Chapter 22

Question 1

Where the S corporation rules are silent, C corporation rules apply to the S corporation.

True
False

Answer 1

True

This is true as a general rule.

Question 2

The S corporation is a flow through entity.

True
False

Answer 2

True

For an S corporation, income is taxed at the shareholder level and not at the corporate level.

Question 3

An S corporation cannot be a shareholder in another corporation.

True
False

Answer 3

False

Although partnerships and corporations cannot own S corporation stock, small business corporations can be partners in a partnership or shareholders in a corporation.

Question 4

Two classes of common stock that are identical, except that one class is voting and the other is nonvoting, are treated as a single class of stock for S corporation purposes.

True
False

Answer 4

True

A small business corporation may have only one class of stock issued and outstanding. This restriction permits differences in voting rights, but not differences in distribution or liquidation rights. Thus, two classes of common stock that are identical, except that one class is voting and the other is nonvoting, are treated as a single class of stock for S corporation purposes.

Question 5

Which of the following is not considered an occurrence for when the 2 ½ month election period for a new corporation begins?

a. When the corporation has shareholder(s).
b. When the corporation incurs a liability.
c. When the corporation acquires assets.
d. When the corporation begins doing business.
e. All of these choices are considered occurrences.

Answer 5

B

A new corporation’s 2 ½-month election period begins at the earliest occurrence of (1) when the corporation has shareholders, (2) when it acquires assets, or (3) when it begins doing business.

Question 6

A new corporation’s 2 ½-month election period cannot begin until it commences doing business.

True
False

Answer 6

False

A new corporation’s 2 ½-month election period begins at the earliest occurrence of (1) when the corporation has shareholders, (2) when it acquires assets, or (3) when it begins doing business.

Question 7

If an S corporation holds C corporation E & P and it generates passive investment income in excess of 50 percent of its gross receipts for three consecutive tax years, the S election is terminated as of the beginning of the fourth year.

True
False

Answer 7

False

The threshold is 25 percent.

Question 8

Passive investment income includes gains but not losses from the sale of securities.

True
False

Answer 8

False

Such gains and losses are included.

Question 9

During 2018, Orion Corporation incurs the following transactions:

Net income from operations $100,000
Interest income from savings account 3,000
Long-term capital gain from sale of securities 10,000
Short-term capital loss from sale of securities 4,000

Orion maintains a valid S election and does not distribute any assets (cash or property) to its sole shareholder, Candice. As a result, Candice must recognize:

a. Ordinary income of $103,000, long-term capital gain of $10,000, and $4,000 short-term capital loss.
b. Ordinary income of $103,000 and long-term capital gain of $6,000.
c. Ordinary income of $109,000.
d. Ordinary income of $100,000 and short-term capital loss of $4,000.
e. None of these choices are correct.

Answer 9

A

Net income and interest income are both ordinary income, so $103,000 of ordinary income must be recognized ($100,000 + $3,000). Capital gains and losses are separately stated items.

Question 10

Tax-exempt income is not separately stated on Schedule K of Form 1120S.

True
False

Answer 10

False

Tax-exempt income is separately stated on Schedule K of Form 1120S.

Question 11

The qualified business income deduction (QBID) is the lesser of 20% of qualified business income or 30% of modified taxable income.

True
False

Answer 11

False

The qualified business income deduction (QBID) is the lesser of 20% of qualified business income or 20% of modified taxable income.

Question 12

A distribution of cash or other property by an S corporation to shareholders that does not exceed the balance of AAA during a one-year period following an S election termination receives special tax-free treatment.

True
False

Answer 12

False

Only cash distributions receive tax-free treatment.

Question 13

An S shareholder who dies during the corporate tax year must report his or her share of the pro rata income (or loss) for the entire S corporation year on the final individual tax return.

True
False

Answer 13

False

Only income (or loss) up to the date of death is included on the final tax return.

Question 14

Evan, a shareholder, owned 20% of Yorker’s stock for 200 days and 25% of Yorker’s stock for the remaining 165 days of the year (not a leap year). Using the required per-day allocation method, Evan’s share of the S corporation’s ordinary income of $60,000 (rounded to the nearest dollar) is:

a. $6,575.
b. $18,000.
c. $15,000.
d. $6,781.
e. $13,356.

Answer 14

E

Using the per-day allocation method:

$60,000 × 20% × 200/365 = $ 6,575
$60,000 × 25% × 165/365 = 6,781
Total $13,356

Question 15

Paper, Inc., an S corporation for fifteen years, distributes a tract of land held as an investment to Esther, its majority shareholder. The land was purchased for $70,000 five years ago and currently is worth $30,000. As a result of this distribution:

a. The $40,000 loss is recognized at the corporate level.
b. Esther takes a basis of $70,000 in the land.
c. The loss decreases Paper’s AAA.
d. The $40,000 loss is recognized by Esther.
e. None of these choices are correct.

Answer 15

C

The loss of $40,000 ($70,000 purchase price less the $30,000 market value is not recognized at the corporate level, but does reduce Paper’s AAA.

Question 16

When an S corporation distributes noncash property to its shareholders, the character of the gain depends on the type of asset being distributed.

True
False

Answer 16

True

The character of the gain—capital gain or ordinary income—depends upon the type of asset being distributed.

Question 17

S corporations recognize a loss when distributing assets that are worth less than their basis.

True
False

Answer 17

False

They do not recognize a loss in such situations.

Question 18

An S shareholder’s basis is decreased by nondeductible expenses.

True
False

Answer 18

True

It is also decreased by nonseparately computed loss and by separately stated loss and deduction items

Question 19

Unlike partnerships, an S corporation shareholder’s basis includes only his or her direct investments, not his or her ratable share of any corporate liabilities.

True
False

Answer 19

True

Liabilities are not included.

Question 20

On January 2, 2018, Cherie loans her S corporation $10,000. By the end of 2018, Cherie’s stock basis is zero, and the basis in her note has been reduced to $8,000. During 2019, the company’s operating income is $10,000. The company also makes distributions to Cherie of $8,000. Which of the following statements is correct?

a. There is an $8,000 LTCG.
b. The loan basis is now $10,000.
c. The stock basis is $2,000.
d. There is a $2,000 LTCG.
e. None of these choices are correct.

Answer 20

B

The “net increase” of $2,000 ($10,000 – $8,000) is first used to increase the loan basis back to $10,000. The stock basis is zero ($8,000 – $8,000), and there is no long-term capital gain.

Question 21

Dmitri, a shareholder in an S corporation, has a basis of $60,000 in his S corporation stock. His share of this year’s S corporation loss is $75,000. Dmitri takes out a $20,000 nonrecourse loan from a local bank and lends the proceeds to the S corporation. As a result of these transactions:

a. Dmitri’s stock basis is $80,000 before deducting the loss.
b. Dmitri can deduct the loss of $75,000.
c. Dmitri has a stock basis of $60,000 and a loan basis of $20,000 before deducting any loss.
d. Dmitri’s stock basis is $5,000 after deducting the loss.
e. None of these choices are correct.

Answer 21

C

Dmitri has a stock basis of $60,000 and a loan basis of $20,000. However, due to the at-risk rules, he can deduct only $60,000 of S corporation losses, reducing his stock basis to zero.

Question 22

A shareholder’s stock basis in not reduced by passive activity losses that the shareholder cannot currently deduct due to the passive activity loss limitations.

True
False

Answer 22

False

A shareholder’s stock basis is reduced by passive activity losses that flow through to the shareholder, even though the shareholder may not be entitled to a current deduction due to the passive activity loss limitations.

Question 23

An S corporation’s net operating losses can be carried back two years by the S corporation.

True
False

Answer 23

False

NOLs pass through an S corporation directly to its shareholders.

Question 24

The LIFO recapture tax is payable in four equal installments.

True
False

Answer 24

True

The LIFO recapture tax is payable in four equal installments, with the first payment due on or before the due date for the corporate return for the last C corporation year (without regard to any extensions). The remaining three installments are paid on or before the due dates of the succeeding corporate returns.

Question 25

Turkey Corp., a cash basis calendar year C corporation in Savannah, Georgia, has $100,000 of accounts receivable on the date of its conversion to an S corporation on February 14. By the end of the year, $70,000 of these receivables is collected. Calculate any built-in gains tax, assuming that there is sufficient taxable income.

a. $6,300.
b. $0.
c. $14,700.
d. $21,000.
e. None of these choices are correct.

Answer 25

C

$70,000 × 21% = $14,700

Question 26

It may be beneficial for an S corporation to issue § 1244 stock.

True
False

Answer 26

True

An S corporation may issue § 1244 stock to its shareholders to obtain ordinary loss treatment.

Question 27

When computing the passive investment income penalty tax, in addition to gross receipts derived from royalties, passive rents, dividends, interest, and annuities, passive investment income gross receipts include only the net gain from the disposition of capital assets.

True
False

Answer 27

True

Only net gains are taken into account.

Question 28

Deductions for various tax-free fringe benefits are available to a more-than-2-percent shareholder-employee of an S corporation.

True
False

Answer 28

False

Deductions for various tax-free fringe benefits are denied to a more-than-2-percent shareholder-employee of an S corporation. Such benefits include group term life insurance, medical insurance, and meals and lodging furnished for the convenience of the employer. These items are treated as wages and are subject to most payroll taxes.

Question 29

March 15 of the current year is the deadline for which an entity must file a valid election with the IRS to become an S corporation.

True
False

Answer 29

True

March 15 of the current year is the deadline for which an entity must file a valid election with the IRS to become an S corporation.

Question 30

Ivan and Jaretta are married and live in a community property state. Danielle and Melanie are married and live in a state that is not a community property state. Jaretta and Danielle incorporate in January and file Form 2553 to become an S corporation. Ivan and Melanie have nothing to do with the operation of the corporation. Which of the following statements is correct regarding shareholder consent to become an S corporation?

a. Ivan and Melanie’s consent is required, even though they have nothing to do with the corporation, because as spouses of the shareholders, they are affected by the tax ramifications of the S election.
b. Because spouses always own corporation stock jointly, both Ivan and Melanie’s consent is required.
c. Even though Danielle and Melanie do not live in a community property state, Melanie’s consent is required.
d. Because Ivan and Jaretta live in a community property state, Ivan’s consent is required.
e. All of these choices are correct.

Answer 30

D

Both spouses must consent if they own their stock jointly, even though they count as one shareholder. This requirement has led to considerable taxpayer grief—particularly in community property states. Because Jaretta is married and lives in a community property state, her husband also must consent to the S election. Danielle does not live in a community property state, so her wife need not consent.

Question 31

A new corporation’s 2 ½-month election period cannot begin until it commences doing business.

True
False

Answer 31

False

A new corporation’s 2 ½-month election period begins at the earliest occurrence of (1) when the corporation has shareholders, (2) when it acquires assets, or (3) when it begins doing business.

Question 32

An S election is not valid unless the corporation qualifies as a small business corporation for the entire tax year.

True
False

Answer 32

True

Even if the 2 ½-month deadline is met, an S election is not valid unless the corporation qualifies as a small business corporation for the entire tax year.

Question 33

There is no consent extension available if Form 2553 is filed on a timely basis.

True
False

Answer 33

False

A consent extension is available only if Form 2553 is filed on a timely basis, reasonable cause is given, and the interests of the government are not jeopardized.

Question 34

A revocation of the S corporation election:

a. Requires the consent of 90 percent of the shareholders owning stock on the day the revocation is made.
b. Can split the corporation’s tax year into a short S corporation year and a short C corporation year.
c. Cannot be made prospectively.
d. Can be made by a new shareholder owning more than 30 percent of the stock.
e. All of these choices are correct.

Answer 34

B

A revocation that designates a future effective date splits the corporation’s tax year into a short S corporation year and a short C corporation year.

Question 35

Passive investment income includes dividends and interest.

True
False

Answer 35

True

Passive investment income includes interest and dividends.

Question 36

S corporations that have total assets on Schedule L at the end of the tax year that equal or exceed $10 million must file Schedule M–3 in lieu of Schedule M–1.

True
False

Answer 36

True

The schedule provides detailed information about the entity’s book-tax differences, and it can be used by the IRS to target specific items that will be subjected to an audit.

Question 37

Indigo, Inc., a calendar year S corporation, has no AEP. During the year, Amir, an individual shareholder of the corporation, receives a cash distribution of $18,500 from Indigo. Amir’s basis in his stock is $15,000. In this case:

a. Amir receives $15,000 tax free.
b. Amir has ordinary income of $15,000.
c. Amir has a negative stock basis of $3,500.
d. Amir has a capital gain of $18,500.
e. None of these choices are correct.

Answer 37

A

Amir has a capital gain of $3,500, the excess of the distribution over the stock basis ($18,500 less $15,000). The remaining $15,000 is tax-free, but it reduces Amir’s basis in his stock to zero.

Question 38

A shareholder’s stock basis in not reduced by passive activity losses that the shareholder cannot currently deduct due to the passive activity loss limitations.

True
False

Answer 38

False

A shareholder’s stock basis is reduced by passive activity losses that flow through to the shareholder, even though the shareholder may not be entitled to a current deduction due to the passive activity loss limitations.

Question 39

Any loss carryover due to insufficient basis remaining at the end of an approximately one-year post-termination transition period can be carried forward five years.

True
False

Answer 39

False

Any loss carryover due to insufficient basis remaining at the end of an approximately one-year post-termination transition period is lost forever.

Question 40

Leroy owns 800 shares in Jupiter, Inc., an S corporation. In 2018, his basis in his stock is $30,000, before the adjustment for this year’s losses. During 2018, Leroy’s share of the corporation’s ordinary loss is $20,000, and his share of its capital loss is $15,000. How much can Leroy deduct due to these losses?

a. $15,000.
b. $20,000.
c. $0.
d. $30,000.
e. None of these choices are correct.

Answer 40

D

The loss is limited to his basis in the stock. Total loss is $35,000 ($20,000 + $15,000). However, the stock basis is $30,000, so the loss is limited to $30,000.

Question 41

An account that represents the cumulative total of undistributed nonseparately and separately stated items (other than tax-exempt income and related expenses) for S corporation taxable years beginning after 1982.

Answer 41

Accumulated Adjustments Account (AAA)

Question 42

This is designed to discourage a shift of the incidence of taxation on unrealized gains from a C corporation to its shareholders, via an S election.

Answer 42

Built in gains tax

Question 43

Used in the context of a distribution from an S corporation. The net accumulation of the entity’s exempt income (e.g., municipal bond interest)

Answer 43

Other Adjustments Account (OAA)

Question 44

Net undistributed tax-basis earnings of a corporation aggregated from March 1, 1913, to the end of the prior tax year. Used to determine the amount of dividend income associated with a distribution to shareholders.

Answer 44

Accumulated earnings and profits

Question 45

In the context of a distribution by an S corporation, an election made by the entity to designate that the distribution is first from accumulated earnings and profits, and only then from the accumulated adjustments account (AAA).

Answer 45

Bypass election

Question 46

When earnings and profits (E & P) also exist, if the passive investment income of an S corporation exceeds 25 percent of the corporation’s gross receipts for three consecutive years, an S election is lost.

Answer 46

Passive Investment Income

Question 47

Under this provision, any recognized gain during the first (5, 7, or) 10 years of S status generates a corporate-level tax on a base not to exceed the aggregate untaxed built-in gains brought into the S corporation upon its election from C corporation taxable years.

Answer 47

Built in gains tax

Question 48

A special account required to track undistributed earnings of an S corporation that have been taxed to shareholders previously.

Answer 48

Accumulated Adjustments Account

Question 49

For Federal income tax purposes, the taxation of S corporations resembles that of partnerships.

True
False

Answer 49

True

Question 50

S corporations are treated as partnerships under state law.

True
False

Answer 50

False

Question 51

Payments to S shareholders by the corporation are distributed tax-free to the extent the distributed earnings were previously taxed.

True
False

Answer 51

True

Question 52

S corporations are subject to sales and capitalization restrictions.

Answer 52

False

Question 53

S corporations may only issue one class of stock.

Answer 53

True

Question 54

S corporations are limited to a theoretical maximum of 100 shareholders.

Answer 54

True

Question 55

S corporations may be U.S. (domestic) or non-U.S. corporations.

Answer 55

False

Question 56

S corporations shareholders may only be individuals, estates, and certain trusts and exempt organizations.

Answer 56

True

Question 57

Nonresident alien shareholders are not allowed for S corporations.

Answer 57

True

Question 58

The designation for a corporation that elects to be taxed similarly to a partnership.

Answer 58

S Corporation

Question 59

Sections 1361–1379 of the Internal Revenue Code. An elective provision permitting certain small business corporations (§ 1361) and their shareholders (§ 1362) to elect to be treated for income tax purposes in accordance with the operating rules of §§ 1363–1379. However, some S corporations usually avoid the corporate income tax, and corporate losses can be claimed by the shareholders.

Answer 59

Subchapter S

Question 60

Definition: A corporation that satisfies the definition of § 1361(b), § 1244(c), or both. Satisfaction of § 1361(b) permits an S election, and satisfaction of § 1244 enables the shareholders of the corporation to claim an ordinary loss on the worthlessness of stock.

Answer 60

small business corporation

Question 61

The owners of a majority of shares in an S corporation elect to terminate the S status of the entity as of a specified date. The day on which the revocation is effective is the first day of the corporation’s C tax year.

Answer 61

voluntary revocation

Question 62

Definition: Gross receipts from royalties, certain rents, dividends, interest, annuities, and gains from the sale or exchange of stock and securities. When earnings and profits (E & P) also exists, if the passive investment income of an S corporation exceeds 25 percent of the corporation’s gross receipts for three consecutive years, S status is lost.

Answer 62

passive investment income (PII)

Question 63

Net undistributed tax-basis earnings of a corporation aggregated from March 1, 1913, to the end of the prior tax year. Used to determine the amount of dividend income associated with a distribution to shareholders. § 316 and Reg. § 1.316–2.

Answer 63

accumulated earnings & profits (AEP)

Question 64

In the context of a distribution by an S corporation, an election made by the entity to designate that the distribution is first from accumulated earnings and profits and only then from the accumulated adjustments account (AAA).

Answer 64

bypass election

Question 65

Used in the context of a distribution from an S corporation. The net accumulation of the entity’s exempt income (e.g., municipal bond interest).

Answer 65

other adjustments account (OAA)

Question 66

A penalty tax designed to discourage a shift of the incidence of taxation on unrealized gains from a C corporation to its shareholders, via an S election. Under this provision, any recognized gain during the first 10 (or 7 or 5) years of S status generates a corporate-level tax on a base not to exceed the aggregate untaxed built-in gains brought into the S corporation upon its election from C corporation taxable years.

Answer 66

built-in gains tax

Question 67

Under prior law, the undistributed taxable income of an S corporation was taxed to the shareholders as of the last day of the corporation’s tax year and usually could be withdrawn by the shareholders without tax consequences at some later point in time. The role of PTI has been taken over by the accumulated adjustments account.

Answer 67

Previously taxed income (PTI)