REG CPA Practice Questions Explained: Taxation of Income from Pass-through Entities

Taxation of Income from Pass-through Entities

Share This...

In this video, we walk through 5 REG practice questions demonstrating the taxation of income from pass-through entities. These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

Also be sure to watch one of our free webinars on the 6 “key ingredients” to an extremely effective & efficient CPA study process here…

Click here to watch the video on YouTube…

The Taxation of Income from Pass-through Entities

When an individual receives income from a pass-through entity, such as a partnership, S corporation, or some LLCs, they must report this income on their individual tax return. Pass-through entities don’t pay income tax at the business level. Instead, the income, deductions, credits, and other financial activities of these entities are passed through to their owners to report on their personal tax returns.

Ordinary Business Income (Loss) and Separately Stated Items

  • Ordinary Business Income (Loss): This refers to the net income or loss from the business operations of the entity. It is calculated as the entity’s gross income minus its deductible business expenses. This figure is reported on Schedule K-1 of the pass-through entity and must be included on the individual’s tax return. For partnerships and S corporations, it is typically reported on the individual’s Form 1040, Schedule E, Part II.
  • Separately Stated Items: Certain items are not included in the ordinary business income (loss) calculation because they are subject to different tax rules at the individual level. These items are “separately stated” on Schedule K-1 so that each owner or beneficiary can report them according to their own tax situation. Examples include:
    • Interest income
    • Dividend income
    • Royalties
    • Net short-term capital gains (or losses)
    • Net long-term capital gains (or losses)
    • Section 1231 gains (or losses)
    • Charitable contributions
    • Rental real estate income (or losses)
    • Guaranteed payments to partners
    • Section 179 expense deduction
    • Foreign taxes paid
    • Investment interest expense
    • Educational expenses deductions
    • Certain state and local tax deductions


  • Distributions are payments made by the entity to its owners. These are not directly taxable when received. Instead, the tax implications of distributions depend on the owner’s tax basis in the entity. Distributions are typically tax-free to the extent of the taxpayer’s basis in the entity. Amounts exceeding the taxpayer’s basis may result in capital gains.

Guaranteed Payments

  • Guaranteed Payments are payments made by a partnership to a partner for services or the use of capital regardless of the partnership’s income. These payments are considered ordinary income to the recipient and are deductible by the partnership, affecting the calculation of the partnership’s ordinary business income or loss.

Loss Limitations

Several limitations may apply to the losses reported by individuals from pass-through entities:

  1. Tax Basis Limitation: An individual can only deduct losses to the extent of their tax basis in the pass-through entity. The basis starts with the initial investment and is adjusted annually by the income, deductions, and distributions of the entity. Any loss amount remaining is carried forward to future years.
  2. At-Risk Limitation: Losses are deductible only to the extent the individual is at risk for the investment. The at-risk amount includes money and property contributed to the entity and certain amounts borrowed for use in the activity.
  3. Passive Activity Loss (PAL) Limitation: If the individual does not materially participate in the business, losses may be classified as passive. Passive losses can only be used to offset passive income, not other types of income, with unused losses carried forward to future years to be used against passive income.
  4. Excess Business Loss Limitation: The Tax Cuts and Jobs Act introduced a limitation on the ability to deduct business losses. If business losses exceed business income plus a threshold amount, the excess is nondeductible in the current year and is treated as a net operating loss (NOL) carryforward.


  • Partnership Name: Ironwood Partners
  • Partner: John Doe (50% ownership)

Partnership’s Financial Results for the Year:

  • Gross Revenue from Operations: $200,000
  • Operating Expenses (excluding guaranteed payments): $120,000
  • Guaranteed Payments to John Doe: $30,000
  • Net Rental Income (Separately Stated): $20,000
  • Interest Income (Separately Stated): $5,000
  • Capital Gain from Sale of Equipment (Separately Stated Long-term): $10,000
  • Distributions to John Doe: $40,000


  1. Ordinary Business Income:
    • Gross Revenue from Operations: $200,000
    • Less: Operating Expenses: $120,000
    • Less: Guaranteed Payments to John: $30,000
    • Ordinary Business Income = $50,000 (This amount is then allocated based on ownership percentage to partners.)
  2. John Doe’s Share of Ordinary Business Income:
    • John’s Ownership Percentage: 50%
    • John’s Share of Ordinary Business Income = $25,000

Implications for John Doe’s Tax Return:

  1. Ordinary Business Income and Guaranteed Payments: These amounts are included in John’s gross income. The $25,000 of ordinary business income from the partnership and $30,000 in guaranteed payments are taxed according to John’s individual income tax rates.
  2. Separately Stated Items:
    • Rental Income, Interest Income, and Capital Gain are reported on John’s Form 1040, Schedule E, and Schedule D as applicable. These items may be taxed at different rates or have different deduction rules (e.g., capital gains are generally taxed at a lower rate than ordinary income).
  3. Distributions: The $40,000 received by John does not directly impact his taxable income for the year, as distributions are generally tax-free to the extent of the partner’s basis in the partnership. However, it affects John’s basis, decreasing it, and could result in capital gains if distributions exceed his adjusted basis in the partnership.

Other Posts You'll Like...

Want to Pass as Fast as Possible?

(and avoid failing sections?)

Watch one of our free "Study Hacks" trainings for a free walkthrough of the SuperfastCPA study methods that have helped so many candidates pass their sections faster and avoid failing scores...