CPA Quiz: S Corporation Income Loss Distribution Rules
20 questions · exam conditions
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S Corporation Income Loss Distribution RulesQuestion 1 of 20

An S corporation's income, loss, deductions, and credits flow through to shareholders based on:

The shareholders' capital account balances at year-end.
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.
The amount of distributions each shareholder received during the year.
Special allocations agreed upon by the shareholders in the operating agreement.
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CPA Quiz

CPA Quiz: S Corporation Income Loss Distribution Rules

Practice S Corporation Income Loss Distribution Rules in CPA with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

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

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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.

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Question 1

An S corporation's income, loss, deductions, and credits flow through to shareholders based on:

  1. The shareholders' capital account balances at year-end.
  2. 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. (correct answer)
  3. The amount of distributions each shareholder received during the year.
  4. Special allocations agreed upon by the shareholders in the operating agreement.
Explanation: 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.

Question 2

A shareholder's basis in S corporation stock is increased by:

  1. Distributions received from the corporation.
  2. The shareholder's share of corporate losses.
  3. The shareholder's pro-rata share of S corporation income (including tax-exempt income) and capital contributions to the corporation. (correct answer)
  4. The corporation's total debt outstanding.
Explanation: 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).

Question 3

An S corporation shareholder may deduct their share of S corporation losses only to the extent of:

  1. Their pro-rata ownership percentage of total corporate losses.
  2. 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. (correct answer)
  3. The amount of their capital contributions during the year.
  4. Their share of the corporation's total assets.
Explanation: 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).

Question 4

A non-cash distribution from an S corporation to a shareholder is treated as:

  1. A distribution at the fair market value of the property - the S corporation recognizes gain as if it sold the property at FMV, and the shareholder treats the FMV as the distribution amount for basis purposes. (correct answer)
  2. A tax-free exchange with no gain recognized at either level.
  3. Ordinary income to the shareholder equal to the property's adjusted basis.
  4. A deductible expense for the S corporation.
Explanation: Non-cash distributions trigger gain recognition at the corporate level (as if sold at FMV), and the shareholder receives a distribution at FMV for stock basis purposes. Answer A is correct. Gain is recognized (B). FMV is the measure, not adjusted basis (C). Distributions are not deductible by S corps (D).

Question 5

An S corporation that was previously a C corporation makes a cash distribution. The distribution ordering rules require:

  1. First from accumulated E&P, then from AAA.
  2. First from paid-in capital, then from AAA.
  3. 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. (correct answer)
  4. All distributions treated as dividends from E&P as long as any E&P exists.
Explanation: 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).

Question 6

A shareholder receives a distribution from an S corporation in excess of their stock basis. The tax treatment of the excess is:

  1. Ordinary income to the extent of the S corporation's accumulated E&P.
  2. 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. (correct answer)
  3. Ordinary income since S corporation distributions are not capital transactions.
  4. Tax-free since the excess represents a return of capital to the shareholder.
Explanation: 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).

Question 7

When a shareholder's S corporation debt basis is reduced by losses, subsequent S corporation income:

  1. First restores stock basis, then debt basis.
  2. Increases both stock basis and debt basis proportionally.
  3. First restores debt basis to its original amount before increasing stock basis - the income allocation first replenishes the reduced debt basis, then any remaining income increases stock basis. (correct answer)
  4. Has no effect on debt basis - debt basis is fixed at the loan amount.
Explanation: Income allocations first restore debt basis (reduced by prior losses) before increasing stock basis. Answer C is correct. Stock basis is restored after debt basis (A - reversed). Income doesn't split between them proportionally (B). Debt basis fluctuates with losses and income (D).

Question 8

When does a shareholder have basis in S corporation debt (debt basis)?

  1. When the shareholder directly lends money or property to the S corporation - the shareholder's direct loans create debt basis, but guarantees of third-party loans do not. (correct answer)
  2. When the S corporation borrows from a third-party lender and the shareholder personally guarantees the debt.
  3. When the S corporation has outstanding bank loans regardless of who made the loans.
  4. When the shareholder owns more than 50% of the S corporation's stock.
Explanation: S corporation debt basis arises only from direct loans from the shareholder to the corporation - loan guarantees do not create basis unless the shareholder actually makes payment on the guarantee. Answer A is correct. Guarantees alone don't create basis (B). Third-party loans don't create shareholder basis (C). Ownership percentage doesn't determine debt basis (D).

Question 9

A shareholder's basis in S corporation stock is initially determined by:

  1. 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). (correct answer)
  2. The fair market value of the S corporation on the date of purchase.
  3. The S corporation's book value per share on the purchase date.
  4. The S corporation's retained earnings attributable to the shareholder's ownership percentage.
Explanation: 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.

Question 10

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:

  1. 30,000−thecombinedstockbasis(30,000 - the combined stock basis (20,000) plus debt basis ($10,000). The remaining $5,000 is suspended. (correct answer)
  2. $35,000 - the full loss since the shareholder is an active participant.
  3. $20,000 - only stock basis is available for loss deductions.
  4. $0 - losses must be separately substantiated before deduction.
Explanation: 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).

Question 11

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:

  1. $0 - the distribution exceeded the beginning basis.
  2. $20,000 - beginning basis plus income.
  3. $10,000 - no change since income and distribution cancel out.
  4. 20,000−beginningbasis(20,000 - beginning basis (10,000) + income (30,000)−distribution(30,000) - distribution (20,000) = $20,000. (correct answer)
Explanation: 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).

Question 12

A shareholder's S corporation stock basis is reduced (but not below zero) by:

  1. The S corporation's current year taxable income.
  2. Amounts the S corporation pays as salaries to non-shareholder employees.
  3. The FMV of distributions received that exceed the shareholder's basis.
  4. Distributions from the corporation, the shareholder's pro-rata share of losses and deductions, and the shareholder's pro-rata share of non-deductible expenses (in that order). (correct answer)
Explanation: Stock basis is reduced by: (1) distributions, (2) loss/deduction items, and (3) non-deductible expenses - but cannot go below zero. Answer D is correct. Income increases basis (A). Employee salaries don't affect shareholder basis (B). Distributions are basis reducers, not excess distribution gains (C - the gain is recognized when distributions exceed basis).

Question 13

The accumulated adjustments account (AAA) of an S corporation represents:

  1. The sum of all shareholder capital contributions to the S corporation.
  2. The S corporation's retained earnings for financial accounting purposes.
  3. The total distributions made by the S corporation during its existence.
  4. 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. (correct answer)
Explanation: 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).

Question 14

The LIFO recapture rule requires an S corporation converted from a C corporation to:

  1. Immediately recognize all LIFO reserves as income.
  2. Eliminate the LIFO method and switch to FIFO.
  3. 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. (correct answer)
  4. Report LIFO reserves as AE&P available for distribution.
Explanation: 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).

Question 15

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:

  1. The S corporation loses its S election.
  2. The IRS may reclassify distributions as wages, subjecting the reclassified amounts to FICA taxes, employer and employee portions, plus potential failure-to-withhold penalties. (correct answer)
  3. The shareholder loses their ability to deduct S corporation losses.
  4. The S corporation loses the ability to make tax-free distributions.
Explanation: 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).

Question 16

The AAA of an S corporation can be reduced below zero if:

  1. 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. (correct answer)
  2. The S corporation makes distributions exceeding accumulated E&P.
  3. A shareholder sells their stock during the year.
  4. The S corporation elects to bypass the AAA for distribution purposes.
Explanation: 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).

Question 17

The built-in gains (BIG) tax under Section 1374 applies to an S corporation that:

  1. 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. (correct answer)
  2. Has accumulated E&P from its C corporation years and makes distributions.
  3. Has passive investment income exceeding 25% of gross receipts for 3 consecutive years.
  4. Converts from an S corporation to a C corporation.
Explanation: 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).

Question 18

An S corporation shareholder's deductible losses are limited not only by basis but also by:

  1. The passive activity rules only - at-risk rules don't apply to S corporations.
  2. The basis limitation only - once basis is available, all losses are fully deductible.
  3. The basis limitation (stock + debt basis), then the at-risk rules (Section 465), and then the passive activity rules (Section 469) - losses must clear all three hurdles in sequence. (correct answer)
  4. The corporate alternative minimum tax computed at the shareholder level.
Explanation: S corp losses face a three-tier limitation: basis, at-risk, and passive activity - each must be cleared before the loss can be deducted. Answer C is correct. Both at-risk and passive rules apply (A). Multiple limitations apply beyond basis (B). The corporate AMT doesn't apply at the shareholder level (D).

Question 19

A distribution from an S corporation reduces the shareholder's stock basis before reducing debt basis. The ordering matters because:

  1. Distributions increase stock basis and decrease debt basis simultaneously.
  2. Distributions to shareholders create deductions for the S corporation.
  3. Reducing debt basis first would prevent future interest income on intra-company loans.
  4. 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. (correct answer)
Explanation: 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).

Question 20

An S corporation with accumulated E&P from prior C corporation years must be careful about passive investment income because:

  1. Passive income is always subject to the built-in gains tax.
  2. 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. (correct answer)
  3. Passive income is automatically characterized as dividends from the C corporation years.
  4. Passive income cannot flow through to S corporation shareholders.
Explanation: 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).