I85PREP
⌘ K
IRS TCO study materials
IRS TCO study resources

IRS TCO practice questions

One question at a time. Build your IRS TCO understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Tax Law and Tax Compliance Fundamentals

A taxpayer files a federal return claiming a filing status of single, but the taxpayer was legally married on December 31 of the tax year and did not qualify for head of household. Under the Internal Revenue Code, which status applies?

  1. Head of household
  2. Married filing separately Correct answer.
  3. Single
  4. Qualifying surviving spouse

Explanation

Marital status for the whole year is determined as of the last day of the tax year, so a taxpayer married on December 31 is treated as married for that entire year. Because the taxpayer does not qualify for head of household or a joint return, the only available status is married filing separately. Filing as single is not permitted once married status applies.

Question 2Tax Law and Tax Compliance Fundamentals

Which individual is generally required to file a federal income tax return regardless of gross income level?

  1. A student with wages below the standard deduction
  2. A dependent with only interest income below the threshold
  3. A self-employed taxpayer with net self-employment earnings of $400 or more Correct answer.
  4. A retiree whose only income is nontaxable Social Security

Explanation

Self-employment tax filing rules require a return when net earnings from self-employment reach $400 or more, even if income is below the standard deduction. This obligation arises from the self-employment tax, not the income tax. Other low-income situations may not trigger a filing requirement.

Question 3Tax Law and Tax Compliance Fundamentals

For a taxpayer who qualifies, the earned income tax credit is classified as which type of tax provision?

  1. An above-the-line deduction
  2. An itemized deduction
  3. A refundable credit Correct answer.
  4. A nonrefundable credit

Explanation

The earned income tax credit is refundable, meaning any amount exceeding the taxpayer's liability can be paid to the taxpayer as a refund. Nonrefundable credits can only reduce tax owed to zero. Deductions reduce taxable income rather than directly offsetting tax liability.

Question 4Tax Law and Tax Compliance Fundamentals

A taxpayer sells shares held for 14 months at a gain. How is the gain characterized for federal income tax purposes?

  1. Nontaxable return of capital
  2. Short-term capital gain
  3. Ordinary income taxed at the taxpayer's marginal rate
  4. Long-term capital gain Correct answer.

Explanation

Capital assets held for more than one year produce long-term capital gain, which is eligible for preferential rates. The holding period begins the day after acquisition and ends on the sale date. Fourteen months exceeds the one-year threshold.

Question 5Tax Law and Tax Compliance Fundamentals

Which of the following best describes the standard deduction for an individual taxpayer?

  1. A deduction available only to itemizers
  2. A credit that directly reduces tax liability
  3. A fixed amount that reduces adjusted gross income to arrive at taxable income Correct answer.
  4. An exclusion that removes income from gross income

Explanation

The standard deduction is a flat amount subtracted from adjusted gross income to determine taxable income. It is available without substantiation and is an alternative to itemizing. It is not a credit or an exclusion.

Question 6Tax Law and Tax Compliance Fundamentals

An employer withholds federal income tax from an employee's wages. What is the employer's obligation regarding those withheld amounts?

  1. The employer may hold them until the employee files a return
  2. The employer may retain them as a fee for payroll services
  3. The employer must deposit them with the Treasury and report them on the appropriate return Correct answer.
  4. The employer must return them to the employee at year-end

Explanation

Withheld income and employment taxes are held in trust for the United States and must be deposited timely with the Treasury. The employer reports the amounts on payroll returns and reconciles them on annual information returns. Failure to deposit can trigger trust fund recovery penalties.

Question 7Tax Law and Tax Compliance Fundamentals

Which document must an employer furnish to an employee by January 31 summarizing wages paid and federal income tax withheld for the prior year?

  1. Form 941
  2. Form 1099-NEC
  3. Form W-2 Correct answer.
  4. Form W-4

Explanation

Form W-2 reports wages, tips, and other compensation along with federal income and payroll tax withheld. Employers must furnish it to employees by January 31. Form W-4 is completed by the employee to set withholding, and Form 941 is the employer's quarterly return.

Question 8Tax Law and Tax Compliance Fundamentals

A taxpayer receives a notice from the IRS proposing additional tax and wants to dispute it without going to court. Which action is most appropriate?

  1. Pay the full amount and forgo any further review
  2. File a protest and request a conference with the IRS Independent Office of Appeals Correct answer.
  3. Ignore the notice until the IRS files a lien
  4. File a new return for the same year without responding

Explanation

A taxpayer who disagrees with a proposed deficiency may file a timely written protest and request review by the Independent Office of Appeals. This administrative process occurs before litigation. Ignoring the notice can lead to enforced collection action.

Question 9Tax Law and Tax Compliance Fundamentals

For most individual taxpayers, the deadline for filing a federal income tax return for a calendar year is which date of the following year?

  1. January 31
  2. March 15
  3. June 15
  4. April 15 Correct answer.

Explanation

The general due date for individual returns is the 15th day of the fourth month after the tax year ends, which is April 15 for calendar-year filers. A timely extension request moves the filing date but not the payment date. Other dates apply to different entity types.

Question 10Tax Law and Tax Compliance Fundamentals

A taxpayer requests an automatic extension of time to file an individual return. Which statement about the extension is correct?

  1. It extends the filing deadline but not the time to pay tax due Correct answer.
  2. It eliminates any penalty for failure to file
  3. It extends both the filing deadline and the time to pay any tax due
  4. It extends the time to pay but not the filing deadline

Explanation

An extension of time to file grants additional time to submit the return but does not extend the deadline for paying tax owed. Interest and failure-to-pay penalties can accrue on unpaid balances. Taxpayers should estimate and pay any balance with the extension request.

Question 11Tax Law and Tax Compliance Fundamentals

Under the Internal Revenue Code, what is the general statute of limitations for the IRS to assess additional tax on a return that was filed and is not fraudulent?

  1. There is no limit for ordinary returns
  2. One year from the filing date
  3. Six years from the filing date in all cases
  4. Three years from the later of the filing date or the due date Correct answer.

Explanation

The general assessment period is three years from the date the return was filed or its due date, whichever is later. Longer periods apply to substantial omissions of income or fraud. The period can also be extended by agreement.

Question 12Tax Law and Tax Compliance Fundamentals

A taxpayer's return omits gross income that exceeds 25 percent of the gross income stated on the return. What assessment period generally applies?

  1. Ten years
  2. Three years
  3. Six years Correct answer.
  4. Four years

Explanation

When a taxpayer omits gross income exceeding 25 percent of the amount reported, the assessment period is extended to six years. This rule addresses substantial understatements of income. The ordinary three-year period applies when the omission is smaller.

Question 13Tax Law and Tax Compliance Fundamentals

Which of the following is an example of income that must be included in gross income?

  1. Interest earned on a municipal bond
  2. A gift received from a family member
  3. Life insurance proceeds paid by reason of death
  4. Rental income from a duplex owned by the taxpayer Correct answer.

Explanation

Rental income is taxable gross income, and related expenses may be deducted subject to passive activity rules. Municipal bond interest is generally excluded, and gifts and death benefits are also excluded from gross income. The taxpayer must report rental income on the appropriate schedule.

Question 14Tax Law and Tax Compliance Fundamentals

A taxpayer operates a sole proprietorship and has net profit from the business. Where is the business income reported on the individual return?

  1. Schedule B
  2. Schedule C Correct answer.
  3. Schedule E
  4. Schedule D

Explanation

Profit or loss from a sole proprietorship is reported on Schedule C, and the net amount carries to Form 1040. Schedule C also serves as the basis for computing self-employment tax. Other schedules handle interest, capital gains, and rental or pass-through income.

Question 15Tax Law and Tax Compliance Fundamentals

A taxpayer has $3,000 of capital losses and no capital gains for the year. How may the loss be used?

  1. The loss may offset ordinary income without limit
  2. Up to $3,000 may offset ordinary income, with the remainder carried forward Correct answer.
  3. The loss is disallowed entirely
  4. The full loss must be carried forward without any current deduction

Explanation

Individual taxpayers may deduct net capital losses against ordinary income up to $3,000 per year, or $1,500 for married filing separately. Any excess carries forward to future years. The carryforward retains its character as short-term or long-term.

Question 16Tax Law and Tax Compliance Fundamentals

Which of the following expenses is generally deductible as an itemized deduction on Schedule A?

  1. Federal income taxes paid
  2. State and local income taxes paid, subject to the applicable cap Correct answer.
  3. Commuting costs between home and a regular workplace
  4. Groceries purchased for personal consumption

Explanation

State and local income taxes are deductible as an itemized deduction, subject to the statutory cap on the combined deduction for state and local taxes. Personal living expenses and commuting costs are nondeductible. Federal income taxes are never deductible.

Question 17Tax Law and Tax Compliance Fundamentals

A taxpayer's adjusted gross income is $80,000 and the taxpayer is under age 65. Which statement about the charitable contribution deduction is generally correct?

  1. Contributions to a political campaign qualify as charitable contributions
  2. Contributions must exceed 90 percent of adjusted gross income to be deductible
  3. Cash contributions to a qualified charity may be deducted if the taxpayer itemizes Correct answer.
  4. Charitable contributions are deductible only if the taxpayer claims the standard deduction

Explanation

Charitable contributions to qualified organizations are deductible as an itemized deduction, subject to percentage limits based on adjusted gross income. Taxpayers who claim the standard deduction generally cannot deduct them, apart from limited special allowances. Political contributions are not deductible.

Question 18Tax Law and Tax Compliance Fundamentals

A taxpayer fails to file a required return and owes tax. Which penalty may the IRS impose?

  1. A penalty assessed solely against the return preparer
  2. A penalty equal to the entire tax owed in every case
  3. Only interest, with no penalty
  4. A failure-to-file penalty based on the net amount due Correct answer.

Explanation

The failure-to-file penalty is generally a percentage of the net amount of tax due, calculated per month or part of a month the return is late. The failure-to-pay penalty may also apply to the unpaid balance. Interest accrues in addition to penalties.

Question 19Tax Law and Tax Compliance Fundamentals

Which of the following describes the purpose of the trust fund recovery penalty?

  1. It holds responsible persons personally liable for willfully failing to remit withheld employment taxes Correct answer.
  2. It replaces the employer's obligation to file payroll returns
  3. It encourages employers to hold withheld taxes until year-end
  4. It applies only to employees who claim too many withholding allowances

Explanation

The trust fund recovery penalty makes responsible individuals personally liable for the trust fund portion of withheld taxes that were willfully not collected, accounted for, or paid over. It is a collection tool, not a substitute for filing. Employees are not liable for the employer's failure to remit.

Question 20Tax Law and Tax Compliance Fundamentals

A taxpayer who cannot pay the full tax due with a timely filed return should generally take which action?

  1. File the return without paying and ignore subsequent notices
  2. File the return on time and request an installment agreement for the balance Correct answer.
  3. File a fraudulent return to avoid the balance
  4. Delay filing the return until the balance can be paid

Explanation

Filing on time avoids the failure-to-file penalty, and an installment agreement allows the taxpayer to pay the balance over time. Interest and failure-to-pay penalties continue to accrue on the unpaid amount. Delaying the return adds penalties on top of the existing balance.

Question 21Tax Law and Tax Compliance Fundamentals

Which of the following is generally required for a taxpayer to qualify as a dependent as a qualifying child?

  1. The child must be unrelated to the taxpayer
  2. The child must live with the taxpayer for more than half the year and meet the age, relationship, and support tests Correct answer.
  3. The child must have gross income below the exemption amount
  4. The child must file a joint return with the taxpayer

Explanation

The qualifying child tests include relationship, age, residency, support, and a joint return test. The child generally must live with the taxpayer for more than half the year. A gross income limit applies to qualifying relatives, not to qualifying children.

Question 22Tax Law and Tax Compliance Fundamentals

A taxpayer sells a principal residence at a gain after owning and using it as a principal residence for three of the last five years. What exclusion may apply for a single filer?

  1. No exclusion is available
  2. Up to $250,000 of gain may be excluded Correct answer.
  3. Up to $500,000 of gain may be excluded
  4. The entire gain is always taxable as ordinary income

Explanation

A single filer who meets the ownership and use tests may exclude up to $250,000 of gain on the sale of a principal residence. Married couples filing jointly may exclude up to $500,000 when both meet the tests. The exclusion applies to gain, not to the full sales price.

Question 23Tax Law and Tax Compliance Fundamentals

A taxpayer receives a distribution from a traditional IRA before reaching age 59½ and does not qualify for an exception. What is the general tax treatment of the distribution?

  1. The distribution is tax-free because it came from a retirement account
  2. The distribution is taxed at capital gains rates
  3. The distribution is included in income and a 10 percent additional tax generally applies Correct answer.
  4. Only the earnings portion is taxed, with no additional tax

Explanation

Early distributions from a traditional IRA are generally includible in gross income and subject to a 10 percent additional tax unless an exception applies. Exceptions include certain disability, medical, and first-time homebuyer situations. The additional tax is imposed on the taxable portion of the distribution.

Question 24Tax Law and Tax Compliance Fundamentals

A taxpayer operates a business and uses the cash method of accounting. Which event generally triggers recognition of income?

  1. When the right to receive income becomes fixed, even if payment is not yet received
  2. When the customer is invoiced regardless of payment terms
  3. When payment is actually or constructively received Correct answer.
  4. When the fiscal year is closed

Explanation

Under the cash method, income is recognized when actually or constructively received, and expenses are deducted when paid. Accrual method taxpayers recognize income when the right to receive it becomes fixed. The cash method generally defers recognition until payment is received.

Question 25Tax Law and Tax Compliance Fundamentals

A taxpayer is audited and the IRS proposes a deficiency. Which statement about the burden of proof is generally correct?

  1. The burden of proof is irrelevant because the IRS must accept the return as filed
  2. The IRS bears the burden of proof in every case regardless of the taxpayer's conduct
  3. The taxpayer generally bears the burden of proof, but it may shift to the IRS in certain court proceedings if the taxpayer substantiates the position and meets other requirements Correct answer.
  4. The taxpayer always bears the burden of proof in every proceeding

Explanation

In general, the taxpayer bears the burden of proving the IRS's determination is incorrect. Under the Internal Revenue Code, the burden may shift to the IRS in certain court proceedings when the taxpayer introduces credible evidence, substantiates items, maintains required records, and cooperates. The IRS does not simply accept a return as filed during an audit.

Question 26Tax Law and Tax Compliance Fundamentals

Which filing status generally provides the most favorable tax rates and the largest standard deduction for an unmarried taxpayer who supports a qualifying dependent?

  1. Head of household Correct answer.
  2. Married filing separately
  3. Qualifying surviving spouse
  4. Single

Explanation

Head of household status is available to an unmarried taxpayer who pays more than half the cost of maintaining a home for a qualifying person and is treated more favorably than single status. It carries a larger standard deduction and wider brackets than the single filing status.

Question 27Tax Law and Tax Compliance Fundamentals

A taxpayer is claimed as a dependent on another person's return and has only interest income. Which rule governs whether the taxpayer must file a return?

  1. The dependent never files because the claimer reports all income
  2. The dependent must always file regardless of income amount
  3. The dependent's standard deduction and unearned income thresholds are lower than those for other filers Correct answer.
  4. The dependent files only if unearned income exceeds the amount earned from work

Explanation

Dependents face special, lower filing thresholds that combine a standard deduction amount with an additional unearned income limit. A dependent with only interest income must file once that unearned income exceeds the applicable threshold.

Question 28Tax Law and Tax Compliance Fundamentals

A taxpayer's employer reimburses documented business mileage under an accountable plan. How is the reimbursement treated?

  1. Treated as a taxable fringe benefit subject to withholding
  2. Excluded from the employee's gross income and not reported as wages Correct answer.
  3. Reported as wages but excluded from Social Security tax
  4. Included in gross income and deductible as a miscellaneous itemized deduction

Explanation

Reimbursements under an accountable plan, where expenses are business-connected, substantiated, and excess advances are returned, are excluded from gross income. They are not wages and are not subject to withholding.

Question 29Tax Law and Tax Compliance Fundamentals

A taxpayer receives employer-provided group term life insurance coverage with a face value of $80,000. What is the tax treatment of the cost of coverage above $50,000?

  1. The coverage is included only if the employee pays the premium
  2. No amount is included because group term life insurance is always tax free
  3. The value of coverage above $50,000 is included in gross income using the IRS table Correct answer.
  4. The entire premium is included in gross income

Explanation

Employer-paid group term life insurance is excluded from income up to $50,000 of coverage. The cost of coverage above that amount, determined under the uniform premium table, is taxable to the employee.

Question 30Tax Law and Tax Compliance Fundamentals

A taxpayer sells shares held for eight months at a gain. How is the gain characterized?

  1. Long-term capital gain taxed at preferential rates
  2. Ordinary income reported on Schedule C
  3. Short-term capital gain taxed at ordinary rates Correct answer.
  4. Section 1231 gain treated as capital

Explanation

Capital assets held one year or less produce short-term gain, which is taxed at ordinary income rates. The one-year holding period is measured from the day after acquisition through the sale date.

Question 31Tax Law and Tax Compliance Fundamentals

A taxpayer's employer pays the premiums on a qualifying long-term care insurance policy for the employee. How is the employer-paid premium treated?

  1. Excluded from the employee's income up to an age-based limit Correct answer.
  2. Taxable only if the policy also covers the employee's spouse
  3. Fully taxable as wages
  4. Deductible by the employee as a medical expense

Explanation

Employer-paid premiums for a qualifying long-term care policy are excluded from the employee's gross income up to an age-based dollar limit. Amounts above that limit are taxable wages.

Question 32Tax Law and Tax Compliance Fundamentals

A taxpayer makes a contribution to a traditional IRA for the tax year. What is the general effect on the current year's taxable income?

  1. The contribution reduces self-employment tax
  2. The contribution is never deductible and only grows tax deferred
  3. The contribution may be deducted if the taxpayer meets the applicable requirements Correct answer.
  4. The contribution is deducted only if made before the return is filed

Explanation

A traditional IRA contribution is deductible when the taxpayer meets the eligibility rules, which depend on coverage by a workplace plan and income. The deduction reduces taxable income in the year for which the contribution is made.

Question 33Tax Law and Tax Compliance Fundamentals

A taxpayer converts a traditional IRA to a Roth IRA during a year in which the account value declines after the conversion. What is the general result?

  1. The conversion is tax free because it stays within retirement accounts
  2. The income is deferred until the Roth account is distributed
  3. The converted amount is included in income at conversion, and a recharacterization is no longer available to undo it Correct answer.
  4. The taxpayer may recharacterize the conversion back to a traditional IRA

Explanation

A Roth conversion is taxable in the year of conversion based on the value converted. Recharacterization of a conversion is no longer permitted, so later declines do not reverse the included income.

Question 34Tax Law and Tax Compliance Fundamentals

A taxpayer sells stock at a loss and buys substantially identical stock 20 days later. What is the result under the wash sale rules?

  1. The loss is treated as a long-term capital loss
  2. The loss is disallowed and added to the basis of the replacement shares Correct answer.
  3. The loss is fully allowed in the year of sale
  4. The loss is disallowed permanently

Explanation

A loss on the sale of stock is disallowed when substantially identical stock is acquired within 30 days before or after the sale. The disallowed loss is added to the basis of the replacement shares, deferring rather than eliminating it.

Question 35Tax Law and Tax Compliance Fundamentals

A taxpayer's home is destroyed by a federally declared disaster, and the taxpayer receives insurance proceeds exceeding the adjusted basis. What is the general treatment of the gain?

  1. Gain is excluded entirely as involuntary conversion relief is automatic
  2. Gain is always recognized in full in the year of the disaster
  3. Gain is treated as ordinary income
  4. Gain may be deferred if replacement property is acquired within the required period Correct answer.

Explanation

Gain from an involuntary conversion is deferred when the taxpayer purchases qualifying replacement property within the replacement period. The deferral is elective, and the basis of the replacement property is reduced by the deferred gain.

Question 36Tax Law and Tax Compliance Fundamentals

A taxpayer pays state income tax and local property tax during the year. How are these taxes treated on the federal return?

  1. They are fully deductible without limit
  2. They are deductible only as business expenses
  3. They are never deductible for individuals
  4. They are deductible as state and local taxes subject to a capped amount Correct answer.

Explanation

Individuals may deduct state and local income, sales, and property taxes as itemized deductions, but the combined deduction is capped. The cap applies to the aggregate of these taxes.

Question 37Tax Law and Tax Compliance Fundamentals

A taxpayer pays $6,000 of qualified mortgage interest on acquisition debt secured by a first home. How is the interest treated?

  1. Deductible only if the taxpayer takes the standard deduction
  2. Deductible as an itemized deduction within the acquisition debt limits Correct answer.
  3. Deductible as a business expense on Schedule C
  4. Nondeductible because mortgage interest is personal interest

Explanation

Qualified residence interest on acquisition indebtedness within the statutory limit is deductible as an itemized deduction. The debt must be secured by a qualified residence and used to buy, build, or improve it.

Question 38Tax Law and Tax Compliance Fundamentals

A taxpayer with modified adjusted gross income of $90,000 pays $5,000 of student loan interest. What is the general treatment?

  1. Nondeductible because it is personal interest
  2. Deductible only if the loan is from a private lender
  3. Deductible as an itemized deduction
  4. Deductible as an adjustment to income subject to the phaseout Correct answer.

Explanation

Student loan interest is an above-the-line deduction that reduces adjusted gross income, subject to a maximum amount and an income phaseout. At the stated income level the taxpayer is generally below the phaseout range.

Question 39Tax Law and Tax Compliance Fundamentals

A self-employed taxpayer pays health insurance premiums for coverage of the taxpayer and family. What is the general treatment?

  1. Nondeductible because the taxpayer is self-employed
  2. Deductible as an adjustment to income, limited to earned income from the business Correct answer.
  3. Deductible as a business expense on Schedule C
  4. Deductible as an itemized medical expense only

Explanation

Self-employed taxpayers may deduct health insurance premiums for themselves and dependents as an above-the-line deduction. The deduction is limited to the earned income from the trade or business and is not available if the taxpayer is eligible for subsidized employer coverage.

Question 40Tax Law and Tax Compliance Fundamentals

A taxpayer donates appreciated stock held more than one year to a qualified charity. What is the general deduction amount?

  1. The lesser of basis or fair market value
  2. Fair market value of the stock, subject to percentage limits Correct answer.
  3. Adjusted basis of the stock
  4. No deduction is allowed for appreciated property

Explanation

A contribution of long-term capital gain property to a public charity generally is deductible at fair market value. The deduction is subject to the applicable percentage-of-AGI limitation for capital gain property.

Question 41Tax Law and Tax Compliance Fundamentals

A taxpayer claims the earned income tax credit on a return prepared by a paid preparer. What duty does the preparer have regarding the credit?

  1. Rely solely on the taxpayer's oral statement
  2. File the return without reviewing eligibility
  3. Perform due diligence and retain records supporting the credit eligibility Correct answer.
  4. Claim the credit only if the taxpayer has no dependents

Explanation

Preparers claiming the earned income tax credit must exercise due diligence, complete the required checklist, and keep records of the taxpayer's eligibility information. Failure to do so can result in preparer penalties.

Question 42Tax Law and Tax Compliance Fundamentals

A taxpayer receives a Form 1099-K reporting payments through a payment card processor. What is the taxpayer's reporting obligation?

  1. Report the income on the return and reconcile it with the taxpayer's records Correct answer.
  2. Treat the payments as nontaxable loans
  3. Ignore the form because it is informational only
  4. Report only amounts exceeding the reporting threshold

Explanation

Information returns such as Form 1099-K report payments to the IRS, and the taxpayer must report the underlying income accurately. The form's amounts should be reconciled with the taxpayer's books to avoid omissions or double counting.

Question 43Tax Law and Tax Compliance Fundamentals

A taxpayer operates a business and receives a Form 1099-NEC from a client. Where is the income reported?

  1. Schedule B as interest income
  2. Schedule C as gross receipts of the business Correct answer.
  3. Schedule D as a capital gain
  4. Form 1040 as wages

Explanation

Nonemployee compensation reported on Form 1099-NEC represents self-employment income and is reported on Schedule C. The taxpayer then computes self-employment tax on the resulting net profit.

Question 44Tax Law and Tax Compliance Fundamentals

A taxpayer uses the cash method and pays a business expense by credit card in December. When is the expense generally deductible?

  1. In the year the expense is billed by the vendor
  2. When the expense is approved by the card issuer
  3. Only when the credit card bill is paid
  4. In the year the card charge is made Correct answer.

Explanation

Under the cash method, a payment made by credit card is treated as made when the card is used, not when the statement is later paid. The expense is therefore deductible in the year of the charge.

Question 45Tax Law and Tax Compliance Fundamentals

A taxpayer's business has gross receipts of $2 million and uses the cash method. Which statement about inventory is generally correct for this small business taxpayer?

  1. The taxpayer must capitalize all inventory costs under the uniform capitalization rules
  2. The taxpayer may use a method that treats inventory as non-incidental materials and supplies Correct answer.
  3. The taxpayer may not deduct the cost of goods until all inventory is sold
  4. The taxpayer must always use the accrual method with full inventory accounting

Explanation

Qualifying small business taxpayers with average annual gross receipts under the threshold may use the cash method and treat inventory as non-incidental materials and supplies or follow the books. This simplifies accounting while still clearly reflecting income.

Question 46Tax Law and Tax Compliance Fundamentals

A taxpayer fails to keep adequate records for claimed business expenses. What is the likely consequence?

  1. The return is treated as timely filed without change
  2. The IRS must accept the taxpayer's estimate
  3. The deduction may be disallowed for lack of substantiation Correct answer.
  4. The expenses are automatically converted to credits

Explanation

Taxpayers bear the burden of substantiating claimed deductions with adequate records. Without credible substantiation, the IRS may disallow the deduction and assess additional tax.

Question 47Tax Law and Tax Compliance Fundamentals

A taxpayer is a sole proprietor and has net self-employment income of $60,000. Which statement about self-employment tax is correct?

  1. Self-employment tax is computed on Schedule SE and is in addition to income tax Correct answer.
  2. Self-employment tax applies only to income above $60,000
  3. Self-employment tax replaces income tax on the business profit
  4. Self-employment tax is withheld by clients who issue Form 1099-NEC

Explanation

Self-employment tax covers Social Security and Medicare for self-employed individuals and is computed on Schedule SE. It is separate from and in addition to federal income tax on the profit.

Question 48Tax Law and Tax Compliance Fundamentals

A taxpayer claims a dependent who provides more than half of the taxpayer's own support. Which test is most directly implicated?

  1. The joint return test for the taxpayer
  2. The residency test for the taxpayer
  3. The gross income test for the taxpayer
  4. The qualifying relative support test, because the dependent cannot be the taxpayer's qualifying child Correct answer.

Explanation

A qualifying relative must not provide more than half of their own support, and the taxpayer must provide more than half of the relative's support. A person who supports the taxpayer cannot be claimed under these rules.

Question 49Tax Law and Tax Compliance Fundamentals

A taxpayer receives unemployment compensation during the year. How is it treated for federal income tax purposes?

  1. Treated as a tax-free gift
  2. Treated as a capital gain
  3. Included in gross income as ordinary income Correct answer.
  4. Excluded from gross income as a public benefit

Explanation

Unemployment compensation is taxable and must be included in gross income. The taxpayer may elect withholding from benefits or make estimated payments to cover the tax.

Question 50Tax Law and Tax Compliance Fundamentals

A taxpayer wins a $10,000 prize in a contest and receives the prize in installments over two years. When is the prize generally includible in income?

  1. In the year received, as the amounts are actually paid Correct answer.
  2. Entirely in the year the contest was won
  3. Only when the total prize is fully paid
  4. Never, because prizes are excluded from income

Explanation

Prize and award winnings are includible in gross income when received. For a cash-method taxpayer paid in installments, each payment is income in the year received.