CHAPTER 12
ANSWERS TO HOMEWORK
SPRING 2013
Lecture.. If shareholders have high marginal rates relative to C corporation rates, it may be desirable to avoid S corporation status. Although C corporation earnings can be subject to double taxation, good tax planning mitigates this result (e.g., when the owners take profits out as salary).
Likewise, profits of the corporation may be taken out by the shareholders as capital gain income through stock redemptions, liquidations, or sales of stock paid to others. Alternatively, C corporation profits may be paid out as dividends, subject to a 15% maximum tax rate. Any distribution of profits or sale of stock can be deferred to a later year, thereby reducing the present value of shareholder taxes. Finally, potential shareholder-level tax on corporate profits can be eliminated by a step-up in the basis of the stock upon the shareholder’s death.
7. An entity must meet these requirements to elect S corporation status:
  Is a domestic corporation (incorporated and organized in the United States).
  Is an eligible corporation.
  Issues only one class of stock.
  Is limited to a theoretical maximum of 100 shareholders.
  Has only individuals, estates, and certain trusts and exempt organizations as shareholders.
  Has no nonresident alien shareholders.
10. a. No. b. No.
No. c.
11. a. b. c.
Yes.
No.
No.
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d. e. f.
No.
Yes.
Yes.
16. a. b. c.
Lecture. S corporations are limited to a total of 100 shareholders, but family members may be treated as one shareholder. “Members of the family” is defined as the common ancestor, the lineal descendants of the common ancestor, and the spouses (or former spouses) of the lineal descendants or common ancestor.
+ OAA
– AAA
+ AAA d. e. f.
+ OAA
– OAA
– AAA g. h. i.
– AAA
– AAA
– AAA
18. TAX FILE MEMORANDUM
Date: November 1, 2012
To: Scott Tyrney
Re: Differences between AAA and stock basis of an S corporation
Stock basis typically opens at a positive amount, and AAA starts out with a zero balance.

AAA is a corporate account, and stock basis is calculated at the shareholder level.

AAA can have a negative balance, but stock basis cannot go below zero.

AAA is not adjusted for tax-exempt income or related expenses or for Federal taxes attributable to a C corporation tax year. Stock basis is adjusted for these items.
Lecture: AAA ByPass Election. The AAA bypass election allows an S corporation to pay out AEP before AAA, e.g., to simplify the books. With no AEP, the S corporation uses the simple approach to distributions. When AEP is present, a negative AAA may cause double taxation. The AAA bypass election also may enable the S corporation to avoid the passive investment income penalty tax.
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19. OPTIONAL. a. b. c.
–
+
– d. e. f. +
+
– g. h. i.
–
–
– j. k. l.
+
+
– m. + n. o.
–
–
OPTIONAL.
13. The two shareholders will have difficulty making the S election effective for 2012.

For the election to be effective as of January 1, 2012, the previous shareholder also must consent to the election. Under § 1362(b)(2)(B)(ii), where any shareholder who owns stock at the beginning of the tax year for which the election is effective, but not on the date of the election, does not consent to the election, the election is effective as of the next taxable year.

Effective if the previous shareholder does consent, this previous shareholder is not a qualified shareholder (i.e., a nonresident alien). Thus, the S election is effective for 2013 (but not for 2012).
20. Pertinent tax issues include the following.

Can the shareholder prove the year’s ending basis in the S corporation stock?

What is the basis of the shareholder’s stock?

What is the basis of loans that the shareholder has made to the S corporation?

In what order should the shareholder apply the year’s adjustments to the S corporation stock basis?

Is there more than one type of loss (e.g., capital, passive, § 1231, etc.) that passes through to the shareholder for the year?

Does the shareholder have at-risk amounts so that the pass-through passive loss can be deducted?

Does the shareholder have passive income amounts so that the pass-through passive loss can be deducted?
PROBLEMS .
24. a. Book income
Add: Short-term capital loss
Deduct:
Dividends received
3
$9,000
$90,000
6,000
$96,000

b.
Tax-exempt interest
Section 1231 gain
Recovery of bad debts
Subchapter S taxable income
$25,000 ($75,000 ÷ 3).
2,000
6,000
4,000 (21,000)
$ 75,000
27.
Beginning balance
LTCG
Balance
Distribution ($6,000)
Balance
Loss ($9,000)
Ending balance
AAA
$2,000
2,000
$4,000
(4,000)
$ –0–
(9,000)
($9,000)
*Taxable dividend
**$1,000 suspended loss, cannot have negative stock basis
Stock Basis AEP
$10,000
2,000
$12,000
(4,000)
$6,000
–0–
$6,000
(2,000)*
$ 8,000
(8,000)
$4,000
No effect
$ –0– ** $4,000
30. A capital gain of $80,000 ($240,000 – $160,000) is reported at the corporate level and each shareholder includes a flow through of $20,000 ($80,000 ÷ 4). David’s stock basis drops to
$50,000 ($270,000 – 240,000 + 20,000).
32. TAX FILE MEMORANDUM
Date: October 3, 2012
Re: S corporation losses and distributions
S corporation tax law now provides that distributions are treated as reductions of stock basis before considering any losses. Thus, Storm Nelson, the sole shareholder, should treat the loss and distribution as follows.
Nelson’s beginning stock basis
Less: Current year distributions
Basis before loss
Less: Partial loss
Ending stock basis
$200,000
(140,000)
$ 60,000
(60,000)
$ –0–
Suspended loss
33. There will be a $60,000 negative balance in AAA, and AEP remains at $110,000.
Beginning balance, 1-1-12
AAA
$200,000
AEP
$110,000
4
$ 50,000

Less: Distributions
Less: Loss
Ending Balance
(140,000)
(120,000)
($ 60,000)
(–0–)
(–0–)
$110,000
Here AAA is adjusted first for the distributions and then for the loss. However, the negative balance must be restored to a positive balance before the shareholders may receive any distributions that will not be taxed as dividend income.
35. a. Beginning AAA
Add:
Sales income
Dividend income
Interest income
Less:
Real estate loss
Charitable contributions
§ 179 expense
Administrative expenses
Less distributions
Ending AAA
$206,000
5
17,000
3,000
$ 5,000
19,000
2,500
42,000
$226,000
(68,500)
$767,050
157,500
$924,550
(71,300)
$853,250
40.
Section 1367(b)(2)(B) indicates that only the ‘‘net increase” is applied to restore any reduction in loan basis. Here there is no net increase ($11,000 – $15,000). Since stock basis has been increased by $11,000, there is $11,000 tax-free income and a $4,000 capital gain.
LECTURE. Once the basis of any debt is reduced, it is later increased (only up to the original amount) by the subsequent net increase resulting from all positive and negative basis adjustments. The debt basis is adjusted back to the original amount by any “net increase” before any increase is made in the stock basis. “Net increase” for a year is computed after taking distributions (other than those from AEP) into consideration. A distribution in excess of stock basis does not reduce any debt basis.
47.
Beginning basis
STCG
Distribution
Nondeductible fees and penalties
Net tax operating loss
LTCL
Ending stock basis
Andre
$12,000
12,500
(6,000) (6,000)
(1,000) (1,000)
(10,000) (10,000)
(2,000)
$ 5,500
Crum
$22,000
12,500
(2,000)
$15,500
Barbara
$31,000
12,500
(6,000)
(1,000)
(10,000)
(2,000)
$24,500

53. Ruby and the corporation save $6,120 in FICA taxes ($40,000 × .153). However, an IRS agent may argue that a reasonable salary is not being paid and recharacterize the distribution as a salary.
OPTIONAL. 41 and 42.
41. None, since the loan basis is back to the original $10,000.
42. Here the loan basis is only back to $8,000, so Jeff has a $2,000 capital gain ($10,000 –
$8,000) with a corporate note. If no corporate note exists, Jeff reports $2,000 ordinary income.
Lecture.
The AAA bypass election allows an S corporation to pay out AEP before AAA, e.g., to simplify the books. With no AEP, the S corporation uses the simple approach to distributions. When AEP is present, a negative AAA may cause double taxation. The AA
A bypass election also may enable the S corporation to avoid the passive investment income penalty tax.
PROBLEMS-OPTIONAL
29. a. Tobias recognizes $90,000 of ordinary income. The corporation has a $90,000 deduction which passes through to Tobias. His stock basis is reduced to zero, and he has a $10,000 loss carryover. b. Tobias recognizes $90,000 of dividend income, with no deduction pass-through, and has an $80,000 remaining stock basis. AEP is reduced to zero.
LOSS EXAMPLE
RE: S corporation losses and distributions
S corporation tax law now provides that distributions are treated as reductions of stock basis before considering any losses. Thus, the shareholder (Bip) should treat the loss and distribution as follows.
Bip’s beginning stock basis
Less: Current year distributions
Basis before loss
Less: Partial loss
Ending stock basis
$100,000
(70,000)
$ 30,000
(30,000)
$ –0–
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Suspended loss $ 25,000
48. $206,500. The net unrealized built-in gain on the conversion date is $685,000 ($105,000 –
$10,000 + $700,000 – $110,000), the maximum amount subject to the §1374 tax. The recognized built-in gains and loss are:
Accounts receivable collected $105,000
Accounts payable
Gain on the land (limited to the built-in gain)
Total
(110,000)
700,000
$695,000
Taxable income is $590,000 and the built-in gains tax is assessed on the smaller amount
($590,000

35% = $206,500). However, there is a carryforward of the net built-in gains amount that escapes taxation due to the taxable income limitation, to be taxed in subsequent years when taxable income is sufficient. Therefore, $95,000 is carried into
2013 and treated as a recognized built-in gain then.
51. TAX FILE MEMORANDUM
Date: June 15, 2012
From: Judy Hernandez
Re: Friedman, Inc., liquidation
I told Arnold Schwartz, CFO, over the phone that S corporations are subject to many of the same liquidation rules applicable to regular corporations. For example, the distribution of the appreciated land and inventory is treated as if the property were sold to the shareholders in a taxable transaction.
The S corporation incurs no corporate tax (except for any § 1374 tax), but the gains flow through to the shareholders. Any corporate gain increases the shareholders’ stock basis by like amounts and reduces any gains realized by the shareholders when they receive the liquidation proceeds. Typically, double tax is avoided, but special tax attributes disappear (i.e., AAA).
With respect to the depreciated marketable securities, the S corporation can recognize the loss.
54. Total gain is $70,000 ($120,000 – $50,000), and the net unrealized built-in gain as of January
2010 is $45,000 ($60,000 – $15,000). The net amount of gains and losses sets the upper limit on the tax base for the built-in gains tax. Thus, $45,000 of the $70,000 is subject to the corporate built-in gains tax. The other $25,000 of gain is subject to the S corporation passthrough rules and bypasses the corporate income tax
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