- An S corporation's income, loss, deductions, and credits flow through to shareholders based on:
Answer: Each shareholder's pro-rata daily share of stock ownership - income and loss items are allocated based on the number of shares owned for each day of the year.
S corporation items are allocated strictly pro-rata based on shares owned per day - unlike partnerships, S corps cannot make special allocations. Answer B is correct. Capital accounts (A) determine partnership allocations. Distributions (C) affect basis but not income allocation. Special allocations (D) are not permitted for S corps.
- A shareholder has an S corporation stock basis of $20,000 and debt basis (from a loan to the corporation) of $10,000. The S corporation allocates $35,000 of losses to this shareholder. The deductible loss is:
Answer: $30,000 - the combined stock basis ($20,000) plus debt basis ($10,000). The remaining $5,000 is suspended.
S corp losses are deductible to the extent of stock basis plus debt basis: $20,000 + $10,000 = $30,000. The $5,000 excess is suspended. Answer A is correct. Full $35,000 (B) exceeds available basis. Debt basis also supports deductions (C). Losses are deductible up to basis (D).
- A shareholder's basis in S corporation stock is increased by:
Answer: The shareholder's pro-rata share of S corporation income (including tax-exempt income) and capital contributions to the corporation.
Basis increases for income pass-throughs (including tax-exempt income) and additional capital contributions. Answer C is correct. Distributions decrease basis (A). Losses decrease basis (B). S corporation debt generally doesn't increase shareholder stock basis (D).
- The accumulated adjustments account (AAA) of an S corporation represents:
Answer: The cumulative undistributed income (net of losses) that has been taxed at the shareholder level during the S corporation's existence - it tracks the amount that can be distributed tax-free after previously taxed post-S election income.
The AAA tracks the post-S election income that has already been taxed to shareholders but not yet distributed - distributions from AAA are tax-free (return of previously taxed income). Answer D is correct. Capital contributions (A) are separate. Book retained earnings (B) differ from AAA. Cumulative distributions reduce AAA (C).
- An S corporation shareholder may deduct their share of S corporation losses only to the extent of:
Answer: Their adjusted basis in the S corporation stock plus any basis in loans made to the corporation - losses exceeding this combined basis are suspended until basis is restored.
S corp shareholders can deduct losses to the extent of stock basis plus debt basis (loans to the corporation). Excess losses are suspended. Answer B is correct. Loss limitation is based on basis, not ownership percentage (A). Only current-year contributions don't determine the total available basis (C). Asset values are irrelevant to the loss limitation (D).
- A shareholder's basis in S corporation stock is initially determined by:
Answer: The amount paid for the stock (purchase price or, for founding shareholders, the amount of cash and adjusted basis of property contributed in exchange for the stock).
Stock basis in an S corporation is initially the purchase price or contribution amount - the same as for any corporate stock. Answer A is correct. FMV determines amount realized, not initial tax basis (B). Book value (C) and retained earnings (D) are accounting concepts, not tax basis.
- An S corporation cannot have more than 100 shareholders. For purposes of this limit:
Answer: All members of a family (up to 6 generations) may elect to be treated as one shareholder for the 100-shareholder limit - substantially reducing the impact of this restriction for family-owned S corporations.
The family attribution rule allows all members of a qualifying family (6-generation group) to be treated as one shareholder for the 100-shareholder limit. Answer D is correct. Each family member doesn't automatically count separately (A). Corporations cannot be S corp shareholders (B). Married couples count as one (C - the rule treats them together, not separately).
- An S corporation that was previously a C corporation makes a cash distribution. The distribution ordering rules require:
Answer: First from the accumulated adjustments account (AAA), then from accumulated E&P (if any), then as a return of capital, and finally as capital gain - the AAA represents post-S election accumulated undistributed income.
The distribution ordering for S corps with prior C corp history is: AAA first, then AE&P, then return of capital, then capital gain. Answer C is correct. The ordering is AAA then E&P (A - reversed). Paid-in capital is not the first source (B). E&P doesn't override AAA (D).
- The built-in gains (BIG) tax under Section 1374 applies to an S corporation that:
Answer: Was formerly a C corporation and sells appreciated assets within the recognition period (5 years after the S election) - the tax is imposed at the highest corporate rate (21%) on net recognized built-in gains.
The BIG tax prevents S corporations from avoiding corporate-level tax on pre-conversion appreciation by electing S status. Answer A is correct. AE&P triggers different S corp issues (B). 25% passive income triggers a different provision (C). Conversion from S to C has different rules (D).
- When an S corporation shareholder sells their stock, the gain or loss is determined by:
Answer: The difference between the amount realized and the shareholder's adjusted stock basis (original cost, increased by income pass-throughs and decreased by distributions and losses) - typically resulting in capital gain or loss.
Gain or loss on sale of S corp stock = amount realized minus adjusted stock basis (which reflects all income/loss pass-throughs and distributions over the holding period). Answer C is correct. Book value is not tax basis (A). Original cost may differ from adjusted basis due to adjustments (B). E&P is not used to compute individual stock gain (D).
- An S corporation shareholder receives a K-1 showing $30,000 of ordinary income and takes a $20,000 cash distribution. The shareholder's stock basis was $10,000 at the beginning of the year. The stock basis at year-end is:
Answer: $20,000 - beginning basis ($10,000) + income ($30,000) - distribution ($20,000) = $20,000.
Year-end basis = $10,000 (beginning) + $30,000 (income) - $20,000 (distribution) = $20,000. Answer D is correct. The basis doesn't go to zero (A). Income is added and distributions reduce (B - correct number but wrong formula). They don't cancel (C).
- The LIFO recapture rule requires an S corporation converted from a C corporation to:
Answer: Include in income in the final C corporation tax year (the year before the S election becomes effective) the LIFO reserve - the amount by which inventory would be higher under FIFO than under LIFO, paid over 4 years.
The LIFO recapture rule requires recognition of the LIFO reserve in the last C corporation year, paid in 4 installments, to prevent permanent avoidance of the LIFO tax benefit through an S election. Answer C is correct. Not immediate but 4-year spread (A). LIFO method doesn't need to be abandoned (B). LIFO reserves are not AE&P (D).
- A shareholder receives a distribution from an S corporation in excess of their stock basis. The tax treatment of the excess is:
Answer: Capital gain - distributions in excess of stock basis (after AAA has been exhausted and no AE&P exists) are treated as gain from the sale of the S corporation stock.
After stock basis is reduced to zero, any excess distribution (from AAA or in the absence of AE&P) is capital gain from the deemed sale of stock. Answer B is correct. Excess over basis creates capital gain, not necessarily ordinary income from E&P (A). Capital gain treatment applies (C). Excess over basis is not tax-free (D).
- An S corporation shareholder who is also an employee must receive reasonable compensation for services. The primary tax consequence of not paying adequate wages is:
Answer: The IRS may reclassify distributions as wages, subjecting the reclassified amounts to FICA taxes, employer and employee portions, plus potential failure-to-withhold penalties.
The IRS can reclassify distributions to wages for shareholder-employees who receive inadequate compensation, triggering FICA and related penalties. Answer B is correct. Inadequate wages don't terminate the S election (A). Loss deductions are tied to basis, not compensation (C). The S election and distribution rules are separate from compensation (D).
- An S corporation with accumulated E&P from prior C corporation years must be careful about passive investment income because:
Answer: If passive investment income exceeds 25% of gross receipts for 3 consecutive years, the S election terminates at the end of the third year - and an excise tax (tax on excess passive net income) may be imposed annually during those years.
Excess passive investment income (over 25% of gross receipts for 3 years when E&P exists) terminates the S election and an excise tax applies annually. Answer B is correct. The BIG tax and passive income tax are separate (A). Passive income retains its character for shareholders (C). Passive income does flow through (D).
- An S corporation's election is terminated when:
Answer: An ineligible shareholder acquires S corporation stock (e.g., a nonresident alien, a C corporation, or certain trusts not qualifying as S corp shareholders) - the S election terminates on the date of the disqualifying transfer.
S election termination occurs when an ineligible shareholder (nonresident alien, C corporation, or disqualified trust) acquires stock - effective on the transfer date. Answer B is correct. Net losses do not terminate the S election (A). No revenue limit exists for S corporations (C). Under Section 1361(c)(4), differences in voting rights among shares of the same class of stock are expressly permitted and do not create a second class of stock or terminate the S election - only differences in economic rights (distribution or liquidation rights) create a prohibited second class of stock (D).
- A distribution from an S corporation reduces the shareholder's stock basis before reducing debt basis. The ordering matters because:
Answer: If a distribution reduces stock basis to zero and no remaining stock basis is available, further distributions are capital gain - distributions do not reduce debt basis.
Only losses (not distributions) reduce debt basis - distributions reduce stock basis and then create capital gain once basis is exhausted. Debt basis is only reduced by loss pass-throughs. Answer D is correct. Distributions only affect stock basis (A). S corp distributions are not deductible (B). Debt basis rules are about loss deductions, not distributions (C).
- An S corporation's tax items retain their character as they pass through to shareholders. Which of the following correctly describes this pass-through treatment?
Answer: Separately stated items (such as long-term capital gains, charitable contributions, Section 1231 gains, and tax-exempt income) retain their specific character and are reported separately on the K-1, while non-separately stated items are combined into ordinary income or loss.
The conduit principle applies - separately stated items retain their character for the shareholder, while ordinary income items are combined. Answer B is correct. Separately stated items are not aggregated (A). Items retain their character (C, D).
- The AAA of an S corporation can be reduced below zero if:
Answer: The S corporation's losses and deductions exceed accumulated undistributed income - the AAA may go negative, and future income must first restore the AAA to zero before distributions from AAA can be made.
AAA can go negative from current year losses exceeding prior accumulated income. Future income must restore AAA before tax-free distributions. Answer A is correct. Distributions don't reduce AAA below zero (B). Stock sales don't affect AAA (C). Bypassing AAA is possible by election but creates different issues (D).
- A new shareholder acquires S corporation stock mid-year. The income and loss allocated to this shareholder for the year is based on:
Answer: A daily pro-rata allocation from the date of acquisition through year-end - or alternatively, under the 'closing of the books' election, items through the date of transfer are allocated to the seller and items after the transfer date to the buyer.
S corporations may use either daily proration or, by consent, the closing-of-the-books method for the year of transfer. Answer D is correct. Not a full year for a mid-year purchaser (A). No negotiated allocation allowed (B). The new shareholder gets their share from acquisition forward (C - this is the seller's share, not the new shareholder's).
