Free sample
Part 2 practice questions
Work each question, then open the answer. Every explanation cites the rule it rests on.
Question 1 · Business Entities
Gloria organized a single-member LLC under state law in March 2025 to run her floral design studio, is its only member, and has never filed Form 8832. The LLC has two employees and pays them wages each quarter. Which statement correctly describes how the LLC is treated for federal tax purposes for 2025?
- A. Its business profit is reported on Gloria's Schedule C, and the LLC is disregarded for employment tax purposes as well, so the wages are reported under Gloria's own taxpayer identification number.
- B. Its business profit is reported on Gloria's Schedule C, but the LLC is treated as a separate entity in its own name for employment tax purposes.
- C. Because the LLC has employees other than its member, it is treated as a partnership for the year and must file Form 1065 reporting the wages paid.
- D. Because the LLC filed no classification election, it defaults to an association taxable as a corporation and reports both the profit and the wages on Form 1120.
Show answer & explanation
Answer: B. A domestic single-member LLC that files no election defaults to a disregarded entity under Reg. §301.7701-3(b)(1)(ii), so an individual owner reports the business on Schedule C. That disregarded status does not extend to employment taxes: Reg. §301.7701-2(c)(2)(iv) treats the LLC as a separate corporation in its own name and EIN for employment tax purposes, so the LLC — not Gloria personally — files the Forms 941 and W-2. The same exception applies to certain excise taxes.
Question 2 · Business Entities
Larkspur Fabrication LLC has three members. It filed Form 8832 electing to be classified as an association taxable as a corporation, effective January 1, 2023. In November 2025 the members conclude the corporate treatment was a mistake and want the LLC taxed as a partnership again as soon as possible. Absent IRS permission, what is the earliest date a new classification election can take effect?
- A. January 1, 2028, because an eligible entity generally may not change its classification by election during the 60 months after a prior election's effective date.
- B. January 1, 2027, because the entity must remain a corporation for four full tax years before a further election is available.
- C. December 1, 2025, because a prior classification election may be revoked at any time by filing a second Form 8832.
- D. January 1, 2026, because a classification election may be changed with effect from the first day of any later tax year.
Show answer & explanation
Answer: A. Reg. §301.7701-3(c)(1)(iv) provides that an eligible entity that makes a classification election generally may not change its classification by election again during the 60 months succeeding the effective date of that election. The 60 months following January 1, 2023 run through December 31, 2027, so the earliest available effective date is January 1, 2028. The Commissioner may permit an earlier change, and the limitation does not apply to an election made by a newly formed entity effective on its formation date.
Question 3 · Business Entities
Which of the following is correct regarding an S corporation that owns 100% of the stock of a domestic corporation?
- A. It may elect to treat the subsidiary as a qualified subchapter S subsidiary, after which the subsidiary is disregarded and its items are reported by the parent.
- B. It may not hold the stock at all, because an S corporation is prohibited from owning stock in another domestic corporation.
- C. The subsidiary must make its own S election, after which the two corporations file a single consolidated return.
- D. Form 8832 must be filed for the subsidiary first, because only an eligible entity may be treated as disregarded.
Show answer & explanation
Answer: A. Under IRC §1361(b)(3), an S corporation that owns 100% of the stock of a domestic corporation may elect on Form 8869 to treat it as a qualified subchapter S subsidiary. A QSub is not treated as a separate corporation; its assets, liabilities and items of income, deduction and credit are treated as those of the parent S corporation. The restrictions in §1361(b)(1) limit who may own S corporation stock, not what an S corporation may own, so an S corporation can hold subsidiary stock.
Question 4 · Business Entities
Which tax-exempt entity may hold stock in an S corporation as an eligible shareholder under IRC §1361(c)(6)?
- A. A social club described in §501(c)(7) that holds the shares purely as a passive investment.
- B. A traditional individual retirement account holding shares of a corporation that manufactures farm equipment.
- C. A political organization described in §527 that reports the shares among its exempt function assets.
- D. A charitable organization described in §501(c)(3) that is exempt from tax under §501(a).
Show answer & explanation
Answer: D. IRC §1361(c)(6) permits only two categories of exempt organization to be S corporation shareholders: a qualified retirement plan trust described in §401(a) (including an ESOP) and a charitable organization described in §501(c)(3), each exempt under §501(a). Social clubs and political organizations are not on that list. An IRA is a permitted shareholder only in the narrow case described in §1361(c)(2)(A)(vi), which covers stock of a bank or depository institution holding company — not an operating manufacturer.
Question 5 · Business Entities
All of the following are requirements a corporation must satisfy to be eligible to elect S corporation status EXCEPT:
- A. Its shareholders must be individuals, estates, or trusts of a type the statute permits to hold the stock.
- B. It must be a domestic corporation, created or organized in the United States or under federal or state law.
- C. It must have at least two shareholders, and no more than 100 shareholders, on the date of the election.
- D. It must have no more than one class of stock outstanding at any time during the tax year.
Show answer & explanation
Answer: C. IRC §1361(b)(1)(A) caps the number of shareholders at 100 but sets no minimum — a corporation with a single shareholder is a perfectly valid S corporation, and one-shareholder S corporations are extremely common. The other three statements restate genuine eligibility requirements: one class of stock under §1361(b)(1)(D), domestic status under §1361(b)(1), and the permitted shareholder categories under §1361(b)(1)(B) and (C).
Question 6 · Business Entities
Ashgrove Dairy, Inc. has 96 shareholders of record. Six of them are Naledi, her husband, her two adult children and her two grandchildren; the other 90 are unrelated individuals, each a U.S. citizen. The board wants to admit additional unrelated individual shareholders. Under IRC §1361, how many more may Ashgrove admit and still be eligible to be an S corporation?
- A. Nine, because the six family members are counted as one shareholder, leaving the corporation with 91.
- B. Four, because each of the 96 shareholders of record is counted separately toward the limit.
- C. Five, because only Naledi and her husband are counted as one shareholder and the other four count individually.
- D. None, because a corporation with more than 75 shareholders may not maintain an S election.
Show answer & explanation
Answer: A. IRC §1361(c)(1) treats all members of a family as a single shareholder. A family means a common ancestor, that ancestor's lineal descendants, and the spouses or former spouses of either, with the common ancestor no more than six generations removed from the youngest member. Naledi, her spouse, her children and her grandchildren therefore count as one shareholder, giving 90 + 1 = 91. The ceiling is 100 shareholders under §1361(b)(1)(A), so nine more unrelated individuals may be admitted. The 75-shareholder limit was raised to 100 for tax years beginning after 2004.
Question 7 · Business Entities
Which of the following is correct regarding entity-level federal taxes on an S corporation that has accumulated earnings and profits from earlier C corporation years?
- A. It may owe the accumulated earnings tax on the earnings and profits it carried over from its C corporation years.
- B. It may owe the corporate alternative minimum tax on its built-in gain, because it was a C corporation within the past ten years.
- C. It owes no entity-level federal income tax of any kind, because subchapter S exempts an S corporation from tax at the entity level.
- D. It may owe the built-in gains tax on gain recognized during the recognition period, and the tax on excess net passive income if passive receipts exceed 25% of gross receipts.
Show answer & explanation
Answer: D. An S corporation is generally not taxed on its income, but §1363(a) makes that exemption subject to the taxes specifically imposed by subchapter S. Two apply here: the §1374 built-in gains tax on net recognized built-in gain during the five-year recognition period following the election, and the §1375 tax on excess net passive income, which applies only to an S corporation that has accumulated earnings and profits from C years and passive investment income exceeding 25% of gross receipts. The accumulated earnings tax and the corporate alternative minimum tax apply to C corporations, not to S corporations.
Question 8 · Business Entities
Brambleton Optics, Inc. is a C corporation with a tax year ending September 30. Its owners are weighing an S election for a later year and want to compare the filing deadlines first. Assuming no extension is requested and no due date falls on a weekend or legal holiday, when is the corporation's Form 1120 for the year ended September 30, 2025 due?
- A. January 31, 2026, the last day of the fourth month following the close of the tax year.
- B. January 15, 2026, the 15th day of the fourth month following the close of the tax year.
- C. April 15, 2026, the 15th day of the fourth month following the close of the calendar year.
- D. December 15, 2025, the 15th day of the third month following the close of the tax year.
Show answer & explanation
Answer: B. Under IRC §6072(b), a C corporation's Form 1120 is due by the 15th day of the fourth month following the close of its tax year, which for a September 30 year end is January 15. The deadline runs from the corporation's own tax year, not the calendar year. Had the corporation been an S corporation, Form 1120-S would have been due the 15th day of the third month — December 15 — the same deadline that applies to a partnership's Form 1065.
Question 9 · Partnership Formation
Under IRC §721(a), when a partner contributes property to a partnership solely in exchange for an interest in that partnership, the general rule is that:
- A. The contributing partner recognizes gain unless the interest received is proportionate to the value contributed.
- B. Neither the partnership nor the contributing partner recognizes any gain or loss on the contribution.
- C. The partnership recognizes gain equal to the appreciation in the property it receives from the partner.
- D. The contributing partner recognizes gain to the extent the property's fair market value exceeds its adjusted basis.
Show answer & explanation
Answer: B. IRC §721(a) provides that no gain or loss is recognized to a partnership or to any of its partners on a contribution of property to the partnership in exchange for an interest in it. The rule is bilateral — it protects the partnership as well as the partner — and it does not depend on the size of the interest received or on how the property's value compares with the interest's value. The deferred gain is preserved through the carryover bases of §722 and §723.
Question 10 · Partnership Formation
Manny contributes a warehouse with a $300,000 adjusted basis and a $500,000 fair market value to a partnership that has been operating for eleven years and already has twelve partners. In exchange he receives a 4% interest in partnership capital and profits, and he holds no other interest in the partnership. What gain does he recognize on the contribution, and why?
- A. $8,000, being the share of the built-in gain that corresponds to the 4% interest he received.
- B. $200,000, because he does not own 80% or more of the partnership immediately after the contribution.
- C. $200,000, because §721(a) applies only to contributions made when a partnership is first formed.
- D. None, because §721(a) imposes no control requirement, so the size of the interest received does not matter.
Show answer & explanation
Answer: D. This is the most important structural difference between §721 and §351. A transfer to a corporation is tax-free only if the transferors control 80% or more of the corporation immediately afterwards, but §721(a) contains no control test at all: a partner who contributes property for even a very small partnership interest recognizes nothing. Nor is §721(a) confined to formation — it applies equally to a contribution made to a long-established partnership. Manny's $200,000 of built-in gain is preserved in his $300,000 outside basis under §722 and in the partnership's carryover basis under §723, and §704(c) will steer it back to him if the warehouse is later sold.
Question 11 · Partnership Formation
Which of the following is correct regarding the built-in loss when a partner contributes property whose adjusted basis exceeds its fair market value?
- A. No one deducts it in the year of the contribution, because §721(a) bars loss recognition just as it bars gain recognition.
- B. The contributing partner deducts it rateably over the property's remaining MACRS recovery period in the partnership's hands.
- C. The contributing partner deducts it in full, as a loss on the disposition of property used in a trade or business.
- D. The partnership deducts it, because it takes the contributed property with a basis equal to fair market value.
Show answer & explanation
Answer: A. Section 721(a) is symmetrical: it denies loss recognition as firmly as it denies gain recognition, so neither the contributing partner nor the partnership deducts anything on the contribution itself. Under §723 the partnership takes the property with the contributor's carryover basis rather than its lower fair market value, so the loss is deferred rather than lost. Section 704(c)(1)(C) then confines that built-in loss to the contributing partner: if the partnership later disposes of the property, only that partner may be allocated the loss, and for every other partner the basis is treated as the fair market value at contribution.
Question 12 · Partnership Formation
Section 721(a) nonrecognition does NOT apply to which of the following transfers to a partnership?
- A. A contribution of cash by a partner joining a partnership that is already operating.
- B. A contribution of services in exchange for a capital interest in the partnership.
- C. A contribution of marketable securities to a partnership that is not an investment company.
- D. A contribution of inventory by a partner who holds it for sale to customers.
Show answer & explanation
Answer: B. Section 721(a) applies only to contributions of 'property,' and services are not property. Reg. §1.721-1(b)(1) provides that a partner who receives a capital interest in exchange for services performed recognizes ordinary compensation income equal to the value of that interest. Property is otherwise read broadly for this purpose: cash, inventory, capital assets, accounts receivable and intangibles all qualify, and the character of the asset in the partner's hands affects later treatment under §724, not the availability of nonrecognition.
Question 13 · Partnership Formation
Two partners receive equal interests in a partnership although one contributes cash worth less than the other's property. Does nonrecognition still apply to the contributions?
- A. No, because the partners' capital accounts must equal their respective contributions for §721(a) to apply.
- B. Only for the partner who contributed the property, because the other received an interest worth more than the cash contributed.
- C. No, because a contribution that buys an interest worth more than the property given up is a taxable exchange.
- D. Yes, because §721(a) does not require the interests received to be proportionate to the values contributed.
Show answer & explanation
Answer: D. Nothing in §721(a) conditions nonrecognition on the partners receiving interests proportionate to what they contributed, and unequal contributions for equal interests are common where the partners bring different things to the venture. A disproportionate result can raise separate questions — the shift in value may be a gift, or compensation for services under Reg. §1.721-1(b)(1), or may be tested under the capital account rules of §704(b) — but none of those causes gain to be recognized under §721 itself.
Question 14 · Partnership Formation
Claire sells a parcel of undeveloped land to a partnership in which she is a 30% partner. The partnership pays her $250,000 in cash at closing on the same terms it would have offered an unrelated seller, and she receives no additional partnership interest. Her adjusted basis in the land is $160,000. How is the transaction treated?
- A. As a §721(a) contribution, so she recognizes no gain because the transferee is a partnership in which she is a partner.
- B. As a nontaxable exchange, because a partner and her partnership are treated as one taxpayer under subchapter K.
- C. As a sale between the partnership and a partner acting outside her capacity as a partner, so she recognizes $90,000 of gain.
- D. As a §721(a) contribution as to her 30% interest, so she recognizes $63,000 of gain on the remaining 70%.
Show answer & explanation
Answer: C. IRC §707(a)(1) provides that where a partner engages in a transaction with the partnership other than in the capacity of a partner, the transaction is treated as occurring between the partnership and someone who is not a partner. Selling land for cash on arm's-length terms, with no partnership interest received, is such a transaction, so Claire recognizes the full $250,000 − $160,000 = $90,000 of gain. Section 721(a) protects only a transfer made in exchange for a partnership interest; it is the consideration received, not the identity of the transferee, that determines which rule applies.
Question 15 · Partnership Formation
Under IRC §721(b), the general nonrecognition rule of §721(a) does NOT apply to a contribution that:
- A. Consists of appreciated inventory rather than of a capital asset held by the partner for investment.
- B. Is made by a limited partner of the partnership rather than by one of its general partners.
- C. Would be treated as a transfer to an investment company if the partnership had been incorporated instead.
- D. Is accompanied by an allocation of profits differing from the partners' relative capital percentages.
Show answer & explanation
Answer: C. IRC §721(b) borrows the investment company test of §351(e): nonrecognition is denied where the contribution, had the partnership been a corporation, would be a transfer to an investment company. In practice this reaches contributions of stocks, securities and similar assets that result in a diversification of the contributing partners' investments. A partner's status as general or limited, the profit-sharing arrangement, and the ordinary-income character of contributed inventory are all irrelevant to §721(b).
Question 16 · Partnership Formation
Several individuals each contribute a portfolio of publicly traded stock in a different industry to newly formed Silvercreek Capital Partners, so that each partner's interest becomes diversified across all of the contributed portfolios. The contribution is most likely:
- A. Taxable under §721(b), because this is a transfer to an entity that would be an investment company if incorporated.
- B. Nontaxable under §721(a), because publicly traded stock is property in the hands of each contributing partner.
- C. Nontaxable under §721(a), because the contributing partners are individuals rather than corporate transferors.
- D. Taxable only in the year the partnership sells some of the contributed stock at a gain to an outside buyer.
Show answer & explanation
Answer: A. Pooling non-identical securities portfolios so that each contributor ends up holding a share of them all is the classic diversification that §721(b) and §351(e) are aimed at, and gain — though not loss — is recognized on the appreciated securities contributed. That the shares are property, and that the contributors are individuals, would matter under §721(a) but are beside the point once §721(b) applies; the tax falls at contribution, not on a later sale by the partnership.
Question 17 · Corporate Formation & §351
Cameron transfers a commercial kitchen fit-out to Verdant Table, Inc. and receives 900 of the corporation's 1,000 outstanding voting common shares. Verdant Table also has 400 shares of nonvoting preferred stock outstanding, all held by an unrelated investor who transfers nothing in this transaction. Cameron transfers nothing else and no other person transfers property. Does §351 apply to his transfer?
- A. No, because control also requires at least 80% of the shares of each nonvoting class, and he holds none of the preferred.
- B. Yes, because he holds 90% of the voting power, comfortably above the 80% threshold set by §368(c).
- C. No, because §351 requires the transferor to hold at least 80% of the total value of all outstanding stock.
- D. Yes, because the preferred stock carries no vote and is left out of account in applying the control test.
Show answer & explanation
Answer: A. Control under §368(c) has two limbs that must both be satisfied: at least 80% of the total combined voting power of all classes entitled to vote, AND at least 80% of the total number of shares of each other class of stock. Cameron clears the first limb at 90% but holds none of the 400 nonvoting preferred shares, so the second limb fails and §351 does not apply. His transfer is a taxable exchange.
Question 18 · Corporate Formation & §351
'Control' for purposes of §351 is defined in IRC §368(c) as ownership of:
- A. More than 50% of the total value of all classes of the corporation's outstanding stock.
- B. At least 80% of the total value of all outstanding stock, whether that stock votes or not.
- C. At least 80% of the combined voting power and at least 80% of the shares of each nonvoting class.
- D. At least two-thirds of the voting stock, measured immediately after the exchange takes place.
Show answer & explanation
Answer: C. Section 368(c) defines control as stock possessing at least 80% of the total combined voting power of all classes entitled to vote, plus at least 80% of the total number of shares of each other class. The test is mechanical and is applied share by share rather than by value.
Question 19 · Corporate Formation & §351
Kestrel Manufacturing, Inc. is newly formed with 1,000 voting common shares outstanding, its only class of stock. Arun transfers equipment for 700 of those shares and Beatriz transfers cash for the remaining 300, both as part of the same transaction. Does §351 apply?
- A. No, because cash is not 'property' for §351 and Beatriz cannot be counted as a transferor.
- B. No, because §368(c) control is tested transferor by transferor and Arun's 70% falls short.
- C. Yes, but only as to Arun's transfer; Beatriz's shares sit outside the exchange.
- D. Yes, because the transferors as a group hold 100% of the stock immediately after the exchange.
Show answer & explanation
Answer: D. Control is tested against the transferors as a group where they transfer property as part of the same transaction, not against each of them separately. Cash counts as property for §351 purposes, so Beatriz is a transferor, and together the two hold 100% of Kestrel's stock — well clear of the 80% required by §368(c).
Question 20 · Corporate Formation & §351
Which of the following is NOT treated as 'property' for purposes of qualifying a transferor under §351?
- A. A patent transferred together with all substantial rights to the invention.
- B. Cash contributed at the same time as the other transferors' property.
- C. Services rendered to the transferee corporation in organizing and launching its business.
- D. Accounts receivable of the transferor's existing unincorporated business.
Show answer & explanation
Answer: C. Section 351(d)(1) provides that stock issued for services is not issued in return for property. A person who transfers only services recognizes ordinary compensation income and does not count toward the control group.
Question 21 · Corporate Formation & §351
Which of the following is correct regarding a person who receives all of a corporation's stock solely in exchange for services performed in organizing it?
- A. The recipient recognizes ordinary compensation income equal to the fair market value of the shares received.
- B. The recipient recognizes no income now, the full amount being taxed on a later sale of the shares.
- C. The recipient recognizes no income, because a transfer to a corporation the recipient controls falls within §351(a).
- D. The recipient recognizes long-term capital gain equal to the fair market value of the shares received.
Show answer & explanation
Answer: A. Under §351(d)(1) and Reg. §1.351-1(a)(1)(i), stock received for services is not received in exchange for property. The service provider recognizes ordinary compensation income equal to the stock's fair market value, and the basis in the shares equals the amount so taxed.
Question 22 · Corporate Formation & §351
A transferor who contributes services AND a relatively small amount of property will not be counted toward the §351 control group with respect to the property transferred if, under Reg. §1.351-1(a)(1)(ii), the property is:
- A. Property the transferor had held for less than one year before the exchange.
- B. Worth less than the stock the transferor receives for the property itself.
- C. Of relatively small value and transferred principally to qualify the other transferors for nonrecognition.
- D. Depreciable property, which the regulation excludes from the control computation.
Show answer & explanation
Answer: C. Reg. §1.351-1(a)(1)(ii) disregards property of relatively small value where it was transferred principally to qualify other exchanges for §351 treatment. The Service's ruling guideline treats property worth at least 10% of the value of the stock received for services as not 'relatively small'.
Question 23 · Corporate Formation & §351
Under §351, control must be measured:
- A. Continuously for the five years following the exchange, under a continuity-of-interest rule.
- B. On the date the corporation is chartered under the law of its state of organization.
- C. As of the close of the corporation's first taxable year after the exchange.
- D. Immediately after the exchange, with no continuing ownership requirement afterward.
Show answer & explanation
Answer: D. Section 351(a) requires control 'immediately after the exchange'. There is no statutory holding requirement thereafter, although a binding disposition of the stock arranged as part of the same plan can defeat control at the tested moment.
Question 24 · Corporate Formation & §351
Which of the following best characterizes a transfer of additional property to a corporation by its sole shareholder who receives no additional stock?
- A. A §351 exchange, which fails because no additional stock was issued.
- B. A constructive dividend to the shareholder, measured by the property's fair market value.
- C. A taxable sale of the property to the corporation at its fair market value.
- D. A contribution to capital, nontaxable to the corporation under §118, with the shareholder adding the basis to his or her stock.
Show answer & explanation
Answer: D. A shareholder who puts property into a wholly owned corporation without taking additional stock has made a contribution to capital. The corporation excludes it from gross income under §118 and takes a carryover basis under §362(a)(2), while the shareholder increases the basis of the stock already held.
Question 25 · Entity Classification & S Elections
Ileana Sarto and Gustaw Nowicki jointly own a strip of farmland. Under their first arrangement they simply lease the whole strip to a neighboring farmer and split the rent. Under their second, they buy seed together, work the land themselves, and divide the crop. For federal tax purposes:
- A. Both arrangements are separate entities, because two people share the receipts from a single property.
- B. Neither is a separate entity, because neither was organized under a state business statute.
- C. The leasing arrangement is a partnership, while the joint farming operation is mere co-ownership of the crop.
- D. The leasing arrangement is mere co-ownership, while the joint farming operation is a separate entity taxed as a partnership.
Show answer & explanation
Answer: D. Reg. §301.7701-1(a)(2) draws the line at joint business activity: co-owners who merely maintain and lease property and divide the rents are not a separate entity, while participants who join together to carry on a business and divide the profits have created one, classified as a partnership by default.
Question 26 · Entity Classification & S Elections
Which of the following describes an 'eligible entity' that may elect its classification under Reg. §301.7701-3(a)?
- A. Any business entity that is neither a per se corporation nor a trust or other specially treated entity.
- B. Any domestic business entity organized under a state limited liability company statute.
- C. Any business entity with at least two members that has not already elected a classification.
- D. Any business entity that has filed Form 8832 at least once since its formation.
Show answer & explanation
Answer: A. An eligible entity is any business entity that is not a per se corporation under Reg. §301.7701-2(b) and is not classified as a trust or otherwise subject to special Code treatment. Only eligible entities may elect their classification on Form 8832.
Question 27 · Entity Classification & S Elections
Which of the following is a 'per se' corporation that may not elect a different federal classification?
- A. An entity organized under a state statute describing it as incorporated or as a corporation.
- B. A state-law business trust with several beneficial owners carrying on an active business.
- C. A limited liability company whose members have elected to have it taxed as a corporation.
- D. A limited liability company with a single member that is itself a domestic corporation.
Show answer & explanation
Answer: A. Reg. §301.7701-2(b)(1) treats an entity organized under a federal or state statute that describes it as incorporated, as a corporation, or as a body corporate as a per se corporation, with no ability to elect otherwise.
Question 28 · Entity Classification & S Elections
Which of the following is correct regarding a domestic limited liability company with three individual members that files no Form 8832 for its first year?
- A. It is a disregarded entity, with each member reporting a one-third share of the business on Schedule C.
- B. It is a partnership for the first year only, after which it defaults to an association taxable as a corporation.
- C. It is a partnership, filing Form 1065 and issuing a Schedule K-1 to each of the three members.
- D. It is a C corporation, filing Form 1120, because every member's liability is limited under state law.
Show answer & explanation
Answer: C. Under Reg. §301.7701-3(b)(1)(i), a domestic eligible entity with two or more members that makes no election is classified as a partnership and files Form 1065, issuing a Schedule K-1 to each member.
Question 29 · Entity Classification & S Elections
Aureliano Sepúlveda and two other individuals own a business entity organized in Chile that is not a per se corporation. Under Chilean law Sepúlveda bears unlimited personal liability for the entity's debts, while the other two members do not. No Form 8832 is filed. Its default classification is:
- A. A partnership, because at least one member has unlimited liability for the entity's debts.
- B. A partnership, but only where a majority of the members have unlimited liability for its debts.
- C. An association taxable as a corporation, because the entity was organized outside the United States.
- D. An association taxable as a corporation, because most of the members have limited liability.
Show answer & explanation
Answer: A. For a foreign eligible entity the default turns on member liability under Reg. §301.7701-3(b)(2): a partnership if it has two or more members and at least one of them has unlimited liability, an association if all members have limited liability, and a disregarded entity if it has a single owner with unlimited liability.
Question 30 · Entity Classification & S Elections
Kenji Morioka, a U.S. citizen, is the sole owner of an entity organized in Singapore that is not a per se corporation. Under local law his liability for the entity's debts is limited to his investment. He files no Form 8832. The entity's default classification is:
- A. A disregarded entity, because Morioka is a U.S. person who reports the results on his own return.
- B. A disregarded entity, because a single-owner eligible entity defaults to disregarded status wherever organized.
- C. An association taxable as a corporation, but only from the date it elects that treatment on Form 8832.
- D. An association taxable as a corporation, because its sole owner has limited liability.
Show answer & explanation
Answer: D. Reg. §301.7701-3(b)(2)(i)(B) makes a foreign single-member eligible entity an association taxable as a corporation where the sole owner has limited liability, and a disregarded entity only where the owner has unlimited liability.
Question 31 · Entity Classification & S Elections
A two-member LLC is to be taxed as a partnership and a single-member LLC as a corporation. Which of them must file Form 8832?
- A. Only the single-member LLC, because the two-member LLC already defaults to partnership treatment.
- B. Only the two-member LLC, because partnership treatment must be affirmatively elected in the first year.
- C. Both of them, because every eligible entity must elect a classification in its first taxable year.
- D. Neither of them, because federal classification simply follows each entity's form under state law.
Show answer & explanation
Answer: A. Form 8832 is filed only to depart from the default. A domestic multi-member eligible entity is already a partnership by default, so the two-member LLC needs no election; a single-member entity is disregarded by default, so the single-member LLC must elect to be an association taxable as a corporation.
Question 32 · Entity Classification & S Elections
An eligible entity's members file Form 8832 on September 10, 2025, and would like the election to take effect as early as the regulations allow. The earliest effective date they may specify is:
- A. January 1, 2025, the first day of the entity's taxable year for which the election applies.
- B. June 27, 2025, which is 75 days before the date the election was filed.
- C. August 11, 2025, which is 30 days before the date the election was filed.
- D. September 10, 2025, the filing date itself, since a retroactive effective date is not permitted.
Show answer & explanation
Answer: B. Reg. §301.7701-3(c)(1)(iii) provides that an election may not take effect more than 75 days before the date it is filed, nor more than 12 months after that date. Counting back 75 days from September 10, 2025 gives June 27, 2025.
Question 33 · Accounting Periods
Under IRC §441(b), what is a taxpayer's 'taxable year'?
- A. The taxpayer's annual accounting period, if that period is a calendar year or a fiscal year.
- B. Any 12-month period the taxpayer selects, whether or not it corresponds to its books.
- C. The calendar year, which every taxpayer must use to compute its taxable income.
- D. The period covered by the taxpayer's audited financial statements for the year.
Show answer & explanation
Answer: A. IRC §441(b) defines the taxable year as the taxpayer's annual accounting period — a calendar year or a fiscal year — if the taxpayer keeps books on that basis, or the calendar year if the taxpayer keeps no books or has no annual accounting period.
Question 34 · Accounting Periods
Which of the following is a 'fiscal year' as IRC §441(e) defines it?
- A. Any 12-month period ending on the same day of the week in each year.
- B. A period of 12 months ending on the last day of any month, December included.
- C. A period of 12 months ending only on March 31, June 30, or September 30.
- D. A period of 12 months ending on the last day of any month except December.
Show answer & explanation
Answer: D. IRC §441(e) defines a fiscal year as a period of 12 months ending on the last day of any month other than December. A year ending December 31 is a calendar year, not a fiscal year.
Question 35 · Accounting Periods
Which of the following describes a 52-53-week taxable year permitted by IRC §441(f)?
- A. It always contains exactly 52 weeks, ending on the same day of the week in each year.
- B. It may be used only by corporations that keep their books on a weekly reporting cycle.
- C. It always ends on December 31, but is divided into 52 or 53 reporting weeks.
- D. It always ends on the same day of the week, so its year-end date shifts slightly each year.
Show answer & explanation
Answer: D. A 52-53-week year always ends on the same day of the week, falling either on the last occurrence of that day in a specified month or on the occurrence nearest the end of that month — so the actual year-end date moves a little from year to year and the year runs 52 or 53 weeks.
Question 36 · Accounting Periods
Perpetua Adeyemi runs a small appliance repair business. She keeps no books beyond a folder of receipts and has never established an annual accounting period. On what basis must she compute her taxable income?
- A. A 52-53-week year, which §441(f) provides for taxpayers without formal accounting records.
- B. A fiscal year ending twelve months after she began business, fixed by her first return.
- C. The calendar year, which §441(g) requires of a taxpayer with no books and no accounting period.
- D. Whatever annual period the IRS assigns her after reviewing the records she has kept.
Show answer & explanation
Answer: C. IRC §441(g) requires a taxpayer who keeps no books, has no annual accounting period, or has a period that does not qualify as a fiscal year, to compute taxable income on the basis of the calendar year.
Question 37 · Accounting Periods
How does a new taxpayer generally adopt its first taxable year?
- A. By requesting a private letter ruling approving the period it wishes to adopt.
- B. By filing its first federal income tax return on the basis of that period.
- C. By filing Form 1128 before the first taxable year it wishes to use begins.
- D. By notifying the IRS in writing at any point during its first taxable year.
Show answer & explanation
Answer: B. Under Reg. §1.441-1(c), a new taxpayer adopts its first taxable year by timely filing its first federal income tax return using that period. No advance IRS approval is needed to adopt a permitted year.
Question 38 · Accounting Periods
Under IRC §442, what must a taxpayer generally do to CHANGE its established annual accounting period?
- A. Obtain the Secretary's approval, usually on Form 1128, unless an automatic-approval procedure applies.
- B. File its next return using the new period, since approval is needed only to adopt one.
- C. Change first to a calendar year, and only then to the period it actually wants.
- D. Wait until five years have passed since it adopted its current accounting period.
Show answer & explanation
Answer: A. IRC §442 requires IRS approval to change an established annual accounting period. Approval is requested on Form 1128, though many changes qualify for automatic approval under revenue procedures such as Rev. Proc. 2006-45 for C corporations.
Question 39 · Accounting Periods
A non-automatic change of annual accounting period generally requires the taxpayer to establish:
- A. A substantial business purpose, which by itself entitles the taxpayer to the change requested.
- B. The written consent of all of its shareholders or partners to the proposed change of year.
- C. A substantial business purpose, and to accept terms and conditions preventing distortion of income.
- D. That it reported a net operating loss in the year immediately before the change was requested.
Show answer & explanation
Answer: C. A non-automatic change generally requires a business purpose — often a natural business year — and agreement to conditions ensuring that income is not distorted by the change. Automatic procedures substitute standardized conditions for a case-by-case showing.
Question 40 · Accounting Periods
When a taxpayer changes its annual accounting period, how is the gap between the close of the old year and the start of the new one reported?
- A. On the first full-year return under the new period, which simply covers the extra months.
- B. On a separate short-period return covering the months between the two accounting periods.
- C. On an amended return for the year preceding the change, extended to cover the gap.
- D. On an information return only, since no separate tax is computed for the gap.
Show answer & explanation
Answer: B. IRC §443(a)(1) requires a short-period return for the period beginning the day after the close of the old taxable year and ending the day before the first day of the new taxable year.
Question 41 · Accounting Methods
Rivera Fabrication Inc., a C corporation, had average annual gross receipts of $27 million for the three-tax-year period ending with the prior tax year. For its 2025 tax year, may Rivera use the cash method under the small-business exemption of §448(c)?
- A. It may, but only if Rivera also carries no inventory at any point during the tax year.
- B. It may not, because the C corporation threshold is fixed at $25 million with no inflation adjustment.
- C. It may not, because a C corporation can never use the cash method whatever its gross receipts.
- D. It may, because its average annual gross receipts are under the 2025 threshold of $31 million.
Show answer & explanation
Answer: D. Under §448(c), a C corporation meets the small-business gross receipts test if average annual gross receipts for the prior three-year period do not exceed the inflation-adjusted threshold, which is $31,000,000 for tax years beginning in 2025. Rivera's $27 million is comfortably below it.
Question 42 · Accounting Methods
Which of the following is barred from using the overall cash method of accounting regardless of its gross receipts?
- A. A partnership with only individual partners and $10 million of average annual gross receipts.
- B. A sole proprietorship with $2 million of average annual gross receipts and no employees.
- C. A tax shelter as defined in §448(d)(3), whatever its average annual gross receipts may be.
- D. A C corporation with $5 million of average annual gross receipts and no inventory.
Show answer & explanation
Answer: C. Section 448(a)(3) bars any tax shelter from using the cash method, and the prohibition applies irrespective of gross receipts. The §448(c) small-business gross receipts exemption is expressly unavailable to tax shelters.
Question 43 · Accounting Methods
Which of the following statements is correct regarding §446(b), which applies when a taxpayer's method of accounting does not clearly reflect income?
- A. The Commissioner may require a change only for tax years beginning after the change is imposed, and may not adjust the year under examination.
- B. The taxpayer must change only if the method it uses is expressly identified as impermissible somewhere in the regulations.
- C. The taxpayer may keep its method if the method conforms to generally accepted accounting principles, which control for federal tax purposes.
- D. The Commissioner may compute the taxpayer's taxable income under a method that, in the Commissioner's opinion, does clearly reflect income.
Show answer & explanation
Answer: D. Section 446(b) gives the Commissioner broad discretion: if the method used does not clearly reflect income, taxable income is computed under a method that, in the Commissioner's opinion, does. The standard is a general one, not a list of prohibited methods, and financial-accounting conformity is not controlling (Thor Power Tool Co. v. Commissioner). The change is imposed for the year under examination, with a §481(a) adjustment.
Question 44 · Accounting Methods
Noor Thibault operates a cash-method consulting practice. On December 30, 2025 a client hands her a $14,000 check with no restriction on when it may be cashed; she deposits it on January 3, 2026. A second client mails a $6,000 check on December 29, 2025 that arrives in Thibault's mailbox on January 2, 2026. How much of these amounts is includible in Thibault's 2025 gross income?
- A. $20,000, because the payer's act of mailing on December 29 placed both amounts beyond the payers' control before year end.
- B. $0, because a cash-method taxpayer includes a check in income in the year the funds are deposited and become collected balances.
- C. $6,000, because a check is constructively received when the payer mails it, whereas a hand-delivered check is included when deposited.
- D. $14,000, because that check was received and unqualifiedly available in 2025, while the mailed check was not received until 2026.
Show answer & explanation
Answer: D. A cash-method taxpayer includes a check in income in the year it is received and is unqualifiedly available, even if not deposited until the following year (Reg. §1.451-2). The $14,000 check was in Thibault's hands on December 30, so it is 2025 income. Constructive receipt turns on the payee's control, not the payer's: a check still in the mail on December 31 has not been received, so the $6,000 is 2026 income.
Question 45 · Accounting Methods
Merle Okafor runs a repair shop. In December 2025 he completed and billed a $9,000 job that the customer paid in January 2026, and he received a $2,500 December utility bill for power already supplied that he paid in February 2026. Ignoring all other items, how does his 2025 taxable income under the accrual method compare with the cash method?
- A. It is $6,500 higher under the accrual method, because both the receivable and the utility liability are taken into account in 2025.
- B. It is $2,500 lower under the accrual method, because the utility liability accrues in 2025 while the fee is taxed on collection.
- C. It is the same under either method, because both items were fixed in 2025 and settled within 3½ months of year end.
- D. It is $9,000 higher under the accrual method, because income accrues when earned while a deduction still requires payment.
Show answer & explanation
Answer: A. Under the cash method neither item touches 2025: the fee is taxed when collected in 2026 and the utility expense is deducted when paid in 2026. Under the accrual method the $9,000 accrues in 2025 because the services were performed and the amount is fixed, and the $2,500 accrues in 2025 because the liability is fixed, determinable, and economic performance occurred as the power was supplied (§461(h)(2)(A)(i)). Net difference: $9,000 − $2,500 = $6,500.
Question 46 · Accounting Methods
Under the all-events test of §451, an accrual-method taxpayer includes an amount in gross income for the tax year in which:
- A. All events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy.
- B. The taxpayer collects the amount, because an accrual-method taxpayer accrues income only to the extent cash is actually received.
- C. The amount is reported as revenue in the taxpayer's applicable financial statement, which controls the year of inclusion.
- D. All events have occurred that fix the right to receive the income, without regard to whether the amount is yet reasonably determinable.
Show answer & explanation
Answer: A. The all-events test has two prongs: the right to the income must be fixed, and the amount must be determinable with reasonable accuracy. Section 451(b) adds an acceleration rule for taxpayers with an applicable financial statement — inclusion no later than the year the amount is taken into account as AFS revenue — but that is a ceiling on deferral, not the governing test.
Question 47 · Accounting Methods
For an accrual-method taxpayer, a liability generally becomes deductible in the tax year in which:
- A. All events have occurred that establish the fact of the liability and the amount is determinable with reasonable accuracy.
- B. All events have occurred establishing the fact of the liability, the amount is reasonably determinable, and economic performance has occurred.
- C. The taxpayer receives an invoice from the provider and records the liability on its books as a payable.
- D. The taxpayer pays the amount, because a deduction cannot precede the actual outlay of cash.
Show answer & explanation
Answer: B. Section 461(h) added economic performance as a third requirement on top of the two-prong all-events test. For services or property provided to the taxpayer, economic performance generally occurs as they are provided; for payment liabilities such as insurance, rebates, or workers' compensation, it occurs on payment. A recurring-item exception is available for certain liabilities.
Question 48 · Accounting Methods
Halvorsen Freight LLC, an accrual-method taxpayer with a calendar tax year, pays a $6,000 insurance premium in November 2025 for a business policy covering December 1, 2025 through November 30, 2026. How much may Halvorsen deduct in 2025?
- A. $5,500, the portion of the coverage falling in 2026, with the December portion deducted in 2025.
- B. $0, because economic performance for an insurance liability occurs only as the coverage period runs.
- C. $500, one month of coverage, because a prepayment must be allocated to the periods it covers.
- D. $6,000, because the benefit runs exactly 12 months and ends before the close of the following tax year.
Show answer & explanation
Answer: D. The 12-month rule of Reg. §1.263(a)-4(f) permits a current deduction where the right or benefit does not extend beyond the earlier of (i) 12 months after the benefit begins or (ii) the end of the tax year following the year of payment. The benefit begins December 1, 2025 and ends November 30, 2026 — exactly 12 months, and before the close of 2026. Economic performance for insurance is satisfied by payment (Reg. §1.461-4(g)(5)), which occurred in November 2025.
