chapter 13

Chapter 13

True/FalseIndicate whether the statement is true or false.

____ 1. A business entity is not always taxed the same way as its legal form.

____ 2. A business organized as a C corporation will always encounter lower tax rates than a business organized as a sole proprietorship or as a partnership.

____ 3. The check-the-box Regulations have made it easier for a business entity to be classified as a partnership for Federal income tax purposes.

____ 4. A limited liability company (LLC) is a hybrid business form that combines the corporate characteristic of limited liability for the owners with the tax characteristics of a partnership.

____ 5. A limited liability company (LLC) can elect under the check-the-box rules to be taxed as an S corporation.

____ 6. Depending on the election made under the check-the-box provisions, a limited liability company (LLC) with two or more owners might have to file a Form 1065 or a Form 1120.

____ 7. Each of the following can pass profits and losses through to the owners: general partnership, limited partnership, S corporation, and limited liability company.

____ 8. Nontax factors are less important than tax factors in making a business decision.

____ 9. The § 465 at-risk provision and the § 469 passive activity loss provision have decreased the tax attractiveness of investments in real estate for partnerships and for limited liability companies.

____ 10. A C corporation offers greater flexibility in terms of the types of owners and capital structure than an S corporation.

____ 11. An S corporation has a lesser degree of limited liability than a C corporation.

____ 12. A limited partner in a limited partnership has limited liability whereas a general partner in a limited partnership has unlimited liability unless the limited partners agree that the general partner will have limited liability.

____ 13. A limited partnership can indirectly avoid unlimited liability of the general partner if the general partner is a corporation.

____ 14. C corporations and their shareholders are subject to double taxation. S corporations and their shareholders typically are subject to single taxation. Therefore, for any given amount of corporate taxable income, the combined tax liability of a C corporation and its shareholders will exceed that of an S corporation and its shareholders.

____ 15. Lime, Inc., has taxable income of $330,000. If Lime is a C corporation, its tax liability must be either $111,950 [($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($230,000 39%)] or $115,500.

____ 16. A major benefit of the S corporation election is the general avoidance of double taxation.

____ 17. Obtaining a deduction on payments made by a C corporation to shareholders is a technique for reducing double taxation.

____ 18. A corporation may alternate between S corporation and C corporation status each year, depending on which results in more tax savings.

____ 19. If a C corporation has earnings and profits at least equal to the amount of a distribution, the tax consequences to the shareholders are the same, regardless of whether the distribution is classified as a dividend or as a stock redemption.

____ 20. When a C corporation is classified as a small corporation for AMT purposes, both the corporation and its shareholders are exempt from the AMT.

____ 21. An S corporation is not subject to the AMT, but its shareholders are in that the S corporation’s AMT adjustments and preferences are passed through to them.

____ 22. The AMT statutory rate for C corporations and for S corporation shareholders on the AMT base is 20%.

____ 23. The AMT tax rate for a C corporation is less than the regular tax rate for C corporations.

____ 24. C corporations and S corporations can generate an AMT adjustment known as Adjusted Current Earnings (ACE).

____ 25. The ACE adjustment associated with the C corporation AMT can only be positive.

____ 26. An S corporation election for Federal income tax purposes also is effective for all states’ income tax purposes.

____ 27. The tax treatment of S corporation shareholders with respect to fringe benefits is not the same as the tax treatment for C corporation shareholders but is the same as the fringe benefit treatment for partners.

____ 28. Some fringe benefits always provide a deduction for the employer and are always excluded from the gross income of the employee.

____ 29. Of the corporate types of entities, all are subject to double taxation on current earnings.

____ 30. If the amounts are reasonable, salary payments to shareholder-employees can reduce or avoid the double taxation result of a C corporation.

____ 31. If lease rental payments to a noncorporate shareholder-lessor are classified as unreasonable, the taxable income of a C corporation remains the same and the gross income of the shareholder increases.

____ 32. If the IRS reclassifies debt as equity under § 385, the repayment of the debt by the corporation to the shareholder automatically is treated as a dividend.

____ 33. Actual dividends paid to shareholders result in double taxation. Likewise, deemed dividends (e.g., free use of corporate assets by a shareholder) result in double taxation.

____ 34. An effective way for all C corporations to avoid double taxation is not to make dividend distributions.

____ 35. The accumulated earnings tax rate in 2011 is the same as the highest tax rate for a C corporation.

____ 36. A corporation can avoid the accumulated earnings tax by demonstrating that it has plans to distribute earnings at a later date.

____ 37. Only C corporations are subject to the accumulated earnings tax (i.e., S corporations are not).

____ 38. Roger owns 40% of the stock of Silver, Inc. (adjusted basis of $500,000). Silver redeems 75% of his shares for $650,000. If the stock redemption qualifies for return of capital treatment, Roger’s recognized gain is $150,000.

____ 39. In its first year of operations, a corporation projects losses of $200,000. Since losses are involved, the corporation definitely should elect S corporation status.

____ 40. Dave contributes land (adjusted basis of $30,000; fair market value of $100,000) to Tan, Inc., in exchange for all of its stock. The land is encumbered by a mortgage of $27,000 which Tan assumes. Since the transaction qualifies for nonrecognition treatment under § 351, Tan’s adjusted basis for the land is $73,000 ($100,000 – $27,000) and Dave’s adjusted basis for the stock is $3,000 ($30,000 – $27,000).

____ 41. Amos contributes land with an adjusted basis of $70,000 and a fair market value of $100,000 to White, Inc., an S corporation, in exchange for 50% of the stock of White, Inc. Carol contributes cash of $100,000 for the other 50% of the stock. If White later sells the land for $110,000, $35,000 [$30,000 + 50%($10,000)] is allocated to Amos and $5,000 ($10,000 50%) is allocated to Carol.

____ 42. To the extent of built-in gain or built-in loss at the time of contribution, partnerships may choose to allocate or not allocate this built-in gain or loss to the contributing partner on the sale of the contributed property by the partnership.

____ 43. If an individual contributes an appreciated personal use asset to a C corporation in a transaction which qualifies for nonrecognition treatment under § 351, the corporation’s basis in the asset is the same as was the shareholder’s adjusted basis.

____ 44. Wally contributes land (adjusted basis of $30,000; fair market value of $100,000) to an S corporation in a transaction which qualifies under § 351. The corporation subsequently sells the land for $120,000, recognizing a gain of $90,000 ($120,000 – $30,000). If Wally owns 30% of the stock, $76,000 [$70,000 + 30%($20,000)] of the $90,000 recognized gain is allocated to Wally.

____ 45. It is easier to satisfy the § 721 requirements for the nonrecognition of gain or loss on partner contributions than it is to satisfy the § 351 requirements for the nonrecognition of gain or loss on shareholder contributions.

____ 46. The profits of a business owned by Taylor (60%) and Maggie (40%) for the current tax year are $100,000. If the business is a C corporation or an S corporation, there is no effect on Taylor’s basis in her stock. If the business is a partnership or an LLC, Taylor’s basis in her partnership interest or basis in her stock is increased by $60,000.

____ 47. Carol is a 60% owner of a business entity and has an adjusted basis in such interest of $60,000. For the current tax year, the entity has profits of $50,000. If the entity is a C corporation, the corporate profits have no effect on Carol’s basis in her stock. However, if the entity is an S corporation, Carol’s basis increases to $90,000 [$60,000 + (60% $50,000)].

____ 48. A benefit of an S corporation when compared with a C corporation is that it is subject to Federal income tax only in limited circumstances.

____ 49. If an S corporation distributes appreciated property as a dividend, it must recognize gain as to the appreciation.

____ 50. Samantha’s basis for her partnership interest is $85,000. If she receives a cash distribution of $95,000, her recognized gain is $10,000 and her basis for her partnership interest is reduced to $0. Samantha is still a partner after the distribution.

____ 51. Personal service corporations can offset passive activity losses against active income, but not against portfolio income.

____ 52. The special allocation opportunities that are available to partnerships are available to S corporations only if a majority of the corporate shareholders elect to do so.

____ 53. From the perspective of the seller of a C corporation business whose assets have appreciated, the seller prefers to sell the assets.

____ 54. Mercedes owns a 40% interest in Teal Partnership (basis of $35,000) which she sells to Eric for $60,000. Mercedes’ recognized gain of $25,000 will be classified as capital gain.

____ 55. Section 1244 ordinary loss treatment is available to shareholders in a C corporation but not to those in an S corporation.

Multiple ChoiceIdentify the choice that best completes the statement or answers the question.

____ 1. Which of the following is correct regarding the form for filing the annual Federal income tax return?

Business entity form Tax forma. Sole proprietorship Form 1040-Schedule Cb. Partnership Form 1065Pc. C corporation Form 1120Cd. LLC Form 1120Se. S corporation Form 1120

____ 2. A limited liability company:a. Could be subject to double taxation.b. Is normally taxed as a partnership.c. Is normally taxed as an S corporation.d. Only a. and b.e. a., b., and c.

____ 3. For a limited liability company with 100 owners,

a. An election can be made to be taxed as a C corporation.b. An election can be made to be taxed as an S corporation.c. An election can be made to be taxed as a partnership.d. Only a. and c. are correct.e. a., b., and c. are correct.

____ 4. Which of the following statements is correct? a. The number of owners of an LLC is not limited.b. If the LLC has three or more corporate characteristics, it will be taxed as a C corporation.c. An LLC can elect to be taxed as a C corporation or as a partnership.d. Only a. and c.e. a., b., and c. are correct.

____ 5. Which of the following statements is not correct?a. An S corporation has a greater opportunity to raise capital than does an C corporation.b. A general partnership has a greater opportunity to raise capital than does a limited

partnership.c. A partnership has a greater opportunity to raise capital than does a sole proprietorship.d. Only a. and b. are not correct.e. a., b., and c. are not correct.

____ 6. Nontax factors that affect the choice of business entity include:a. Ease of capital formation.b. Limited liability.c. Single versus double taxation.d. Only a. and b.e. a., b., and c.

____ 7. Amber, Inc., has taxable income of $212,000. In addition, Amber accumulates the following information which may affect its AMT.

Depreciation on buildings placed in service in the early 1990s was $52,000. ADS would have been $41,000.

The president of Amber exercised stock options on Amber stock. She paid $30,000 for the stock, which had a fair market value at exercise date of $49,000. At the end of the year, the stock was worth $54,000.

Amber deducted percentage depletion of $65,000. The adjusted basis of the natural resource at the beginning of the year was $39,000.

Amber contributed CSX stock worth $20,000 to the Red Cross. Amber purchased the stock four months ago for $19,000.

What is Amber’s AMTI?a. $212,000.b. $233,000.c. $238,000.d. $249,000.e. None of the above

____ 8. Which of the following statements is correct?

a. The AMT applies to both the individual taxpayer and the C corporation.b. The individual AMT rates are 26% and 28%.c. The C corporation AMT rate is 20%.d. Only a. and b. are correct.e. a., b., and c. are correct.

____ 9. Techniques that can be used to minimize the current period tax liability include:a. Recognizing the interaction between the regular income tax liability and the alternative

minimum tax liability.b. Utilization of special allocations.c. Favorable treatment of certain fringe benefits.d. Minimizing double taxation.e. All of the above.

____ 10. Maria has a 70% ownership interest in a business entity. She is in the 28% tax bracket. The entity incurs $18,000 of meals and lodging expense for Maria, which she believes qualify for exclusion under § 119. Which of the following statements is correct?a. If the entity is a partnership, the effect of the $18,000 expenditure by the partnership on

Maria’s tax liability is an increase of $5,040.b. If the entity is a sole proprietorship, the effect of the $18,000 expenditure by the sole

proprietorship on Maria’s tax liability is $0.c. If the entity is a C corporation, the effect of the $18,000 expenditure by the corporation on

Maria’s tax liability is $0.d. Only a. and c. are correct.e. a., b., and c. are correct.

____ 11. Brown, Inc., has accumulated earnings and profits at the end of the year of $600,000. Brown pays a salary and bonus of $175,000 to Alice, its CEO. Brown’s taxable income before the salary and bonus is $200,000. The IRS classifies $75,000 of the salary and bonus as unreasonable. Calculate Brown’s taxable income after the reclassification.a. $21,250.b. $25,000.c. $77,750.d. $100,000.e. None of the above.

____ 12. Robin Company has $100,000 of income before payment of $100,000 of reasonable salaries to its owners/employees (who are in the 33% bracket). Which form of business results in the least amount of combined tax being paid by the company and its owners?a. Partnership.b. C corporation.c. S corporation.d. a., b., and c. all result in the same amount of tax.e. a. and c. result in the least amount of tax.

____ 13. Aaron purchases a building for $500,000 which is going to be used by his wholly-owned corporation. Which of the following statements are correct?a. If Aaron contributes the building to the corporation, there will be no recognition under

§ 351 and a carryover basis of $500,000.b. If Aaron leases the building to the corporation, lease-rental payments of $30,000 per year

to Aaron will result in a $30,000 deduction for the corporation.c. If Aaron leases the building to the corporation, lease-rental payments of $30,000 per year

to Aaron will result in $30,000 of gross income for Aaron.d. Leasing the building to the corporation will contribute to the tax avoidance objective of

minimizing double taxation.e. All of the above are correct.

____ 14. Tonya contributes $150,000 to Swan, Inc., for 80% of the stock. In addition, she loans Swan $600,000. The maturity date on the loan is 5 years and the interest rate is 6%, the same as the Federal rate. Which of the following statements are correct?a. If the loan is reclassified as equity under § 385, Swan qualifies for a deduction of

$600,000 when the loan is repaid, and Tonya receives dividend income of $600,000 (assuming that Swan’s earnings and profits are at least $600,000).

b. If the loan is not reclassified as equity under § 385, Swan can deduct interest expense annually of $36,000, and Tonya includes in gross income annually interest income of $36,000.

c. If the loan is reclassified as equity under § 385, Swan claims no interest deduction, and Tonya recognizes no income.

d. Only a. and b.e. a., b., and c.

____ 15. Rocky and Sandra (shareholders) each loan Eagle Corporation $10,000 at the market rate of 10% interest. Which of the following statements are false?a. Eagle may deduct the interest expense, and the interest income is taxable to Rocky and

Sandra.b. When the note principal is repaid, neither Rocky nor Sandra recognizes gross income from

the repayment.c. If the IRS were successful in reclassifying the notes as equity, the interest payments would

not be deductible by Eagle, and Rocky and Sandra would still recognize income.d. If the IRS were successful in reclassifying the notes as equity, repayment of the note

principal to Rocky and Sandra would not qualify for return of capital treatment and would most likely result in dividend income treatment for Rocky and Sandra.

e. All of the above are true.

____ 16. Austin is the sole shareholder of Purple, Inc. Purple’s accumulated E & P at the beginning of the year is $700,000. Purple’s taxable income after paying a salary and bonus to Austin of $100,000 is $500,000. Assume the salary and bonus payment are reasonable. Purple’s maximum exposure in calculating accumulated taxable income for purposes of the accumulated earnings tax for the current tax year is: a. $330,000.b. $500,000.c. $600,000.d. $1,300,000.e. None of the above.

____ 17. Which of the following statements regarding the accumulated earnings tax is correct in 2011?a. If Blue, Inc.’s accumulated taxable income for 2011 is $180,000, the calculated

accumulated earnings tax liability would be $53,450 [($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($80,000 39%)].

b. Blue, Inc., calculates accumulated taxable income for 2011 of $100,000. Therefore, it should increase the amount paid to the IRS for 2011 by $15,000 ($100,000 15%).

c. The accumulated earnings tax applies to C corporations, but applies to S corporations at only the shareholder level.

d. The tax rate for the accumulated earnings tax of 35% is the same as the highest tax bracket for the corporate taxpayer.

e. None of the above.

____ 18. Factors that should be considered in making the S corporation election for the current tax year include the following:a. Are greater than 50% of the shareholders willing to consent to the election?b. Can the requirements for qualification be satisfied by the 15th day of the third month of

the tax year and also for the period of the tax year that precedes this date?c. Will the corporation have total capital not in excess of $1 million?d. Only b. and c.e. a., b., and c.

____ 19. Steve and Karen are going to establish a business entity. They expect the business to be very successful in the long-run, but project losses of approximately $100,000 for each of the first five years. Due to potential environmental concerns, limited liability is a requisite for the owners. Which form of business entity should they select?a. General partnership.b. Limited partnership.c. C corporation.d. S corporation.e. Any of the above should satisfy Steve and Karen.

____ 20. Beige, Inc., has 3,000 shares of stock authorized and 1,000 shares outstanding. The shares are owned by Sam (700 shares) and Lois (300 shares). Sam’s adjusted basis for his stock is $100,000 and Lois’ adjusted basis for her stock is $90,000. Beige’s earnings and profits are $500,000. Beige redeems 200 of Lois’ shares for $150,000. Determine the amount of Lois’ recognized gain (1) if she is Sam’s mother and (2) if they are unrelated.a. $0 and $0.b. $150,000 and $60,000.c. $150,000 and $90,000.d. $50,000 and $150,000.e. None of the above.

____ 21. Shania, Taylor, and Kelly form a corporation with the following contributions.

Basis FMVShania:

Cash $100,000 $100,000Taylor:

Land 60,000 100,000Kelly:

Building 110,000 100,000

a. If the corporation is a C corporation, Taylor has a recognized gain of $40,000, a stock basis of $100,000, and the corporation has a basis for the land of $100,000.

b. If the corporation is an S corporation, Kelly has a recognized gain or loss of $0, a stock basis of $110,000, and the corporation has a basis for the building of $110,000.

c. If the corporation is a C corporation, Shania has a recognized gain or loss of $0, a stock basis of $100,000, and the corporation has a basis for the cash of $100,000.

d. Only a. and c. are correct.e. Only b. and c. are correct.

____ 22. Barb and Chuck each own one-half of the stock of Wren, Inc., a C corporation. Each shareholder has a stock basis of $125,000. Wren has accumulated E & P of $200,000. Wren’s taxable income for the current year is $90,000, and it distributes $60,000 to each shareholder. Barb’s stock basis at the end of the year is:a. $0.b. $65,000.c. $110,000.d. $125,000.e. None of the above.

____ 23. Barb and Chuck each own one-half the stock of Wren, Inc., an S corporation. Each shareholder has a stock basis of $125,000. Wren has no accumulated E & P. Wren’s taxable income for the current year is $90,000, and it distributes $60,000 to each shareholder. Barb’s stock basis at the end of the year is:a. $0.b. $65,000.c. $110,000.d. $125,000.e. None of the above.

____ 24. Barb and Chuck each have a 50% ownership in Wren Partnership. Each partner has a partnership interest basis of $125,000. Wren’s taxable income for the current year is $90,000, and it distributes $60,000 to each partner. Barb’s basis in the partnership interest at the end of the year is:a. $0.b. $65,000.c. $110,000.d. $125,000.e. None of the above.

____ 25. Trolette contributes property with an adjusted basis of $80,000 and a fair market value of $100,000 to a newly formed business entity. If the entity is a C corporation and the transaction qualifies under § 351, the corporation’s basis for the property and the shareholder’s basis for the stock are:

Asset Basis Stock Basisa. $ 80,000 $100,000b. $100,000 $ 80,000c. $ 80,000 $ 80,000d. $100,000 $100,000e. None of the above.

____ 26. Alanna contributes property with an adjusted basis of $80,000 and a fair market value of $100,000 to a newly formed business entity. If the entity is a partnership and the transaction qualifies under § 721, the partnership’s basis for the property and the partner’s basis for the partnership interest are:


____ 27. Marcus contributes property with an adjusted basis of $80,000 and a fair market value of $100,000 to a newly formed business entity. If the entity is an S corporation and the transaction qualifies under § 351, the S corporation’s basis for the property and the shareholder’s basis for the stock are:


____ 28. Brenda contributes appreciated property (i.e., adjusted basis of $65,000 and a fair market value of $100,000) to her business entity in a transaction which qualifies for nonrecognition of gain. Brenda’s ownership interest is 60%. The business entity later sells the appreciated property for $110,000. The property is not depreciable. Which of the following statement(s) is correct?a. If the entity is a partnership, Brenda’s gross income is increased by $41,000 [($35,000

100%) + ($10,000 60%)] in the year of the sale of the property by the partnership.b. If the entity is a C corporation, the corporation’s gross income is increased by $10,000 in

the year of the sale of the property by the corporation.c. If the entity is an S corporation, the S corporation’s gross income is increased by $10,000

in the year of the sale of the property by the S corporation and Brenda’s gross income is increased by $6,000 ($10,000 60%).

d. All of the above.e. None of the above.

____ 29. Alice contributes equipment (fair market value of $50,000; adjusted basis of $15,000), subject to a $10,000 liability, to form Orange Partnership, a general partnership. Mary contributes $40,000 cash. Alice and Mary share equally in partnership profits and losses. What is Alice’s and Mary’s basis for their partnership interests?a. $10,000 to Alice, $45,000 to Mary.b. $25,000 to Alice, $25,000 to Mary.c. $15,000 to Alice, $40,000 to Mary.d. $5,000 to Alice, $40,000 to Mary.e. $20,000 to Alice, $45,000 to Mary.

____ 30. Melba contributes land (basis of $190,000; fair market value of $250,000) to a business entity in exchange for 100% of the stock. During the first year of operations, the entity earns a profit of $75,000. At the end of the first year, the entity has outstanding liabilities of $30,000 ($20,000 recourse and $10,000 nonrecourse).a. If the entity is a C corporation, Melba’s basis for her stock at the end of the first year is

$265,000 ($190,000 + $75,000) and her at-risk basis is $265,000. b. If the entity is a partnership, Melba’s basis for her partnership interest (outside basis) at

the end of the first year is $355,000 ($250,000 + $75,000 + $30,000) and her at-risk basis is $345,000 ($250,000 + $75,000 + $20,000).

c. If the entity is an S corporation, Melba’s basis for her stock at the end of the first year is $345,000 ($250,000 + $75,000 + $20,000) and her at-risk basis is $345,000.

d. Only a. and c. are correct.e. a., b., and c. are incorrect.

____ 31. Catfish, Inc., a closely held corporation which is not a PSC, owns a 45% interest in Trout Partnership, which is classified as a passive activity. Trout’s taxable loss for the current year is $250,000. During the year, Catfish receives a $60,000 cash distribution from Trout. Other relevant data for Catfish are as follows:

Net income from operations $800,000Dividend income 25,000Rent income 20,000

How much of Catfish’s share of Trout’s loss may it deduct in calculating its taxable income?a. $0.b. $20,000.c. $45,000.d. $112,500.e. None of the above.

____ 32. Bart contributes $160,000 to the Tuna Partnership for a 30% interest. During the first year of operations, Tuna has a profit of $30,000. At the end of the first year, Tuna has outstanding loans from the following banks.

First Bank (recourse) $20,000Second Bank (nonrecourse) 40,000

What is Bart’s at-risk basis in Tuna at the end of the first year?a. $160,000.b. $169,000.c. $175,000.d. $187,000.e. None of the above.

____ 33. Which of the following special allocations are mandatory for the partners in a partnership?a. Section 704(a) special allocation requiring limited partners to share losses in accordance

with their capital interests in the partnership.b. Section 704(c) special allocation for the difference between the adjusted basis and fair

market value of contributed property.c. Section 734 (optional adjustment to basis) special allocation for distributions to partners

when the partnership does have a § 754 election in effect or does make a § 754 election.d. Only b. and c. are mandatory.e. a., b., and c. are mandatory.

____ 34. Albert’s sole proprietorship owns the following assets:

Adjusted Basis Fair Market ValueAccounts receivable $ –0– $ 60,000Inventory 20,000 30,000Machinery and equipment* 50,000 90,000Buildings** 120,000 170,000Land 80,000 140,000

$270,000 $490,000

* Potential § 1245 recapture of $45,000.** Straight-line depreciation was used.

Albert sells his sole proprietorship for $500,000. Calculate Albert’s recognized gain or loss and classify it as capital or ordinary.a. $230,000 ordinary income.b. $230,000 capital gain.c. $115,000 ordinary income and $115,000 capital gain.d. $110,000 ordinary income and $120,000 capital gain.e. None of the above.

____ 35. Mr. and Ms. Smith’s partnership owns the following assets:


$270,000 $490,000


Mr. and Ms. Smith each have a basis for their partnership interest of $135,000. Calculate their combined recognized gain or loss and classify it as capital or ordinary if they sell their partnership interests for $500,000.a. $230,000 ordinary income.b. $230,000 capital gain.c. $115,000 ordinary income and $115,000 capital gain.d. $110,000 ordinary income and $120,000 capital gain.e. None of the above.

____ 36. Kristine owns all of the stock of a C corporation which owns the following assets:


$270,000 $490,000


Her adjusted basis for her stock is $270,000. Calculate Kristine’s recognized gain or loss and classify it as capital or ordinary if she sells her stock for $500,000.a. $230,000 ordinary income.b. $230,000 capital gain.c. $115,000 ordinary income and $115,000 capital gain.d. $110,000 ordinary income and $120,000 capital gain.e. None of the above.

____ 37. Devon owns 40% of the Agate Company for which his basis is $300,000. He sells one-fourth of his ownership interest to Bernice for $100,000. Which of the following statements is correct?a. If Agate is an S corporation, Devon has a recognized gain of $25,000, some of which may

be capital and some of which may be ordinary income.b. If Agate is a C corporation, Devon has a recognized capital gain of $25,000.c. If Agate is a partnership, Devon has a recognized capital gain of $25,000.d. Only b. and c. are correct.e. a., b., and c. are correct.

____ 38. Which of the following statements is correct?a. The sale of an unincorporated sole proprietorship is always treated as the sale of the

individual business assets.b. The sale of a partnership is treated as the sale of the individual assets only if the sales

transaction is structured as the sale of the individual assets.c. The sale of a corporation is either treated as the sale of the corporate stock or as the sale of

the individual assets.d. Only a. and b. are correct.e. a., b., and c. are correct.

____ 39. Which of the following statements is correct?a. The purchase of an unincorporated sole proprietorship is always treated as the purchase of

the individual business assets.b. A taxpayer purchasing a corporation in which the assets are appreciated would prefer to

purchase the stock of the corporation.c. The purchase of a corporation is always treated as the purchase of the corporate stock.d. Only a. and b. are correct.e. a., b., and c. are correct.

Matching

Match the following tax attributes with the different forms. A particular attribute may apply to more than one entity form.a. Ability of all owners to have limited liability.b. Ability to pass tax attributes through to the owners.c. Right of all owners to participate in the management of the business.d. Number of owners is limited.e. Ability to have multiple owners.

____ 1. S corporation

____ 2. C corporation

____ 3. Limited partnership

____ 4. General partnership

____ 5. Sole proprietorship

Match the following statements:a. Transaction in this form enables double taxation to be avoided.b. Gain or loss is calculated separately for each asset and is subject to single taxation.c. Subject to double taxation.d. The sale is treated as the sale of a capital asset under § 741 subject to ordinary income

potential under § 751.e. Not subject to double taxation on the sale of corporate stock.

____ 6. Sale of the individual assets of an unincorporated sole proprietorship by the owner.

____ 7. Sale of the corporate assets by the C corporation.

____ 8. Sale of corporate stock by the C corporation shareholders.

____ 9. Sale of corporate stock by the S corporation shareholders.

____ 10. Sale of an ownership interest by a partner.

Match the following statements:a. For the corporate taxpayer, are taxed using the regular tax rates.b. Must be capitalized, but can be amortized over 180 months.c. For the corporate taxpayer, the rate is 20%.d. For the corporate taxpayer, cannot be deducted at all in the current tax year.e. For the corporate taxpayer, limited to 10% of taxable income before certain deductions.

____ 11. Organization costs

____ 12. Alternative minimum tax

____ 13. Net capital gain

____ 14. Net capital loss

____ 15. Charitable contributions

Match the following:a. Contribution of appreciated property to the business entity by an owner is never subject to

taxation.b. Realized gains on the contribution of appreciated property to the entity are not recognized

by the contributor when an 80% control requirement is satisfied.c. Realized losses on the contribution of loss property to the entity are never recognized by

the contributor.d. Realized losses on the contribution of loss property to the entity are recognized by the

contributor unless an 80% control requirement is satisfied.e. Basis of ownership interest to the owner is dependent on whether gain or loss is

recognized to the owner on the contribution of assets to the business entity.

____ 16. S corporation

____ 17. C corporation

____ 18. Limited partnership

____ 19. General partnership

Match the following statements:a. Status applies only if elected by the taxpayer.b. Not making distributions to shareholders.c. Rate for a corporate taxpayer is 20%.d. Subject to double taxation.e. Eligible for special allocations.

____ 20. Technique for minimizing double taxation

____ 21. AMT

____ 22. S corporations

____ 23. C corporations

____ 24. Partnerships

Problem

1. Agnes is going to invest $90,000 in a business entity. She will manage the business entity. Her projected share of the loss for the first year is $36,000. Agnes’ marginal tax rate is 33%. Determine the cash flow benefit of the loss to Agnes if the business form is:

a. A general partnership.

b. An S corporation.

c. An LLC.

d. A C corporation.

2. Candace, who is in the 33% tax bracket, is establishing a business which could have potential environmental liability problems. Therefore, she is trying to decide between the C corporation form and the S corporation form. She projects that the business will generate earnings of about $75,000 each year. Advise Candace on the tax consequences of each tax form.

3. Mallard, Inc., is a C corporation that is not eligible for the small business exception to the AMT. Its adjusted current earnings (ACE) and unadjusted alternative minimum taxable income (unadjusted AMTI) for 2011 and 2012 are as follows:

2011 2012ACE $212,000 $250,000Unadjusted AMTI 175,000 300,000

Calculate the amount of the ACE adjustment for 2011 and 2012.

4. Saul’s AMT base is $300,000. Green, Inc.’s (a C corporation) AMT base also is $300,000.

a. Calculate the tentative AMT for Saul.

b. Calculate the tentative AMT for Green, Inc.

c. Why are the amounts in a. and b. not the same since the AMT base for both is $300,000?

d. Would your answer in b. change if Green, Inc. was an S corporation?

5. Kirby, the sole shareholder of Falcon, Inc., leases a building to the corporation. The taxable income of the corporation for 2011, before deducting the lease payments, is projected to be $300,000.

a. What are the tax consequences to Kirby and to Falcon if Kirby leases a building to the corporation for $280,000?

b. Is there a potential pitfall? How would it change the tax consequences to Kirby and to Falcon?

6. Blue, Inc., has taxable income before salary payments to its president of $700,000 in 2011. Blue is in the 34% tax bracket, and the president is in the 35% tax bracket.

a. Calculate the tax liability to Blue if the president’s salary is $400,000 and if it is $100,000.

b. What tax benefit is there of paying the larger salary to the president?

c. What negative tax result may occur associated with the payment of the higher salary?

7. Albert and Bonnie each own 50% of the stock of Crow, Inc. (a C corporation). To cover what is perceived as temporary working capital needs, each shareholder loans Crow $150,000 with an annual interest rate of 5% (same as the Federal rate) and a maturity date of one year. The loan is made at the beginning of 2011.

a. What are the tax consequences to Albert, Bonnie, and Crow if the loans are classified as debt?

b. What are the tax consequences to Albert, Bonnie, and Crow if the loans are classified as equity?

8. Daisy, Inc., has taxable income of $850,000 during 2011, its first year of operations. Daisy distributes dividends of $200,000 to its 10 shareholders (i.e., $20,000 each). Daisy earmarks $361,000 of its earnings for potential future expansion into other cities.

a. Calculate Daisy’s total tax liability associated with the current tax year if the $361,000 is treated as representing reasonable needs of the business.

b. Calculate Daisy’s total potential tax liability associated with the current tax year if none of the $361,000 qualifies as reasonable needs of the business.

9. Eagle, Inc. recognizes that it may have an accumulated earnings tax problem. According to its calculation, Eagle anticipates it has accumulated taxable income, before reduction for dividends paid, of $600,000 in 2011. Assume that its shareholders are in the 35% marginal tax bracket.

a. Calculate the maximum amount of tax that Eagle and its shareholders might pay if the accumulated earnings tax is assessed.

b. Calculate the maximum amount of tax that Eagle and its shareholders might pay if it distributes dividends to prevent an accumulated earnings tax assessment from occurring.

10. Swallow, Inc., is going to make a distribution of $550,000 to Marjean who is in the 35% tax bracket.

a. Determine the tax liability to Marjean if the form of the distribution is a dividend.

b. Determine the tax liability to Marjean if the form of the distribution is a stock redemption. Assume Marjean’s adjusted basis for the stock redeemed is $400,000 and that she has owned the stock for five years.

11. Kirk is establishing a business in 2011 which could have potential environmental liability problems. Therefore, he is trying to decide between the C corporation form and the S corporation form. He projects that the business will generate losses of approximately $100,000 each year for the first 3 years and then will generate profits of at least $200,000 each year thereafter. All profits will be reinvested in the growth of the business. Kirk projects he will be in the 35% bracket in 2011 and thereafter. Advise Kirk on which tax form he should select.

12. Melanie and Sonny form Bird Enterprises. Sonny contributes cash of $100,000 and land worth $50,000 (adjusted basis of $30,000). Melanie contributes land and building worth $280,000 (adjusted basis of $200,000) and performs services worth $20,000 associated with the formation of the entity. Melanie receives a two-thirds ownership interest and Sonny receives a one-third ownership interest. Determine the tax consequences of the contributions to Melanie, Sonny, and Bird if the business is:

a. An S corporation.

b. A C corporation

c. A partnership.

13. Sam and Vera are going to establish a business. Sam will contribute cash of $100,000 for a 50% interest, and Vera will contribute land and a building worth $135,000 (adjusted basis of $65,000) for a 50% interest. The land and building is encumbered by a $35,000 mortgage which the entity assumes. Determine the tax consequences of the contribution to Sam, Vera, and the entity if the business is:

a. An S corporation.

b. A partnership.

c. A C corporation.

14. Colin and Reed formed a business entity several years ago. At that date, Colin’s basis for his ownership interest was $40,000 and Reed’s basis for his ownership interest was $50,000. Colin’s profit and loss percentage is 40% and Reed’s profit and loss percentage is 60%. During the intervening period, the entity has reported profits of $200,000. At the beginning of the current year, the entity had liabilities (all recourse) of $50,000. At the end of the current year, the liabilities (all recourse) had increased to $70,000. Determine Colin and Reed’s basis for their ownership interest if the entity is:

a. A partnership.

b. A C corporation.

c. An S corporation.

15. Ashley contributes property to the TCA Partnership which was formed 7 years ago by Clark and Tara. Ashley’s basis for the property is $70,000 and the fair market value is $150,000. Ashley receives a 25% interest for his contribution. Because the TCA Partnership is unsuccessful in having the property rezoned from agricultural to commercial, it sells the property 12 months later for $210,000.

a. Determine the tax consequences to Ashley and to the partnership on the contribution of the property to the partnership.

b. Determine the tax consequences to Ashley and the other partners on the sale of the property.

c. Would the tax consequences in b. differ if the entity were an S corporation?

16. Alice has a 70% interest in a business entity. Her basis for her ownership interest is $260,000. The net income of the business for the tax year is $100,000 and the entity liabilities have increased by $50,000. Determine the effect of the earnings and the liabilities on Alice’s basis for her ownership interest if the business is:

a. A C corporation.

b. An S corporation.

c. A partnership.

17. Wren, Inc. is owned by Alfred (30%) and Mabel (70%). Alfred’s marginal tax rate is 25% and Mabel’s marginal tax rate is 33%. Wren’s taxable income for 2011 is $400,000.

a. Determine the amount of the distribution that Wren would make to enable Alfred and Mabel to pay their tax liabilities associated with Wren’s $400,000 taxable income if Wren is an S corporation.

b. If Wren is a C corporation.

18. Eagle, Inc., a C corporation, distributes $250,000 to its shareholder, Jean, and land worth $250,000 (adjusted basis of $190,000) to its shareholder, Pam. Eagle has earnings and profits of $700,000. Determine the tax consequences to Eagle, Jean, and Pam.

19. Maurice purchases a bakery from Philip for $410,000. He spends an additional $150,000 (financed with a nonrecourse loan) updating the bakery equipment. During the first year of operations as a sole proprietorship, the bakery incurs a loss of $125,000. Maurice has $300,000 of salary income as the chief financial officer of a publicly-traded corporation. He has interest income of $30,000 and dividend income of $50,000.

a. What amount can Maurice deduct for the loss if he is a material participant?

b. What amount can Maurice deduct for the loss if he is not a material participant?

20. Lee owns all the stock of Vireo, Inc., a C corporation for which he has an adjusted basis of $150,000. The assets of Vireo, Inc., are as follows:

Adjusted Basis FMV Cash $35,000 $35,000Accounts receivable 20,000 20,000Inventory 22,000 25,000Building 28,000 30,000Land 40,000 90,000

Lee sells his stock to Katrina for $200,000.

a. Determine the tax consequences to Lee.

b. Determine the tax consequences to Katrina.

c. Determine the tax consequences to Vireo, Inc.

21. Ralph owns all the stock of Silver, Inc., a C corporation for which his adjusted basis is $225,000. Ralph founded Silver 12 years ago. The assets and liabilities of Silver are as follows:

Assets Basis FMV Cash $ 15,000 $ 15,000Accounts receivable –0– 25,000Inventory 30,000 35,000Machinery and equipment* 70,000 90,000Land 60,000 150,000

$175,000 $315,000

Liabilities Basis FMV Accounts payable $ 5,000 $ 5,000Notes payable 10,000 10,000

$15,000 $15,000

*Accumulated depreciation of $55,000 has been deducted.

Ralph and the purchaser, Marilyn, have agreed to a purchase price of $350,000 less any outstanding liabilities. They are both in the 35% tax bracket, and Silver is in the 34% tax bracket.

a. Advise Ralph on whether the form of the sales transaction should be a stock sale or an asset sale.

b. Advise Marilyn on whether the form of the purchase transaction should be a stock purchases or an asset purchase.

Essay

1. Included among the factors that influence the choice of the form of a business entity are the following:

Capital formation.

Limited liability.

Estimated life of the business.

Number of owners and their roles in the management of the business.

Freedom of choice in transferring ownership interest.

Organizational formality including the related cost and extent of governmental regulations.

Evaluate the validity of the statement.

2. Lisa is considering investing $25,000 in a limited partnership which is raising additional capital. According to the prospectus, for the past 10-year period the average earnings have been 15% and for the past 5-year period the average earnings have been 8%. Lisa is in the 33% tax bracket.

a. List some factors Lisa should consider in making a decision on the potential investment.

b. Assuming the partnership finances its activities with equity rather than debt, what is the maximum cash flow benefit Lisa can receive if the partnership generates losses?

3. Which of the following business entity forms are subject to single taxation on the profits and which are subject to double taxation?

a. Sole proprietorship.

b. Partnership.

c. C corporation.

d. S corporation.

e. LLC.

4. List some techniques which can be used to avoid and/or reduce double taxation for a C corporation.

5. List some techniques for reducing and/or avoiding double taxation by making distributions to the shareholders that are deductible to the corporation.

6. What is the major pitfall associated with attempting to reduce and/or avoid double taxation by a corporation not making distributions to shareholders?

7. Why does stock redemption treatment for an individual shareholder produce more favorable tax consequences than a dividend?

8. What special adjustment is required in calculating the AMT of a C corporation that does not apply in calculating the AMT of an individual taxpayer?

9. What tax rates apply for the AMT for an individual taxpayer and for a C corporation?

10. To which of the following entities does the AMT apply?

Sole proprietorship.

Partnership.

LLC.

S corporation.

C corporation.

11. How can double taxation be avoided or reduced by owning assets outside a C corporation?

12. Normally a C corporation shareholder would prefer to receive a return of capital distribution (e.g., stock redemption) rather than a dividend distribution. Provide an example of where the opposite is true.

13. Aubrey has been operating his business as a C corporation for the past 5 years. The corporation pays him a reasonable salary. The profits of the corporation, after paying Federal income tax, are distributed to him each year as a dividend. He is considering electing S status for his corporation in order to avoid double taxation. What factors should he consider assuming after-tax earnings will continue to be distributed to him?

14. Why are S corporations not subject to the accumulated earnings tax?

15. Marsha is going to contribute the following assets to a business entity in exchange for an ownership interest.

Adjusted Basis FMVCash $100,000 $100,000Land and building 60,000 95,000

What are the tax consequences of the contribution to Marsha if the business entity is a(n):

a. Sole proprietorship?

b. Partnership?

c. C corporation?

d. S corporation?

16. Gladys contributes land with an adjusted basis of $70,000 and a fair market value of $100,000 to a business entity in which she is an 80% owner on the first day of the tax year. Discuss the tax consequences to Gladys if the business entity sells the land six months later for $130,000 if:

a. The business entity is a partnership?

b. The business entity is a C corporation?

c. The business entity is an S corporation?

17. Terry has a 20% ownership interest in a business for which his basis is $100,000. During the year, the entity earns profits of $90,000 and makes cash distributions to the owners of $50,000. How do these transactions affect Terry’s basis if:

a. The entity is a C corporation?

b. The entity is a general partnership?

c. The entity is an S corporation.

18. A business entity has appreciated land (basis of $50,000 and fair market value of $75,000) which it is going to distribute to Craig, one of its owners. The entity has earned substantial profits during its 15 years of operations and has reinvested most of them in the business. What are the tax consequences of the distribution to the business entity and to Craig if the business entity is a(n):

a. C corporation?

b. S corporation?

c. Partnership?

19. In calculating the owner’s initial basis for an ownership interest, which of the following business entity forms have a carryover basis and which have a stepped-up or stepped-down basis associated with its formation?

a. C corporation.

b. S corporation.

c. Partnership.

20. Under what circumstances, if any, do the § 469 passive activity loss rules apply to C corporations?

21. For a C corporation to be classified as a personal service corporation (PSC) for § 469 purposes, what requirements must be satisfied?

22. Do the § 465 at-risk rules apply to partnerships, LLCs, and S corporations?

23. Do the § 465 at-risk rules treat recourse debt and nonrecourse debt differently?

24. With respect to special allocations, is the S corporation treated more like a partnership or a C corporation?

25. Agnes owns a sole proprietorship for which the assets have appreciated in value. If she is going to sell the business to Abner, should she structure the sale as (1) a sale of the individual assets or (2) a sale of the sole proprietorship?

26. Peter is going to purchase the assets of Kirsten’s sole proprietorship. The assets of Kirsten’s sole proprietorship have appreciated in value. From Peter’s perspective, does it matter whether the purchase is structured as (1) the purchase of the individual assets or (2) the purchase of the sole proprietorship?

27. Ralph wants to purchase either the stock or the assets of Red, Inc., a C corporation.

a. Under what circumstances would Ralph prefer to purchase the stock from the shareholders?

b. Under what circumstances would Ralph prefer to purchase the assets from the corporation?

28. Walter wants to sell his wholly-owned C corporation, Cream, Inc. The fair market value of his stock exceeds the corporation’s adjusted basis for the assets. Should Walter sell his stock or have Cream sell its assets and make a liquidating distribution to him?

29. In the sale of a partnership, does the way the sale is structured (i.e., sale of the partnership interests versus the sale of the assets) produce different tax consequences?

Chapter 13Answer Section

TRUE/FALSE

1. ANS: TIn most instances the legal form and the tax form of a business entity are the same. However, in some cases, the IRS may attempt to tax a business entity in a manner different from its legal form.

PTS: 1 DIF: 1 REF: p. 13-3 OBJ: 1NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

2. ANS: FThe maximum individual tax rate of 35% in 2011 is the same as the maximum C corporation tax rate of 35% (except for the 39% rate and the 38% rate during the phaseout). However, what is relevant is the actual rate that applies in a particular situation. For example, the 34% rate could apply in a particular situation for the C corporation form, whereas the 10%, 15%, 25%, 28%, or 33% rate could apply for the sole proprietorship or partnership form.

PTS: 1 DIF: 1 REF: p. 13-3 OBJ: 1NAT: AICPA FN-Measurement | AACSB Analytic MSC: 2 min

3. ANS: TThe check-the-box Regulations provide an elective procedure that enables certain entities to be classified as partnerships for Federal income tax purposes even though they have corporate characteristics.


4. ANS: T PTS: 1 DIF: 1 REF: p. 13-3OBJ: 1 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

5. ANS: FA limited liability company (LLC) can choose under the check-the-box provisions to be taxed as a partnership or as a C corporation but not as an S corporation.


6. ANS: TIf an LLC elects to be taxed as a partnership, it files a Form 1065. If an LLC elects to be taxed as a C corporation, it files a Form 1120.


7. ANS: TEach of these types of entities can pass profits and losses through to the owners.


8. ANS: F

Nontax factors may be more or less important in a particular circumstance. Above all, the business decision should make economic sense.


9. ANS: TBoth the § 465 at-risk provision and the § 469 passive activity loss provision have reduced the tax attractiveness of investments in real estate for entities taxed as partnerships.


10. ANS: T PTS: 1 DIF: 1 REF: p. 13-4 to 13-6OBJ: 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

11. ANS: FBoth entities are corporations under local law. Thus, they both have limited liability. The S election only affects the tax status.


12. ANS: FThe general partner (or partners) has unlimited liability.


13. ANS: TThe limited partnership form provides limited liability for the limited partners. However, there must be at least one general partner who has unlimited liability. Such liability protection would be available only if the general partner is a corporation.

PTS: 1 DIF: 1 REF: p. 13-5 | p. 13-6 | Figure 13.1OBJ: 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

14. ANS: FA comparative calculation must be made to see which entity will produce the smaller tax liability. Factors that influence this include the tax rates which apply to the C corporation and its distribution policy.

PTS: 1 DIF: 1 REF: p. 13-6 | p. 13-7OBJ: 3 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

15. ANS: TThe $111,950 is the appropriate tax liability unless Lime is a personal service corporation. However, if Lime is a PSC, the tax liability is $115,500 ($330,000 35%).

PTS: 1 DIF: 1 REF: p. 13-3 | p. 13-6OBJ: 1 | 3 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 5 min

16. ANS: TOnly in limited circumstances is Federal income tax imposed at the S corporation level (e.g., built-in gains tax and passive investment income tax).

PTS: 1 DIF: 1 REF: p. 13-18 | Concept Summary 13.2OBJ: 3 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

17. ANS: TDouble taxation can occur only when distributions are made to the shareholders. If no distributions are made, double taxation will not occur. Other techniques also exist such as salary payments to shareholder-employees, lease rental payments to shareholder-lessors, and interest payments to shareholder-creditors.

PTS: 1 DIF: 1 REF: p. 13-11 | p. 13-12OBJ: 4 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

18. ANS: FIf an S corporation election is terminated, another election generally is not available for five years.


19. ANS: FThe full amount of the dividend is included in the shareholder’s gross income, whereas only part of the stock redemption (i.e., return of capital concept applies to stock redeemed) is included in the shareholder’s gross income.

PTS: 1 DIF: 1 REF: Example 8 | Example 9 | Figure 13.2OBJ: 3 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

20. ANS: FIf the C corporation is classified as a small corporation for AMT purposes, there is no AMT effect on the shareholders.


21. ANS: T PTS: 1 DIF: 1 REF: p. 13-8OBJ: 3 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

22. ANS: FThe AMT rate for a C corporation is 20%. For an S corporation, all AMT adjustments and preferences pass through to the shareholders. For shareholders who are individuals, the AMT rates are 26% and 28%.


23. ANS: FThe AMT tax rate for a C corporation (20%) can be greater than or less than the regular tax rate (minimum of 15% and maximum of 39%).


24. ANS: FOnly C corporations have an AMT adjustment for adjusted current earnings (ACE).


25. ANS: FThe ACE adjustment can be either positive or negative. Note, however, that the total negative adjustments for ACE cannot exceed the total positive adjustments.


26. ANS: FSome states do not permit an S corporation election.


27. ANS: TFor certain fringe benefits, the recipient must be an “employee.” For this purpose, partners are not treated as employees, whereas shareholders of a C corporation who are employed by the corporation are treated as employees. For these fringe benefit purposes, an S corporation is treated as a partnership and a greater than 2% shareholder is treated as a partner.


28. ANS: TExamples of such favorably taxed fringe benefits are the § 119 meals and lodging and the § 79 group term life insurance exclusions.


29. ANS: FOnly C corporations are subject to double taxation on current earnings.


30. ANS: TThe key issue is whether the compensation is reasonable. However, to the extent reclassified as unreasonable by the IRS, the salary deduction is converted to a nondeductible dividend.

PTS: 1 DIF: 1 REF: p. 13-11 | p. 13-12 | Example 11OBJ: 4 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

31. ANS: FThe unreasonable amount of the lease rental payment is classified as a dividend rather than as a rental expense for the C corporation. Therefore, the taxable income of the corporation increases. From the perspective of the shareholder, gross income does not change. The unreasonable amount of the lease rental is classified as dividend income rather than as lease rental income. Note, however, that there is a beneficial effect on the shareholder from the reclassification to a dividend due to the beneficial tax rate on qualified dividends (i.e., 15%/0%).


32. ANS: FIn this situation, the repayment of the debt by the corporation is treated as a dividend only to the extent of E & P. Otherwise, the debt repayment is treated as a return of capital.

PTS: 1 DIF: 1 REF: p. 13-11 | p. 13-12 | Example 12OBJ: 4 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

33. ANS: TBoth actual dividends and deemed (constructive) dividends result in double taxation, assuming adequate E & P.

PTS: 1 DIF: 1 REF: Example 12 OBJ: 4NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

34. ANS: FThis technique has the potential for avoiding double taxation. Combining the absence of dividend distributions with the step-up in stock basis rules for property passing through estates could avoid taxation at the shareholder level (i.e., stock basis equals fair market value). However, unless the earnings retentions are supported by reasonable business needs, the accumulated earnings tax may apply.


35. ANS: FThe accumulated earnings tax rate is 15%. The highest tax rate for a corporation is 35%.


36. ANS: FThe accumulated earnings tax can be avoided if the corporation has reasonable needs for retaining the earnings in the business. Plans to distribute earnings in the future will not avoid the tax.


37. ANS: TS corporations are not subject to the accumulated earnings tax.


38. ANS: FSince Gold redeemed only 75% of Roger’s shares, only 75% of his adjusted basis is used in calculating his recognized gain.

Amount realized $650,000 Adjusted basis ($500,000 75%) (375,000)Recognized gain $275,000

PTS: 1 DIF: 1 REF: p. 13-13 | Example 14OBJ: 4 NAT: AICPA FN-Measurement | AACSB Analytic

MSC: 2 min39. ANS: F

Additional data is needed before concluding that a loss corporation should automatically elect S corporation status. Additional data that would be useful are the marginal tax rates of the shareholders, whether losses or profits are expected in subsequent tax years, and the projected marginal tax rates for the C corporation if the S election is not made.

PTS: 1 DIF: 1 REF: p. 13-14 | Example 15OBJ: 4 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

40. ANS: FTan’s adjusted basis for the land is $30,000, the same as Dave’s adjusted basis prior to the transfer. Dave’s adjusted basis for the stock is $3,000 ($30,000 – $27,000).


41. ANS: FSpecial allocations apply to partnerships and not to S corporations. The $40,000 recognized gain is allocated based on stock ownership; that is, $20,000 to Amos and $20,000 to Carol.


42. ANS: FPartnerships are required to make such an allocation under § 704(c).

PTS: 1 DIF: 1 REF: p. 13-15 | p. 13-16 | Example 16OBJ: 5 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

43. ANS: TSection 351 does result in the application of the carryover basis rule. Therefore, the shareholder’s adjusted basis will carry over to the corporation.


44. ANS: FThe $90,000 gain is calculated at the S corporation level. The $90,000 gain flows through to the shareholders based on stock ownership (i.e., for Wally, 30% $90,000 = $27,000) since the entity is an S corporation. If the transaction were a contribution to a partnership under § 721, there is a special allocation of the $90,000 gain under § 704 (c) with $76,000 going to Wally, the contributing partner.


45. ANS: T

If a partner contributes property to a partnership in exchange for an ownership interest, any realized gain or loss is not recognized. If a shareholder contributes property to a C corporation in exchange for an ownership interest, any realized gain or loss is not recognized only if the 80% control requirement is satisfied. While failing the 80% control requirement can happen at the time of the creation of the corporation, it is more likely to occur with subsequent shareholder contributions.


46. ANS: FIf the business is a C corporation, the corporate profits have no effect on a shareholder’s basis in the stock. However, if the business is a partnership, LLC, or S corporation, Taylor’s basis for her ownership interest will increase.


47. ANS: TC corporation profits have no effect on a shareholder’s stock basis. However, under the conduit concept, S corporation profits increase a shareholder’s stock basis.


48. ANS: TWhile the S corporation is generally a tax reporter rather than a taxpayer (i.e., the situation for a C corporation), the S corporation may be subject to Federal income tax on built-in gains and on certain passive investment income.

PTS: 1 DIF: 1 REF: p. 13-18 | Concept Summary 13.2OBJ: 5 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

49. ANS: TThe same rules apply to C corporations and S corporations with respect to distributions of appreciated property, and gain is recognized at the corporate level.


50. ANS: TThe cash distribution reduces Samantha’s basis for her partnership interest from $85,000 to $0 ($85,000 – $85,000). She has a $10,000 ($10,000 – $0) recognized gain.


51. ANS: FPersonal service corporations cannot offset passive activity losses against either active income or portfolio income. A closely held corporation that is not a PSC can offset passive activity losses against active income, but not against portfolio income.


52. ANS: FThe § 704(c) allocations are not available to S corporations.


53. ANS: FThe seller would prefer to sell the stock in order to avoid double taxation.


54. ANS: FIf the entity has unrealized receivables or substantially appreciated inventory, some or all of the recognized gain may be classified as ordinary income under § 751.

PTS: 1 DIF: 1 REF: p. 13-24 | Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 5 min

55. ANS: FSection 1244 ordinary loss treatment is available to both groups of shareholders.

PTS: 1 DIF: 1 REF: Concept Summary 13.2OBJ: 6 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min

MULTIPLE CHOICE

1. ANS: A PTS: 1 DIF: 1 REF: p. 13-3OBJ: 1 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

2. ANS: DA limited liability company is a hybrid business form which combines the corporate characteristic of limited liability for the owners with the tax characteristics of the partnership. Under the check-the-box regulations, normally the election is made to tax an LLC as a partnership. However, the election could be made to tax the entity as a C corporation. In this case, the LLC would be subject to double taxation (choice a.). If no election is made, the entity will be taxed as a partnership.


3. ANS: DA limited liability company is a hybrid business form that combines the corporate characteristic of limited liability for the owners with the tax characteristics of the partnership. The LLC can elect under the check-the-box procedure to be taxed as a partnership or as a C corporation. If no election is made, it will be taxed as a partnership.


4. ANS: DEven though the LLC possesses corporate characteristics (choice b.), it can elect to be taxed as a partnership (choice c.).


5. ANS: DThe greater the number of potential owners results in the greater ability to raise capital. An S corporation is subject to a statutory limit of 100 unrelated shareholders. There is no limit on the number of shareholders for a C corporation (choice a.). A partnership can have more owners than a sole proprietorship (choice c.). A limited partnership can have more owners than a general partnership (choice b.).


6. ANS: DSingle versus double taxation is a tax factor.


7. ANS: DAmber has the following positive adjustments and preferences:

Depreciation ($52,000 – $41,000) $11,000Depletion in excess of basis ($65,000 – $39,000) 26,000

$37,000

The stock options are a positive adjustment of $19,000 ($49,000 – $30,000) for Amber’s president rather than for Amber. Charitable contributions are neither a tax preference nor an adjustment.

Taxable income $212,000Plus: Adjustments and preferences 37,000AMTI $249,000

PTS: 1 DIF: 2 REF: p. 13-8 | Chapter 3OBJ: 3 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 10 min

8. ANS: EThe individual AMT rates are 26% and 28% and the C corporation rate is 20%.


9. ANS: E PTS: 1 DIF: 1 REF: p. 13-10OBJ: 4 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

10. ANS: DTo qualify for exclusion treatment under § 119, Maria must be an employee. Thus, the exclusion is not available if the business entity is a partnership or a sole proprietorship. The meals and lodging exclusion is available if the business entity is a C corporation.


11. ANS: DPrior to the reclassification, Brown’s taxable income is $25,000 ($200,000 – $175,000). The $75,000 portion of the salary and bonus which is classified as unreasonable is treated as a dividend which is not deductible by Brown. Thus, Brown’s taxable income is $100,000 ($200,000 – $100,000).


12. ANS: DA C corporation has taxable income of zero since the salary payments are deductible. In each case, therefore, the salary payments are taxed to the owners/employees at the 33% rate.

PTS: 1 DIF: 1 REF: p. 13-6 to 13-8 | p. 13-11 | p. 13-12OBJ: 3 | 4 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 5 min

13. ANS: EAssuming the lease-rental payments are reasonable, they are deductible by the corporation and includible in Aaron’s gross income.

PTS: 1 DIF: 1 REF: p. 13-11 OBJ: 4 | 5NAT: AICPA FN-Measurement | AACSB Analytic MSC: 10 min

14. ANS: BIf the loan is reclassified as equity (choices a. and c.), Swan receives no interest deduction, but Tonya receives dividend income of $36,000. At the time the loan is repaid, Tonya recognizes dividend income of $600,000 and Swan receives no deduction.


15. ANS: E PTS: 1 DIF: 1 REF: p. 13-11 | p. 13-12 | Example 12OBJ: 4 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 10 min

16. ANS: ASince the salary and bonus payments are reasonable, Purple’s taxable income is $500,000. In converting taxable income into accumulated taxable income, the corporate tax liability of $170,000 ($500,000 34%) is deducted.

Taxable income $500,000 Less: Corporate tax liability (170,000)Accumulated taxable income $330,000

Any accumulated earnings tax assessment by the IRS would be per tax year.


17. ANS: EThe accumulated earnings tax rate in 2011 is 15%. The accumulated earnings tax is not self-assessing and does not apply to the S corporation.

PTS: 1 DIF: 1 REF: p. 13-13 OBJ: 4

NAT: AICPA FN-Measurement | AACSB Analytic MSC: 5 min18. ANS: B

All of the shareholders are required to consent to the S corporation election (choice a.). The qualification requirements must be satisfied by the tax return due date (15th day of third month of tax year and for the period of the tax year which precedes this date which is choice b.). Since the qualification requirements become maintenance requirements, these requirements must continue to be satisfied. The not in excess of $1 million capital requirement is associated with § 1244 treatment rather than a requirement for an S corporation election (choice c.).


19. ANS: DThe S corporation will permit the losses of $100,000 to be passed through to the shareholders and will satisfy the limited liability requirement. The general or limited partnership will permit the losses to be passed through to the partners, but will not satisfy the limited liability requirement (i.e., unlimited liability for all partners in a general partnership and unlimited liability for the general partners in a limited partnership). The C corporation will satisfy the limited liability requirement, but will not permit the losses to be passed through to the shareholders.

PTS: 1 DIF: 1 REF: p. 13-5 | p. 13-6 | p. 13-18OBJ: 2 | 5 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

20. ANS: CIf Lois is Sam’s mother, then she constructively owns the stock that Sam owns. Therefore, she is deemed to own all the stock of Beige both before and after the stock redemption. The $150,000 distribution is treated as a dividend.

If Lois and Sam are unrelated, the distribution qualifies as a stock redemption under § 302(b)(2); that is, a substantially disproportionate distribution. Lois owned 30% of the stock before the redemption and only 12.5% (100 shares/800 shares) after the redemption. Therefore, she has a recognized gain of $90,000 [$150,000 – (2/3 $90,000)].

PTS: 1 DIF: 2 REF: p. 13-13 | Example 14OBJ: 4 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 10 min

21. ANS: EIf the corporation is a C corporation, Taylor has a recognized gain or loss of $0, a stock basis $60,000, and the corporation has a basis for the land of $60,000.


22. ANS: DNeither Wren’s taxable income of $90,000 nor the dividends paid by Wren to Barb of $60,000 have any effect on Barb’s stock basis. So her stock basis remains at $125,000.

PTS: 1 DIF: 1 REF: p. 13-17 to 13-19OBJ: 5 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 5 min

23. ANS: CBarb’s stock basis is increased by her share of Wren’s taxable income and is decreased by the distribution she receives from Wren.

Initial basis $125,000 Share of taxable income 45,000 Distribution (60,000)Stock basis $110,000


24. ANS: CBarb’s partnership basis is increased by her share of Wren’s taxable income and is decreased by the distribution she receives from Wren.

Initial basis $125,000 Share of taxable income 45,000 Distribution (60,000)Partnership interest basis $110,000


25. ANS: CUnder § 351 the carryover basis rules apply. Therefore, the C corporation’s basis for the asset is $80,000, and the shareholder’s basis for the stock is $80,000.


26. ANS: CUnder § 721 the carryover basis rules apply. Therefore, the partnership’s basis for the asset is $80,000, and the partner’s basis for the partnership interest is $80,000.


27. ANS: CAs § 351 nonrecognition applies to both S corporations and regular C corporations, the carryover basis rules apply.


28. ANS: AThe § 704(c) special allocation provision applies if the form of the business entity is a partnership. As to choices b. and c., since the property has a carryover basis of $65,000, a $45,000 gain is recognized at the corporate level.

PTS: 1 DIF: 2 REF: p. 13-15 | p. 13-16 | p. 13-21OBJ: 5 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 10 min

29. ANS: AAlice’s basis for the partnership interest is $10,000.

Adjusted basis of equipment $15,000 – Share of liability decrease (5,000)Alice’s basis $10,000

Mary’s basis for the partnership interest is $45,000.

Cash contributed $40,000 + Share of liability increase 5,000 Mary’s basis $45,000


30. ANS: EThe basis and at-risk basis are as follows:

BasisC corporation Partnership S corporation

Contribution $190,000 $190,000 $190,000Profits –0– 75,000 75,000Liabilities –0– 30,000 –0–

$190,000 $295,000 $265,000

At-Risk BasisC corporation Partnership S corporation

Contribution $190,000 $190,000 $190,000Profits –0– 75,000 75,000 Liabilities –0– 20,000 –0–

$190,000 $285,000 $265,000

PTS: 1 DIF: 2 REF: p. 13-15 to 13-18 | p. 13-20OBJ: 5 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 10 min

31. ANS: DCatfish’s share of Trout’s taxable loss of $250,000 is $112,500 ($250,000 45%). However, since Catfish’s investment in Trout is classified as a passive activity and Catfish is a closely held corporation, the passive activity rules apply. The passive activity loss cannot be offset against Catfish’s portfolio income of $45,000 ($25,000 + $20,000), but since Catfish is a closely held corporation (but not a PSC) the passive activity loss can be offset against the active income of $800,000. Thus, Catfish can deduct all of its $112,500 share of Trout’s loss.


32. ANS: C

Bart’s at-risk basis at the end of the first year is:

Original contribution $160,000Share of profits ($30,000 30%) 9,000Share of recourse debt ($20,000 30%) 6,000At-risk basis $175,000

Bart’s share of the nonrecourse debt of $12,000 ($40,000 30%) is not included in his at-risk basis.


33. ANS: D PTS: 1 DIF: 2 REF: p. 13-21OBJ: 5 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 10 min

34. ANS: DAmount realized $500,000 Adjusted basis (270,000)Realized gain $230,000

Recognized gain $230,000

The recognized gain is $230,000. However, since the sale of a sole proprietorship is treated as the sale of individual assets, the gain or loss on each asset must be calculated in order to determine the amount of ordinary income and the amount of capital gain.

Recognized Gain ClassificationAccounts receivable $60,000 OIInventory 10,000 OIMachinery and equipment 40,000 OIBuildings 50,000 CG*Land 60,000 CG*Goodwill 10,000 CG

*Actually § 1231 gain, which in this case will be treated as LTCG.


35. ANS: DThe sale of a partnership interest is treated as the sale of a capital asset under § 741, subject to ordinary income treatment for unrealized receivables and substantially appreciated inventory under § 751. The recognized gain on the unrealized receivables and substantially appreciated inventory is as follows:

Accounts receivable (UR) $ 60,000Machinery and equipment (UR for depreciation recapture) 40,000Inventory (SAI)* 10,000

$110,000

* Inventory also includes the unrealized receivables in determining whether the inventory is substantially appreciated.

The remaining gain of $120,000 (which includes $10,000 for goodwill) is gain from the sale of a capital asset, which is classified as a capital gain.


36. ANS: BThe sale of the stock is treated as the sale of a capital asset. Thus, Kristine has a recognized gain of $230,000 ($500,000 – $270,000) which is classified as a capital gain.


37. ANS: BIn choice a., Devon has a recognized capital gain of $25,000. In choice c., Devon’s recognized gain of $25,000 may be classified as a capital gain under § 741. However, if the partnership has unrealized receivables or substantially appreciated inventory, some or all of the $25,000 recognized gain may be classified as ordinary under § 751.

PTS: 1 DIF: 2 REF: p. 13-24 to 13-26 | Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 5 min

38. ANS: E PTS: 1 DIF: 1 REF: p. 13-23 to 13-26OBJ: 6 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

39. ANS: A PTS: 1 DIF: 1 REF: p. 13-23 to 13-26OBJ: 6 | 7 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

MATCHING

1. ANS: A PTS: 1 DIF: 1 REF: p. 13-3 to 13-6OBJ: 1 | 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min NOT: B, C, D, E, are also correct.

2. ANS: A PTS: 1 DIF: 1 REF: p. 13-3 to 13-6OBJ: 1 | 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min NOT: C and E are also correct.

3. ANS: B PTS: 1 DIF: 1 REF: p. 13-3 to 13-6OBJ: 1 | 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min NOT: E is also correct.

4. ANS: B PTS: 1 DIF: 1 REF: p. 13-3 to 13-6OBJ: 1 | 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min NOT: C and E are also correct.

5. ANS: B PTS: 1 DIF: 1 REF: p. 13-3 to 13-6OBJ: 1 | 2 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 2 min NOT: C and D are also correct.

6. ANS: B PTS: 1 DIF: 1 REF: Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

7. ANS: C PTS: 1 DIF: 1 REF: Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

8. ANS: A PTS: 1 DIF: 1 REF: Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min NOT: E is also correct.

9. ANS: A PTS: 1 DIF: 1 REF: Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min NOT: E is also correct.

10. ANS: D PTS: 1 DIF: 1 REF: Concept Summary 13.1OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

11. ANS: B PTS: 1 DIF: 1 REF: Concept Summary 13.2OBJ: 5 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

12. ANS: C PTS: 1 DIF: 1 REF: Concept Summary 13.2OBJ: 3 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

13. ANS: A PTS: 1 DIF: 1 REF: Concept Summary 13.2OBJ: 1 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

14. ANS: D PTS: 1 DIF: 1 REF: Concept Summary 13.2OBJ: 1 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

15. ANS: E PTS: 1 DIF: 1 REF: Concept Summary 13.2OBJ: 1 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 2 min

16. ANS: B PTS: 1 DIF: 1REF: p. 13-15 | p. 13-16 | Concept Summary 13.2 OBJ: 5NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 minNOT: D and E are also correct.

17. ANS: B PTS: 1 DIF: 1REF: p. 13-15 | p. 13-16 | Concept Summary 13.2 OBJ: 5NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 minNOT: D and E are also correct.

18. ANS: A PTS: 1 DIF: 1REF: p. 13-15 | p. 13-16 | Concept Summary 13.2 OBJ: 5NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 minNOT: C and E are also correct.

19. ANS: A PTS: 1 DIF: 1REF: p. 13-15 | p. 13-16 | Concept Summary 13.2 OBJ: 5NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 minNOT: C and E are also correct.

20. ANS: B PTS: 1 DIF: 1REF: p. 13-8 | p. 13-9 | p. 13-11 | p. 13-16 | p. 13-21 OBJ: 4NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

21. ANS: C PTS: 1 DIF: 1REF: p. 13-8 | p. 13-9 | p. 13-11 | p. 13-16 | p. 13-21 OBJ: 3NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

22. ANS: A PTS: 1 DIF: 1REF: p. 13-8 | p. 13-9 | p. 13-11 | p. 13-16 | p. 13-21 OBJ: 4NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

23. ANS: D PTS: 1 DIF: 1REF: p. 13-8 | p. 13-9 | p. 13-11 | p. 13-16 | p. 13-21 OBJ: 3NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

24. ANS: E PTS: 1 DIF: 1REF: p. 13-8 | p. 13-9 | p. 13-11 | p. 13-16 | p. 13-21 OBJ: 5NAT: AICPA FN-Reporting | AACSB Analytic MSC: 2 min

PROBLEM

1. ANS:a. Under the conduit concept applicable for a general partnership, Agnes will deduct the $36,000

loss on her Form 1040. Thus, the cash flow benefit to Agnes will be $11,880 ($36,000 33%).

b. Under the conduit concept applicable for an S corporation, Agnes will deduct the $36,000 loss on her Form 1040. Thus, the cash flow benefit to Agnes will be $11,880 ($36,000 33%).

c. Under the conduit concept applicable for an LLC, Agnes will deduct the $36,000 loss on her Form 1040. Thus, the cash flow benefit to Agnes will be $11,880 ($36,000 33%).

d. Under the entity concept applicable for C corporations, the corporate loss is not passed through to the shareholders. Thus, the cash flow benefit to Agnes will be $0.

PTS: 1 DIF: 2 REF: p. 13-3 | p. 13-6 to 13-8OBJ: 1 | 3 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 15 min

2. ANS:If the form selected is an S corporation, the corporation has no tax liability, and Candace has a tax liability associated with the business of $24,750 ($75,000 33%). A distribution of the $75,000 of earnings to Candace would result in no additional tax liability.

If the form selected is a C corporation, the corporation has a tax liability of $13,750. A distribution of the after-tax earnings of $61,250 ($75,000 – $13,750) would result in an additional tax liability for Candace of $9,188 ($61,250 15%). Thus, the total tax liability on the $75,000 would be $22,938 ($13,750 + $9,188). The C corporation could follow a no-dividend distribution policy without any adverse tax consequences (i.e., accumulated earnings tax) if the earnings are invested in the growth of the business.

Thus, a significant factor affecting the choice between a C corporation and an S corporation for Candace is the projected distribution policy. For C corporations, the marginal tax rate increases from 25% to 34% (i.e., for taxable income between $75,000 and $100,000) and to 39% (i.e., for taxable income between $100,000 and $335,000).

PTS: 1 DIF: 2 REF: p. 13-6 to 13-8 | p. 13-11 to 13-14OBJ: 2 | 3 | 4 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 15 min

3. ANS:For 2011, there is a positive ACE adjustment of $27,750.

ACE $212,000 Unadjusted AMTI (175,000)

$ 37,000 75%

Positive ACE adjustment $ 27,750

For 2012, the calculation appears to produce a negative ACE adjustment of $37,500.

ACE $250,000 Unadjusted AMTI (300,000)

($ 50,000) 75%

Tentative negative ACE adjustment ($ 37,500)

However, negative ACE adjustments are limited to the amount of the prior positive ACE adjustments. So the negative ACE adjustment is limited to $27,750.


4. ANS:a. Saul’s tentative AMT is $80,500.

$175,000 26% = $45,500$125,000 28% = 35,000

$80,500

b. Green, Inc’s tentative AMT is $60,000.$300,000 20% = $60,000

c. The individual AMT rates are higher than the corporate AMT rates. So for a given amount of AMT base, the tentative AMT for a C corporation will be less than the tentative AMT for an individual.

d. Yes, the AMT attributes would pass through to the S corporation shareholders and be part of the individual taxpayer tentative AMT calculation.

PTS: 1 DIF: 3 REF: p. 13-8 | p. 13-9OBJ: 3 NAT: AICPA FN-Measurement | AnalyticMSC: 15 min

5. ANS:a. Kirby would include the $280,000 of lease income in his gross income. By deducting

the lease payment, Falcon would reduce its taxable income and related tax liability to $20,000 ($300,000 – $280,000).

b. If the IRS determines that Falcon’s lease payments of $280,000 are not reasonable, then it will reclassify part of the lease payments as a dividend. Since dividends are not deductible by the corporation, the corporate taxable income increases by the amount of lease payments deemed unreasonable. Kirby’s gross income would not change. His lease income decreases and dividend income increases by the amount of the lease payments reclassified as a dividend. Note that Kirby’s dividend income would be eligible for the beneficial tax rate (15%).


6. ANS:a. Taxable income before salary $700,000 $700,000

Salary (400,000) (100,000)Taxable income $300,000 $600,000

Tax liability $100,250* $204,000**

* ($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($200,000 39%) = $100,250.** ($600,000 34%) = $204,000.

b. The salary is included in the gross income of the recipient. Therefore, for the $400,000 salary, the president’s tax liability will increase by $140,000 ($400,000 35%), whereas for the $100,000 salary, his or her tax liability will increase by $35,000 ($100,000 35%). Even though the president’s tax liability increase (35% rate) in either case is greater than the corporation’s tax savings (34%) rate, the salary provides a way to get funds out of the corporation to shareholder/employees with the corporation deducting the salary. A payment to the president in the form of a dividend would not be deductible by the corporation and would still be included in his or her gross income. Qualified dividends are taxed to noncorporate shareholders at a beneficial 15% rate.

c. If the IRS should classify part of the president’s salary as unreasonable compensation, the president would have dividend income rather than salary income. While the president’s taxable income would not change as a result of this, his or her tax liability would decrease (i.e., dividend income is taxed at a 15% rate whereas salary income is taxed at a 35% rate). However, the corporation would not receive a deduction of the amount classified as a dividend. Thus, the corporate tax liability would increase.


7. ANS:a. If the loans are classified as debt, Crow would deduct interest expense of $15,000 ($300,000

5%). Albert and Bonnie would each include $7,500 ($150,000 5%) of interest income in gross income. The repayment of the $300,000 one year hence by Crow would be the repayment of a liability by Crow and a nontaxable return of capital to Albert and Bonnie.

b. If the loans are reclassified as equity by the IRS, Crow would treat the $15,000 annual payment as a nondeductible dividend. Albert and Bonnie would each include $7,500 of dividend income in gross income. The repayment of the $300,000 one year hence by Crow (assuming adequate

E & P) would be treated as the payment of a nondeductible dividend. Albert and Bonnie would each include $150,000 of dividend income in gross income.


8. ANS:a. If the reasonable needs provision is satisfied, then Daisy’s tax liability consists only of the

regular tax liability.

$850,00034% = $289,000

b. If the reasonable needs provision is not satisfied, Daisy’s potential tax liability consists of both the regular income tax liability and the accumulated earnings tax.

Regular tax liability: $850,00034% = $289,000

Accumulated earnings tax:Taxable income $850,000 Less: Accumulated earnings credit $250,000 Dividends paid 200,000 Current income tax 289,000 (739,000)Accumulated taxable income $111,000 Rate 15% Accumulated earnings tax $ 16,650

Therefore, Daisy’s total tax liability if the IRS assesses the accumulated earnings tax is $305,650 ($289,000 + $16,650).


9. ANS:a. The accumulated earnings tax levied on Eagle would be $90,000 ($600,000 15%). If Eagle

were later to make a distribution to its shareholders of the after-tax amount of $510,000 ($600,000 – $90,000), the shareholders’ tax liability would be $76,500 ($510,000 15%). Thus, the combined corporation/shareholder tax liability would be $166,500 ($90,000 + $76,500).

b. By distributing $600,000 in dividends to its shareholders, Eagle could reduce its accumulated taxable income to $0. The shareholders’ tax liability would be $90,000 ($600,000 15%).


10. ANS:a. If the distribution is a dividend, Marjean’s tax liability is $82,500 ($550,000 15%).

b. If the distribution is a stock redemption, Marjean’s recognized gain is calculated as follows:

Amount realized $550,000 Adjusted basis (400,000)Realized gain $150,000

Recognized gain $150,000

The gain is classified as a long-term capital gain. Using the alternative tax rate of 15%, Marjean’s tax liability is $22,500 ($150,000 15%).

PTS: 1 DIF: 1 REF: Example 8 | Example 9 | Example 14 | Figure 13.2OBJ: 3 | 4 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 10 min

11. ANS:If the business operates as a C corporation, the $300,000 of projected losses will not benefit Kirk on his individual tax return. Instead, the corporation will carry the losses forward to offset against future profits. Assuming profits of $200,000 in year 4 and thereafter, $200,000 of the net operating loss will be used in year 4 and the remaining $100,000 will be used in year 5. From a cash flow perspective, this will result in tax savings to the corporation in years 4 and 5 of $100,250 ($61,250 + $39,000).

Year 4 Year 5Tax liability if no NOL carryforward $61,250 $61,250 Tax liability with NOL carryforward (–0–) (22,250)Tax savings $61,250 $39,000

For year 6 and thereafter, the annual tax liability will be $61,250.

If the S election is made, the $100,000 losses for each of the first 3 years can be passed through to Kirk and deducted on his individual tax return. This will result in tax savings to him of $35,000 ($100,000 35%) in 2011, $35,000 ($100,000 35%) in 2012, and $35,000 ($100,000 35%) in 2013. When the time value of money concept is considered, the benefit of the S election is even greater compared with C corporation status.

At the end of year 3 (2013), Kirk may want to terminate the S corporation election. If the election is maintained, Kirk’s annual tax liability will be increased by $70,000 ($200,000 35%) in 2014, and $70,000 ($200,000 35%) each year thereafter for the S corporation earnings. If the election is terminated, the annual tax liability of the C corporation will be $61,250 [($50,000 15%) + ($25,000 25%) + ($25,000 34%) + ($100,000 39%)]. This assumes that the after tax earnings of the C corporation will be reinvested in the growth of the business rather than distributed to the shareholders as dividends.


12. ANS:a. Under § 351, no gain or loss is recognized at the time of the contribution of the assets to the S

corporation. Since Melanie and Sonny satisfy the 80% control requirement, § 351 applies. Sonny’s basis for his stock is $130,000 ($100,000 + $30,000) and Melanie’s basis for her stock is $220,000 ($200,000 + $20,000). The corporation’s basis for its assets is a carryover basis (i.e., $100,000 for the cash, $30,000 for the land, $200,000 for the land and building, and $20,000 for the organization costs). Melanie has $20,000 of ordinary income for the services provided.

b. The tax consequences for Melanie, Sonny, and the C corporation are the same as in a., above (i.e., § 351 applies to both C corporations and S corporations).

c. Under § 721, no gain or loss is recognized at the time of the contribution of the assets to the partnership. Note that § 721, unlike § 351, does not have a control requirement. Sonny’s basis for his partnership interest is $130,000 ($100,000 + $30,000), and Melanie’s basis for her partnership interest is $220,000 ($200,000 + $20,000). The partnership’s basis for its assets is a carryover basis (i.e., $100,000 for the cash, $30,000 for the land, $200,000 for the land and building, and $20,000 for the organization costs). Melanie has $20,000 of ordinary income for the services she provided.


13. ANS:a. Under § 351, no gain or loss is recognized at the time of the contribution of the assets to the S

corporation. Since Sam and Vera satisfy the 80% control requirement, § 351 applies. Sam’s basis for his stock is $100,000 and Vera’s basis for her stock is $30,000 ($65,000 – $35,000), a carryover basis. The corporation’s basis for its assets is a carryover basis (i.e., $100,000 for the cash and $65,000 for the land and building).

b. Under § 721, no gain or loss is recognized at the time of the contribution of the assets to the partnership. Note that § 721, unlike § 351, does not have a control requirement. Sam’s basis for his partnership interest is $117,500 [$100,000 + (50% $35,000)], and Vera’s basis for her partnership interest is $47,500 ($65,000 – $17,500), a carryover basis. The partnership’s basis for its assets is a carryover basis (i.e., $100,000 for the cash and $65,000 for the land and building).

c. The tax consequences for Sam, Vera, and the C corporation are the same as in a., above (i.e., § 351 applies to both C corporation and S corporations).


14. ANS:a. Colin Reed

Original basis $ 40,000 $ 50,000+ Share of profits 80,000 120,000+ Share of liabilities 28,000 42,000Ending basis $148,000 $212,000

Profits and liability increases both increase the partner’s basis for his or her ownership interest.Colin Reed

b. Original basis $40,000 $50,000+ Adjustments –0– –0–Ending basis $40,000 $40,000

Profits and liability increases have no effect on a shareholder’s basis for his or her stock in a C corporation.

c. Colin ReedOriginal basis $ 40,000 $ 50,000+ Share of profits 80,000 120,000Ending basis $120,000 $170,000

Profits increase a shareholder’s basis for his or her stock in an S corporation.


15. ANS:a. Ashley has no recognized gain under § 721 and a carryover basis for his partnership interest

of $70,000. The partnership has a carryover basis for Ashley’s property of $70,000.

b. Amount realized $210,000 Basis for property (70,000)Recognized gain $140,000

The precontribution appreciation of $80,000 ($150,000 – $70,000) is allocated to Ashley. Of the $60,000 balance, $15,000 ($60,000 25%) is allocated to Ashley and $45,000 ($60,000 75%) is allocated to the other partners.

c. If the entity were an S corporation, the recognized gain would be allocated based on stock ownership. Thus, $35,000 ($140,000 25%) would be allocated to Ashley and $105,000 ($140,000 75%) would be allocated to the other partners.

PTS: 1 DIF: 2 REF: p. 13-15 | p. 13-16 | p. 13-21 | Example 16OBJ: 5 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 15 min

16. ANS:a. If the entity is a C corporation, Alice’s basis for her stock remains at $260,000.

b. If the entity is an S corporation, Alice’s basis for her stock increases by $70,000 ($100,000 70%) to $330,000 ($260,000 + $70,000).

c. IIf the entity is a partnership, Alice’s basis for her partnership interest increases by $105,000 [($100,000 70%) + ($50,000 70%)] to $365,000.


17. ANS:a. If Wren is an S corporation, then Wren is the tax reporter and Alfred and Mabel are the

taxpayers. Their tax liabilities on their shares of Wren’s $400,000 taxable income would be as follows:

Alfred ($400,000 30% 25%) $30,000Mabel ($400,000 70% 33%) $92,400

Thus, Wren would need to distribute $122,400 ($30,000 + $92,400) to enable Alfred and Mabel to pay their tax liabilities associated with Wren.

b. If Wren is a C corporation, Wren is the taxpayer. Its tax liability would be $136,000 ($400,000 34%). There would be no need to make any distributions to Alfred and Mabel since they are taxed only if they receive distributions from Wren.


18. ANS:The distribution of the appreciated land is a taxable transaction to Eagle under § 311. Therefore, Eagle has a recognized gain of $60,000 ($250,000 – $190,000). Jean has dividend income of $250,000, and Pam has dividend income of $250,000. The recognized gain to Eagle increases earnings and profits by $60,000, and the dividend distributions decrease earnings and profits by $500,000.


19. ANS:a. If Maurice is a material participant in the bakery, the § 469 passive activity loss rules do not

apply. So the only limit on his ability to deduct the $125,000 loss is his § 465 at-risk basis. Since his at-risk basis is greater than $125,000, he can deduct the entire loss against his active income and portfolio income.

b. If Maurice is not a material participant in the bakery, the § 469 passive activity loss rules apply. Assuming that he does not have any passive income, he cannot deduct any of the $125,000 passive activity loss against his active income and portfolio income.


20. ANS:a. Lee has a recognized gain of $50,000 ($200,000 amount realized – $150,000 adjusted basis).

The gain is a capital gain and is a long-term capital gain if the holding period for the stock is over one year.

b. Katrina has an adjusted basis for her stock of $200,000.

c. Vireo, Inc., was not involved in the transaction. Therefore, the adjusted basis for its assets remains unchanged.


21. ANS:a. Ralph would prefer that the form of the transaction be a stock sale in order to avoid double

taxation.

Amount realized ($350,000 – $15,000) $335,000 Stock basis (225,000)

Recognized gain (LTCG) $110,000

A LTCG of $110,000 on the sale of the stock will result in an increase of Ralph’s tax liability of $16,500 ($110,000 LTCG 15%).

Liquidating Silver, Inc., (i.e., an asset sale) would result in the following recognized gain and the related classification at the corporate level.

ClassificationAsset Gain OI LTCGCash $ –0– $ –0–Accounts receivable 25,000 25,000Inventory 5,000 5,000Machinery and equipment 20,000 20,000Land 90,000 $ 90,000*Goodwill 20,000 20,000

$160,000 $50,000 $110,000

*If this is the only § 1231 transaction, the § 1231 gain is LTCG.

The sale of Silver, Inc., assets will result in a corporate tax liability of $54,400 ($160,000 34%).

In addition, when Silver distributes the available cash to Ralph, his tax liability will be as follows:

Amount realized ($350,000 – $15,000 – $54,400) $280,600 Stock basis (225,000)Recognized gain (LTCG) $ 55,600

The LTCG of $55,600 to Ralph produces a tax liability of $8,340 ($55,600 LTCG 15%). Thus, the combined tax liability associated with the liquidation of Silver is $62,740 ($54,400 + $8,340).

b. Marilyn would prefer to purchase the assets so she can step the basis of each asset up to the purchase price (i.e., FMV) of $335,000. With a stock purchase, the assets of the corporation will have a carryover basis of $175,000.


ESSAY

1. ANS:All of these factors are relevant factors in selecting the form of a business entity.


2. ANS:a. Above all, the investment should make economic sense. Among the nontax factors,

Lisa should consider the following:

What has caused the decline in the average earnings rate for the 10-year average of 15% to the 5-year average of 8%?

What is the projected earnings rate for the future?

To what extent do the limited partners participate in profits and losses?

Why does the limited partnership need additional owner financing?

Are there any contingent liabilities that could affect the limited partner’s ability to recoup his or her investment?

What distributions, if any, can limited partners expect?

What other investment options does Lisa have?

b. If the partnership generates losses, the maximum amount Lisa will be able to deduct on her individual income tax return is her investment of $25,000. From a cash flow perspective, this could generate tax savings of $8,250 ($25,000 33%). A related issue that needs to be addressed by Lisa is the risk that she will not recover her investment.

PTS: 1 DIF: 2 REF: p. 13-3 to 13-7OBJ: 1 | 2 | 3 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 10 min

3. ANS:a., b., c., d., and e.

The sole proprietorship, partnership, and S corporation are subject to single taxation (i.e., the owners rather than the entity are subject to Federal income tax). The C corporation is subject to double taxation (i.e., the entity is subject to Federal income tax on its profits and the owners are taxed on distributions received from the corporation). The LLC could be subject to either single taxation or double taxation depending on what election is made under the check-the-box Regulations (i.e., normally single taxation since the partnership form usually is selected).

PTS: 1 DIF: 1 REF: p. 13-6 to 13-8OBJ: 3 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

4. ANS:Techniques that can be used to avoid and/or reduce double taxation include the following:

Making distributions to the shareholders that are deductible to the corporation.

Not making distributions to the shareholders.

Making distributions that qualify for return of capital treatment.

Making the S corporation election.


5. ANS:Making distributions to the shareholders that are deductible to the corporation include the following:

Salary payments to shareholder-employees.

Lease rental payments to shareholder-lessors.

Interest payments to shareholder-creditors.


6. ANS:The major pitfall in this case is the potential assessment by the IRS of the accumulated earnings tax.


7. ANS:Both a stock redemption (assuming the holding period is long-term) and a dividend (assuming the dividend is a qualified dividend) are taxed at beneficial tax rates (i.e., 15%/0%). The full amount of a dividend is subject to taxation (i.e., included in gross income). For a stock redemption, only the recognized gain (amount realized – basis) is subject to taxation (i.e., included in gross income).

PTS: 1 DIF: 1 REF: p. 13-13 | Example 14OBJ: 4 NAT: AICPA FN-Reporting | AACSB AnalyticMSC: 5 min

8. ANS:In calculating the AMT of a C corporation, the ACE adjustment applies. The amount of the positive adjustment is 75% of the excess of adjusted current earnings (ACE) over unadjusted alternative minimum taxable income (AMTI) for the tax year. If unadjusted AMTI exceeds ACE for the tax year, the adjustment is negative. Note, however, that the total negative ACE adjustments cannot exceed the total positive ACE adjustments in prior tax years.


9. ANS:For the individual taxpayer, the AMT tax rates are as follows:

AMT base up to $175,000 26%

AMT base above $175,000 28%

For a C corporation, the AMT rate is 20%.

PTS: 1 DIF: 1 REF: p. 13-8 | p. 13-9OBJ: 3 NAT: AICPA FN-Reporting | AACSB Analytic

MSC: 5 min10. ANS:

The AMT applies directly to a C corporation. The AMT applies indirectly to the other four entities in that the AMT attributes flow through to the individual’s tax return where the AMT is imposed.


11. ANS:The shareholder can lease the assets to the corporation. Assuming such rental payments are deductible, the corporate taxable income is reduced and the corporation gets cash out of the corporation to the shareholder. Although the shareholder must include the rental income in gross income, single taxation is achieved.


12. ANS:Return of capital distributions result in recognized gain being the difference between the amount of the distribution and the adjusted basis for the stock. Dividend distributions result in the full amount of the distribution being included in gross income. In terms of the effect on gross income, therefore, return of capital treatment is preferred.

Return of capital distributions normally qualify for beneficial capital gain treatment (e.g., 15%). Qualified dividend distributions also qualify for the same beneficial rate (e.g., 15%). Since identical tax rates apply, a return of capital treatment is favored because less income results.

However, it is possible for the dividend treatment to yield a smaller tax liability than return of capital treatment. This could be caused by substantial appreciation and the return of capital distribution being taxed at ordinary income rates (e.g., short-term capital gain). For example, assume a distribution of $100,000, an adjusted basis of $5,000, a short-term holding period, and a marginal tax rate of 35%.

Return of capital treatment: As a short-term capital gain results, the tax liability on the distribution is $33,250 [($100,000 – $5,000) 35%].

Dividend treatment: If the dividend is qualified, the tax liability on the distribution is $15,000 ($100,000 15%).


13. ANS:Normally, one needs to consider the following factors:

Are all the shareholders willing to consent to the election?

Can the qualification requirements under § 1361 be satisfied at the time of the election?

Since the qualification requirements become maintenance requirements, can these requirements continue to be satisfied?

For what period will the conditions that make the election beneficial continue to prevail?

Will the corporate distribution policy create wherewithal to pay problems at the shareholder level?

An analysis of Aubrey’s situation indicates that none of the above factors should deter him from electing S status for his corporation. A factor normally considered that is not present for Aubrey is the existence of NOLs for the C corporation. An S corporation cannot offset C corporation NOLs against S corporation profits, but the 20-year time period does run.


14. ANS:The purpose of the accumulated earnings tax is to penalize the C corporation for not making dividend distributions and thereby avoiding double taxation. The earnings of the S corporation are taxed at the shareholder level rather than at the corporate level. Thus, the S corporation is not subject to double taxation.


15. ANS:a. Since the business entity is a sole proprietorship, transactions between Marsha and the entity

are not taxable. The sole proprietorship has a carryover basis for the assets received from her (i.e., cash = $100,000, land = $60,000).

b. Contributions by a partner to a partnership are not subject to taxation under § 721. Marsha’s basis for her ownership interest is a carryover basis of $160,000 under § 722. The partnership’s basis for the assets is a carryover basis (i.e., cash = $100,000, land and building = $60,000) under § 723.

c. If Marsha and any other shareholders involved in the transaction satisfy the § 368(c) control requirement (i.e., 80%), § 351 provides that realized gain is not recognized. In this case, Marsha’s basis for her stock is a carryover basis of $160,000. The C corporation’s basis for the assets is a carryover basis (i.e., cash = $100,000, land and building = $60,000). However, if the control requirement is not satisfied, then Marsha’s realized gain of $35,000 is recognized. In this case, Marsha’s basis for her stock is the fair market value of the assets contributed of $195,000. The C corporation’s basis for the assets also is the fair market value (i.e., cash = $100,000, land and building = $95,000).

d. The tax consequences for the S corporation are the same as those for the C corporation in c. above.


16. ANS:a. For a partnership, the precontribution gain of $30,000 ($100,000 – $70,000) must be allocated

to Gladys. Thus, Gladys’ share of the recognized gain of $60,000 ($130,000 – $70,000) on the sale of the land by the partnership is $54,000 [$30,000 + ($30,000 80%)].

b. None of the $60,000 gain is allocated to the shareholders. All of the gain is taxed to the corporation.

c. The $60,000 gain is passed through to the shareholders of the S corporation based on the stock ownership. Thus, $48,000 ($60,000 80%) is allocated to Gladys.


17. ANS:a. If the entity is a C corporation, Terry’s stock basis remains at $100,000. The profits are taxed

at the C corporation level. Since the $50,000 distribution is a dividend (i.e., current E & P is $90,000), this transaction does not affect Terry’s stock basis.

b. If the entity is a general partnership, Terry’s basis for his ownership interest is affected by both the profits and by the distribution.

Beginning basis $100,000 Plus: Share of profits ($90,000 20%) 18,000 Less: Distribution received (10,000)Ending basis $108,000

c. If the entity is an S corporation, Terry’s stock basis is affected by both the profits and the distribution.

Beginning stock basis $100,000 Plus: share of profits ($90,000 20%) 18,000 Less: Distribution received ($50,000 20%) (10,000)Ending basis $108,000


18. ANS:a. Gain of $25,000 [$75,000 (fair market value) – $50,000 (adjusted basis)] is recognized

by the corporation under § 311(b) on the distribution of the land. Since the corporation apparently has substantial earnings and profits, Craig recognizes dividend income of $75,000.

b. Gain of $25,000 [$75,000 (fair market value) – $50,000 (adjusted basis)] is recognized by the S corporation under § 311(b) on the distribution of the land. This gain is passed through to the shareholders to report on their tax returns and increases their stock basis. Assuming that Craig’s stock basis is at least $75,000, he incurs no additional recognized gain due to the distribution and reduces his stock basis by $75,000. If his stock basis is less than $75,000, he reduces his stock basis to zero, and the excess of the distribution over the stock basis is capital gain.

c. The distribution of the land does not result in recognition of gain to the partner or partnership. If Craig’s basis in his partnership interest is at least $50,000, he reduces the basis by $50,000 and assigns a $50,000 basis to the land. If his basis for his

partnership interest is less than $50,000, he reduces the basis to zero and assigns the amount of the partnership interest basis before the distribution to the land (e.g., if his partnership interest basis was $42,000, then his basis for the land is $42,000).


19. ANS:a., b., and c.

For the partnership, a partner’s basis for his or her ownership interest is a carryover basis under § 722. For the corporation (i.e., both C and S), a shareholder’s basis for his or her stock is a carryover basis under § 358 if the 80% control requirement under § 351 is satisfied. If the control requirement is not satisfied, then a shareholder’s basis for his or her stock is a stepped-up or stepped-down basis (i.e., fair market value of the assets on the date of contribution).


20. ANS:The general passive activity loss rules (i.e., passive activity losses cannot be offset against active income or portfolio income) apply to C corporations that are personal service corporations (PSCs). The passive activity loss rules apply to a closely held C corporation that is not a PSC in a different manner. While passive activity losses cannot be offset against portfolio income, they can be offset against active income.


21. ANS:The following requirements must be satisfied.

The principal activity of the corporation is the performance of personal services.

The services are substantially performed by owner-employees.

Owner employees own more than 10% in value of the stock of the corporation.


22. ANS:The statutory language of § 465 does not mention partnerships, LLCs, or S corporations. However, since the conduit concept applies to each of these entities, the at-risk rules do apply at the owner level.


23. ANS:Yes. In calculating the at-risk basis for a taxpayer, only recourse debt is included in the calculation.


24. ANS:

With respect to special allocations, an S corporation is treated more like a C corporation than a partnership. For example, the § 704(c)(1) allocations of built-in gain or loss are mandatory for partnerships. Such a special allocation is not permitted for an S corporation under the per share/per day rule.


25. ANS:The form of the sale does not matter to Agnes for Federal income tax purposes. The sales transaction will be treated as the sale of the individual assets. Thus, ordinary and capital gain or loss will result depending on the nature of the asset sold.


26. ANS:No. Regardless of the legal form of the purchase transaction, the basis of the individual assets will be assigned a cost (same as fair market value) basis. If the purchase price exceeds the FMV of the assets, such excess is assigned to goodwill.


27. ANS:a. If the fair market value of the corporate assets does not exceed the adjusted basis, a stock

purchase is preferable. The adjusted basis of the corporate assets will remain unchanged.

b. If the fair market value of the corporate assets exceeds the adjusted basis, an asset purchase from Red, Inc. is preferable. Then Ralph could contribute the assets to a corporation under § 351. The adjusted basis of the corporate assets will equal the amount Ralph paid for them (i.e., FMV).


28. ANS:Selling the stock will result in single taxation at the beneficial capital gain rate. Selling the assets will result in double taxation with only Walter’s recognized gain qualifying for the beneficial capital gain rate. Therefore, Walter should sell his stock.


29. ANS:The sale of the assets is treated as the sale of the individual assets. Consequently, the recognized gain or loss is calculated for each asset and is classified accordingly (i.e., capital and/or ordinary). The sale of a partnership interest is treated as the sale of a capital asset (subject to ordinary income treatment for unrealized receivables and substantially appreciated inventory). So the sale of the assets is likely to produce more ordinary income and less capital gain for the selling partners than in the case of the sale of partnership interests.

PTS: 1 DIF: 1 REF: p. 13-24 | p. 13-25

OBJ: 6 NAT: AICPA FN-Measurement | AACSB AnalyticMSC: 5 min

chapter 13

Documents

limited partnership

small corporation

c corporation status

limited liability companies

s corporation election

limited liability company

combined tax liability

unlimited liability