Solutions to Chapter 10 Problem Assignments

Transcription

1 206 Solutions Manual for Taxation for Decision Makers Solutions to Chapter 10 Problem Assignments Check Your Understanding 1. Liability Insulation Which entities discussed in this chapter insulate the owners from the general liabilities of the entity? Solution: C corporations, S corporations and limited liability companies insulate all owners from the general liabilities of the entity; a limited partner only is insulated from partnership liabilities. 2. LLP vs. LLC Explain the principal difference between an LLP and an LLC. Solution: The partners in an LLP can be held liable for the general partnership debts; the members of an LLC are insulated from the general liabilities of the business. 3. Health Insurance Premiums The Gem Company, a sole proprietorship, provides health insurance for its owner and two employees. The cost per person is $200 per month. Explain how the Gem Company and its sole proprietor will treat this expense. Solution: Gem will deduct the cost of the health insurance for the two employees from its income ($4,800 for the year); it cannot deduct the cost for the owner. Instead, the owner will deduct the $2,400 cost as a deduction for adjusted gross income. 4. Entity Liabilities Compare an owner's personal liability for debts of a business organized as a sole proprietorship, general partnership, limited partnership, LLP, LLC, and S corporation. Solution: The owner of a sole proprietorship and the general partners in a general partnership are all fully liable for the obligations of the business. Only the general partner(s) in a limited partnership are personally liable for the obligations of the limited partnership; the limited partners are only liable for the amount of their partnership contribution. Partners in an LLP are liable for the general obligations of the partnership but not for the acts of the other partners. The members of an LLC and the S corporation shareholders are protected from the liabilities of the businesses. 5. Partnership Liabilities Explain how an increase or decrease in partnership liabilities can affect the basis of a general partner and a limited partner. Solution: Recourse debt undertaken by a partnership increases a general partner s basis in his or her partnership interest for his or her share of the liability determined by the losssharing ratio. When the recourse debt is paid off, his or her basis is reduced for the share of the liability discharged. Recourse liabilities do not affect the basis of limited partners. Nonrecourse debt undertaken by a partnership increases both the general and limited partners bases in their partnership interests in their profit sharing ratio. When the

2 Chapter 10: Sole Proprietorships and Flow-Through Entities 207 nonrecourse debt is paid off, their bases are reduced for their share of the liability discharged. 6. S Corporation Liabilities Do liabilities of an S corporation affect the basis of a shareholder s stock in the same manner as partnership liabilities affect the basis of a partner s partnership interest? Explain. Solution: No. Liabilities of a partnership increase one or more partner s basis in the partnership interest, based on the type of debt (recourse or nonrecourse) and type of partner (general or limited). Liabilities of an S corporation, however, have no effect on a shareholder s basis in his or her stock. 7. Loss Deductions Although partners can generally deduct their share of losses from a partnership, what three things can limit their ability to deduct these losses on their current year's tax return? Solution: To deduct partnership losses, partners first must have basis in their partnership interest equal to or greater than the loss; if the basis is less, only the lesser amount equal to basis can be deducted. Next, the amount that can be deducted is limited to the amount that the partner is at risk, and finally the loss deduction is limited by the passive loss limitation rules. 8. Flow-Through Income Reporting Why are partnerships and S corporations required to separately state certain items on their Schedule K rather than combining these items with the organization's operating profit or loss? Provide examples of the items that must be separately stated. Solution: Partnerships and S corporations separately state certain items on the Schedule K because the owners must treat these items in specific ways such as applying limitations or being required to combine them with other like items to determine their final disposition and taxation. Capital gains and losses, dividends, investment interest, charitable contributions and Section 179 expenses are examples of items that must be separately stated. 9. Income Allocation How is income allocated to S corporation shareholders? Develop an example to illustrate this procedure. Solution: S corporation income and loss items are first allocated to each day of the corporation s tax year; then they are allocated to the shareholders based on their percentage ownership on each day of the year. Example: An S corporation has $36,500 of income and it has two shareholders, one owning 40 percent, the other 60 percent. The corporation s income is first allocated to each day $100 per day ($36,500/365 days). The 40 percent owner is then allocated $40 of each day s income and the 60 percent owner is allocated $60. The 40 percent is allocated a total of $14,600 ($40 x 365) of income and the 60 percent owner is allocated $21,900 ($60 x 365) of income.

3 208 Solutions Manual for Taxation for Decision Makers 10. S Corporation Restrictions What are the corporate and shareholder restrictions on making an S corporation election? Solution: The S corporation must be a domestic corporation; it can have only one class of stock outstanding and it can have no more than 75 shareholders. The shareholders must be individuals or certain trusts or estates. (No corporate or partnership shareholders are permitted.) The individuals must be either citizens or residents of the United States (no nonresident alien shareholders are permitted). 11. S Corporation Elections What is the difference between a prospective S election and a retroactive S election? Solution: A retroactive election is an election that is made by the 15th day of the third month of the corporation s tax year and is effective from the beginning of the tax year. The prospective election is an election that is made at any time during the year but which will not be effective until the beginning of the next (or a later) tax year. 12. Terminating Event What is a terminating event in relation to an S corporation? Solution: A terminating event is any event that violates the corporate or shareholder restrictions on an S corporation and which can cause the termination of the S corporation election. 13. Loss Limitations Why do the basis and at-risk rules usually prevent the same amount of losses from passing through to shareholders of S corporations? Solution: Because debt of an S corporation has no effect on a shareholder s stock basis, a shareholder s basis in his stock is normally equal to the amount he or she is at risk. 14. AAA What is the purpose of the accumulated adjustments account if the S corporation has always been an S corporation? Solution: The amount in the accumulated adjustments account is the measure of the amount a corporation that was previously an S corporation can distribute in cash to its shareholders during its post termination period without receiving dividend treatment for the distribution. 15. S Corporation Taxes What types of taxes may an S corporation have to pay and under what circumstances? Solution: S corporations are subject to the BIG (built-in gains) tax, excess net passive investment income tax, and the LIFO recapture tax. The BIG and LIFO recapture taxes are only levied on S corporations that were previously C corporations with appreciated assets and appreciated inventory, respectively. The excess passive investment income tax applies to S corporations that have earnings and profits from a prior C corporation year and whose passive income exceeds a threshold based on its total revenue.

4 Chapter 10: Sole Proprietorships and Flow-Through Entities 209 Crunch the Numbers 16. Sole Proprietorship Income John Mason operates a consulting business, Mason Enterprises, as a sole proprietorship. He had to transfer $100,000 of stocks and securities into Mason Enterprise s name to show financial viability for the business. During the current year, the business had the following income and expenses from operations: Consulting revenue $125,000 Travel expenses 40,000 Transportation 3,000 Advertising 7,000 Office expense 3,000 Telephone 1,000 Dividends 5,000 Interest 2,000 Charitable contribution 1,000 Political contribution 6,000 Determine the Schedule C net income. How are items not included in the Schedule C net income reported? Solution: Schedule C net income = $125,000 - $40,000 - $3,000 - $7,000 - $3,000 - $1,000 = $71,000 The dividends and interest will be reported on Mason s Schedule B of his Form 1040; the charitable contribution will be included with his personal charitable contributions and reported as an itemized deduction if he itemizes; the political contribution is nondeductible. 17. Partnership Income Refer to the information in the preceding problem, except that John and his wife Mary are equal partners in Mason Enterprises, which operates as a partnership. How would they report the income and loss items from partnership operations? Solution: The $71,000 of items that make up net income on Schedule C in the preceding problem will all be reported as net income on Form The dividends, interest and charitable contributions will be reported on Schedule K (Form 1065) as separately stated items and the political contribution will be reported as a nondeductible item. John and Mary will each receive a Schedule K-1 reporting their shares of the net income, separately stated items, and nondeductible item. These will then be included in their Form 1040, with dividends and interest income on Schedule B and the charitable contributions included with other charitable contributions and reported as an itemized deduction. 18. S Corporation Income Refer to the information in problem 16, except that John operates Mason Enterprises as an S corporation. How would John report the income and loss items from S corporation operations? Solution: The business s $71,000 of net income (refer to solution to problem 16) will be reported as net income on Form 1120S. The dividends, interest and charitable

5 210 Solutions Manual for Taxation for Decision Makers contributions will be reported on Schedule K (Form 1120S) as separately stated items and the political contribution will be reported as a nondeductible item. John will receive a Schedule K-1 detailing these items for inclusion on his Form The dividends and interest income will be included on Schedule B and the charitable contribution included with other charitable contributions and reported as an itemized deduction. 19. Sole Proprietorship Income Maggie Brown works for a clipping service from her home. She spends three to four hours per day reading newspaper clippings and making notes for the clipping service. During the year, she earned $9,300 from the service. She had automobile expense of $300, phone expense of $100, and child care expense related to the job of $800. Explain how she will report her income and expenses. Calculate her income from the business and her selfemployment taxes if she has no other income. Solution: Net income: $9,300 - $300 - $100 = $8,900. Self-employment tax: $8,900 x 92.35% x 15.3% = $1,258. She should be eligible to take a dependent care credit based on the $800 of child care expense and the AGI reported on her return. (See Chapter 11 for information on the dependent care credit.) 20. Personal Property Converted to Business Use Julie transferred a personal-use computer to her sole proprietorship. The computer originally cost her $3,000. At the date of transfer, the computer had a fair market value of $1,000. Explain how both Julie and the sole proprietorship will treat this for tax purposes. Solution: Julie will use the fair market value of the computer at conversion as the basis for business use. To determine gain or loss on a subsequent disposition, however, she should keep the depreciation schedule based on the $3,000 and the $1,000. The $3,000 less depreciation basis will be used to determine gain, but the $1,000 less depreciation basis will be used to determine loss on a future disposition. 21. Partnership Operations Jim and Angie form the JAZ Partnership with Zoe by contributing $75,000 each to partnership equity. Zoe, the third partner, contributes property with a basis of $50,000 and fair market value of $75,000. The three are equal partners in the partnership. a. Determine the tax consequences to Zoe for the contribution of property to the partnership. b. What are the partnership s tax consequences? c. What is each partner s basis in the partnership interest? d. What is the partnership s basis in the property? Solution: a. There are no tax consequences to Zoe for the contribution of property to the partnership. Her partnership interest will have a $50,000 basis, the same basis she had in the property transferred. b. The partnership has no tax consequences; it simply takes a $50,000 basis in the property transferred from Zoe. c. Jim s basis = $75,000; Angie s basis = $75,000; Zoe s basis = $50,000. d. The partnership has a $150,000 basis in the money contributed and a $50,000 basis in the property.

6 Chapter 10: Sole Proprietorships and Flow-Through Entities Partnership Operations George and Georgenne formed the GG Partnership as equal partners. Each partner contributed cash and property with a value of $100,000 for partnership operations. As a result of these contributions, George had a basis of $80,000 and Georgenne a basis of $60,000 in their partnership interests. At the end of their first year of operations, they had the following results: Gross sales $150,000 Cost of goods sold 95,000 Rent 15,000 Salaries to employees 15,000 Utilities 4,000 Charitable contribution 1,000 Section 1231 gain 2,000 a. What is the net income, excluding separately stated items, that each partner is required to report at the end of the year? b. How is each of the separately stated items treated on the partners tax returns? c. What is each partner s basis at year-end? Solution: a. Partnership net income is $21,000 ($150,000 - $95,000 - $15,000 - $15,000 $4,000). Each partner reports $10,500 (50% x $21,000). b. Each partner s share of the Section 1231 gain will be included with any other Section 1231 gains and losses in the Section 1231 gain and loss netting process. Each partner s share of the charitable contribution will be included with his or her other charitable contributions and reported as an itemized deduction. c. George s basis at year end: $80,000 + (50% x $21,000) + (50% x $2,000) (50% x $1,000) = $91,000 Georgenne s basis at year end: $60,000 + (50% x $21,000) + (50% x $2,000) (50% x $1,000) = $71, S Corporation Operations Refer to the information in the preceding problem, except that George and Georgenne are equal shareholders in an S corporation. a. What is the net income, excluding separately stated items, that each shareholder is required to report at the end of the year? b. How is each of the separately stated items treated on the shareholders tax returns? c. What is each shareholder s basis at year-end? Solution: a. S corporation net income is $21,000 ($150,000 - $95,000 - $15,000 - $15,000 $4,000). George and Georgenne will each report $10,500 ($21,000 x 50%) of net income at the end of the year. b. George and Georgenne will include their individual shares of the Section 1231 gain with their other Section 1231 gains and losses for the Section 1231 netting process. Their share of the charitable contribution will be included with other charitable contributions and reported as an itemized deduction. c. George s basis at year end: $80,000 + (50% x $21,000) + (50% x $2,000) (50% x $1,000) = $91,000

7 212 Solutions Manual for Taxation for Decision Makers Georgenne s basis at year end: $60,000 + (50% x $21,000) + (50% x $2,000) (50% x $1,000) = $71, Self-Employment Taxes Bob is a 50 percent owner of Barco Enterprises. During the year, Barco earned $80,000 in net income after subtracting Bob's $50,000 salary. Bob also withdrew $20,000 from Barco during the year. Bob would like to know how much of this would be subject to selfemployment taxes if: a. Barco is a general partnership. b. Barco is an S corporation. Solution: a. $90,000 [(50% x $80,000 net income) + $50,000 salary (guaranteed payment)] is subject to self-employment taxes. The $20,000 withdrawal does not affect selfemployment taxes. b. None of this is subject to self-employment taxes. Bob and the corporation will each pay their share of FICA taxes on the $50,000 salary. 25. Partnership Formation Alpha, Beta, and Gamma form the ABG partnership by transferring the following to the partnership: Alpha $10,000 cash, machinery valued at $20,000 with a basis of $15,000. Beta Land valued at $30,000 with a basis of $35,000. Gamma Cash of $20,000 and services valued at $10,000. a. Determine the tax consequences of these transfers to Alpha, Beta, and Gamma, including identifying their bases in their partnership interests. b. What basis does the partnership have in each of the properties transferred to it? Solution: a. Alpha: No gain or loss recognized; basis in partnership interest = $25,000 ($10,000 + $15,000). Beta: No gain or loss recognized; basis in partnership interest = $35,000. Gamma: $10,000 of income recognized for services performed; basis in partnership interest = $30,000 ($20,000 + $10,000). b. Basis in cash = $30,000; machinery = $15,000; land = $35,000; and the services will have a basis of $10,000 if capitalized, or they could be expensed, in which case there would be no basis remaining. 26. Sale of Contributed Property Refer to the information in the preceding problem. If the partnership sells the land for $27,000 after holding it for three years, what are the tax consequences to Alpha, Beta, and Gamma? Solution: The sale of the land results in a loss of $8,000 ($27,000 - $35,000). The first $5,000 of loss is allocated to the contributing partner (Beta) as the loss had accrued prior to its transfer to the partnership. The remaining $3,000 loss is divided equally between the 3 partners, each being allocated $1,000 of the total loss. Thus, Alpha and Gamma each have a $1,000 loss and Beta a $6,000 ($5,000 + $1,000) loss that flows through.

8 Chapter 10: Sole Proprietorships and Flow-Through Entities Liability Allocations Explain the difference in recourse and nonrecourse liabilities when distinguishing between general and limited partners. Assume the partnership has $100,000 of recourse liabilities and $60,000 of nonrecourse liabilities. It has one general partner, Matt, who has a 20 percent interest in income and loss, and two limited partners, each of whom has a 40 percent interest in income and loss. Illustrate the difference in allocation of liabilities to these three partners. Solution: Recourse liabilities increase the basis of general partners only based on the losssharing ratio. Nonrecourse liabilities increase the basis of both general and limited partners based on their profit-sharing ratio. The $100,000 of recourse liabilities will be allocated entirely to Matt as the only general partner and his basis will increase by the $100,000 allocated liability. The $60,000 of nonrecourse liabilities will be allocated as follows: $12,000 (20% x $60,000) to Matt, bringing his total allocated liabilities to $112,000; $24,000 (40% x $60,000) to each of the two limited partners. 28. Liability Allocations CCC Partnership borrowed $100,000 on a five-year recourse note from a local bank. It also purchased land for $60,000, putting $10,000 down and signing a qualified nonrecourse loan secured by the land for the balance. The partners interests in partnership profits and losses are as follows: Partner Loss Profit Carol (general partner) 25% 50% Charles (limited partner) 40% 25% Charlotte (limited partner) 35% 25% a. How is the $100,000 recourse note allocated to the partners bases? b. How is the $50,000 nonrecourse note allocated to the partners bases? c. How would your answers change if Carol, Charles, and Charlotte were all general partners? Solution: a. All $100,000 of the recourse note is allocated to Carol, the only general partner. b. The $50,000 nonrecourse note is allocated based on the profit-sharing ratio as follows: Carol $25,000 (50% x $50,000); Charles $12,500; Charlotte $12,500 (25% x $50,000). c. If the three were all general partners, the answer to a. would change as follows: Carol would be allocated $25,000 of the $100,000 recourse liability; Charles would be allocated $40,000; and Charlotte would be allocated $35,000 as the allocations would be based on their loss sharing ratio. The answer to b. would not change. 29. Partnership Operations Luis and Jennifer formed the JL Partnership as equal partners. Each partner contributed cash and property with a value of $80,000 for partnership operations. As a result of these contributions, Luis had a basis of $80,000 and Jennifer a basis of $60,000 in their partnership interests. At the end of their first year of operations, they had the following results:

9 214 Solutions Manual for Taxation for Decision Makers Gross sales $110,000 Cost of goods sold 75,000 Rents 18,000 Employees salaries 20,000 Utilities 3,000 Charitable contribution 500 Section 1231 gain 1,000 Tax-exempt interest income 2,000 a. What is the net income, excluding separately stated items, that each partner is required to report at the end of the year? b. How is each of the separately stated items treated on the partners tax returns? c. What is each partner s basis at year-end? Solution: a. $110,000 - $75,000 - $18,000 - $20,000 - $3,000 = $6,000 net loss b. Each partner s share of the charitable contribution would be included with his or her own charitable contributions if itemizing and the Section 1231 gain would be included with other Section 1231 gains and losses for the Section 1231 netting process. The tax-exempt interest would be reported on page 1 for Form 1040 but it would not be included in partnership ordinary income. c. Each partner s basis at year end would decrease by $1,750 [50% (-$6,000 + $2,000 + $1,000 - $500)]. Thus Luis s basis would be $78,250 ($80,000 - $1,750) and Jennifer s would be $58,250 ($60,000 $1,750). 30. Loss Deductions In year 1, Sally invested $45,000 for a 10 percent interest in a limited partnership. This is Sally s only passive investment. The limited partnership has $100,000 of nonrecourse debt (The debt is not secured by real property.) At the end of years 1 through 5, the partnership passed income and losses through to Sally as follows: Year Income (Loss) 1 ($31,000) 2 ($21,000) 3 $4,000 4 $8,000 5 ($22,000) At the beginning of year 6, Sally sells her interest in the partnership for $40,000. For each of the years, determine Sally s deductible and nondeductible (suspended) losses. Explain the reason for the nondeductibility of any losses. What are the results of the sale of her interest? Solution: Year 1: Sally s basis in her interest $55,000 [$45,000 + (10% x $100,000)]. She is at risk, however, for only her $45,000 investment. The $31,000 loss reduces her basis to $24,000 and her at-risk amount to $14,000. She cannot deduct any of the loss, however, because this is a passive investment and she must have passive income against which to deduct the loss. It is all held in suspense. Year 2: Sally s basis is reduced to $3,000 ($24,000 - $21,000) by the $21,000 loss in year 2. Her at-risk amount is reduced to zero and she has a $7,000 loss that is suspended because of the at-risk limitations. The $14,000 that reduces her basis to

10 Chapter 10: Sole Proprietorships and Flow-Through Entities 215 zero cannot be deducted, however, because she has no passive income against which to deduct it. Her losses that are suspended because of the passive loss rules are now $45,000 ($31,000 + $14,000) Year 3: Sally includes the $4,000 in income; this increases her basis to $7,000 ($3,000 + $4,000) and her at-risk amount from zero to $4,000. She then deducts $4,000 of her $45,000 suspended passive losses against this income, reducing the suspended passive loss amount to $41,000. The net effect is zero on her income. Her at-risk amount is returned to zero because of the deduction and her basis is reduced to $3,000. Year 4: Sally includes the $8,000 in income; this increases her basis to $11,000 ($3,000 + $8,000) and her at-risk amount to $8,000. She deducts $8,000 of her suspended passive loss against this income, reducing her suspended passive losses to $33,000. The net effect is zero on her income. Her at-risk amount is returned to zero because of the deduction and her basis is again reduced to $3,000. Year 5: Sally reduces her basis to zero for $3,000 of the $22,000 loss and the remaining $19,000 is held in suspense due to the basis limitations as her basis cannot be reduced below zero. Her at-risk amount remains zero and she has suspended passive losses of $33,000 Year 6: When Sally sells her partnership interest for $50,000 ($40,000 sales proceeds and $10,000 debt relief), she has a gain on the sale of $50,000 because her basis in the partnership is zero. She can now deduct the $33,000 of losses that are suspended due to the passive loss limitations against this gain because this is a complete disposition of her interest. Her net gain to be recognized is $17,000. She cannot, however, deduct any additional losses that are held in suspense due to either the at-risk limitations or the basis rules. Thus, she loses the benefit of the $26,000 ($19,000 suspended by the basis limitation and $7,000 suspended by the at-risk limitations) of losses from the partnership. 31. Partnership Distributions Partner X, a 1/3 partner in XYZ Partnership, needs a distribution from the partnership for some unexpected bills. The partnership, however, does not have any extra cash to distribute. It will distribute to the partner land that has a value of $30,000 and a basis to the partnership of $25,000. X s basis in his partnership interest is $45,000. a. How will this distribution be treated for tax purposes? b. Assume alternatively, that the partnership sells the land for its fair market value and distributes the cash to Partner X. What are the tax consequences of the sale and distribution? Solution: a. There is no gain or loss recognized on the distribution of the land to Partner X. Instead, Partner X has a basis of $25,000 in the land and the distribution reduces his basis in his partnership interest to $20,000 ($45,000 - $25,000). Any gain on a subsequent sale will be recognized only by Partner X. b. The partnership will have a realized and recognized gain of $5,000 ($30,000 - $25,000) on the sale of the land. The gain will be allocated one-third to each of the partners increasing Partner X s basis by $1,667 ($5,000 x 1/3) to $46,667. Partner

11 216 Solutions Manual for Taxation for Decision Makers X receives $30,000 cash, which reduces his basis in his partnership interest to $16,667 ($46,667 $30,000). 32. Partnership Distributions Maria, a 25 percent partner in MARS Partnership, needs a distribution from the partnership for some unexpected bills. The partnership, however, does not have any extra cash to distribute. It will distribute land to Maria that has a value of $27,000 and a basis to the partnership of $50,000. Maria s basis in her partnership interest is $55,000. a. How will this distribution be treated for tax purposes? b. Assume alternatively, that the partnership sells the land for its fair market value and distributes the cash to Maria. What are the tax consequences of the sale and distribution? Solution: a. There is no gain or loss recognized on the distribution of the land to Maria. Maria will take a $50,000 basis in the land and her basis in the partnership interest is reduced to $5,000 ($55,000 - $50,000). She will realize the loss on the subsequent sale of the land. b. The partnership will have a realized and recognized loss on the sale of the asset of $23,000 ($27,000 - $50,000), which will be allocated to the partners based on their loss sharing ratios. Maria will be allocated a loss of $5,750 ($23,000 x 25%), reducing her basis to $49,250 ($55,000 $5,750). She will then receive $23,000 in cash, which will reduce her basis in her partnership interest to $26,250 ($49,250 - $23,000). 33. S Corporation Basis Charles owns a 25 percent interest in Cal Corporation, an S corporation. The corporation has run into some difficulties recently and Charles lent it $10,000. At the beginning of the year, Charles s basis in his stock was $16,000. a. What is Charles s basis in his stock and debt at the end of the year if the corporation reports losses of $60,000? b. What is Charles s basis in his stock and debt at the end of the year if the corporation reports losses of $90,000? c. What is Charles s basis in his stock and debt at the end of the year if the corporation reports losses of $120,000? Solution: a. Charles s share of the loss is $15,000 ($60,000 x 25%) and the basis in his stock is $1,000 ($16,000 - $15,000 share of the corporation s loss). His basis in his debt remains $10,000. b. Charles s share of the loss is $22,500 ($90,000 x 25%) and the basis in his stock is reduced to zero by $16,000 of the loss; his basis in his debt is reduced to $3,500 ($10,000 $6,500). c. Charles s share of the loss is $30,000 ($120,000 x 25%) and the bases of both his stock and debt are reduced to zero. He is able to deduct only $26,000 of the loss as a result. The remaining $4,000 loss is suspended and cannot be deducted until he again has either debt or stock basis.

12 Chapter 10: Sole Proprietorships and Flow-Through Entities Shareholder-Employee Considerations Is there any tax advantage to a 100 percent shareholder-employee of an S corporation compared to a shareholder-employee of a C corporation under the following circumstances: shareholder-employee salary is $75,000; the corporate income before the $75,000 salary and any related employment expense is $100,000. The corporation also distributes $15,000 to the shareholder. The shareholder is single, has no dependents, and uses the standard deduction. Solution: There is a tax advantage of $99 ($30,583 - $30,484) using the C corporation rather than an S corporation. Employment taxes: Both an S and a C corporation pay FICA and unemployment taxes for the shareholder of $6,172 [($75,000 x 7.65%) + ($7,000 x 6.2%)]. The shareholder-employee will have $5,738 in FICA taxes deducted from his salary. S corporation: Net income = $100,000 - $75,000 - $6,172 = $18,828. This is passed through the shareholder-employee and taxed along with the $75,000 salary. Shareholder-employee: Income = $75,000 + $18,828 = $93,828. Taxable income = $93,828 - $3,100 - $4,850 = $85,878. Tax on $85,878 = $14,325 + [($85,878 - $70,350)28%] = $18,673. Total taxes = $6,172 + $5,738 + $18,673 = $30,583 on the $100,000 of income. C corporation: Net income = $18,828; tax = $18,828 x 15% = $2,824. Shareholder-employee income = $75,000 + $15,000 dividend = $90,000. Taxable income = $90,000 - $3,100 - $4,850 = $82,050. Tax on $15,000 dividend income = $2,250 ($15,000 x 15%). Tax on the remaining $67,050 ($82,050 - $15,000 dividend) = $4,000 + [($67,050 - $29,050)25%] = $13,500; $2,250 + $13,500 = $15,750. Total taxes = $6,172 + $5,738 + $2,824 + $15,750 = $30,484 on the $100,000 of income with a $15,000 dividend distribution to the shareholder-employee. There is a tax advantage of $99 ($30,583 - $30,484) using the C corporation rather than an S corporation. 35. S Corporation Allocations At the beginning of year 1, Lisa and Marie were equal shareholders in LM Corporation, an S corporation. On April 30, year 1, Lisa sold half of her interest to Shelley. On August 8, year 1, Marie sold her entire interest to George. On December 31, year 1, the corporation reported net income of $50,000. How is this income allocated to Lisa, Marie, Shelley, and George? (Year 1 is not a leap year, and the date of sale is allocated to the seller.) Solution: Daily allocation of $50,000 = $137 per day. Lisa: (50% x 120 x 137) + (25% x 245 x 137) = $16,611 Shelley (25% x 245 x 137) = $8,391 Marie (50% x 220 x 137) = $15,070 George (50% x 145 x 137) = $9, S Corporation Operations During the current year, Biggie, Inc., a delivery company operating as an S corporation, reported the following results from operations:

13 218 Solutions Manual for Taxation for Decision Makers Revenue $280,000 Salaries 130,000 Truck expense 30,000 Taxes 18,000 Section 1231 loss 8,000 Traffic fines 1,200 Interest on truck loans 2,000 Interest income (bonds) 500 What are the corporation s net income and its separately reported items? Solution: Net income from operations is $100,000 ($280,000 - $130,000 - $30,000 $18,000 $2,000). The Section 1231 loss and the interest income from the bonds are passed through separately. The traffic fines are nondeductible. 37. Passive Investment Income Tax Crow Corporation, an S corporation from the date of its incorporation, is in the process of liquidating. During the current year, it reports gross receipts of only $40,000; it has passive investment income of $25,000 from the money it invested after the sale of a large portion of its operating assets. It has expenses related to this income of $1,000. Is the corporation liable for the passive investment income tax? Solution: No. The corporation must have C corporate earnings and profits to be liable for this tax. As the corporation has been an S corporation from its beginning, it is unlikely it has any C corporation earnings and profits. 38. S Corporation Distributions The Jane Corporation, an S corporation, makes several property distributions to its two equal shareholders, A and B, during the year. The distributions are as follows: A B Cash $5,000 $5,000 Land (Basis = $5,000) $10,000 (FMV) Equipment (Basis = $15,000) $10,000 (FMV) At the beginning of the year, the corporation s accumulated adjustments account is $35,000; A s basis in his shares is $24,000; and B s basis is $32,000. The corporation reports net income of $6,000 for the year, excluding any effect of the distributions. Determine the basis in A and B s shares and the balance in the corporation s AAA at the end of the year. Solution: The AAA is reduced to $11,000 and Shareholder A s stock basis is $12,000 and B s is $20,000. The corporation must recognize the $5,000 gain ($10,000 FMV - $5,000 basis) on the distribution of the land to A but it cannot recognize the loss on the distribution of the equipment to B. In addition, a specific priority must be followed for the adjustments to the AAA: taxable net income and separately stated income items are added first; the fair market values of distributions reduce AAA next, followed by nondeductible and deductible expense and loss items. Thus, the $6,000 net income and the $5,000 gain on the land increase the AAA to $46,000. The $30,000 fair market value of the distributions ($10,000 cash + $10,000 land +$10,000

14 Chapter 10: Sole Proprietorships and Flow-Through Entities 219 equipment) reduces the corporation s AAA to $16,000; the $5,000 nondeductible loss further reduces the AAA to $11,000. Shareholder basis adjustments follow the same priority order: Shareholder A s basis: $24,000 + $3,000 (50% x $6,000 income) + $2,500 (50% x $5,000 gain) = $29,500 basis before reduction for the property distributions. His basis is reduced to $14,500 for the $15,000 property distribution. The $2,500 (50% x $5,000) of the nondeductible loss reduces his basis to $12,000. Shareholder B s basis: $32,000 + $3,000 (50% x $6,000 income) + $2,500 (50% x $5,000 gain) = $37,500 basis before reduction for the property distributions. The $15,000 fair market value of equipment and cash distributed to him reduces his basis to $22,500. $2,500 of the $5,000 unrecognized loss reduces his stock basis to $20, Corporate Liquidation and Distributions PA Corporation, an S corporation, has two equal shareholders, P and A. Prior to the end of the current year, PA decides to liquidate and sell its three remaining assets and distribute the cash received to P and A. Asset 1 has a basis of $10,000 and is sold for $6,000. Asset 2 has a basis of $4,000 and is sold for $12,000. Asset 3 has a basis of $9,000 and is sold for $10,000. Shareholder P has a basis of $4,000 in her shares, and A has a basis of $20,000. The corporation has a net loss (excluding the sales of the assets) of $2,500. Detail the tax consequences to PA Corporation and its two shareholders on the liquidation of the corporation. Solution: PA Corporation: The corporation realizes and recognizes a loss of $4,000 ($6,000 - $10,000) on Asset 1, a gain of $8,000 ($12,000 - $4,000) on Asset 2, and a gain of $1,000 ($10,000 - $9,000) on Asset 3 for a net gain of $5,000. It has a total gain on the liquidation, including its operating loss, of $2,500 ($5,000 - $2,500). The corporation has $28,000 ($6,000 + $12,000 + $10,000) cash to distribute to the shareholders and each will receive $14,000. Shareholder A. $4,000 basis is increased to $5,250 by one-half of the corporation s net gain [($5,000 - $2,500) x 50%] which the shareholder must recognize. The $14,000 distribution reduces the basis to zero and the shareholder has an $8,750 ($14,000 - $5,250) gain on the liquidation. Shareholder B. $20,000 basis is increased to $21,250 for the net gain [($5,000 - $2,500) x 50%] the shareholder must recognize. The $14,000 distribution reduces the basis to $7,250. The shareholder will recognize a $7,250 loss on the liquidation of the corporation in addition to the gain passed through to him. 40. S Corporation Operations The operating results for Peep Corporation, an S corporation, for last year were as follows: Revenues Gross sales $2,000,000 Tax-exempt bond interest 2,000 Dividend income 8,000 Section 1231 gain (land) 10,000

15 220 Solutions Manual for Taxation for Decision Makers Expenses Cost of goods sold $900,000 Salaries 600,000 Rent 200,000 Utilities 60,000 Depreciation 40,000 Charitable contribution 12,000 Section 179 expense 20,000 a. Determine the corporation s net income and its separately stated items. b. Determine the corporation s financial accounting income if the gain on the sale of the land is only $6,000 and depreciation is $32,000 under financial accounting rules. c. Complete a Schedule M-1 for the corporation. You can obtain forms from the IRS Web site. Sample filled-in forms are also in Appendix C of this text. Solution: a. $2,000,000 $900,000 - $600,000 - $200,000 - $60,000 - $40,000 = $200,000 net income; Separately stated items are the $8,000 dividend income, the $10,000 Section 1231 gain, the $12,000 charitable contribution, and the $20,000 Section 179 expense. The $2,000 tax-exempt bond interest will also be reported to shareholders but will not be taxable. b. Financial accounting income: $2,016,000 total revenues ($2,000,000 + $2,000 + $8,000 + $6,000); $1,804,000 deductions ($900,000 + $600,000 + $200,000 + $60,000 + $32,000 + $12,000); $212,000 net income ($2,016,000 - $1,804,000). c. Schedule M-1: $212,000 net income per books + $4,000 ($10,000 - $6,000) excess Section 1231 gain - $2,000 tax-exempt interest - $28,000 ($40,000 + $20,000 Section $32,000) excess tax depreciation = $186,000 taxable income including separately stated items. $186,000 is taxable income including dividend income, Section 1231 gain, the charitable contribution, and the Section 179 expense. 41. Comprehensive Problem On March 15, year 1, James Smith formed a business to rent and service vending machines providing healthy snack alternatives and juices to the local middle and high schools. He operates the business as a sole proprietorship from his home, turning the den into an office from which he manages the business. The den contains 400 of the home s total 1,800 square

16 Chapter 10: Sole Proprietorships and Flow-Through Entities 221 feet. In addition, he rents additional space in a warehouse complex where he stores his inventory. When he formed the business, he converted his Ford pick-up truck solely to business use to deliver machines and products to the schools. When converted, the truck had a basis of $18,250 and a fair market value of $12,500. He purchased a small car for his personal use. During the current year, year 3, the business reported the following: Rental income $ 20,000 Sales of products 288,000 Cost of sales 121,000 Truck expense (excl. depreciation) 14,000 Telephone 600 Rent expense 2,400 Part-time delivery person 25,000 Machine repairs 5,500 Meals and entertainment 4,000 Charitable contributions 10,000 Liability insurance 12,000 In April of year 1, James bought 20 vending machines for $60,000; in April of year 2, he bought 20 more machines for $65,000; in June of the current year, he purchased 10 more vending machines for $35,000. All vending machines have a seven-year life and are depreciated under MACRS. James did not elect Section 179 expensing or bonus depreciation in any year. James s expenses related to his home are: Rent $24,000 Utilities 600 In December, James sold the original truck for $5,000 and purchased a new truck for $24,000. Determine James s income or loss from the business. Do not include in this figure items that would not be included on his Schedule C but detail those items separately. Calculate James s self-employment taxes assuming he has no other income subject to FICA taxes. Solution: Net income reported on Schedule C is $84,972 Net Income: Rental Income $20,000 Sales of Products 288,000 Total Revenue $308,000 Expenses: Cost of Sales $121,000 Truck Expense 14,000 Telephone 600 Rent Expense 2,400 Part-time Delivery Person 25,000 Machine Repairs 5,500 50% of Meals and Entertainment 2,000 Liability Insurance 12,000 Depreciation 35,061 Business Use of Home (400/1800 x $24,600) 5,467 Total Deductible Expenses $223,028 Net Income $84,972

17 222 Solutions Manual for Taxation for Decision Makers Depreciation is determined as follows: Ford Truck: $12, x.5 = $1,200 Year 1 Machines: $60,000 x.1749 = $10,494 Year 2 Machines: $65,000 x.2449 = $15,919 Year 3 Machines: $35,000 x.1785 = $6,248 (mid-quarter convention) New Truck: $24,000 x.05 = $1,200 (mid-quarter convention) Items not included on Schedule C: Car sale: Basis = $12,500 x (1 [ (.5 x.1920)]) = $4,800 $5,000 selling price - $4,800 basis = $200 Section 1245 gain reported directly on Form 1040 The charitable contribution of $10,000 is included with his other charitable contributions and is an itemized deduction on Schedule A. Self-employment tax: $84,972 x.9235 x.153 = $12,006; half of this ($6,003) is deductible for AGI on page 1 of Form Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter. 42. Sole Proprietorship What do you believe led to the conclusion that a sole proprietorship should report its results on the owner s tax return? Solution: From a legal standpoint, the sole proprietorship cannot be separated from the owner. The tax law follows this basic premise that they cannot be separated. The reporting of operations on a separate form rather than the schedule within the Form 1040 would imply a separation that does not exist. 43. LLCs Why do you think Congress passed the law that allows an LLC to elect to be treated as a corporation or a partnership? Solution: Because of the differences in the manner in which LLC characteristics were prescribed by different states, many disagreements arose over whether the LLC was a partnership or a corporation. To eliminate the uncertainty of treatment, members may elect the desired form. 44. Services Contributions Why do you think services are excluded from the definition of property when a partner receives a partnership interest in exchange for property? Solution: Receiving an interest in a business is similar to being paid for services and then contributing the money in exchange for the business interest. As something of value has been received for one s labors, the person has income regardless of whether cash or property is received. 45. Limitations on S Corporations Why do you think an S corporation is limited to having common stock with no differences other than voting rights?

18 Chapter 10: Sole Proprietorships and Flow-Through Entities 223 Solution: Because the net income and separately stated items are passed through to the shareholders based on their ownership percentages, the addition of a second class of stock would complicate the manner in which these items are passed to the shareholders. As is, a shareholder owning one percent gets exactly the same amount of income/loss items as every other shareholder owning one percent. 46. Distributions Compare the treatment of distributions of depreciated and appreciated property by an S corporation to that of a partnership. Solution: A partnership recognizes neither gain nor loss on nonliquidating or liquidating distributions of appreciated or depreciated property to the partners. S corporations recognize gain but not loss on nonliquidating distributions, but recognize both gain and loss on liquidating distributions. Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question. 47. Fringe Benefits Craig is a 20 percent shareholder in an S corporation and works an average of 20 hours per week in the business. His wife, Lynn, is a full-time employee of the corporation. The corporation provides her fully paid health and life insurance benefits for herself, Craig, and their children. Solution: What are the tax consequences of the corporation providing these fringe benefits for the family? Are they tax free to the family? 48. Acquisition by S Corporation The Gemini Corporation, an S corporation, wants to expand its lines of business. To do so quickly, it acquires 85 percent of the stock of Trojan Corporation, a regular C corporation. Solution: What are the tax consequences to the S corporation of acquiring 85 percent of a C corporation? 49. Sales of Partnership Interests ABCD partnership, a calendar-year partnership, has four owners: A owns a 20 percent interest; B a 25 percent interest; C a 40 percent interest; and D the remaining 15 percent interest. Some of the partners have been having difficulty working with each other, so, with partnership agreement, D sells his 15 percent interest to F on October 20, year 1; B sells her interest to G on January 15, year 2; and C sells his interest to H on December 1, year 1. Solution: Are there any tax problems created by these various sales of partnership interests? What are the tax consequences of these sales? 50. Abandoning a Partnership Interest Shana is a 20 percent limited partner in the STU partnership. Her basis in her partnership interest is $40,000 when she decides to abandon her partnership interest. The partnership s balance sheet is as follows:

19 224 Solutions Manual for Taxation for Decision Makers Net Assets $203,000 Liabilities $200,000 Shana-Capital 1,000 Tom-Capital 1,000 Urban-Capital 1,000 Solution: What are Shana s tax consequences as a result of her abandonment of her partnership interest? 51. Purchase of Land from Partner Carol and her husband own 35 percent each of a land development partnership. Carol owns a piece of land purchased six years ago for $60,000 that has been declining in value. The partnership wants to buy the land for development but is only willing to pay $40,000. Solution: What are the tax consequences that would result from a sale of the land by Carol to the partnership? Develop Research Skills Solutions to research problems are included in the Instructor s Manual. Search the Internet 55. Go to the IRS Web site ( and print out copies of Schedule C for Form 1040, Schedule SE, Form 4562 Form 4797, and the first page of Form Using the information in comprehensive problem 41, complete these schedules and forms to the extent possible from the information given. Solution: Filled-in forms for 2003 are included at the end of the solutions for this chapter. Note: Neither Form 8829 nor Schedule D (Form 1040) is required. 56. Refer to the information in problems 22 and 23. a. Go to the IRS Web site ( and print out the first page and Schedule K for Form Use the information in problem 22 to complete these two forms to the extent possible with the information given. b. Go to the IRS Web site ( and print out the first page and Schedule K for Form 1120S. Use the information in problems 22 and 23 to complete these two forms to the extent possible with the information given. Solution: Filled-in forms for 2003 are included at the end of the solutions for this chapter. 57. LLC Filing Requirements Go to and locate your state. Find and read your state s filing requirements for forming an LLC and write a one-paragraph summary of these requirements. Does your state recognize a single member LLC? Solution: Answers will vary by state.

20 Chapter 10: Sole Proprietorships and Flow-Through Entities State Tax Issues In addition to the federal income tax, an entity is subject to the laws of the state in which it is organized. Use the Internet to locate sources of tax law that govern the tax treatment of partnerships, LLCs, and S corporations for your state. Write a brief description regarding how each of those entities is treated for tax purposes in your state. Solution: Answers will vary by state. 59. S Corporation Issues Go to the IRS Web site ( and locate the form that a corporation uses to make an S election and its related instructions. Summarize the information required on the form. Do the instructions include information on how to obtain an extension of time for filing the S election? If so, summarize this information. If not, is this information available elsewhere on this Web site? Solution: Form 2553 is the form used to elect S corporation status. Information required on this form includes: the corporation name, address, identification number, and the effective date of election. The corporation must supply the names of all of the shareholders with their signature of consent to the S election, the date, their number of shares, their Social Security numbers, and the date of each shareholder s tax year end. It must be signed by a corporate officer. The instructions for Form 1120S state that elections made after the due date will be accepted as timely filed if the corporation can show that the failure to file on time was due to reasonable cause. To request relief for a late election, the corporation must generally request a private letter ruling and pay a user fee. But if the election is filed within 12 months of its due date and the original due date for filing the corporation s initial Form 1120S has not passed, the ruling and user fee requirement do not apply. To request relief in this case, write filed pursuant to Rev. Proc at the top of page 1 of Form 2553, attach a statement explaining the reason for failing to file the election on time, and file Form 2553 as otherwise instructed. Develop Planning Skills 60. S Corporation Losses An S corporation shareholder is currently in the 28 percent tax bracket. His S corporation is going to pass a very large loss through to him that would otherwise offset other income, except for the fact that he lacks sufficient stock basis to absorb the loss. The shareholder is coming to your office tomorrow to discuss the situation. Make a list of questions you will ask before you will advise him on possible alternatives? Suggested Questions: What is his current tax bracket? What does he expect his income and tax bracket to be in the next several years? Does he have money to invest or loan to the S corporation? If he does not have the money, can he borrow money that could be invested or loaned to the corporation? What does he believe the future of the company will be? If he loans it money, does he believe the corporation will be able to pay it back? Is he interested in disposing of his stock in the near term?