22 Businesses & Entities Practice Questions & Answers

1. 1. A domestic limited liability company is formed with two members and files no election on Form 8832. How is it classified for federal income tax purposes?

   • A.As a partnership✓ Answer
   • B.As an S corporation
   • C.As a disregarded entity
   • D.As a C corporation

   Under the check-the-box classification regulations, a domestic eligible entity with two or more members is classified as a partnership unless it affirmatively elects corporate treatment. Only a single-member eligible entity defaults to disregarded status, and S status additionally requires Form 2553 after a corporate classification exists.

   Source: Treasury Regulations, entity classification (check-the-box) default rules; Form 8832Report a problem with this question

2. 2. An individual is the sole member of a domestic limited liability company that operates a consulting business. No classification election is filed. How is the LLC's income reported?

   • A.The LLC files Form 1120 and pays tax at the corporate level
   • B.The owner reports the income and expenses on Schedule C of the owner's individual return✓ Answer
   • C.The LLC files Form 1120-S and issues the owner a Schedule K-1
   • D.The LLC files Form 1065 and issues the owner a Schedule K-1

   A single-member domestic eligible entity that makes no election is disregarded as separate from its owner, so an individual owner reports the activity as a sole proprietorship on Schedule C. The LLC is still treated as a separate entity for employment and certain excise taxes and may need its own EIN for those purposes.

   Source: Treasury Regulations, entity classification — single-member disregarded entity; Form SS-4Report a problem with this question

3. 3. All of the following may hold stock in an S corporation EXCEPT:

   • A.The estate of a deceased shareholder
   • B.A domestic partnership✓ Answer
   • C.An electing small business trust
   • D.A qualified organization exempt under section 501(c)(3)

   Eligible S corporation shareholders are limited to individuals other than nonresident aliens, estates, certain qualifying trusts, and certain tax-exempt organizations. A partnership or a corporation is not a permitted shareholder, so its ownership of even one share prevents or terminates the election.

   Source: IRC §1361 — S corporation eligible shareholdersReport a problem with this question

4. 4. An S corporation has outstanding voting common stock and nonvoting common stock. Both classes carry identical rights to distributions and to liquidation proceeds. What is the effect on the one-class-of-stock requirement?

   • A.The corporation has two classes of stock and its S election is terminated
   • B.The arrangement is permitted only if the nonvoting shares are a minority of the outstanding stock
   • C.The arrangement is permitted only if every shareholder consents to it each year
   • D.The requirement is still met, because differences in voting rights alone are disregarded✓ Answer

   The one-class-of-stock test looks to whether all outstanding shares confer identical rights to distribution and liquidation proceeds; differences in voting rights are expressly ignored. Because both classes share the same economic rights, the corporation has a single class of stock and the election survives.

   Source: IRC §1361 — one class of stock requirementReport a problem with this question

5. 5. For a transfer of property to a corporation solely in exchange for stock to be tax-free, the transferors as a group must own, immediately after the exchange:

   • A.More than 50 percent of the total combined voting power of all classes entitled to vote
   • B.At least 50 percent of the value of all outstanding stock
   • C.At least 80 percent of the total combined voting power of all classes entitled to vote and at least 80 percent of the total number of shares of each class of nonvoting stock✓ Answer
   • D.100 percent of all outstanding stock of the corporation

   Nonrecognition on a transfer of property to a controlled corporation requires "control" as statutorily defined, which is a two-part 80 percent test measured by voting power and by the number of shares of each class of nonvoting stock. Falling below either prong makes the entire exchange taxable.

   Source: IRC §351 and IRC §368(c) — control requirementReport a problem with this question

6. 6. An attorney receives stock in a newly formed corporation solely in exchange for legal services rendered in organizing it. Which statement is correct?

   • A.The attorney recognizes ordinary compensation income equal to the fair market value of the stock, and those shares do not count toward the control requirement✓ Answer
   • B.The attorney recognizes capital gain equal to the fair market value of the stock
   • C.The exchange is nontaxable because the attorney received only stock
   • D.The attorney recognizes no income and takes a zero basis in the stock

   Nonrecognition applies only to transfers of property, and services are not property. Stock received for services is taxable compensation at fair market value, and the shares are excluded from the control computation unless the same person also transfers property that is not of relatively small value.

   Source: IRC §351 — stock issued for services; IRC §61 compensation incomeReport a problem with this question

7. 7. In a transaction in which the transferors together own all of the corporation's stock immediately afterward, Dana transfers machinery with an adjusted basis of $40,000 and a fair market value of $100,000 to a newly formed corporation in exchange for stock worth $80,000 plus $20,000 in cash. How much gain must Dana recognize?

   • A.$40,000
   • B.$20,000✓ Answer
   • C.$0
   • D.$60,000

   Realized gain is $60,000 ($100,000 received less $40,000 basis), but in a controlled-corporation transfer gain is recognized only to the extent of boot received, here the $20,000 of cash. Gain is therefore $20,000, and Dana's stock basis is $40,000 basis plus $20,000 gain minus $20,000 boot, or $40,000.

   Source: IRC §351 — recognition limited to boot received; IRC §358 stock basisReport a problem with this question

8. 8. Ken transfers land with an adjusted basis of $30,000 and a fair market value of $100,000 to his newly formed corporation in exchange for all of its stock. The corporation assumes the $45,000 mortgage on the land, and there is no tax-avoidance purpose for the assumption. How much gain must Ken recognize?

   • A.$70,000
   • B.$0
   • C.$15,000✓ Answer
   • D.$45,000

   An assumption of liabilities is generally not treated as boot, but gain is forced when the liabilities assumed exceed the adjusted basis of the property transferred. The $45,000 liability exceeds the $30,000 basis by $15,000, so Ken recognizes $15,000 of gain and his stock basis is zero.

   Source: IRC §357(c) — liabilities in excess of basisReport a problem with this question

9. 9. Maria contributes equipment with an adjusted basis of $50,000 and a fair market value of $80,000 to a partnership in exchange for a partnership interest. The partnership assumes the $20,000 recourse liability secured by the equipment. Immediately after the contribution, Maria's share of all partnership liabilities is $6,000. What is Maria's basis in her partnership interest?

   • A.$50,000
   • B.$36,000✓ Answer
   • C.$56,000
   • D.$30,000

   A contributing partner takes a substituted basis equal to the basis of the property contributed, then treats the partnership's assumption of her debt as a deemed cash distribution and her share of partnership liabilities as a deemed cash contribution. That is $50,000 minus $20,000 plus $6,000, or $36,000; no gain arises because the net relief does not exceed her basis.

   Source: IRC §722 and IRC §752 — partner's basis and partnership liabilitiesReport a problem with this question

10. 10. A partner contributes unencumbered land with an adjusted basis of $50,000 and a fair market value of $80,000 to a partnership in exchange for a 25 percent interest. What is the partnership's basis in the land?

    • A.$50,000✓ Answer
    • B.$62,500
    • C.$20,000
    • D.$80,000

    The partnership takes a transferred (carryover) basis in contributed property equal to the contributing partner's adjusted basis, because neither party recognizes gain on the contribution. Fair market value is irrelevant to the partnership's inside basis, so the built-in gain remains in the property and is allocated back to the contributing partner when recognized.

    Source: IRC §723 — partnership's basis in contributed propertyReport a problem with this question

11. 11. A business borrows $100,000 from an unrelated bank. Compare a partner who is allocated a $40,000 share of that recourse partnership liability with the sole shareholder of an S corporation who personally guarantees the identical $100,000 corporate loan but makes no payment on it. Which statement is correct?

    • A.The S corporation shareholder receives $100,000 of debt basis, while the partner receives none
    • B.Neither owner receives any basis from the bank debt
    • C.The partner's basis increases by $40,000, but the guarantee gives the S corporation shareholder no basis✓ Answer
    • D.Both owners increase their basis by their share of the debt

    An increase in a partner's share of partnership liabilities is treated as a deemed cash contribution that raises outside basis, which is why the partner adds $40,000. An S corporation shareholder gets basis only from contributions to capital and from direct loans he makes to the corporation, so a mere guarantee creates no basis until the shareholder actually pays the debt.

    Source: IRC §752 (partnership liabilities) and IRC §1366(d) (S corporation stock and debt basis)Report a problem with this question

12. 12. At the beginning of the year Ellen's stock basis in an S corporation is $20,000 and she has made no loans to the corporation, so she has no debt basis. During the year the corporation makes a $18,000 nondividend cash distribution to her, and her Schedule K-1 reports an ordinary business loss of $12,000. The corporation has no accumulated earnings and profits. How much of the loss may Ellen deduct this year?

    • A.$2,000✓ Answer
    • B.$0
    • C.$8,000
    • D.$12,000

    Basis adjustments follow a fixed order: increases for income items first, then reductions for distributions, and only then reductions for losses and deductions. The $18,000 distribution reduces the $20,000 basis to $2,000 before the loss is applied, so only $2,000 of the loss is allowed and the remaining $10,000 is suspended and carried forward indefinitely until basis is restored.

    Source: IRC §1367 — order of basis adjustments; IRC §1366(d) loss limitationReport a problem with this question

13. 13. A business has been using an improper method of accounting for its inventory and now wants to change to a proper method. Which statement is correct?

    • A.A change in accounting method is permitted only when the ownership of the entity changes
    • B.It must amend every open prior-year return to reflect the correct method
    • C.It may simply begin using the correct method on its next return without any filing, because the new method is proper
    • D.It must request the consent of the IRS by filing Form 3115, and an adjustment is required so that no item of income or deduction is duplicated or omitted✓ Answer

    A taxpayer generally may not change a method of accounting without the consent of the Commissioner, and that is true even when moving from an impermissible method to a permissible one. Consent is requested on Form 3115, and a cumulative adjustment is computed so that amounts are neither duplicated nor omitted in the year of change.

    Source: IRC §446(e) and IRC §481(a) — change of accounting method; Form 3115Report a problem with this question

14. 14. Before any distribution, Raj's basis in his partnership interest is $22,000. The partnership makes a current (nonliquidating) distribution of $30,000 cash to him. What is the result to Raj?

    • A.$30,000 of capital gain, and his basis in the partnership interest becomes zero
    • B.No gain is recognized, because a partner never recognizes gain on a current distribution
    • C.$8,000 of ordinary income, and his basis in the partnership interest becomes zero
    • D.$8,000 of capital gain, and his basis in the partnership interest becomes zero✓ Answer

    On a current distribution a partner recognizes gain only to the extent the money distributed exceeds the basis of the partnership interest, and that gain is capital because it is treated as gain from the sale of the interest. Here $30,000 of cash exceeds the $22,000 basis by $8,000, and basis cannot go below zero.

    Source: IRC §731 — gain on a current distribution of moneyReport a problem with this question

15. 15. An S corporation that has never been a C corporation and has no accumulated earnings and profits distributes $15,000 cash to its sole shareholder. After all income and loss adjustments for the year, the shareholder's stock basis immediately before the distribution is $10,000. How is the distribution treated?

    • A.The entire $15,000 is tax free and the shareholder's basis becomes negative $5,000
    • B.The entire $15,000 is a taxable dividend
    • C.$10,000 is a tax-free reduction of basis and $5,000 is capital gain✓ Answer
    • D.$10,000 is tax free and $5,000 is ordinary income

    When an S corporation has no accumulated earnings and profits, a distribution is a tax-free return of investment to the extent of the shareholder's stock basis and any excess is treated as gain from the sale of the stock, which is capital gain. Stock basis is reduced to zero and never below.

    Source: IRC §1368 — S corporation distributions with no accumulated earnings and profitsReport a problem with this question

16. 16. A C corporation has current earnings and profits of $30,000 and an accumulated earnings and profits deficit of $50,000. It distributes $40,000 cash to its sole shareholder, whose stock basis is $25,000. How is the distribution treated by the shareholder?

    • A.No dividend, because the accumulated deficit exceeds current earnings and profits; the entire $40,000 is a return of capital
    • B.$30,000 is a taxable dividend and $10,000 is a tax-free return of capital that reduces stock basis to $15,000✓ Answer
    • C.$30,000 is a taxable dividend and $10,000 is capital gain
    • D.The entire $40,000 is a taxable dividend

    A distribution is a dividend first to the extent of current earnings and profits, and current earnings and profits are not netted against an accumulated deficit. The remaining $10,000 is a nontaxable return of capital that reduces stock basis from $25,000 to $15,000; only amounts beyond basis would be capital gain.

    Source: IRC §316 and IRC §301 — dividend and return of capital orderingReport a problem with this question

17. 17. A closely held C corporation with substantial earnings and profits pays the personal country club dues and home mortgage payments of its sole shareholder. The payments are not reported as compensation and no services justify them. How are the payments treated?

    • A.They are a nontaxable loan to the shareholder that need not be documented
    • B.They are constructive dividends, taxable to the shareholder to the extent of earnings and profits and not deductible by the corporation✓ Answer
    • C.The corporation deducts them as ordinary and necessary business expenses and the shareholder has no income
    • D.They are automatically wages subject to income tax withholding and employment taxes

    A corporate payment of a shareholder's personal expenses that is not compensation for services and is not a bona fide loan is an economic benefit distributed with respect to stock, so it is a constructive dividend. The shareholder includes it in income to the extent of earnings and profits and the corporation gets no deduction, which is what makes constructive dividends costly to a C corporation.

    Source: IRC §301 and IRC §316 — constructive dividendsReport a problem with this question

18. 18. In what order must an individual owner of a pass-through business apply the limitations on deducting a loss from the business?

    • A.Basis limit, then at-risk limit, then passive activity limit, then excess business loss limit✓ Answer
    • B.Passive activity limit, then at-risk limit, then basis limit, then excess business loss limit
    • C.At-risk limit, then basis limit, then excess business loss limit, then passive activity limit
    • D.Excess business loss limit, then passive activity limit, then at-risk limit, then basis limit

    The limitations are applied as successive hurdles: a loss must first survive the owner's basis in the interest, then the amount the owner has at risk, then the passive activity rules, and finally the excess business loss limitation at the individual level. A loss stopped at any hurdle is suspended and carried forward rather than lost.

    Source: IRC §704(d), IRC §465, IRC §469 and IRC §461(l) — ordering of loss limitationsReport a problem with this question

19. 19. A partnership agreement provides a general partner with a $60,000 guaranteed payment for services. For the year, the partnership has an operating loss before taking the payment into account. Which statement is correct?

    • A.The payment is not deductible because the partnership has a loss, and the partner reports nothing
    • B.The payment is reported as a dividend and is not subject to self-employment tax
    • C.The payment is deductible by the partnership in computing its ordinary business income or loss and is ordinary income to the partner subject to self-employment tax, regardless of the partnership's profitability✓ Answer
    • D.The payment is a distribution that is tax free to the extent of the partner's basis and reduces that basis

    A guaranteed payment is determined without regard to partnership income, so it is treated like a payment to a non-partner: the partnership deducts it in arriving at ordinary business income or loss and the recipient partner reports it as ordinary income. Because it compensates services, it is also net earnings from self-employment to the partner.

    Source: IRC §707(c) — guaranteed payments; IRC §1402 self-employment incomeReport a problem with this question

20. 20. A self-employed taxpayer uses a spare room in the home regularly as the principal place of business, but the taxpayer's family also uses the room several evenings a week to watch television. What is the result for the home office deduction?

    • A.The deduction is allowed, but only if the taxpayer uses the simplified method
    • B.No home office deduction is allowed, because the space is not used exclusively for business✓ Answer
    • C.The deduction is allowed if business use of the room exceeds half of its total use
    • D.The deduction is allowed because the business use is regular and the room is the principal place of business

    The home office rules require that a specific portion of the dwelling be used both regularly and exclusively for business; regular use alone is not enough. Any meaningful personal use of the same space, such as family television watching, destroys exclusivity and disallows the deduction under either the actual expense method or the simplified method.

    Source: IRC §280A — exclusive and regular business use of a dwelling unitReport a problem with this question

21. 21. An activity is presumed to be engaged in for profit, rather than treated as a hobby, if it produced a profit in at least:

    • A.2 of the last 5 consecutive tax years, including the current year
    • B.2 of the last 7 consecutive tax years, including the current year
    • C.4 of the last 7 consecutive tax years, including the current year
    • D.3 of the last 5 consecutive tax years, including the current year✓ Answer

    The statutory presumption of a profit motive arises when the activity is profitable in 3 of 5 consecutive tax years ending with the current year; the special test for activities consisting mainly of breeding, training, showing or racing horses is 2 of 7 years. The presumption only shifts the burden to the IRS, and the profit motive can still be established under the facts and circumstances factors when the presumption is not met.

    Source: IRC §183 — presumption that an activity is engaged in for profitReport a problem with this question

22. 22. A company signs a written agreement calling a worker an independent contractor, but the company sets his daily hours, provides all tools, and closely directs the methods he uses to do the job. Which statement is correct?

    • A.The worker is likely an employee, because the common-law right to direct and control how the work is done governs regardless of the label, and misclassification leaves the business liable for the employment taxes it failed to withhold and pay✓ Answer
    • B.Classification depends solely on whether the company issues a Form 1099-NEC rather than a Form W-2
    • C.Classification depends on whether the worker performs services full time rather than part time
    • D.The worker is an independent contractor because a signed agreement controls the classification

    Worker status is decided under the common-law control test, which weighs behavioral control, financial control and the type of relationship; the substance of the arrangement, not the parties' label or the form issued, is what matters. Setting hours, furnishing tools and directing methods are strong indicators of behavioral and financial control by an employer, and a business that misclassifies a worker remains liable for the withholding and its share of employment taxes.

    Source: Common-law control test for worker classification; IRS Special Enrollment Examination — Part 2, BusinessesReport a problem with this question

Practice questions based on the Internal Revenue Code, Treasury Department Circular No. 230, and the IRS Special Enrollment Examination content outline. Enrolled Agent and the SEE are administered by the IRS; this site is not affiliated with or endorsed by the IRS or Treasury. Questions deliberately avoid inflation-adjusted figures — rates, brackets, standard deductions, contribution and phase-out limits, mileage rates and penalty amounts change every year, so look those up for the tax year you are tested on. This is study material, not tax advice. About the Enrolled Agent exam →