- A business owner sells their business to a key employee using an earnout arrangement. Under an earnout, additional payments are contingent on future performance. The seller's tax treatment of earnout payments received is:
Answer: Capital gain (or ordinary income for hot assets) recognized as earnout payments are actually received - the installment method may apply to spread the recognition over the payment period.
Earnout payments are recognized as received under the installment method - capital gain or ordinary income depending on the underlying asset. Answer B is correct. FMV recognition upfront (A) applies when the FMV can be reasonably ascertained (the open transaction doctrine applies when FMV is uncertain). Not ordinary income automatically (C). Earnouts are taxable (D).
- A business sells equipment used in its trade or business for $80,000. The equipment cost $100,000, has $60,000 of accumulated depreciation, and an adjusted basis of $40,000. The gain of $40,000 is characterized as:
Answer: $40,000 Section 1245 ordinary income - because the entire gain ($40,000) does not exceed the accumulated depreciation ($60,000), the full gain is recaptured as ordinary income under Section 1245.
Section 1245 recapture converts gain on depreciable personal property to ordinary income to the extent of accumulated depreciation. The equipment has an adjusted basis of $40,000 ($100,000 cost minus $60,000 accumulated depreciation). Sale price $80,000 minus adjusted basis $40,000 = $40,000 gain. Since the entire gain ($40,000) does not exceed the accumulated depreciation ($60,000), the full $40,000 is recaptured as ordinary income under Section 1245. Answer D is correct. Capital gain treatment does not apply because the gain is entirely within accumulated depreciation (A). Answer B ($60,000) is incorrect - the recaptured amount cannot exceed the actual gain realized ($40,000), even though accumulated depreciation was $60,000. Answer C is incorrect because there is no Section 1231 capital gain component when the entire gain falls within accumulated depreciation.
- When a business is acquired in a stock purchase, the acquiring corporation's basis in the target's assets:
Answer: Remains at the target's historical tax basis - a stock acquisition does not change the inside basis of the acquired company's assets unless a Section 338 election is made.
In a stock purchase, the target retains its existing asset tax basis - the acquirer's step-up is only in the stock, not the underlying assets, unless a Section 338 election is made. Answer A is correct. Automatic step-up (B) requires a Section 338 election. The residual method (C) applies to asset purchases. Inside basis is not affected by goodwill paid (D).
- A C corporation sells all of its assets in an asset sale rather than a stock sale. The primary tax disadvantage of an asset sale to the seller is:
Answer: Double taxation - the corporation pays tax on the gain at the entity level, and shareholders pay tax again when the after-tax proceeds are distributed in liquidation.
Asset sales from C corporations result in double taxation: corporate-level tax on asset gains, then shareholder-level tax when proceeds are distributed in liquidation. This is why sellers often prefer stock sales. Answer C is correct. Double taxation is the key disadvantage (A). Selling costs may be deductible (B). IRS approval is not required (D).
- A buyer of a business typically prefers an asset purchase over a stock purchase because:
Answer: The buyer gets a stepped-up basis in the acquired assets equal to the purchase price allocation, allowing increased depreciation deductions on depreciable assets going forward.
Asset purchases allow buyers to step up asset bases to FMV, creating larger future depreciation and amortization deductions. Answer B is correct. Prices vary independently of purchase structure (A). Buyers often assume liabilities in asset deals (C). Goodwill must be allocated in asset deals (D).
- A business owner's estate sells business assets after the owner's death. The heirs benefit from:
Answer: A step-up in basis to the FMV at the date of death (or alternate valuation date) - allowing heirs to sell the business assets with little or no capital gain if sold shortly after death.
Inherited assets receive a basis equal to FMV at death under Section 1014 - the step-up eliminates the unrealized appreciation in the hands of the decedent. Answer C is correct. Full step-up is provided (A). 50% step-up (B) is not the law. The step-up applies to all inherited property (D).
- When a business is sold and the purchase price includes an assumption of the seller's liabilities, the effect on the seller's amount realized is:
Answer: The assumed liabilities are included in the seller's amount realized - increasing the total amount realized and potentially the gain on the sale.
Under Section 1001, amount realized includes cash, FMV of property received, and liabilities assumed by the buyer - increasing the seller's amount realized. Answer A is correct. Liabilities increase, not decrease, amount realized (B). Liabilities definitely affect amount realized (C). Assumed liabilities are part of the consideration to the seller (D).
- Under Section 1231, net gains from sales of business property held more than one year are treated as:
Answer: Long-term capital gain - but only if Section 1231 gains exceed Section 1231 losses for the year; net Section 1231 losses are treated as ordinary losses.
Section 1231 provides favorable treatment: net Section 1231 gains are long-term capital gains; net Section 1231 losses are ordinary losses - the 'best of both worlds' for business property. Answer D is correct. Not ordinary income if net gains are positive (A). Not short-term (B). Section 1231 gains are taxable (C).
- A business sells real property used in its trade or business for $500,000. The property was purchased for $300,000, has straight-line depreciation of $80,000, and has an adjusted basis of $220,000. The gain of $280,000 is characterized as:
Answer: $80,000 of Section 1250 unrecaptured depreciation (taxed at 25% for individuals) and $200,000 of Section 1231 gain (treated as long-term capital gain if net Section 1231 gains are positive).
For real property with straight-line depreciation, Section 1250 actual recapture is zero (only additional depreciation creates recapture for real property). The $80,000 of depreciation is 'unrecaptured Section 1250 gain' taxed at 25% for individuals, and the remaining $200,000 is Section 1231/capital gain. Answer A is correct. Section 1250 full recapture (B) only applies to additional depreciation. Not all is capital (C). The 25% unrecaptured amount is separate from the capital gain rate (D).
- A Section 338(h)(10) election in a stock acquisition allows:
Answer: The acquirer to treat the stock purchase as an asset purchase for tax purposes - the target is treated as having sold all its assets at FMV and immediately reconstituted, giving the acquirer a stepped-up basis in the target's assets while the transaction is still a stock deal for legal purposes.
Section 338(h)(10) (available for qualified stock purchases from S corps or when both parties consent) treats the transaction as an asset purchase for tax, giving the buyer a stepped-up basis while the transaction remains a stock purchase for legal purposes. Answer C is correct. The target recognizes gain on the deemed sale (A). It applies to federal tax purposes (B). The seller typically bears the tax cost of the deemed asset sale (D).
- The sale of a partnership interest where the partnership has hot assets results in which form filing requirement?
Answer: Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests) must be filed by the partnership, and the selling partner reports ordinary income from hot assets and capital gain from the remaining interest separately.
Form 8308 must be filed by the partnership when a partner sells an interest and hot assets are present. The selling partner reports the hot asset ordinary income and capital gain separately. Answer B is correct. Form 4797 covers business property but not specifically the hot asset split (A). Not all capital gain (C). The partnership return reflects the sale but Form 8308 is the required form (D).
- When a partnership interest is sold, Section 751 'hot assets' cause:
Answer: The portion of the gain attributable to unrealized receivables and substantially appreciated inventory to be recharacterized as ordinary income - even though the overall sale is a capital asset transaction.
Section 751 converts the portion of partnership interest sale gain attributable to hot assets (unrealized receivables and appreciated inventory) from capital to ordinary income. Answer B is correct. Hot assets prevent full capital gain treatment (A). The allocation is based on the specific hot asset values, not a simple ratio (C). Installment sale treatment is separate (D).
- A taxpayer who previously recognized Section 1231 ordinary losses must apply the Section 1231 recapture rule when:
Answer: They have net Section 1231 gains in a subsequent year - the gains are converted to ordinary income to the extent of unrecaptured Section 1231 losses from the prior 5 years.
Section 1231 gains are 'tainted' by prior ordinary Section 1231 losses - gains in future years are converted to ordinary income to recapture the prior ordinary losses from the 5 preceding years. Answer A is correct. The recapture applies to subsequent net gains regardless of which assets (B). No holding period applies (C). Taxpayers cannot elect out (D).
- A business owner transfers their business to their adult child as a gift. The child's tax basis in the gifted business assets is:
Answer: The parent's adjusted basis (carryover basis), with a special rule that the basis for determining loss cannot exceed the FMV at the time of the gift.
Gift recipients generally take the donor's carryover basis - but the basis for determining loss is limited to the lower of carryover basis or FMV at gift date. Answer D is correct. FMV basis (A) applies only to inherited property. Zero basis (B) would be incorrect. Gift tax attributable to appreciation may increase basis (C - partially correct but D is more complete and accurate).
- Under Section 1060, when a business is sold in an asset sale, the purchase price must be allocated among assets using a residual method. The allocation order under Section 1060 is:
Answer: Class I (cash/cash equivalents), Class II (securities), Class III (accounts receivable/debt instruments), Class IV (inventory), Class V (all other assets), Class VI (IRC ยง197 intangibles except goodwill), Class VII (goodwill and going concern value) - goodwill receives the residual allocation.
Section 1060 requires the residual method allocating purchase price in order from Class I through VII, with goodwill receiving any residual amount. Answer A is correct. Goodwill receives the residual (last), not first (B). Equal FMV allocation ignores the required order (C, D).
- A taxpayer sells their sole proprietorship and allocates $150,000 to a personal goodwill covenant. The IRS may challenge this allocation because:
Answer: If the business is actually a personal service business where the goodwill is inseparable from the owner's personal skills and relationships (rather than the business entity itself), there may be no transferable business goodwill - only personal goodwill that the owner is selling separately.
The distinction between business goodwill (owned by the entity) and personal goodwill (belonging to the individual) is significant - if the goodwill is truly personal, the entity has no goodwill to sell. Answer C is correct. Personal goodwill can be sold by a sole proprietor (A). Goodwill is allocated based on value (B). Covenants are separate assets from goodwill (D - this is correct but not the challenge described).
- A business owner uses Section 1031 to exchange business real property for other business real property. 'Boot' received in the exchange is:
Answer: Taxable gain recognized to the extent of boot received - the lesser of the realized gain or the boot received is recognized, while the remaining gain is deferred.
Boot (cash or non-like-kind property received) triggers gain recognition in a Section 1031 exchange - the lesser of realized gain or boot received is recognized. Answer D is correct. Boot is not tax-free (A). Boot is not a deductible expense (B). Boot is received by the taxpayer, not added to the new property's basis (C).
- A business engages in a like-kind exchange under Section 1031. The basis in the replacement property is calculated as:
Answer: The adjusted basis of the relinquished property, minus boot received, plus boot paid, plus any gain recognized - preserving the deferred gain in the lower basis of the replacement property.
Replacement property basis = adjusted basis of relinquished property - boot received + boot paid + recognized gain. This formula ensures the deferred gain is embedded in the new property's lower basis. Answer B is correct. FMV (A) would eliminate the deferred gain. Purchase price (C) would represent a full step-up. Zero basis (D) is incorrect.
- When a corporation purchases assets from another corporation, depreciation recapture under Section 1245 or 1250 applies to:
Answer: The seller in the year of sale - the seller recognizes recapture income; the buyer takes a stepped-up basis and begins a new depreciation schedule.
Depreciation recapture is taxed to the seller in the year of disposition - the buyer starts fresh with the new (stepped-up) basis for future depreciation. Answer A is correct. Recapture occurs at the seller level in the sale year (B). Only the seller recognizes recapture (C). Installment sales don't eliminate recapture - it's recognized in the year of sale (D).
- A sole proprietor sells their business for $500,000. The assets include inventory ($80,000 FMV, $60,000 basis), equipment ($120,000 FMV, $40,000 adjusted basis with $60,000 of accumulated depreciation), goodwill ($200,000 FMV, $0 basis), and a non-compete covenant ($100,000 FMV, $0 basis). The tax consequences include:
Answer: Ordinary income on inventory ($20,000), Section 1245 recapture on equipment ($60,000 of ordinary income equal to the accumulated depreciation, which is less than the total gain of $80,000), long-term capital gain on remaining equipment appreciation ($20,000), and capital gain on goodwill ($200,000) - the non-compete is typically ordinary income.
Business asset sales are taxed asset-by-asset. Inventory gain = $80K - $60K = $20K ordinary income. Equipment: FMV $120K - adjusted basis $40K = $80K total gain; Section 1245 recapture = $60K (the accumulated depreciation, which is fully within the $80K gain) as ordinary income; remaining $20K is long-term capital gain. Goodwill: $200K - $0 basis = $200K capital gain. Non-compete covenants generate ordinary income. Answer D is correct. Not all gain is capital (A) or ordinary (B). Multiple asset classes generate different character income (C).
