chapter 13 - Taxation of the Business Entity

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2006
CHAPTER 13
COMPARATIVE FORMS OF DOING BUSINESS
SOLUTIONS TO PROBLEM MATERIALS
DISCUSSION QUESTIONS
1.
The principal legal forms for conducting a business entity are the sole proprietorship,
partnership, limited liability company, and corporation. The principal Federal income tax
forms are the same, except that the corporation is divided into the C corporation and
the S corporation. pp. 13-3 and 13-4
2.
The legal and tax forms of a business entity usually are the same, but differences can
develop. If the corporate entity lacks substance, the IRS may ignore the corporate legal
form and tax the owners directly. Likewise, the IRS may attempt to treat a partnership as
if it were a corporation. This latter likelihood has been reduced due to the issuance of the
check-the-box Regulations. pp. 13-3 and 13-4
3.
The business advantage of a limited liability company is limited liability. The tax
advantage is that the entity can be taxed under the conduit concept available to
partnerships. Thus, only single taxation, rather than double taxation, applies. Also,
losses can be passed through from the entity to the owners. pp. 13-4, 13-6, and 13-7
4.
The maximum statutory rate for a C corporation and for an individual is 35%. However,
at certain levels of income the individual rates are lower than the corporate rates. For
example, in 2005 income between $100,000 and $250,000 is taxed at 28% or 33% for a
married taxpayer filing a joint return, whereas for a corporation the rate is 39%. In
addition, at certain levels of income, the individual rates are higher than the corporate
rates. For example, in 2005 income between $500,000 and $10,000,000 is taxed to a
corporation at 34%, whereas for a married taxpayer filing a joint return, the rate is 35%.
So what is relevant is the actual rates that apply in a particular situation and not the
maximum statutory rates. Also double taxation may apply with corporations if dividend
distributions are made to shareholders. p. 13-8 and Example 7
5.
The motivation for the change in legal form is to limit liability. Under the general
partnership form, there is unlimited liability with the personal assets of each of the firm
partners being subject to the claims of the partnership creditors. Under the limited
liability partnership form, the personal assets of a particular partner are subject to the
13-1
13-2
2006 Annual Edition/Solutions Manual
claims of the partnership creditors for his or her actions. (Note in some states that even
this amount is limited.) However, the personal assets of a particular partner are not
subject to the claims of partnership creditors for the actions of other partners.
The income tax consequences associated with the general partnership form and the
limited liability form are the same. That is, the entity is not subject to taxation (i.e., the
partnership is a tax reporter and the partners are the taxpayers). Both profits and losses
are passed through to the partners.
pp. 13-4, 13-5, and Tax in the News on p. 13-5
6.
7.
The limited liability objective can be achieved by forming a limited partnership whose
general partner is a corporation. The liability of the limited partners is limited by the
statute. The owners of the corporation have effectively limited their liability by having
the corporation be the general partner. Prior to the issuance of the check-the-box
Regulations, it was necessary to structure the entity carefully in order to avoid the limited
partnership being classified as an association and taxed as a corporation. Under the
check-the-box Regulations, the limited partnership cannot be reclassified as an
association and taxed as a corporation. Figure 13-1
a. and b. The ability to raise capital and the shelter of limited liability are advantages of
the corporate form. While the limited partnership form enables the limited
partners to limit their liability to the amount invested, the general partner or
partners have unlimited liability. Both corporate shareholders and limited partners
could forfeit this protection to the extent they guarantee corporate or partnership
debts.
c.
There is no limit on the life of a corporation. Changes in the owners of a
partnership can result in its termination.
d.
There is no limit on the number of owners for a corporation; a partnership must
have at least two. Centralized management is a characteristic of a corporation.
While the typical general partnership lacks centralized management, it exists in
the usual limited partnership.
pp. 13-5 to 13-7 and Concept Summary 13-2
8.
Gary can benefit by passing the losses through and offsetting them against his other
income. Since he is the sole owner, the three business forms available that will permit
this are the sole proprietorship, limited liability company (LLC), and the S corporation.
A benefit of the S corporation and the limited liability company when compared with the
sole proprietorship is limited liability. Once Gary’s business starts producing a profit,
each of these three business forms will result in single taxation (i.e., the entity is not
subject to taxation and Gary is subject to taxation). pp. 13-7 to 13-9
9.
The S corporation and its owners are subject to single taxation and the C corporation and
its owners are subject to double taxation. As Sue suggests, one way to avoid double
taxation is to reduce the corporate taxable income to zero. However, one must be aware
of the possibility of the IRS raising the unreasonable compensation issue. To the extent
that the IRS is successful, the salary is reclassified as a dividend and double taxation is
produced.
Comparative Forms of Doing Business
13-3
Sam is correct that being an S corporation does provide certain constraints in that the
requirements that must be satisfied in order to elect S status (e.g., number and types of
shareholders, only one class of stock) become maintenance requirements. For example,
issuing preferred stock would result in termination of the S election.
One approach would be for Sam to elect S corporation status presently. If at some time in
the future he cannot continue to satisfy the maintenance requirements, he would then
become a C corporation. During the period that the S corporation election is in effect, he
would not have to be concerned about double taxation.
Note that a tax advisor should not limit his or her analysis to the options provided by the
client. Sam should also consider the limited liability company (LLC).
pp. 13-8, 13-12, 13-13, and Concept Summary 13-2
10.
A C corporation is subject to double taxation only if it makes distributions to the
shareholders. Since Paul’s corporation currently pays no dividends and does not intend to
do so in the future, double taxation is not present. In addition, the $60,000 salary paid to
Paul was deductible by the corporation in calculating its taxable income of $100,000.
By making the S election, Paul may have created a wherewithal to pay problem for
himself. He is taxed on the $100,000 even though he is receiving no dividends from the
corporation. Thus, he may have generated a cash flow problem. In addition, by making
the S election, he has increased the entity/owner tax liability for a C corporation from
$22,250 [($50,000 X 15%) + ($25,000 X 25%) + ($25,000 X 34%)] to that for an S
corporation of $33,000 ($100,000 X 33%). However, as the entity earnings increase each
year, this $10,750 ($33,000 – $22,250) difference will decrease. Ultimately the C
corporation tax could be greater than the S corporation tax at the shareholder level.
pp. 13-8, 13-12, 13-13, and Example 7
11.
All four of the entities, either directly or indirectly, are subject to the AMT. For the sole
proprietorship and the C corporation, the impact is direct (i.e., the AMT is calculated on
the sole proprietorship’s Form 1040 and on the C corporation’s Form 1120). For the
partnership and S corporation, the impact is indirect (i.e., the entities are conduits and the
AMT is calculated on the owners’ tax returns). pp. 13-9 and 13-10
12.
Violet’s acceleration of income and deferral of deductions for a year in which it is subject
to the AMT can be beneficial. Since Violet is subject to the AMT for the current year,
any net income increases are taxed at the 20% AMT rate. If such income were taxed next
year, it would be subject to a 34% regular corporate tax rate. pp. 13-9 and 13-10
13.
If Nell chooses the partnership form, the losses can be deducted on both her Federal and
state income tax returns (assuming the three states each have a state income tax).
However, if she chooses the corporate form, not all states permit the S corporation
election for state income tax purposes. In such case, Nell would not be able to deduct the
corporate losses on her state income tax return. Thus, Nell needs to inquire whether the
states permit the S election. p. 13-11
14.
The statement describes the most favorable type of fringe benefit available taxwise. For
example, meals and lodging which qualify under § 119 receive this tax treatment.
However, many fringe benefits (e.g., pension and profit sharing plans) provide an
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2006 Annual Edition/Solutions Manual
immediate deduction for the employer, but only tax deferral for the employee. Thus, the
employee is taxed in the future when he or she actually receives the benefit. While not as
favorable as a complete exclusion, deferral treatment is a positive tax advantage.
pp. 13-11 and 13-12
15.
The relevant issue for Oscar and Lavender, Inc., is the long-term effect of the dividend
policy. Assuming there is no immediate accumulated earnings tax problem, the present
dividend policy avoids double taxation. But do reasonable needs exist for keeping the
earnings in the corporation rather than distributing them as dividends? If not, then the
corporation is vulnerable to the imposition of the accumulated earnings tax. Oscar may
also want to consider having his salary increased as a way of insulating additional funds
from being subject to double taxation. pp. 13-13 and 13-14
16.
The following payments to shareholders are deductible in calculating corporate taxable
income.

Salary payments to shareholder-employees.

Lease or rental payments to shareholder-lessors.

Interest payments to shareholder-creditors.
Because of the tax benefit that results, the IRS scrutinizes these types of transactions
carefully in terms of reasonableness. In addition, the interest payments may result in the
IRS raising the § 385 thin capitalization issue. p. 13-13 and Examples 11 and 12
17.
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.
p. 13-13
18.
The second approach (i.e., a combined capital contribution of $500,000 and loan of
$300,000) has two potential advantages. First, the interest payments of $18,000
($300,000 X 6%) on the loan are deductible by the corporation. Second, the repayment of
the loan by the corporation does not produce income to Teresa.
The potential pitfall is that the IRS may consider the corporation to be thinly capitalized.
This could result in interest payments being reclassified as dividend payments (making
them not deductible by the corporation). The loan repayment will be treated as a dividend
to the shareholder.
p. 13-13
19.
The absence of dividends may result in the IRS assessing the accumulated earnings tax.
If this should occur, accumulated taxable income would be taxed at a 15% rate in 2005.
Comparative Forms of Doing Business
13-5
The penalty tax will not be assessed if Martin has reasonable needs for its accumulated
earnings (e.g., is investing in the expansion of the business). If Martin is not a closely
held corporation, it is unlikely that the accumulated earnings tax will be assessed. While
the accumulated earning tax does apply to corporations that are not closely held, it is
assessed only if the corporate earnings are retained for the purpose of avoiding double
taxation. Finally, the accumulated earnings tax does not apply to S corporations. Thus, if
Martin has been an S corporation since inception, the penalty tax would not apply.
pp. 13-13, 13-14, Chapter 6, and Concept Summary 13-2
20.
Operating as a C corporation would provide Arnold with greater flexibility in that he
would not have to be concerned with satisfying the qualification requirements under
§ 1361 in order to elect S corporation status. Once the election is made, the qualification
requirements become maintenance requirements. The principal negative attribute of
being a C corporation is the potential for double taxation.
Factors to consider in making the S election include the following:

Are all the shareholders willing to consent to the election?

Can the qualification requirements under § 1361 be satisfied at the time of the
election?

Since the qualification requirements become maintenance requirements, can these
requirements continue to be satisfied?

For what period will the conditions that make the election beneficial continue to
prevail?

Will the corporate distribution policy create wherewithal to pay problems at the
shareholder level?
pp. 13-14 and 13-15
21.
S corporations can have a maximum of 100 shareholders. For this limitation, married
shareholders and certain family members 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.
p. 13-15, Chapter 12, and Concept Summary 13-2
22.
The tax consequences to Sadie and to the entities will be the same. The fair market value
of the truck of $15,000 is less than Sadie’s adjusted basis (i.e., cost) of $37,000 for the
truck. Therefore, the adjusted basis of the truck to the S corporation or to the C
corporation is the lower fair market value of $15,000. Sadie’s realized loss of $22,000
(i.e., the value decline while she held the truck for personal use) is disallowed. p. 13-16
and Concept Summary 13-2
23.
Section 721 applies the conduit concept with respect to partnership contributions, and
realized gains and losses are not recognized. Since the corporation generally is governed
by the entity concept, realized gains and losses associated with shareholder contributions
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2006 Annual Edition/Solutions Manual
of assets to the corporation would be recognized. If the requirements of § 351 are
satisfied, however, the conduit concept is substituted for the entity concept and any
realized gains and losses are not recognized. Paramount to the application of § 351 is the
80% control requirement. pp. 13-16, 13-17, and Concept Summary 13-2
24.
Section 704(c) provides for a mandatory special allocation if a partner contributes an
asset to a partnership whose basis is not equal to the fair market value. The amount of the
special allocation for the contributing partner is the difference between the partner’s
adjusted basis for the asset and the fair market value. The purpose for the special
allocation is to provide for the eventual taxation of the value increment or decrement to
the contributing partner, rather than to have it shared among all the partners. Other
elective special allocations are available if they have substantial economic effect.
The concept of special allocations does not apply for the corporate form because of the
entity concept. The recognition of gains or losses and the taking of deductions occurs at
the corporate rather than at the shareholder level. S corporations use the per share and per
day allocation method.
pp. 13-16, 13-17, 13-21, and Concept Summary 13-2
25.
Increases in partnership liabilities increase a partner’s basis for his or her partnership
interest, and decreases in partnership liabilities decrease such basis. This is appropriate
because the general partners are liable for the liabilities if not paid by the partnership.
Corporate liability increases and decreases do not have any effect on the shareholder’s
basis for his or her stock. This is appropriate because the shareholder has limited
liability.
p. 13-17 and Example 17
26.
Item
Partner
Effect on Basis
Shareholder in
Shareholder in
C corporation
S corporation
Profits
+
no effect
+
Losses
–
no effect
–
Liability increase
+
no effect
no effect
Liability decrease
–
no effect
no effect
Contribution of
Assets
+
+
+
Distribution of assets
–
no effect
if classified
as a dividend
–
if classified
as a return of
–
Comparative Forms of Doing Business
13-7
capital
p. 13-17 and Example 17
27.
The conduit concept generally applies to the S corporation. Therefore, the S corporation
is a tax reporter rather than a taxpayer, with the taxation occurring at the shareholder
level. However, there are several instances in which the S corporation is the taxpayer.
Included are the tax on built-in gains and the tax on certain passive investment income.
p. 13-18 and Concept Summary 13-2
28.
The conduit concept applies in the case of a partnership. Therefore, the partnership is
merely a tax reporter and the partners are the taxpayers. The partners are taxed on the
earnings of the partnership rather than on the receipt of distributions. Thus, Dexter has
already been taxed on his share of the partnership earnings. p. 13-19
29.
The C corporation is treated as a separate taxable entity and is subject to double taxation.
The benefit of the S election is that the corporation generally is not subject to taxation.
Similar to the partnership, the earnings of an S corporation are passed through and taxed
at the owner level. Therefore, if the S corporation shareholder later receives a
distribution, such earnings have already been taxed. p. 13-19
30.
If Sandra and Reese each sell their stock of Olive, they will be taxed on the recognized
gain (i.e., excess of amount realized over the adjusted basis for the stock). Olive
Corporation is not affected by the sale.
If Olive sells the assets, pays its liabilities, and distributes the net assets to the
shareholders, the recognized gain is passed through to the shareholders. The
shareholders’ adjusted basis for their stock is increased by the amount of the gain they
recognized. The shareholders are also taxed on the excess of the amount distributed to
them by Olive over the adjusted basis of their stock.
Both the stock sale and the asset sale will produce the same total amount of recognized
gain to Sandra and Reese. However, there may be a difference in its classification. All of
the recognized gain on the stock sale is a long-term capital gain (the stock is a capital
asset). On the asset sale, some of the gain could be ordinary income because the assets
may not be capital assets.
Another factor favoring the stock sale is that it is less complex and costly to consummate
than the asset sale.
pp. 13-25, 13-26, and Concept Summary 13-1
31.
The complete liquidation of a C corporation subjects the corporation/shareholders to
double taxation. First, the C corporation is taxed on any gain on the sale of its assets.
Second, the shareholders are taxed on the difference between their stock basis and the
value of the assets distributed to them by the corporation.
If the form of the transaction is a stock sale by the shareholders, then only the
shareholders are subject to taxation. They are taxed on the difference between their stock
basis and the sales proceeds received. Consequently, the seller benefits from structuring
the disposition as a stock sale rather than as a liquidation.
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2006 Annual Edition/Solutions Manual
p. 13-25 and Concept Summary 13-1
32.
33.
a.
S corporation and C corporation (S and C). p. 13-6
b.
C corporation (C). pp. 13-5 and 13-6
c.
C corporation (C). pp. 13-7 to 13-9
d.
Sole proprietorship, partnership, and S corporation (SP, P, and S). pp. 13-7 and
13-8
e.
C corporation (C). p. 13-13 and Concept Summary 13-2
f.
S corporation (S). Concept Summary 13-2
g.
Sole proprietorship and partnership (SP and P). p. 13-6
h.
C corporation (C). p. 13-25 and Concept Summary 13-1
i.
Sole proprietorship, partnership, and S corporation (SP, P, and S). p. 13-17
j.
Sole proprietorship and partnership (SP and P). p. 13-17
k.
C corporation (C). p. 13-19
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).
p. 13-17 and Concept Summary 13-2
34.
At least four factors should be considered when evaluating whether to make the election
under § 754 which will activate the operational provisions of § 743. These four factors
are: (1) the partnership must make the election, (2) the election could produce negative
basis adjustments if the adjusted basis exceeds the fair market value of the partnership
assets at the acquisition date, (3) the election also activates the optional adjustment to
basis under § 734 that results from partnership distributions, and (4) the complexity of
recordkeeping. p. 13-24 and Example 23
PROBLEMS
35.
a.
Since a sole proprietorship has unlimited liability, the sole proprietorship and the
owner is liable for the remaining $2 million after the $3 million is paid by
Comparative Forms of Doing Business
13-9
insurance. Since the net 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 net 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).
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.
p. 13-6
13-10
36.
2006 Annual Edition/Solutions Manual
a.
The tax liability of each of the corporations is as follows:
Red Corporation
15% X
25% X
34% X
$50,000
25,000
17,000
=
=
=
$ 7,500
6,250
5,780
$19,530
$ 50,000
25,000
250,000
225,000
=
=
=
=
$
White Corporation
15%
25%
34%
5%
X
X
X
X
7,500
6,250
85,000
11,250
$110,000
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 30,000,000
3% X
3,333,333
=
=
=
$ 3,400,000
10,500,000
100,000
$14,000,000
or 35% X $40,000,000
=
$14,000,000
Orange Corporation
The effective tax rate for each of the corporations is as follows:
Red Corporation
$19,530
$92,000
=
21.23%
=
33.85%
=
34%
White Corporation
$110,000
$325,000
Blue Corporation
$272,000
$800,000
Comparative Forms of Doing Business
13-11
Orange Corporation
$14,000,000
$40,000,000
=
35%
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%.
Chapter 2
37.
Hoffman, Raabe, Smith, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
March 15, 2005
Amy and Jeff Barnes
5700 Redmont Highway
Washington, D.C. 20024
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 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
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2006 Annual Edition/Solutions Manual
(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. 13-3 to 13-7
38.
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 aftertax 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. 13-5 to 13-8
39.
a.
If Clay is a C corporation, the corporate tax liability is:
15% X
25% X
34% X
$50,000 =
25,000 =
15,000 =
$ 7,500
6,250
5,100
$18,850
Since Clay will not distribute any dividends, the shareholders will have no tax
liability associated with it.
Comparative Forms of Doing Business
13-13
If Clay is an S corporation, the corporate tax liability will be $0 and the
shareholders’ tax liability will be $29,700 ($90,000 X 33%). Viewed from an
entity-owner perspective, operating as a C corporation will result in tax savings of
$10,850 ($29,700 – $18,850). 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 Clay is a C corporation, the corporate tax liability is $18,850. The tax at the
shareholder level on the distribution of after-tax earnings of $71,150 is $10,673
($71,150 X 15%) assuming the dividends are qualified dividends. Therefore, the
combined corporation and shareholder tax is $29,523 ($18,850 + $10,673).
If Clay is an S corporation, the corporate tax liability will be $0 and the
shareholder tax liability will be $29,700. The $90,000 will be a distribution out of
AAA and thus will be tax-free to the shareholders.
Viewed from an entity-owner perspective, operating as a C corporation will result
in tax savings of $177 ($29,700 – $29,523).
pp. 13-8, 13-9, and Example 8
40.
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.
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:
13-14
2006 Annual Edition/Solutions Manual
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
p. 13-8 and Example 7
41.
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
4,915,000
=$
7,500
=
6,250
=
8,500
=
91,650
= 1,671,100
$1,785,000
The AMT of the corporation is calculated as follows:
Taxable income
+ Positive AMT adjustments including
ACE adjustment ($425,000 + $720,000)
– Negative AMT adjustments
+ Tax preferences
= Alternative minimum taxable income (AMTI)
– Exemption [$40,000 – 25%($12,365,000 – $150,000)]
= AMT base
X Rate
= Tentative AMT
– Regular income tax liability
= AMT
$ 5,250,000
1,145,000
(30,000)
6,000,000
$12,365,000
(-0-)
$12,365,000
20%
$ 2,473,000
(1,785,000)
$ 688,000
Thus, if Parrott is a C corporation, its tax liability is $2,473,000 ($1,785,000
regular income tax + $688,000 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. 13-9 and 13-10
42.
Falcon’s tax liability for 2005 and 2006 is as follows if the cash option is selected.
Comparative Forms of Doing Business
13-15
Regular Income Tax Liability
2005
2006
Taxable income before sale
Gain from sale ($500,000 – $400,000)
Taxable income
$400,000
100,000
$500,000
$400,000
-0$400,000
Tax liability (34% rate)
$170,000
$136,000
2005
2006
Taxable income before sale
AMT gain from sale ($500,000 – $425,000)
Other AMT adjustments and tax preferences
AMTI
Exemption amount
AMT base
Rate
Tentative AMT
$400,000
75,000
425,000
$900,000
(-0-)
$900,000
X 20%
$180,000
$400,000
-0-0$400,000
(-0-)
$400,000
X 20%
$ 80,000
AMT
$ 10,000
$
AMT
-0-
Falcon’s tax liability for 2005 and 2006 is as follows if the installment option is selected.
Regular Income Tax Liability
2005
2006
Taxable income before sale
Gain from sale ($500,000 – $400,000)
Taxable income
$400,000
-0$400,000
$400,000
100,000
$500,000
Tax liability (34% rate)
$136,000
$170,000
2005
2006
Taxable income before sale
AMT gain from sale ($500,000 – $425,000)
Other AMT adjustments and tax preferences
AMTI
Exemption amount
AMT base
Rate
Tentative AMT
$400,000
-0425,000
$825,000
(-0-)
$825,000
X 20%
$165,000
$400,000
75,000
-0$475,000
(-0-)
$475,000
X 20%
$ 95,000
AMT
$ 29,000
$
AMT
-0-
13-16
2006 Annual Edition/Solutions Manual
If the cash option is selected, the combined tax liability for the two years is $316,000
($180,000 in 2005 and $136,000 in 2006). If the installment option is selected, the
combined tax liability for the two years is $335,000 ($165,000 in 2005 and $170,000 in
2006). Thus, Falcon saves $19,000 ($335,000 – $316,000) by selecting the cash option.
pp. 13-9, 13-10, and Chapter 6
43.
a.
If the farm is incorporated as a C (regular) corporation, then the sisters as
shareholder-employees can qualify as employees. Thus, the $48,000 ($30,000 for
lodging and $18,000 for meals) is excludible to the sisters under the § 119 meals
and lodging exclusion. If the farm is an S corporation, the sisters 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
sisters do not satisfy the definition of an employee. Therefore, they are not
eligible for the § 119 exclusion and the $48,000 must be included in their gross
income.
pp. 13-11, 13-12, and Example 10
44.
a.
Taxable income before cost of
certain fringe benefits
– Deductible fringe benefits
Taxable income
Partnership
C Corporation
$400,000
(235,000)
$165,000
$400,000
(305,000)
$ 95,000
S Corporation
$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.
Comparative Forms of Doing Business
13-17
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.
pp. 13-11 and 13-12
45.
a.
Under option 1, Beaver can deduct salaries of $300,000. Thus, Beaver’s taxable
income will be $0 ($300,000 – $300,000). No dividends will be distributed since
there are no after-tax earnings. Gerald will include $180,000 of salary in his gross
income, and Joanie will include $120,000 of salary in her gross income.
Under option 2, Beaver can deduct salaries of $100,000. Thus, Beaver’s taxable
income will be $200,000 ($300,000 – $100,000) and Beaver’s tax liability will be
$61,250.
15%
25%
34%
5%
X
X
X
X
$50,000
25,000
125,000
100,000
=
=
=
=
$ 7,500
6,250
42,500
5,000
$61,250
Gerald include $60,000 of salary and $69,375 [($200,000 – $61,250) X 50%] of
dividend income in his gross income. Joanie will include $40,000 of salary and
$69,375 ($138,750 X 50%) of dividend income in her gross income.
b.
Under option 1, the salary payments reduce Beaver’s taxable income to $0. Thus,
Beaver should be aware of the possibility of the unreasonable compensation issue
being raised by the IRS.
pp. 13-12 and 13-13
46.
a.
Swallow will deduct interest expense each year of $36,000 ($600,000 X 6%).
Sandra and Fran will each report interest income of $18,000 ($300,000 X 6%)
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 $300,000.
p. 13-13 and Example 12
47.
If Lavender acquires the shopping mall, its tax liability would increase as follows:
Additional liability ($500,000 net rental income X 34%)
$170,000
13-18
2006 Annual Edition/Solutions Manual
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
$300,000
(37,000)
$263,000
Additional tax liability ($263,000 X 35%)
$ 92,050
At the corporate level, the corporate taxable income would increase as follows:
Net rental income
– Rental payments to Marci and Jennifer
= Additional taxable income
$500,000
(300,000)
$200,000
Additional tax liability ($200,000 X 34%)
$ 68,000
Thus, under the option recommended by the CPA, the combined tax liability of $160,050
($92,050 + $68,000) is slightly less than the $170,000 tax liability under the corporate
acquisition option (34% X $500,000). In addition, Lavender has been able to channel
$300,000 to Marci and Jennifer with the amount being deductible in calculating
Lavender’s taxable income.
p. 13-13
48.
a.
Petal, Inc.’s corporate tax liability is calculated as follows:
15%
25%
34%
5%
X
X
X
X
$ 50,000
25,000
550,000
235,000
=
=
=
=
$
7,500
6,250
187,000
11,750
$212,500
In addition, Petal may be subject to the accumulated earnings tax. This tax
liability could be as high as $61,875 ($412,500 X 15%). The $412,500 represents
the after-tax earnings of the corporation ($625,000 – $212,500).
b.
In this case, Petal would not be subject to the accumulated earnings tax. Thus, the
total corporate tax liability would be $212,500. The shareholders of Petal would
be taxed on their dividend income of $412,500 ($625,000 – $212,500).
c.
Petal’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
$625,000 is passed through to the shareholders’ tax returns. The accumulated
earnings tax does not apply to S corporations.
pp. 13-8, 13-9, 13-13, and 13-14
Comparative Forms of Doing Business
49.
13-19
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 all the shareholders
is $49,500 ($150,000 X 33%). If the S election is revoked effective for 2005, the
corporate tax liability is $41,750. The tax liability for all of the shareholders on the
dividend distribution, assuming the dividends are qualified dividends, is $16,238
[($150,000 – $41,750) X 15%]. Therefore, the total corporate and shareholder tax
liability would be as follows:
S Corporation
Corporate tax liability
Shareholder tax liability
$
-049,500
$49,500
C Corporation
$41,750
16,238
$57,988
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 $8,488 ($57,988 – $49,500). Thus, if all of the earnings are going to be distributed, the
S election should be maintained.
p. 13-15 and Example 15
50.
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 6, 2005
FROM:
Seth Addison
SUBJECT:
Contributions and Loans to Deer, Inc.
13-20
2006 Annual Edition/Solutions Manual
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.
Capital contributions
Asset
Bob: Cash
Carl: Land*
Basis
$200,000
125,000
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. 13-13, 13-16, and 13-17
51.
a.
Section 721 provides that no gain or loss is recognized by the partners upon the
contribution of property to a partnership. Thus, neither Agnes nor Becky has any
recognized gain. Since Carol is contributing services rather than property, she has
a recognized gain of $50,000.
Comparative Forms of Doing Business
13-21
Section 722 provides for a carryover basis for the partners. The $20,000 mortgage
assumed by the partnership results in the adjustments indicated below. Thus, the
partner’s basis for the partnership interest is as follows:
Agnes ($100,000 + $8,000)
Becky ($60,000 – $20,000 + $8,000)
Carol ($50,000 + $4,000)
$108,000
48,000
54,000
Section 723 provides for a carryover basis to the partnership for the assets
received.
Cash
Land
Organization costs
b.
$100,000
60,000
50,000
Section 351 provides that no gain or loss is recognized upon the contribution of
property to a corporation if the shareholders control (i.e., at least 80%) the
corporation immediately after the transfer. Since the combined ownership of
Agnes and Becky (40% + 40% = 80%) satisfies this requirement, neither has any
recognized gain. Since Carol is contributing services rather than property, she has
a recognized gain of $50,000.
Section 358 provides for a carryover basis for the shareholders.
shareholder’s basis for the stock is as follows:
Agnes
Becky ($60,000 – $20,000)
Carol
Thus, the
$100,000
40,000
50,000
Section 362 provides for a carryover basis to the corporation for the assets
received.
Cash
Land
Organization costs
c.
$100,000
60,000
50,000
Same tax consequences as in (b.), since S status involves a corporation.
pp. 13-16 and 13-17
52.
a.
Initial basis under § 351
Effect of corporate earnings
Effect of corporate liability
Alicia’s stock basis: regular corporation
$25,000
-0-0$25,000
b.
Initial basis under § 351
Effect of corporate earnings ($150,000 X 20%)
Effect of corporate liability
Alicia’s stock basis: S corporation
$25,000
30,000
-0$55,000
13-22
2006 Annual Edition/Solutions Manual
c.
Initial basis under § 731
Effect of corporate earnings ($150,000 X 20%)
Effect of corporate liability ($60,000 X 20%)
Alicia’s basis for partnership interest
$25,000
30,000
12,000
$67,000
pp. 13-17 and 13-18
53.
a.
(1)
Operations
Tax-exempt interest income (excludable)
Long-term capital gain
Taxable income for C corporation
(2)
Operations
Taxable income for S corporation
$ 92,000
-060,000
$152,000
$92,000
$92,000
Each shareholder reports his or her share of the taxable income from operations of
$92,000 and the long-term capital gain of $60,000. The tax-exempt interest of
$19,000 passes through to the shareholders but is excludible from gross income.
b.
(1)
For C corporation shareholders, the $200,000 distribution is a dividend
because it is paid out of earnings and profits. The earnings and profits of
the corporation at the end of the year is arrived at as follows:
Beginning balance
+ Taxable income
+ Tax-exempt interest
– Tax liability
– Dividend distribution
= Ending E & P
$900,000
152,000
19,000
(42,530)*
(200,000)
$828,470
*The corporate tax liability is $42,530 [($50,000 X 15%) + ($25,000 X
25%) + ($25,000 X 34%) + ($52,000 X 39%)].
(2)
For the S corporation shareholders, the $200,000 distribution is treated as
a return of capital and reduces the shareholders’ stock basis.
pp. 13-17 and 13-18
54.
a.
James reduces the basis for his partnership interest by $50,000 to $10,000. Karen
reduces the basis for her partnership interest by $60,000 to $20,000. Neither
James nor Karen recognizes any gain since the outside basis of each partner prior
to the distribution exceeds the amount of the cash received. JK has no recognition
and reduces the basis of partnership assets by $110,000 ($50,000 + $60,000).
b.
James has dividend income of $50,000, and Karen has dividend income of
$60,000. JK reduces its earnings and profits account by $110,000 ($50,000 +
$60,000). James’ stock basis remains at $60,000 and Karen’s stock basis remains
at $80,000.
p. 13-19
55.
a.
Beige’s taxable income is calculated as follows:
Comparative Forms of Doing Business
Active income
Portfolio income
Passive activity losses
Taxable income
13-23
$212,000
20,000
(-0-)*
$232,000
*The assumption is made that Beige 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.
Beige’s taxable income is calculated as follows:
Active income
Portfolio income
Passive activity losses
Taxable income
$212,000
20,000
(212,000)*
$ 20,000
*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.
pp. 13-19 and 13-20
56.
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 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 2005, Rosa’s basis
for her partnership interest is $55,000 [$50,000 + 10% of $700,000 (partnership
debt) – $65,000 (at-risk amount of loss 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 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 2005 is $50,000, the
amount of her initial contribution.
pp. 13-17, 13-18, and 13-20
57.
a.
Since the 80% control requirement of § 351 is not satisfied at the time Sanford
contributes the land to the C corporation, the basis of the land to the corporation is
the fair market value of $120,000. Therefore, the sale of the land by the
corporation for $140,000 produces a recognized gain of $20,000 [$140,000
(amount realized) – $120,000 (adjusted basis)]. The sale has no effect at the
shareholder level.
b.
The 80% control requirement of § 351 is again not satisfied. As in part a.,
therefore, the sale of the land for $140,000 produces a recognized gain of $20,000.
Since the entity is an S corporation, the recognized gain is passed through to the
three shareholders based on their stock ownership. Thus, $7,000 ($20,000 X
13-24
2006 Annual Edition/Solutions Manual
35%) is reported on Sanford’s return and the balance of $13,000 is reported on the
returns of the other two shareholders.
c.
The nonrecognition requirements of § 721 are satisfied at the time Sanford
contributes the land to the partnership. Therefore, the partnership has a carryover
basis in the land of $83,000, and its recognized gain is $57,000 [$140,000
(amount realized) – $83,000 (adjusted basis)]. Section 704(c) requires that the
precontribution appreciation of $37,000 be allocated to Sanford. The balance of
the recognized gain ($20,000) is allocated among all three partners based on the
profit and loss sharing ratio.
pp. 13-16, 13-17, and 13-21
58.
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
* § 1245 recapture
** § 1231 gain.
Recognized
Gain
Classification
Capital
Ordinary
$
$
-0-010,000
20,000
50,000
110,000
158,000
$348,000
-0-0-0-050,000**
110,000**
158,000
$318,000
$
-0-010,000
20,000*
-0-0-0$30,000
Comparative Forms of Doing Business
13-25
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).
c.
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. 13-25 and Concept Summary 13-1
59.
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
Accounts receivable
Office furniture and fixtures
Building
Land
Goodwill
Ordinary
$25,000
2,000
Capital and § 1231
$
-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 assets of fair market value, and a basis for
goodwill of $38,000.
c.
Under existing rules, 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 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
13-26
2006 Annual Edition/Solutions Manual
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.
Example 22 and Concept Summary 13-1
60.
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
$307,000
(100,000)
$207,000
Harry
$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), there is a sale or exchange of at least 50%
of the total interest in partnership capital and profits within a 12-month period,
b.
If the assets are appreciated, an individual purchasing an interest in a partnership
normally would prefer to purchase the 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). With the purchase of a partnership interest, however, a
carryover basis results. This negative result associated with the purchase of a
partnership interest can be offset if the partnership makes the § 754 election. This
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 usual choices do not apply because the GH Partnership is
terminated. 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).
pp. 13-23, 13-24, and Concept Summary 13-1
Hoffman, Raabe, Smith, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
61.
August 16, 2005
Mr. Bill Evans
100 Village Green
Chattanooga, TN 37403
Dear Mr. Evans:
Comparative Forms of Doing Business
13-27
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.
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.
If I can be of further assistance, please let me know.
Sincerely,
Robert Ames, CPA
Partner
TAX FILE MEMORANDUM
DATE:
August 12, 2005
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.
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. 13-25
The answers to the Research Problems are incorporated into the 2006 Annual Edition of the
Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION:
CORPORATIONS, PARTNERSHIPS, ESTATES & TRUSTS.
13-28
2006 Annual Edition/Solutions Manual
NOTES
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