Part 2 - Businesses - Unit 1 - Questions

Question 1

Wanda owns 100% of S corporation, Milk Enterprises. At the beginning of 2023, she had a zero basis and an unused ordinary loss carryover from Milk Enterprises in the amount of $5,000. During the year, Wanda secured a bank loan of $10,000 on her personal residence and made a shareholder loan of that amount to Milk Enterprises. At the end of 2023, Milk Enterprises reported on its Schedule K a $1,000 ordinary loss and a $3,000 cash distribution made to Wanda. Wanda has $10,000 in flow-through reportable income from other S corporations. How much of Milk Enterprises’ ordinary loss can Wanda deduct on her personal return?

A. $6,000 in loss
B. $5,000 in loss
C. $3,000 in loss
D. $0 in loss

Answer 1

A. $6,000 in loss.

• The basis of an S corporation shareholder’s stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:

1. Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
2. Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation reported on Schedule K-1, box 16, code D, minus (b) the amount of such distributions in excess of the basis of the shareholder’s stock.
3. Basis is decreased (but not below zero) by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder’s pro rata share of the property’s adjusted basis exceeds that deduction.
4. Basis is decreased (but not below zero) by all deductible losses and deductions reported on Schedule K-1.

• Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3).
• Additionally, a shareholder’s distributive share of loss from an S corporation is limited to the shareholder’s stock basis in that corporation. Therefore, losses that exceed a shareholder’s basis are disallowed for that year. In addition, the adjusted basis of a shareholder in an S corporation is increased by any loans made by the shareholder to the corporation.
• Accordingly, the amount of Milk Enterprises’ ordinary loss (before passive and at-risk limitations) that Wanda can deduct on her personal return is $6,000, computed as follows:

Beginning Basis $ 0
Plus: Shareholder Loan 10,000
Less: Distributions 3,000
Ending Basis $ 7,000

Unused Carryover Losses 5,000
Current-Year Losses 1,000
Allowable Loss $ 6,000

• Wanda’s new basis in Milk Enterprises is $1,000.

Question 2

Henry is a partner in XYZ Partnership. Henry’s adjusted basis of his partnership interest is $20,000, which includes his $5,000 share of partnership liabilities. Henry sells his interest in the partnership for $15,000. What is Henry’s gain or (loss) on the sale?

A. $0
B. $5,000
C. $(5,000)
D. $10,000

Answer 2

A. $0.

• Publication 541, page 11, provides that the sale or exchange of a partner’s interest in a partnership usually results in capital gain or loss. In addition, gain or loss is the difference between the amount realized and the adjusted basis of the partner’s interest in the partnership. If the selling partner is relieved of any partnership liabilities, that partner must include the liability relief as part of the amount realized for his or her interest.
• Example: Kumar became a limited partner in ABC Partnership by contributing $10,000 in cash on the formation of the partnership. The adjusted basis of his partnership interest at the end of the current year is $20,000, which includes his $15,000 share of partnership liabilities. The partnership has no unrealized receivables or inventory items. Kumar sells his interest in the partnership for $10,000 in cash. He had been paid his share of the partnership income for the tax year. Kumar realizes $25,000 from the sale of his partnership interest ($10,000 cash payment + $15,000 liability relief). He reports $5,000 ($25,000 realized - $20,000 basis) as a capital gain.
• If, however, a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership’s unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset.
• In this problem, Henry realizes $20,000 from the sale of his partnership interest ($15,000 cash payment + $5,000 liability relief). Henry has no gain or loss since his adjusted basis of $20,000 equals the amount realized from the sale.

Question 3

New ABC Partnership is organized in 2023 with three general partners. The partners include a corporation with a tax year ending on March 31 and a 60% interest in partnership capital and profits, and two individuals, each having a calendar tax year and a 20% interest in partnership capital and profits. The partnership’s required tax year ends on:

A. March 31
B. September 30
C. October 31
D. December 31

Answer 3

A. March 31

• A partnership generally must conform its tax year to its partners’ tax years. The rules for determining the required tax year are as follows:
  
  • Majority interest tax year is adopted if one or more partners having the same tax year own an interest in partnership profits and capital of more than 50% (a majority interest).
  • Principal partner tax year is adopted if there is no majority interest tax year; a principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
  • Least aggregate deferral of income is adopted if there is no majority interest tax year and the principal partners do not have the same tax year; the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.
• Since the corporation has the majority interest in the partnership, its tax year of March 31 is adopted.

Question 4

Jack and Ted formed an equal partnership. Jack contributed $10,000 cash and Ted contributed depreciable equipment that he has owned for 6 months with a fair market value of $10,000 and an adjusted basis of $2,000. Ted had taken $3,000 in depreciation on the equipment before he transferred it to the partnership. What amount should Ted report as a gain as a result of this transaction?

A. $0
B. $3,000
C. $4,000
D. $8,000

Answer 4

A. $0

• Publication 541, page 9, states, in part, that the basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. If the partner must recognize gain as a result of the contribution, this gain is included in the basis of his or her interest. Any increase in a partner’s individual liabilities because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner.
• However, neither the partner nor the partnership usually recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest. This applies whether a partnership is being formed or is already operating. The partnership’s holding period for the property includes the partner’s holding period. (Publication 541, page 8)
• Ted’s contribution of property with an FMV of $10,000 and an adjusted basis of $2,000 does not result in a gain from the transfer to the partnership. Assume the basis of $2,000 already included depreciation of $3,000.

Question 5

Which of the following are true?

1. Members of a controlled group no longer need to take into account the one $50,000, one $25,000, and one $9,925,000 taxable income bracket amounts.
2. When a controlled group adopts or changes an apportionment plan, each member must attach to its tax return a copy of its consent to this plan.
3. The filing of a Schedule O by a component member provides the required information as to the status of the group’s apportionment plan.
4. If no apportionment plan is adopted, members of a controlled group must divide the amount of any tax-benefit item equally among themselves.

A. 1, 2, and 3
B. 2, 3, and 4
C. 1, 3, and 4
D. All of the answer choices are correct.

Answer 5

C. 1, 3, and 4.

• The instructions for Form 1120, Schedule O, page 1, provides, in part, that with the replacement of the graduated corporate tax structure with a flat 21% corporate tax rate means that members of a controlled group no longer need to take into account the one $50,000, one $25,000, and one $9,925,000 taxable income bracket amounts.
• If no apportionment plan is adopted, members of a controlled group must divide the amount of any tax-benefit item equally amongst themselves (without regard to whether any members also are members of a consolidated group).
• A corporation must file Schedule O with its income tax return, amended return, or claim for refund for each tax year that the corporation is a component member of a controlled group, even if no apportionment plan is currently filed or the amounts apportioned have not changed from the previous tax year.
• The filing of a Schedule O, however, by a component member provides the required information as to the status of the group’s apportionment plan. Such information must indicate, when applicable, whether all the component members of the controlled group are adopting, amending, or terminating an apportionment plan. In addition, the agreement must be signed by a person authorized to sign on behalf of each component member of the controlled group. NO member should attach this agreement (or a copy of it) to their income tax return. Each component member must keep, as part of its records, either the original or a copy of the signed agreement.

Question 6

All of the following statements are correct concerning an S corporation except which of the following?

A. It is a “pass through” entity for tax purposes.
B. It files an informational return.
C. It is not subject to any taxes at the corporate level.
D. Form 2553 is used to elect S corporation status.

Answer 6

C. It is not subject to any taxes at the corporate level.

• Even though an S corporation is a “pass through” entity for tax purpose and an “informational return” is filed, S corporations may still owe tax (see lines 22a, 22b, and 22c of Form 1120-S Instructions, pages 20 through 21). An S corporation may owe income tax in the following instances:

1. If, at the end of any tax year, the corporation had accumulated earnings and profits, and its passive investment income under IRC Section 1362(d)(3) is more than 25% of its gross receipts, the corporation may owe tax on its excess net passive income.
2. A corporation with net recognized built-in gain (as defined in IRC Section 1374(d)(2)) may owe tax on its built-in gains.
3. A corporation that claimed investment credit before its first year as an S corporation will be liable for any investment credit recapture tax.
4. A corporation that used the LIFO inventory method for the year immediately preceding its first year as an S corporation may owe an additional tax due to LIFO recapture. The tax is paid in four equal installments, the first of which must be paid by the due date (not including extensions) of the corporation’s income tax return for its last tax year as a C corporation.

• Form 2553 is used to elect S corporation status.
• For more details on these taxes, see the instructions for lines 22a, 22b, and 22c of Form 1120-S.

Question 7

Ned accepted stock in his employer’s company valued at $1,000 instead of his $1,000 salary payment. Which tax consequence of this transaction is correct?

A. No income to Ned because stock distributions are not taxable.
B. No salary expense for his employer because no payment of salary was made.
C. Ned must recognize $1,000 income because the stock is payment for services.
D. This is a nontaxable exchange of property for stock.

Answer 7

C. Ned must recognize $1,000 income because the stock is payment for services.

• Distributions by a corporation of its own stock are commonly known as stock dividends. Stock rights (also known as “stock options”) are distributions by a corporation of rights to acquire its stock. Distributions of stock dividends and stock rights are generally tax-free to shareholders.
• However, if any shareholder has the choice to receive cash or other property instead of stock or stock rights, the stock and stock rights are treated as property and are governed by different rules, and the shareholder must recognize income. (See IRS Publication 542, pages 17 to 18, for more details on property distributions.)
• The term “property” does not include services rendered or to be rendered to the issuing corporation. Thus, the value of stock received for services is income to the recipient (Publication 542, page 4).
• Therefore, the tax consequence is that Ned must recognize $1,000 income because the stock is payment for services.

Question 8

Michael has a partnership interest with a zero basis. The partnership has inventory valued at $350,000. Michael’s share of the ordinary income to be received from the sale of the inventory would be $40,000. In 2023, Michael sells his partnership interest for $55,000. Michael will report the following gain in 2023:

A. $55,000 capital gain
B. $40,000 ordinary gain and $15,000 capital gain
C. $15,000 ordinary gain and $40,000 capital gain
D. No gain or loss

Answer 8

B. $40,000 ordinary gain and $15,000 capital gain.

• Publication 541, page 11, provides that the sale or exchange of a partner’s interest in a partnership usually results in capital gain or loss. In addition, gain or loss is the difference between the amount realized and the adjusted basis of the partner’s interest in the partnership. If the selling partner is relieved of any partnership liabilities, that partner must include the liability relief as part of the amount realized for his or her interest.
• If, however, a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership’s unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset.
• The income or loss realized by a partner upon the sale or exchange of its interest in unrealized receivables and inventory items is the amount that would have been allocated to the partner if the partnership had sold all of its property for cash at fair market value, in a fully taxable transaction, immediately prior to the partner’s transfer of interest in the partnership. (Publication 541, page 12)
• In this case, Michael has a gain of $55,000 ($55,000 − $0) from the sale of his interest in the partnership. The treatment of the gain, however, is $40,000 ordinary income, which is attributable to the inventory, and $15,000 capital gain, which is attributable to the capital investment.

Question 9

Given the fact patterns below, which of the following entities may NOT use the cash method of accounting?

A. The Acme Partnership had gross receipts of $17.5 million in 2022. Its gross receipts for 2021 were $40 million and its gross receipts for 2020 were $9.5 million.
B. John Jones manufactures and sells fans. His average annual gross receipts from 2020 to 2022 are $27,000,000.
C. Dallas Partnership has two partners since 2020—Joe Dallas, an individual, and Deer, Inc., a corporation. Dallas Partnership averaged annual gross receipts from 2020 to 2022 of $35 million.
D. John Gibb files his 2023 Form 1040 with an attached Schedule C reflecting $30 million in gross receipts from selling real estate.

Answer 9

C. Dallas Partnership has two partners since 2020—Joe Dallas, an individual, and Deer, Inc., a corporation. Dallas Partnership averaged annual gross receipts from 2020 to 2022 of $35 million.

• Most individuals and many small businesses use the cash method of accounting. Generally, however, if a taxpayer produces, purchases, or sells merchandise, the taxpayer must keep an inventory and use an accrual method for sales and purchases of merchandise (Publication 538, page 8).
• The following entities cannot use the cash method; including any combination of methods that include the cash method (see Publication 538, page 9):

1. A corporation (other than an S corporation) with average annual gross receipts for the three preceding tax years exceeding $29 million for 2023 (indexed for inflation).
2. A partnership with a corporation (other than an S corporation) as a partner and with the partnership having average annual gross receipts for the three preceding tax years exceeding $29 million (indexed for inflation). This is the situation for Dallas Partnership.
3. A tax shelter, as defined in Section 448(d)(3).

• An entity’s average annual gross receipts are determined by adding the gross receipts for the 3 preceding tax years and dividing the total by 3.
• In the case where a taxpayer must account for inventories (e.g., production, purchase, or sale of merchandise is an income-producing factor), the accrual method is required unless the taxpayer satisfies the qualifying small business taxpayer exceptions (see Publication 538, pages 13 and 14).
• A qualifying small business taxpayer satisfies the gross receipts test with average annual gross receipts of $29 million or less for 2023 (indexed for inflation) for the 3 prior tax years (e.g., John Jones).
• A qualifying small business taxpayer satisfies the gross receipts test with average annual gross receipts of $29 million or less for 2023 (indexed for inflation) (e.g., Acme).
• Finally, John Gibb qualifies to use the cash method because real estate held for sale by a real estate dealer in the ordinary course of business is not included as inventory (see Publication 538, page 14).

Question 10

If a corporation’s tax year ends December 31, it generally must file its income tax return by:

A. June 15 of the following year.
B. March 15 of the following year.
C. April 15 of following year.
D. October 15 of the following year.

Answer 10

C. April 15 of the following year.

• Generally, for the tax years beginning after December 31, 2015, a corporation must file its income tax return by the 15th day of the 4th month after the end of its tax year. A new corporation filing a short-period return must generally file by the 15th day of the 4th month after the short period ends. The IRS will grant a corporation an extension of time to file a corporation income tax return if the company completes the form properly, files it, and pays any tax due by the original due date for the return.
• If the due date falls on a Saturday, Sunday, or legal holiday, the due date for filing is extended to the next business day.
• Accordingly, if a corporation’s tax year ends December 31, it generally must file its income tax return by April 15 of the following year.

Note: For an individual, the filing date is the 15th day of the 4th month.

Question 11

Which of the following statements is correct about nonrecourse liabilities?

A. A partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability.
B. A partnership cannot legally have nonrecourse liabilities.
C. A partnership’s liability is a nonrecourse liability if a person related to one of the partners has an economic risk of loss for that liability.
D. A partner’s share of nonrecourse liabilities is generally split equally among the partners.

Answer 11

A. A partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability.

• A partnership liability is a recourse liability to the extent that any partner or a related person has an economic risk of loss for that liability. Conversely, a partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability.
• In addition, a partner’s share of nonrecourse liabilities is generally proportionate to his or her share of partnership profits. However, this rule may not apply if the partnership has taken deductions attributable to nonrecourse liabilities or the partnership holds property that was contributed by a partner.

Question 12

York, Inc., directly owns stock of Ajax Corporation. To determine if Ajax Corporation is a member of a controlled group with York, Inc., as the common parent, York must own at least what percentage of the voting and total value of the Ajax Corporation stock?

A. 100%
B. 80%
C. 75%
D. 51%

Answer 12

B. 80%.

• A controlled group of corporations is a group that is related through common ownership. There are two types of controlled groups: parent-subsidiary and brother-sister. This question deals with the parent-subsidiary type of relationship.
• A parent-subsidiary control group exists when a group of one or more chains of corporations are connected through ownership with a common parent if:

1. At least 80% of the total combined voting power of all classes of stock entitled to vote or at least 80% of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is directly or indirectly owned by one or more of the other corporations; and
2. The common parent corporation directly or indirectly owns stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote or at least 80% of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations (Schedule O (Form 1120) Instructions, pages 1 and 2).

• In this case, Ajax Corporation is a member of a controlled group with York, Inc., as the common parent if York owns at least 80% of the voting and total value of Ajax Corporation stock.

Question 13

Which of the following charitable contributions is deductible for tax year 2023 for a calendar-year corporation that uses the accrual method of accounting?

A. A charitable contribution paid on April 10, 2024, for tax year 2023.
B. A charitable contribution paid on June 10, 2024, for tax year 2023.
C. Both answer choices are correct.
D. Neither answer choice is correct.

Answer 13

A. A charitable contribution paid on April 10, 2024, for tax year 2023.

• A corporation using an accrual method of accounting can choose to deduct unpaid contributions for the tax year the board of directors authorizes them if it pays them by the due date for filing the corporation’s tax return (not including extensions). A declaration stating that the board of directors adopted the resolution during the tax year must accompany the return. The declaration must include the date the resolution was adopted.
• Note: Generally, for tax years beginning after December 31, 2015, a corporation must file its income tax return by the 15th day of the 4th month after the end of its tax year. Also, a corporation with a fiscal tax year ending June 30 must file by the 15th day of the 3rd month after the end of its tax year. But according to the law, C corporations with a June 30 filing also can make a charitable contribution by the 15th day of the 4th month even though they must file by the 15th day of the 3rd month, which would make the IRS publication incorrect for these corporations.

Question 14

Which of the following types of domestic business entities, formed after 1996, generally is taxed as a partnership unless it elects to be classified as a corporation?

A. A two-member limited liability company (LLC).
B. A business formed under a state law that refers to it as a joint-stock company or joint-stock association.
C. An insurance company.
D. A business wholly owned by a state or local government.

Answer 14

A. A two-member limited liability company (LLC).

• Publication 541, pages 2 and 3, states that a limited liability company (LLC) is an entity formed under state law and, unlike a partnership, none of the members of an LLC are personally liable for its debts. An LLC may be classified for federal income tax purposes as a partnership, a corporation, or an entity disregarded as an entity separate from its owner.
• A two-member limited liability company will be classified as a partnership for federal income tax purposes unless it elects to be classified as a corporation (Form 8832) or was formed before 1997 and was taxed as a corporation. (Publication 541, pages 2 and 3)
• For more information, see the instructions in Form 8832 on pages 4 and 5.

Question 15

All of the following are correct when a partnership is notified of an exchange of partnership interests involving unrealized receivables or inventory items, except:

A. Form 8308 is filed with Form 1065 for the tax year that includes the last day of the calendar year in which the exchange took place.
B. The partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, only if the notification occurs after the Form 1065 for the year of the exchange has been filed.
C. Form 8308 is filed separately within 30 days of the notification, if notified of an exchange after filing Form 1065.
D. Form 8308 states the date of the exchange.

Answer 15

B. The partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, only if the notification occurs after the Form 1065 for the year of the exchange has been filed.

• Publication 541, page 12, states that a partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, when it is notified of an exchange of partnership interests involving unrealized receivables or inventory items. More specifically:

1. Form 8308 is filed with Form 1065 for the tax year that includes the last day of the calendar year in which the exchange took place, or
2. Form 8308 is filed separately within 30 days of the notification, if the partnership is notified of an exchange after filing Form 1065.

• Form 8308 provides the telephone number of the partnership, states the date of the exchange, and states the names, addresses, and taxpayer identification numbers of the partnership filing the return and the transferee and transferor in the exchange.

Question 16

Which of the following statements is correct concerning a qualifying small business taxpayer in 2023?

A. The taxpayer can use the cash method of accounting even if he or she produces, purchases, or sells merchandise.
B. The taxpayer’s business is a tax shelter.
C. The taxpayer must meet the gross receipts test of $5 million or less for each of the 3 prior tax years.
D. All of the answer choices are correct.

Answer 16

A. The taxpayer can use the cash method of accounting even if he or she produces, purchases, or sells merchandise.

• Publication 334, page 15, provides, in part, that if a taxpayer produces, purchases, or sells merchandise in his or her business, the taxpayer must keep an inventory and use the accrual method for purchases and sales of merchandise.
• Some taxpayers, however, can use the cash method of accounting even if they produce, purchase, or sell merchandise by accounting for inventoriable items as materials and supplies that are not incidental. These taxpayers are a qualifying small business taxpayer if:

1. Average annual gross receipts of $29 million or less for the three prior tax years; and
2. The taxpayer’s business is not a tax shelter as defined under IRC Section 448(d)(3).

Question 17

In 2023 Green, Inc., had gross receipts from sales of $500,000, dividends of $100,000 from a domestic corporation in which Green, Inc., owned 50% of the stock, and operating expenses of $800,000. What is the 2023 net operating loss for Green, Inc.?

A. $200,000.
B. $265,000.
C. $300,000.
D. $330,000.

Answer 17

B. $265,000.

• A corporation figures a net operating loss (NOL) in the same way it calculates taxable income. It starts with its gross income and subtracts its deductions. If its deductions are more than its gross income, the corporation has an NOL (Publication 542, page 14).
• Furthermore, a corporation is permitted to deduct a percentage of certain dividends received during its tax year. A corporation can deduct, within certain limits, 50% of the dividends received if the corporation receiving the dividend owns less than 20% of the corporation distributing the dividend. If the corporation owns 20% or more of the distributing corporation’s stock, it can, subject to certain limits, deduct 65% of the dividends received.
• If a corporation has an NOL for a tax year, the dividends-received deduction limit of 65% (or 50%) of taxable income does not apply. To determine whether a corporation has an NOL, figure the dividends-received deduction without the 65% (or 50%) of taxable income limit. (Publication 542, page 11)
• Given the above, Green, Inc., owns 50% (more than 20%) of a domestic corporation; therefore, Green may take a 65% deduction on the dividends received in 2023 from the domestic corporation.
• Therefore, Green, Inc.’s, net operating loss for 2023 is $(265,000), determined as follows:

Income from Business: $500,000
Dividends Received: $100,000
Gross Income: $600,000
Deductions (Expenses): $(800,000)
Taxable Income before Special Deductions: $(200,000)
Minus: Deduction for Dividends Received (65%): $(65,000).
Net Operating Loss: $(265,000).

Question 18

Alberta Partnership sold a capital asset to Firsts Partnership at a loss of $70,000. Alberta had held the property for 5 months. Alberta is owned 30% by Dorothy, 30% by Fred, and 40% by Dale, Dorothy’s brother. Firsts Partnership is owned 80% by ABC Corporation. Dorothy owns 25% of the stock of ABC Corporation and Dale’s daughter, Deb, owns 60% of the stock of ABC Corporation. How much of the loss should Alberta allow for tax purposes on their tax return for the year of the sale?

A. $70,000.
B. $3,000.
C. $0.
D. $35,000.

Answer 18

C. $0.

• Publication 541, page 8, addresses the special rules applying to a sale or exchange of property between a partnership and certain persons. In the case of a loss, the losses will not be allowed from a sale or exchange of property (other than some interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%.
• If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed. The basis of each partner’s interest, however, in the partnership is decreased (but not below zero) by the partner’s share of the disallowed loss.
• If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. If any gain from the sale of the property is not recognized because of this rule, the basis of each partner’s interest in the partnership is increased by the partner’s share of that gain.
• Publication 541, page 8, further provides the rule to determine if a partner has more than 50% ownership. More specifically:

1. An interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered to be owned proportionately by or for its shareholders, partners, or beneficiaries.
2. An individual is considered to own the interest directly or indirectly owned by or for the individual’s family. For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants.
3. If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner.

• Dale is the focus because he is the owner with the greatest percentage of ownership of the Alberta Partnership at 40% before attribution is considered. Thus, when Alberta does their sale with Firsts Partnership, it is Dale that should be first analyzed because once the over 50% attribution is established, the question is answered and the loss disallowed. That is, Dale owns 70% of Alberta Partnership (40% Dale and 30% Dorothy, Dale’s sister). Dale owns by attribution 68% (which is 85% of 80%) of Firsts Partnership (ABC Corporation owns 80% of Firsts Partnership, therefore Dale owns 85% of ABC Corporation (25% Dorothy, Dale’s sister and 60% of Deb, Dale’s daughter)).

Question 19

Bob Moon forms Moon Enterprises LLC (Limited Liability Company) during the year. What form must Moon Enterprises LLC file in order to elect to be taxed as a C corporation?

A. Form 1065, U.S. Partnership Tax Return.
B. Form 8832, Entity Classification Election.
C. Form 1120, U.S. Corporation Income Tax Return.
D. Form 7004, Application for Extension of Time to File for Corporations.

Answer 19

B. Form 8832, Entity Classification Election.

• Publication 541, pages 2 and 3, states that a limited liability company (LLC) is an entity formed under state law and, unlike a partnership, none of the members of an LLC are personally liable for its debts. An LLC may be classified for federal income tax purposes as a partnership, a corporation, or an entity disregarded as an entity separate from its owner.
• Publication 541, page 3, states, in part, that a domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes.
• Generally, an eligible entity that does not file Form 8832 will be classified under the default rules, which holds that a domestic eligible entity is:

1. A partnership if it has two or more members or
2. Disregarded as an entity separate from its owner if it has a single owner. (Form 8832, page 4)

• In the case of an LLC with one member that is not treated as a corporation, the taxpayer is treated as a sole proprietorship. Hence, Bob Moon would need to file Form 8832 in order to be treated as a corporation.

Question 20

Carol owns 50% of the capital interest in ABC Partnership and 50% of the profits interest in XYZ Partnership. In 2021 for $100,000, ABC Partnership sells land to XYZ Partnership, which XYZ Partnership will use in its trade or business. The ABC Partnership’s adjusted basis in the land at the time of the sale was $120,000. In 2023, the XYZ Partnership sells the land to an unrelated third party for $160,000. How much gain will the XYZ Partnership recognize in 2023?

A. $30,000
B. $40,000
C. $60,000
D. $20,000

Answer 20

C. $60,000.

• Publication 541, page 8, addresses the special rules applying to a sale or exchange of property between a partnership and certain persons. In the case of a loss, the losses will not be allowed from a sale or exchange of property (other than some interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%.
• If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed. The basis of each partner’s interest, however, in the partnership is decreased (but not below zero) by the partner’s share of the disallowed loss.
• If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. If any gain from the sale of the property is not recognized because of this rule, the basis of each partner’s interest in the partnership is increased by the partner’s share of that gain.
• Carol owns 50% (not more than 50%) in both the ABC partnership and the XYZ partnership. Hence, the transfer of the property (adjusted basis of $120,000) from ABC to XYZ for $100,000 produces a $20,000 loss that ABC is able to take and recognize. Hence, the subsequent sale of the land by XYZ to an unrelated third party produces a $60,000 recognized gain, which is the difference between the sale price of $160,000 and the adjusted basis of $100,000.

Question 21

Jane gave each of her two children, Jake and Jeff, a 30% interest in her clothing store. Capital is a material income-producing factor. Jeff is 21, has worked in the store since he was 15, has developed significant sales skills, and helps his mom with the management duties. Jake is 25, married, has a job in another state, and does not participate in any of the store’s management decisions. Who are recognized as partners?

A. Jane
B. Jane and Jake
C. Jane, Jake, and Jeff
D. Jane and Jeff

Answer 21

C. Jane, Jake, and Jeff.

• Publication 541, pages 2 and 3, states that members of a family can be partners. However, family members (or any other person) will be recognized as partners only if one of the following requirements is met:

1. If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest, or
2. If capital is not a material income-producing factor, they joined together in good faith to conduct a business. They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner.

• In this problem, Jane gave each of her two children a 30% interest in the partnership where capital is a material income-producing factor. Therefore, Jane and both children are recognized as partners. Participation in the business is not a relevant factor for this issue.

Question 22

Kevin, the 100% owner of an S corporation, has an adjusted basis in stock before losses and deductions at the end of 2023 in the amount of $12,000. The 2023 corporate return shows a $20,000 ordinary loss and a $5,000 charitable contribution expense. What are the allowable losses and deductions Kevin may claim on his 2023 tax return?

A. $12,000 ordinary loss and $0 contribution expense
B. $9,600 ordinary loss and $2,400 contribution expense
C. $7,000 ordinary loss and $5,000 contribution expense
D. $12,000 ordinary loss and $5,000 contribution expense

Answer 22

B. $9,600 ordinary loss and $2,400 contribution expense.

• As provided in the instructions for Schedule K-1 (Form 1120-S), the basis of an S corporation shareholder’s stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:

1. Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
2. Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation minus (b) the amount of such distributions in excess of the basis of the shareholder’s stock.
3. Basis is decreased (but not below zero) by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder’s pro rata share of the property’s adjusted basis exceeds that deduction.
4. Basis is decreased (but not below zero) by all deductible losses and deductions reported on Schedule K-1.

• Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3).
• Per Regulation Section 1.1366-2(a)(5), if the shareholder’s pro rata share of the aggregate amount of losses and deductions is greater than the adjusted basis of the shareholder’s stock in the corporation, then the limitation on losses and deductions must be allocated among the shareholder’s pro rata share of each loss or deduction. The disallowed losses and deductions are carried forward from prior years.
• As such, Kevin may claim $9,600 ordinary loss and $2,400 contribution expense, calculated as follows:

Beginning Basis: $12,000
Less: Contribution Expense: $2,400 ($5,000 x 12,000, divided by the sum of $5,000 and $20,000)
Allowable Loss: $9,600 (loss of $20,000 limited to basis).

Question 23

In 2019, Mark purchased 100 shares of Roman, Inc., for $10 per share. In 2023, Roman, Inc., completely liquidated and distributed $8,000 to Mark. Mark must report income from this distribution as:

A. Ordinary other income.
B. Dividends.
C. Capital gains.
D. Return of capital.

Answer 23

C. Capital gains.

• Publication 550, page 21, provides that liquidating distributions, sometimes called liquidating dividends, are distributions the taxpayer receives during a partial or complete liquidation of a corporation. These distributions are, at least in part, one form of a return of capital. They may be paid in one or more installments. The taxpayer will receive Form 1099-DIV from the corporation showing the taxpayer the amount of the liquidating distribution in box 8 or 9.
• Any liquidating distribution the taxpayer receives is not taxable to the taxpayer until he or she has recovered the basis of his or her stock. After the basis of the taxpayer’s stock has been reduced to zero, the taxpayer must report the liquidating distribution as a capital gain. Whether the taxpayer reports the gain as a long-term or short-term capital gain depends on how long the taxpayer has held the stock.
• Therefore, Mark must report income from this transaction as capital gains.

Question 24

The adjusted basis of Rebecca’s partnership interest is $17,500. She received a distribution of $9,000 cash and a piece of land with an adjusted basis of $2,500 and a fair market value of $4,000. What is the gain to be recognized at the time of these distributions?

A. $1,500
B. $0
C. $4,500
D. $6,000

Answer 24

B. $0.

• Publication 541, page 5, provides, in part, that a partner generally recognizes a gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner’s interest in the partnership.
• Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she generally does not recognize any gain/loss until the sale or other disposition of the property.
• As a result, Rebecca would not recognize any gain from the receipt of the $9,000 in cash and the piece of land with an FMV of $4,000 (adjusted basis of $2,500) because the cash does not exceed her adjusted basis of $17,500 in the partnership, and she has not sold the land yet.
• With respect to the basis of the property received by Rebecca, Publication 541, page 6, states that unless there is a complete liquidation of a partner’s interest, the basis of property (other than money) distributed to the partner by a partnership is its adjusted basis to the partnership immediately before the distribution. However, the basis of the property to the partner cannot be more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction.
• Example: The adjusted basis of Steve’s partnership interest is $10,000. He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives).

Question 25

Generally, if a new corporation is filing a short-period return with a tax year ending on July 31, it must file its income tax return by:

A. October 15.
B. November 15.
C. December 15.
D. January 31 of the following year.

Answer 25

B. November 15.

• Generally, for tax years beginning after December 31, 2015, a corporation must file its income tax return by the 15th day of the 4th month after the end of its tax year. A new corporation filing a short-period return must generally file by the 15th day of the 4th month after the short period ends. The IRS will grant a corporation an extension of time to file a corporation income tax return if the company completes Form 7004 (Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns) properly, files it, and pays any tax due by the original due date for the return.

Question 26

Auto Body Express, LLC, a limited liability company, filed Form 1065 for calendar year 2023 on March 15, 2024. The general partner was not available to sign the return, so the in-house tax manager signed the return. The tax manager prepared the return but is not a limited liability company member. All of the following statements are correct, except:

A. The partnership has timely filed its tax return.
B. Since the tax manager is not a member of the LLC, the return has not been signed.
C. Form 1065 may be signed by any member of the LLC.
D. Form 1065 may be signed by a general partner.

Answer 26

A. The partnership has timely filed its tax return.

• Note that this question is asking for the incorrect statement, so “the partnership has timely filed its tax return” is the correct (false) answer.
• In general, every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. The partnership return must show the names and addresses of each partner and each partner’s distributive share of taxable income. (Publication 541, page 4)
• Form 1065 is not considered to be a return unless it is signed. The return must be signed by either a partner or LLC member (Form 1065 Instructions, page 5). When a return is made for a partnership by a receiver, trustee, or assignee, the fiduciary must sign the return, instead of the partner or LLC member, and it must be accompanied by a copy of the order or instructions of the court authorizing signing of the return or form.
• When filing an AAR (administrative adjustment request), Form 1065 must be signed by the partnership representative (or the designated individual if the partnership representative is an entity) for the reviewed year.
• Since the tax manager is not a member of the LLC, the return has not been signed; therefore, it is not timely filed.

Question 27

Which of the following statements is correct concerning an S corporation?

A. A corporation that has elected S status and has filed Form 1120-S for several years may terminate its S election by simply filing a Form 1120 in a subsequent year.
B. An S election may be revoked only with the consent of all shareholders who hold issued and outstanding shares of stock at the time revocation is made.
C. Once an S corporation has been terminated, the corporation cannot make another S corporation election for any tax year before the 5th tax year after the 1st tax year in which the termination took effect.
D. All of the answer choices are correct.

Answer 27

C. Once an S corporation has been terminated, the corporation cannot make another S corporation election for any tax year before the 5th tax year after the 1st tax year in which the termination took effect.

• To revoke the election, the corporation must file a statement with the appropriate service center listed under “Where to File” in the instructions for Form 2553. In the statement, the corporation must notify the IRS that it is revoking its election to be an S corporation. An S election may be revoked only with the consent of shareholders who hold more than 50% of the number of issued and outstanding shares of stock (including nonvoting stock) at the time revocation is made.
• It should be noted that after an S election has been terminated, the corporation (or a successor corporation) can make another election on Form 2553 only with IRS consent for any tax year before the 5th tax year after the 1st tax year in which the termination took effect.

Question 28

Robert owns 50% of an S corporation, Blue Sky, Inc., and has a basis in that corporation of $5,000 at the beginning of 2023. At the end of 2023, Blue Sky reports ordinary income of $10,000 and makes a distribution to Robert of a manuscript originally purchased for $1,000 but now valued at $8,000. How much income must Robert report on his personal 2023 return from this distribution?

A. $0
B. $1,000
C. $5,000
D. $8,000

Answer 28

A. $0.

• Generally, a corporate distribution to an S corporation shareholder is applied against and reduces the adjusted basis of the stock in the hands of the shareholder. To the extent the balance is more than the adjusted basis of the stock, the shareholder has a gain (usually a capital gain) from the sale or exchange of property.
• The basis of an S corporation shareholder’s stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:

1. Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
2. Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation reported on Schedule K-1, box 16, code D, minus (b) the amount of such distributions in excess of the basis of the shareholder’s stock.
3. Basis is decreased (but not below zero) by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder’s pro rata share of the property’s adjusted basis exceeds that deduction.
4. Basis is decreased (but not below zero) by all deductible losses and deductions reported on Schedule K-1.

• Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3).
• An S corporation can distribute property to its shareholders. If property is distributed, the amount of the distribution is considered to be the property’s fair market value (IRC Section 301(b)). When appreciated property is distributed, gain is recognized in the same manner as if the S corporation had sold the property to the shareholders at its FMV (Section 311(b)). The gain passes through to the shareholders and increases their basis in such property. However, losses are not recognized, unless the property is distributed in a liquidation of a corporation.
• As such, Robert is not required to report any income, determined as follows:

FMV of Property Received: $8,000
Less Basis (lesser of FMV and ending basis; see calculation below): $8,000 (return of capital)
Remaining: $0

Basis Calculation:
Beginning Basis: $5,000
Plus Ordinary Income (50% of $10,000): $5,000
Ending Basis before Property Distribution: $10,000

Question 29

In 2017, Adam purchased 100 shares of Call Corporation stock for $50 per share. During 2023, Call Corporation completely liquidated. After paying its liabilities, Call Corporation distributed to its shareholders $10,000 in cash and appreciated property sold for $90,000. Adam’s portion received a liquidating distribution from Call Corporation of $10,000. Adam must report what amount of capital gains income from this distribution?

A. $4,500
B. $5,000
C. $22,500
D. $25,000

Answer 29

B. $5,000.

• When a corporation distributes property as part of a complete liquidation, the distribution is treated as full payment in exchange for the stock. The shareholder’s gain or loss from a distribution is determined by subtracting the basis of the stock from the amount distributed. The difference is a capital loss or gain.
• Therefore, Adam will recognize $5,000 in capital gain, calculated as follows:

Amount Distributed: $10,000
Less:
Basis in Stock: $(5,000) (100 shares x $50)
Capital Gain: $5,000

Question 30

As of December 31, 2023, John is a 50% shareholder of XYZ, Inc., an S corporation, as well as a 75% shareholder of ABC, Inc., also an S corporation. Both companies are calendar-year taxpayers. Because of profitable years, each company elected to use the maximum depreciation deduction allowable under IRC Section 179 for the year. Assuming that each election was valid, what is the maximum amount of Section 179 deductions that can be recognized by John?

A. $2,700,000
B. $1,160,000
C. $1,080,000
D. None; depreciation is not a pass-through item.

Answer 30

B. $1,160,000.

• Pursuant to page 26 of the Instructions for Form 1120-S, the amount of depreciation claimed under IRC Section 179 by an S corporation is not deductible by the corporation. Rather, the amount of Section 179 depreciation is passed through to the shareholder.
• For 2023, the maximum Section 179 expense is $1,160,000. In addition, this limit is reduced by the amount by which the cost of Section 179 property placed in service during the year is more than $2,890,000 (Instructions for Form 4562, pages 3 to 5).
• Therefore, the maximum amount of Section 179 deductions, which can be passed through to John is $1,160,000, computed as follows:

                               XYZ, Inc.         ABC, Inc. Max. Deduction    $1,160,000     $1,160,000 Shareholder %         0.50                0.75
                               $580,000     $870,000

  Total: $1,450,000 ($540,000 + $870,000)
• Although the maximum amount of Section 179 deduction that can be passed through to John is $1,450,000, only $1,160,000 may be recognized in any single year. John’s basis in each S Corporation will be reduced by the full depreciation ($580,000 for XYZ and $870,000 for ABC) regardless of the limitation applied to John on his personal return.

Question 31

The Cole Corporation distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. What gain, if any, must Cole Corporation recognize?

A. $10,000
B. $75,000
C. $25,000
D. $-0-

Answer 31

A. $10,000.

• Most distributions from a corporation are in the form of money, but they may also be in stock or other property. Distributions of cash do not generate recognized gains for the corporation. However, a corporation will recognize a gain on the distribution of property to a shareholder IF the FMV of the property is more than its adjusted basis. This is the same treatment the corporation would receive if the property were sold. For this purpose, the FMV of the property is the greater of:

1. The actual FMV or
2. The amount of any liabilities the shareholder assumed in connection with the distribution of the property.

• Thus, the Cole Corporation will have a recognized gain of $10,000, computed as follows:

FMV of the Land $60,000
Less:
Adjusted Basis of the Land (50,000)
Recognized Gain $10,000

Question 32

Rand Corporation distributes land to a shareholder. The fair market value of the land exceeds its basis to the corporation. Which of the following statements is true with regard to this transaction?

A. Rand Corporation must recognize gain on this distribution.
B. Rand Corporation realizes but does not recognize gain on this distribution.
C. Rand Corporation has neither a realized nor a recognized gain on this distribution.
D. The stockholder has a recognized loss on this distribution.

Answer 32

A. Rand Corporation must recognize gain on this distribution.

• A corporation will recognize a gain on distribution of property to a shareholder if the FMV of the property is more than its adjusted basis. Generally, this is the same treatment the corporation would receive if the property were sold. However, for this purpose, the FMV of the property is the greater of:

1. The actual FMV or
2. The amount of any liabilities the shareholder assumed in connection with the distribution of the property.

• If the property was depreciable or amortizable, the corporation may have to treat all or part of the gain as ordinary income resulting from the depreciation recapture provision.
• Given that Rand Corporation’s fair market value of the land exceeds its basis to the corporation, Rand Corporation must recognize gain on this distribution.

Question 33

Which of the following would NOT total more than 50% ownership in T, F, and J Partnership for Ted?

A. Ted 40%, Ted’s Wife 5%, Ted’s Son 10%, Ted’s Brother 45%
B. Ted 40%, Ted’s Wife 20%, Ted’s Dad’s estate 10%, Ted’s Brother 30%
C. Ted 40%, Ted’s Wife 5%, Ted’s Cousin 55%
D. Ted 40%, Ted’s Wife 5%, Ted’s Son’s Corporation 55%

Answer 33

C. Ted 40%, Ted’s Wife 5%, Ted’s Cousin 55%.

• Publication 541, page 8, provides a rule to determine if a partner has more than 50% ownership, which is as follows:

1. An interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered to be owned proportionately by or for its shareholders, partners, or beneficiaries,
2. An individual is considered to own the interest directly or indirectly owned by or for the individual’s family. For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants, or
3. If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner.

• In this problem, Ted does not have more than 50% ownership in the case where he owns 40% and his wife owns 5%, which is 45% ownership. The other 55% ownership by Ted’s cousin does not constructively count for Ted.

Question 34

Which of the following is correct for purposes of determining whether a distribution from a corporation is taxable to a shareholder as a dividend?

A. Taxable income may be substituted for current earnings and profits when reporting dividends.
B. Only current earnings and profits are reported as dividend.
C. Only accumulated earnings and profits are reported as dividend.
D. Current or accumulated earnings and profits are reported as dividend.

Answer 34

D. Current or accumulated earnings and profits are reported as dividend.

• Generally, a corporate distribution to a shareholder is treated as a distribution of earnings and profits. Distributions made from either current or accumulated earnings and profits are reported as dividends to the shareholder(s).
• Any part of a distribution that is not from earnings and profits is applied against and reduces the adjusted basis of the stock in the hands of the shareholder. To the extent the balance is more than the adjusted basis of the stock, the shareholder has a gain (usually capital gain) from the sale or exchange of property.

Question 35

Under terms of the partnership agreement, Joyce is entitled to a fixed annual payment of $20,000 and her partner $30,000 without regard to the income of the partnership. Joyce’s distributive share of the partnership income is 10%. The partnership income is $60,000 of ordinary income after deducting the guaranteed payments. How much ordinary income from the partnership will be included on Joyce’s individual income tax return?

A. $6,000
B. $24,000
C. $26,000
D. $29,000

Answer 35

C. $26,000.

• Publication 541, page 7, states that guaranteed payments are treated as a partner’s distributive share of ordinary income. The individual partner reports guaranteed payments on Schedule E (page 2) (Form 1040) as ordinary income, along with his or her distributive share of the partnership’s other ordinary income.
• Example: Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the guaranteed payment. She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership’s tax year ends.
• Joyce in this problem would report $26,000 on her income tax return, which is the sum of $20,000 as a fixed annual payment (i.e., a guaranteed payment) and $6,000 as her 10% share of the profits from the partnership ($60,000).

Question 36

A corporate payer of an individual shareholder dividend does not have the taxpayer identification number for that shareholder. What backup withholding percentage rate must the corporate payer use for this shareholder’s dividend payments?

A. 15%
B. 24%
C. 28%
D. 37%

Answer 36

B. 24%.

• If a recipient does not furnish its TIN (taxpayer identification number) to the taxpayer in the manner required, the taxpayer must backup withhold at a 24% rate on certain dividend payments reported on Form 1099-DIV. Hence, if a corporate payer of an individual shareholder dividend does not have the taxpayer identification number for that shareholder, the corporate payer is required to withhold 24% in backup withholdings.

Question 37

An election to amortize may be made for qualifying costs of organization for a partnership. Which of the following is not considered a qualifying cost?

A. A cost incurred in the creation of the partnership and not for starting or operating the partnership trade or business
B. Accounting fees for services incident to the organization of the partnership
C. Legal fees for preparation of the partnership agreement
D. The costs of acquiring assets for the partnership

Answer 37

D. The costs of acquiring assets for the partnership

• Publication 583, pages 9 and 10, states a partnership can amortize an organizational cost only if it satisfies all of these five tests:

1. It is for the creation of the partnership and not for starting or operating the partnership.
2. It is chargeable to a capital account.
3. It could be amortized over the life of the partnership if the partnership had a fixed life.
4. It is incurred by the due date of the partnership return (excluding extensions) for the first tax year.
5. It is for a type of item normally expected to benefit the partnership throughout its entire life.

• If the five tests are satisfied, then the organization expenses that can be amortized by a partnership include the following:
  
  • Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of a partnership agreement
  • Accounting fees for services incident to the organization of the partnership
  • Filing fees
• Some expenses cannot be amortized (regardless of how the partnership characterizes them), including expenses connected with the following actions:
  
  • Acquiring assets for the partnership or transferring assets to the partnership,
  • Admitting or removing partners other than at the time the partnership is first organized,
  • Making a contract relating to the operation of the partnership trade or business (even if the contract is between the partnership and one of its members), and
  • Syndicating the partnership.
• In this problem, the one item that is listed that cannot be amortized as an organization cost is the costs of acquiring assets for the partnership.

Question 38

Weal, Inc., had taxable income in 2023 of $10,000. Due to a downturn in its core business operations, Weal isn’t sure if he is expected to make estimated tax payments for the 2024 tax year. Which of the following statements is correct concerning Weal making estimated tax payments for the 2024 tax year?

A. Weal must make installment payments of estimated tax because the company had taxable income in the prior year.
B. Weal must make installment payments of estimated tax if the company expects income to be $500 or more for 2024.
C. Weal must make installment payments of estimated tax if the company expects estimated tax to be $500 or more for 2024.
D. Weal must make installment payments of estimated tax if the company expects income or taxable income to be $500 or more for 2024.

Answer 38

C. Weal must make installment payments of estimated tax if the company expects estimated tax to be $500 or more for 2024.

• Generally, a corporation is required to make installment payments if the estimated tax (not estimated income) is $500 or more. If the corporation does not pay the installments when they are due, it could be subject to an underpayment penalty.

Question 39

Which of the following statements is correct if a corporate distribution to a shareholder exceeds earnings and profits (both current and accumulated) and exceeds the shareholder’s basis in the corporate stock?

A. The shareholder has a gain from the sale or exchange of property.
B. The shareholder has a loss from the sale or exchange of property.
C. The shareholder has no gain or loss from the sale or exchange of property.
D. The shareholder has dividend income from the sale or exchange of property.

Answer 39

A. The shareholder has a gain from the sale or exchange of property.

• Generally, a corporate distribution to a shareholder is treated as a distribution of earnings and profits. Distributions made from current or accumulated earnings and profits are reported as dividends to the shareholder(s).
• If the corporation does not have adequate earnings and profits, the excess amount distributed is applied against and reduces the adjusted basis of the shareholder’s stock. To the extent that the balance is more than the adjusted basis of the stock, the shareholder realizes a gain (usually a capital gain) from the sale or exchange of property.

Question 40

Ed and Bob form a partnership with contributions of $30,000 each. Bob is not a general partner. Under the partnership agreement, Ed and Bob share all partnership profits and losses equally. The partnership borrows $70,000 to purchase depreciable equipment to be used in the partnership’s business. Ed was required under the partnership agreement to pay the creditor if the partnership defaulted. Based upon these facts, what are Ed and Bob’s basis in the partnership?

A. Ed, $30,000; Bob, $30,000
B. Ed, $65,000; Bob, $65,000
C. Ed, $100,000; Bob, $30,000
D. Ed, $100,000; Bob, $100,000

Answer 40

C. Ed, $100,000; Bob, $30,000.

• Publication 541, pages 9 and 10, states, in part, that the basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. In addition, a partner’s interest increases by any additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities; the partner’s distributive share of taxable and nontaxable partnership income; and the partner’s distributive share of the excess of the deductions for depletion over the basis of the depletable property.
• A partnership liability is a recourse liability to the extent that any partner or a related person has an economic risk of loss for that liability. Conversely, a partnership liability is a nonrecourse liability if no partner or related person has an economic risk for that liability.
• In addition, a partner’s share of nonrecourse liabilities is generally proportionate to his or her share of partnership profits. However, this rule may not apply if the partnership has taken deductions attributable to nonrecouse liabilities or the partnership holds property that was contributed by a partner.
• As a result of the above information, Ed’s adjusted basis in the partnership is $100,000, which is his investment of $30,000 and assumed liabilities of $70,000, and Bob’s adjusted basis in the partnership is $30,000, which is his investment.

Question 41

Tech Corporation was formed by three shareholders: Able, Baker, and Charlie. Charlie agreed to provide all of the legal work of organization and incorporation for $5,000 cash and $5,000 worth of stock in Tech Corporation. Which of the following statements regarding the exchange is true?

A. Charlie will recognize $5,000 in ordinary income.
B. Charlie will recognize $10,000 in ordinary income.
C. Charlie will recognize $5,000 ordinary income and $5,000 capital gain.
D. Charlie will not have to recognize any income because the transfer is nontaxable.

Answer 41

B. Charlie will recognize $10,000 in ordinary income.

• If one or more shareholders transfer money or property to a corporation in exchange for stock in that corporation, and immediately afterwards the shareholder(s) control the corporation, the exchange is usually not taxable.
• The term “property” does not include services rendered or to be rendered to the issuing corporation. Therefore, the value of stock received for services is income to the recipient.
• Given that the $10,000 of services performed in exchanged for cash and stock does not fall under the tax-free exchange rules, Charlie will recognize $10,000 of ordinary income. Stock received in exchange for services rendered must be included in Charlie’s income as ordinary income (Publication 17, page 67).

Question 42

What is the filing date for Form 1120-H by an association?

A. April 15.
B. 15th day of the 4th month after the end of the association’s tax year.
C. 15th day of the 5th month after the end of the association’s tax year.
D. 15th day of the 6th month after the end of the association’s tax year.

Answer 42

B. 15th day of the 4th month after the end of the association’s tax year.

• The instructions for Form 1120-H, pages 2 through 4, provide that an association must file Form 1120-H by the 15th day of the 4th month after the end of the association’s tax year. However, an association with a fiscal year ending June 30 must file by the 15th day of 3rd month after the end of its tax year. Also, the liability cannot be included with the tax return. Rather, it must be deposited using EFTPS (Electronic Federal Tax Payment System) or by its tax professional, financial institution, payroll service, or other trusted third party to make deposits on its behalf.
• An association can file Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns, to request a 6-month extension of time to file or a 7-month extension of time with a fiscal year ending June 30.

Question 43

Which of the following situations does not require an employer to have an employer identification number (EIN)?

A. Any taxpayer that starts a new business.
B. A taxpayer that pays wages to one or more employees.
C. A taxpayer that files pension or excise tax returns.
D. All of the answer choices require an EIN.

Answer 43

A. Any taxpayer that starts a new business.

• Publication 334, page 5, states that a taxpayer must have an employer identification number (EIN) to use as a taxpayer identification number if the taxpayer either pays wages to one or more employees or files pension or excise tax returns.
• The taxpayer who must have an EIN, must include it along with their SSN on Schedule C as instructed.
• Therefore, an EIN is not needed by all new businesses.

Question 44

If a partner receives money or property inventory in exchange for any part of a partnership interest, the amount due to his/her share of the partnership’s inventory items results in:

A. Capital gain or loss.
B. Ordinary income or loss.
C. Ordinary income or capital loss.
D. Capital gain or ordinary loss.

Answer 44

B. Ordinary income or loss.

• If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership’s unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset. Hence, it does not result in a capital gain or loss.
• This treatment applies to the unrealized receivables part of a payment to a retiring partner or successor in interest of a deceased partner only if that part is not treated as paid in exchange for partnership property.

Question 45

On December 1, 2023, Bob elected to terminate his corporation’s S status, effective January 1, 2024. Bob owns 55% of the corporation’s stock. If Bob changes his mind, what is the earliest date that Bob could have his S corporation status reinstated without IRS consent?

A. January 1, 2026.
B. December 1, 2028.
C. January 1, 2029.
D. Since election to terminate S corporation status requires 100% of the outstanding shareholders’ consent, the revocation is not valid and the S corporation qualifies until properly terminated.

Answer 45

C. January 1, 2029.

• An S election may be revoked only with the consent of shareholders who hold more than 50% of the number of issued and outstanding shares of stock (including nonvoting stock) at the time revocation is made. The revocation may specify an effective revocation date that is on or after the day the revocation is filed. If no date is specified, the revocation is effective at the start of a tax year, if the revocation is made on or before the 15th day of the 3rd month of that tax year.
• After an S election has been terminated, the corporation (or a successor corporation) can make another election on Form 2553 only with IRS consent for any tax year before the 5th tax year after the 1st tax year in which the termination took effect.
• Therefore, the earliest date at which Bob could re-elect S status for his corporation without IRS consent is January 1, 2029.

Question 46

Mark owns 50% of an S corporation, Wick, Inc., and has a basis in that corporation of $3,000 at the beginning of 2023. At the end of 2023, Wick, Inc., reports ordinary income of $2,000 and makes a distribution to Mark of a truck with an adjusted basis of $5,000 and a fair market value of $7,000. How much income must Mark report on his personal 2023 return from this distribution?

A. $0.
B. $1,000.
C. $3,000.
D. $5,000.

Answer 46

C. $3,000.

• Generally, a corporate distribution to an S corporation shareholder is applied against and reduces the adjusted basis of the stock in the hands of the shareholder. To the extent the balance is more than the adjusted basis of the stock, the shareholder has a gain (usually a capital gain) from the sale or exchange of property.
• The basis of an S corporation shareholder’s stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:

1. Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
2. Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation reported on Schedule K-1, box 16, code D, minus (b) the amount of such distributions in excess of the basis of the shareholder’s stock.
3. Basis is decreased (but not below zero) by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder’s pro rata share of the property’s adjusted basis exceeds that deduction.
4. Basis is decreased (but not below zero) by all deductible losses and deductions reported on Schedule K-1.

• Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3).
• When appreciated property is distributed, gain is recognized in the same manner as if the S corporation had sold the property to the shareholders at its FMV (Section 311(b)). As such, the gain passes through to the shareholders (increasing the shareholder’s basis in S corporation stock) and increases their basis in the property received. However, losses are not recognized, unless the property is distributed in a liquidation of a corporation.
• The type of gain is unknown in this problem and, as such, the problem asks only for the income amount.
• Therefore, Mark will have to report income of $3,000, determined as follows:

FMV of Property Received: $7,000
Less Basis (lesser of FMV and ending (basis; see calculation below): $5,000 (Return of Capital)
Remaining: $2,000 Capital Gain
Plus Gain on Truck: $1,000 (Capital or Ordinary)
Total Income Reported: $3,000

Basis Calculation:
Beginning Basis: $3,000
Plus Ordinary Income (50% of $2,000): 1,000
Plus Gain on Truck (50% of $2,000): 1,000
Ending Basis before truck dist.: $5,000

Question 47

Which of the following statements is correct about charitable contributions?

A. Contributions made from a self-employed business account are deductible in full on Schedule C in the year of contribution.
B. Contributions made from an S corporation account are deductible in full on Schedule C in the year of contribution.
C. Contributions made from a corporation account (including S corporations) are deductible in full on Schedule C in the year of contribution.
D. None of the answer choices are correct.

Answer 47

D. None of the answer choices are correct.

• Cash payments to an organization, charitable or otherwise, may be deductible as business expenses if the payments are not charitable contributions or gifts and are directly related to the taxpayer’s business. If the payments are charitable contributions or gifts, you cannot deduct them as business expenses. See exception below for C corporations.
• For example, a taxpayer paid $15 to a local church for a half-page ad in a program for a concert it is sponsoring. The purpose of the ad was to encourage readers to buy the taxpayer’s product. The payment is not a charitable contribution. However, it can be deducted as an advertising expense.
• Corporations (other than S corporations), on the other hand, can deduct charitable contributions on their income tax returns. However, these deductions are subject to limitations.

Question 48

Able, a calendar-year, domestic for-profit corporation, is in a Chapter 11 bankruptcy proceeding and has no income for 2023. When must the bankruptcy trustee of Able Corporation file a Form 1120 for tax year 2023?

A. No later than March 15, 2024, or request an extension.
B. No later than March 15, 2024; an extension is not permissible.
C. No later than April 15, 2024, or request an extension.
D. No later than April 15, 2024; an extension is not permissible.

Answer 48

C. No later than April 15, 2024, or request an extension.

• Unless exempt under IRC Section 501, all domestic corporations in existence for any part of a taxable year (including corporations in bankruptcy) must file an income tax return whether or not they have taxable income.
• Generally, for tax years beginning after December 31, 2015, a corporation must file its income tax return by the 15th day of the 4th month after the end of its tax year.
• A new corporation filing a short-period return must generally file by the 15th day of the 4th month after the short period ends.
• A corporation that has dissolved must generally file by the 15th day of the 4th month after the date it dissolved.
• The IRS will grant a corporation a 6-month extension of time to file a corporation income tax return if the company completes the form properly (Form 7004), files it, and pays any tax due by the original due date for the return.
• Accordingly, Able Corporation must file Form 1120 for the current year no later than April 15, 2024, or request an extension.

Question 49

Under which of the following situations is a corporation required to make estimated tax payments?

A. Estimated income is $500 or more.
B. Estimated income is $1,000 or more.
C. Estimated tax is $500 or more.
D. Estimated tax is $1,000 or more.

Answer 49

C. Estimated tax is $500 or more.

• Generally, a corporation is required to make installment payments if the estimated tax is $500 or more.
• Installment payments are due by the 15th day of the 4th, 6th, 9th, and 12th months of the corporation’s tax year.

Question 50

The following statements regarding qualified personal service corporations are true, except:

1. A qualified personal service corporation is taxed at a flat rate of 21%.
2. A qualified personal service corporation
   must meet two tests:
   
   • One of performance of certain personal services and
   • Ownership directly or indirectly of at least 95% of the corporation’s stock.
3. The passive activity rules may apply to a personal service corporation if the corporation is not an S corporation and the employee-owners own 10% of the fair market value of the personal service corporation’s outstanding stock on the last day of the current tax year.
4. Personal services are those performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.

A. 2 and 3.
B. 3 only.
C. 1 and 3.
D. 4 only.

Answer 50

B. 3 only.

• Pursuant to Publication 542, page 16, for tax years beginning after 2017, a corporation, including a qualified personal service corporation is taxed at a flat rate of 21% on taxable income. Additionally, as provided with further detail in IRC Section 448(d)(2) and Publication 542, page 3:

1. Substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and
2. Substantially, all of the stock of which (by value) is held directly (or indirectly through 1 or more partnerships, S corporations, or qualified personal service corporations) by:
   
   • Employees performing services for such corporation in connection with the activities involving a field referred to in subparagraph 1,
   • Retired employees who had performed such services for such corporation,
   • The estate of any individual described in the first two categories,
   • Any other person who acquired such stock by reason of the death of an individual described in the first two bullet points.

• Publication 542, page 3 further stipulates that a personal service corporation is required to meet the following requirements:

1. Its principal activity during the “testing period” is performing personal services. The testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the 1st day of its tax year and ends on the earlier of:
   
   • The last day of its tax year or
   • The last day of the calendar year in which its tax year begins.
2. Its employee-owners substantially perform the services in item (1). This requirement is met if more than 20% of the corporation’s compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.
3. Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.

• The IRS limits the deductions a personal service corporation (PSC) can take for passive activity losses. If the personal service corporation has a loss from a passive activity, that loss can only be used to offset passive activity income. The PSC is required to file Form 8810 to compute the amount of passive activity losses allowed for the filing period. Page 1 of Form 8810 Instructions defines a PSC as a corporation whose principal activity for the testing period for the tax year is the performance of personal services. The services must be substantially performed by employee-owners. Employee-owners must own more than 10% of the fair market value of the corporation’s outstanding stock on the last day of the testing period. Principal activities, types of personal services, and definition of substantial performance by employee-owners are the same as described above, in paragraphs 1, 2, and 3.
• Therefore, all of the above statements regarding qualified personal services corporations are true except the passive activity rules may apply to a personal service corporation if the corporation is not an S corporation and the employee-owners own 10% of the fair market value of the personal service corporation’s outstanding stock on the last day of the current tax year. Here the statement indicates the employee-owners own 10% and the correct rule is more than 10%.

Question 51

Bob and John make the following transfers to Builders Corporation in return for 100% of the stock in the corporation:

Bob:
Asset and Value Transferred to Builders: $100,000 Cash
Asset and Value Transferred to Shareholder: $10,000 Land
Percentage of Stock Received: 80%

John:
Asset and Value Transferred to Builders:
$30,000 Property ($10,000 basis)
Asset and Value Transferred to Shareholder: $5,000 Cash
Percentage of Stock Received: 20%

What is the amount of gain Bob and John must recognize on the transfers?

A. Bob must recognize $10,000 gain and John must recognize $25,000 gain.
B. Bob recognizes $10,000 gain and John recognizes $5,000 gain.
C. Bob recognizes no gain and John recognizes $5,000 gain.
D. Bob recognizes $10,000 gain and John recognizes $20,000 gain.

Answer 51

C. Bob recognizes no gain and John recognizes $5,000 gain.

• Publication 542, page 3, provides, in part, that if a taxpayer transfers property (or money and property) to a corporation in exchange for stock in that corporation (other than nonqualified preferred stock) and immediately afterward the taxpayer is in control of the corporation, the exchange is usually not taxable. This rule applies both to individuals and to groups who transfer property to a corporation. It also applies whether the corporation is being formed or is already operating.
• To be in control of a corporation, the taxpayer or group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock.

EXAMPLE:
You and Bill Jones buy property for $100,000. You both organize a corporation when the property has a fair market value of $300,000. You transfer the property to the corporation for all its authorized capital stock, which has a par value of $300,000. No gain is recognized by you, Bill, or the corporation.

• If, in an otherwise nontaxable exchange of property for corporate stock, the taxpayer also receives money or property other than stock, the taxpayer may have to recognize gain. That is, the taxpayer must recognize gain only up to the amount of money plus the fair market value of the other property the taxpayer receives. Per Publication 542, page 4, the rules for figuring the recognized gain in this situation generally follow those for a partially nontaxable exchange discussed in Publication 544 under the subject of like-kind exchanges. Publication 544, page 16, notes that if a gain is realized it must be recognized, but only to the extent of the money and the fair market value of the unlike property received.
• In this problem, therefore, Bob does not recognize any gain due to there being no realized gain ($90,000 fair market value of stock received plus $10,000 value of land received less $100,000 cash transferred to the corporation). John recognizes $5,000 gain despite realizing a $20,000 gain ($25,000 fair market value of stock received plus $5,000 cash received less $10,000 basis of property transferred to the corporation) due to the recognition being limited up to the amount of money he received.

Question 52

For property contributed after June 8, 1997, a partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during:

A. The 3-year period before the distribution.
B. The 5-year period before the distribution.
C. The 7-year period before the distribution.
D. The 10-year period before the distribution.

Answer 52

C. The 7-year period before the distribution.

• A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution.
• Be aware that a 5-year period applied to property contributed before June 9, 1997, or under a written binding contract (1) that was in effect on June 8, 1997, and at all times thereafter before the contribution and (2) that provides for the contribution of a fixed amount of property. (This rule has been taken out of the current Publication 541 but is noted here to give an historical perspective of why the date June 8, 1997, was given in the question above and how rules can change over time.)

Question 53

Bob and Sally, unmarried taxpayers, were equal sole shareholders of Lostalot, Inc., an S corporation. The corporation realized a $50,000 operating loss for the tax year ending December 31, 2023. As of December 31, 2022, Bob’s basis in his stock was $15,000 and Sally’s was $5,000. During the 2023 tax year, Sally mortgaged her home for $25,000 and lent the money to the corporation. Although not personally liable, Bob told her not to worry and that if anything happened, he would help pay the mortgage debt. Calculate the amount of allowable loss deduction each shareholder would be able to recognize on his or her individual 2023 tax return.

A. Bob $25,000 and Sally $25,000.
B. Bob $15,000 and Sally $5,000.
C. Bob $15,000 and Sally $30,000.
D. Bob $15,000 and Sally $25,000.

Answer 53

D. Bob $15,000 and Sally $25,000.

• A shareholder’s distributive share of loss from an S corporation is limited to the shareholder’s stock basis in that corporation. Therefore, losses that exceed a shareholder’s basis are disallowed for that year but can be carried forward indefinitely and deducted in a later year, subject to the basis limit for that year. In addition, the adjusted basis of a shareholder in an S corporation is increased by any loans made by the shareholder to the corporation.
• Accordingly, the amount of allowable loss deduction for each shareholder is as follows:

                                          Bob            Sally  Beginning Basis        $15,000          $5,000 Shareholder Loan             0             25,000 Adjusted Basis         $15,000         $30,000
                                   ================ Allowable Loss         $15,000*        $25,000 *Loss of $25,000, which is $50,000 × 50%, is limited to basis of $15,000.

NOTE: Watch out for this type of problem. You may be so busy calculating the basis that you forget to calculate how much loss is attributable to each shareholder. Also, Sally is still liable for the contributed debt amount even though Bob says he will help (not enforceable onto Bob).

Question 54

Hughes Corporation paid a $400 dividend to a shareholder in 2023. Which of the following statements is correct?

A. No Form 1099-DIV was required because the payment was not $600 or more.
B. No Form 1099-DIV was required because the payment was not $500 or more.
C. Form 1099-DIV was required because the payment was $400 or more.
D. Form 1099-DIV was required because the payment was $10 or more.

Answer 54

D. Form 1099-DIV was required because the payment was $10 or more.

• A corporation is required to issue Form 1099-DIV to each person:
  
  • To whom they have paid dividends (including capital gains dividends and exempt-interest dividends) and other distributions on stock of $10 or more,
  • For whom they have withheld and paid any foreign tax on dividends and other distributors on stock,
  • For whom they have withheld any federal income tax on dividends under the backup withholding rules, or
  • To whom they have paid $600 or more as part of a liquidation.
• Thus, the Hughes Corporation is required to issue Form 1099-DIV.

Question 55

Heron, Inc., made a distribution of real estate with an FMV of $100,000 to its only shareholder, Jennifer, on December 31, 2023. Heron’s basis in the property was $60,000. Current-year earnings and profits of Heron (before the distribution) are $10,000 and it has accumulated $20,000 earnings and profits from prior years. Jennifer’s basis in her Heron stock is $5,000. What will be the tax effect to Jennifer?

A. $100,000 dividend and $5,000 return of capital.
B. $70,000 dividend, $5,000 return of capital, and $25,000 capital gain.
C. $30,000 dividend, $5,000 return of capital, $25,000 capital gain.
D. $30,000 dividend, $5,000 return of capital, and $60,000 capital gain.

Answer 55

B. $70,000 dividend, $5,000 return of capital, and $25,000 capital gain.

• Generally, for a C corporation, a distribution to shareholder is considered to be made out of current Earnings and Profits (E&P) and Accumulated E&P. Per Publication 542, page 17, distributions made from current or accumulated earnings and profits are reported as dividends to the shareholder(s). If the corporation does not have adequate earnings and profits, the excess amount distributed is applied against and reduces the adjusted basis of the shareholder’s stock. To the extent that the balance is more than the adjusted basis of the stock, the shareholder realizes a gain (usually a capital gain) from the sale or exchange of property.
• The order that the items are addressed is first E&P/Acc. E&P, then stock basis. Any remaining amount is a gain.
• The corporation itself does record a gain at the corporate level because it is distributing appreciated property: FMV = $100,000 vs. basis of $60,000. Property distributions from C corporations are described in Section 312.
• Therefore, Jennifer will have dividend income of $70,000, which is the sum of current-year and accumulated E&P, and a capital gain of $25,000, determined as follows:

FMV of Property Received: $100,000
Less:
Current-Year E&P: $50,000
Accumulated E&P: $20,000
$70,000 ($30,000 Remaining Amount)
Less:
Basis: $5,000 Return of Capital
Remaining: $25,000 Capital Gain

• Current-year E&P is derived from $10,000 as given in the problem plus $40,000 of gain the corporation must recognize upon distribution of appreciated property.

Question 56

On January 1, 2023, Ben and Jerry each own 50% of the B&J Fudge partnership. B&J Fudge employs the cash method of accounting and receives $1,000 in interest income each month from an unrelated party loan receivable. On July 1, 2023, Jerry purchased 50% of Ben’s partnership interest. There were no other changes in partnership interest for the remainder of the 2023 year. How much does Ben report as his ratable share of the interest income for 2023?

A. $7,500.
B. $6,000.
C. $4,500.
D. $3,000.

Answer 56

C. $4,500.

• If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership’s unrealized receivables or inventory items results in ordinary income or loss. Unrealized receivables include any rights to payment not already included in income. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset. Hence, it does not result in a capital gain or loss.
• In this case, Ben would report $4,500 as ordinary income, which is the sum of his pro rata share of the interest ($3,000, which is 50% of $6,000) from the first 6 months of the year and his pro rata share of the interest ($1,500, which is 25% of $6,000) from the final 6 months of the year.
• Likewise, Jerry would report $7,500 as ordinary income, which is the sum of his pro rata share of the interest ($3,000, which is 50% of $6,000) from the first 6 months of the year and his pro rata share of the interest ($4,500, which is 75% of $6,000) from the final 6 months of the year.

NOTE: There are two tricks in this question. The first trick is that Jerry purchases 50% of Ben’s 50% ownership, which results in Ben owning 25% and Jerry owning 75% for the second half of the year. The second trick is the question pertains to Ben and not Jerry.

Question 57

At the beginning of 2023, Tim had a $2,000 stock basis in the S corporation, World, Inc. Tim owns 25% of the outstanding World, Inc., stock. At the end of 2023, World, Inc., reported on its Schedule K a $16,000 ordinary loss, $4,000 of tax-exempt interest income, and $2,000 in nondeductible expense. Tim has $10,000 in flow-through reportable income from other S corporations. How much of the 2023 World, Inc., ordinary loss can Tim deduct on his personal return?

A. $0 in loss.
B. $2,500 in loss.
C. $3,000 in loss.
D. $4,000 in loss.

Answer 57

B. $2,500 in loss.

• The basis of an S corporation shareholder’s stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:

1. Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
2. Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation reported on Schedule K-1, box 16, code D, minus (b) the amount of such distributions in excess of the basis of the shareholder’s stock.
3. Basis is decreased (but not below zero) by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder’s pro rata share of the property’s adjusted basis exceeds that deduction.
4. Basis is decreased (but not below zero) by all deductible losses and deductions reported on Schedule K-1.

• Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3).
• Additionally, a shareholder’s distributive share of loss from an S corporation is limited to the shareholder’s stock basis in that corporation. Therefore, losses that exceed a shareholder’s basis are disallowed for that year.
• Accordingly, the maximum amount of ordinary loss (before passive and at-risk limitations) Tim can deduct on his 2023 tax return is $2,500, computed as follows:

Beginning Basis: $2,000
Plus:
Tax-Exempt Interest (25%): $1,000
Less:
Nondeductible Expenses (25%): $500
Ending Basis: $2,500
Allowable Loss: $2,500, which is limited to the basis

Question 58

What is the tax rate that applies to capital gain income for a condominium management homeowners association that files its tax return on Form 1120-H?

A. 15%.
B. 30%.
C. 32%.
D. 35%.

Answer 58

B. 30%.

• Pages 1 and 2 of the instructions for Form 1120-H provides that the taxable income of a homeowners association that files its tax return on Form 1120-H is taxed at a flat rate of:
  
  • 30% for condominium management associations and residential real estate associations and
  • 32% for timeshare associations.
• These rates apply to both ordinary and capital gains income.

Question 59

A loss incurred from the abandonment of a partnership interest is an ordinary loss when:

A. The partner receives a de minimis or deemed distribution.
B. The partner’s capital account reflects a positive balance.
C. The partner transfers the entire interest to a non-related party.
D. The transaction is not a sale or exchange and the partner has not received an actual or deemed distribution from the partnership.

Answer 59

D. The transaction is not a sale or exchange and the partner has not received an actual or deemed distribution from the partnership.

• Publication 541, page 11, provides that a loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss only if both of the following tests are met:
  
  • The transaction is not a sale or exchange, and
  • The partner has not received an actual or deemed distribution from the partnership.
• If, however, the partner receives even a de minimis actual or deemed distribution, the entire loss generally is a capital loss. Information for reporting an abandonment loss can be found in the instructions for Form 4797.

Question 60

The adjusted basis in Carol’s partnership interest is $50,000. She receives a distribution of $10,000 cash and land that has an adjusted basis of $30,000 and an FMV of $50,000. What is Carol’s adjusted basis in the land?

A. $20,000.
B. $30,000.
C. $40,000.
D. $50,000.

Answer 60

B. $30,000.

• Publication 541, page 6, states that unless there is a complete liquidation of a partner’s interest, the basis of property (other than money) distributed to the partner by a partnership is its adjusted basis to the partnership immediately before the distribution. However, the basis of the property to the partner cannot be more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction.

EXAMPLE 1: The adjusted basis of Emily’s partnership interest is $30,000. She receives a distribution of property that has an adjusted basis of $20,000 to the partnership and $4,000 in cash. Her basis for the property is $20,000.

EXAMPLE 2: The adjusted basis of Steve’s partnership interest is $10,000. He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives).

• Carol’s basis in the land would be $30,000, which is the partnership’s adjusted basis in the property. This is not a complete liquidation, and Carol’s partnership interest after reducing it for the cash distribution is $40,000 ($50,000 − $10,000), which is greater than the adjusted basis of the land.

Question 61

Mary owns a farm with an adjusted basis of $500,000 and a mortgage of $200,000. She exchanged the farm for stock in a transfer under IRC Section 351. What is her basis in the new stock?

A. $300,000.
B. $200,000.
C. $500,000.
D. $700,000.

Answer 61

A. $300,000.

• Generally, the basis of the stock a shareholder receives is the adjusted basis of the property that was transferred. This is increased by any amount treated as a dividend, plus any gain recognized on the exchange. Additionally, the basis is decreased by any cash received, the fair market value of any other property received, and any loss recognized on the exchange. The basis is also decreased by the amount of any liability the corporation or another party to the exchange assumes.
• Thus, Mary’s basis in the new stock is $300,000, computed as follows:Adjusted Basis $500,000
  Less:
  Liability Assumed 200,000
  Basis in New Stock $300,000

Question 62

Upon the receipt of a distribution, a retiring partner or successor in interest of a deceased partner will recognize:

A. Gain only to the extent that any money distributed is less than the partner’s adjusted basis in the partnership.
B. Gain only to the extent that any money distributed is more than the partner’s adjusted basis in the partnership.
C. Gain only to the extent that any money and property distributed is more than the partner’s adjusted basis in the partnership.
D. Gain only to the extent that any money and inventory distributed is more than the partner’s adjusted basis in the partnership.

Answer 62

B. Gain only to the extent that any money distributed is more than the partner’s adjusted basis in the partnership.

• The rules on a gain or loss on a distribution to a retiring partner are found on page 13 of Publication 541. Upon the receipt of the distribution, the retiring partner or successor in interest of a deceased partner will recognize gain only to the extent that any money (and marketable securities treated as money) distributed is more than the partner’s adjusted basis in the partnership. The partner will recognize a loss only if the distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any other property is received.

Question 63

Bob transfers property worth $50,000 to the Acme Corporation and provides personal services worth $5,000 in exchange for stock valued at $55,000. Immediately after the exchange Bob owns 90.9% of Acme’s outstanding stock. What is Bob’s gain, if any?

A. No capital gain, no ordinary income.
B. No capital gain, $5,000 ordinary income.
C. No capital gain, $50,000 ordinary income.
D. $5,000 capital gain, no ordinary income.

Answer 63

B. No capital gain, $5,000 ordinary income.

• If one or more shareholders transfer money or property to a corporation in exchange for stock in that corporation, and immediately afterwards the shareholder(s) control the corporation, the exchange is usually not taxable. To be in control of a corporation, the shareholder or group of shareholders must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock.
• Note: In this situation, Bob owns 90.9% of the outstanding stock (50,000 ÷ 55,000), which is greater than the 80% required.
• In addition, the term “property” does not include services rendered or to be rendered to the issuing corporation. Therefore, the value of stock received for services is ordinary income to the recipient.
• The transfer of property worth $50,000 in exchange for stock falls under the tax-free exchange rules. However, the $5,000 of services performed in exchange for stock does not, and therefore Bob will recognize $5,000 of ordinary income, calculated as follows:

Stock received: $55,000
Property (tax-free): $(50,000)
Remaining: $5,000 Services performed (not property under the tax-free rule)

Question 64

The shareholders of Hope, Inc., an S corporation, wish to revoke its S election effective December 31, 2023. The total number of shares issued and outstanding at the time of the election is 100,000 shares. Which of the following shareholders are required to consent to have the S corporation election revoked?
- Bob owns 20,000 shares
- Dana owns 50,000 shares
- Sally owns 30,000 shares

A. Dana.
B. Bob and Sally.
C. Dana and one other shareholder.
D. Dana, Bob, and Sally.

Answer 64

C. Dana and one other shareholder.

• An S election may be revoked only with the consent of shareholders who hold MORE THAN 50% of the number of issued and outstanding shares of stock (including nonvoting stock) at the time revocation is made. The revocation can specify an effective revocation date that is on or after the day the revocation is filed.
• Therefore, in order to have the S corporation election revoked, Dana who owns 50% needs at least one other shareholder to consent to the revocation to achieve more than the 50% requirement as follows:

                  Shares     Percentage           Bob             20,000     20% (20,000/100,000) Dana           50,000     50% (50,000/100,000)  Need MORE THAN     50% Sally             30,000     30% (30,000/100,000) Total Shares   100,000

Question 65

Robert owns 50% of an S corporation, Blue Sky, Inc., and has a basis in that corporation of $5,000 at the beginning of 2023. At the end of 2023, Blue Sky reports ordinary income of $10,000 and makes a distribution to Robert of a manuscript originally purchased for $1,000 but now valued at $8,000. How much income must Robert report on his personal 2023 return from this distribution?

A. $0.
B. $1,000.
C. $5,000.
D. $8,000.

Answer 65

A. $0.

• Generally, a corporate distribution to an S corporation shareholder is applied against and reduces the adjusted basis of the stock in the hands of the shareholder. To the extent the balance is more than the adjusted basis of the stock, the shareholder has a gain (usually a capital gain) from the sale or exchange of property.
• The basis of an S corporation shareholder’s stock (generally, its cost) is adjusted as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code:

1. Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1 and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.
2. Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation reported on Schedule K-1, box 16, code D, minus (b) the amount of such distributions in excess of the basis of the shareholder’s stock.
3. Basis is decreased (but not below zero) by (a) nondeductible expenses and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent the shareholder’s pro rata share of the property’s adjusted basis exceeds that deduction.
4. Basis is decreased (but not below zero) by all deductible losses and deductions reported on Schedule K-1.
   Note that the taxpayer can make an election to deduct items in (4) in the list above before nondeductible items in (3).

• An S corporation can distribute property to its shareholders. If property is distributed, the amount of the distribution is considered to be the property’s fair market value (IRC Section 301(b)). When appreciated property is distributed, gain is recognized in the same manner as if the S corporation had sold the property to the shareholders at its FMV (Section 311(b)). The gain passes through to the shareholders and increases their basis in such property. However, losses are not recognized, unless the property is distributed in a liquidation of a corporation.
• As such, Robert is not required to report any income, determined as follows:

FMV of Property Received: $8,000
Less Basis (lesser of FMV and ending basis; see calculation below): $8,000 Return of Capital
Remaining: $0

Basis Calculation:
Beginning Basis: $5,000
Plus Ordinary income (50% of $10,000): $5,000
Ending Basis before property dist. $10,000

Question 66

James Corporation made various payments and transfers to and for its shareholders, Rob and Jim, during the year. Which of the following is not a reportable distribution? (Assume sufficient earnings and profits.)

A. Monthly cash payments of $500 to Rob
B. Transfer of stocks held for investment to both Rob and Jim
C. Use of a company vehicle by Jim’s daughter at college
D. Reasonable salary to both Rob and Jim

Answer 66

D. Reasonable salary to both Rob and Jim

• If a corporation pays an employee who is also a shareholder a salary that is unreasonably high considering the services actually performed by the shareholder-employee, the excessive part of the salary may be treated as a distribution to the shareholder-employee. (For more information on reasonableness, see Publication 542, page 17.)
• Thus, James Corporation’s payment of a reasonable salary to both Rob and Jim (shareholders) would not be a reportable distribution.

Question 67

An S corporation generally must file its Form 1120-S by the 15th day of the ________ month after the end of its tax year.

A. 3rd
B. 4th
C. 5th
D. 6th

Answer 67

A. 3rd

• The instructions for Form 1120-S, page 3, provide that an S corporation must file its Form 1120-S by the 15th day of the 3rd month after the end of its tax year. For a calendar-year corporation, the due date is March 15. This is true for most S corporations.
• Hence, the correct response for an S corporation is it must file its Form 1120-S by the 15th day of the 3rd month after the end of its tax year.

Question 68

A partnership, S corporation, or personal service corporation (PSC) can elect to use a tax year other than its required tax year if it:

A. Elects a year that meets the deferral period requirement.
B. Is not a member of a tiered structure as defined by the regulations.
C. Has not previously had an election in effect to use a tax year other than its required tax year.
D. All of the answer choices are correct.

Answer 68

D. All of the answer choices are correct.

• Publication 538, page 6, provides that a partnership, S corporation, electing S corporation, or personal service corporation (PSC) can elect under IRC Section 444 to use a tax year other than its required tax year if it satisfies certain restrictions.

NOTE: A partnership or S corporation that makes a Section 444 election must make certain required payments and a PSC must make certain distributions. The Section 444 election does not apply to any partnership, S corporation, or PSC that establishes a business purpose for a different period.

• A partnership, S corporation, or PSC can make a Section 444 election if it meets all of the following requirements:
  
  • It is not a member of a tiered structure (defined in Regulation Section 1.444-2T).
  • It has not previously had a Section 444 election in effect.
  • It elects a year that meets the deferral period requirement.
• In this problem, all of the answer choices are correct.