GAC Tax Planning & Compliance 3 — Questions and Answers
Question 1: A municipal utility sells electricity to both governmental and private customers. The income from private customer sales is best characterized as:
- Exempt from federal tax because the utility is government-owned
- Potentially subject to federal tax as a proprietary activity outside IRC Section 115 (Correct answer)
- Exempt only if private sales constitute less than 10% of total revenue
- Subject to state sales tax but not federal income tax
Correct answer: Potentially subject to federal tax as a proprietary activity outside IRC Section 115
Revenue from activities that compete with private enterprise may not qualify for exclusion under IRC Section 115 and could be subject to federal taxation.
Question 2: Under the IRS rules for governmental plans, a 457(b) deferred compensation plan differs from a private-sector 401(k) primarily because:
- 457(b) contributions are made post-tax only
- 457(b) has no 10% early withdrawal penalty for separation from service (Correct answer)
- 457(b) plans cannot accept employer matching contributions
- 457(b) distributions are excluded from federal gross income permanently
Correct answer: 457(b) has no 10% early withdrawal penalty for separation from service
Governmental 457(b) plans do not impose the 10% early distribution penalty that applies to 401(k) and 403(b) plans upon separation from service.
Question 3: A school district issues bonds and uses the proceeds to invest in higher-yielding securities before spending on construction. This practice is called:
- Bond swapping
- Arbitrage (Correct answer)
- Refunding
- Defeasance
Correct answer: Arbitrage
Arbitrage occurs when bond proceeds are invested at a yield higher than the bond's interest rate, potentially triggering IRS rebate or penalty obligations.
Question 4: Which IRS form must governmental employers use to report wages and taxes withheld for employees subject to FICA?
- Form 941 (Correct answer)
- Form 944
- Form 1099-NEC
- Form W-3SS
Correct answer: Form 941
Form 941 (Employer's Quarterly Federal Tax Return) is used by governmental employers to report wages, withholding, and FICA taxes each quarter.
Question 5: A governmental entity classifies a worker as an independent contractor but the IRS determines the worker is actually an employee. The primary consequence is:
- Only the worker owes back taxes; the government has no liability
- The government owes back FICA and federal income tax withholding plus penalties and interest (Correct answer)
- The IRS can only assess penalties, not back taxes, against governmental entities
- The worker is exempt from back taxes due to governmental immunity
Correct answer: The government owes back FICA and federal income tax withholding plus penalties and interest
Worker misclassification makes the employer responsible for both the employer and employee share of FICA and any federal withholding not collected, plus penalties.
Question 6: What is the primary purpose of IRS Form 8038-G?
- To report unrelated business income of tax-exempt governmental entities
- To report information about tax-exempt governmental obligations at issuance (Correct answer)
- To apply for recognition of tax-exempt status under IRC Section 115
- To certify compliance with arbitrage rebate requirements annually
Correct answer: To report information about tax-exempt governmental obligations at issuance
Form 8038-G is filed by state and local governments to report information about each tax-exempt bond issuance as required by IRC Section 149(e).
Question 7: A government employee receives a $600 award for an outstanding safety record. How should this be treated for tax purposes?
- Fully excludable as a de minimis fringe benefit under IRC Section 132
- Excludable as a qualified employee achievement award up to IRS limits (Correct answer)
- Fully taxable as compensation reportable on Form W-2
- Exempt because government employees are not subject to fringe benefit rules
Correct answer: Excludable as a qualified employee achievement award up to IRS limits
Qualified employee achievement awards for safety achievement are excludable up to $400 (non-plan) or $1,600 (qualified plan) under IRC Section 74(c).
GAC Tax Planning & Compliance 3
A municipal utility sells electricity to both governmental and private customers.
The income from private customer sales is best characterized as: