R3-2

Question 1

If an S corporation has no accumulated earnings and profits, the amount distributed to a shareholder:

a.

Must be returned to the S corporation.

b.

Decreases the shareholder’s basis for the stock.

c.

Increases the shareholder’s basis for the stock.

d.

Has no effect on the shareholder’s basis for the stock.

Answer 1

Choice “b” is correct. If an S corporation has no accumulated earnings and profits, the amount distributed to a shareholder decreases the shareholder’s basis for the stock. The distribution is nontaxable to the extent of the shareholder’s basis.

Choice “a” is incorrect. The amount distributed to a shareholder does not need to be returned to the S corporation.

Choice “c” is incorrect. Distributions do not increase a shareholder’s basis.

Choice “d” is incorrect. Distributions have no effect on a shareholder’s basis ifthey are out of accumulated earnings and profits and are therefore taxable. They would also have no effect on a shareholder’s basis if the basis is already zero, which would result in the shareholder recognizing a gain to the extent of the distribution. In this case, we are not told whether or not the basis is already zero.

Question 2

Stahl, an individual, owns 100% of Talon, an S corporation. At the beginning of the year, Stahl’s basis in Talon was $65,000. Talon reported the following items from operations during the current year:

Ordinary loss $ 10,000

Municipal interest income 6,000

Long-term capital gain 4,000

Short-term capital loss 9,000

What was Stahl’s basis in Talon at year-end?

a.

$55,000

b.

$50,000

c.

$56,000

d.

$61,000

Answer 2

Explanation

Choice “c” is correct. Stahl’s basis would be computed as follows:

Beginning basis:

$ 65,000

+ Income

6,000

(Tax-free income increases basis)

− Loss

(10,000)

− Net capital loss

(5,000)

($4,000 gain netted with $9,000 loss)

$ 56,000

Choice “b” is incorrect. This choice excludes the $6,000 of municipal interest income from the above calculation. Remember, both taxable and tax exempt items of income give the taxpayer additional basis.

Choice “a” is incorrect. This choice excludes both the municipal interest income and the net capital loss from the above calculation. Remember, both taxable and tax exempt and separately and non-separately stated items (stated on the K-1) of income or loss affect a shareholder’s basis.

Choice “d” is incorrect. This choice excludes the net capital loss from the above calculation. Remember, both separately and non-separately stated items (stated on the K-1) of loss affect a shareholder’s basis.

Question 3

Baker, an individual, owned 100% of Alpha, an S corporation. At the beginning of the year, Baker’s basis in Alpha Corp. was $25,000. Alpha realized ordinary income during the year in the amount of $1,000 and a long-term capital loss in the amount of $3,000 for this year. Alpha distributed $30,000 in cash to Baker during the year. What amount of the $30,000 cash distribution is taxable to Baker?

a.

$5,000

b.

$0

c.

$30,000

d.

$7,000

Answer 3

Choice “d” is correct. The taxability of distributions to shareholders in S corporations with no C corporation earnings and profits is as follows:

To the extent of basis in stock - tax free; treated as return of capital.

Any distributions in excess of the shareholder’s basis - taxable; treated as capital gain.

Based upon this rule and the information in the question, Baker’s basis is calculated as follows:

Beginning basis $ 25,000

Plus: Ordinary income 1,000

Less: Long-term capital loss (3,000)

Baker’s Basis $ 23,000

Baker’s basis should then be compared to the amount distributed to determine how much constitutes return of capital. In this instance, $23,000 would be nontaxable return of basis, and the remaining $7,000 would be taxable capital gain to Baker.

Choice “b” is incorrect. Baker’s basis is less than the cash distributed so there would be some gain.

Choice “a” is incorrect. This choice does not take into account the current year activity of the S corporation in determining Baker’s basis.

Choice “c” is incorrect. Based upon the above rule, amounts distributed to the extent of the shareholder’s basis are not taxable.

Note: This question is the official released question of the AICPA. The question appears to assume that the S corporation was organized as such and has no prior C corporation earnings and profits. If this were the case (i.e., corporation E&P exist), ordering rules for distributions would apply, and an election would have had to be made to obtain the same tax effects as in the provided choice.

Question 4

Lane Inc., an S corporation, pays single coverage health insurance premiums of $4,800 per year and family coverage premiums of $7,200 per year. Mill is a ten percent shareholder-employee in Lane. On Mill’s behalf, Lane pays Mill’s family coverage under the health insurance plan. What amount of insurance premiums is includible in Mill’s gross income?

a.

$720

b.

$4,800

c.

$7,200

d.

$0

Answer 4

Choice “c” is correct. $7,200 of insurance premiums (the amount of family coverage premiums, as indicated in the question) is includible in Mill’s gross income.

Rule: Fringe benefits paid by an S corporation are deductible by the S corporation only for non-shareholder employees and those employee-shareholders owning 2% or less of the S corporation. Other fringe benefits paid are deductible by the S corporation if included as part of gross income from the S corporation for the individual receiving the benefits (i.e., included as part of income on the shareholder’s W-2).

Choices “d”, “a”, and “b” are incorrect, per the above rule.

Question 5

Beck Corp. has been a calendar-year S corporation since its inception on January 2, Year 1. On January 1, Year 4, Lazur and Lyle each owned 50% of the Beck stock, in which their respective tax bases were $12,000 and $9,000. For the year ended December 31, Year 4, Beck had $81,000 in ordinary business income and $10,000 in tax-exempt income. Beck made a $51,000 cash distribution to each shareholder on December 31, Year 4. What was Lazur’s tax basis in Beck after the distribution?

a.

$52,500

b.

$1,500

c.

$57,500

d.

$6,500

Answer 5

Choice “d” is correct. Lazur’s tax basis after the distribution was $6,500.

Rule: The adjusted basis of S corporation stock goes up for undistributed earnings (including tax-exempt income) and vice-versa, as it would in a partnership.

Rule: Amounts distributed (including distributions not taxable as dividends) reduce the adjusted basis of the stock.

Lazur’s basis at 1/1/Year 4 $ 12,000

Add:

50% of ordinary income 40,500 [$81,000 × 50%]

50% of tax-exempt income 5,000 [$10,000 × 50%]

Less:

Distribution to Lazur (51,000)

Basis at 12/31/Year 4 $ 6,500

Question 6

Village Corp., a calendar year corporation, began business in Year 1. Village made a valid S corporation election on December 5, Year 3, with the unanimous consent of its shareholders. The eligibility requirements for S status continued to be met throughout Year 4. On what date did Village’s S status become effective?

a.

December 5, Year 4.

b.

December 5, Year 3.

c.

January 1, Year 3.

d.

January 1, Year 4.

Explanation

Choice “d” is correct.

Rule: In order to be effective for the current taxable year, the S corporation election must be made by the 15th day of the third month of the taxable year. If the election is made after that date, it becomes effective on the first day of the next taxable year, January 1, Year 4, in this case.

Choices “c”, “b”, and “a” are incorrect, per the above rules.

Answer 6

Choice “d” is correct.

Rule: In order to be effective for the current taxable year, the S corporation election must be made by the 15th day of the third month of the taxable year. If the election is made after that date, it becomes effective on the first day of the next taxable year, January 1, Year 4, in this case.

Choices “c”, “b”, and “a” are incorrect, per the above rules.

Question 7

A shareholder’s basis in the stock of an S corporation is increased by the shareholder’s pro rata share of income from:

~Tax-exempt interest

~Taxable interest
a.

No

No

b.

Yes

Yes

c.

No

Yes

d.

Yes

No

Answer 7

Choice “b” is correct.

Rule: Both tax-exempt and taxable interest income increase a shareholder’s basis in S corporation stock.

Choices “a”, “c”, and “d” are incorrect, per the above rule.

Question 8

Zinco Corp. was a calendar year S corporation. Zinco’s S status terminated on April 1, Year 1, when Case Corp. became a shareholder. During Year 1 (365-day calendar year), Zinco had nonseparately computed income of $310,250. If no election was made by Zinco, what amount of the income, if any, was allocated to the S short year for Year 1?

a.

$233,750

b.

$155,125

c.

$0

d.

$76,500

Answer 8

Choice “d” is correct. ($310,250/365) x 90 = $76,500. Zinco will be taxed as an S corporation from January 1 to March 31, Year 1, and a C corporation from April 1 to December 31, Year 1. Absent the election to calculate the incomes of the S and C corporation portions of the year separately, Zinco’s income is allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year. Year 1 has 365 days, 90 of which occurred before April 1.

Choice “a” is incorrect. Absent the election to calculate the incomes of the S and C corporation portions of the year separately, Zinco’s income is allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year. This is the income allocated to the C corporation portion of the year.

Choice “b” is incorrect. Absent the election to calculate the incomes of the S and C corporation portions of the year separately, Zinco’s income is allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year, not on a 50/50 split.

Choice “c” is incorrect. Zinco’s income must be allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year.

Question 9

Bristol Corp. was formed as a C corporation on January 1, Year 1, and elected S corporation status on January 1, Year 3. At the time of the election, Bristol had accumulated C corporation earnings and profits, which have not been distributed. Bristol has had the same 25 shareholders throughout its existence. In Year 6, Bristol’s S election will terminate if it:

a.

Adds a decedent’s estate as a shareholder to the existing shareholders.

b.

Has passive investment income exceeding 90% of gross receipts in each of the three consecutive years ending December 31, Year 5.

c.

Increases the number of shareholders to 100.

d.

Takes a charitable contribution deduction.

Answer 9

Choice “b” is correct. S corporations that are former C corporations with undistributed C corporation earnings and profits are restricted in the amount of passive investment income they can realize without terminating their S election. The restriction is 25% of total gross receipts from passive investment income. The S election is terminated if the S corporation has passive investment income greater than 25% of gross receipts for three consecutive years. After 3 years with 90% of its gross receipts from passive sources, Bristol will lose its S corporation status on the first day of its Year 6 taxable year.

Choice “c” is incorrect. An S corporation can have as many as 100 shareholders.

Choice “a” is incorrect. A decedent’s estate may be an S corporation shareholder.

Choice “d” is incorrect. S corporations pass their charitable contribution deductions through to their shareholders.

Question 10

As of January 1 of the current year, Kane owned all the 100 issued shares of Manning Corp., a calendar year S corporation. On the 41st day of the year, Kane sold 25 of the Manning shares to Rodgers. For the current year ended December 31 (a 365-day calendar year), Manning had $73,000 in nonseparately stated income and made no distributions to its shareholders. What amount of nonseparately stated income from Manning should be reported on Kane’s current year tax return?

a.

$56,750

b.

$0

c.

$16,250

d.

$54,750

Answer 10

Choice “a” is correct. The mid-year change of ownership causes Manning’s S corporation income to be allocated between the shareholders on a per-share, per-day basis. The first 40 days’ income is allocated 100% to Kane: 40 x ($73,000/365) = $8,000. 75% of the remaining 325 days’ income is allocated to Kane: 75% x 325 x ($73,000/365) = $48,750. The total income allocated to Kane is $56,750 ($8,000 + $48,750).

Choice “d” is incorrect. Manning’s income will be allocated on a per-share, per-day basis; although Kane owned 75% of the shares starting on April 1, he owned 100% of the shares through March 31.

Choice “c” is incorrect. This is the income that should be allocated to Rodgers; the question asks how much should be allocated to Kane.

Choice “b” is incorrect. The mid-year change of ownership causes Manning’s S corporation income to be allocated between the shareholders on a per-share, per-day basis.

Question 11

On February 10, Year 1, Ace Corp., a calendar-year corporation, elected S corporation status and all shareholders consented to the election. There was no change in shareholders in Year 1. Ace met all eligibility requirements for S status during the preelection portion of the year. What is the earliest date on which Ace can be recognized as an S corporation?

a.

January 1, Year 1.

b.

February 10, Year 1.

c.

February 10, Year 2.

d.

January 1, Year 2.

Answer 11

Choice “a” is correct.

Rule: An S election made by the 15th day of the third month of the taxable year is retroactively effective on the first day of the taxable year.

Choices “c”, “b”, and “d” are incorrect, per the above rule.

Question 12

An S corporation has 30,000 shares of voting common stock and 20,000 shares of non-voting common stock issued and outstanding. The S election can be revoked voluntarily with the consent of the shareholders holding, on the day of the revocation:

~Shares of voting stock
~Shares of nonvoting stock
a.

0

20,000

b.

10,000

16,000

c.

7,500

5,000

d.

20,000

0

Answer 12

Choice “b” is correct. S corporation status can be revoked if shareholders owning more than 50% of the total number of issued and outstanding shares consent. The specific percentage of voting and nonvoting shareholders is not considered, just the total. Holders of more than 25,000 total shares must approve the revocation.

Choices “a”, “c”, and “d” are incorrect. S corporation status can be revoked if shareholders owning more than 50% of the total number of issued and outstanding shares consent. The specific percentage of voting and nonvoting shareholders is not considered, just the total.

Question 13

The Haas Corp., a calendar year S corporation, has two equal shareholders. For the current year, Haas had taxable income and current earnings and profits of $60,000, which included $50,000 from operations and $10,000 from investment interest income. There were no other transactions that year. Each shareholder’s basis in the stock of Haas will increase by:

a.

$30,000

b.

$25,000

c.

$50,000

d.

$0

Answer 13

Choice “a” is correct. The basis of a shareholder’s stock in an S corporation is increased by any item of income and decreased by any item of loss or deduction that passes through to the shareholder. Each shareholder reports ½ of $60,000.

Choice “c” is incorrect. The S corporation had $50,000 income from operations, of which ½ is reported by each shareholder. However, investment income must also be considered.

Choice “b” is incorrect. Investment income must also be considered.

Choice “d” is incorrect. The basis of a shareholder’s stock in an S corporation is increased by any item of income and decreased by any item of loss or deduction that passes through to the shareholder.

Question 14

Which of the following conditions will prevent a corporation from qualifying as an S Corporation?

a.

One shareholder is an estate.

b.

The corporation has both common and preferred stock.

c.

The corporation has one class of stock with different voting rights.

d.

One shareholder is a grantor trust.

Answer 14

Choice “b” is correct. An S corporation can only have one class of stock outstanding. Common and preferred stock would constitute two classes of stock.

Choice “c” is incorrect. One class of stock with different voting rights is allowed for S corporations.

Choice “a” is incorrect. Individuals, estates, and certain trusts may be shareholders in an S corporation.

Choice “d” is incorrect. Grantor trusts, Section 678 trusts, qualified Subchapter S trusts (QSSTs), certain testamentary trusts, and voting trusts are allowed to be shareholders in an S corporation.

Question 15

Boles Corp., an accrual-basis calendar-year S corporation, has been an S corporation since its inception and is not subject to the uniform capitalization rules. In the current year, Boles recorded the following:

Gross receipts $ 50,000

Dividend income from investments 5,000

Supplies expense 2,000

Utilities expense 1,500

What amount of net business income should Boles report on its Form 1120S, U.S. Income Tax Return for an S corporation, Schedule K?

a.

$53,000

b.

$48,000

c.

$46,500

d.

$53,500

Answer 15

Choice “c” is correct. An S corporation reports both separately stated and non-separately stated (net business) items of income. The dividend income is a separately stated item and is not included in the calculation of net business income. Therefore, net business income is calculated as follows:

Gross receipts $ 50,000

Supplies expense (2,000)

Utilities expense (1,500)

Net business income $ 46,500

Choice “d” is incorrect. Dividend income is not included in net business income. Supplies expense is included in net business income.

Choice “a” is incorrect. Dividend income is not included in net business income. Utilities expense is included in net business income.

Choice “b” is incorrect. Utilities expense is included in net business income.

Question 16

Boles Corp., an accrual-basis calendar-year S corporation, has been an S corporation since its inception and is not subject to the uniform capitalization rules. In Year 1, Boles recorded the following:

Gross receipts $ 50,000

Dividend income from investments 5,000

Supplies expense 2,000

Utilities expense 1,500

On Bole’s Year 1 S corporation Form Schedule K, Shareholders’ Shares of Income, Credits Deductions, etc., what amount of income should be separately stated from business income?

a.

$5,000

b.

$48,000

c.

$50,000

d.

$0

Answer 16

Choice “a” is correct. An S corporation reports both separately stated and non-separately stated (net business) items of income. The dividend income is a separately stated item and is not included in the calculation of net business income.

Choice “c” is incorrect. Dividend income is a separately stated item and is not included in net business income. Gross Receipts are included in net business income.

Choice “b” is incorrect. Dividend income is a separately stated item and is not included in net business income. Supplies expenses and utilities expense would be deducted from net business income.

Choice “d” is incorrect. Dividend income is a separately stated item and is not included in net business income. Supplies expenses and utilities expense would be deducted from net business income.

Question 17

Which of the following entities may adopt any tax year end?

a.

Limited liability company.

b.

S corporation.

c.

C corporation.

d.

Trust.

Answer 17

Choice “c” is correct. C corporations may adopt any year end, provided the year end is approved by the IRS.

Choice “b” is incorrect. S corporations must generally adopt a calendar year end; however, certain S corporations may establish a valid business purpose for a different fiscal year by filing an election using Form 8716.

Choice “a” is incorrect. Limited liability companies generally elect to be taxed as partnerships. Partnerships must generally use the year end of the majority of its partners. If there is no majority, then the partnership must generally use a calendar year end.

Choice “d” is incorrect. All trusts (except tax-exempt trusts) must use a calendar year end.

Question 18

Evan, an individual, has a 40% interest in EF, an S corporation. At the beginning of the year, Evan’s basis in EF was $2,000. During the year, EF distributed $100,000 and reported operating income of $200,000. What amount should Evan include in gross income?

a.

$118,000

b.

$40,000

c.

$38,000

d.

$80,000

Answer 18

Choice “d” is correct. Like partnerships, S corporations report both separately and non-separately stated items of income and/or loss. Allocations to shareholders are made on a per-share, per-day basis in accordance with ownership percentage. Shareholders in an S corporation must include on their personal income tax return their distributive share of each separate “pass-through” item. Shareholders are taxed on these items, regardless of whether or not these items have been distributed to them during the year.

EF’s operating income $ 200,000

x Evan’s ownership % 40%

Gross income for Evan $ 80,000

Choice “c” is incorrect. This answer option incorrectly assumes that Evan’s gross income is calculated as 40% of the distribution for the year ($100,000 x 40% = $40,000) less the basis of $2,000 as of the beginning of the year ($40,000 - $2,000 = $38,000).

Choice “b” is incorrect. This answer option incorrectly assumes that Evan’s gross income is calculated as 40% of the distribution for the year ($100,000 x 40% = $40,000).

Choice “a” is incorrect. This answer option incorrectly assumes that Evan’s gross income is 1 - 40%, or 60%, of the corporation’s operating income for the year ($200,000 x 60% = $120,000), less the basis of $2,000 as of the beginning of the year ($120,000 - $2,000 = $118,000).

Question 19

Magic Corp., a regular C corporation, elected S corporation status at the beginning of the current calendar year. It had an asset with a basis of $40,000 and a fair market value (FMV) of $85,000 on January 1. The asset was sold during the year for $95,000. Magic’s corporate tax rate was 35%. What was Magic’s tax liability as a result of the sale?

a.

$15,750

b.

$3,500

c.

$19,250

d.

$0

Answer 19

Choice “a” is correct. A distribution or a sale of an S corporation’s assets may result in a tax on any “built-in gain” at the corporate level. An unrealized “built-in gain” results when the following two conditions occur: (1) a C corporation elects S corporation status, and (2) the fair market value of the corporate assets exceeds the adjusted basis of corporate assets on the election date. The two conditions exist in the facts of the question. The net unrealized built-in gain is the excess of the fair market value of corporate assets over the adjusted basis of corporate assets at the beginning of the year in which the S corporation status is elected.

FMV at January 1 $ 85,000

Adjusted basis at January 1 (40,000)

Excess 45,000

× 35% tax rate x35%

Corporate tax liability $ 15,750

Note: The gain to the corporation is a total of $55,000 ($95,000 − $40,000). An S corporation generally does not pay tax at the corporate level; however, in this case, there was built-in gain of $45,000 upon the election to become an S corporation, so the related C corporation tax must be paid upon the sale of the asset.

Choice “d” is incorrect. The gain to the corporation is a total of $55,000 ($95,000 − $40,000). An S corporation generally does not pay tax at the corporate level; however, in this case, there was built-in gain of $45,000 upon the election to become an S corporation, so the related C corporation tax must be paid upon the sale of the asset.

Choice “b” is incorrect. This choice incorrectly assumes that the tax is calculated as 35% of the difference between the sales price of the asset ($95,000) and the fair market value at the effective date of the S election ($85,000). [$95,000 − $85,000 = $10,000; $10,000 × 35% = $3,500]

Choice “c” is incorrect. This choice incorrectly uses the actual total gain on the sale (the sales price of $95,000 less the basis of $40,000) and then calculates the tax liability as 35% of that amount. [$95,000 − $40,000 = $55,000; $55,000 × 35% = $19,250]

Question 20

Commerce Corp. elects S corporation status as of the beginning of the current year. At the time of Commerce’s election, it held a machine with a basis of $20,000 and a fair market value of $30,000. In March of the current year, Commerce sells the machine for $35,000. What would be the amount subject to the built-in gains tax?

a.

$10,000

b.

$5,000

c.

$0

d.

$15,000

Answer 20

Choice “a” is correct. The built-in gain for the machine is $10,000, the difference, on the date of the election of S status, between the $20,000 adjusted basis of the machine to the C corporation and the $30,000 fair market value. That is the amount of the gain that occurred while the corporation was a C corporation, and it is also the amount that is subject to the built-in gains tax.

Choice “c” is incorrect. The $0 indicates that there is no built-in gain on the machine. There are a number of exceptions to the built-in gains tax, but none of them apply in this question.

Choice “b” is incorrect. The $5,000 is the amount of the gain recognized on the sale ($35,000 - $20,000 - $10,000) that is not built-in gain. The $5,000 gain occurred while the corporation was an S corporation and is not subject to the built-in gains tax.

Choice “d” is incorrect. The $15,000 is the total gain recognized on the sale ($35,000 - $20,000), not the amount of gain subject to the built-in gains tax.

Question 21

Sandy is the sole shareholder of Swallow, an S corporation. Sandy’s adjusted basis in Swallow stock is $60,000 at the beginning of the year. During the year, Swallow reports the following income items:

Ordinary income $ 30,000

Tax-exempt income 5,000

Capital gains 10,000

In addition, Swallow makes a nontaxable distribution to Sandy of $20,000 during the year. What is Sandy’s adjusted basis in the Swallow stock at the end of the year?

a.

$85,000

b.

$60,000

c.

$70,000

d.

$80,000

Answer 21

Rules: The rules for determining a shareholder’s basis in S corporation stock follow:

Initial basis (or beginning of year)

+ Income items (separately and non-separately stated items)

+ Additional shareholder investments in corporation stock

• Distributions to shareholders

- Loss or expense items

Ending basis

Choice “a” is correct.

Initial basis (or beginning of year amount) $ 60,000

Income items (separately and non-separately stated items) 45,000

Additional shareholder investments in corporation stock −

Distributions to shareholders (20,000)

Loss or expense items −

Ending basis $ 85,000

Choice “b” is incorrect. This is only the amount of Sandy’s basis at the beginning of the year ($60,000). The income items and distributions also affect Sandy’s basis as of the end of the year.

Choice “c” is incorrect. This answer option includes the $60,000 basis at the beginning of the year plus the $10,000 in capital gains during the year, but it incorrectly excludes the ordinary and tax-exempt income from the year and the effect of the distributions during the year.

Choice “d” is incorrect. This answer option incorrectly excludes the $5,000 of tax-exempt income received by Swallow during the year.

Question 22

Which of the following can be an advantage of a limited liability company over an S corporation?

a.

Owners receive limited liability protection.

b.

Double taxation of profits is avoided.

c.

Incentive stock options can be used to compensate owners.

d.

Appreciated property can be distributed tax-free to an owner.

Answer 22

Rule: IRC Section 311 controls the taxability of corporate distributions. An S corporation (and a C corporation) recognizes a gain on any distribution of appreciated property (a property dividend) in the same manner as if the asset had been sold to the shareholder at its fair market value.

Choice “d” is correct. An S corporation cannot distribute appreciated property to its shareholders without gain. In general, a partnership can distribute appreciated property tax-free to its partners (in general, a non liquidating distribution to a partner is nontaxable). Since a limited liability company (LLC) is taxed like a partnership (an LLC properly structured and with two or more owners is taxed like a limited partnership with no general partners), a limited liability company can distribute appreciated property to its owners tax-free.

Choice “a” is incorrect. Owners receive limited liability protection with both an S corporation and a limited liability company so there is no advantage for a limited liability company over an S corporation here.

Choice “c” is incorrect. Incentive stock options can be used to compensate owners with both an S corporation and a limited liability company. There is no entity restriction for these stock options, other than that they can be granted only by corporations. There is no advantage for a limited liability company over an S corporation here.

Question 23

Tap, a calendar-year S corporation, reported the following items of income and expense in the current year:

Revenue $ 44,000

Operating expenses 20,000

Long-term capital loss 6,000

Charitable contributions 1,000

Interest expense 4,000

What is the amount of Tap’s ordinary income?

a.

$20,000

b.

$24,000

c.

$13,000

d.

$19,000

Answer 23

Rule: IRC Section 1366 controls the pass-through of S corporation income items to shareholders. In general, items are divided into separately stated items (items that could potentially affect the tax liability of the shareholders) and non-separately stated items. Non-separately stated items are lumped together and constitute the S corporation’s ordinary income. Separately stated items are passed through to the shareholders (in a manner similar to partnerships) and retain their tax attributes to the shareholders.

Choice “a” is correct. Tap’s ordinary income is calculated as follows:

Revenue $ 44,000

Operating expenses (20,000)

Interest expense (4,000)

Ordinary income $ 20,000

The long-term capital loss and the charitable contributions are not included in Tap’s ordinary income. They are separately stated items and thus are passed through to the shareholders and retain their tax attributes.

Choice “c” is incorrect. The $13,000 would include both the long-term capital loss and the charitable contributions.

Choice “d” is incorrect. The $19,000 would include the long-term capital loss but not the charitable contributions.

Choice “b” is incorrect. The $24,000 would not include the interest expense.

Question 24

Stone Corp. has been an S corporation since inception. In each of Year 1, Year 2, and Year 3, Stone made distributions in excess of each shareholder’s basis. Which of the following statements is correct concerning these three years?

a.

In all three years, the excess distributions are taxed as capital gains.

b.

In Year 3 only, the excess distributions are taxed as capital gain.

c.

In Year 1 only, the excess distributions are tax free.

d.

In Year 1 and Year 2 only, the excess distributions are taxed as capital gain.

Answer 24

Rule: Per IRC Section 1368, the amount of any distribution to an S corporation shareholder is equal to the cash plus the fair market value of any other property distributed. How the distribution is taxed depends on whether the S corporation has C corporation accumulated earnings and profits (E&P). If the S corporation has never been a C corporation or if it has no C corporation accumulated E&P, the distribution is a tax-free recovery of capital to the extent it does not exceed the shareholder’s adjusted basis in the stock of the S corporation. When the amount of the distribution exceeds the shareholder’s adjusted basis of the stock, the excess is treated as a gain from the sale or exchange of property (normally a long-term capital gain).

Choice “a” is correct. In each of the years, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains.

Choice “d” is incorrect. In each of the years, and not just the first and second years, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains; they are not tax free.

Choice “c” is incorrect. In each of the years, and not just the first year, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains.

Choice “b” is incorrect. In each of the years, and not just the third year, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains.

Question 25

Stone owns 100% of an S corporation and materially participates in its operations. The stock basis at the beginning of the year is $5,000. During the year, the corporation makes a distribution of $3,500 and passes through a loss from operations of $2,000 for the year. What loss can Stone deduct on Stone’s personal tax return?

a.

$2,000

b.

$5,500

c.

$1,500

d.

$0

Answer 25

Choice “c” is correct. An S Corporation shareholder’s basis is reduced by distributions to the shareholders as well as loss or expense items. However, loss deductions are limited to a shareholder’s adjusted basis in S corporation stock plus direct shareholder loans to the corporation. Any losses disallowed may be carried forward indefinitely and will be deductible as the shareholder’s basis is increased.

Beginning Basis $ 5,000

Less: Distributions to Shareholder (3,500)

Less: Shareholder share of losses (1,500)

(Excess $500 carried forward indefinitely.)

Ending Shareholder Basis $ 0

Choice “d” is incorrect. Losses are deductible only to the extent of the shareholder’s basis.

Choice “a” is incorrect. The shareholder cannot deduct the full loss without a sufficient amount of basis in the S corporation stock.

Choice “b” is incorrect. The shareholder cannot have a negative basis as a result of distributions and losses.

Question 26

Absent an election to close the books, the allocation of nonseparately stated income or loss for an S corporation shareholder that changed his ownership interest during the year is computed based on which of the following ownership percentages?

a.

Ownership percentage at the beginning of the S corporation year.

b.

Ownership percentage determined as an average of the beginning and ending ownership percentages.

c.

Ownership percentage computed on a per-share per-day basis.

d.

Ownership percentage at the end of the S corporation year.

Answer 26

Choice “c” is correct. Allocations to shareholders are made on a per-share, per-day basis.

Choice “d” is incorrect. Ownership in the S Corporation could change during the year.

Choice “a” is incorrect. Ownership in the S Corporation could change during the year.

Choice “b” is incorrect. Ownership in the S Corporation could change during the year.

Question 27

Miyasyke, Inc., a calendar year S corporation, has 5 equal shareholders at the end of the tax year. Miyasyke had $75,000 of taxable income. Miyasyke made distributions to its shareholders of $32,000 each, for a total of $160,000. Each shareholder’s basis in the S corporation is $100,000 at the beginning of the tax year. What amount from Miyasyke should be included in each shareholder’s gross income?

a.

$32,000

b.

$0

c.

$15,000

d.

$47,000

Answer 27

Choice “c” is correct. Each shareholder reports his/her pro rata share of the S corporation’s taxable income in his or her gross income. The distributions are not taxable to the extent the shareholders’ basis exceeds the distribution (and increased for any income reported by them during the year).

Choice “b” is incorrect. Each shareholder’s share of taxable income (non-separately stated) is reported in the shareholder’s gross income.

Choices “a” and “d” are incorrect. Choice “a” only includes the distribution, which is not taxable in this case as the shareholder’s basis exceeds the distribution. Choice “d” includes both the shareholder’s pro rata share of the taxable income and the distribution. The distribution is not taxable in this situation.

Question 28

A sole proprietorship incorporated on January 1 and elected S corporation status. The owner contributed the following assets to the S corporation:

Basis Fair market value

Machinery $7,000 $8,000

Building 11,000 100,000

Cash 1,000 1,000

Two years later, the corporation sold the machinery for $4,000 and the building for $110,000. The machinery had accumulated depreciation of $2,000, and the building had accumulated depreciation of $1,000. What is the built-in gain recognized on the sale?

a.

$0

b.

$99,000

c.

$100,000

d.

$6,000

Answer 28

Choice “a” is correct. An S corporation is subject to the “built-in gains” tax (as well as the “LIFO Recapture” tax and the “Passive Investment Income” tax) only if the S corporation had previously been a C corporation. In this question, the corporation elected “S” status on the day or incorporation; hence, the corporation was never a C corporation. So, the “built-in gains” tax doesn’t apply to the facts presented.

Choices “c”, “b”, and “d” are incorrect per the above rule.

Question 29

Which of the following items must be separately stated on Form 1120S, U.S. Income Tax Return for an S Corporation, Schedule K-1?

a.

Unearned revenue.

b.

Gain or loss from the sale of collectibles.

c.

Section 1245 Gain.

d.

Mark-to-market income.

Answer 29

Choice “b” is correct. Gain or loss from the S corporation’s sale of collectibles is separately reported on the Schedule K-1 of IRS form 1120S.

Choice “d” is incorrect. The S corporation’s mark-to-market income is part of “ordinary business income (loss),” which is separately stated on the Schedule K-1 of IRS form 1120S. However, the various components of “ordinary business income,” such as mark-to-market income, are not separately stated on the K-1 of IRS form 1120S.

Choice “a” is incorrect. The S corporation’s unearned revenue is not separately stated but is a component of “ordinary business income” or “net rental real estate income (loss)” or “other net rental income (loss),” each of which is separately stated on the Schedule K-1 of IRS form 1120S. However, the various components (such as unearned revenue) of “ordinary business income,” “net rental real estate income (loss),” and “other net rental income (loss)” are not separately stated on the K-1 of IRS form 1120S.

Choice “c” is incorrect. The S corporation’s section 1245 gain (and section 1250 gain) is not separately stated but is a component of “ordinary business income” or “net rental real estate income (loss)” or “other net rental income (loss),” each of which is separately stated on the Schedule K-1 of IRS form 1120S. However, the various components (such as section 1245 gain) of “ordinary business income,” “net rental real estate income (loss),” and “other net rental income (loss)” are not separately stated on the K-1 of IRS form 1120S.

Question 30

For which of the following entities is the owner’s basis increased by the owner’s share of profits and decreased by the owner’s share of losses but is not affected by the entity’s bank loan increases or decreases?

a.

Limited liability company.

b.

Partnership.

c.

S corporation.

d.

C corporation.

Answer 30

Choice “c” is correct. The owner’s basis in an S Corporation is increased by the owner’s share of profits and decreased by the owner’s share of losses. It is not affected by any bank loans increased or decreased by the corporation. It is only increased by direct loans made to the corporation by the owner.

Choice “d” is incorrect. C Corporations are not flow through entities and the owner’s basis is not affected by profits, losses, or loans made by the corporation.

Choice “b” is incorrect. The owner’s basis in a partnership is increased by the owner’s share of profits and decreased by the owner’s share of losses. For a partnership, the basis is also affected by increases and decreases of bank loans.

Choice “a” is incorrect. Limited Liability Companies are taxed as C corporations or partnerships, which are both incorrect as per above.

Question 31

Frank is a 1/3 shareholder in an S corporation. At the beginning of the year, Frank’s basis in his S corporation stock was $10,000. Frank’s share of the S corporation items of income included $35,000 of income from operations; $1,000 of charitable contributions, and $1,000 of capital gains. During the year, Frank also contributed $15,000 of additional capital and received a $3,000 distribution from the S corporation. What is Frank’s basis at the end of the tax year?

a.

$60,000

b.

$65,000

c.

$46,000

d.

$57,000

Answer 31

Choice “d” is correct. Frank’s basis is calculated as follows:

Beginning basis $ 10,000

Add: Separate and non-separate items

Income 35,000

Capital gains 1,000

Additional contributions 15,000

Less: Distributions (3,000)

Loss or expense items (1,000)

Frank’s ending basis $ 57,000

Question 32

Carson owned 40% of the outstanding stock of a C corporation. During a tax year, the corporation reported $400,000 in taxable income and distributed a total of $70,000 in cash dividends to its shareholders. Carson accurately reported $28,000 in gross income on Carson’s individual tax return. If the corporation had been an S corporation and the distributions to the owners had been proportionate, how much income would Carson have reported on Carson’s individual return?

a.

$160,000

b.

$132,000

c.

$28,000

d.

$188,000

Answer 32

Choice “a” is correct. S Corporations work in a similar fashion to partnerships. The income is passed through to the shareholder and included in taxable income whether or not it is actually distributed. Therefore, Carson will report 40% of the $400,000 taxable income, or $160,000. The $28,000 distribution will not affect the taxable income, but will reduce Carson’s basis in the S Corporation stock.

Choice “c” is incorrect. This is simply the same answer as if the corporation were a C Corporation.

Choice “b” is incorrect. This is the correct answer of $160,000 reduced by the $28,000 distribution. The $28,000 will not reduce taxable income, but will reduce Carson’s basis in the S Corporation stock.

Choice “d” is incorrect. This is the correct answer of $160,000 increased by the $28,000 distribution. The $28,000 will not increase taxable income, but will reduce Carson’s basis in the S Corporation stock.

Question 33

Beech Corp., an accrual-basis, calendar-year S corporation, has been an S corporation since its inception. At the beginning of the current year, Gold owned 50% of the 100 issued shares of Beech stock, and had a $3,000 tax basis in the Beech stock. During the current year, Beech had $200,000 in net business income and $4,000 in Oak County municipal bond interest income. Beech made no distributions to its shareholders. What was Gold’s tax basis in Beech stock at year end?

a.

$104,000

b.

$103,000

c.

$102,000

d.

$105,000

Answer 33

Choice “d” is correct. A shareholder’s basis in an S corporation is increased by his or her proportionate share of all income, including tax-free income. Gold’s ending basis in Beech is $105,000. $3,000 beginning basis + $100,000 (50% of net business income) + $2,000 (50% of municipal bond interest income).

Choices “c”, “b”, and “a” are incorrect, per the above explanation.

Question 34

Which of the following increases the accumulated adjustments account of an S corporation?

a.

Capital contributions by the shareholders.

b.

Distribution to shareholders.

c.

Charitable contributions.

d.

Interest and dividends.

Answer 34

Choice “d” is correct. The accumulated adjustments account (AAA) is increased by separately stated and non-separately stated income and gains (except tax-exempt income and certain life insurance proceeds).

Choice “a” is incorrect. Capital contributions by shareholders do not increase AAA.

Choice “b” is incorrect. Distributions to shareholders would decrease AAA, not increase AAA.

Choice “c” is incorrect. Charitable contributions would decrease AAA, not increase AAA.