Chapter C11
S Corporations
Discussion Questions
C11-1 Seven advantages of S corporation treatment are illustrated on page C11-3.
disadvantages of S corporation treatment are illustrated on pages C11-3 and C11-4.
Nine
C11-2 There are many items that must be considered when converting a C corporation to an S
corporation. It would be necessary to compare Julio's potential tax liabilities under both the C and S
corporation scenarios. While his marginal tax rate is lower than the marginal corporate rate, he is
getting some benefit from the lower corporate rates on the first $75,000 of corporate taxable income.
If Julio elects S corporation status, the entire amount of corporate income would be taxable to him
regardless of whether it is distributed or not. This means that most of the income would be taxed at
the 31% to 39.6% marginal rates. However, none of the $25,000 in dividends that are currently
being paid would be subject to the double taxation of the current C corporation status if an S election
is made. In addition, the income that is passed through to Julio will step-up the basis of Julio's S
corporation stock. Such a basis step-up does not occur with a C corporation. He must also consider
the possible effect of the built-in gains tax that often arises during the first 10 years after a C
corporation converts to an S corporation. A thorough analysis of the short- and long-term benefits of
S corporation status should be made including a comparison of the treatment of pensions and fringe
benefits for each class of corporation, and the potential estate planning considerations. Some of the
advantages and disadvantages of making an S election are outlined on pages C11-3 and C11-4.
Under the check-the-box regulations, a C corporation can elect to be taxed as a partnership or
proprietorship depending on the number of owners that it has (see Chapter C2). It is unlikely that a
C corporation would find such an election advantageous since it would require the entity to undergo
a corporate liquidation. The tax consequences of such a liquidation are explained in Chapter C6 and
generally require any unrealized gains and losses to be recognized at both the corporate and
shareholder levels.
It is also unlikely that a C corporation would undergo a formal dissolution and then
reorganize as an LLC. Like with the check-the-box regulations election, the C corporation and its
shareholders would be taxed on their unrealized gains and losses under the corporate liquidation
rules (see Chapter C6). In addition, the entity would incur the costs to undergo a formal dissolution
under state law.
C11-3 There are many items that must be considered in making the decision regarding the initial tax
form of a business. The corporate (either C or S corporation) form offers the advantage of limited
liability which is important for a new business. S corporations are often an attractive form for a new
business since the losses in the initial years can be passed through to the shareholder and used on
their tax return to offset any income that Celia would earn from other sources. The S corporation
status can be terminated fairly easily if in the future C corporation status becomes more desirable.
C11-1
The noncorporate entity form known as a limited liability company (LLC) should be
investigated. This business form provides the limited liability benefits usually associated with a
corporation. It provides the tax benefits associated with a partnership. Under the check-the-box
regulations, an LLC can elect to be taxed as either a C corporation or an S corporation even though it
was not organized as a corporation under federal or state law. It is possible that it may prove
advantageous for an LLC to elect to be taxed as a C corporation. It is less likely that an LLC would
want to elect to be taxed as an S corporation since in most instances it is already taxed as a
partnership under the check-the-box regulations.
A thorough analysis of the short- and long-term tax advantages of the possible tax forms for
the business should be conducted before a decision is made. Some of the advantages and
disadvantages of creating a corporation and making an S election are outlined on pages C11-3 and
C11-4.
C11-4 An LLC is taxed like a partnership and as such offers a number of advantages that are not
available with an S corporation. Some of the more important of these advantages include:
·
·
·
·
·
No restrictions are imposed on the type or number of owners that an LLC can have.
An S corporation is limited to 35 shareholders, none of which may be a corporation
or a partnership.
No restrictions are imposed on the operation of an LLC (e.g., investments in
corporate entities).
Income and deduction allocations are based on the LLC agreement, and not based on
the number of shares of stock that are owned. Special income, gain, loss, and
deduction allocations are permitted for an LLC.
The basis of the LLC interest includes a ratable share of the LLC's liabilities. This
amount can be greater than the basis provided for the S corporation's stock and
permit a greater loss or deduction passthrough.
LLCs are not subject to the corporate level taxes (e.g., built-in gains stock, excess net
passive income tax).
pp. C11-3 through C11-6 (see also Chapters C2 and C10).
C11-5 b, c, and f. A domestic corporation that is an S corporation can be a shareholder in a
Qualified Subchapter S Subsidiary (QSSS). pp. C11-4 through C11-8.
C11-6 a, b, c, and f. p. 11-7.
C11-7 b.
A special reporting rule was added to item c if the second, domestic corporation is a
Qualified Subchapter S Subsidiary (QSSS). A QSSS is a domestic corporation that is 100%-owned
by an S corporation, qualifies as an S corporation, and for which an election is made to be treated as
a QSSS. The 1996 tax legislation eliminated the restriction which prohibited a C corporation from
being more than 80%-owned by an S corporation. Item d is no longer a prohibited action. The 1996
C11-2
tax legislation permitted the creation of eligible small business trusts which include the type of trust
described in item d. pp. C11-5 through C11-11.
C11-8 An inadvertent termination is a termination that the IRS, corporation, and shareholders all
agree was unintentional (e.g., failing the passive investment income test for three consecutive years
as a result of improperly computing the corporation's Subchapter C E&P). Once such a determination
is made, the S corporation or its shareholders must take the necessary steps, within a reasonable time
period after discovering the event causing the termination, to restore its small business corporation
status (e.g., distributing the money or property needed to eliminate the E&P balance in the preceding
situation). By having the termination classified as inadvertent, the income is passed through to the S
corporation's shareholders and not taxed to the corporation under the C corporation rules. p. C11-11.
C11-9 An S corporation that terminates its S election must wait five tax years before making a new
election. This delay applies unless the IRS consents to an earlier reelection. Regulation Sec. 1.13625(a) indicates that permission for an early reelection can occur when (1) more than 50% of the
corporation's stock is owned by persons who did not own stock on the date of the termination or (2)
the termination was caused by events not reasonably within the control of the corporation or the
shareholders owning a substantial interest in the corporation and was not part of a plan to terminate
the election involving the corporation or its shareholders. p. C11-12.
C11-10 An S corporation must generally adopt a permitted tax year (which is normally a calendar
year or a 52-53 week year) as its tax year. Alternatively, it can adopt a fiscal year for which the
necessary business purpose has been established (e.g., natural business year). If the business purpose
exception is used as authority to adopt a fiscal year, then IRS approval of the tax year is required.
Alternatively, the S corporation can elect under Sec. 444 to adopt or change to a tax year with a
limited deferral period (e.g., three months or shorter period), if the adoption or change does not result
in a greater deferral period than the year presently being used. The adoption of a fiscal year with a
limited deferral period is permitted in the corporation's initial tax year or after the S corporation has
been in business for one or more years. Other acceptable tax years include an ownership year, a
"grandfathered" fiscal year, or a tax year based on a business purpose other than a natural business
year (e.g., facts and circumstances year). pp. C11-13 and C11-14.
C11-11 In order to maintain a fiscal year under a Sec. 444 election, Cable must choose a year-end of
September 30, October 31, or November 30 so that the deferral period is three months or less. The
corporation must also make the required payments mandated under Sec. 7519 and file a Form 8752
annually. pp. C11-13 and C11-14.
C11-12 Subchapter C earnings and profits (E&P) were earned in a tax year for which an S
corporation election was not in effect (e.g., a tax year that preceded the making of an S corporation
election for which the corporation was taxed as a C corporation) or that were inherited from a C
corporation under the tax attribute carryover rules of Sec. 381 (see Chapter C7). The existence of
Subchapter C E&P at the close of a tax year prevents the corporation from earning an unlimited
amount of passive investment income and being exempt from the excess net passive income tax for
C11-3
the year in question. An S corporation having Subchapter C E&P at the end of its tax year is subject
to the excess net passive income tax if its passive investment income for the tax year exceeds 25% of
its gross receipts. Failing the 25% test for three consecutive tax years while having Subchapter C
E&P at the end of each tax year results in termination of the S election at the beginning of the fourth
year in addition to imposition of the tax for each of the three years. pp. C11-11 and C11-16.
C11-13 c, h and j. Items a, b, d, e, f, g, and i are separately stated income and expense items because
they are eligible for possible preferential treatment or subject to special limitations on a shareholder's
tax return. pp. C11-14 and C11-15.
C11-14 The S corporation's ordinary income or loss and each separately stated item are allocated to
each shareholder as follows:
a.
Allocate an equal portion of the item to each day in the tax year (by dividing the
amount of the item by the number of days in the S corporation's tax year).
b.
Allocate an equal portion of the daily amount for the item to each share of stock that
is outstanding on each day (by dividing the daily amount for the time period by the number of shares
of stock outstanding on a particular day).
c.
Total the daily allocations for each outstanding share of stock.
d.
Total the amounts allocated to each share of stock held by the shareholder.
Special allocations of income, gain, loss, or deduction items (like those available to a
partnership) are not permitted under the S corporation rules. Special rules apply if the S election is
terminated in the tax year or a shareholder sells or otherwise disposes of his entire S corporation
stock interest. pp. 11-19 and C11-20.
C11-15 Each shareholder's deduction for his or her share of the ordinary loss and the separately
stated loss and deduction items is limited to the sum of the adjusted basis for his or her S corporation
stock plus the adjusted basis of any indebtedness owed directly by the S corporation to the
shareholder. Excess loss and deduction items are carried over to subsequent years in which the
shareholder again has a positive basis amount. Positive basis adjustments are made for any
separately stated income or gain items reported in the "loss" year before the shareholder's loss
limitation is determined. In addition to this loss limitation, the shareholder's loss or deduction
allocation may be subject to the at-risk rules, the passive activity limitation rules, the investment
interest deduction rules, the hobby loss rules, or the regular shareholder deduction limitations (e.g.,
the shareholder's charitable contribution deduction limitation). These other limitations may prove
more restrictive than the general basis limitation. pp. C11-20 through C11-23.
C11-16 The shareholder can make additional capital contributions or lend additional monies to the
corporation by year-end. This permits the loss deduction to be larger in the current year provided the
special loss limitations such as the at-risk rules or passive activity limitation rules do not restrict the
deduction available under the shareholder's basis limitation. Depending upon the shareholder's
marginal tax rates for the current year and next year, the shareholder should consider deferring the
additional capital contributions or loans until after year-end when the marginal tax rate is expected to
be higher in the next tax year in order to obtain a larger tax savings. pp. 11-34 and C11-35.
C11-4
C11-17 A post-termination transition period is generally a one-year period immediately following
the last day of the final S corporation tax year in which loss and deduction carryovers can be used by
the S corporation's shareholders even though the S election has been revoked or terminated. In some
cases the post-termination transition period may run to the due date for the S corporation tax return
[including extensions]. A post-termination transition period also includes the 120-day period
beginning on a determination date (e.g., date on which a court decision becomes final, a closing
agreement is finalized, or an audit determination is made involving the S corporation. The loss and
deduction carryovers can be deducted only up to the adjusted basis of the shareholder's stock at the
end of the post-termination transition period. Loss and deduction carryovers can not be deducted
against the basis for amounts owed by the corporation to a shareholder. To prevent losses from not
being deductible, the shareholder should consider making capital contributions before the end of the
post-termination transition period. pp. C11-22 and C11-23.
C11-18 b, c (if a C corporation in any of its three preceding tax years), d, e, f, and g. pp. C11-14,
C11-15, C11-21, and C11-22.
C11-19 Positive adjustments are made to the basis of the S corporation stock annually for additional
capital contributions made during the tax year and the shareholder's allocable share of ordinary
income and separately stated income and gain items. Negative adjustments are made to the basis of
the S corporation stock annually for the shareholder's allocable share of ordinary loss and separately
stated loss and deduction items, expense items that are not deductible in determining ordinary
income (loss) and that cannot be charged to the capital account, and distributions that are excluded
from the shareholder's gross income. Special stock basis adjustment rules apply to S corporations
that claim a deduction for percentage depletion with respect to oil and gas wells. The same positive
and negative income and loss basis adjustments can be made to the basis of any S corporation debt
that is owed to the shareholder. The downward loss and deduction adjustments are made to the basis
of S corporation debt only after the shareholder's basis for the S corporation stock has been reduced
to zero. Any positive basis adjustments are made to restore the basis of S corporation debt owed to
the shareholder before any positive basis adjustments are made to the shareholder's basis for the S
corporation stock. pp. C11-25 and C11-26.
C11-20 Gain (but not loss) is recognized under Sec. 311(b) by an S corporation when making a
nonliquidating property distribution to its shareholders. No gain or loss is recognized by a
partnership making a nonliquidating property distribution except to the extent that (1) the Sec. 751
rules may apply to certain disproportionate distributions or (2) the precontribution gain rules of Sec.
737 apply to the distribution. S corporations having no E&P will make tax-free distributions if the
total amount of the distribution does not exceed the shareholder's basis for his or her stock. This
procedure generally follows the rules for partnership distributions, except to the extent that the S
corporation must recognize gain when distributing appreciated property and therefore the shareholder
reduces the basis of his or her S corporation stock by the property's FMV. Unlike partnership
taxation, some S corporations must maintain records of their Accumulated Adjustments Account,
Previously Taxed Income, and E&P. Similar concepts are not found in partnership taxation. For S
C11-5
corporations having an E&P balance, distributions follow a complex set of rules and are sourced in
part or in full from the three accumulated earnings accounts described above. pp. C11-26 through
C11-31.
C11-21 Nonliquidating distributions that are paid by an S corporation that does not have any
accumulated E&P are treated as coming out of the shareholder's basis for his or her stock investment.
As such, all distributions paid to the shareholder up to the amount of his or her basis for the stock
are tax-free. Distributions in excess of the shareholder's basis for his or her stock are taxable as being
received in exchange for the shareholder's stock and thus are generally capital gains.
Different rules apply to S corporations that have accumulated E&P. Distributions that are
out of the S corporation's accumulated E&P are taxable as dividend income. Distributions that are in
excess of the S corporation's accumulated E&P are also tax-free and reduce the shareholder's basis
for his or her stock. Distributions that are out the Accumulated Adjustments Account, and
Previously Taxed Income are tax-free and reduce (but not below zero) the shareholder's basis for his
or her stock. Distributions in excess of the shareholder's basis for his or her stock are generally
taxable as capital gains. pp. C11-26 through C11-31.
C11-22 The Accumulated Adjustments Account (AAA) is the cumulative total of the ordinary
income or loss and separately stated items for the S period. According to the Code, the AAA is
required only of S corporations that have an accumulated E&P balance. The S period is the most
recent continuous period during which the corporation has been an S corporation. No tax years
beginning before January 1, 1983 are included in this period. Tax-exempt income and nondeductible
expenses related to the production of the tax-exempt income do not increase or decrease the AAA
but are instead included in the Other Adjustments Account which is not a separate earnings balance,
but is included in the basis of the S corporation stock. All other income, gain, loss, and deduction
items increase and decrease AAA and the shareholder's basis for his or her stock investment.
Authors' Note: If there is no accumulated E&P at year-end, an AAA is still required according to the
instructions for the Form 1120S for reporting the S corporation's income on its tax return. For
corporations without accumulated E&P, the AAA includes all items of income, gain, loss, and
deductions, including tax-exempt income and any nondeductible expenses and losses related to the
tax-exempt income. pp. C11-26 through C11-31.
C11-23 a.
Ordinary income or loss (as well as separately stated items) is reported by the S
corporation's shareholders on their individual returns. Ordinary income or loss of a C corporation is
reported by the C corporation in its taxable income.
b.
Capital gains and losses are passed through by the S corporation as a separately-stated
item and reported by the S corporation's shareholders on their individual returns along with their
other capital gains and losses. Capital gains and losses recognized by a C corporation are reported in
the corporation's taxable income.
c.
Tax-exempt interest income is passed through to the S corporation's shareholders as a
separately-stated item. It is not taxed either to the S corporation's shareholders or to the S
corporation. C corporations are not taxed on their tax-exempt income; however, such amounts are
included in the C Corporation's E&P and are taxable to its shareholders when distributed.
C11-6
d.
Charitable contributions are passed through by the S corporation as a separately-stated
item and reported by the S corporation's shareholders on their tax returns along with their other
charitable contributions. The charitable contribution deduction limitation is applied at the
shareholder level. Charitable contributions made by a C corporation are deducted by the C
corporation and are limited to 10% of its adjusted taxable income.
e.
Nonliquidating property distributions made by an S corporation without accumulated
E&P are treated as a tax-free return of capital and reduce the shareholder's basis for his or her S
corporation stock. Distributions that are paid once the basis of the stock is reduced to zero are
generally taxed as capital gains. Different rules apply to S corporations that have accumulated E&P.
Any such distributions made by these corporations out of accumulated E&P are taxable as a
dividend. Distributions made out of the Accumulated Adjustments Account (AAA), and Previously
Taxed Income are tax-free until the shareholder's basis for his or her stock has been reduced to zero.
Nonliquidating distributions made by a C corporation are taxable as a dividend if paid out of current
or accumulated E&P. Distributions in excess of E&P reduce the shareholder's basis for his or her
stock or, if made in excess of the shareholder's basis, are taxed as capital gains.
f.
Fringe benefits paid to or on behalf of an owner-employee owning more than 2% of
the S corporation's stock are treated as if the corporation were a partnership. As such, the
owner-employee is not an employee and the fringe benefit is treated as compensation taxable to the
shareholder-employee, unless the benefit is excludible from the gross income of a partner. The
compensation is deductible by the corporation. Fringe benefits paid to or on behalf of an
owner-employee of a C corporation, or to an S corporation shareholder-employee owning less than
2% of the stock, are tax-exempt to the individual and deductible by the corporation.
pp. C11-14, C11-15, C11-26 through C11-31, C11-32 and C11-33.
C11-24 The S corporation's tax return is due on 15th day of the third month following the close of
the tax year. An automatic six-month extension of time to file the return can be requested. pp.
C11-36 and C11-37.
C11-25 S corporations must make estimated tax payments for the two special corporate level taxes-the excess net passive income tax and built-in gains tax. Estimated tax payments are also required
for any investment tax credit recapture which was claimed when the corporation was a C
corporation. The estimated tax minimums for an S corporation are different from a C corporation.
Both require 100% of the tax shown on the return for the current year. The prior year tax rule for S
corporations is 100% of the built-in gains tax and investment tax credit recapture for the current year
and 100% of the excess net passive income tax for the preceding year (instead of the 100% of prior
year tax liability rule applicable to C corporations). Any tax payments made by the S corporation do
not reduce the shareholder's needed estimated tax payments, but the estimated payments reduce the
ordinary income and separately stated items passed through to the shareholders. p. C11-37.
C11-26 Some of the similarities and differences are listed below; however, this should not be
considered all inclusive:
C11-7
Similarities between all three returns:
1.
Cost of goods sold is calculated the same.
2.
A balance sheet is presented for all business forms.
3.
Schedule M-1 on the Form 1120, 1120S and 1065 reconciles book income with
income reported on the return. For the S corporation return this reconciliation is to the ordinary
income (loss) amount plus also separately stated income and deduction items. Schedule M-2 on the
Form 1120 reconciles accumulated book income (retained earnings) and Form 1120S reconciles
three accumulated earnings account balances while the Form 1065 reconciles the capital account
balance.
Differences:
1.
Form 1120 taxable income includes all income earned by the corporation during the
tax year, but Forms 1065 and 1120S ordinary income excludes many separately stated items.
2.
Forms 1065 and 1120S have Schedules K and K-1 to report the items passed through
in total and to each of the owners, where the Form 1120 does not.
3.
Forms 1065 and 1120S require specific information on rental real estate activities
while Form 1120 does not.
4.
Controlling ownership information is given on all three forms; however, the Forms
1065 and 1120S list all ownership interests on the Schedule K-1s for the owners.
5.
Form 1065 does not include any tax calculations or estimated tax payments. Forms
1120 and 1120S requires tax calculations and possibly estimated tax payments.
6.
All three forms request different additional information.
7.
Form 1120 includes the dividends-received deduction calculation. Forms 1065 and
1120S do not.
8.
Form 1120 requests information on officer's compensation. Forms 1065 and 1120S
do not.
Appendix B.
Issue Identification Questions
C11-27 ·
·
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Does the incorporation transaction qualify as tax-free under Sec. 351?
Are there advantages to be gained by transferring the partnership's assets to the
corporation in exchange for its stock and then liquidating the partnership?
·
Are there advantages to be gained by liquidating the partnership and then
transferring the assets to the corporation in exchange for its stock?
What is the amount of character of the gain or loss recognized on the incorporation
by the partnership? the S corporation? the partners?
·
What is the basis of the assets to the S corporation?
·
What is the basis of the S corporation stock to each shareholder?
·
When does the holding period start for the assets? The S corporation's stock?
What tax year should be elected by the corporation? Does this have to be the same
tax year that was used by the partnership?
C11-8
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What accounting methods should be elected by the corporation? Do these have to be
the same accounting methods that were used by the partnership?
What procedures must be followed to make an S election?
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By what date must the election be made?
·
What format does the election take?
·
What consents are required of the shareholders?
One underlying question which might be brought up is: Should the tax practitioner and the
transferor consider using an LLC instead of an S corporation?
The method of incorporation does matter. In fact, the entity making the selection does not
have to be a corporation. Under the check-the-box regulations, a noncorporate entity can elect to be
taxed as a corporation and then make a selection. The tax consequences (e.g., gain recognized, basis
amounts, etc.) can be different depending on which of the three basic methods are used to terminate
the partnership and transfer the assets to the corporation. Without further information, the gain and
basis amounts can not be determined, nor can we say which of the three ways are better. The S
corporation can use a tax year different from the partnership, but it does have to be a required year.
Likewise, the S corporation can elect any accounting method that it chooses, without regard to the
method that was employed by the partnership. An S election (Form 2553) must be filed in a timely
manner and the appropriate consents must be obtained from the shareholders. A transfer of assets
from a partnership to an LLC is covered by rules different from a corporate formation (see Chapter
C10).
pp. C11-2 through C11-9, C11-13, C11-14, C11-25, and C11-36.
C11-28 The questions listed below are based on the presumption that an S election is going to be
advantageous and that the S corporation is in fact the best entity choice for the corporation.
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What procedures must be followed to make an S election?
·
By what date must the election be made?
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What format does the election take?
·
What consents are required of the shareholders?
What tax year should be elected by the S corporation? Does this have to be the same
tax year that was used by the C corporation?
What accounting methods should be elected by the S corporation? Do these have to
be the same accounting methods that were used by the C corporation?
What possible built-in gains tax liability will be incurred while an S corporation?
·
Should the corporation obtain an appraisal of the assets as of the first day of
the S election?
·
What tax attributes (e.g., NOLs and capital losses) will be suspended as a
result of making the S election?
What possible excess net passive income tax liability will be incurred while an S
corporation?
C11-9
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Should the corporation consider distributing its Subchapter C E&P to
eliminate this tax liability?
What possible LIFO recapture tax liability will be incurred by the corporation in its
final C corporation tax year?
An S election (Form 2553) must be filed in a timely manner and the appropriate consents
must be obtained from the shareholders. The S corporation can not use a tax year different from the
C corporation, but it may have to change to a required tax year. The S corporation must continue to
use the accounting methods that the C corporation has used.
A built-in gains tax liability will be imposed on asset dispositions occurring within 10 years
of the first day of the S election period. An appraisal is suggested to establish the amount of the
built-in gains and losses in order to minimize the built-in gains tax liability. C Corporation NOLs
and net capital losses can reduce the built-in gains tax liability, but can not be passed through to the
shareholders. In addition, if the S corporation has Subchapter C E&P, it may incur the excess net
passive income tax liability if it earns a substantial amount of passive income. Also, the S
corporation may incur the LIFO recapture tax if it used the LIFO inventory method in its final C
corporation tax year.
pp. C11-7 through C11-9, C11-13, C11-14, C11-16 through C11-19 and C11-36.
C11-29 ·
What is Peter's allocable share of the Air South ordinary loss?
·
·
What portion of the loss is limited by the basis of the S corporation stock and
debt? The at risk rules? The passive activity loss rules? The hobby loss
rules?
If his use of the loss is only limited by the basis of the S corporation stock
and debt, should Peter invest additional monies before year-end in order to
increase the basis of the stock and/or debt? When should such an investment
be made? Before year-end? After year-end? Should no additional
investment be made and the loss be used against future profits?
Peter should anticipate a $187,500 ordinary loss passthrough which is in excess of his
$100,000 basis for the Air South stock. The additional investment should be made only if it is
economically wise. Even if the additional investment is made, there is no guarantee that he will be
able to deduct the loss. The passive activity loss rules may deny the loss until Peter has passive
income from this or another activity, or he completely disposes of his investment. The tax-year in
which to make the additional investment, and deduct the loss will be the year in which Peter
anticipates the highest marginal tax rate (discounted for the time value of money.)
pp. C11-19 through C11-23, C11-34 through C11-36.
C11-10
C11-30 ·
·
·
·
·
What gain or loss is recognized by Glacier Smokeries on making the distribution?
Does the gain or loss trigger any built-in gains tax liability? Excess net passive
income tax liability?
What is each shareholder's basis for the Glacier Smokeries stock immediately
preceding the distribution?
What basis reduction does the distribution cause for each shareholder? Does the
basis reduction trigger the recognition of any income by the shareholder (e.g., if the
distribution reduces the shareholder's basis to zero).
What is each shareholder's basis for the Glacier Smokeries stock immediately
following the distribution?
What is each shareholder's basis and holding period for the land that is received?
Glacier Smokeries will recognize $225,000 ($300,000 - $75,000) of ordinary income from
the distribution. This gain may be subject to the Sec. 1374 or Sec. 1375 tax, but insufficient facts are
provided to make such a determination. This gain and Glacier Smokeries ordinary income from
operations will increase the shareholders' stock bases. Adam and Rodney take $350,000 ($175,000 +
$112,500 + $62,500) and $400,000 ($225,000 + $112,500 + $62,500) bases, respectively, assuming
that no corporate level taxes are imposed. Each shareholder will reduce their bases by $150,000
(0.50 x $300,000) for the distribution.
pp. C11-26 through C11-31.
Problems
C11-31 a.
King Corporation:
$50,000 x 0.15 =
$25,000 x 0.15 =
$25,000 x 0.34 =
Total
$ 7,500
6,250
8,500
$22,250
Ken Munro: $-0Total tax liability = $22,250 + 0 = $22,250
b.
King Corporation: $22,250 (same as part a). Ken Munro: ($100,000 -$22,250 taxes)
gross income - $4,250 standard deduction - $2,700 personal exemption = $70,800 taxable income;
$17,092.50 tax liability. Total tax liability: $22,250 + $17,092.50 = $39,247.50.
c.
King Corporation: $100,000 - $50,000 salary = $50,000 taxable income; $7,500
($50,000 x 0.15) tax liability. Ken Munro: $50,000 gross income - $4,250 standard deduction $2,700 personal exemption = $43,050 taxable income; $8,849.50 tax liability. Total tax liability:
$7,500 + $8,849.50 = $16,349.50.
The lowest liability is in part (c) since no income is taxed twice and, because the
income is split between the two taxpayers, the lowest marginal tax rates are used for each taxpayer.
C11-11
The above calculations ignore the fact that payroll taxes are incurred with respect to the salary
payment.
d.
King Corporation: No tax liability for parts a, b, and c. The shareholder's gross
income for parts a, b, and c all equal to $100,000. In part (a), all $100,000 of income is passedthrough to Ken. In part (b), all $100,000 is passed through to Ken, and none of the distribution is
taxable. In part (c), $50,000 is taxed to Ken as salary, and $50,000 is passed through to Ken. This
answer again ignores the fact that payroll taxes are imposed on the S corporation's salary payment.
The tax liability for Ken Munro in all three cases is: $100,000 gross income - $4,250 standard
deduction - $2,700 personal exemption = $93,050 taxable income; $23,708 tax liability for Ken
Munro and $23,708 total tax liability. For all three parts the total corporate and individual tax
liability is $23,708 (-0- + $23,708).
pp. C11-19 and C11-20.
C11-32 a.
Voyles Corporation makes the S election by filing Form 2553 in a timely manner with
all of its shareholders consenting to the election.
b.
The S election can be made (1) at any time during the tax year preceding the year for
which the election is to be effective (1997) or (2) on or before the fifteenth day of the third month of
the year for which the election is effective (1998). Corporations making an S election in their initial
tax year must make the election not later than the 15th day of the third month of the initial tax year.
c.
The election will take effect on the first day of the next tax year (1999). pp. C11-7
through C11-9.
C11-33 a.
The sale of the second class of stock terminates the S election at the close of business
on September 15, 1998.
b.
Two tax returns are required covering the following time periods: (1) an S corporation
return for January 1, 1998 through September 15, 1998; and (2) a C corporation return for September
16, 1998 through December 31, 1998. Both returns are due on March 15, 1999.
c.
The IRS does not recognize the Class B common stock as a second class of stock and
the S corporation election is not terminated if the only difference between the original common stock
and the Class B common stock is the voting rights. pp. C11-4 through C11-6, C11-9 through C1111.
C11-34 a.
Tango Corporation must file a revocation statement on or after June 15, 1998 which is
consented to by the sole shareholder. If the revocation is filed before the end of 1998, Tango
Corporation can designate a prospective revocation date in 1998 or a later year. If the revocation is
filed in the first 2 1/2 months of 1999, the revocation can be made retroactive to the beginning of
1999; otherwise, it must be made on a prospective basis.
b.
An S corporation return is filed for the period January 1, 1998 through June 30, 1998.
C corporation returns are filed for the period July 1, 1998 through December 31, 1998 and January
1, 1999 through December 31, 1999. Both 1998 returns are due on March 15, 1999. The 1999
return is due on March 15, 2000.
C11-12
c.
The S corporation must wait five tax years before making a new election unless IRS
consent is obtained for the earlier reelection. The new election takes effect on January 1, 2003.
Note: Congress enacted a special one-time waiver of the 5-year reelection waiting period for S
corporation terminations occurring in a tax year beginning before January 1, 1998. These
corporations can reelect S corporation status immediately with IRS consent. pp. C11-9 through C1112.
C11-35 The sale will result in termination of the S corporation election because the partnership is an
ineligible shareholder. Under the general S corporation rules, the termination will be effective on
December 31, 1998. Galleon Corporation files an S corporation return for the period January 1,
1998 through December 31, 1998. For 1999 and later tax years, Peter and Alice must include the
Galleon distributions in their taxable income, provided Galleon has E&P. No other income or loss
pass-throughs will occur while operating as a C corporation.
To avoid the results of termination, Galleon could claim relief under the inadvertent
termination rules if they take immediate steps to eliminate the cause of the termination. To effect the
inadvertent termination, Rob and Susan should liquidate their partnership and distribute the Galleon
Corporation stock to themselves, holding it again as individuals; therefore, the ineligible shareholder
would be eliminated. Alternatively, the stock could be sold back to Peter and Alice.
Peter and Alice are also able to reelect S corporation status after a 5-year waiting period.
They are not eligible for the special one-time waiver of the 5-year waiting period that was enacted in
1996 since the termination did not occur in a tax year beginning before January 1, 1997. pp. C11-10
through C11-13.
C11-36 a.
No. The maximum deferral that can be elected is three months unless a business
purpose exists for the fiscal year ending January 31. A September 30 year-end can be adopted if
Classic Corporation makes a timely Sec. 444 election and makes the required payments under Sec.
7519. The September 30 year-end will permit a three-month income deferral.
b.
Yes. The June 30 year-end conforms to its natural business year; therefore, it satisfies
the business purpose requirement. IRS approval of the natural business year is required, as is
conformity to the income requirement for the last two months of the natural business year.
c.
The tax year used by Elite is a "grandfathered" tax year. Elite Corporation can
continue to use its January 31 year-end because it made a timely election under Sec. 444 for the 1987
tax year and has continued to makes the required payments under Sec. 7519 in all subsequent tax
years. pp. C11-13 and C11-14.
C11-37 a.
North Corporation is subject to the excess net passive income tax since (1) it has
passive investment income ($160,000) that exceeds 25% of its gross receipts (0.25 x $210,000 =
$52,500) and (2) it has Subchapter C E&P at the close of 1998. The services income is not passive
investment income since it is derived from the active conduct of a trade or business. North
Corporation's tax liability is determined as follows:
Excess net
passive
=
Net
passive x
C11-13
$160,000 - (0.25 x $210,000)
income
($87,344)
income
($130,000)a
$160,000
a
($100,000 + $60,000) - $30,000 direct expenses = $130,000
Tax = 0.35 x $87,344 = $30,570
The Sec. 1375 tax is paid by the S corporation in the form of estimated tax payments made during
the tax year.
b.
The excess net passive income tax reduces, on a pro rata basis, the amount of ordinary
income and separately stated items (dividends and rents in this case) that were subject to tax and
which are passed through to the shareholders. The reduction is as follows:
$60,000
Dividends: $30,570 x
= $11,464
$60,000 + $100,000
Rents:
$100,000
$30,570 x
= $19,106
$60,000 + $100,000
The dividend pass-through is $48,536 ($60,000 - $11,464). The rental income pass-through is
$50,894 ($100,000 - $30,000 - $19,106).
c.
Tax planning alternatives available to North Corporation include: (1) earning more
active income (e.g., services income); (2) earning less passive income (e.g., dividend or rental
income); (3) distributing the $60,000 of Subchapter C E&P to its shareholders; or (4) distributing the
stocks and/or rental properties to the shareholders. pp. C11-16, C11-35 and C11-36.
C11-38 Receivables
Automobile (Sec. 1245 gain)
Land (Sec. 1231 gain)
Accounts payables
Recognized built-in gains
$200,000
1,000a
20,000b
(125,000)c
$ 96,000
Limited to: smaller of: 1998 taxable income
Net unrealized built-in gain
Recognized built-in gains
a
$400,000
295,000d
96,000
$2,500 [$3,500 - ($2,000 - $1,000)] recognized gain. Limited to $1,000-built-in gain on first day of
first S corporation tax year (1998).
b
$35,000 ($60,000 - $25,000) recognized gain. Limited to $20,000--built-in gain on first day of first
S corporation tax year (1998).
c
Deductible accounts payable only.
C11-14
d
$420,000 unrealized built-in gains - $125,000 unrealized built-in losses = $295,000 net unrealized
built-in gain.
Neither special limitation (taxable income or net unrealized built-in gain) applies since the total
recognized built-in gains are less than either limitation.
The built-in gains tax liability equals $33,600 ($96,000 x 0.35). The built-in gains tax
liability reduces the income pass-through for the receivables and automobile gain (ordinary income)
and the land gain (Sec. 1231 gain) on a ratable basis.
pp. C11-16 through C11-18.
C11-39 a and b.
Ordinary
Income (Loss)
Operating profit
Dividend income
Separately
State
$275,000
- domestic corporation
- foreign corporation
Interest income
- installment sale
- municipal bonds
- corporate bonds
Gains and losses on property sales
Sec. 1231 gain
Net long-term capital gain
Short-term capital gain
Sec. 1245 gain
MACRS depreciation
Charitable contribution deduction
Salary expense
Rental expense
Repairs expense
State and local taxes
Interest expense on stock investment
Foreign taxes
Total
a
$12,000
6,000
9,000
7,000
3,000
9,000
5,000
8,000
10,000
(46,000)
25,000
(60,000)
(30,000)a
(36,000)
( 6,000)
$116,000
10,000b
1,200c
XXX
The $6,000 unpaid amount at year-end is nondeductible under Sec. 267(c). The liability for the
unpaid rents is owed to a shareholder (Amelia) and remains unpaid at year-end. It is deductible in
the year in which it is paid and included in the shareholder's gross income.
b
The interest expense is investment interest and subject to a special shareholder limitation.
c
Foreign taxes withheld on dividend.
C11-15
pp. C11-14 and C11-15.
C11-16
C11-40 John:
$125,000 x 100% x 161* = $
365
$125,000 x 90% x 204
55,137
=
62,877
365
$118,014
*The donee is assigned the income for the gift date.
$125,000 x 10% x 204
365
Michael:
= $ 6,986
pp. C11-19 and C11-20.
C11-41 Under the general rule, the income would allocated on a daily basis, as follows:
Al: OI:
Sec. 1231:
Ruth: OI:
Sec. 1231:
Patty: OI:
Sec. 1231:
$180,000 x 50% =
$ 90,000
$ 75,000 x 50% =
37,500
$127,500
$180,000 x 50% x 94 =
365
$ 75,000 x 50% x 94 =
365
$ 23,178
$180,000 x 50% x 271 =
365
$ 66,822
$ 75,000 x 50% x 271 =
365
27,843
$ 94,665
a
9,657
$ 32,835
a
The purchaser is allocated the income for the sale date.
However, since Ruth terminated her interest on April 5, Chemical Corporation can make a
special election to allocate income according to the accounting methods used by the corporation.
Such an election produces the following income allocation:
Al: OI:
Sec. 1231:
$180,000
x 50%
=
$ 90,000
$ 75,000
x 50%
=
37,500
$127,500
C11-17
Ruth:
$ 47,000a x 50%
=
$ 23,500
Patty:
$133,000b x 50%
=
$ 66,500
$ 75,000
=
37,500
$104,000
x 50%
a
($15,000 x 3) + (4/30 x $15,000) = $47,000. Only 4 days of income are allocated to Ruth
in the fourth month since the purchaser is allocated the income for the sale date. No Sec. 1231 gain
is allocated to Ruth since the asset was sold after Ruth sold her stock investment. Only Al and Patty
receive an allocation of the Sec. 1231 gain.
b
$180,000 - $47,000 = $133,000
The election must be agreed to by all affected shareholders in Chemical Corporation.
Affected shareholders are any shareholder whose interest is terminated and all shareholders to whom
the terminating shareholder transferred his/her interest. In this case, the affected shareholders are
Ruth and Patty. Because of the difference in the income reported by Ruth and Patty under the two
alternatives, this should be a point for negotiation at the time of entering into the sales agreement.
pp. C11-19 and C11-20.
C11-42 a.
The changes in stock ownership that took place during the year require an allocation
calculation to be performed based on the number of days the stock was held. The results of this
allocation and the formulas used are presented below.
Allocation to Shareholder
Ordinary income
Long-term capital loss
Charitable contributions
a
60
Boba
Aliceb
Carterc
$72,000
6,000
3,600
$26,926
2,244
1,346
$10,981
915
549
365
100 x 365 x Amount
b
30
c
181
x
100 365 x Amount
10
334
100 x 365 x Amount
d
15
15
+
184
100 x 365 x Amount
+
100 x
184
65
10
31
100 x
365
x Amount
x
Amount
C11-18
Miked
Total
$10,093
841
505
$120,000
10,000
6,000
b.
Adjusted basis = $26,000 + $10,981 - $915 - $549 = $35,517
Recognized gain = $45,000 - $35,517 = $9,483
pp. C11-19 and C11-20.
C11-43 The sale of the additional stock terminates the S corporation election at the close of business
on June 30. The income for the first half of the year is allocated equally to Rod and Ken. The
income for the last half of the year is taxed to Redfern Corporation under the C corporation rules.
Daily allocation:
Shareholder
Rod
Ken
Blackfoot Corporation
Redfern Corporation
Total
a
Pre-7/1a
Ordinary
Income
Post-6/30b
Capital
Loss
$30,993
30,993
-0-
($3,719)
( 3,719)
-0-
$61,986
($7,438)
Ordinary
Income
-0$63,014
$63,014
Capital
Loss
-0($7,562)
($7,562)
181
365 x Amount = Amount allocated to pre-July 1 period.
b
184
365 x Amount = Amount allocated to post-June 30 period.
Accounting method allocation:
Pre-July 1:
Ordinary income: $125,000 x 0.20 = $25,000 allocated to S corporation
short-year; $12,500 to each Rod and Ken.
Capital loss: -0-, since the asset was sold in the C short year.
Post-June 30:
Ordinary income: $125,000 - $25,000 (allocated to S short year) =
$100,000. Taxed to Redfern Corporation in C short year.
Capital loss: $15,000 (carried forward to next year by Redfern).
Some tax savings might accrue by creating a second tax paying entity (the C corporation after the
loss of its S election), having the income taxed at the lower 15% and 25% corporate tax rates, and
retaining the income within the corporation. Thus, the accounting method election might be elected
to maximize the income taxed at the corporate level in the last half of the tax year. Annualization is
required for the first C corporation tax year. This requirement will reduce the advantage of
allocating income to the C corporation portion of the year. As a result, the general daily allocation
rule probably is the best for all parties involved.
pp. C11-19 and C11-23.
C11-19
C11-44 a.
The answers below presume that the three sons are considered to be bona fide owners
of the S corporation stock.
Betty:
$60,000 salary and $132,000 ordinary income (0.55 x $240,000)
John:
$36,000 ordinary income (0.15 x $240,000)
Andrew:
$36,000 ordinary income (0.15 x $240,000)
Stephen:
$36,000 ordinary income (0.15 x $240,000)
Since Andrew and Stephen are less than 14 years of age, their income will be taxed at Betty's
marginal tax rate. John is 16, therefore, he will be taxed under the regular progressive rate structure.
The distributions do not trigger any additional tax liability.
b.
Betty:
John:
Andrew:
Stephen:
$120,000 salary and $99,000 ordinary income (0.55 x $180,000)
$27,000 ordinary income (0.15 x $180,000)
$27,000 ordinary income (0.15 x $180,000)
$27,000 ordinary income (0.15 x $180,000)
c.
Betty: $60,000 salary and $240,000 ordinary income.
pp. C11-23 and C11-24.
C11-45 a.
Monte
Allocation to shareholders
Ordinary loss
Tax-exempt interest income
Long-term capital loss
Loss limitation:
Stock basis
Tax-exempt interest
Note basis
Loss deduction:
Ordinary loss
Capital loss
a
Allie
$87,500
10,000
16,000
$ 87,500
10,000
16,000
$80,000
10,000
-0$90,000
$ 90,000
10,000
10,000
$110,000
$76,087a
$13,913c
$ 87,500b
$ 16,000d
- [$87,500/($87,500 + $16,000)] x $90,000 = $76,087
- No limitation applies since the total loss of $103,500 ($87,500 + $16,000) is less than the Allie's
$110,000 limitation.
c
- [$16,000/($87,500 + $16,000)] x $90,000 = $13,913
d
- No limitation for the reason outlined in footnote b.
b
C11-20
b.
c.
Monte's stock ($80,000 + $10,000) - $90,000 = $0
Allie's stock: ($90,000 + $10,000) - $100,000 = $0
Allie's note: $10,000 - $3,500 = $6,500
d.
Monte has an $11,413 ($87,500 - $76,087) ordinary loss carryover and a $2,087
($16,000 - $13,913) capital loss carryover to the next year. Allie has no loss carryovers.
e.
Monte
Allocation to partners
Ordinary loss
Tax-exempt interest income
Long-term capital loss
Allie
$87,500
10,000
16,000
$ 87,500
10,000
16,000
Loss limitation:
Capital investment basis
Tax-exempt interest
Note basis
Accounts payable
Mortgage payable
Total
$80,000
10,000
-045,000
15,000
$150,000
$ 90,000
10,000
10,000
45,000
15,000
$170,000
Deduction:
Ordinary loss
Capital loss
$ 87,500
$ 16,000
$ 87,500
$ 16,000
The larger basis under the partnership interest basis rules will permit the ordinary and capital losses
to be deducted in full by the two individuals.
pp. C11-20 through C11-23.
C11-21
C11-46 a.
Monte
Allie
Allocation to shareholders:
Ordinary loss
Tax-exempt interest income
Long-term capital loss
$37,500
10,000
12,500
$37,500
10,000
12,500
Carryover from prior years:
Ordinary loss
Long-term capital loss
$11,413
2,087
$ -0-0-
$ -037,500
10,000
12,500
-0$60,000
$ -037,500
10,000
12,500
6,500
$66,500
$26,087a
10,413b
$37,500
12,500
Loss limitation for current year:
Stock basis on 1/1
Ordinary income
Tax-exempt income
Long-term capital gain
Note basis on 1/1
Income/loss reported in current year:
Ordinary income
Long-term capital gain
a
$37,500 - $11,413 carryover = $26,087.
$12,500 - $2,087 carryover = $10,413.
b
b.
1/1 Basis
Plus: Income: OI
T/E interest
LTCG
Minus: OI carryover
LTCG carryover
12/31 Basis
$37,500
37,500
10,000
12,500
(11,413)
( 2,087)
$46,500
c.
Stock: $0 + ($37,500 - $3,500 restoration of note basis) + $10,000
+ $12,500 = $56,500.
Note: $6,500 + $3,500 = $10,000.
d.
Monte has fully deducted his ordinary and capital loss carryovers from the prior year,
therefore no further carryovers exist. pp. C11-20 through C11-23.
C11-22
C11-47 a.
$150,000 ($100,000 basis for stock + $50,000 basis for note).
b.
Stock: -0- Note: -0c.
Current year activities: $60,000 ordinary income; loss carryover from last year,
$25,000 ordinary loss; note repayment, $15,000 [$50,000 - (-0- + $60,000 - $25,000) = $15,000]
long-term capital gain. Even though the note was repaid before the year-end, its basis was still
increased for the restoration at the time of the repayment. The basis of the stock at year-end is -0-.
pp. C11-24 through C11-26.
C11-48 a.
$60,000 each.
b.
$45,000 each [($210,000/2) - $60,000].
c.
The losses in excess of $5,000 go to create a NOL on Chuck's individual tax return.
d.
None, unless Chuck and Linda have basis in their Stein Corporation stock at the end
of the post-termination transition period (December 31, 1998 since the revocation takes place
retroactive to the beginning of 1998). The basis amount could come about through additional capital
contributions that Chuck and Linda make.
e.
The revocation could be made with a prospective revocation date late enough in 1998
so that each shareholder would be allocated $45,000 of ordinary income. By revoking the S election
on March 1, 1998, the revocation takes effect at the beginning of the tax year and forces Chuck and
Linda to make additional capital contributions in order to be able to deduct the losses under the posttermination transition period rules. An April 1, 1998 prospective revocation should permit enough
ordinary income ($15,000 per month per shareholder x 3 months = $45,000 income) to flow through
to each shareholder to fully use the $45,000 of loss carryover. pp. C11-20 through C11-23.
C11-49 Rocket Corporation is expected to report a $120,000 ordinary loss in the current year.
Additional capital contributions of $40,000 ($120,000 loss - $80,000 basis) made in the current year
would permit the entire loss to be deductible currently at a 36% or 39.6% marginal tax rate
(assuming Tina is single). An additional capital contribution of $20,000 is needed in the following
year to enable the loss incurred in that year to be deductible at a 31% marginal tax rate. If the
additional capital contributions are not made, then $60,000 of the losses ($40,000 from year 1 and
$20,000 from year 2) are carried over. $50,000 can be used in year 3 and $10,000 in year 4 and will
offset the profits reported in those years. These losses can be deducted at a 36% marginal tax rate.
Since the marginal rate in the current year is the same as in the year profits are ultimately expected,
Tina should consider making the additional capital contributions in the current year to take into
account the time value of money and use the losses up as soon as possible. The losses from year 2
should probably be deferred and used in the year in which Rocket Corporation becomes profitable
when the marginal tax rate again reaches 36%. Alternatively, Tina could contribute additional
capital and use the losses in the year that they are incurred.
If the alternative set of facts are used and Tina makes the additional $40,000 capital
contribution in the current year, Tina will generate a $45,000 ($120,000 loss - $75,000 profit) NOL
in the current year. This NOL will be carried back three years and carried forward fifteen years.
Tina could get an immediate refund from the loss carryback, at the marginal tax rate that applied in
the prior year. If Tina had a low marginal tax rate in the prior year, she should delay making the
additional capital contribution until next year. By delaying the contribution, she can fully utilize the
C11-23
loss against the larger income to be earned next year which will be taxed at marginal tax rates of 36%
and 39.6%. pp. C11-20 through C11-23, C11-34 and C11-35.
C11-50 Alice's personal tax situation for the current year (using 1998 rates, etc.) is presented below:
Other income
$100,000
Salary from Morning
-0Operating loss
( 90,000)
Adjusted gross income
$ 10,000
Minus: Personal exemption
( 2,700)
Standard deduction
( 4,250)
Taxable income
$ 3,050
Tax liability
$
457
The loss passthrough from Morning Corporation will eliminate almost all of Alice's current
year personal tax liability. Based on this information the ordinary loss passthrough that is available
from an S election would be a good recommendation. All of the losses can be used in the current
year since they are less than Alice's basis for her S corporation stock and she materially participates
in the business.
Alice's tax liability, for future years, using the S corporation alternative and current year
(1998) tax rates for a single individual is outlined below. In all three cases her marginal tax rate is
39.6%.
S corporation income level
$250,000
$350,000
$500,000
Other income
Salary to Alice from Morning
S corporation ordinary incomea
Adjusted gross income
Minus: Standard deductionb
Taxable income
Tax liability
$100,000
100,000
150,000
$350,000
( 4,250)
$345,750
$115,350
$100,000
100,000
250,000
$450,000
( 4,250)
$445,750
$154,950
$100,000
100,000
400,000
$600,000
( 4,250)
$595,750
$214,350
a
Ordinary income = Pre-tax operating profits - Alice's salary
A personal exemption is not allowed due to the exemption phase-out provisions.
b
Morning's tax liability using the C corporation alternative is outlined below.
Pre-tax operating profits
Minus: Salary to Alice
Taxable income
Corporate tax liability
$250,000
(100,000)
$150,000
$ 41,750
C11-24
$350,000
(100,000)
$250,000
$ 80,750
$500,000
(100,000)
$400,000
$136,000
Alice's tax liability using the C corporation alternative is outlined below.
Other income
Salary from Morning
Adjusted gross income
Minus: Standard deduction
Personal exemptionc
Taxable income
Tax liability
$100,000
100,000
$200,000
( 4,250)
( 1,026)
$194,724
$ 58,558
c
Personal exemption: $2,700 - [$2,700 x (2% x $200,000 - $124,500)] = $1,026*
$2,500
*The phase-out percentage is rounded to 62%.
Alice's marginal personal tax rate is 36% for the salary drawn under the C corporation
alternative. The marginal corporate tax rate is 39% for the $250,000 and $350,000 alternatives and
34% for the $500,000 alternative.
The combined C corporation and individual tax liabilities and S corporation tax liabilities
for each of these income levels are illustrated below:
Income "pool"
S corporation
alternative
$250,000
350,000
500,000
$115,350
154,950
214,350
C corporation
alternative
$100,308
139,308
194,558
The higher C corporation tax liability situation is exacerbated by the second tax that is imposed on
dividend distributions made by the C corporation. With little need to retain capital in the business,
Alice's C corporation faces a need to make dividend distributions or be subject to the accumulated
earnings penalty tax. Therefore, an S election may prove to be even more advantageous than is
illustrated in the summary table. Some additional tax savings might accrue for the C corporation
alternative by increasing the size of Alice's salary so that only $100,000 of taxable income was left in
Morning Corporation, or by paying Alice fringe benefits or making pension contributions. This
table, however, omits the payroll taxes that are required to be paid on Alice's salary from the
calculation. Therefore, the S election appears to be a good decision even after the business becomes
profitable.
Two additional considerations that might enter into the decision-making is that Alice's basis
for her S corporation stock is increased by the income pass-through. No such basis adjustment
occurs for a C corporation. A C corporation shareholder, on the other hand, can exclude 50% of
their gain on the sale of corporate stock if they are a qualified small business corporation (as defined
by Sec. 1202) and have held the stock for more than five years. Under post-1997 Tax Act law,
C11-25
capital gains are generally taxed at a maximum tax rate of 20%. pp. C11-19, C11-20, C11-36 and
C11-37.
C11-51
Ordinary
income/loss
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
Operating profit
Dividend income from stocks
Interest income from bonds
Life insurance proceeds
Long-term capital gain
Sec. 1231 loss
Sec. 1245 gain
Charitable contributions
Fines paid for overweight trucks
Depreciation
Employee pension plan contributions
Salary paid to owner
Life insurance premiums on policy in
(d)
Money distribution
+
+
-
AAA
Stock basis
+
+
+
+
+
+
+
+
+
-
+
+
-
Items b, c, d, e, f, h, i, and m are separately-stated items.
Items (d) and (m), the life insurance policy and the premiums paid on the policy, are taken into
account when determining the Other Adjustments Account balance.
The salary payment (item l) reduces ordinary income (loss) and is separately reported to the
shareholder-employee on a Form W-2. Salary payments made to a shareholder-employee are subject
to social security tax and income tax withholding. Such treatment is different from the treatment for
a guaranteed payment made to a partner which is reported on Schedules K and K-1 of Form 1065
and that are treated as self-employment income.
pp. C11-14, C11-15, C11-24 through C11-26 and C11-27 through C11-31.
C11-52 a.
None. The corporation recognizes no gain since a cash distribution is made. The
shareholder recognizes no gain since the distribution does not exceed the basis of her stock.
b.
$40,000 + $36,000 - $4,000 - $1,000 - $10,000 = $61,000
c.
The basis for the stock is $71,000 immediately preceding the basis adjustment for the
distribution. Thus, $71,000 is tax-free as a return of capital and $4,000 is taxed to Tammy as a
C11-26
capital gain resulting from the sale or exchange of her stock. The basis of the stock is zero
immediately after the distribution. pp. C11-26 and C11-27.
C11-53 a.
This distribution is a tax-free return of capital, therefore, it does not result in
reportable income by Curt. Vogel Corporation reports an $8,000 gain ($18,000 FMV - $10,000
basis) under Sec. 311(b) as a result of distributing appreciated property in addition to the ordinary
income, Sec. 1231 gain, and charitable contribution reported in the facts. The tax-exempt interest
income is excluded from Curt's gross income. The basis of the land is $18,000 to Curt.
b. and c.
Basis
Original capital contribution
Ordinary income
Sec. 1231 gain
Tax-exempt interest income
Gain recognized on distribution of FMV of land
Charitable contribution
Distribution ($5,000 cash + $18,000 land)
Adjusted basis
$ 60,000
60,000
40,000
5,000
8,000
( 3,000)
( 23,000)
$147,000
AAAa
$ -060,000
40,000
5,000
8,000
( 3,000)
(23,000)
$87,000
a
The tax-exempt income is included in the AAA balance here and on Form 1120S since the
corporation does not have any accumulated E&P. If the corporation had accumulated E&P, then the
tax-exempt income would be included in the Other Adjustments Account.
Maintenance of the AAA records and balance is recommended in the Form 1120S instructions in
case the S corporation acquires E&P in a transaction (e.g., a tax-free reorganization).
Authors' Note: The basis and AAA portions of the solution might be shown to the students by using
T accounts.
pp. C11-27 through C11-31.
C11-54 a.
b.
c.
No income, gain, or loss is recognized.
Basis = $120,000 + $30,000 + $15,000 - $20,000 - $65,000 = $80,000
AAA: $85,000 + $30,000 - $20,000 - $65,000 = $30,000
Accumulated E&P: $20,000
Other Adjustment Account: -0- + $15,000 = $15,000
Authors' Note: The basis and AAA portions of the solution might be shown to the students by using
T accounts.
d.
Part a. $20,000 is taxable from accumulated E&P (the balance of the distribution is
tax-free since it ($95,000) comes from AAA).
C11-27
Part b. $120,000 + $30,000 + $15,000 - $20,000 - $95,000 from AAA = $50,000.
Part c. AAA: $85,000 + $30,000 - $20,000 - $95,000 = -0Accumulated E&P: $20,000 - $20,000 = -0Other Adjustment Account: -0- + $15,000 = $15,000
pp. C11-27 through C11-31.
C11-55 C and S corporation formation--The Sec. 351 rules do not apply to the transfer since more
than 80% of the total consideration transferred to the corporation by Cara, Bob, and Steve is
in the form of services.
Consideration: $100,000 = $40,000 by Bob + $39,000 by Cara + $21,000 by Steve)
Services: $20,400/$100,000 = 20.40%. [Note: The cash contributed by Steve is less than the
10% minimum required for a private letter ruling, therefore the stock received by Steve can
not be counted towards the 80% control test.]
Since control is not achieved by the three transferors, Sec. 351 does not apply and the entire
realized gain is recognized (Sec. 1001).
Land
Cara's transfer:
Stock received
Debt assumption
Consideration received
Minus: Adjusted basis
Recognized gain or loss
$30,769a
19,231
$50,000
(40,000)
$10,000
a
FMV of land
$50,000
FMV of building
15,000
Total
$65,000
Minus: Debt assumed(25,000)
FMV of stock
$40,000
Allocation of consideration received by Cara:
Stock: Land--50/65 x $40,000 = $30,769
Building--15/65 x $40,000 = $9,231
Debt: Land--50/65 x $25,000 = $19,231
Building--15/65 x $25,000 = $5,769
C11-28
Building
$ 9,231
5,769
$ 15,000
( 25,000)
($10,000)
Total
$40,000
25,000
$65,000
(65,000)
$ -0-
Cara’s basis for the stock is $40,000. The stock’s holding period commences on the day
after the exchange date. The land has a $50,000 basis on the corporation’s books. The
building has a $15,000 basis on the corporation’s books. The holding period for each asset
commences on the day after the exchange date.
Bob’s transfer:
Acquired cost for machinery and equipment
Minus: Depreciation (4 years)
Adjusted basis
FMV of machinery
Minus: Adjusted basis
Recognized gain
$100,000
( 68,760)
$ 31,240
$ 39,000
( 31,240)
$ 7,760
Bob’s basis for the stock is $39,000. His holding period commences on the day after the
exchange date. The machinery and equipment have a $39,000 basis on the corporation’s
books. The corporation’s holding period for the asset commences on the day after the
exchange date. The corporation makes a new depreciation election under the MACRS
rules.
Steve: No gain is recognized on the transfer of the cash. The $20,400 in stock that is
received for services is taxed as ordinary income. Steve’s basis for the stock is $21,000
($20,400 + $600). His holding period commences on the day after the exchange. The cash
has a $600 basis on the corporation’s books. The services have a $20,400 basis on the
corporation’s books. Part or all of the services are likely to be amortizable under Secs. 248
or 195. Some of the services, if a current operating expense, are deductible under Sec. 162.
The $50,000 recourse borrowing does not become part of the stock basis whether the
corporation makes an S election or not.
Partnership formation: The partnership formation transaction is not dependent on
receiving a particular percentage of the interests in exchange for property. None of the three
partners will recognize gain on their property transfers. Steve will recognize $20,400 of
ordinary income since he receives a portion of his partnership interest in exchange for
services. (An assumption is made here that Steve’s partnership interest is in both partnership
capital and profits, and not just a profits interest.)
C11-29
The basis of the three partnership interests are as follows:
Property contributed
Minus: Liabilities transferred
Plus: Liabilities
Plus: Share of recourse debt
Basis of interest
Cara
Bob
$65,000
(15,000)
$31,240
$21,000
9,750
19,500
$60,490
5,250
10,500
$36,750
20,000
$70,000
Steve
Total
$117,240
( 15,000)
15,000
50,000
$167,240
Allocation of Cara’s liabilities to Bob and Steve are based on the relative interests of Bob
and Steve in the partnership. For simplicity’s sake, the assumption is made that the
partnership interests are proportionate to the FMVs of the three partners contributions to the
partnership (Cara = 40%, Bob = 39%, and Steve = 21%). All partners are considered to be
general partners and share profits and losses in the same proportions. A similar allocation is
performed to allocate the recourse debt to the three partners.
The holding period for the partnership interest includes the holding period for the property
that is transferred.
The partnership takes a carryover basis for the assets that are transferred to the partnership.
The basis for the assets are: land, $40,000; building, $25,000; machinery and equipment,
$31,240; cash, $1,600; and services, $20,400. Part or all of the services are amortizable as
organizational expenditures under Sec. 709. Some of the remaining services may be
deductible as an operating expense under Sec. 162.
Alternate Facts: C and S corporation formation--The Sec. 351 rules apply to the transfer
since less than 20% of the total consideration transferred to the corporation by Cara, Bob,
and Steve is in the form of services.
Consideration: $100,000 = $40,000 by Bob + $39,000 by Cara + $21,000 by Steve)
Services: $18,400/$100,000 = 18.40%. [Note: The cash contributed by Steve is more than
the 10% minimum required for a private letter ruling, therefore the stock received by Steve
can be counted towards the 80% control test.]
C11-30
Since control is achieved by the three transferors (100% ownership), Sec. 351 applies.
Land
Cara's transfer:
Stock received
Debt assumption
Consideration received
Minus: Adjusted basis
Realized gain or loss
Boot received
Recognized gain or loss
a
FMV of land
FMV of building
Total
Minus: Debt assumed
FMV of stock
$30,769a
19,231
$50,000
(40,000)
$10,000
-0-0-
Building
$
9,231
5,769
$ 15,000
( 25,000)
($10,000)
-0-0-
Total
$40,000
25,000
$65,000
(65,000)
$ -0-0-0-
$50,000
15,000
$65,000
(25,000)
$40,000
Allocation:
Stock: Land--50/65 x $40,000 = $30,769
Building--15/65 x $40,000 = $9,231
Debt: Land--50/65 x $25,000 = $19,231
Building--15/65 x $25,000 = $5,769
This answer is based on Sec. 357(b) not applying to the transaction (i.e., there was a
business purpose for the transfer of the liability to the corporation). If Sec. 357(b) applies
to treat the entire amount of the debt as boot, then gain must be recognized in the amount of
$10,000 on the land transfer (i.e., the smaller of the $10,000 realized gain or the $19,231 of
liabilities assumed that are treated as money under Sec. 357(b)). No gain is recognized on
the building transfer since a loss has been realized.
Cara’s basis for the stock is $40,000 ($40,000 basis of land + $25,000 basis of building $25,000 debt assumed) . Its holding period is divided up into two parts and includes the
time that the transferor held the two properties that were transferred. The land has a $40,000
basis on the corporation’s books. The building has a $25,000 basis on the corporation’s
books. The corporation’s holding period for both assets includes the transferor’s holding
period.
Bob’s transfer:
Acquired cost for machinery and equipment
Minus: Depreciation (4 years)
Adjusted basis
C11-31
$100,000
( 68,760)
$ 31,240
FMV of machinery
Minus: Adjusted basis
Realized gain
Boot received
Recognized gain
$ 39,000
( 31,240)
$ 7,760
$ -0$ -0-
Bob’s basis for the stock is $31,240. Its holding period includes his holding period for the
machinery and equipment. The machinery and equipment have a $31,240 basis on the
corporation’s books. The corporation’s holding period for the assets includes Bob’s holding
period. The corporation continues to depreciate the property using the MACRS election
that Bob used.
Steve: No gain is recognized on the transfer of the cash. The $21,000 in stock that is
received is taxed as ordinary income equal to the FMV of the services contributed by Steve,
or $18,400. Steve’s basis for the stock is $21,000 ($2,600 cash + $18,400 services). Its
holding period commences on the day after the exchange. The cash has a $2,600 basis on
the corporation’s books. The services have a $18,400 basis on the corporation’s books.
Part or all of the services are likely to be amortizable under Secs. 248 or 195. Some of the
services, if a current operating expense, are deductible under Sec. 162.
The $50,000 recourse borrowing does not become part of the stock basis whether the
corporation makes an S election or not.
Partnership formation: The partnership formation transaction is not dependent on
receiving a particular percentage of the interests in exchange for property. None of the three
partners will recognize gain on their property transfers. Steve will recognize $18,400 of
ordinary income since he receives a portion of his $21,000 partnership interest in exchange
for services. (An assumption is made here that Steve’s partnership interest is in both
partnership capital and profits, and not just a profits interest.)
The basis of the three partnership interests are as follows:
Property and services contributed
Minus: Liabilities transferred
Plus: Liabilities acquired
Plus: Share of recourse debt
Basis of interest
Cara
Bob
$65,000
(15,000)
$31,240
$21,000
9,750
19,500
$60,490
5,250
10,500
$36,750
20,000
$70,000
Steve
Total
$117,240
( 15,000)
15,000
50,000
$167,240
Allocation of Cara’s liabilities to Bob and Steve are based on the relative interests of Bob
and Steve in the partnership. For simplicity’s sake, the assumption is made that the
C11-32
partnership interests are proportionate to the FMVs of the three partners contributions to the
partnership (Cara = 40%, Bob = 39%, and Steve = 21.6%). All partners are considered to be
general partners and share profits and losses in the same proportions. A similar allocation is
performed to allocate the recourse debt to the three partners.
The holding period for the partnership interest includes the holding period for the property
that is transferred.
The partnership takes a carryover basis for the assets that are transferred to the partnership.
The basis for the assets are: land, $40,000; building, $25,000; machinery and equipment,
$31,240; cash, $2,600; and services, $18,400. Part or all of the services are amortizable as
organizational expenditures under Sec. 709. Some of the remaining services may be
deductible as an operating expense under Sec. 162.
C11-56
C Corporation
Amount
Operating profit
Dividends
State of Florida interest
G.E. bond interest
Capital gain on land
Sec. 1245 gain
Sec. 1231 loss
LTCL
STCL
MACRS depreciation
Charitable contribution
Inv. interest expense
Salary
Div. recd. dedn.
Total
Tax calculation:
First $50,000 TI
Remaining $13,100
Total
C11-57 a.
120,000
19,000
18,000
29,000
40,000
5,000
-28,000
-4,000
-5,000
-36,000
-23,000
-16,000
-37,000
82,000
Taxable Income
120,000
19,000
0
29,000
31,000
5,000
-28,000
0
0
-36,000
-8,700
-16,000
-37,000
-15,200
63,100
S Corporation
Ord. Inc.
Partnership
Sep. Stat.
120,000
Ord. Inc.
Sep. Stat.
120,000
19,000
18,000
29,000
40,000
5,000
19,000
18,000
29,000
40,000
5,000
-28,000
-4,000
-5,000
-36,000
-28,000
-4,000
-5,000
-36,000
-23,000
-16,000
-23,000
-16,000
-37,000
-37,000
52,000
52,000
7,500
3,275
10,775
E&P, January 1, 1998
1998 taxable income
Capital gain on distribution of land
Minus: Federal income taxes
E&P before distribution
Minus: Cash distribution
Minus: Property distribution
E&P, December 31, 1998
C11-33
(12,500)
$155,000
$40,000
30,000
57,500
$212,500
(100,000)
(100,000)
$ 12,500
Both distributions are fully taxable to Jeff and John in the amount of $100,000. John
takes a $100,000 basis in the land that he receives.
b.
AAA, January 1, 1998
1998 ordinary income
Capital gain on distribution of land
AAA before distribution
Minus: Cash distribution
Minus: Non-cash distribution
AAA, December 31, 1998
AE&P, January 1, 1998
Minus: Remainder of property distributions
AE&P, December 31, 1998
30,000
$125,000
$40,000
70,000
$195,000
( 97,500)
( 97,500)
$ -0$ 30,000
( 5,000)
$ 25,000
$97,500 of each distribution is tax-free assuming that the shareholder has sufficient
basis in his stock. The remaining $2,500 of each distribution is a dividend that is
included in the shareholder’s gross income. John takes a $100,000 basis in the land
that he receives.
c.
Jeff’s basis:
Basis, January 1, 1998
Plus: Allocable share of 1998 ordinary income and gain
Pre-distribution basis
Minus: Cash distribution from AAA
Basis, December 31, 1998
$100,000
35,000
$ 135,000
( 97,500)
$ 37,500
John’s basis:
Basis, January 1, 1998
Plus: Allocable share of 1998 ordinary income and gain
Pre-distribution basis
Minus: Property distribution from AAA
Basis, December 31, 1998
$ 80,000
35,000
$ 115,000
( 97,500)
$ 17,500
Jeff’s basis:
Basis, January 1, 1998
Plus: Allocable share of 1998 ordinary income
Pre-distribution basis
Minus: Cash distribution
Basis, December 31, 1998
$100,000
20,000
$120,000
(100,000)
$ 20,000
John’s basis:
Basis, January 1, 1998
$ 80,000
C11-34
Plus: Allocable share of 1998 ordinary income
Pre-distribution basis
C11-35
20,000
$100,000
Minus: Property distribution
Basis, December 31, 1998
( 70,000)
$ 30,000
Neither distribution is taxable to the partners. John takes a $70,000 basis in the land
that he receives.
d.
There is no change to the C corporation answer or the S corporation answer.
However, the partnership answer in part (c) will change as follows:
Jeff’s basis:
Basis, January 1, 1998
$100,000
Plus: Allocable share of 1998 ordinary income
20,000
Plus: Precontribution gain on land distributed
25,000
Pre-distribution basis
$145,000
Minus: Cash distribution
( 100,000)
Basis, December 31, 1998
$ 45,000
John’s basis:
Basis, January 1, 1998
Plus: Allocable share of 1998 income
Pre-distribution basis
Minus: Property distribution
Basis, December 31, 1998
$ 80,000
20,000
$ 100,000
( 95,000)
$ 5,000
Neither distribution is taxable to the partners. John takes a $95,000 basis in the land
that he receives.
Tax Form/Return Preparation Problem
C11-58 (See Instructor's Guide)
Case Study Problems
C11-59 (See Instructor's Guide)
C11-60 (See Instructor's Guide)
Tax Research Problems
C11-61 (See Instructor's Guide)
C11-62 (See Instructor's Guide)
C11-63 (See Instructor’s Guide)
C11-36