Free CPA TCP Full-Length Practice Exam: 68 Questions

This free full-length CPA TCP multiple-choice question (MCQ) diagnostic includes 68 original Mastery Exam Prep questions across the TCP blueprint areas.

The CPA TCP 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 TCP guide on CPAExamsMastery.com.

Before you start

CPA means Certified Public Accountant. TCP means Tax Compliance and Planning. This page is useful when you want one uninterrupted TCP multiple-choice diagnostic before returning to individual planning, entity compliance, entity planning, and property transaction drills.

Use the score as a diagnostic signal, not as a guarantee. TCP also involves task-based simulations and exhibit-heavy work, so a high score here should be paired with continued review of planning facts, taxpayer objectives, and tax-document interpretation.

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Practice questions

Questions 1-25

Question 1

Topic: Entity Tax Compliance

Maple, a C corporation, made a $300,000 loan on January 1 to Dana, its sole shareholder, at 0% stated interest. Dana is not an employee. Assume the applicable federal rate is 6%, no below-market-loan exception applies, and Maple has current and accumulated earnings and profits greater than the year’s foregone interest.

How should the year’s foregone interest be characterized for federal income tax purposes?

• A. Additional compensation to Dana, with Maple deducting the foregone interest as wage expense
• B. A constructive dividend to Dana to the extent of Maple’s earnings and profits, with Maple recognizing imputed interest income
• C. A capital contribution from Dana to Maple, with Dana recognizing imputed interest income
• D. A pure loan-principal adjustment, with no deemed transfer or imputed interest

Best answer: B

What this tests: Entity Tax Compliance

Explanation: Because Maple lent money to its shareholder at a below-market rate, the foregone interest is recharacterized under the imputed-interest rules. Since Dana is acting as a shareholder rather than an employee, and Maple has sufficient earnings and profits, the deemed transfer is a constructive dividend and Maple recognizes imputed interest income.

For a below-market loan between a C corporation and a shareholder, the tax law treats the foregone interest as if it were transferred between the parties and then paid back as interest. When the corporation is the lender and the shareholder is the borrower, the first deemed transfer runs from the corporation to the shareholder. That transfer is characterized by the relationship between them. Here, Dana is borrowing as a shareholder, not as an employee, so the deemed transfer is a distribution rather than compensation. Because Maple has enough current and accumulated earnings and profits, that distribution is a dividend. The second deemed step is an interest payment from Dana back to Maple, so Maple has imputed interest income.

• “Additional compensation” fails because the facts say Dana is not an employee, so the deemed transfer is not wage-related.
• “A capital contribution from Dana to Maple” reverses the transaction direction; that characterization fits a below-market loan from shareholder to corporation.
• “No deemed transfer or imputed interest” ignores the below-market loan rules, which require recharacterization when no exception applies.

A below-market loan from a C corporation to a shareholder is treated as a deemed distribution to the shareholder and a deemed interest payment back to the corporation, so sufficient earnings and profits produce dividend treatment.

Question 2

Topic: Entity Tax Compliance

A CPA is reviewing U.S. withholding for Atlas GmbH, a foreign corporation resident in a country with no income tax treaty with the United States.

• Atlas maintains a branch office in New Jersey.
• Branch employees perform on-site installation services in New Jersey for a U.S. customer, and Atlas gives that customer a valid Form W-8ECI for the service fees.
• Atlas also receives royalties from a different U.S. customer for the use of Atlas’s patent only in the United States. The royalty arrangement is handled entirely by Atlas’s foreign headquarters and is not effectively connected with the U.S. branch.

Which treatment is correct?

• A. The service fees are U.S.-source effectively connected income, so the 30% FDAP withholding does not apply if supported by Form W-8ECI; the royalties are U.S.-source FDAP and are subject to 30% withholding.
• B. Both the service fees and the royalties are U.S.-source effectively connected income because Atlas has a U.S. branch, so neither payment is subject to 30% withholding.
• C. The service fees are U.S.-source FDAP subject to 30% withholding, and the royalties are foreign-source because the license is administered outside the United States.
• D. The service fees are foreign-source because Atlas is a foreign corporation; the royalties are U.S.-source FDAP and are subject to 30% withholding.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: The correct treatment separates sourcing from effective connection. The installation fees are U.S.-source because the services are performed in New Jersey and, with Form W-8ECI, are treated as effectively connected income rather than subject to the 30% FDAP withholding regime. The royalty is U.S.-source because the patent is used in the United States and is subject to 30% withholding because it is not effectively connected.

For a foreign corporation, service income is generally sourced by where the services are performed. Because Atlas’s employees performed the installation work in New Jersey, those fees are U.S.-source. Since the facts say Atlas has a U.S. branch and provided a valid Form W-8ECI, the service fees are treated as effectively connected income and are not subject to the 30% gross withholding that normally applies to U.S.-source FDAP income.

Royalty income is generally sourced by where the intangible property is used. Here, the patent is used only in the United States, so the royalty is U.S.-source. The facts also state that the royalty is not effectively connected with the U.S. branch, so it remains U.S.-source FDAP income and is subject to 30% withholding absent treaty relief.

• Treating the service fees as foreign-source because the corporation is foreign confuses taxpayer residence with the sourcing rule for services; services are sourced where performed.
• Treating both payments as effectively connected just because Atlas has a U.S. branch ignores the explicit fact that the royalty is not effectively connected.
• Treating the royalty as foreign-source because the contract is administered abroad applies the wrong sourcing rule; royalties are sourced by place of use, not place of negotiation or administration.
• Treating the service fees as automatically subject to 30% FDAP withholding overlooks the valid Form W-8ECI and the ECI treatment in the facts.

Service income is sourced where the services are performed, while royalty income is sourced where the intangible is used, and only the royalty is stated to be non-ECI.

Question 3

Topic: Entity Tax Planning

Quartz, Inc., a calendar-year C corporation, is a large corporation for federal estimated tax purposes. Its controller prepared this plan to avoid estimated tax underpayment penalties:

Projected current-year federal income tax liability: \$420,000
Prior-year federal income tax shown on a 12-month return: \$300,000
Controller's plan: pay four equal estimated tax installments of \$75,000
Assumptions: all installments are timely, no tax credits apply, and Quartz does not use the annualized income installment method.

What is the best correction to the controller’s plan?

• A. Use $75,000 for the first installment, then $135,000, $105,000, and $105,000 for the remaining three installments.
• B. Use four equal installments of $75,000 and pay the remaining $120,000 with the return.
• C. Use $75,000 for the first installment and $115,000 for each of the remaining three installments.
• D. Use four equal installments of $105,000 because a large corporation may not use prior-year tax for any installment.

Best answer: A

What this tests: Entity Tax Planning

Explanation: Quartz is a large corporation, so it cannot rely on prior-year tax for all four installments. It may use the prior-year amount only for the first payment, then must catch up the first-quarter shortfall in the second installment and use current-year amounts for the rest.

For a large C corporation, the prior-year tax safe harbor is limited to the first estimated tax installment. Here, 25% of prior-year tax is $75,000, so that amount can be used for installment one. But 25% of projected current-year tax is $105,000, creating a $30,000 shortfall in the first installment. That shortfall is recaptured in installment two, so the second payment is $135,000 ($105,000 + $30,000). Installments three and four are each $105,000. This schedule totals the projected current-year tax of $420,000 and avoids the mistake of treating a large corporation like a regular corporation that can use prior-year tax for all four equal installments.

• Four equal installments of $105,000 overstate the required response because a large corporation may still use prior-year tax for the first installment.
• Four equal installments of $75,000 underpay the required annual amount after the first quarter because the prior-year safe harbor does not apply to all four payments for a large corporation.
• Spreading the catch-up evenly as $115,000 for the last three installments ignores that the first-installment shortfall is specifically recaptured in the second installment.

A large corporation may use prior-year tax only for the first installment, so the $30,000 first-quarter shortfall against the current-year amount is added to the second installment.

Question 4

Topic: Entity Tax Compliance

Granite C Corp made a nonliquidating distribution of land to its sole shareholder, Mason, on July 1, Year 1. Assume Granite had no current E&P other than any gain from this distribution, had no other distributions during Year 1, and ignore federal income tax effects on E&P.

Which conclusion is supported by the exhibit?

• A. Granite recognizes no gain, and Mason recognizes an $85,000 dividend.
• B. Granite recognizes a $25,000 gain, and Mason recognizes a $55,000 dividend and no capital gain.
• C. Granite recognizes a $35,000 gain, and Mason recognizes a $55,000 dividend and a $10,000 capital gain.
• D. Granite recognizes a $35,000 gain, and Mason recognizes a $35,000 dividend and a $30,000 capital gain.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: On a nonliquidating distribution of appreciated property, a C corporation recognizes gain as if it sold the property for fair market value. Here that creates $35,000 of corporate gain, and Mason’s $85,000 net distribution is taxed first as a $55,000 dividend to the extent of E&P, then $20,000 return of capital, leaving $10,000 capital gain.

In a nonliquidating property distribution, the corporation recognizes gain on appreciated property equal to fair market value minus adjusted basis. The shareholder’s assumed liability does not reduce the corporation’s gain when the liability is below fair market value; instead, it reduces the shareholder’s amount of distribution. Granite therefore recognizes $35,000 ($95,000 - $60,000). That gain increases E&P, so Granite has $55,000 of E&P available for dividend treatment ($20,000 accumulated E&P + $35,000 current gain), ignoring tax effects as stated. Mason’s amount of distribution is $85,000 ($95,000 FMV - $10,000 mortgage). Mason recognizes $55,000 as dividend income, then recovers $20,000 of stock basis, and recognizes the remaining $10,000 as capital gain.

• Saying the corporation recognizes no gain because Mason assumed the mortgage is incorrect; appreciated property distributed by a C corporation still triggers corporate gain.
• Using $25,000 of corporate gain incorrectly subtracts the mortgage from the corporation’s gain; the mortgage reduces the shareholder’s distribution amount instead.
• Limiting the dividend to $35,000 ignores the increase to E&P from the corporation’s recognized gain and skips the required return-of-capital step before capital gain.

The corporation recognizes $35,000 gain on the appreciated land, and Mason’s $85,000 net distribution is taxed as a $55,000 dividend, then $20,000 return of capital, leaving $10,000 capital gain.

Question 5

Topic: Property Transactions (Disposition of Assets)

A CPA is reviewing a draft return for Lee’s sole proprietorship. The workpaper currently reports the disposition as “long-term capital gain on sale of equipment — $30,000.”

Source data used to prepare the return:

Which correction makes the reported disposition amount and character complete and accurate?

• A. Report $30,000 of long-term capital gain from the sale.
• B. Report $26,000 of Section 1231 gain from the sale.
• C. Report $28,000 of ordinary income from sale of Section 1245 property.
• D. Report $26,000 of ordinary income from sale of Section 1245 property.

Best answer: D

What this tests: Property Transactions (Disposition of Assets)

Explanation: The sale produces a $26,000 gain after reducing the gross selling price by the selling commission and comparing that amount to adjusted basis. Because the asset is depreciable business equipment, the entire gain is recaptured as ordinary income under Section 1245.

For a depreciable business asset, first compute amount realized net of selling costs, then compare it with adjusted basis. Here, amount realized is $70,000 less the $2,000 selling commission, or $68,000. Adjusted basis is original cost of $120,000 less depreciation allowed or allowable of $78,000, or $42,000. That creates a $26,000 gain.

The asset is business equipment, which is Section 1245 property. Gain on Section 1245 property is ordinary income to the extent of prior depreciation. Since prior depreciation is $78,000 and the gain is only $26,000, the entire $26,000 is ordinary income. No remaining Section 1231 gain or capital gain is left after recapture. The draft return is wrong on both amount and character.

• Reporting $26,000 as Section 1231 gain fixes the amount but misses the Section 1245 recapture rule, which makes the gain ordinary.
• Reporting $28,000 of ordinary income gets the character right but ignores the $2,000 selling commission that reduces amount realized.
• Reporting $30,000 of long-term capital gain ignores selling costs and incorrectly treats recapture gain on business equipment as capital gain.

Net amount realized is $68,000 and adjusted basis is $42,000, so the $26,000 gain is fully ordinary under Section 1245 because it does not exceed prior depreciation.

Question 6

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

A CPA is reviewing a high-income individual’s year-end source documents to identify items that require a separate alternative minimum tax (AMT) adjustment or preference entry rather than only regular-tax treatment. Assume the taxpayer is otherwise exposed to AMT. Which item should be classified that way?

• A. The bargain element from incentive stock options exercised this year when the acquired shares were still held on December 31
• B. Compensation income recognized from nonqualified stock options exercised this year
• C. Tax-exempt interest from state general obligation municipal bonds
• D. Qualified dividend income reported on Form 1099-DIV

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The bargain element on an incentive stock option exercise is a classic AMT adjustment when the stock is still held at year-end. The other items may affect regular taxable income, but they do not create a separate AMT preference or adjustment entry.

AMTI starts with regular taxable income and is then modified for specific AMT adjustments and preference items. For individuals, one of the most tested adjustments is the bargain element on incentive stock options exercised during the year when the acquired shares are not sold in the same year. That spread is included for AMT even though no regular-tax income is recognized at exercise, which is why it creates a planning concern and can also lead to an AMT basis difference and later AMT credit issues. In contrast, compensation from nonqualified stock options is already included in wages for regular tax and does not create a separate AMT adjustment. Interest on state general obligation municipal bonds is generally exempt for both regular tax and AMT. Qualified dividends keep their preferential treatment under AMT and are not AMT preference items.

• Compensation from nonqualified stock options is regular wage income, so there is no separate AMT adjustment tied to the exercise.
• Interest on state general obligation municipal bonds is generally tax-exempt for both regular tax and AMT; the classic AMT bond issue is private activity bond interest.
• Qualified dividends affect taxable income, but they are not classified as AMT adjustments or preference items.

An ISO exercise with year-end stock ownership creates an AMT adjustment equal to the bargain element, making it a classic AMT planning item.

Question 7

Topic: Property Transactions (Disposition of Assets)

Greer, a calendar-year sole proprietor, sold land used as the site of her retail store in 2025. Relevant facts are:

• Purchase price in 2019: $320,000
• Capitalized legal fees at purchase: $8,000
• Gross selling price in 2025: $430,000
• Broker commission and other selling costs: $22,000
• No depreciation was allowed or allowable on the land
• The land was used continuously in the business from acquisition through sale
• Greer has no nonrecaptured net Section 1231 losses from the prior 5 years

What amount and character should Greer recognize from the sale?

• A. $88,000 Section 1231 gain treated as long-term capital gain
• B. $102,000 Section 1231 gain treated as long-term capital gain
• C. $80,000 ordinary gain
• D. $80,000 Section 1231 gain treated as long-term capital gain

Best answer: D

What this tests: Property Transactions (Disposition of Assets)

Explanation: Greer recognizes an $80,000 gain: amount realized of $408,000 minus adjusted basis of $328,000. Because the asset is business land held for more than one year and Greer has no nonrecaptured net Section 1231 losses from the prior five years, the gain receives long-term capital gain treatment.

For property used in a trade or business, start by computing amount realized and adjusted basis. Here, amount realized is the gross selling price reduced by selling expenses: $430,000 less $22,000, or $408,000. Adjusted basis is the original cost plus capitalized acquisition costs: $320,000 plus $8,000, or $328,000. The recognized gain is therefore $80,000.

Because the asset is land used in Greer’s business and it was held for more than one year, the gain is a Section 1231 gain. Since the facts state there are no nonrecaptured net Section 1231 losses from the prior five years, the Section 1231 gain is treated as long-term capital gain rather than recharacterized as ordinary income.

• The $88,000 amount ignores the capitalized legal fees that increase the land’s basis.
• The $102,000 amount ignores selling expenses, which reduce amount realized.
• Ordinary gain is incorrect because land is not depreciable personal property, and the facts also remove the five-year Section 1231 lookback issue.

Amount realized is $408,000 ($430,000 − $22,000) and adjusted basis is $328,000 ($320,000 + $8,000), so the $80,000 gain on business land held more than one year is Section 1231 gain treated as long-term capital gain because no five-year lookback losses exist.

Question 8

Topic: Entity Tax Compliance

Amy and Ben form AB Partnership. Amy contributes land with a fair market value of $150,000 and an adjusted basis of $40,000. The land is subject to a $90,000 nonrecourse mortgage that AB Partnership assumes.

Ben contributes $60,000 cash. Amy and Ben each receive a 50% partnership interest and will share profits, losses, and nonrecourse liabilities equally. Assume the contribution qualifies under the general nonrecognition rule for partnership property contributions and no disguised sale rules apply.

What are Amy’s realized gain and recognized gain on the contribution?

• A. Realized gain $150,000; recognized gain $50,000
• B. Realized gain $65,000; recognized gain $5,000
• C. Realized gain $110,000; recognized gain $0
• D. Realized gain $110,000; recognized gain $5,000

Best answer: D

What this tests: Entity Tax Compliance

Explanation: Amy realizes gain equal to the land’s $150,000 fair market value minus its $40,000 adjusted basis, or $110,000. She recognizes only $5,000 because the assumed mortgage reduces her liabilities by a net $45,000, which exceeds her basis by $5,000.

For a partnership contribution of property, the general rule is nonrecognition. Amy’s realized gain is the built-in gain in the land: $150,000 FMV minus $40,000 basis = $110,000. Recognition is tested separately.

When the partnership assumes Amy’s $90,000 nonrecourse mortgage, Amy is treated as relieved of that debt. But because she owns 50% of the partnership and nonrecourse liabilities are shared equally, $45,000 of that liability is allocated back to her. Her net liability decrease is therefore $45,000 ($90,000 relieved less $45,000 reallocated). That net decrease is treated like a cash distribution. A partner recognizes gain only if deemed cash received exceeds the adjusted basis of property contributed. Since $45,000 exceeds Amy’s $40,000 basis by $5,000, she recognizes $5,000 gain.

• The choice with realized gain of $110,000 and recognized gain of $0 ignores the rule that excess net liability relief over basis triggers gain.
• The choice with realized gain of $65,000 incorrectly reduces realized gain by the liability shift; realized gain is based on FMV minus basis.
• The choice with realized gain of $150,000 and recognized gain of $50,000 treats the full mortgage assumption as taxable, instead of only the net liability decrease over basis.

Amy’s realized gain is FMV less basis, and she recognizes gain only to the extent her net liability relief of $45,000 exceeds her $40,000 basis by $5,000.

Question 9

Topic: Entity Tax Planning

Blue Ridge, Inc. is deciding whether to place equipment in service on December 30, Year 1, or January 3, Year 2. Ignore financing considerations.

Based on the exhibit, which additional assumption would most strongly support the controller’s recommendation?

• A. Management expects higher GAAP book income next year, but tax rates and tax bases will otherwise be unchanged.
• B. The equipment will qualify for the same immediate federal deduction whether it is placed in service in Year 1 or Year 2.
• C. The corporation can fully use the $300,000 deduction in either year and has no NOL carryovers or limitation issues.
• D. Next year the corporation will begin taxable operations in a state with an 8% corporate income tax, and the equipment deduction will reduce that state’s tax base.

Best answer: D

What this tests: Entity Tax Planning

Explanation: With the same projected federal taxable income, the same $300,000 deduction, and the same 21% federal rate in both years, the federal tax benefit is not greater in Year 2. A missing assumption that next year includes additional state income tax exposure would make delaying the deduction potentially more valuable.

For a C corporation, a timing recommendation must be tied to a real tax-rate or tax-base difference between years. Here, the exhibit shows identical federal taxable income before the deduction, the same immediate deduction amount, and the same 21% federal corporate rate in both years. On those facts alone, delaying the purchase does not create greater federal tax savings; if anything, taking the deduction earlier is usually preferable because the tax benefit is realized sooner. The recommendation becomes supportable only if an unstated assumption changes the combined tax result, such as expansion into a new taxable state next year. If the corporation will owe state income tax next year and the equipment deduction also reduces that state tax base, the same deduction can produce larger total tax savings in Year 2.

• Being able to fully use the deduction in either year does not support delaying it; with the same federal rate, that fact does not make Year 2 more favorable.
• Having the same immediate federal deduction treatment in both years merely confirms there is no federal difference from timing alone.
• Higher GAAP book income is not the key driver here; tax planning depends on taxable income, tax base, and tax rates, not book income by itself.

A higher combined federal-state tax burden next year would make the same deduction more valuable in Year 2 than in Year 1.

Question 10

Topic: Entity Tax Compliance

Martin, CPA, is reviewing a planned year-end nonliquidating distribution from Pine C Corp to its sole shareholder, Dana.

• Cash to be distributed: $10,000
• Land to be distributed: FMV $80,000; adjusted basis $25,000
• Dana’s stock basis: $18,000
• Pine’s accumulated E&P on January 1: $22,000
• Pine’s current-year E&P has not yet been computed
• The controller states that Pine will not recognize gain because the land is being distributed rather than sold

Before Martin concludes how much Dana should treat as dividend income, return of capital, or capital gain, what should he do next?

• A. Treat the full $90,000 distribution as dividend income to Dana now because nonliquidating C corporation distributions are taxed at FMV when received.
• B. Ignore Pine’s corporate-level tax effect and determine only Dana’s capital gain because the shareholder-level result controls the reporting.
• C. Reduce Dana’s stock basis by Pine’s $25,000 basis in the land first and treat only the cash portion as potentially taxable.
• D. Compute Pine’s current-year E&P after including the gain Pine recognizes on the appreciated land, then use E&P and Dana’s stock basis to classify the distribution.

Best answer: D

What this tests: Entity Tax Compliance

Explanation: The next step is to complete Pine’s E&P analysis, including the gain recognized on distributing appreciated land. Only after E&P is known can the distribution be classified properly as dividend, return of capital, or capital gain, with Dana’s stock basis limiting any return-of-capital portion.

A C corporation nonliquidating distribution is taxed to the shareholder in order: first as a dividend to the extent of current and accumulated E&P, then as return of capital to the extent of the shareholder’s stock basis, and then as capital gain for any excess. When a C corporation distributes appreciated property, the corporation generally recognizes gain as if it sold the property for FMV, even though no third-party sale occurred. That recognized gain affects current E&P, so Pine’s E&P must be computed before Dana’s treatment can be finalized. Here, the controller’s statement is incorrect because the land has built-in gain. After Pine’s E&P is determined, any amount distributed beyond E&P reduces Dana’s stock basis, and only the excess over basis is capital gain.

• Treating the entire FMV as a dividend is premature because dividend treatment depends on E&P, not just on the amount distributed.
• Reducing stock basis by the corporation’s basis in the land uses the wrong measurement and skips the required E&P analysis.
• Ignoring the corporation’s tax effect is incorrect because a C corporation generally recognizes gain on an appreciated property distribution.

Current and accumulated E&P, including the corporation’s recognized gain on appreciated land, must be determined before the distribution can be classified as dividend, return of capital, or capital gain.

Question 11

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

During year-end planning, Melissa asks her CPA about helping her adult daughter buy a home.

• Melissa owns publicly traded stock with a fair market value of $300,000 and a tax basis of $40,000.
• Melissa wants to reduce her taxable estate and avoid paying current capital gains tax herself.
• She is considering either gifting the stock directly now or selling the stock first and gifting the net cash.
• Ignore annual exclusion and lifetime exemption limits.

Which conclusion is most appropriate?

• A. Neither alternative reduces Melissa’s taxable estate until the daughter later disposes of the stock.
• B. Selling the stock first generally best meets Melissa’s objectives because a lifetime gift gives the daughter a stepped-up basis equal to fair market value.
• C. Gifting the stock directly generally best meets Melissa’s stated objectives because she recognizes no gain on the gift and the daughter takes Melissa’s carryover basis.
• D. Gifting the stock directly will cause Melissa to recognize the $260,000 built-in gain in the year of the gift.

Best answer: C

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The direct gift of appreciated stock best fits Melissa’s goals. Melissa does not recognize gain on the gift, and the stock’s value and future appreciation leave her estate immediately, although the daughter receives a carryover basis.

When a donor makes a lifetime gift of appreciated property to an individual, the donor generally does not recognize the built-in gain at the time of the gift. That means Melissa can transfer the stock without paying current capital gains tax herself. The gift also removes the stock’s current value and future appreciation from Melissa’s estate once the transfer is complete. However, the built-in gain is not eliminated; it carries over to the daughter through carryover basis. By contrast, if Melissa sells the stock first, she must recognize the gain immediately and then can gift only the after-tax cash. Because Melissa’s stated objectives are estate reduction and avoiding current capital gains tax herself, gifting the stock directly is the better recommendation.

• Selling first fails Melissa’s tax objective because it accelerates her capital gain; lifetime gifts do not create a fair-market-value basis step-up.
• A direct gift of appreciated property generally does not trigger gain recognition by the donor; gain is usually recognized only on a sale or exchange.
• Estate reduction occurs when Melissa completes the gift, not when the daughter later sells the stock.

A lifetime gift of appreciated property removes the asset from Melissa’s estate without triggering donor-level gain, but the donee keeps the built-in gain through carryover basis.

Question 12

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Jordan and Taylor file married filing jointly and want to maximize their 2026 deductible amount without increasing their total charitable giving for 2026-2027.

Projected facts:

• 2026 standard deduction: $30,000
• 2027 standard deduction: $30,000
• Fixed itemized deductions each year (mortgage interest and taxes already reflected): $21,500
• Planned cash gifts to qualifying public charities: $7,000 in 2026 and $7,000 in 2027
• Assume AGI limits will not restrict any charitable deduction, and all gifts are otherwise deductible.

Based on the exhibit, which planning step best achieves the couple’s goal?

• A. Accelerate the 2027 planned gift into 2026, such as through a donor-advised fund, so 2026 itemized deductions total $35,500.
• B. Replace the 2026 cash gift with donated services because the value of services is deductible as a charitable contribution.
• C. Postpone the 2026 planned gift to 2027 because unused 2026 itemized deductions will carry over to 2027.
• D. Keep the $7,000 gift in each year because both annual gifts will be deductible in addition to the standard deduction.

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The couple’s fixed itemized deductions of $21,500 are below the $30,000 standard deduction, so a normal $7,000 annual gift does not improve the 2026 deduction. Moving the 2027 gift into 2026 raises 2026 itemized deductions to $35,500, allowing itemizing in 2026 while still using the standard deduction in 2027.

This is a deduction-bunching planning issue. If Jordan and Taylor give $7,000 in each year, their itemized deductions are $28,500 each year ($21,500 + $7,000), which is less than the $30,000 standard deduction, so they would claim the standard deduction in both years. That means the charitable gifts do not increase their deductible amount for 2026.

If they accelerate the 2027 planned gift into 2026, 2026 itemized deductions become $35,500 ($21,500 + $14,000), which exceeds the standard deduction, so itemizing in 2026 produces the larger deduction. In 2027, with no planned charitable gift, itemized deductions stay at $21,500, so they would simply use the $30,000 standard deduction. Because the exhibit states AGI limits are not a constraint, bunching the gifts is the supported planning choice.

• Spreading the gifts evenly leaves each year’s itemized deductions at $28,500, so the couple would still take the $30,000 standard deduction rather than stack both deductions.
• Accelerating the second year’s gift works because it creates one year in which itemized deductions exceed the standard deduction.
• Postponing the 2026 gift does not help the 2026 goal, and unused itemized deductions do not carry over just because they were below the standard deduction.
• Donated services are generally not deductible as charitable contributions, even though cash gifts to qualifying charities can be.

Bunching both years’ planned gifts into 2026 pushes itemized deductions above the 2026 standard deduction without increasing total two-year giving.

Question 13

Topic: Entity Tax Compliance

During review of Spruce Corp.’s 2026 Form 1120, the senior concludes that Spruce generated a 2026 net operating loss (NOL) carryforward of $60,000 to 2027 and a separate $14,000 capital loss carryforward.\n\nReturn data for 2026:\n\n| Item | Amount |\n|—|—:|\n| Gross income from operations | $540,000 |\n| Ordinary deductions (excluding DRD and capital losses) | $(620,000) |\n| Dividend income from a domestic corporation | $20,000 |\n| Allowable dividends received deduction (DRD) | $(10,000) |\n| Long-term capital gain | $8,000 |\n| Long-term capital loss | $(22,000) |\n\nSpruce has no charitable contribution deduction and no NOL carryover into 2026.\n\nWhich workpaper best supports the senior’s conclusion?

• A. A tax workpaper showing a $70,000 taxable loss and adding the excess $14,000 capital loss, resulting in an $84,000 NOL carryforward.
• B. A tax workpaper showing a $70,000 taxable loss, then adding back the $10,000 DRD and excluding the excess $14,000 capital loss from the NOL, resulting in a $60,000 NOL carryforward.
• C. A financial statement workpaper showing a $96,000 pretax book loss as the support for the tax NOL carryforward.
• D. A tax workpaper showing a $70,000 taxable loss and carrying that full amount forward as the 2026 NOL because it is the loss reported on Form 1120.

Best answer: B

What this tests: Entity Tax Compliance

Explanation: The best support is the workpaper that starts with the $70,000 taxable loss, adds back the $10,000 DRD, and keeps the excess $14,000 capital loss out of the NOL. That produces the stated $60,000 NOL carryforward and a separate capital loss carryforward.

For a C corporation, taxable loss and NOL are not always the same. In computing an NOL, the dividends received deduction is not allowed, so it must be added back. Also, corporate capital losses are deductible only to the extent of capital gains, and any excess capital loss does not create or increase an NOL; it carries forward separately as a capital loss. Here, the $22,000 capital loss offsets only the $8,000 capital gain, leaving a $14,000 capital loss carryforward. Taxable income is a $70,000 loss after the $10,000 DRD. Adding back that DRD gives a 2026 NOL of $60,000, which carries forward to 2027.

• Carrying forward the full $70,000 taxable loss misses the required addback of the $10,000 DRD.\n- Using $84,000 incorrectly includes the excess $14,000 capital loss in the NOL; that amount carries forward separately.\n- The pretax book loss is not sufficient tax support because book income does not apply the statutory NOL adjustments.

A corporate NOL adds back the DRD, and excess capital losses are carried separately rather than included in the NOL.

Question 14

Topic: Entity Tax Compliance

Marin owns 100% of Tidewater, Inc., a C corporation. She is not an employee.

For Year 1:

• Tidewater made Marin a bona fide demand loan.
• The stated interest rate was 0%.
• Marin used all loan proceeds for personal living expenses.
• Tidewater had sufficient current earnings and profits.
• Assume the annual forgone interest under the below-market loan rules is $10,000.

Which statement best describes the Year 1 federal income tax effect?

• A. Tidewater has $10,000 of imputed interest income, and Marin is treated as receiving a $10,000 constructive dividend and paying $10,000 of personal interest expense that is generally nondeductible.
• B. Tidewater has no taxable interest income because the loan is bona fide debt and no cash interest was charged.
• C. Tidewater has $10,000 of imputed interest income, and Marin is treated as receiving $10,000 of compensation, allowing Tidewater a compensation deduction.
• D. Tidewater has $10,000 of imputed interest income, and Marin is treated as receiving a $10,000 constructive dividend and paying $10,000 of fully deductible interest expense.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: Because the corporation made an interest-free loan to a shareholder, the below-market loan rules impute interest to the corporation. With sufficient earnings and profits and no employment relationship, the deemed transfer is a constructive dividend to Marin, followed by a deemed personal interest payment that is generally nondeductible.

Below-market loan rules recharacterize forgone interest as two deemed transfers: first, a transfer based on the relationship between the parties; second, a deemed interest payment back to the lender. Here, Tidewater is the lender and Marin is a shareholder, so Tidewater must recognize $10,000 of imputed interest income. Because Marin is not an employee and Tidewater has sufficient earnings and profits, the deemed transfer from the corporation to Marin is a constructive dividend, not compensation. Marin is then treated as paying $10,000 of interest back to Tidewater. Whether that interest is deductible depends on how the borrowed funds were used. Since the proceeds were used for personal living expenses, the deemed interest is personal interest, which is generally nondeductible.

• A bona fide debt instrument can still be a below-market loan, so the absence of cash interest does not prevent imputed interest.
• Compensation treatment would require an employee or service relationship; the facts say Marin is not an employee.
• A constructive dividend is supported because Tidewater has sufficient earnings and profits.
• The deemed interest payment is not fully deductible here because the loan proceeds were used for personal living expenses.

An interest-free corporation-to-shareholder loan causes imputed interest income to the corporation and, with sufficient E&P and no employee relationship, a constructive dividend followed by deemed personal interest paid by the shareholder.

Question 15

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

A CPA is reviewing a staff planning memo for an individual client. The client is in the 35% marginal tax rate for ordinary income and the 15% tax rate for qualified dividends and long-term capital gains. Ignore state taxes and transaction costs, and assume the alternatives are equally risky.

Investment 1: Corporate bond
Cost today: \$20,000
Interest expected during holding period: \$1,300
Expected sale price at end of holding period: \$20,000

Investment 2: Equity fund
Cost today: \$20,000
Qualified dividends expected during holding period: \$400
Expected sale price after a holding period of more than 1 year: \$21,200

The staff memo concludes: “The corporate bond has the better after-tax ROI because its after-tax return is $845, while the equity fund’s after-tax return is only $1,040 since the full $1,600 total return is taxed at 35%.”

Which response is the best correction to the memo?

• A. Revise the memo to show the equity fund has the higher after-tax ROI: net return of $1,540, or 7.7%, because only the qualified dividends are taxed when received.
• B. Revise the memo to show the equity fund has the higher after-tax ROI: net return of $1,360, or 6.8%, because the qualified dividends and long-term gain are each taxed at 15%.
• C. Keep the memo’s conclusion because the equity fund’s sale proceeds are primarily basis recovery, so only the $400 dividend should be included in after-tax ROI.
• D. Keep the memo’s conclusion, but recalculate the corporate bond using the 15% rate applicable to marketable security returns, giving a net return of $1,105, or 5.5%.

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The memo incorrectly taxed the equity fund’s entire return at the client’s 35% ordinary rate. Because the fund’s $400 dividend is qualified and the $1,200 appreciation becomes a long-term capital gain on sale, both components are taxed at 15%, giving the fund the higher after-tax ROI.

After-tax ROI is computed by separating each return component by its tax character, subtracting tax, and dividing the net return by the investment cost. For the corporate bond, the $1,300 interest is ordinary income, so after tax it is $845 ($1,300 × 65%), or 4.2% of the $20,000 cost. For the equity fund, the expected return consists of $400 of qualified dividends and a $1,200 long-term capital gain ($21,200 sale price less $20,000 cost). Both are taxed at 15%, so after tax the dividend is $340 and the gain is $1,020, for total after-tax return of $1,360. That is a 6.8% after-tax ROI, so the equity fund is the better choice based on the facts given.

• Treating only the dividend as taxable ignores the realized gain when the fund is sold; the $1,200 appreciation is not tax-free.
• Applying the 15% rate to bond interest confuses ordinary interest income with preferentially taxed qualified dividends and long-term capital gains.
• Focusing only on basis recovery misses that sale proceeds include both recovery of basis and taxable gain; the gain still affects ROI.
• The correct fix is to recompute the equity fund using the proper tax rates by income type, not to defend the memo’s original conclusion.

The memo used the wrong tax rate for the equity fund; $400 of qualified dividends and $1,200 of long-term gain taxed at 15% produce $1,360 after tax, which exceeds the bond’s $845 after-tax return.

Question 16

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

A staff preparer drafted the following by-activity loss-limitation workpaper for Nina Reed. The workpaper is intended to show each activity’s current-year allowed loss and any suspended amount by limitation. Nina has no prior-year suspended losses, does not qualify for any special rental real estate allowance, and all three activities are passive.

For Canyon LP, $28,000 of basis comes from nonrecourse financing that is not included in amount at risk.

The staff draft shows Lakeside Rental allowed at $18,000, Canyon LP allowed at $25,000, and one combined suspended passive loss of $28,000.

Which correction best makes the workpaper complete and accurate?

• A. Allow $15,000 of total passive loss against passive income and carry the unused $15,000 forward as one combined passive suspension with no separate at-risk carryforward.
• B. Limit Canyon LP to a $12,000 at-risk loss, suspend $13,000 under the at-risk rules, and allocate the $15,000 passive suspension as $9,000 to Lakeside Rental and $6,000 to Canyon LP.
• C. Limit Canyon LP to a $12,000 loss, suspend the remaining $13,000 as passive loss, and allow the full $18,000 Lakeside Rental loss.
• D. Keep Canyon LP’s $25,000 loss because basis exceeds the loss, then allocate the $28,000 passive suspension between the two loss activities.

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The loss limits must be applied in order: basis, then at-risk, then passive activity. Canyon LP has enough basis but only $12,000 at risk, so $13,000 is suspended under the at-risk rules; after that, the remaining passive limitation suspends $9,000 of Lakeside Rental and $6,000 of Canyon LP.

A complete loss-limitation workpaper must apply the rules in sequence and track carryforwards by activity. First, both loss activities have enough basis, so basis does not limit either loss. Next, the at-risk rules apply: Canyon LP has only $12,000 at risk, so only $12,000 of its $25,000 loss can move to the passive activity calculation, and $13,000 is suspended under the at-risk rules. Lakeside Rental’s full $18,000 loss moves forward because its amount at risk is $30,000. The passive activity calculation then uses $30,000 of total passive losses ($18,000 + $12,000) against $15,000 of passive income, leaving $15,000 of passive loss disallowed. That passive suspension must be allocated by activity based on the post-at-risk losses: 60% to Lakeside Rental ($9,000) and 40% to Canyon LP ($6,000).

• Treating Canyon LP’s excess $13,000 solely as passive loss skips the at-risk limitation, which is applied before passive loss rules.
• Allowing Canyon LP’s full $25,000 loss because basis is sufficient ignores that amount at risk can be lower than basis.
• Carrying one combined passive suspension is incomplete for a by-activity workpaper, and it also omits Canyon LP’s separate $13,000 at-risk carryforward.

At-risk limits apply before passive loss limits, so Canyon LP is first reduced to $12,000, and the remaining passive disallowance is then allocated between the loss activities based on their post-at-risk losses.

Question 17

Topic: Entity Tax Planning

A CPA is advising two unrelated U.S. individual clients who are forming a venture to hold land for future appreciation. They expect little current operating income and want the option to wind up the business in five years by distributing the appreciated land to themselves instead of selling it. Both owners are eligible S corporation shareholders and are comfortable with pass-through taxation. Assume no debt, no hot-asset issues, and no special allocations. Which entity choice generally produces the most favorable federal income tax result if the exit occurs through a liquidating in-kind distribution of the land?

• A. C corporation, because the distributed land can be transferred to the shareholders without immediate corporate-level gain.
• B. C corporation that later elects S status, because any appreciation that occurred before the S election is no longer relevant once the election becomes effective.
• C. Multimember LLC taxed as a partnership, because a liquidating in-kind distribution of appreciated land is generally a nonrecognition event that defers gain until a later disposition by the owners.
• D. S corporation, because pass-through status prevents gain recognition when appreciated property is distributed in liquidation.

Best answer: C

What this tests: Entity Tax Planning

Explanation: The multimember LLC taxed as a partnership is the best choice for this stated exit goal. A liquidating in-kind distribution of appreciated property is generally not a taxable event to the partnership, so the built-in gain is usually preserved for later rather than triggered immediately on liquidation.

When owners expect value to be realized through appreciation and want the flexibility to liquidate by distributing appreciated property, a partnership-style entity is often most tax-efficient. In a typical partnership liquidation, distributing appreciated land to partners generally does not cause the entity to recognize gain, and the partners usually take a carryover or substituted basis that preserves the built-in gain for later sale. By contrast, a C corporation generally recognizes gain when it distributes appreciated property as if the property were sold at fair market value, and the shareholders may also recognize gain on the liquidation, creating double-tax exposure. An S corporation usually avoids the classic C corporation double tax, but it still generally recognizes gain on an appreciated property distribution, with that gain passing through to the shareholders. A later S election also does not erase pre-election built-in gain concerns.

• The C corporation choice fails because distributing appreciated property generally triggers corporate gain as if sold at fair market value, and liquidation can also create shareholder-level gain.
• The S corporation choice is tempting because it is a pass-through entity, but appreciated property distributions still generally trigger gain recognition at the corporate level that flows through to the owners.
• The multimember LLC taxed as a partnership best matches the owners’ exit plan because an in-kind liquidating distribution usually defers, rather than accelerates, tax on the appreciation.
• The later S election choice ignores that appreciation from the C corporation period can remain significant through built-in gain rules and does not simply disappear.

A partnership generally does not recognize gain on a liquidating property distribution, so the built-in gain is usually deferred rather than triggered at liquidation.

Question 18

Topic: Entity Tax Planning

Harper and Jones are evaluating a formation plan for a new design business.

Based on the exhibit, which conclusion is most supported?

• A. The proposed plan should instead use a general partnership because that structure best permits flexible distributions and future investor admission.
• B. The proposed plan does not fit the ownership and cash-flow objectives; an LLC taxed as a partnership would better match the stated goals while preserving pass-through treatment and limited liability.
• C. The proposed plan does not fit the tax objective because early losses would remain at the entity level unless the LLC elects C corporation status.
• D. The proposed plan fits all stated objectives because an S corporation allows pass-through losses, limited liability, admission of a corporate investor, and nonpro rata cash distributions.

Best answer: B

What this tests: Entity Tax Planning

Explanation: The proposed S corporation election meets the pass-through tax and limited-liability goals, but it conflicts with two other stated objectives. An LLC taxed as a partnership better fits the desire to admit a corporate investor and to make disproportionate cash distributions while keeping pass-through treatment.

An S corporation is generally a pass-through entity, so it can satisfy the objective of having early losses flow to the owners. Using an LLC under state law can also satisfy the legal objective of limited liability. However, S corporation status is restrictive for the other stated goals: a corporation generally cannot be an S corporation shareholder, and S corporations must maintain one class of stock, so economic rights and distributions generally must be pro rata to ownership. Because Harper and Jones want the ability to admit Maple Inc. and to distribute more cash to Jones without changing ownership percentages, the proposed S election does not fit the ownership and cash-flow objectives. An LLC taxed as a partnership is the better fit because it keeps limited liability and pass-through taxation while allowing more flexible ownership and distribution arrangements.

• The claim that the S corporation plan fits all goals fails because a corporate investor is generally not an eligible S corporation shareholder, and nonpro rata distributions are inconsistent with S corporation economic-rights rules.
• The claim that early losses stay at the entity level is incorrect because both S corporations and partnerships generally pass tax items through to owners, subject to owner-level limits.
• The general partnership alternative improves flexibility, but it does not satisfy the stated legal objective that both owners have limited liability.

An LLC taxed as a partnership preserves pass-through taxation and limited liability while offering more flexibility than an S corporation for investor eligibility and nonpro rata cash distributions.

Question 19

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Assume an individual avoids a projected estimated-tax underpayment penalty if total prepayments equal the lesser of:

• 90% of current-year tax, or
• 100% of prior-year tax, increased to 110% if prior-year AGI exceeded $150,000 for married filing jointly.

A staff-prepared worksheet for a married couple shows no projected penalty.

Worksheet excerpt:

• Required annual payment = lesser of $26,100 (90% × $29,000) or $24,000 (100% × $24,000) = $24,000
• Total prepaid = $24,000
• Projected underpayment penalty = none

Which correction identifies the missing or incorrect fact that causes the worksheet to miss a projected underpayment penalty?

• A. No correction is needed, because total prepayments equal the prior-year tax of $24,000 and that always satisfies the safe harbor for married taxpayers.
• B. Replace the $24,000 required annual payment with $29,000, because taxpayers must prepay 100% of current-year projected tax to avoid any estimated-tax penalty.
• C. Replace the $24,000 required annual payment with $26,100, because the couple’s $182,000 prior-year AGI requires using 110% of prior-year tax in the safe-harbor comparison, creating a $2,100 shortfall.
• D. Replace total prepaid of $24,000 with $14,000, because withholding does not count toward estimated-tax prepayments.

Best answer: C

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The worksheet used the wrong prior-year safe-harbor percentage. Because prior-year AGI was $182,000 for a married couple, the comparison should use 110% of prior-year tax, making the required annual payment $26,100 and leaving a $2,100 underpayment.

Estimated-tax safe harbor is based on the lesser of 90% of current-year tax or the applicable percentage of prior-year tax. Here, 90% of current-year tax is $26,100. Because the couple’s prior-year AGI exceeded the stated $150,000 threshold, the prior-year comparison is 110% of $24,000, or $26,400, not $24,000. The required annual payment is therefore the lesser of $26,100 and $26,400, which is $26,100. Since withholding plus timely estimated payments total only $24,000, the worksheet missed a projected $2,100 underpayment. Withholding does count as prepaid tax for this annual safe-harbor calculation, and taxpayers are not required to prepay 100% of current-year projected tax when the safe-harbor rules are met.

• Using full projected current-year tax of $29,000 is a common error; the stated rule uses 90%, not 100%, of current-year tax.
• Excluding withholding is incorrect here because withholding is counted as prepaid tax for the safe-harbor total.
• Treating $24,000 as automatically sufficient ignores the stated 110% prior-year rule for higher-AGI married taxpayers.

Because prior-year AGI exceeds the stated threshold, the worksheet must compare 90% of current-year tax with 110% of prior-year tax, so the required annual payment is $26,100 rather than $24,000.

Question 20

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Lee received nonqualified stock options with no readily ascertainable fair market value at grant. On January 2, Year 1, after the options had vested, Lee exercised the options by paying $20 per share for stock worth $35 per share. Lee’s employer included the spread in Lee’s Year 1 Form W-2. Lee sold all shares on February 10, Year 2 for $38 per share. How should Lee characterize the federal income tax consequences of the exercise and sale?

• A. The $15 per share spread is ordinary compensation income at exercise, and the $3 per share increase is long-term capital gain at sale.
• B. The $15 per share spread is ordinary compensation income at exercise, and the $3 per share increase is short-term capital gain at sale.
• C. The $15 per share spread is ordinary compensation income when the option vests, and the $3 per share increase is long-term capital gain at sale.
• D. The full $18 per share increase is long-term capital gain when the shares are sold.

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: For a nonqualified stock option with no readily ascertainable value at grant, tax generally occurs at exercise, not at grant or vesting. Lee recognizes ordinary wage income on the $15 spread at exercise, and the later $3 increase is long-term capital gain because the shares were held for more than one year after exercise.

Nonqualified stock options usually do not create taxable income at grant if the option lacks a readily ascertainable fair market value. When the employee exercises the option, the difference between the stock’s fair market value and the exercise price is ordinary compensation income, and employers commonly report that amount on Form W-2. That same fair market value at exercise becomes the employee’s tax basis in the shares. Here, Lee paid $20 for stock worth $35, so the $15 spread is compensation income in Year 1. Lee later sold the shares for $38, so only the post-exercise appreciation of $3 is gain on sale. Because the shares were held from January 2, Year 1 to February 10, Year 2, that $3 gain is long-term capital gain.

• Treating the full $18 increase as capital gain ignores that the $15 bargain element was already taxed as W-2 compensation at exercise.
• Treating the $15 spread as taxable at vesting misstates the timing rule for a nonqualified option with no readily ascertainable value at grant.
• Treating the $3 post-exercise increase as short-term gain ignores that Lee held the shares for more than one year after exercise.

Because these are nonqualified options without a readily ascertainable fair market value at grant, the bargain element is W-2 compensation at exercise and later appreciation after exercise is capital gain based on the exercise-date fair market value.

Question 21

Topic: Entity Tax Compliance

Alpha Partnership provided the following ownership-change summary:

Based on the exhibit, which conclusion is most supported regarding the effects of the ownership change?

• A. Chen’s outside basis is $180,000; Lee and Chen are each allocated $25,000 of the transferred interest’s share of Year 1 ordinary income; and no common inside-basis change or transferee-only asset basis adjustment occurs.
• B. Chen’s outside basis is $120,000; Lee and Chen are each allocated $25,000 of the transferred interest’s share of Year 1 ordinary income; and no inside-basis change occurs.
• C. Chen’s outside basis is $180,000; Lee and Chen are each allocated $25,000 of the transferred interest’s share of Year 1 ordinary income; and the partnership increases common inside basis by $50,000 for all partners.
• D. Chen’s outside basis is $180,000; Lee and Chen are each allocated $25,000 of the transferred interest’s share of Year 1 ordinary income; and a $50,000 transferee-only asset basis adjustment is tracked to Chen.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: The buyer of a partnership interest generally takes a cost-based outside basis, so Chen starts with $180,000. Because the partnership uses an interim closing method, Lee is allocated pre-transfer items and Chen post-transfer items; without a Section 754 election or mandatory adjustment, the sale does not change common inside basis or create a special transferee-only basis adjustment.

A sale of a partnership interest is an ownership change at the partner level, not an automatic re-basing of partnership assets. Chen’s outside basis equals the purchase price paid, $180,000, because the interest was acquired by purchase and there are no liabilities to change that amount. For income allocation, the varying-interests rules apply, and the exhibit says the partnership uses an interim closing of the books. Since the $200,000 of ordinary income was earned evenly throughout the year, the transferred 25% interest is allocated $25,000 for the first half to Lee and $25,000 for the second half to Chen. The partnership’s common inside basis remains unchanged by the sale. A special Section 743(b) adjustment would be separately tracked only if a Section 754 election were in effect or a mandatory basis adjustment applied; the exhibit says neither condition exists.

• A $120,000 basis would be Lee’s pre-sale outside basis, not Chen’s purchase basis; a taxable purchase gives Chen a cost basis.
• A sale of a partnership interest does not automatically step up common inside basis for all partners just because purchase price differs from the share of inside basis.
• A transferee-only $50,000 basis adjustment would be the Section 743(b) concept, but the exhibit states there is no Section 754 election and no mandatory adjustment requirement.

A purchased partnership interest takes a cost outside basis, the interim closing method allocates items by period of ownership, and without a Section 754 or mandatory adjustment no Section 743(b) basis adjustment is created.

Question 22

Topic: Property Transactions (Disposition of Assets)

Jordan, a sole proprietor, sold equipment used in the business for $74,000. The equipment was purchased for $100,000, had $36,000 of accumulated depreciation, and had been held for more than 1 year. Jordan has no other Section 1231 transactions this year.

How should Jordan characterize the recognized gain on the sale?

• A. Long-term capital gain
• B. Section 1231 gain
• C. Unrecaptured Section 1250 gain
• D. Ordinary income under Section 1245 recapture

Best answer: D

What this tests: Property Transactions (Disposition of Assets)

Explanation: Jordan recognizes a $10,000 gain: $74,000 amount realized less $64,000 adjusted basis. Because the asset is Section 1245 property and prior depreciation of $36,000 exceeds the gain, the full $10,000 is ordinary income rather than Section 1231 gain.

Depreciable personal property used in a trade or business and held more than 1 year is generally Section 1231 property. However, Section 1245 recapture applies first. Any gain on the sale of Section 1245 property is treated as ordinary income to the extent of prior depreciation deductions. Here, the equipment’s adjusted basis is $64,000 ($100,000 cost less $36,000 depreciation), and the sale price is $74,000, so Jordan has a $10,000 gain. Since the prior depreciation taken ($36,000) is greater than the gain, the entire $10,000 is recaptured as ordinary income. No part of the gain remains for Section 1231 treatment.

• “Section 1231 gain” is tempting because the equipment was business property held more than 1 year, but Section 1245 recapture applies before any Section 1231 gain remains.
• “Long-term capital gain” is incorrect because depreciable business equipment is not treated as a capital asset in this sale context.
• “Unrecaptured Section 1250 gain” applies to certain depreciable real property, not to business equipment that is Section 1245 property.

Because the equipment is depreciable personal property and the $10,000 gain is less than prior depreciation, the entire gain is recaptured as ordinary income under Section 1245.

Question 23

Topic: Entity Tax Compliance

Redwood Co., a calendar-year C corporation, made one nonliquidating cash distribution to its sole shareholder, Lee, on December 20, Year 1.

Relevant facts:

• Accumulated E&P at January 1, Year 1: $40,000
• Current E&P for Year 1, computed without regard to distributions: $25,000
• Cash distributed to Lee: $90,000
• Lee’s stock basis immediately before the distribution: $18,000

What is the best interpretation of the federal income tax treatment of the $90,000 distribution to Lee?

• A. $65,000 is dividend income and the remaining $25,000 is capital gain because stock basis is not recovered in a nonliquidating distribution.
• B. The full $90,000 is dividend income because the distribution was made by a C corporation out of corporate cash.
• C. Only $40,000 is dividend income because accumulated E&P controls; the remaining $50,000 first reduces basis and then creates capital gain.
• D. $65,000 is dividend income, $18,000 reduces Lee’s stock basis to zero, and the remaining $7,000 is capital gain.

Best answer: D

What this tests: Entity Tax Compliance

Explanation: Lee is taxed on the distribution in three layers. First, the distribution is a dividend to the extent of Redwood’s total E&P of $65,000; next, the excess reduces Lee’s $18,000 stock basis; any amount beyond that basis is capital gain, producing $7,000 of gain.

For a nonliquidating cash distribution from a C corporation, the shareholder applies a three-step rule. The distribution is treated as a dividend to the extent of the corporation’s current and accumulated earnings and profits. Here, Redwood has $25,000 of current E&P and $40,000 of accumulated E&P, so $65,000 of the $90,000 distribution is dividend income. The remaining $25,000 is not a dividend because E&P has been exhausted. That excess next reduces the shareholder’s stock basis, so Lee recovers $18,000 of basis and his basis becomes zero. Any remaining excess after basis recovery is capital gain. Since $25,000 exceeds Lee’s $18,000 basis by $7,000, Lee recognizes $7,000 of capital gain.

• Treating the full $90,000 as a dividend ignores the basic limit that dividend treatment cannot exceed current plus accumulated E&P.
• Treating the entire excess over E&P as capital gain skips the required return-of-capital step through stock basis.
• Using only accumulated E&P ignores current E&P; both current and accumulated E&P determine the dividend portion here.

A nonliquidating C corporation cash distribution is a dividend only to the extent of current and accumulated E&P, then a return of basis, with any excess over basis treated as capital gain.

Question 24

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Olivia, a single taxpayer, owns a rental condo that is a passive activity. She has sufficient basis and amount at risk, and no special rental real estate allowance applies. On December 31, 2026, she sold her entire interest in the condo in a fully taxable transaction to an unrelated buyer.

Facts for 2026:

• Suspended passive losses from prior years: $52,000
• Current-year operating loss from the condo before sale: $8,000
• Recognized gain on sale of the condo: $15,000
• Net passive income from Olivia’s other passive activities: $9,000

How much of the condo-related loss is deductible against Olivia’s nonpassive income on her 2026 return?

• A. $36,000
• B. $45,000
• C. $51,000
• D. $60,000

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: Olivia’s condo losses total $60,000 before considering the sale gain. After netting the $15,000 recognized gain, the disposed activity has a $45,000 net loss; that loss must first offset $9,000 of other passive income, leaving $36,000 deductible against nonpassive income.

When a taxpayer disposes of an entire passive activity in a fully taxable transaction to an unrelated party, suspended passive losses from that activity are released. To determine how much becomes deductible against nonpassive income, first combine the prior-year suspended losses with the current-year operating results and the recognized gain or loss from the disposition of that same activity. Here, the condo activity produces a net loss of $45,000: $52,000 suspended loss + $8,000 current-year operating loss - $15,000 recognized gain. That $45,000 is then applied against passive income from Olivia’s other passive activities, which is $9,000. The remaining $36,000 is no longer limited by the passive activity rules and is deductible against nonpassive income.

• \$45,000 is the condo activity’s net loss after including the sale gain, but before offsetting Olivia’s $9,000 of other passive income.
• \$51,000 incorrectly ignores the $15,000 recognized gain on the condo sale when computing the released loss amount.
• \$60,000 incorrectly treats all suspended and current-year losses as immediately deductible against nonpassive income without netting the sale gain or other passive income.

On a fully taxable disposition to an unrelated party, the activity’s suspended and current-year losses are netted with that activity’s sale gain, then any remaining loss first offsets other passive income, and the balance is deductible against nonpassive income.

Question 25

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Jordan and Lee, who file jointly, project the following before year-end:

They are considering paying both years’ planned charitable gifts in December 2026 instead of giving $8,000 in each year. Assume no AGI limitation, carryover, or phaseout applies.

Which is the best interpretation of this year-end action?

• A. It improves both 2026 and 2027, because each year’s planned charitable gift creates a tax benefit in its intended year.
• B. It does not improve either year, because they already itemize in 2026 and the second gift is simply paid earlier.
• C. It improves 2027 only, because the second $8,000 gift is economically attributable to 2027.
• D. It improves 2026 only, because 2027 remains a standard-deduction year either way, so bunching increases the combined two-year deduction.

Best answer: D

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The proposal helps the current year because paying both gifts in 2026 raises itemized deductions from $32,000 to $40,000. It does not help 2027 by itself, because Jordan and Lee would claim the $30,000 standard deduction in 2027 whether they make that second gift then or not.

This is a classic bunching analysis. If Jordan and Lee give $8,000 in each year, their deductions are $32,000 in 2026 and $30,000 in 2027, for a two-year total of $62,000. If they pay both $8,000 gifts in 2026, their deductions become $40,000 in 2026 and $30,000 in 2027, for a two-year total of $70,000. The extra $8,000 deduction appears because 2027 is a standard-deduction year either way: $17,000 of other itemized deductions plus an $8,000 gift still would not exceed the $30,000 standard deduction. So accelerating the second gift improves the current year and the overall two-year result, but not 2027 as a separate year.

• The “improves both years” view fails because 2027 does not change; they still use the $30,000 standard deduction.
• The “improves 2027 only” view ignores that cash charitable gifts are deducted when paid and misses the larger 2026 itemized deduction.
• The “no improvement” view misses that already itemizing in 2026 does not eliminate the benefit of adding another $8,000 deduction that year.

Bunching both cash gifts into 2026 creates an extra $8,000 deduction in a year that already benefits from itemizing, while 2027 stays a standard-deduction year regardless.

Questions 26-50

Question 26

Topic: Entity Tax Compliance

During review of Alder Corp.’s 2025 draft federal return, a staff accountant wrote: “Because Alder has $400,000 of ordinary taxable income, it may deduct its full 2025 net capital loss on the 2025 return, and any unused amount simply carries forward.” Alder is a calendar-year C corporation and has no other capital loss carryovers.

2025 ordinary taxable income before capital items: \$400,000
2025 capital gains:                               \$30,000
2025 capital losses:                            \$(120,000)
Prior years' net capital gains:
  2022                                             \$20,000
  2023                                             \$15,000
  2024                                             \$10,000

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

• A. Only $30,000 of 2025 capital loss is utilized in 2025; the remaining $90,000 bypasses carryback and becomes a $90,000 5-year carryforward.
• B. Alder may deduct the full $90,000 net capital loss in 2025 because its ordinary taxable income exceeds the loss.
• C. Only $30,000 of 2025 capital loss is utilized in 2025; the remaining $90,000 is carried back only to 2024, using $10,000 there and leaving an $80,000 carryforward.
• D. Only $30,000 of 2025 capital loss is utilized in 2025; the remaining $90,000 is carried back to 2022 through 2024, using $45,000 there and leaving a $45,000 5-year carryforward.

Best answer: D

What this tests: Entity Tax Compliance

Explanation: A C corporation cannot deduct net capital losses against ordinary income. Alder uses $30,000 of current-year capital losses against $30,000 of current-year capital gains, leaving a $90,000 net capital loss that must be carried back 3 years first; prior gains absorb $45,000, so $45,000 carries forward 5 years.

For a C corporation, capital losses are deductible only to the extent of capital gains. They do not offset ordinary income and do not create an ordinary deduction in the loss year. Here, Alder’s 2025 capital gains of $30,000 are fully offset by part of its $120,000 capital losses, so $30,000 of loss is utilized in 2025. That leaves a $90,000 net capital loss.

A corporate net capital loss is carried back 3 years and then forward 5 years, applied to years with net capital gains. Alder’s prior 3 years show net capital gains of $20,000, $15,000, and $10,000, for total available carryback utilization of $45,000. After that carryback, the remaining $45,000 is carried forward for up to 5 years.

• Deducting the full $90,000 net capital loss in 2025 is wrong because corporate capital losses cannot offset ordinary taxable income.
• Sending the full $90,000 directly to carryforward is wrong because the 3-year carryback must be used before any 5-year carryforward.
• Carrying back only to 2024 understates utilization; Alder can apply the net capital loss to all 3 preceding years’ net capital gains, not just the immediately preceding year.

A C corporation may use capital losses only against capital gains, and any net capital loss is carried back 3 years first and then forward 5 years.

Question 27

Topic: Entity Tax Compliance

A staff CPA is preparing shareholder workpapers for the complete liquidation of Pine C Corp. Dana, the sole shareholder, has a $120,000 basis in her stock. In the liquidation, Pine distributes land to Dana. On the distribution date, the land has a fair market value of $260,000, Pine’s adjusted basis in the land is $190,000, and the land is subject to a $40,000 mortgage that Dana takes subject to.

What basis does Dana take in the land received in the liquidation?

• A. A $190,000 basis in the land
• B. A $220,000 basis in the land
• C. A $260,000 basis in the land
• D. A $120,000 basis in the land

Best answer: C

What this tests: Entity Tax Compliance

Explanation: Dana’s basis in the land is the land’s $260,000 fair market value on the liquidation date. The mortgage may affect Dana’s gain or loss on the stock exchange, but it does not reduce the basis Dana takes in the distributed property, and Pine’s inside basis does not carry over.

In a complete liquidation of a C corporation, the shareholder is treated as exchanging stock for the assets received. For the shareholder’s basis in property received, the general rule is fair market value at the date of distribution. Here, the land’s fair market value is $260,000, so Dana takes a $260,000 basis in the land. The $40,000 mortgage is relevant to the net value Dana receives and can affect the shareholder-level gain or loss calculation on the liquidation, but it does not reduce the basis of the land itself below fair market value. Pine’s $190,000 adjusted basis is relevant to the corporation’s own tax consequences on the liquidating distribution, not to Dana’s basis in the land.

• The $220,000 amount incorrectly subtracts the mortgage from fair market value; that confuses net equity received with the shareholder’s basis in the property.
• The $190,000 amount incorrectly uses the corporation’s adjusted basis; a liquidating distribution generally does not give the shareholder a carryover basis.
• The $120,000 amount incorrectly uses Dana’s stock basis; stock basis is used to compute liquidation gain or loss, not the basis of the land received.

In a complete liquidation, the shareholder’s basis in distributed property is its fair market value at the distribution date, even when the property is subject to a liability.

Question 28

Topic: Entity Tax Compliance

A CPA is preparing the Year 1 federal returns for Maple, a calendar-year C corporation, and Reed, its sole shareholder. The file shows:

What should the CPA do next to determine the Year 1 tax effect of the below-market terms?

• A. Wait until Reed repays the principal before recognizing any tax effect from the below-market loan terms.
• B. Determine Reed’s stock basis first to decide whether the $8,000 foregone interest is treated as a dividend.
• C. Reclassify the entire $200,000 advance as compensation because a below-market shareholder loan is not respected as debt.
• D. Calculate the $8,000 foregone interest as a deemed dividend to Reed and a deemed interest payment back to Maple, with no individual deduction for personal-use interest.

Best answer: D

What this tests: Entity Tax Compliance

Explanation: The next step is to apply the below-market loan rules to the annual foregone interest, not to the full principal. Because the lender is a C corporation and the borrower is its shareholder, the $8,000 foregone interest is treated as a deemed dividend to Reed and a deemed interest payment back to Maple.

When a C corporation makes a below-market loan to a shareholder, the tax analysis focuses on the foregone interest for the year. That amount is treated as if the corporation first transferred it to the shareholder and the shareholder then paid it back as interest. Because Maple has sufficient earnings and profits, the deemed transfer to Reed is a dividend rather than a return of capital. Maple therefore has interest income from the imputed amount, and Reed is treated as paying interest back to Maple. Since Reed used the borrowed funds for personal living expenses, that deemed interest is personal interest and generally nondeductible. The correct procedural next step is to apply this imputed-interest framework to the supplied $8,000 foregone interest figure.

• Waiting until principal repayment is wrong because below-market loan consequences are tested annually while the loan remains outstanding.
• Reclassifying the full $200,000 as compensation is wrong because the issue here is imputed interest on a shareholder loan, not automatic wage treatment of the entire advance.
• Reviewing stock basis first is unnecessary under these facts because sufficient earnings and profits already make the deemed transfer a dividend; basis matters only after earnings and profits are exhausted.

A below-market loan from a C corporation to its shareholder causes annual foregone interest to be treated as a deemed distribution to the shareholder and a deemed interest payment back to the corporation.

Question 29

Topic: Entity Tax Compliance

You are reviewing the year-end Form 1120-S workpapers for Cedar, an S corporation with no accumulated earnings and profits. Dana owns 100% of Cedar and has stock basis of $10,000 immediately before Cedar makes a nonliquidating distribution of land. The land’s adjusted basis to Cedar is $18,000 and its fair market value is $30,000. There are no other income, loss, or distribution items for the year. Which treatment is correct?

• A. Cedar recognizes a $12,000 gain; Dana’s stock basis first increases to $22,000, then is reduced to $0 by the $30,000 distribution, and Dana recognizes $8,000 capital gain.
• B. Cedar recognizes a $12,000 gain; Dana’s stock basis is reduced only by the land’s $18,000 adjusted basis to $4,000, and Dana recognizes no gain.
• C. Cedar recognizes no gain; Dana’s stock basis is reduced by the $30,000 fair market value to $0, and Dana recognizes $20,000 capital gain.
• D. Cedar recognizes a $12,000 gain; Dana’s stock basis is reduced by the $30,000 distribution before the passthrough gain is added, so Dana ends with $0 basis and recognizes $20,000 capital gain.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: For a nonliquidating distribution of appreciated property, the S corporation recognizes gain as if it sold the property for fair market value. That gain passes through and increases the shareholder’s stock basis before the fair market value of the distribution reduces basis; any excess distribution over post-increase basis is capital gain.

When an S corporation distributes appreciated noncash property, it is treated as if it sold the property at fair market value and must recognize the built-in gain. Here, Cedar recognizes $12,000 of gain ($30,000 FMV minus $18,000 adjusted basis). Because Dana owns 100% of the S corporation, that $12,000 passes through to Dana and increases stock basis from $10,000 to $22,000. The nonliquidating distribution is then measured at the property’s fair market value, so Dana reduces stock basis by $30,000. Stock basis cannot go below zero, so Dana’s stock basis becomes $0, and the $8,000 excess distribution ($30,000 minus $22,000) is taxed as capital gain. The key ordering rule is gain passthrough first, distribution reduction second.

• Reducing basis only by the land’s adjusted basis misses that the shareholder’s distribution amount is measured at fair market value, not the corporation’s inside basis.
• Applying the $30,000 distribution before adding the passthrough gain overstates Dana’s capital gain; the recognized corporate gain increases basis first.
• Treating the distribution as producing no corporate gain confuses S corporation property distribution rules; appreciated property distributions trigger gain recognition at the entity level.

Appreciated property distributions trigger corporate gain at fair market value, that gain increases stock basis first, and the fair market value distribution then reduces basis with any excess taxed as capital gain.

Question 30

Topic: Entity Tax Compliance

Maple C Corp. advanced $250,000 on January 2 to its 100% shareholder, who is not an employee, for the shareholder’s personal use. The CPA has already confirmed:

• Maple has sufficient current and accumulated earnings and profits.
• The applicable federal rate for the loan period is 5%.
• No exception to the below-market loan rules applies.

The CPA’s tentative conclusion is that the advance is a below-market shareholder loan that creates imputed interest and a constructive dividend to the shareholder. Which file item best supports that conclusion?

• A. A bank statement showing the shareholder received a $250,000 deposit from Maple.
• B. A general ledger report showing a $250,000 debit to loans receivable from shareholder.
• C. An executed promissory note stating the advance is payable on demand and bears 0% stated interest.
• D. Board minutes authorizing a $250,000 advance to the shareholder.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: The signed promissory note is the strongest support because it directly states the loan terms, including demand status and 0% stated interest. Those terms show the shareholder loan is below market when the applicable federal rate is 5%. With sufficient earnings and profits, the forgone interest is treated as a constructive dividend.

When a C corporation advances funds to a shareholder, the imputed-interest result depends on the actual loan terms, not just on the fact that cash changed hands. The best supporting evidence is the executed loan document because it shows the stated interest rate and repayment terms. Here, a demand loan with 0% stated interest is below the 5% applicable federal rate, so it supports imputed interest treatment. Because the borrower is a nonemployee shareholder and Maple has sufficient earnings and profits, the forgone interest is treated as a deemed distribution and therefore as a constructive dividend. Accounting records, corporate approval, and proof of deposit may show that an advance occurred, but they do not establish the below-market interest terms that drive this tax conclusion.

• The general ledger report shows that Maple recorded an advance, but it does not prove the interest rate or demand-loan terms.
• Board minutes show that the corporation approved an advance, but without the debt terms they do not establish that the loan was below market.
• The bank statement confirms the shareholder received cash, but it does not show whether adequate stated interest was charged.

A signed note showing a 0% demand loan directly proves the below-market terms that trigger imputed interest, and with sufficient earnings and profits the forgone interest is treated as a constructive dividend.

Question 31

Topic: Entity Tax Planning

Northfield, Inc., a calendar-year C corporation, is evaluating year-end planning ideas.

Based on the exhibit, which conclusion is best supported if Northfield wants a true current-year federal tax saving rather than a timing benefit, state and local planning benefit, or cash-flow benefit?

• A. The fully usable 2026 federal research credit is the best example of a true current-year federal tax saving.
• B. The December equipment purchase is the best example of a true current-year federal tax saving.
• C. The lower-tax state choice is the best example of a true current-year federal tax saving.
• D. The larger 2026 federal estimated tax payments are the best example of a true current-year federal tax saving.

Best answer: A

What this tests: Entity Tax Planning

Explanation: The fully usable federal research credit is the clearest current-year federal tax saving because it directly reduces Northfield’s 2026 federal income tax liability dollar for dollar. By contrast, accelerated depreciation is mainly timing, the state-location choice affects state taxes only, and larger estimated payments change cash flow rather than tax liability.

A true current-year federal tax saving is an item that actually lowers the corporation’s current-year federal income tax, not just the timing of deductions or payments. Here, Northfield’s $50,000 federal research credit is fully usable in 2026, so it reduces 2026 federal income tax by $50,000. The equipment purchase may still help cash flow, but because the same $200,000 deduction would otherwise be claimed in 2027, it mainly accelerates a deduction into 2026 rather than creating a permanent additional federal tax benefit. Choosing State Y may be good state and local tax planning, but the exhibit states that it has no federal income tax effect. Increasing estimated tax payments only changes when Northfield remits tax; it does not change the amount of federal tax owed.

• The equipment purchase can reduce 2026 federal tax now, but the exhibit says the same deduction would otherwise be taken in 2027, so the benefit is primarily timing.
• The State Y expansion choice may lower overall state tax cost, but the exhibit explicitly says it has no federal income tax effect.
• Larger estimated payments can reduce the balance due or underpayment exposure, but they do not reduce actual federal tax liability.
• The fully usable federal research credit directly cuts 2026 federal income tax and therefore is the strongest current-year federal tax saving shown.

A fully usable federal credit directly reduces current-year federal income tax dollar for dollar, unlike accelerated deductions, state-tax planning, or larger tax payments.

Question 32

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Amira is evaluating a year-end gift of publicly traded stock to a qualified public charity. She itemizes deductions, has held the stock for more than 1 year, and can use the full charitable deduction this year. If she donates the stock directly, no gain is recognized. Ignore NIIT and state income tax.

Which statement best interprets Amira’s federal income tax savings from donating the stock directly rather than selling it and keeping the after-tax cash?

• A. The direct donation produces $19,200 of federal tax savings because only the fair-value charitable deduction matters.
• B. The direct donation produces $24,450 of federal tax savings: $19,200 from the charitable deduction plus $5,250 from avoiding capital gains tax.
• C. The direct donation produces $5,250 of federal tax savings because the only benefit is avoiding tax on the built-in gain.
• D. The direct donation produces $13,250 of federal tax savings because the deduction is based on tax basis and the avoided capital gains tax is added separately.

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: A direct gift of appreciated long-term stock to a public charity can create two tax benefits when the full deduction is usable: a charitable deduction based on fair value and permanent avoidance of capital gains tax on the appreciation. Here, that is $19,200 from the deduction and $5,250 from avoided gain tax, for total savings of $24,450.

When a taxpayer donates appreciated capital gain property held more than one year to a qualified public charity, the tax planning benefit generally has two parts. First, the taxpayer receives a charitable contribution deduction measured by fair market value if the full deduction is allowed. Second, the taxpayer does not recognize the built-in gain that would have been taxed if the property were sold. In Amira’s case, the deduction is $60,000, producing tax savings of $19,200 ($60,000 × 32%). The stock’s appreciation is $35,000 ($60,000 fair value less $25,000 basis), so avoiding a sale also avoids $5,250 of long-term capital gains tax ($35,000 × 15%). Total potential federal income tax savings from the direct donation are $24,450.

• Using only the $60,000 fair-value deduction misses the separate benefit of never recognizing the $35,000 built-in gain.
• Using tax basis for the deduction is inconsistent with the facts; the stem states Amira can deduct the full value this year.
• Counting only avoided capital gains tax ignores that the direct gift also generates an itemized charitable deduction.

The tax benefit equals the fair-value deduction at Amira’s ordinary rate plus the avoided tax on the built-in long-term gain.

Question 33

Topic: Entity Tax Planning

Cobalt, Inc., a calendar-year C corporation, has two unrelated shareholders. Dana owns 40% of the stock with a $150,000 basis, and Noel owns 60%. Cobalt has $400,000 of cash, land held for investment with a $400,000 fair market value and a $100,000 basis, and sufficient earnings and profits.

Dana wants to completely terminate her ownership this year and receive $400,000 of value. The planning objective is to produce the lowest current combined federal income tax after considering both Dana’s tax and Cobalt’s entity-level tax consequences. Assume a complete termination redemption qualifies for sale-or-exchange treatment, and qualified dividends and long-term capital gains are taxed at the same rate.

Which proposed transaction best meets the objective?

• A. Cobalt redeems all of Dana’s stock for $400,000 cash.
• B. Cobalt pays Dana a $400,000 cash dividend.
• C. Cobalt sells the land for $400,000 cash and then redeems all of Dana’s stock for $400,000 cash.
• D. Cobalt redeems all of Dana’s stock by distributing the land with a $400,000 fair market value.

Best answer: A

What this tests: Entity Tax Planning

Explanation: The cash redemption best satisfies the objective because Dana gets sale-or-exchange treatment and may recover her stock basis, while Cobalt avoids entity-level gain by using cash. The appreciated-land alternatives trigger corporate gain, and the dividend taxes the full amount to Dana without terminating her ownership.

For a C corporation, distributing appreciated property causes the corporation to recognize gain as if it sold the property for fair market value. That makes a property redemption costly at the entity level, and selling the land first produces the same built-in gain. By contrast, using cash for a qualifying complete termination redemption avoids corporate gain and gives Dana exchange treatment, so she recognizes gain only on the excess of the $400,000 proceeds over her $150,000 stock basis, or $250,000. A cash dividend does not trigger entity-level gain, but it does not accomplish Dana’s exit and generally taxes the full $400,000 as a dividend because Cobalt has sufficient earnings and profits. Therefore, the cash redemption is the best overall planning choice when both shareholder-level and entity-level consequences matter.

• A redemption with appreciated land fails because Cobalt must recognize the $300,000 built-in gain on the land before considering Dana’s exchange treatment.
• Selling the land and then redeeming with cash also fails because the land sale creates the same $300,000 corporate gain.
• A cash dividend avoids corporate gain, but Dana does not get sale-or-exchange treatment or basis recovery, and her ownership is not terminated.

A cash redemption qualifying as a complete termination gives Dana sale-or-exchange treatment with basis recovery and does not cause Cobalt to recognize gain.

Question 34

Topic: Entity Tax Planning

Oak Ridge, Inc., a calendar-year C corporation, wants to minimize its 2026 federal estimated tax payments while avoiding underpayment penalties.

Planning facts:

• Oak Ridge timely filed its 2025 Form 1120, which showed federal income tax of $168,000.
• Oak Ridge projects 2026 taxable income of $960,000.
• Assume the federal corporate tax rate is 21%, with no credits, AMT, or other special taxes.
• Assume Oak Ridge is not a large corporation for estimated tax purposes.
• Assume Oak Ridge will not use the annualized income installment method.
• No 2026 estimated tax payments have been made yet.

What should the controller do next?

• A. Compute the payments from the shareholders’ expected individual tax liabilities.
• B. Schedule four equal federal estimated tax payments of $50,400 each.
• C. Defer estimated payments until midyear actual results are available.
• D. Schedule four equal federal estimated tax payments of $42,000 each.

Best answer: D

What this tests: Entity Tax Planning

Explanation: To avoid underpayment penalties while minimizing cash outflow, Oak Ridge should use the required annual payment rule. Under the stated assumptions, that amount is the lesser of current-year projected tax and prior-year tax, which results in four equal $42,000 installments.

A C corporation generally avoids estimated tax underpayment penalties by paying its required annual payment. Under the assumptions given, that amount is the lesser of 100% of current-year tax or 100% of prior-year tax shown on a timely filed return. Oak Ridge’s projected 2026 tax is $960,000 × 21% = $201,600. Its 2025 tax was $168,000. The lesser amount is $168,000, so the corporation should plan to pay that amount through estimated taxes. Because the facts also state that Oak Ridge is not a large corporation and will not use the annualized income installment method, the practical next step is to divide $168,000 into four equal installments of $42,000 each.

• Paying $50,400 each quarter uses projected current-year tax, which is safe but does not meet the stated goal of minimizing estimated payments.
• Deferring payments until midyear ignores the required installment schedule and can create underpayment exposure.
• Using shareholders’ individual tax liabilities applies to pass-through entities, not to a C corporation that pays its own federal income tax.

The required annual payment is the lesser of projected current-year tax of $201,600 or prior-year tax of $168,000, so Oak Ridge should pay $168,000 in four $42,000 installments.

Question 35

Topic: Property Transactions (Disposition of Assets)

Mason, a sole proprietor, sold the following business assets during 2025. A staff preparer assigned each sale to an initial character bucket before any Section 1231 netting. Assume all depreciation shown was allowed or allowable, no related-party rules apply, and ignore the Section 1231 lookback rule.

Which line is assigned to the wrong character category?

• A. The machine line; its $30,000 gain should be ordinary income, not Section 1231 gain.
• B. The land line; its $60,000 gain should be long-term capital gain, not Section 1231 gain.
• C. The office building line; its $30,000 loss should be ordinary loss, not Section 1231 loss.
• D. The delivery van line; its $8,000 loss should be Section 1231 loss, not ordinary loss.

Best answer: A

What this tests: Property Transactions (Disposition of Assets)

Explanation: The machine line is the only misclassification. Although the machine is business-use property held more than one year, Section 1245 recapture makes gain ordinary to the extent of prior depreciation, and the prior depreciation exceeds the entire $30,000 gain.

Section 1231 generally covers depreciable business property and real property used in a trade or business and held more than one year. However, gains on depreciable personal property are tested first under Section 1245. Any gain is ordinary income up to the amount of depreciation allowed or allowable, and only excess gain can move into the Section 1231 netting process. Here, the machine had $140,000 of depreciation and only a $30,000 realized gain, so the full gain is ordinary income. The office building loss is properly placed in the Section 1231 loss bucket because business real property held more than one year is Section 1231 property. The land gain is also a Section 1231 item. The van loss is ordinary because the van was held only 10 months, so it does not meet the more-than-one-year holding period for Section 1231.

• The office building line is acceptable because a loss on business real property held more than one year enters the Section 1231 loss bucket before any netting.
• The land line is acceptable because land used in a trade or business and held more than one year produces a Section 1231 gain, not a direct capital gain.
• The delivery van line is acceptable because property held 10 months does not qualify for Section 1231, so its loss is ordinary.

Gain on depreciable personal property is ordinary under Section 1245 to the extent of prior depreciation, so this entire $30,000 gain is ordinary income.

Question 36

Topic: Property Transactions (Disposition of Assets)

Mason exchanges investment real estate on October 1, Year 1. The exchange qualifies as a like-kind exchange under Sec. 1031.

No liabilities or exchange expenses were involved.

What amounts should Mason compute for realized gain, recognized gain, and deferred gain, respectively?

• A. $120,000 realized; $0 recognized; $120,000 deferred
• B. $120,000 realized; $40,000 recognized; $80,000 deferred
• C. $120,000 realized; $120,000 recognized; $0 deferred
• D. $80,000 realized; $40,000 recognized; $40,000 deferred

Best answer: B

What this tests: Property Transactions (Disposition of Assets)

Explanation: Mason’s realized gain is the fair market value of what he received minus the adjusted basis of what he gave up: $300,000 - $180,000 = $120,000. Because the exchange included $40,000 of cash boot, Mason recognizes $40,000 currently and defers the remaining $80,000.

In a qualifying like-kind exchange, first compute realized gain as the amount realized minus the adjusted basis of the relinquished property. Here, Mason received like-kind real estate worth $260,000 plus $40,000 cash, so the total amount realized is $300,000. Subtracting Mason’s $180,000 adjusted basis gives a $120,000 realized gain. Recognized gain in a like-kind exchange is generally limited to the lesser of the realized gain or the boot received. Mason received $40,000 of cash boot, so he recognizes $40,000. The rest of the realized gain, $80,000, is deferred rather than taxed currently. That deferred gain carries into the replacement property through its basis.

• The choice with zero recognized gain ignores the $40,000 cash boot; boot triggers current recognition up to the realized gain.
• The choice with $80,000 realized gain incorrectly leaves the cash out of the amount realized; both the like-kind property and the cash received count.
• The choice with full $120,000 recognized gain treats the exchange as fully taxable, but only the boot portion is recognized currently in a qualifying like-kind exchange.

Realized gain is $300,000 less $180,000, recognized gain is limited to the $40,000 cash boot received, and the remaining $80,000 is deferred.

Question 37

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Olivia operates a sole proprietorship. At the beginning of the year, she had $30,000 invested in the business and no prior suspended losses. During the year, the business generated a $50,000 loss. Assume the loss is otherwise deductible and only the at-risk rules are at issue. Which source-data item should be classified as NOT increasing Olivia’s amount at risk, causing $20,000 of the loss to be suspended?

• A. Business equipment with adjusted basis of $25,000 that Olivia contributes to the business
• B. $25,000 nonrecourse debt secured only by business assets
• C. $25,000 cash Olivia contributes to the business
• D. $25,000 recourse bank debt for which Olivia is personally liable

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: Under the at-risk rules, cash contributed, property contributed at adjusted basis, and recourse debt for which the taxpayer is personally liable generally increase the amount at risk. Nonrecourse debt secured only by business assets generally does not, so Olivia would be limited to her existing $30,000 at-risk amount and would suspend the remaining $20,000 loss.

The at-risk rules limit an individual’s deductible loss to the amount the individual has economically at risk in the activity. Olivia starts with $30,000 at risk. If she adds cash, contributes property, or borrows on a recourse basis so that she is personally liable, her at-risk amount increases and the full $50,000 loss could be allowed. By contrast, nonrecourse debt secured only by assets used in the activity generally does not put Olivia personally at risk, because she is not personally exposed beyond the activity property. In that case, her at-risk amount stays at $30,000, so only $30,000 of the loss is currently deductible and $20,000 is suspended under the at-risk rules.

• $25,000 nonrecourse debt secured only by business assets is the only item that generally does not increase Olivia’s at-risk amount.
• $25,000 cash Olivia contributes to the business increases her at-risk amount dollar for dollar.
• Business equipment with adjusted basis of $25,000 that Olivia contributes to the business increases her at-risk amount by the contributed property’s adjusted basis.
• $25,000 recourse bank debt for which Olivia is personally liable increases her at-risk amount because she bears personal repayment risk.

Nonrecourse debt secured only by activity assets generally does not increase the taxpayer’s at-risk amount, so Olivia remains at risk for only $30,000 and must suspend the excess $20,000 loss.

Question 38

Topic: Entity Tax Compliance

A CPA reviews a draft compliance memo for Helping Hands Foundation, a recognized §501(c)(3) public charity. The memo states that none of the year’s activities threatens exempt status because any issue would be handled only through unrelated business income tax.

During the year, the foundation:

• continued its food pantry and educational programs,
• operated a thrift shop staffed entirely by volunteers and selling donated goods,
• earned interest on reserve funds, and
• posted website endorsements of a named mayoral candidate and paid for emails urging supporters to vote for that candidate.

What is the best correction to the memo?

• A. Revise the memo to state that the interest income is unrelated business income and is the activity most likely to cause revocation of exempt status.
• B. Revise the memo to state that the candidate endorsement and vote solicitation are political campaign intervention that can jeopardize or revoke §501(c)(3) status.
• C. Revise the memo to state that the volunteer-run thrift shop automatically causes loss of exemption because selling merchandise is a commercial activity.
• D. Revise the memo to state that the campaign activity creates only a filing or tax-payment issue, so exempt status is not at risk.

Best answer: B

What this tests: Entity Tax Compliance

Explanation: The memo is wrong because a §501(c)(3) cannot support or oppose a candidate for public office. Campaign intervention can threaten the organization’s exemption, whereas volunteer-run sales of donated goods and passive interest income generally do not cause loss of status in these facts.

For a §501(c)(3) organization, political campaign intervention is a prohibited activity. Endorsing a named candidate and urging the public to vote for that candidate is not just a UBI issue; it can jeopardize or revoke the organization’s tax-exempt status. By contrast, a thrift shop staffed entirely by volunteers and selling donated goods is generally not the kind of activity that automatically causes exemption loss on these facts, and interest on reserve funds is passive investment income rather than the key disqualifying event here. The best correction is to identify the campaign endorsement and solicitation as the compliance problem that threatens exemption.

• The volunteer-run thrift shop is a tempting trap because commercial activity can raise exempt-organization concerns, but these facts point instead to a common exception pattern rather than automatic revocation.
• Interest income is another trap because candidates often overclassify passive income as unrelated business income; passive investment income is not the disqualifying event here.
• Treating the endorsement as only a filing or tax-payment issue understates the problem: for a §501(c)(3), campaign intervention can threaten the exemption itself.

A §501(c)(3) organization is prohibited from participating in or intervening in a political campaign for or against a candidate for public office.

Question 39

Topic: Entity Tax Compliance

Maple, a C corporation, makes a nonliquidating distribution of land to its sole shareholder, Rios.

How should this distribution be characterized for federal income tax purposes?

• A. Maple recognizes a $12,000 gain; Rios has $30,000 dividend income, $2,000 return of capital, and $2,000 capital gain.
• B. Maple recognizes no gain because the property was distributed; Rios has $30,000 dividend income, $2,000 return of capital, and $2,000 capital gain.
• C. Maple recognizes a $12,000 gain; Rios has $34,000 dividend income and no capital gain.
• D. Maple recognizes a $6,000 gain; Rios has $30,000 dividend income, $2,000 return of capital, and $2,000 capital gain.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: Maple recognizes gain on the distribution of appreciated property as if it sold the land for its $40,000 fair market value, so the corporate gain is $12,000. Rios’s distribution amount is $34,000 after reducing fair market value by the $6,000 mortgage, so with $30,000 of E&P and $2,000 stock basis, the result is dividend income, then return of capital, then capital gain.

In a nonliquidating distribution, a C corporation recognizes gain on appreciated property as though it sold the property for fair market value. Maple therefore recognizes $12,000 of gain, computed as $40,000 fair market value minus $28,000 adjusted basis. For the shareholder, the amount of the property distribution is the fair market value reduced by liabilities assumed or taken subject to, so Rios is treated as receiving a $34,000 distribution. That amount is taxed under the normal ordering rules: dividend to the extent of E&P, then return of capital to the extent of stock basis, and any excess as capital gain. Because Maple has $30,000 of E&P available for the distribution, Rios reports $30,000 of dividend income. The next $2,000 reduces Rios’s stock basis to zero, and the remaining $2,000 is capital gain.

• Treating the full $34,000 as a dividend ignores the stated $30,000 E&P limit; excess over E&P is not dividend income.
• Using $6,000 as Maple’s gain wrongly nets the mortgage against fair market value for the corporation; corporate gain is based on fair market value over adjusted basis here.
• Saying Maple recognizes no gain incorrectly assumes property distributions are nonrecognition events for appreciated property; that is not the rule for nonliquidating C corporation distributions.

A C corporation recognizes gain on appreciated property distributed at fair market value, and the shareholder’s distribution amount is fair market value reduced by the assumed liability, taxed as dividend first, then basis recovery, then capital gain.

Question 40

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

A CPA is reviewing Dana Lee’s 2025 Form 1040. Dana owns 25% of Red Oak LLC, which is taxed as a partnership. Dana deducted the full 2025 K-1 loss on Schedule E.

Based on the exhibit, what is the most appropriate next step before determining Dana’s deductible 2025 loss?

• A. Allow a $10,000 current-year loss and suspend the rest, because beginning basis plus cash contributions are the only amounts that matter.
• B. Request the missing activity detail, debt allocation and loan support, and participation records before computing any allowed or suspended loss.
• C. Add the $30,000 liability increase to basis and at-risk amount based solely on the K-1 footnote, then release the prior-year suspended passive loss.
• D. Suspend all losses as passive immediately, because the mention of equipment rentals controls the classification of the entire activity.

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The file is missing the core documents needed to test all three loss limitations. The CPA cannot determine basis, at-risk amount, or passive versus nonpassive treatment from a liability footnote and a vague statement about participation, so the proper step is to request supporting documentation first.

A pass-through loss review requires support for basis, at-risk amount, and passive activity treatment before any loss is allowed. Dana’s beginning basis and cash contribution show only part of the basis picture. Because Red Oak is a partnership, allocated liabilities may affect outside basis, but the CPA needs the liability allocation schedule and underlying loan information to verify the amount and whether the debt supports at-risk treatment. The CPA also needs activity detail to determine whether the loss is from rental activity, an operating business, or a mixed activity, and needs participation records to evaluate material participation. A taxpayer’s statement that she “helped often” is not enough by itself to classify the loss or release suspended passive losses. Therefore, the next step is to obtain the missing debt, activity, and participation documentation before computing the deductible or suspended amount.

• Using only beginning basis plus cash contributions ignores possible liability-based basis and skips the separate at-risk and passive-loss tests.
• Treating the K-1 liability footnote as automatic basis and at-risk support is improper without allocation details and loan documentation.
• Suspending everything as passive based only on the word “rentals” is premature because the activity may be mixed and participation has not been substantiated.

Basis, at-risk amount, and passive-loss treatment cannot be determined from the exhibit alone because the liability increase, activity type, and material participation are unsupported.

Question 41

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Olivia owns 50% of Oak Street Catering LLC, which is taxed as a partnership, and she materially participates in the business. At the beginning of the year, her outside basis and amount at risk were both $24,000.

During the year:

• Olivia contributed $10,000 cash to the LLC.
• Olivia borrowed $18,000 from First Bank on a personal recourse note and contributed the proceeds to the LLC.
• The LLC borrowed $80,000 on a nonrecourse note secured only by LLC equipment; Olivia’s share of this liability increase for basis purposes is $40,000.
• Olivia received a $6,000 cash distribution from the LLC.
• Olivia’s share of the LLC’s ordinary loss for the year was $55,000.

A staff memo states that Olivia may deduct the entire $55,000 loss because she materially participates and has sufficient basis. What is the best correction to the memo?

• A. Limit Olivia’s current deduction to $46,000 and carry forward $9,000 as an at-risk suspended loss.
• B. Allow the full $55,000 because material participation and sufficient basis remove any owner-level loss limitation.
• C. Limit Olivia’s current deduction to $28,000 and carry forward $27,000 because only cash contributions, not personally borrowed contributed funds, increase amount at risk.
• D. Limit Olivia’s current deduction to $52,000 and carry forward $3,000 because the cash distribution does not reduce amount at risk.

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: Olivia’s loss is limited by the at-risk rules, not just by basis. Her year-end amount at risk is $46,000, so only $46,000 of the $55,000 loss is currently deductible and the remaining $9,000 is suspended.

For an individual who materially participates, the passive activity rules may not block the loss, but the at-risk rules still apply. Compute Olivia’s year-end amount at risk by starting with $24,000, adding her $10,000 cash contribution and the $18,000 she borrowed personally and contributed, then subtracting the $6,000 cash distribution. That produces $46,000 at risk before the current-year loss. The LLC’s $80,000 nonrecourse borrowing, including Olivia’s $40,000 share for outside basis purposes, does not increase her amount at risk because she is not personally liable for that debt. Therefore, Olivia may deduct only $46,000 of her $55,000 share of loss this year, and $9,000 is suspended until she has additional amount at risk.

• The full-loss approach confuses basis with amount at risk and also incorrectly assumes material participation eliminates the at-risk limitation.
• The $52,000 approach incorrectly ignores the $6,000 cash distribution, which reduces amount at risk.
• The $28,000 approach incorrectly excludes the $18,000 personally borrowed and contributed funds; because Olivia is personally liable, that amount is at risk.

Olivia’s amount at risk is $24,000 + $10,000 + $18,000 - $6,000 = $46,000, and the LLC’s nonrecourse borrowing increases basis but not her amount at risk.

Question 42

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Alex and Jordan, a married couple filing jointly, ask their CPA for a year-end planning recommendation. They are cash-basis taxpayers.

Projected facts:

• Fixed 2026 wage income: $190,000
• Federal income tax withholding through Nov. 30, 2026: $26,000
• One spouse will receive a December bonus of $12,000, and payroll can add any requested federal withholding if instructed by Dec. 20.
• The other spouse completed consulting work for a client. If billed on Dec. 27, the client will pay $30,000 on Dec. 30. If billed on Jan. 2, the client will pay $30,000 on Jan. 7.
• If the $30,000 is received in December, their 2026 marginal federal rate will be 32%.
• If that $30,000 is deferred to January, their projected 2027 marginal federal rate on that income will be 24%.
• To avoid a 2026 federal underpayment penalty, their total 2026 withholding and estimated tax payments must equal at least $32,000.
• Their goals are to minimize 2026 taxable income, avoid an underpayment penalty, and avoid making a separate year-end tax payment if possible.

What should the CPA recommend next?

• A. Delay billing the $30,000 until January and request at least $6,000 of additional federal withholding from the December bonus.
• B. Bill the $30,000 in December and send a $6,000 fourth-quarter estimated tax payment in January.
• C. Delay billing the $30,000 until January and make no additional withholding or estimated tax payment.
• D. Bill the $30,000 in December and request at least $6,000 of additional federal withholding from the December bonus.

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The best next step is to defer the consulting income into January and add $6,000 of withholding to the December bonus. That moves income out of a 32% year into a projected 24% year while still satisfying the underpayment safe harbor through withholding rather than a separate estimated payment.

For a cash-basis taxpayer, delaying billing so payment is not received until January can defer income into the next tax year, assuming the income was not already made available in December. Here, deferral is favorable because the $30,000 would otherwise be taxed at 32% in 2026 but is projected to be taxed at 24% in 2027. The couple also needs total 2026 payments of $32,000 to avoid an underpayment penalty, and they have only $26,000 withheld so far. Requesting an extra $6,000 of withholding from the December bonus solves that gap. Late-year withholding is especially useful in planning because it is treated as paid throughout the year, unlike waiting to simply discover the shortfall at return time. This recommendation best aligns tax-rate planning, penalty avoidance, and year-end cash management.

• Delaying the billing without adding any payment leaves total 2026 payments at $26,000, which is below the $32,000 safe-harbor amount.
• Billing in December and adding withholding addresses the penalty issue, but it accelerates $30,000 into the higher 32% tax year.
• Billing in December and making a January estimated payment is weaker still because it both accelerates income and requires a separate cash payment instead of using payroll withholding.

This shifts income from a 32% year to a projected 24% year and uses year-end withholding to reach the $32,000 safe-harbor payment amount without a separate estimated tax payment.

Question 43

Topic: Property Transactions (Disposition of Assets)

During review of a client’s exchange file, a staff preparer wrote: “No gain should be recognized because the taxpayer exchanged one parcel of real estate for another in a like-kind exchange.”

Relevant closing data:

• Relinquished property: business warehouse
• Adjusted basis of relinquished property: $220,000
• FMV of relinquished property: $300,000
• Replacement property received: investment land with FMV of $260,000
• Cash received by taxpayer at closing: $40,000
• Liabilities assumed by either party: none
• Both properties were held for productive use in a trade or business or for investment

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

• A. Revise the memo to state that no gain is recognized because cash received in a qualifying real property exchange only reduces the basis of the replacement land.
• B. Revise the memo to state that the entire $80,000 realized gain must be recognized because receiving any cash makes the exchange fully taxable.
• C. Revise the memo to state that the entire exchange is taxable because business real estate and investment real estate are not like-kind to each other.
• D. Revise the memo to state that the exchange is partially taxable and that $40,000 of gain must be recognized because cash boot was received.

Best answer: D

What this tests: Property Transactions (Disposition of Assets)

Explanation: The warehouse and the investment land are qualifying real property, so the exchange can still receive like-kind treatment. But the $40,000 cash received is boot, so the transaction is not fully nontaxable; the taxpayer must recognize gain up to the lesser of boot received or total realized gain, which is $40,000.

A like-kind exchange of qualifying real property held for business or investment is generally eligible for nonrecognition treatment. Here, both the relinquished warehouse and the replacement investment land are qualifying real property, so the staff preparer was wrong only in calling the transaction fully nontaxable. The taxpayer received $40,000 cash in addition to the replacement land, and that cash is boot. Realized gain is $80,000, calculated as the $300,000 total value received minus the $220,000 adjusted basis of the relinquished property. In a like-kind exchange, recognized gain is limited to the lesser of realized gain or boot received. Therefore, $40,000 of gain must be recognized currently, and the remaining gain is deferred.

• Treating the whole $80,000 realized gain as taxable overstates the correction; boot causes partial recognition, not full recognition, when the rest of the exchange qualifies.
• Treating the exchange as fully nontaxable ignores the cash boot, which triggers current gain recognition to the extent of realized gain.
• Treating business real estate and investment real estate as not like-kind misstates the rule; qualifying U.S. real property held for business or investment is generally like-kind to other qualifying U.S. real property.

Cash boot causes recognition of gain up to the lesser of realized gain or boot received, so $40,000 is recognized even though the real-property exchange otherwise qualifies for like-kind treatment.

Question 44

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Taylor and Morgan, married filing jointly, are evaluating one year-end tax-planning action.

Assume each proposed action involves $20,000. Also assume:

• Any state income tax payment is fully deductible for regular tax but not deductible for AMT.
• A cash charitable contribution is fully deductible for both regular tax and AMT.
• Interest on a personal-use home equity loan is not deductible.
• Exercising incentive stock options with a $20,000 bargain element creates a $20,000 AMT adjustment and no current regular-tax deduction.

Which action produces the largest actual current-year federal tax reduction without an offsetting AMT concern?

• A. Exercise incentive stock options with a $20,000 bargain element and hold the shares
• B. Prepay $20,000 of next year’s state income tax
• C. Prepay $20,000 of interest on a personal-use home equity loan
• D. Make a $20,000 cash charitable contribution

Best answer: D

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The cash charitable contribution is the best choice because it is deductible for both regular tax and AMT. That means it lowers regular tax without triggering a tentative minimum tax offset, producing the full $4,800 current-year tax savings.

Actual federal income tax is the greater of regular tax or tentative minimum tax. Before any action, Taylor and Morgan pay regular tax of $32,600 because it exceeds tentative minimum tax of $29,000. A $20,000 cash charitable contribution reduces regular tax by $4,800 ($20,000 × 24%) and also reduces tentative minimum tax by $5,600 ($20,000 × 28%), so actual tax becomes $27,800. By contrast, prepaying state income tax reduces only regular tax to $27,800 while tentative minimum tax stays $29,000, so AMT limits the benefit and actual tax only falls to $29,000. Personal-use home equity interest is nondeductible, and the ISO exercise increases AMTI, potentially causing AMT rather than tax savings.

• Prepaying next year’s state income tax appears to save $4,800 under regular tax, but AMT disallows that deduction, so actual tax only drops to $29,000.
• Making the cash charitable contribution works under both systems, so the full regular-tax benefit is preserved.
• Prepaying personal-use home equity interest does not help because personal interest is nondeductible.
• Exercising the incentive stock options adds a $20,000 AMT adjustment, increasing tentative minimum tax instead of reducing current-year tax.

The charitable contribution reduces regular tax by $4,800 and tentative minimum tax by $5,600, so actual tax falls from $32,600 to $27,800 with no AMT clawback.

Question 45

Topic: Entity Tax Compliance

During 20X5, Granite, a calendar-year C corporation, made a single nonliquidating cash distribution of $90,000 to its sole shareholder, Lee, on December 15. Granite’s current earnings and profits for 20X5 is $30,000, and its accumulated earnings and profits immediately before the distribution is $20,000. Lee’s stock basis is not yet available in the client file. The CPA is determining the tax treatment of the distribution on Lee’s return. What should be done next?

• A. Determine whether Granite may deduct the $40,000 excess distribution in computing its corporate taxable income.
• B. Report the entire $90,000 as dividend income because a cash distribution from a C corporation is fully taxable to the shareholder.
• C. Report the $40,000 excess over earnings and profits directly as capital gain without reviewing Lee’s stock basis.
• D. Obtain Lee’s stock basis and treat the $40,000 excess over earnings and profits first as basis recovery and then as capital gain only if the excess is greater than basis.

Best answer: D

What this tests: Entity Tax Compliance

Explanation: The corporation has only $50,000 of total earnings and profits available for dividend treatment, so the remaining $40,000 cannot automatically be treated as dividend income. The next required step is to review Lee’s stock basis because excess cash first reduces basis and becomes capital gain only after basis reaches zero.

For a nonliquidating cash distribution from a C corporation, the shareholder treatment follows a fixed order. First, the distribution is dividend income to the extent of the corporation’s current and accumulated earnings and profits. Second, any amount above earnings and profits is a nontaxable return of capital that reduces the shareholder’s stock basis. Third, once basis is reduced to zero, any remaining excess is capital gain.

Here, Granite has total earnings and profits of $50,000 ($30,000 current plus $20,000 accumulated). Because the cash distribution is $90,000, there is a $40,000 amount above earnings and profits. That excess cannot be classified correctly until Lee’s stock basis is known. Therefore, the CPA should obtain Lee’s basis information next and apply the ordering rules to that $40,000 excess.

• Treating the entire $90,000 as a dividend ignores the limit imposed by total current and accumulated earnings and profits.
• Looking for a corporate deduction addresses the wrong taxpayer; a cash distribution does not become deductible merely because it exceeds earnings and profits.
• Treating the $40,000 excess immediately as capital gain skips the required basis-recovery step for the shareholder.

A nonliquidating cash distribution is a dividend only up to current and accumulated earnings and profits, with any remaining amount reducing stock basis before any capital gain is recognized.

Question 46

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Elaine’s executed will leaves her residuary probate estate to a testamentary trust for her son. During a personal financial planning review, her CPA concludes that, if Elaine dies this year, her home will pass directly to her spouse and her traditional IRA will pass directly to her daughter, so neither asset will fund the testamentary trust. Which evidence best supports the CPA’s conclusion?

• A. The homeowners insurance declarations page for the home, and Elaine’s email to her CPA stating that the daughter should receive the IRA.
• B. The home closing statement showing Elaine originally paid for the house, and an unsigned IRA beneficiary change form naming the daughter.
• C. Elaine’s executed will leaving the residuary estate to the son’s trust, and the latest IRA account statement showing the year-end balance.
• D. A recorded deed showing the home is owned by Elaine and her spouse as joint tenants with right of survivorship, and the most recent IRA beneficiary form on file naming the daughter as primary beneficiary.

Best answer: D

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The best support is the recorded deed plus the current beneficiary designation on file. A survivorship deed determines who takes the home at death, and the IRA beneficiary form determines who receives the retirement account, so both assets pass outside the will.

When deciding who receives an asset at death, the controlling evidence is usually the legal title document or the contract beneficiary designation, not a general statement of intent. A recorded deed showing joint tenancy with right of survivorship means the surviving joint owner takes the home automatically by operation of law. Likewise, a valid beneficiary designation accepted by the IRA custodian controls who receives the IRA, even if the will leaves the probate estate to someone else. Because both the home and the IRA transfer outside the will, they would not fund the testamentary trust created under the residuary clause. Planning documents, emails, statements, and unsigned forms may show intent, but they do not override operative ownership and beneficiary records.

• The will and IRA balance statement do not prove that these assets pass under the will; the will does not override a survivorship deed or a valid IRA beneficiary designation.
• An insurance declarations page and an email may show coverage or intent, but neither is the operative document controlling title or beneficiary rights.
• A closing statement shows how the home was originally purchased, not its current legal title, and an unsigned beneficiary change form is not effective evidence of a completed designation.
• The recorded deed plus the current custodian-held beneficiary form directly support the conclusion about who receives each asset.

Those are the operative transfer documents: the deed controls legal ownership of the home and the beneficiary form controls who receives the IRA at death.

Question 47

Topic: Property Transactions (Disposition of Assets)

Oak Corp sold vacant land to Lee, its 90% shareholder, on January 1, Year 1, in exchange for a $300,000 note. The note bears 1% annual stated interest, with principal due at maturity in 5 years. The applicable federal rate for a comparable loan on January 1, Year 1, was 5%, and the full $300,000 remained outstanding for all of Year 1. Oak has sufficient current and accumulated E&P. Assume the transaction is subject to the below-market loan rules and that Year 1 foregone interest equals outstanding principal multiplied by the difference between the AFR and the stated rate. What should the CPA do next in preparing the Year 1 federal tax treatment of this related-party transaction?

• A. Calculate $12,000 of foregone interest, add it to Oak’s $3,000 stated interest, and treat the $12,000 foregone amount as a deemed dividend to Lee.
• B. Increase Oak’s amount realized on the land by $12,000 and report that amount as additional gain on the sale.
• C. Treat the $12,000 foregone amount as Lee’s capital contribution to Oak and adjust Lee’s stock basis.
• D. Wait until the note matures or Lee later disposes of the land before recording any imputed-interest adjustment.

Best answer: A

What this tests: Property Transactions (Disposition of Assets)

Explanation: Because the 1% note rate is below the 5% AFR, Oak has $12,000 of foregone interest for Year 1 on the $300,000 balance. In a corporation-to-shareholder below-market loan, that foregone interest is treated as a deemed distribution to the shareholder and a deemed interest payment back to the corporation; with sufficient E&P, the distribution is a dividend.

Foregone interest is computed from the outstanding principal for the year: $300,000 × (5% AFR − 1% stated rate) = $12,000. Because Oak is the lender and Lee is its 90% shareholder, the below-market loan rules treat Oak as making a deemed distribution of the $12,000 to Lee, followed by Lee making a deemed interest payment of $12,000 back to Oak. Since Oak has sufficient current and accumulated E&P, the deemed distribution is a dividend to Lee. Oak also includes the foregone amount as additional interest income, so Oak’s total Year 1 interest is the $3,000 stated interest plus $12,000 imputed interest. The $12,000 is not added to land sale proceeds and is not deferred until maturity.

• Reporting the $12,000 as extra sale gain is wrong because imputed interest is separately characterized as interest, not additional land proceeds.
• Deferring the adjustment until note maturity or Lee’s later land sale is wrong because foregone interest is determined for the current year while the principal is outstanding.
• Treating the amount as Lee’s capital contribution reverses the deemed transfer; Oak is the lender, so the deemed transfer runs from Oak to Lee.

The foregone interest is $300,000 × (5% − 1%) = $12,000, and a corporation-to-shareholder below-market loan is recharacterized as a dividend to the extent of E&P plus deemed interest back to the corporation.

Question 48

Topic: Property Transactions (Disposition of Assets)

Paula owns 100% of Ridge Corp.

Ridge Corp.’s $60,000 loss on the sale to Paula was disallowed under the related-party rules. Assume no selling expenses and no other basis adjustments.

Which of the following is the best interpretation of Paula’s recognized gain or loss on the later sale?

• A. $40,000 recognized gain, because Paula’s basis is her $150,000 purchase price and Ridge Corp.’s prior disallowed loss does not affect her later sale.
• B. No recognized gain or loss, because Paula’s $40,000 realized gain is reduced to zero by Ridge Corp.’s previously disallowed $60,000 loss.
• C. $20,000 recognized loss, because Paula uses Ridge Corp.’s $210,000 basis when she later sells the land.
• D. $60,000 recognized loss, because Ridge Corp.’s disallowed loss becomes deductible when Paula sells the land to an unrelated buyer.

Best answer: B

What this tests: Property Transactions (Disposition of Assets)

Explanation: Paula’s basis is her $150,000 purchase price, so she realizes a $40,000 gain when she sells for $190,000. Because the land was bought from a related party and Ridge Corp.’s $60,000 loss was previously disallowed, Paula’s recognized gain is reduced to zero, but the rule cannot create a loss.

When property is sold at a loss between related parties, the seller’s loss is disallowed. If the buyer later sells that same property to an unrelated third party at a gain, the buyer does not ignore the earlier disallowed loss. Instead, the buyer first computes realized gain using the buyer’s own cost basis, then reduces that gain by the transferor’s previously disallowed loss, but not below zero.

Here, Paula and Ridge Corp. are related because Paula owns 100% of the corporation. Paula’s basis is $150,000, so her realized gain on the later sale is $40,000 ($190,000 - $150,000). That $40,000 gain is offset by Ridge Corp.’s earlier $60,000 disallowed loss. Because the offset cannot produce or increase a loss, Paula recognizes $0.

• Using only Paula’s $150,000 purchase basis gives the $40,000 realized gain, but it misses the required reduction for Ridge Corp.’s previously disallowed related-party loss.
• Using Ridge Corp.’s $210,000 basis is incorrect because Paula purchased the land; she does not take a carryover basis in this taxable related-party purchase.
• Treating the $60,000 disallowed loss as newly deductible on Paula’s sale is wrong because the prior loss can only offset later gain, not create a recognized loss.

A transferee’s later gain on an unrelated-party sale is reduced, but not below zero, by the transferor’s previously disallowed related-party loss.

Question 49

Topic: Entity Tax Planning

Harper, Neal, and Sofia are comparing entity choices for a new business.

Proposed owners and goals
- Harper: U.S. citizen, contributes \$210,000 cash
- Neal: U.S. citizen, contributes \$45,000 cash
- Sofia: nonresident alien individual, contributes \$45,000 cash
- Each owner will hold a one-third voting interest and a one-third ongoing profit interest after formation.
- All owners want limited liability under state law.
- The business expects a \$180,000 ordinary loss in year 1 and profits thereafter.
- Harper wants 70% of the year-1 tax loss because of the larger capital contribution.
- The owners want flexibility to admit additional non-U.S. investors later.
- The business expects to distribute, not retain, most future profits.
- Assume loss limitation rules outside entity choice are not an issue.

Which choice is the best interpretation of the entity-selection issues for the proposed formation?

• A. An S corporation is the best fit because it offers pass-through taxation with limited liability and can admit Sofia while allocating 70% of the first-year loss to Harper.
• B. A C corporation is the best fit because foreign ownership is allowed and the year-1 loss will flow through to the owners based on their capital contributions.
• C. An LLC taxed as a partnership is the best fit because the LLC can provide limited liability, while partnership taxation can pass through items and allow flexible allocations if structured properly.
• D. A general partnership is the best fit because pass-through taxation determines liability protection, so it can provide both special allocations and limited liability.

Best answer: C

What this tests: Entity Tax Planning

Explanation: An LLC taxed as a partnership best fits because it separates the state-law liability shield from the federal tax classification. That combination can provide limited liability, accommodate a nonresident alien owner, and support flexible loss allocations if the arrangement is properly structured.

When comparing entities at formation, legal characteristics and tax consequences must be analyzed separately. An LLC is a state-law entity that generally gives owners limited liability. If that LLC is taxed as a partnership, tax items usually pass through to the owners, nonresident aliens may be owners, and allocations can be tailored to the deal economics if the allocation rules are satisfied. By contrast, an S corporation is a pass-through regime, but it cannot have a nonresident alien shareholder and it does not permit special allocations of loss because items are generally allocated pro rata. A C corporation allows foreign ownership and limited liability, but its losses remain at the corporate level rather than passing through to owners. A general partnership offers pass-through taxation and allocation flexibility, but it does not meet the stated goal of limited liability for all owners.

• The S corporation choice fails because a nonresident alien cannot be an S corporation shareholder, and the requested 70% loss allocation to one one-third owner is not permitted.
• The C corporation choice gets foreign ownership and liability protection right, but it incorrectly treats the corporate loss as if it passes through to the owners.
• The general partnership choice confuses tax status with legal protection; pass-through treatment does not create limited liability.

This choice correctly separates the legal form from the tax regime: the LLC addresses liability protection, and partnership taxation best matches the requested allocation and ownership flexibility.

Question 50

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Rosa paid $38,000 in 2026 for her grandson Evan’s college costs. Her CPA concludes that the entire $38,000 transfer qualifies for the federal gift tax educational exclusion and is not a taxable gift. Which item would best support that conclusion?

• A. Evan’s receipt for tuition and Rosa’s check reimbursing Evan for $38,000 after he paid the bill
• B. A university invoice for $38,000 covering tuition, room, and meal plan, paid by Rosa directly to the university
• C. Rosa’s brokerage statement showing a $38,000 withdrawal marked “for Evan’s college costs”
• D. A university tuition invoice for $38,000 and Rosa’s canceled check payable directly to the university

Best answer: D

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The best support is a tuition invoice and proof that Rosa paid the university directly. Federal gift tax excludes qualified tuition payments only when they are for tuition and are made straight to the educational institution, so documentation of both elements is decisive.

For federal gift tax purposes, amounts paid on another person’s behalf directly to an educational institution for that person’s tuition are excluded from gift tax. This exclusion is separate from the annual exclusion and is not limited to a specific dollar amount, but it applies only to qualified tuition charges. It does not apply to room and board, meal plans, books, or amounts reimbursed to the student or another person. Therefore, the strongest evidence is documentation showing that the charge was tuition and that Rosa paid the university directly. A reimbursement to Evan would be a gift to Evan, and a mixed invoice including non-tuition charges would not support excluding the entire $38,000 transfer.

• Reimbursing Evan after he paid the tuition does not satisfy the direct-payment requirement, so it would not support the exclusion.
• An invoice that includes room and meal plan does not support excluding the entire amount, because those charges are not qualified tuition.
• A brokerage withdrawal shows only that Rosa had funds available; it does not prove a direct payment to the school for tuition.

A tuition bill plus Rosa’s check payable directly to the university shows both required elements of the exclusion: qualified tuition charges and direct payment to the school.

Questions 51-68

Question 51

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

A CPA is preparing 2026 federal estimated tax vouchers for Leah, a single taxpayer. Leah expects the following:

• 2025 total tax shown on return: $24,000
• 2025 AGI exceeded $150,000, so the prior-year safe harbor uses 110% of prior-year tax
• 2026 projected total tax: $28,000
• 2026 federal income tax withholding: $6,000

Assume Leah’s 2025 return covered 12 months and she will make four equal, timely estimated payments.

What amount should each 2026 estimated tax payment be to avoid an underpayment penalty?

• A. $4,500
• B. $5,100
• C. $6,300
• D. $4,800

Best answer: D

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: Each quarterly payment should be $4,800. The required annual payment is the lesser of 90% of current-year tax ($25,200) or 110% of prior-year tax ($26,400), and Leah’s $6,000 of withholding reduces the amount that must be paid through estimates to $19,200.

To avoid the federal estimated tax underpayment penalty, an individual generally must pay a required annual amount through withholding and timely estimated payments. For a high-income taxpayer, the prior-year safe harbor is 110% of prior-year tax, but the required annual payment is still the lesser of that amount or 90% of current-year tax. Here, 90% of Leah’s projected 2026 tax of $28,000 is $25,200. Her prior-year safe harbor is 110% of $24,000, or $26,400. Because $25,200 is lower, that is the required annual payment. Expected withholding of $6,000 counts toward that total, so Leah must cover the remaining $19,200 with estimated tax payments. Dividing by four equal installments gives $4,800 per payment.

• \$4,500 uses 100% of prior-year tax after withholding, but Leah’s high-income prior-year safe harbor is 110%, not 100%.
• \$5,100 correctly computes 110% of prior-year tax less withholding, but it ignores that the required annual payment is the lesser of the current-year and prior-year safe harbors.
• \$6,300 uses 90% of current-year tax divided by four, but it fails to subtract expected withholding before determining the quarterly estimate amount.

The required annual payment is the lesser of $25,200 (90% of current-year tax) or $26,400 (110% of prior-year tax), reduced by $6,000 of withholding, leaving $19,200 or $4,800 per quarter.

Question 52

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Elena expects her estate to be taxable at death and wants to make one outright gift this year to her adult son. She does not need any of the assets for support. Her goals are to remove as much future appreciation as possible from her estate and to avoid making a gift that wastes a built-in tax loss. Assume Elena has sufficient remaining lifetime gift tax exemption for any transfer, no valuation discounts apply, and gift tax value is based on current fair market value.

Which proposed transfer is best characterized as the most tax-efficient gifting option for Elena?

• A. An outright gift of the growth stock
• B. An outright gift of the depressed stock
• C. An outright gift of the money market account
• D. An outright gift of the artwork

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The growth stock is the best fit because the gift uses today’s fair market value, yet all post-gift appreciation is shifted out of Elena’s taxable estate. Built-in loss property is usually a poor gift choice, and low-growth assets do less to reduce future estate tax.

When a donor’s estate is expected to be taxable, a strong gifting strategy is to transfer the asset with the greatest expected future appreciation. The taxable gift is measured at the asset’s current fair market value, so choosing a high-growth asset removes later appreciation from the donor’s estate without increasing the current gift value. By contrast, gifting built-in loss property is usually inefficient because the donor gives up the chance to recognize the loss by selling the asset first; a gift of that property can produce unfavorable basis results for the donee. Cash and other low-growth or stable-value assets may be simple to transfer, but they do much less to shift future value out of the estate. Under these facts, the growth stock best matches both the current tax and future estate planning goals.

• An outright gift of the depressed stock is unattractive because built-in loss property is usually better sold first so the donor can preserve the tax loss before gifting cash.
• An outright gift of the money market account removes little future appreciation, so it is less effective for estate-tax reduction when each option has the same current fair market value.
• An outright gift of the artwork shifts less expected future growth and also gives up the possibility of retaining a low-basis asset for a basis step-up at death.

Because the gift is valued at current fair market value, transferring the highest-growth asset removes the most future appreciation from Elena’s estate without wasting a built-in loss.

Question 53

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

While preparing Mia’s individual return, you review her Schedule K-1 from a limited partnership that owns rental real estate. Mia’s allocable loss is $40,000. She has sufficient tax basis in the partnership interest, is at risk for only $25,000 at year-end, does not materially participate in the activity, and has $10,000 of passive income from another rental activity. What is the correct treatment of the $40,000 loss on Mia’s current-year return?

• A. Deduct $10,000 currently; suspend $15,000 under the at-risk rules and $15,000 under the passive activity rules.
• B. Deduct $25,000 currently; suspend $15,000 under the passive activity rules.
• C. Deduct $10,000 currently; suspend $30,000 under the passive activity rules.
• D. Deduct $25,000 currently; suspend $15,000 under the at-risk rules.

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The loss is limited first by the at-risk rules and then by the passive activity rules. Mia may use only $25,000 after the at-risk test, and because she has just $10,000 of passive income, only $10,000 is deductible currently while the rest is suspended under the applicable rule.

When both rules may apply, the loss is tested in sequence. Here, basis is not a problem because Mia has sufficient tax basis. The $40,000 partnership loss is next limited by her $25,000 amount at risk, so $15,000 is suspended under the at-risk rules. The remaining $25,000 passes to the passive activity loss rules because Mia does not materially participate and the rental activity is passive to her. Since she has only $10,000 of passive income from another activity, she may deduct only $10,000 currently. The remaining $15,000 is suspended as a passive loss and generally carries forward until she has passive income or a qualifying disposition.

• Treating $25,000 as fully deductible ignores the passive activity limit that still applies after the at-risk limitation.
• Suspending $30,000 as passive applies the passive rules before the at-risk rules, which is the wrong compliance order.
• Suspending only $15,000 under the at-risk rules but deducting $25,000 overlooks that Mia has only $10,000 of passive income available to absorb passive loss.

Loss limitations apply in order, so the loss is first reduced to Mia’s $25,000 amount at risk and then limited to $10,000 of available passive income.

Question 54

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

An individual taxpayer’s 2025 passive activity summary shows the following:\n\n| Activity | Current-year income (loss) | Prior-year suspended loss | 2025 facts |\n|—|—:|—:|—|\n| Rental condo | $9,000 | $0 | No sale |\n| Oak Restaurant LP interest | $(14,000) | $(11,000) | Taxpayer sold 30% of the interest in a fully taxable sale to an unrelated buyer, retained 70%, and did not materially participate |\n\nThe staff preparer deducted the full $25,000 Oak Restaurant LP loss against the taxpayer’s salary, stating that the LP was disposed of during the year. No other passive activities or special loss exceptions apply.\n\nWhich adjustment best corrects the passive activity schedule?

• A. Apply the $25,000 active-participation rental real estate allowance and deduct the Oak Restaurant LP loss against salary.
• B. Reverse the salary deduction; allow $9,000 of the Oak Restaurant LP loss against rental passive income and suspend the remaining $16,000.
• C. Keep the $25,000 salary deduction because a taxable sale to an unrelated buyer releases the losses tied to the portion sold.
• D. Reverse the salary deduction and suspend all $25,000 because losses from one passive activity cannot offset income from another passive activity.

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: Because the taxpayer retained 70% of the Oak Restaurant LP interest, there was no complete taxable disposition of the entire passive activity. The LP’s current-year and suspended losses can offset passive income from the rental condo, but any excess cannot offset salary and must remain suspended.

Passive losses generally offset only passive income. Suspended passive losses are released for use against nonpassive income only when the taxpayer disposes of the entire interest in the passive activity in a fully taxable transaction to an unrelated party. Here, the taxpayer sold only 30% of the Oak Restaurant LP interest and kept 70%, so no full-disposition release occurs. The Oak Restaurant LP current-year loss of $14,000 plus the prior-year suspended loss of $11,000 gives a total passive loss of $25,000 from that activity. That passive loss may be netted against the $9,000 passive income from the rental condo. The remaining $16,000 is not currently deductible against salary and must continue as suspended passive loss carryforward.

• The taxable-sale rationale is overstated because selling only part of the LP interest does not unlock suspended losses for use against salary.\n- Suspending the full $25,000 goes too far because passive losses from one activity can offset passive income from another passive activity.\n- The rental real estate allowance does not apply to the LP loss here, and the question states that no special loss exceptions apply.

A partial sale does not release passive losses for nonpassive use, so the LP losses may offset only passive income and the excess stays suspended.

Question 55

Topic: Entity Tax Compliance

Jade and Rios are equal partners in JR Partnership. The partnership projects $180,000 of ordinary business income before considering any payment for partner services.

The CPA concludes that Jade must report $120,000 of ordinary income related to the partnership for the year: $60,000 as a guaranteed payment for services and $60,000 as her distributive share of the remaining ordinary business income.

Which evidence best supports this conclusion?

• A. An excerpt from Jade’s time records showing that she spent 1,200 hours managing partnership operations during the year.
• B. An excerpt from an email from Jade stating that she should receive compensation equal to one-half of annual partnership profits because she spends more time on operations.
• C. An excerpt from the signed partnership agreement stating that, as part of Jade’s duties as a partner, she will receive $60,000 annually for management services, payable monthly without regard to partnership income, plus 50% of remaining profits and losses.
• D. An excerpt from the cash disbursements journal showing twelve monthly payments of $5,000 to Jade during the year, with no description of the reason for the payments.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: The partnership agreement excerpt is the best support because it states all decisive tax facts: Jade performed the services in her capacity as a partner, the $60,000 amount was fixed, and it was payable without regard to partnership income. That makes the payment a guaranteed payment, leaving $120,000 of remaining ordinary business income to split equally, so Jade reports $120,000 total.

For partner services, the key tax issue is whether the amount is a distributive share or a guaranteed payment. A guaranteed payment exists when a partner, acting in partner capacity, is entitled to a fixed amount determined without regard to partnership income. The partnership deducts that amount in computing ordinary business income, and the recipient partner includes it separately as ordinary income. Here, the agreement language is decisive because it says Jade’s management work is part of her duties as a partner and that she receives $60,000 annually regardless of partnership income, plus 50% of the remaining profits and losses. Starting with $180,000 of projected ordinary business income before the payment, JR deducts the $60,000 guaranteed payment, leaving $120,000. Jade then receives 50% of that remaining income, or $60,000, for total ordinary income of $120,000.

• The cash disbursements journal shows that money was paid, but it does not establish partner capacity or that the amount was fixed without regard to partnership income.
• The email tying compensation to annual profits supports a distributive-share concept, not a guaranteed payment.
• The time records show services were performed, but hours worked alone do not determine the tax character of the payment.

A fixed amount for services performed in partner capacity and payable without regard to partnership income is a guaranteed payment, so the remaining income is allocated separately.

Question 56

Topic: Entity Tax Planning

Rivet LLC is taxed as a partnership.

• Lane is a 50% partner.
• Under the partnership agreement, Lane receives $30,000 each year for management services, payable regardless of partnership income.
• Later in the year, Rivet makes a $12,000 cash nonliquidating distribution to Lane.
• Lane’s outside basis immediately before the $12,000 distribution is $50,000.

How should the $30,000 payment and the $12,000 cash distribution be characterized for federal income tax purposes?

• A. The $30,000 is a nonliquidating cash distribution that reduces Lane’s outside basis; the $12,000 is ordinary income because any cash paid to a partner is taxable.
• B. Both the $30,000 and the $12,000 are nonliquidating cash distributions that reduce Lane’s outside basis because Lane is already a partner.
• C. The $30,000 is a guaranteed payment that is ordinary income to Lane and generally deductible by the partnership; the $12,000 is a nonliquidating cash distribution that is not currently taxable and reduces Lane’s outside basis to $38,000.
• D. The $30,000 is Lane’s distributive share of partnership income; the $12,000 is a guaranteed payment because it was separately paid in cash.

Best answer: C

What this tests: Entity Tax Planning

Explanation: The fixed $30,000 management payment is a guaranteed payment because it is determined without regard to partnership income. The $12,000 cash payment is a separate nonliquidating distribution, and because Lane’s outside basis exceeds the cash received, no current gain is recognized and basis is reduced.

A guaranteed payment is a payment to a partner for services or the use of capital that is determined without regard to partnership income. That payment is ordinary income to the recipient partner and is generally deductible by the partnership if it would otherwise qualify as a business deduction. A nonliquidating cash distribution is treated under the partnership distribution rules instead. For cash distributions, the partner generally recognizes gain only to the extent the cash received exceeds outside basis. Here, Lane’s $12,000 cash distribution does not exceed the $50,000 outside basis, so there is no current taxable gain; Lane’s basis is simply reduced to $38,000. The fact that both amounts were paid in cash does not make both items guaranteed payments.

• Treating the $30,000 as a distributive share is incorrect because the payment is fixed and does not depend on partnership income.
• Treating the $12,000 as taxable merely because it is cash is incorrect; current cash distributions are generally nontaxable up to outside basis.
• Treating both amounts as distributions ignores that a payment for services can be a guaranteed payment even when made to an existing partner.

A fixed payment for services made without regard to partnership income is a guaranteed payment, while a nonliquidating cash distribution is generally tax-free unless it exceeds outside basis.

Question 57

Topic: Entity Tax Compliance

Rivera owns 100% of Pine C Corp. On January 1, Year 1, Pine advanced Rivera $180,000. The CPA is evaluating whether the advance creates shareholder-level dividend income from imputed interest or remains only a loan with stated interest. Assume Pine has enough current and accumulated E&P that any deemed transfer from the corporation would be a dividend. The AFR for a 3-year term loan on January 1, Year 1, was 5%.

Which evidence in the loan file best supports the conclusion that no dividend income will be imputed from foregone interest on this advance?

• A. Rivera’s year-end personal balance sheet showing the $180,000 as a liability to Pine
• B. Board minutes stating the advance will be recorded as a shareholder loan receivable until Rivera repays it when cash flow permits
• C. An executed promissory note dated January 1, Year 1, requiring 6% annual interest on a 3-year term loan, with interest payable annually and principal due at maturity
• D. A signed collateral agreement pledging Rivera’s brokerage account as security, but the note does not state an interest rate

Best answer: C

What this tests: Entity Tax Compliance

Explanation: The best support is the executed note showing a stated interest rate above the AFR for the loan term. That fact directly addresses whether foregone interest must be imputed, which is what would create deemed dividend income here.

For a corporation-shareholder loan, the below-market loan rules focus on whether the loan has adequate stated interest. If stated interest is less than the applicable federal rate, the foregone interest is treated as a deemed transfer from the corporation to the shareholder and then as interest paid back to the corporation. When the corporation has sufficient earnings and profits, that deemed transfer is generally dividend income to the shareholder. Here, the strongest evidence is a signed 3-year promissory note requiring 6% interest when the AFR for that 3-year term was 5%, because that directly supports that the loan is not below-market for imputed-interest purposes. Collateral, bookkeeping entries, and the shareholder’s own financial statement may be relevant to intent or repayment, but they do not substitute for adequate stated interest in the loan terms.

• Collateral can support debt characterization, but it does not prevent imputed interest if the loan lacks adequate stated interest.
• Recording the advance as a loan receivable in board minutes or accounting records does not control the tax result.
• The shareholder’s personal balance sheet is not the key tax evidence for below-market loan analysis.
• The executed note with 6% stated interest directly supports that no foregone-interest dividend should be imputed.

A documented term loan with stated interest at or above AFR avoids foregone-interest imputation under the below-market loan rules.

Question 58

Topic: Entity Tax Compliance

Harbor C Corp received equipment from its sole shareholder, Lee, in exchange for all Harbor stock in a transaction intended to qualify under Sec. 351.

Controller’s contributed-property schedule:

• Lee’s adjusted basis in equipment: $60,000
• Equipment FMV on transfer date: $95,000
• Liability on equipment assumed by Harbor: $70,000
• Harbor basis recorded on schedule: $25,000

The tax manager concludes the schedule must be corrected because Harbor used the wrong basis rule for property contributed to a C corporation. Which source item best supports that conclusion?

• A. An appraisal report confirming that the equipment’s FMV was $95,000 on the transfer date.
• B. A signed loan assumption agreement confirming that Harbor assumed the $70,000 liability on the equipment.
• C. Lee’s depreciation schedule showing that the equipment’s adjusted basis immediately before the transfer was $60,000.
• D. An authority excerpt stating that a corporation receiving property in a Sec. 351 exchange generally takes the transferor’s adjusted basis, increased by any gain recognized, rather than FMV less liabilities assumed.

Best answer: D

What this tests: Entity Tax Compliance

Explanation: The best support is the authority excerpt because the issue is the tax rule used to compute Harbor’s basis, not whether the listed amounts are accurate. In a qualifying Sec. 351 contribution, the corporation generally takes a carryover basis, increased by any gain recognized, so FMV less assumed debt is the wrong formula.

When property is contributed to a C corporation in a qualifying Sec. 351 exchange, the corporation generally takes the transferor’s adjusted basis in the property, increased by any gain recognized by the transferor. The corporation does not compute its basis as fair market value minus liabilities assumed. Here, the controller recorded $25,000 by subtracting the $70,000 liability from the $95,000 FMV, which reflects the wrong basis rule. Because the conclusion challenges the legal computation method, the strongest support is an authority excerpt describing the proper corporate basis rule. The appraisal, loan assumption agreement, and depreciation schedule may verify individual facts in the schedule, but they do not by themselves establish that the controller applied the wrong tax rule.

• The FMV appraisal verifies value, but FMV is not the corporation’s basis rule in a qualifying contribution.
• The loan assumption agreement confirms the debt amount, but the conclusion is about the basis formula, not whether a liability was assumed.
• The shareholder’s depreciation schedule helps verify adjusted basis, but it does not by itself prove that using FMV less debt was improper.

This excerpt directly states the corporation’s basis rule and shows that recording FMV minus the assumed liability is incorrect.

Question 59

Topic: Property Transactions (Disposition of Assets)

A sole proprietor sells machinery used in the business. The machinery was purchased for $240,000, and $150,000 of depreciation was allowed or allowable. It is sold for $260,000 cash after being held for more than 1 year. There are no selling expenses.

How should the recognized gain be characterized for federal income tax purposes?

• A. $170,000 Section 1231 gain
• B. $150,000 ordinary income under Section 1245 and $20,000 Section 1231 gain
• C. $150,000 ordinary income under Section 1245 and $20,000 long-term capital gain
• D. $170,000 ordinary income under Section 1245

Best answer: B

What this tests: Property Transactions (Disposition of Assets)

Explanation: The machinery’s adjusted basis is $90,000 ($240,000 cost less $150,000 depreciation), so the sale produces a $170,000 gain. Section 1245 recaptures the lesser of depreciation taken or total gain as ordinary income, so $150,000 is ordinary income and the remaining $20,000 is Section 1231 gain.

For Section 1245 property, depreciation previously allowed or allowable is recaptured as ordinary income when the asset is sold at a gain. First compute adjusted basis by subtracting depreciation from original cost. Then compute the total recognized gain by subtracting adjusted basis from the amount realized. The Section 1245 recapture amount is the lesser of accumulated depreciation or total recognized gain. Here, the adjusted basis is $90,000 and the recognized gain is $170,000, so $150,000 is recaptured as ordinary income. Because the machinery was held for more than one year, the remaining $20,000 gain above original cost is Section 1231 gain. It is not additional Section 1245 recapture and is not directly classified as capital gain at the asset level.

• “$170,000 ordinary income under Section 1245” is too high because recapture cannot exceed the $150,000 of depreciation taken.
• “$150,000 ordinary income under Section 1245 and $20,000 long-term capital gain” gets the recapture amount right but mislabels the excess; the excess is Section 1231 gain.
• “$170,000 Section 1231 gain” ignores the mandatory ordinary-income recapture required for Section 1245 property.

Section 1245 recapture is the lesser of the $170,000 total gain or the $150,000 depreciation taken, so $150,000 is ordinary income and the remaining $20,000 is Section 1231 gain.

Question 60

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Taylor is a cash-basis individual taxpayer. This year, Taylor’s marginal federal income tax rate is 24%. Pending legislation, if enacted as proposed and effective January 1, will increase Taylor’s marginal rate to 32% next year. Taylor will itemize deductions in both years, and a planned $8,000 charitable contribution would be fully deductible in either year. Taylor can also choose whether a $20,000 year-end bonus is paid on December 31 or on January 2.

How should Taylor’s most tax-efficient year-end planning strategy be characterized?

• A. Defer both the bonus and the charitable contribution to next year.
• B. Accelerate both the bonus and the charitable contribution into the current year.
• C. Defer the bonus to next year and accelerate the charitable contribution into the current year.
• D. Accelerate the bonus into the current year and defer the charitable contribution to next year.

Best answer: D

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: If Taylor expects to be in a higher marginal rate next year, the usual strategy is to recognize income in the lower-rate year and claim deductions in the higher-rate year. That means taking the bonus now at 24% and waiting to deduct the charitable contribution when it offsets income taxed at 32%.

Timing decisions often depend on whether tax rates are expected to increase or decrease. When rates are expected to increase next year, a taxpayer generally benefits by accelerating income into the current lower-rate year and deferring deductible expenses into the future higher-rate year. In Taylor’s case, the $20,000 bonus is ordinary income, so receiving it this year subjects it to the 24% marginal rate instead of the expected 32% rate next year. The charitable contribution is fully deductible in either year, and Taylor itemizes in both years, so the deduction is more valuable next year when it offsets income taxed at the higher rate. If rates were expected to fall, the opposite strategy would usually be preferred.

• Deferring the bonus and accelerating the charitable contribution is generally the better pattern when future tax rates are expected to be lower, not higher.
• Accelerating both items captures the lower current tax on income but wastes the chance to use the deduction in the higher-rate year.
• Deferring both items is unfavorable because it pushes income into the higher-rate year and also delays the deduction without any offsetting rate advantage.

When tax rates are expected to rise, income is generally accelerated into the lower-rate year and deductions are deferred to the higher-rate year.

Question 61

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Maris, a single taxpayer, is deciding whether to exercise vested incentive stock options (ISOs) in December 20X5 or wait until January 20X6.

Planning facts
Shares available to exercise: 4,000
Exercise price per share: \$18
Market value on proposed December exercise date: \$53
Planned sale date: No sale in 20X5

Her CPA concludes that a December exercise is more likely than a January exercise to create a current-year AMT cost, even if Maris does not sell the shares in 20X5. Which item would best support that conclusion?

• A. Maris’s 20X5 Form W-2 showing wages, withholding, and elective retirement deferrals
• B. A year-end tax projection showing regular taxable income, AMTI, and a $140,000 ISO bargain-element adjustment from a December exercise that causes tentative minimum tax to exceed regular tax
• C. The ISO grant summary showing vesting dates, expiration dates, and the number of shares available to exercise
• D. Maris’s prior-year Form 6251 showing that she owed AMT in 20X4 before any ISO exercise

Best answer: B

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: The best support is a current-year projection that specifically incorporates the planned ISO exercise into an AMT computation. For ISOs, exercising and holding the shares through year-end creates an AMT adjustment based on the spread between fair market value and exercise price, so the key evidence is whether that adjustment makes tentative minimum tax exceed regular tax.

This question turns on how AMT changes the timing of income from an ISO exercise. For regular tax, an ISO exercise generally does not create immediate taxable income if the shares are held. For AMT, however, exercising and holding the shares through year-end creates an adjustment equal to the bargain element: fair market value minus exercise price, multiplied by the shares exercised. Here, that spread is $35 per share ($53 − $18), or $140,000 total. The strongest support for the CPA’s conclusion is therefore a current-year tax projection that includes that $140,000 AMT adjustment and shows tentative minimum tax exceeding regular tax. A prior-year AMT form, a W-2, or a grant summary may be relevant background, but none directly demonstrates the current-year AMT effect of the planned exercise timing.

• A prior-year AMT form is only historical evidence; current-year AMT depends on current-year income and the planned ISO exercise.
• A Form W-2 helps estimate regular taxable income, but by itself it does not measure the ISO bargain element or show whether AMT applies.
• An ISO grant summary may confirm that the options can be exercised, but without the exercise-date value and a tax projection, it does not support the AMT conclusion.

An ISO exercised and held through year-end creates an AMT adjustment equal to the bargain element, so the best support is a current-year projection showing that adjustment pushes tentative minimum tax above regular tax.

Question 62

Topic: Entity Tax Compliance

Orion, a C corporation, made a nonliquidating distribution of equipment to its sole shareholder.

• Orion’s adjusted basis in the equipment: $90,000
• Equipment fair market value on the distribution date: $60,000
• E&P available for dividend treatment on this distribution: $20,000
• Shareholder’s stock basis before the distribution: $10,000

A staff memo states: “Orion recognizes a $30,000 loss on the distribution. The shareholder recognizes only a $20,000 dividend, and the equipment takes a carryover basis of $90,000.”

What is the best correction to the memo?

• A. Orion recognizes no loss, and the shareholder recognizes a $50,000 capital gain because the equipment’s $60,000 fair market value exceeds the shareholder’s $10,000 stock basis by $50,000.
• B. Orion recognizes no loss, and the shareholder recognizes only a $20,000 dividend because a nonliquidating property distribution cannot create shareholder gain until the equipment is later sold.
• C. Orion realizes but does not recognize the $30,000 loss; the shareholder recognizes a $20,000 dividend, a $10,000 return of capital, and a $30,000 capital gain, and takes a $60,000 basis in the equipment.
• D. Orion recognizes the $30,000 loss, but the shareholder takes a $60,000 basis in the equipment and recognizes only the $20,000 dividend because the rest reduces stock basis.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: The memo incorrectly deducts a corporate loss and stops the shareholder analysis too early. On a nonliquidating distribution of depreciated property, the corporation recognizes no loss, and the shareholder taxes the FMV distribution first as dividend, then return of capital, then capital gain, with FMV basis in the property.

For a nonliquidating distribution of property by a C corporation, built-in gain is recognized by the corporation, but built-in loss is not. Here, the equipment has a $30,000 built-in loss because its $60,000 FMV is below Orion’s $90,000 basis, so Orion realizes that decline economically but recognizes no tax loss.

At the shareholder level, the distribution is measured by the property’s FMV of $60,000. That amount is taxed in order: dividend to the extent of available E&P ($20,000), then return of capital reducing stock basis ($10,000), then gain once stock basis is exhausted ($30,000). The shareholder’s basis in the distributed property is its FMV on the distribution date, or $60,000, not Orion’s carryover basis.

• Treating the corporation’s $30,000 decline in value as a recognized loss is incorrect; nonliquidating distributions of depreciated property do not generate deductible corporate loss.
• Stopping at the $20,000 dividend ignores the required ordering rules after E&P is used up: stock basis is recovered next, and excess becomes capital gain.
• Treating the full $50,000 excess of FMV over stock basis as capital gain skips the $20,000 portion taxed first as a dividend.
• Using Orion’s $90,000 adjusted basis as the shareholder’s basis is wrong; basis in distributed property is FMV at the distribution date.

A C corporation does not recognize loss on a nonliquidating distribution of depreciated property, and the shareholder measures the distribution at FMV, then applies dividend, basis-recovery, and capital-gain ordering rules.

Question 63

Topic: Entity Tax Planning

Harbor LLC is a calendar-year partnership. Partner Moss will retire this year, and the partners are evaluating how to structure the payout.

Relevant facts
- Ownership before transaction: Lee 40%, Moss 30%, Nash 30%
- Planned payout to Moss from partnership cash: \$260,000
- Moss's outside basis immediately before the payout: \$190,000
- Partnership assets: cash and investment land only
  * Cash: basis/FMV \$700,000
  * Land: basis \$300,000; FMV \$900,000
- Liabilities: none
- No unrealized receivables, inventory, or other Section 751 assets
- No Section 754 election is in effect, and the partners do not want one
- Lee and Nash do not want to use personal funds

Tax objective
Use partnership cash to retire Moss, give Moss capital-gain treatment only to the extent the cash exceeds outside basis, and avoid a partnership deduction.

Which alternative best satisfies Harbor LLC’s tax objective?

• A. Have Lee and Nash purchase Moss’s partnership interest directly for $260,000, so Moss gets capital-gain treatment and Harbor LLC automatically steps up the basis of its land by $70,000.
• B. Treat the entire $260,000 as a guaranteed payment to Moss under Section 736(a), so Moss reports ordinary income and Harbor LLC deducts the payment.
• C. Make a nonliquidating cash distribution of $260,000 to Moss and keep Moss as a partner, because cash distributions in excess of outside basis are generally tax-free until the partnership interest is sold.
• D. Structure the payout as a Section 736(b) liquidating cash distribution to Moss, so Moss recognizes $70,000 of capital gain and Harbor LLC has no deduction or automatic inside basis adjustment.

Best answer: D

What this tests: Entity Tax Planning

Explanation: The best choice is the Section 736(b) liquidating cash distribution. It meets all stated goals: the partnership uses its own cash, Moss gets capital gain only for the $70,000 excess over his $190,000 outside basis, and the partnership does not receive a deduction.

A retiring partner payout can produce very different tax results depending on whether it is treated as a guaranteed payment, a liquidating distribution for the partner’s interest, or a sale to other partners. Here, the partners want to use partnership cash, avoid a partnership deduction, and give Moss capital-gain treatment only to the extent cash exceeds outside basis. A Section 736(b) liquidating payment fits that objective. Because Moss receives $260,000 cash and has $190,000 outside basis, he recognizes $70,000 capital gain. The partnership does not deduct a Section 736(b) payment, and without a Section 754 election there is no automatic inside basis adjustment. Guaranteed payment treatment would create ordinary income to Moss and a partnership deduction, which is the opposite of the stated goal.

• Treating the payout as a guaranteed payment fails the character and entity-level goals because it produces ordinary income to Moss and a deduction to the partnership.
• A direct purchase by Lee and Nash could give Moss capital-gain treatment, but it does not use partnership cash, and there is no automatic inside basis step-up without a Section 754 election.
• A cash distribution in excess of outside basis is not tax-free; gain is recognized to the extent cash exceeds basis, and keeping Moss as a partner also misses the retirement objective.

A Section 736(b) liquidating cash payment for Moss’s partnership interest uses partnership cash, gives capital-gain treatment for cash received over outside basis, and does not create a partnership deduction.

Question 64

Topic: Entity Tax Compliance

Maple Corp, a C corporation, made a nonliquidating distribution to its sole shareholder, Lee. Ignore any reduction of E&P for federal income taxes.

• Cash distributed: $5,000
• Land distributed: FMV $50,000; Maple adjusted basis $10,000
• Maple current E&P immediately before the distribution: $30,000
• Maple accumulated E&P immediately before the distribution: $0
• Lee’s stock basis immediately before the distribution: $8,000

A staff preparer wrote: “Lee should report a $30,000 dividend, then an $8,000 return of capital, then $17,000 capital gain. Maple recognizes no gain because it distributed the land instead of selling it.”

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

• A. Lee should report a $30,000 dividend, $8,000 return of capital, and $17,000 capital gain; Maple should also recognize a $40,000 gain on the land.
• B. Lee should report a $55,000 dividend; Maple should recognize a $40,000 gain on the land; Lee’s stock basis remains $8,000, but Lee’s basis in the land is Maple’s $10,000 adjusted basis.
• C. Lee should report a $55,000 dividend; Maple should recognize a $40,000 gain on the land; Lee’s stock basis remains $8,000, and Lee’s basis in the land is $50,000.
• D. Lee should report a $55,000 dividend, but Maple should not recognize gain until Lee later sells the land.

Best answer: C

What this tests: Entity Tax Compliance

Explanation: The distribution is measured at $55,000: $5,000 cash plus land worth $50,000. Because Maple recognizes $40,000 of gain on the appreciated land, its E&P is sufficient to cover the full distribution, so Lee has only dividend income, no return of capital or capital gain, and Lee’s land basis is FMV.

For a C corporation’s nonliquidating distribution, the shareholder treats the distribution as a dividend to the extent of current and accumulated E&P. Any excess is return of capital that reduces stock basis, and any remaining excess over basis is capital gain. When appreciated property is distributed, the corporation recognizes gain as if it sold the property for FMV.

Here, Maple distributes $55,000 total: $5,000 cash plus land with $50,000 FMV. Maple must recognize $40,000 of gain on the land ($50,000 FMV less $10,000 basis). Under the stem’s assumption to ignore tax effects on E&P, that gain increases Maple’s current E&P from $30,000 to $70,000, which is enough to cover the full $55,000 distribution. Therefore, Lee reports a $55,000 dividend, not return of capital or capital gain. Lee’s stock basis stays at $8,000 because dividend distributions do not reduce stock basis, and Lee’s basis in the distributed land is its $50,000 FMV.

• Treating only the original $30,000 E&P as available for dividend treatment misses that the corporation’s recognized gain on appreciated property increases E&P under the stated assumption.
• Deferring Maple’s gain until Lee later sells the land is incorrect; the distributing corporation recognizes gain at the time of the property distribution.
• Using Maple’s $10,000 adjusted basis as Lee’s basis in the land is incorrect; in a nonliquidating taxable property distribution, the shareholder’s basis in the property received is FMV.

A C corporation recognizes gain on an appreciated property distribution, that gain increases E&P under the stated assumption, and the shareholder takes the distributed property at FMV basis.

Question 65

Topic: Entity Tax Compliance

Jade, Kim, and Lee each owned a 1/3 interest in JKL Partnership, a calendar-year partnership. On June 30, Lee sold Lee’s entire partnership interest to Moss, an unrelated buyer, effective at the end of that day.

The partnership agreement requires tax items to be allocated using an interim closing of the books on the transfer date. JKL had no separately stated items. Its ordinary business results for the year were:

• January 1-June 30: $(30,000)$ loss
• July 1-December 31: $210,000 income

A staff accountant prepared the K-1s by allocating the full-year $180,000 income equally to Jade, Kim, and Lee, and none to Moss.

What is the best correction to the staff accountant’s allocation?

• A. Reallocate ordinary income as follows: Lee $(10,000)$, Jade $60,000, Kim $60,000, and Moss $70,000.
• B. Reallocate ordinary income as follows: Lee $30,000, Jade $60,000, Kim $60,000, and Moss $30,000.
• C. Prepare two short-year partnership returns, one through June 30 and one from July 1 through December 31.
• D. Leave Lee at $60,000 because Lee was a partner during the year, and begin allocating income to Moss next year.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: The staff accountant ignored the transfer-date allocation rule in the partnership agreement. With an interim closing of the books, the first-half loss is allocated to the pre-sale partners and the second-half income is allocated to the post-sale partners, so Lee gets a $10,000 loss and Moss gets $70,000 of income.

When a partner sells an interest during the year, partnership tax items must be allocated between the transferor and transferee for the year of transfer. Here, the partnership agreement specifically requires an interim closing of the books on June 30, so JKL’s tax year is divided into two allocation periods rather than spread ratably over the full year.

For January 1 through June 30, the $30,000 ordinary loss is shared by Jade, Kim, and Lee: $10,000 each. For July 1 through December 31, the $210,000 ordinary income is shared by Jade, Kim, and Moss: $70,000 each. Combining both periods gives Jade $60,000, Kim $60,000, Lee $(10,000)$, and Moss $70,000. The partnership continues as one tax year; the transfer changes who receives allocations, not whether the partnership files two returns.

• Allocating $30,000 each to Lee and Moss reflects a simple full-year proration of total annual income, which is wrong here because the agreement requires an interim closing of the books.
• Leaving Lee at $60,000 and starting Moss next year ignores that the buyer becomes the partner for tax allocations after the transfer date.
• Filing two short-year partnership returns overstates the required response; the partnership generally keeps one annual return and allocates items within that year between the old and new owners.

Because the partnership uses an interim closing of the books, Lee is allocated only 1/3 of the first-half $30,000 loss and Moss is allocated 1/3 of the second-half $210,000 income.

Question 66

Topic: Property Transactions (Disposition of Assets)

A staff preparer assigned character categories on the asset disposition schedule below before any §1231 netting. Assume no related-party, installment-sale, casualty, or depreciation-recapture rule changes the basic category.

Which schedule line best supports the conclusion that a gain or loss was assigned to the wrong character category?

• A. The vacant parcel line
• B. The inventory lot line
• C. The delivery van line
• D. The retail warehouse line

Best answer: D

What this tests: Property Transactions (Disposition of Assets)

Explanation: The retail warehouse line is the misclassified item. Business real property held more than one year is generally §1231 property, so its gain first enters the §1231 netting process rather than being directly classified as long-term capital gain on the schedule.

To review disposition character, first identify the type of property and then apply the holding period. Investment land is typically a capital asset, so a gain after more than one year is long-term capital gain. Inventory is not a capital asset, so its gain or loss is ordinary. Property used in a trade or business is also not a capital asset; if it is held more than one year, it is generally §1231 property and its gain or loss is placed in the §1231 category before annual netting. Here, the retail warehouse is depreciable business real property held six years, so reporting its gain directly as long-term capital gain is the wrong category at the schedule stage. The other listed items are assigned to appropriate basic character categories.

• The retail warehouse line is the error because business-use depreciable real property held more than one year belongs in §1231 before netting.
• The vacant parcel line is acceptable because investment land held more than one year can produce long-term capital gain.
• The delivery van line is acceptable because business property held only 10 months is not §1231 property, so its loss is ordinary.
• The inventory lot line is acceptable because property held for sale to customers produces ordinary, not capital, gain or loss.

Depreciable real property used in a trade or business and held more than one year is §1231 property, so its gain should not be directly labeled long-term capital gain before §1231 netting.

Question 67

Topic: Entity Tax Compliance

Apex Partnership completely liquidates Rivera’s partnership interest. Assume realized gain or loss is measured using FMV of the property distributed.

No liabilities shift to or from Rivera, and no §751 hot-asset issues apply.

Which interpretation is most accurate regarding the realized and recognized gain or loss to Apex and Rivera?

• A. Apex has a $30,000 realized gain and $0 recognized gain; Rivera has a $30,000 realized gain and $0 recognized gain.
• B. Apex has a $30,000 realized gain and $30,000 recognized gain; Rivera has a $30,000 realized gain and $30,000 recognized gain.
• C. Apex has a $30,000 realized gain and $0 recognized gain; Rivera has no realized or recognized gain because only cash can create gain in a liquidating distribution.
• D. Apex has no realized or recognized gain; Rivera has no realized or recognized gain because Rivera’s basis carries over to the land.

Best answer: A

What this tests: Entity Tax Compliance

Explanation: Apex distributes appreciated land, so the land carries a $30,000 built-in gain, but the partnership generally recognizes no gain on a liquidating distribution. Rivera receives $80,000 of value against a $50,000 outside basis, creating a $30,000 realized gain, yet recognizes none because the cash distributed does not exceed outside basis.

In a liquidating distribution, a partnership generally does not recognize gain or loss on property distributed to a partner unless a special exception applies. Here, the land’s FMV is $60,000 and its partnership basis is $30,000, so Apex has a $30,000 realized gain in the appreciated property but recognizes $0 on the distribution.

Rivera’s realized gain is based on the FMV received: $20,000 cash + $60,000 land = $80,000. Compared with Rivera’s $50,000 outside basis, that produces a $30,000 realized gain. However, Rivera recognizes gain only to the extent money distributed exceeds outside basis. Because the cash received is only $20,000, Rivera recognizes no gain. Rivera’s remaining outside basis after the cash distribution becomes the basis assigned to the land.

• Treating the $30,000 realized gain as automatically recognized ignores the general nonrecognition rule for partnership distributions and the partner cash-over-basis rule.
• Saying neither party even realizes gain confuses basis carryover with realization; the appreciated land still represents built-in gain, and Rivera received FMV above outside basis.
• Saying only cash can create gain is wrong. Cash controls partner recognition, but realized gain can still exist when noncash property is distributed.

The land has $30,000 of built-in gain at the partnership level, and Rivera receives assets worth $80,000 against a $50,000 outside basis, but neither recognizes gain because the partnership generally does not recognize gain on the distribution and Rivera’s cash received does not exceed outside basis.

Question 68

Topic: Tax Compliance and Planning for Individuals and Personal Financial Planning

Olivia made the following 2026 transfers:

• $90,000 cash to her U.S.-citizen spouse
• $30,000 paid directly to Green College for her grandson’s tuition
• $25,000 cash to her adult daughter
• $40,000 transferred to an irrevocable trust for her niece; the niece has no present right to income or principal until age 30

Assume the annual gift tax exclusion is $19,000 and Olivia made no other gifts during the year.

Which statement is the best interpretation for federal gift tax purposes?

• A. The spouse transfer qualifies for the unlimited marital deduction, the tuition payment is excluded, $6,000 of the daughter’s cash gift is taxable, and the trust transfer is fully taxable as a future-interest gift.
• B. The spouse transfer qualifies for the unlimited marital deduction, the tuition payment is excluded, $6,000 of the daughter’s cash gift is taxable, and only $21,000 of the trust transfer is taxable after the annual exclusion.
• C. The spouse transfer qualifies for the unlimited marital deduction, the tuition payment is taxable to the grandson, none of the daughter’s cash gift is taxable, and the trust transfer is fully taxable as a future-interest gift.
• D. The spouse transfer is limited to the $19,000 annual exclusion, the tuition payment is excluded, $6,000 of the daughter’s cash gift is taxable, and the trust transfer is fully taxable as a future-interest gift.

Best answer: A

What this tests: Tax Compliance and Planning for Individuals and Personal Financial Planning

Explanation: A gift to a U.S.-citizen spouse qualifies for the unlimited marital deduction, and tuition paid directly to an educational institution is excluded from gift tax. The daughter’s cash gift is a present-interest gift, so only the amount over the $19,000 annual exclusion is taxable, while the trust transfer is a future-interest gift that does not qualify for the annual exclusion.

For federal gift tax, some transfers are removed from taxable gifts before any unified credit is considered. A gift to a U.S.-citizen spouse qualifies for the unlimited marital deduction, so the $90,000 spouse transfer is not taxable. Tuition paid directly to the educational institution for someone else’s tuition is also excluded, so the $30,000 payment to Green College is not a taxable gift. The $25,000 cash gift to Olivia’s adult daughter is a present-interest gift, so the $19,000 annual exclusion applies and leaves $6,000 taxable. The trust transfer to the niece is different because she cannot presently use, possess, or enjoy the property until age 30. That makes it a future-interest gift, and future-interest gifts do not qualify for the annual exclusion, so the full $40,000 is taxable.

• Limiting the spouse transfer to the annual exclusion is wrong because gifts to a U.S.-citizen spouse qualify for the unlimited marital deduction.
• Treating the tuition payment as taxable is wrong because direct payment to the school for tuition is excluded from gift tax.
• Treating the daughter’s cash gift as fully sheltered is wrong because only $19,000 is covered by the annual exclusion.
• Applying the annual exclusion to the trust transfer is wrong because the niece received only a future interest, not a present interest.

Gifts to a U.S.-citizen spouse are fully deductible, direct tuition payments are excluded, the annual exclusion applies to the daughter’s present-interest cash gift, and the trust gift is a future interest that gets no annual exclusion.

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• CPA TCP: Individual and Personal Tax Planning
• CPA TCP: Entity Tax Compliance
• CPA TCP: Entity Tax Planning
• CPA TCP: Property Transactions

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