CPA Regulation Reg Quiz: S Corporation Income And Loss Rules

What this quiz covers

This quiz focuses on S Corporation Income And Loss Rules, giving you a quick way to practice the rules, question types, and explanations that matter most for CPA Regulation Reg.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

Question 1

1. The S corporation pays tax at the corporate rate on all income; shareholders are not taxed.
2. The S corporation pays tax on corporate-level income; shareholders are taxed only on dividends received.
3. 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. (correct answer)
4. Shareholders are taxed only when they sell their S corporation stock.

Explanation: 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.

Question 2

1. $0
2. $30,000 (correct answer)
3. $40,000
4. $10,000

Explanation: 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.

Question 3

1. Gross receipts from services performed in the ordinary course of business.
2. Cost of goods sold.
3. Officer salaries paid by the corporation.
4. Long-term capital gains, Section 1231 gains, charitable contributions, investment interest expense, and tax credits. (correct answer)

Explanation: 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.

Question 4

1. 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. (correct answer)
2. The shareholder's pro-rata share of all S corporation liabilities.
3. Only the shareholder's original cash investment in the S corporation.
4. Only amounts for which the shareholder has personal liability and has paid out of pocket.

Explanation: 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.

Question 5

1. $0
2. $15,000, because the cash contribution restores$15,000 of stock basis, releasing $15,000 of the suspended loss. (correct answer)
3. $20,000, because cash contributions restore all suspended losses.
4. $7,500, limited to 50% of the restored basis.

Explanation: 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.

Question 6

1. Unlimited; all built-in gains are taxed whenever recognized.
2. 10 years after the S election date.
3. 3 years after the S election date.
4. 5 years after the S election date (per TCJA). (correct answer)

Explanation: 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.

Question 7

1. Excess losses are permanently disallowed.
2. Excess losses are allocated to the other shareholders.
3. Excess losses are suspended and carry forward indefinitely to future years, deductible when the shareholder restores sufficient basis. (correct answer)
4. Excess losses reduce the shareholder's basis in other investments.

Explanation: 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.

Question 8

1. The entire $70,000 is ordinary income.
2. The gain of $30,000 ($70,000 - $40,000) is ordinary income.
3. The gain of $30,000 is Section 1231 gain.
4. The gain is $25,000 ($70,000 - $45,000 adjusted basis including current year income), treated as capital gain from the sale of stock. (correct answer)

Explanation: The shareholder's stock basis at the time of sale must be adjusted for the current-year income allocation. Basis increases by the $5,000 of current-year income allocated =$40,000 + $5,000 =$45,000. Gain on sale = $70,000 -$45,000 = $25,000. The gain is capital gain (long-term if held more than one year) from the sale of S corporation stock. The Section 1374 BIG analysis does not affect the shareholder's personal gain on stock sale. Answer A (ordinary income) is incorrect; the sale of stock produces capital gain. Answer B uses the wrong basis (pre-income-allocation). Answer C (Section 1231) applies to business assets, not stock.

Question 9

1. The deduction for net operating losses and the special deductions for corporations (such as the dividends-received deduction) are not available to S corporations. (correct answer)
2. S corporations may not deduct salaries paid to employees.
3. S corporations may not deduct interest expense.
4. S corporations may not deduct depreciation.

Explanation: 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.

Question 10

1. $35,000 each (50$80,000 income less 50% of $10,000 corporate tax =$40,000 - $5,000 =$35,000; distributions do not reduce taxable income). (correct answer)
2. $20,000 each (only the distribution is taxable).
3. $40,000 each (50$80,000 without any adjustment for taxes).
4. $25,000 each ($40,000 less the $20,000 distribution divided by two).

Explanation: Each shareholder's taxable income = 50% of $80,000 ordinary income minus 50$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.

Question 11

1. Debt basis arises from the shareholder's pro-rata share of all S corporation liabilities.
2. 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. (correct answer)
3. Debt basis arises from any guarantee or endorsement of an S corporation's debt by the shareholder.
4. Debt basis arises when the shareholder co-signs a bank loan on behalf of the S corporation.

Explanation: 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.

Question 12

1. The S corporation's books automatically close on the date of the sale, regardless of whether affected shareholders consent.
2. The books always close on December 31 for all shareholders.
3. Under the default daily pro-ration rule, the books do not close at the termination date; however, if all affected shareholders (the transferor and transferee) and the S corporation consent, an interim closing of the books may be elected, allocating income and loss based on actual results through the termination date. (correct answer)
4. The election to close the books is available only if the corporation terminates its S election in the same year.

Explanation: Under Section 1377(a) and (b), the default method for allocating S corporation income when a shareholder's interest terminates is the daily pro-ration method (income is treated as accruing ratably throughout the year and allocated based on ownership percentage and days held). However, if all affected shareholders (those whose interests are being terminated and those acquiring the interest) consent, the corporation may elect to make an interim closing of the books as of the termination date, allocating income and loss based on actual results. This election can prevent inappropriate shifting of income between old and new shareholders. Answer A is incorrect because automatic closure requires no consent under default rules. Answer B is incorrect because daily pro-ration is the default. Answer D is incorrect because the closing-of-books election does not require S election termination.

Question 13

1. The S corporation may distribute appreciated property without recognition of gain at the entity level.
2. The distribution is treated as a tax-free exchange for both the corporation and the shareholder.
3. The shareholder recognizes gain equal to the full fair market value of the property.
4. The S corporation must recognize gain as if it sold the property at fair market value; the gain flows through to shareholders and increases their stock basis; the shareholder then receives the property with a basis equal to its FMV. (correct answer)

Explanation: Under Section 311(b), when an S corporation distributes appreciated property, the corporation recognizes gain as if it sold the property at fair market value. This gain flows through to shareholders under the pass-through rules, increasing each shareholder's stock basis (and taxable income). The distributing shareholder receives the property with a basis equal to its FMV (the amount they were taxed on through the gain recognition). Answer A is incorrect because the S corporation must recognize gain on appreciated property distributions. Answer B is incorrect because gain is recognized and passed through. Answer C is incorrect about the shareholder's gain; the shareholder's taxable income comes from the pass-through of corporate-level gain, not from a direct distribution gain.

Question 14

1. Corporate-level taxes are ignored for shareholder income calculations.
2. Corporate-level taxes are passed through to shareholders as additional deductions.
3. Corporate-level taxes are paid by shareholders individually based on their pro-rata shares.
4. 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. (correct answer)

Explanation: 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.

Question 15

1. Distributions are always treated as dividends from AEP first.
2. 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. (correct answer)
3. Distributions are applied equally between AAA and AEP.
4. The S corporation must first distribute all AEP before any AAA distributions are made.

Explanation: 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.

Question 16

1. The shareholder who received the distribution reports $30,000; the other shareholder reports$70,000.
2. Each shareholder reports $15,000 (the distribution divided by two).
3. Each shareholder reports $50,000 of income (50$100,000), regardless of the distribution; distributions do not affect income allocation. (correct answer)
4. Only the shareholder who received the distribution reports income.

Explanation: S corporation income is allocated to shareholders based on their pro-rata stock ownership, not based on distributions. Each 50% shareholder is allocated 50% of the $100,000 ordinary income =$50,000 each, regardless of whether they received a distribution. The $30,000 cash distribution reduces the receiving shareholder's stock basis (rather than being additional income) since the corporation already allocated income proportionally. Answer A incorrectly ties income to distributions. Answer B allocates the distribution amount as income. Answer D is incorrect because income flows through based on ownership percentages.

Question 17

1. Losses reduce basis first, then income increases it, then distributions reduce it.
2. Stock basis is first increased by income items, then reduced by distributions, then reduced by losses and non-deductible expenses. (correct answer)
3. All adjustments are made simultaneously at year-end.
4. Distributions increase basis; losses and income have no effect until the stock is sold.

Explanation: 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.

Question 18

1. All fringe benefits are excluded from income for 2% shareholder-employees.
2. Only health insurance premiums are taxable; all other fringes are excluded.
3. 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. (correct answer)
4. Fringe benefits for 2% shareholders are deductible but not includible in income.

Explanation: 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.

Question 19

1. Losses are unlimited and always fully deductible by S corporation shareholders.
2. Losses are limited only by the at-risk rules under Section 465.
3. 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). (correct answer)
4. Losses are limited to the shareholder's percentage ownership times the corporation's total assets.

Explanation: 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.

Question 20

1. The departing shareholder reports all income and loss for the entire year.
2. The departing shareholder reports none of the income or loss for the year.
3. All income is allocated to the remaining shareholders as of the disposal date.
4. 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. (correct answer)

Explanation: 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.