CPA REG: Entity Taxation and Tax Preparation

CPA means Certified Public Accountant. REG means Taxation and Regulation. Use this focused page when your CPA REG misses are about entity returns, owner-level tax effects, basis, distributions, separately stated items, or tax-preparation consequences. Drill this topic before returning to mixed practice.

Topic snapshot

What this topic tests

This topic tests entity-level tax consequences and the owner-level effects that follow. Strong answers identify the entity type, transaction, taxable income effect, separately stated item, basis implication, and return-preparation consequence.

Common traps

• mixing C corporation, S corporation, and partnership treatment
• stopping at entity income and missing the owner-level basis, distribution, or loss-limitation effect
• treating book income, taxable income, and separately stated items as interchangeable
• missing when a filing, election, or return-preparation rule controls the answer more than the computation

How to reason through these questions

Name the entity first, then decide whether the issue belongs at the entity level, owner level, or both. If a calculation ignores basis, distribution ordering, separately stated items, or loss limitations, it is probably incomplete.

Sample questions

These questions are original Mastery Exam Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.

Question 1

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is reviewing a calendar-year Form 1120S draft for Mesa Design Inc., an S corporation that is not a financial institution. No special 100% meal deduction rule applies, and all expenses are properly substantiated. Schedule K currently reports only ordinary business income and no separately stated or nondeductible items.

Which review conclusion or next action is supported by the exhibit?

• A. Revise to report ordinary business income of $145,000; separately state only the $4,000 interest income; and report $38,000 of nondeductible expenses.
• B. Leave the draft as prepared with ordinary business income of $111,000 and no separately stated or nondeductible items.
• C. Revise to report ordinary business income of $149,000; separately state only the $6,000 charitable contributions and $25,000 Section 179 expense; and report $7,000 of nondeductible expenses.
• D. Revise to report ordinary business income of $145,000; separately state $4,000 interest income, $6,000 charitable contributions, and $25,000 Section 179 expense; and report $7,000 of nondeductible expenses.

Best answer: D

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: S corporation ordinary business income excludes items that must be separately stated because shareholders may treat them differently. The correct review adjustment removes interest income, charitable contributions, and Section 179 expense from ordinary income, deducts only 50% of meals, and reports the nondeductible meals portion and penalty separately.

For an S corporation, page 1 ordinary business income generally includes trade or business income and deductions. Portfolio interest income, charitable contributions, and Section 179 expense are separately stated on Schedule K because their treatment depends on shareholder-level rules or limitations. The deductible meal amount is limited to 50%, so only $5,000 of the $10,000 meals reduces ordinary business income. The remaining $5,000 of meals and the $2,000 IRS penalty are nondeductible expenses. Ordinary business income is therefore $800,000 service revenue minus $650,000 other ordinary deductions minus $5,000 deductible meals, or $145,000.

• Leaving the draft unchanged incorrectly deducts separately stated items and nondeductible expenses in ordinary income.
• Keeping bank interest in ordinary income ignores that nonfinancial S corporations separately state portfolio interest income.
• Treating charitable contributions and Section 179 expense as nondeductible misclassifies items that should be separately stated deductions.
• Omitting the nondeductible meal portion or penalty would make Schedule K incomplete for shareholder reporting and basis effects.

This correctly separates shareholder-level items from ordinary income and reports the nondeductible 50% meals amount plus the penalty.

Question 2

Topic: Federal Taxation of Entities (Including Tax Preparation)

At year-end, Li owns 100% of Sable, Inc., an S corporation. The preparer concludes that Li may deduct $27,000 of Sable’s $36,000 ordinary business loss on Li’s current-year Form 1040 and must suspend $9,000 for lack of basis. Sable had no separately stated items or distributions during the year. Which tax-file evidence best supports the preparer’s conclusion?

• A. A bank loan agreement showing that Li personally guaranteed Sable’s $27,000 corporate line of credit, on which Sable made all payments.
• B. Schedule K-1 showing Li as a 100% shareholder and reporting a $36,000 ordinary business loss from Sable.
• C. A prior-year shareholder basis worksheet showing $2,000 ending stock basis and zero debt basis, bank records for a $10,000 cash capital contribution, and a signed Sable note payable to Li for a $15,000 cash advance.
• D. Sable’s year-end balance sheet showing $27,000 of positive book equity before recording the current-year tax loss.

Best answer: C

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: An S corporation shareholder may deduct passed-through losses only to the extent of stock basis and direct debt basis. The correct evidence supports $2,000 beginning stock basis, a $10,000 capital contribution, and a $15,000 direct loan, totaling $27,000 of usable basis.

For S corporation losses, the shareholder’s deduction is limited first by stock and debt basis. Stock basis is increased by capital contributions, and debt basis generally arises only from bona fide indebtedness of the S corporation directly to the shareholder. Here, the supported basis is $2,000 prior stock basis plus a $10,000 capital contribution plus a $15,000 direct shareholder loan, or $27,000 total. Because the passed-through loss is $36,000 and there are no other items or distributions, Li may currently deduct $27,000 and must suspend the remaining $9,000 until sufficient basis is restored.

• A Schedule K-1 reports the allocated loss but does not establish that the shareholder has enough basis to deduct it.
• A personal guarantee of corporate debt does not create debt basis unless the shareholder actually pays the debt or otherwise becomes the creditor.
• Corporate book equity is not the same as a shareholder’s tax stock or debt basis.

This evidence supports $27,000 of available stock and direct debt basis against the $36,000 passed-through loss.

Question 3

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is preparing the 2025 Form 1120 for Apex Corp., a calendar-year C corporation. Apex has taxable income of $500,000 before any net operating loss (NOL) deduction. Apex has a $700,000 NOL carryforward, all generated after 2017, and no ownership change or special carryback rule applies. What is the correct current-year NOL treatment?

• A. Deduct $700,000 of the NOL and report a $200,000 current-year NOL.
• B. Carry the $700,000 NOL back to prior years before using it against 2025 taxable income.
• C. Deduct $500,000 of the NOL, report zero taxable income, and carry forward $200,000 of NOL.
• D. Deduct $400,000 of the NOL, report $100,000 of taxable income, and carry forward $300,000 of NOL.

Best answer: D

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: A C corporation’s post-2017 NOL carryforward is generally limited to 80% of taxable income before the NOL deduction. Apex may deduct $400,000, leaving $100,000 taxable income and a $300,000 NOL carryforward.

For C corporations, NOLs generated after 2017 generally are carried forward indefinitely, but the annual deduction is limited to 80% of taxable income computed before the NOL deduction. Apex’s pre-NOL taxable income is $500,000, so the maximum current-year NOL deduction is $500,000 × 80% = $400,000. Because Apex has $700,000 of available NOL carryforward, it may deduct only $400,000 in 2025. The unused $300,000 remains available as a carryforward, and Apex reports $100,000 of taxable income for 2025.

• Offsetting all $500,000 of taxable income ignores the 80% limitation for post-2017 NOLs.
• Deducting the full $700,000 would improperly create taxable income below zero using an NOL carryforward.
• Carrying the NOL back is not permitted under the general rule for post-2017 C corporation NOLs in this fact pattern.

A post-2017 C corporation NOL carryforward generally may offset only 80% of taxable income computed before the NOL deduction.

Question 4

Topic: Federal Taxation of Entities (Including Tax Preparation)

Ridge Corp., a calendar-year accrual-basis C corporation, is reviewing a draft Form 1120. Source data show the following:

No other credits or payments apply. Which adjustment should Ridge make before filing the return?

• A. Decrease the taxes and licenses deduction by $18,000 and leave estimated tax payments at $0 because federal estimated tax payments are not deductible.
• B. Leave the taxes and licenses deduction at $30,000 and report the $18,000 estimated tax payments as payments reducing the Form 1120 balance due.
• C. Decrease the taxes and licenses deduction by $24,000 and report the $18,000 estimated tax payments as payments reducing the Form 1120 balance due.
• D. Deduct only the $6,000 state income tax and claim a $24,000 credit for the federal income tax provision.

Best answer: C

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: Ridge should deduct the $6,000 state income tax but not the $24,000 federal income tax provision. The $18,000 federal estimated payments do not affect taxable income; they are reported as payments that reduce the amount due or increase the overpayment on Form 1120.

For a C corporation, state income taxes are generally deductible business taxes, but federal income taxes are specifically nondeductible. Therefore, the draft taxes and licenses deduction must be reduced from $30,000 to $6,000. Separately, timely federal estimated income tax payments are not deductions or tax credits generated by operations. They are payments applied after computing total tax to determine the corporation’s balance due or overpayment. The correction is both to remove the nondeductible federal tax provision from deductions and to enter the $18,000 estimated payments in the payment section of the return.

• Keeping the $30,000 deduction fails to remove the nondeductible federal income tax provision.
• Reducing the deduction by $18,000 confuses estimated payments with federal income tax expense; the nondeductible amount is $24,000.
• Claiming a credit for the $24,000 provision is incorrect because an accrued federal income tax provision is neither deductible nor a tax credit.

Federal income tax expense is not deductible, while federal estimated tax payments are reported as payments rather than deductions.

Question 5

Topic: Federal Taxation of Entities (Including Tax Preparation)

A calendar-year corporation incorporated in Delaware filed Form 2553 on February 15 to elect S corporation status for the current tax year. All shareholders signed the election. The corporation has 92 shareholders: 90 U.S. resident individuals, one estate, and one nonresident alien individual. It has voting and nonvoting common stock with identical distribution and liquidation rights. How should the corporation’s S election eligibility be characterized?

• A. Ineligible because an estate cannot be an S corporation shareholder.
• B. Eligible because it is domestic, has no more than 100 shareholders, has one class of stock, and filed a timely unanimous election.
• C. Ineligible because voting and nonvoting common stock are treated as two classes of stock.
• D. Ineligible because a nonresident alien individual is not an eligible S corporation shareholder.

Best answer: D

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: The corporation is not eligible for S status because one shareholder is a nonresident alien individual. The domestic status, shareholder count, timely unanimous election, and voting differences in stock do not cure an impermissible shareholder.

To qualify as an S corporation, a corporation generally must be domestic, have no more than 100 shareholders, have only eligible shareholders, have only one class of stock, and make a valid election with required shareholder consents. Eligible shareholders include U.S. individuals and estates, and certain trusts and exempt organizations. Nonresident alien individuals are not eligible shareholders. Voting and nonvoting common stock can still be one class of stock if the shares have identical economic rights to distributions and liquidation proceeds. Here, the only disqualifying fact is the nonresident alien shareholder.

• Domestic incorporation, 92 shareholders, identical economic rights, and timely consent would support eligibility only if all shareholders were eligible.
• Voting and nonvoting common stock are not separate classes solely because voting rights differ.
• An estate may be an eligible S corporation shareholder, so the estate does not prevent the election.

An S corporation may not have a nonresident alien individual as a shareholder, even if the other eligibility and election requirements are satisfied.

Question 6

Topic: Federal Taxation of Entities (Including Tax Preparation)

Blue Ridge Products, Inc., a calendar-year C corporation headquartered in State H, manufactures goods in State H and maintains a sales office and inventory in State M. Management has already concluded that Blue Ridge has state income tax nexus in both states. The federal return is complete, and federal taxable income includes ordinary operating income from the manufacturing business and a gain from selling a passive investment parcel held outside the operating business. Before preparing the state income tax returns, what should the tax manager do next to determine how Blue Ridge’s income is reported to the states?

• A. File an administrative appeal in State M challenging the tax before determining the income assigned to that state.
• B. Analyze each state’s allocation and apportionment rules to identify specifically allocable items and apportionable business income, then apply the applicable formula to the business income.
• C. Apportion every item of federal taxable income between State H and State M using total sales, without separately analyzing the investment gain.
• D. Assign all federal taxable income to State H because the corporation is headquartered there.

Best answer: B

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: Allocation and apportionment are used after state tax nexus is established to divide a corporation’s income among taxing states. The next step is to classify income under state rules, allocate certain nonbusiness items to a particular state, and apportion business income by formula.

State income tax nexus determines whether a state may tax the corporation. Once nexus exists in more than one state, the corporation must determine how much income each state may tax. Allocation generally assigns certain nonbusiness or specifically sourced items to one state, such as income tied to a particular situs or commercial domicile depending on state law. Apportionment divides the corporation’s business income among states using a formula, commonly based on sales or other activity factors. The rationale is to fairly attribute income to states connected to the corporation’s business activity and reduce the risk that multiple states tax the same income in full.

• Assigning all income to the headquarters state ignores nexus and business activity in State M.
• Apportioning every item without analyzing the investment gain skips the required allocation-versus-apportionment classification.
• Filing an administrative appeal is premature because no assessment, notice, or dispute has been identified.

After nexus is established, the next step is to determine which income is allocated to one state and which business income is apportioned among states under applicable state rules.

Question 7

Topic: Federal Taxation of Entities (Including Tax Preparation)

A tax preparer reviewed a draft individual return for Morgan, an individual partner in Alpha Partnership. The draft deducts Morgan’s entire $72,000 Schedule K-1 ordinary business loss. The basis workpaper contains the following information for the same tax year:

Assume Morgan is not limited by the at-risk, passive activity, or excess business loss rules. Which correction should the preparer make?

• A. Deduct the full $72,000 loss because the loss was allocated to Morgan on Schedule K-1.
• B. Deduct $42,000 of the loss and carry forward $30,000 as a suspended basis-limited partnership loss.
• C. Deduct $52,000 of the loss and carry forward $20,000 as a suspended basis-limited partnership loss.
• D. Deduct $68,000 of the loss and carry forward $4,000 as a suspended basis-limited partnership loss.

Best answer: C

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: A partner may deduct partnership losses only to the extent of the partner’s adjusted outside basis before the loss is deducted. Morgan’s basis must include the net increase in partnership liabilities and other basis increases, then be reduced for distributions and nondeductible expenses before applying the loss limitation.

Morgan starts with $50,000 of outside basis. Basis is increased by the $5,000 cash contribution, $3,000 of tax-exempt income, and the $10,000 net increase in Morgan’s share of partnership liabilities ($34,000 ending share less $24,000 beginning share). Basis is reduced by the $14,000 cash distribution and $2,000 of nondeductible, noncapital expenses. Thus, basis before the ordinary loss is $52,000. The $72,000 ordinary loss can reduce basis only to zero, so $52,000 is currently deductible and the remaining $20,000 is suspended until Morgan has sufficient basis.

• Deducting $42,000 ignores the $10,000 increase in Morgan’s share of partnership liabilities, which increases outside basis.
• Deducting $68,000 fails to reduce basis for the cash distribution and nondeductible, noncapital expenses.
• Deducting the full Schedule K-1 loss overstates the deduction because an allocated partnership loss is still limited at the partner level by outside basis.

Morgan’s adjusted outside basis before the loss is $52,000, so the $72,000 loss is deductible only to that extent.

Question 8

Topic: Federal Taxation of Entities (Including Tax Preparation)

At the beginning of Year 1, Owens had an adjusted outside basis of $25,000 in OP Partnership, including Owens’s share of partnership liabilities. During Year 1, Owens contributed $5,000 cash, was allocated $7,000 of ordinary business income, received a $20,000 cash distribution, and Owens’s share of partnership liabilities decreased by $22,000. Assume no other basis adjustments and that any gain recognized on the cash or deemed cash distribution would be capital gain. How should Owens’s Year 1 ending outside basis and any gain be characterized?

• A. A $0 ending outside basis with $5,000 capital gain recognized.
• B. A $39,000 ending outside basis with no recognized gain.
• C. A $15,000 ending outside basis with no recognized gain.
• D. A $17,000 ending outside basis with no recognized gain.

Best answer: A

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: A partner’s outside basis increases for cash contributions, allocated taxable income, and increases in the partner’s share of liabilities. It decreases for cash distributions and decreases in the partner’s share of liabilities. Here, total distributions exceed the available basis by $5,000, so basis ends at zero and gain is recognized.

Start with Owens’s beginning outside basis of $25,000. Add the $5,000 cash contribution and $7,000 ordinary business income allocation, bringing basis to $37,000. The $20,000 cash distribution reduces basis. The $22,000 decrease in Owens’s share of partnership liabilities is treated as a deemed cash distribution and also reduces basis. Total actual and deemed distributions are $42,000. Because distributions exceed the $37,000 available basis by $5,000, Owens recognizes $5,000 of capital gain and the ending outside basis is reduced to zero.

• A $17,000 ending basis ignores the $22,000 liability decrease, which is treated as a deemed cash distribution.
• A $15,000 ending basis reflects the liability decrease but ignores the actual $20,000 cash distribution.
• A $39,000 ending basis incorrectly treats the liability decrease as increasing, rather than decreasing, outside basis.

Owens’s basis is increased to $37,000, then the $20,000 cash distribution and $22,000 liability decrease reduce basis to zero and create $5,000 gain.

Question 9

Topic: Federal Taxation of Entities (Including Tax Preparation)

Larkin Corp., a calendar-year C corporation, is preparing Schedule M-1. Federal income tax expense is ignored for this reconciliation. Larkin reports adjusted book income of $850,000 and taxable income before special deductions of $785,000.

Known reconciling items:

The only remaining book-tax difference relates to prepaid rent deducted currently for tax purposes but deferred and expensed in a later period for book purposes. How should this remaining prepaid rent difference be characterized?

• A. $30,000 favorable temporary difference, reported as a subtraction from book income
• B. $30,000 unfavorable temporary difference, reported as an addition to book income
• C. $30,000 unfavorable permanent difference, reported as an addition to book income
• D. $30,000 favorable permanent difference, reported as a subtraction from book income

Best answer: A

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: The known reconciling items bring book income to $815,000 of taxable income before considering the prepaid rent difference. Because actual taxable income is $785,000, the remaining item must reduce taxable income by $30,000. A current tax deduction for an amount deferred for book purposes is a favorable temporary difference.

Schedule M-1 reconciles book income to taxable income by adding expenses deducted for books but not for tax and subtracting income included in books but not taxable or deductions allowed for tax but not yet expensed for books. Starting with $850,000, add nondeductible penalties of $15,000 and the warranty accrual of $45,000, then subtract tax-exempt interest of $25,000 and excess tax depreciation of $70,000. This yields $815,000. Taxable income is $785,000, so the remaining difference is a $30,000 subtraction. Because prepaid rent was deducted currently for tax but deferred for book purposes, the timing difference will reverse when book expense is later recognized.

• Treating the item as an unfavorable temporary difference reverses the sign; it would increase taxable income rather than reduce it.
• Treating the item as permanent ignores that prepaid rent deferred for books will be expensed in a later book period.
• Characterizing the item as an addition conflicts with the reconciliation amount needed to reach taxable income of $785,000.

Reconciling $850,000 of book income to $785,000 of taxable income requires an additional $30,000 subtraction, and prepaid rent deducted for tax before book expense reverses in a future period.

Question 10

Topic: Federal Taxation of Entities (Including Tax Preparation)

A calendar-year domestic C corporation is preparing its Form 1120. The controller gives the tax preparer a draft “taxable income” schedule that starts with GAAP book income and deducts both federal income tax expense accrued on the financial statements and cash dividends paid to individual shareholders. The controller says the dividends should reduce corporate taxable income because the shareholders also report them. The return has not yet been filed. What should the preparer do next?

• A. Submit the issue to IRS Appeals before filing to obtain agreement with the controller’s treatment.
• B. Deduct the shareholder dividends on the corporate return because the shareholders will include them in dividend income.
• C. Prepare amended shareholder returns excluding the dividends before completing the corporate return.
• D. Make book-to-tax adjustments on the corporate return to add back federal income tax expense and shareholder dividends as nondeductible items.

Best answer: D

What this tests: Federal Taxation of Entities (Including Tax Preparation)

Explanation: The preparer should correct the corporate taxable-income computation before filing. GAAP book income must be reconciled to taxable income, and shareholder-level dividend reporting does not create a C corporation deduction.

A C corporation is a separate taxable entity. Its Form 1120 taxable income is not simply GAAP book income, and book expenses must be adjusted when tax law treats them differently. Federal income taxes are not deductible in computing federal taxable income. Dividends paid to shareholders are distributions of corporate earnings, not deductible business expenses of the corporation, even though shareholders may have dividend income. The next step is to make the required book-to-tax adjustments and complete the corporate return using the correct entity-level tax treatment.

• Deducting dividends because shareholders report them confuses shareholder-level tax consequences with the corporation’s taxable-income computation.
• Amending shareholder returns addresses the wrong taxpayer and is unnecessary based on the facts given.
• Going to IRS Appeals is out of sequence because there is no IRS examination or proposed adjustment to appeal.

A C corporation’s taxable income is computed at the entity level, and neither federal income tax expense nor shareholder dividends are deductible in that computation.

Continue with full practice

Use the CPA REG Practice Test page for the full practice route, mixed-topic practice, timed mock exams, and explanations.

Related focused pages

• Free CPA REG Full-Length Practice Exam
• CPA REG: Ethics and Federal Tax Procedures
• CPA REG: Business Law
• CPA REG: Federal Taxation of Property Transactions
• CPA REG: Federal Taxation of Individuals

Free review resource

Read the CPA REG guide on CPAExamsMastery.com, then return to Mastery Exam Prep for timed practice.