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Free Questions › CPA › Tax Compliance and Planning
Free CPA Tax Compliance and Planning Practice Questions & Answers
400 exam-style Tax Compliance and Planning questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 181
An S corporation owner earning $500,000 pays a $150,000 salary. The SE tax saving arises because:
Select an option first.
Correct answer: A — The remaining $350,000 distributive share escapes FICA — but the salary must be REASONABLE
Explanation: Only the $150,000 SALARY bears FICA. The $350,000 distributive share escapes it entirely — a substantial saving versus a sole proprietorship or partnership, where the whole amount would face SE tax. The constraint is REASONABLE COMPENSATION, and $150,000 must be defensible for the role.
Question 182
Lowering the S corporation salary to increase the FICA saving may BACKFIRE by:
Select an option first.
Correct answer: A — SHRINKING the QBI deduction (capped at 50% of W-2 wages above the threshold) and inviting IRS recharacterisation
Explanation: The two effects PULL IN OPPOSITE DIRECTIONS. A LOWER salary saves FICA but SHRINKS the W-2 wage cap on the QBI deduction (above the threshold). The optimum must be MODELLED — and it is often HIGHER than the FICA-minimising salary. Plus, too low a salary invites recharacterisation.
Question 183
For a taxpayer ABOVE the QBI threshold, the optimal S corporation salary is often:
Select an option first.
Correct answer: D — HIGHER than the FICA-minimising level — because W-2 wages drive the QBI cap
Explanation: Counterintuitively, above the QBI threshold, PAYING MORE SALARY can INCREASE total after-tax income — because the QBI deduction is capped at 50% of W-2 wages. The FICA cost of extra salary may be less than the QBI deduction it unlocks. This requires actual modelling, not a rule of thumb.
Question 184
A C corporation's 21% rate versus a pass-through's top rate (37% less a 20% QBI deduction = ~29.6%) means:
Select an option first.
Correct answer: A — The C corporation wins on RETAINED earnings, but the pass-through usually wins if profits are DISTRIBUTED
Explanation: On RETAINED earnings: C corp at 21% beats a pass-through at ~29.6%. But on DISTRIBUTED earnings: the C corp faces 21% + a dividend tax (23.8% including NIIT) = an effective ~39.8%, LOSING to the pass-through's 29.6%. The answer depends entirely on the DISTRIBUTION POLICY.
Question 185
A profitable C corporation that DISTRIBUTES all earnings faces an effective combined rate of approximately:
Select an option first.
Correct answer: B — About 39.8% — 21% corporate, then 23.8% (20% + 3.8% NIIT) on the after-tax dividend
Explanation: Combined = 21% + (79% × 23.8%) = 21% + 18.8% = 39.8%. That comfortably EXCEEDS the pass-through's ~29.6% (37% less the QBI deduction). Double taxation is real, and it is why full-distribution businesses generally choose pass-through status.
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Question 186
The C corporation's rate advantage on RETAINED earnings is undermined by:
Select an option first.
Correct answer: D — The ACCUMULATED EARNINGS TAX — you cannot retain earnings indefinitely without a documented business need
Explanation: You cannot simply retain earnings forever at 21% to avoid the shareholder layer — the ACCUMULATED EARNINGS TAX (20%) exists precisely to prevent that. The C corp's retention advantage requires a DOCUMENTED, LEGITIMATE business need for the accumulated funds.
Question 187
The strongest argument for a start-up choosing C corporation status is:
Select an option first.
Correct answer: D — §1202 QSBS — a potential 100% exclusion of gain on exit, which can dwarf the cost of double taxation
Explanation: For a start-up expecting a large exit, §1202 QSBS can EXCLUDE an enormous gain — a benefit that dwarfs years of double taxation. It requires C CORPORATION stock held MORE THAN 5 YEARS, with the gross asset test met at issuance. The entity decision must therefore be made at FORMATION, years before the exit.
Question 188
A founder converting an LLC to a C corporation for QSBS purposes should note that:
Select an option first.
Correct answer: B — Only appreciation AFTER the conversion qualifies — the pre-conversion built-in gain does NOT
Explanation: On converting an LLC/partnership to a C corporation, the stock's basis reflects the contributed property. Only the appreciation AFTER conversion qualifies for §1202 — the PRE-CONVERSION built-in gain does not. And the 5-YEAR CLOCK starts at ISSUANCE. Converting late means most of the gain misses out.
Question 189
STACKING §1202 across family members involves:
Select an option first.
Correct answer: A — GIFTING QSBS shares to family or trusts — each recipient gets their OWN exclusion cap
Explanation: §1202's exclusion cap is PER TAXPAYER, PER ISSUER. GIFTING shares to children or to non-grantor trusts (each a separate taxpayer) MULTIPLIES the available exclusion. The gift is a carryover-basis transfer, and the recipient TACKS the holding period — a legitimate and widely used technique.
Question 190
A partnership admitting a new partner with APPRECIATED PROPERTY must apply:
Select an option first.
Correct answer: B — §704(c) — the PRECONTRIBUTION gain is allocated to the CONTRIBUTING partner when the property is sold or depreciated
Explanation: §704(c) is MANDATORY: BUILT-IN GAIN at contribution must be allocated to the CONTRIBUTING partner. Otherwise a taxpayer could contribute appreciated property and shift the gain to lower-bracket partners. It is an anti-abuse rule, not an election.
Question 191
A §754 election is valuable to a partner BUYING an interest because:
Select an option first.
Correct answer: B — It STEPS UP the buyer's share of INSIDE basis to match what they PAID — increasing their depreciation and reducing their gain on sale
Explanation: Without a §754 election, a buyer paying $1m for an interest whose inside basis is $600,000 inherits the LOW inside basis — meaning less depreciation and more gain on a subsequent sale. §743(b) (enabled by a §754 election) STEPS UP the inside basis for THAT PARTNER ONLY. A buyer should always ask whether the partnership has one.
Question 192
The DISADVANTAGE of a §754 election is that it:
Select an option first.
Correct answer: B — Is BINDING for all FUTURE years — including years when a step-DOWN would be required
Explanation: Once made, a §754 election is BINDING for all future years unless the IRS consents to revoke it. That means it applies even when it produces a step-DOWN (where an interest is sold at a LOSS, or a distribution requires a downward adjustment) — which the partnership may not want. It also creates ongoing administrative complexity.
Question 193
A partner with a NEGATIVE capital account who abandons their interest:
Select an option first.
Correct answer: D — Recognises GAIN — the relief from their share of partnership DEBT is a deemed cash distribution exceeding basis
Explanation: Walking away from a partnership interest with NEGATIVE capital and allocated DEBT triggers GAIN: the relief from the debt is a DEEMED CASH DISTRIBUTION, and it exceeds basis. This 'phantom gain' catches real estate partners who assume that abandoning a worthless interest is costless. It is not.
Question 194
A GUARANTEED PAYMENT to a partner is subject to:
Select an option first.
Correct answer: D — SELF-EMPLOYMENT tax — and it is ORDINARY income to the partner, DEDUCTIBLE by the partnership
Explanation: GUARANTEED PAYMENTS are ORDINARY income, DEDUCTIBLE by the partnership, and subject to SE TAX. They do NOT reduce basis as a distribution would. Structuring compensation as a guaranteed payment versus a preferred allocation has real tax consequences and is a genuine planning choice.
Question 195
A PROFITS INTEREST granted for services is generally:
Select an option first.
Correct answer: A — NOT taxable on receipt — it has no liquidation value
Explanation: A PROFITS INTEREST (a share only of FUTURE profits, with no claim on existing capital) is generally NOT taxable on receipt under long-standing safe-harbour guidance, because its LIQUIDATION VALUE is ZERO. A CAPITAL interest, by contrast, IS taxable at FMV. This is the foundation of the carried-interest structure.
Question 196
An S corporation shareholder wanting to deduct a loss but lacking basis should:
Select an option first.
Correct answer: A — BORROW PERSONALLY and LEND the proceeds to the corporation — creating genuine DEBT BASIS
Explanation: A GUARANTEE creates NO basis. The FIX: borrow personally from the bank, then LEND those funds to the corporation. That creates a DIRECT shareholder loan and therefore REAL debt basis, unlocking the loss deduction. The extra step is the whole point.
Question 197
A shareholder restoring basis to use a suspended S corporation loss should note:
Select an option first.
Correct answer: A — Income restores DEBT basis FIRST, then STOCK basis — the reverse of the reduction order
Explanation: REDUCTION order: stock first, then debt. RESTORATION order: DEBT FIRST, then stock. The inversion matters — and it means that after a loss year followed by an income year, the shareholder's debt basis is rebuilt before any stock basis returns.
Question 198
An S corporation's AAA distribution is limited by:
Select an option first.
Correct answer: A — The shareholder's STOCK BASIS — an AAA distribution exceeding basis produces CAPITAL GAIN
Explanation: Even a distribution from AAA is TAX-FREE only to the extent of STOCK BASIS. Beyond basis, it is CAPITAL GAIN. Contrast an AE&P DIVIDEND, which is taxable regardless of basis and does NOT reduce it. Basis and AAA are separate accounts that must both be tracked.
Question 199
A PARTNERSHIP distribution of cash exceeding outside basis produces:
Select an option first.
Correct answer: D — CAPITAL GAIN — and a DEBT REDUCTION is a deemed cash distribution that can trigger it with no actual cash
Explanation: Cash exceeding outside basis produces CAPITAL GAIN. Critically, a DECREASE in a partner's share of partnership DEBT is a DEEMED cash distribution — so a partner can recognise PHANTOM GAIN when the partnership pays down debt, with no cash received at all.
Question 200
A real estate partner whose partnership REFINANCES and distributes the proceeds:
Select an option first.
Correct answer: B — Recognises NO gain if the distribution is within basis — a refinancing distribution is generally TAX-FREE
Explanation: A REFINANCING DISTRIBUTION is generally TAX-FREE: the new debt INCREASES the partner's outside basis (a deemed contribution), which then absorbs the cash distribution. This is the classic way real estate partners extract cash tax-free — 'refi and distribute' — without triggering the deferred gain.
Question 201
The 'DISGUISED SALE' rule threatens a refinancing distribution when it:
Select an option first.
Correct answer: A — Occurs shortly after a PROPERTY CONTRIBUTION — the two together may be recharacterised as a SALE
Explanation: A CONTRIBUTION of property followed by a DISTRIBUTION of cash within TWO YEARS is PRESUMED a disguised SALE. A DEBT-FINANCED distribution has a limited exception where the distribution is traceable to a genuine borrowing — but the timing and documentation matter enormously.
Question 202
A partnership with a §754 election in effect at a partner's DEATH:
Select an option first.
Correct answer: C — STEPS UP the deceased partner's share of INSIDE basis to match the heir's stepped-up OUTSIDE basis
Explanation: At DEATH, the heir's OUTSIDE basis steps up to FMV under §1014. Without a §754 election, INSIDE basis remains low — so the heir gets little depreciation and a large gain on sale. A §754 election triggers a §743(b) adjustment that STEPS UP inside basis for THAT HEIR. This can be worth a fortune and is routinely missed.
Question 203
A partnership WITHOUT a §754 election at a partner's death leaves the heir with:
Select an option first.
Correct answer: A — A stepped-up OUTSIDE basis but a LOW INSIDE basis — meaning less depreciation and MORE gain on the eventual sale
Explanation: The MISMATCH: the heir's OUTSIDE basis is stepped up, but the partnership's INSIDE basis in its assets is NOT. The heir inherits the LOW depreciation and, on a sale of the partnership's assets, is allocated the LOW-basis GAIN. The §754 election fixes this — and estate planners should always check for it.
Question 204
An S corporation at a shareholder's death provides:
Select an option first.
Correct answer: C — A step-up in STOCK basis only — NOT in the corporation's INSIDE basis, and there is no §754 equivalent
Explanation: S corporation stock gets a §1014 STEP-UP — but there is NO §754 equivalent to step up the CORPORATION'S INSIDE basis. So the heir holds high-basis STOCK while the corporation still holds low-basis ASSETS. If the corporation sells the assets, the gain flows through and is taxed. This is a REAL disadvantage of the S corporation versus the partnership for estate planning.
Question 205
For estate planning, a PARTNERSHIP is superior to an S corporation because:
Select an option first.
Correct answer: A — A §754 election can step up INSIDE basis at death — an S corporation has no such mechanism
Explanation: This is a significant and underappreciated advantage. At death, a partnership with a §754 election steps up INSIDE basis, so the heir gets full depreciation and no built-in gain. An S corporation cannot do this — its inside basis remains stubbornly low. For an asset-heavy business intended to pass at death, this matters greatly.
Question 206
The reasonable compensation standard for an S corporation shareholder considers:
Select an option first.
Correct answer: B — DUTIES, EXPERIENCE, TIME devoted, comparable salaries, and the corporation's dividend history
Explanation: Courts and the IRS consider: the shareholder's duties and responsibilities; their training and experience; the TIME devoted; comparable market salaries; the corporation's dividend history; and what an independent investor would pay. There is NO safe-harbour percentage — the 60/40 'rule' is a myth.
Question 207
The IRS's remedy for an unreasonably LOW S corporation salary is:
Select an option first.
Correct answer: C — RECHARACTERISING distributions as WAGES — with back payroll tax, interest and penalties
Explanation: The IRS RECHARACTERISES distributions as WAGES, assessing back FICA (both halves), interest and penalties. The corporation also owes the employer share. The remedy is expensive, and a zero-salary S corporation with substantial profits is a near-certain audit target.
Question 208
An S corporation's health insurance for a >2% shareholder is:
Select an option first.
Correct answer: C — INCLUDED in W-2 wages (taxable for income tax but NOT FICA), and DEDUCTIBLE above the line by the shareholder
Explanation: For a >2% shareholder, health insurance premiums are INCLUDED in W-2 wages (subject to income tax but NOT FICA), and the shareholder then deducts them ABOVE THE LINE. Note this ALSO increases W-2 wages for the QBI cap — a small bonus. Failing to run them through payroll forfeits the above-the-line deduction.
Question 209
A C corporation can deduct fringe benefits for its shareholder-employees that an S corporation:
Select an option first.
Correct answer: B — CANNOT provide tax-free to >2% shareholders — health, life and disability insurance are taxable to them
Explanation: A C CORPORATION shareholder-employee receives health insurance, group term life (up to $50k), disability coverage and other fringes TAX-FREE. A >2% S corporation shareholder is treated like a PARTNER — those benefits are TAXABLE. This is a genuine, and often decisive, C corporation advantage for a benefits-heavy owner.
Question 210
A business with HIGH owner medical costs might favour:
Select an option first.
Correct answer: B — A C CORPORATION — fringe benefits are tax-free to shareholder-employees, and an HRA/medical reimbursement plan can be deducted
Explanation: For an owner with substantial medical expenses, a C corporation's ability to provide TAX-FREE health benefits and to deduct a MEDICAL REIMBURSEMENT PLAN can be worth more than the pass-through's rate advantage. It is a real factor in entity choice that spreadsheets built purely on rates miss.
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