CHAPTER 14
COMPARATIVE FORMS OF DOING BUSINESS
SOLUTIONS TO PROBLEM MATERIALS
Question/
Problem
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Topic
Entity attributes
Entity attributes
Liability exposure
Ethics problem
Corporate tax rates: marginal and effective
Choice of business entity: tax and
nontax factors
Choice of business entity
Choice of business entity
Choice of business entity
Single versus double taxation
Alternative minimum tax
Alternative minimum tax; asset sales
Ethics problem
Fringe benefits
Fringe benefits
Reasonable compensation
Shareholder loans to corporation
Avoiding double taxation: lease
rental payments
Rental property or corporate asset
Accumulated earnings tax
Stock redemption
Issue recognition
Issue recognition
S corporation: maintaining or revoking status
Recognition under § 351 and debt
versus equity
Recognition at time of contribution and basis
Basis for ownership interest
14-1
Status:
Present
Edition
Q/P
in Prior
Edition
Modified
Unchanged
Unchanged
New
Modified
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3
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Modified
Modified
Modified
Modified
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Modified
Modified
Unchanged
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Modified
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Modified
Modified
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2003 Entities Volume/Solutions Manual
Question/
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Status:
Present
Edition
Q/P
in Prior
Edition
Conduit versus entity concept
Conduit versus entity concept
Contributions, profits, and
distributions to owners
Distributions to owners
Passive activity losses
Basis and at-risk rules: partnership
versus corporation
Special allocations
At-risk amount and basis
Special allocations
Special allocations
Asset sale versus stock sale
Sale of a business: sole proprietorship
Sale of a business: partnership
Purchase of partnership
Issue recognition
Purchase of a corporation
Unchanged
Unchanged
Modified
28
29
30
Unchanged
Modified
Unchanged
31
32
33
Unchanged
Unchanged
Unchanged
Unchanged
Modified
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Modified
34
35
36
37
38
39
40
41
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43
Tax and financial reporting of corporate
formation
S corporation formation
Partnership formation
Alternative minimum tax
Unchanged
1
Unchanged
Unchanged
Unchanged
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4
Internet activity
Internet activity
Internet activity
Internet activity
Unchanged
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Unchanged
New
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Bridge Discipline
Problem
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Research/
Problem
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4
PROBLEM MATERIAL
1.
a.
S corporation and C corporation (S and C). p. 14-6
b.
C corporation (C). p. 14-6
c.
C corporation (C). p. 14-8
d.
C corporation (C). p. 14-13
e.
S corporation (S). pp. 14-5 and 14-8
f.
Sole proprietorship and partnership (SP and P). p. 14-7
Comparative Forms of Doing Business
2.
g.
C corporation (C). Concept Summary 14-1
h.
Partnership (P), S corporation (S), and C corporation (C). Concept Summary 14-1
i.
Sole proprietorship, partnership, and S corporation (SP, P, and S). p. 14-17
a.
Partnership, S corporation and C corporation (P, S, and C).
b.
Partnership and S corporation (P and S).
c.
Partnership and S corporation (P and S).
d.
Partnership and S corporation (P and S).
e.
Partnership (P).
f.
Partnership (P).
14-3
pp. 14-16 to 14-19
3.
a.
Since a sole proprietorship has unlimited liability, the sole proprietorship and the owners
are liable for the remaining $2 million after the $3 million is paid by insurance. Since the
FMV of the net assets is $850,000 ($950,000 - $100,000), the owner is liable for the
remaining $1,150,000 ($2,000,000 - $850,000).
b.
Since a partnership has unlimited liability, the partnership and the partners are liable for
the remaining $2 million after the $3 million is paid by insurance. Since the FMV of the
net assets is $850,000 ($950,000 - $100,000), the partners are liable for the remaining
$1,150,000 ($2,000,000 - $850,000). The corporate characteristic of limited liability
applies to an LLC.
c.
A C corporation has limited liability (i.e., equal to the FMV of the assets of $950,000).
The plaintiff will share with the other creditors (i.e., $100,000) of the entity with respect
to claims against the $950,000 of assets. The shareholders of the C corporation have no
personal liability for the remaining corporate debts of $1,150,000 ($2,000,000 +
$100,000 - $950,000).
d.
Same response as in (c) for an S corporation.
pp. 14-4 to 14-7
4.
The first issue to be addressed is a business issue rather than an ethical issue. Reducing the
income tax liability through sound business planning should be a goal of any business owner or
business entity.
The business issue to be addressed is whether Ted’s alleged tax knowledge results in a prudent
business decision in restructuring the transaction as an asset sale rather than the sale of
ownership interests. Unfortunately, the revised transaction produces a negative cash flow
effect for Ted in terms of the two-percent discount and in terms of the tax costs of the sale
transaction.
For the sole proprietorship, regardless of the legal form of the sales transaction, the sale is
treated as the sale of the individual assets of the business for income tax purposes. For the
partnership, more beneficial tax results can occur from a sale of partnership interests rather
than from a sale of the partnership assets. For the sale of partnership assets, any ordinary
14-4
2003 Entities Volume/Solutions Manual
income property that is appreciated will produce ordinary income. The sale of a partnership
interest results in capital gain treatment, except for ordinary income associated with unrealized
receivables and substantially appreciated inventory.
The second issue to be addressed is the reallocation of the sales proceeds between the radio
station and the TV station. Since the reallocation reduces the proceeds to be received by Uncle
Frank, who was not informed of the original offer, an ethical issue definitely is present and a
legal issue may be present. In addition, proceed reallocations between the radio station and the
TV station should not be made if they are arbitrary and do not reflect the asset values.
Concept Summary 14-1
5.
a.
The tax liability of each of the corporations is as follows:
Red Corporation
15% X
25% X
34% X
$50,000
25,000
5,000
=
=
=
$ 7,500
6,250
1,700
$15,450
$ 50,000
25,000
245,000
220,000
=
=
=
=
$ 7,500
6,250
83,300
11,000
$108,050
White Corporation
15%
25%
34%
5%
X
X
X
X
Blue Corporation
15%
25%
34%
5%
X
X
X
X
$ 50,000
25,000
725,000
235,000
=
=
=
=
$
7,500
6,250
246,500
11,750
$272,000
or 34% X
$800,000
=
$272,000
34% X $10,000,000
35% X 15,000,000
3% X
3,333,333
=
=
=
$3,400,000
5,250,000
100,000
$8,750,000
or 35% X $25,000,000
=
$8,750,000
Orange Corporation
The effective tax rate for each of the corporations is as follows:
Red Corporation
$15,450
$80,000
=
19.31%
Comparative Forms of Doing Business
14-5
White Corporation
$108,050
$320,000
=
33.77%
=
34%
=
35%
Blue Corporation
$272,000
$800,000
Orange Corporation
$ 8,750,000
$25,000,000
The marginal tax rate for each of the corporations is as follows:
Red
White
Blue
Orange
b.
34%
39%
34%
35%
The marginal tax rate can be 39% (34% + 5%) or 38% (35% + 3%) as the result of the
phase-out of the benefits of the lower brackets. The effective tax rate will never exceed
the statutory rate of 35%.
pp. 14-8 to 14-10
6.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
March 15, 2002
Amy and Jeff Barnes
5700 Redmont Highway
Alexandria, VA 22300
Dear Amy and Jeff:
I am responding to your request for advice on the business entity form to be selected for
operating the florist shop. In our conversation, the inclination was to conduct the business as a
partnership or as an S corporation. After paying salaries of $45,000 to each of you, the profits
of the business will be about $60,000. The intent is to invest the earnings in the growth of the
business rather than make distributions.
In selecting an entity form, consideration should be given to both tax and nontax factors. The
tax consequences for the partnership form versus the S corporation form would be the same.
The salary of $45,000 is included in your gross income, and the partnership or S corporation
would deduct the $90,000 in calculating its taxable income. In addition, regardless of whether
the entity is a partnership or an S corporation, each of you would include one-half of the
$60,000 projected floral earnings in gross income.
A substantial difference does exist, however, with respect to the nontax factors. If the floral
shop is conducted as a general partnership, there is unlimited liability. Conversely, if the floral
14-6
2003 Entities Volume/Solutions Manual
shop is conducted as an S corporation, limited liability results. Although in many cases
shareholders of small businesses operating as S corporations are required to guarantee
corporate debts, the corporate form still provides protection against contingent liabilities.
In choosing between the partnership and the S corporation form, I recommend the S
corporation form. However, you may want to consider the limited liability company (LLC)
form. This legal form provides limited liability, the same tax consequences as those of the
partnership form, and greater flexibility than the S corporation form. Call me at your
convenience. I look forward to resolving any questions you have regarding the business entity
form for your floral shop.
Sincerely,
Carlene Sims, CPA
pp. 14-6 to 14-9
7.
Gary can benefit by passing the losses through and offsetting them against his other income.
Since he is the sole owner, the two business forms available that will permit this are the sole
proprietorship and the S corporation. A benefit of the S corporation when compared with the
sole proprietorship is limited liability. pp. 14-6 to 14-9
8.
The three forms of business entity available to Jack are the sole proprietorship, corporation,
and S corporation. The partnership is not a viable option, since Jack is to be the sole owner. In
selecting the business form, Jack should consider both tax and nontax factors.
Nontax factors to consider include the ability to raise capital and limited liability. The
corporate form normally provides the greatest ease and potential for obtaining owner
financing. However, for Jack this does not appear to be an advantage, when compared with an
unincorporated entity (i.e., sole proprietorship), because he is to be the only owner. The
corporate form does however, in this case, offer the advantage of limited liability.
If Jack selects the sole proprietorship form, the profits of the entity will be taxed to him. Since
Jack will be in the 35% tax bracket, the tax liability on the projected earnings of $200,000 for
the initial year would be $70,000 ($200,000 X 35%).
If Jack selects the corporate form, the earnings of the business will be taxed to the corporation.
The tax liability on the projected earnings of $200,000 for the initial year would be $61,250
[($50,000 X 15%) + ($25,000 X 25%) + ($25,000 X 34%) + ($100,000 X 39%)]. In addition,
to the extent that the corporation distributes part or all of the after-tax earnings to Jack as a
dividend, double taxation would result. On the other hand, if the corporation pays Jack a
salary, Jack will be able to receive cash from the corporation without double taxation. The
total income tax would increase, however, as amounts received by Jack as salary will be taxed
at 35%. This may be the best solution.
Another solution would be to elect S corporation status. The earnings of the corporation would
be taxed to Jack rather than at the corporate level. While the initial year, the tax liability of
$70,000 would be higher than the C corporation tax liability of $61,250, the potential for being
subject to double taxation would be avoided. Finally, the advantage of limited liability would
be achieved.
pp. 14-6 to 14-9
Comparative Forms of Doing Business
9.
a.
14-7
If Silver is a C corporation, the corporate tax liability is:
15% X
25% X
34% X
$50,000 =
25,000 =
25,000 =
$ 7,500
6,250
8,500
$22,250
Since Silver will not distribute any dividends, the shareholders will have no tax liability
associated with it.
If Silver is an S corporation, the corporate tax liability will be $0 and the shareholders'
tax liability will be $30,000 ($100,000 X 30%). Viewed from an entity-owner
perspective, operating as a C corporation will result in tax savings of $7,750 ($30,000 $22,250). Note that these savings are based on the assumption that the after-tax
earnings are reinvested in the growth (i.e., reasonable needs for purposes of
accumulated earnings tax) of the business and that no distributions are made to the
shareholders.
b.
If Silver is a C corporation, the corporate tax liability is $22,250. The tax at the
shareholder level on the distribution of after-tax earnings of $77,750 is $23,325
($77,750 X 30%). Therefore, the combined corporation and shareholder tax is $45,575
($22,250 + $23,325).
If Silver is an S corporation, the corporate tax liability will be $0 and the shareholder
tax liability will be $30,000. The $100,000 will be a distribution out of AAA and thus
will be tax-free to the shareholders.
Viewed from an entity-owner perspective, operating as an S corporation will result in
tax savings of $15,575 ($45,575 - $30,000).
pp. 14-8 and 14-9
10.
a.
The corporate tax liability on taxable income of $300,000 is $100,250 for the C
corporation.
$ 50,000 X 15%
25,000 X 25%
25,000 X 34%
200,000 X 39%
=
=
=
=
$
7,500
6,250
8,500
78,000
$100,250
Since the tax liability on the $300,000 is assessed at the corporate level, there will be no
dividend distribution to Mabel and Alan. They will each receive a salary of $100,000.
b.
The tax liability is assessed at the shareholder level rather than at the corporate level for
the S corporation. Mabel and Alan will each have a tax liability of $52,500 ($150,000
X 35%) associated with their respective shares of the corporate taxable income of
$300,000. Therefore, the corporation will need to distribute $52,500 each to Mabel and
Alan to pay their tax liability. They also will receive their salary of $100,000 each.
14-8
2003 Entities Volume/Solutions Manual
c.
The combined entity/owner tax liability in (a) will be as follows:
C corporation
Shareholders on distribution
Shareholders on salaries ($200,000 X 35%)
Combined tax liability
$100,250
-070,000
$170,250
The combined entity/owner tax liability in (b) will be as follows:
S corporation
Shareholders taxed on S corporation earnings
($300,000 X 35%)
Shareholders on salaries ($200,000 X 35%)
Combined tax liability
$
-0-
105,000
70,000
$175,000
pp. 14-8 and 14-9
11.
a.
Parrott’s regular income tax liability on taxable income of $5,000,000 is calculated as
follows:
15%
25%
34%
39%
34%
X
X
X
X
X
$50,000
25,000
25,000
235,000
4,665,000
=
$7,500
=
6,250
=
8,500
=
91,650
= 1,586,100
$1,700,000
The AMT of the corporation is calculated as follows:
Taxable income
+ Positive AMT adjustments including
ACE adjustment ($400,000 + $690,000)
- Negative AMT adjustments
+ Tax preferences
= Alternative minimum taxable income (AMTI)
- Exemption [$40,000 - 25% ($12,060,000 - $150,000)]
= AMT base
X Rate
= Tentative AMT
- Regular income tax liability
= AMT
$ 5,000,000
1,090,000
(30,000)
6,000,000
$12,060,000
-0$12,060,000
20%
$ 2,412,000
(1,700,000)
$ 712,000
Thus, if Parrott is a C corporation, its tax liability is $2,412,000 ($1,700,000 regular
tax + $712,000 AMT).
b.
An S corporation is a tax reporter rather than a taxpayer. Thus, Parrott will pass the
regular taxable income, the separately stated items, and AMT attributes through to its
shareholders who will make the regular tax liability calculation and the AMT
calculation on their individual income tax returns.
c.
The results in a. will be the same. Whether the C corporation is closely-held is not
relevant. An S corporation, however, cannot have 5,000 shareholders. It would be
taxed as a C corporation. The answer to b. then would be the same as the result in a.
pp. 14-8 to 14-10
Comparative Forms of Doing Business
12.
14-9
CLIENT LETTER
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
August 16, 2002
Ms. Corey Longwell/Tax Director
Pelican Corporation
200 Brando Row
Grand Isle, LA 70535
Dear Ms. Longwell:
I am responding to your inquiry regarding whether you should do a cash or installment
sale of your land and building. Based on the analysis below, I recommend that you do an
installment sale which will delay recognition of the gain on the sale and the payment of tax.
The analysis of the tax consequences of the two options is presented below.
Pelican's tax liability for 2002 and 2003 is as follows if the cash option is selected.
Regular Income Tax Liability
Taxable income before sale
Gain from sale ($500,000 - $400,000)
Taxable income
2002
$600,000
100,000
$700,000
2003
$600,000
-0$600,000
Tax liability (34% rate)
$238,000
$204,000
2002
$600,000
75,000
$675,000
(-0-)
$675,000
X 20%
$135,000
2003
$600,000
-0$600,000
(-0-)
$600,000
X 20%
$120,000
AMT
Taxable income before sale
AMT gain from sale ($500,000 - $425,000)
AMTI
Exemption amount
AMT base
Rate
Tentative AMT
AMT
$
-0-
$
-0-
Pelican's tax liability for 2002 and 2003 is as follows if the installment option is selected.
Regular Income Tax Liability
2002
2003
Taxable income before sale
Gain from sale ($500,000 - $400,000)
Taxable income
$600,000
-0$600,000
$600,000
100,000
$700,000
Tax liability (34% rate)
$204,000
$238,000
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2003 Entities Volume/Solutions Manual
AMT
2002
Taxable income before sale
AMT gain from sale ($500,000 - $425,000)
AMTI
Exemption amount
AMT base
Rate
Tentative AMT
AMT
2003
$600,000
-0$600,000
(-0-)
$600,000
X 20%
$120,000
$
-0-
$600,000
75,000
$675,000
(-0-)
$675,000
X 20%
$135,000
$
-0-
Since neither year is an AMT year under either option, the normal planning attribute of
delaying the recognition of gain applies. Thus, Pelican should select the installment option
which will delay the payment of taxes. If you have any questions, please call.
Sincerely,
Jack Jones
Partner
pp. 14-9 and 14-10
13.
Andy's belief that if the accumulated earnings tax issue is satisfactorily resolved on the current
audit that it will not be raised on any subsequent audits is unfounded. In terms of the audit
practices of the IRS, there is no basis for this belief.
The other issue is Andy's responsibility for providing the revenue agent with information on
the changes in the expansion policy of his business. The accumulated earnings tax is not a
self-assessing tax. Andy has no responsibility to volunteer information to the revenue agent
regarding the change in policy. However, if questions regarding this are raised by the revenue
agent, Andy should be forthright in his responses.
In terms of the present audit, it is probably for a period that precedes the change in expansion
policy. Thus, Andy's corporation should not have an accumulated earnings tax problem
associated with the period under examination. However, due to the change in expansion
policy, Andy should evaluate the corporation's dividend policy and compensation policy (i.e.,
may want to increase his $200,000 salary) in light of the accumulated earnings tax risks.
p. 14-13
14.
a.
If the farm is incorporated as a C (regular) corporation, then the brothers as
shareholder-employees can qualify as employees. Thus, the $32,000 ($20,000 for
lodging and $12,000 for meals) is excludible to the brothers under the § 119 meals and
lodging exclusion. If the farm is an S corporation, the brothers are treated as are
partners (see part b.).
b.
If the farm is not incorporated (i.e., a partnership), the IRS position is that the brothers
do not satisfy the definition of an employee. Therefore, they are not eligible for the
§ 119 exclusion and the $32,000 must be included in their gross income.
Concept Summary 14-2
Comparative Forms of Doing Business
15.
a.
14-11
Partnership C Corporation S Corporation
Taxable income before cost of
certain fringe benefits
- Deductible fringe benefits
Taxable income
$400,000
(235,000)
$165,000
$400,000
(305,000)
$ 95,000
$400,000
(235,000)
$165,000
Assuming that the fringe benefit plans are not discriminatory, the potential exists for
the employer business entity to deduct the amounts paid for fringe benefits. Thus,
regardless of the entity form, the amounts paid to a qualified pension plan (H.R. 10 plan
for owner/employees of a partnership or an S corporation) are deductible by the
business entity. For the partners and S corporation shareholders, the pension amount is
included in their gross income and then is eligible for deduction as a contribution to an
H.R. 10 plan. Group-term life insurance and meals and lodging are only deductible by
the C corporation (see part b.).
For beneficial fringe benefit treatment for group-term life insurance and meals and
lodging to be received, the individual must be an employee. Partners do not qualify as
employees, and greater than 2% shareholders of an S corporation are treated the same
as partners in a partnership for fringe benefit purposes.
b.
For beneficial fringe benefit treatment for group-term life insurance and meals and
lodging to be received, the individual must be an employee. Partners do not qualify as
employees, and greater than 2% shareholders of an S corporation are treated the same
as partners in a partnership for fringe benefit purposes. Since partners and greater than
2% S corporation shareholders do not qualify as employees, they do not qualify for
either § 79 exclusion treatment for group-term life insurance or § 119 exclusion
treatment for meals and lodging. Therefore, the amounts paid by the business entity for
these fringe benefits are included in the gross income of the partners and S corporation
shareholders. For the corporate shareholders, the amounts paid are deductible by the
corporation and excludible by the employee-shareholders.
The pension plan contributions made for employees are excludible by the covered
employees. Income will not be recognized by the employees until they receive
payments from the pension plan. For the owner/employees of a partnership or an S
corporation who have contributions made to their H.R. 10 plans by the business entity,
the amounts paid must be included in their gross income. However, this inclusion can
be offset by a corresponding deduction for adjusted gross income on the individual's
tax return. When benefits are paid from the H.R. 10 plan, the recipient includes the
amount in his or her gross income.
Concept Summary 14-2
16.
a.
Under option 1, Fawn, Inc. can deduct salaries of $400,000. Thus, Fawn, Inc.'s taxable
income will be $0 ($400,000 - $400,000). No dividends will be distributed since there
are no after-tax earnings. Gus will include $240,000 of salary in his gross income, and
Janet will include $160,000 of salary in her gross income.
Under option 2, Fawn, Inc., can deduct salaries of $150,000. Thus, Fawn, Inc.'s taxable
income will be $250,000 ($400,000 - $150,000) and Fawn, Inc.'s tax liability will be
$80,750.
14-12
2003 Entities Volume/Solutions Manual
15%
25%
34%
5%
X
X
X
X
$ 50,000
25,000
175,000
150,000
=
=
=
=
$ 7,500
6,250
59,500
7,500
$ 80,750
Gus will include $90,000 of salary and $84,625 ($169,250 X 50%) of dividend income
in his gross income. Janet will include $60,000 of salary and $84,625 ($169,250 X 50%)
of dividend income in her gross income.
b.
Under option 1, the salary payments reduce Fawn, Inc.'s taxable income to $0. Thus,
Fawn, Inc., should be aware of the possibility of the unreasonable compensation issue
being raised by the IRS.
pp. 14-11 and 14-12
17.
a.
Swallow will deduct interest expense each year of $36,000 ($400,000 X 9%). Sandra
and Fran will each report interest income of $18,000 ($200,000 X 9%) each year.
b.
Swallow will not be allowed a deduction each year for the interest payments of
$36,000. Instead, the payments will be labeled as dividends. Sandra and Fran will each
report dividend income of $18,000 each year. When the loan is repaid in 5 years,
assuming adequate earnings and profits, Sandra and Fran will each report dividend
income of $200,000.
pp. 14-11 and 14-12
18.
TAX FILE MEMORANDUM
DATE:
August 12, 2002
FROM:
Bob Thomas
SUBJECT:
Incorporating a Sole Proprietorship
Liane Taxpayer is going to incorporate her sole proprietorship. She owns land and a building
that has been used in her business. She wants to know whether she should contribute the land
and building or lease it to the new corporation.
One of the issues that Liane needs to be concerned about is avoiding double taxation. Once she
incorporates her sole proprietorship as a C corporation, the C corporation is subject to taxation
on its taxable income. Then, Liane is taxed on any after-tax earnings distributed to her as
dividends.
One way to avoid or reduce the effect of double taxation is to reduce corporate taxable income.
If Liane leases the land and building to the corporation, the lease rental payments (assuming
they are reasonable) made by the corporation to Liane are deductible in calculating corporate
taxable income. Note, however, the corporation will forgo the depreciation deduction it would
have received on the building.
pp. 14-11 and 14-12
Comparative Forms of Doing Business
19.
14-13
If Lavender acquires the shopping mall, its tax liability would increase as follows.
Additional liability ($600,000 net rental income X 34%)
$204,000
The individual tax liabilities of Marci and Jennifer would not be affected by the shopping mall
acquisition by the corporation.
If Marci and Jennifer acquire the shopping mall and lease it to the corporation, their combined
tax liabilities would increase as follows.
Net rental income
Depreciation
=
Increase in their taxable incomes
$ 400,000
(37,000)
$ 363,000
Additional tax liability ($363,000 X 38.6%) =
$ 140,118
At the corporate level, the corporate taxable income would increase as follows.
Net rental income
Rental payments to Marci and Jennifer
=
Additional taxable income
$ 600,000
(400,000)
$ 200,000
Additional tax liability ($200,000 X 34%)
$ 68,000
Thus, under the option recommended by the CPA, the combined tax liability of $208,118
($140,118 + $68,000) is more than the $204,000 tax liability under the corporate acquisition
option. However, Lavender has been able to channel $400,000 to Marci and Jennifer with the
amount being deductible in calculating Lavender’s taxable income.
pp. 14-11 and 14-12
20.
a.
Rose, Inc.’s corporate tax liability is calculated as follows:
15%
25%
34%
5%
X
X
X
X
$ 50,000
25,000
325,000
235,000
=
=
=
=
$
7,500
6,250
110,500
11,750
$136,000
In addition, Rose may be subject to the accumulated earnings tax. This tax liability
could be as high as $101,904 ($264,000 X 38.6%). The $264,000 represents the
after-tax earnings of the corporation ($400,000 - $136,000).
b.
In this case, Rose would not be subject to the accumulated earnings tax. Thus, the total
corporate tax liability would be $136,000. The shareholders of Rose would be taxed on
their dividend income.
c.
Rose’s regular income tax liability is $0 because the S election results in the
corporation not being subject to Federal income tax. The taxable income of $400,000
is passed through to the shareholders’ tax returns. The accumulated earnings tax does
not apply to S corporations.
p. 14-13
14-14
21.
2003 Entities Volume/Solutions Manual
a.
Pigeon, Inc., has a recognized gain of $65,000 ($75,000 FMV - $10,000 adjusted
basis) on the distribution of the land to Tim.
Tim’s recognized gain on the receipt of the land is calculated as follows:
Amount realized
Basis for stock redeemed
Realized gain
Recognized gain
$75,000
(30,000)
$45,000
$45,000
If Tim’s holding period for the stock is over one year, the $45,000 gain is classified as
a long-term capital gain. Note that if the transaction had not qualified as a § 302
stock redemption, Tim would have reported dividend income of $75,000.
b. Pigeon, Inc. has a recognized gain of $65,000 ($75,000 FMV - $10,000 adjusted basis) on
the distribution of the land to Tim. However, since Pigeon Inc. is an S corporation, the
$65,000 is passed through and taxed to the shareholders.
Tim’s recognized gain on the receipt of the land is calculated as follows:
Amount realized
Basis for stock redeemed
Realized gain
Recognized gain
$75,000
(30,000)
$45,000
$45,000
If Tim’s holding period for the stock is long-term, the $45,000 gain is classified as a
long-term capital gain.
pp. 14-14 and 14-19
22.
Since David and Tan, Inc.’s objective is to avoid double taxation, the following need to be
addressed:

Tan’s taxable income can be reduced through compensation payments that are reasonable.
Does the $400,000 annual salary for David meet the requirements for reasonable
compensation? Might it be possible to increase the amount and still be considered
reasonable?

Based on the data, it appears that Tan is not distributing dividends to David. While such a
technique can be used to avoid or defer double taxation, is the retention defensible in terms
of the accumulated earnings tax?

Would an S corporation election be advisable?
pp. 14-11 to 14-15
23.
S corporations can have a maximum of 75 shareholders. Married shareholders are counted as
one shareholder. Therefore, Tammy and Arnold need to structure the property settlement so
that this requirement is not violated (i.e., only one of them will remain a shareholder). When
there are enough shareholders that there may eventually be a problem with this requirement, a
sound tax strategy would include a right of first refusal provision on the part of the corporation
or other shareholders with regard to transferring stock outside the extant shareholder group.
pp. 14-14 and 14-15
Comparative Forms of Doing Business
24.
14-15
If the S election is voluntarily terminated, another election for Eagle Corporation cannot be
made for a five-year period. Therefore, the decision regarding revoking the S election should
be considered a long-run, rather than a short-run, one. The revocation of the election can be
made only if a majority of the shareholders consent. Thus, Nell will need one of the other
shareholders to agree with her in order to voluntarily revoke the election.
Assuming that the S election is maintained and the earnings of $150,000 are distributed to the
shareholders, the tax liability associated with the distribution for each of the shareholders is
$15,000 ($50,000 X 30%). If the S election is revoked effective for 2002, the corporate tax
liability is $41,750. The tax liability for each of the shareholders on the dividend distribution
of $36,083 ($108,250  3) is $10,825 ($36,083 X 30%). Therefore, the total corporate and
shareholder tax liability would be computed as follows.
S Corporation
Corporate tax liability
Shareholder tax liability
C Corporation
$
0
45,000
$ 45,000
$ 41,750
32,475
$ 74,225
Revocation of the S election combined with a policy of distributing all the earnings to the three
shareholders will result in a greater combined corporation/shareholder tax liability of $29,225
($74,225 - $45,000). Thus, if all of the earnings are going to be distributed, the S election
should be maintained.
pp. 14-14 and 14-15
25.
a.
No gain or loss is recognized on the contribution of property by Bob and Carl to the
corporation. For Bob, there is no realized gain or loss. Carl's realized gain of $115,000
[$240,000 (amount realized) - $125,000 (adjusted basis)] is not recognized because the
§ 351 requirements are satisfied. Therefore, the realized gain is deferred, and Carl has
a carryover basis for his stock of $85,000 [$125,000 (adjusted basis) - $40,000
(mortgage assumed)]. Bob's basis for his stock is $200,000. Deer, Inc.'s basis for the
land is a carryover basis of $125,000. Each shareholder has a basis for his loan of
$75,000. In addition, each shareholder has interest income each year of $6,000
($75,000 X 8%) and Deer, Inc. deducts $12,000 of interest expense each year.
b.
The asset contributions will be treated the same as in part a. If all of the debt is
reclassified as equity, Bob's and Carl's basis for their stock will each increase by
$75,000. The interest payments of $12,000 annually will be reclassified as dividends
and will not be deductible by Deer, Inc.
c.
TAX FILE MEMORANDUM
DATE:
January 5, 2002
FROM:
Seth Addison
SUBJECT:
Contributions and Loans to Deer, Inc.
Today I met at lunch with Bob Bentz to discuss the tax consequences of the capital
contributions and loans to Deer made by him and Carl Pierce.
14-16
2003 Entities Volume/Solutions Manual
Capital contributions
Asset
Basis
$200,000
125,000
Bob: Cash
Carl: Land*
FMV
$200,000
240,000
* Mortgage of $40,000 assumed by Deer, Inc.
Loans to Deer, Inc.
Bob
Carl
$75,000
$75,000
Maturity date: 10 years
Interest rate: 8% (same as Federal rate).
I reviewed with Bob the following tax consequences:

Recognition of gain: Since Bob and Carl own all of the stock, the realized gain of
$115,000 ($240,000 - $125,000) to Carl is not recognized under § 351.

Basis for stock: Bob’s is $200,000 and Carl’s is $85,000 ($125,000 - $40,000).

Basis for assets: Deer’s basis for its assets is as follows:
Cash
Land
$200,000
$125,000

Assuming the loans made by Bob and Carl to Deer are classified as loans, Deer can
deduct $12,000 of interest expense each year and Bob and Carl must each include
$6,000 of interest income in their gross income each year for the 10-year period.
Each has a basis for their loan of $75,000.

If the IRS should reclassify the loans as equity (i.e., thin capitalization issue), the
interest payments would be treated as dividends. Thus, Deer would lose its
$12,000 interest deduction and Bob and Carl each would be receiving dividend
income each year rather than interest income. If E & P is at least $150,000 at the
time of the loan repayment, Bob and Carl would each be required to report $75,000
of dividend income rather than treating the repayment as a return of capital.
pp. 14-11, 14-12, and 14-16
26.
a.
No gain or loss is recognized on the contribution of property to a partnership.
Therefore, Bobby’s realized gain of $60,000 ($150,000 - $90,000) is not recognized.
Buddy’s basis for his partnership interest is $150,000 and Bobby’s basis for his
partnership interest is $90,000. The recognized gain on the sale of the land is $75,000
($165,000 amount realized - $90,000 adjusted basis) and is allocated to the partners as
follows:
Comparative Forms of Doing Business
Pre-Contribution Gain
Buddy $ -0Bobby
60,000
b.
14-17
Post-Contribution Gain
$7,500
7,500
No gain or loss is recognized on the contribution of property to an S corporation if the
contributing shareholders satisfy the 80% control requirement. Therefore, Bobby’s
realized gain of $60,000 ($150,000 - $90,000) is not recognized. Buddy’s stock basis
is $150,000 and Bobby’s is $90,000. The recognized gain on the sale of the land is
$75,000 ($165,000 amount realized - $90,000 adjusted basis) and is allocated to the
shareholders as follows:
Buddy
Bobby
$37,500
37,500
c.
No gain or loss is recognized on the contribution of property to a C corporation if the
contributing shareholders satisfy the 80% control requirement. Therefore, Bobby’s
realized gain of $60,000 ($150,000 - $90,000) is not recognized. Buddy’s stock basis
is $150,000 and Bobby’s is $90,000. The C corporation has a recognized gain on the
sale of the land of $75,000 ($165,000 amount realized - $90,000 adjusted basis). This
recognized gain has no effect on Buddy and Bobby.
d.
An exchange of the original parcel of land for another parcel of land could qualify for
deferral as a §1031 like-kind exchange. However, since the business of the entity is
real estate development, it appears that the land is inventory. Section 1031 deferral
treatment does not apply to inventory. Thus, structuring the disposition and acquisition
as an exchange would produce the same tax consequences as the sale and purchase
option.
pp. 14-16 and 14-17
27.
a.
Initial basis under § 351
Effect of corporate earnings
Effect of corporate liability
Alicia’s stock basis – regular corporation
$ 180,000
-0-0$ 180,000
b.
Initial basis under § 351
Effect of corporate earnings (30%)
Effect of corporate liability
Alicia’s stock basis – S corporation
$ 180,000
48,000
-0$ 228,000
c.
Initial basis under § 721
Effect of partnership earnings (30%)
Effect of partnership liability (30%)
Alicia’s basis for partnership interest
$ 180,000
48,000
18,000
$ 246,000
pp. 14-17 to 14-21
28.
a.
The conduit concept applies for the partnership. The effect of these transactions on
partnership taxable income is $0 since each of these transactions is reported separately
(i.e., "as is") on the partners' tax returns. Thus, each partner reports his or her distributive
share of each of the following with the identity maintained.
14-18
2003 Entities Volume/Solutions Manual



LTCG of $10,000 ($30,000 - $20,000)
§ 1231 gain of $25,000 ($65,000 - $40,000)
Dividend income of $8,000
The tax-exempt interest would be passed through to the partners on their respective
Schedules K-1. Since the conduit concept applies, such interest is excludible in
calculating each partner's taxable income.
b.
The entity concept applies for the C corporation. Thus, each of these transactions, except
for the tax-exempt income, would affect the calculation of corporate taxable income.
The dollar amount and classification of income is as follows.



$10,000 LTCG
$25,000 § 1231 gain
$8,000 ordinary income
The $5,000 of municipal bond interest is excludible in calculating the corporate taxable
income. The IBM dividend qualifies for a 70% dividends received deduction ($5,600).
c.
The treatment for the S corporation is similar to that for the partnership. The conduit
concept applies with these transactions producing no effect on the calculation of
corporate taxable income.
Each of the shareholders will report his or her share of each item, except for the
municipal bond interest which is excludible from gross income, based on the per
share/per day rule.
pp. 14-17 and 14-18
29.
a
Amber can take her share ($200,000 X 20% = $40,000) of the losses to her individual tax
return. This reduces her basis for her partnership interest (outside basis) to $60,000
($100,000 - $40,000). Her share of the distribution in year 3 further reduces her outside
basis to $45,000 [$60,000 - ($75,000 X 20%)]. She must report her share ($150,000 X
20% = $30,000) of the partnership profits on her individual tax return in year 4. This
increases her outside basis to $75,000 ($45,000 + $30,000). Amber has no recognized
gain or loss on the distribution in reduction of her ownership interest in year 4. The
distribution reduces her outside basis to $15,000 ($75,000 - $60,000).
b.
Amber can take her share ($200,000 X 20% = $40,000) of the losses to her individual tax
return. This reduces her stock basis to $60,000 ($100,000 - $40,000). Her share of the
distribution in year 3 further reduces her stock basis to $45,000 [$60,000 - ($75,000 X
20%)]. She must report her share ($150,000 X 20% = $30,000) of the S corporation
profits on her individual tax return in year 4. This increases her stock basis to $75,000
($45,000 + $30,000). The redemption distribution qualifies as a stock redemption with
Amber’s recognized gain being $41,250 [$60,000 - ($75,000 X 25%)]. Amber’s
remaining stock basis is $56,250 ($75,000 - $18,750).
c.
The corporate losses of $200,000 belong to the C corporation rather than to the
stockholders. Thus, Amber’s stock basis of $100,000 is not affected. Since the C
corporation has no E&P, Amber’s share of the year 3 distribution of $75,000 reduces her
stock basis to $85,000 [$100,000 - ($75,000 X 20%)]. The $150,000 of earnings in year
4 are taxed at the corporate level and have no effect on Amber. The redemption
distribution qualifies as a stock redemption with Amber’s recognized gain being $38,750
Comparative Forms of Doing Business
14-19
[$60,000 - ($85,000 X 25%)]. Amber’s remaining stock basis is $63,750 ($85,000 $21,250).
pp. 14-16 to 14-19
30.
a.
Recognition of gain
Since John and Maria control the C corporation as provided in §
351, there is no recognized gain. Likewise, there is no
recognized gain at the C corporation level.
Original basis for stock
John ($80,000 - $12,000)
Maria
$ 68,000
300,000
Effect of entity earnings
C Corporation:
TI
$130,000
Tax Liability:
$50,000
$25,000
$25,000
$30,000
John
Maria
X
X
X
X
15%
25%
34%
39%
=
=
=
=
$
7,500
6,250
8,500
11,700
$ 33,950
No effect
No effect
Effect of distribution
Dividend income
John
Maria
$ 35,000
52,500
Tax Liability
John ($35,000 X 30%)
Maria ($52,500 X 30%)
$ 10,500
15,750
Adjusted basis for stock
John
Maria
$ 68,000
300,000
14-20
2003 Entities Volume/Solutions Manual
b.
Recognition of gain
Same as in (a).
Original basis for stock
Same as in (a).
Effect of entity earnings
S corporation: The taxable income of $130,000 is passed through to John and Maria as
follows.
John ($130,000 X 40%)
Maria ($130,000 X 60%)
$ 52,000
$ 78,000
The Accumulated Adjustments Account (AAA) increases by $130,000.
John: His tax liability is increased by $15,600 ($52,000 X 30%) and his stock basis is
increased by $52,000.
Maria: Her tax liability is increased by $23,400 ($78,000 X 30%) and her stock basis is
increased by $78,000.
Effect of distribution The distribution reduces the S corporation’s AAA by $87,500,
John’s stock basis by $35,000, and Maria’s stock basis by
$52,500.
Adjusted basis for stock
John ($68,000 + $52,000 - $35,000)
Maria ($300,000 + $78,000 - $52,500)
c.
$ 85,000
$325,500
The combined C corporation/shareholder’s tax liability is as follows.
C corporation
John
Maria
$ 33,950
10,500
15,750
$ 60,200
The combined S corporation/shareholder’s tax liability is as follows.
S corporation
John
Maria
$
-015,600
23,400
$ 39,000
Assuming the earnings and distribution policy remain constant, the annual tax liability
savings from electing S status is $21,200.
Comparative Forms of Doing Business
C corporation combined tax liability
S corporation combined tax liability
Tax liability savings
14-21
$ 60,200
(39,000)
$ 21,200
The savings result because the C corporation and shareholders are subject to double
taxation on $87,500 of the $130,000 annual earnings. In addition, the remaining
$8,550 of undistributed after-tax earnings may eventually be subject to a second layer
of taxation at the shareholder level.
pp. 14-8, 14-9, and 14-14 to 14-19
31.
a.
Return of capital treatment applies to partnership distributions. The partners reduce
their basis in the partnership interest by the adjusted basis of the partnership property
received. This is limited to the partner’s basis in the partnership interest. Anita and
Hector’s adjusted basis for the land is $140,000 each.
Anita
Hector
b.
Recognized Gain
$40,000
$40,000
Basis for Stock
$200,000 + $40,000 - $180,000 = $60,000
$150,000 + $40,000 - $180,000 = $10,000
Dividend treatment applies, using the fair market value of the land, to C corporation
distributions. There is no effect on the shareholders’ stock basis. In addition, §311(b)
requires that the appreciation of $80,000 ($360,000 - $280,000) on the land be
recognized by the C corporation with the related taxation being at the C corporation
level. Anita and Hector’s adjusted basis for the land is $180,000 each.
Anita
Hector
d.
Partnership Basis
$200,000 - $140,000 = $60,000
$150,000 - $140,000 = $10,000
Return of capital treatment applies to S corporation distributions for S corporations
(assuming there is no accumulated E & P from C corporation tax years). However,
§311(b) requires that the appreciation of $80,000 ($360,000 - $280,000) on the land be
recognized by the S corporation. This amount then flows through and is taxed at the
shareholder level. The shareholders’ basis for their stock is increased by the amount of
the recognized gain. Anita and Hector’s adjusted basis for the land is $180,000 each.
Anita
Hector
c.
Recognized Gain
$-0$-0-
Recognized Gain
$-0-0-
Dividend Income
$180,000
180,000
Stock Basis
$200,000
150,000
A limited liability company is taxed as a partnership. Thus, the tax consequences to
Anita and Hector are the same as in a. above.
p. 14-19
14-22
32.
2003 Entities Volume/Solutions Manual
a.
Yellow's taxable income is calculated as follows:
Active income
Portfolio income
Passive activity losses
Taxable income
$190,000
15,000
-0- *
$205,000
* The assumption is made that Yellow satisfies the three requirements for being labeled
a personal service corporation for § 469 purposes. Therefore, none of the passive
activity losses can be offset against either the active income or the portfolio income.
b.
Yellow's taxable income is calculated as follows:
Active income
Portfolio income
Passive activity losses
Taxable income
$190,000
15,000
(170,000)*
$ 35,000
* The passive activity losses can be offset against the active income of a closely held
corporation if the corporation does not meet the stock ownership requirements under
the personal holding company provisions. If the corporation does meet the PHC
provisions requirements, the answer is the same as in a.
p. 14-19
33.
a.
Rosa's basis for her partnership interest prior to consideration of the loss is $120,000
[$50,000 + 10% of $700,000 (partnership debt)]. However, the loss pass-through from
the partnership which Rosa can deduct is limited to her at-risk basis of $65,000 [$50,000
+ 10% of $150,000 (recourse debt)]. At the end of 2002, Rosa's basis for her partnership
interest is $55,000 [$50,000 + 10% of $700,000 (partnership debt) - $65,000 (at-risk
amount passed through)]. Although Rosa's share of the partnership loss is $90,000 (10%
X $900,000), her basis is reduced only by the $65,000 which produces a tax benefit. The
$25,000 ($90,000 - $65,000) which Rosa cannot deduct in 2002 can be used in future
taxable years, once her at-risk basis is adequate to absorb it.
b.
Since the entity concept applies, none of the C corporation's loss can be deducted on
Rosa's tax return. The basis for Rosa's stock at the end of 2002 is $50,000, the amount of
her initial contribution.
pp. 14-17 to 14-20
34.
a.
Special allocations are permitted for partnerships. Thus, under the agreement for sharing
losses, the $100,000 loss will be allocated to the partners as follows.
Megan ($100,000 X 10%)
Vern
($100,000 X 90%)
b.
$10,000
90,000
If the entity is a C corporation, the corporation has a $100,000 loss on its tax return.
There is no direct effect on the shareholders.
Comparative Forms of Doing Business
c.
14-23
If the entity is an S corporation, special allocations are not permitted. The $100,000 loss
is allocated to the shareholders based on the per share/per day rule.
Megan ($100,000 X 60%)
Vern
($100,000 X 40%)
$60,000
40,000
p. 14-21
35.
a.
The outside basis of each partner is calculated as follows:
Contribution
Recourse financing
Nonrecourse financing
b.
Abby
Velma
$ 75,000
100,000
50,000
$225,000
$ 50,000
100,000
50,000
$200,000
The at-risk basis of each partner is calculated as follows:
Contribution
Recourse financing
Abby
Velma
$ 75,000
100,000
$175,000
$ 50,000
100,000
$150,000
pp. 14-16, 14-17, and 14-19
36.
Partnership
C Corporation
S Corporation
a.
Yes
No
No
b.
Yes
No
No
c.
Yes
No
No
d.
Yes
No
No
e.
Yes
No
No
pp. 14-16 and 14-21
37.
a.
Since the 80% control requirement of § 351 is not satisfied at the time Sanjay contributes
the land to the C corporation, the basis of the land to the corporation is the fair market
value of $100,000. Therefore, the sale of the land by the corporation for $110,000
produces a recognized gain for the corporation of $10,000 [$110,000 (amount realized) $100,000 (adjusted basis)]. The sale produces no effect at the shareholder level.
b.
As in part a., the sale of the land by the S corporation for $110,000 produces a recognized
gain of $10,000. Since the entity is an S corporation, the recognized gain is passed
through to the three shareholders based on their stock ownership. Therefore, $3,000
($10,000 X 30%) is reported on Sanjay's return and the balance of $7,000 is reported on
the returns of the other two shareholders.
c.
The nonrecognition requirements of § 721 are satisfied at the time Sanjay contributes the
land to the partnership. Therefore, the partnership's basis for the land is a carryover basis
14-24
2003 Entities Volume/Solutions Manual
of $60,000, and the partnership's recognized gain is $50,000 [$110,000 (amount
realized) - $60,000 (adjusted basis)]. Section 704(c) requires that the precontribution
appreciation of $40,000 be allocated to Sanjay. The recognized gain balance of $10,000
is allocated among the three partners depending on the profit and loss sharing ratio.
pp. 14-16 and 14-21
38.
a.
The basis for the stock purchased by Emily and Freda would be its cost of $908,000.
The basis of the assets to the corporation would not be affected, since the corporation is
not involved in the purchase/sale transaction.
George would have a recognized gain of $348,000 from the stock sale and the gain
would be classified as a capital gain.
Amount realized
- Basis for stock
Recognized gain
b.
$908,000
(560,000)
$348,000
Emily and Freda would have a basis for each of the assets purchased equal to the cost
(i.e., FMV). Since the FMV of the listed assets is $750,000, the $158,000 excess of the
purchase price over $750,000 will be assigned to goodwill. Goodwill is amortized over
a period of 15 years for tax purposes.
If Emily and Freda desire to conduct the business in corporate form, they can contribute
the assets to a corporation in a tax-free transaction under § 351. The basis of the
contributed assets to the corporation will be a carryover basis (i.e., total basis of
$908,000).
Pelican will be assigned the following recognized gain from the sale of the assets to
Emily and Freda for $908,000:
Asset
Cash
Accounts receivable
Inventory
Furniture and fixtures
Building
Land
Goodwill
Recognized
Gain
$
-0-010,000
20,000
50,000
110,000
158,000
$348,000
Classification
Capital
Ordinary
$
-0-0-0-050,000**
110,000**
158,000
$318,000
$
-0-010,000
20,000*
-0-0-0$30,000
* § 1245 recapture
** § 1231 gain.
George, as the shareholder, is not involved in the purchase/sale transaction. Thus, this
transaction will produce no tax consequences for George. Logically, however, the
corporation would liquidate and distribute the available cash to George. Since Pelican
is in the 34% tax bracket, the corporate tax liability associated with the asset sale would
be $118,320 ($348,000 X 34%). Therefore, when George receives a liquidating
distribution of $789,680 ($908,000 - $118,320), he will recognize a capital gain of
$229,680 ($789,680 amount realized - $560,000 adjusted basis for stock).
Comparative Forms of Doing Business
c.
14-25
The basis for the stock purchased by Emily and Freda is its cost of $550,000. The basis
of the assets to the corporation would not be affected, since the corporation is not
involved in the purchase/sale transaction.
George would receive a recognized loss of $10,000 from the stock sale and the loss
would be classified as a capital loss.
Amount realized
- Basis for stock
Recognized loss
$ 550,000
(560,000)
($ 10,000)
p. 14-23 and Concept Summary 14-1
39.
a.
Amount realized
Less: adjusted basis
Realized gain
$260,000
(160,000)
$100,000
Recognized gain
$100,000
Even though Linda sold her business, the transaction is treated as the sale of the
individual assets. This is necessary to classify the recognized gain as capital or ordinary.
Asset
Ordinary
Capital and § 1231
Accounts receivable
Office furniture and fixtures
Building
Land
Goodwill
$ 25,000
2,000
$
-0-015,000
20,000
38,000
Since the sales price exceeds the fair market value of the listed assets by $38,000
($260,000 - $222,000), the excess is treated as paid for goodwill.
b.
Juan has a basis for each of the listed assets of fair market value, and a basis for goodwill
of $38,000.
c.
Prior to the Revenue Reconciliation Act of 1993, the goodwill amortization could not be
deducted by Juan for tax purposes. Thus, if Juan were successful in negotiating with
Linda to have the excess $38,000 labeled a payment for a covenant not to compete, Juan
could then deduct the $38,000 over the life of the covenant. From Linda's perspective,
this would result in the $38,000 gain being classified as ordinary income. As a result of
the Revenue Reconciliation Act of 1993, both goodwill and a covenant not to compete
are amortized and deducted over a 15-year statutory period. Thus, from Juan's
perspective, the tax consequences of assigning the $38,000 excess payment to goodwill
or to a covenant are the same. However, the tax consequences to Linda still differ. That
is, gain on the covenant is classified as ordinary income, whereas gain on the goodwill is
classified as a capital gain. Thus, if the covenant has no legal relevance to Juan, he
should negotiate with Linda for a price reduction which reflects the tax benefit of the
alternative tax on capital gains to Linda (assuming there is a benefit to Linda).
Conversely, if a covenant would have legal relevance to Juan, then at least part of the
$38,000 should be assigned to a covenant.
pp. 14-21, 14-22, Example 17, and Concept Summary 14-1
14-26
40.
2003 Entities Volume/Solutions Manual
a.
The sales are treated as the sales of ownership interests. Thus, each partner calculates his
or her recognized gain as follows:
Amount realized
- Basis
Recognized gain
Gail
Harry
$307,000
(100,000)
$207,000
$307,000
(150,000)
$157,000
The recognized gain is classified as long-term capital gain under § 741 subject to any
ordinary income recognition under § 751 for "hot" assets. Since GH Partnership has no
unrealized receivables or substantially appreciated inventory, all of the gain is classified
as long-term capital gain.
The sale of the partnership interests by Gail and Harry results in the termination of GH
Partnership under § 708(b)(1)(B) [within a 12-month period, there is a sale or exchange
of at least 50% of the total interest in partnership capital and profits].
b.
If the assets are appreciated, an individual purchasing an interest in a partnership
normally would prefer to purchase partnership assets rather than an ownership interest.
This preference occurs because the basis of the assets will be equal to the amount paid
for them (i.e., FMV) rather than having a carryover basis associated with the purchase of
a partnership interest. This negative result associated with the purchase of a partnership
interest can be offset for the acquiring partner if the partnership makes the § 754 election
which activates the special basis provisions under § 743 for the acquiring partner.
However, there are a variety of reasons why the partnership may be unwilling to make
this election.
In the case at hand, the normal preference does not apply because the GH Partnership is
terminated. Thus, regardless of the method of purchase, the assets of the new
partnership (i.e., KL Partnership) will have a basis equal to the amount paid by Keith and
Liz (i.e., FMV).
p. 14-23 and Concept Summary 14-1
41.
CLIENT LETTER
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, Ohio 45040
August 16, 2002
Mr. Ted Taxpayer
50 Lake Shore Drive
Erie, PA 16501
Dear Ted:
Comparative Forms of Doing Business
14-27
I am responding to your inquiry regarding your purchase of the Carp Partnership for $400,000.
Your outside basis is $200,000 and Skip’s outside basis is $200,000.
Since you and Skip have acquired a greater than 50 percent interest in capital and profits, the
original Carp Partnership terminates. It is survived by a new Carp Partnership owned by you
and Skip. The basis of the partnership assets is the cost of $400,000. Thus, in this case, a § 754
election is not necessary.
If you have any questions, please call.
Sincerely,
Janet Thomas, CPA
Partner
p. 14-23 and Concept Summary 14-1
42.
From Vladimir's perspective, the sale of Ruby, Inc., should be structured so as to avoid double
taxation. A sale of the stock of Ruby, Inc., to the investor group will achieve this objective.
The sale of the assets by the corporation (or the distribution of the assets to Vladimir to sell)
followed by the liquidation of the corporation would result in double taxation. Thus, Vladimir
needs to recognize this difference in tax consequences to effectively conclude the negotiations.
p. 14-23 and Concept Summary 14-1
43.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
August 16, 2002
Mr. Bill Evans
100 Village Green
Chattanooga, TN 37403
Dear Mr. Evans:
I am responding to the inquiry regarding whether you should negotiate to purchase the stock or
the assets of Dane Corporation.
From a tax perspective, you should acquire the assets of Dane Corporation rather than the
stock. By purchasing the assets, the basis for the assets will be the purchase price of $750,000.
Then contribute the assets to a new corporation under § 351 without any recognition. The
basis of the assets to the corporation will be $750,000. If the stock of Dane Corporation is
purchased instead, the basis for the stock is the purchase price of $750,000. However, the
corporation's basis for its assets would remain at $410,000. In order to step the asset basis up
to the purchase price of $750,000, the corporation would need to make a § 338 election.
However, the disadvantage of a § 338 election is that the corporation would have a recognized
gain as a result of a deemed sale of its assets.
A nontax advantage of the asset purchase is the avoidance of legal responsibility for any
liabilities of Dane Corporation. Although Dane has no recorded liabilities, there is the
possibility of unrecorded or contingent liabilities.
14-28
2003 Entities Volume/Solutions Manual
If I can be of further assistance, please let me know.
Sincerely,
Robert Ames, CPA
Partner
TAX FILE MEMORANDUM
DATE:
August 12, 2002
FROM:
Robert Ames
SUBJECT:
Purchase of Dane Corporation by Bill Evans
Bill Evans is going to purchase either the stock of Dane Corporation or its assets. Bill has
agreed with the seller that Dane has a fair market value of $750,000. Dane's adjusted basis for
its assets is $410,000. Bill has requested our advice on whether he should negotiate to
purchase the stock of Dane or its assets.
If Bill purchases the assets of Dane, his basis for the assets would be the purchase price of
$750,000. He then could contribute the assets to a new corporation without any recognition
under § 351. The corporation's adjusted basis for the assets would be $750,000.
If Bill purchases the stock of Dane, his basis for the stock would be $750,000. However, since
Dane is not involved in the transaction, the corporation's basis for its assets would remain at
$410,000. In order to step the asset basis up to the purchase price of $750,000, Dane would
need to make a § 338 election. However, the disadvantage of a § 338 election is that the
corporation would have a recognized gain as a result of the deemed sale of its assets.
Thus, from a tax perspective, Bill should purchase the assets rather than the stock of Dane. In
addition, the asset purchase will avoid any potential unrecorded or contingent liability
problem.
p. 14-23 and Concept Summary 14-1
BRIDGE DISCIPLINE PROBLEMS
1.
a.
Assets
Cash
Land
Financial Accounting Balance Sheet
Liabilities and Owners Equity
$100,000
120,000
$220,000
Mortgage on land
Common stock
$ 20,000
200,000
$220,000
Entity theory applies in constructing the financial accounting balance sheet. Thus, the fair
market values are used for the assets and the related common stock account.
Comparative Forms of Doing Business
14-29
Tax Balance Sheet
b.
Assets
Cash
Land
Liabilities and Owners Equity
$100,000
40,000
Mortgage on land
Common stock
$ 20,000
120,000
$140,000
$140,000
Conduit theory applies in constructing the tax balance sheet. Thus, a carryover basis is used
for the assets and the related shareholders’ basis for their common stock.
c.
Financial
Accounting
$150,000
(120,000)
$30,000
Amount realized
- Adjusted basis
= Recognized gain
Tax
$150,000
(40,000)
$110,000
Because the assets were valued at fair market value at the time of the contribution to the entity,
the $30,000 gain represents the appreciation occurring after the assets were contributed to the
entity. Because the assets were valued at a carryover basis at the time of the contribution to the
entity, the $110,000 gain represents both the appreciation ($80,000) occurring at the time of
the contribution to the entity and the appreciation ($30,000) occurring after the assets were
contributed to the entity.
2.
a., b., and c. Both the financial accounting and the tax results are the same as in 1. above. The
only difference is that the $110,000 recognized gain for tax purposes is taxed at the shareholder
level (S corporation is a flow-through entity) rather than at the corporate level as in 1. above.
3.
a.
Assets
Cash
Land
Financial Accounting Balance Sheet
Liabilities and Owners Equity
$100,000
120,000
Mortgage on land
$ 20,000
Partners’ Ownership Interest 200,000
$220,000
$220,000
Entity theory applies in constructing the financial accounting balance sheet. Thus, the fair
market values are used for the assets and the related partners’ ownership interests.
Tax Balance Sheet
b.
Assets
Cash
Land
Liabilities and Owners Equity
$100,000
40,000
Mortgage on land
$ 20,000
Partners’ Ownership Interest 120,000
$140,000
$140,000
14-30
2003 Entities Volume/Solutions Manual
Conduit theory applies in constructing the tax balance sheet. Thus, a carryover basis is used
for the assets and the related partners’ partnership interests.
c.
Amount realized
- Adjusted basis
= Recognized gain
Financial
Accounting
$150,000
(120,000)
$30,000
Tax
$150,000
(40,000)
$110,000
Because the assets were valued at fair market value at the time of the contribution to the entity,
the $30,000 gain represents the appreciation occurring after the assets were contributed to the
entity. Because the assets were valued at a carryover basis at the time of the contribution to the
entity, the $110,000 gain represents both the appreciation ($80,000) occurring at the time of
the contribution to the entity and the appreciation ($30,000) occurring after the assets were
contributed to the entity.
The $110,000 recognized gain for tax purposes is taxed at the partner level (partnership is a
flow-through entity). Section 704(c)(1)(A) requires that the $110,000 gain be allocated to Jake
and Fran as follows:
Precontribution gain
Post-contribution gain
Jake
$ 0
15,000
$15,000
Fran
$80,000
15,000
$95,000
If Parchment is an LLC that has checked the box to be taxed as a partnership, then the
partnership tax rules apply. So the results would be exactly the same as those for an entity that
legally is a partnership.
4.
a.
For the first tax year of a corporation, a corporation is exempt from the AMT. So neither
Teal nor Lavender needs to make an AMT calculation for their first tax year.
b.
The Code contains a number of instances of beneficial tax treatment for small
businesses. One such treatment appears in § 55(e) for small corporations. If a
corporation satisfies the statutory definition of a small corporation for this purpose, the
corporation is exempt from the AMT for tax years subsequent to the first tax year.
Lavender is a small corporation as defined in § 55(e)(1) whereas Teal is not. Thus, only
Teal is subject to the AMT.
c.
The different tax treatment for Teal and Lavender is consistent with a theme in several
code sections that small business deserves beneficial tax treatment when compared with
large business entities.
p. 14-10
Comparative Forms of Doing Business
14-31
RESEARCH PROBLEMS
1.
The Internet Activity research problems require that the student access various sites on the
Internet. Thus, each student’s solution likely will vary from that of the others.
You should determine the skill and experience levels of the students before making the
assignment, coaching them where necessary so as to broaden the scope of the exercise to the
entire available electronic world.
Make certain that you encourage students to explore all parts of the World Wide Web in this
process, including the key tax sites, but also information found through the web sites of
newspapers, magazines, businesses, tax professionals, government agencies, political outlets,
and so on. They should work with Internet resources other than the Web as well, including
newsgroups and other interest-oriented lists.
Build interaction into the exercise wherever possible, asking the student to send and receive
e-mail in a professional and responsible manner.
2.
See the Internet Activity comment above.
3.
See the Internet Activity comment above.
4.
See the Internet Activity comment above.
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2003 Entities Volume/Solutions Manual
NOTES