CPA Exam — Taxation and Regulation (REG) — Study Guide

Pass-through entities are tested in two ways. First, classification: can this corporation be an S corporation, and what is this LLC for tax purposes? Second, flow-through arithmetic: split the entity's items into ordinary business income and separately stated items, then roll each owner's basis forward. The basis roll-forward is where most candidates lose marks, so this chapter spends the most time on it.

V.C S corporations

V.C.1 Eligibility and election

A corporation can elect S status only if it is a small business corporation: a domestic corporation, not an ineligible corporation, that does not^[1]

• have more than 100 shareholders (a husband and wife, and all members of a family, are treated as one shareholder^[1]);
• have a shareholder that is not an individual, other than an estate, certain trusts and certain exempt organizations — so no corporations or partnerships as shareholders;
• have a nonresident alien shareholder; or
• have more than one class of stock. Differences in voting rights among common shares do not create a second class^[1]; differences in rights to distributions or liquidation proceeds do.

Making the election. The corporation files Form 2553 with the consents of its shareholders — for an election filed before its effective date, every shareholder who owns stock on the day the election is made must consent^[2]. An election is effective for a tax year if made during the preceding year or on or before the 15th day of the third month of the tax year^[3]; a later election generally takes effect the following year. Relief for late elections is available.

Termination.

• Revocation — by shareholders holding more than one-half of the shares on the day of revocation^[3].
• Ceasing to qualify — for example, a 101st shareholder, a corporate shareholder or a second class of stock; the termination is effective on the date of the terminating event.
• Excess passive investment income — the election terminates if the corporation has accumulated earnings and profits (from C corporation years) at the close of each of three consecutive years and passive investment income is more than 25% of gross receipts in each of those years^[3].

After a termination, the corporation generally cannot re-elect until its fifth tax year after the year the termination took effect^[3].

V.C.2 Ordinary business income and separately stated items

An S corporation generally pays no income tax. Each shareholder takes into account a pro rata share of the corporation's items of income (including tax-exempt income), loss, deduction and credit whose separate treatment could affect any shareholder's tax, and of its nonseparately computed income or loss^[4].

Pro rata share. Each item is assigned equally to each day of the year and then divided among the shares outstanding on that day^[5] — so a shareholder who owned 40% for half the year is allocated 20% of the year's items.

The accumulated adjustments account (AAA)

The AAA tracks S corporation earnings that have been taxed to shareholders but not yet distributed. It is adjusted like stock basis, with two differences: no adjustment for tax-exempt income and its related expenses, and the AAA can go negative (the "but not below zero" limit in the basis rules is disregarded)^[6]. Distributions reduce the AAA but cannot make it negative.

Distributions.

• S corporation with no accumulated E&P: a distribution is tax-free to the extent of the shareholder's stock basis; any excess is gain from the sale or exchange of property^[6].
• S corporation with accumulated E&P from C years: distributions come first from the AAA (tax-free to the extent of basis), then as a dividend to the extent of accumulated E&P, then as a return of remaining basis and gain^[6].

V.C.3 Shareholder's stock and debt basis

A shareholder's stock basis starts with the amount paid (or basis of property contributed). Each year it is^[7]:

1. increased by the shareholder's share of all income items — separately stated income, including tax-exempt income, and nonseparately computed income;
2. decreased (not below zero) by non-taxable distributions, by losses and deductions, and by nondeductible, noncapital expenses^[7].

Under the regulations the order is: increases, then distributions, then nondeductible expenses, then losses and deductions. Because distributions come before losses, a distribution is tested against basis before that year's losses reduce it.

Debt basis. A shareholder who lends money directly to the S corporation has basis in that debt. Losses that exceed stock basis reduce debt basis (not below zero)^[7]. In later years, net increases restore debt basis first, before any increase to stock basis^[7]. If the corporation repays a loan whose basis has been reduced, part of each repayment is income to the shareholder. Losses above combined stock and debt basis carry forward indefinitely^[4].

A shareholder's guarantee of a bank loan to the corporation does not create debt basis; only a loan the shareholder actually made to the corporation does.

V.D Partnerships

V.D.1 Ordinary business income, separately stated items and guaranteed payments

A partnership files Form 1065 but pays no income tax. Its items flow to the partners on Schedule K-1 in the same two groups as an S corporation's: ordinary business income (loss) and separately stated items. The difference is guaranteed payments.

Guaranteed payments — payments to a partner for services or for the use of capital, determined without regard to the partnership's income — are treated as made to a non-partner for purposes of gross income and the deduction for business expenses^[8]. So the partnership deducts them in computing ordinary business income, and the partner reports them as ordinary income in addition to his or her distributive share^[9]. Guaranteed payments are not QBI (Chapter 5).

Contributions

No gain or loss is recognized by the partnership or the partner when property is contributed in exchange for a partnership interest^[10]. The partner's initial basis in the interest (outside basis) is the money plus the adjusted basis of the property contributed^[11]; the partnership's basis in the property (inside basis) is the partner's adjusted basis carried over^[12].

V.D.2 Basis of a partner's interest

A partner's basis is^[13]:

• increased by the distributive share of partnership taxable income, tax-exempt income and additional contributions;
• decreased (not below zero) by distributions, the distributive share of losses, and nondeductible expenditures not chargeable to capital^[13].

Liabilities. An increase in a partner's share of partnership liabilities is treated as a contribution of money by the partner, increasing basis; a decrease is treated as a distribution of money, decreasing basis^[14]. This is the key difference from an S corporation, where a shareholder gets no basis for the corporation's bank debt.

Distributions (non-liquidating).

• A partner recognizes gain only to the extent money distributed exceeds his or her basis immediately before the distribution; loss is not recognized in a current distribution^[15].
• Property distributed takes the partnership's basis, but not more than the partner's outside basis reduced by any money distributed in the same transaction^[16].

A partner's loss deduction is limited to outside basis at year-end (Chapter 6)^[17].

Reviewing Form 1065 and Form 1120-S

The blueprint's review tasks ask you to classify items from a trial balance as ordinary, separately stated or nondeductible. Common errors: portfolio interest or dividends netted into ordinary income; charitable contributions deducted on page 1; §179 deducted on page 1 instead of passing through; guaranteed payments omitted from the deduction list (partnership) or treated as distributions; a shareholder's health insurance or a shareholder's salary misclassified; fines and the nondeductible part of meals deducted.

V.E Limited liability companies — classification

Under the "check-the-box" regulations, a domestic eligible entity that does not elect otherwise is a partnership if it has two or more members, or is disregarded as separate from its owner if it has a single owner^[18]. Either kind of LLC may elect to be taxed as a corporation on Form 8832^[19], and an LLC taxed as a corporation may then elect S status if it meets the S requirements. A disregarded single-member LLC is still treated as a separate entity for employment and certain excise taxes^[19].

V.F Tax-exempt organizations

Section 501(c) lists the types of exempt organization. The ones REG expects you to recall:

Source for (c)(4)–(c)(7):^[21].

Only contributions to 501(c)(3)-type organizations (and certain others, such as government units) are generally deductible charitable contributions. A 501(c)(3) organization is either a public charity or a private foundation; private foundations face additional excise taxes.

Unrelated business income tax. An exempt organization pays tax at corporate rates on its unrelated business taxable income^[22] — gross income from an unrelated trade or business regularly carried on, less directly connected deductions^[23]. A trade or business is unrelated if its conduct is not substantially related (apart from the need for income) to the organization's exempt purpose^[24]. A museum's gift shop selling reproductions of its collection is related; the same museum running a commercial car wash every weekend is not.

Worked example: a partner's year from K-1 to basis

Cedar Partners has three equal general partners. At January 1, Mia's outside basis is $50,000, which includes her one-third share ($20,000) of the partnership's $60,000 of recourse bank debt. During the year:

Mia's return. Ordinary income $30,000 plus the $36,000 guaranteed payment, both reported as ordinary income^[9]; interest $2,000; a $3,000 charitable contribution that she claims on her own return under the individual charitable rules (Chapter 5).

Mia's outside basis at December 31.

Sources: basis increases for taxable and tax-exempt income and decreases for distributions, losses and nondeductible expenditures^[13]; a decrease in a partner's share of liabilities is a deemed distribution of money^[14]. The guaranteed payment does not change basis: it is paid to Mia as if she were not a partner, and the partnership deducted it before computing the ordinary income she was allocated^[8]. Because the total money distributed ($35,000 including the deemed distribution) never exceeds her basis, she recognizes no gain^[15].

Choosing among entities — the tax comparison

Worked example: an S corporation with C-corporation earnings and profits

Birch Inc. was a C corporation until 2023 and has $30,000 of accumulated E&P from those years. At the end of 2026, before distributions, its AAA is $50,000. Its sole shareholder, whose stock basis is $90,000, receives a $100,000 cash distribution.

1. From AAA: $50,000 — tax-free to the extent of basis, reducing basis to $40,000^[6].
2. Then from accumulated E&P: $30,000 — a dividend^[6].
3. Remainder: $20,000 — applied against remaining basis ($40,000 → $20,000), tax-free^[6].

Result: $30,000 dividend income; stock basis $20,000; AAA zero. Had Birch never been a C corporation, the whole $100,000 would have been measured only against basis: $90,000 tax-free and $10,000 capital gain.

Sources cited in this excerpt

1. 26 U.S. Code § 1361 - S corporation defined. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/1361
2. Instructions for Form 2553, Election by a Small Business Corporation (Rev. December 2020). Internal Revenue Service, 2020-12. https://www.irs.gov/pub/irs-pdf/i2553.pdf
3. 26 U.S. Code § 1362 - Election; revocation; termination. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/1362
4. 26 U.S. Code § 1366 - Pass-thru of items to shareholders. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/1366
5. 26 U.S. Code § 1377 - Definitions and special rule. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/1377
6. 26 U.S. Code § 1368 - Distributions. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/1368
7. 26 U.S. Code § 1367 - Adjustments to basis of stock of shareholders, etc. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/1367
8. 26 U.S. Code § 707 - Transactions between partner and partnership. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/707
9. Publication 541, Partnerships (Rev. December 2025). Internal Revenue Service, 2025-12. https://www.irs.gov/pub/irs-pdf/p541.pdf
10. 26 U.S. Code § 721 - Nonrecognition of gain or loss on contribution. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/721
11. 26 U.S. Code § 722 - Basis of contributing partner’s interest. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/722
12. 26 U.S. Code § 723 - Basis of property contributed to partnership. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/723
13. 26 U.S. Code § 705 - Determination of basis of partner’s interest. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/705
14. 26 U.S. Code § 752 - Treatment of certain liabilities. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/752
15. 26 U.S. Code § 731 - Extent of recognition of gain or loss on distribution. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/731
16. 26 U.S. Code § 732 - Basis of distributed property other than money. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/732
17. 26 U.S. Code § 704 - Partner’s distributive share. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/704
18. 26 CFR § 301.7701-3 - Classification of certain business entities. Legal Information Institute, Cornell Law School (e-CFR), current text as retrieved. https://www.law.cornell.edu/cfr/text/26/301.7701-3
19. Limited liability company (LLC). Internal Revenue Service, page as retrieved. https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
20. 26 U.S. Code § 501 - Exemption from tax on corporations, certain trusts, etc. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/501
21. Other tax-exempt organizations. Internal Revenue Service, page as retrieved. https://www.irs.gov/charities-non-profits/other-tax-exempt-organizations
22. 26 U.S. Code § 511 - Imposition of tax on unrelated business income of charitable, etc., organizations. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/511
23. 26 U.S. Code § 512 - Unrelated business taxable income. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/512
24. 26 U.S. Code § 513 - Unrelated trade or business. Legal Information Institute, Cornell Law School (U.S. Code), current text as retrieved. https://www.law.cornell.edu/uscode/text/26/513