Free CPA REG Full-Length Practice Exam: 72 Questions

This free full-length CPA REG multiple-choice question (MCQ) diagnostic includes 72 original Mastery Exam Prep questions across the REG blueprint areas.

The CPA REG section also involves task-based simulations and exhibit-heavy work, so use this page as an MCQ diagnostic rather than a complete simulation of every item type. The questions are original practice questions and are not official exam questions.

Practice count note: exam sponsors can describe total questions, scored questions, task-based simulations, duration, or unscored/pretest-item rules differently. Always confirm current exam-day rules with the sponsor.

For concept review before or after this diagnostic, use the CPA REG guide on CPAExamsMastery.com.

Before you start

CPA means Certified Public Accountant. REG means Taxation and Regulation. This page is useful when you want one uninterrupted REG multiple-choice diagnostic before returning to tax, business-law, ethics, and procedure drills.

Use the score as a diagnostic signal, not as a guarantee. REG also involves task-based simulations and exhibit-heavy work, so a high score here should be paired with continued review of tax-document interpretation, statutory facts, and rule-application judgment.

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Practice questions

Questions 1-25

Question 1

Topic: Federal Taxation of Individuals

A CPA is completing Lin’s individual Form 1040. Lin owns 100% of a qualified non-SSTB sole proprietorship, and the return is complete except for the qualified business income (QBI) deduction. The CPA has verified the following facts:

Lin’s taxable income is above the upper end of the applicable phase-in range, and Lin has no REIT dividends or PTP income. What should the CPA do next to complete the QBI deduction review?

• A. Reduce Lin’s Schedule C income by $40,000 before computing AGI.
• B. Enter a $60,000 QBI deduction based on 20% of QBI.
• C. Enter a $40,000 QBI deduction on Lin’s individual return.
• D. Enter a $50,000 QBI deduction based on 20% of taxable income reduced by net capital gain.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: Because Lin’s income is above the phase-in range, the full W-2 wage/UBIA limitation applies. The limited business amount is $40,000, and the taxable-income cap is $50,000, so the allowable QBI deduction is $40,000.

The QBI deduction is generally 20% of QBI, but for a taxpayer above the phase-in range, the qualified business amount is limited by the greater of 50% of allocable W-2 wages or 25% of W-2 wages plus 2.5% of UBIA. Here, 20% of QBI is $60,000. The wage/UBIA limit is the greater of $40,000 ($80,000 × 50%) or $30,000 (($80,000 × 25%) + ($400,000 × 2.5%)), so the business amount is $40,000. The overall taxable-income cap is $50,000, computed as 20% of taxable income before the QBI deduction reduced by net capital gain: ($260,000 − $10,000) × 20%. The deductible amount is the lesser of $40,000 and $50,000.

• Entering $60,000 skips the required wage/UBIA limitation for a taxpayer above the phase-in range.
• Entering $50,000 uses only the taxable-income cap and ignores the lower business-level limitation.
• Reducing Schedule C income is incorrect because the QBI deduction is claimed on the individual return and does not reduce business income or AGI.

The QBI amount is limited to $40,000 by the full W-2 wage/UBIA limitation, which is less than the $50,000 taxable-income cap.

Question 2

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is reviewing Nora’s outside basis support for her 30% interest in Flint LLC, which is taxed as a partnership. Nora’s beginning outside basis of $80,000 included her beginning share of partnership liabilities. The current-year worksheet shows:

The support file also shows that Nora’s allocated share of partnership recourse liabilities decreased from $50,000 to $32,000 during the year. No liability-change adjustment was included in the worksheet. How should the omitted item be characterized?

• A. A $18,000 deemed cash contribution that increases Nora’s outside basis.
• B. No outside-basis adjustment because partnership liabilities affect only inside basis.
• C. A $18,000 separately stated deduction subject only to passive loss limitations.
• D. A $18,000 deemed cash distribution that reduces Nora’s outside basis.

Best answer: D

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

Explanation: Nora’s share of partnership liabilities decreased by $18,000, from $50,000 to $32,000. For partner outside basis, a decrease in a partner’s share of partnership liabilities is treated as a deemed cash distribution, which reduces basis.

A partner’s outside basis includes the partner’s share of partnership liabilities. During the year, increases in that share are treated like deemed cash contributions, while decreases are treated like deemed cash distributions. Nora’s beginning basis already included her beginning liability share, so the current-year reduction from $50,000 to $32,000 must be reflected as an additional $18,000 basis decrease. The worksheet included the cash distribution and income/loss items but omitted this liability decrease. After including the omitted item, Nora’s ending basis before passive limitations would be $22,000 rather than $40,000.

• Treating the decrease as a deemed contribution reverses the rule; only liability increases are treated as contributions.
• Calling the item a separately stated deduction confuses a liability allocation change with a deductible partnership item.
• Ignoring the adjustment is incorrect because partnership liabilities affect a partner’s outside basis, not only inside basis.

A decrease in a partner’s share of partnership liabilities is treated as a cash distribution to the partner, reducing outside basis.

Question 3

Topic: Business Law

A parts supplier is owed $60,000 for inventory sold on open account. The supplier has not obtained a judgment, security interest, or lien. The debtor filed a voluntary Chapter 7 bankruptcy petition yesterday, and the supplier received notice of the filing and a proof-of-claim deadline. Which conclusion is correct?

• A. The supplier may continue collection because the debt arose before the bankruptcy petition was filed.
• B. The supplier must stop collection efforts outside bankruptcy and timely file a proof of claim as an unsecured creditor.
• C. The supplier is automatically paid ahead of secured creditors because it received notice of the claims deadline.
• D. The supplier may seize the debtor’s inventory because the debt relates to goods previously sold to the debtor.

Best answer: B

What this tests: Business Law

Explanation: The Chapter 7 petition immediately triggers the automatic stay, which bars unsecured creditors from pursuing outside collection. Because the supplier has no lien or security interest, its proper bankruptcy response is to file a timely unsecured proof of claim.

In bankruptcy, the filing of the petition creates an estate and generally imposes an automatic stay against collection actions for prepetition debts. An unsecured trade creditor cannot sue, garnish, seize property, or otherwise continue collection outside the bankruptcy process unless the bankruptcy court grants relief from the stay. The creditor’s claim is handled through the claims process, typically by filing a proof of claim by the stated deadline. Because the supplier sold on open account and has no judgment, lien, or security interest, it is an unsecured creditor and does not have priority merely because it received notice.

• Continuing collection for a prepetition debt violates the automatic stay; the timing of when the debt arose does not create an exception.
• Seizing inventory is improper because the supplier has no security interest or lien and the stay protects estate property.
• Receiving notice of the claims deadline does not elevate an unsecured claim above secured or priority claims.

A voluntary bankruptcy filing creates an automatic stay, and an unsecured creditor generally protects its right to distribution by filing a timely proof of claim.

Question 4

Topic: Federal Taxation of Entities (Including Tax Preparation)

Blue Harbor LLC is classified as a partnership for federal tax purposes. A staff preparer marked the following current-year items for review:

Which return-review conclusion is supported by the exhibit?

• A. The fixed management fee should be reported as a guaranteed payment to Dana.
• B. The consulting fees should be separately stated to the partners.
• C. The cash charitable contribution should be deducted in computing ordinary business income.
• D. The state civil penalty should be deducted as a separately stated item.

Best answer: A

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

Explanation: Dana’s fixed management fee is payable regardless of partnership profits, so it is a guaranteed payment. It is not treated as a profit allocation or a partner draw.

A partnership must distinguish ordinary business items from items that retain a special character or require partner-level treatment. Payments to a partner for services or use of capital are guaranteed payments when determined without regard to partnership income. The facts state that Dana’s $60,000 fee is required by the agreement and payable regardless of profits, which supports guaranteed payment treatment. By contrast, charitable contributions are separately stated because partner-level limitations may apply. Government civil penalties for violations of law are nondeductible. Consulting fees earned in the ordinary course are included in ordinary business income.

• Charitable contributions are separately stated; they are not deducted in computing ordinary business income.
• A civil penalty for violating law is nondeductible, not a separately stated deduction.
• Consulting fees from the partnership’s regular business are ordinary business income, not separately stated income.

A fixed amount paid to a partner for services without regard to partnership income is reported as a guaranteed payment.

Question 5

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

A CPA is preparing an individual client’s federal income tax return. The client’s records omit $48,000 shown on a Form 1099-NEC that the client provided to the CPA. The client says the payer “must have made a mistake,” refuses to provide invoices, bank records, or a corrected Form 1099-NEC, and instructs the CPA to leave the amount off the return without disclosure. What is the CPA’s best response?

• A. Omit the amount and attach Form 8275 to avoid preparer responsibility for the position.
• B. Make reasonable inquiries and request support; absent credible support that the Form 1099-NEC is erroneous, do not prepare or sign a return omitting the $48,000, and withdraw if the client insists.
• C. Omit the amount because a practitioner may rely on client-provided information unless the IRS has already challenged it.
• D. Prepare the return as instructed, but send the IRS a separate notice explaining the client’s refusal to substantiate the amount.

Best answer: B

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The CPA has a duty to make reasonable inquiries when client information appears incorrect, incomplete, or inconsistent. A Form 1099-NEC showing income not included in the client’s records creates a discrepancy that cannot be ignored, and the CPA should not sign a return omitting the amount without credible support.

IRS practice standards allow a practitioner to rely on client-provided information in many circumstances, but not when the information appears inconsistent or incomplete. Here, the CPA has an information return showing $48,000 of income while the client’s records omit it. The client’s unsupported statement that the payer “must have made a mistake” is not enough. The CPA should request supporting evidence, advise the client of the reporting issue and possible consequences, and either report the income or obtain credible support for excluding it. If the client insists on an unsupported omission, the CPA should decline to prepare or sign the return and may need to withdraw from the engagement.

• Reliance on client information is not appropriate when a known Form 1099 discrepancy creates a reason to question completeness or accuracy.
• Disclosure does not cure a return position that lacks reasonable support or due diligence.
• Preparing the return as instructed would still violate practitioner responsibilities, and the CPA generally should not notify the IRS separately without client authorization or a legal duty.

The known information-reporting discrepancy requires due diligence, and the CPA may not sign a return taking an unsupported omission merely because the client instructs it.

Question 6

Topic: Federal Taxation of Individuals

A CPA is documenting why a single individual client will not be subject to the individual estimated tax underpayment penalty for 2026. The client filed a 2025 individual income tax return for a full 12-month year. The 2025 return showed adjusted gross income of $180,000 and total tax of $30,000. The client’s 2026 total tax is projected to be $42,000, and the client made timely withholding and estimated tax payments totaling $33,000 for 2026. Which evidence best supports the CPA’s conclusion?

• A. The 2025 Form 1040 showing AGI of $180,000 and total tax of $30,000, together with 2026 payment records showing $33,000 paid timely
• B. The 2026 tax projection showing total tax of $42,000 and an expected balance due of $9,000
• C. The 2026 payment records showing $33,000 paid, without reference to the 2025 return
• D. The 2025 Form 1040 showing that the client filed as single and had wage income

Best answer: A

What this tests: Federal Taxation of Individuals

Explanation: The best support is the evidence that proves the applicable prior-year safe harbor. For a higher-income individual, the required annual payment can be 110% of the prior-year total tax if the prior-year return covered 12 months, and $33,000 equals 110% of $30,000.

An individual generally avoids the estimated tax underpayment penalty by paying enough tax through withholding and timely estimated payments. One safe harbor is based on the prior year’s tax: 100% of prior-year tax, or 110% if prior-year AGI exceeded $150,000 for a non-married-filing-separately taxpayer. Here, the client was single, had 2025 AGI of $180,000, and had 2025 total tax of $30,000. The 2026 payments of $33,000 equal 110% of the prior-year tax. Because the 2025 return covered a full 12-month year and the payments were timely, that evidence directly supports the no-penalty conclusion.

• The 2026 projection supports neither the $1,000 balance-due exception nor the 90% current-year tax safe harbor.
• Filing status and wage income alone do not establish the applicable prior-year safe harbor amount.
• Payment records alone are incomplete because the prior-year AGI and total tax determine whether $33,000 is enough.

Because prior-year AGI exceeded $150,000, timely 2026 payments of 110% of the 2025 total tax, or $33,000, satisfy the prior-year safe harbor.

Question 7

Topic: Federal Taxation of Property Transactions

Maria asks a CPA about investment land she received as a gift from her aunt. At the date of the gift, the aunt’s adjusted basis was $120,000 and the land’s fair market value was $90,000. No gift tax was paid on the transfer. Maria later sells the land to an unrelated buyer for $80,000, with no selling expenses. What basis should be used to determine Maria’s loss on the sale?

• A. Use $120,000, the donor’s adjusted basis, resulting in a $40,000 loss.
• B. Use $80,000, the sale price, resulting in no gain or loss.
• C. Use no basis because a donee may not recognize a loss on gifted property.
• D. Use $90,000, the gift-date fair market value, resulting in a $10,000 loss.

Best answer: D

What this tests: Federal Taxation of Property Transactions

Explanation: Gifted property with a gift-date FMV below the donor’s adjusted basis is subject to a dual-basis rule. For determining a loss, the donee uses the gift-date FMV, so Maria’s loss basis is $90,000 and the sale for $80,000 produces a $10,000 loss.

For property received by gift, the donee generally takes a carryover basis from the donor for purposes of determining gain. However, when the property’s fair market value on the gift date is less than the donor’s adjusted basis, the donee has a dual basis. The donor’s adjusted basis is used to determine gain, while the gift-date fair market value is used to determine loss. This rule prevents the donor’s built-in loss from shifting to the donee. Here, the land’s FMV at the gift date was $90,000, which was lower than the aunt’s $120,000 adjusted basis. Because Maria sold the land for $80,000, below the $90,000 loss basis, she recognizes a $10,000 loss.

• Donor adjusted basis generally applies for gain, but using it for loss would transfer the aunt’s built-in loss to Maria.
• The sale price is the amount realized, not the basis for the gifted property.
• Losses on gifted property are not automatically disallowed; a post-gift decline below gift-date FMV can create a recognized loss.
• No gift tax basis adjustment applies because no gift tax was paid.

When gift-date FMV is less than donor basis, the donee uses FMV as the basis for determining loss.

Question 8

Topic: Federal Taxation of Entities (Including Tax Preparation)

Delta Partnership is owned 50% by Ari and 50% by Bea. Immediately after all current-year tax allocations, but before any distribution or sale, Delta’s records show:

The land is subject to a $120,000 recourse mortgage. Under the partners’ economic risk of loss arrangement, the mortgage is allocated 75% to Ari and 25% to Bea. Ari’s outside basis before considering any share of partnership liabilities is $100,000. Which statement is the best interpretation of these records?

• A. Delta’s inside basis is $420,000, and Ari’s outside basis is $210,000.
• B. Delta’s inside basis is $260,000, and Ari’s outside basis is $160,000.
• C. Delta’s inside basis is $260,000, and Ari’s outside basis is $190,000.
• D. Delta’s inside basis is $140,000, and Ari’s outside basis is $100,000.

Best answer: C

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

Explanation: Inside basis belongs to the partnership and equals Delta’s adjusted tax basis in its assets: $30,000 + $70,000 + $160,000 = $260,000. Outside basis belongs to the partner and includes the partner’s allocated share of partnership liabilities, so Ari adds 75% of the $120,000 mortgage to Ari’s $100,000 basis.

A partnership’s inside basis is the partnership’s tax basis in each asset it owns. Here, Delta’s inside basis is the total adjusted tax basis of its cash, inventory, and land, or $260,000. A partner’s outside basis is the partner’s tax basis in the partnership interest. A partner’s outside basis is increased by the partner’s share of partnership liabilities. Because the mortgage is recourse and Ari bears 75% of the economic risk of loss, Ari is allocated $90,000 of the $120,000 debt. Ari’s outside basis is therefore $100,000 + $90,000 = $190,000.

• Netting the mortgage against asset basis confuses inside basis with net equity; the liability allocation does not reduce Delta’s adjusted tax basis in its assets.
• Allocating the recourse mortgage 50/50 ignores the stated economic risk of loss arrangement.
• Using fair market value confuses valuation with tax basis; neither inside basis nor outside basis is measured by FMV in this fact pattern.

Inside basis is Delta’s adjusted tax basis in its assets, while Ari’s outside basis includes Ari’s $90,000 allocated share of the recourse mortgage.

Question 9

Topic: Federal Taxation of Individuals

While reviewing a draft Form 1040, a CPA finds that Maya’s return was prepared as single with no dependent. The workpapers state that her son should not be claimed because his wages exceed the $5,200 qualifying-relative gross income limit. Which correction should the CPA make?

Maya is unmarried, paid more than half the cost of keeping up her home, and is not a dependent of another taxpayer. Her son Noah was age 20 at year-end, unmarried, lived with her all year, and was a full-time student for at least five months. Noah earned $8,800 of wages, used $3,000 for his own support, and Maya provided the remaining $15,000 of his total support. No other taxpayer can claim Noah.

• A. Claim Noah as Maya’s dependent qualifying child but retain single filing status because Noah is older than 16.
• B. Claim Noah as Maya’s qualifying relative and change Maya’s filing status to head of household.
• C. Claim Noah as Maya’s dependent qualifying child and change Maya’s filing status to head of household.
• D. Leave Maya’s return as single with no dependent because Noah’s wages exceed the qualifying-relative gross income limit.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: The draft applied the qualifying-relative gross income test to a child who meets the qualifying child rules. Noah is Maya’s son, under age 24 and a full-time student, lived with her all year, and did not provide more than half of his own support.

A dependent can be a qualifying child or a qualifying relative, but the tests differ. A qualifying child must satisfy relationship, residency, age or student status, joint return, and support tests; there is no gross income ceiling. Noah is Maya’s son, was age 20 and a full-time student, lived with Maya all year, and provided only $3,000 of his $18,000 total support. Therefore, he is Maya’s qualifying child. Because Maya is unmarried, paid more than half the cost of keeping up the home, and Noah lived there more than half the year, Noah is also a qualifying person for head of household filing status.

• Applying the qualifying-relative gross income limit ignores that Noah satisfies the qualifying child tests.
• Treating Noah as a qualifying relative is not the best correction because he qualifies under the qualifying child rules.
• Age 17 affects certain child-related credits, not whether a full-time student under age 24 can be a qualifying child for head of household purposes.

Noah meets the qualifying child tests, and the qualifying-relative gross income limit does not apply to qualifying children.

Question 10

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

Mira is a CPA licensed by the State Y board of accountancy. She also prepares federal tax returns and represents clients in IRS examinations. After repeated Circular 230 violations, the IRS Office of Professional Responsibility starts a disciplinary proceeding, and the State Y board separately reviews whether she violated state accountancy rules. How should the disciplinary authority be characterized?

• A. The state board controls Mira’s eligibility to represent taxpayers before the IRS because she is a CPA.
• B. Only the IRS may discipline Mira because federal tax practice preempts state CPA licensure rules.
• C. The IRS controls Mira’s CPA license because the misconduct involved federal tax matters.
• D. The state board controls Mira’s CPA license, while the IRS controls her eligibility to practice before the IRS.

Best answer: D

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: State boards of accountancy have authority over CPA licensure, including suspension or revocation of a CPA license. The IRS has separate authority to discipline practitioners by restricting or barring practice before the IRS, but it does not revoke a state CPA license.

A CPA’s professional status can involve two separate sources of authority. A state board of accountancy grants and disciplines the CPA license under state law. Separately, the IRS regulates who may practice before it, including through Circular 230 disciplinary actions such as censure, suspension, or disbarment from IRS practice. Misconduct in tax practice may trigger both proceedings, but each authority acts within its own jurisdiction: the state board over licensure and the IRS over representation before the IRS.

• Treating the IRS as controlling the CPA license confuses federal practice authority with state licensure authority.
• Treating the state board as controlling IRS representation rights confuses CPA licensure with federal practice privileges.
• Saying only the IRS may discipline Mira ignores that state boards may discipline CPAs for professional misconduct under state accountancy law.

State boards regulate CPA licensure, and the IRS regulates practice rights before the IRS under Circular 230.

Question 11

Topic: Business Law

Lena, a purchasing employee for Harbor Print LLC, has authority only to approve repair contracts up to $5,000. Without actual or apparent authority, Lena signs an $18,000 contract with PressFix to repair Harbor’s printing press. Harbor’s owner learns all material terms and knows Lena lacked authority before the repair work is completed, but allows PressFix to finish the work and then uses the repaired press. PressFix demands payment. What is the correct business-law conclusion?

• A. Harbor is not bound because Lena lacked actual and apparent authority when the contract was signed.
• B. Lena alone is bound because an unauthorized agent’s act cannot later bind the principal.
• C. Harbor may keep the repair benefit while rejecting payment because ratification can be limited to favorable terms.
• D. Harbor ratified the contract by knowingly accepting the repair services, so Harbor is bound to pay PressFix.

Best answer: D

What this tests: Business Law

Explanation: Harbor became bound because it accepted the benefit of PressFix’s work after learning the material facts and Lena’s lack of authority. Ratification can make an originally unauthorized act effective as though it had been authorized from the start.

Ratification occurs when a principal, with knowledge of the material facts, affirms or accepts the benefits of an agent’s unauthorized act. The affirmation may be express or implied through conduct. Here, Harbor’s owner knew Lena lacked authority and knew the material terms before the repair was completed, yet allowed PressFix to finish and used the repaired press. That conduct is an implied ratification of the entire contract, making Harbor liable to PressFix.

• Lack of actual or apparent authority does not end the analysis because later ratification can still bind the principal.
• The agent is not necessarily the only liable party once the principal ratifies the unauthorized transaction.
• Ratification applies to the transaction as a whole; the principal cannot accept the benefits while avoiding the related payment obligation.

A principal may ratify an unauthorized act by accepting its benefits with knowledge of the material facts.

Question 12

Topic: Federal Taxation of Individuals

For 2026, Taylor was legally married to Casey for the entire year, and no divorce or separate maintenance decree was issued by December 31. Casey moved out on June 30 and did not live in Taylor’s home at any time from July 1 through December 31. Taylor will file a separate return. Taylor paid 70% of the cost of maintaining Taylor’s own home and also paid 100% of the rent and support for Taylor’s widowed mother, who lived in her own apartment all year and qualifies as Taylor’s dependent. Taylor has no child, stepchild, foster child, or other dependent. Which filing status is Taylor entitled to use for 2026?

• A. Head of household
• B. Married filing separately
• C. Single
• D. Qualifying surviving spouse

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: Taylor is still married for filing status purposes because there was no divorce or separate maintenance decree by year-end. Although Taylor supported a dependent parent, a married taxpayer living apart from a spouse must satisfy the special “considered unmarried” rules, which require a qualifying child, stepchild, or foster child in the home.

Marital status is generally determined on the last day of the tax year. A taxpayer who is legally married on that date must file jointly or separately unless an exception applies. Head of household may be available to some married taxpayers who are treated as unmarried, but the abandoned-spouse rule requires, among other conditions, that the taxpayer’s home be the main home for more than half the year of the taxpayer’s child, stepchild, or foster child who can be claimed as a dependent. A dependent parent can be a qualifying person for head of household when the taxpayer is unmarried, but that fact does not satisfy the special rule that treats a married taxpayer as unmarried. Because Taylor will not file jointly and has no qualifying child, the available status is married filing separately.

• Head of household is tempting because a dependent parent may qualify for an unmarried taxpayer, but Taylor is still married and lacks the required qualifying child for the considered-unmarried rule.
• Single is incorrect because living apart does not by itself end marital status for tax purposes.
• Qualifying surviving spouse is unavailable because Taylor’s spouse did not die and the status generally requires a dependent child.

Taylor remained married at year-end and cannot be treated as unmarried for head of household status because Taylor did not maintain a home for a qualifying child, stepchild, or foster child.

Question 13

Topic: Federal Taxation of Individuals

A CPA is preparing a Form 1040 for a single taxpayer. The taxpayer has wages of $180,000 and net investment income of $70,000, consisting of taxable interest, dividends, and net capital gains. The taxpayer’s modified adjusted gross income is $250,000. For this taxpayer, the net investment income tax applies at 3.8% to the lesser of net investment income or modified adjusted gross income above the $200,000 threshold. What net investment income tax should be reported?

• A. $9,500
• B. $1,900
• C. $6,840
• D. $2,660

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: The NIIT base is not total MAGI or total investment income automatically. It is the lesser of net investment income or the excess of MAGI over the applicable threshold, multiplied by 3.8%.

For an individual, the net investment income tax equals 3.8% of the lesser of net investment income or modified adjusted gross income above the applicable threshold. Here, MAGI is $250,000 and the threshold is $200,000, so the excess is $50,000. Net investment income is $70,000. The lesser amount is $50,000, so the NIIT is $50,000 × 3.8% = $1,900.

• $2,660 incorrectly applies 3.8% to all $70,000 of net investment income.
• $6,840 incorrectly applies the tax to wages, which are not net investment income.
• $9,500 incorrectly applies the rate to total MAGI rather than the limited NIIT base.

The tax is 3.8% of the lesser of $70,000 net investment income or the $50,000 MAGI excess over the threshold.

Question 14

Topic: Business Law

Marin is an individual employee with regular wages who filed bankruptcy to adjust consumer debts through monthly plan payments. Her CPA needs evidence supporting the conclusion that Marin’s qualifying unsecured credit card debts were legally discharged in that bankruptcy. Which record provides the best support?

• A. The creditor’s proof of claim, filed to state the amount of the credit card balance.
• B. The bankruptcy court’s Chapter 13 discharge order, entered after the trustee reported completed plan payments.
• C. The client’s email stating that the trustee deducted payments from her wages for three years.
• D. The bankruptcy court’s Chapter 13 plan confirmation order, entered when the repayment plan began.

Best answer: B

What this tests: Business Law

Explanation: The best support is the bankruptcy court’s discharge order. For an individual Chapter 13 debtor, discharge generally follows completion of required plan payments and court entry of the discharge, not merely filing or confirming the plan.

Chapter 13 is commonly used by an individual with regular income to adjust debts through a repayment plan. Confirmation of the plan authorizes the debtor to proceed, but it does not by itself discharge debts. The legal discharge generally occurs only when the debtor satisfies the required conditions, such as completing plan payments, and the bankruptcy court enters a discharge order. A court order is more reliable and directly relevant than a creditor filing or client communication because it is the legal source showing that the discharge was granted.

• A plan confirmation order supports that a repayment plan was approved, but it does not prove debts were discharged.
• A creditor’s proof of claim supports the amount asserted by the creditor, not whether the debt was discharged.
• A client email about wage deductions is informal and does not establish that the court granted a discharge.

A Chapter 13 discharge order entered by the court after plan completion is the operative evidence that qualifying debts were discharged.

Question 15

Topic: Business Law

Ridge LLC entered into a common-law service contract with Stone Services to repair Ridge’s office roof by June 30 for $60,000. No unexpected conditions occurred. On June 15, Stone requested an additional $8,000 to complete the same roof work by the original deadline because it could earn more on another job, and Ridge promised the extra amount if Stone finished by June 30. Ridge also promised its founder’s daughter $2,000 as a congratulatory gift, without asking her to do or refrain from doing anything. Separately, Ridge asserted in good faith that Stone had damaged an HVAC unit and claimed $6,000; Stone denied liability. To avoid litigation, Ridge agreed to forbear from suing on the disputed HVAC claim if Stone installed a small access hatch not required by the roof contract, and Stone agreed. Assume no statute of frauds or duress issue is raised. Which is the best interpretation of whether consideration is present?

• A. The additional-payment promise and the forbearance-and-access-hatch agreement are supported by consideration; only the gift promise is not.
• B. All three promises are supported by consideration because each provides Ridge with a practical benefit.
• C. The additional-payment promise is supported by consideration; the gift promise and the forbearance-and-access-hatch agreement are not.
• D. Only the forbearance-and-access-hatch agreement is supported by consideration; the additional-payment promise and the gift promise are not.

Best answer: D

What this tests: Business Law

Explanation: The enforceable exchange is the agreement to forbear from a good-faith disputed claim in return for new work not required by the original contract. The extra $8,000 promise relates only to Stone’s preexisting duty, and the congratulatory gift promise asks for no return performance or forbearance.

Consideration generally requires a bargained-for legal detriment or benefit. Performing, or promising to perform, a duty already owed under an existing common-law contract is not new consideration for an added payment when there are no new obligations or unexpected circumstances. A gratuitous gift promise also lacks consideration because the recipient is not asked to give, do, or forbear from anything in exchange. By contrast, forbearance from pursuing a claim can be consideration when the claim is asserted in good faith, even if liability is disputed. Here, Ridge’s forbearance from suing on the HVAC claim and Stone’s promise to install an access hatch not required by the roof contract form a valid bargained-for exchange.

• Treating roof completion as consideration ignores the preexisting duty rule; Stone was already obligated to finish by June 30.
• Rejecting the settlement exchange because Stone denied liability misstates the rule; good-faith disputed claims may be settled for valid consideration.
• Calling every practical benefit consideration is too broad; a benefit must be part of a bargained-for legal exchange.

Stone already owed the roof completion, the gift promise requested no legal detriment, and the good-faith disputed claim was exchanged for new performance.

Question 16

Topic: Federal Taxation of Entities (Including Tax Preparation)

Lee owns 100% of Terra Inc., a calendar-year S corporation. A CPA is preparing Lee’s 2026 Form 1040 and has obtained the following records. Lee materially participates and is at risk for all amounts; no passive, at-risk, or excess business loss limitation applies. Terra has no accumulated earnings and profits.

What should the CPA do next to support the S corporation items on Lee’s return?

• A. Amend Terra’s Form 1120-S to deduct the $12,000 cash distribution at the S corporation level.
• B. Suspend the $15,000 ordinary loss until Lee establishes shareholder debt basis.
• C. Report a $2,000 capital gain from the distribution before considering the current-year contribution or tax-exempt income.
• D. Complete Lee’s stock basis schedule showing $5,000 ending stock basis, no taxable distribution, and a current deduction for the full $15,000 ordinary loss.

Best answer: D

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

Explanation: An S corporation shareholder’s stock basis is updated before deciding whether a distribution is taxable or a loss is suspended. Lee’s beginning basis, contribution, and tax-exempt income provide enough stock basis to absorb both the distribution and ordinary loss, leaving $5,000 of stock basis.

An S corporation shareholder’s stock basis starts with beginning stock basis. It increases for capital contributions and income items, including tax-exempt income. It then decreases for nondividend distributions to the extent of basis, and losses reduce the remaining basis; losses are deductible only to the extent of stock and debt basis, subject to other limitations. Here, Lee’s basis before the distribution is $32,000: $10,000 + $20,000 + $2,000. The $12,000 distribution reduces stock basis to $20,000 and is not taxable. The $15,000 ordinary business loss is fully allowed because $20,000 of basis remains before applying the loss. Ending stock basis is $5,000.

• Reporting capital gain from the distribution ignores the current-year contribution and tax-exempt income that increase basis before measuring distribution taxability.
• Suspending the loss until debt basis is established ignores that available stock basis can support an S corporation loss deduction.
• Amending the S corporation return to deduct the distribution is improper because cash distributions are owner-level basis reductions, not corporate deductions.

Lee’s basis increases to $32,000 before distributions, falls to $20,000 after the $12,000 distribution, and then falls to $5,000 after the $15,000 loss.

Question 17

Topic: Federal Taxation of Property Transactions

On March 1, Dana died owning publicly traded stock that was included in her gross estate. Dana’s adjusted basis in the stock was $60,000. The executor made a valid alternate valuation election for federal estate tax purposes. The estate distributed the stock to Dana’s son on June 1, when its fair market value was $140,000. The stock’s fair market value was $150,000 on March 1 and $130,000 on September 1, six months after death. What is the best interpretation of the son’s income tax basis in the inherited stock?

• A. The son’s basis is $60,000 because inherited property carries over the decedent’s adjusted basis.
• B. The son’s basis is $150,000 because inherited property always receives a date-of-death basis.
• C. The son’s basis is $130,000 because the six-month alternate valuation date controls for all estate property.
• D. The son’s basis is $140,000 because the alternate valuation election applies and the stock was distributed before the six-month valuation date.

Best answer: D

What this tests: Federal Taxation of Property Transactions

Explanation: Inherited property generally receives a fair market value basis, but a valid alternate valuation election can replace the date-of-death value. Because the stock was distributed within six months of death, the distribution-date value controls.

For property acquired from a decedent, the beneficiary’s basis is generally the property’s fair market value on the date of death. If the executor validly elects alternate valuation for estate tax purposes, the basis generally follows the value used under that election. Property that is distributed, sold, or otherwise disposed of within six months after death is valued as of the disposition or distribution date rather than the six-month date. Here, the estate distributed the stock on June 1, before the September 1 six-month date, so the son’s basis is the June 1 fair market value of $140,000.

• The date-of-death value would apply if no valid alternate valuation election controlled.
• The six-month value is not used for property distributed before that date.
• The decedent’s adjusted basis is not carried over for inherited property under these facts.

When alternate valuation is validly elected, property distributed within six months is valued for basis purposes on the distribution date.

Question 18

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

Orion Corp., a calendar-year C corporation in the Tenth Circuit, paid $30,000 described in a state consent order as a “civil penalty for violation of the state licensing law.” A CPA’s research memo concludes that Orion should not deduct the payment because the highest-ranking, directly applicable authority controls over lower-level or distinguishable authorities. Which research item best supports the memo’s conclusion?

• A. Internal Revenue Code excerpt: “No deduction is allowed for any fine or similar penalty paid to a government for the violation of any law.”
• B. IRS revenue ruling excerpt: “A compensatory payment to a government agency may be deductible when it reimburses the agency for measurable damages.”
• C. Final Treasury regulation excerpt: “Amounts paid as restitution or to come into compliance with law may be deductible if the order identifies them as such.”
• D. Tax Court memorandum opinion excerpt: “A settlement payment was deductible where the agreement did not label the payment as a penalty and the payment was remedial.”

Best answer: A

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The Internal Revenue Code is the highest-ranking federal tax authority listed and directly addresses fines or penalties paid to a government for violating law. Because Orion’s order labels the payment as a civil penalty, the statutory excerpt best supports the nondeduction conclusion.

Tax authority hierarchy matters when sources appear to point in different directions. The Internal Revenue Code, enacted by Congress, is the highest authority in this set. Treasury Regulations generally carry substantial authority because they interpret the Code, but they cannot override a directly applicable statute. IRS guidance, such as revenue rulings, is useful but lower in authority than the Code and regulations. Court decisions may be important, especially from the Supreme Court or the taxpayer’s appellate circuit, but a fact-specific or distinguishable decision does not outweigh a clear statutory rule. Here, Orion’s payment is expressly described as a civil penalty for violating state law, matching the Code excerpt.

• The Code excerpt directly covers government penalties and is the controlling statutory authority.
• The final regulation addresses restitution or compliance payments, not a stated civil penalty.
• The revenue ruling concerns compensatory reimbursements and is lower-level IRS guidance.
• The Tax Court memorandum opinion is distinguishable because the payment there was remedial and not labeled a penalty.

A directly applicable Internal Revenue Code provision is the highest-ranking authority among the listed sources.

Question 19

Topic: Federal Taxation of Individuals

For 2025, Maya is legally married on December 31 and has no divorce or legal separation decree. She will not file a joint return. Maya’s 8-year-old son lived in her home for all of 2025, and Maya paid more than half the cost of maintaining the home. Maya’s spouse moved out during August 2025. Which record best supports the preparer’s conclusion that Maya’s correct nonjoint filing status is married filing separately rather than head of household?

• A. Maya’s son’s birth certificate showing Maya is his parent.
• B. A landlord occupancy record showing Maya’s spouse occupied the home with Maya through August 15, 2025.
• C. Bank statements showing Maya paid more than half the home’s rent, utilities, and food costs for 2025.
• D. A school record showing Maya’s son used Maya’s home address for all of 2025.

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: The decisive fact is that Maya’s spouse lived in the home during the last six months of the year. Because Maya is still legally married and cannot be treated as unmarried, her nonjoint status is married filing separately, not head of household.

Head of household status may be available to certain married taxpayers only if they are treated as unmarried. One requirement is that the taxpayer’s spouse did not live in the home during the last six months of the tax year. Maya otherwise has facts that could support head of household status: a qualifying child lived with her and she paid more than half the cost of maintaining the home. However, her spouse moved out in August, which means the spouse lived in the home during the July-through-December period. That prevents Maya from being treated as unmarried. Since she is legally married on December 31 and will not file jointly, married filing separately is the correct nonjoint filing status.

• The son’s birth certificate supports the qualifying-child relationship but does not address Maya’s marital-status limitation.
• Bank statements showing household costs support the support test, but Maya still fails the treated-as-unmarried rule.
• The school record supports the child’s residency, but the child’s residency does not overcome the spouse’s presence during the last six months.

A married taxpayer generally cannot be treated as unmarried for head-of-household purposes if the spouse lived in the home at any time during the last six months of the year.

Question 20

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

A licensed CPA prepared and signed a client’s federal income tax return with deductions the CPA knew were unsupported. The IRS assessed a preparer penalty and referred the matter for possible discipline affecting the CPA’s ability to represent taxpayers before the IRS. The client also wants to file a complaint seeking action against the CPA’s CPA license. Which interpretation best identifies the authority most directly relevant to the licensing complaint?

• A. The state board of accountancy, because CPA licensure and license discipline are governed by state accountancy laws and board rules.
• B. The IRS Office of Professional Responsibility, because it has exclusive authority to suspend or revoke a CPA license for tax-practice misconduct.
• C. The AICPA Professional Ethics Division, because its ethics rules supersede state licensing requirements for all CPAs.
• D. The IRS examination division, because assessment of a preparer penalty automatically determines state CPA license discipline.

Best answer: A

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The licensing consequence is primarily a state board matter. IRS authorities may impose tax-practice penalties or restrict practice before the IRS, but they do not issue or revoke a state CPA license.

Tax-practice misconduct can implicate more than one authority. The IRS may assess preparer penalties, and the IRS Office of Professional Responsibility may discipline a practitioner’s ability to practice before the IRS. However, CPA licensure is created and regulated under state law. A complaint seeking suspension, revocation, or other action against a CPA license is directed to the state board of accountancy, which applies the state accountancy act and board rules. AICPA ethics enforcement may matter if the CPA is a member, but it does not replace state licensing discipline.

• IRS practice discipline affects representation before the IRS, not the state-issued CPA license itself.
• AICPA ethics rules may create membership consequences, but they do not supersede state boards.
• A preparer penalty is evidence of misconduct, but it does not automatically decide license discipline.

State boards of accountancy are the primary authorities for issuing, renewing, and disciplining CPA licenses.

Question 21

Topic: Federal Taxation of Entities (Including Tax Preparation)

At year-end, a CPA is reviewing Apex, Inc.’s draft Form 1120-S. Apex has been an S corporation for all years and has no accumulated E&P. The CPA has verified the current-year return items, but Schedule M-2 has not yet been updated. Before reviewing a $40,000 cash distribution to shareholders, what should the CPA do next to update the accumulated adjustments account (AAA) for current-year operations?

• A. Apply the $40,000 distribution against the $28,000 beginning AAA before recording current-year operating adjustments.
• B. Record a $67,000 net increase from current-year operations, bringing AAA to $95,000 before applying the distribution.
• C. Record a $72,000 net increase from current-year operations, bringing AAA to $100,000 before applying the distribution.
• D. Record a $87,000 net increase from current-year operations, bringing AAA to $115,000 before applying the distribution.

Best answer: B

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

Explanation: The next step is to update AAA for the current-year items that affect AAA before reviewing the distribution. Apex’s AAA increases by ordinary income and decreases by the capital loss, charitable contributions, and nondeductible penalties, but tax-exempt interest is excluded. The net increase is $67,000, so AAA becomes $95,000 before distributions.

An S corporation’s AAA tracks undistributed post-S-election taxable income and related reductions. AAA is increased by ordinary business income and separately stated income or gain items, and it is reduced by deductible losses, separately stated deductions, and nondeductible noncapital expenses such as penalties. Tax-exempt interest does not increase AAA; it is tracked outside AAA. Here, the current-year AAA adjustment is $90,000 − $12,000 − $8,000 − $3,000 = $67,000. Adding that to the $28,000 beginning AAA gives $95,000 before considering the $40,000 cash distribution.

• Including tax-exempt interest would overstate AAA because tax-exempt income is not an AAA increase.
• Ignoring separately stated losses and deductions confuses K-1 presentation with AAA treatment; those items still reduce AAA.
• Applying the distribution to beginning AAA first is premature because the current-year AAA activity must be updated before the distribution review in this scenario.

AAA increases for taxable income items and decreases for separately stated deductions, losses, and nondeductible penalties, but excludes tax-exempt interest.

Question 22

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

During preparation of Rao’s 2025 Form 1040, a CPA discovers that Rao did not report a $42,000 consulting payment on the 2024 return the CPA prepared. The income is clearly taxable, and Rao confirms it was intentionally omitted. Rao refuses to amend the 2024 return and asks the CPA to “keep it out of the file” and finish the 2025 return using the same incomplete records. Under IRS practice standards, what should the CPA do?

• A. Notify the IRS of the intentional omission because the CPA prepared the 2024 return and now knows it is materially incorrect.
• B. Advise Rao of the 2024 noncompliance and its potential consequences, document the advice, and decline or withdraw from the 2025 engagement unless complete and accurate information is provided.
• C. Complete the 2025 return from the incomplete records because a practitioner may rely on client information unless independently audited.
• D. File an amended 2024 return reporting the omitted consulting income even though Rao does not authorize the filing.

Best answer: B

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The CPA must promptly advise the client about the known omission and its possible consequences. The CPA is not required to report the client to the IRS, but the CPA may not participate in preparing a return using information known to be false or incomplete.

IRS practice standards require due diligence in preparing returns and other submissions. When a practitioner learns that a client has not complied with tax law or has made an error or omission, the practitioner must advise the client promptly of the issue and the potential consequences. The practitioner generally does not have authority or an obligation to disclose the error to the IRS without client consent. However, if the client refuses to correct the matter and asks the practitioner to continue using incomplete or false information, the practitioner should not prepare or sign the return and should consider withdrawing from the engagement.

• Filing an amended return without authorization exceeds the practitioner’s authority and may violate confidentiality obligations.
• Notifying the IRS is generally not required merely because the practitioner discovered a client’s prior omission.
• Reliance on client information is not reasonable when the practitioner knows the information is incomplete or false.

A practitioner must advise the client of known tax noncompliance and cannot prepare or sign a return based on information known to be incomplete or false.

Question 23

Topic: Business Law

Delta Bank asserts that it created and perfected a security interest in Apex LLC’s commercial copier, which Apex uses as business equipment. Apex is an LLC organized in State X, and no certificate-of-title law applies to the copier. Under Article 9, the applicable filing office for a financing statement covering Apex’s business equipment is the State X secretary of state. Which evidence best supports Delta’s conclusion?

• A. A loan-file packet containing Apex’s signed security agreement granting Delta a security interest in the copier, Delta’s wire confirmation for the loan proceeds, Apex’s supplier invoice showing Apex acquired the copier, and a UCC-1 filed with the State X secretary of state naming Apex and describing the copier.
• B. A UCC-1 filed with the State X secretary of state naming Apex and describing the copier, but no signed security agreement or other authenticated collateral grant.
• C. A signed promissory note, a repayment schedule, and an insurance certificate listing Delta as loss payee for the copier.
• D. Apex’s signed security agreement granting Delta a security interest in the copier and Apex’s supplier invoice showing Apex acquired the copier, but no UCC-1 filing or other perfection evidence.

Best answer: A

What this tests: Business Law

Explanation: The best evidence must support both attachment and perfection. For business equipment, attachment requires value, debtor rights in the collateral, and an authenticated security agreement, while perfection is generally shown by a properly filed financing statement.

A security interest is created, or attached, when the secured party gives value, the debtor has rights in the collateral, and the debtor authenticates a security agreement that reasonably describes the collateral. For ordinary business equipment, perfection is commonly accomplished by filing a financing statement in the correct filing office. The complete loan-file packet is strongest because it shows all attachment elements and the UCC-1 filing with the State X secretary of state. Evidence that shows only filing, only attachment, or only the existence of debt does not fully support the conclusion that the security interest was both created and perfected.

• A filed UCC-1 alone supports a perfection step but does not show that the debtor granted an enforceable security interest.
• A signed security agreement plus an invoice supports attachment, but without a filing or other perfection method it does not show perfection.
• A promissory note and insurance certificate show a debt relationship and loss-payee status, not a perfected security interest.

This packet evidences attachment through an authenticated grant, value, and debtor rights, and perfection through filing in the proper office.

Question 24

Topic: Business Law

An accountant is reviewing a business-structure summary for a new client:

• Mina and Omar signed a contract to operate a delivery business for profit and share profits and losses equally.
• No formation document or registration was filed with the state.
• The summary classifies the business as an LLC, states both owners have a liability shield, and states Omar may transfer his full ownership interest, including management rights, to a buyer without Mina’s consent.

Assume state law requires a public filing to form an LLC, LP, or LLP. Which correction should be made?

• A. Revise the classification to a general partnership; both owners have default management and ordinary-course agency authority, both have personal liability, and a transfer gives only economic rights absent admission as a partner.
• B. Treat the business as a corporation because continuity and free transferability arise automatically when multiple owners operate for profit.
• C. Revise the classification to a limited partnership because the written profit-sharing agreement creates one general partner and one limited partner.
• D. Keep the LLC classification because signing an operating agreement is sufficient to create limited liability and transferable management rights.

Best answer: A

What this tests: Business Law

Explanation: The best correction is to treat the business as a general partnership. A general partnership can arise without a state filing when co-owners carry on a business for profit, but an LLC, LP, or LLP requires a statutory filing to obtain those characteristics.

Under default business-organization rules, two or more persons who co-own and operate a business for profit generally form a general partnership, even without a formal filing. General partners typically have equal rights to participate in management and may bind the partnership in the ordinary course of business. They also have personal liability for partnership obligations. By contrast, an LLC, LP, or LLP generally requires a state filing to create limited liability or limited-partner status. A partner may transfer the economic interest in the partnership, but that transfer does not automatically give the buyer management rights or partner status without the required consent or admission.

• An operating agreement alone does not create an LLC when state filing is required.
• A limited partnership is not created merely by sharing profits and losses; it requires statutory formation and at least one general and one limited partner.
• Corporate continuity and free transferability do not arise automatically from having multiple owners; corporate formation requires compliance with incorporation requirements.

With no required state filing for a limited-liability entity, co-owners carrying on a for-profit business are generally treated as general partners.

Question 25

Topic: Federal Taxation of Individuals

Nora, a calendar-year cash-method taxpayer, left her employer in 2025. Her entire traditional 401(k) account consisted of pre-tax contributions and earnings. On December 20, 2025, the plan distributed $80,000 by sending $64,000 to Nora and withholding $16,000 for federal income tax. On February 10, 2026, Nora deposited the $64,000 she received into a traditional IRA and did not replace the withheld amount with other funds. Ignore any additional tax on early distributions. What is the best interpretation of Nora’s Form 1040 income inclusion from the distribution?

• A. Nora includes $80,000 in gross income for 2025 because the distribution was paid directly to her rather than trustee-to-trustee.
• B. Nora includes $16,000 in gross income for 2026 because the rollover deposit occurred in 2026.
• C. Nora includes $0 in gross income for 2025 because she rolled over the cash she received within 60 days.
• D. Nora includes $16,000 in gross income for 2025.

Best answer: D

What this tests: Federal Taxation of Individuals

Explanation: A distribution from a traditional 401(k) is included in income unless it is properly rolled over. The amount withheld for federal income tax is treated as distributed to Nora, and because she did not replace and roll over that $16,000, it remains taxable in 2025.

For a cash-method individual, a retirement-plan distribution is generally reported in the year received. A 60-day rollover can exclude the amount actually rolled over, even if the rollover contribution is made early in the following calendar year. However, income tax withholding is still treated as part of the distribution. To avoid taxable income on the full distribution, Nora would have needed to roll over the $64,000 received plus $16,000 from other funds. Because she rolled over only $64,000, the remaining $16,000 is taxable in 2025.

• Treating the full distribution as nontaxable ignores that the withheld amount was not rolled over.
• Using 2026 as the inclusion year confuses the rollover contribution date with the distribution year.
• Treating the full $80,000 as taxable ignores the valid 60-day rollover of the $64,000 Nora deposited into the IRA.

The withheld $16,000 was part of the 2025 distribution and is taxable because only the $64,000 actually rolled over within 60 days was excluded.

Questions 26-50

Question 26

Topic: Federal Taxation of Individuals

In 2026, Lane, an individual taxpayer, sold the following assets. Lane had no other capital transactions. Assume all assets were held for investment and all sales expenses are selling commissions or transaction fees that reduce amount realized.

What amount of total capital gain should Lane report from these sales?

• A. $26,100
• B. $35,000
• C. $34,100
• D. $38,100

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: Lane’s amount realized is reduced by selling expenses. For the gifted stock sold at a gain, the donor’s adjusted basis carries over; for inherited shares, basis is the FMV at the decedent’s death. Adding the gains from all four capital asset sales gives $34,100.

Capital gain equals amount realized minus adjusted basis. Selling commissions and transaction fees reduce the amount realized. Lane’s purchased stock gain is $29,500 amount realized less $18,000 basis, or $11,500. The virtual currency gain is $13,900 less $9,000, or $4,900, because virtual currency held for investment is treated as property. The gifted stock was sold for more than both donor basis and gift-date FMV, so the donor’s $20,000 basis is used, producing a $15,000 gain. The inherited mutual fund shares use FMV at death as basis, so the gain is $54,700 less $52,000, or $2,700. Total capital gain is $34,100.

• $35,000 ignores the selling commissions and transaction fees that reduce amount realized.
• $26,100 incorrectly uses the gift-date FMV as the basis for the gifted stock sold at a gain.
• $38,100 combines the wrong basis for the gifted stock with the decedent’s original basis for inherited property.

The total gain is $11,500 on stock, $4,900 on virtual currency, $15,000 on gifted stock, and $2,700 on inherited shares.

Question 27

Topic: Business Law

A bank seeks payment from Morgan after Delta LLC defaulted on a business loan. The following excerpt summarizes the relevant documents:

Which conclusion is best supported by the exhibit?

• A. Morgan is discharged from all liability because the bank changed the loan terms without Morgan’s written consent.
• B. The bank may demand payment from Morgan for up to $75,000 without first proceeding against Delta, but Morgan is not liable for the additional $25,000 advance.
• C. The bank must first sue Delta and foreclose on collateral before demanding payment from Morgan.
• D. Morgan is liable for the full $100,000 because the guaranty was unconditional.

Best answer: B

What this tests: Business Law

Explanation: Morgan signed a guaranty of payment, so the bank may seek payment from Morgan after Delta’s default without first exhausting remedies against Delta. However, the guaranty expressly limits Morgan’s liability to the original $75,000 and excludes additional advances without Morgan’s signed consent.

A guarantor’s liability is determined by the terms of the guaranty. An unconditional guaranty of payment allows the creditor to proceed directly against the guarantor when the debtor defaults, especially when the guarantor waives any requirement that the creditor first sue the debtor or foreclose on collateral. Changes to loan terms must also be evaluated under the guaranty. Here, Morgan agreed that the bank could extend or renew the maturity date without notice, so the extension does not discharge Morgan. But Morgan did not agree to guarantee additional advances unless Morgan signed a written consent. Because no such consent was given, Morgan remains liable for the covered $75,000 obligation but not the later $25,000 advance.

• Treating any loan change as a complete discharge ignores the guaranty clause permitting extensions or renewals without notice.
• Requiring the bank to sue Delta first conflicts with the unconditional guaranty of payment and Morgan’s collection waiver.
• Extending liability to the full $100,000 ignores the express exclusion for additional advances without Morgan’s signed consent.

The guaranty is an unconditional guaranty of payment for the original $75,000, permits extensions, waives collection-first rights, and excludes unsigned additional advances.

Question 28

Topic: Federal Taxation of Entities (Including Tax Preparation)

Metro Components, Inc., a calendar-year C corporation, is commercially domiciled in State A and has income tax nexus in States A, B, and C. Metro operates one integrated manufacturing and distribution business in all three states. It also sold an investment parcel located in State C that was never used in the business.

State A’s corporate income tax instructions provide:

• Business income from a unitary trade or business must be apportioned among the states in which the taxpayer conducts that business under the state’s apportionment formula.
• Nonbusiness income must be allocated to the state specifically identified by the income-producing property or activity.

Which statement is the best interpretation of these instructions?

• A. Apportionment assigns the land gain based on the parcel’s location, while allocation divides Metro’s operating income among the states by formula.
• B. Each state with nexus may tax all of Metro’s business income and all of the land gain because nexus eliminates the need for division among states.
• C. State A must follow federal taxable income without adjustment, so apportionment and allocation do not affect the state income tax base.
• D. Apportionment divides Metro’s business income by formula to reflect each state’s share, while allocation assigns the nonbusiness land gain to a specific jurisdiction.

Best answer: D

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

Explanation: Apportionment and allocation are methods for assigning income among taxing jurisdictions. Apportionment generally divides multistate business income by formula, while allocation assigns nonbusiness income to a specific state connected with the income item.

For state corporate income tax, nexus determines whether a state may impose tax, but it does not mean the state taxes all of a multistate corporation’s income. Apportionment is used for business income from an integrated or unitary business conducted in multiple states; a formula is intended to approximate the portion fairly attributable to each state. Allocation applies to nonbusiness income, which is assigned to a particular jurisdiction based on rules tied to the property, activity, or commercial domicile. Here, Metro’s integrated manufacturing and distribution income is business income subject to apportionment, while the gain from investment land not used in the business is nonbusiness income allocated under the relevant state rule.

• Treating nexus as permission to tax all income ignores the role of apportionment in dividing multistate business income.
• Reversing the terms is a common trap: apportionment divides business income; allocation assigns nonbusiness income.
• Federal taxable income may be the starting point, but state tax systems can apply allocation and apportionment to determine the state tax base.

Apportionment applies to multistate business income, while allocation assigns nonbusiness income to the jurisdiction connected with the property or activity.

Question 29

Topic: Business Law

A group is choosing a state-law entity for a new operating business. Based on the exhibit, which business structure best matches the stated legal characteristics?

• A. A corporation selected primarily because it can elect S corporation tax treatment
• B. A manager-managed limited liability company
• C. A limited partnership with one founder serving as general partner
• D. A general partnership

Best answer: B

What this tests: Business Law

Explanation: A manager-managed LLC best matches the exhibit because it addresses the legal characteristics, not just tax treatment. It provides limited liability for owners, flexible operating-agreement terms, and centralized management without corporate-style formalities.

Business structure selection should consider legal rights and obligations in addition to tax classification. An LLC is a state-law entity that generally gives all members limited liability for entity obligations solely by reason of ownership. It can be member-managed or manager-managed, and its operating agreement can set customized voting, management, and distribution arrangements. These characteristics align with the founders’ priorities better than a partnership form with personal liability exposure or a corporation chosen mainly for a tax election.

• A general partnership fails because partners generally have personal liability for partnership obligations.
• A limited partnership with a founder as general partner fails because the general partner generally has personal liability.
• A corporation with an S election overemphasizes tax status and usually involves corporate formalities and less flexible economic arrangements than an LLC.

A manager-managed LLC can provide limited liability to all members, centralized management by a manager, flexible governance and economic terms, and fewer formalities than a corporation.

Question 30

Topic: Business Law

A CPA is reviewing whether CallCo should treat a group of remote customer-service workers as employees or independent contractors for federal employment tax purposes. The worker file includes the following facts:

Which conclusion is best supported by the exhibit?

• A. Treat the workers as independent contractors if CallCo reports the payments on Forms 1099-NEC.
• B. Treat the workers as employees because CallCo retains significant behavioral and financial control over how the services are performed.
• C. Treat the workers as independent contractors because they work remotely and do not receive employee benefits.
• D. Treat the workers as independent contractors because the written agreement labels them as independent contractors.

Best answer: B

What this tests: Business Law

Explanation: Worker classification depends on the substance of the relationship, especially the payer’s right to control the manner and means of the work. The facts show substantial behavioral control and little independent business risk, supporting employee treatment for federal employment tax purposes.

For federal tax and compliance purposes, common-law worker classification focuses on behavioral control, financial control, and the relationship of the parties. A contract label is relevant but not controlling. Here, CallCo sets shifts, requires scripts, supervises deviations, provides tools and training, reimburses required costs, pays by the hour, and gives the workers little opportunity for profit or loss. Those factors indicate CallCo controls both how the work is performed and the economic aspects of the work. Therefore, the supported conclusion is employee classification, with the related withholding and employment tax obligations.

• A contract label alone does not override the actual facts showing control.
• Remote work and lack of benefits do not, by themselves, establish independent contractor status.
• Filing Forms 1099-NEC does not determine classification if the underlying relationship is employment.

Set schedules, required procedures, company-provided tools, reimbursement, hourly pay, and limited profit or loss opportunity support employee classification.

Question 31

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is reviewing a calendar-year S corporation’s draft Form 1120S. The supporting documentation for the year shows the following items:

All ordinary operating expenses listed are deductible unless otherwise indicated. What amount should be reported as ordinary business income on Form 1120S, Schedule K?

• A. $276,000
• B. $288,000
• C. $267,000
• D. $256,000

Best answer: A

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

Explanation: The S corporation’s ordinary business income is computed from business operations only. Separately stated items, such as portfolio interest, capital gains, charitable contributions, Section 179 expense, and tax-exempt income, are not included in ordinary business income.

Form 1120S ordinary business income includes gross receipts from business operations reduced by cost of goods sold and ordinary business deductions. The deductible business meals amount is limited to 50%, so only $9,000 of the $18,000 paid reduces ordinary income. The computation is $960,000 − $430,000 − $150,000 − $60,000 − $35,000 − $9,000 = $276,000. Interest income from corporate bonds, long-term capital gain, charitable contributions, Section 179 expense, and tax-exempt municipal bond interest are separately stated to shareholders. The federal tax penalty is nondeductible and should not reduce ordinary business income.

• $267,000 incorrectly deducts 100% of the meals instead of the allowed 50%.
• $288,000 incorrectly includes corporate bond interest in ordinary business income instead of separately stating it.
• $256,000 reflects mixing separately stated and nondeductible items into the ordinary income computation.

Ordinary business income includes business receipts less ordinary deductions and only the deductible 50% of meals, while portfolio income, capital gain, charitable contributions, Section 179 expense, tax-exempt interest, and nondeductible penalties are separately stated or nondeductible items.

Question 32

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is reviewing a draft Form 1120-S for a calendar-year S corporation before the return is filed. The draft reports Schedule K ordinary business income of $185,000, no separately stated deductions, no nondeductible expenses, and a $185,000 increase to accumulated adjustments account (AAA). Beginning AAA is $0, and there were no distributions. The reviewer notes that book income of $185,000 includes these items, with no other book-tax differences:

What should the reviewer do next?

• A. Leave ordinary business income at $185,000 and disclose the charitable contribution, penalty, and municipal bond interest only in a shareholder footnote.
• B. Release the K-1s as drafted because all S corporation items ultimately pass through to shareholders pro rata.
• C. Revise the draft return to report $193,000 of ordinary business income, separately state the $10,000 charitable contribution, report the $4,000 nondeductible expense, and compute the AAA increase as $179,000.
• D. File the return as drafted and prepare an appeals protest if the IRS later questions the Schedule K classifications.

Best answer: C

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

Explanation: The draft return has a classification error, not an audit controversy. Ordinary business income should exclude separately stated charitable contributions, nondeductible expenses, and tax-exempt interest, and AAA should reflect only the proper taxable income and reduction items.

For an S corporation, Schedule K line 1 ordinary business income is not simply book income. Starting with book income of $185,000, add back the $10,000 charitable contribution because it is separately stated, add back the $4,000 nondeductible government penalty because it is not deductible in computing ordinary income, and subtract the $6,000 tax-exempt interest because it is not taxable ordinary income. Ordinary business income is therefore $193,000. AAA increases for taxable income items and decreases for deductible separately stated items and nondeductible noncapital expenses, but tax-exempt income does not increase AAA. The AAA net increase is $193,000 − $10,000 − $4,000 = $179,000.

• Passing items through pro rata does not eliminate the need to classify Schedule K and AAA items correctly.
• A footnote does not substitute for separately stating required pass-through items on the return.
• Appeals procedures are premature because the issue is a pre-filing return review discrepancy, not an IRS examination dispute.

Book income must be reclassified for S corporation reporting so separately stated and nondeductible items are not incorrectly included in ordinary business income or AAA.

Question 33

Topic: Federal Taxation of Individuals

Maya owns publicly traded stock as an investment. On December 15, she sold 100 shares for $6,000; her adjusted basis in the shares sold was $10,000. On December 28, she purchased 60 shares of the same corporation’s stock for $3,900. Maya had no other transactions in this stock during the year. What is the correct wash sale treatment?

• A. Disallow $1,600 of the loss and recognize a $2,400 capital loss.
• B. Disallow $4,000 of the loss and recognize no capital loss.
• C. Disallow $2,400 of the loss and recognize a $1,600 capital loss.
• D. Disallow $0 of the loss and recognize a $4,000 capital loss.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: A wash sale disallows a loss only to the extent substantially identical stock is acquired within 30 days before or after the sale. Because Maya replaced 60 of the 100 shares sold at a loss, 60% of the $4,000 loss is disallowed.

The wash sale rule applies when a taxpayer sells stock or securities at a loss and acquires substantially identical stock or securities within the 61-day window that begins 30 days before and ends 30 days after the sale date. Maya’s realized loss is $4,000, computed as $10,000 basis minus $6,000 amount realized. She bought 60 replacement shares within the window, so the disallowed portion is 60/100 of the $4,000 loss, or $2,400. The remaining $1,600 loss is currently recognized as a capital loss. The disallowed $2,400 is generally added to the basis of the replacement shares.

• Recognizing the full $4,000 loss ignores the replacement purchase within the wash sale period.
• Disallowing $1,600 reverses the allowed and disallowed portions.
• Disallowing the full $4,000 would be correct only if all 100 shares had been replaced within the wash sale window.

The $4,000 loss is disallowed for 60 of the 100 shares replaced within the wash sale window, so $2,400 is disallowed.

Question 34

Topic: Federal Taxation of Entities (Including Tax Preparation)

An accrual-basis, calendar-year C corporation’s draft Form 1120 includes a $95,000 charitable contributions deduction. The current-year cash disbursements ledger shows $35,000 paid to a qualified public charity on December 20 and a separate $60,000 contribution accrued at December 31 and paid on March 20 of the following year. Taxable income before the charitable contribution deduction is $1,200,000. Which workpaper item best supports the conclusion that the full $95,000 deduction is proper on the current-year Form 1120?

• A. A January 10 email from the CFO requesting that the preparer include the accrued $60,000 contribution on Form 1120.
• B. Board minutes dated December 28 of the tax year approving the $60,000 contribution, with a copy of the March 20 canceled check.
• C. A December 31 general ledger entry debiting charitable contributions and crediting accrued expenses for $60,000.
• D. A March 20 charitable receipt acknowledging the $60,000 payment to the qualified charity.

Best answer: B

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

Explanation: An accrual-basis C corporation may deduct an accrued charitable contribution for the tax year if the board authorized it by year-end and it is paid within 3.5 months after year-end. The board minutes plus canceled check directly resolve the discrepancy between cash paid during the year and the Form 1120 deduction.

For a C corporation using the accrual method, a charitable contribution accrued at year-end can be deducted on the current-year Form 1120 if it is authorized by the board of directors before the close of the tax year and paid within 3.5 months after year-end. The deduction also must fit within the corporate charitable contribution limitation. Here, the total $95,000 deduction is less than 10% of $1,200,000 taxable income before the contribution deduction, so the limitation does not reduce it. The best support is evidence showing both timely corporate authorization and timely payment of the accrued $60,000 amount.

• A general ledger entry supports that an accrual was recorded, but not that the board authorized the contribution by year-end.
• A charitable receipt supports the later payment, but not the required year-end corporate authorization.
• A CFO email is not equivalent to board authorization and was sent after year-end.

This evidence shows both year-end board authorization and payment within 3.5 months after year-end, with the total deduction within the C corporation charitable contribution limit.

Question 35

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

A CPA licensed by State A prepared federal income tax returns and later admitted to altering client-provided receipts before submitting them to an IRS examiner. The IRS Office of Professional Responsibility has begun a Circular 230 investigation. The CPA firm has already secured the client files and is evaluating the licensing consequences of the CPA’s conduct. What should the firm do next?

• A. Refer the matter only to the AICPA peer review program because the issue arose in a CPA firm practice.
• B. File a Tax Court petition on behalf of the CPA to prevent license suspension.
• C. Request an IRS Appeals conference to contest the examination adjustments for the affected clients.
• D. Determine and comply with State A Board of Accountancy reporting and disciplinary requirements for the CPA’s license.

Best answer: D

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The most directly relevant licensing authority is the state board of accountancy that issued the CPA’s license. IRS OPR may address federal tax-practice privileges, but state boards handle CPA licensure discipline and related reporting obligations.

Tax-practice misconduct can involve more than one authority. The IRS Office of Professional Responsibility administers Circular 230 standards for practice before the IRS, such as suspension or disbarment from IRS practice. However, CPA licensure is granted and disciplined at the state level. When misconduct also affects CPA licensing responsibilities, the next step is to identify and comply with the applicable state board of accountancy rules, including any required self-reporting or disciplinary procedures.

• An IRS Appeals conference concerns client tax adjustments, not the CPA’s licensing responsibilities.
• A Tax Court petition is a taxpayer remedy and does not prevent CPA license discipline.
• AICPA peer review is not the primary licensing disciplinary authority for a CPA’s state license.

CPA licensure and related discipline are administered by the state board of accountancy, even when the misconduct occurred in federal tax practice.

Question 36

Topic: Federal Taxation of Property Transactions

In 2026, Mira Manufacturing, a calendar-year C corporation, placed in service equipment used 100% in its active trade or business. Mira’s total qualifying Section 179 property cost for the year was $3,400,000. The Section 179 dollar limit is $1,250,000 and is reduced dollar-for-dollar for qualifying property placed in service above $3,130,000. Mira’s taxable income from the business before any Section 179 deduction is $1,100,000. If Mira elects the maximum Section 179 expense and does not claim special depreciation, what Section 179 deduction is allowed for the year?

• A. $1,100,000
• B. $1,250,000
• C. $980,000
• D. $3,400,000

Best answer: C

What this tests: Federal Taxation of Property Transactions

Explanation: The Section 179 dollar limit must first be reduced for excess qualifying property placed in service during the year. After that reduction, the allowed deduction is also limited by business taxable income, so Mira may deduct $980,000.

Section 179 expense is limited by multiple rules. First, the annual dollar limit is reduced dollar-for-dollar when total qualifying property placed in service exceeds the phase-out threshold. Mira placed in service $3,400,000 of qualifying property, which exceeds the $3,130,000 threshold by $270,000. Therefore, the $1,250,000 dollar limit is reduced to $980,000. The taxable income limitation then caps the deduction at Mira’s $1,100,000 business taxable income before Section 179. Because $980,000 is less than $1,100,000, the phase-out-adjusted amount is the allowed Section 179 deduction.

• $1,100,000 uses only the taxable income limitation and ignores the dollar-limit phase-out.
• $1,250,000 applies the unreduced annual dollar limit, ignoring the excess qualifying property cost.
• $3,400,000 treats the full equipment cost as immediately deductible without applying Section 179 limits.

The $270,000 excess cost over the phase-out threshold reduces the $1,250,000 limit to $980,000, which is below taxable income.

Question 37

Topic: Federal Taxation of Property Transactions

A CPA is reviewing a corporation’s draft tax depreciation workpaper for newly acquired manufacturing equipment. The workpaper reports a current-year MACRS deduction of $3,570. Assume no Section 179 expense or bonus depreciation is elected or allowed. Which record best supports the conclusion that the depreciation amount reflects the correct cost basis, recovery convention, and current-year service period?

• A. A financial reporting depreciation schedule showing the equipment is depreciated over seven years using straight-line depreciation beginning on the invoice date.
• B. A bank statement showing a $100,000 payment to the equipment vendor on December 10 and management’s notation that the equipment is used in manufacturing operations.
• C. A prior-year tax depreciation schedule showing similar manufacturing equipment was classified as 7-year MACRS property and depreciated using the half-year convention.
• D. A fixed-asset workpaper matching the $100,000 invoice and installation costs to depreciable basis, showing the equipment was installed and available for use on December 10, classified as 7-year MACRS property, and depreciated using the fourth-quarter mid-quarter rate of 3.57% because more than 40% of current-year additions were placed in service in the last quarter.

Best answer: D

What this tests: Federal Taxation of Property Transactions

Explanation: The strongest support must verify all three elements: depreciable cost basis, the correct convention, and the placed-in-service period for the current year. The fixed-asset workpaper does that and shows $100,000 × 3.57% = $3,570.

For MACRS depreciation, the deduction depends on the asset’s depreciable basis, recovery classification, placed-in-service date, and applicable convention. When more than 40% of depreciable personal property additions are placed in service during the last quarter, the mid-quarter convention generally applies instead of the half-year convention. The supporting record should therefore connect source cost to tax basis, show when the asset was ready and available for use, justify the 7-year classification, and document the fourth-quarter mid-quarter rate used to compute the current-year deduction.

• A payment record supports cash disbursement but does not establish tax basis, recovery period, convention, or placed-in-service status.
• A book depreciation schedule uses financial reporting assumptions and does not support the MACRS convention or tax deduction.
• A prior-year schedule for similar property may support classification by analogy, but it does not establish the current asset’s basis, service date, or applicable current-year convention.

This record supports basis, placed-in-service timing, recovery period, and the mid-quarter convention rate that produces $3,570.

Question 38

Topic: Federal Taxation of Entities (Including Tax Preparation)

Paige owns 100% of Lake Inc., an S corporation, and materially participates in its business. Lake’s Form 1120S Schedule K-1 issued to Paige reports an $85,000 ordinary business loss. Paige’s Form 1040 Schedule E deducts only $32,000 of the loss and carries forward $53,000 as a basis-limited suspended loss. Assume no passive activity or at-risk limitation applies. Which evidence best supports the conclusion that Paige’s individual return properly limited the S corporation loss deduction to $32,000?

• A. Lake’s year-end balance sheet showing a $53,000 bank loan that Paige personally guaranteed but did not repay during the year.
• B. Paige’s Schedule E showing the $32,000 S corporation loss deduction reported on the filed Form 1040.
• C. Lake’s Schedule K-1 showing Paige’s $85,000 allocated ordinary business loss and 100% ownership percentage.
• D. A completed shareholder basis schedule/Form 7203, supported by corporate and bank records, showing $20,000 beginning stock basis, $12,000 direct shareholder loan basis before the loss, no other basis increases, and a $53,000 suspended loss.

Best answer: D

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

Explanation: A shareholder may be allocated an S corporation loss on Schedule K-1 but may deduct it only to the extent of stock basis and direct debt basis. The basis schedule supported by records explains why only $32,000 of the $85,000 pass-through loss was currently deductible.

An S corporation Schedule K-1 reports the shareholder’s share of corporate items, but it does not by itself establish that the shareholder has enough basis to deduct a loss. For an S corporation shareholder, deductible losses are limited to the shareholder’s stock basis plus debt basis from direct loans made by the shareholder to the corporation. Here, the supported basis computation shows $20,000 of stock basis plus $12,000 of direct shareholder loan basis before the loss, for total available basis of $32,000. The remaining $53,000 loss is suspended until Paige has sufficient basis in a later year.

• The K-1 supports Paige’s allocation of the $85,000 loss, not the amount deductible after applying the basis limitation.
• A personal guarantee of corporate bank debt does not create S corporation debt basis unless Paige actually pays the debt or otherwise becomes the direct creditor.
• Schedule E shows the reported deduction, but it is circular evidence and does not substantiate the basis computation.

This evidence directly substantiates Paige’s available stock and direct debt basis, which limits the deductible S corporation loss to $32,000.

Question 39

Topic: Federal Taxation of Individuals

Lina, a cash-method individual taxpayer, gave the following records to her tax preparer for 2026. Which conclusion is supported for Lina’s 2026 federal individual income tax return?

• A. Include a $64,000 long-term capital gain in gross income; exclude the $4,000 cash gift.
• B. Include a $10,000 long-term capital gain in gross income; exclude the $4,000 cash gift.
• C. Include only a $9,000 long-term capital gain in gross income; exclude the $4,000 cash gift.
• D. Include $109,000 in gross income for the stock sale proceeds and the cash gift.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: A seller includes gain from the sale of property in gross income, not the entire sale proceeds. Lina recovers her inherited basis and selling cost before measuring gain, and the separate cash gift is not taxable to her as recipient.

For federal income tax purposes, gain from selling property equals the amount realized minus adjusted basis. Amount realized is generally the sales price reduced by selling expenses such as brokerage commissions. Property acquired from a decedent generally takes a basis equal to fair market value at the date of death when no alternate valuation is elected, and inherited property receives long-term holding-period treatment. Lina’s amount realized is $104,000 ($105,000 sales price less $1,000 commission), and her inherited basis is $95,000, so she has a $9,000 long-term capital gain. The original inheritance of the stock and the $4,000 birthday gift are non-taxable receipts to Lina, although the later sale is taxable to the extent proceeds exceed basis.

• A $10,000 gain ignores the $1,000 brokerage commission, which reduces the amount realized.
• A $64,000 gain incorrectly uses the aunt’s $40,000 basis; inherited property generally receives a date-of-death fair market value basis.
• Including $109,000 confuses gross proceeds and a cash gift with taxable gross income; basis recovery and gifts to the recipient are not taxable income.

The inherited stock basis is $95,000, the commission reduces amount realized to $104,000, and the cash gift is excluded from the recipient’s gross income.

Question 40

Topic: Business Law

A corporation’s controller internally instructed its purchasing manager not to sign supply contracts exceeding $50,000 without prior approval. The corporation had previously informed a vendor that the purchasing manager was authorized to handle all supply purchases, and the vendor had no notice of the internal dollar limit. The purchasing manager signed a $70,000 supply contract in the corporation’s name with the vendor. A draft legal memo states: “Because the purchasing manager exceeded actual authority, the corporation is not liable to the vendor, but the purchasing manager is personally liable to the vendor on the contract.” Which correction best states the legal consequences?

• A. The purchasing manager is personally liable to the vendor because any agent who exceeds actual authority becomes the contracting party.
• B. The corporation is not liable to the vendor because internal dollar limits always defeat apparent authority.
• C. The corporation is liable to the vendor based on apparent authority, and the purchasing manager may be liable to the corporation for exceeding internal authority.
• D. The corporation is liable to the vendor, and the purchasing manager has no possible liability because apparent authority validates the transaction for all purposes.

Best answer: C

What this tests: Business Law

Explanation: The memo incorrectly treats the same transaction as having only one legal consequence. The corporation may be bound to the vendor through apparent authority, while the purchasing manager may separately be liable to the corporation for violating internal instructions.

Actual authority concerns the agent’s relationship with the principal. Apparent authority concerns the principal’s manifestations to the third party and the third party’s reasonable belief that the agent is authorized. Here, the corporation told the vendor that the purchasing manager handled all supply purchases and did not disclose the $50,000 internal limit. That supports principal liability to the vendor. However, the purchasing manager’s failure to follow the internal approval limit may breach the agent’s duty to the principal, creating possible liability to the corporation for resulting loss.

• Treating internal limits as automatically defeating apparent authority confuses actual authority with third-party reliance.
• Making the purchasing manager personally liable to the vendor overstates the rule for an agent contracting for a disclosed principal.
• Saying apparent authority eliminates the agent’s possible liability to the corporation ignores the agent’s separate duty to follow the principal’s instructions.

The vendor could reasonably rely on the corporation’s manifestations, while the agent’s violation of internal limits may create liability to the principal.

Question 41

Topic: Business Law

Spruce Design LLC’s articles of organization state that the LLC is manager-managed. The operating agreement names Mina as the sole manager and provides that members may vote only on admitting new members, amending the agreement, and approving a sale of substantially all assets. The agreement also authorizes the manager to enter ordinary-course contracts up to $75,000 without member approval. Leo, a 35% member who is not a manager, signs a $40,000 supply contract in Spruce’s name. The vendor had a copy of the operating agreement before signing. How should Leo’s authority be characterized?

• A. Leo held owner voting rights on reserved matters but lacked management authority to bind Spruce to the supply contract.
• B. Leo had actual authority because the contract amount was below the $75,000 limit in the operating agreement.
• C. Leo had statutory default management authority because every LLC member may bind the LLC in the ordinary course.
• D. Leo had apparent authority because his ownership interest alone made him an agent of Spruce.

Best answer: A

What this tests: Business Law

Explanation: Leo’s rights were owner rights, not management rights. The LLC documents assigned ordinary-course contracting authority to the manager, and the vendor knew those limits before signing.

Entity owners often have economic rights and voting rights without having management authority. In a manager-managed LLC, management authority generally belongs to the designated manager, not to members merely because they own membership interests. Here, the operating agreement reserved only specified major decisions for member voting and separately gave the manager authority over ordinary-course contracts up to $75,000. Leo was not the manager, and the vendor had the agreement showing the authority allocation. Therefore, Leo’s 35% ownership interest did not authorize him to bind Spruce to the supply contract.

• Statutory default member-management rules do not control when the LLC is validly manager-managed under its organizational documents.
• Ownership alone does not create apparent authority, especially when the vendor knew the operating agreement limited authority to the manager.
• The $75,000 contract limit applied to the manager’s authority, not to every member’s authority.

In a manager-managed LLC, a nonmanager member’s ownership and voting rights do not create management or agency authority to bind the LLC.

Question 42

Topic: Federal Taxation of Individuals

A CPA is performing a final review of Mira’s Form 1040 before filing. Mira states that she bought a 30% profits, losses, and capital interest in Cedar LLC on January 1 and held it all year; Cedar LLC is taxed as a partnership. No special allocation or ownership change has been explained.

What should the CPA do next before filing the return?

• A. Change Mira’s return to reflect a 30% distributive share without requesting a corrected K-1 or explanation from Cedar LLC.
• B. Hold the return and reconcile the K-1 with the ownership file by requesting a corrected K-1 or supporting explanation, then update the Form 1040 for all applicable K-1 items.
• C. Prepare an IRS Appeals protest challenging Cedar LLC’s K-1 percentages before the IRS processes the return.
• D. E-file the return as drafted because only ordinary business income from a partnership is reportable on Schedule E.

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: The return review identified both an ownership-percentage inconsistency and omitted separately stated K-1 items. The next step is to resolve the source-document conflict and then ensure the individual return reports the pass-through items in the proper places.

A partner’s individual return should be consistent with the Schedule K-1 unless there is a supported reason to report differently. Here, the K-1 shows 20% ownership, while the client file shows a 30% profits, losses, and capital interest for the entire year. That conflict should be reconciled before filing, typically by obtaining a corrected K-1 or a documented explanation. In addition, partnership items such as interest income and long-term capital gain are separately stated because they retain their character and are reported on the individual return outside ordinary Schedule E income. Filing as drafted would omit required pass-through information.

• Reporting only Schedule E income ignores separately stated K-1 items, which flow through to the individual return with their character.
• Overriding the K-1 based only on the client ownership file skips needed substantiation or corrected source information.
• An IRS Appeals protest is out of sequence because there is no IRS examination or proposed adjustment to appeal.

The K-1 percentage conflicts with the ownership facts, and the draft return omits separately stated pass-through items that must be addressed before filing.

Question 43

Topic: Federal Taxation of Entities (Including Tax Preparation)

During review of a draft Form 1120 for a calendar-year C corporation, the CPA notes that the corporation sold investment stock, held for two years and not held as inventory, for a $70,000 loss. The corporation has no capital gains in the current year and had no capital gains in the prior three tax years. The draft return reports the $70,000 loss as an ordinary deduction. Which correction is required?

• A. Reclassify the loss as ordinary because C corporations do not receive preferential capital gain rates.
• B. Leave the deduction as filed because the stock was an investment asset of the corporation.
• C. Deduct $3,000 of the loss currently and carry forward the remaining $67,000.
• D. Remove the loss from ordinary deductions and carry it forward as a capital loss to offset future capital gains only.

Best answer: D

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

Explanation: The draft return used the wrong category for the stock loss. A C corporation’s capital loss cannot reduce ordinary income; it may offset only capital gains, so the loss must be removed from ordinary deductions and carried forward because no carryback capital gains exist.

Investment stock held by a C corporation is generally a capital asset unless held as inventory or by a dealer. When a C corporation has a net capital loss, it cannot deduct that loss against ordinary income. The loss is applied only against capital gains, generally through a 3-year carryback and 5-year carryforward system. Here, the corporation has no current-year capital gains and no capital gains in the prior three years, so there is no current deduction and no useful carryback. The required correction is to remove the $70,000 from ordinary deductions and carry it forward to offset future capital gains only.

• The $3,000 capital loss deduction is an individual tax rule, not a C corporation rule.
• Lack of preferential corporate capital gain rates does not convert a capital loss into an ordinary loss.
• Holding stock as an investment supports capital asset treatment; it does not justify an ordinary deduction.

A C corporation may use capital losses only against capital gains, and with no current or prior capital gains, the unused loss is carried forward.

Question 44

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is reviewing an individual partner’s draft basis schedule for the current year. The draft allowed a $26,000 partnership loss and suspended $5,000. No at-risk, passive activity, or excess business loss limitations apply.

The draft basis schedule did not include the liability change. What correction should the CPA make?

• A. Reduce basis by an $8,000 deemed distribution, allow an $18,000 loss, and suspend a $13,000 loss.
• B. Leave the allowed loss at $26,000 because only actual cash distributions reduce partner basis.
• C. Report an $8,000 taxable gain from the liability decrease and continue to suspend only $5,000 of the loss.
• D. Increase basis by $8,000 for the liability change, allow the full $31,000 loss, and report ending basis of $3,000.

Best answer: A

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

Explanation: The omitted liability decrease is treated as a deemed distribution to the partner. After reducing basis for that $8,000 decrease, only $18,000 of basis remains available to absorb the $31,000 partnership loss.

A partner’s outside basis is increased by contributions and increased shares of partnership liabilities, and decreased by distributions and decreased shares of partnership liabilities. Here, the beginning basis is $25,000. The cash contribution increases basis to $29,000, the cash distribution reduces it to $26,000, and the liability decrease from $18,000 to $10,000 creates an additional $8,000 deemed distribution, reducing basis to $18,000 before the loss. Because partnership losses are deductible only to the extent of outside basis, the partner may deduct $18,000 of the $31,000 loss and must suspend the remaining $13,000.

• Treating only the cash distribution as a basis reduction ignores the deemed distribution from the liability decrease.
• Increasing basis for the liability change uses the wrong direction; basis increases when a partner’s liability share increases, not decreases.
• Reporting taxable gain is not appropriate because the combined distributions do not exceed the partner’s available basis before the loss.

A decrease in a partner’s share of partnership liabilities is treated as a deemed cash distribution that reduces basis before applying the basis limitation on losses.

Question 45

Topic: Federal Taxation of Property Transactions

Marla received land from her uncle as a completed gift and later sold it. The following property record contains all facts relevant to the federal income tax basis determination. Which conclusion is supported by the exhibit?

• A. Marla has a $90,000 basis for determining gain and a $64,000 basis for determining loss, resulting in no recognized gain or loss.
• B. Marla uses the donor’s $90,000 adjusted basis for both gain and loss, resulting in a $15,000 recognized loss.
• C. Marla uses the $64,000 gift-date fair market value for both gain and loss, resulting in an $11,000 recognized gain.
• D. Marla uses a $75,000 basis equal to the sale proceeds, resulting in no recognized gain or loss because no gift tax was paid.

Best answer: A

What this tests: Federal Taxation of Property Transactions

Explanation: When gifted property has a fair market value below the donor’s adjusted basis on the gift date, the donee has a dual basis. The donor’s basis is used to determine gain, and the gift-date fair market value is used to determine loss. A sale between those amounts produces no gain or loss.

For property received by gift, the donee generally takes the donor’s adjusted basis for purposes of measuring gain. However, if the property’s fair market value on the gift date is less than the donor’s adjusted basis, a special dual-basis rule applies. The donee uses the donor’s adjusted basis to determine gain and the gift-date fair market value to determine loss. Here, Marla’s gain basis is $90,000 and her loss basis is $64,000. Because she sold the land for $75,000, the amount realized is not greater than the gain basis and not less than the loss basis. Therefore, the sale produces neither recognized gain nor recognized loss.

• Using the donor’s basis for both gain and loss ignores the lower gift-date fair market value loss basis.
• Using fair market value for both gain and loss incorrectly denies the carryover basis rule for measuring gain.
• Setting basis equal to sale proceeds reaches the right no-gain/no-loss outcome for the wrong reason; basis is determined from the gift rules, not the sale price.

Because the gift-date fair market value was less than the donor’s adjusted basis, the dual-basis rule applies and the sale price falls between the gain basis and loss basis.

Question 46

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

An IRS revenue agent completed an examination of Lee’s individual income tax return and issued a revenue agent’s report with a 30-day letter proposing a $42,000 deficiency. Lee timely disagrees with the adjustment and has invoices and legal support for the reported position. No statutory notice of deficiency has been issued. What should Lee do next to pursue the administrative appeal path?

• A. Pay the proposed deficiency and file a refund claim as the only available administrative remedy.
• B. Submit a timely written protest requesting a conference with the IRS Independent Office of Appeals and include supporting facts and authority.
• C. File a petition in the U.S. Tax Court immediately to challenge the proposed deficiency before payment.
• D. Wait for the IRS to assess the tax and then request a collection due process hearing.

Best answer: B

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: Because Lee received a 30-day letter and no statutory notice of deficiency has been issued, the next administrative step is to request an Appeals conference. The written protest should explain the disputed issues and provide supporting facts and authority.

After an IRS examination, a 30-day letter generally gives the taxpayer a chance to disagree with the examiner’s proposed adjustments and request review by the IRS Independent Office of Appeals. For a larger proposed deficiency, the taxpayer generally submits a formal written protest describing the disputed issues, facts, law, and requested relief. A Tax Court petition is tied to a statutory notice of deficiency, commonly called a 90-day letter, not merely a revenue agent’s report or 30-day letter. Paying and filing a refund claim is another possible route in some disputes, but it is not the next step when the taxpayer wants the pre-assessment administrative appeal offered by the 30-day letter.

• Filing in Tax Court is premature because no statutory notice of deficiency has been issued.
• Paying and filing a refund claim skips the available pre-assessment Appeals process.
• Waiting for assessment and seeking a collection hearing confuses examination appeals with collection procedures.

A 30-day letter gives the taxpayer the opportunity to request administrative review by IRS Appeals before a statutory notice of deficiency is issued.

Question 47

Topic: Federal Taxation of Entities (Including Tax Preparation)

A calendar-year C corporation is preparing its Schedule M-1 reconciliation. Adjusted book income before federal income tax expense is $940,000, and taxable income before any NOL deduction or special deductions is $875,000. The corporation identified the following book-tax differences:

What is the net temporary book-tax difference, expressed as an adjustment to adjusted book income to arrive at taxable income?

• A. $50,000 increase to adjusted book income
• B. $65,000 decrease to adjusted book income
• C. $50,000 decrease to adjusted book income
• D. $80,000 decrease to adjusted book income

Best answer: C

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

Explanation: Temporary book-tax differences reverse in future periods and affect the timing of taxable income. Here, the allowance-method bad debt difference increases taxable income by $15,000, while excess tax depreciation decreases taxable income by $65,000, resulting in a net $50,000 decrease to adjusted book income.

For a book-to-tax reconciliation, determine the direction of each temporary item from book income to taxable income. Book bad debt expense is $36,000, but only $21,000 of specific write-offs are currently deductible for tax, so taxable income is $15,000 higher than book income. Tax depreciation exceeds book depreciation by $65,000, so taxable income is $65,000 lower than book income. Net temporary difference: $15,000 increase − $65,000 decrease = $50,000 decrease. The permanent items reconcile the remaining difference: tax-exempt interest decreases taxable income by $24,000 and nondeductible lobbying expense increases taxable income by $9,000.

• Treating the net amount as an increase reverses the direction of the excess tax depreciation adjustment.
• Using only the $65,000 decrease ignores the temporary bad debt addback.
• Using an $80,000 decrease incorrectly combines the $15,000 bad debt difference in the same direction as excess tax depreciation.

The temporary adjustments are a $15,000 increase for excess book bad debt expense and a $65,000 decrease for excess tax depreciation, for a net $50,000 decrease.

Question 48

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is reviewing Morgan’s draft Form 1040. Morgan is a calendar-year individual partner in AB Partnership and materially participates in the activity. Assume the at-risk and passive activity loss rules do not further limit any deduction.

Which conclusion is supported by the exhibit?

• A. Morgan should deduct only $42,000 of the ordinary loss and carry forward the remaining $6,000 as a basis-limited loss.
• B. Morgan should deduct the full $48,000 loss because the amount was reported on Schedule K-1 by the partnership.
• C. Morgan should request that the partnership amend Schedule K-1 to report a $42,000 ordinary business loss.
• D. Morgan should deduct only $35,000 of the loss because partnership liability increases do not affect a partner’s outside basis.

Best answer: A

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

Explanation: A partner’s deduction for partnership losses is limited to the partner’s adjusted outside basis. Morgan’s basis available before deducting the loss is $42,000, so the draft Form 1040 overstates the current deductible loss by $6,000.

Schedule K-1 reports the partner’s distributive share of partnership items, but the partner must apply owner-level limitations before deducting losses on the individual return. Outside basis is increased by contributions and increases in the partner’s share of partnership liabilities, and reduced by distributions before applying loss deductions. Here, Morgan’s basis available for the ordinary loss is $32,000 + $8,000 + $7,000 - $5,000 = $42,000. Because the K-1 ordinary loss is $48,000, only $42,000 is currently deductible. The $6,000 excess is suspended and carried forward until Morgan has sufficient basis.

• Reporting the full K-1 loss ignores the partner-level basis limitation.
• Excluding the liability increase understates outside basis because a partner’s share of partnership liabilities generally increases basis.
• Amending the K-1 is not supported; the K-1 can correctly report a $48,000 distributive share even though Morgan cannot currently deduct all of it.

Morgan’s basis available for the loss is $32,000 + $8,000 - $5,000 + $7,000, so only $42,000 of the $48,000 K-1 loss is currently deductible.

Question 49

Topic: Federal Taxation of Individuals

Dana was legally married on December 31, 2026, but Dana’s spouse moved out on May 1, 2026, and did not live in Dana’s home for the rest of the year. Dana will not file a joint return. Dana paid more than half the cost of keeping up the home, and Dana’s 8-year-old child lived in the home for all of 2026. Dana may claim the child as a dependent. Which filing status should Dana use for 2026?

• A. Married filing separately
• B. Head of household
• C. Single
• D. Qualifying surviving spouse

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: Dana qualifies for head of household even though legally married at year-end. The abandoned-spouse rule treats Dana as unmarried because Dana will not file jointly, paid more than half the home costs, and maintained the home for a qualifying child while the spouse was absent for the last six months.

A taxpayer who is still legally married may qualify as head of household if treated as unmarried. The key requirements include filing a separate return, paying more than half the cost of keeping up the home, having the home be the principal home of a qualifying child for more than half the year, being able to claim that child as a dependent, and not having the spouse live in the home during the last six months of the year. Dana meets these requirements, so head of household is the proper filing status under the facts given.

• Married filing separately is a plausible default for a married taxpayer who does not file jointly, but Dana qualifies for the more favorable head of household status.
• Single is incorrect because Dana was still legally married on December 31 and is only treated as unmarried for head of household purposes.
• Qualifying surviving spouse is incorrect because Dana’s spouse did not die.

Dana is considered unmarried for filing-status purposes because the spouse did not live in the home during the last six months and Dana maintained a home for a qualifying child.

Question 50

Topic: Business Law

Patton Corp. appointed Ellis as its purchasing manager. In its vendor portal, Patton listed Ellis as the contact authorized to place orders, and for a year Patton paid purchase orders Ellis signed for standard inventory. Privately, Patton instructed Ellis not to place any single order over $25,000 without written approval. Ellis signed a $40,000 purchase order with Vega Supply for standard inventory in Patton’s name. Vega had no notice of the private limit. Patton’s draft response to Vega states, “Patton is not liable because Ellis exceeded actual authority; Vega must seek payment from Ellis.” Which revision is the best correction?

• A. State that Patton is not bound unless Patton expressly ratifies the order after Vega demands payment.
• B. State that Patton is bound to Vega and cannot seek any recourse from Ellis because apparent authority makes Ellis’s act fully authorized.
• C. State that Ellis alone is liable because private limits on actual authority automatically defeat apparent authority.
• D. State that Patton is bound to Vega based on Ellis’s apparent authority, but Patton may have a claim against Ellis for violating private instructions.

Best answer: D

What this tests: Business Law

Explanation: A principal may be liable to a third party when the principal’s words or conduct create apparent authority, even if the agent violates private instructions. The undisclosed dollar limit does not defeat Vega’s reasonable reliance on Patton’s vendor portal and prior dealings.

Apparent authority arises from the principal’s manifestations to the third party, not merely from the agent’s statements or the principal’s private instructions. Patton listed Ellis as the authorized purchasing contact and consistently paid orders Ellis signed for standard inventory. Because Vega had no notice of the $25,000 private limit, Vega could reasonably believe Ellis had authority to bind Patton on the $40,000 order. Patton therefore may owe liability to Vega on the contract. Separately, Ellis may have breached duties owed to Patton by exceeding the private purchasing limit, so Patton may have an internal claim against Ellis.

• Requiring express ratification ignores apparent authority that already can bind the principal.
• Treating Ellis as solely liable confuses private actual-authority limits with notice to the third party.
• Saying Patton has no recourse against Ellis overstates the effect of apparent authority; it protects the third party but does not excuse the agent’s breach of instructions.

Patton’s manifestations reasonably led Vega to believe Ellis had authority, while Ellis’s undisclosed violation may create an internal liability to Patton.

Questions 51-72

Question 51

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

An individual taxpayer lives in Illinois. No applicable Treasury regulation or U.S. Supreme Court case addresses a disputed federal income tax issue. The CPA finds the following authorities on materially identical facts:

If the IRS disallows the return position and the taxpayer petitions the U.S. Tax Court, which authority should the CPA treat as controlling?

• A. The Seventh Circuit decision, because an Illinois taxpayer’s Tax Court case would be appealable to that circuit.
• B. The Southern District of New York decision, because any federal district court decision controls federal tax issues nationally.
• C. The Tax Court regular opinion, because Tax Court opinions apply uniformly unless reversed by the U.S. Supreme Court.
• D. The IRS revenue ruling, because published IRS guidance controls unless a court in the taxpayer’s district has ruled otherwise.

Best answer: A

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The Seventh Circuit decision controls because the taxpayer lives in Illinois, and appeal from the Tax Court would go to the Seventh Circuit. When a directly applicable appellate decision conflicts with other lower authority, the Tax Court follows the appellate court for that venue.

In federal tax disputes, authority depends not only on the type of authority but also on jurisdiction. The U.S. Supreme Court controls nationally, and valid Treasury regulations generally carry high authority. When those are absent, a U.S. Court of Appeals decision is controlling for cases appealable to that circuit. Under the Golsen rule, the Tax Court follows the precedent of the Court of Appeals to which the taxpayer’s case would be appealed. Because an individual Illinois taxpayer’s Tax Court appeal would go to the Seventh Circuit, the Seventh Circuit’s taxpayer-favorable holding controls over a conflicting Tax Court opinion, IRS revenue ruling, or out-of-circuit district court decision.

• A Tax Court regular opinion is strong authority, but it does not override controlling precedent from the taxpayer’s appellate circuit.
• An IRS revenue ruling states the IRS’s position, but it is not controlling over a contrary decision from the relevant Court of Appeals.
• A Southern District of New York decision is not binding nationally and is not controlling for an Illinois taxpayer’s Tax Court case.

Under the Golsen rule, the Tax Court follows controlling precedent of the Court of Appeals to which the case is appealable.

Question 52

Topic: Federal Taxation of Entities (Including Tax Preparation)

A CPA is documenting the conclusion that Oak & Pine LLC, a domestic LLC formed under state law, should be classified as a partnership for federal income tax purposes for 2026. Which evidence best supports this conclusion?

• A. The prior-year Form 1065 reports partnership income, but the file does not include current-year ownership records or election records.
• B. The EIN confirmation letter lists the entity as a limited liability company and names one member as the responsible party.
• C. The signed 2026 operating agreement and membership ledger show two members with 70% and 30% interests, and the LLC’s federal tax election file includes no Form 8832 or accepted Form 2553 in effect for 2026.
• D. The state articles of organization identify the entity as a limited liability company and state that members are not personally liable for company debts.

Best answer: C

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

Explanation: The best support shows both decisive facts: the LLC had more than one member and no effective corporate tax election. A domestic multi-member LLC defaults to partnership classification for federal income tax purposes unless it elects otherwise.

For federal tax purposes, a domestic LLC is an eligible entity. Its default classification depends on ownership: a single-member LLC is generally disregarded as separate from its owner, while an LLC with two or more members is treated as a partnership. That default can be changed if the LLC makes an effective entity classification election, generally on Form 8832, or an effective S corporation election on Form 2553. Therefore, the strongest support for partnership classification is documentation showing current-year multi-member ownership and the absence of an effective corporation or S corporation election.

• State LLC formation documents establish legal status and limited liability, not federal tax classification.
• An EIN letter naming a responsible party does not prove the number of members or whether a tax election is in effect.
• A prior-year Form 1065 is consistent with partnership treatment but is incomplete without current-year ownership and election evidence.

A domestic LLC with two or more members is classified as a partnership by default unless it has an effective election to be taxed as a corporation.

Question 53

Topic: Federal Taxation of Entities (Including Tax Preparation)

On December 10, 2025, Willow, Inc., a domestic calendar-year corporation, is preparing Form 2553 to elect S corporation status effective January 1, 2026. The draft ownership schedule for the planned effective date shows:

The preparer marked all shareholders as eligible. What is the best correction before the election becomes effective?

• A. Convert Willow to an LLC because corporations with any LLC owner cannot elect S status.
• B. File the election as drafted because Harbor LLC is eligible if it consents to pass-through tax treatment.
• C. Restructure ownership so Harbor LLC does not own Willow stock on the S election effective date.
• D. Remove Maria Family Trust because trusts can never be S corporation shareholders.

Best answer: C

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

Explanation: The ownership schedule includes one ineligible shareholder: Harbor LLC, which is classified as a partnership for federal tax purposes. An S corporation generally may have U.S. individuals, estates, certain trusts, and certain exempt organizations as shareholders, but not partnerships.

To qualify as an S corporation, a domestic corporation must have only eligible shareholders. Eligible shareholders generally include U.S. citizens or resident individuals, estates, certain trusts such as grantor trusts, and certain tax-exempt organizations. Partnerships and corporations are generally not eligible shareholders. Because Harbor LLC is classified as a partnership, Willow would not be eligible for S status if Harbor LLC owned stock on the effective date. The best correction is to restructure the ownership before January 1 so that the stock is held by an eligible shareholder. The grantor trust is not the problem because it is treated as owned by Maria, a U.S. resident individual.

• A grantor trust treated as wholly owned by an eligible individual may be an eligible S corporation shareholder.
• The issue is not Willow’s corporate form; a domestic corporation is the entity that makes an S election.
• Harbor LLC’s consent does not cure the problem because an LLC classified as a partnership is an ineligible shareholder.

An LLC classified as a partnership is an ineligible S corporation shareholder, so its stock must be transferred to an eligible shareholder before the election is effective.

Question 54

Topic: Federal Taxation of Individuals

Jordan is preparing an individual Form 1040. Jordan owns 100% of Harbor Design LLC, which has not elected corporate tax treatment and is disregarded for federal tax purposes. Jordan also owns a 40% member interest in Lakeview LLC, which is taxed as a partnership. The draft return reports Harbor’s net profit on Schedule C and reports $28,400 from Lakeview on Schedule E as Jordan’s share of ordinary business income. Which source document best supports the $28,400 Schedule E amount?

• A. Lakeview LLC’s internal income statement showing total entity net income of $71,000.
• B. Lakeview LLC’s Schedule K-1 (Form 1065) issued to Jordan showing $28,400 as ordinary business income.
• C. Harbor Design LLC’s profit and loss statement showing net profit from the disregarded LLC.
• D. Lakeview LLC’s cash distribution statement showing Jordan received $28,400 during the year.

Best answer: B

What this tests: Federal Taxation of Individuals

Explanation: The best support is the Schedule K-1 from the LLC taxed as a partnership. It reports the owner’s tax share of ordinary business income to be carried to Schedule E of Form 1040.

A partnership or LLC taxed as a partnership passes tax items through to its owners, and each owner uses Schedule K-1 to report the owner’s share on the individual return. Ordinary business income from a partnership is generally reported on Schedule E, not based merely on cash distributions or the entity’s book income statement. By contrast, a single-member LLC that is disregarded is not reported through Schedule K-1; its business activity is generally reported directly by the owner, such as on Schedule C when appropriate.

• A cash distribution can differ from taxable pass-through income and does not establish ordinary business income.
• An internal entity income statement may help prepare the entity return, but it is not the owner’s tax reporting source.
• The disregarded LLC’s profit and loss statement supports Schedule C reporting, not the partnership Schedule E amount.

A partner or LLC member reports pass-through ordinary business income from the entity using the owner’s Schedule K-1.

Question 55

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

A CPA is reviewing a draft 2025 corporate return file for a non-tax-shelter deduction. The draft concludes that Form 8275 disclosure is required because an IRS revenue ruling disallows the deduction. However, the taxpayer has a published U.S. Court of Appeals decision from the circuit to which its Tax Court case would be appealable, and that decision allows the deduction on materially identical facts. No Code provision, Treasury regulation, or Supreme Court case addresses the issue. Which correction should the CPA make to the file?

• A. Keep the Form 8275 disclosure conclusion because an IRS revenue ruling overrides a circuit court decision unless the Supreme Court has ruled.
• B. Remove the deduction because conflicting authorities automatically mean the position lacks reasonable basis.
• C. Revise the analysis to treat the controlling appellate decision as the strongest support and conclude that it can provide substantial authority for taking the deduction without Form 8275 disclosure.
• D. File Form 8275-R because any position contrary to an IRS revenue ruling is treated as contrary to a Treasury regulation.

Best answer: C

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The strongest support is the published decision from the taxpayer’s controlling Court of Appeals. Because the issue is a non-tax-shelter item and the controlling case supports the return position on materially identical facts, the position can have substantial authority despite an adverse revenue ruling.

For federal tax authority analysis, court decisions generally outrank IRS administrative guidance when determining the strength of support for a return position. A Tax Court case is appealable to a specific U.S. Court of Appeals, and the Tax Court generally follows precedent from that controlling circuit. Here, the favorable published appellate decision is directly on point, and no higher authority such as the Code, a Treasury regulation, or the Supreme Court conflicts with it. A contrary revenue ruling is relevant authority, but it does not override controlling appellate precedent. Therefore, the file should be corrected to rely on the appellate decision as substantial authority rather than treating disclosure as required solely because of the revenue ruling.

• Treating the revenue ruling as overriding the circuit court reverses the authority hierarchy.
• Removing the deduction overstates the consequence of conflicting authorities; the favorable controlling case can still provide substantial authority.
• Form 8275-R is for positions contrary to regulations, not merely contrary to a revenue ruling.

A published decision from the controlling appellate circuit is stronger support than a contrary IRS revenue ruling when no higher authority is on point.

Question 56

Topic: Federal Taxation of Individuals

Riley, an individual taxpayer, owns 25% of an S corporation. For the current year, Riley’s Schedule K-1 reports an $18,000 ordinary business loss. Before considering the loss, Riley has $10,000 of combined stock and direct shareholder-loan basis and is at risk for that amount; Riley made no contributions or distributions during the year. Riley did not materially participate in the S corporation activity and has $4,000 of passive income from an unrelated activity. What is the correct current-year federal income tax treatment of the S corporation loss?

• A. Deduct $10,000 currently; suspend $8,000 under the basis limitation.
• B. Deduct none currently; suspend all $18,000 under the passive activity loss rules.
• C. Deduct $4,000 currently; suspend $6,000 under the passive activity loss rules and $8,000 under the basis limitation.
• D. Deduct $4,000 currently; suspend the remaining $14,000 solely under the passive activity loss rules.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: The S corporation loss is first limited by Riley’s available basis and at-risk amount, so only $10,000 can move to the next limitation. Because Riley did not materially participate, that $10,000 is passive and may offset only $4,000 of passive income currently.

An individual shareholder’s S corporation loss is limited first by stock and direct debt basis, then by at-risk and passive activity rules. Riley has only $10,000 of basis and is at risk for that amount, so $8,000 of the $18,000 K-1 loss is suspended under the basis limitation. The remaining $10,000 is from an activity in which Riley did not materially participate, making it passive. Passive losses generally may offset passive income, but not wages, portfolio income, or active business income. Riley has $4,000 of passive income, so $4,000 of the basis-allowed loss is deductible currently and $6,000 is suspended as a passive activity loss.

• Deducting $10,000 currently ignores that non-material participation makes the basis-allowed loss passive.
• Treating the entire remaining $14,000 as passive ignores the separate basis limitation applied before passive loss rules.
• Suspending all $18,000 as passive ignores Riley’s $4,000 of passive income and the basis limitation ordering.

Only $10,000 is allowed through the basis limitation, and that passive loss is deductible currently only to the extent of Riley’s $4,000 passive income.

Question 57

Topic: Federal Taxation of Entities (Including Tax Preparation)

Maro Corp. is a calendar-year C corporation preparing its current-year Schedule M-1 workpapers. The tax staff identified the following book-tax differences:

Which conclusion is supported by the exhibit?

• A. The municipal bond interest and life insurance premiums are temporary differences because they relate to cash flows that may occur in future years.
• B. The excess tax depreciation is a permanent difference because the current-year tax deduction exceeds book depreciation expense.
• C. The unpaid warranty accrual is a permanent difference because the amount is not deductible on the current-year tax return.
• D. The excess tax depreciation and the unpaid warranty accrual are temporary differences, while the municipal bond interest and life insurance premiums are permanent differences.

Best answer: D

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

Explanation: Temporary differences affect book income and taxable income in different years but reverse over time. Permanent differences affect only book income or taxable income and are not expected to reverse in a later tax year.

A temporary difference is caused by timing: the same income or deduction is recognized for both book and tax purposes, but in different periods. Accelerated tax depreciation is temporary because total depreciation over the asset’s life will be the same. The unpaid warranty accrual is also temporary because the book expense is recognized now, while the tax deduction is allowed later when claims are paid. Municipal bond interest is permanent because it is included in book income but excluded from federal taxable income without future reversal. Key-person life insurance premiums are permanent because the corporation is the beneficiary and the premiums are nondeductible with no future tax deduction expected.

• Treating municipal bond interest or nondeductible premiums as temporary confuses future cash flows with future taxable reversal.
• Treating excess tax depreciation as permanent focuses only on the current-year amount and ignores later reversal.
• Treating the unpaid warranty accrual as permanent overlooks that the tax deduction is deferred until payment, not disallowed forever.

The depreciation and warranty items reverse in future tax years, but the tax-exempt interest and nondeductible insurance premiums do not.

Question 58

Topic: Federal Taxation of Individuals

A CPA is reviewing a draft Form 1040 for a single taxpayer who cannot be claimed as a dependent, is not filing separately, and meets all income limits for the student loan interest deduction.

Support and draft return excerpt:

Which review note correctly characterizes the student loan interest item?

• A. Leave the $1,800 on Schedule A because education-related interest is an itemized deduction.
• B. Remove the $1,800 entirely because interest on personal obligations is never deductible by individuals.
• C. Reclassify the $1,800 from Schedule A to Schedule 1 as an adjustment to income.
• D. Report the $1,800 on both Schedule A and Schedule 1 because it is supported by Form 1098-E.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: The student loan interest deduction is an above-the-line deduction reported as an adjustment to income. Because the taxpayer meets the eligibility requirements, the issue is not lack of support but classification in the wrong place.

Student loan interest paid on a qualified student loan may be deductible by an eligible individual as an adjustment to income on Schedule 1. It is not reported on Schedule A with itemized deductions such as mortgage interest, real estate taxes, or charitable contributions. In this draft return, the Form 1098-E supports the amount, and the stem states the taxpayer meets the filing status, dependency, and income requirements. Therefore, the correct review note is to move the $1,800 from Schedule A to Schedule 1 rather than disallow or duplicate it.

• Treating education-related interest as a Schedule A item confuses it with itemized deductions.
• Reporting the same $1,800 on both schedules would duplicate the deduction.
• Disallowing the amount ignores the specific above-the-line deduction allowed for qualified student loan interest.

Qualified student loan interest is deductible as an adjustment to income, not as an itemized deduction, when eligibility requirements are met.

Question 59

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

A CPA is preparing an individual income tax return. The taxpayer emails, “Report a $65,000 loss from my cousin’s partnership; the Schedule K-1 is not available yet, but I invested cash late in the year.” The prior-year return and the current-year organizer show no partnership interest, and the claimed loss would eliminate the taxpayer’s taxable income. The CPA does not ask for the K-1, ownership details, basis, at-risk amount, or passive activity information and files the return with the loss. Under IRS practice standards, how should the CPA’s conduct be characterized?

• A. Permissible reliance on client-provided information because practitioners are not required to audit or verify every taxpayer statement
• B. Acceptable written tax advice because the CPA relied on the taxpayer’s stated facts and assumptions
• C. Competent representation because reporting a partnership loss is a routine individual return preparation matter
• D. A failure to exercise due diligence because the information was incomplete or inconsistent and required reasonable inquiry before reporting the loss

Best answer: D

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The CPA’s conduct is best classified as a due diligence failure. IRS practice standards allow reliance on client information in good faith, but not when the facts supplied appear incomplete, inconsistent, or questionable without reasonable follow-up.

A practitioner preparing a return must exercise due diligence as to the accuracy of the return and related representations. The practitioner does not have to audit the client’s statements, but cannot ignore implications of information furnished or facts already known. Here, a large partnership loss is claimed without a K-1 or supporting ownership, basis, at-risk, or passive activity information, and the taxpayer’s records do not otherwise show a partnership interest. Those facts make simple reliance unreasonable. The CPA should make reasonable inquiries and obtain sufficient information before reporting the loss or advise the taxpayer that the position cannot be reported as presented.

• General reliance on client information is allowed only when reliance is reasonable under the facts.
• Competence is not the best classification because the issue is not merely whether the CPA can prepare an individual return; it is the failure to follow up on questionable information.
• Written advice standards do not excuse filing a return position based on incomplete facts and unsupported assumptions.

A practitioner may generally rely on client information, but must make reasonable inquiries when the information appears incomplete, inconsistent, or questionable.

Question 60

Topic: Ethics, Professional Responsibilities and Federal Tax Procedures

A CPA prepared Falcon Inc.’s federal income tax return. The engagement file includes the following excerpt:

Which conclusion is best supported under common-law liability principles?

• A. The CPA can have common-law liability only if the IRS first assesses a tax return preparer penalty.
• B. The CPA has no potential liability to Ridge unless Ridge signed the tax return engagement letter.
• C. The CPA’s no-audit engagement language eliminates any duty to exercise reasonable care in preparing the return.
• D. The CPA may face negligence liability to Falcon and negligent misrepresentation liability to Ridge because Ridge was an identified user for a specific transaction.

Best answer: D

What this tests: Ethics, Professional Responsibilities and Federal Tax Procedures

Explanation: The CPA owed Falcon a common-law duty to perform the tax preparation engagement with reasonable care. Ridge also was specifically identified before completion, and the CPA agreed to send the return for Ridge’s loan decision, supporting potential third-party negligent misrepresentation liability.

Common-law liability in a CPA tax engagement is separate from IRS penalty rules. A CPA generally may be liable to the client for ordinary negligence if the CPA fails to use reasonable professional care and the client is damaged. Liability to nonclients for ordinary negligence is narrower, but it can arise when the nonclient is a known or intended user and the CPA knows the specific transaction in which the work will be used. Here, Ridge was not merely a remote foreseeable user; Falcon identified Ridge and the equipment loan before completion, and the CPA agreed to send the return directly for that purpose. The no-audit language limits the scope of assurance but does not excuse an obvious preparation error.

• Requiring Ridge to sign the engagement letter overstates the privity requirement when the third party is specifically known and intended to rely on the work.
• A no-audit clause does not waive the CPA’s basic duty of reasonable care in tax return preparation.
• IRS preparer penalties are not a prerequisite to a civil common-law claim by a client or qualifying third party.

A CPA may owe due care to the client and may owe a duty to a specifically known third party expected to rely on the CPA’s work for a particular transaction.

Question 61

Topic: Federal Taxation of Property Transactions

Moore operates a calendar-year sole proprietorship. In Year 1, Moore placed $95,000 of qualifying business equipment in service and elected to expense the full cost under Section 179. Before any Section 179 deduction or depreciation, Moore had $62,000 of taxable income from the active business. Assume the annual Section 179 dollar limit is not exceeded, no special depreciation allowance is available, and regular MACRS depreciation is ignored. What amount should Moore deduct under Section 179 for Year 1?

• A. $0, because Section 179 cannot be elected when the full election would create a business loss
• B. $33,000, because only the amount exceeding active business income is deductible currently
• C. $95,000, because Moore elected to expense the full equipment cost
• D. $62,000, with the $33,000 excess carried forward

Best answer: D

What this tests: Federal Taxation of Property Transactions

Explanation: Moore may elect Section 179 for qualifying equipment, but the current deduction cannot exceed taxable income from the active business. Because the active business income is $62,000, only $62,000 is deductible in Year 1 and the remaining $33,000 is carried forward.

Section 179 allows a taxpayer to expense the cost of qualifying business property, subject to limitations. One key limitation is that the Section 179 deduction cannot create or increase a loss from the taxpayer’s active trade or business. Here, Moore elected to expense $95,000, but taxable income from the active business before Section 179 and depreciation is only $62,000. Therefore, the current-year Section 179 deduction is limited to $62,000. The unused $33,000 elected amount is not lost; it is carried forward and may be deductible in a later year, subject to the applicable limits in that year.

• Deducting the full $95,000 ignores the active business taxable income limitation.
• Deducting only $33,000 reverses the limitation; the deductible amount is the income-supported portion, not the excess.
• Claiming $0 is too restrictive because Section 179 can still be used up to the amount that does not create a loss.

Section 179 expense is limited to taxable income from the active trade or business, and the disallowed elected amount is carried forward.

Question 62

Topic: Federal Taxation of Entities (Including Tax Preparation)

A calendar-year S corporation earns $18,000 of interest on municipal bonds held as an investment. The interest is tax-exempt for federal income tax purposes. The corporation has no distributions during the year and maintains an accumulated adjustments account (AAA). How should the municipal bond interest be characterized for S corporation and shareholder reporting?

• A. Separately stated tax-exempt income that passes through to shareholders, increases shareholder stock basis, and does not increase AAA.
• B. Ordinary business income included in the S corporation’s nonseparately computed income and increasing AAA.
• C. An item omitted from Schedule K/K-1 and from shareholder basis because it is tax-exempt.
• D. Separately stated taxable portfolio interest that increases shareholder gross income and increases AAA.

Best answer: A

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

Explanation: Tax-exempt municipal bond interest is not part of S corporation ordinary business income. It is separately stated because shareholders need the information to exclude the income and adjust stock basis, but it does not increase AAA.

S corporation items that may affect shareholders differently must be separately stated and retain their character when passed through. Federal tax-exempt municipal bond interest is reported separately on Schedule K and K-1, not included in nonseparately computed ordinary income. At the shareholder level, the income is excluded from gross income but increases the shareholder’s stock basis because it represents economic income previously taxed or tax-exempt at the owner level. However, AAA generally tracks taxable S corporation income and deductible losses; tax-exempt income does not increase AAA. The item may be tracked outside AAA, but it is not ignored for K-1 or basis purposes.

• Treating the interest as ordinary business income incorrectly includes tax-exempt investment income in nonseparately computed income and AAA.
• Treating it as taxable portfolio interest incorrectly makes shareholders include federally tax-exempt income in gross income.
• Omitting it entirely overlooks that tax-exempt income still passes through and affects shareholder stock basis.

Tax-exempt interest is separately stated on Schedule K/K-1, increases shareholder stock basis, and is excluded from AAA.

Question 63

Topic: Federal Taxation of Individuals

A taxpayer received an IRS matching notice for an investment sale omitted from the taxpayer’s Form 1040. Which next action is best supported by the exhibit?

• A. Respond to the notice with a corrected Form 8949 and Schedule D reporting $42,000 proceeds, $40,000 basis, and a $2,000 long-term capital gain.
• B. Amend the return to report a $34,000 short-term capital gain using the aunt’s $8,000 cost basis.
• C. Take no action because inherited property receives a stepped-up basis and therefore the sale is not reportable.
• D. Pay the notice because the IRS may treat the entire $42,000 proceeds as taxable gain when the broker did not report basis.

Best answer: A

What this tests: Federal Taxation of Individuals

Explanation: The diagnostic mismatch arose because gross proceeds were reported to the IRS but the taxpayer omitted the sale. The correct resolution is to report the sale with inherited-property basis equal to the date-of-death fair market value and long-term holding period treatment.

For property acquired from a decedent, the beneficiary’s basis is generally the property’s fair market value at the date of death unless a valid alternate valuation applies. The decedent’s original cost does not carry over. Also, inherited capital assets are treated as held long-term by the beneficiary, regardless of how soon after inheritance the asset is sold. Here, the taxpayer should not ignore the notice, because the Form 1099-B proceeds created an IRS matching discrepancy. The taxpayer should respond with documentation and report $42,000 of proceeds, $40,000 of basis, and a $2,000 long-term capital gain.

• Treating the full $42,000 as taxable gain ignores the taxpayer’s basis, even though the broker did not report it.
• Using the aunt’s $8,000 cost basis incorrectly applies carryover basis instead of inherited-property basis.
• Ignoring the sale is incorrect because proceeds reported on Form 1099-B still must be reconciled on the return.

Inherited property generally takes a date-of-death fair market value basis and is treated as long-term, so only the $2,000 post-inheritance appreciation is reportable gain.

Question 64

Topic: Federal Taxation of Individuals

Rae, a sole proprietor, has positive net Schedule C income that exceeds Rae’s health insurance premiums. Rae was covered all year by an HSA-eligible high-deductible health plan, was not eligible for employer-subsidized health coverage, was not covered by an employer retirement plan, and all contribution dollar limits are met. During the year, Rae made a traditional IRA contribution, made an HSA contribution, paid health insurance premiums for Rae’s own coverage, and owed self-employment tax on the Schedule C income. Which treatment is correct in arriving at adjusted gross income?

• A. Report only the HSA contribution and self-employed health insurance premiums as adjustments to income, and treat the traditional IRA contribution as an itemized deduction.
• B. Report all four amounts as itemized deductions because they are personal payments rather than direct business expenses.
• C. Report the traditional IRA contribution, HSA contribution, self-employed health insurance premiums, and the deductible part of self-employment tax as adjustments to income.
• D. Report the traditional IRA and HSA contributions as adjustments to income, but deduct the health insurance premiums and full self-employment tax only on Schedule C.

Best answer: C

What this tests: Federal Taxation of Individuals

Explanation: Qualified traditional IRA contributions and HSA contributions are adjustments to income when eligibility and limits are satisfied. A qualifying self-employed taxpayer may also deduct self-employed health insurance premiums and the deductible portion of self-employment tax in arriving at AGI.

Adjustments to income are above-the-line deductions that reduce gross income in computing adjusted gross income. For an eligible taxpayer, deductible traditional IRA contributions and HSA contributions are reported as adjustments rather than itemized deductions. A self-employed taxpayer may also deduct qualifying self-employed health insurance premiums for AGI, limited by earned income from the business and subject to the rule denying the deduction when eligible for employer-subsidized coverage. The deductible part of self-employment tax is also an adjustment to income. These items are not deducted as Schedule C business expenses, although Schedule C income helps determine eligibility and limitations.

• Treating the traditional IRA contribution as itemized is incorrect because an eligible deductible IRA contribution is an adjustment to income.
• Putting health insurance premiums and the full self-employment tax on Schedule C is incorrect; only the deductible part of self-employment tax is an AGI adjustment, and qualifying self-employed health insurance is also reported as an adjustment.
• Classifying all items as itemized deductions ignores the above-the-line treatment specifically allowed for these contributions and self-employment-related deductions.

Each listed item qualifies as a deduction for AGI when the stated eligibility and limitation requirements are met.

Question 65

Topic: Federal Taxation of Individuals

Chen, a single taxpayer, prepared a draft return showing taxable income of $58,000. The draft return computed regular income tax by multiplying all taxable income by the 22% marginal rate and reported a $2,560 balance due.

The following facts are not in dispute:

No other taxes, credits, payments, penalties, or NIIT apply. What is the best correction to the draft return?

• A. Use tax of $7,813 before credits, omit the credit because payments exceed tax, and report a $1,187 overpayment.
• B. Use tax of $12,760 before credits, total tax of $11,560 after the credit, and keep the $2,560 balance due.
• C. Use tax of $7,813 before credits, treat the credit as both a tax reduction and a tax payment, and report a $3,587 overpayment.
• D. Use tax of $7,813 before credits, total tax of $6,613 after the credit, and report a $2,387 overpayment.

Best answer: D

What this tests: Federal Taxation of Individuals

Explanation: The draft return incorrectly applied the 22% marginal rate to all taxable income. The tax schedule gives tax before credits of $7,813, which is reduced by the $1,200 nonrefundable credit to $6,613; total payments of $9,000 create a $2,387 overpayment.

A tax rate schedule includes a base tax amount for income taxed in lower brackets, so only the excess over the bracket threshold is taxed at the stated marginal rate. Chen’s tax before credits is $5,426 + [22% × ($58,000 − $47,150)] = $7,813. The allowable nonrefundable credit reduces tax to $6,613 because the credit does not exceed the tax before credits. Withholding and estimated tax payments are then applied against total tax. Chen’s total payments are $8,000 + $1,000 = $9,000, so the corrected return should show an overpayment of $9,000 − $6,613 = $2,387.

• Applying 22% to all taxable income ignores the schedule’s base amount and overstates tax.
• Omitting the credit because payments exceed tax confuses credits with withholding; the nonrefundable credit is limited by tax before payments.
• Treating the same credit as both a tax reduction and a payment double-counts the credit.

The correct tax is computed using the schedule base amount plus the marginal tax on only the excess, then reduced by the credit and compared with payments.

Question 66

Topic: Business Law

Arbor Manufacturing’s written purchasing policy states that only its CFO may sign supply contracts. Mira, an operations employee, signed a $40,000 supply contract with West Supply. Arbor refuses to perform, asserting that Mira lacked authority. West argues that Mira had apparent authority to bind Arbor. Which evidence best supports West’s conclusion?

• A. Arbor’s internal purchasing policy identified the CFO as the only authorized contract signer.
• B. Before the contract was signed, Arbor’s CFO emailed West that Mira would handle pricing and approve purchase orders, and Arbor had paid two earlier West invoices on orders Mira approved.
• C. Mira told West’s sales representative that she had authority to sign supply contracts for Arbor.
• D. Mira’s supervisor privately told Mira that she could order supplies when production deadlines were tight.

Best answer: B

What this tests: Business Law

Explanation: The strongest evidence is Arbor’s own communication and prior conduct directed to West. Apparent authority arises from the principal’s words, conduct, or prior dealings that reasonably lead the third party to believe the agent is authorized.

Actual authority depends on communications from the principal to the agent, such as express instructions or implied authority from the agent’s role. Apparent authority depends on manifestations from the principal to the third party. Here, an email from Arbor’s CFO to West, combined with Arbor’s prior payment of orders Mira approved, is evidence that Arbor caused West to reasonably believe Mira could approve purchase orders. Mira’s own statement is not enough by itself because apparent authority cannot be created solely by the agent’s representations.

• Mira’s own statement is weak because an agent cannot create apparent authority merely by claiming authority.
• A private instruction to Mira would relate to actual authority, not West’s reliance on Arbor’s manifestations.
• Arbor’s internal policy supports Arbor’s denial of authority and does not show a manifestation to West.

Apparent authority is based on the principal’s manifestations to the third party and the third party’s reasonable reliance on those manifestations.

Question 67

Topic: Business Law

On March 1, Arc Equipment contracted to deliver to a museum a specific 1920 letterpress identified in the contract by serial number LP-418 on May 1. The contract contains no force majeure clause, and Arc had not delivered or tendered the press. Arc asserts that its duty to deliver was discharged by objective impossibility. Which file item best supports Arc’s conclusion?

• A. An email from the museum dated April 25 stating that the exhibit for which the press was intended was canceled.
• B. A supplier quote dated April 20 showing that Arc could acquire a similar 1920 press only at twice the expected cost.
• C. A carrier letter dated April 30 stating that a labor shortage delayed pickups from Arc’s warehouse for two weeks.
• D. A fire marshal’s report dated April 12 stating that press LP-418 was destroyed in an accidental warehouse fire not caused by Arc.

Best answer: D

What this tests: Business Law

Explanation: Objective impossibility requires evidence that performance cannot be done, not merely that it became more expensive or inconvenient. Because the contract required a specific identified press, proof that that exact press was accidentally destroyed before delivery directly supports discharge.

A contractual duty may be discharged when performance becomes objectively impossible after contract formation and without the obligor’s fault. Destruction of the specific subject matter of the contract is a classic example. Here, Arc promised to deliver press LP-418, not any substitute press. A fire marshal’s report showing that LP-418 was accidentally destroyed before delivery is the strongest support for Arc’s position that delivery became impossible.

• A higher replacement cost suggests increased burden, not objective impossibility of delivering the identified press.
• The museum’s canceled exhibit may relate to the buyer’s purpose, but it does not prove Arc could not perform.
• A temporary pickup delay may support delay or inconvenience, but not discharge of the duty to deliver the specific press.

Destruction of the specifically identified subject matter without Arc’s fault before delivery best supports discharge by objective impossibility.

Question 68

Topic: Federal Taxation of Individuals

Marla is unmarried and paid more than half the cost of maintaining her home for the year. Her sister’s 15-year-old son, Alex, lived in Marla’s home from February 1 through December 31, did not provide more than half of his own support, and did not file a joint return. Marla’s preparer concluded that Alex is a dependent qualifying child who supports Marla’s head of household filing status. Which record would best support that conclusion?

• A. Marla’s lease and utility bills showing that she paid household expenses throughout the year.
• B. A text message from Alex stating that he considers Marla to be his guardian.
• C. Alex’s Form W-2 showing no federal income tax withheld for the year.
• D. Birth certificates showing Alex is the son of Marla’s sister, plus school records showing Alex’s address as Marla’s home from February through December.

Best answer: D

What this tests: Federal Taxation of Individuals

Explanation: A nephew can meet the qualifying child relationship test because he is a descendant of the taxpayer’s sibling. The best support also documents that the child lived with the taxpayer for more than half the year, which is critical for head of household filing status.

For head of household status, an unmarried taxpayer generally must pay more than half the cost of maintaining a home for a qualifying person. A qualifying child relationship includes a child, sibling, stepsibling, or a descendant of any of them, so a sister’s son may qualify. The facts already state Alex is age 15, did not provide more than half of his own support, and did not file a joint return. The strongest record therefore supports the remaining key elements: legal family relationship and residency for more than half the year. Birth certificates establish the nephew relationship, and school records with Marla’s address during the year support Alex’s residency.

• Household bills support Marla’s cost-of-home requirement, but they do not prove Alex’s dependent relationship or residency.
• A Form W-2 with no withholding does not establish Alex’s relationship, residency, or support status.
• A text message about guardianship is informal and does not establish a qualifying legal or family relationship for dependency rules.

These records support both the qualifying child relationship and the more-than-half-year residency required for head of household status.

Question 69

Topic: Federal Taxation of Entities (Including Tax Preparation)

On July 1, Year 1, Quinn had an adjusted basis of $78,000 in Quinn’s partnership interest immediately before a proportionate, nonliquidating distribution. That basis includes Quinn’s share of partnership liabilities immediately before the distribution. Quinn received $22,000 cash and land with a partnership adjusted basis of $34,000 and a fair market value of $49,000. As a result of the distribution, Quinn’s share of partnership liabilities decreased by $12,000. Assume there are no marketable securities, no disguised sale, and no Section 751 ordinary income. What are Quinn’s recognized gain or loss and adjusted basis in the partnership interest immediately after the distribution?

• A. No recognized gain or loss; adjusted basis of $22,000.
• B. $15,000 recognized gain; adjusted basis of $10,000.
• C. No recognized gain or loss; adjusted basis of $0.
• D. No recognized gain or loss; adjusted basis of $10,000.

Best answer: D

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

Explanation: A partner generally recognizes gain on a current partnership distribution only to the extent money distributed exceeds the partner’s outside basis. A decrease in the partner’s share of partnership liabilities is treated as money distributed. Here, total money is $34,000, leaving enough basis to absorb the land’s $34,000 adjusted basis.

For a nonliquidating partnership distribution, the partner first reduces outside basis by money received, including any decrease in the partner’s share of partnership liabilities. Quinn’s money distribution is $22,000 cash plus the $12,000 liability decrease, or $34,000. Because $34,000 does not exceed Quinn’s $78,000 outside basis, Quinn recognizes no gain. Quinn’s remaining outside basis is $44,000 before considering the land. In a current distribution, the land takes a carryover basis limited to the partner’s remaining outside basis; therefore, the land’s basis is $34,000. Quinn’s partnership interest basis after the distribution is $44,000 minus $34,000, or $10,000.

• Ignoring the $12,000 liability decrease overstates Quinn’s remaining partnership basis.
• Using the land’s $49,000 fair market value instead of its $34,000 adjusted basis improperly reduces outside basis.
• Recognizing the land’s $15,000 built-in appreciation is incorrect because property appreciation generally is not recognized in a proportionate current distribution.

The $34,000 money distribution does not exceed Quinn’s $78,000 outside basis, and the remaining basis is reduced by the land’s $34,000 carryover basis.

Question 70

Topic: Federal Taxation of Entities (Including Tax Preparation)

During review of a calendar-year C corporation’s Form 1120, the tax manager found that the return claimed a $40,000 foreign tax credit equal to the foreign income taxes paid. The return otherwise used the correct taxable income and rate.

Facts:

• Taxable income before credits: $600,000
• Foreign-source taxable income included above: $150,000
• U.S. corporate tax rate: 21%
• Foreign income taxes paid and otherwise creditable before limitation: $40,000
• No other credits, estimated payments, or carryovers apply
• Foreign tax credit limitation: precredit U.S. income tax × foreign-source taxable income ÷ total taxable income

What is the best correction?

• A. Compute the allowable credit as 21% of the foreign income taxes paid, or $8,400.
• B. Allow the $40,000 credit because all foreign income taxes paid are creditable in the year paid.
• C. Reduce the foreign tax credit to $31,500 and increase the reported tax liability by $8,500.
• D. Disallow the full $40,000 credit and report tax liability of $126,000.

Best answer: C

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

Explanation: The claimed credit must be limited using the foreign tax credit limitation formula provided in the stem. The corporation may claim only $31,500 currently, so the previously claimed $40,000 credit is overstated by $8,500.

A C corporation first computes its precredit regular tax using the corporate tax rate. Here, $600,000 of taxable income at 21% produces $126,000 of precredit U.S. tax. The foreign tax credit cannot exceed the portion of U.S. tax attributable to foreign-source taxable income: $126,000 × $150,000 ÷ $600,000 = $31,500. Because the return claimed $40,000, the credit is overstated by $8,500. The correction is to reduce the credit to $31,500 and increase the reported tax liability by $8,500.

• Allowing the full $40,000 ignores the stated foreign tax credit limitation.
• Disallowing the full credit overstates the correction because $31,500 is allowable.
• Applying the 21% tax rate to foreign taxes paid uses the wrong base; the limitation is based on precredit U.S. tax and foreign-source taxable income.

Precredit U.S. tax is $126,000, and the foreign tax credit is limited to $126,000 × $150,000 ÷ $600,000, or $31,500.

Question 71

Topic: Federal Taxation of Property Transactions

A CPA is preparing the current-year federal return for a calendar-year retail business. The business purchased equipment for $96,000 and placed it in service on September 10. The equipment is 5-year tangible MACRS (GDS) property depreciated under the 200% declining-balance method, and the mid-quarter convention applies. No Section 179 expense or bonus depreciation is claimed. What is the first-year MACRS depreciation deduction for the equipment?

• A. $38,400
• B. $19,200
• C. $14,400
• D. $7,200

Best answer: C

What this tests: Federal Taxation of Property Transactions

Explanation: The equipment is 5-year MACRS property using the 200% declining-balance method, so the annual rate is 40%. Because the mid-quarter convention applies and the asset was placed in service in the third quarter, only 4.5 months of depreciation is allowed in the first year.

For 5-year MACRS property depreciated under the 200% declining-balance method, the first-year full annual depreciation rate is 2 ÷ 5, or 40%. The mid-quarter convention treats property placed in service during a quarter as placed in service at the midpoint of that quarter. Equipment placed in service on September 10 is third-quarter property, so it is treated as placed in service halfway through the third quarter, leaving 4.5 months of depreciation for the year. The deduction is $96,000 × 40% × 4.5/12 = $14,400. Section 179 and bonus depreciation are ignored because the facts state neither is claimed.

• $7,200 uses a straight-line approach rather than the required 200% declining-balance MACRS method.
• $19,200 applies the half-year convention instead of the stated mid-quarter convention.
• $38,400 takes a full year of 200% declining-balance depreciation and ignores the first-year convention.

The 5-year 200% declining-balance annual rate is 40%, and the mid-quarter convention for third-quarter property allows 4.5 months, or 37.5%, of that annual amount.

Question 72

Topic: Federal Taxation of Individuals

A CPA is reviewing Taylor’s 2026 Form 1040. Draft Schedule D reports the following transaction as a short-term capital gain because Taylor sold the shares less than one year after inheriting them. The shares were a capital asset held for investment, and there were no selling expenses.

What is the best correction?

• A. Leave the $2,000 gain as a short-term capital gain.
• B. Report the gain as long-term only if the decedent’s holding period exceeded one year.
• C. Attach a disclosure statement and leave the gain as short-term because the sale occurred within one year of inheritance.
• D. Reclassify the $2,000 gain as a long-term capital gain.

Best answer: D

What this tests: Federal Taxation of Individuals

Explanation: The draft return classified the gain using Taylor’s actual holding period, which is not the correct rule for inherited capital assets. A gain or loss from inherited capital property is treated as long-term, even when sold shortly after death.

For individual capital gain classification, most assets are short-term if held one year or less and long-term if held more than one year. However, inherited capital assets have a special holding-period rule: the recipient is treated as having held the asset for more than one year. Here, Taylor inherited investment shares on February 10, 2026, and sold them on June 1, 2026, for a $2,000 gain using the stated date-of-death basis. Even though the actual period after inheritance was less than one year, the gain should be reported as long-term on Schedule D.

• Leaving the gain as short-term incorrectly applies the normal one-year holding-period test to inherited property.
• Requiring the decedent to have held the shares more than one year confuses inherited property rules with holding-period tacking concepts.
• Disclosure is not the remedy when the classification is known; the return should report the gain correctly as long-term.

Inherited capital assets are treated as held long-term regardless of the heir’s actual holding period or the decedent’s holding period.

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Focused topic pages

• CPA REG: Ethics and Federal Tax Procedures
• CPA REG: Business Law
• CPA REG: Federal Taxation of Property Transactions
• CPA REG: Federal Taxation of Individuals
• CPA REG: Entity Taxation and Tax Preparation

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