- Which of the following statements is true regarding the federal income taxation of distributions made by a C corporation to its shareholders?
Answer: A distribution is a taxable dividend to the extent of the corporation's current or accumulated earnings and profits; any excess is a return of capital that reduces the shareholder's basis, and any further excess is gain from the sale of the stock.
Under IRC §§ 301 and 316, a distribution by a C corporation is a dividend to the extent of the corporation's current or accumulated earnings and profits. Amounts exceeding earnings and profits are first a return of capital, reducing the shareholder's stock basis, and any excess over basis is gain from the sale of the stock. The statement that measures the dividend by the shareholder's basis is wrong: basis does not determine dividend treatment, and return of capital is not permanently tax-free beyond basis. The statement that excess over earnings and profits is permanently tax-free and does not reduce basis is wrong: it reduces basis and may produce later gain. The statement that distributions are tax-free until basis is exhausted regardless of earnings and profits is wrong because distributions out of earnings and profits are taxable dividends.
A client works full time as a surgeon and owns a 15% limited partnership interest in a partnership that owns and rents apartment buildings. She contributed $40,000 in cash and is personally liable for a $20,000 share of the partnership's recourse debt, so her adjusted basis in the partnership interest is $60,000. For 2026 her Schedule K-1 reports a $60,000 ordinary loss from the partnership. She has $80,000 of salary income, no passive income from any source, does not participate in managing the properties, and does not qualify as a real estate professional. Under the rental real estate loss allowance, a taxpayer who actively participates in a rental real estate activity may deduct up to $25,000 of rental real estate losses against nonpassive income.
What is the correct treatment of the $60,000 partnership loss on the client's 2026 individual income tax return? Answer: The $60,000 loss is a passive activity loss, suspended until she has passive income or until a taxable sale of her entire interest.
Under IRC § 469, a limited partner's interest is passive as a matter of law, and a passive loss may offset only passive income, not salary. Her basis ($40,000 cash plus the $20,000 recourse debt, which also satisfies the at-risk rules) is sufficient to support the loss, but the passive activity limitation suspends the entire $60,000 until she has passive income or makes a taxable disposition of her entire interest. The rental real estate allowance cannot help: IRC § 469(i)(6)(C) provides that no limited partnership interest is ever treated as one in which the taxpayer actively participates, so the allowance is unavailable to her even though her ownership and income level would otherwise qualify. The full-deduction answer stops at the basis and at-risk tests. The $40,000 answer wrongly excludes the recourse debt from a limited partner's basis. The $25,000 answer ignores the statutory bar on limited partners claiming the active participation allowance.
A client owns all of the outstanding stock of a C corporation. For the 2026 tax year the corporation has $100,000 of pre-tax earnings, and the client wants the corporation to distribute all of its after-tax earnings to her as a dividend. The corporation pays federal income tax at a 21% rate. The client's marginal tax rate on qualified dividend income is 20%, and the dividend will also be subject to the 3.8% net investment income tax. No other taxes apply to the distribution.
What is the combined federal tax burden on the $100,000 of corporate earnings if the corporation distributes all of its after-tax earnings as a dividend, expressed as a percentage of the original $100,000? Answer: 39.8%
Under the Internal Revenue Code, a C corporation is taxed under IRC § 11 on its earnings, and a shareholder is taxed again under § 301 when those earnings are distributed as a dividend; qualified dividends are taxed under § 1(h)(11), and the § 1411 net investment income tax applies as well. The corporation owes 21% of $100,000, or $21,000, leaving a $79,000 dividend. The shareholder owes 23.8% (20% plus 3.8%) of that $79,000, or $18,802. The combined burden is $39,802, which is 39.8% of the original $100,000. The 21.0% figure reflects only the corporate-level tax and ignores the shareholder-level tax. The 23.8% figure applies the shareholder-level rate to the full pre-tax $100,000 and ignores the corporate tax. The 44.8% figure incorrectly adds 21% and 23.8% directly to the full pre-tax $100,000, which has the effect of taxing the $21,000 corporate tax as though it were also distributed to the shareholder.
A client created an irrevocable trust for estate planning purposes. The trust instrument gives the client the power to reacquire any trust asset by substituting other property of equivalent value. The trust's portfolio generates $25,000 of dividend income each year, and the trustee accumulates that income. The client receives no distributions from the trust.
How is the trust's dividend income taxed for the 2026 tax year? Answer: The client reports the dividends on her individual return each year even though the trustee does not distribute them to her.
Under IRC § 675(4), a grantor who holds the power to reacquire trust property by substituting property of equivalent value is treated as the owner of the trust. Under the grantor-trust rules of IRC §§ 671-677, the client must therefore report the dividend income currently, whether or not it is distributed, and the trust is not a separate taxpayer. The answer stating that the trust pays tax at compressed trust rates overlooks the substitution power; irrevocability and accumulation alone do not defeat grantor-trust treatment. The answer tying the client's tax to a later distribution of principal misstates the rule, which taxes the grantor as the income is earned. The completed-gift answer confuses gift taxation with income taxation: a completed gift does not shift the income tax burden, because grantor-trust status is determined by retained powers, not by gift completion.
- Which of the following statements is true regarding the federal income taxation of a non-grantor trust and its beneficiaries for tax year 2026?
Answer: A trust is generally allowed a distribution deduction for amounts distributed to beneficiaries, limited by distributable net income, and beneficiaries include those amounts only up to that same limit.
Under IRC §§ 651, 661, and 643, a non-grantor trust is allowed a distribution deduction for amounts distributed to beneficiaries, but not more than distributable net income, and beneficiaries include distributions in gross income only to the extent of DNI. A simple trust is allowed a distribution deduction for income required to be distributed currently. Corpus distributions do not escape the DNI cap, and a beneficiary's inclusion is not the greater of distributions and DNI; DNI is the ceiling.
A client is the sole beneficiary of an irrevocable non-grantor trust that earns $40,000 of interest income each year. The trustee currently accumulates this income, and the trust's marginal federal rate on undistributed income is 37%. The client, age 24, has $30,000 of W-2 income, and her marginal rate on ordinary income is 22%. The net investment income tax applies to single filers with modified adjusted gross income above $200,000. The trustee proposes to distribute the full $40,000 to the client each year beginning in 2026.
Which statement about the tax effect of the proposed change is correct? Answer: The distributions will be deductible by the trust and included in the client's gross income, so total federal income tax will be lower.
Under IRC §§ 661-662, a non-grantor trust deducts distributions to beneficiaries to the extent of distributable net income, and the beneficiary includes the same amount, so the income is taxed only once. Shifting $40,000 from the trust's 37% marginal rate to the client's 22% rate therefore lowers the total federal income tax. The client's MAGI after the distribution would be $70,000, well below the $200,000 NIIT threshold, so no net investment income tax applies to her. The double-tax answer ignores the trust's distribution deduction. The DNI answer reverses the rule: a beneficiary is taxed on distributions up to DNI, and the excess is a nontaxable principal distribution, not the other way around. The NIIT answer ignores that the client's MAGI remains below the $200,000 threshold.
A client is the sole shareholder of an S corporation and works full time in the business, so the passive activity rules do not apply to the loss. At the beginning of the 2026 tax year her adjusted basis in the stock was $50,000. During the year she loaned the corporation $30,000 in exchange for a promissory note, and the corporation made a $10,000 cash distribution to her. The corporation's ordinary loss for the year was $90,000, and no other limitations apply.
What amount of the loss may the client deduct on her individual return for 2026? Answer: $70,000
Under IRC § 1366(d), an S corporation shareholder may deduct a loss only to the extent of the adjusted basis of the stock plus the basis of any debt the corporation owes the shareholder. IRC § 1368(d) requires the shareholder's stock basis to be adjusted for distributions before it is reduced by losses. The $10,000 distribution reduces the $50,000 stock basis to $40,000. The $90,000 loss then reduces the stock basis to zero, allowing $40,000, and reduces the $30,000 loan basis to zero, allowing another $30,000, for a current deduction of $70,000. The remaining $20,000 loss is suspended and carries forward. The $90,000 figure ignores the basis limitation entirely. The $80,000 figure (stock plus loan) ignores the basis-reducing distribution. The $40,000 figure applies the loss only to the stock basis after the distribution and ignores the loan basis.
- For tax year 2026, which of the following statements is true regarding the federal income tax treatment of dividends received by a C corporation from another domestic C corporation?
Answer: A C corporation is generally allowed a dividends-received deduction for dividends from another domestic C corporation, but the deduction can be limited by the corporation's taxable income and depends on its percentage ownership of the payor.
Under IRC § 243, a C corporation generally may take a dividends-received deduction for dividends from another domestic C corporation. The deduction percentage depends on the recipient corporation's ownership of the payor, and the deduction may be subject to taxable-income limitations. The statement that a corporation pays tax at individual qualified-dividend rates is wrong: the qualified-dividend rate schedule applies to noncorporate taxpayers, while corporate recipients generally use the DRD. The statement that all such dividends may be excluded is wrong: the DRD is a percentage deduction, not a full exclusion, and its size depends on ownership. The statement that a corporation deducts dividends paid to its own shareholders and receives no deduction for dividends from other corporations is wrong: C corporations do not deduct dividends paid, and the DRD generally applies to dividends received from domestic corporations; the payor's prior tax is the reason the DRD exists, not a reason to deny it.
- For tax year 2026, which of the following statements is true regarding the federal income taxation of a grantor trust?
Answer: A grantor who can revoke the trust without an adverse party's consent is treated as the trust's owner and reports its income, deductions, and credits on the grantor's return.
Under IRC §§ 671-677, particularly § 676, a grantor who can revoke the trust without the consent of an adverse party is treated as the owner of the trust and reports all of its income currently. A grantor trust is not a separate taxpayer for income tax purposes. Income taxation does not wait for distributions and is not controlled by whether the transfer was a completed gift. If revocation requires the consent of a nonadverse party, the grantor generally remains the owner; consent by an adverse party is what prevents grantor-owner treatment under § 676.
A client is a general partner in a real estate development partnership. For the 2026 tax year the partnership's ordinary business income was $200,000 before deducting the client's guaranteed payment. The partnership paid her a $60,000 guaranteed payment for management services and a $25,000 cash distribution. Her share of the remaining partnership profits is 30%, and her basis in the partnership interest is sufficient to make the distribution nontaxable.
What amount and character of income from the partnership must the client report on her individual return for 2026? Answer: $102,000 of ordinary income; the $25,000 distribution is a nontaxable cash distribution.
Under IRC § 707(c), a guaranteed payment for services is ordinary income to the partner and is deducted by the partnership in computing its income; under § 702, the partner's distributive share of the remaining income retains its character. The partnership's income after the guaranteed payment is $200,000 - $60,000 = $140,000, and her 30% share is $42,000, so she reports total ordinary income of $60,000 + $42,000 = $102,000. Under § 731, the $25,000 cash distribution is not income because her basis is sufficient; it reduces her basis. The $120,000 figure treats the guaranteed payment as an addition to 30% of the full $200,000 (30% × $200,000 = $60,000, plus the $60,000 guaranteed payment) instead of first reducing partnership income by the guaranteed payment. The $127,000 figure adds the $25,000 distribution to the correct $102,000 and mischaracterizes it as taxable. The capital-gain answer gives the $42,000 distributive share the wrong character: ordinary business income of a partnership passes through as ordinary income, not as long-term capital gain.
An irrevocable trust's governing instrument requires the trustee to distribute all of the trust's accounting income annually and prohibits any distribution of principal. During the 2026 tax year the trust received $30,000 of interest income and realized a $10,000 long-term capital gain that the instrument allocates to principal. The trustee distributed $30,000 to the sole beneficiary. The trust has no other income, deductions, or credits.
Which statement correctly describes the income tax treatment of these amounts for 2026? Answer: The beneficiary reports $30,000 of interest income, and the trust reports the $10,000 capital gain.
Under IRC §§ 651-652, a simple trust deducts the income it is required to distribute currently, and the beneficiary includes that amount, but only up to the trust's distributable net income (DNI). Under § 643(a)(3), capital gains allocated to principal and not distributed are excluded from DNI. Because the instrument requires all accounting income to be distributed and prohibits principal distributions, this is a simple trust: its DNI is the $30,000 of interest income, so the beneficiary reports $30,000 of interest income, and the trust is taxed on the $10,000 retained capital gain. The $40,000 figure incorrectly includes the principal gain in the beneficiary's DNI. Treating the gain as taxed to no one ignores that the trust is a separate taxpayer on income it retains in principal. The last option inverts the rule: the trust gets the distribution deduction, and the beneficiary, not the trust, pays tax on distributed income.
- Which of the following statements is true regarding the federal income taxation of a partnership and its partners?
Answer: A partner's distributive share of partnership income is reported on the partner's return for the taxable year in which the partnership's taxable year ends, whether or not the income is distributed.
Under IRC §§ 701, 702, 706, and 707(c), a partnership generally does not pay income tax; each partner reports a distributive share for the partnership taxable year ending within or with the partner's taxable year, regardless of whether it is distributed. Guaranteed payments are deductible by the partnership and are ordinary income to the partner. Partnership liabilities do increase outside basis, but loss deductions are then limited by the basis, at-risk, and passive activity rules, not by contributed cash and property alone.
- Which of the following statements is true regarding the federal income tax treatment of an S corporation and its shareholders for tax year 2026?
Answer: A shareholder's stock basis is increased by the corporation's income items, including tax-exempt income, and reduced by nontaxable distributions; corporate bank debt does not increase stock basis.
Under IRC §§ 1366 and 1367, an S corporation shareholder's stock basis is increased by items of income, including tax-exempt income, and reduced by nontaxable distributions and by losses and deductions. Unlike a partner, an S corporation shareholder receives no basis for the corporation's own liabilities, so corporate bank debt does not increase stock basis. The statement that borrowed funds increase stock basis as partnership liabilities increase a partner's outside basis is wrong; the partnership liability rule does not apply to S corporations. The statement that third-party corporate debt supports losses is wrong: losses may be deducted against stock basis and, after it is exhausted, against the basis of debt the corporation owes directly to the shareholder. The statement that losses are limited to stock basis and that direct shareholder debt is ignored is therefore wrong.
