S Corporation Income And Loss Rules - CPA Reg

1. Under Section 1363(b), which deductions are not allowed at the S corporation level?
   Answer: The deduction for net operating losses and the special deductions for corporations (such as the dividends-received deduction) are not available to S corporations. Under Section 1363(b), in computing S corporation taxable income, certain deductions available to C corporations are not allowed, specifically: (1) the deduction for net operating losses under Section 172; and (2) special deductions allowed to corporations under Sections 241-247, including the dividends-received deduction. The rationale is that the NOL rules and DRD are entity-level concepts that do not make sense for a pass-through entity where income and losses flow through to shareholders. Answer B is incorrect because S corporations may deduct employee and officer salaries. Answer C is incorrect because interest expense is deductible. Answer D is incorrect because depreciation is deductible.
2. An S corporation has two equal shareholders and earns $80,000 of ordinary income. The corporation pays $10,000 in federal income taxes (e.g., from built-in gains tax) and distributes $20,000 cash to each shareholder. What is each shareholder's taxable income from the S corporation?
   Answer: $35,000 each (50% of $80,000 income less 50% of $10,000 corporate tax = $40,000 - $5,000 = $35,000; distributions do not reduce taxable income). Each shareholder's taxable income = 50% of $80,000 ordinary income minus 50% of $10,000 corporate-level tax (per Section 1366(f)(2)) = $40,000 - $5,000 = $35,000. Distributions are not additional income; they reduce stock basis and are not deducted from pass-through income. Answer A is correct. Answer B is incorrect because it counts only the $20,000 distribution as taxable income and ignores the pass-through ordinary income entirely. Answer C arrives at the correct pre-adjustment income allocation of $40,000 per shareholder but fails to reduce it by each shareholder's pro-rata share of the corporate-level tax under Section 1366(f)(2), overstating each shareholder's taxable income by $5,000. Answer D incorrectly reduces pass-through income by the distribution amount; distributions reduce stock basis but are not subtracted from ordinary income for taxable income purposes.
3. Under Section 1366(f), if an S corporation has corporate-level taxes (such as the built-in gains tax or the tax on excess passive income), how are these taxes treated?
   Answer: Corporate-level taxes paid by the S corporation reduce each shareholder's pro-rata share of income by the amount of the tax, treating the tax as a deductible loss to the corporation. Under Section 1366(f)(2), each shareholder's pro-rata share of net recognized built-in gain (and excess passive income) is reduced by the shareholder's pro-rata share of the tax paid by the corporation on that income. This prevents double taxation: if the S corporation pays a corporate-level tax on a gain, the shareholders' pass-through income from that gain is reduced by their share of the tax. Answer A is incorrect because corporate taxes do affect shareholder income. Answer B is incorrect because the taxes reduce income, not create separate deductions. Answer C is incorrect because shareholders do not pay the corporate-level tax; the entity does.
4. An S corporation is a pass-through entity. Which of the following correctly describes how S corporation income is taxed?
   Answer: The S corporation itself generally pays no income tax; instead, each shareholder includes their pro-rata share of S corporation income, loss, deductions, and credits on their own return, regardless of actual distributions. An S corporation is a flow-through entity for federal income tax purposes. Under Section 1363(a), the S corporation itself generally pays no federal income tax (with exceptions for built-in gains tax and passive income tax for former C corporations). Instead, each shareholder includes their pro-rata share of S corporation items on their personal return under Section 1366. This allocation is based on stock ownership percentage and the number of days in the tax year the shareholder held the stock. Answer A is incorrect because the entity-level tax generally does not apply. Answer B is incorrect because shareholders are taxed on their allocable share, not just dividends. Answer D is incorrect because shareholders are taxed annually on their pro-rata shares regardless of when stock is sold.
5. Under Section 1374, a former C corporation that has converted to S status is subject to the built-in gains (BIG) tax. What is the recognition period for the BIG tax under current law?
   Answer: 5 years after the S election date (per TCJA). Under Section 1374(d)(7) as modified by the Tax Cuts and Jobs Act, the recognition period for the built-in gains tax is 5 years after the first day the S corporation election is effective. During this 5-year window, if the S corporation recognizes gain that would have been built-in gain on the conversion date, the gain is subject to the BIG tax at the highest corporate rate (21%). After the 5-year period expires, no BIG tax applies. Answer A is incorrect because there is a defined recognition period. Answer B (10 years) was an earlier statutory period before the TCJA. Answer C (3 years) was a temporary provision that applied for certain years.
6. Under Section 1375, an S corporation that was previously a C corporation and has accumulated E&P may be subject to a tax on excess net passive income. When does this tax apply?
   Answer: The tax applies when the S corporation has accumulated C corporation E&P and passive investment income exceeds 25% of gross receipts; the tax is imposed on the lesser of excess net passive income or taxable income, at the highest corporate rate. Section 1375 imposes a corporate-level tax on excess net passive income when: (1) the S corporation has accumulated E&P from C corporation years at the close of the tax year; and (2) passive investment income exceeds 25% of gross receipts. The tax is imposed on excess net passive income (passive investment income minus associated deductions, limited to the amount by which passive investment income exceeds 25% of gross receipts), at the highest corporate tax rate (21%). If this continues for three consecutive years, the S election is terminated under Section 1362(d)(3). Answer B is incorrect because accumulated C E&P is required. Answer C incorrectly ties this to shareholder count. Answer D is incorrect because the 25% threshold must be exceeded.
7. An S corporation that was previously a C corporation has accumulated earnings and profits (AEP) from its C corporation years. The S corporation also has an accumulated adjustments account (AAA). How are distributions treated when both AAA and AEP exist?
   Answer: Distributions are first applied against AAA (tax-free to the extent of basis), then against AEP (taxable as dividends), then any remaining amount reduces stock basis or creates gain. Under Section 1368(c), when an S corporation has both AAA and accumulated C corporation E&P, distributions are processed in this order: (1) distributions from AAA (previously taxed S income) reduce stock basis and are tax-free to the extent of basis; (2) distributions from AEP are treated as C corporation dividends (taxable as ordinary income to the extent of AEP); (3) any remaining amounts reduce stock basis, with excess over basis treated as gain. The shareholder may elect to bypass AAA and distribute from AEP first. Answer A is incorrect because AAA distributions come first by default. Answer C is incorrect because there is no equal allocation. Answer D is incorrect because AEP is distributed second, not first.
8. An S corporation shareholder has a suspended loss of $20,000 from a prior year (loss exceeded basis). In the current year, the shareholder contributes $15,000 cash to the S corporation as additional equity. The corporation has no current-year income or loss. How much of the suspended loss may the shareholder deduct?
   Answer: $15,000, because the cash contribution restores $15,000 of stock basis, releasing $15,000 of the suspended loss. Suspended losses under Section 1366(d) are released and become deductible as the shareholder restores basis. The $15,000 cash contribution creates $15,000 of new stock basis, which releases $15,000 of the $20,000 suspended loss. The remaining $5,000 continues to be suspended until additional basis is created. Answer A ($0) ignores the basis restoration. Answer C ($20,000) exceeds the basis restored. Answer D (50%) applies an incorrect limitation.
9. An S corporation shareholder has a stock basis of $0 and a loan basis of $30,000 (from a direct loan to the S corporation). The corporation allocates a $40,000 loss to the shareholder. How much of the loss may the shareholder deduct currently?
   Answer: $30,000 Under Section 1366(d), a shareholder may deduct S corporation losses only to the extent of their basis in stock plus the adjusted basis of any indebtedness of the S corporation directly to the shareholder. The shareholder has $0 stock basis and $30,000 loan basis, for a total of $30,000 available. The $40,000 loss is limited to $30,000. The remaining $10,000 is a suspended loss that carries forward indefinitely until the shareholder restores sufficient basis. Answer A ($0) ignores the debt basis. Answer C ($40,000) exceeds available basis. Answer D ($10,000) is the suspended loss amount, not the deductible portion.
10. Under the basis ordering rules of Section 1367, in what order are adjustments made to an S corporation shareholder's stock basis?
    Answer: Stock basis is first increased by income items, then reduced by distributions, then reduced by losses and non-deductible expenses. Under Section 1367 and the ordering rules in Reg. Section 1.1367-1, the following order applies for adjustments to S corporation stock basis: (1) increase by income items (including tax-exempt income); (2) decrease by distributions; (3) decrease by losses and deductions; and (4) decrease by non-deductible, non-capitalized expenses. This ordering is important because income items first restore basis that distributions can then reduce tax-free, and losses reduce whatever basis remains after distributions. Answer A incorrectly places losses before distributions. Answer C is incorrect because ordering matters significantly for basis calculations. Answer D reverses the effects of distributions and income/losses.
11. Under the at-risk rules of Section 465 as applied to S corporation shareholders, a shareholder's at-risk amount includes which of the following?
    Answer: The shareholder's cash and property contributions, amounts borrowed for which the shareholder is personally liable, and amounts borrowed from related persons not excluded, but generally NOT the shareholder's share of entity-level recourse or nonrecourse liabilities. For S corporation shareholders, the at-risk amount under Section 465 includes: (1) the amount of money contributed; (2) adjusted basis of property contributed; (3) amounts borrowed for which the shareholder is personally liable (recourse debt at the shareholder level); and (4) amounts borrowed from certain related persons. Critically, unlike partnerships where partners' at-risk amounts include their share of recourse liabilities, S corporation shareholders' at-risk amounts generally do not include entity-level liabilities of the S corporation - those liabilities are not owed by the shareholders personally. Answer B is incorrect because entity-level liabilities are not included. Answer C is too narrow. Answer D is partially correct but incomplete.
12. Under Section 1367, how does S corporation income affect a shareholder's stock basis?
    Answer: A shareholder's stock basis is increased by their pro-rata share of S corporation income (including tax-exempt income) and decreased by distributions and losses (in that order). Under Section 1367, a shareholder's stock basis in an S corporation is adjusted annually. Increases include: pro-rata share of separately stated income items (including tax-exempt income), and pro-rata share of non-separately stated income. Decreases include: distributions (first), then separately stated loss items, non-separately stated losses, and non-deductible expenses (in the order specified). Basis cannot go below zero; excess losses create suspended losses. Answer B is incorrect because income allocations, not just contributions, increase basis. Answer C reverses the effect (income increases basis; losses decrease it). Answer D is incorrect because operations substantially affect basis.
13. Under Section 1366, an S corporation shareholder's deductible losses are limited by which of the following?
    Answer: Losses are limited first by the shareholder's stock and debt basis (Section 1366(d)), then by the at-risk rules (Section 465), and then by the passive activity loss rules (Section 469). S corporation shareholders face three sequential layers of loss limitation: (1) basis limitation under Section 1366(d) - losses cannot exceed the shareholder's basis in stock plus basis in loans made directly to the S corporation; (2) at-risk rules under Section 465 - losses deductible only to the extent the shareholder is at risk; and (3) passive activity loss rules under Section 469 - losses from passive activities may only offset passive income. Each limitation must be cleared in sequence before losses are deductible. Answer A is incorrect because all three limitations apply. Answer B is incorrect because basis limitation applies first, before at-risk rules. Answer D is incorrect because there is no asset-based percentage limitation.
14. Under the S corporation rules, which of the following is an example of a separately stated item that must be reported separately on Schedule K-1 to each shareholder?
    Answer: Long-term capital gains, Section 1231 gains, charitable contributions, investment interest expense, and tax credits. Under Section 1366(a)(1)(A), separately stated items are those that could affect different shareholders' tax liability differently depending on their individual tax situations. Items that must be separately stated include: capital gains and losses (short-term and long-term), Section 1231 gains and losses, charitable contributions, investment interest expense, tax credits (Section 38 and 48), passive activity items, and other items specified in regulations. Answer A (gross receipts), B (COGS), and C (officer salaries) are ordinary business items that are combined into net income from trade or business operations and reported as non-separately stated income.
15. Under Section 1377(a)(1), how is S corporation income and loss allocated to a shareholder who disposes of all their shares during the tax year?
    Answer: Under the daily proration method (default), the departing shareholder is allocated income or loss based on the number of days they owned the stock relative to the total days in the tax year; alternatively, the parties may elect a closing-of-books method to make an interim closing at the date of sale. Under Section 1377(a)(1), the default method for allocating S corporation income to a shareholder who sells their shares is the daily proration method: the departing shareholder's allocated share equals their percentage ownership multiplied by the pro-rata portion of the year they owned the shares (days owned / total days). Alternatively, under Section 1377(a)(2), if all affected shareholders consent, the corporation may make an interim closing of the books at the date of the disposition, allocating income and loss based on actual results through that date. Answer A is incorrect because the entire year's allocation goes to the departing shareholder only under specific circumstances. Answer B is incorrect because the departing shareholder is allocated their pro-rata share. Answer C is incorrect because the departing shareholder retains their allocated share for their ownership period.
16. Under the S corporation rules, what is the accumulated adjustments account (AAA)?
    Answer: The AAA is a corporate-level account that tracks undistributed S corporation income that has already been taxed to shareholders; it represents the amount that can be distributed tax-free to shareholders (to the extent of stock basis). The Accumulated Adjustments Account (AAA) under Section 1368(e) is a corporate-level account that tracks the aggregate amount of S corporation income (net of losses) that has been included in shareholders' gross income but not yet distributed. When a distribution is made, it first comes from AAA (and is tax-free to the extent of the shareholder's stock basis), preventing double taxation of income already taxed to shareholders at the pass-through level. The AAA can go negative (if losses exceed income). Answer A is incorrect because AAA is not the same as retained earnings. Answer B is incorrect because distributions reduce AAA, they are not the AAA itself. Answer D is incorrect because even S corporations that were always S corporations maintain AAA.
17. Under Section 1366(d)(2), what happens to S corporation losses that exceed a shareholder's combined stock and debt basis?
    Answer: Excess losses are suspended and carry forward indefinitely to future years, deductible when the shareholder restores sufficient basis. Under Section 1366(d)(2), any S corporation loss or deduction that is disallowed due to insufficient basis is suspended and carries forward to the following tax year. The suspended loss is treated as incurred in the following year and may be deducted when the shareholder has restored sufficient basis (through additional contributions, loans to the corporation, or income allocation that increases basis). There is no time limit on the carryforward. Answer A is incorrect because suspended losses are not permanently lost; they carry forward. Answer B is incorrect because losses cannot be reallocated to other shareholders. Answer D is incorrect because suspended losses do not affect the shareholder's basis in other investments.
18. Under the S corporation rules, how is debt basis in a loan from a shareholder directly to the S corporation created?
    Answer: Debt basis arises only from bona fide, direct loans from the shareholder to the S corporation; guarantees of third-party loans by the shareholder do not create debt basis. Under Section 1366(d)(1)(B), a shareholder's at-risk and basis amount includes the adjusted basis of any indebtedness of the S corporation to the shareholder. This requires a direct, bona fide loan from the shareholder personally to the S corporation. Guaranteeing a third-party loan (such as a bank loan to the S corporation) does not create debt basis because no money flows from the shareholder to the corporation. Even if the shareholder must pay as guarantor, debt basis only arises when the shareholder actually makes a payment. Answer A incorrectly applies the partnership rule (where liability shares create basis). Answer C and D are incorrect because guarantees and co-signing do not create debt basis.
19. Under the S corporation rules, what is the tax treatment of fringe benefits provided to a shareholder-employee who owns more than 2% of the S corporation's stock?
    Answer: Most fringe benefits (such as health insurance premiums, group-term life insurance, and parking benefits) provided to a more-than-2% shareholder-employee are included in the shareholder's W-2 wages as compensation. Under Section 1372, S corporation shareholders who own more than 2% of the stock are treated like partners (not employees) for purposes of certain fringe benefit exclusions. As a result, most tax-free fringe benefits that would be excludable for regular employees (such as employer-paid health insurance premiums under Section 106, group-term life insurance under Section 79, and qualified transportation fringes under Section 132) are taxable as W-2 compensation to the 2% shareholder-employee. The S corporation may then deduct these amounts as compensation. Answer A is incorrect because exclusions are not available for 2%+ shareholders. Answer B is incorrect because it understates the scope of inclusion. Answer D is incorrect because the amounts are includible in income.
20. Under Section 1368, how are cash distributions from an S corporation that has no accumulated earnings and profits (E&P) from prior C corporation years treated?
    Answer: Distributions are first applied against the shareholder's stock basis (tax-free return of capital); any excess over basis is treated as gain from the sale of the stock. Under Section 1368(b), when an S corporation has no accumulated C corporation E&P, distributions are treated as follows: (1) first, reduce stock basis (tax-free return of capital); (2) any amount exceeding stock basis is treated as gain from the sale of the stock (typically capital gain). This is distinct from C corporation dividends, which are taxable to the extent of E&P. Answer B is incorrect because S corporation distributions without C E&P are not dividends. Answer C creates a fictional income threshold. Answer D is incorrect because distributions from an S corporation are not self-employment income.

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