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REG CPA Practice Questions: Taxation of Income from Pass-through Entities
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May 3, 2024
In this video, we walk through 5 REG CPA exam practice questions on how to calculate the income reported in the year of death for a decedent. Important Links Link to the free study training webinar mentioned in the video: https://www.superfastcpa.com/strategic-study See the full post for this video: https://www.superfastcpa.com/reg-cpa-practice-questions-explained-taxation-of-income-from-pass-through-entities/ See the other REG walkthrough videos here: https://www.superfastcpa.com/free-reg-cpa-practice-question-walkthroughs/ 00:00 Intro 00:47 Question 1: Income and Distributions from a Partnership 03:45 Question 2: Guaranteed Payments from a Partnership 06:12 Question 3: Separately Stated Items for an S Corporation 08:53 Question 4: A Deeper Look Into Separately Stated Items 12:01 Question 5: Considering Loss Limitations 16:39 Pillar Topics
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Welcome to another reg walkthrough video. I'm Logan, and in today's video, we're going to be
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going over reporting income from a pass-through entity on an individual's tax return, and we're
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going to be doing that the Super Fast CPA way, which is diving straight into questions to learn
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the material. If this is the first thing you're seeing from us, or if you're unfamiliar
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with our strategies, make sure you go to superfastcpa.com to watch our free one-hour webinar
0:23
training, where we go over the six key ingredients to passing the CPA exam. Again, it's only one
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hour long, it's free, and it will save you months and months of struggling with your study process
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Also, if you like the idea of going through questions as your main learning material, be sure to check out our Super Fast CPA app where we have five question mini quizzes that you can
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easily access on your phone throughout the day to continue practicing. With that said
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let's go straight into the questions. All right, here's question one. Maple Group, a partnership that
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used the calendar year for tax reporting, has three partners with equal stakes. During the tax year
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Maple Group reported $90,000 in taxable income. Additionally, each partner received a cash distribution of $15,000
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At the start of the year, the basis for each partner in Maple Group was $40,000
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For the purposes of individual tax returns, determine the amount each partner should report as income from Maple Group
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All right, so if you don't know much about pass-through entities, and if you don't really know how they work with individual tax returns
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you're in the right place. Because this is the first question, and we're just trying to get an understanding of what's going on
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Let's go straight into the answer to start learning. All right, so the answer is $30,000
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Since the partners share equally in Maple Group, each partner must report their share of the partnership's taxable income
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which is one-third of $90,000, resulting in $30,000 for each partner's gross income
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The cash distribution does not affect the gross income reported from the partnership
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as it is a return of capital, and it is less than their beginning basis in the partnership
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Partners have a basis in their partnership's interest, which generally starts as the amount of money and the basis of price
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property they contributed to the partnership. As the partnership earns income, this income is taxed
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on the partner's tax returns, and their basis in the partnership increases by the amount of
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the income reported. Since the income has already been taxed at the partner level, when it's
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distributed, it's not taxed again. Essentially, the tax has already been accounted for. Okay, so basically
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to get at the meat of that, when partners join a partnership, they probably contribute some money
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or some assets to the partnership, and that is their starting basis, whatever they contributed
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to the partnership. And then as time goes on, income and distributions and things like that may affect the partner's basis
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However, the way it works is the partner is taxed on the income of the partnership, whether they
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actually got the money from the partnership or not. So let's go ahead and look at the question we just looked at
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So Maple Group had $90,000 of taxable income. Okay. So that $90,000 is split up between the partners for $30,000
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That does not necessarily mean that each of the partners actually received $30,000
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That's where the distributions come in. Distributions are where you actually give money to a partner
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And since the partner has already been taxed on their portion of the income, whether they
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actually got the money or not, when they actually do get the money through a distribution
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that is not taxable because, again, they've already been taxed. We'll talk a little bit more about basis a little further in the video, but for now, this is a good start point to learn more about pass-through entities
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And one more thing I want to say, pass-through entities are things like partnerships, S-corporations, and certain LLCs
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So, C-corporations, and then, you know, disregarded entities like sole proprietorships and single-member LLCs are not considered pass-through entities
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Let's go ahead and go to the next question to learn more. All right, question two. Bright Star Partnership has decided to provide one of its partners, Joanne, with a guaranteed payment for her specialized management services
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The partnership agreement stipulates that Joanne will receive $50,000 annually, regardless of the partnership's income
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In the current tax year, Bright Star earned $200,000 in net ordinary business income before considering guaranteed payments
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How should the guaranteed payment to Joanne be treated on the partnership's tax return and Joanne's individual tax return
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Okay, so we already talked a little bit about how income is treated and how distributions are treated with partnerships
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Now we're learning about guaranteed payments. Take a second. See if you can remember anything about guaranteed payments, maybe from college or from your work
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Maybe even pause the video. But if not, let's go ahead and go straight to the answer to learn more about guaranteed payments
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Okay, so the correct answer was a partnership decreases its income by $50,000, or the partnership, excuse me
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and Joanne includes $50,000 as ordinary income on her individual tax return
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Okay so guaranteed payments to partners are treated as a deductible expense to the partnership ordinary business income On the partner individual tax return the guaranteed payment is reported as ordinary income separate from the distributive share of partnership income though the guaranteed payment is noted on the K Guaranteed payments are
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payments that a partnership or an LLC treated as a partnership makes to a partner for services
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or capital contributed, regardless of the partnership's income. These payments are made according
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to the partnership agreement and are considered a first claim on partnership income. On the
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partnership's tax return, guaranteed payments are treated as a separate deductible expense
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similar to a salary paid to a non-partner, which reduces the partnership's overall taxable
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income. For the partner receiving them, guaranteed payments are reported as ordinary income on their
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individual tax return, separate from their distributive share of the partnership's profits
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This ensures that the partner is compensated for their services or capital contribution
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even if the partnership does not generate a profit. Okay, so essentially, guaranteed payments are separate
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from the percentage share that a partner would receive if the partnership had profit
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They are guaranteed to receive that payment even if the partnership didn't do that well
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Essentially, guaranteed payments are almost like a guaranteed salary to a partner
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which is why the partnership can deduct it as an expense to reduce their taxable income
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All right, let's go ahead and go to the next question to learn a little bit more. Here is question three
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Martin holds a 15% interest in Clean Energy S Corporation. which reports on the calendar year. For the tax year, Clean Energy has an ordinary business income of $300,000
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In addition, Clean Energy reported a $15,000 loss from rental real estate activities, and paid $25,000 in dividends from stock investments
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At the start of the tax year, Martin's basis in Clean Energy was $60,000
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How should Martin reflect his share of Clean Energy's ordinary business income, rental real estate loss, and dividend income on his individual income tax return
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Okay, we're three questions in. This is an S corporation instead of a partnership, but it's pretty similar
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This question, we're starting to focus on something called separately stated items. So take a second, pause the video, see if you can kind of think your way through
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maybe even figure out the correct answer based off of the information here. And when you're ready, we'll go to the answer and learn a little bit more about S corporations
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and separately stated items. Okay, here's the answer. So the correct answer is report $45,000 as ordinary business income, a $2,250 rental real estate loss
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and $3,750 as qualified dividend income. Okay, so let's learn a little bit more about this
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Martin must report his share of each type of income or loss separately. His share of the ordinary
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business income is $45,000, which is 15% of $300,000. His share of the rental real estate loss is $2,250
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which he can report as a passive activity loss to the extent he has passive income
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That's a very important point right there, and we will cover that a little bit more in the last
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question of this video. And his share of the dividends is $3,750, which is reported as qualified dividend income if the
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dividends are from domestic corporations or qualified foreign corporations. And so B would have been incorrect because the rental real estate loss is a separately stated
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item, and it should not be netted against the ordinary business income. and Choice C was incorrect because even though there are passive activity loss limitations
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the loss does still have to be reported. And again, we're going to talk about passive activity loss limitations in the last question of this video
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Basically, though, this is a small introduction into separately stated items, and we'll learn a little bit more about them in the next question
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But essentially, separately stated items are things that you don't just mush them all together
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to figure out what ordinary income is. They are reported in different parts of the individual's tax return
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So even though you see them on a K-1, they are put into different parts of the taxpayer's individual tax return instead of all just lumped together in their ordinary income
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Again, we're going to learn more about separately stated items in the next question, so let's go ahead and go to the next question
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Here's question four. Riverbend Partners is a partnership that has various types of income and expenses
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In the current tax year, Riverbend has reported the following items. $10,000 in dividend income, a net long-term count
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capital loss of $4,000, $1,500 in net section 1231 gains, and a charitable contribution of $2,000
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As a partner with an equal 25% interest in Riverbend, Sarah received a Schedule K-1 that included
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her share of these items. How should Sarah report these items on her individual tax return
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Now, we just learned a little bit about separately stated items. Are these things up here separately
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stated items? That's what we're going to learn. So if they are separately stated items, would they all be
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combined into one thing to be ordinary income? Probably not based off what I just explained
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But again we not 100 sure what all the different separately stated items are So let go into the answer and learn a lot more about it All right So the answer would have been report each item separately on the tax return in the respective sections for dividends capital gains and losses section 1231 gains and
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charitable contributions. Okay, here's the explanation. The separately stated items on a partner's
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schedule K1 must be reported in their respective sections on the individual's tax return
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Sarah will report dividend income of $2,500 on the schedule for dividend income, which would be Schedule B
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a long-term capital loss of $1,000 on the schedule for capital gains and losses, which would be Schedule D
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a net Section 1231 gain of $375, which is also most likely in Schedule D
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and a charitable contribution of $500 on the schedule for itemized deductions, which is Schedule A
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all of which are her 25% share. And we're not necessarily trying to teach you all the different schedules in this
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But basically separately stated items, like it says here, are specific types of income, deductions, and credits that a pass-through entity reports individually to its owners
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So they are reported as separate items instead of smushing them altogether
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These items retain their unique tax characteristics and must be reported separately on the owner's tax returns to ensure they receive the correct tax treatment
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Okay, so finally, here's a list of the typical separately stated items
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So it would be interest income and dividend income and royalties. net short-term capital gains or losses, and net long-term capital gains or losses
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section 1231 gains or losses, charitable contributions, rental real estate income, or losses
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guaranteed payments to partners, section 179 expense deductions, foreign taxes paid, educational expenses deductions, and certain state and local tax deductions
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So again, these items on a K-1 are called separately stated items
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and they would go directly to the different portions of the individual's tax return and be reported
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on each individual section that they belong instead of being smushed altogether and just
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add it up to be ordinary income or loss. All right, we've learned a lot so far in this video
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We've learned about the percentage of ordinary income that goes to an individual. We've learned that distributions are not taxable because that money has already been taxed
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We've learned about guaranteed payments, and now we've learned about separately stated items
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Let's go ahead and go to the last question just to learn a little bit more. All right, here is question five
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John holds a 40% interest in Pine Tree Partnership, which reports a $160,000 loss for the current tax year
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At the beginning of the year, John's outside or tax basis in the partnership interest was $25,000
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He made an additional capital contribution of $15,000 during the year. John did not receive any distributions, nor did he have any recourse debt or guaranteed payments from Pine Tree Partnership
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What is the maximum loss John can claim on his individual tax return from Pine Tree Partnership for the current year
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Okay, so this is the final question of the video. This question is introducing one new topic
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So go ahead, take a second, pause the video, try to figure out if you can get the correct answer
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And once you're ready, come back and we will look at the answer. All right, here's the correct answer
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So he would only be able to deduct $40,000 of the loss
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So let's go ahead and read about this. John can claim a deduction for his share of the partnership's loss up to the amount of
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his adjusted tax basis. His initial tax basis of $25,000 plus his additional capital contract
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contribution of $15,000 gives him a total adjusted tax basis of $40,000. This is the maximum
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loss he can claim on his individual tax return because a partner's loss deduction is limited
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to the extent of their tax basis in the partnership. The remaining loss of $24,000, his total
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share of $64,000 minus the $40,000 deduction is suspended and can be carried forward to future
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years when he may have additional basis. So let's read a little bit more about loss limitations
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Here are a few of the loss limitations that I felt like we should go over
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First, there's the tax basis loss limitation. This is the one that we just applied in this question, so let's read more about it
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A taxpayer can only deduct losses to the extent of their adjusted tax basis in the pass-through
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entity, which includes their initial investment and any subsequent adjustments like share
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of income, additional contributions, or distributions. If a loss exceeds the taxpayer's basis, the excess loss is suspended and carried forward
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indefinitely to future years when the taxpayer may have a sufficient basis to deduct the loss
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Okay, we dealt with basis in the first question. If a pass-through entity has a loss and the basis
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of the individual who has interest in that pass-thir-entity isn't big enough to eat their portion of the
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loss, then the remaining loss that they couldn't take on their individual return is carried forward
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Now let's go ahead and read about passive activity loss limitations. Losses from passive activities
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where the taxpayer does not materially participate. So basically they don't spend a ton of their time
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participating in this activity. They can generally only be deducted against income from other passive activities
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So let me say that one more time. Losses from passive activities can generally only be deducted against income from other passive activities If passive activity losses exceed passive activity income the excess losses are not deductible in the current year
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Instead, they are suspended and carried forward to offset passive income in future years or until the taxpayer disposes of the activity in a fully taxable transaction
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So if you'll remember right, in one of the previous questions, there was a passive activity loss that was given to one of the partners, or the shareholders
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Now in that question, we didn't talk about whether he had passive income or not
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but if he wanted to actually be able to take the passive loss that had come to him
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he would only be able to deduct it or net it against other passive income that he had received
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So if he hadn't received any passive income, most likely he would have had to carry that passive activity loss forward to a future year
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And again, passive activities are things you don't materially participate in. And so, you know, a lot of times stuff like rentals or things like that
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And then finally, let's talk about the excess business loss limitation. You probably won't deal with this very much, but I still wanted to throw it in so you know about it
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The Tax C Cuts and Jobs Act introduced a limitation on excess business losses for non-corporate taxpayers
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So, by the way, non-corporate meaning not part of an S corporation or a C corporation
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If a taxpayer's total business losses exceed business income, the excess can only be used to offset non-business
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income up to a certain threshold. Losses beyond that threshold are treated as a net operating
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loss that can be carried forward to future years. So again, you don't need to know too much about this
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but basically if a non-corporate, if there's a big business loss, there is a limit to how much of the
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loss the individual can take, but it's a very large limit. Again, not something that you'll
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probably deal with very much, but it is out there. So this is something that could limit how
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much of a loss somebody could take from a pass-through entity as well. All right. So we went through a lot
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in this video. Before we finish, let's do one last part of the superfast CPA strategy, which is
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something called pillar topics. So pillar topics is essentially taking all the most important things
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that you saw in the questions that you did, or you can even do this as you're going through
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the questions, and pulling them out and putting them into one place so that you know what is most
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important. Again, these are the concepts, the rules, the things that are obviously important
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according to your review course. So let's go ahead and make some pillar topics
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Pass-through entities are things like partnerships, S-corporations, and certain LLC's
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Income generated by a pass-through entity is passed-through and taxed proportionately to, I don't
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if I spelled that right. Fortunately to each individual who has an ownership interest
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this income is taxed even if the individual did not actually receive any money from the pass-through
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entity. This is why distributions are not taxed because the money has already been
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taxed. And let's see. Separately stated items are not added all together. Instead, they are put into each
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corresponding area of an individual's tax return. This is things like guaranteed payments
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interest, dividends, etc. Also, there are some loss limitations that exist for losses from a passive
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entity like the tax basis limitation and the passive activity loss limitation. Okay, so again
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those are some basic pillar topics. You can make them more detailed if you'd like, or maybe there's
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some pillar topics in there that you learned that I didn't put here. And that's the beauty of it
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is it is individual. You are pulling out what seems to be the most important to you and what you
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learned. With all that said, that is the end of the video. Thank you for watching. If you liked this
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make sure you go to superfast CPA.com to learn more about our strategies and especially to watch
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our free one-hour webinar training where we go over the six key ingredients to passing the CPA exam
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Again, it is free. It's only one hour long, and it will save you more. months and months of struggling with this exam. Also, if you liked going through the questions as
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your main learning material, be sure to check out our Superfast CPA app where we have five question
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mini quizzes that you can take on the go throughout your day to continually learn from questions
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The link to the webinar will be in the description, and again, thank you for watching. I'll see you
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in the next video