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REG CPA Practice Questions: S Corporation Ordinary Income and Separately Stated Items
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May 3, 2024
In this video, we walk through 5 REG CPA exam practice questions teaching how to calculate S Corporation ordinary income and separately stated items. 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-how-to-calculate-s-corporation-ordinary-income-and-separately-stated-items/ See the other REG walkthrough videos here: https://www.superfastcpa.com/free-reg-cpa-practice-question-walkthroughs/ 00:00 Intro 00:51 Question 1: Ordinary Business Income 02:33 Question 2: Separately Stated Items 06:21 Question 3: Section 179 Deduction 08:03 Question 4: Shareholder Salaries 10:23 Question 5: Calculating Ordinary Income and Separately State Items 12:15 Pillar Topics
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Welcome to another reg walkthrough video
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I'm Logan, and in today's video, we're going to be going over S-Corporation Ordinary Income and Separately Stated items
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And we're going to be doing that, the Superfast CPA way, which is diving straight into questions to learn the material
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If you don't know much about our strategies and you want to learn more, make sure you go to superfastcpa.com and check out our free one-hour webinar training
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We go over the key ingredients to passing the CPA exam. And again, it's only one hour, it's free, and it will save you so much to
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time struggling with your process. Make sure you go check it out. Also, if you like the idea of going
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through questions as your main learning material, make sure you check out our super fast CPA app
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We not only have audio notes and review notes, but also five question mini quizzes that you can
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easily access on your phone, on the go, to continue practicing throughout your day. With all that
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said, let's dive straight into the questions. Okay, here is question one. Quantum Solutions Inc
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and S Corporation, using the calendar year as its tax year, reported the following financial activities
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for the year ended December 31st, year one. Service revenue of $200,000, inventory cost of $80,000
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administrative expenses, $25,000, marketing expenses, $15,000, repair expense, $3,000, interest income, $5,000
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interest expense on mortgage $9,000, short-term capital loss, $4,000, and donations to qualified
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organizations of $2,000. So we need to compute the ordinary income of quantum solutions
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Inc. for the tax year one. So if you don't really know what ordinary income is for an S corporation
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that's okay. Let's dive straight into the answer to learn what goes into that calculation
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Okay, and the answer is $68,000. So let's learn how that works. To calculate quantum solutions
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ordinary income combine all revenues and expenses related to its main business operations
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excluding separately stated items that have special tax treatment. And we're going to learn about separately stated items in the next question. Ordinary income
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calculation for quantum solutions would include revenue, inventory cost, administrative expenses, marketing expenses, repair expense, interest expense, and that would give you the ordinary
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income of $68,000. Now, one note here, the interest income, the short-term capital loss
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and the donations are separately stated items and are not included in the ordinary income
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calculation for an S corporation. Okay, so basically ordinary income is most of the normal
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business stuff. However, there are certain things that are considered separately stated items
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and we're going to learn about that, and they are not included in ordinary income. So let's go
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ahead and go to the next question to start learning about that. Okay, here is question two. Galactic
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consulting LLC and S corporation has provided the following financial details for the year
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Okay, there's a lot of things here. I'm not going to list the amounts. I'm just going to list
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the names of the items. So they have consulting revenue, office rental income, interest earned on
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corporate bonds, ordinary business expenses, royalty income from patents, dividend income from
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stock investments, loss on sale of short-term investments, gain on sale of commercial
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property, and that was long-term gain, donation to a local charity, and a depreciation expense
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on their office equipment. Okay, so big list of items there. We need to identify the total amount of separately stated items that should be reported to the
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shareholders of Galactic Consulting LLC. So we need to figure out what of all these is a..
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separately stated item and what the total is adding those altogether. That's not what you would
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typically do but this is just to kind of teach you what are the separately stated items So take a second pause the video look through those different items and try to figure out which ones you think would be part of ordinary income
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and which would be separately stated items. Remember, in the previous question, we talked about
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the things that are just kind of normal business expenses and business income, and those were the
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ordinary income. So what of these do you think would be a separately stated item? Once you're done
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with that, come back and we will look at the answer together. Okay, and the answer is $46,000
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So here's the explanation. Separately stated items are those that must be reported individually to shareholders due to their potential impact on the shareholders' individual tax liabilities
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These items retain their character as they pass through to the shareholders and are not included in the S corporation's ordinary business income calculation
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The calculation for separately stated items would be, and then this is taking all the separately stated items and adding them up together
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You wouldn't necessarily always add these items up together, but for this question we were trying to do that just to show you which
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items are separately stated and which ones aren't. So office rental income, interest earned, dividend income, royalty income, loss on sale of short-term
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investments, gain on sale of commercial property, donation to local charity. All those things added up together to be $46,000
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And you'll notice this was a loss, so, you know, it would be considered a loss when it
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flows through and this was a donation. This would be a deduction that would flow through to the taxpayer that they could use
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on their own personal tax return. And then as it notes here, the consulting revenue, the ordinary business expenses, and the depreciation would be ordinary business income items instead of separately stated items
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So let's kind of dive into this. Separately stated items are things that, again, are not included in ordinary business income, and they are separately stated on the K1 that is given to the shareholder to show them the different things that flowed through to them
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Because again, just a reminder, S corporations are considered pass-through entities or flow-through entities
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They're not like a normalcy corporation, S corporations, similar to partnerships, take all the income, all the expenses and everything, and it all flows through to the shareholders or partners, and it's taxed to them. Their share of everything is taxed to them instead of the S corporation being taxed itself. So these are the kinds of things that you have to list out separately on the K1 that is given to the shareholder because they have different characteristics and they might be treated differently for different tax purposes
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So, just to kind of sum it up, things like passive activities like rental, interest, dividend, royalties, those would be separately stated items typically
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Capital gains and losses typically would also be considered separately stated items
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And then donations to local charities also would be a separately stated item
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So with those two questions, we've already learned a lot about ordinary income and separately stated items
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Let's go ahead and do a few more questions just to help it all sink in. Okay, here is question three
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Pinnacle Tech Solutions and S-Corporation has the following expenses detailed in its financial reports for the fiscal year
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Salaries and employee wages $150,000, advertising costs of $20,000, section 179 expense deduction for computer systems, $40,000, and rent for office space $30,000
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Which of the following expenses should be reported as a separately stated item on the S-corporations Schedule K-K-1 for shareholders
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Okay, before we even get into this, we've learned a lot so far. These look like they would be pretty normal business expenses you know employee wages advertising rent Those are all pretty normal business activities So I would assume that those would be part of ordinary business income This Section 179 expense deduction you might not
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know what that is, but that seems different than the rest of these. So that's probably the
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separately stated item. Let's go ahead and look at the answer to see the explanation for this
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Okay, and we were right. The Section 179 expense deduction is unique in that it allows
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businesses to deduct the full purchase price of qualifying property. It is treated as a separately stated
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item on an S corporation's tax return because it is subject to limitations at the shareholder level
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So just to kind of explain that a bit better, under normal depreciation, you know, a company buys
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equipment and they depreciated over time. The Section 179 deduction allows them to expense the
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whole item in that year for tax purposes. And because that can affect things so drastically
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there are specific tax treatments for this, and they have to flow through to the S-corporation
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shareholders to be treated there. So that's one specific separately stated item that you would
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probably need to know, which is the Section 179 deduction. Let's go to the next question
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Okay, here is question four. Nova Dynamics and S-corporation reported the following payments
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in its financial statements for the year. Shareholder employee salary of $120,000
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non-employee sales commissions of $30,000, and rent expense of $50,000. Allen is a shareholder
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employee who works as a manager at Nova Dynamics and received a salary of $120,000, the one that
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was listed above. How should this payment be treated for tax purposes and what should be considered
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when determining the reasonableness of the amount? Okay, so how would salary to a shareholder
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be treated? Would it be a guaranteed payment? Would it just be a normal deductible expense
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Would it be considered a dividend because he's a shareholder? Or would it just not be deductible
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because, again, he's a shareholder? Let's go ahead and look at the answer to see how this
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treated. Okay, and the answer is that his salary would be a deductible expense for the S corporation
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and it would just be reported as wage income for him. So this is an important distinction
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that we're about to learn here. In S corporations, shareholder employees are paid salaries for services
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rendered, which are considered deductible business expenses for the corporation and are reported
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as wages on the individual's form W2. Unlike in partnerships, where guaranteed payments are made to
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partners for services or the use of capital and are subject to self-employment tax, S corporations do
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not make guaranteed payments to their shareholder employees
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This is a really important distinction that you will see as you continue studying
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guaranteed payments are only in partnerships. It's a normal business expense that is deductible by the S corporation
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For the shareholder employee, it is reported as earned income, typically on a form W2, and it is subject to regular payroll taxes
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This option also implies the importance of determining that the salary is reasonable for the
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services rendered, which the IRS scrutinizes to ensure that S corporations do not avoid payroll
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taxes by underpaying shareholder employees and distributing the income as dividends, which would
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not be subject to employment taxes. So another important thing here is they have to give a reasonable salary
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They can't underpay someone on purpose and give them dividends. dividends instead. All right, that was one important distinction between partnerships and S corporations. Let's go to the last question in the video
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Okay here is question five During the fiscal year Courts and Co and S Corporation had various financial transactions The company reported in sales revenue their cost of goods sold was recorded as and operating expenses amounted to In addition to its
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main operations, courts and co earned $20,000 in dividends and $30,000 from rental properties
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it owns. Interest paid on a business loan for the year was $10,000. The company also took a
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Section 179 expense deduction of $25,000 for new manufacturing equipment and made charitable
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contributions totaling $5,000. Based on the information provided, calculate the ordinary income and the total of separately stated items for courts and co for the year. Select the correct
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pair of amounts from the options below. Okay, this is the last question of the video. You've
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learned a lot, so you should be able to figure this out. Pause the video, calculate it yourself
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Remember separately stated items, we don't normally add them up together. The purpose of this
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question is just to see if you can pick out which items are separately stated. So go
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ahead and do that and when you're ready come back and we will look at the answer together okay here is the answer ordinary income of 150,000 dollars and separately stated
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items total $20,000 so let's do the look at the calculations for both of these
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so we have the sales revenue less the cost of goods sold and the operating
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expenses and that gives you $150,000 of ordinary income and then the separately stated
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items were the dividend income the rental income the section 179 deduction remember
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that's separate and charitable contributions and remember this $5,000 of charitable contributions, the reason it is subtracted from this little total right here is because
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it would be a deduction for the individual shareholder if they're able to take it on their tax return
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All right, that was the last question of the video. Let's finish out the video by doing one more part of the super fast CPA strategy, which is something called
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Pillar Topics. Now, the idea behind Pillar Topics is, as you're going through the questions to learn the material
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you will notice things that are obviously important. These are the things that are popping up three or four times throughout the questions that you're doing
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and you know, based off of your review course, that these are the things you need to know for the
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CPA exam. So let's go ahead and look at the pillar topics for this video. Okay, here are the
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pillar topics. S corporations are considered passed through entities. This means that income and
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expenses are passed through to the shareholders to be taxed at their level. Certain income and
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expenses are added together to get total ordinary income or loss, and this total amount is passed
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through to each shareholder based on shares held. Other items called separately stated items are not
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included in ordinary income and are each separately listed on the shareholders K1
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This is because certain items are taxed differently or have different consequences
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so they need to be separated from the ordinary income. These typically include passive income like rental income, interest income
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dividend income, royalties, capital gains or losses, charitable contributions, and special depreciation deductions specifically like the Section 179 deduction
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And again, remember, you typically don't add up all the separately stated items like we did
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sometimes in this video, in this video we were doing that for the purpose of trying to help you
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pick out which items were separately stated. And the way it would typically work would be that they
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are separately stated on their own line on a K-1 that is given to a shareholder. All right, that is the
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end of the video. Thanks for watching. Make sure you go to superfastcpa.com and check out our free one-hour
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webinar training. We teach the key ingredients to passing the CPA exam. Again, it's something you don't
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want to miss. Also, be sure to check out our Superfast CPA app. We have five question mini quizzes
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so you can continue practicing questions all throughout your day. If you like this video
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make sure to like it and leave a comment. I hope this was helpful, and I will see you in the next video
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