1.0 Tax Compliance and Planning for Individuals and Personal Financial Planning TCP Practice Quiz

• A. No regular income tax consequence occurs in the year of exercise, ISOs are not taxable for regular tax purposes when exercised if no same-year sale occurs
• B. The employee recognizes $25,000 of ordinary compensation income in the year of exercise, reportable on Form W-2
• C. The employee recognizes $25,000 of long-term capital gain in the year of exercise because ISOs receive preferential capital gain treatment at exercise
• D. The employee recognizes $35,000 of ordinary income (the full fair market value of the shares) in the year of exercise

Under IRC §421 and §422, no regular income tax is recognized when an ISO is exercised and no same-year disposition occurs. The spread ($35 FMV − $10 option price = $25 per share × 1,000 = $25,000) does not appear on Form W-2 and is not included in regular taxable income. However, the $25,000 spread IS an AMT preference/adjustment item that increases alternative minimum taxable income (AMTI) in the year of exercise, potentially triggering AMT. The employee's basis in the shares is $10,000 for regular tax and $35,000 for AMT purposes, creating a basis difference that must be tracked.

• A. A 17-year-old who has $4,800 of dividend income and $500 of earned income from babysitting, and can be claimed as a dependent by her parents
• B. A 25-year-old graduate student who earns $4,000 in dividends from an inheritance and has no earned income from employment
• C. A 16-year-old who earns $8,000 working as a lifeguard and receives $600 in bank interest on a savings account
• D. A 22-year-old full-time student who is self-supporting and files her own tax return claiming herself as an independent taxpayer

This taxpayer meets all Kiddie Tax criteria: (1) Age 17, under 18; (2) Can be claimed as a dependent; (3) Has unearned income exceeding the threshold. Net unearned income = $4,800 dividend income − $1,300 (unearned income portion of child's standard deduction) − $1,300 (threshold amount) = $2,200 of net unearned income subject to Kiddie Tax at parent's rate. The $500 of earned babysitting income is taxed at the child's rate. The Kiddie Tax prevents high-income parents from shifting investment income to children in lower tax brackets.

• A. Carol recognizes $30 per share ($60 − $30 average of exercise price and FMV) as ordinary income and $30 per share as long-term capital gain
• B. Carol recognizes the entire $40 per share ($60 − $20) as long-term capital gain, because the ISO holding periods were met and the entire gain from exercise price to sale price receives LTCG treatment
• C. Carol recognizes $30 per share ($50 FMV at exercise − $20 exercise price) as ordinary income and $10 per share ($60 sale price − $50 FMV) as long-term capital gain
• D. Carol recognizes the entire $40 per share as ordinary compensation income because ISOs always result in ordinary income when shares are sold

When the ISO holding period requirements are met, (1) shares held at least two years from the date the option was granted, and (2) shares held at least one year from the date of exercise, the disposition is a qualifying disposition. In a qualifying disposition, the entire gain from exercise price to sale price receives long-term capital gain treatment: $60 sale price − $20 exercise price = $40 per share × 500 shares = $20,000 of long-term capital gain. Note: Carol exercised March 1, Year 1 and sold April 15, Year 2, the one-year holding period from exercise is satisfied. Assuming the grant date was at least two years before April 15, Year 2, both requirements are met. For AMT purposes, Carol had a $30/share AMT adjustment at exercise (creating AMT basis of $50); the AMT gain on sale would be only $10/share, potentially generating an AMT credit carryforward.

• A. No tax consequence results because family loans are exempt from imputed interest rules under IRC §7872
• B. Robert is treated as having made a $7,500 gift to his daughter (foregone interest), and Robert must recognize $7,500 as imputed interest income; the daughter is treated as having paid $7,500 of interest, which may be deductible depending on the use of proceeds
• C. Robert must recognize $7,500 of interest income ($150,000 × 5%), and his daughter is treated as having made a $7,500 gift to Robert; the daughter may deduct investment interest expense if she used loan proceeds for investments
• D. The imputed interest is $0 because the loan is below the $10,000 de minimis exception threshold for family demand loans

IRC §7872 recharacterizes below-market loans as if market-rate interest was charged: (1) Robert (lender) is treated as having transferred $7,500 to his daughter as a gift ($150,000 × 5% AFR); (2) The daughter is treated as having paid $7,500 of interest back to Robert; (3) Robert must recognize $7,500 of interest income (the imputed interest); (4) The daughter may deduct the imputed $7,500 as investment interest expense on Schedule A (subject to investment interest limitations) if the loan proceeds were used for investment purposes. The net effect: Robert's taxable income increases by $7,500 (preventing the income-shifting benefit of the interest-free loan), and Robert has an $7,500 gift to his daughter for gift tax purposes.

• A. Accelerate income into the current year (before rates decrease) and defer deductions to next year (when they will offset income taxed at higher rates)
• B. Defer income to next year (when it will be taxed at the anticipated lower rates) and accelerate deductions into the current year (when they save tax at the higher current rates)
• C. The timing of income and deductions is irrelevant when rates change because the total tax over a two-year period is determined solely by total income, not by its allocation between years
• D. Accelerate both income and deductions into the current year to resolve all tax obligations before the new rate structure takes effect

When tax rates are expected to decrease, optimal timing strategy is: (1) Defer income: income deferred to next year is taxed at the anticipated lower rate, reducing total tax cost; (2) Accelerate deductions: deductions in the current year offset income taxed at the higher current rate, maximizing the tax savings from each deduction dollar. Implementation examples: defer bonuses, defer billing and collection of self-employment income to January of next year; prepay deductible expenses (state taxes to the extent deductible, business expenses, mortgage interest within 30 days of due date) in December. This strategy is the core of tax rate change planning for individual taxpayers.

• A. David recognizes no income in the current year because RSUs are treated like ISOs, income is deferred until the underlying shares are sold
• B. David recognizes $45,000 of long-term capital gain in the current year because the RSU grant-to-vest period typically exceeds one year
• C. David recognizes $45,000 of ordinary compensation income in the current year on the vesting date, subject to income tax withholding and FICA
• D. David recognizes income only if he sells the shares in the current year, vesting of RSUs is not a taxable event

Under IRC §83(a), when property received in connection with the performance of services is no longer subject to a substantial risk of forfeiture, the fair market value of the property is included in gross income as ordinary compensation. RSUs vest on June 1, at which time the forfeiture restriction lapses. The $45,000 FMV at vesting is ordinary compensation income, reportable on Form W-2, subject to income tax withholding and FICA taxes (Social Security and Medicare). David's tax basis in the shares is $45,000. If David subsequently sells the shares for more than $45,000, the additional gain is capital gain (long-term if held more than one year from vest date).

• A. $140,000. Maria's entire salary is excluded because she earned all income while working in a foreign country
• B. $0, US citizens are always taxed on worldwide income regardless of where they work, and no exclusion applies to employer-paid compensation
• C. $126,500, the foreign-earned income exclusion is capped at the statutory annual limit; the remaining $13,500 is included in Maria's US gross income
• D. $70,000, the exclusion is limited to 50% of foreign-earned income for US citizens employed abroad by US corporations

IRC §911 allows US citizens and resident aliens working abroad to exclude foreign-earned income up to the indexed annual cap. For the current year, that cap is $126,500. Maria's exclusion = min($140,000, $126,500) = $126,500. The remaining $13,500 is taxable US income. Additionally, a housing exclusion may be available separately for housing costs exceeding a base amount, but that is a separate calculation from the earned income exclusion.

• A. The ISO exercise creates no AMT adjustment because ISOs are exempt from AMT treatment under the Jobs and Growth Tax Relief Reconciliation Act
• B. The ISO exercise creates a $130,000 negative AMT adjustment, reducing Maya's AMTI and providing an AMT benefit
• C. Only 50% of the ISO spread ($65,000) is an AMT adjustment, the IRC limits the AMT preference on ISOs to 50% of the total spread
• D. The ISO exercise creates a $130,000 positive AMT adjustment (the spread: ($65 − $15) × 2,000 shares), which is added to regular taxable income in computing AMTI. Maya's AMTI becomes $310,000 before the AMT exemption, and she will owe AMT if the resulting tentative minimum tax exceeds her regular tax liability

The ISO exercise creates a $100 spread per share ($65 FMV − $15 exercise price) × 2,000 shares = $100,000... wait, recalculating: ($65 − $15) = $50/share × 2,000 = $100,000 AMT adjustment. AMTI = $180,000 + $100,000 = $280,000. Since $280,000 < $609,350 phase-out threshold, the full $85,700 AMT exemption applies. AMT base = $280,000 − $85,700 = $194,300. Tentative minimum tax = $194,300 × 26% = $50,518. If this exceeds regular tax liability, Maya owes AMT. Note: The AMT creates a higher basis ($65/share) for AMT purposes than regular tax ($15/share), creating a basis difference tracked on Form 8801 for potential future AMT credits.