- Under the tax benefit rule, if an accrual-basis taxpayer deducts an expense in one year and later recovers that amount, the recovery is:
Answer: Includible in gross income in the year of recovery, but only to the extent the prior deduction reduced the taxpayer's tax liability.
The tax benefit rule requires income inclusion upon recovery only to the extent the original deduction provided a tax benefit - if the deduction produced no tax benefit (e.g., due to AMT or zero tax), the recovery is excluded. Answer D is correct. Recoveries are not always excludable (A, C). Answer B is partially correct but incomplete - the recovery must be included to the extent the deduction benefited the taxpayer (D is more precise).
- Under the tax law, a cash-basis taxpayer who uses a credit card to pay a business expense may deduct the expense:
Answer: In the year the credit card charge is made, even though the credit card bill is paid in the following year.
A cash-basis taxpayer who pays by credit card is treated as having made payment when the charge is made - the credit card issuer effectively loans the taxpayer the funds. The deduction is in the year charged. Answer A is correct. The bill payment date (B) is not controlling for credit card charges. Benefit receipt (C) is an accrual concept. Spreading over balance period (D) is not the rule.
- A cash-basis attorney pays for office supplies in December. The supplies are used in the following January. Under the cash method, the deduction is taken in:
Answer: December, when the cash payment is made.
Under the cash method, deductions are generally taken when payment is made - the December payment creates a December deduction, regardless of when the supplies are consumed. Answer B is correct. Consumption timing (A) is the accrual matching principle. Tax benefit (C) and election (D) are not the cash method rules.
- The 'recurring item exception' to the economic performance rule allows an accrual-basis taxpayer to deduct a liability in the current year when:
Answer: Economic performance occurs within 8½ months after year-end, the item is recurring, and either the amount is not material or accrual results in better matching of income and deductions.
The recurring item exception requires: economic performance within 8½ months after year-end, the item must be recurring, and it must be immaterial or result in better matching. Answer C is correct. Mere recurrence without the other requirements is insufficient (A). The 30-day rule (B) applies to certain exceptions but not the recurring item exception. Services performed (D) is part of economic performance but not the recurring item test.
- The constructive receipt doctrine requires a cash-basis taxpayer to report income when:
Answer: The income is set apart for the taxpayer without substantial limitations or conditions, even if not actually received.
Constructive receipt occurs when income is set apart for the taxpayer and available without substantial limitation - the taxpayer cannot defer income by simply refusing to accept it. Answer A is correct. Mere legal entitlement (D) or ability to receive (B) alone is insufficient if there are substantial conditions. A deposit accessible to the taxpayer (C) is close but incomplete without the 'without substantial limitation' element.
- Which of the following entities is NOT permitted to use the cash method of accounting for tax purposes?
Answer: A C corporation (other than a farming business or qualified personal service corporation) with average annual gross receipts exceeding $31 million (the inflation-adjusted Section 448(c) threshold for 2024).
Under Section 448(c), as amended by the Tax Cuts and Jobs Act and adjusted for inflation, C corporations (except farming businesses and qualified personal service corporations) with average annual gross receipts exceeding the applicable threshold - $31 million for 2024 tax years - must use the accrual method. Answer D is correct. Sole proprietors (A), S corporations (B), and C corporations with gross receipts well below the threshold (C) may use the cash method if they otherwise qualify.
- The 'economic performance' requirement for accrual method deductions means that:
Answer: The deduction generally requires the provider to actually perform the services or deliver the property giving rise to the liability.
Economic performance requires the underlying activity to have actually occurred - services must be performed, goods delivered, or use of property provided. Answer D is correct. Financial resources (A) are irrelevant. Future certainty (B) does not satisfy economic performance. Management approval (C) is not the standard.
- An accrual-basis taxpayer contests a liability and the amount is genuinely disputed. Under the tax benefit rule and all-events test, a deduction for the contested liability:
Answer: Cannot be taken until the dispute is resolved and the liability becomes fixed.
The all-events test requires the liability to be fixed - a genuinely contested liability is not fixed until resolution. Answer A is correct. Disputed liabilities are not fixed (B). Notice alone (C) and setting aside funds (D) do not satisfy the all-events test.
- Which of the following is the primary advantage of the cash method over the accrual method for a service business?
Answer: The cash method allows the taxpayer to defer income by delaying billing or collection and accelerate deductions by prepaying expenses within limits.
The primary tax planning advantage of the cash method is the ability to manage the timing of income and deductions - deferring income until cash is received and accelerating deductions by early payment. Answer D is correct. There is no systematic lower tax over time (A). Estimated future deductions are not allowed on cash basis (B). Administrative simplicity (C) is a practical, not tax, advantage.
- A taxpayer changes from the cash method to the accrual method. Which of the following adjustments is required?
Answer: A Section 481(a) adjustment is required to prevent items from being omitted or double-counted as a result of the method change, with the adjustment spread over a period under IRS procedures.
Section 481(a) requires an adjustment when changing accounting methods to account for items that would be duplicated or omitted due to the change, typically spread over 4 years for unfavorable adjustments. Answer A is correct. Amending prior returns (B) is not required. Prospective-only changes without adjustment (C) would cause distortion. IRS consent is needed in advance, not just for the adjustment (D).
- An accrual-basis taxpayer receives a $12,000 advance payment in November for a 12-month service contract beginning December 1. Under the TCJA's conformity rule (Section 451(c)), the taxpayer must recognize:
Answer: The amount earned in the current year (one month = $1,000), with the option to defer the remaining $11,000 to the next year under the one-year deferral rule.
Section 451(c) allows deferral of advance payments to the next tax year for the portion not yet earned - one month ($1,000) is earned and recognized currently, with $11,000 deferred to the next year. Answer C is correct. Full immediate recognition (A) ignores the deferral election. One month allocation (B) is partially correct but misstates the $11,000 treatment. Full 12-month spreading (D) is not the Section 451(c) rule.
- Under the 12-month rule, a cash-basis taxpayer who prepays an expense may deduct it currently if:
Answer: The benefit from the prepayment does not extend beyond the earlier of 12 months after the first date of benefit or the end of the tax year following the year of payment.
The 12-month rule allows current deduction of prepaid expenses when the benefit does not extend beyond 12 months after the benefit begins or the end of the following tax year. Answer B is correct. The rule is not simply 24 months (A). Recurrence (C) and dollar amount (D) are not determinative.
- Which of the following statements about the hybrid method of accounting is correct?
Answer: A taxpayer may use the accrual method for purchases and sales of inventory and the cash method for other income and expense items, provided the combination clearly reflects income.
The hybrid method is permitted when it clearly reflects income - most commonly, accrual for inventory-related items (required if inventories are maintained) and cash for other items. Answer D is correct. Hybrid methods are permitted (A). The hybrid method is not limited to one specific combination (B). IRS approval may be needed for changes but not for initial use (C).
- Under the accrual method, a taxpayer incurs warranty expense but has not yet made repairs. The taxpayer may deduct the estimated warranty costs when:
Answer: The warranty liability becomes fixed (products sold and warranties outstanding) and economic performance has occurred through actual repairs or a recurring item exception applies.
Warranty deductions require the all-events test (liability fixed when products sold) plus economic performance (repairs made), unless the recurring item exception applies to allow deduction before year-end repairs. Answer A is correct. Financial statement accrual (B) alone doesn't satisfy tax requirements. Customer claims (C) are when repairs become probable, not when liability is fixed. Reserves (D) don't create tax deductions.
- A calendar-year accrual-basis taxpayer receives advance payment in December for services to be performed over the following 18 months. Under Rev. Proc. 2004-34, the taxpayer may:
Answer: Defer the recognition of income to the year the services are performed, but only to the extent the income is deferred for financial accounting purposes and included in the next tax year.
Rev. Proc. 2004-34 allows a one-year deferral for advance payments - the portion allocable to the next year can be deferred, but amounts not earned by year-end of the following year must be recognized. Answer A is correct. Deferral beyond the next tax year is not permitted (B). Full recognition in the year received (C) is the default without Rev. Proc. 2004-34. Straight-line 18-month spreading (D) is not the rule.
- Under the cash method of accounting, income is generally recognized when:
Answer: Payment is actually or constructively received by the taxpayer.
Under the cash method, income is recognized when actually or constructively received - when the taxpayer has control over the funds. Answer B is correct. Earning the right to receive (A) describes accrual. Providing services (C) is the performance standard. Form 1099 reporting (D) does not determine cash method timing.
- A cash-basis law firm receives a check for legal services on December 31. The firm does not deposit or cash the check until January 3. In which year is the income recognized?
Answer: December, because a check received before year-end is constructively received when it is delivered to the payee.
Under the constructive receipt doctrine, a check received before year-end is income in that year - the taxpayer has control over it regardless of when it is deposited. Answer C is correct. The deposit date doesn't determine recognition under cash method (A, B). The year of service is the accrual method (D).
- A calendar-year cash-basis taxpayer mails a check to a creditor on December 31 to pay a business expense. The creditor does not receive the check until January 3. When is the deduction available?
Answer: December 31, when the check is mailed, provided the payment is unconditional and the check is honored.
Under the cash method, mailing an unconditional check before year-end constitutes payment in that year when the check is mailed, even if not received until the following year - the 'mailbox rule' applies. Answer B is correct. Receipt date (A) is not the standard for mailed checks. Creditor agreement (C) is not required. Year of incurrence (D) is the accrual method.
- A cash-basis taxpayer borrows $50,000 and deposits it in their bank account. Which of the following correctly states the tax treatment of the borrowed funds?
Answer: The $50,000 is not includible in income because borrowed funds create a corresponding obligation to repay, resulting in no accession to wealth.
Borrowed funds are not income because they are offset by the repayment obligation - there is no accession to wealth. Answer B is correct. Constructive receipt doesn't apply to loan proceeds (A). No income is recognized (C). Loan forgiveness (D) would create cancellation of debt income but the original borrowing is not income.
- Under the accrual method, a deduction is allowed when:
Answer: All events have occurred establishing the fact of liability, the amount can be determined with reasonable accuracy, and economic performance has occurred.
Accrual method deductions require the all-events test (liability fixed, amount determinable) plus economic performance (the activity giving rise to the liability has occurred). Answer C is correct. Cash payment (A) is the cash method. Book recording (B) and invoice receipt (D) alone do not satisfy the all-events plus economic performance requirement.
