,000. Now, at this point, I'm going to mention that there's also potentially another election. The business can make, they can elect to take bonus depreciation. So just to build it into the example, if the business elects to take bonus depreciation, Now the bonus depreciation can only be taken for new personal property, not used new personal property with a useful life of 20 years or less that you're using in a trader business.

Again, not, not used personal property, just new. And if the business elects to take bonus depreciation. They'll take another 50%. So I'm going to take the basis before my bonus depreciation of 50,000, and I'm going to back out another 25,000 as my bonus depreciation, 50%. But notice the bonus depreciation is taken after the section one 79.

So if I take the bonus depreciation and again, that's an election, the business makes, and I do think the CPA Exam will be very clear. If this, if this is worked into a problem, they will state. That the business elects, the 50% bonus depreciation. I just want you to be clear on how it works in it's taken after the section one 79.

So if you back out that 25,000 bonus depreciation, that leaves us with a basis for maker's depreciation of 25,000. Now what's your maker's depreciation for the year? Well, we know that trucks are five-year property, right? Maker's five-year property. So we know the straight line rate would be one fifth every year.

Makers would let us double that to two fifths, but don't forget the half year convention in the year of acquisition, we can't take two fifths, just one fifth of 25,000 or 5,000 of depreciation. Remember it's five-year property straight line rate is one fifth every year. Makers lets you double that to two fifths, but not in the year of acquisition because of the half year convention.

You only get a half a year's depreciation or one fifth. Of 25,000 or 5,000 of maker's depreciation. So back that out, that leaves the adjusted basis going forward to be 20,000. So with that schedule in mind, if they asked you when the CPA Exam what's the business's total deduction for year one, the total deduction for year one is the 500,000 section one 79, the 25,000 bonus depreciation.

And the 5,000 makers depreciation, your total deduction is 530,000. They could ask you for that. That's your total deduction for year one, 500,000. Section one 79, 25,000 bonus, 5,000 makers told the deduction 530,000. Let me ask you this. What would be the deduction for year two while year two? You would now be twice the straight line rate.

Two fifths times. The balance that has declined the adjusted basis now has declined down to 20,000 to 50 times, 20,000 in year two, you would get an $8,000 deduction. Now you've got to be careful because there is a phase-out with that section one 79, you start to lose that maximum section one 79 election deduction dollar for dollar.

Once your purchases are greater than $2 million. So let me illustrate, let's say that the five trucks cost 2 million, $100,000. If the five trucks cost 2 million, 100,000, you're a hundred thousand over the threshold. So you just lost a hundred thousand of your maximum section one 79. So your maximum section one 79.

Goes from 500,000 down 100,000 down to 400,000. So watch out for that phase out as well. And I, I should also mention that the maximum section one 79 election deduction of 500,000. That is the maximum section one 79 per return. Not per asset, right? It's per return. It's not taking asset per asset.

Let's talk about real property up till this point we've been talking about personal property used in a trader business machinery equipment. Let's talk about real property, no under makers. There are two categories of real property. First there's residential rental property. Residential rental property would be like an apartment house.

And under makers, residential rental property is depreciated straight line over 27 and a half years. It's straight line over 27 and a half years. Then the other category would be non-residential real property using a trader business. What do I mean by non residential real property used in a trader business.

On a par uh, on a, uh, office building a warehouse, right? Non residential, real property used in a trader business, a warehouse, an office building under makers. Non-residential real property using a trader business is depreciated straight line over 39 years. And I know I don't have to say this, but I'll feel better if I do.

You don't appreciate the land, right? Not the land. Just the building and with real property, we use the mid month convention. You know what that means? I know you're ahead of me. What's the mid-month convention mean with real property. We're allowed to take one half months depreciation in the month of acquisition and one half months depreciation in the month of disposal.

So don't forget with real property. It's the mid month convention where we're allowed under makers. With real property to take one half month depreciation in the month of acquisition and one half months depreciation in the month of disposal. Now with real property, can you take a section one 79 election deduction?

You can, but only if it's qualified real property only qualified real property qualified real property is leasehold improvement property. It is restaurant property and it is retail improvement property. That's it. But there is a section one 79 election deduction of up to 250,250,000 for qualified real property using the trader business.

And again, the only qualified real property is leasehold improvement, property, restaurant, property, and retail. Improvement property, that's it. But you are allowed to take up too $250,000 deduction. And here again, that's going to phase out if you purchase as a greater than $2 million phases out dollar for dollar, and you know what the phase outs show you is that these section one 79 election deductions are meant for small businesses.

Right? Microsoft doesn't get a section one 79. General electric. Doesn't get a section one 79, you know, big corporations. Don't get it. That's that's what the phase out really shows you that it's intended to be a deduction for small businesses.

We know that if you sell or exchange capital assets, that results in capital gains and losses, we know that, and I bring it up because when you go in the exam, it is essential that you know, whether or not you are dealing with a capital asset. So how do you know what is a capital asset? How do you know for sure?

Well, I've always felt the best way to study. This is to be absolutely confident on what capital assets are. Not just remember capital assets are not Mr. CIA. That's what capital assets are not Mr. CIA, Mr. CIA, let's fill it in the M machinery equipment. Used in a trader business. In other words, any personal property using a trader business, but think of the M as machinery equipment used in a trader business, the R real property used in a trader business, the C uh, copyright held by the original artist C would be a copyright held by the original artist.

I is inventory and a would be accounts. Or notes receivable. That's what capital assets are not. And my point is once you know what capital assets or not, then you can be pretty confident about what capital assets are. Stocks, securities, personal property, not used in a trader business, real property, not using a trader business.

That's a capital asset. A partnership interest is a capital asset. Okay. A copyright that you purchase from somebody you're not the original artists, that would be a capital asset. So as long as you're confident about what capital assets are not, hopefully you can always infer what a capital asset is.

All right now, we're going to stay on Mr. CIA and what we're going to concentrate. Now, what we're going to concentrate on is the Mr. And Mr. CIA. All right, so we're going to narrow our focus and now we're just going to talk about the M and the R. The Mr. And Mr. CIA now listen carefully. We have the M machinery equipment used in a trader business.

The, our real property used in a trader business. We've held it more than a year. We sell it at a gain or loss. These are section 1231 assets. So it's the Mr. And Mr. CIA machinery equipment used in a trader business, real property used in a trader business. We've held it more than a year. We sell it at a gain or loss.

These are section 1231 assets. It's important that, you know, a section 1231 asset, when you see it. Welcome to biscuit, CPA review comprehensive CPA Exam review materials for the CPA exam. To let you customize your own review programs to meet your individual learning style and ensure your success.

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I'm Jack Gorman. And this is the CPA review focusing on gross income tax liability and credits in this program. We're going to identify items of inclusion and gross income. And exclusions from gross income. We'll talk about how those items are reported on a tax return. We'll review some Seadrill issues, including filing requirements and due dates, tax payments, and penalties.

And finally, we'll wrap up the program was a discussion of refundable and nonrefundable tax credits. Let's review very quickly. The basic tax formula it's gross income. And here we're going to both put items into gross income and exceed and exclude certain items of gross income. We'll take adjustments from gross income in computing, AGI, commonly called adjustments for adjusted gross income.

From that AGI number we will deduct itemized or standard deductions and the personal exemptions to compute taxable income. The taxable income is then multiplied by the appropriate tax rates to produce a regular tentative income tax. We subtract tax credits from that amount. And we may have to add in other credits, such as the alternative minimum tax or the self-employment tax will deduct payments made over the course of the year and end up with either a tax due.

Undesirable or a tax refund desirable to both taxpayers.

Let's start with gross income. What is it? It is all accretions to wealth from whatever source derived. And those are included on the tax return, unless expressly excluded under the statutory or regulatory provisions of the law, while all income is reportable on form 10 40, some items are initially reported on other backup schedules that then come forward to the form 10 40.

Some of those other supporting forms include the schedule B. For interest in dividends, schedule C for business income schedule E for rental income and pass through entities. And we'll discuss particularly the C and D C and E later in this program, schedules D and F may also be required. Schedule D talking about capital gains and losses, and the subject of another program offered by Bisk and schedule F which deals with farming might also be required for a particular taxpayer.

Now when you have a taxpayer bringing in information, you need to analyze gross income. How do we analyze accretions to wealth? The first question you should be asking yourself is, is the item included in gross income? Do any exclusions apply? And if part of it is includable, the question is what amount is included?

Is it all of it or only a portion? From there we go on and ask the question, where is the income reported on what form, what line, and then do any special rules apply with respect to that income or the special elections that should be made or that the taxpayer might consider and decide not to make during the year let's begin our analysis with gross income inclusions.

Almost all of, you know, that salary and wages are reportable on the tax return, salaries and wages include the fair market value of any property that's paid as compensation. Uh, you may, most of us will get our income and forms of checks or cash, but occasionally there may be a property payment, fair market value is includable salary and wages or compensation from the employer.

Also includes bonuses, taxable benefits. And the like any expense reimbursement under a non-accountable plan is included in gross income. Now you noticed, I use the word non-accountable plan that there are two items set forth in the regulations that employers may offer an accountable plan or a non-accountable plan.

If an expense reimbursement is handled under an accountable plan. Then that those reimbursements are not included in the taxpayer's gross income. Those under a non-accountable plan are included in gross income. Well, what constitutes what makes something either accountable or non-accountable, I'm going to define an accountable plan.

Anything that doesn't meet this definition is by default Aidan accountable plan. An accountable plan relates to payments for services provided by an employee to an employer. The employee must make an adequate accounting of the expenses to the employer and the employee must return to the employer. Any excess reimbursements that were not used for accounted expenses within a reasonable period of time.

So anything that doesn't meet that. Definition becomes a non-accountable plan and is included in gross income. Gross income also includes the recovery of any tax benefit item. A great example here, and there's a specific line on the tax return for it. Assume that a taxpayer at year one itemizes and ducks state income taxes paid when the return is filed, the taxpayer receives a refund it year two.

That refund of state taxes is included in income. To the extent the taxpayer received a benefit in year one from the deduction, unemployment benefits are included in gross income.

Gross income also includes gambling winnings. And in this case, we're putting in gross gambling winnings, not the net. So if you go to the racetrack, for example, when a thousand dollars and have put in $600 of tickets that have not paid off, you include the $1,000 in gross income, not the net of 400. Those $600 of expenses may be deducted as a miscellaneous itemized deduction, not subject to the 2% limitation.

So just remember gross gambling winnings, go in gross income. Punitive damages and compensatory damages for physical injuries are excluded from tax. If those punitive damages and compensatory damages relate to a psychological, a mental, a discrimination type injury, they are included in gross income. Pay for jury duty or reserve.

Uh, military reserve pay is included in gross income. Uh, and this is true, even if the taxpayer turns around and remits that money to the employer in exchange for regular compensation. What happens is that regular pay be a jury duty or reserve as pay is included in gross income. And then a deduction is taken in computing, adjusted gross income for the amount for that same amount.

So effectively zeroed out. But the gross must be right now. Gross income also includes alimony. The. Taxpayer who is paying alimony will be entitled to a deduction for it. The recipient of alimony does pick that up as gross income. Now it must be made very clear. Child support is not taxable income. The payer doesn't get a deduction.

The recipient does not have to report child support. So there's a very important distinction between these two. Let's define what constitutes alimony. It is paid in cash. To a former spouse. It is not a property settlement. Alimony is paid pursuant to a written divorce instrument. It cannot be designated as anything other than alimony.

Those payments must terminate on the death of the recipient. The payments may not be paid to a member of the same household and may not be paid to a spouse with whom the taxpayer is filing jointly. That last one, it was a little bit crazy if there's a divorce, but nonetheless, those are the requirement to have true alimony, gross income includes interest received on corporate and treasury bonds.

They also include interest received on tax refunds. Now there are something called municipal bonds, state, and local bonds that are issued, and those are not taxable for federal purposes. For regular tax purposes. A portion of them may be picked up under the alternative name tax dividends. Those two two are included in gross income.

Ordinary dividends, at least through 2012 have been taxed at a preferential 15% tax rate. Ordinary dividends, exclude dividends paid by mutual funds. Investing in tax exempt securities. They excluded stock dividends. They also excluded dividends on life insurance and amounts that are not paid from incorporations.

Earnings and profits. So we're looking at ordinary dividends, paid from a company's earnings and profits. It also happens to include below market corporate shareholder loans. That benefit that's derived by the shareholder for below market loan is considered a dividend and subject to inclusion on the tax return.

Those are the major items that will appear we're on the front page on specific line items, but there are also items of gross income that will be on supporting schedules. They come forward to them. First page of the return schedule C reports, the net profits or loss from self-employment. These are essentially schedule C sole proprietorships.

I personally am an attorney who has my own practice. Not incorporated. It's a schedule C business and my net profit from that schedule C business rolls forward to the first page of tax of the tax return and is included in gross income schedule D reports, capital gains, and losses. And most of you will remember that long-term capital gains qualify through 2012 for a highest tax rate of 15%.

And in some cases as low as 10%. Schedule, he reports the net rental income and loss. These are rental properties that the taxpayer owns. It also reports any royalty incomes, and also let's schedule E or the flow through income and loss from estates, trust partnerships, and S corporations. So all of these amounts have reported on supplemental schedule E again, called forward into the gross income of the taxpayer.

Although many practices don't have farming clients. For those of you who do the net income or loss will, would be reported on schedule F also a component of gross income. So that lengthy list is all of those accretions to wealth. That must be reported as gross income by the taxpayer.

Let's shift our focus now and talk to items of that are truly accretions to wealth, but are excluded from taxable income, life insurance, proceeds, or death benefits. Now there's some special rules here. The employer provided benefits are taxable, but the general rule is that proceeds of life insurance that you own.

Uh, let's say our payment on your death, your wife is filing the tax return. That life insurance settlement is not included in gross income. However, any interest on installment payments from that insurance proceeds are taxable. Gifts and inherited, inherited says are not included in gross income. One exception here, a gift from an employer is taxable to the employee child support.

I mentioned previously, we were talking about alimony is not includable in the income of the recipient at the same time. The payor may not take a deduction for this assume that. An individual taxpayer receives a single check, which is part alimony and took part child support. How is it characterized child support first alimony.

Second, if the payments are reduced based on sub contingency, then they are deemed child support. Even if they are labeled alimony. And again, just to reinforce child support is not included in gross income. There are further exclusions from gross income. They include divorce, property settlements interest on municipal bonds.

As I mentioned a moment ago, any benefits received under Medicare are not subject to the gross income inclusion employer contributions to a qualified retirement plan and to qualified health plan. Those are not subject to tax they're exclusions. And these are probably some of the largest exclusions under the internal revenue code.

When your employer provides contributions to the retirement accounts or pays a portion of health plan insurance premiums excluded great benefit for the employees, any welfare or other assistance benefits are exclusions from taxable income. Damages received for a physical injury. These are compensatory damages for physical injuries are excluded.

If the injury is not physical, but as a discrimination type case, it's psychological injuries. Those are included in taxable income. As I mentioned previously, all punitive damages are also taxable, not subject to exclusion. Distributions for Roth. IRA accounts are excluded from gross income. Of course you remember that distributions from us.

Other types of tax deductible, IRAs are includable income. So regular tax deductible, IRA distributions are taxable Roth. IRA distributions. Non-taxable. Let's add a few more exclusions to the list because everybody likes non taxable income. There are scholarships and fellowships. Those are excluded from income.

Now, in this case, there's several requirements. The proceeds must be used for tuition or course related expenses. The recipient must be a degree candidate. And those payments must not be for the performance of services. So if the payments are conditioned upon teaching a couple of courses, uh, working as a lab assistant, those will disqualify the amount for the exclusion.

But if it's a pure tuition related scholarship to a degree candidate, it is excluded from tax.

And awards are excluded. The requirements here are that the recipient be selected without action on their part. No future services are required of the recipients and the award is assigned to a charity or government. Classic case here, Nobel prize, uh, there's a large cheque associated with that while the recipients have done work in the past, they are nominated by others.

There's no action required on the part of the recipients and no future services are required. It's simply a recognition of their contributions to society. I have a couple of more exclusions and then we'll move on to some problems. Gross income exclusion include qualified fringe benefits. These are fringe benefits that your employer may provide.

There is a series of them such as a no additional cost benefit. Uh, it may be a, uh, an employee discount. Many times people working in stores will receive discounts for purchasing items from the stores. So an employee may get 5% off. You may be allowed to use the copier, uh, for some personal small items in the firm.

These are. Qualified fringe benefits. One of the larger ones is of course, uh, frequent flyer miles, uh, for employees of airlines, where they could fly on a space available basis on those flights interest on series w savings. Bonds are also excluded from gross income. If the proceeds are used for qualified education expenses, the purchaser of those bonds must be the sole owner must be older than 24.

The proceeds from those bonds must be used for education expenses. And those expenses can not be double dipped by also being claimed as part of a qualifying credit, social security benefits. Most people think social security benefits are non-taxable. You're not going to find a provision in the code that says.

Or didn't for a number of years that they were or were not taxable. There was a revenue ruling that said social security benefits are completely excluded from tax. Then a few years ago, Congress came in and said, we are going to tax a portion of social security benefits based on provisional income for a married couple filing jointly.

If they're adjust, if their income is less than $32,000. None of social security benefits are subject to tax. If the income is between 32 and $44,000, 50% of the benefits are taxable. If the income is above $44,000, 85% of the benefits are taxable. These taxation amounts are slightly lower for single individuals.

I mentioned pensions before. Pensions and annuities and traditional IRA deductions are subject to tax. If the contribution was deductible, the proceeds are taxable. And remember earnings on these amounts are also subject to tax. You can recover your post-tax initial investments, let's say a Roth or 401k contribution.

You recover those basis amounts tax-free any amount contributed by the employer. And any earnings are taxable when they are withdrawn. Well, that was a lot of inclusion. Yeah. A lot of exclusions, a lot of complicated material, the best way to illustrate it is with problems. And if you'll take a look at the thick set of Q and A's, I'll be back in a moment to help walk you through the correct answer and why the other selections were inappropriate.

See you in a moment.

Pearl a dentist build would $600 for dental services would paid Pearl $200 in cash and built a bookcase for pro's office in full settlement of the bill wood sells comparable bookcases for $350. The question is what amount should Perl include in taxable income as a result of this transaction? Is it a zero B $200, C five 50 or D 600?

Well, we remember the compensation for services rendered. The amount that must be reported is any cash payments plus the fair market value of any property received. So in this case, we would add together the $200 of cash and the three 50 fair value of the bookcase. So the answer is $550 answer C and by the way, the same $550 is the amount that would, would take as a medical deduction on his itemized return.

Our next question, concerns, DAC foundation. It awarded Kent seventy-five thousand dollars in recognition of lifelong literary achievement. Kent was not required to render future services as a condition to receive the 75,000. What condition or conditions. Must've been met for the award to be excluded from Kent's gross income.

And we have two statements staved, the number one or condition number one, Kent was selected for the award by DAC, without any action on his part statement to pursue it to Ken's designation. DEC paid the amount of the award either to a governmental unit or to a charitable organization. The question is which if, if any of those two statements must be satisfied?

Well, we know that for the gift to be excluded. No action on Ken's part deck must make the selection without any involvement of Kent. So state boat number one is a condition. It must be met. Furthermore, the payment, the award must be made to a government unit or charitable organization condition to bus be met.

So the only correct answer here is item number C. Both one and two in your one. Emily Jud received the following dividends. Granted life insurance company paid on her life insurance policy. The total dividends received had not yet exceeded the accumulated premiums. Paid is a hundred dollar dividend there.

She received $300 dividend on national banks. Common stock. And she received $500 for B-roll manufacturing corporation on its preferred stock. As I told you before, dividends are generally included, but dividends on life insurance policies are excluded. So in this case, the correct answer is the 300 plus the 500 $800, which is answer B is the amount of dividend income that Emily should report on her year.

One tax return.

And our next question with regard to the inclusion of social security benefits at gross income, which of the following statements is correct. Hey, the social security benefits in excess of modified adjusted gross income are included in gross income B the social security benefits in excess of 85% of the modified adjusted gross income are included in gross income.

See 85% of the social security benefits is the maximum amount of benefits to be included in gross income. Or D the social security benefits in excess of the modified adjusted gross income over $34,000 are included in gross income. Well, if you think back to the rules, social security benefits, we could start with a premise are generally excluded from gross income and then a sliding scale.

Per percentage is included based upon modified, adjusted gross income. There is a partial exclusion for a lower amount, and then there is a higher, uh, inclusion amount, 85% for benefits. Uh, above a double threshold, but in that particular case, no more than 85% of the social security benefits will ever be subject to tax.

The answer here is C that's. The only one that correctly explains the 85% inclusion amount with the 15% exclusion amount based upon the modified, adjusted gross income limitation. Yeah.

Tax year where the taxpayer pays qualified education expenses, interest income on the redemption of qualified double E bonds may be excluded from gross income. The exclusion is subject to a modified gross income limitation and a limit of aggregate bond proceeds in excess of qualified higher education expenses.

So your question is which of the following two statements. Is our true statement. Number one, the X illusion applies for education expenses incurred by the taxpayer, the taxpayer spouse, or any person whom the taxpayer may claim as a dependent for the year. So is that a true statement or not, and stable in number two, otherwise right.

Higher education expenses must be reduced by qualified scholarships. Not includable in gross income. As you've reviewed the material, you have to recognize that the statement number one is a true statement. It's education expenses for the taxpayer taxpayer spouse, or any dependent of the taxpayer.

Likewise statement. Number two is true. The expenses must be reduced by qualified scholarships, not included in gross income. So both statements must be true. The answer again, number C both one and two. Kline a master's degree candidate at Briar university was awarded a $12,000 scholarship. In 1996, the scholarship was used to pay clients 1996, university tuition and fees.

That same year he received $5,000 for teaching two courses at a nearby college. What amount is includable inclines? Gross. Income is zero 5,000. 12,000 or 17,000 well scholarships when they are true scholarships used to pay tuition and fees are excludable from gross income. If a payment is a stipend for rendering services, such as teaching, it is includable in gross income, no exclusion is available.

So here are the 12,000 is out. The 5,000 is in, and the correct answer is B. Dar an employee of source C corporation is not a shareholder, which of the following would be included in his gross income. So he isn't an employee, but not a shareholder. A employer provided medical insurance coverage under a health plan, B an $11,000 gift from the taxpayer's grandparents.

See the fair market value of land that the taxpayer inherited from an uncle. Or D the dividend income on shares of stocks, the taxpayer received for services rendered. Let's take the two easy ones. First. We know the gifts and inheritances are excluded from gross income. So clearly answers B and C could be stricken.

Employer provided medical insurance coverage to an employee under a qualified health plan is excluded. So the answer a should not be considered it's wrong. The only correct answer here is D dividend income is generally included and certainly would be here on the shares of stock received for services rendered, answer D your correct answer.

In the current year, Jane won $6,000 in the state lottery. She also spent $300 for the purchase of lottery tickets. Jane elected the standard deduction on her current year income tax return. The amount of lottery winnings that should be included in Jane's current year taxable income is, is it zero, $2,000, $5,700 or $6,000.

Now this question really bodys two parts because lottery winnings, state lotteries scratch off tickets. Those proceeds are includible in gross income. So the $6,000. Must be included. What about the $300 she spent on a lottery tickets? She can not net those against the earnings. The gross must be included in income.

Now Jane could take a deduction for the $300 as a miscellaneous itemized deduction. If she itemized. However, in this particular case, claiming the standard deduction she'll get no benefit for the $300 she spent the correct answer is the full $6,000. Must be included and will be reflected in taxes.

Income answer D is appropriate. Our next question, concerns Kent who received the following interest income on a veterans administration insurance policy left on deposit with the VA $20 on treasury certificates, $30 and his state income tax refund. $40. Your question, what amount should can include for interest income?

On his tax return, 90, 70, 50, or 20. Well, we know that the interest income derived from insurance or the dividends left on the insurance policy are not included. They're excludable. So the $20 is out however interest or the treasury certificates of 30 and on the state tax refund are both includable. So your correct answer here is the $70 in answer B.

Easel company elected to reimburse employees for business expenses under a non-accountable plan. Easel does not require employees to provide proof of expenses and allows employees to keep any amount not spent under the plan mill, an easel employee for a full year received $500 per month for business automobile expenses.

At the end of the year, melon formed easel that the only business expenses occurred this for business violet, you have 12,000, 12,000 miles at a rate of 40 cents per mile. The IRS standard mileage rate at the time, Mellon closes a check for $1,200 to refund the overpayment to easel. What amount should be reported in Mel's gross income for the year?

Is it zero? He can exclude it all. Is it the $1,200? Did he repaid $4,800, the net of the two amounts or the full 6,000 expense reimbursement, as you recall, the problem, it says this is a non-accountable plan, which means that Mel did not have to account for his expenses to the employer. And he did not have to take, make a timely reimbursed, would have any unused amounts.

However, in this case, Mel reported after the end of the year, he wasn't required to do so. He didn't do a proper accounting in the course of the year, it was a non-accountable plan. So he must report the force, the full $6,000 answer D he cannot reduce it by the $1,200. He admitted it to the co to the co to his employer that simply lost to mil.

This is one of those kind of strange REG CPA Exam questions that you wonder why he did it. Nevertheless, it was an exam question.

Our next problem speaks about Ralph who in calendar year one earned a thousand dollars interest at rich savings banks on a CD scheduled to mature in year three. So you're what he received a thousand dollars maturity in year three in January of year two, before filing his year one tax return. Ralph occurred a forfeiture penalty of $500 for premature withdrawal of the firm of the funds.

Now, the question is, how should Ralph treat this 500 or forfeiture penalty? Is it a reduction of interest earned in year one? So the only $500 is taxable and Ralph's return. Is it a deduction from year to AGI deductible only if Al itemizes deductions for year two. Is it answer C a penalty not deductible for tax purposes, or is it D a deduction from gross income and arriving at year two?

AGI let's take the easiest one. First answer C while penalties are generally not deductible for tax purposes. We're talking about. Tax and legal penalties. This is a penalty imposed by the financial institution. This is clearly a wrong answer and irrelevant to the question. Now, Ralph has a requirement to report the full amount of the thousand dollars interest received in year one.

The forfeiture occurred in year two. He'll be entitled to a deduction for it, but he takes it as a deduction from gross income in computing, AGI. That's answered D the deduction, uh, for the common in B as a deductible, only if he itemizes is wrong, because he gets it as a deduction toward AGI, irrespective of whether he itemizes and item a is wrong, because you do not do a NetIG in that year.

Our next problem deals with a 33 year old taxpayer who was drew $30,000. Pre tax from a traditional IRA. The taxpayer has a 33% effective tax rate and a marginal tax rate of 35%. What is the total liability associated with the withdrawal? Now we're talking about a traditional IRA and these are income from that where he's taking a deduction for the contributions.

We know that the contributions have been deductible are going to be taxable. When withdrawn plus any earnings on it. So this full $30,000 will be subject to tax. That tax is not at the effective tax rate. It's at the marginal tax rate. And this is a 33 year old who withdrew prematurely. So there will be a 10% excise tax on that premature withdrawal.

So we're going to make a calculation 35% of the $30,000. He's going to give us an income tax liability of $10,500. Plus the 10% excise tax penalty of another three. The correct answer is item D $13,500.

Ash made the following, had the, had the following cash receipts, wages of 13,000 interest income from us treasury bonds three 50. Worker's compensation follows a job related injury. What is the total amount that must be included in gross income on ashes? Individual return is at $13,000. Answer a is it $13,350 and two B.

Is it 21,500 and to C or 2100, 150 answer D well, clearly you know that the wages are going to be subject to inclusion. So that's easy interest income from treasury bonds also included. So we know the three 50 will be picked up, but what about the worker's compensation? Workers' compensation is designed to make, to make payments to an injured worker, a job-related injury.

That's what the 8,500 reflects. It is an exclamation from taxable income from gross income. So Ash was good to report. 13,350 is going to exclude the workers' compensation. And let's just make a reminder note to here. Worker's compensation is excluded. Unemployment compensation is included. Don't confuse the two as you're taking the exam.

We're now going to discuss accounting methods. And while the focus has been primarily on individuals as we go through this program, these rules with respect to accounting methods, both cash and accrual apply equally to individual taxpayers and any other taxpayer, a corporation, a partnership limited liability company.

So as we review these materials, remember they apply to all taxpayers. First the cash basis. Income is recognized when actually or constructively received and by constructive receipt, we've been at the right to that income is not subject to a substantial risk forfeiture just because laid depositing, the income does not delay the income tax recognition of it.

So for instance, if you received a check on December 30th, Waited until January of year two to deposit it and cash it at is still taxable income in year one. There is no current income inclusion. If there is an obligation upon the taxpayer to repay those funds. Now, what about expenses? Expenses are deductible when paid.

A promise to pay is not sufficient. And they are actually paid when either the check is sent or a credit card is charged. If we switch over now to the accrual method of accounting, income is recognized when there is a right to receive the payment. Expenses are deductible. When there is an obligation to pay the co the expense, there are a couple of special rules that we need to focus on while we're looking at a cruel basis expenses.

First of all, there must be economic performance. In other words, the amount of the expense can be determined with reasonable accuracy and the events have occurred, which triggered the payment accrued vacation pay is deductible only when paid. And a taxpayer must use the direct write-off for bad debts.

Essentially, the allowance for bad debt is not allowed for income tax purposes. Now, while taxpayers are generally allowed to select whether they want to be cash or accrual basis, the accrual basis must be used for C corporations, tax shelters, and partnerships with a corporate partner. There is an exception for what is called a small C corporation.

And that is one whose average annual gross receipts are less than $5 million. And there's a further exception for personal service corporations. So we've looked at the cruel and the cash method. Let's talk about some general rules that apply to both methods. Prepaid items generally can not be deducted when paid under either method when they're applied to the relevant period.

And here we're talking about such things as interest rent and insurance. However, prepaid taxes are deductible when they're paid rents and royalties constitute income when received, and we must use the same method for income and expenses. So we can't be on the cash basis for recognizing income and the accrual method for expenses.

You're either accrual or cash for both income and expenses. However, if the taxpayer has different businesses, for instance, they are running a schedule C business and they also have rental activities. You could have one under the accrual method and one under the cash method. So the same income for, for income and expenses, but different methods could be used for different businesses.

I mentioned earlier in the program that we were going to look at a couple of supplemental schedules, schedule C and E particularly. Let's turn over to the schedule C now, which is business income. These are net earnings from self-employment and if the taxpayer is a self employed individual, there is also going to be required.

A schedule S E, which is to report self-employment tax. We'll talk about the self-employment tax a little bit later. Let's focus right now on the schedule C itself. First we report all business income. And then just as a case of a corporation, we're going to report ordinary necessary business expenses to so-called one 62 deductions.

We cannot deduct capital expenses because as the name implies, they have to be capitalized and may be either depreciable or amortizable. We can deduct meals and entertainment, but only 50% of those charges. If travel expense is more than if travel expense is more than 25% personal, the none of the costs are deductible.

If less than that, we may be doing an allocation between business and non-business travel. We'll remember the 25% cutoff test in a schedule C a business bad debt is a short term capital loss. Charitable contributions are not reported on schedule C they're taken as itemized deductions on schedule. A membership dues to a social club are non-deductible.

However entertainment at a social club may be deductible subject to the 50% entertainment rules. Now that the self-employment self-employed individual, as I mentioned may have health insurance and retirement plans. These are not deducted on schedule C, but are deductions for adjusted gross income. In addition, while that self-employment self-employed individual pays a self-employment tax on schedule se a portion of that tax will be deductible.

It will be claimed again, as an adjustment in computing.

When we turn to schedule II, we'll notice there are several types of income reported. The front of that form deals with rental income, the backside. The page two is the schedule reports, distributions and income reported from pass through entities like trust estates and partnerships. Let's begin by focusing on the front, the first page of schedule E in which we're going to report rental activities.

First, where we report all of our rental income, then we will be taking the deductions associated with that rental property. Now there are a number of special rules dealing with real estate. Let's take the simplest one. First, the taxpayer owns a property that they rent out full time in its entirety classic example, a single family home.

It's owned by the taxpayer and it is rented to an unrelated party for 12 months. All of the rental income will be reported and all of the appropriate business expenses, including insurance utilities, potentially mortgages on there are going to be deductible expenses. We must include in the income free paid rents, lease cancellation fees or any lease improvements made in lieu of rent.

However that business income does not include or is excluded any refundable, deposits or improvements, not in lieu of rent. Now I own a condominium that I ran out and in that particular case, the way I handle the transaction is I do require a deposit. I make sure that it is refundable and that's how the lease specifies.

If there is no damage, it will be refundable in full. I take that deposit and buy a CD with it. So I have no access to those funds during the term of the lease that is therefore excluded from business income at the end of the lease term, or after a couple of years, if I don't have an issue, I may cash out the CD and refunded to the tenant.

That's not a deductible expense either because I did not pick up the income at the front end. Now let's talk about the deductions associated with the rental property. As I said, all ordinary and necessary expenses, taxes related to the rental property depreciation on the rental property. And this may include the so-called one 79 or immediate expensing deduction.

We're going to take utilities. If you have condo or homeowner fees, those are deductible. All repairs to the units frequently you'll be painting or perhaps replacing carpeting as tenants move in and out. So all is ordinary and necessary. Plus depreciation deductions are claimed from the business income.

Hopefully from that, you will end up with a net profit from your rental activities. There may be net losses and a few moments. We're going to talk about the passive activity limitations. If there is a loss, it may constitute part of a net operating loss, which can be carried back two years and forward five years.

We're not going to get into the scope of calculating net operating losses in an individual environment right now.

All right. I also said that there were several rules. The first example I gave you was a detached home rented for 12 months and no major issues there. But suppose that property that you're renting out is a vacation home or a second home that is owned. By the taxpayer, a classic example of this would be a beach house or a, uh, a condominium at a ski resort where the taxpayer occupies it part of the year and rents it out to unrelated parties during the year.

The rule is that if the taxpayer occupies that property for more than 15 days, but less than 10% of the time that it is rented. At fair rental value to an unrelated party, then the income is included on schedule E and expenses other than mortgage interest and real estate taxes that would apply to that property are claimed as deductions on the return.

Just whatever they are for that property allocated for the time use. Those expenses that I just cited, utilities charges are not otherwise deductible for the personal use time for both the personal and the rental time, the mortgage interest and the real estate taxes will be deductible. However, they're allocated between schedule a for the personal use time and schedule E for the rental time.

So you'll get all of the mortgage interest deduction and all of the real estate taxes. It will simply show up in two places on the return. The other business expenses allocated to the rental time period will show up on schedule C. This may give rise again to a loss. If you meet the 15 day 10% rule, suppose however, the taxpayer occupies that property for more.

Then those 15 days, 10% of rent a time, then the expenses are still allocated, but there may be no deductions in excess of the income reported. There's another rule. Yeah. And this frequently occurs in towns where there may be sports events. Uh, it was originally enacted to deal with the Augusta Georgia situation with the, the U S masters, but it also could include for instance, uh, salt Lake city during the Olympics.

If you rent out property that you otherwise occupy for less than 15 days. No income is reported. No expenses are allowed other than the mortgage interest of the real estate taxes. So when the Olympics were in salt Lake city, uh, my wife's sister had a condominium there and we debated very seriously whether she should come visit us for the two weeks of the, uh, The Olympics rent out the place for 14 days and have non-reportable income.

Non-expensive that's the way that third rule would work. So we have rented, full-time rented for less than 15 days. Another set of rules for rented for more than 15 days, but less than 10% of the time where the taxpayer does not violate that rule. And a fourth rule where the taxpayer does violate the rules.

Now I mentioned passive activity, losses code section four 69, limits both losses and credits arising from passive activities. These are generally defined as a trader business activity. For, for a closely held operation where the taxpayer does not materially operate. Uh, materially participated in the operations of the business.

I don't particularly want to focus on that one right now. I want to focus on the real estate rule. And that says that losses from a rental real estate activity or any rental activity actually, but primarily rental real estate is a per se passive activity. In other words, losses may not be deducted. And what we do is we say that any portfolio income.

Any investment income like dividends or interest from that activity, perhaps interest on a deposit are automatically included on the return. It's the profit or loss from the rental activity, which is suspended. In other words, can't offset other income and are suspended until one of two things happens either.

I said, activities give rise, not to losses, but to income. In that case, the passive income can be offset by passive losses. A loss may also be triggered and claimed when the rental activity is disposed of in a taxable transaction to an unrelated party. So this is a fairly complicated measure. You may not take passive losses except against passive income or on disposition of the property.

Now naturally Congress, wouldn't let this simple rule stand. So they added two complications. If the taxpayer actively participates and that's a standard lower than material participation, but actively is involved. For instance, uh, overseeing the rental property, perhaps interviewing clients, interviewing prospective leasees, doing some work and maintenance on the unit that active participation.

We'll allow a taxpayer to claim a passive loss against their ordinary income up to $25,000 a year. The problem is that allowance of $25,000 is phased out when income is over $150,000. Secondly, there is an exception for real estate professionals. And these are people who are engaged in real estate activities on virtually a full time basis.

It's very important to have a good handle on the passive loss rules, because as you'll see, when we start to work, some of the problems, rental income rental expenses is an issue frequently tested on the CPA Exam and the passive loss rules do apply. So let's review again, we've talked about cash and accrual basis of accounting.

The special rules applicable to both, for instance, on prepaid items. We've talked about several types of rental activity that show up on schedule E and we've discussed the passive activity rules. And we've talked about the individual, who's got a schedule C business and the implications of that. Let's now turn to some problems.

We'll work those and I will return to walk you through the answers and the explanations on these problems.

Motion is sole proprietor uses the cash basis of accounting at the beginning of the current year. Accounts receivable were $25,000 during the year, most collected a hundred thousand dollars from customers. At the end of the year, the counselor said we're $15,000. What was Moshe's gross taxable income for the current year?

Was it a 75,000, B 90,000 C 100,000 or D $110,000. You might consider this a trick question. Actually, it's a question that focuses on how clearly you can read the first sentence, gives it away cash basis of accounting accordingly. You don't need any information about accounts receivable for the question.

Most collected a hundred thousand dollars from his customers. He's a cash basis. Taxpayer. The answer here is C. A B and D are all incorrect. And if you picked either B or D, you were probably misled by the language, dealing with accounts receivable, read carefully. Our next question talks about Don Wolf who became a general partner and get an associates on January one year one.

He had a 5% interest in us profits losses in capital. Get as a distributor of auto parts, Wolf does not materially participate in the partnership business for year one, get ahead an operating loss of $100,000. In addition, get it, or an interest of $20,000 on a temporary investment. Get a has kept the principle temporarily invested while presently awaiting delivery of equipment.

That is on order. The principal will be used to pay for this equipment. Wolf's passive loss for year one, is, is it zero $4,000, $5,000 or $6,000. Let's go back to the facts. We have $20,000 of interest on a temporary investment. That's a portfolio item. And so Wolf will pick up 5% of that. In his tax return as interest income, the operations of gadda gave rise to a hundred thousand dollar loss as a 5% partner.

That would be 5% of $100,000. And the passive loss for Mr. Wolf. And you one is $5,000 subject to the passive loss limitations.

Mark operates, a retail business, selling illegal narcotic substances, which of the following items may mock deduct in calculating business income, one, the cost of merchandise or cost of goods sold and two business expenses. Other than the cost of the merchandise. The answers are statement one. The cost of merchandise is the only thing he can deduct.

He can only deduct his business expenses. He can deduct both or he can deduct neither. Now, if this problem bothers you a little bit, it did appear on the CPA exam and it illustrates a point illegal income must be reported on the tax return. Tax returns are confidential and are held tightly by the IRS.

So the rule here is the income must be reported. And MOC is allowed to deduct the cost of goods, sold the cost of the merchandise item one. He is not allowed any additional expenses other than the cost of goods sold. So the correct answer is a only number one.

Adams owns the second resident that is used both personal and rental during year one. He is the second residence, four 50 days a year, and rented the residence for 200 days. Which of the following statements is correct. A depreciation may not be deducted on the property under any circumstances. Be a rental loss may be deducted.

If rental related expenses, exceed rental income, see utilities and made it on the property must be divided between personal and rental use all mortgage, interest and taxes on the property will be deducted to determine the property's net income or loss. All right. If we go back to the facts, this is a second resident used for personal and rental purposes.

Notice Jackson used the residence for 50 days and rented it for 200 days. 10% of the 200 is 20 days. Jackson has violated the 10%, 15 day rule. So we're not going to be allowed to take any deductions in excess of income, but both the income and the expenses are to be reported. Let's go back and look at our four possible answers.

Depreciation may not be deducted well, yes, depreciation is allowable here. So answer a is wrong. He rent the loss may be deducted if expenses exceed rental income. No, because of the violation of the 10%, 15 day rule answer B is incorrect. Utilities and maintenance must be divided between personal and rental use.

Yes, they must be. For the personal use, they will not be deductible. They will be allowed to offset the income from the rental activity. So C is probably the correct answer. Let's take a look at D all mortgage and interest taxes will be deductible to determine the net and government loss. That is not true.

Again, we have to go through the allocation. So indeed C was the correct answer in doing this problem. Make sure you understand the various rules affecting. Vacation home or second home properties that are used, both are used for both personal and rental time. Wow. And it turned to Mr. Baker, a sole proprietor CPA who has several clients that do business in Spain.

Well on a four week vacation in Spain, bait Baker took a five day seminar on Spanish business practices. It cost him $700. Baker's round trip airfare to Spain was $600. Boy don't I wish I could get a round trip ticket for that today. While in Spain, Baker's spent an average of a hundred dollars per day on accommodations, local travel, and other incidental expenses for total expenses of $2,800.

What amount of educational expense could Baker deduct on the form? 10 40 schedule C it's $700, $1,200, 1800 or $4,100. Well, here, the answer hinges on the length of the trip. Baker took a four week trip of which only five days really related to business. So none of the travel expenses are going to be allowed.

The airfare to Spain is disallowed. However, he will be allowed to take the $700 cost of the seminar, plus the a hundred dollars per day while he was in the five day seminar. So $500 there, plus 700 for the cost of the course, $1,200. His answer be. $1,200 is the correct answer lane. A single taxpayer received $160,000 in salary, $15,000 in income from an S corporation in which lane does not materially participate and a $35,000 passive loss from a real estate rental activity.

In which lane materially participated. Lanes modified adjusted gross income was $165,000. What amount of the real estate rental activity loss was deductible? Right? There's several things buried in this passive loss question. First, the income from the S-corporation even though lane does not materially participate is passive.

It since he did not materially participate is passive income. So we're going to be reporting that passive income could be offset by passive losses. To the extent of the income. We know that the real estate rental activity is per se, a passive activity, even though lane materially participated that doesn't take it out.

Of the passive loss per se rule. Now material participation is greater than active participation. So in all probability, if lane met the material participation rules, he would beat the active participation rules. Remember those active rules say if the modified adjusted gross income is less than $150,000 lane might be able to take some of that.

Passive rental loss against other income. However, with his MBA GI over 165, none of it's allowed as an offset, ordinary income with all of those statements on the record, let's put this problem together. We're going to report passive income of $15,000 and a passive loss of 35,000. We can zero that out. We can use 15 of the passive loss against the 15,000.

That is the sole extent of our use of the rental real estate loss for the year. Answer B what about the $20,000 differential? That's carried forward as a passive loss into the subsequent year. And again, in that second year, you'll again, go through the passive loss testing rules. In answer to this question, however you want to select B $15,000.

The next question says with regard to the passive loss rules involving rental real estate activity, which of the following statements is correct. And we're going to have four statements here. Statement a, the term passive activity includes any rental real estate activity without regards to whether or not the taxpayer materially participates in the activity.

That looks pretty good. That looks like a true statement. So let's test the other three answers. Passive rental activity losses may be deducted only against passive income, but passive rental activity credits may be used against tax attributable to non passive activities. That's clearly wrong. Passive rental activity losses may be deducted against passive income.

Passive real estate credits are subject to the same testing. So they also may be disallowed and may not be used against non-passive activities. How about C is that possibly right? Gross income, gross investment income from interest and dividends not derived in the ordinary course of a trader business is treated as passive activity income that could be offset by passive.

Rental activity losses when the active participation requirement is not met no investment income, particularly not derived in the ordinary course of business is always reported as investment income outside of the passive loss rules. So there's going to be showing up on schedule B as interest or dividend income.

This statement is clearly wrong. Also. And statement D the passive activity rules do not apply to taxpayers. It was adjusted gross income is $300,000 or less. You know, that this one is wrong because I've stressed over and over again, that the threshold is a phase out to begins at a hundred thousand and is completely phased out at $150,000.

Answer D is wrong as a consequence. In this particular set of four statements only statement a is correct. The term passive activity includes any rental activity without regard as to whether or not the taxpayer materially participates.

The next problem. Discusses a gentlemen named billings, a retired corporate executive here into consulting fees of $9,000. And director's fees of $4,000 of the current year buildings. Gross income from self-employment in the current year is well it's either zero answer a 4,000 answer B 9,000 answers C or the whole 13,000 in D.

And the answer is both consulting fees and director's fees are self-employment income. And the correct answer is $13,000 as noted in D.

If an individuals, if an individual taxpayers, passive losses and credits relating to rental real estate activities cannot be used to the current year. They may be carried a forward up to a maximum period of 15 years, but they cannot be carried back, be forwarded definitely. Or until the property is disposed of in a taxable transaction C.

Back three years or forward up to 15 years at the taxpayer's election or D back three years, but they cannot be carried forward. Your review of this material should already tell you a. C and D are all incorrect. There are no time limitations and there are no carrybacks passive activities. Whether they be losses or credits that are disallowed in the present year are carried forward indefinitely, or until the property is disposed of any taxable transaction to an unrelated party.

No. Jim owns a two family house, which has two identical apartments. Jim lives in one apartment and rents out the other in year one. The rental apartment was fully occupied and Jim receives $7,200. In rent during the year he paid the following expenses, real estate taxes, $6,400. Painting of the rental apartment $800 annual fire insurance premiums, $600 in year.

One depreciation for the entire house was determined to be $5,000. What about should Jim include it is adjusted gross income for year one. This is not a hard problem, but it's one where you have to make a couple of decisions. First, we're going to pick up 100% of the rental income that Jim receives $7,200.

The other that we're going to be reporting on the schedule E expenses, half of the real estate taxes relate to Jim's personal residence, half to the rental property divide, 6,400 and half 30, 200. The annual fire insurance premium, again, covers both houses and we're going to split the 600 in half the depreciation.

The statement is that it applies to the entire house determined to be $5,000. $2,500 will be deductible on schedule E but the painting of the rental apartment only applies to that rental apartment. So the full $800 is deductible. We're looking at half the real estate taxes, half the fire insurance premiums.

And half of the depreciation, plus 100% of the painting after picking up the total income of $7,200, the expenses that we just alluded to the adjusted gross income for inclusion in year one is answer C $400.

The following will result in an accruable expense for the cruel basis. Taxpayer. Remember, we're talking a cruel expenses, a cruel basis. Taxpayer, be careful. Is it a, an invoice dated prior to year end, but the repair completed after year end be a repair completed prior to two year end and not invoiced a repair completed prior to year end and paid upon completion.

A signed contract for repair work to be done. And the work has to be completed at a later date. We're looking for something that is the crucible expense, the first one, an invoice dated prior to year end. But the repair completed after you're in here, we have not complied with the economic performance test.

If the work has not been done after the end of the year. That's part of the key to taking this deduction. So answer a is wrong. Answer C a repair completed prior to year end and paid upon completion will, if it's completed and paid, it is certainly not an accrual expense. C is wrong. D a signed contract for repair work to be done completed at a later date again, since the economic performance test is not met, answer D is wrong.

But answer B is correct. The repair is completed. We have economic performance and we know the amount that is due, even though it has not yet been invoiced. So assuming we know the amount of the cost of the repair and the work has been done, this would be an accruable expense answer B yeah. Yeah. The next problem we were asked, which of the following taxpayers may use the cash method of accounting.

A tax shelter, be a qualified personal service corporation, C a corporation with annual gross receipts of $15 million and D a manufacturer. Well, this is a fairly easy question. Let's knock them off one at a time. A tax shelter is prohibited from using the cash method of accounting. A is out a qualified personal service corporation is permitted to use the cash method.

That is the correct answer. How about a C corporation with annual gross receipts of 50 million? No, because I said that there was a small. C corporation, exclusion, where they can use the cash method, but the test is annual gross receipts averaging less than 5 million C is wrong. And a manufacturer is going to have inventory.

Taxpayers with inventory are not allowed to use the cash method of accounting. Answer D is wrong and only answer B is correct.

The following information pertains to installment sales of personal use property made by Carl Wood in his retail furniture store. And you're given a chart with installment sales. Year of sale, gross profit and collections in year three. These sales were not under revolving credit plan under the installment method, which should report a gross profit for year three of, is it seventy thousand one hundred thousand one hundred and sixty thousand or 260,000.

And if we look at the chart for year three, we are going to be picking up. $100,000. The reason being a dealer in personal property cannot use the installment method. So the whole gross profit amount is reportable in year three. That happens to be answer B it's the only correct answer. Don't get confused about this problem.

Dealers cannot use the installment method it's designed for casual sales. Now we're going to turn to a cash basis, taxpayer that taxpayers should report gross income. A only for the year in which income is actually received in cash B only received for the year in which income is actually received, whether in cash or in property C for the year in which income is either actively or constructively received in cash only.

Or D for the year in which income is either actively or constructively received, whether in cash or property, a cash basis, taxpayer has to report gross income for both cash and the fair market value of property either actually, or constructively received during the year. That means that answer D is the correct answer here.

It's the only one where we talk about. Both cash and property and both actually, and constructively receive circle D

in year one, far a cash basis. Individual taxpayer received an $8,000 invoice for personal property taxes. Believing the amount to be overstated by $5,000 for pay the invoice about under protest and immediately started legal action to recover the overstatement. In November year to the better was resolved in his farm's favor.

And he received a $5,000 refund farm itemizes his deductions of the tax return, which of the following statements is correct regarding the deductability of the property taxes. Remember farm is a cash basis, taxpayer. So is the answer. A farm should deduct 8,000 in year one and report the 5,000 refund as income.

In year two or is it answer B Forbes should not deduct any amount of year one on the tax return and should deduct 3000 in year two. This is assuming that it's not deductible as it's, it's under protest in year three. I'm sorry. In answer C farm should deduct 3000 as year three return. And that's what an assumes that he knows what the right amount is.

Or is the answer D farm should not deduct any amount in his year. One return when originally filed and should file an amended year. One return in year two. The answer is that as a cash basis, taxpayer, you should report the amount actually paid. So in year one, farm should deduct on his return. The $8,000.

And then in year two, when he receives the $5,000 refund, it should be reported in gross income under the tax benefit rule in effect, he got the benefit of the $8,000 deduction in year one and the rebate or the refund in year two is reported as miscellaneous income in the second year. Answer a is the correct answer here.

Many individuals believe that the internal revenue code. Basically addresses only income taxes, whether they're imposed on individuals or on corporations or other taxable entities. There are many taxes included in the code. And here we're going to pause and talk about a few of them. These additional taxes include the social security tax frequently known as FICA, the self-employment tax Seca and the unemployment tax Fooda.

First let's turn to the social security tax and virtually everyone knows that. Social security taxes are taken out of your paycheck. What you need to focus on is that there are two components to the social security tax and to payers of the social security tax. First, both the employer and the employee pay into the social security fund.

The employer makes the payment directly and the employer withhold social security tax from your paycheck. The two components of social security are what is called O S D I, the old age survivors and disability piece, which is equal to 6.2% of taxable wages up to a maximum out in 2012. That number is about $110,000, but it's indexed for inflation each year.

Now, while I said the rate is 6.2% Congress put in a special rate for 2011 and 12 of only 4.2%. So they reduced it. Two percentage points. It's unclear exactly how that will play out in future years. So please keep updated on the official rate. The second component of social security tax is HR or health insurance.

It's 1.45%. For both the employer and the employee, and there is no wage cap there. So all income is all taxable wages are subject to the 1.4, 5%. That's FICA. If we turn over to the self-employment tax or Seca, this is imposed on self-employed individuals. And the way Congress is structured is the self-employed individual pays.

What is. Equivalent to both the employer and the employee share. So if you think about it, that comes out to a total of 15.3%. However, again, for 2011 and 12, that rates reduced to 13.3% of the self-employment income now because the employer under FICA pays half of those wages. When the self-employed individual pays that secret tax, a portion of it is deductible in computing.

The individual's adjusted gross income, the unemployment tax or FUTA federal unemployment tax act is imposed only on the employer. It applies for a maximum of 6% of the verse $7,000 of wages of every employee that is covered.

Let's talk about some tax compliance and procedure rules. All taxpayers have a filing obligation and that obligation arises when gross income is greater than the sum of the personal exemption. Plus the standard deduction. Obviously, since both the personal exemption and the standard deduction are indexed for inflation annually, the filing threshold changes with those numbers.

They're adjusted. There's also a filing obligation. Irrespective of that last rule. If the taxpayer self-employment income in excess of $400, they automatically must file. And the dependent of another person who has unearned income must file. If their gross income exceeds $900. As we all know that generally the time to file that tax return is the 15th day of the fourth month after the end of the year.

And so we have April 15th clear in our head. There is an automatic extension of time to file if requested by the taxpayer. That extension is for six months until October 15th. However, As I've mentioned previously, if you get an extension of time to file, it does not extend the time to pay your taxes.

Neither does it extend the time to make an IRA contribution. So April 15th is the deadline for having major tax payments for the year, as well as funding a deductible IRA. For many individuals, most of their tax obligations will be met through withholding on their weekly bi-weekly or monthly paycheck.

However, some individuals will owe additional taxes and self-employed individuals will not have taxes withheld. As a consequence, estimated taxes must be paid. These taxes are due on April 15th, June 15th, September 15th. And January 15th of the following or the second year, those payments are made into the IRS.

And most States also require estimated taxes.

Yeah. There are penalties for underpaying, your estimated taxes during the year. And there are payments. If you have not paid in full by the April 15th deadline, let's look at the underpayment penalties first. If the taxpayer does not make sufficient estimated payments, there will be a penalty unless the payments in the current year are equal to the payments of the current year or equal to 90% of the tax liability for the current year.

Or the payments made to the current year or equal to 100% of the prior year's tax liability. That's the general rule. Now, if the prior year's tax law liability exceeded $150,000, that hundred percent test increases to 110% of the prior year. Now what happens if you get to April 15th? You've made estimated payments.

You've had withholding and you thought your taxes were paid in full. Yet you have a balance due. There is no penalty. If the remaining tax is less than a thousand dollars, here is a trick that needs to be used by many taxpayers who requested your extensions. You estimate what your tax liability is. Going to be for year one and you make a payment with your extension filed.

Let us say on April 13th, you normally will make a payment a little bit above what you think is owed for the first year in order to cover your April 15th estimated tax payment. And then you could true this up later as we go through the year. That's the big penalty and it's estimated tax rules. Suppose you file your taxes turn and find there is a mistake either in your favor or in the IRS's favor.

Well, I think most taxpayers will say, if it's in my favor, I'm going to file an amended return and make a further claim for refund that's filed on a 10 40 X. You should also be aware that if you find a mistake in the IRS, it probably behooves you to file an amended return. Unless it's a very diminimous amount.

If you file that claim for refund, what does the IRS have to do? They will examine and probably pay the refund right off, but they also may examine the return. There's a statute of limitations. The statute of limitations is three years from the date. The return is filed or two years from when the tax was paid.

If there is no return filed. Then the statute of limitations for a refund is two years from the tax was paid. Now some taxpayers feel that gee, if I don't have a liability and I've paid in more than enough taxes, I just don't have to file a return. I can get around to it later. Be aware that the claim for refund will expire two years from those tax, from when those taxes were paid in.

So you need to file the return to get your refund. There's also a statute of limitation for the IRS to assess a deficiency that statute of limitations is three years from the later of when the tax return was due or the actual date, the return was filed. If however, there is an omission of gray of gross income, more than 25%.

So in other words, you've admitted more than 25% of what you've reported. The statute of limitations is no longer three years. It's six years. And if a tax return is not filed, the statute of limitations never runs. If a tax return is filed early, it is deemed to be filed or the due date of the return. Now the internal revenue code is replete with penalties and you should be aware of penalties are not deductible.

There are penalties for late payment attacks. There are penalties for underpayment attacks and there are accuracy related penalties that accuracy related penalty, maybe 25, 20%, if there's a substantial underpayment of tax or if the court and the IRS determined there, there is negligence or disregard of the rules and regulations.

The accuracy penalty might be abated or not imposed. If there is disclosure by the taxpayer of a particular issue that may be in controversy, or if they've taken reasonable measures, use due care and relied on a tax advisor. That's the so-called tax advisor do care. Defense disclosure also may get you out of the accuracy related penalty.

Should it be determined that there is willful tax evasion or fraud involved the penalty baby, as much as 75%, let's turn to a few REG CPA Exam questions and see if we can take a look at estimated taxes, tax compliance and penalties.

Bomb an unmarried optometrist and sole proprietor optics buyers, and maintains the supply of eyeglasses and frames to sell in the ordinary course of business. Eight year one optics had $350,000 in gross business receipts. And it's the inventory was not subject to the uniform capitalization rules bombs year one, adjusted gross income was $90,000 and he qualified to itemize deductions during year one bomb recorded the following information, optics business expenses, cost of goods sold $35,000 rent expense, 28,000 liability insurance premium 52 50.

Other expenditures for self-employment tax of 29, seven 50 self-employment health insurance, 8,750 and estimated payments of year one, federal income taxes, $13,500. The question you were asked is what amount should BOM report as year one net earnings from self-employment? Well, if we go back and look at the facts, we clearly know that his self-employment income begins was a $350,000 in gross business receipts.

From that we're going to deduct the cost of goods sold of 35,000, the rent expense of 28,000 and the liability insurance of $5,250. What about these other expenditures? Well, the self-employment tax. Is reported on form S E the self-employment tax, and as added as an additional tax liability, it will not show up in any way as part of the self-employment income.

Self-employment health insurance. The premiums paid on that will be deducted as an adjustment in computing adjusted gross income. So those will be deducted from gross income to compute AGI, and they will not be part of his self-employment income calculation, estimated taxes. For federal income taxes in year one, $13,500 are simply payments that will be reported on page two of the return to offset bombs liability.

So what are we going to report as net earnings from self-employment $350,000 minus the expenses of 35 28. $5,250. That totals to 281,750. You should circle schedule D. Now, let me make one point about if this were a 2011 or 2012, uh, tax situation, we're talking about the self-employment tax is deducted also in computing adjusted gross income in.

Those two years, 2011 and 12, the amount will be slightly more than half of what is paid for other years. It is generally exactly half the employer share.

Now we're going to look at another self-employed individual. Rich, who is an air conditioning repair man. He has gross business receipts at $20,000. His disperse for the twists follows. Air conditioning parts, 2,500 yellow page listing 2000 estimated federal income taxes on self-employment income. A thousand business long distance calls, 400 and charitable contributions, 200.

Your question. What about should rich report as Mel net self-employment income, we're going to take $20,000 of course reported as the income. Can we deduct the parts, certainly part of cost of goods sold his advertising. Yes, we can. His business long distance calls. Yes we can. So we know we've got at least 49, $4,900 of expenses.

What about the self-employment income again? That is simply a payment. Taken on the tax return, not deductible at all. Charitable contributions do not go into the self-employment calculation. They will show up as itemized deductions on schedule a. So we've got $4,900 of expenses, $20,000 of income. The answer a $15,100 should be reported as net self-employment income.

When computing a corporations income tax expense for estimated tax purposes, which of the following should be taken into account corporate tax credits, alternative minimum tax. Well, two columns, two sets of answers in a it's. No, and no in B is knowing yes. In C it's. Yes and no. And in D it's yes. And yes.

Well, in computing. Either a corporation or an individual's income tax expense for estimated tax purposes, you should take into account all tax credits to which the taxpayer is entitled and any potential liability for the alternative minimum tax, both should be taken into consideration. The answers should be yes.

And yes. The corelative answer is D but remember, these rules apply, whether you're talking about a corporation or an individual, it's simply that the credits and the AMT calculations may be different. The principles are the identical bent Corp, a calendar year C corporation purchased in place to disservice residential real property during February, no other property was placed into service during the year.

What convention must Brent use to determine the depreciation deduction for purposes of the alternative minimum tax? Well, when we talked about minimum tax, we will remember that any, that the alternative minimum tax is built off of the regular tax system and any election or any binding, uh, principles that are used for regular tax purposes are used for AMT purposes, unless specified otherwise.

Since this company purchased a place to service real property, no other property during the year. The convention for real property is bid month. Not full year, not half year, not mid quarter mid month. The answer should be D.

In this question, we're asked to evaluate the hierarchy of authority in tax law, which of the following carries the greatest authoritative value for tax planning of transactions? Is it a, the internal revenue code B IRS regulations? See tax court reports D IRS agent reports. Well, this should be almost a gimme on the returns.

You should consider the D IRSA jewel reports are the lowest authoritative value and eliminate that one. B R I R S regulations, their interpretations of the service. And they certainly sit below the internal revenue code and tax court decisions. So B is not appropriate. And the definitive authoritative value is the internal revenue code answer.

A tax court decisions are pretty weighty and basically unless the Supreme court. Provides that a provision of the internal revenue code is unconstitutional. Tax court decisions are going to fit in second place. The code is the defining authority and you should have selected a however, as a practitioner, you better put pretty high priorities on a, B and C.

You could do a lot to argue with D but the first three are all authoritative. It's just that the code is preeminent. Which of the following statements are correct regarding the internal revenue service audit and appeals process. One in a revenue agent's report prepared a connection with an audit, the age of recommends adjustments based on the code regulations and on the likelihood of success in court.

If the taxpayer disagrees with the proposed adjustments. Or two or perhaps, and to the appeals division is bound by a technical advice memo in favor of the IRS position to pursue the taxpayer for the full amount of the adjustments proposed to the evidence revenue agent's report. Well, let's go back to the first statement, an agent's report.

He recommends adjustments based on the code and regs that's perfectly appropriate, but the examining agent is not supposed to take into account the likelihood of success in court. If litigated now the appellate decision in console stationed with the taxpayer after the report is being appealed. They may take into consideration hazards of litigation, but the examining agent is not to do so.

The second state went about appeals, division and technical advice memos. The technical advice. Memorandum is the advice of chief counsel, uh, within the IRS. It says what they believe the position should be. However, the appeals division is not bound by a Tam. They've placed great weight on it, uh, but they can negotiate a settlement without following the technical advice.

So the answer is neither one, nor two, that leads to an answer of D for this question. The taxpayer filed his income tax return after the due date, but neglected to file an extension for them. The return indicated a tax liability of $50,000 and taxes withheld of 45,000. On what amount would the penalties for late filing and late payment be computed?

Is it zero? 5,000. The difference too was still owed on the due date of the return. Is it 45,000 or the full $50,000 liability? And the answer is the IRS imposes penalties based on the amount of that is not paid up in full by the filing date. So it was going to be the $5,000 difference that will be subject to the late filing and late payment penalties.

Martinson. Okay. Calendar year, individual pause a year, one tax return on March 31st year, too. So it's timely filed Martens and reports. $20,000 of gross income. He inadvertently omits $500 interest income, the IRS VSS, additional tax up until which of the following dates March 1st year five, April 15th, year five, March 31st year eight.

Or April 15th year eight. Remember that the statute of limitations. Basically is three years for the date of filing the return. However, if the return is filed early, it is deemed to be filed on the due date. So even though Martins had filed on March 31st, it is deemed to be filed for purposes of the assessment of additional tax on April 15th.

Three-year statute of limitations. April 15th means we'll be looking at answer B the 15th day of April in year five.

In this problem, if an individual paid income tax in year one, But did not file a year one return because his income was insufficient to require the filing of a return. The deadline for claiming a refund claim is, Hey, two years from the date, the tax was paid two years from the tax from the date, a return would have been due at the answer B answer C three years to the date the tax was paid or D three years from the date.

The tax return would have been due. Remember when I was lecturing to you, I warned about this one. If you have money paid in, you would do a refund. And you did not file a return. Then the deadline is two years. The date, the return, the tax was paid. It's answer a, you have to get up early to get that money back, even if a return was not required and was not filed.

So like answer a and warn all of your clients about how important this deadline is.

Our next problem, ask which of the following statements best describes what has meant by the legislative re-enact, but doctrine a, a longstanding finalized regulation, presumably has congressional approval. If Congress has not amended the relevant section of the internal revenue code B. A presidential veto of a bill may be overruled by two thirds, majority vote of both houses of Congress.

See if the Senate originates a tax bill as an amendment to another legislative proposal, the bill must re-enter the process at the point where the bills are considered by the house ways and means committee. Or D if the Senate passes a different version of a tax bill than the house of representatives, did both houses vote on a joint version of the bill, the resolves, the differences?

Well, I'm going to review these REG CPA Exam questions. Reverse order answer D is incorrect is all often true that the Senate passes a different version of the bill than the house did. Then we have what is called a congressional conference committee representatives, the houses and in meat work out the differences, come up with a conference bill and conference report, and both houses passed that that is the normal legislative process and it is not the reenactment doctrine.

Item C if the Senate originates a tax bill as an amendment to another proposal, we have a problem because all revenue bills must originate in the house. According to the us constitution, as a consequence, if the Senate originates a bill, a tax bill, as an amendment to another one, the whole process has to go back so ways and means can consider it.

This is not part of the reenactment doctrine. It is an uncommon process, but it has happened in the house. And I could remember it when I was a Hill staff person. That answer is incorrect. The next question, the earlier two statements were be a presidential veto of a bill may be overruled by a two thirds majority.

Well, this. Happens, not all that frequently, but this is again authorized by the constitution. It is not the reenactment doctrine. It is simply a veto, which has been overwritten by Congress and to be, is also incorrect. Answer a, this is the Congress not amending the relevant section of the code. We've got long time regulations or even finalized, uh, Develop it from, uh, the IRS or treasury department, which do not rise even to the level of regulations.

This is what is described as the legislative re-enact. But

our next ask about Martin who finally, who filed a timely return on April 15th, Martin inadvertently omitted income, that amount it to 30% of his gross income stated on the return. The statute of limitations for Martins term return would end at the end of how many years, three years enter a six years, answer B seven years, answer C or unlimited answer.

D Morton is admitted more than 25% of his gross income on the return. As a consequence, the normal three year statute of limitations does not apply. And the extended statute of limitations of six years.

And why don't we turn to the next problem? We have a couple of interesting issues on April 15th, year two, a married couple filed a joint one first year calendar year return show the gross income of $120,000. Their return had been prepared by a professional tax preparer who mistakenly admitted $45,000 of income, which the prepare in good faith considered to be non taxable.

No information with regard to this admitted income was disclosed on the return or in attached statements. By what date must the IRS assert a notice of deficiency before the statute of limitations expires. Is it April 15th, year eight, December 31st year seven, April 15th, year five or December 31st year for this question, first and foremost goes to the statute of limitations.

And as we said, it is the 15th day of the fourth month, six years after the return was filed because more than 25% of the gross income. Was unreported so that a limited income triggers the six year statute of limitations. It runs from April 15th of the year, the return, and brings us to April 15th of year eight.

Answer a, but also in this question is do the taxpayers have a defense for penalties after all the tax payers relied on a tax return? Preparer? And the answer here is no, they can knock get out of the penalties because of that for two reasons. One, no information with regard to the admitted Inca was disclosed on the return.

So if the preparer thought, for instance, this was non taxable income, there should have been a disclosure statement. Attached to the return saying why the tax payers believed. And of course the taxpayers through the tax advisors believed it was not income. That disclosure would have gotten them out of the penalties.

Secondly, just to say that we relied. And here I'm speaking as a tax, uh, payer, just to say that I relied on my tax preparer to prepare an accurate return. The courts have said is not sufficient because the taxpayer, it is the taxpayer's return. They have an obligation to review it. And when you look at a gross income of 120,040 $5,000 of income, not being included, that is so significant.

The taxpayers should have been aware of it and it should have taken other steps. So there's no good faith due diligence, reliance defense. There was no disclosure answer a is correct for this return.

We're now asked an accuracy related penalty applies to the portion of the tax underpayment, a Trudel to one negligence or disregard of the tax rules or regulations. To any statement, any understable of income tax, which is substantial. Is it stable? One only stay, but to both statements one and two or neither of these two statements.

And the answer is that an accuracy related penalty applies to negligence or disregard of the tax rules and regulations. And an accuracy related penalty applies to any substantial understatement of income tax, the 20% rule. So both statements one and two are true and applicable to the accuracy leaded penalty.

You will in a select answer. C

Chris eight, an unmarried taxpayer with income, exclusively from wages filed her initial income tax return for the year. One calendar year. By December 30. First of that year, her employer had withheld $16,000 in federal income taxes and created, made no estimated payments on Monday, April 17th year to create timely, filed an extension request to file a return.

And she paid the $300 of additional taxes do creates year one tax liability was $16,500 when she filed a return on April 30th. And she paid the remaining income tax balance. What amount would be subject to the penalty for the underpayment of estimated taxes? Is it answer a zero? The answer be $200. The answer is C $500 or the answer D $16,500.

Now, first of all, we're going to back up and say, I'm going to take one question off the table USA. If she filed on April 17th, it was a late return. No, it was filed on April 17th because April 15th would've been Saturday. And the taxpayer has until the first business day, Monday, April 17th. So don't worry about that.

Secondly, do we have penalty issues and here, if the underpayment is less than a thousand dollars, penalties are not good to be imposed. The panel, the underpayment and out turned out to be $300. The answer is no penalty. The answer you should have circled is a zero would be subject to the penalty for underpayment of estimated tax.

We're now going to discuss tax credits. Now, most of the credits I'm going to review here. Apply primarily to individuals, but there are an awful lot of credits in the internal revenue code. And some of them, for instance, the foreign tax credit we'll briefly mentioned also apply to corporations. There are two types of tax credits non-refundable credits, which means that the credit may only be claimed to the extent of any tax due and refundable credits.

Which means that should the amount of the credits exceed the taxpayer's liability. Those credits will still be refunded. The taxpayer will receive a check. Let's begin with the non-refundable credits while they're limited to the amounts owed. Some of them may have carry overs. If they're excess credits, we'll begin with a foreign tax credit.

That's a non-refundable credit, which is allowed to a taxpayer for taxes paid. Two F overseas government income taxes paid to an overseas, uh, government for income, which is also taxed in the United States. You may remember that these foreign taxes can be deducted as itemized deductions, but the more preferable method particularly for larger amounts is to claim a foreign tax credit.

Since they're non-refundable, there is a carry over and it can be carried back one year and forward 10 years. There's a non-refundable credit for elderly, for the elderly or permanently tabled. This credit applies to a taxpayer who's at least 65 years old and is a 15% tax credit. There is a credit again, nonrefundable for a retirement for retirement savings.

And this applies to a taxpayer over the age of 18, who is not a full-time student or a dependent of another person. The credit is based upon a sliding scale from 10 to 50%. And the maximum credit is $1,000 per year. It's designed to encourage savings for retirement. I very significant credit is the credit for dependence and childcare.

And here we have a base amount which is equal to the lower of qualified expenses or the earned income of the taxpayer. The maximum qualified expenses for one dependent is $3,000 for two or more individuals, $6,000. Now the base amount. Is multiplied by a sliding scale from 20 to 35%. And this complicated credit is also phased out for taxpayers as AGI increases.

There is a phase down of the allowable rate from 35 to 20%, but in no case below 20%, in order to obtain the childhood dependent care credit, at least one taxpayer. Must be working and a qualifying child must be under 18 or a disabled dependent. As we continue with the non-refundable credits. There's something called the American opportunity credit today.

It used that's its name. It used to be known as the hope credit. This is a per student credit who, and it applies to a person who has at least a 50% full-time student in a degree program. It applies for four years of post-secondary education. The maximum credit is a hundred percent of the first $2,000 of qualifying expenditures and 25% of the second, 2000, which means there's a maximum credit of $2,500 per year.

It applies to expenditures for tuition fees and textbooks. Another education credit is called the lifetime learning credit. This is a per taxpayer credit. Based on undergraduate or graduate coursework, you do not have to be a full-time or an a degree program to obtain this credit. The backs of credit is $2,000.

It applies to tuition and fees only, and may be claimed by the taxpayer, a spouse and dependent. Now here's a warning for you on these credits. The basic rule is no double-dipping. In the tax law, Congress has provided a number of incentives to encourage people, to take advantage of all of the educational opportunities in the country.

They provided tax credits, exclusions for scholarships, even a Coverdale IRA savings account and double E's savings. Bonds. We've talked about a number of these items, but there are some very special rules to remember that disallow, any type of double-dipping. For example, you cannot claim the American opportunity credit and the lifetime learning credit in the same year for the same tax pay for the same student, the family can, a taxpayer may have a number of these opportunities on the return, but for the same student, you may not take.

Two credits. In addition, you have to make certain that in a year that you withdraw off of a Coverdell account or cash, triple double E's savings bonds. Those same expenses are not covered nor is the taxpayer claiming a double dip with a credit in there. Another significant non-refundable credit and a fairly large credit is the adoption credit.

It applies to the lower of a ceiling amount. Approximately $13,000 or the amount spent the adoption. It includes adoption, uh, cost attorney and court fees, but not medical expenses for the adopted child. Now, remember the medical expenses can be claimed as an itemized deduction, subject to the seven and a half percent floor.

That's the general rule. If, however, the taxpayer is adopting a special needs child, the credit is a ceiling amount irrespective of the amount spent. So now you're going to get the $13,000, no matter how much you spent this adoption credit is phased out for higher income tax payers. And if it exceeds the tax liability for the year, the unused amount may be carried forward for as much as five years.

Let's turn our attention now from non-refundable to refundable tax credits. The biggest one here is probably the earned income credit. And in this case, the taxpayer must have earned income. However, the taxpayer does not need to have a dependent qualifying child in that situation. There is still a credit allowed for a taxpayer.

Uh, it's a reduced amount, but it still applies. The taxpayer is not eligible. If investment income exceeds certain thresholds and the amount is phased out based upon the taxpayer's AGI. In other words, the earned income credit is designed for lower income. Taxpayers, but it is a refundable credit he condition is that if the taxpayer is married, the couple must file a joint return.

And if the credit is claimed fraudulently, Then the taxpayer is barred for 10 years from claiming the credit. Unfortunately, this is a credit that's been subject to abuse. Uh, I think every member of our audience would never be involved in a situation with a fraudulent claim, but you need to be aware that there's a draconian penalty.

If the taxpayer should fraudulently claim an earned income credit, when they're not entitled, there's also a child tax credit and the child credit applies. To a child under the age of 17, who is a us citizen at the maximum credit is a thousand dollars and there is no carry over. Now, if there, if the family is large enough, this credit baby partially refundable, uh, if the family is small, it may not be refundable at all.

There is something called an excess social security credit. And this is when you may see more and more frequently now because people are holding multiple jobs. As you recall for employees, there must be FICA withholding on wages. There is also a wage cap. In other words, FICA, it does not apply after you go over about $110,000 for purposes of the OSDI.

If there is excess FICA withholding from two employers, which exceed the wage amounts, then that total amount is refundable and is claimed as a payment against tax liability. We have a few problems which will help illustrate both refundable and nonrefundable credits. So let's begin with those problem sets.

The first problem says to qualify for the child care credit on a joint return. At least one smells must be gainfully employed when related expenses are incurred. Or have adjusted gross income of $15,000 or less. Now you need to determine which of those statements may apply or may not apply. Is the answer.

Yes, yes, no, no. Yes. For the 15 AGI and no for the employment or no, for the 15 and yes. For the gainfully employed. And the answer here is it doesn't make any difference that taxpayer have adjusted gross income of $15,000 or less. That's not correct. The taxpayer may have more than $15,000 of adjusted gross income, but it may affect the amount of the credit.

So you want to know answer there, but. There must be earned income when the expenses are incurred in need a yes. Answer for this column. The only possible solution that fits a no. Yes is answer T

wow. Following statements about the child and dependent care credit is correct. Is it a, the credit is nonrefundable B. The child must be under the age of 18 years. See, the child must be a direct descendant of the taxpayer or D the maximum credit is $600. Well, the answer here is that the credit is non-refundable the answer a is the right answer.

The credit is nonrefundable. It doesn't make a difference that the child is under the age of 18. Uh, It could be a dependent. Remember this is not just a child care. Credit is a dependent care credit. So you could have a dependent teacher claiming there's a senior citizen and you may qualify for the credit.

The child must be a direct descendant of the taxpayer. No, it could be an adopted child, a foster child that would qualify for the childcare credit and a maximum credit is not $600. It's a sliding scale, which is greater than $600. B, C, and D are wrong. Answer a is the correct? Correct amount. Next question.

Uh, Sanex corporate ration and accrual basis. Calendar year domestic C corporation is taxed on its worldwide income. In the current year. So the next is us tax liability on his domestic and foreign source. Income is $60,000. No prior year foreign taxes have been carried forward, but we're okay. Asked which of the following factors may affect the amount of Synnex is foreign tax credit available in its current year corporate income tax return?

Is it the income source, the foreign tax rate? Again, we're looking for yes and no answers. A is. Yes. Yes. BB. Yes, no CNO. Yes. And D don't know. Well, clearly the amount of foreign tax rate. Does have a great deal to do because the foreign tax credit effectively zeroes out, but does not subsidize, uh, or does not give a relief greater than the effective us tax rate.

So the foreign tax rate is important and we need a yes. Answer there, both the income source in terms of the type and the country are important in determining the foreign tax credit. We need a yes. Answer here. And the only correct answer is. A yes, N yes.

Turning now to the following question, which of these credits can result in a refund, even if the individual had no income tax liability, the credit for prior year minimum tax, the elderly and permanently, and totally disabled tax credit, the earned income tax credit, or the child independent care credit.

Well, as you recall, just a few moments ago, I said both the elderly and disabled credit is non-refundable and the child independent care credit is non-refundable. We've also previously talked about the minimum tax and the minimum tax credit may be carried forward, but it is not refundable. The earned income credit answer C is the only refundable credit on this list.

Select C.

In this problem we're asked which of the four following statements disqualifies the individual from the earned income credit. Is it statement a, the taxpayer's qualifying child is a 17 year old grandchild. Be the taxpayer has earned income of $5,000. See the taxpayer's five-year-old child lived in the taxpayer's home for only eight months or deed.

The taxpayer has a filing status of married filing separately. Remember where we're looking for the statement that disqualifies the individual from the earned income credit answer a is incorrect just because the child is a grandchild does not disqualify the taxpayer from claiming. The credit. So a is out the taxpayer has earned income of $5,000.

Well, the taxpayer needs to have earned income, but the amount of that earned income is not going to make any difference as to their qualification for the credit. It may affect the amount of the credit and ultimately it may affect the phase-out, but not at $5,000. The length of time the child lived in the taxpayer's household.

Uh, here only eight months is not relevant to whether they're eligible for the credit and to see Israel. However, as I did mention to you, if the taxpayer is married, they must file a joint return filing separately. We'll disqualify the taxpayer from the credit answer. D is the one that you should have selected.

An employee who has had social security withheld in an amount greater than the maximum for a particular year, may claim a such excess as either a credit or an itemized deduction at the election of the employee. If that excess resulted from the correct withholding by two or more employers. B reimbursement of such access from his employers.

If that excess resulted from correct withholding by two or more employers, see the excess as a credit against income tax. If the excess resulted from correct withholding by two or more employers or D the excess is a credit against the income tax. If that excess was withheld by one employer, well, this one.

Has a couple of wrinkles to it, but it's fairly straight forward. First of all, we're looking at. The provision where with two or more employers over withhold. So let's take an immediately drop off off the list. Item number D the excess is a credit. If it was held by one employer that doesn't apply, if there is an excess, the employee needs to go back to the employer and get it corrected.

So now we're down to three choices. How about a, so Texas is either a credit or an itemized deduction at the election of the employee. This is clearly wrong because that is an automatic provision for a credit. There is no itemized deduction in this over withholding situation. So scratch a B reimbursement of the excess from his employers.

What Congress said is we don't want the employee and the employees to have to go through reimbursement and hassling it out among multiple employers. So B is wrong. The way this is handled is the excess is a credit against income tax. It's automatic. It's a statutory provision. If the excess resulted from two Memorial employers and the correct withholding.

See, now I'll caveat this by saying if the withholding. Is incorrect by one or more employers. Then the employee has to go back and get it corrected at the employer. But if it's the correct amount, then it's a credit it's answer C. And that finishes this question. Now, Mr. And Mrs. Sloan paid the following expenses on a December 15th, 2012, when they adopted a child.

The medical expenses of $7,000 legal expenses of 9,000 and an agency fee of 15,000. The question is what amount of the above expenses may be claimed as an adoption credit on their 2012 tax return. Is it $21,000? Answer a answer B 16,000 answer C 14,000 or answer D. $12,650. Let's look at the child's medical expenses.

Where would they be claimed not as part of the adoption credit. They are claimed as an itemized deduction on schedule a subject to the threshold. So take that out. And now we're going to be looking at the $9,000 of legal fees. Plus the $5,000 of agency fee. Can those be deducted or put into the credit?

The answer is yes. Both of those qualify. So what amount is going to be qualified of 14,000?

Yeah. Now it is $12,650. Why? Because that is the maximum that is allowed under the code provision while they incurred 14,000, you get the ceiling amount, which is 12, six 50, not the allowed expenses. So remember medical expenses going itemized list, regular adoptions are subject to the ceiling and special needs.

You get the sealant irrespective of the amount paid.

Now we've talked about a number of things in this program. We've talked about gross income, inclusions and exclusions. We've talked about accounting methods, whether it be cash basis or accrual basis. We've talked about the reporting on schedule C for self-employment income. We've talked about reporting of passive activities, particularly rental properties on schedule E.

We've reviewed a bit about compliance, filings, estimated taxes, and potential penalties. And we've explored the areas of both refundable and nonrefundable tax credits. There's a lot in this program and a lot of great information as you review for them, the CPA exam and its test dealing with income taxes.

I know you'll do well. You're bright people and you've mastered the material best wishes.

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I'm Jack Gorman. And this is the CPA review program on individual taxation. Would it begin by talking about the tax formula? The matrix by which the individual income tax liability of a particular individual or family is computed. I'm going to lay out the formula for you and tell you that in this program, we'll discuss parts of the tax formula.

And in another program, other parts of the formula will be discussed. The basic formula begins with gross income. And here as a tax advisor or a tax return preparer, you will need to figure out both income that is included on the return and income that is excluded from the gross income amount. We will take a deduction or a reduction for a group of expenses called adjustments for adjusted gross income.

And that will lead us to align entitled, adjusted, gross income or AGI. From AGI, the individual taxpayer subtracts, either a standard deduction or itemized deduction and also subtracts personal exemptions. So by taking those two amounts from AGI, we come up with a tentative taxable income amount that taxable income is multiplied by the appropriate tax rate.

Which is determined by the filing status of the taxpayer that tentative regular tax is reduced by tax credits. The amount is also increased by other taxes, which may be imposed on the taxpayer, such as the alternative minimum tax or the self-employment tax. Now there's a further reduction for any payments to the taxpayer has made during the year, either in the form of withholding or perhaps estimated tax payments.

When all of these items are summed together, we ended up with either a tax due, hopefully not, or a tax refund, the desired result. Now, as I said in this program, we're going to talk about several items. We will discuss the adjustments for we're in computing adjusted gross income, we'll address the issues of personal exemptions, the standard deduction, and more fully itemized deductions.

And we will talk about the alternative minimum tax. The other program that I mentioned will cover such items as gross income, inclusions and exclusions. Tax credits and the determination of tax liability,

let's begin with the initial determination that you have to make for every client who's returned. You're examining what is their filing status? That filing status determines the applicable tax rates, the standard deduction amount, certain credit amounts, phase out levels, et cetera. So making this initial determination is a quite important starting point.

What filing statuses could a taxpayer have? Well, we could have a single individual, obviously the filing status there is single. We could have a married couple and they may file either a joint return or they may be a married couple filing, separate returns. In addition, there is the possibility of a surviving spouse filing status.

And this is used by the surviving spouse for two years after the death of their spouse. If there is a dependent child, There may also be a head of household filing status. And here we have an individual who has qualified a single individual who has a qualifying person in their household. Now, a couple of rules here, married, filing, jointly.

The couple must be legally married and must be married on the last day of the year. There is an issue currently in the. Tax arena, which also couples with federal, federal law, as many of you know, that certain States have passed laws, allowing same sex marriage. For instance, California, Massachusetts, the district of Columbia, Vermont has such a status and these people are legally married under state law.

However, the United States Congress passed what they call the. Uh, defense of marriage act, which says that for federal law, such same-sex marriages will not be recognized in handling federal laws, which would include the internal revenue code. There's a lot of litigation going on, uh, at the present time between the various taxpayers in some jurisdictions that have such, uh, statutes and where they have been married.

And the conflict that, that poses with respect to the defense of marriage act stay tuned for further developments there, a married couple may also voluntarily decide to file separately in the course of a year, they may do this for reasons of personal preference. Now, when we come later in the program, we'll talk about the alternative minimum tax.

And I must tell you that whatever filing status the taxpayers take for regular tax purposes, they will also have to follow through for the minimum tax.

Exemptions independence. Many of you have focused on the fact that you can claim an exemption on the tax return for the taxpayer. And certain other members of that taxpayers family, the total exemption amount is equal to the statutory exemption amount times. The number of qualifying exemptions. Now that statutory exemption amount was set by Congress a number of years ago.

And it's indexed for inflation annually. Please check your written materials to stay in, stay up with the current exemption statutory amount. Now who qualifies for an exemption? Well, the taxpayer and a qualifying child and a qualifying relative, a taxpayer can not claim any dependent if that, if that dependent or that other person can be claimed as a dependent by another person, the exemption amount also requires that the individual be a citizen of the United States.

Or a resident of the United States, Canada or Mexico? Well, let's take a look. First of all, at the test for a qualifying child, there are four factors in there. The child must meet a relationship test. Obviously the child stepchild adopted child of the taxpayer. There is an age requirement. The text, the child must live with the taxpayer for more than a half of a year.

That's the residency test. And finally a support test that child who is wants to qualify for the exemption may not provide more than half of their own support. Now in today's world of. Uh, blended marriages of divorce of custody arrangements, uh, of stepchildren. There's some tiebreaker rules as to who may qualify for a child in a divorce situation.

The rules are as follows, start with a general rule. The qualify the child is the qualifying child and the parent may claim the exemption. If that is the child of the custodial parent. So the custodial parent normally gets the exemption for the child. What happens if there's joint custody, then the exemption goes.

To the parent where the child lived longest during the year. So if there's joint custody, the child is with the mother for eight months of the year, the father for four months of the year, the exemption will go to the mother where the child lives. The longest supposedly joint custody agreement provides for equal time, six months during the year with each parent.

Then the exemption is handed to the parent with the highest adjustable gross income. Now those are the rules, the general rule in the two joint custody tiebreaker rules, but any custodial parent may waive the right to the exemption and give it to the other spouse. For instance, in my case where the, let's say the mother.

May have custody for eight months of the year. And the exemption would normally be claimed on the mother's return. She made sign and waive that right to her. Ex-husband who then claims the child. Why would this happen? Well, perhaps he's in a higher income bracket and can use the benefit of that exemption.

This is a factor that is frequently negotiated in divorce and separation arrangements. But let me warn if that waiver does occur, not only does the waving parent lose the right to the exemption, it may affect several other tax benefits such as the child tax credit and potentially even the earned income credit.

So once the election is made, it's an annual election year by year, but it does affect several different tax benefits. So it must be carefully thought through. What we just discussed was the requirements for a qualifying child. Let's turn over now to the qualifying relative. And here, there are three tests, the relationship or residence test, and these are set forward in the materials, a gross income test, which is the taxable income, less the personal exemption for the amount, but including tax exempt income.

And again, that personal exemption amount, as I mentioned earlier, is adjusted every year by an inflation index. And finally there is a support test. And in this particular case, the taxpayer who wishes to claim an exemption for a qualifying resident must provide more than 50% of the support for that qualifying relative.

There are special rules relating. To multiple support arrangements. Now we're going to work through some problems. There are 12 problems. I'd like you to take a look at dealing with filing status and exemptions. So after you've quickly reviewed not only this discussion, but also those portions of the written materials pick up the 12 problems, work through them.

And I'll be back in a moment to explain the correct answer and why certain other answers are not appropriate.

A divorced person provided over one half of support of his widowed mother, Ruth and his son, clay. Both of them are us citizens. Ruth did not live with Smith. She received $9,000 in social security benefits, clay, a full-time graduate student and his wife live with Smith. Clay had no income, but filed a joint return for the year.

Oh. And an additional $500 in taxes on his wife's income. How many exemptions was Smith entitled to claim on his return for three, two or one? No. Remember we have Smith. His mother, Ruth Clay, his son and Clay's wife. The correct answer here is to Smith, may claim an exemption for himself and an exemption for his widowed mother.

He provided more than half her support. She bet the income test and a qualifying relative is not required to live in the residence. Now, what about clay? Clay had no income, but he filed a joint return with his wife and is not eligible to be claimed on Sebesta return. The correct answer is C number two.

Our second question reads Al and very Lou were married and filed a joint 2012 income tax return and which they validly claimed the $3,800 personal exemption for their 17 year old daughter, Doris. So the stores are in $6,400 for my part-time job at the college she attended full-time. She was also required to file a tax return.

What amount was Doris entitled to claim as a personal exemption in her individual return? Zero. Could she clip 2,500 to 3,800 personal exemption or 59 50 here. Doris was a 17 year old full-time student and could be claimed. And as an exemption on Al and Mary Lou's return, however, since she is claimed on the return, she, they not claim a personal exemption on her individual return.

Although Doris is going to be paying tax on the $6,400 that she earned for the part-time job. She gets no personal exemption. Question number three, Sarah Hantz who is single and lives alone in Idaho has no income of her own and is supported in full by the following three people. Alan, an unrelated friend contributes $14,400.

Barbara, who is Sarah sister contributes $12,900. And Chris, Sarah son kicks $2,700 in. Toward her support. So Sarah has $30,000 of income during the year 48% from Alan and unrelated friend, 43% for Barbara, her sister, and 9% from Chris, her son. The question is under a multiple support agreement. Sarah's dependency exemption could be claimed by no one, Alan.

Barbara or Chris, and there's only one correct answer here. It's C Barbara can claim the exemption because she has provided the support of 43%. She is a relative and it's more than 10% in the total contributions. Although Allen has contributed 48%, he is not a relative. And so he cannot claim the exemption.

And Chris as Sarah son does dot come up to the 10% threshold Hema claim. The exemption only Barbara Sarah sister meets the requirements under the mutual support, multiple support agreement.

Let's turn to number four. This is Jim and Kay Ross who contribute to the support of their two children, Dale and Kim, and Jim's widow parent grant Dale, a 19 year old full-time college student. We're in $4,500 as a babysitter. Kim, a 23 year old bank teller earned a $12,000 grant received a fi receive $5,000 in dividend income and $4,000 in non taxable.

Social security benefits grant Dale and Kim are us citizens and we're over half supported by Jim and Kay, how many exemptions be Jim and Kay claim? On their joint income tax return. All right. We know that in all probability, Jim and, uh, Jim and Kay can clean their own exemptions. That's two for answer one.

How about anybody else? Well, Kim earning over $12,000, 23 years old, and a bank teller may not be claimed as an exemption. She is over the age and income limits. Uh, what about grant? The widowed parent? Although he has been support, he has income in excess of the allowable amount. He has $9,000 in income and he's going to be over the threshold.

So grant may not be claimed as the exemption. However, Dale, the 19 year old full-time student is under 23, a full-time student earning $4,500. Is an eligible dependent of Jim and Kay, and maybe claims. So the correct answer two for Jim and K plus one more for Dale answered three. And it's B

number five, filed a joint return in prior tax years. During this current year one spouse died during the year. The couple had no dependent children. What is the filing status available to the surviving spouse for the first subsequent year. Now notice this is not the year of death, but the following year does that survivor surviving spouse file.

As a surviving spouse, married, filing separately, single or head of household. Well, since they, since we have a deceased spouse, they're not going to be filing married at all. It has to be as clearly wrong. And since this couple did not have any children, no dependent children. The survivor may not use either the a or D filing status must file as a single taxpayer answer.

See our next followup says while Emma and John were married. John died on July one, year three with regard to John and Emma's filing status for that year. Now, remember this is the year in which John died and we should file a as a single individual and a separate return should be filed for John as unmarried head of household or B as a qualifying widow, and a separate return should be filed for John has buried head of household.

See, and we should file as a qualified widow and a separate return should be filed for John as a single deceased individual or D a joint return included John as buried taxpayers will in the year of death, the married couple. Are deemed married throughout the year, even though one spouse has died. So on the last day of the year and still carries a marriage status, she will file a joint return, including John as buried, filing together joint return with a heading up at the top that the spouse died on July 1st year three.

Problem number seven, ask for head of household filing status. Which of the following costs are considered in determining whether the taxpayer has contributed more than half of the cost of maintaining the household. And remember, this is a requirement for head of household filing status food consumed home.

We have a yes or no matrix. And then I live services rendered by the taxpayer. Again, a yes or no matrix. Answer a is yes. A yes. B no. And yes. See the answer is yes. For food consumed in the home. No. For the value of services rendered by the taxpayer and in indeed the reverse, no for food consumed in the home.

Yes. For value of services. The answer again is yes. For food consumed in the home. No. For the value of services rendered, the matrix yields us a C answer, moving along to problem. Number eight, Joe and Barb are buried. Barbara refuses to sign a joint tax return on Joe's separate return. So he's going to be filing married, filing separately, and exemption may be claimed fi for Barb, if a she was a full-time student for the entire school year, Barbara attaches a written statement to Joe's income tax return, agreeing to be claimed as the exemption by Joe.

See Barb was under the age of 19 or D Barb had no gross income and has not claimed as, as another person's dependent the answer here. Is clearly D the internal revenue code says that a spouse who refuses to sign a joint return may be claimed as an exemption if she had no gross income and is not claimed as another person's dependent.

That's the correct answer. Although I will tell you there's nothing wrong with the answer C. Or be Barb could be a full-time student and Barb could be under the age of 19 and still beat these facts. However, the answer you want to put on the return is answered D because that is tied into the study  provisions in number nine, which of the following situations pay taxpayers file as married, filing jointly.

Don't get confused over this question, read it carefully. A taxpayers who were married, but lived apart during the year, be taxpayers who were married, but lived under a legal separation agreement at the end of the year, answer C taxpayers who were divorced during the year D taxpayers who were legally separated, but lived together for the entire year.

Let's take the easy ones first. Answer. See if taxpayers were divorced during the year, they cannot file married, filing jointly. Clearly X that out is taxpayers are legally separated. They cannot file as married, filing jointly, even if they live together for the entire year. So answer D is wrong and answer B is wrong, legally married, but lived under a legal separation agreement.

Now answer a, you may have thought, well, if they lived a portrait in the year, They can't file a married, filing jointly, not correct. I've even had clients who, because of their particular careers, one lives in California, one lived in New York. They were married on the first day of the year, the last day of the year, but lived apart throughout the course of the year because of their job, they could clearly file married, filing jointly.

In year one, Ellen Cox provided more than half the support for his following relatives. None of them qualified as a member of Allen's household, his cousin, his nephew, a foster parent. Now, none of these relatives had any income, nor did any of these relatives file an individual or a joint return. All of the relatives are us citizens, which of these relatives could be claimed as a dependent on Alan's year.

One return answer a none of the three relatives, answer B nephew, answer C the cousin answer D the foster parent. And the answer is only one of these relatives could be claimed. And that's the nephew answer B the other two relatives, the cousin and the foster parents are not on the list of qualifying relatives.

The nephew is, so the correct answer is B turning to problem 11, a husband and wife in filing a joint tax return. Even if a, the spouses have different tax years. Provided that both spouses are alive at the end of the year, B the spouses have different accounting methods. See either spouse was a non-resident alien at any time during the year provided that at least one spouse makes the proper election or D they were divorced before the end of the tax year.

Let's strike out the answer we know is wrong. Answer D we've already talked about if the couple were divorced before the end of the tax year, they may not file a joint tax rate. Turn answer is incorrect. It's a spouses have different tax years, even though they are both alive at the end of the year, they may not file a joint tax return.

The husband and wife must have the same taxable year end. Now answer C is also incorrect. If a husband and wife are married and one is a non-resident alien, they must file. They cannot file married, filing jointly. They must file on a separate basis. This leaves answer B the spouses have a different accounting methods and I'll be perfectly honest.

I have never seen. Is one spouse on the accrual basis of accounting. It does happen. There are individuals out who use the accrual method of accounting and the spouse uses the cash method. Not withstanding that they may file a joint tax return. Problem. Number 12 says that the Mercers are a married couple with one 15 year old dependent child residing in state a.

State aid requires individual taxpayers to use the same filing status on their state return. As on their federal return before considering the earned income credit of $3,000, the Mercers aggregate federal income tax liability is $1,640 for married filing separate returns and $1,940 for a married filing a joint return.

The Mercers aggregate you. One state income tax liability is $500 for married filing separate returns and $1,000 for a married filing joint returns. Now you're given two statements, Steven, number one, the Mercer's may use the married filing separate filing status only if they are legally separated.

Statement number two, it is most advantageous for the Mercers to use the married filing separate status for year one is the correct answer. A one only B to only see both one and two or D neither one and two. And the answer is D first of all, the. Mercer's may use the married filing separate status only if they are legally separated.

We already know that's not true. They can elect to file married, filing separately if they wish so that one's wrong. And if you make the calculations, you will find that it is most advantageous here for the Mercers to file a joint return. So the answer is wrong for one wrong for two, the correct answer to this problem is D.

In this program we have now talked about filing status and exemptions. I told you that one of the other things we have to do is discuss adjustments for AGI or adjusted gross income. Subtractions from gross income are referred to as often as deductions to arrive at G AGI now. Hmm. Why do we have on a tax return, certain deductions, which are called itemized deductions, which are claimed on the return after alternate, after adjusted gross income is computed and we have certain expenditures when you're taking in computing adjusted gross income.

Well, Congress has made some more or less political decisions. Deductions have value, but deductions are taken in such a way that the tax rate plays into the effectiveness of the subsidy being given. We know that individuals could claim credits or claim, uh, Deductions. Usually we want to take the credit because it gives us a bigger bang for the buck in the same way.

There is a standard deduction and their itemized deductions, the taxpayer could claim one or the other. However, all deductions claimed in computing adjusted gross income are of benefit to the taxpayer. If a standard deduction. Is larger than itemized deductions. The taxpayer would have walked the claim, the standard deduction.

So these particular, your adjustments right now that we're talking about give a greater incentive for those taxpayers who are not going to have a lot of itemized deductions. There are probably 20 or so deductions in computing, AGI. Congress frequently is modifying them to give greater advantage to lower income people who are not itemizing deductions.

I'm not going to attempt to go through all current 20 items. I'm going to focus on some of them, the first one, and probably for many people, the most important is called the traditional individual retirement account. This is a deduction that individuals could take for placing money. Into an IRA, an IRA individual retirement account they've been around since the early 1970s.

And currently the maximum deduction that an individual taxpayer could take is $5,000. However, that maximum is limited to the amount of the taxpayers' earned income. That income does include alimony, but does not include pensions. Interest dividends, other type of, uh, portfolio income. So earned income plus alimony is a ceiling.

Now I said a $5,000 maximum, and there's one more modification to that. If the taxpayer is at least 50 years old, they can claim an extra $1,000 or I catch up about, so if a taxpayer is over 50, 50 years or older, The maximum each year is $6,000. That deduction is subject to some limitations. If a taxpayer is not a participant.

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education.

Welcome to Bisk CPA review hotspot on sales. I am Jack Norman, and we're going to spend this program discussing article two of the uniform commercial code. We will be reviewing all of those rules contained in the UCC that affect the sale of goods. Now, the first question you're going to be confronted with is what are goods.

Okay. This is talking specifically about personal property, not real estate, but personal property. It includes specially manufactured goods. So if, for instance, I ask a particular manufacturer to build something for me to install a door on a house. Uh, Specific piece of equipment for my new factory specifically, or especially manufactured goods are considered under the uniform commercial code as article two goods.

What must occur is the asset. That thing we're talking about must be movable at the time. It can be identified to the sales contract. So we have to be able to identify it separately, segregate it and say, this is a good that it's being handled. Under our particular sales contract. Now you've already learned an awful lot about contract law, the common law of contracts, where we have to have consideration and a meeting of the minds for the moment, keep those contract principles in the back of your head.

But remember, article two has some changes that are very different from the old common law of contracts. First consideration is not needed. Either to make the contract or to modify the contract firm offers must be written. Remember we could have had an oral contracts under the old common law, but here firm offers must be written.

Article two, applies to offers made by a merchant. This is somebody who's in the regular business activity of selling the goods that is subject to our contract. An offer must state that it's irrevocable cannot be revoked. And if there's an option contract, then if it's more than three months, there must be consideration.

If it is less than three months, consideration is not required. A couple of further changes. When we compare article two against contract law of common law, there is a mailbox rule. Which basically says we have to respond as fast or faster than an offer ERs method, the way they sent it to us. So for instance, if they sent us something by mail, we send it back by mail or faster.

For instance, a fax response was generally be faster under the so-called mailbox rule, the offer, or the acceptance is valid when sent. So in other words, uh, if I put my acceptance of it, of a proposal in the mail, even though it's not received until three days later, that acceptance is valid. At the point I put it in the mail.

That's the change from contract law. Okay. That's the general rule, but I want you to remember, there's also an exception as there so often isn't the law to every rule and that exception says. If the offer or stipulates that the acceptance must be received in order for it to be effective, then that rule applies and it supersedes the mailbox rule.

So you can generally use the mailbox rule unless your offer says that he must receive your acceptance for it to be valid. Now, if you remember under the common law, we said that. Changes from the offer to the, uh, acceptance really didn't constitute a binding contract. It was simply a counter offer and the parties had to come to an actual meeting of the minds and the terms all the way down the line, if there were any variations and it was simply regarded as a rejection and a counter proposal or a counter offer.

Article two is different. We may have different or additional terms. In other words, we can have some minor variations. It can't be something so significant that it completely changes the nature of the proposed transaction. Minor changes are okay. And there will be a valid acceptance. So this little kind of battle of the forms, if you will.

Minor changes are acceptable. It's not a counter offers. It will constitute a valid and binding contract unless one party or the other says, these are my terms and there may be no changes in that case, you have to be actually in agreement. In other words, we can have variations unless a party says no changes, then you're bound by the no change rule.

In this article to contract, you don't have to stipulate the time of delivery. It's assumed by the courts, by the other parties that I reasonable delivery period is what's meant we don't have to state a place of delivery. The courts will assume in the absence of something defined that it's the seller's place of business.

If there are conflicts between, as I said, the forms could be slightly different. We can have minor variances. If those minor variances conflict, what will happen is if it has to come to litigation and settling this out, the court will knock out what they call the knockout rule will knock out both.

Provisions that are inconsistent and will supply a default rule or a fallback rule as, as specified in article two. So these are some of the variations you need to keep in mind between the old common law of contracts, facts that you learned and the special rules of UCC. Article two, basically. And if we want to focus on a couple of the key ones, they are no consideration required, uh, informing the contract or modifying it.

Unless we're talking about an option extending beyond three months, we can have minor variances in the terms and they will still be considered valid and not every particular provision must be stipulated. We need to know what the subject of the contract is. We need to have an agreement that we have a contract, but we don't have to specify such items as delivery place or delivery terms.

Let's turn to another concept that you remember from your contract law, the statute of frauds now in most sale of goods by a merchant, we do not have to have a writing. We don't have to comply with the statute of frauds unless the contract is for $500 or more, then it must be in writing the contract must state the major terms and the quantity supplied.

So that's our general rule under $500, no required writing contract of $500 or more. We do need to comply. I have a written contract, however, as I said, always, there are exceptions. Here's your exception to the statute of frauds rule. And you can remember this with the new model spam S P a M no contract is required for specially manufactured goods.

Remember a little bit earlier in the program, I talked about how article two covers these specially manufactured goods. I asked you to build something specifically for me that does not require a writing. Now, most contractors of course, will specify that a contract must be executed for these specially manufactured goods, but it's not required under the statute of frauds.

Neither is a written contract required. If the purchaser makes a part payment or receives the goods. So a part payment is an exception under the statute of frauds, a third exception, the a and R spam pneumonic is that if one of the parties admits in court, that they do have a contract and admits to being bound by it, that admission takes the requirement out of the statute of frauds.

Finally the most important of these exceptions probably is the merchants confirming letter. If a purchaser sends to a merchant, uh, a letter saying I would like to buy X 300, 300 wrenches, 5,000, uh, uh, reams of paper, and the seller then sends back a note that says, I have received your order. We're compiling it.

And it will be shipped shortly. That is a merchant's confirming letter. And is outside the statute of frauds the review. One more time, $500 or more. It must be in writing. That's the statute of frauds requirement. Even under article two, the exceptions, my spam pneumonic, especially manufactured goods, part payment, or receipt of the goods and admission in court, or the merchants confirming letter.

Now that we've talked about. Sort of forming the contract and the requirements under article two for a merchant sale of goods, please review REG CPA Exam questions one through 14 and the supporting materials and we'll come back and work through those problems.

All right, you've done those first few problems. Let's review them now so that when we get to the exam, sales is a piece of cake and you are scoring a hundred percent here. Question number one. Under the UCC sales article, which of the following conditions will prevent the formation of an enforceable sales contract.

Open price, open delivery, opened quantity. We're open acceptance. This one should be clear to you easily. The answer is D open acceptance. As we mentioned talking about article two, we have to have a meeting of the binds that we indeed we'd have a contract, but in contrast to the common law, we may have open price, open delivery, or open quantity in that contract.

Let me just give you an example of open price. Does this sound like a good contract to you? I promise to sell you the output from my 80 acres of corn at the prevailing market price when I harvest it. Well, of course we can sign a contract in December knowing that that crop is not going to be harvested until September.

Nevertheless, I have an enforceable binding sales contract. It's movable merchandise. It's been identified, but we have an open price. It will simply be set at the day. I harvest it. So a is a wrong answer, open delivery when, when I get it harvested. So we know that we've still got a, a valid contract, but the date is open.

It's going to be under the reasonable harvesting time. So be as an incorrect answer and open quantity, how much corn am I going to get out of that field? It could be. X bushels. It could be Y bushels. Nevertheless, the quantity is known. The contract will be enforceable even though price delivery time and quantity are all open.

It is only open acceptance that will prevent the formation of the contract. In question number two, patch, a frequent shopper at soon. Shop stores received a rain check for an advertised sale at an item. After soon shop supply of the product ran out. I'm sure you've run across this situation. The rain check was in writing as they did at the item would be offered to the customer at the advertised sales price for an unspecified period of time.

As soon shop employees signed the rain check. When Pat returned to the store one month later to purchase the item, the stork refused to honor the rain check. Under the sales article of the UCC we'll patch. When a suit to enforce the rain check a no, because one month is too long, a period for the check to be effective.

No, because the rain check did not state the effective time period necessary. Keep the offer open. Yes. Patch will win because soon shop is required to have sufficient supplies of the sale item to satisfy all customers and D. Yes, patch will win because the rain check met the requirements of a merchants from offer, even though no effective time period was stated.

Well, the answer again is D but let's go back and look at the others as you're trying to answer this question first, I believe you should automatically throw, see out soon. Shop is never required to have sufficient supplies to satisfy all customers. There's absolutely no requirement in the law for that C should have been immediately dismissed.

Let's look at a and B one month is too long for a rain check to be effective. Not necessarily. How do you know when the person is going to come back in? Now, the key here is it's going to have to be a reasonable period. If the individual comes back 10 years later and asked for it, that's not reasonable, but the UCC and the courts will assume a reasonable time period.

One month is not unreasonable. No, because the rain check did not state the effective time period. There is no requirement that we state a time period when a merchant is making an offer like this. So a and B fall C is clearly ridiculous. And D yeah. Yes, because the rain check met the requirements. The merchant made an offer, identified the product and left a reasonable time period.

Even though there was no close date on it. So you should have answered this one. D turning to question three EG door company, a manufacturer of custom exterior doors, verbally contracted with art contractors to design and build a $2,000 custom door for a house that art was restoring after EEG had completed substantial work on the door.

Art was advised art advised DG that the house had been destroyed by fire and art was canceling the contract. Nevertheless, EG finished the door and shipped it to art. Art refused to accept delivery. Art contends that the contract cannot be enforced because it violated the statute of frauds by not being in writing under the sales article is art's contention.

Correct? Now let's go back and think about that statute of frauds rule I gave to you any contract in for goods by a merchant in excess of $500 must be in writing. That's the general rule, but we also talked about the spam exceptions to the general rule. One of them was specially manufactured product. So bearing those two facts in mind, the general rule and the exception rule, let's look at the possible answers.

Art's contention is correct because the contract was not in right. Writing B arts. The engine is correct because the contract cannot be fully performed due to the fall. Fire art will lose his case because, because the goods were specially manufactured for him and cannot be resold in EGS, regular course of business and D will not win because the cancellation of the contract was not made in writing.

Well first, if you remember the statute of fraud rules and the exception I gave you, the answer to a is clearly wrong because a specially manufactured good is an exception to the statute of frauds rule a is out B. This one, again is an incorrect solution because just because the fire destroyed the house.

Doesn't mean that EEG hasn't complied with the contract, they built the special piece, the special door that art had or ordered. So although they completed their side of the contract, art may not have the house to put it in, but he's going to have to pay for the door. No art will not win because the goods were manufactured for art and cannot be resold in EGS, regular course of business.

This is the correct answer and let's focus on something here. The goods were specially manufactured and that's what takes it out of the statute of frauds provision. But secondly, to mitigate the damages and the harm to art EEG does have an obligation to try and sell it, sell that door in the regular course of their business.

However, because it was specially manufactured to art specifications for restoration job. EG probably can't sell it. So art's going to lose his contention here. Uh, we're going to have to work out the, the damages that arise. Finally, art is not going to win. Uh, the cancellation was not made in writing has no effect on this.

It is an enforceable contract. Uh, Under the special manufactured rules. So the correct answer is, again,

turning to problem. Number four, you were asked under the sales article of the UCC, which of the following statement is correct regarding risk of loss. And titled to the goods under a sale or return contract now sale or return contract is one in which the seller says, here's, here's the merchandise. If you're not happy with it, you may return it to us.

So that's a sale or return contract. So we're asking now who has the risk of loss and title, a title and risk of loss are shared equally between the buyer and the seller. B title remains with the seller until the buyer approves or accepts the goods. But the risk of loss passes to the buyer immediately following the delivery of the goods.

So title is with the seller, but the risk of loss passes to the buyer in item C. The answer is title and risk of loss remain with the seller until the buyer pays for the goods. So that's staying with a seller. And indeed title and risk of loss rest with the buyer until the Riga goods are returned to the seller.

Now, if you remember, we said that this is a sale or return contract, so it is a completed and accepted contract. The seller ships, the merchandise to the buyer, the buyer has the goods in house looks at them. Does whatever they want with them. And it has the right to return them to the seller. Under these circumstances, the seller has parted with title, title vests.

Now with the buyer, the risk of loss has been shifted from the seller over to the buyer. And as a consequence answer D is correct both title and risk of loss rest with the buyer until. That buyer makes a decision that they don't want the goods and actually returns them to the seller. So when you understand a sale and return contract, the sale is completed.

The seller has parted with title risk of loss shifts to the buyer and remains there until the buyer returns the goods to the seller. Question five. Under the sales article of the UCC, when a contract for the sale of goods, stipulates that the seller shipped the goods by common carrier, F O B purchasers loading dock, which of the party bears the risk of loss during shipment.

Now F O B. You're going to remember from your days of taking some business law classes and probably from your early accounting courses on inventory, that FLB means free. On board purchasers loading dock. That means that this is a seller's obligation to get that merchandise from its warehouse or its manufacturing site onto the buyer's loading dock.

So with that, knowing that the shipper has got to get it all the way to the purchaser's loading dock who bears the risk of loss. A, the purchaser, because the risk of loss passes when the goods are delivered to the common carrier, the truck or the rail line, that's carrying it to his merchandise site or be the title passes.

The risk of loss is with the purchaser because title to the goods passes at the time of it shipment or C. The seller bears that risk of loss because the risk of loss passes only when the goods reach the purchaser's loading dock or D the seller again, has that risk because the risk of loss remains until the goods are accepted by the purchaser.

Well, FLB purchasers loading dock means we have a shipping obligation on the seller. The seller bears the risk of loss and continues to hold title until those goods actually get on the purchaser's loading dock. So the clearly correct answer is C the seller has all those obligations until it's sitting unloaded at the purchaser's loading dock.

Now the seller parts with title and risk of loss, even if the seller has not yet accepted them. Because they are deemed there on his dock and the seller has complied with all of the obligations of the contract to get them to his loading dock. Obviously, since it's a shipper's obligation answers, a and B are wrong, the purchaser bears, none of these obligations.

The only question came down to C or D the correct answer is C when the good reaches the purchaser's loading dock, not when the purchaser accepts them. I should tell you a little quick story about that one. I had ordered some merchandise of my own. I had arrived in my garage because it was to be at the sellers at the purchasers garage.

It was a shed being delivered. It arrived in broken condition. Now who bore the risk of that damage, the seller, because it was obligated to get it to my garage and the risk remained with him until I had the merchandise in hand.

Question number six under the sales article of the UCC, when a written offer has been made without specifying a means of acceptance, but provided that the offer will only remain open for 10 days, which of the following statements represents a valid acceptance of the offer. No, as soon as you read that question, you should have been thinking mailbox rule.

So let's take a look at the possible answers and acceptance sent by regular mail. The day before the 10 day period expires the reaches the offer on the 11th day. So we put it in the mail on the ninth day, the contract said 10 days, it arrives on the 11th. That's item number one, item number option number two, and acceptance faxed the day before the 10 day period expires there, reaches the offer or on the 11th day doodle malfunction of the offer orders printer.

What do you think on acceptance here? Only number one, which talks about putting it in the mail only number two, the fax machine, both one and two. Or neither one in two. Well, I think you clearly knock out D neither one or two. You've already figured out under the mailbox rule that the first case sending it by U S postal mail does work under the article to rule on the mailbox.

So we're clearly under one. What about number two? And the answer is it's an equally. Fast method as the mail. So the fax is deemed acceptable under the mailbox rule, even though the malfunction prevented it from arriving before the 11th day, the correct answer here is both one and two, or answer C

your problem. Number seven, asked the following under the sales article of the UCC. Which of the following statements is correct regarding a good faith requirement. That must be met by emergent. Hey, the merchant must adhere to all written and oral terms of the sales contract. B the merchant must provide more extensive warranties than the minimum required by law.

And we're going to talk about warranties a little later in the program, but this is a good faith kind of issue here. See, the merchant must charge the lowest available price for the product and the geographic market or D the merchant must observe the reasonable commercial standards of fair dealing in the trade.

And if you think back, let's look at the question one more time, which of the following statements is correct regarding the good faith requirements that must be met by a merchant here. We're talking commercial practices. We're not talking statutory provisions. We're not talking about ethical rules. We're talking about conduct.

That's expected of a merchant in normally dealing with his or her customers. The answer is D article two, the UCC is intended. It's overarching principle is commercial viability. We want free trade. We want trade that is easily done. Not encumbered by nitpicking details, not subject to extensive litigation.

We want to facilitate commercial dealings. And so the standard that. Sort of underlays. All of article two is the merchant is bound by the reasonable commercial standards of fair dealing in the trade. Some of these other items in a, B and C, the merchant must adhere to all written and oral terms of the contract.

Well, article two says there can be variations and we're trying to work those through there. If they're inconsistencies good faith dealing is the key to it. The merchant must provide more extensive warranties in the minimum required by law. Well, the merchant certainly may, but is not required to provide warranties more extensive than minimum to be is also incorrect.

See, the merchant must choose the lowest available price in the geographic market. Well, I don't know about you, but I can go to different stores, a gas station, a grocery store, and find different products. Uh, or the same product at different prices in different stores. There's no requirements at the merchant towards the lowest available price.

The answer is D the merchant must observe reasonable commercial standards in the trade.

Let's do number eight Webster web star corporation orally agreed to sell North coast a computer for $20,000. North coast sent a signed purchase order to web star confirming the agreement. So we have an oral agreement. Northstar sent a purchased order, confirming the agreement web received the purchase order and did not really stumped bond to it.

Webstore refused to deliver the computer to North co claiming that the purchase order did not satisfy the statute of frauds because it was not signed by web star. North coast sells computers to the general public and web star is a computer. Wholesaler. So there are a couple of underlying facts here. We clearly have a merchant Northco is a merchant web star is also a merchant.

So we've got merchants dealing with each other and we have tangible goods that would fall under article two. The UCC under this provision Webster's position is incorrect because it failed to object to North coast purchase order. In other words, Northcote did not come back and say, web star, we reject your purchase order.

That's answer a web star B is incorrect because only the buyer in a sales transaction must sign. The contract web position is correct. In other words, it could reject it because it was the party against whom enforcement was being sought or D correct, because of the statute of frauds and the computer exceeded $500.

Well, web starts position is incorrect. First of all, the statute of frauds, uh, situation doesn't apply because we've got merchants dealing with merchants and we have a merchant acceptance. Uh, we also don't have to worry about the, uh, Party being against whom enforcement is sought. We have a merchant merchant binding contract arrangement here, C and D are wrong.

Now web store is incorrect, but why? Because it failed to object to North coast purchase order the buyer or the seller signed in the contract. That's not a correct answer here. They're incorrect because they had a period of time and we said they had the option. They had 10 days in which to reject that purchase order they failed to do so they're bound by it.

They must supply, uh, North co with the computer question number two nine under the sales article of the UCC, unless the contract provides otherwise. Unless a contract provides otherwise. So what's that word before title to goods can pass from a seller to a buyer. The goods must be tendered to the buyer.

In other words, made available to him, be identified to the contract, accepted by the buyer or paid for. This is a simple rule under the UCC. All we have to do is identify the goods to the contract, for instance, If I have received an order, I've got goods in the warehouse. I actually separate those goods.

Put them on a pallet, have them out on the loading dock. They're identified to the contract. That's all that has to happen for titles to pass. Assuming that our contract terms say, uh, That it's point of delivery is at the sellers. I've identified them to the contract. There that's all that's required. They don't have to be accepted by the buyer.

They don't have to be paid for. They do not have to be tendered to the buyer. A C and D are incorrect. The answer to number nine is B identified to the contract. Watch for that word, identified to the contract. The key term in a lot of these REG CPA Exam questions. Number 10. Pulse warehouse or pulse corporation maintain the warehouse.

Here we go. Where it's stored it's manufactured goods. Pulse received an order from star shortly after pulse identified the goods to be shipped to star, but before moving them to the loading dock, a fire destroyed the ware house and its contents with respect to the goods, which statement is correct pulse.

This is the manufacturer here had no tie had title, but no insurable interest star. The buyer has title and insurable interest. See pulse has both title and an insurable interest D star has titled, but no insurable interest. So here's the question of who's bearing the loss on this. The goods have been identified.

But we still only have them out on the shipping dock. Remember we have no terms yet on the contract what's happened is we've got a binding contract, but pulse still has retained title and must have those goods ensure the answer is C pulse has title and insurable interest, not withstanding the fact that the goods have been identified.

So the correct answer is C pulse has both title and insurable interest. So answer a is wrong. Answered B and D are wrong because star has neither title nor an insurable interest in this property. Again, make sure you have circled item six.

We're moving a pace here on the number 11 under the sales article of the UCC. In an auction announced an explicit terms to be without reserve. And that means that there's no minimum that has to be bid on the good without reserve. When man auctioneer withdraw the goods put up for sale, this doesn't sound like a UCC title, but it really is because the auctioneer is a merchant and they're selling goods.

So we're under article two at this point, when may an auctioneer withdraw the goods, put up for sale. Your first choice is at any time until the auctioneer and now announces completion of the sale. So, yeah, even if the bidding opens at $2 and they bill and the auctioneer believes the merchandise is worth 500, if there's a $2 bid, can the auctioneer, the auction item it's item number one, alternative number two, if no bid is made within a reasonable period.

So the auctioneer opens the auction. Saying, he's looking for a bit of a, a hundred dollars, $50, $10. Nobody says a word. Can he withdraw the item from the auction, then your two options, then one and two item a only allows for the first one B item to only see one or two and D neither one or two here. You should have clearly circled B.

If there is any bid, since there was no reserve specifically stated there in the advertisement for the auction, no reserve. That means he must, the oxygen must take any bid. It could be 2 cents, but there's two, we'll a bid on the merchandise. So item number one, he cannot withdraw a is out. Uh, C is out D is out.

Only if no bid is made, can the auctioneer withdraw the item from the sale? Only B is a correct answer under number 12, the sales contract to the UCC, which of the following statements is correct. The obligations of the party to the contract must be performed in good faith merchants and non-merchant are treated alike.

The contract must involve the sale of goods for a price of more than $500 or finally D none of the provisions of the UCC may be disclaimed by agreement. Alright, I've mentioned to you earlier in the program that the underlying premise of article C is good faith, uh, performance answer a here is correct.

So you should have opted for number eight. Let's look at BC and D merchants and non merchants are treated differently. Under article two, the rules specifically are binding merchants. Article two is focused on merchants and that's where the provisions are actually targeted. Non merchants are treated differently.

The contract must involve the sale of goods nonsense. We talked about goods more than $500. Needed to be under the statute of frauds, unless one of the spam exception applies, but no article two can apply to any merchandise that's being sold. Any goods being sold by a merchant and, uh, provisions of the UCC may be disclaimed by agreement.

So certainly B, C and D are incorrect. Only a the good faith requirement is present here under article under number 13. On May 2nd Mason orally con contracted with Acme appliances to buy for $480 under the statute of frauds, a washer and a dryer for household use Mason and the acne salesperson agreed that delivery would be paid on July 2nd on May 5th Mason telephone, Dak Bay, and requested the delivery.

Be moved to June 2nd. The sales person agreed with this request. On June 2nd act, we failed to deliver the washer and dryer to Mason because of an inventory shortage, Acme advised basin that it would deliver the appliance on July 2nd as originally agreed. Mason believes that Acme has breached its agreement with him.

Actively contends that the agreement to deliver on June 2nd was not binding. Now you were asked. Acne is contention is correct because basin is not a merchant and was buying the appliances for household be active. That is correct because the agreement to change the delivery date was not right. Adding, see Acme is wrong long because the agreement to change the delivery date was binding or de acne was wrong because its agreement to change.

The delivery date is a firm offer that cannot be withdrawn by acne. Well, Acme is wrong. The sales representative was acting as an agent of Acme and Ken changed that delivery date. It is a binding change. Uh, it can be withdrawn. Uh, It can be changed. The July 2nd date is not binding. It could be modified and was modified by Acme sales representative.

Acme is wrong because what we're trying to do in article two is encouraged transactions between merchants and consumers, just because it was bought for household use. Doesn't change the facts at all. Uh, acne can prevail on that ground. And finally, the delivery date is not in writing. Delivery days don't have to be in writing in, uh, under the article two provisions.

So a is wrong. B is wrong. D is wrong. Uh, the correct answer is Acme is bound by the June. Second date what's going to happen now is we've got a disagreement. Acme has breached the contract and we're going to have to find the appropriate remedy. Number 14 as Lee's coming to a conclusion here under the sales article of the UCC, a firm offer will be created only if the offer States the time period during which it will remain open.

The offer is made by a merchant in assigned writing the offer. He gives some form of consideration. The offeree is a merchant. Okay. In this case, you should have opted for answer B. The offer is made by a merchant in a signed writing. So the offer must be made by the merchant. Uh, that'll be a firm offer.

The we've already talked about the time period during which it will remain open. Doesn't have to be stated in there a reasonable time period. If we want an option period beyond three months, there has to be consideration. But a is incorrect. See, the offering is some form of consideration. I began the program by saying that unlike the common law consideration is not required under a UCC article two sales contract C is incorrect and the firm offer can be created whether or not the offeree is a merchant.

Uh, the answer D is incorrect. You should have picked answer B as in boy. That's the end of our first 14 REG CPA Exam questions. We'll resume in one moment.

We've talked now about getting the contract formed and some of the terms and requirements of a UCC article two sales contract. Let's turn our attention now to warranties. We can talk about express warranties. And implied warranties and there's a lot in this material. So I want you to walk through with me first express warranties.

They are a sale seller statement of fact that is relied on by a buyer. An express warranty is exactly what it says it is expressly made by the seller. Now an opinion. Or a statement of value is not a warranty. And there's some real interesting, fine lines here between what is puffery or sales pitch. And what is a warranty.

If I told you that this diamond bracelet is made up of very, very, the, the S. Chips, uh, diamond stones. That's an expression of statement. That's a statement of fact and that's, that is a warranty. Those stones better be of that quality. However, if I say this will be an invaluable bracelet, a great, uh, piece that will attract attention at an, at a.

The next gala that you go to that's, uh, that's puffery, that's a sales pitch. So do you have to be very careful now they can get kind of blurry? What if I told you this is the best stereo that money can buy? Is that a statement of fact or is it puffery? Well, Now, the question is going to come down. How much of an expert is the salesman?

How much of an expert are you in it? But on balance, I would say that's probably more a sales pitch than it is an expression or a warranty of fact. If on the other hand, uh, I tell you that this stereo system has got, is the only stereo system with surround sound. Then that is a statement of fact. So you have to parse through.

What is a statement of fact, that must be real. There's being relied on by the buyer and which the buyer knows. And the seller is making as a sales pitch. Nevertheless, these are all express statements. You don't need to use the word warranty. In my example, I gave you about the diamond bracelets. I didn't say I warrant that these are VVS diamonds.

I simply said this bracelet is made up of 16 VVS diamonds without the word warranty doesn't make any difference. It is still a statement of fact on which the buyer is relying. Now, a warranty must be part of the basis of the bargain between the buyer and seller. I must be buying that bracelet because I'm willing to pay the price that you're asking for it because of that representation, that warranty that you have given me on the quality of the diamonds, the buyer may always rely on a statement of facts made by the seller.

Now let's turn to a slightly different thing, which is still an express warranty. All the previous cases I was telling you about. The seller actually said something made a statement. Suppose instead they simply said we will build a cabinet like this for you and shows you a sample or shows you a description in a catalog.

Is that a warranty? And the answer is absolutely. Yes. The merchandise must conform to the sample or description that was provided to you. That became the basis of your bargain. You were only buying that, which they told you they would make available to you. So we're talking here, express warranties.

Now the UCC also says there are a number of implied warranties. Implied means the seller is not going out and saying, dear buyer, I am giving you a warranty of merchantability. You never hear the sales clerk in a store. Say. Mr. Norman, did you know that you are getting a warranty of merchantability with this, all that means, and it's implied under the UCC.

If you're buying goods from a merchant, is that the goods that you purchase are of a standard that is common for that type of merchandise is commercially reasonable and suitable for sale to you. It is of like kind and quality, uh, and they are giving you that item. It's merchantable. There can also be a warranty of fitness for a particular purpose.

Now, this one is called an implied warranty because the seller, again, doesn't say I want that this is fit for a particular purpose. It's an implied warranty because they will say, yes, this is suitable for what you want. And here, the warranty for fitness for particular purpose has to be part. Of the contract.

It has to be part of the basis of the bargain and a couple of items. A couple of points needed to be stressed with this. The seller must know that the buyer is relying on this representation. The buyer must get and disclose what they want. And let me give you an example. I am in Tampa, Florida, I'm looking for a chipper shredder, uh, that will chew up trees.

And I go to a particular dealer and he's got these huge machines for shredding, uh, trees, lumber and everything else. And I'm interested in it. He shows me one it's high quality. And so when I said, I need a heavy duty one, I'm going to be clearing some, some very dense, uh, areas. And it has to specifically handle mangroves.

Let's just take. That for example, I have to be able to shred in define molt mangrove with this. All right. I have now said what I want and the silicon's ranks. I can assure you if you buy this machine, it will chew mangrove trees into tiny little shreds. He has given me a warranty of fitness for a particular purpose.

Let's assume I buy that. Take it out to my job site and it shreds everything inside excepted jams on mango of trees. Then I have a breach of warranty because they said, sure, it'll chip up everything. But we specifically warrant you told us, you asked us about mangoes. We told you it would, if it didn't reach a warranty.

So here we have two implied warranties merchantability and fitness for a particular purpose.

Now can a seller say I'm going to void or walk away. I don't want to give these warranties. And the answer to that is yes, they can. They can specifically exclude the warranties of merchantability and the warranties of fitness for a particular purpose. How. First of all an exclusion from warranties must be boldly made.

And so, so frequently when you read a label on something, you'll see exclusions in bold letters. It's because the law requires any exclusions from warranties being made prominently to the buyer, to the purchaser. So warranty of merchantability, what might we see there? For instance, I'm selling goods. As is, they may be used.

They may say, uh, no warranty that it's merchantable uh, if you go into a secondhand store, if you buy things over the web frequently, they will say as is, or they may say has certain defects in it. They are excluding that merchantability or, uh, qualifying it with this disclaimer, with respect to a fitness, for a particular purpose.

They're the way not to have that warranty is just say I can't represent, or my sales person cannot represent that it will fit that particular purpose. You simply don't give that warranty, but on merchantability you need to decline it or limit it in some way. Anyone selling also has an implied warranty of title.

They're saying I'm going to give you title to this property without liens. Without encumbrances. I have clear title to it. It's not stolen. It's not fraudulent. Uh, now you can limit that warranty also in the sense that you could say I'm selling you this property subject to a lien, you become aware of the lien, you know, and you're willing to accept.

The property that way. The classic example of it is not under article two, because we're talking about goods and real estate is not under it, but so frequently real property is sold subject to a mortgage. That's the same thing, but a warranty of title is implied in all transactions. Under article two, if that warranty is breached, Then you have an infringement, uh, uh, I'm sorry, you have a breach of warranty, uh, and you know, may recover some damages under one of the theories.

Uh, property can also be subject to infringements or encumbrances. Again, these need to be disclosed. And if not, you may have causes of action for infringements. And for instance, in a patent or trademark case or encumbrances, liens, and so forth that are not disclosed. But in terms of warranties, let's go back and look at two things.

First, we may have either express or implied warranties. We have an implied warranty of title. We have an implied warranty of merchantability and we may have an implied warranty of fitness for a particular purpose. Warranties may be waived or maybe limited.

Now there is something else dealing with the sale of goods and that's injury. Almost any product I can think of can cause some type of injury. And so an injured buyer frequently will attempt to recover damages. Uh, we'll Sue the manufacturer, the retailer, the wholesaler, and attempt to obtain some type of damages for what is called product liability.

Under the common law. There is a concept that you remember from your discussions of torts, uh, the private wrongs of privity P R I V I T Y privity is who can Sue whom for damages? It means you have to be in a relationship between the parties in order to recover damages. And in the particular case of product liability, we're talking about most specifically merchant ability that the goods are saleable in and perform the function that they are being advertised for.

Now, what the UCC has done has changed the common law rule with respect to privity. Under the UCC rule, the buyer of the goods members of the family, people in the household, guests can Sue the merchant who sold the goods or anyone else in the chain of title. So in effect, if I purchase, let's just say a snowblower and in using the snowblower in accordance with its instructions, I'm injured.

I can clearly Sue. The retailer who sold it to me, I can Sue the wholesaler who moved it from the manufacturer to the retailer. I can Sue the manufacturer, suppose my next door neighbor, borrows my snowblower to do his driveway. Again, I have made it available to him. He's using it in the manner to which it was intended to be used.

He also can Sue in that same chain. That's the UCC rule now. Anyone can Sue a negligent seller, anyone who's injured here. And what you're talking about is negligence. Negligence is the failure to exercise reasonable care and it's reasonable care in making that product. There can be a design defect. They can be a manufacturing defect.

There can be a packaging defect. So elements of negligence, give rise to product liability. Let me take you back a few years to a classic example of packaging negligence. Some people may remember the title situation where someone. Went and tampered with Tylenol medications. They were, uh, poisoning the Tylenol and in effect the manufacturer withdrew all the Tylenol, repackaged it and so forth.

It used to be a very simple method to get into a package of Tylenol. Capsules today. It is much more difficult. You've got all kinds of seals. There was a charge of negligence, the company redesigned all the packaging, uh, for that tidal product. So in the case of negligence, you have to prove four things in order to recover under theory of negligence.

As I said, negligence in product design, product manufacturing, or product packaging. You need to remember these four letters. These are the elements of negligence. D B H C. I don't have any great mnemonic for you here, but it shouldn't be too hard to remember these four letters, particularly after I explained what happens.

DB agency stand for the duty. Somebody owes a duty to somebody else. The manufacturer has a duty. To whoever's going to buy the product to design it properly and to manufacture it without fault. Pretty obvious that they have a duty. They owe responsibility to someone, be the person who is negligent has breached that duty.

They have failed to do what they should have done. In other words, they manufactured a defective product. The third element harm. The buyer, someone in the family, some user is actually hurt by the breach of the duty that was owed. The last element is see causality. There must be a direct connection between the harm and the negligent act.

So if you think about the elements of negligence, it's very simple. First, there is a duty that duty is breached that breached caused harm. And last, but not least that harm was caused all the way back up that breach and duty to the person who committed the negligent act. That's the simple rule for recovery under a theory of negligence,

but. The law has also moved to another concept on liability, which has nothing to do with negligence. That's called strict liability. Strict liability applies in the case of a defective or unreasonably dangerous product. The law has said we don't really care about having to have this injury party go through and prove all of the negligence.

There is strict liability on the manufacturer, the seller. The whole chain, if there is a defective or unreasonably dangerous product and a classic example here, let's just take a gasoline space heater that's designed inappropriately and it tips over easily. And when it tips over easily, of course, the heater is on the gasoline spills out fire ensues.

There is strict liability on this because a product like this, a gas heater should not tip over easily. That's a dangerous design, a dangerous manufacturing, a dangerous product. So as long as that product reaches the end user without substantial modification. So somebody didn't suddenly put it on wheels so that it rolled across the floor more easily.

But if the product is sold the way it was manufactured, you don't need to show negligence. All you have to say is I was injured by this defectively designed. Product period, not only may the, the purchaser members of the household, any casual users, even innocent bystanders may recover under this. What is now called a strict theory of product liability?

So you're going to remember under this portion of our program, some rules about warranties and liabilities warranties are expressed or implied. Warranties maybe modified or maybe disclaimed. There is liability for breaches of care. That liability makes them all the way up the chain from the manufacturer, the wholesaler and the retailer.

There is a negligence rule of duty breach harm and causality D V H C. There is a strict liability provision in here. Now, the one thing we haven't talked about yet, before we get into the REG CPA Exam questions is defenses defenses of the seller or the retailer when there is a charge of either negligence or strict liability and under negligence, certainly it is fairly common for the seller or the people being sued to say contributory negligence.

The person who's injured, contribute to that negligence. And under the rules in most States, contributory negligence, doesn't negate winning. It simply has an effect on how much recovery, the, uh, the plaintiffs, the person who is suing is able to recover. Yeah. The, there is also a concept of assumption of risk and using the product in a way.

It was designed a classic example. I've always heard in law school is. The manufacturer of a lawnmower, let's just take one of the rotary lawnmowers with the blade that spins around underneath not the real type. So it works perfectly well on the ground while it's being used to mow the lawn. You have an idiotic purchaser who decides that he wants to trim some hedges and being too lazy to go get the hedge trimmer, picks up the lawn mower by the handle and is standing.

Swinging the lawnmower back and forth to trim the hedge. It slips and slices his leg. Clearly, this is not a case where the color, the designer, the manufacturer of the lawnmower should be found liable at all, because one, the, the purchaser was injured. Uh, not using it in the way it was designed to be used and contributing to his own negligence.

So this kind of defense plays out in both negligence and in the strict liability case, if the person does something stupid, the assumption of risk also goes to the case of, are there injuries which may arise even if the product is used properly? Again, my lawsuit school classic example, you decide that you want to do a parachute jumping.

Why? I have no idea, but let's assume you do. If you jump out of the plane and the parachute doesn't open. Well, now you would probably do have a cause of action because of the parachute is supposed to open there. The lawsuit is appropriate. If the parachute may have been designed improperly, it may have been packed in properly, but suppose it does deploy.

And as you were landing, you break your leg. Clearly this was not caused by a fault of the product. This was a natural course of parachute jumping. It is an assumption of risk. Generally, these issues are going to show up in the tort side of any discussions on the exam, but I wanted you to be aware of when we talk about negligence and product liability, that there are defenses.

So now let's begin to look at. REG CPA Exam questions 15 to 28. And look, we will go back and illustrate some warranty issues and some liability issues. Take a moment and work on them and we'll come back to the answers.

All right now that you've had your chance. Let's turn to problem. Number 15, we're an appliance seller promise to restaurant owner. That a home dishwasher would fulfill the dishwashing requirements of the large restaurant. The dishwasher was purchased, but of course it wasn't powerful enough to handle the restaurant's business under the sales contract or warranty was violated.

This one should have been obvious to you. Answer C is the correct one, the express warranty, because he said it that the goods conformed to the sellers promises. This is an express warranty. The seller did say. Don't worry this one before she will take care of your needs. Fitness for a particular purpose was violated answer.

See the implied warranty of marketability. It did operate as a home dishwasher, the implied warranty of merchantability. It was suitable as a home dishwasher and the express warranty against infringement. No problem there. So a, B and D are wrong. Clearly the answer to this one should have been C. Question 16 asks you under the sales article, the warranty of title may be excluded by a merchants or non-merchant provided the exclusion is in writing B non-merchant sellers only see the seller statement that it is selling only such right.

Or title that it has. And D use of an as is disclaimer. Well, let's dispense with the easiest answer first. As is goes to the condition of the property and not the title. So clearly D is knocked out of your answer. The UCC article two does apply to both merchant and non-merchant sellers. So answer B is wrong.

This title of warranty, uh, does apply to both. You can't deal with it by saying that there's no title and the exclusion is in writing. That's just a ridiculous answer. The only answer that made logical sense here is whether the seller is a merchant or a non-merchant that solely States that it is selling only such right or titled did it has.

Now in practical terms, you're rarely going to see a disclaimer of title virtually every merchant is going to say that they have titled to the goods that they're selling you a. Non-merchant seller may have a limited title. In that case, you better look carefully to see whether they have put in something like the restriction found in C, but that's the only correct answer here.

SI number 17, Vic bought a used boat from ocean Marina that disclaimed any and all warranties in connection with the sale any and all ocean was unaware. The boat had been stolen from kid. Vic sued the boat to kid when confronted with proof of the theft victim sued ocean, who is likely to prevail and why?

Well, a Vic might prevail because of the implied warranty of title has been breached. Be Vic because a merchant cannot disclaim implied warranties. Sea ocean will win because of the disclaimer of warranties or de ocean because Vic surrendered the boat to the kid to kid. Well, first of all, ocean is going to lose in this particular case, uh, answer C and D are wrong.

The disclaimer of warranties, they can't disclaim warranties of title just by saying, there are no warranties. They would have to do a disclaimer, similar to the preceding problem where they were saying they only had such warranties. Uh, there were only passing on and such warrant. Title as they had D because Vic surrendered, the boat has absolutely nothing to do with anything else in this case, uh, that was simply Vic solution to having received a stolen boat.

Vic is going to prevail in this case because the implied warranty of title has been breached and there was no appropriate disclaimer on there. Uh, A recipient of stolen property cannot pass on stolen property to somebody else. And the answer be FIC because a merchant cannot disclaim. The implied warranties, uh, is incorrect.

As we've already learned, uh, warrants, uh, warranties can be disclaimed by a merchant. They're just certain ways in certain ones. They, uh, ways that it has to be done in certain ones, uh, cannot be waived. All right. Let's move over to 18 and the large corporation, it manufactured and sold Oak a stove. The sale documents included a disclaimer of warranty for personal injury.

It's an interesting disclaimer, isn't it. The stove was defective. It exploded causing serious injury to OIC spouse. Large was notified one week after the explosion. Under the UCC sales article, which of the following statements concerning Lawrence has liability for personal injury to OIC spouse would be correct.

Large cannot be liable because of a lack of privity large will not be liable because of a failure to give proper notice. Large will be liable because the disclaimer was not in disclaimer of all liability or large will be liable because liability for personal injury cannot be disclaimed. Again, a fairly straightforward question on product liability.

Let's go back and review a couple of facts. Answer a is wrong because we already said that under article two, the privity issue is superseded by the UCC rule that says the purchaser's spouse is certainly covered. So a is incorrect answer. B Lloyd's will not be leveled because of proper notice.

Absolutely not. Large was informed within a week of the injuries. This is not an all unreasonable, uh, answer B is incorrect. Large will be leveled because of the disclaimer was not a disclaimer of all liability. Again, a silly answer because as we've already noted in this program, sellers can disclaim certain liabilities.

You certainly don't have to have a liability for fitness for a particular purpose. You can limit your liability for title. You can disclaim a merchant ability using as his language. So C is a wrong answer. The answer is D largest liable because liability for personal injury. Particularly in a product liability case cannot be disclaimed answer D

19 to establish a cause of action based on strict liability in tort for personal injuries that result from the use of a defective product. One of the elements. The injured party must prove is that the seller was aware of the defect of the product, sold the product to an injury party, failed to exercise due care, or sold the product in a defective condition.

Well, you might've been a little bit misled by some of these answers. Let's take them one at a time. A is clearly wrong because even if the seller knew there was a defect in the product, if they didn't sell it to him, Throng sold the product to the injured party, not necessarily a party, uh, that is a guest is a member of the family.

Uh, can also Sue if injured. So it doesn't have to be just the injured party failed to exercise due care. No, they could exercise due care, but still be liable for the defect. The answer is sold the product in a defective condition answer D. And number 20, the question reads under the sales article of the UCC.

Most good sold by markets are covered by certain warranties. As we've discussed an example of an express warranty would be a warranty of usage of trade. No, that's not a warranty fitness for a particular purpose. Well, that could be a, uh, an express warranty. Usually it's implied, uh, merchant ability. Again, that's an implied warranty, but an express warranty is clearly conformity of goods to a sample.

So although BNC could be made express warranties is the one that they're looking for here is conformity of goods to a sample. I think this is one of the harder REG CPA Exam questions, but clearly you can't imply conformity of goods to a sample. So D should be the answer that you selected. In question 21, which of the following factors have resulted in an express warranty with respect to sale of goods, option one, the seller's description of the goods as part of the basis of a bargain to the seller selects goods, knowing the buyer's intended use.

Well, an express warranty with respect to a sale of goods. The answer is going to be answer a one only, uh, just because the seller selects goods doing the buyer's intended use has nothing to do with an express warranty. With respect to the sale of the goods. Answer a is the only one that meets that requirement.

In question 22, we were asked about the warranty of title under the sales article. Does a, does it provide the seller cannot disclaim the warranty. If the sale is made to a bonafide purchaser for value? No, it does not provide that. Does it provide it, the seller deliver the goods free from any lien to which the buyer lacked knowledge when the contract was made?

Yes. That is the correct answer. Goods free from a lien of which the buyer lack knowledge does a sales article, warranty of title apply only if it's in writing. Absolutely not. Does it apply only if the seller is a merchant? Absolutely not. So the warranty of title applies when the seller that the seller deliver the goods free from any lanes of which it has now.

Yeah. Number 23, which of the following conditions must be met for an implied warranty of fitness for a particular purpose to arise in connection with a sale of goods, the warranty must be in writing. The seller must know that the buyer was relying on the seller in selecting the goods. Well, we know the number two is correct.

We've talked about this a number of times the seller must know the buyer is relying on the seller's expertise. So two is clearly right now. What about one? No, a warranty may be oral if it is for particular purpose. So one is wrong. Two is right. The only correct answer here is B. Number 24 under the UCC sales article, an action for breach of the implied warranty for merchant ability, by a person who sustained personal injuries may be successful against the seller of the product.

Only when, and in this case, we asked the sellers of merchant of the product sold an action based on negligence can also be maintained. The injured party is in privity with a seller. Or an action based on strict liability can also be successfully maintained. Let's address one of the concepts that's embedded to these answers.

You've got negligence and you've got strict liability. An injured party can Sue under either one or both theories and most plaintiff's attorneys will suggest trying to Sue under both theories, therefore answers B and D should be knocked out immediately. No one does not depend upon the other. So B and C or B and D are clearly wrong.

Let's look at C the injured party is in privity with a seller. This is not a requirement. C is incorrect. The only correct answer to problem. Number 24 is a, the seller is a merchant of the product involved. Finally, question number 25. Hi sues the manufacturer wholesaler and retailer for bodily injuries caused by a power saw he purchased, which of the following statements is correct under the strict liability theory.

Now, remember, we're not going to negligence. We're strict theory here. A contributory negligence will always be a bar to recovery. The answer here is no contributory negligence may mitigate the damages. You most States today have a. Theory of comparative negligence where you compare the fault of both parties.

So contributory negligence is not automatically a bar to recovery. A is wrong. B the manufacturer will avoid liability. If it could show that it followed the custom of the industry. Well, Customary activities do not get you out of liability under strict liability theory. If the product is defective, strict liability will apply no matter what the customer, the industry is.

After all every manufacturer can be wrong. B is incorrect. How about C privily will? Bart will be a bar to recovery in so far as the wholesaler is concerned. If the wholesaler did not have a reasonable opportunity to inspect. No privity is not a problem here under strict liability. You can go back to the entire chain.

The only way the wholesaler might have gotten out of any liability is if the wholesaler or if the retailer, excuse me, had changed. The, the chain saw the power saw after left the wholesaler's hands before it reached the ultimate consumer. That's not in the facts. See, as an incorrect answer answer, D is the correct one.

Hi may recover. Even if he can not show any natal Indians. Why? Because under strict liability negligence does not have to be proved. The strict liability theory will give high every car recovery here.

Let's shift our discussion a bit to title and risk of loss. Earlier in the program, we talked about forming contracts under article two, we've talked about warranties and liability issues. Now we're going to talk about title and risk of loss. Contracts requiring transportation. Let's say that we're not walking into a retail store, buying something over the counter, but we are purchasing from a manufacturer who must ship us merchandise.

Now remember earlier in the program, I said that if the contract does not provide a point of delivery, it's the sellers place. But what happens if we do have shipped the terms. The title and the risk of loss pass. When the goods are delivered to the carrier, the shipping point in a shipping contract, in a destination contract, the title and risk of loss passed when they reach the destination.

If the contract is unclear, the courts construe it as a shipping contract. What's the difference between these two? Well, You remember from some of your earlier work in accounting, you ran across terms like fob free on board shipping, free onboard destination. That's what we're talking about. Who has the title?

Who has the risk of loss during the shipment process? Reiterate one more time. Shipping contract, shipping, document, title, and risk of loss remain. Uh, Uh, past the buyer, rather in a shipping contract at the point, the seller delivers them to the carrier in a destination contract, title and risk of loss remain with a shipper until they reach that desk a nation.

Now. Documents of title include things like bills of lading, dock warrants, warehouse, receipts, and here the title and the risk of loss pass when the buyer receives those documents. Because at that point they have the right to pick up the merchandise from the dock, go to the warehouse and pull it out of the warehouse.

I've got one client who orders merchandise from India. When does she get titled to this? Will all of the documents say their fob when they arrive at the dock in the warehouse here in the United States. So she gets a warehouse, receipt goes down and then has them transported from the warehouse to her selling facility.

She's got title then. Title with the seller. The manufacturer remains with him from the time they leave India until they get onto the dock and are in the warehouse where a warehouse receipt is made up goods held by a seller. There's no transportation or document of title, title passes. When the contract is made and the seller completes his performance.

For instance, when the buyer receives the goods over the counter, where they're tendered. What happens if the merchandise doesn't fit the specifications, it's commonly called non-performing goods. The risk of loss is on the seller title passes when the buyer receives the proper goods. So if you ship the wrong thing that stays with the seller, here's our.

I don't want to call them pneumonics because they're not ways to remove member things. They're just some terms that you are going to see thrown out in PR in the problems and the discussion REG CPA Exam questions on the exam. So let's review free on board fob. The seller has the expense and the risk of loss in getting the goods to the fob point, the shipping point or the destination point shipping contract, destination contract.

FAS you see this much less often free alongside title and the risk of loss pass. Once the goods are delivered to the carrier, it's basically fob shipping. It tends to occur when you are dealing with ocean transportation, but both, both terms, uh, will be seen in some of these problems. Cod straightforward cash on delivery ex ship.

Title and the risk of loss passed when the goods are safely unloaded at the destination, it is the same as fob destination. So just bear those in mind, kind of review them from time to time. You also need to bear in mind. C I F costs, freight and insurance. That means title and the risk of loss pass at the shipping point sale on approval.

Title and risk of loss pass when the buyer accepts the goods and here's a classic case, you've probably been solicited through the, uh, through the mails or over the internet. Try this on approval. We'll send you for a 30 day approval if you don't like it returned to us. Well, that's one of the sales on approval contracts, title, and risk of loss.

Pass only when the buyer accepts the goods, either it doesn't return them within the 30 days or pays for them and keeps the goods in contrast sale or return means title and risk of loss. Pass on delivery to the buyer and remain with the buyer until they return them to the seller. So be careful in reading a problem, the difference between sale on approval or sale or return.

Now a buyer can acquire no greater title than that, that the seller had. That's the general rule. The buyer can acquire no greater title than invested in a seller. There are a couple of exceptions. Let's talk about them. Title acquired by fraud. An innocent buyer can take good title. If the title is acquired.

If the title is acquired by fraud. It's only an innocent buyer who has no knowledge or reason to know fraud. If there is an entrusted arrangement, the good faith, purchaser, obtains, good title, consignment points, tense, uh, and good remaining in the seller's possession. After the sale, the seller can resell to a good faith purchaser.

Who receives good title? I don't think you're going to see these very often. You just need to read through the materials, be aware that there are several exceptions to the general rule. A buyer can acquire no greater title than that vested in the seller.

You've had a chance to look at him. We've got seven REG CPA Exam questions to go on this particular segment items, 26 and 27 are based on the following information on May 2nd handy hardware sent Ram industries assigned purchase order that stated. In part quote, ship for may eight delivery, 300 model a X socket sets at the current dealer price terms two 10 net 30 Ram received Andy's purchase order on May 4th on May 5th Ram discovered it at only 280 dash X socket sets and 100 model w Z socket sets in stock.

Ram shipped the model a X and the model w Z sets to handy without any explanation concerning the shipment, the socket sets were received by handy on May 8th. The first question is assuming a contract existed between handy and Ram, which of the following implied warranties would result. Number one, implied warranty of merchantability.

Number two implied warranty of fitness for a particular purpose. Number three implied warranty of title. Let's look at the first one. W merchantability are these goods reasonable? Are they the kind of thing used as a socket set? Is that what you would expect being sold by Ram? Uh, or any other company that's selling these sockets?

That's the answer is yes. One is correct. Number two. Was there any implied warranty of fitness for a particular purpose? Did Ram make any representation based on Handy's request of these socket wrenches to do a specific job? The answer is no. Two is knocked out three. Is there an implied warranty of title?

Certainly Ram is implied that they have. Titled to the socket sets all 300 of them, which they're shipping to, uh, to handy hardware. So three does apply. One is a yes. Two is a no three as a yes. The only correct answer here then is item C. Now let's look at the second question though, which of the following statements concerning the shipment is?

Correct? Ram shipment is the acceptance of Handy's offer. B Ram shipment is a counter offer. See Handy's order must be accepted by Ram in writing before Ram ships socket sets, D Handy's order can only be accepted by Ram shipping could forming goods. Well, first of all, this is a contract between two merchants.

So. Handy send in a purchase order Ram acknowledged it. So they were shipping things. Uh, we don't have to have an acceptance, uh, in writing there's no counter offer. The terms are a little bit different. Admittedly handy asked for 300 of one type ramps and 200 of the first type that were requested and 100 of the others.

So there is some difference, but there's not a counter offer. Handy can ship the non-conforming goods. I mean, if they get the, the a hundred that were not exactly what they asked for, they may decide to keep them. They may like that. They may think they're better. So handy. Doesn't have to, uh, automatically reject.

They can accept the non-conforming goods. B, C and D are incorrect answers. The only correct answer here for number 27 is a Ram's shipment. Wasn't acceptance of Handy's offer number 28 Smith contracted in writing. Remember, we got statute of frauds question potentially here. He used computer. He's going to sell it to Peters for $600.

The contract did not specifically address the time for payment, the place of delivery or Peter's right to inspect the computer. Which of the following statements is correct. Smith is obligated to deliver the computer to Peter's home. That's not correct. Remember what we said early on in this program? If it's not specified, then it's deemed at the seller's place.

So a is an incorrect answer. B Peters is entitled to inspect the computer before paying for it. Yes, the purchaser does have a right to inspection whether or not that is stipulated in the contract. B looks pretty good. Let's see why C and D might not be correct. Peters may not pay for the computer using a personal check-in list.

Smith agrees. Where did we find anything in the contract? All Peters has to do is pay for the computer. If Smith wants a personal check. Well, once a certified check or whatever that's going to have to be in the contract, absent that it simply has to be paid for C is wrong. D Smith is not entitled to payment until 30 days after Peter receives the equipment.

Again, upon delivery Smith is entitled to be paid for the computer unless they agree on other terms, not specified it's payment. When the Peter is delivered, answer D is correct. Lou we're right in our first thinking that B is the correct answer.

In question 29, we were asked about the sales article and unless otherwise agreed to. So we need to think back about the article itself as is, unless otherwise agreed to the seller's obligation to the buyer is to. A deliver the goods to the buyer's place of business B hold conforming goods and give the buyer whatever notification is reasonably necessary to enable the buyer to take delivery.

C deliver all goods called for in the contract to a common carrier D set aside conforming goods for inspection by the buyer before delivery. Well, Let's go back to our early thoughts about forming contract and then our discussion about delivery. This answer is drived really by focusing in on answer B the seller has to have conforming goods and tell the buyer whatever notification is necessary for the buyer to get the goods.

Remember if not specified otherwise in the contract. It's at the seller's place of business. So as our problems that unless otherwise agreed to it's going to be the seller's place he has to give the buyer, notice how to get those goods. B looks like again, like a correct answer under a, does he have to deliver to the buyer's place of business?

No, he is wrong. Does he have to deliver the goods to the common carrier? No. The buyer may want to pick them up at the seller's place of business. Or they can agree on some term type of silly trips where they will be a carrier involved to transport them. But that's not the facts of this situation. See as incorrect does the seller have to set aside conforming goods for inspection by the buyer before delivery not required, absence something else in the contract.

Now it may be that the parties want to contract to this, but it's not required. And it's not part of the. Article two rules unless specified in the contract a is not required. C is not required. D is not required. Only answer B is required under the sales article of the UCC. Now let's raise another subject slightly off of anything we've talked about before.

Although we talked about the UCC, this question says under the sales article, the UCC. And the United nations convention for the international sale of goods, C I S G absent specific terms in an international sales ship had gone dry one will risk of loss past the seller. Now, before we get into the answer, let me just mention that the U N C I S G is a international compact of which the United States is a party.

Most of Europe is China is Russia is, and it deals with specific terms. That apply in the international shipping arrangement. If the parties don't specify what national law is going to apply, or if there's a conflict in international, in the national laws of the two contracting parties. So that's what the UN convention deals with with that background.

Let's look at the UCC and the CIS G in, in light of this question. When does the risk of loss passed to the buyer? A, when the goods are delivered to the first carrier? For transportation to the buyer. When the goods are tended to the buyer, see at the conclusion of the execution of the contract or D at the time the goods are identified to the contract.

Well, here we're again, talking about risk of loss. Risk of loss happens when the goods are shipped under one of the conditions, the free on board destination free onboard shipping point FAS. Whatever the those arrangements are. That's what we're going to have the risk of loss passing. So here, absent something else.

When the goods are delivered to the first carrier they're out of the shippers plant, that is the point at which the risk of loss will pass. So the answer is correct when they're tended to the buyer. Incorrect answer conclusion of the contract after all payments are made incorrect answer identified to the contract, even, even though identified in sitting in the shipper's warehouse.

No, there's still a with the shipper. It is only when the delivered to the first carrier for transmission answer a is the correct answer. 31 sales article of the UCC, which of the following factors. Is most important in determining who bears the risk of loss in a sale of goods contract, the method of shipping the goods?

Well, does it make any difference in your mind whether it's on a rail car, on an ocean liner or on a big flatbed truck? The answer a no, the contracts shipping terms since risk of loss talks about when the party talk parts with dominion and control over it. I E the shipper's dock, the loading dock of the recipient.

That seems to be the correct answer. B looks pretty good here titled of the goods. Again, this is not true. Title may not change between a buyer and a seller at the same time, the risk of loss shifts here. We're talking about the risk of loss. So the title and risk of loss can be several and see as an incorrect answer and how the goods are lost.

Of course not whether they fall in the ocean or are destroyed in an animal, in a truck crash, it doesn't make any difference. Risk of loss is bound by the contracts, shipping terms. Number 32, an interesting question here. Bond purchased a painting from wall who is not in the business of selling art. So he's not a merchant will tend to delivery of the painting after receiving payment in full for bond.

Bond informed wool that he would be unable to take possession of the painting until later that day. So bond leaves, it's going to come back later the day and pick it up. But wool has already tended to him in the interim before bond is able to return thieves, stole the painting. Who do you think bears the risk of loss?

Did it pass to bond and Will's tender? Did it pass to bond at the time the contract was formed at payment was made, even though the painting was not handed over, did the risk of loss remained with wool because the parties agreed on a later time of delivery or did it remain with wool because bond had not yet received the painting.

Well, as you're analyzing this problem, you can clearly knock out answer D because we know that the painting has already been handed over. It doesn't make any difference about the contract when it was made or when the payment was made, because we're talking about risk of loss on the delivery of the painting.

So you should be coming down to a and C and now you have a question in your mind. It probably passed to bond when we'll give him the painting, but because it remained with wall, did that leave the risk of loss with wool? And the answer to that is no, just be once the tender, the handing over of the painting past title, past risk of loss passed by bond bears, the risk of loss, even though it is sitting in wool shop, uh, and they agreed that he would come by and pick it up at a later time.

So the answer here is yes. Hey, this is a harder problem. You should've been puzzling between a and C. The correct answer is a. That takes us through the first 32 REG CPA Exam questions of sales.

Was there, you talked about many of the components of article two. We still have to focus on the buyers and the sellers rights and remedies. Let's take the situation where there are non-conforming goods. The. Byron solar have reached a contract. Everything is proceeding a pace, but what happens is when the buyer opens the packages opens the goods that he's expecting, they are nonconforming.

They are not exactly what he asked for. Well, the buyer has three choices now. He could accept the goods that were shipped. Uh, they may be the newest model. They've the, for some reason he may want to sell those instead of the ones originally ordered. So he has the option of accepting those. The buyer can also reject the goods saying just as they are, these are not what I ordered.

These are not in conformity. I'm sending them back or. If he's already accepted the goods and subsequently finds that there may be some problems with it. He can revoke the acceptance of the goods. Now. If any of these things happen, the seller has a right to cure the defect in effect, the seller can deliver conforming goods within the original timeframe of the contract.

That's one thing he can do. And if that happens, the buyer must accept these conforming goods, which have been shipped in accordance with the terms of the contract. Let me, let me give you an example of this. I had mentioned, yeah. When we were talking about shipping, uh, some merchandise that I had shipped to my garage.

Well, I had ordered a shed that was going to be a garden shed to be built in the back of the house. It was a cat that was going to be assembled when it arrived at the house, the common carrier, the truck that brought, it said that the pallet had been dropped. Uh, but they had put everything together. Uh, and we're just delivering it.

It wasn't bundled up the way it had been put together at the, uh, sellers business. Well, I began to look through this pile of kit that had been dropped in my garage and discovered that they were parked to two different sheds. They hadn't dropped one pallet. They had dropped two pallets of different sheds, one for me and one for somebody else, and then attempting to put them together.

They'd mixed them up. So what was my approach? The common carrier. Wasn't going to take them back. He said, I, all I was told to do is drop them off at your house. I said, fine. I'm rejecting them. But you can leave me here in the garage until I contact the seller, I then explained to them what had happened.

And they said, what do you want to do? I said, well, I'm certainly not going to accept half of two separate kits. Uh, I said, okay, here's what we'll do. We will ship you a new shed, the one you ordered, uh, and then the carrier will pick up the pieces of the ones. That they had left with you. I said, that's fine.

That will be acceptable. Even though it's outside of the timeframe of the contract, I will accept that, but here's what I want. I want, I want something over and above, right? Just the new kit. So I said, for instance, there are glass windows in this. There are shades that, uh, we're options with it. I want you to provide me an additional two sets of.

Glenn, uh, glass windows in case I don't get broken in the construction and I want the shades to go over with the, uh, there were options before and now I want them to part of the deal. And that's how we cured the non-conforming goods that I received, uh, in the initial shipment. So the buyers remedies, except the goods that were delivered, reject the goods, revoke acceptance of the goods.

The seller has a right to cure. Now let's look at what happens on a breach by the seller. The buyer has a right to cover. In other words, the seller says, I can't send you what I told you. I would do. They have breached their side of the deal. Now the buyer has the right to purchase the substitute goods from elsewhere.

That's called the right to cover. They may, for instance, the buyer may be on a very tight timeframe and need this part to complete work they're doing so they have that option. The buyer may collect damages from the seller for their inability to fulfill the contract or in the case of. Certain assets, the buyer may have the ability to assert specific performance.

In other words, require them seller to do what they said they weren't currently able to do. And that may mean the seller has to, to contract with somebody else as a substitute, but this specific performance only applies in the case of you unique goods. This is the only person who manufacturers it, or they've been building a special piece of equipment for us.

Or if the goods are not unique, but the buyer has been unable to find it elsewhere in their search to, to cover the shortfall. So in that particular case, the buyer may assert specific performance and require the seller to make good on the deal either by finding a way to make it themselves or to contract with someone else to provide it.

Another item that we need to discuss briefly under sellers and buyers rights and remedies is something called adequate assurance of performance. And I suppose buyer and seller have a contract, but I'm going to use the instance here. Now the buyer learns that the. Uh, the sellers industry is having some financial problems.

They may credit may be tight or something else, and they want assurances that, that seller is going to be able to fulfill their contract. Then this. Particular technique, uh, comes into play where you demand assurance of performance from the other party. And this is a right that either party, uh, has to receive assurance from the other party.

If the buyer becomes insolvent, turning my scenario around the seller has a right to demand a cash payment immediately before they even decide to ship the goods, they may have said, we'll do a. We'll provide the goods to ship, but terms now, uh, two, 10 net 30, a common provision. And then they say, gee, we here, this particular retail company is having cashflow issues.

I demand cash upon delivery of the goods perfectly, uh, within their rights to assure performance of the contract. In this rights and remedies provision, we also need to focus on something called identified goods. The buyer, as I said, acquires an insurable interest in the goods. Once they're identified, the buyer can recover the goods from an insolvent seller.

So now you've got goods that have been identified in the hands of the seller, but they haven't been shipped yet. The seller becomes insolvent and the buyer can recover those goods once they've been identified and keep them away from the sellers creditors. So all of these rights and remedies, uh, are part of this whole discussion, coupled with it, uh, statute of limitations, generally there's only a four year statute of limitations on these rights and remedies.

Uh, the parties can through their contracts. Modify that statute of limitations to a period of more than one year, they can reduce it from four down to one, but they can't go below one year and they can't extend it beyond four years. So you're looking at a general rule of four years can be shortened to one.

Can't be lengthened beyond for that statute of limitations for seeking the remedies. Runs from the date. The contract was breached, not from the date. The contract was executed, not from any other point, but the point in time at which either the buyer or the seller identified that the contract had been breached through non-performing goods, through insolvency, whatever those are the major wrap-up points on rights and remedies under article two.

Of the uniform commercial code. If we could take a couple of moments, now we have a few more problems to go through, and I think these will illustrate the rights and remedies. So please look at REG CPA Exam questions. 33 through 50, we'll go through those with the answers and then do a brief wrap-up of this material.

All right. You becoming experts in sales now. So let's turn to the Jefferson hardware company and problem. Number 33, Jefferson hardware orders, 300 Ram hammers from Ajax. Hard from Ajax hardware. Ajax accepts the order in writing. On the final date allowed for delivery. Ajax discovered it did not have enough Ram hammers to fill the order.

Instead ran instead, Ajax send 300 strong hammers Ajax stated on the invoice that the shipment was sent only as an accommodation. In other words, they were trying to meet the request, but they didn't have the Ram hammers. They only had strong hammers. So the question now becomes which of the following statements is correct.

And remember we're talking about rights and remedies, Ajax, note of accommodation cancels the contract between Jefferson and Ajax B Jefferson's order can only be accepted by Ajax is shipment of the goods. Ordered Ajax is shipment of strong hammers is a breach of contract or Ajax. Shipment of strong hammers is a counteroffer and no contract exists between Jefferson and Ajax.

All right. Taking these intern Ajax note of accommodation cancels the contract. No, they still play. They did not cancel the contract. All they said is we're shipping you material for you to make a decision on we're trying to accommodate your order. So a as an incorrect answer, B Jefferson's order can only be accepted by Ajax.

The shipment of the goods ordered. Absolutely not true. Even though Ajax ordered Ram hammers. They can accept the strong hammers. They may feel like this is a better product. They need to have hammers on hand for some particular reason. So they have the option of accepting these. And as a consequence, answer B is incorrect.

Ajax is shipment of strong hammers is a breach of contract. Well, yes it is. Ajax ordered Ram hammers. Ajax did not receive Ram hammers. There is a breach of contract. Now, the remedies that are going to fall out of this is an issue that we're not addressing in this question, but it is definitely a breach of contract.

And finally, Ajax is hammers is a offer and no contract exists between Jefferson and Ajax. Clearly incorrect. If you go back to the very beginning of this program, we talked about differences. Have to be worked out. We're trying under article two to get commercially acceptable transactions done. We're not dealing with a counter offer here.

There was a contract, there was a contract that was breached. So answer D is incorrect. If we turn it over to problem. Number 34 under the UCC sales article, a plaintiff who proves fraud in the formation of a contract. May EI elect to rescind the contract and need not return the consideration received from the other party B, be entitled to rescind the contract and Sue for damages resulting from fraud, C be entitled to punitive damages provided physical injuries, resulted from the fraud D rescind the contract, even if there was no reliance on the fraudulent statement.

This one may look like it's a little bit of on the hard side and you're practicing law, but really the answer is straightforward. The correct answer is B the plaintiff is entitled to rescind the contract. There was fraud and Sue for damages resulting from that fraud, straightforward answer. You've got a fraudulent transaction.

You rescind the contract, you Sue for fraud in terms of the other alternatives, electing to rescind the contract, not return the consideration. Well, that's not going to probably be sufficient here. We may not even had consideration on the formation of the contract. So let's rule out a punitive damages.

Generally not provided in contract actions, physical injuries, resulting from the fraud. Probably extraordinarily rare. This just this answer doesn't seem to make sense with respect to the question in the subject matter D rescind the contract, even though there was no reliance on the fraudulent statement.

No, this was fraud in the absolute creation of the contract. Uh, we don't have to go to the reliance question. Uh, it was fraud in the inducement and as a consequence, answer B is the only correct answer for problem 34. In 35 under the sales article, which of the following rights he is or are available to the buyer.

When a seller commits an anticipatory breach of contract anticipatory, now they haven't shipped the wrong goods. They are anticipating a breach of contract. Can they demand assurance of performance? Can they cancel the contract? Can they collect punitive damages? Well, before we pick ABC or D let's look at the three options, can they demand assurance of performance?

Yes. In this particular case, the seller is auntie committed, an anticipatory breach of contract. The buyer could say, I demand that you assure performance of this contract. That is one of the rights that the buyer would have. So we're looking for a yes. Answer on the first part. Can the buyer canceled the contract.

If there's an anticipatory breach by the seller again, the answer is yes, they can cancel the contract. They can rescind it. Actually they'll cancel it, not rescind it, but, uh, so we're looking for a yes. Answer for that column. And how about collect punitive damages? No, you do not have punitive damages in contract actions.

Uh, so we're looking for a no answer there. Clearly the only one that meets a yes, yes, no. Is the B answer

under the sales act of the UCC, which of the following statements regarding liquidated damages is or are correct? The injured party may collect any. Any amount of liquidated damages provided for in the contract. Now, remember liquidated damages are stipulated damages that the parties have set in the contract.

If there's a breach, the liquidated damages may be up to X amount. The seller may, or the second statement we have is the seller may retain a deposit of up to $500 when a buyer defaults, even if there is no liquidated damages provision in the contract. The answer. The analysis is the first statement is you may only collect liquidated damages up to the amount of your damages.

So the wording in here that they, that they may collect any amount of damages is incorrect. We do not want number one. And article two of the UCC says that a seller may retain a deposit of up to $500 on a buyer default. Whether or not, there's a liquidated damages provision in the contract. So we do want number two, the only one that eliminates one and provides for two is answer B Bravo, turning to the Cara fabricating company and tastes of Corp it problem.

Number 37, these two companies agreed orally that Taissa would custom manufacture a compressor for Kara. At the price of $120,000 after Tasso completed its work at a cost of $90,000. Kara notified Tesla that the compressor was no longer needed. Tesla is holding the compressor and has requested payment from Kara Teso has been unable to resell the compressor for any price while holding the compressor, Tasso encouraged storage fees of $2,000.

Now if Cara refuses to pay Tasso and TASA sues, the most TASA will be entitled to recover is 90,000, which is their cost of manufacturing 92,000, which is the cost of manufacturing plus storage. C 120,000, which was the sales price or D the sales price, plus the storage cost. And the answer here is because it was specially manufactured and Tasso is unable to sell this.

They're entitled to recover the cost of the sale that they lost. Plus the storage cost. In other words, $122,000 answer D.

Continuing on with problem 38 under the sales article of the UCC, the remedies available to a seller. When a buyer breaches a contract for the sale of goods, they include the right to resell the contracts. I'm sorry, the right to resell goods identified to the contract or the right to stop a carrier from delivering the goods.

Now, this is a remedy available to a seller. The buyer has breached the contract and the seller has the right to resell the goods identified in the contract. And that seller also has a right to stop a carrier. Who's delivering the goods that have not yet reached the buyer's place of business. So we want yes.

Answers to both column a and column B, which of course gives us answer a.

Now problem 39 says under the sales article, which of the following rights is available to a seller when a buyer materially breaches a contract. So now that's a right available to the seller buyer. Breaching the contract again, may the seller cancel the contract? Yes, they may. May the seller recover damages.

Of course they've lost their contract. If they're able to sell the merchandise, they may not have any damages, but they do have the right to Sue for any damages they've incurred. We need to yes. Answers. And just like in the last problem, we have answer a being correct problem. 40 is a long one. So let's take a look at the facts.

Eagle corporation solicited bids for various parts that used in the manufacturer of jet engines. Eagle received six offers and selected sky Corp to provide the parts. The written contract specified a price for 100,000 units delivery on June one at sky's plant with payment. 30 days later on July one on June 1st sky had completed a 200,000 unit run of the parts similar to those under the contract for Eagle.

But also for other customers, sky has not identified the parts to specific contracts. When Eagles truck arrived to pick up the parts on June 1st sky refused to deliver claiming the contract price was too low. Eagle was unable to cover in a reasonable period of time. Its production lines were in danger of shut down because of the parts were delivered.

Here's your classic case of just in time delivery and what might unfold, what are the options here? Eagle would a have, as it's only remedy the right of replevin, R E P L E V I N. Now I'm going to tell you that what replevin means is to take the goods that have been identified.

Okay. Are these goods been identified? No. Our fact pattern said that we had 200,000 units. But the supplier sky had not yet identified them to Eagle. So they do not have the right of replevin B. Do they have the right of replevin only if Eagles tended to purchase price on June 1st again, no, they have not been identified.

The right of replevin has not arisen answer. B is incorrect answers. See, does Eagle have, is his only remedy the right to recover dollar damages? Well, they certainly have the right to Sue for dollar damages, but I think the correct answer is D because the way the facts have been set up, these just-in-time parts have endangered Eagles line.

This is the only place they can get them. They need them by July. By June 1st. Uh, so they would have a right to Sue sky to get their hundred thousand units out of this 200,000 production run. So they have the right to specific performance item D.

Question 41 under the sales article of the UCC. Which two of the following statements are correct regarding a seller's obligation under an fob destination contract. Now notice in contrast to every other problem we've been through thus far, this is asking you to select, to stay bits, which are correct. A, the seller is required to arrange for the buyer to pick up the conforming goods at a specified destination.

B the seller is required to tender delivery of the conforming goods at a specified designation C title passes on tender at destination D. The seller is required to attend to delivery of conforming goods at the buyer's place of business. E. The seller is required to tend to delivery of conforming goods, to a carrier who delivers them to a designation specified by the buyer.

Let's get a couple of things straight right here. This is an fob destination contract. All it doesn't say to the buyer's place of business, which may be a bit of a misleading. Answer here. The two things that are absolutely clear is under an fob destination contract. The seller is required to tend to delivery of conforming goods.

At the specified designation. Doesn't have to be the buyer's place of business and C title passes at that destination. When the goods are tendered B and C are the correct answers here. It's not putting it on the common carrier is not getting them to the buyer's place of business because the contract said F O B destination.

That's what governs B and C are correct. In problem 42 row corporation purchase goods from stair. There were shipped Cod. Remember that's cash on delivery under the sales article of the UCC, which of the following rights does Rowe have? Do they have the right to inspect the goods before paying? No. They have the obligation to pay upon receiving.

Do they have the right to possession of the goods before paying? Not if it's cash on delivery, be as incorrect. D says the right to delay payment for a reasonable period of time. No, that's all it cash on delivery says it says cash when delivered. So the only possible correct answer here is the right to reject non-conforming goods.

You must pay for them. Then you have the right to inspect them. And if they're non-conforming, you have the right to reject them and put them back to the seller. A B and D are incorrect because they are inconsistent with the terms C O D only answer C is correct tear. Now are problems three and 44 are based on the scenario on may two lace corporation and appliance wholesaler offered to sell appliances where $3,000 to Parco a wholesale appliance retailer.

So we've got two merchants dealing with each other. The offer was signed by laces president and provided it would not be withdrawn before June 1st and also include included the shipping terms. FLB parkers were house. So we're talking about a delivery contract here. Destination contract. Okay. On may 29, Parco mailed an acceptance of laces offer lace received the acceptance on June two.

Okay. So may may to lace makes the offer it's accepted, uh, on a mail in basis on the 29th, which lace received on June 1st, which of the following statements is correct. If lacent, Parco a telegram revoking its offer and Parkhill received the telegram on May 25th. So this is before Parco scent. Their acceptance notice, which of the following statements is correct?

A contract was formed on May 2nd laces revocation effectively terminated its office offer of May 25th. See Lacey's revocation was ineffective because the officer could not, the offer could not be revoked before June 1st. D no contract was formed because lace received Parker's acceptance after June 1st.

Well, first was the con a contract was formed on may. Second is incorrect. We have an offer, but wheedled have any acceptance from the merchant. Uh, Parco on this. They wait until the 29th to accept the contract. And there is no meeting of the buy-ins don't contract was formed. Uh, On May 2nd, a is incorrect laces revocation effectively terminated its offer.

Well, that would have been nice, but for the comment that the laces president agreed to, that it would not be withdrawn or revoked before June 1st. So B is wrong. C is correct. Lisa's revocation is ineffective. The offer could not be revoked before June 1st, if they'd wanted that. Right. They would have had to put it in the contract.

Since they said it would be open until June 1st. And remember that was not a period of more than three months. No considerations required on it. Nothing is required here. It remains open until June 1st. And did Parco agree to it before then? Yes. They mailed the letter, even though that letter was not received until after June 1st under the mailbox rule of article two, the contractor Rose and was valid on June 1st.

Parco wins. Lace loses answer C, correct? Yeah. Looking at problem 44. We have to remember that this is a destination contract. We laid out the facts for this. We talked about that lace was to ship the goods, fob, destination. That's when Parco would receive them. So the answer a here. Past Parco when the goods were identified, does not apply being a destination contract.

The title to the goods will occur at the destination point. Answer a is wrong answer. Be passed to Parker when the goods are shipped. No, that might be true of a fob shipping point, but not a destination point. Answer B is wrong. The third answer, the title remains with Parkville until the goods are returned to lace.

Once the goods have arrived at Parkrose facility, title passes under the shipping documents. Now, if Parco rejects them and returns them, then the title will revert to lace when they get back, when they are back in laces hands. But initially title will pass the Parco when the goods arrive. So answer C is wrong.

Answer D is correct. Titled goes from lace to Parco. Then upon rejection will revert to lace. There will be two changes of title in this particular case problem, 44 answer D.

In problem 45, we are told that on September 10th bell corporation, and it didn't have a contract to purchase 50 lamps from glow manufacturing. Belpre paid 40% of the purchase price. Global became insolvent on September 19th, before segregating in its inventory, the lamps to be delivered to bell. So glow has not yet identified the lamps that are being sold to bell.

Bell will not be able to recover the lamps, even though they've paid 40% on them because a bell is regarded as a merchant B the lamps were not identified to the contract C. Glow became insolvent fewer than 10 days after receipt of Bell's Bri payment or D bill did not pay the full purchase price at the time of the purchase.

Well, whether bell is a merchant or not is irrelevant, answer a is wrong. The article two is going to apply to both Burchetts in non-merchant here. The lamps were not identified to the contract is a problem. So bill will not be able to recover. You have to have that identification to the contract for bell to be able to pull these out of the bankruptcy proceeding.

Answer B is the correct answer. Answer C is wrong for this reason. It says global became insolvent fewer than 10 days after receipt of Bell's prepayment. There is nothing about time payment in here at all. The priority goes to the identification under the contract. C is wrong. And whether Belle paid 40% or a hundred percent of the purchase price again, is irrelevant.

If the lamps had not been identified to the contract, and this is clearly one of the issues in dealing with. Buyers of your product or sellers, where there are insolvency issues. Uh, that's why you see so much of the cash on demand or, uh, immediate identification, because you want to make sure that you are not thrown into the general creditor pool under bankruptcy here.

Bell had to be able to identify the lamps as having been segregated. Pursuant to their contract. Answer B is the only right answer to this problem. And problem 46, we are asked which of the following statements applies to a sale on approval. Remember I told you during the program to watch carefully for the terms that are used here is a sale on approval under the UCC article two, which is the statement is true.

Hey, both the buyer and seller must be merchants B the buyer must be purchasing the goods for resale. See the risk of loss for the goods passes to the buyer. When the goods are accepted after the trial period or D titled to the good passes to the buyer on delivery of the goods, to the buyer, your common sense.

Knowing that you've probably seen offers for purchasing on approval. Should you lead you straight to the correct answer here, which is item C when the goods are shipped on approval, the risk of loss and title stays with a seller until the buyer accepts them after the trial period, that may be by the trial period ending.

Even if they haven't paid for it or sending in the payment short of the trial period, saying that they are taking the goods titled does not pass to the buyer on delivery of goods. And to D is incorrect. Whether the buyer purchased the goods for resale or for personal use is irrelevant and to be as wrong and the buyer or the seller do not.

Both of them do not have to be merchants. Generally one is, and often one is not answer a is incorrect. Problem 46, answer C the only correct answer again, and problem 47. We need to analyze two statements under the sales article of the UCC, which of the following circumstances will relieve a buyer from the obligations, from the obligation of accepting the tender or delivery of goods.

Statement one, if the goods do not meet the buyer's needs at the time of tender or delivery statement, the two. If the goods at the time of tender delivery did not exactly conform to the requirements of the contract. If you read the two statements carefully, this answer should be a cakewalk for you, whether or not the goods meet the buyer's needs is irrelevant.

It doesn't make any difference. My needs may have changed. The only one that's important is if I have a contract and the goods do not conform to the requirements, then I can reject. The delivery, but if I don't want them any longer, I can't reject it. I'm bound by the contract. One is wrong. Two is right.

The correct answer is the second one. Be answered statement. Number two only.

Problem 48 under the sales article, the UCC, which of the following events will release the buyer from its obligations under a sales contract. We'll release. Now a destruction of the goods after risk of loss has passed to the buyer. B impracticality of delivery under the terms of the contract. See anticipatory repudiation by the buyer that is retracted before the seller cancels the contract or D refusal of the seller to give written assurance of performance when reasonably demanded by the buyer.

Now, remember this question is asking you, which will release the buyer from its obligations. The answer here is the last one. A buyer will be released if he asked the seller to assure performance and the seller refuses answer D is the correct answer just because the goods are destroyed after the buyer has the risk of loss.

He can't get out of the contract is clearly wrong. The buyer cannot get out because of the impracticability of delivery under the terms of the contract. And alternatives have, is going to have to be found, but it doesn't release the buyer from its obligations under the contract and an anticipatory repudiation that's retracted.

Well, of course, that's not going to release him from the sales contract because he's repudiated and then retracted it. So, as I mentioned at the outset, only answer D the request for assurance that is not given is the only reason that the buyer may be released from its obligation. D David coming down to the kilo's here.

We're on problem. Number 49 under the UCC sales article, if a buyer wrongfully rejects goods, the grieve seller may, may he resell the goods and Sue for damages? Absolutely. The answer to that is yes, they can sell the goods, Sue for damages for the amount that they have lost on the sales transaction. Can he cancel the agreement again?

If the buyer wrongfully rejects the goods, the seller can reject, cancel the agreement a yes for the first call a yes for the second and the column I answer a correctly finishes off problem 49. Our last problem on February 15th, Missouri Corp contracts to sell a thousand bushels of wheat to good bread at $6 per bushel delivery to be made on June 23rd.

On June 1st good advise Missouri that it would not accept or pay for the wheat. They're rejecting it. Now on June 2nd, Missouri sold the wheat to another customer at the market price of $5. A bushel Missouri has advised good that it attended to resell the wheat, which of the following is correct.

Missouri can successfully Sue good for the difference between the resale price and the contract price. That's answer a Missouri can resell the wheat only after June 23rd. Answer C good came to retract its anticipatory breach at any time before June 23rd or D good conceptually Seumas or for specific performance.

Well, the answer here is if Missouri, uh, has the opportunity to resell the goods, they need to make that good faith effort. And as a consequence, a is the right answer. They've been told that, uh, they're not, the good is not going to buy it. Missouri sells it for a lower price and they can Sue for damages just for the difference between the contract price and the amount that they were able to resell it for.

Can they resell it only after June 23rd? No, they've been told, uh, that it's not going to be, uh, purchased by good. They have got the opportunity for another deal and they can go ahead and consummate that deal. Good can retract it's anticipatory breach. Well, they can try, but not if Missouri has already, uh, solely merchandise.

So C is a bad answer here and good can successfully assume Missouri for specific performance. That makes absolutely no sense because good. Was the purchaser here. Why would they sell Missouri to sell it to them? When they've already told them they don't want it. So D should fall out, immediately answer a problem.

50, the only correct answer we have now worked through any number of problems on sales.

If you were to think back to the very beginning of this program, we talked about article two, the uniform. Commercial code how it's going to appear in the CPA exam? Well, I can't tell you which problems or which answers are the right ones for the CPA Exam that you'll be taking, but let's talk about a couple of points on sales first.

Remember that the underlying principles or the overarching theme of the article is to make commercial transactions work. We're trying to make it as easy as possible for business to go on without. Too much controversy without litigation. As a consequence, article two varies from your traditional concepts of contract law.

We're talking here about the sale of goods, identifiable, separate, tangible, personal property. It does not apply to real property. It doesn't apply to intangibles. We're generally talking about merchants, dealing with goods that you and I would buy every day. From a retailer, we're talking about manufacturers selling to wholesalers and wholesalers, selling to retailers.

As a consequence, there can be differences in the terms, the offer and the acceptance. If they're minor, then there'll be worked out by the parties. If there's a real conflict, then the courts generally use what they call a knockout rule and settle on default provisions. Does everything have to be in the contract?

No, we can talk about no place of delivery. Well, in that case, it's the seller's place. We can talk about reasonable dates of delivery. Uh, so you need to approach these problems with a certain flexibility, but assume that there is a contract most often, uh, consummated here, we talked about. Warranties and rights and remedies in here.

We talked about express warranties and implied warranties. And yeah, in that discussion, we focused on warranties of title of merchantability of fitness for a particular purpose. We talked about strict liability if their injuries and we talked about negligence and you will remember the components of negligence, we have a duty.

A breach of duty harm and causality. In our third segment, we talked about shipping terms and fob and FAS and destination, uh, contracts and, uh, shipping contracts review the terms and make sure you understand where title passes and where risk of loss may pass. We've talked about. Cash on delivery, Cod transactions, goods, and re and returns and sales on approval.

And finally, we've talked about buyers and sellers rights and remedies, including cure provisions. So if you go back through our four segments and review again, the 50 problems that we use to try and illustrate these principles, you'll do very, very well. When these issues are raised on the exam.

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Welcome to Bisk CPA review hotspot on secured transactions. I'm Jack Norman, and we're going to begin to look at the uniform commercial code and article nine, essentially what we're looking at with a few very limited exceptions. Is transactions. It create a security interest in either personal property or fixtures, even negotiable instruments by contract.

We're not going to be covering and he leans on real property, mechanics, lanes, or vessels and aircraft liens. These are covered under, under special rules, but we're basically looking at any security interest in either goods. Or intangibles, uh, including such things potentially as patents, trademarks, uh, any other type of instrument.

Now here's our rule. A secure transaction is a debt secured by personal property. Notice the word personal property. It may be tangible or intangible, but does not include real property. One of the very important things you're going to have to focus on. In this particular program and on the CPA Exam is something called a purchase money, security, interest, purchase, money, security interest you'll frequently.

See it abbreviated P M S I a PMC, and it also may be referred to it as a purchase money security agreement, P M S a. So as you go through this material and through the exam, Bear in mind that a PMSI purchase money security interest has some very special attributes attached to it. Now that I've told you how important it is, what is it?

It's it arises if collateral any particular good is bought with money loans or credit given. So the PMSI gives that creditor special rights as against any other creditors of the person with the collateral. If we're getting into secure transactions, we need to focus on a couple of terms and you will see these crop up in some of the problems that we're going to be doing.

One term is a floating lien. And what this means is that the creditor has an, a security interest, not only in the collateral that is securing it, but any proceeds that arise, if the holder of that collateral sells it, for instance, Let us assume that I have an automobile that's been financed the auto dealer, and I'm just going to assume for the moment Ford credit Ford motor credit.

Hole's a security interest in my car, which I had not fully paid for yet. And at some point before I've paid off the car, I decided to sell it. Will Ford motor credit. Having a floating lien has an interest in the cash that I receive for selling the car or. In a replacement car. If I swap off that collateral for another car, that's a floating lien.

The second phrase that you need to be focused on is after acquired property interest. And in that particular case, the creditor takes a, a right, not only in the collateral, but in that same collateral, the same type of collateral that's later acquired by the debtor. A frequent example of this would be, let's just say a retail store wishes to purchase inventory.

And so they tell the, uh, their credit company, well, you can't get to my, uh, inventory because the person who's selling that to me has already got a lien on it. But what I will do is I will give you a lien against all of my accounts receivable. And so the. The banks is, are, will advance money to you secured by your accounts receivable, both existing now and all subsequent accounts receivable.

That's an acquired property interest. Uh, my stepson has a business where he buys a lot of equipment and some of the bank loans say it's secured by the equipment on hand. At the time the loan is advanced and subsequent equipment purchased by your company. So that's an after acquired property interest as well, reviewing security, transact, secure transactions.

We also need to bear in mind that there are special types of goods. There are consumer goods, which of course are those items used by you and me. Ultimate individual consumer product goods. There are inventory goods, which are those items in the hands of a retailer or wholesaler. For sale to an ultimate purchaser and there are equipment goods, and that's the machinery, the fixtures that are used in the conduct of the business.

So watch for the difference between consumer goods, inventory goods and equipment goods. As we are proceeding through this material.

how do you create this security interest? Which we said really is the basis for article nine is security interest essentially is any property, right? That allows the creditor to take possession of the property. In the event that the debtor does not pay most people who advance money or low money want to make sure they're being repaid.

So what do they do? They take a security interest in the collateral. Now there are ways to take that security interest. One, you could simply possess the collateral. And for instance, negotiable instruments, documents, titles, stocks, and bonds. You can actually take possession of the collateral itself if you want to hold title to a car because you've loaned money.

As I previously mentioned, you don't go out and hold the car because the person wants to drive it. What do you hold the title to the car? And that's the possession that you have on that. Negotiable instruments could be stocks or bonds. Now you can't actually seize or hold intangible property. What do you do with accounts receivable?

How do you grab hold of accounts receivable? Now you need to have a written security agreement signed by the debtor, and this'll be a chattel paper as they call it. So you can create it by possession or you can create it through a written security agreement. Signed by the debtor. There's a third category.

We haven't seen too much testing on as yet. And that's something called an authenticated signature could be either manual or electronic, and that's designed to facilitate transactions over the internet or III based, uh, transactions. We're not going to focus on that one. Let's stay focused primarily on the written security agreement, but we'll also talk about holding, uh, assets.

Now there are two key elements that are part of this whole secure transaction arrangement. And those two you need to understand and keep very, very distinct in your mind. The first is attachment and attachment is the creditors' rights against the debtor. The second term is perfection. I'll come to that one in a moment, but let's keep in mind.

Attachment first perfection. Second here's what's required to have an attachment. The creditors' rights against the debtor three elements. First, there must be a security agreement between the debtor and the creditor. So there must be a security agreement. The debtor must have rights in the collateral.

They did not necessarily have to have title, but they have to have rights in it. And third, there must be value given by the creditor in effect alone. So security agreement rights in the collateral value given by the creditor. These three items can arise in any particular order, but all three of them have to come together for there to be an attachment.

We're going to illustrate this with a number of problems a little bit later. Perfection in contrast to attachment is the creditors' rights against third parties. So attachment is the creditor with the debtor. Perfection is the creditor against other creditors, and there are a couple of ways to get perfection.

The first is to possess the collateral. As I said before, title to the car, holding a stock or bond that's possession of the collateral that gives you perfection. Second, you can file a financing statement. And these are filed with the often it's the recorder of deeds at the business at I'm sorry, at the state where the business is incorporated or where the individual is.

Resident generally a financial statement is good for five years. It can be renewed, uh, by a subsequent filing at that courthouse. So that's filing a financing statement. The third way to obtain perfection is automatic perfection. And that arises only for a PMSI. Remember that a purchase money, security interest, automatic attachment, or automatic perfection arises only for PMSI in consumer goods.

And it beats all of the creditors if they have any lock on, if they try and collect on that collateral, but it also loses. Two good faith purchasers in certain circumstances, a little later in the program, we're going to talk about the battle of creditors, but for the moment I want you to focus on two points, attachment the rights against the debtor that the creditor has and the three elements that must be met security agreement between the debtor and creditor, the debtors rights in the collateral value given by the creditor.

Second, I want you to focus on perfection. The creditors' rights against third parties. And how do you get it first possess the collateral. Second file. A financing statement or third through automatic perfection for a PMSI. These are key concepts in the area of secure transactions. So I think the best way to illustrate them is for you to turn to REG CPA Exam questions one through 15.

And I'll be back in just a second and we'll go through all the answers for right now, open the book and get to work.

All right. I hope you're finished. And you are now an expert in attachment and perfection. Let's see how you did problem. Number one. Under the secure transactions article, the UCC, which of the following requirement is necessary to have a security interest attach. Remember security, interests, attach. There are three requirements.

The debtor has a right in the collateral. Is that one of the requirements? Yes, it is proper filing of a security agreement. Is that one of the three criteria I gave you for an attachment? No, it is not. How about value given by the creditor? Absolutely. That one was so we were looking for a yes, no, yes.

Clearly the answer is number C. Problem. Number two, on March 1st, green went to easy car sales to buy a car green, spoke to a sales person and agreed to buy a car that easy had an it showroom. On March 5th, green made a $500 down payment and signed a security agreement to secure the payment of the balance of the purchase price.

On March 10, green picked up the car on March 15th, easy filed the security agreement on what date did easy security agreement attach March 1st, which was the date he went to buy the car March 5th. Which is the database, the down payment and sign the security agreement March 10th. When he picked up the car or March 15th, when the security agreement was filed, if you remembered our three rules on attachment, I said they could happen in any order, but clearly it was only on March 10th.

When all three things had come together, there was a security agreement signed. There was an extension of credit by the creditor and. Yeezy's uh, easy cars attachment occurred because Mr. Green picked up the car on the 10th. So answer C is the correct answer to problem. Number two now in problem number three Winslow company, which is in the business of selling furniture borrow $60,000 from pine bank Winslow executed a promissory note for that amount and used all of its accounts receivable as collateral for the loan.

Winslow executed a security agreement to describe the collateral Winslow did not file a financing statement, which of the following transactions best describes the transaction. A perfection of the security interest occurred even though Winslow did not file a financing statement, perfection to the security agreement of the security interest occurred by Pyne having an interest in the accounts receivable.

See attachment of the security interest did not occur because Winslow failed to file a financing statement or D attach with the security interest occurred when the loan was made and Winslow executed the security agreement. Well, this problem number three is big sting. The two concepts I wanted you to keep crystal clear.

It has two answers dealing with perfection and two dealing with attachment. Let's look at answer a. Perfection of the security interest occurred, even though it did not file a financing statement. No perfection can file only in one of three ways by filing the security agreement by possession or by automatic attachment in a PMSI, which we did not have here, answer a is wrong.

Perfection has the security interest perfection of the security interest occurred by having interested accounts receivable? No, it didn't meet one of the three criteria. For perfection answer B is wrong. Attachment occurred because of the security interest attached with a security. It just did not occur because Winslow failed to file a financing statement.

Filing a financing statement has nothing to do with attachment that has the other, the three requirements of the loan, the interest in it, and the security agreement being executed, not filing answer C is wrong. You're left with the only true and correct answer here. Welcome to Bisk CPA review comprehensive CPA Exam review materials for the CPA exam.

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Welcome to government regulation of business. My name is Adam lippy. This program is an overview of the important terms and concepts needed, uh, for the topics of regulation on the uniform CPA examination. It does not. However, replace your review, the comprehensive Bisk materials, particularly the question drills.

What we're going to first start talking about is federal securities regulation later. We'll talk about income protection, workers' safety and rights, and as well as employment discrimination, antitrust property.

But let's go back and talk about federal securities regulation and the wake of the financial meltdown in the late 1920s and early 1930s. Congress enacted federal securities legislation to provide public investors with both disclosure and anti-fraud protections. And this was done obviously because of what happened and wall street, the stock market breakdown, and there was a need, there was a desire to fix.

The problems that were perceived to have occurred in the sale of securities. So as a response, Congress passed the securities act of 1933, the securities act of 1933 broadly provides disclosure and anti-fraud protections. And what does this mean? Well, I want you to think about disclosure as being the magnifying glass, the ability of the investor to adequately, uh, be informed as the risk and rewards of any corporate venture.

What this means is that the investor is going to have the information necessary for them to make a decision, to be fully informed. The other protection of the 1933 securities act is the anti-fraud section or the anti-fraud protections, which is equal to a spotlight. This is the ability of the investor.

And the seller of any security to be forewarned as the rules of the game in the sale and purchase of any security and prohibiting unfair practices, manipulation or deception. So I want you to think about this as disclosure, equaling a magnifying glass, being able to carefully look at the securities and what is being offered and the anti-fraud protections.

Uh, which is the spotlight, which is supposed to be that you're able to shine on what the rules are, the game, so that everyone knows exactly what's supposed to happen when securities are registered. The specific purpose of the securities act of 1933. So deals with the primary offerings or the initial sale.

And it's defined as what is a security, the requirements of registration, and for, for most securities, which has many exceptions and provides for the punishment of violations. We have to look at definitions and when we have to see what is covered and what is the security now, security is generally any items of corporate ownership, stock, or debt, which is bonds.

And can be any note or any instruments such as a certificate and investment contracts in which there is some of the following. So you have to look and see what is the security. And say to yourself, is it an investment which is whether or not there's money involved, whether or not there is a common enterprise, whether or not it involves real business, whether or not it's premised on a reasonable expectation of profits, meaning is there a rate of return and is it to be derived from the managerial efforts of others?

Which means do others do the heavy lifting? So just to go back through this again, what is the security? A security is an investment. It means there's money involved. There's a real business. There's some sort of rate of return, which means that there's going to be something given back to those investors and it's based upon the efforts of others.

So what's important to know, is that unlike a general partnership, a limited, limited partnership, interests is a security. Because limited partners don't have the managerial control, but profit from the works of others, general partners, they all work together. If they all work together, that doesn't fit that definition that we talked about about whether or not it is a common enterprise premised on a reasonable expectation of profits to be derived from the managerial efforts of others.

So again, tricky, and sometimes it comes up on the examination that a limited partner interests. Is a security because they don't involve themselves with the control of the company. They're limited.

The most important part that we talk about in the 1933 securities act is the registration, which is odd. The process. And in order to offer security to the public, it must be pop properly, registered through a registration statement, accompanied by proper advertisement or prospectus send to the sec. The plain purpose is to give the investor, the buyer, all the important information needed about the company and all, and in the offering to make so that there's people that can make an informed decision as to whether or not to purchase the security.

So again, There is in part of the registration process is both the registration statement and then the proper advertisement to the buying public or the prospectus, and both of these have to be done properly. And just to note, the registration process is cumbersome, which requires a lot of detail and review.

What is filed, creates a record that will serve as the basis for liability later. So it has to be done properly. And as a result, a lot of companies feel that this is very difficult. What is involved in registration statement? Look at step one, the registered registration statement must include a description or explanation of first the security and its relation to any other securities, to the corporation's business management and operations.

Three, a corporation's financial statement by an independent order. This is related to its assets and debts of the company. And for other materials, such as pending lawsuits, which are future risks. So, if you look at the registration statement as a whole, the purpose is to describe that security. It is what it's being offered.

And anything else that the company has in the way of securities to adequately describe the company, how it's run, what it does, its operations, and as well as to have that independent review of its financial statements so that when you are investing in the company, you know what it does, but as well as how it's run and what its financial status is.

And the other is about future risks. To know that there's something in the future that may affect the corporation's financial statement. That's the most important part of the registration statement where step one, after the registration statement, we talk about the proper advisement. So that is called the prospectus.

And this is the notice or advisement or the security, which has to have a proper description or explanation of the security. The corporation and the risk reward of the investment. This perspective is what is given to investors. And they should be able to be adequately informed through the advertisement or notice it shouldn't be misleading.

Now once the prospectus and once the registration statement are filed during the next 21 day waiting period, the issuer of this security may make oral statements on the sale and offer, um, And they can offer. What's called a red herring prospectus, which is well written in bold and red that the security has not become registered.

This is an opportunity for the company to while waiting for approval. To be able to talk to customers to talk to investors. Now, there's also an interesting note, which is that the issuer of a security can engage an underwriter who will essentially buy the security and offered for resale to the public.

This removes the burden on the company itself, and the underwriter then takes certain responsibilities as far as it's the notices or the advertisements. To the public, but always when the registration and perspectives are filed during that next 21 day waiting period, that issuer essentially has to wait because they have knock on an official approval.

And that's why you have the red herring prospectus, which again has red warnings. Um, so that anyone that's looking at this knows that it's not fully registered after this. Um, we look at what the registration, um, requires, but the next part is to see what is exempted.

Not everything is required for registration and certain securities and certain transactions are exempt, which is a great benefit again to these companies. And they want to, um, basically minimize the impact on investors. Uh, for these type of offerings and what you're looking at here, if the goal of registration is disclosure, there are either some securities which are so common, so limited, too little or subject to some other regulation that it's just not worthy of the process of registration.

And what did these include? These include short-term paper generally have less than a nine month maturity, and they're just so common or ones for governmental purposes. These are just very limited. Um, so they're not subject to the registration requirements. Insurance products. Again, may fit the definition of a security, but they're regulated by others.

Usually state insurance agencies or administrations. Court controlled or bankruptcy offerings. They're regulated by others as well. So there's no need for the informal registration pro access. And what about interstate offerings? Well, interest state offerings, and you will see this tested deal with, with something that's called a 80% rule.

And again, they're regulated generally by others in the sense that they're regulated by state agencies or other. Uh, agencies other than the securities and exchange commission, but to have the 80% rule, what is required for these intrastate offerings is that 80% of the insurers or the issuers. Sales or assets have to be within that state.

And a hundred percent of the purchasers are also within that state. So this makes this a purely local offering, which then makes it subject to state agencies, which would obviously regulate this as well. And there is something called the blue sky laws. We'll talk about this a little bit more later, but this blue sky laws are, are the state securities regulations, which are generally not preempted, uh, preempted by federal law legislation.

Blue sky laws, which are state regulations, which are generally not preempted by federal legislation. So they will apply to interstate offerings, no sale transactions. Uh, these are exempt from formal registration because they're essentially exchanges they're dividends or splits. So when these offerings occur, um, I guess the underlying theory is that they've already been.

Subject to the registration process. So as such, there's no need for formal registration as well. We also talk about small issues or what's called regulation. A and these are too little. So as a result, they're exempt from registration. And what do I mean by too little? Well, generally their offerings of under $5 million within a 12 month period of time.

Rather than a full prescribed versus prospectus, which has required a circular instead can be offered small issues dealt with under regulation. A there are too little and as such, they're not subject to registration or formal process as well. So what do I mean by too little. Generally, these are ones that are under $5 million within a 12 month period of time.

And they only call for a circular rather than a prospectus, so that the circular obviously doesn't have the same formal requirements of the registration process. And this is again, a benefit to a company which has a very small offering, are small issues, not for profit, such as charities. They don't have to go through formal registration either.

When we talk about no registration or does certain transactions they're exempt from formal registration as well while exempt securities do not require full registration, certain transactions do not require it either though the resale may. These would include what we call small offerings again under rule five Oh four, five Oh five or five Oh six.

And we also talk about resales as well. Small offerings, which are found under regulation D include five Oh four, five Oh five and five Oh six. So you'll, you'll get comfortable. And you hear those numbers often, but what do they actually mean in rule five Oh four? These are offerings which are up to a million dollars within a 12 month period and only limited advertising is, is allowed.

They are different than rule five Oh five and five Oh six in such that rule five Oh five. The limit is up to $5 million in a 12 month period, but there's no advertising. That's allowed same for five Oh six. These are our limited or small offerings. There's no advertising to the general public. So they are going to be exempt for full registration.

Five Oh five requires the additional, uh, element that there's no more than 35 on accredited, not sophisticated investors. And when we talk about unaccredited investors, these are not individuals or corporations that would have a lot of knowledge about securities law. I'm not a lounge about, um, transactions.

Involving the sale of securities and as such, they must be given materials. If there is less than 35 at them, if there's more than 35 of them, obviously it doesn't fulfill the requirement under rule five Oh five under five Oh six. There is no limit as to the dollar amount of the offering. There's no time limit on how much it could be offered and how, when, but again, there's no advertising and again, there's no more than 35 unaccredited.

Uh, investors, every investor should have some knowledge then, uh, about the offering. And if there's any unaccredited as well, up to that 35, they must all be given information about the offering. Now there are no non-exempt or unregistered sales, uh, under a five Oh six offering, which means the sec has got to be notified of the sale.

So when you look at five Oh four, five Oh five and five Oh six, we're talking again about small offerings under regulation D and the purpose behind this is so that when these offerings are made, they are made to a very limited amount of people under a limited time setting. And there's no advertising. I see.

So as such, the general public is not going to be aware of these. And if. There are people that are unaccredited. Again, that's an important definition. They're not sophisticated investors. There's only up to 35 of them and they've got to be given information. When we talk about resales, we're talking about the sale of securities.

Now the average investor is fine. They buy a security, they sell a security. There's not going to be an issue, whether or not there has to be a full registration process when it's not okay. Is when it's an exempt security. So if we're talking about one of those securities that didn't have to go through formal registration process, then when it's offered for resale, obviously the public should know.

What's in that security and because it wasn't registered and there wasn't a prospectus and there wasn't that formal process. The resale must require registration.

Let's talk about violations of the 1933 securities act. And these are because of nondisclosure that's where liability will begin. And that's where liability. We'll force punishment. When we talk about the 1933 securities act that liability for non-disclosure. What we're talking about is misstatements omissions of material fact, and it extends to all persons who prepare the registration or certified any part.

You'll recall that the registration process is cumbersome. And as a result, many seek exemptions either for the security or the transaction, and if they could fall into those categories, they won't have a problem with. Registration cause it won't be required, but if registration is required, then liability will lay when there is a misstatement again of, uh, or an omission of a material fact.

And it'll extend to everyone that's involved in the registration process. When we look at penalties, we're looking at several different varieties of penalties. The first of which is a civil penalty. And this is through these securities and exchange commission. The sec is a regulatory agency. And as a result, it has the power to offer injunctions, to prevent behavior.

And as well as to force refunds of any profits made on the offering of a security criminal penalties, lie with the department of justice, uh, us attorney's office, which will prosecute willful violations. Where that need for proof of center or the guilty mind criminal intent will. Where you required.

Punishment will include for criminal execution, uh, the possibility of incarceration of up to five years in prison and, and, or a $10,000 fine for each offense. So this could be hefty and obviously, uh, worrisome if there's a problem in the registration and as well, if you can prove the criminal intent, the fraud.

Civil liability is when you get sued. And what civil liability allows is purchasers to Sue in federal court. Because again, this is part of a federal cause of action. The securities exchange act, and what is not required is any proof by the purchaser to show negligence or to prove reliance simply stated if there is a misstatement omission.

Of a material fact, if there's something that can be shown that the registration statement is faulty, the purchasers can run right to the federal courthouse and Sue. Now where is an accountant's liability. I'm sure you're interested to hear about that. And accountant's liability is low. They are liable for lack of due diligence in the preparation of the financial statement.

Again, you work remember that the, in the registration statement, there is a requirement for an independent audit, and this is so that the investor can adequately assess whether or not the security being offered by this company is a value to them. And if there is a problem, That the accountant did not exercise due diligence and the preparation of the financial statement.

If the accountant didn't do their job minimum competence, then they will be liable as well. These are the penalties for the violations of the 1933 securities act. And again, remember it is important that the registration statement be done properly and the registration statement includes both the statement itself.

And then the later perspectives. Let's test your knowledge. We're going to look at some multiple choice REG CPA Exam questions. And I want you to remember to read the REG CPA Exam questions thoroughly, because you will find often that the answer is right in the question itself. What is important is to read the REG CPA Exam questions fully, look at those multiple choice, um, and quite possible answers to the REG CPA Exam questions.

And then this will test your knowledge and whether or not you're prepared for the exam.

Looking at the first question. Um, we're going to look and see that the correct answer is B. Here are the focus of the 1933 act is about disclosure and the anti-fraud provisions, not at detection of fraud. That's the focus of the 33 act. For the next question. The correct answer is B here. The answer is in the question as misstatements of material fact are part of the 1933 act prohibiting untrue statements to defraud investors.

Yes.

For the next question, the correct answer is a true of what we said before the 1933 act exempts certain security, such as governmental issues. And non-profits these offerings are exactly

the correct answer for the next question is a here the 1933 act permits exemption from the formal registration requirements for certain interest state offerings sold only to state residents. You remember that 80% rule that we talked about before?

here. The CA the correct answer is a, the 1933 act permits certain registrations or certain securities to be exempt from formal registration under regulation, a for small issues, those under $5 million within 12 months calling for a circular, rather than a prospectus.

The correct answer is B here. This is a trick question because from the list, you know, that regulation a issues are always exempt from formal registration. Yeah, the correct answer is B the 1933 act permits certain transactions to be exempt from formal registration, all of regulation D including small offerings under five Oh four, five Oh five and four Oh six.

The correct answer is D under regulation D issues under $5 million and a 12 month period with no advertising and no more than 35 unaccredited investors. Our investors are premier. Yeah,

the correct answer is B here, or you will remember that. As an exempt transaction, a small offering all the five Oh six and five Oh five offerings can not be made with general advertising. That's the big no-no don't tell the correct answer is a here the 1933 act is designed to promote disclosure. So remember that registration and perspectives go hand in hand with full disclosure to the investing public.

Next, the correct answer is B a variation of the same theme. The 1933 act requires both registration and a prospectus, unless there is an exempt security or transaction.

Here the correct answer is D remember that during the 21 day waiting period, after the registration and perspectives are filed with the sec, a red herring perspectives can be distributed. Perspectives can be distributed with bold warnings. And the warnings of course, are to tell everyone that they are not been fully registered.

This is that 21 day waiting period. Here, the correct answer is C a security that has been devised defined as an investment common enterprise with the expectation of profits to be derived from the management efforts of others, a general partnership calls for each partners efforts. So again, it's not the management of others.

The correct answer again is C.

Now let's turn to the securities act of 1934, its broad purpose is to provide disclosure. It created the sec, which regulates the people involved in securities trading and investigates, insider trading and fraud. The. Specific requirement again, of the 1933, 1934 act is to provide disclosure. And in providing disclosure, there is the requirement of reporting.

And what we're talking about here, and you will be familiar with it is the 10 K, which is the annual, the 10 Q, which is the quarterly or the AK, uh, reporting requirement, which is the unusual event, the change in control or a proxy fight. And also the 16 B, which is the discovery or disclosure of officer and director holdings.

Also when there's proxy statements that are required, there needs to be adequate disclosure. Proxy statements are request by officers to vote shareholders stock, and this requires full information as to why they're doing it. Full disclosure again is required under the 1934 act for this specific reportings and the proxy statements.

Now. In the creation of the sec, it had to do something. So there was enabling legislation in the 1934 act, which then regulated brokers and dealers. And it also then gave the authority to the sec to investigate insider trading and fraud. Again, the specific purpose of the 1934 act deals with secondary offerings and an implemented legislation to create the securities exchange commission, which in turn regulates the securities markets, the people who work in it, and those who try to manipulate it such as through insider trading, along with providing punishment for those violations.

This is teeth of the 1934 act. Now, when we talk about insider trading, it's the big no-no in the corporate world. The offering of securities is usual and the access to information affecting his price is common, but has to be safeguarded in the consumer world or the securities world of investors. This information is coveted to be able to make that informed decision and to turn a profit.

Improper use of insider trading information is strictly forbidden because it's a form of cheating and erodes confidence in the markets. If you have information that no one else does about a particular security, you can trade on it and make a profit either when the stock goes up or goes down. The holder of that information is likely to be someone on the inside of the company.

And again, if you trade on it, it's it's wrong. It's illegal. It cheats the system section rule 10 B of the 1934 act and the sec rule 10 B five. They're the important things to remember when looking at the 1934 act and how it's going to be tested on the exam, both these sections and the sec rule, prohibit fraud in connection with the purchase of a security, particularly the use of insider trading and extends liability to anyone who uses it.

With regards to confidential information, which is part of the fiduciary responsibility of an employee of the company. It's to be treated just like any other corporate asset. Obviously, if you work for a company and you know, things about the company that are not fully known to the investing public, you have that fiduciary or confidential relationship and you have to keep it.

So the people that get in trouble are the insiders and the outsiders, the insiders are the people within the company that know the confidential information and they trade on it. So you must remember when it talks about insiders that thou shall not trade on inside. Information sounds simple, but people get in trouble for outsiders.

It may not seem as clear how they become liable, but they're not allowed to either receive or use confidential information, which will then obviously be used for them to turn a profit. Usually when we talk about outsiders, we talk about two different theories. We talk about the tipper and tippy theory, and we talk about the misappropriation theory.

The tipper and tippy theory are based upon the concept that the person who breaches their fiduciary responsibility and the person who knows that there was a breach of fiduciary confidentiality, we'll both get in trouble. So there is a collusion, a conspiracy between the tipper and the tipi to go trade on information.

And it flows the tippy because they get the information from the tipper, they trade on it and obstensively either the tipper makes money off of this as a kickback, or they don't. But it's an improper because it obviously, again, cheats the system, the misappropriation theory, which again, applies to outsiders deals with someone who stole the information, they stole it.

Maybe they hacked into the computer systems of the company, whatever they've done, but they've taken confidential information material, which is not known to the general investing public. And then they've traded on it.

Violations of the 1934 act, create liability for non-disclosure for misstatements or omissions of a material fact. Now these material facts could be not disclosing that there was a fraud not disclosing that there was a change in the corporate condition or that there was pending litigation. This extends to all persons who prepared the registration or certified any part of it.

And as well can be brought by sellers or purchasers of the securities. Now you have to note in 1995, the private securities litigation reform act sought to limit lawsuits against normal corporate financial projections, which turned out to be wrong by providing what's called a safe Harbor and limited forward looking statements.

This is where a company is trying to guess where they're going to be in a couple of years, whether or not they're going to do well or not. And. Prior to 1995, a lot of the litigation, a lot of the lawsuits that were filed were about the projection turned out to be wrong. And if it turned out to be wrong, well then 1934 normally applied.

But now because of the 1995 private securities litigation reform act, there's a safe Harbor. As long as there is a limit to the forward looking statements. Usually it's a, a statement saying that we're providing guidance. This act also established guidelines for CPAs to disclose corporate fraud. And he created liability for the failure to report it to the corporation's board or audit committee or the sec.

So two things happened in 1995. One companies could say we're projecting certain financial situations to occur. And the other, it was a wake up call for CPAs to say that if you find fraud, you have to do something. You have a duty to report it. And there was a chain of command. To report it to the board, the audit committee, or ultimately yes, he see what are the penalties again for the 1934 securities act?

There are civil penalties in which the sec does enforcement. And again, as a regulatory agency, they're permitted to impose injunctions and ask for a refund of profits. In 1990 amended amendment prohibited those engaged in fraud from serving as an officer or director of a publicly held company. You may think of Martha in this situation, because what happened to her is after conviction for 1934 violation, she then was prohibited from serving as a head of a publicly traded company.

And this is true of many corporate executives and essentially what the 1934 act does. These civil penalties, by the sec, it imposes banishment. You're not allowed to come back and play the game anymore. Criminal penalties again are prosecuted by the department of justice. They're the prosecutors, the us attorney's office.

They deal with willful violations, again, a finding a center, which is a criminal intent or the guilty in mind, punishment for this includes twenty-five years of incarceration and up to $5 million fine for each instance. Civil liability generally extends to shareholder derivative actions. This is a it's unique in the law, but the shareholder is essentially suing on behalf of the company for the company against the company or any corporate action and any money that is actually recovered in shareholder.

Derivative actions is generally returned to the corporation. It is a civil suit to protect the company from itself and to return any. Losses, any profit that was made during wrongdoing back to the company to preserve the corporate entity itself. Accountant liability is clear in the 1934 act because of misstatements or omissions of material fact and a failure of the order to have adequate audit procedures only to a seller or purchaser that can prove the fraud effected the securities price and relied on it.

This is the negligence theory, a good defense for an accountant. If you're interested, uh, would be that they are not liable, but they can be liable only under gross negligence, recklessness or center for again, misstatements omissions, material of material fact, a failure to have audit or adequate audit procedures makes an accountant liable and only to a seller and purchaser, but that seller and purchaser again, has to show reliance a good faith defense.

Will allow an accountant to escape liability, but at the accountant was grossly negligent or reckless didn't care, or was involved in some sort of fraud or scheme or scam. They would have enough center and that would make them liable under the 1934 act. Now, another note is that state regulation of securities is again covered under the blue sky laws, which generally are not preempted by federal legislation.

Normally when the federal government gets involved in an area of regulation, there's a issue of preemption, which that means that it occupies the field and that the States can't pass anything that's inconsistent, but this is not true in blue sky laws. The term comes from a 1917 Supreme court case, which allows state regulation against speculative schemes, which have no more basis than so many feet of blue sky.

So they created the nifty term of blue sky laws. Now congressional efforts in 1996 gave the sec exclusive authority towards most regulation. And there's been a move towards adoption of the uniform securities act. Which began in 2002, there is duplicative efforts, but if you're going to be engaged in selling to the public, uh, securities, then there's two minefields.

One is the federal government. The other one is the state.

Yeah. Let's look at some REG CPA Exam questions to test your knowledge again, read them fully as well as the potential answers. And sometimes you'll be, it'll be odd enough, but the answer is going to be sitting there right in the question itself.

For this question, the correct answer is C under the 1934 act accountant liability is limited to intentional preparation and or the certification of the financial statements, including the quarterly reports. For this question, the correct answer is B. Remember the sec is a regulatory agency, which has the power to affect the licensing of individuals along with issuing injunctions, prohibiting involvement, but not the actual criminal prosecution, which is left to the department of justice.

The United States attorney's offices.

At this point, let's turn to other federal regulation. Congress has enacted major legislation to provide for the public welfare protection, such as through social security. And worker's compensation, unemployment protections against discrimination and workplace safety. Along with prohibiting anti-competitive behavior through antitrust regulation and along with enforcing property, environmental rights.

When we talk about income protection, we're talking about the federal government's involvement in the federal security social security act of 1935 Fooda, or if UTA, which is the federal employment unemployment tax act of 1935 as well, Cobra, which oddly enough, comes from the federal consolidated budget reconciliation act.

That's a mouthful and Arosa employee retirement income security act of 1974. These four items will be tested on the CPA examination and therefore general income protection. Now let's go through each one of them to explain what we mean.

Dealing with worker and safety and health, the federal government legislation was passed by Congress deals with either OSHA workman's comp or S F LSA, which is the fair labor standards act, OSHA, the occupational safety and health act of 1970. Is administered by the department of labor workman's comp is administered by the States.

And similarly, the F LSA is administered by the States as well. Unfair labor and standard procedures. Now, what does OSHA do? OSHA, the occupational safety and health act of 1970 covers employers, workplace standards, including inspections, notification of accidents and record keeping of those accidents.

Preventing retaliation against whistleblowers as well. OSHA has the ability to assess fines for violations. Where you see OSHA common is in manufacturing. When there's injuries on the job, there may be a re maybe compensation that's given to an employee by workman's comp, which we'll talk about in a moment there may be coverage, as far as private health insurance.

But that's not what OSHA gets involved in. What ocean gets involved with again, is that there are proper inspections of the process that's at work. And even if the employer and the employee are happy with whatever, uh, resolution there was to the accident, OSHA will come in, do an investigation and prevent it from happening again to another employee.

And as well, employees that know of problems that a company where there's not, it's not been reported to OSHA. There is a. Provision in the OSHA act of 1970, that prevents retaliation against whistleblowers.

workman's compensation. You hear about that a lot. That's administered by the States and it is no fault insurance for injured workers that are injured on their job through the employer's payment of either a private insurance or, or to a government fund or through a proof of self-insurance. Again, this money that's paid for workman's compensation.

Doesn't come out of the employee's paycheck. It comes straight from the employer. Now who is covered for this qualified workers, adding minors, but excluding temporary or independent contractors they're covered as long as they were injured during the scope of their employment, regardless of fault, unless it's intentional, they must notify their employer.

File a claim with an independent state agency, which is usually called the workman's compensation commission and accept payment for lost wages and the percentage of. Permanent disability given in lieu of their suing, their employer for negligence, except for intentional acts. Well, let me go through this again so that you've got it straight qualified workers.

They're the ones they get workman's compensation, not temporary independent contractors and the ones that are injured through the scope of their employment. They're injure injuries, regardless of how it happened. They could be. Just plain stupid. And if they are, and they cause injuries hit himself, they will find coverage under the workman's compensation act.

But what they have to do is then notify their employer, file a claim with a state agency, and they're going to be compensated for loss income and maybe potentially receive a percentage disability, a percentage disability of whatever the loss is, maybe to a hand or to an eyesight. But in return for all of this regulatory process, they can't Sue their employer unless their employer intentionally hurt them.

So to note, injured workers cannot tap the no insurance default coverage under workman's compensation when it was a result of their own intentional act, such as if they're intoxicated or if they self-inflicted injury, or they were fighting with another worker. Injuries caused by third parties are covered a little differently, and this is to prevent, uh, basically double-dipping injuries caused by third parties where the worker was injured by someone other than employer can Sue.

The third party or seek workman's compensation benefits, but they have a duty under what's called subrogation to reimburse those benefits if collected from any litigation. So you have someone that's on the job, someone who's working they're injured and when they're injured, it's not because of their employer, but someone else coming into the building or some other third person.

And when they're injured, they could either seek benefits under workman's compensation to make themselves whole. Or they can Sue that third party, but if they receive any money from the third party, having already received saved money from workman's comp, it wouldn't be right for them to keep both. They have to pay back into the workman's compensation fund.

The Federalist social security act of 1935 is administered by the social security administration. This covers employer and employee mandatory contributions through the federal insurance contributions act. Or FICA for their social security or retirement survivor and disability insurance OSDI. And again, what does this cover?

What is it, what you get for your social security dollar, dollar or bucks, you get retirement and old age benefits. You get survivor benefits and there's disability insurance. Medicare covers medical care for those 65 years or older and other permanently disabled individuals. And it pays both hospital and non-hospital costs.

Individuals may purchase supplemental insurance to cover items that are not part of Medicare.

The federal unemployment tax act of 1935 is administered with the States. So there's regulation and procedures where each state is going to cover. Uh, unemployment plans along with certain state plans. And these are paid for, by a tax on the employer to qualified employees that are not fired or quit or self-employed.

So again, when this money comes out, it comes out of where it comes out of the employers. It's a tax on employers, so it should not be coming out of any employee's paycheck. Cobra which comes from the federal consolidated budget. Reconciliation act covers employees, health insurance for set period of time, generally 18 to 36 months.

And it's paid for by the employee ARESA, which is the employment employee retirement income security act in 1974. Is administered by the department of labor and it covers private pension plans and the standards for their management. Now companies don't have to offer private pension plans and indeed many are not.

But if they do, there are standards in place for both the contributions that are made and the standards of the management of those contributions. And it also deals with the employees right to vest, which means the right to future payments. The fair labor standards act. The F L S a if 1938 is administered by the States.

It covers minimum wages, maximum hours, and combined with overtime. And restricting child labor. So what you have to remember is that the FLS protects workers by how much the money they can make. And also how many hours, the maximum hours, 40 hours combined with overtime. So if there's ever a question of what someone's entitled to after four and a half 40 hours of work, it's time and a half, and as well, the F LSA deals with restriction of child labor.

Now at this point, I'll ask you to do some REG CPA Exam questions. When you come back, we'll answer them.

Alice, look at the multiple choice REG CPA Exam questions. The correct answer for this question is D remember that the OSDI benefits, social security. Act benefits, which cover old age, retirement, or survivor and disability income is meant as a social welfare, which may be reduced based upon other incomes. You're entitled to money, but if you make too much, then why are you getting it here?

The correct answer is a. Qualify individuals, ones who generally have paid into the system are eligible despite a private pension pan and plan. The other responses are incorrect, such as children who are eligible to recover up to the age of 2018, not 25

here. The correct answer is D importantly, both unemployment insurance and workman's compensation are employer paid, not by the employee. The correct answer is D just a reminder workman's compensation is not available if you're a temporary.

Okay. Here, the correct answer is B workman's. Compensation is a no fault insurance, regardless of the employee's fault, unless it was intentional.

The correct answer is C same as before workman's compensation is no fault insurance based on negligent acts, regardless of fault, but not if the employee cause intentional harms themselves, you don't get to fall down deliberately and then claim workman's comp.

The correct answer is a remember the minimum wage. Maximum hours, 40 combined with overtime time and a half and restricting child labor. This is part of F L S a here. The correct answer is a yes. OSHA is an administrative agency tasked to cover employers, workplace standards, including inspections, notification of accidents, and record-keeping of accidents along as preventing retaliation against whistleblowers.

OSHA can set standards, but not develop equipment. That's not what they do. Here, the correct answer is a remember that Arista does not does cover private pension plans and the standards for their management, including the right to invest, meaning the right to future payments. The correct answer is B workman's compensation is a no fault insurance to promote worker safety and health, regardless of negligence or the response or the, the potential mistakes made by workers.

Another aspect that you'll find on the CPA examination is employment discrimination. These are the benefits that were provided by the federal government through congressional. Uh, legislation to provide protection to the, in the workplace to employees so that they can come to work and not worry about certain physical disabilities that they have, or, uh, characteristics that they have, that they will somehow be impacted on whether or not they get a job, don't get a job or otherwise discriminated against.

So for the purposes of the examination, we look at four. Uh, congressional acts. We look at title seven, which is the civil rights act of 1964. We look at the age discrimination and employment act, also known as ADEA. We look at the ADA, which is the American disabilities act, which is part of, uh, the 1964 civil rights act was passed around the same time and that as well as title seven.

Are administered by the EOC, the equal opportunity commission. And lastly, the rehabilitation act of 1973. And again, these four acts, what they do is they provide protection, specifically title seven, the civil rights act is again administered by the EOC, which is a independent agency. Um, and what it does is it prohibits discrimination based on race.

Color religion, sex, national origin. And now recently sexual orientation. This is, uh, Particularly important in terms of promotions, hirings, firings, um, any type of workplace decision that's made. And if it's in contravention or against, or it's done for a reason of one of these protected categories, then title seven will be implicated.

The equal opportunity commission will investigate this type of discrimination and can bring lawsuits on behalf of the individual. Or provide an individual with what they call a letter in which to be able to Sue state law may cover additional categories, such as gender, but in all aspects, federal legit lettuce legislation, such as title seven protects employees, and they can go to federal court and then Sue their employer to remedy discrimination.

The ADEA, the age discrimination and the employment act that specifically prohibits discrimination based on age for workers over the age of 40, you may see a question that deals with an employee under the age of 40. They do not have the same level of protection under the ADEA, so forth and above that's.

When you get implicated, that's when you start feeling old for federal legislation. The American with disabilities act, um, was also administered again by the equal employment opportunity commission, this prohibits discrimination based upon disability and guarantees, equal access to services. You may hear about the ADA, ADA.

When it comes to, um, the ability for an employer to hire someone and then have to provide reasonable accommodation. Um, if someone becomes disabled or if they're disabled to help them perform the categories of work, this would be if someone needed, um, hearing assistance, vision assistance, the ADA also deals with access, um, to services or access to buildings, whether or not doors have to be wider.

Whether or not there has to be elevators or ramps, or you may see this as a question we're dealing with access to public transportation, that everyone can be able to enjoy that. So anytime there's an issue about disability and whether or not there is an equal access to some public service, the American with disabilities act will be implicated the rehabilitation act of 1973.

Some people confuse us in the American disabilities act. It's a little bit different because this applies to federal employers who must have an affirmative action program to hire disabled persons. So what this means is, is that for federal employers, they have to have some sort of program in which to reach out into the community and hire people who are disabled regardless of their, of their, any type of limitations they have.

So it's a little bit different than the American disabilities act. Make sure that, you know, the difference. Now at this point, there's certain REG CPA Exam questions for you to do when you come back, we'll answer them

here. The correct answer is B title seven covers race, religion, and sex discrimination, and now gender, but age discrimination is handled under the ADEA. The correct answer here is a, the American with disabilities act, prohibits discrimination based on a disability and guarantees equal access to services such as public transportation and services related to the public.

Now let's look at antitrust regulation efforts to ensure a competitive marketplace force federal legislation to prevent the creation of business trust were unreasonable restraints on trade and monopolistic behavior. Her consumers. This is to provide a level playing field to everyone. That was in, involved in business.

If you had too much of one thing, it obviously was bad. So what we look at is we look at the Sherman act and then we later look at the Clayton act, the Sherman act, which was passed back in 1890, prohibits on reasonable restraints on trade of interstate commerce, section one declares conspiracies that affect trade illegal while section two forbids efforts to create a monopoly.

Underneath the Sherman act. There are three important qualifications or three things to look at the first being per se violations and the second vertical restraints. And the third talks specifically about monopolies. What is a per se violation? Well, a per se violation is when someone has gobbled up so much of the market or made some agreement with competitors or other members in the marketplace that just on looking on the face of it, it drives out all competition and consumers are left with no choice.

We first look at horizontal restraints. These are unlawful agreements between competitors, such as price fixing or territorial restrictions such as market division based upon geography. What does this mean? Well, if we talk about horizontal restraints, In terms of agreements amongst competitors. This would be like every gas station getting together and saying, this is the price we're going to charge.

They're not all the same company, but they control all four corners in the intersection. And the price is the same. This type of price fixing obviously is bad for consumers because there is no choice. There is no competition and it drives out anyone else willing to charge less or more because the majority of the companies have been linked together and fix the price.

When we talk about territorial restriction, this is when certain companies agree. Behind closed doors that they're only going to operate in certain areas and other people will not operate in their area. It's almost like gang territory where this is our spot, not your spot. What does that do? Obviously, to a consumer, they only have one choice and when they only have one choice, there's no competition.

It's again, bad for competitive competition. It's bad for the free flow of goods in the marketplace. We also look at vertical restraints, unlawful agreements between companies at different levels of the manufacturing, distribution chain, such as wholesalers distributors, and retailers is unlawful. Such practices include territorial restrictions, resales, or price maintenance agreements, and boycotts.

Now vertical restraints are different obviously than horizontal. Horizontal is everybody at the same level. Getting together here vertical is that everybody from top to bottom, the manufacturer is linked directly to the distributor, which may ultimately district be linked to the retailer, which means that no one else can get to the product.

If something's produced at the factory, it should go out to everyone. So everyone can sell it and have an opportunity to make some money. But if the manufacturer is saying only these distributors can get together and only these distributors can only sell to those retailers, that means that product good or service can never be offered at a different price or at a different location than what's already linked into this vertical restraint.

And that's obviously bad. Such practices such as resale or praise maintenance agreements with that has to deal with is when, if a company sells it, they can only sell it to certain people. If they somehow, um, have what we call price maintenance agreement. What that means is that a company is saying that you can only offer something for sale.

As a matter of fact, we're offering it to you and you can only sell it within a certain range that doesn't allow for competitive pricing at all. What it does, is it fix the price? It fixes it in such a way that there's no possibility that anyone else who would have a similar product or a similar, um, service that's being offered, could compete with it.

And again, that would be unlawful under the Sherman act. Monopolies in dealing with monopolies. There's a prohibition against a single corporation exercising total or near total market dominance courts will apply the market share test to C's see the size impact of the accompany and the intent such as.

Whether or not there's predatory pricing to drive out a competition. You can be essentially good at what you do, and if you're good at what you do, that's fine. But if you're doing it in such a way where you dominate the market so effectively and you drive out all the competition, then the worry is that the monopoly, when the monopoly wakes up and sees that there is no competition will then raise the price and consumers won't have any options, consumers then would say, Wow.

This is the only company that I can actually deal with and I have to pay whatever price they offer because there is no competition.

The Clayton act of 1914 is different than the Sherman act. Make sure you know the difference. The Clayton act, prohibits discrimination between consumers exclusive dealing contracts, tying agreements, such as a tie and requirement to buy additional products, any legal mergers to eliminate competition competition.

When we talk about mergers, obviously this is when companies joined together. There are the horizontal mergers where competitive competitors actually merged together or vertical mergers were suppliers merged with actual customers. Where you have conglomerate mergers, where you have the assembling of unrelated businesses.

Welcome to Bisk CPA Review, comprehensive CPA Exam review materials for the computer-based CPA exam that lets you customize your own review program to meet your individual learning style and ensure your success. Thank you for selecting this hotspot video, which contains a targeted intensive review of the specified topic area.

We hope to utilize this video to be an effective tool in your CPA exam preparation.

Welcome to hotspots business entities. I'm Jack Norman. In this program, we will review the areas of the types of business entities, which will be tested on the CPA exam.

As you remember when you began your entire educational and business career, you were exposed to different types or ways organizations through which a business could be conducted. These ranged from a sole proprietorship where a single individual simply began business on his own. Without any limitations as to liability and without double full taxation, the sole proprietorship second type of horrific form of business that you may have seen is the partnership.

And initially, when we begin to think of partnerships, we think of what are called general partnerships, two or more individuals conducting a business in unincorporated format. Remember a general partnership is two or more. Partners two or more individuals or other types of entities getting together to discuss and carry on a type of business.

A variation on the general partnership is called a limited partnership where there are, again, at least two partners, one of which is a general and has unlimited liability. And one of which is a partner who has limited liabilities. Hence the name limited partnership. In the past few years, state in the United States has adopted laws that allow for limited liability companies.

You may have heard of these as LLC. These limited liability companies here members get together for entity under state law to carry on a trade or business. All of the members have limited liability. A variation on the LLC is something called a limited liability partnership. Again, these are creatures of state law and each state law varies.

Generally they are limited to professional practices. We're going to discuss the general and limited partnerships, and we're going to discuss the limited liability company in more detail in a moment. Probably the largest single sector of the United States economy is conducted by corporations in dollar volume.

Now those corporations are frequently referred to as regular or C corporations. You think of these as the general motors, the Microsofts, the federated department stores, the largest companies in the United States. But a corporation can be as small as a neighborhood retail store owned by one individual.

A corporation is simply a legal entity established by a state law, and which has a whole number of characteristics that we're going to discuss a little later in the program, including limitations on liability, unlimited life and free transferability of stock. A variation on the regular or C corporation is an S corporation also called a tax option corporation.

As corporations really begin their lives as a C corporation under state law, and then make elections under the internal revenue code. We do have specialized tax treatment. We'll explore both the S and the C corporation toward the end of this program. And finally, another area that you may have heard of is something called a Massachusetts business trust.

We don't see very many of these in practice, but a trust is a way in which businesses can be operated. So let's take the range again as a quick review, sole proprietorships, general partnerships, limited partnerships, limited liability companies, limited liability partnerships, regular corporations. Tax option corporations and business trust of these.

We're going to focus in our next few minutes on the partnerships, the LLCs and the corporations.

Well, to begin, what is a partnership? I alluded to this a little bit by saying that it's at least two individuals or two other entities who come together for the purpose of carrying on a trade or business, the principles of a partnership are essentially the same principles that you reviewed in agency law.

A partner has apparent authority to operate and conduct contracts, make agreements, make decisions. For all of the partners and the partnerships. In addition, all partners have fiduciary duties, obligations to the other partners of that partnership. Well, there's a partnership have to be formally created.

The answer is no, a partnership may be informal. Now most lawyers, most practitioners would tell you that they would like to see a partnership agreement, a written partnership agreement. But it is not required to individuals can simply meet and say, Baba, I'd like to conduct a business with you. Why don't the two of us begin a auto parts store.

So Bob and Jack open. An auto parts store. We are a partnership. We're two individuals conducting a business. Should we have a written agreement? It would make sense to set forth our obligations and expectations of each other, but it's not required. Do remember however that should we move into an area where we are acquiring and subsequently disposing of real estate, then under the statute of frauds, because we're dealing with real estate.

The partnership must be created with a written partnership agreement. Now, under that partnership arrangement, how has it treated? Bob and I in our hardware store are equal partners. We're each 50% owners. We each put capital in to the partnership to get it started without a written agreement. Then all profits are deemed to be equally divided between Bob and me.

And any losses that we might sustain are shared equally by Bob and I. So an absence of an agreement, otherwise profits and losses are shared equally between the partners. Should we admit Edith as our third partner, again, absent to change with a written partnership agreement or some specified method for allocating profits and loss.

One third of the loss or one third of the profit will go to Bob Edith and myself. That is the general principle of the partnership. But what about taxation? You're asking yourself in the general partnership, the entity itself does not pay tax, rather Bob and Edith, and I will take the earnings of the partnership.

After we've divided it among ourselves, we report it individually. And as general partners, we are equally liable for all of the debts. Anything that may arise as general partners, we share those liabilities jointly and severally.

Joint venture is sometimes called a partnership. Well, it is, it's a special form of partnership. It is a partnership formed for a specific purpose and the classic example of a joint venture. Let's say that Lockheed aircraft and. Grumman aircraft want to bid on a new federal government contract. They both have expertise that they were bringing to the table and because this is a high dollar and very complex proposal that they submitted to the government, each agrees to become a 50, 50 partner in a joint venture.

The reason it is a joint venture, a special form of partnership is because it is designed for the specific purpose of bidding on winning that government contract and building the ensuing aircraft. We find joint ventures all the time. There are sometimes known as associations, but they are in effect a general type of partnership.

That general partner, whether it was Bob or Edith and I, in my earlier example, I said, we're personally liable. What does that exactly mean? It means that if Bob goes out and contracts for something on behalf of the partnership he has under agency rules, apparent authority to contract. The partnership is bound by that.

And should the partnership not honor that commitment Edith or I is equally bound by it. We are jointly and severally liable for all of the actions that took this liability applies for contracts. As I just mentioned, it's also applicable for torts. Well, You remember back in your law days, we had contracts and torts.

What is a tort? It is a civil wrong. So if in some manner, our employee in the retail store, for instance, commits a tort, let's just say that on delivery, he's delivering supplies to, uh, an auto dealership. The delivery van being driven by our employee in the course of his business has an automobile accident and someone is injured.

He has committed a wrong that injured party sues the partnership. And if the partnership is unable to satisfy the judgment, Bob and Edith and I are all jointly and severally liable for that debt. So when you're thinking about general partnerships, And general partners, several things to remember, they have apparent authority to act on behalf of the partnership.

You have unlimited liability for contracts and for tourists, they have a fiduciary obligation duties of loyalty and care to all of the other partners. I mentioned to you as we began this segment. That there is a variety of partnership called a limited partnership. Again, since it's a partnership, we know that there are at least two partners in the agreement.

One of them must be a general partner, must have the unlimited liability, but there can be any number of other partners whose liability is limited. Now. A limited partnership is set up under state law. And generally under the revised uniform limited partnership act, there are special requirements for the limited partner.

The partner's liability is limited to the capital account that he or she has in the partnership, but, and there's always a, but in partnership law, While the limited partner has that limited liability, it can change to unlimited liability. If the limited partner engages in significant management activities, the original thought of the limited partnership was that the limited partner is a passive investor.

And if you want to think of the classic limited partnership case, think real estate. In the heyday of real estate investments before the limited liability company really became available, most real estate ventures were conducted through limited partnerships. A general partner was set up to have that required general liability, but many individual investors might be brought in to support and provide the funding for that real estate project.

Their liability was limited. And they received a guaranteed return on their investment. We're as the general partner, after a period of time took the remaining profits. Although the limited partner may not directly participate in management, he or she soonly has the right to vote on partnership matters has the right to consult with the general partners and has rights of inspection on the partnership.

Books and records. What about the tax consequences? It's the same as a general partnership. The limited partnership is taxed in the same manner. In other words, all of the profits or losses flow through to the partners in a limited partnership arrangement, generally there are specified allocations of the profits and losses among the partners in contrast to the general partnership.

Where they are generally equally divided.

let's review one more time. The limited partnership requirements they're formed under the state statute, the uniform limited partnership act, there must be one general partner and there may be any number of limited partners, one or more. The liability of the limited partners. Is constrained so that although they may vote and consult on significant partnership matters, they may not engage in the management of the activity.

Yeah. All right. Now that we've set out the general rules with respect to general and limited partners and partnerships, let's talk about admitting new partners. As I had mentioned in our earlier scenario, Bob and I originally had the auto parts store. As a general partnership, when we admit Edith as our new partner, is she liable for the debts of the partnership?

What happens to what was going on before and after she comes in? Well, when Edith assumes her position in the company, she is not liable for the pre-existing debts of the partnership. In other words, those before her date of admission to the partnership, Except to the extent of her capital accounts.

However, once Edith is a partner, she now just like Bob and I is a general partner and has unlimited liability for subsequently acquired depths. Bob and I have agreed on a bidding Edith as a partner. That would be true over in a limited partnership arrangement, consent of the partners is required to admit a new partner, whether they be general or limited.

So consent is always required to admit partners. Does it dissolve and create a new partnership? No changes in partnerships. Unless it is one partner leaving a two partner ship from, and I'm going to talk about that in a moment, but in general admitting or, uh, exiting partners do not dissolve the partnership.

If however, you have a two person partnership. Now, what happens when one partner leaves by definition, you no longer have a partnership. You have a sole proprietorship. So the general rule is any admission or leaving of partners does not change the partnership and admission of new partners, whether limited or general does require the consent of all of the partners.

I am a partner in a partnership and I'm having financial difficulties. Can I assign my right to the income from that partnership to my creditor, or can I assign my interest in the property of the partnership to my creditor? For instance, Jack is having some financial difficulties. My creditor wants an additional source of security.

So I tell the first bank of my hometown. I will assign you my interest in the Bob and Jack auto partnership. There's not a problem here. The assigning of my interest in the partnership does not dissolve the partnership, but okay. Also gives the bank no rights beyond the ability. To receive the income and distributions, if any, from the partnership that I can do, all I have to do is get Bob to agree to the assignment.

So as long as Bob will agree, or if I have Edith also as a partner, Edith also. So every of was consent to the assignment, but it really has no effect on the operations of the partnership itself. It simply takes by share the profits or any distributions and passes them over to my creditors. Now, I want you to be very careful with this subject because the AICPA loves to try and trick you with a question I can with consent, assign my partnership interest, however.

I cannot assign an interest in partnership property. So watch the two words. Are we talking about partnership, interest or partnership? Property interest is okay. Property is not okay. That deals with the question of assigning interest.

Review again and take a more detailed look at partnership changes, a partnership of 10 partners. For example, let's just say a small, uh, uh, agricultural partnership farming property. One partner decides to leave. Does that dissolve the partnership? No, we still have more than one individual involved. We've got nine partners instead of 10.

So just the leaving of a partner does not dissolve the partnership. Suppose that partner declares bankruptcy. Generally, that's not going to dissolve the partnership, but if there is a written agreement or state law also provides, you may have a. Disillusion on the bankruptcy of a partner there, you have to look to any written partnership agreement, but the general rule is that the bankruptcy of a partner is not going to terminate the partner death of a partner.

Okay. Again, depending on the contract arrangement, you may or may not have the partnership terminating, but in general, partnerships will continue after the death of. Of a partner in a more than two person partnership. What happens to the partners interest upon death? It simply passes as an asset of the estate of the former partner, and it will then be dealt with as a partnership, as a asset of the estate and the partnership.

Probably we'll redeem out that partner or that descendants deceased partners share of the partnership, but the partnership itself again, does not automatically dissolve unless it's a provision of the partnership agreement. Suppose we do decide to dissolve the partnership here, Bob Edith and I have been very successful for 20 years running our parts dealership.

We've now all decided that it's time to end the business venture. We're all tired. We're ready to retire. Take our earnings, solar property and live a happy life. In Tampa, Florida. We have half to wind up the business and distribute all of the assets out to the partners, but there is an ordering of how those distributions are made.

First, all creditors must be paid. Your first creditor are going to be the outside creditors vendors, uh, employees, those who have claims against the partnership partners may also be credited as a partnership have had. They made loans. For instance, at some point in the past, Edith may have made not a capital contribution, but a loan to the partnership.

Properly treated as alone and properly documented as alone either stands as a creditor in a high priority on distribution of those assets. So first outside creditors are paid, then loans to the partners are repaid. Nurses are entitled then to a return of their capital accounts. This is the amount that they initially put in to the partnership or over the years.

Have continued to contribute to the capital of the partnership. Capital accounts also include accumulated the earnings that have not been distributed to the partners. So that entire capital account is distributed to the partners. If you want to think of, think of it as the third tier of the distributions on winding up the partnership, what happens?

However, if there are insufficient assets, To pay out all the claims, because remember that balance sheet of the partnership had to balance assets equals liabilities, but there may be negative capital accounts for the partners. Well, first of all, your outside creditors are going to be repaid that first tier of distributions.

Secondly, to the extent loans are available, then you will repay the loans to the partners. Third and finally, whatever, if any of a diminished capital account may be repaid, let's take the worst case scenario. However, partner's capital accounts are so negative that there are insufficient assets to pay all the creditors.

Now, the partners have an obligation, assuming they're general partners to make up that deficit in the capital accounts to pay out to the creditors. What we're saying in effect is that the creditors always stand first and the partners always stand last. In the case of a limited partnership, of course, the limited partners have an obligation only up to the amount of their capital accounts.

They do not have to make up any further deficits that will fall to the general partner. Okay. So those are the general rules on the dissolution of a partnership. Outside creditors loans to partners, partners, capital accounts, and potentially deficit makeups.

We talked earlier about incoming partners and I'd like to review that for a moment. As we been move over to leaving partners, let's go back to the incoming partners. In my ongoing hypothetical here of Bob and Jack's auto business. When we brought Edith in as a partner, what did we say? Edith is not liable on pre-existing debts, debts incurred by the partnership or obligations of the partnership that arose before Edith became a partner.

Again, they'll buck word. But Edith is liable to the extent of her capital account. What we're saying is she does not have general obligations beyond the amount of her personal capital contribution. However, after Edith becomes our partner, she is liable on all new debts of the partnership. So incoming partners draw a line.

If you want to think about it, old debts, old obligations, protected. Uh, in the sense that the new partner does not have to assume them new debts. Of course the incoming partner is liable, but what happens now, if Bob and I want to continue the partnership and Edith decides that it just is not the right deal for her, she would like to leave the partnership.

Is she free of all obligations? No. Any obligations that arose. By the partnership or obligations of the partnership that were contracted after Edith became a partner con, she continues to have liability for those debts, even if leaving the partnership, unless I told you they're always butts. And unless as in legal legal discussions, unless the creditors and the other partners agree to relieve Edith of those debts.

And you'll remember a word novation. These contracts, these obligations with respect to Edith are canceled and agreed upon by the creditors and by her existing partners in effect we've held her harmless for anything in the future. Now, once Edith leaves. Can she be liable for any new debts contracted by Bob and I, as the partnership continues.

And the answer is no, she's not. Unless. Famous, unless word again, unless potential creditors are not aware that she has left the partnership. In other words, they think she still has some authority and still is a partner in the partnership. So we have to give notice and make it clear that Edith has left every frequently.

You will see notices. Put it in the newspapers or mailed to a partnerships, uh, creditors, business associates saying such and such individual has left the partnership that's to give notice. So let's review one more time on the exiting partner. They are not liable on debts contracted after they leave. If the partnership and the partners have given notice to others, to outsiders, however, They remain liable on the partnership debts that were incurred while that partner was a member of the partnership on less again, a novation or cancellation of liability is agreed to by the creditors and the other party.

We now have clear in our minds, incoming partners, departing partners, and the rules on dissolution of a partnership.

Yeah, there are many legal rights duties and obligations of partners. Let's talk about a couple of these because the fiduciary and agency implications all are inherent in the partnership concept of entity. First of all, absent an agreement. Otherwise, all partners are equal. Can the partners agree that things will not be shared equally?

Absolutely. This is part of their negotiation, but absent an agreement. Otherwise, two partners share everything. 50 53 partners shared one third each and four partners is 25% each, obviously the larger, the number of partners, the smaller, the interest of each partner. But in a partnership agreement, we can make any number of arrangements.

We can say, for instance, that profits are distributed 40% to one partner and 60% to the other, even though they're both 50 50 in terms of capital contributions, why might we do this? Well, perhaps one is a, uh, involved as a manager, much more than the other one. Bit's a bit more passive investor. We can say, even that losses are shared one way maybe 40, 60, and profits are shared 30, 70.

We Henley have to be careful here that we comply with the tax rules, but partners can agree among themselves on any number of allocations in addition partners. Oh, absolute. Fieldy. Absolute trust, consistency, diligence to the partnership affairs and to each other. There are duties of loyalty duties of care.

You use the best judgment that you can, but you are held to a very high standard because you have authority in effect to operate and contract and bind and make liable all of your fellow partners. Some obligations of partners and some activities that are carried on by partners require unanimous consent.

For instance, as I mentioned earlier in this segment, if I wish to assign my partnership interest to creditors or to another party that requires unanimous consent of all of my partners. I cannot submit claims of the partnership or claims against the partnership to arbitration without the consent of all partners cannot confess a judgment in effect, agree to a liability for the partnership without the consent of all of my partners.

Interesting. It also requires the consent of all partners to completely change the partnership name finally. Okay. Well, not quite finally. I have two more items on my list to admit a new partner, as we mentioned before, requires unanimous consent of all the partners. And lastly, I cannot sell the Goodwill of the partnership.

Without the consent of all of my partners. So you can see that in looking at a partnership, we have many duties, many rights, and a few of those do require the consent of all of the parties.

As we bring to the conclusion, our discussion of partnerships, there are several points I want you to bear in mind before we move to the discussion problems. A partnership may be a general partnership or a limited partnership. In any case, a partnership consists of two or more individuals or other entities, because remember two companies can also be partners in a partnership.

Two individuals can be partners in a partnership, a corporation, and 10 individuals can be partners in a partnership. So a partnership two or more gathered together to conduct a business, a general business enterprise, a partnership agreement does not have to be in writing, although it's strongly encouraged.

And if the statute of frauds applies, then the partnership agreement must be in writing a partnership. Of a general nature, a general partnership, all of the partners have unlimited joint and several liability for both contracts and torts. In a limited partnership, there must be one general partner who has that unlimited liability, but the liability of all of the limited partners is confined to the amount of their capital account.

When. The AICPA gives you the question of assignments. What do you remember there? The partner with the consent of all partners may have sign his or her partnership interest. It does not dissolve the partnership is simply transfer as the right to income and distributions, but a partner may not assign partnership property.

With that, let's take a break for a moment and I'd like you to work the REG CPA Exam questions related to partnerships in the study guide. And I'll be back in a few moments to go through those answers. There are nine REG CPA Exam questions and I would like you to take not more than 18 minutes to complete those REG CPA Exam questions. See if you can handle them in under two minutes each and we shall be back in a moment.

Now that you've completed the REG CPA Exam questions in the viewer's guide. Let's see how you did. If we turn to question one. Here is the basic definition of a general partnership. And the answer is clearly item B or Baker have two or more partners. If you remember, in our discussion, we said a general partnership has at least two partners.

They can be individuals, corporations, or any other entity, but it's two or more that have joined together to carry on a business venture. So the answer B is the correct answer. Now what about the other three answers? A talks about paying federal income tax general partnerships are passed through entities and the partners pick up the appropriate loss or income from the partnership on their individual returns.

So answer a is incorrect. The answer C talks about having a written partnership agreement. And while a written partnership agreement is certainly recommended by virtually every practitioner, lawyer consultant on partnership law. It is not a requirement unless the partnership is engaged in activities such as real estate, which would fall under the written requirements of the statute of frauds.

So C is clearly incorrect and finally on D. The partnership agreement does not have to provide for the apportionment of losses or income among the partners. The general rule is that unless it's specified otherwise such gains losses, income are divided equally among the partnership. So a 50, 50 ownership of partners would distribute the income or losses in a 50 50 ratio.

So it is not a requirement. And answer D is incorrect. If we turn to the second question you're asked, which of the following statements is correct with respect to the distinction between corporations and a limited, not a general, but a limited partnership directors owe fiduciary duties to the corporation.

This is answer a, but it is not the correct answer. The reason being limited partners do not owe fiduciary obligations to the limited partnerships. They're simply passive investors. C is incorrect because although that question says that shareholders may be entitled to vote on corporate matters, limited partners are prohibited.

And they are not limited partners do have the right to vote on certain matters in the partnership agreement, including admission of other partners. So answer C is incorrect. Answer D as in David is also incorrect because corporate securities stocks. Maybe required to be registered with the securities and exchange commission or under state blue sky laws.

However, it's no question that partnership interests limited, limited partnership interests are securities under the law. Therefore the answer we come back to B. Under B a corporation and a limited partnership may be created only pursuant to state law. And the organizational documents must be filed with the government.

That is correct. A limited partnership is a creature of state law under the revised uniform limited partnership act to that state. And a corporation is established under the state corporation law. So answer B. Baker is correct for number two, number three, ask us to focus again on the assignment of a partnership interest in a general partnership.

Remember I mentioned to you that the ASCPA loves to address this issue in their REG CPA Exam questions. The answer here is D D for Delta, the  of a partnership interest. Never becomes a partner, a is clearly wrong. The partner ship, I'm sorry. The acidy is not responsible for partnership debts. Obviously B is wrong. Then also assigning a partnership interest does not dissolve the partnership.

So C should be eliminated and we are left with the only correct answer. D the assignment transfers an interest in the partnership. Profits or loss and distributions to the knee. That is question number three. Looking at question number four here. We're talking about a descendant, a person who was a partner in a partnership and has since died.

The deceased partners executor would automatically become a partner. No, the partnership continues. Unless the partnership agreement says it terminates on death of a partner, but the executor or the estate does not become a partner in the partnership. So that first column you need to have a no answer in it.

The deceased partner would be free from partnership liabilities. No, the partnership interest passes into the estate. It continues for a moment as liable. Just as any other exiting partner does until the novation or other arrangement is taken care of or the partnership acquires and terminates that partnership interest.

So the second column, you're again, looking for a, no answer. Third, the partner would be disassociated from the partnership automatically. Yes. Now here is the yes. Answer. We're looking for. That individual, when he dies, becomes disassociated from the partnership. So now we need to find an answer of a, B, C, or D in which the first column is no, the second column is no.

And the third column is yes, only one answer meets that requirement letter, D as in David,

question number five. We're back to the question of  and here an individual assigned his partnership interest, and that individual is not made a partner. Certainly what you'd expect. However, the asset asserts to rights, participate in management and to share in the partnership profits. As we already know, That Anthony has only the right to participate in profits.

The second of the two rights he asserts and has absolutely no right in management as a consequence, there could be only one, correct answer here B Baker, because the individual only has the right to profits item two and not the right to participate in management item. Number one. Your question number six and here ask you to focus on a word that crops up in question after question.

And it's a word that you have to focus on, usually, which of the following statements is usually correct? Correct. Regarding a general partnerships liability. You're given two statements. All general partners are jointly and severally liable for partnership torts. And we talked about that example, uh, in the lecture, when I mentioned the driver who has an automobile accident.

Oh. And second, all general partners are liable only for the partnership obligations that they actually authorize. Well, what's an, a general partnership joint, and several liability for contract. Yeah. And tort clearly statement one is correct. And statement two is incorrect. General partners generally cannot disassociate themselves from the debts of the partnership.

So with one being right and two being wrong, the only correct answer is, Hey, number seven is a question that needed to be read carefully. We have three partners and they have made an agreement to split. The 40% of the partnership profits to two partners and 30% to the third partner. So this is not an equal distribution.

The partners have made an agreement. Remember that absolute agreement. It would be one third each, but here we have a specified agreement. We have losses that have not yet been allocated to the partners. So how much loss is allocated to Mr. Vick? Since the partners agreed on 30%, he will report 30% of the $30,000 loss or $9,000.

This means answer C must be the correct answer. And there's no point in trying to reach the other numerical calculations. It's a flat 30% by agreement among the partners answer C.

Question number eight, again gives us two columns of possible yeses and nos. The limited partner is subject to personal liability for partnership debts, which partner? We, the question again, the limited partner is liable for partnership. Debts. Answer that you're looking for is no. The limited partner has the right to take part to take control.

In the partnership or participate in the management of the partnership. Again, you're looking for a no answer because what happens if a limited partner involves themselves overly in the management or takes control of the partnership, limited partner becomes general partner. So to keep the limited partnership status, we need to have a no in the answer to the question of personal liability.

And we need to know for the answer to participation in management. With two nos, there's only one possible answer D for Douglas, the other, a, B and C are incorrect answers because they don't have the proper answers in the matrix. No, and no. And let's conclude this segment with looking at question number nine.

And here's another key word when you were reading the REG CPA Exam questions, unless unless otherwise provided in the agreement, which of these statements is correct. Well, a general partners, capital contribution may not consist of services. Absolutely incorrect. A general partner may contribute to cash property past or future service as part of his contribution or her contribution to the partnership.

Answer a is incorrect. Answer B is incorrect because upon the death of a limited partner, What happens to the partnership? It continues. The partnership is not dissolved. B is wrong. How about answers? C a person may own a limited partnership interest, any general partnership interest? Is there anything wrong with this?

Absolutely not. As long as you have a general and a limited, it can be the same person. As a matter of fact, I have a limited partnership with my wife. She's a general and the limited, I'm a general and a limited. So answer C is the correct answer. And why is answer D wrong upon the assignment of a limited partners interest?

The SME will become a substituted limited partner. What have we said about assignments of partnership interest over and over again? The Aczone of a partnership interest never, ever. Becomes a partner in the partnership. I hope you have answers C for number nine. With that, we will begin our next segment to take a look at limited liability companies and limited liability partnerships.

For years, business owners, lawyers, accountants, all types of advisors to businessmen. Have tried to find the Holy grail of business entities that is they've been looking for a device, which would allow limited liability for the owners at the same time setting forth minimal, or if possible, virtually no taxation of the owners, at least at the double level, which was true of the corporate environment.

So until the early 1980s, the only two vehicles of choice. We're either partnerships with the complete flow through and perhaps some limited liability. If you were using a limited partnership, of course, no liability, no limitations on liability. If a general partnership was involved, the other choice was the S corporation.

The tax option, uh, election was available to the regular corporation. However, beginning in 1979, the state of Ohio develop the concept of a limited liability company. LLC, which every country, which every state, not every country, every state has now adopted. So we have 50 States inclu, and the district of Columbia now have limited liability.

Corporate statutes. Most of these States also have limited liability partnership statutes, which allow professionals to incorporate under the LLP rubric. We're going to focus in this discussion on the LLCs and the general requirements for limited liability companies, because you will see the AICPA is taking more and more steps, protesting this material.

The reason being LLCs have become practically the vehicle of choice in organizing new business ventures. Well, what exactly is an LLC first? It's a legal entity, a separate and distinct legal entity organized under state law. In 1996, there was developed the uniform limited liability company act. And many of the state statutes are patented on this uniform law.

Let's look at the owners of an LLC. The owners are called members. You don't have partners. You don't have shareholders. You have members of a limited liability company. Members can be individuals. Trust partnerships, corporations, any type of entity can be a shareholder or rather a member of a limited liability company.

The only exception might be that if the specific state law prohibits certain types of entities from having ownership interest they're few, but occasionally you will see this. All of the members, all of the owners of the LLC have limited liability limited as to contract and as to tort actions. Now does a limited liability company have to have two or more individuals.

Two or more entities as owners. The answer is clearly no, every state now permits what they call a single member LLC. So Jack has two choices. He can establish a limited liability company with only myself as the owner. I am a single member LLC, let's say under Virginia law, which is where I live.

Alternatively I and my next door neighbor, Roger. Can each become members of a two member, LLC. These are known as multiple member LLCs, quite obviously, because there's more than one. The LLC has the legal characteristics of a separate entity, but it has some very strange tax attributes. Although called the corporation, it is not treated as a corporation.

For federal or state income tax purposes. Let's take a quick look at the tax consequences of an LLC. A single member, LLC jacks, LLC is called by the IRS, a disregarded entity in effect, the taxing authorities believe that the entity doesn't exist. They look through to the owner. So an LLC, my LLC that makes money is not taxed at the end of the level.

It is a pass through and all of the profits will be taxed on my personal tax return just as if I were a sole proprietor. How about a corporation? Let's just say a regular old C corporation, as we know, and love them, sets up a subsidiary. Sets up a subsidiary as a single member LLC, certainly possible to do.

And what happens that subsidiary is also considered a disregarded entity. Its operations are treated like a division of its parent corporation and all of its profits are taxed to the corporate owner. So single member LLC is a disregarded entity. The multiple member LLC is treated just like a general partnership.

So in effect, just as we discussed earlier in this program, the income profits loss, whatever it is from the LLC is divided equally among the member owners. And in my case, I told you that Roger and I were 50 50 owners. So just like a partnership. The LLC will file a partnership return. Roger will report 50% of the income.

Jack will report 50% of the income, no different than any other partnership. Now, just like in a partnership, we can agree on dividing profits and losses, those type of activities in our operating agreements differently so that Roger wouldn't get 50. Uh, Uh, he might get 60 and I would only get 40 that's all part of the governing provisions.

But the general rule is an LLC is not a tax paying entity. If it's a single member, it's treated like a proprietorship. If it's a multiple member, it's treated like a partnership.

No. How do we create an LLC? An LLC? Being organized under state law must file with the appropriate state regulatory body. They do not file articles of incorporation. Generally they file articles of organization and these agreements are filed with the appropriate state authority. I'm from Virginia. So we file with the state corporation commission and that LLC operating agreement.

I'm sorry that, uh, articles of organization, not the operating agreements, the articles of organization must include several items. The name of the entity, including the letters, LLC, after the name, they must designate the, uh, initial office of the LLC, the name and address of the registered agent. Very importantly, the name and address of each organizer of the LLC.

In addition, it must describe whether or not there is a term. In other words, does the LLC end after 50 years, does it have an unlimited life? Is it 99 years? So is it a term company and whether there is any member of the LLC, that's liable for the entities debts. Because remember the general rule of an LLC is owners members are not libel.

It's a limited liability entity. However, a member can agree to accept liability for the entities debts. So if that's to be true, that must be included in the articles of organization. Now, in addition to that, the entity. Puts together what they call the operating agreement. This is similar to a corporation's bylaws.

These do not have to be filed with the state regulators and are really the method by which the LLC is run and managed. Who operates, who runs an LLC? Well ships, remember all the partners had fiduciary duties and could act on behalf of the partnership. In an LLC, all the members have authority to transact business on behalf of the LLC, unless restricted in the operating agreement.

So generally all members have management rights. All members have fiduciary obligations. All of the owners can bind the other owners to the transactions. Also, the liability is limited as to each member. Most LLCs make a selection of a managing member. At least one of the owners who is named as the manager of the organization.

Alternatively, the members can also agree in the operating agreement to actually retain management personnel, people who are not owners, but who are professional managers of the LLC, just as you'd find in the corporation executives, officers. Hired who may or may not be owners of the business. Many of the provisions of the LLCs when they statutes were initially enacted most in the early 1980s, state-by-state had varying, uh, forms of restrictions.

Some were quite flexible. Some were quite inflexible over time. And with the adoption of the uniform act, Most state laws with respect to the LLCs have been greatly liberalized and many state statutes have what they called opt in provisions. Opt-in provisions are almost a checklist or a set of default provisions provided by state statute.

And this is one of the areas where. The organizers and the initial members of the LLC must be very careful about what they're choosing because in the opt in provisions, as you are putting together the LLC agreements, the articles of organization and the operating agreement, you can determine what rights managers have, what restrictions are there on the managers, how are voting rights handled?

What are terms of disillusion? What are allocations all of these various choices fall under the opt in provisions, or sometimes the opt out provisions of state statutes. It's important for the tax advisors, the legal advisors and the organizers of an LLC to review the state statutes and determine which provisions they wish to opt in or opt out of.

The LLC operations are very straightforward. It is just as the same, essentially as a corporation, it operates through the managers on behalf of the owners. Most always, you will find today that every owner of a. LLC does not try and manage it. These have become flexible tools and can have a large number of owner managers of owner members, so that the managers tend to be selected down to a few key executives each and every member, whoever has the fiduciary duties of care and loyalty to the organization and to the other members rights and remedies of creditors.

These are exactly the same as the corporate environment. The creditors have the claim against the assets of the LLC for the repayment of debts, for the fulfillment of obligations. Just remember however that the creditor is not going to be able to go against the owner member. Why? Because by definition, they are limited.

Members they can lose their capital account, but they can not be held liable for obligations over and above that capital account transfers of interest. Most I'll see arrangements allow for the transferability of membership interest. Can they be sold? Yes, they can. And they be transferred for the benefit of creditors.

Yes, they can. Do. They. Have to have approval of the other members of the LLC in order to make those transfers. Yes, they do. In this particular case because they are like, the partnerships can LLCs go through reorganizations. Of course they can be merged. They could be dissolved. They could be divided in the same manner as almost any corporate environment.

Very similar, uh, in nature there. However, when you begin to look to the tax consequences, you don't look to the corporate side, even though they're coal corporations, you look to the partnership rules, these entities, if you want to think about it are almost a hybrid. In some ways they follow the tax rules of partnerships and they follow a number of the legal rules, more closely akin to the corporate environment upon the dissolution of an LLC.

How was that handled? Same way as in the partnership, same way in effect the corporations, the creditors, the outside creditors, first in priority, they receive their payments secured than unsecured creditors. If there are loans to the LLC, they're repaid, then the members are repaid their capital accounts.

And remember since this is treated like a partnership, the capital accounts of the members of the LLC will in effect also contain profits less, any losses minus any distributions.

So if we can try and put the LLCs in focus, let's emphasize a couple of key points. They are creatures of state law. They can only be organized by filing articles of organization with the appropriate state regulatory body. Each member of an LLC has limited liability unless they agree. Otherwise the LLC can be multiple member.

In which case it's treated for tax purposes and certain other accounting ways as a partnership. A single member LLC is treated as a disregarded entity. And if owned by a individual will be treated as a proprietorship. And if owned by a corporation will be treated as a division of that corporation, the LLC also has operating agreements.

The operating agreements provide for the management, the way that the. LLC is run on a day-to-day basis. And in that operating agreement will be spelled out who are the managers of the LLC? Are there any special allocations? Are there any restrictions on what the LLC can do? And in general, most LLCs are organized in a way that allows them to conduct any legal activity anywhere in the world.

The operating agreement may also provide for special voting rights for additional powers or restrictions on powers of the members. It may provide for guarantees or assumptions, uh, by members to pay the debts of the organization. So in effect, the LLC becomes a quite flexible. Quite flexible business entity.

And as I've said, has become the entity of choice frequently and organizing new ventures, why it has unlimited. It has limited liability for all of the members. It has only one level of taxation. In other words, flow through treatment. It has free transferability of interest. Virtually every LLC today has an unlimited life.

And it can, depending on how the operating agreement is worded, have centralization of management. So in that sense, it has the powers and benefits of a corporation while providing the flexibility and tax benefits. So desired by business managers, the new tool, L L CS, we have three REG CPA Exam questions in the study guide, which I'd like you to take a look at and we'll come back and review those answers in just a moment.

Remember three REG CPA Exam questions. I'll give you two minutes for each one.

Question 10 focuses on the membership of an LLC. And the answer is B Bravo or Baker. Now let's understand first why the other three answers are not correct. A, an LLC member must have at least two members. Well, if you recall, I said, every state now allows single member LLCs. So you may either have an Ella limited liability company with one member or more than one member.

Clearly answer a is incorrect. C says that all members of the LLC must be us citizens or resident aliens. Again, this is incorrect. An LLC can be have members who are a virtually any type and any nationality. This CRA this answer would have been correct if we've been talking about S corporations, but we're not, we're talking limited liability companies and us citizens.

Us resident aliens or foreign individuals, or even foreign corporations can be members of a limited liability company. Answer D is incorrect because again, the flexibility of the LLC program allows corporations, individuals, trust of any kind, all types of entities to be members of the LLC. Clearly, then the answer comes back to B.

Anyone can be a member of an LLC and the LLC can be managed either by owner managers or by non-owner managers. Answer B is correct. Question number 11. We're talking about the tax status of a limited liability company. The answer here is D David, a single member, LLC. And how was that treated before? A single member, LLC is a disregarded entity could be a proprietorship or it could be a division of a company if it admits a second member.

And now we have a multiple member, LLC. What do we have? We have a partnership just as we discussed earlier on in the program. So D is the correct answer a is wrong because they, multiple member LLC is not treated. As a corporation, it is a pass through entity. And as we said, it's a partnership. A single member, LLC is treated in the same manner as an S-corporation with a single shareholder.

Absolutely not is an S-corporation with a single member. It was a single shareholder. It is a corporation. It must file a corporate return and yes, the income flow through to the owner, but it is not a disregarded entity. It is an entity with tax significance and it must file a tax return. And when the members, when a two member LLC, one member withdraws or dies, the LLC does not dissolve the LLC simply goes from being a multiple member, LLC, a partnership to a single member, LLC, a proprietorship or corporate division.

The answer is D. And our third and final question was best describing the operating characteristics of an LLC. So it is C in general, unless restricted by state law, an LLC can engage in any, any lawful activity. A few state statutes might restrict, might restrict, uh, an LLC in terms of carrying on a banking business.

Or insurance. There are certain States that have specific prohibitions, but in general answers see any lawful activity is the correct answer. Answer a is wrong because just like any other enterprise, an LLC can operate in any state, it may have to register and file documentation with that state, uh, we're wishes to conduct business as a foreign.

I E not organized in that state, uh, LLC, but it can operate in those other States. It can operate anywhere in the world that, that foreign country doesn't prohibit it and virtually anywhere in Europe, Asia, uh, most of central America, South America, Africa, us LLCs are operating today. So, uh, the answer B is wrong.

And finally answer D an LLC may engage in state regulated professional activities may only engage in state regulated activities. No, an LLC, as we said, can engage in any lawful activity D comes closer to addressing the question of LLP, the limited liability partnership, which in most cases are restricted by state law to certain professions, but this is not true of the LLC.