20 Regulation (REG) Practice Questions & Answers

1. 1. While preparing a client's current-year return, a CPA discovers that the client's prior-year return, prepared by another firm, omitted taxable interest income. Under Circular 230, what is the CPA required to do?

   • A.Advise the client of the omission and of the consequences under the Code and regulations of not correcting it✓ Answer
   • B.Promptly notify the IRS in writing of the omission
   • C.Immediately withdraw from the engagement and return all client records
   • D.Refuse to prepare the current-year return unless the client first files an amended prior-year return

   Circular 230 sec. 10.21 creates a duty owed to the client, not to the IRS: on learning of an error or omission the practitioner must promptly advise the client of it and of the consequences of not correcting it. Disclosing the error to the IRS without client consent would violate confidentiality (IRC sec. 7216), and the rule compels neither withdrawal nor an amended return.

   Source: Treasury Department Circular No. 230, sec. 10.21 (knowledge of client's omission)Report a problem with this question

2. 2. A tax return preparer takes a position on a client's return that is not a tax shelter or a reportable transaction, and the position is NOT disclosed on the return. To avoid the IRC sec. 6694(a) preparer penalty, the position must be supported by at least:

   • A.A realistic possibility of being sustained on the merits
   • B.More likely than not
   • C.Substantial authority✓ Answer
   • D.Reasonable basis

   The standards ladder runs frivolous < reasonable basis (about 20%) < substantial authority (about 40%) < more likely than not (over 50%). Under sec. 6694(a) an undisclosed, non-shelter position needs substantial authority; reasonable basis is enough only if the position is adequately disclosed (Form 8275), and more likely than not is required only for tax shelters and reportable transactions.

   Source: IRC sec. 6694(a); Treas. Reg. sec. 1.6694-2Report a problem with this question

3. 3. An individual filed a timely income tax return. The IRS later determines that the taxpayer omitted an amount of gross income exceeding 25% of the gross income stated on the return. What is the period during which the IRS may assess additional tax?

   • A.Six years from the later of the due date or the date the return was filed✓ Answer
   • B.Three years from the later of the due date or the date the return was filed
   • C.Ten years from the date of assessment
   • D.Unlimited; no period of limitation applies

   The general assessment period is three years, but IRC sec. 6501(e)(1) doubles it to six years when the taxpayer omits gross income exceeding 25% of the gross income reported. The period is unlimited only for a false or fraudulent return or a failure to file; the ten-year figure is the collection period after assessment, not the assessment period.

   Source: IRC sec. 6501(a), (c) and (e)(1)Report a problem with this question

4. 4. Under agency law, apparent authority is created by:

   • A.A written agency agreement signed by the principal and the agent
   • B.The agent's good-faith belief that his act will benefit the principal
   • C.The principal's words or conduct toward the third party that reasonably lead the third party to believe the agent is authorized✓ Answer
   • D.The agent's own statements to the third party describing the scope of his authority

   Apparent authority rests on manifestations made by the PRINCIPAL to the third party; an agent cannot manufacture his own authority by telling a third party he has it. A signed agency agreement creates actual express authority, and the agent's private beliefs create no authority at all, which is why lingering apparent authority persists after termination until proper notice is given.

   Source: Restatement (Third) of Agency sec. 2.03 (apparent authority)Report a problem with this question

5. 5. Two merchants contract for the sale of goods. The buyer's purchase order is met by the seller's prompt written acceptance that states additional terms not in the offer. Under UCC Article 2, what is the result?

   • A.A contract is formed, and between merchants the additional terms become part of the contract unless they materially alter it, the offer expressly limited acceptance to its terms, or the offeror objects within a reasonable time✓ Answer
   • B.A contract is formed only if the offeror signs a writing expressly assenting to the additional terms
   • C.A contract is formed, but the additional terms are merely proposals that never become part of it
   • D.No contract is formed, because an acceptance must mirror the offer exactly

   UCC sec. 2-207 rejects the common-law mirror image rule: a definite expression of acceptance forms a contract even though it states additional or different terms. Between merchants those additional terms automatically become part of the contract subject to the three stated exceptions; the 'mere proposals' treatment applies only when at least one party is a non-merchant.

   Source: UCC sec. 2-207 (battle of the forms)Report a problem with this question

6. 6. Which statement correctly describes attachment and perfection of a security interest under UCC Article 9?

   • A.A purchase money security interest in consumer goods can be perfected only by filing a financing statement
   • B.A security interest must attach before it can be perfected, and perfection is what generally establishes priority against third parties✓ Answer
   • C.Attachment establishes priority over other creditors, while perfection makes the interest enforceable against the debtor
   • D.Filing a financing statement is the only way to perfect a security interest in any type of collateral

   Attachment (value given, the debtor has rights in the collateral, and an authenticated security agreement or possession/control) makes the interest enforceable against the DEBTOR, and it is a precondition to perfection. Perfection, achieved by filing, possession, control, or automatically for a PMSI in consumer goods, is what determines priority against THIRD PARTIES.

   Source: UCC secs. 9-203, 9-308, 9-309(1), 9-322Report a problem with this question

7. 7. Which statement about the liability characteristics of business entities is correct?

   • A.A limited partner becomes personally liable for all partnership debts simply by contributing capital
   • B.Shareholders of a C corporation are personally liable for corporate debts in proportion to their shareholdings
   • C.Members of an LLC forfeit their limited liability if they participate in managing the LLC
   • D.Each partner in a general partnership has unlimited personal liability for partnership obligations, and the partners are jointly and severally liable✓ Answer

   A general partnership provides no liability shield: under RUPA every partner is jointly and severally liable for all partnership obligations, which is the classic reason for choosing an LLC or corporation instead. Limited partners and corporate shareholders risk only their investment, and modern LLC statutes expressly allow members to manage without losing the shield, unlike the older limited-partnership control rule.

   Source: Revised Uniform Partnership Act sec. 306; RULPA and ULLCA limited liability provisionsReport a problem with this question

8. 8. A donor gives stock to a donee. The donor's adjusted basis is $10,000 and the fair market value at the date of the gift is $6,000. No gift tax is paid. The donee later sells the stock for $8,000. What does the donee recognize?

   • A.A $4,000 loss
   • B.No gain or loss✓ Answer
   • C.A $2,000 loss
   • D.A $2,000 gain

   When the fair market value at the date of gift is below the donor's basis, the dual basis rule applies: basis for computing gain is the donor's carryover basis ($10,000) and basis for computing loss is the FMV at the gift date ($6,000). Because the $8,000 sale price falls between the two, there is no gain (it is under $10,000) and no loss (it is over $6,000).

   Source: IRC sec. 1015(a); Treas. Reg. sec. 1.1015-1(a)Report a problem with this question

9. 9. On November 1 a taxpayer sells 100 shares of ABC stock at a $5,000 loss. On November 20 the taxpayer buys 100 shares of the same ABC stock for $18,000. What is the tax result?

   • A.The $5,000 loss is permanently disallowed and does not affect the basis of the new shares
   • B.The $5,000 loss is disallowed and added to the basis of the replacement shares, giving them a $23,000 basis, and the holding period of the old shares tacks on✓ Answer
   • C.The $5,000 loss is deductible currently and the basis of the new shares is $18,000
   • D.The loss would be disallowed only if the replacement shares had been purchased before the date of sale

   IRC sec. 1091 disallows a loss when substantially identical securities are acquired within 30 days BEFORE or AFTER the sale, a 61-day window that the November 20 purchase falls inside. The loss is deferred rather than lost: sec. 1091(d) adds the disallowed loss to the basis of the replacement shares ($18,000 + $5,000) and sec. 1223(3) tacks the old holding period.

   Source: IRC sec. 1091 (wash sales); sec. 1223(3)Report a problem with this question

10. 10. A calendar-year business places tangible personal property in service during the year. Under MACRS, the mid-quarter convention must be used instead of the half-year convention when:

    • A.Any property at all is placed in service during the fourth quarter
    • B.More than 40% of the aggregate basis of MACRS personal property placed in service during the year is placed in service during the last three months of the year✓ Answer
    • C.The taxpayer elects to expense part of the property's cost under sec. 179
    • D.More than 50% of the property's use is for business rather than personal purposes

    The half-year convention is the default for MACRS personal property, but sec. 168(d)(3) makes the mid-quarter convention mandatory when more than 40% of the aggregate basis of such property placed in service for the year falls in the final quarter. Real property is excluded from the 40% test because it always uses the mid-month convention, and the sec. 179 election and the more-than-50% business use test are unrelated rules.

    Source: IRC sec. 168(d)(3) and (d)(4)Report a problem with this question

11. 11. Which of the following amounts is EXCLUDED from an individual's gross income?

    • A.Unemployment compensation
    • B.The portion of a scholarship used to pay room and board
    • C.Punitive damages awarded in a personal physical injury lawsuit
    • D.Life insurance proceeds received by a beneficiary because of the insured's death✓ Answer

    IRC sec. 101(a) excludes life insurance proceeds paid by reason of the insured's death. The other three are includible: sec. 104(a)(2) excludes only compensatory damages for physical injury or sickness, so punitive damages remain taxable even in a physical injury case; sec. 117 excludes scholarship amounts only for tuition, fees, books and supplies, not room and board; and sec. 85 makes unemployment compensation fully taxable.

    Source: IRC secs. 101(a), 104(a)(2), 117 and 85Report a problem with this question

12. 12. Which of the following is deductible in arriving at adjusted gross income (an above-the-line deduction) rather than as an itemized deduction?

    • A.Qualified residence mortgage interest
    • B.One-half of the self-employment tax paid by a sole proprietor✓ Answer
    • C.State and local real property taxes on a personal residence
    • D.Unreimbursed medical expenses

    IRC secs. 62(a)(1) and 164(f) allow one-half of self-employment tax as a deduction in computing AGI; the other three are itemized deductions taken from AGI. The distinction matters because above-the-line deductions lower AGI itself, which in turn loosens AGI-based floors and phase-outs, and they are available whether or not the taxpayer itemizes.

    Source: IRC secs. 62(a)(1) and 164(f)Report a problem with this question

13. 13. In what order are the limitations applied to an individual's deduction of a loss from a pass-through business?

    • A.At-risk, then basis, then excess business loss, then passive activity
    • B.Basis, then at-risk, then passive activity, then excess business loss✓ Answer
    • C.Passive activity, then at-risk, then basis, then excess business loss
    • D.Basis, then passive activity, then at-risk, then excess business loss

    The limitations are applied sequentially, each one operating on the amount that survived the previous test: basis (secs. 704(d) and 1366(d)), then at-risk (sec. 465), then passive activity (sec. 469), then excess business loss (sec. 461(l)). The order matters because a loss blocked at an earlier step never reaches the later tests, and each suspended amount carries forward under its own rules.

    Source: IRC secs. 704(d)/1366(d), 465, 469 and 461(l)Report a problem with this question

14. 14. Which statement correctly distinguishes a refundable tax credit from a nonrefundable tax credit?

    • A.Refundable credits reduce adjusted gross income, while nonrefundable credits reduce taxable income
    • B.A refundable credit can reduce the tax liability below zero and be paid out as a refund; a nonrefundable credit can reduce the liability only to zero✓ Answer
    • C.A nonrefundable credit can reduce the tax liability below zero and be paid out as a refund; a refundable credit can reduce the liability only to zero
    • D.Both types can reduce the liability below zero, but a nonrefundable credit must first be carried back to a prior year

    A refundable credit is treated as a payment of tax under IRC sec. 6401(b), so any excess over the liability is refunded to the taxpayer; the earned income credit is the classic example. A nonrefundable credit, such as the foreign tax credit or the lifetime learning credit, can only offset tax down to zero, with any excess either lost or carried over under its own provision. Credits reduce tax dollar for dollar, not income.

    Source: IRC sec. 6401(b); secs. 32 and 27Report a problem with this question

15. 15. Which fact pattern qualifies a taxpayer for head of household filing status?

    • A.The taxpayer is unmarried and paid more than half the cost of maintaining a household that was the principal home of the taxpayer's dependent child for more than half the year✓ Answer
    • B.The taxpayer paid the entire cost of a household in which a friend, who is not the taxpayer's dependent, lived all year
    • C.The taxpayer paid more than half the cost of a household that was the principal home of the taxpayer's dependent child for two months of the year
    • D.The taxpayer is married, lived with the spouse for the entire year, files a separate return, and maintains the household for their child

    IRC sec. 2(b) requires the taxpayer to be unmarried (or considered unmarried), to furnish more than half the cost of maintaining the household, and for that household to be the principal place of abode of a qualifying person for more than half the year. A nondependent friend is not a qualifying person, two months fails the more-than-half-year test, and a taxpayer who lived with a spouse for the entire year cannot be considered unmarried under sec. 7703(b). Note the special rule that a dependent parent need not live with the taxpayer.

    Source: IRC sec. 2(b); sec. 7703(b)Report a problem with this question

16. 16. A partner's outside basis in a partnership interest is $30,000 at the beginning of the year. During the year the partner is allocated $10,000 of ordinary business income, receives a $4,000 cash distribution, and the partner's share of partnership recourse liabilities increases by $6,000. What is the partner's basis at year end?

    • A.$46,000
    • B.$36,000
    • C.$32,000
    • D.$42,000✓ Answer

    Basis is increased by the partner's share of income and decreased by distributions under secs. 705 and 733, and IRC sec. 752(a) treats an increase in a partner's share of partnership liabilities as a deemed CASH CONTRIBUTION that also increases outside basis: $30,000 + $10,000 - $4,000 + $6,000 = $42,000. This liability rule is the key difference from an S corporation, where entity-level debt gives the shareholder no basis.

    Source: IRC secs. 705, 733 and 752(a)Report a problem with this question

17. 17. An S corporation borrows $100,000 from a bank. Which statement correctly describes the effect on a shareholder's ability to deduct the corporation's losses?

    • A.Losses are limited to the shareholder's adjusted stock basis plus the basis of any loan the shareholder made directly to the corporation; corporate-level debt creates no basis✓ Answer
    • B.Losses in excess of the shareholder's stock basis are permanently disallowed and may never be used
    • C.A shareholder who personally guarantees the corporation's bank loan increases basis by the guaranteed amount
    • D.The shareholder increases stock basis by a pro rata share of the corporation's bank debt, just as a partner does under sec. 752

    IRC sec. 1366(d)(1) limits a shareholder's loss deduction to adjusted stock basis plus the basis of indebtedness of the corporation TO THE SHAREHOLDER, so only a direct shareholder loan creates debt basis. Unlike sec. 752 for partnerships, entity-level borrowing gives the shareholder nothing, and a mere guarantee is not an economic outlay until the shareholder actually pays. Disallowed losses are suspended and carried forward indefinitely while the person remains a shareholder.

    Source: IRC sec. 1366(d)(1); Treas. Reg. sec. 1.1366-2(a)(2)Report a problem with this question

18. 18. A partnership pays a partner a guaranteed payment for services, determined without regard to partnership income. How is the payment treated?

    • A.The partnership deducts it in computing ordinary business income, and the partner reports it as ordinary income regardless of whether the partnership has any profit✓ Answer
    • B.The partnership may not deduct it, but the partner must report it as ordinary income
    • C.The partnership deducts it, and the partner treats it as a tax-free return of capital to the extent of basis
    • D.It is a distribution that only reduces the partner's capital account and is not income to the partner

    Under IRC sec. 707(c) a guaranteed payment is treated as made to a person who is not a partner for purposes of secs. 61 and 162, so the partnership deducts it in arriving at ordinary business income and the partner includes it as ordinary income. Because the payment is fixed without regard to profits, the partner reports it even in a year the partnership has a loss, which is why it appears both in the ordinary income computation and separately on the K-1.

    Source: IRC sec. 707(c)Report a problem with this question

19. 19. Which of the following events would terminate or prevent a corporation's S election?

    • A.The estate of a deceased shareholder holds shares in the corporation
    • B.The corporation issues a second class of stock that differs from the first only in voting rights
    • C.Members of one family elect to be treated as a single shareholder for the shareholder-count limit
    • D.A partnership acquires shares in the corporation✓ Answer

    IRC sec. 1361(b)(1) limits S corporation shareholders to individuals, estates, certain trusts and certain exempt organizations, so ownership by a partnership, a corporation, or a nonresident alien is an immediately disqualifying event. The other three choices are expressly permitted: differences in voting rights alone do not create a second class of stock under sec. 1361(c)(4), estates are eligible shareholders, and family members may be counted as one shareholder under sec. 1361(c)(1).

    Source: IRC sec. 1361(b)(1), (c)(1) and (c)(4)Report a problem with this question

20. 20. On a C corporation's Schedule M-1 reconciliation of book income to taxable income, which item produces a PERMANENT difference?

    • A.Bad debt expense recorded under the allowance method for book and the specific charge-off method for tax
    • B.MACRS tax depreciation in excess of book depreciation
    • C.Warranty expense accrued for book purposes but deducted for tax when paid
    • D.Interest income on state and local bonds included in book income but excluded from taxable income✓ Answer

    A permanent difference is one that never reverses in a later period, and tax-exempt municipal bond interest is never included in taxable income under IRC sec. 103, so the book amount is subtracted on Schedule M-1 and no future adjustment offsets it. The other three are temporary (timing) differences: accelerated depreciation, accrued warranties and the allowance versus specific charge-off treatment of bad debts all reverse as the underlying items are deducted for tax in later years.

    Source: IRC sec. 103; Form 1120, Schedule M-1 (book-tax reconciliation)Report a problem with this question

Concept-focused practice questions based on the AICPA CPA Exam Blueprints. Not affiliated with the AICPA or NASBA, and not accounting, tax, or legal advice. Specific dollar thresholds change yearly — confirm current figures with authoritative sources. About the CPA Exam →