Sample practice questions

A few real questions from this free bank, with full explanations. Use the practice tool above for the whole set.

1. 1. Tax Compliance and Planning for Individuals and Personal Financial Planning

   In 2025, Dana exercises an incentive stock option (ISO) to buy 1,000 shares at the $20 option price when the shares are worth $50 each. She still holds the shares at year-end. How does the exercise affect her 2025 return?

   • a.No regular taxable income and no AMT effect until she sells
   • b.$30,000 of wage income for both regular tax and AMT
   • c.No regular tax income; a $30,000 AMT adjustment
   • d.$30,000 of capital gain for regular tax, with no AMT effect

   Answer: c

   Explanation: Under IRC §421(a), exercising an ISO produces no regular-tax income. IRC §56(b)(3) switches §421 off for AMT, so the $30 × 1,000 = $30,000 spread becomes a positive AMT adjustment in the year of exercise. Wage treatment belongs to a nonstatutory option or a disqualifying disposition. Exercise is not a sale, so no capital gain arises. Saying there is no AMT effect until sale ignores §56(b)(3), which reaches the spread when the shares are held past year-end.

2. 2. Tax Compliance and Planning for Individuals and Personal Financial Planning

   Nora, age 50, takes a $4,000 distribution from her health savings account and uses it for a vacation. Her marginal federal income tax rate is 24%. What is the federal tax cost of the distribution?

   • a.$960
   • b.$1,360
   • c.$1,760
   • d.$800

   Answer: c

   Explanation: A distribution not used for qualified medical expenses is included in gross income under IRC §223(f)(2), costing 24% × $4,000 = $960. IRC §223(f)(4)(A) adds 20% of the includible amount, $800, unless the holder is disabled, has died or is 65 or older. The total is $1,760. $960 and $800 each count only one of the two. $1,360 uses a 10% additional tax, the rate that applied before the law raised it to 20%.

3. 3. Tax Compliance and Planning for Individuals and Personal Financial Planning

   Lena's share of an S corporation's ordinary loss is $40,000. Her stock basis is $30,000, her amount at risk is $25,000, and she does not materially participate. She has no passive income. How does her loss sort out?

   • a.$40,000 passive-suspended, with basis and at-risk limits not reached
   • b.$10,000 basis-limited, $5,000 at-risk-limited, $25,000 passive-suspended
   • c.$15,000 at-risk-limited and $25,000 passive-suspended
   • d.$10,000 basis-limited and $30,000 passive-suspended

   Answer: b

   Explanation: The limits apply in order. First, IRC §1366(d)(1) limits the loss to stock basis, $30,000, suspending $10,000. Second, §465 limits the remaining $30,000 to the $25,000 at risk, suspending $5,000. Last, the $25,000 left is a passive loss under §469, and with no passive income it is fully suspended (Temp. Reg. §1.469-2T(d)(6)). The other splits skip one limit or apply them out of order.

4. 4. Tax Compliance and Planning for Individuals and Personal Financial Planning

   Ian paid $60,000 for an annuity that will pay him $500 a month for life. His expected return is $100,000. He receives $6,000 this year. How much is taxable?

   • a.$6,000
   • b.$2,400
   • c.$3,600
   • d.$0

   Answer: b

   Explanation: Under IRC §72(b), the exclusion ratio is investment in the contract divided by expected return: $60,000 ÷ $100,000 = 60%. That excludes $3,600 of the $6,000, leaving $2,400 taxable. $6,000 ignores his investment. $3,600 is the excluded portion. $0 treats every payment as a return of capital.

5. 5. Entity Tax Compliance

   Holly Corp., a C corporation, completely liquidates by distributing land (basis $200,000, value $500,000) to its sole shareholder, whose stock basis is $100,000. What are the shareholder's recognized gain and basis in the land?

   • a.No gain; land basis $100,000
   • b.Gain $400,000; land basis $200,000
   • c.Gain $400,000; land basis $500,000
   • d.Gain $300,000; land basis $200,000

   Answer: c

   Explanation: Under IRC §331(a), amounts received in complete liquidation are treated as full payment for the stock: $500,000 − $100,000 = $400,000 of gain. The shareholder's basis in the land is its value under §334(a). Separately, the corporation recognizes $300,000 of gain under §336(a), so the gain is taxed twice. $300,000 is the corporation's gain, not the shareholder's. Only a qualifying parent-subsidiary liquidation under §332 is tax-free. Carryover basis applies only under §334(b).

6. 6. Entity Tax Compliance

   An S corporation with no accumulated E&P distributes land (basis $20,000, value $50,000) to Kay, its sole shareholder, whose stock basis before any current-year items is $40,000. The corporation has no other items for the year. What are Kay's results?

   • a.$10,000 gain on the distribution itself; land basis $50,000
   • b.$30,000 gain passes through; stock basis $40,000; land basis $20,000
   • c.No gain, stock basis then $20,000 and land basis $20,000
   • d.$30,000 gain passes through; stock basis $20,000; land basis $50,000

   Answer: d

   Explanation: The S corporation recognizes $30,000 of gain under IRC §311(b), applied through §1371(a). The gain passes through to Kay under §1366 and raises her basis to $70,000 (§1367(a)(1)). The $50,000 distribution then reduces basis to $20,000 without gain (§1368(b)), and her basis in the land is its value (§301(d)). Leaving out the gain, or measuring the distribution before adding it to basis, gives the wrong results.

7. 7. Entity Tax Compliance

   Vic, who owns a 60% interest in a partnership, sells his entire interest to an outside buyer on July 1. The remaining partners continue the business. What is the effect on the partnership?

   • a.It continues; its tax year closes only for Vic
   • b.Its tax year closes for all partners on July 1
   • c.It continues, and Vic reports his full-year share of income
   • d.It terminates because more than 50% of the interests were sold

   Answer: a

   Explanation: IRC §708(b)(1) treats a partnership as terminated only if no part of its business continues to be carried on by its partners in a partnership. The rule that a sale of 50% or more of the interests within twelve months terminated a partnership was repealed for tax years beginning after 2017. Under §706(c)(2)(A), the tax year closes for a partner who sells his entire interest, and §706(d) allocates items for the varying interests. Vic reports only his share through the date of sale.

8. 8. Entity Tax Planning

   Lin will contribute land (basis $100,000, value $500,000) subject to a $180,000 mortgage to a new entity owned 50/50 with a cash investor. The entity will assume the mortgage. Compare the gain Lin recognizes if the entity is a corporation (control test met) versus a partnership sharing liabilities 50/50.

   • a.Corporation: $80,000 gain; partnership: no gain
   • b.Corporation: no gain; partnership: $80,000 gain
   • c.No gain in either case
   • d.Corporation: $80,000 gain; partnership: $90,000 gain

   Answer: a

   Explanation: In a §351 exchange, liabilities assumed in excess of the basis of the property transferred are gain under IRC §357(c): $180,000 − $100,000 = $80,000. In a partnership, only the net decrease in Lin's share of liabilities is a deemed distribution: $180,000 − her 50% share of $90,000 = $90,000 (IRC §752(b)). That is less than her $100,000 basis, so §731(a)(1) recognizes no gain. The partnership structure avoids the gain here.

9. 9. Entity Tax Planning

   Bay Corp. converted from a C corporation to an S corporation effective January 1, 2023. On that date it held land with a basis of $120,000 and a value of $200,000. It sells the land in 2025 for $230,000. Assume the taxable income and net unrealized built-in gain limits do not bind. What is the built-in gains tax at 21%?

   • a.$6,300
   • b.$16,800
   • c.$0
   • d.$23,100

   Answer: b

   Explanation: The 2025 sale falls within the five-year recognition period that began January 1, 2023 (IRC §1374(d)(7)). The recognized built-in gain is limited to the gain built in at conversion, $200,000 − $120,000 = $80,000 (§1374(d)(3)), and is taxed at the highest §11 rate: 21% × $80,000 = $16,800 (§1374(b)(1)). $23,100 taxes the whole $110,000 gain, including post-conversion appreciation. $6,300 taxes only the post-conversion gain. $0 would apply only after the recognition period.

10. 10. Property Transactions (Disposition of Assets)

    This year, a sole proprietor has a $40,000 section 1231 gain (after depreciation recapture) and a $15,000 section 1231 loss. In the prior five years she had $10,000 of net §1231 losses, none of it yet recaptured. How is her net §1231 gain characterized?

    • a.$10,000 ordinary income and $15,000 long-term capital gain
    • b.$15,000 ordinary income and $10,000 long-term capital gain
    • c.$25,000 long-term capital gain
    • d.$25,000 ordinary income

    Answer: a

    Explanation: The net §1231 gain is $40,000 − $15,000 = $25,000 (IRC §1231(a)(1)). Under §1231(c), the net gain is ordinary income to the extent of non-recaptured net §1231 losses from the five most recent preceding years, here $10,000. The remaining $15,000 is long-term capital gain. Treating all $25,000 as capital ignores the lookback rule. Treating it all as ordinary overapplies the rule. $15,000 ordinary and $10,000 capital swaps the two amounts.