CPA TCP: Entity Tax Compliance

CPA means Certified Public Accountant. TCP means Tax Compliance and Planning. Use this focused page when your CPA TCP misses are about entity returns, taxable income, basis, distributions, owner-level effects, or loss limitations. Drill this topic before returning to mixed practice.

Topic snapshot

What this topic tests

This topic tests entity return treatment and the owner-level consequences that follow from entity activity. Strong answers identify the entity type, tax year, taxable income item, separately stated item, basis effect, distribution, and limitation before choosing a result.

Common traps

• mixing partnership, S corporation, and C corporation compliance rules
• computing entity income but missing basis or loss-limit effects at the owner level
• treating distributions as automatically taxable without checking ordering and basis
• overlooking filing, election, or tax-preparation facts that change the compliance answer

How to reason through these questions

Start with the entity type. Then decide whether the question asks for entity-level taxable income, an owner-level item, a basis change, a distribution result, or a filing consequence. The best answer follows that level all the way through.

Sample questions

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

Question 1

Topic: Entity Tax Compliance

Maple Corp, a C corporation, makes a nonliquidating distribution of land to its sole shareholder, Dana. Immediately before the distribution, Maple has current earnings and profits of $20,000 and no accumulated earnings and profits. Dana’s stock basis is $15,000. The land has an adjusted basis to Maple of $10,000, a fair market value of $40,000, and no attached liability. Ignore corporate income tax on any recognized gain.

Which characterization is correct?

• A. Maple recognizes no gain; Dana has $20,000 of dividend income and $20,000 of return of capital; Dana’s basis in the land is $10,000.
• B. Maple recognizes no gain; Dana has $40,000 of capital gain; Dana’s basis in the land is $40,000.
• C. Maple recognizes a $30,000 gain; Dana has $40,000 of dividend income; Dana’s basis in the land is $40,000.
• D. Maple recognizes a $30,000 gain; Dana has $20,000 of dividend income and $20,000 of capital gain; Dana’s basis in the land is $15,000.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: A C corporation generally recognizes gain when it distributes appreciated property as if it sold the property for fair market value. Here, that $30,000 gain increases Maple’s earnings and profits enough to make the full $40,000 distribution a dividend, and Dana’s basis in the land is its $40,000 fair market value.

In a nonliquidating C corporation distribution of appreciated property, the corporation recognizes gain equal to the property’s fair market value minus its adjusted basis. That recognized gain increases earnings and profits, assuming taxes are ignored as stated. The shareholder treats the distribution as a dividend to the extent of current and accumulated earnings and profits, then as return of capital reducing stock basis, and only then as capital gain. The shareholder’s basis in property received is generally its fair market value on the distribution date.

Here, Maple distributes land worth $40,000 with a $10,000 basis, so Maple recognizes $30,000 of gain. Maple’s current earnings and profits become $50,000 ($20,000 existing + $30,000 gain), which is enough to cover the full $40,000 distribution. Therefore, Dana has $40,000 of dividend income, no return of capital, no capital gain, and a $40,000 basis in the land. Dana’s stock basis is unchanged because there is no return of capital.

• Treating only $20,000 as a dividend ignores that Maple’s recognized gain on the appreciated land increases earnings and profits before testing the distribution.
• Using a $10,000 carryover basis or Dana’s $15,000 stock basis for the land is wrong; property received in this C corporation distribution takes a fair market value basis.
• Treating the distribution as capital gain is premature because capital gain arises only after earnings and profits are exhausted and stock basis is fully reduced.

A C corporation recognizes gain on an appreciated property distribution, that gain increases earnings and profits here to $50,000, and the shareholder takes the distributed property at fair market value.

Question 2

Topic: Entity Tax Compliance

Alex and Bailey form AB Partnership. No gain is recognized on formation, and there are no other assets or liabilities.

Assume the debt on the contributed land is nonrecourse and, for this question, is allocated solely by the 50/50 profit-sharing ratio.

Based on the exhibit, what conclusion is supported about Alex’s initial basis in AB Partnership immediately after formation?

• A. Alex’s initial outside basis is $70,000.
• B. Alex’s initial outside basis is $40,000.
• C. Alex’s initial outside basis is $55,000.
• D. Alex’s initial outside basis is $95,000.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: A partner’s initial outside basis from a property contribution starts with the property’s adjusted basis, not its fair market value. Alex’s basis is reduced for the partnership’s assumption of his debt and then increased for his post-contribution share of that partnership liability, resulting in $55,000.

When a partner contributes noncash property to a partnership, the partner’s initial outside basis generally begins with the adjusted basis of the contributed property. If the partnership assumes debt on that property, the contributing partner is treated as receiving a deemed cash distribution for the liability relief, which decreases outside basis. The partner then adds back the partner’s share of partnership liabilities after the contribution. Here, Alex contributes land with a $70,000 adjusted basis. The partnership assumes $30,000 of debt, decreasing Alex’s basis by $30,000. Because that nonrecourse debt is allocated 50/50, Alex is allocated $15,000 of partnership liability, which increases his outside basis. So Alex’s initial outside basis is $70,000 - $30,000 + $15,000 = $55,000. The land’s $110,000 fair market value does not determine initial outside basis in this fact pattern.

• $40,000 subtracts the full assumed debt from adjusted basis but ignores Alex’s $15,000 share of partnership liabilities after formation.
• $70,000 uses the contributed land’s adjusted basis but ignores both the debt relief decrease and the liability allocation increase.
• $95,000 improperly uses the land’s fair market value rather than Alex’s adjusted basis for outside basis purposes.

Alex starts with the land’s $70,000 adjusted basis, decreases it by the $30,000 debt relief, and then increases it by his $15,000 share of the partnership liability.

Question 3

Topic: Entity Tax Compliance

Harbor View LLC is taxed as a partnership and has two equal partners, Diaz and Chen. During 2025, Diaz performed all day-to-day management services and received $12,000 at the end of each month. The cash disbursements journal labels the payments “manager compensation,” and the bookkeeper recorded them as an expense. The current workpapers do not include the partnership agreement language describing when Diaz is entitled to those payments.

Before finalizing Diaz’s Schedule K-1, what should the CPA do next?

• A. Review the partnership agreement or other source documents to determine whether Diaz is entitled to the payments without regard to partnership income.
• B. Treat the payments as part of Diaz’s 50% distributive share and complete the K-1 without further review.
• C. Classify the payments as guaranteed payments because they were paid monthly and recorded as compensation expense.
• D. Issue Diaz a Form W-2 because the payments were made for management services.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: The next step is to review the source data showing whether Diaz is entitled to the payments regardless of partnership income. That fact determines whether the amounts are service-related guaranteed payments or simply part of Diaz’s distributive share.

For a partner providing services, the critical classification question is whether the payment is determined without regard to partnership income. If the payment is fixed or otherwise payable even when the partnership has little or no income, it is generally treated as a guaranteed payment for services. If the amount depends on partnership profits, it is generally part of the partner’s distributive share instead. Book labels such as “manager compensation” and monthly payment patterns may suggest one result, but they do not control the tax treatment. The CPA should first inspect the partnership agreement or related source documents for the compensation formula before finalizing the partner’s K-1.

• Reviewing the agreement for whether the payment is due regardless of income is the required next step because that fact drives the tax classification.
• Monthly payments and expense treatment on the books are not enough by themselves to conclude the amounts are guaranteed payments.
• A partner is generally not treated as a wage employee of the partnership merely because the partner performs management services, so W-2 treatment is not the right next step.
• Using the 50% ownership split immediately skips the needed review of whether the payment is actually tied to profits or is fixed for services.

Whether the payment is due regardless of partnership income is the key fact that distinguishes a service-related guaranteed payment from a distributive share of partnership profits.

Question 4

Topic: Entity Tax Compliance

Avery and Blake form AB Partnership. Avery contributes land with an adjusted basis of $90,000 and a fair market value of $150,000. The land is subject to a $30,000 recourse note. The partnership assumes the note, the lender releases Avery, and after formation Avery and Blake each bear 50% of the economic risk of loss for the debt. Blake contributes $150,000 cash. No gain is recognized on formation.

What is Avery’s initial outside basis in the partnership interest immediately after the contribution?

• A. $90,000 initial outside basis
• B. $60,000 initial outside basis
• C. $105,000 initial outside basis
• D. $75,000 initial outside basis

Best answer: D

What this tests: Entity Tax Compliance

Explanation: Avery begins with the land’s $90,000 adjusted basis. The partnership’s assumption of the $30,000 debt reduces basis, but Avery gets a $15,000 increase for the 50% share of that liability allocated back after formation, so outside basis is $75,000.

When a partner contributes property to a partnership, outside basis generally starts with the adjusted basis of the property contributed, not its fair market value. If the partnership assumes debt on the contributed property, the contributing partner is treated as receiving a cash distribution for the liability relief. The partner then increases outside basis by any share of partnership liabilities allocated back after the contribution. Here, Avery contributes land with a $90,000 adjusted basis, is relieved of $30,000 of recourse debt, and is allocated $15,000 of that debt because Avery bears 50% of the economic risk of loss after formation. Therefore, Avery’s outside basis is $90,000 - $30,000 + $15,000 = $75,000.

• The $90,000 amount uses only the land’s adjusted basis and ignores the debt shift.
• The $60,000 amount subtracts the full assumed debt but fails to add Avery’s 50% share of partnership liabilities.
• The $105,000 amount adds Avery’s allocated liability share without first reducing basis for the liability relief from the partnership’s assumption.

Outside basis starts with the land’s $90,000 adjusted basis, decreases by the $30,000 liability assumed, and increases by Avery’s $15,000 share of partnership liabilities, yielding $75,000.

Question 5

Topic: Entity Tax Compliance

RST Partnership is owned equally by Ana, Ben, and Cara. RST has no liabilities and no unrealized receivables or inventory items. Ana sells her entire one-third partnership interest directly to Diego for $240,000 cash. RST continues to own the same assets, makes no distributions, sells no assets, and has not made a Sec. 754 election. Which is the best characterization of the federal income tax effects of Ana’s transfer?

• A. A direct sale of a partnership interest that automatically changes the tax basis of RST’s assets for all partners.
• B. A purchase by Diego of a one-third undivided interest in each partnership asset, so Ana recognizes gain or loss separately by asset category.
• C. A direct sale of a partnership interest, producing seller-level gain or loss for Ana, no entity-level gain or loss for RST, and no change to RST’s asset bases.
• D. A deemed sale of partnership assets by RST, producing entity-level gain or loss that must be allocated to all partners.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: This transaction is a sale of a partnership interest, not a sale of partnership assets. Ana recognizes gain or loss at the owner level, while RST recognizes no entity-level gain or loss, and without a Sec. 754 election RST’s inside basis in its assets does not change.

When one partner sells an interest directly to another person, the transferred item is the partnership interest itself. That generally creates a tax event for the selling partner, not for the partnership entity. By contrast, if the partnership had sold assets, the partnership would recognize gain or loss on those assets and allocate the results among the partners. Here, RST sold no assets and made no distributions, so there is no entity-level gain or loss. The basis consequence is also important: absent a Sec. 754 election, a sale of a partnership interest does not change the partnership’s inside basis in its assets. Diego acquires a cost-based outside basis in the purchased interest, but any buyer-specific inside basis adjustment generally requires a Sec. 754 election and Sec. 743(b) adjustment.

• Treating the transaction as a partnership asset sale is wrong because RST did not dispose of any assets.
• Saying RST’s asset bases change automatically is wrong because no Sec. 754 election was made.
• Treating Diego as buying a direct share of each underlying asset is wrong because the property sold was Ana’s partnership interest, not the partnership’s assets.

Because Ana sold her partnership interest directly to Diego and RST neither sold assets nor made a Sec. 754 election, the tax effects are owner-level only with no entity-level gain or inside basis change.

Question 6

Topic: Entity Tax Compliance

Maple Corp., a calendar-year C corporation, provided the following 20X5 tax data. Assume the tax year is after 2020, no special NOL carryback rule applies, and Maple had no prior-year NOL or capital loss carryovers.

A staff-prepared loss schedule reports:

• 20X5 NOL carryforward: $290,000
• 20X5 capital loss carryforward: $0

Which interpretation is most appropriate?

• A. The schedule is incorrect because the NOL should be $210,000 after reducing the ordinary loss by the $30,000 capital gain, and there is no capital loss carryforward.
• B. The schedule is incorrect because the NOL should be $240,000, and only $20,000 of capital loss remains after carrying the $50,000 net capital loss back to prior taxable capital gains.
• C. The schedule is correct because the entire $290,000 loss is a current-year NOL, and no separate capital loss remains.
• D. The schedule is incorrect because the NOL should be $240,000, and the full $50,000 net capital loss is a carryforward.

Best answer: B

What this tests: Entity Tax Compliance

Explanation: The reported NOL is overstated because a C corporation cannot use a net capital loss to create or increase an NOL. Maple’s NOL is $240,000, and its $50,000 net capital loss must first be applied to the $30,000 of prior-year taxable capital gains, leaving a $20,000 capital loss carryforward.

For a C corporation, capital losses are deductible only to the extent of capital gains. Here, Maple’s $30,000 current-year capital gain is offset by $30,000 of the $80,000 capital loss, leaving a $50,000 net capital loss. That excess capital loss is not part of the NOL. Therefore, the 20X5 NOL comes only from the $240,000 ordinary business loss. The $50,000 net capital loss must be carried to prior years with taxable capital gains before any remainder is carried forward. Maple had $10,000, $15,000, and $5,000 of prior-year taxable capital gains, so $30,000 of the net capital loss is absorbed there, leaving a $20,000 capital loss carryforward.

• Treating the full $290,000 as an NOL wrongly includes a corporate net capital loss in the NOL amount.
• Reporting a full $50,000 capital loss carryforward ignores that corporate capital losses are applied to prior taxable capital gains first.
• Reducing the NOL to $210,000 misreads the current-year capital gain; it is already offset by current-year capital loss and does not separately reduce the ordinary loss.

A C corporation’s net capital loss does not increase an NOL and must be used against prior capital gains before any remaining amount is carried forward.

Question 7

Topic: Entity Tax Compliance

Maple LLC, a calendar-year partnership, has two equal partners, Diaz and Frost. Before any payment for partner services, Maple has $260,000 of ordinary business income.

Under the partnership agreement:

• Diaz receives a fixed $40,000 annual payment, regardless of partnership income, for bookkeeping services performed in Diaz’s capacity as a partner.
• Remaining partnership profit is allocated 50% to Diaz and 50% to Frost.

A staff preparer concluded that Diaz should report $130,000 of ordinary income and treat the $40,000 payment as a nontaxable cash distribution.

What is the best correction to the staff preparer’s conclusion?

• A. Treat the $40,000 as a guaranteed payment; still allocate the full $260,000 equally, so Diaz reports $170,000 of ordinary income.
• B. Treat the $40,000 as a guaranteed payment; allocate the remaining $220,000 equally, so Diaz reports $150,000 of ordinary income.
• C. Keep the $40,000 as a cash distribution because a partner cannot be separately compensated for services, so Diaz reports $130,000 of ordinary income.
• D. Treat the $40,000 as a guaranteed payment and allocate the remaining $220,000 only to Frost, so Diaz reports $40,000 of ordinary income.

Best answer: B

What this tests: Entity Tax Compliance

Explanation: Because Diaz performed services in Diaz’s capacity as a partner and receives a fixed amount regardless of partnership income, the $40,000 is a guaranteed payment, not a distribution. Maple reduces ordinary business income to $220,000, allocates that remainder equally, and Diaz reports total ordinary income of $150,000.

A fixed payment to a partner for services rendered in the partner’s capacity as a partner is a guaranteed payment. It is not treated as a nontaxable cash distribution, and it is separately included in the recipient partner’s ordinary income. The partnership generally accounts for the guaranteed payment before determining the ordinary business income left for partner allocation.

Here, Maple had $260,000 of ordinary business income before the service payment. After the $40,000 guaranteed payment, $220,000 remains. That remaining profit is split 50/50, so Diaz and Frost each receive a $110,000 distributive share. Diaz also includes the $40,000 guaranteed payment, for total ordinary income of $150,000. The staff preparer both mislabeled the payment and understated Diaz’s taxable income.

• Allocating the full $260,000 equally and then adding the $40,000 double counts the service payment.
• Treating the $40,000 as a cash distribution ignores that the stem describes compensation for services in partner capacity, paid regardless of partnership income.
• Giving all remaining profit to Frost contradicts the agreement, which says only the residual profit is shared equally after the fixed payment.

A fixed payment for services performed in partner capacity is a guaranteed payment, so Maple allocates only the remaining $220,000 after that payment and Diaz reports $40,000 plus $110,000.

Question 8

Topic: Entity Tax Compliance

A CPA is preparing the current-year return for Oak Partnership. In a nonliquidating distribution, Partner Lee receives $10,000 cash and a parcel of land. Lee’s outside basis in the partnership interest immediately before the distribution is $60,000. The partnership’s adjusted basis in the land is $70,000, and its fair market value is $95,000. No liabilities are involved.

What basis should Lee take in the distributed land?

• A. $60,000
• B. $95,000
• C. $70,000
• D. $50,000

Best answer: D

What this tests: Entity Tax Compliance

Explanation: Lee’s basis in the land is limited to the remaining outside basis after the cash distribution. Starting with $60,000 outside basis and reducing it by $10,000 cash leaves $50,000 available for the land, even though the partnership’s inside basis is $70,000.

For a nonliquidating partnership distribution, cash reduces the partner’s outside basis first. The basis of noncash property distributed to the partner is generally the partnership’s adjusted basis in that property immediately before the distribution, but it cannot exceed the partner’s remaining outside basis after any cash distributed. Here, Lee’s outside basis is $60,000. After the $10,000 cash distribution, Lee has $50,000 of basis remaining. Although the land has a partnership adjusted basis of $70,000, Lee can take only $50,000 basis in the land because the carryover basis rule is capped by the remaining outside basis.

• $60,000 ignores that cash distributed in a nonliquidating distribution reduces outside basis before assigning basis to noncash property.
• $70,000 uses the partnership’s inside basis in the land but misses the cap based on Lee’s remaining outside basis.
• $95,000 incorrectly uses fair market value; nonliquidating distributions generally do not give the partner an FMV basis.

In a nonliquidating distribution, distributed property generally takes the partnership’s inside basis, but not above the partner’s remaining outside basis after reducing for cash received.

Question 9

Topic: Entity Tax Compliance

Redwood LLC is taxed as a partnership and has a valid Sec. 754 election in effect. During the year, Partner A sells the entire partnership interest to New Partner B in a taxable purchase. No partnership property is distributed, and B’s outside basis in the purchased interest differs from B’s share of the partnership’s inside basis in its assets. How should the resulting basis adjustment be characterized?

• A. A Sec. 743(b) special basis adjustment for the transferee partner only
• B. A Sec. 734(b) basis adjustment triggered by a partnership distribution
• C. A Sec. 444 election to use a different partnership tax year
• D. A Sec. 704(c) allocation for contributed property with built-in gain or loss

Best answer: A

What this tests: Entity Tax Compliance

Explanation: Because the event is a taxable sale of a partnership interest, a Sec. 754 election causes any basis adjustment to be made under Sec. 743(b). That adjustment is special to the transferee partner and does not create a common basis change for all partners.

A Sec. 754 election allows a partnership to adjust the basis of partnership property when certain transfers or distributions occur. When the triggering event is a taxable transfer of a partnership interest, the relevant adjustment is a Sec. 743(b) adjustment. It compares the transferee partner’s outside basis in the acquired interest with that partner’s share of the partnership’s inside basis in its assets. The adjustment is personal to the transferee partner, so it affects that partner’s depreciation, gain, or loss calculations rather than changing basis for all partners. By contrast, Sec. 734(b) applies to certain distributions, Sec. 704(c) applies to contributed property with built-in gain or loss, and Sec. 444 relates to partnership tax year elections.

• A Sec. 734(b) adjustment is associated with certain partnership distributions under a Sec. 754 election, but no distribution occurred here.
• A Sec. 704(c) allocation deals with precontribution built-in gain or loss on contributed property, not a purchase of an existing partnership interest.
• A Sec. 444 election concerns using a different partnership tax year and does not classify a basis adjustment from a partner-level sale.

A taxable transfer of a partnership interest with a Sec. 754 election produces a Sec. 743(b) special basis adjustment for the transferee partner.

Question 10

Topic: Entity Tax Compliance

Cedar LLC, taxed as a partnership, has three equal partners. On July 1, Liam sells his entire one-third interest directly to Maya for $150,000 cash. Immediately after the purchase, Maya’s share of Cedar’s inside basis in the partnership assets is $110,000. Cedar has a valid §754 election in effect for the year. Assume no partnership liabilities and no §751 hot assets.

How should the $40,000 difference be characterized for tax purposes?

• A. A mandatory reallocation of pre-sale partnership income to Maya
• B. A transferee-only §743(b) basis adjustment allocated to Cedar’s assets
• C. A book increase to Cedar’s common inside basis for all partners
• D. An increase to the outside basis of Cedar’s continuing partners

Best answer: B

What this tests: Entity Tax Compliance

Explanation: Because Cedar has a valid §754 election, Maya’s purchase creates a §743(b) adjustment equal to the difference between her outside basis and her share of inside basis. That adjustment is tracked only for Maya and allocated to partnership assets; it does not change Cedar’s common inside basis for everyone.

When a partner buys an interest from another partner, the buyer generally takes an outside basis equal to the purchase price, adjusted for liabilities if any. The partnership’s common inside basis usually does not change just because the ownership changed. However, if a §754 election is in effect, the partnership makes a §743(b) adjustment for the transferee partner equal to the difference between the transferee’s outside basis and the transferee’s share of the partnership’s inside basis. Here, Maya paid $150,000 and her share of inside basis is $110,000, so the $40,000 difference becomes a special basis adjustment. It is allocated among partnership assets and affects only Maya’s tax results, such as depreciation or gain or loss on later disposition.

• A book increase to common inside basis for all partners is incorrect because a §743(b) adjustment is partner-specific, not a partnership-wide inside-basis change.
• An increase to the outside basis of the continuing partners is incorrect because their basis is not changed by Maya’s purchase from Liam.
• A mandatory reallocation of pre-sale partnership income to Maya is incorrect because the question asks about the basis mismatch created by the transfer, not the allocation of pre-transfer operating results.

A §754 election turns the difference between Maya’s outside basis and her share of inside basis into a §743(b) adjustment tracked only for Maya.

Continue with full practice

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

Related focused pages

• Free CPA TCP Full-Length Practice Exam
• CPA TCP: Individual and Personal Tax Planning
• CPA TCP: Entity Tax Planning
• CPA TCP: Property Transactions

Free review resource

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