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SOUTH-WESTERN FEDERAL
TAXATION 2017 CORPORATIONS
PARTNERSHIPS ESTATES AND
TRUSTS 40TH EDITION HOFFMAN
SOLUTIONS MANUAL
CHAPTER 1
UNDERSTANDING AND WORKING WITH THE FEDERAL TAX LAW
SOLUTIONS TO PROBLEM MATERIALS
DISCUSSION QUESTIONS
1. (LO 1) When enacting tax legislation, Congress often is guided by the concept of revenue neutrality
so that any changes neither increase nor decrease the net revenues raised under the prior rules.
Revenue neutrality does not mean that any one taxpayer’s tax liability remains the same. Since this
liability depends upon the circumstances involved, one taxpayer’s increased tax liability could be
another’s tax saving. Revenue-neutral tax reform does not reduce deficits, but at least it does not
aggravate the problem.
2. (LO 2) Economic, social, equity, and political factors play a significant role in the formulation of tax
laws. Furthermore, the IRS and the courts have had impacts on the evolution of tax laws. For
example, control of the economy has been an important economic consideration in passing a number
of laws (e.g., rapid depreciation, changes in tax rates).
3. (LO 2) The tax law encourages technological progress by allowing immediate (or accelerated)
deductions and tax credits for research and development expenditures.
4. (LO 2) Saving leads to capital formation and thus makes funds available to finance home construction
and industrial expansion. For example, the tax laws provide incentives to encourage savings by giving
private retirement plans preferential treatment.
5. (LO 2)
a. Section 1244 allows ordinary loss treatment on the worthlessness of small business
corporation stock. Since such stock normally would be a capital asset, the operation of § 1244
converts a less desirable capital loss into a more attractive ordinary loss. Such tax treatment
was designed to aid small businesses in raising needed capital through the issuance of stock.
b. The corporate income tax rates favor those corporations with taxable income under $75,000.
On a relative basis, it is the smaller corporations that will benefit the most from the graduated
corporate tax rates. Further, the $11,750 in tax savings that result from the graduated rate
structure is phased out for corporations with taxable income in excess of $100,000.
c. By allowing corporations to split or combine (i.e., merge or consolidate) without adverse tax
consequences, small corporations are in a position to compete more effectively with larger
counterparts.
6. (LO 2) Reasonable persons can, and often do, disagree about what is fair or unfair. In the tax area,
moreover, equity is generally tied to a particular taxpayer’s personal situation. For example, one
equity difference relates to how a business is organized (i.e., partnership versus corporation). Two
businesses may be equal in size, similarly situated, and competitors in the production of goods or
services, but they may not be comparably treated under the tax law if one is a partnership and the
other is a corporation. The corporation is subject to a separate Federal income tax; the partnership is
1-1
not. The tax law can and does make a distinction between these business forms. Equity, then, is not
what appears fair or unfair to any one taxpayer or group of taxpayers. It is, instead, what the tax law
recognizes.
7. (LO 2) This deduction can be explained by social considerations. The deduction shifts some of the
financial and administrative burden of socially desirable programs from the public (the government)
sector to the private (the citizens) sector.
8. (LO 2) Private retirement plans’ preferential treatment encourages saving. Not only are contributions
to Keogh (H.R. 10) plans and certain Individual Retirement Plans (IRA) deductible, but income from
these contributions accumulates on a tax-free basis.
9. (LO 2) The availability of percentage depletion on the extraction and sale of oil and gas and specified
mineral deposits and a write-off (rather than capitalization) of certain exploration costs encourage the
development of natural resources.
10. (LO 2) Favorable treatment of corporate reorganizations provides an economic benefit. By allowing
corporations to combine and split without adverse consequences, corporations are in a position to
more effectively compete with other businesses.
11. (LO 2) Although the major objective of the Federal tax law is the raising of revenue, other
considerations explain many provisions. In particular, economic, social, equity, and political factors play
a significant role. Added to these factors is the impact the Treasury Department, Internal Revenue
Service, and the courts have had and will continue to have on the evolution of Federal tax law.
12. (LO 2) The deduction allowed for Federal income tax purposes for state and local income taxes is not
designed to neutralize the effect of multiple taxation on the same income. At most, this deduction
provides only partial relief. Only the allowance of a full tax credit would achieve complete neutrality.
a. With the standard deduction, a taxpayer is, indirectly, obtaining the benefit of a deduction for
any state or local income taxes he or she may have paid. This is so because the standard
deduction is in lieu of itemized deductions, which include the deductions for state and local
income taxes.
b. If the taxpayer is in the 10% tax bracket, one dollar of a deduction for state or local taxes
would save ten cents of Federal income tax liability. In the 33% tax bracket, the saving
becomes thirty-three cents. The deduction approach (as opposed to the allowance of a credit)
favors high bracket taxpayers.
13. (LO 2) Under the general rule, a transfer of a partnership’s assets to a new corporation could result in
a taxable gain. However, if certain conditions are met, § 351 postpones the recognition of any gain (or
loss) on the transfer of property by Heather to a controlled corporation.
The wherewithal to pay concept recognizes the inequity of taxing a transaction when Heather lacks
the means with which to pay any tax. Besides, Heather’s economic position would not change
significantly as a result of such a transfer. Heather owned the assets before the transfer and still would
own the assets after a transfer to a controlled corporation.
14. (LO 2) Yes, once incorporated, the business may be subject to the Federal corporate income tax.
However, the corporate tax rates might be lower than Heather’s individual tax rates, especially if
dividends are not paid to Heather.
The corporate income tax could be avoided altogether by electing to be an S corporation. An
S corporation is generally not taxed at the corporate level; instead, the income flows through the
corporate veil and is taxed at the shareholder level. An S election allows a business to operate as a
corporation but be taxed like a partnership.
15. (LO 2) Examples include like-kind exchanges, involuntary conversions, transfers of property to a
controlled corporation, transfers of property to a partnership, and tax-free reorganization.
16. (LO 2) Generally, a recognized (taxable) gain cannot exceed the realized gain.
17. (LO 2) Recognition of gain ultimately occurs when the property is disposed of.
18. (LO 2) One year.
19. (LO 2) The installment method on the sale of property permits the gain to be recognized over the
payout period.
20. (LO 2) Requiring a taxpayer to make a contribution to a Keogh retirement plan by the end of the year
would force an accurate determination of net self-employment income long before the income tax
return must be prepared and filed.
21. (LO 2) The difference between common law and community property systems centers around the
property rights possessed by married persons. In a common law system, each spouse owns whatever
he or she earns. Under a community property system, one-half of the earnings of each spouse is
considered owned by the other spouse. Assume, for example, Harold and Ruth are husband and wife,
and their only income is the $80,000 annual salary Harold receives. If they live in New York (a common
law state), the $80,000 salary belongs to Harold. If, however, they live in Texas (a community property
state), the $80,000 salary is divided equally, in terms of ownership, between Harold and Ruth.
22. (LO 2) Deterrence provisions include:
Alternative minimum tax.
Imputed interest rules.
Limitation on the deductibility of interest on investment indebtedness.
Gift and estate tax.
Unreasonable accumulated earnings tax.
Personal holding company tax.
23. (LO 4) Primarily concerned with business readjustments, the continuity of interest concept permits
tax-free treatment only if the taxpayer retains a substantial continuing interest in the property transferred
to the new business. Due to the continuing interest retained, the transfer should not have tax
consequences because the position of the taxpayer has not changed. This concept applies to transfers
to controlled corporations (Chapter 4), corporate reorganizations (Chapter 7), and transfers to
partnerships (Chapter 10).
24. (LO 3) Under § 482 the IRS has the authority to allocate income and deductions among businesses
owned or controlled by the same interests when the allocation is necessary to prevent the evasion of
taxes or to clearly reflect the income of each business. Pursuant to § 482, therefore, the IRS might
allocate interest income to White Corporation even though none was provided for in the loan
agreement.
25. (LO 5) False. Federal tax legislation generally originates in the House of Representatives, where it is
first considered by the House Ways and Means Committee. Tax bills can originate in the Senate only
when they are attached as riders to other legislative proposals as was the case with the American
Taxpayer Relief Act of 2012.
26. (LO 5) A president’s veto can be overridden by a two-thirds vote in both the House and Senate.
27. (LO 5)
§ 1563 (a) (1) (A)
Abbreviation of “Section”
Section number
Subsection number
Paragraph designation
Subparagraph designation
28. (LO 5) Yes, some Code Sections omit the subsection designation and use, instead, the paragraph
designation as the first subpart [e.g., §§ 212(1) and 1221(1)].
29. (LO 5) When the 1954 Code was drafted, the omission of some Code section numbers was intentional.
This omission provided flexibility to incorporate later changes into the Code without disrupting its
organization. This technique is retained in the 1986 code.
30. (LO 6) Proposed, final, and Temporary Regulations are published in the Federal Register and are
reproduced in major tax services. Final Regulations are issue as Treasury Decisions (TDs).
31. (LO 6)
a. A Temporary Regulation, with 1 referring to the type of regulation (i.e., income tax), 428 is
the related code section number, (7) is the subsection number, T means temporary, b is the
paragraph designation, and (4) is the subparagraph designation.
b. Revenue Ruling number 11, appearing on page 174 of Volume 1 of the Cumulative Bulletin
issued in 1960.
c. Technical Advice Memorandum number 3 issued during the 37th week of 1988.
32. (LO 5) Hoffman, Raabe, Maloney, & Young, CPAs
5191 Natorp Boulevard
Mason, OH 45040
October 12, 2016
Ms. Jennifer Olde
3246 Highland Drive
Clifton, VA 20124
Dear Ms. Olde:
In response to your recent request, the fact-finding determination of a lower trial court is binding on a
Federal Court of Appeals. A Federal Court of Appeals is limited to a review of the record of trial
compiled by a trial court. Rarely will an appellate court disturb a lower court’s fact-finding
determination.
Should you need more information, do not hesitate to contact me.
Sincerely,
Marilyn S. Crumbley
Tax Partner
33. (LO 5)
TAX FILE MEMORANDUM
DATE: September 12, 2016
FROM: Sarah Flinn
RE: Telephone conversation with Will Thomas regarding the failure of the IRS to appeal
I explained to Mr. Thomas that there were numerous reasons why the IRS may decide not to appeal
a decision it loses in a District Court. For example, the work load may be too heavy. Or the IRS
may have decided that this particular case is not a good decision to appeal (e.g., sympathetic
taxpayer). Third, the IRS might not wish to appeal this case to the appropriate Court of Appeals. I
stressed that the failure to appeal does not necessarily mean that the IRS agrees with the results reached.
34. (LO 5, 8)
a. If the taxpayer decides to choose a District Court as the trial court for litigation, the District
Court of Utah would be the forum to hear the case. Unless the prior decision has been
reversed on appeal, one would expect the same court to follow its earlier holding.
b. If the taxpayer decides to choose the Court of Federal Claims as the trial court for litigation,
the decision previously rendered by this Court should have a direct bearing on the outcome. If
the taxpayer selects a different trial court (i.e., the appropriate U.S. District Court or the U.S.
Tax Court), the decision rendered by the Court of Federal Claims would be persuasive but not
controlling. It is assumed that the results reached by the Court of Federal Claims were not
reversed on appeal.
c. The decision of a Court of Appeals will carry more weight than one rendered by a trial court.
Since the taxpayer lives in California, however, any appeal from a District Court or the U.S.
Tax Court would go to the Ninth Court of Appeals. Although the Ninth Court of Appeals might
be influenced by what the Second Court of Appeals has decided, it is not compelled to follow
such holding.
d. Since the U.S. Supreme Court is the top appellate court, complete reliance can be placed on its
decisions. Nevertheless, one should investigate any decision to see whether or not the Code has
been modified to change the results reached. There also exists the rare possibility that the Court
may have changed its position in a later decision.
e. When the IRS acquiesces in a decision of the Tax Court, it agrees with the results reached.
As long as such acquiescence remains in effect, taxpayers can be assured that this represents
the position of the IRS on the issue involved. Keep in mind, however, that the IRS can
change its mind and can, at any time, withdraw the acquiescence and substitute a
nonacquiescence.
f. The issuance of a nonacquiescence reflects that the IRS does not agree with the results
reached by a Tax Court decision. Consequently, taxpayers are placed on notice that the IRS
will continue to challenge the issue involved.
35. (LO 6) Mack Rogers has a number of approaches available, depending upon the available materials.
One approach is to begin with the keyword index in an online tax research service. Since the subject
matter “§ 1244 stock” is somewhat self-contained, he could also start with the Internal Revenue Code
and Treasury Regulations. The text identifies the major tax services which Mr. Rogers could consult.
Another approach for Mr. Rogers is to use CCH’s Federal Tax Articles. After looking up “§ 1244
stock” in the subject index, Mr. Rogers should be able to find a number of articles written about this
subject. In addition, Thomson Reuters publishes the Index to Federal Tax Articles that is organized
using RIA’s paragraph index system. He also should check Bloomberg BNA Tax Management
Portfolios.
36. (LO 7) Some tax researchers begin with a keyword search on an online tax service. If the problem is
not complex, the researcher may bypass a tax service and turn directly to the Internal Revenue Code
and the Treasury Regulations (both are available online; see Exhibit 1.7). For the beginner, this
process saves time and will solve many of the basic problems. If the researcher does not have access
to the Code or Regulations, the resources of a tax service may be necessary. Several of the major tax
services publish paperback editions of the Code and Treasury Regulations that can be purchased at
modest prices.
37. (LO 8)
a. Primary source.
b. Secondary source.
c. Primary source.
d. Secondary source, but substantial authority for purposes of the accuracy-related penalty in
§ 6662.
e. Secondary source, but substantial authority for purposes of the accuracy-related penalty in
§ 6662.
38. (LO 9) Key components of effective tax planning are:
Avoid the recognition of income (usually by resorting to a nontaxable source or nontaxable
event).
Defer recognition of income (or accelerate deductions).
Convert the classification of income (or deductions) to a more advantageous form (e.g., ordinary
income into capital gain).
Choose the business entity with the desired tax attributes.
Preserve formalities by generating and maintaining supporting documentation.
Act in a manner consistent with the intended objective.
Don’t only focus on tax considerations. Keep sound business judgment and overall economic
outcomes in mind as well.
39. (LO 10) Simulations are small case studies designed to test a candidate’s tax knowledge and skills
using real-life, work-related situations. Simulations include a four-function, pop-up calculator, a blank
spreadsheet with some elementary functionality, and authoritative literatures appropriate to the subject
matter. The taxation database includes authoritative excerpts (e.g., Internal Revenue Code and
Regulations, IRS publications, and Federal tax forms) that are necessary to complete the tax case study
simulations.
PROBLEMS
40. (LO 2)
a. Bart has a realized gain of $200,000 determined as follows:
Amount received on the exchange:
Real estate worth $900,000
Cash 100,000 $1,000,000
Amount given up on the exchange:
Basis of real estate (800,000)
Realized gain $ 200,000
Bart’s recognized gain is limited to the lesser of realized gain of $200,000 or the other property
(boot) received of $100,000. Thus, the recognized gain is limited to other property (boot)
received of $100,000 [the amount of cash (boot) received by Bart]. § 1031
b. Roland has a realized loss of $300,000, determined as follows:
Amount received on the exchange
Amount given up on the exchange:
$1,000,000
Real estate with a basis of $1,200,000
Cash
Basis of property given up
100,000
(1,300,000)
Realized loss
$ (300,000)
None of Roland’s realized loss can be recognized.
c. Under the wherewithal to pay concept, forcing Bart to recognize a gain of $100,000 makes
sense. Because of the $100,000 cash received, not only has Bart’s economic position
changed, but he now has the means to pay the tax on the portion of the realized gain that is
recognized.
The disallowance of Roland’s realized loss is consistent with the usual approach of the
wherewithal to pay concept. Not only is this the price that must be paid for tax-free treatment,
but also a carryover basis and adjustment under § 1031(d) prevents a deterioration of
Roland’s tax position. Note: After the exchange, Roland has a basis of $1,300,000 in the real
estate received from Bart [i.e., $1,200,000 (basis in the real estate given up) + $100,000 (cash
given up)].
41. (LO 2, 3)
a. W. Wherewithal to pay concept.
b. CE. Control of the economy.
c. ESB. Encouragement of small business.
d. SC. Social considerations.
e. EI. Encouragement of certain industries.
f. AF. Administrative feasibility.
g. SC. Social considerations.
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42. (LO 2)
a. Louisiana, community property.
b. Virginia, common law.
c. Arizona, community property.
d. Rhode Island, common law.
e. Alaska, community property may be elected by spouses.
f. California, community property.
43. (LO 4) The real question is whether the parties acted in an arm’s length manner. In other words, was
the $100,000 selling price the true value of the property?
a. Where the parties to a transaction are related to each other, the IRS is quick to apply the
arm’s length concept. It might, for example, find that the value of the property was less than
$100,000. In this event, the difference probably is dividend income to Benny.
b. The same danger exists even if Benny (the seller) is not a shareholder in Jet Corporation (the
purchaser) as long as he is related to the one in control. If the value of the property is less
than $100,000, the IRS could find a constructive dividend to Benny’s father of any
difference. Because Benny ended up with the benefit, it follows that the father has made a gift
to the son of such difference. (Chapter 5)
c. Since Benny is neither a shareholder in Jet Corporation nor related to any of its shareholders,
it is doubtful that the IRS would question the $100,000 selling price or the substance of the
sale.
44. (LO 5)
a. Letter rulings are issued for a fee by the National Office of the IRS upon a taxpayer’s request
and describe how the IRS will treat a proposed transaction for tax purposes. In general, they
apply only to the taxpayer who asks for and obtains the ruling, but post-1984 rulings may be
substantial authority for purposes of avoiding the accuracy-related penalties.
b. The National Office of the IRS releases technical advice memoranda (TAMs) weekly. TAMs
resemble letter rulings in that they give the IRS’s determination of an issue. Letter rulings,
however, are responses to requests by taxpayers, whereas TAMs are issued by the National
Office of the IRS in response to questions raised by taxpayers or IRS field personnel during
audits. TAMs deal with completed rather than proposed transactions and are often requested
for questions relating to exempt organizations and employee plans. Although TAMs are not
officially published and may not be cited or used as precedent, post-1984 TAMs may be
substantial authority for purposes of the accuracy-related penalties.
45. (LO 5)
a. Revenue Procedure number 10, appearing on page 272 of Volume 1 of the Cumulative
Bulletin for 2001.
b. Revenue Ruling number 14 appearing on page 31 of the 27th weekly issue of the Internal
Revenue Bulletin for 2011.
c. The 30th letter ruling issued during the 25th week of 2011.
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46. (LO 6)
a. IRC.
b. FR, IRB, CB.
c. IRB, CB.
d. FR, IRB, CB.
e. IRB, CB.
f. NA, a court decision.
g. NA, a letter ruling.
47. (LO 5)
a. Fifth Circuit.
b. Tenth Circuit.
c. Eleventh Circuit.
d. Ninth Circuit.
e. Second Circuit.
48. (LO 5)
a. A
b. T
c. U
d. T
e. T
f. C
g. N
h. D
49. (LO 6)
a. United States Tax Reporter is published by Research Institute of America (formerly
published as Federal Taxes by Prentice-Hall, Inc.).
b. Standard Federal Tax Reporter is published by Commerce Clearing House, Inc.
c. Federal Tax Coordinator 2d is published by Research Institute of America.
d. Mertens Law of Federal Income Taxation is published by West Group.
e. Tax Management Portfolios is published by Bloomberg BNA.
f. CCH Tax Research Consultant is published by Commerce Clearing House, Inc.
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50. (LO 5, 8)
a. P.
b. P.
c. P.
d. P.
e. S.
f. P.
g. S.
h. P.
i. B. Primary to the taxpayer to whom issued, but secondary for all other taxpayers.
j. P.
k. S. Cannot be cited as precedent.
l. P.
m. S.
n. S. Courts generally do not recognize proposed regulations.
51. (LO 5)
a. For a regular decision of the U.S. Tax Court that was issued in 1970. The decision can be
found in Volume 54, page 1514, of the Tax Court of the United States Reports, published by
the U.S. Government Printing Office.
b. For a decision of the U.S. Second Circuit Court of Appeals that was rendered in 1969. The
decision can be found in Volume 408, page 1117, of the Federal Reporter, Second Series (F.
2d), published by West Publishing Company.
c. For a decision of the U.S. Second Circuit Court of Appeals that was rendered in 1969. The
decision can be found in Volume 1 for 1969, paragraph 9319, of the U.S. Tax Cases,
published by Commerce Clearing House.
d. For a decision of the U.S. Second Circuit Court of Appeals that was rendered in 1969. The
decision can be found in Volume 23, page 1090, of the Second Series of American Federal
Tax Reports, now published by RIA (formerly P-H).
[Note that the citations that appear in parts b., c., and d. are for the same case.]
e. For a decision of the U.S. District Court of Mississippi that was rendered in 1967. The
decision can be found in Volume 293, page 1129, of the Federal Supplement Series,
published by West Publishing Company.
f. For a decision of the U.S. District Court of Mississippi that was rendered in 1967. The
decision can be found in Volume 1 for 1967, paragraph 9253, of the U.S. Tax Cases,
published by Commerce Clearing House.
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g. For a decision of the U.S. District Court of Mississippi that was rendered in 1967. The
decision can be found in Volume 19, page 647, of the Second Series of American Federal
Tax Reports, now published by RIA (formerly P-H).
[Note that the citations that appear in parts e., f., and g. are for the same case.]
h. For a decision of the U.S. Supreme Court that was rendered in 1935. The decision can be
found in Volume 56, page 289, of the Supreme Court Reporter, published by West Publishing
Company.
i. For a decision of the U.S. Supreme Court that was rendered in 1935. The decision can be found
in Volume 1 for 1936, paragraph 9020, of the U.S. Tax Cases, published by Commerce Clearing
House.
j. For a decision of the U.S. Supreme Court that was rendered in 1935. The decision can be
found in Volume 16, page 1274, of the American Federal Tax Reports, now published by
RIA (formerly P-H).
[Note that the citations that appear in parts h., i., and j. are for the same case.]
k. For a decision of the former U.S. Court of Claims that was rendered in 1970. The decision
can be found in Volume 422, page 1336, of the Federal Reporter, Second Series, published
by West Publishing Company. This court is the Claims Court (renamed the Court of Federal
Claims effective October 30, 1992) and current cases are in the Federal Claims Reporter.
RESEARCH PROBLEMS
1. a.
An environmental tax on corporations is imposed on modified alternative minimum taxable
income of a corporation in excess of $2 million.
b.
For purposes of the 5-year deferral, 10-year estate tax installment payment provision, a holding
company is any corporation holding stock in another company. [Reg. § 1.6166(a)(8)(D)(i)]
c. This letter ruling deals with a C corporation that switched to S status (and is subject to the
10-year, built-in gain (BIG) recognition period). In a subsequent switch back to the C status
(as a real estate investment trust), the 10-year BIG recognition period includes the time the
corporation was an S corporation.
d. This field service advice involves the application of § 83 to the taxation of nonqualified stock
options exercised after a transfer under a divorce.
2.
a.
rev’d 929 F.2d 1252 (CA-8, 1991).
b.
aff’d 734 F.2d 20 (CA-9, 1984), cert. den., 469 U.S. 857 (1984).
c.
aff’d 341 F.2d 341 (CA-5,1965).
d.
aff’d per curiam, 487 F.2d 515 (CA-8, 1973).
e.
rev’d 335 F.2d 507 (CA-6, 1964).
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3. The vacation may not be 100% free. Australia will pay around $2.7 million of the costs for the 300
vacations, but the trip is considered a taxable prize or award under IRC § 74(a) and not a nontaxable gift.
Reg. § 1.74-1(a)(1) requires all amounts received as prizes and awards (unless such prizes or awards
qualify as an exclusion from gross) to be included in gross income. Prizes and awards which are includible
in gross income include amounts received from radio and television giveaway shows. Reg. § 1.74-1(a)(2)
further states that, if the prize or award is not made in money but is made in goods or services, the fair
market value of the goods or services is the amount to be included in income. Thus, the lucky recipients
would have to pay taxes on the fair market value of the trip, not the amount actually paid for the trip by the
Oprah show.
Oprah states that she is paying any taxes of the lucky fans. Under Old Colony Trust Co., 279 U.S. 716
(1929), the amount of any tax liability paid by Oprah is also taxable income. See Reg. § 1.61-14. If the
initial tax liability is paid, another amount is taxable. Thus, an infinite amount of taxes would need to be
paid by Oprah to make the vacation trip totally tax-free. The only way to make the prize tax-free is for
Oprah to “gross up” the prize for any taxes due. Keep in mind there are also probably state taxes to be
paid. All in all, this tax problem should create a lot of work for the accountant Oprah chose to handle the
tax problems of the 300 taxpayers.
Research Problems 4 and 5
The Internet Activity research problems require that students utilize online resources to research and answer
the questions. As a result, solutions may vary among students and courses. You should determine the skill and
experience levels of the students before assigning these problems, coaching where necessary. Encourage
students to explore all parts of the Web in this research process, including tax research databases, as well as
the websites of the IRS, newspapers, magazines, businesses, tax professionals, other government agencies,
and political outlets. Students should also work with resources such as blogs, Twitter feeds, and other
interest-oriented technologies to research their answers.
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CHECK FIGURES
40.a. Realized gain $200,000; recognized gain
$100,000.
40.b. Realized loss $300,000; recognized loss
$0.
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SOLUTION TO ETHICS & EQUITY FEATURE
Choosing Cases for Appeal (p. 1-40). The issue is whether it is appropriate for the Government to select a
case to appeal because of its potential for success (i.e., a reversal on appeal) rather than purely on its merits.
Without a question, the tax laws treat taxpayers differently and often unfairly. Many laws are passed as the
result of pressure from various groups (i.e., lobbying). “Don’t tax you, don’t tax me, tax that fellow behind
the tree” is an appropriate statement of tax law development in many circumstances.
Part of the IRS’s function is to maximize revenue with the limited time and budget resources at its disposal.
By litigating specific cases in order to develop judicial law, the IRS does “save” taxpayers’ dollars by
avoiding marginal issues. And, if the IRS position is sustained on appeal in Virginia, the judicial precedent
might be important should the IRS choose to appeal the Iowa decision.
Certainly, there is an unfairness in such an approach. If the IRS decides to appeal the Virginia case, the CPA
must bear the burden of litigation expenses (rather than the minister). Further, should the IRS position be
sustained on appeal, the CPA’s trusts would be collapsed, while the minister’s trusts may be allowed to
remain—even though the tax issues are identical.
CHAPTER 2
CORPORATIONS: INTRODUCTION AND OPERATING RULES
SOLUTIONS TO PROBLEM MATERIALS
DISCUSSION QUESTIONS
1. (LO 1) You should ask questions that will enable you to assess both tax and nontax factors that will
affect the entity choice. Some relevant questions are addressed in the following table, although there
are many additional possibilities.
Question Reason for the Question
What type of business are you going to
operate?
This question will provide information that may affect
the need for limited liability, ability to raise capital, ease
of transferring interests in the business, how long the
business will continue, and how the business will be
managed.
What amount and type of income (loss)
do you expect from the business?
Income from a business will eventually be reported on
the tax returns of the owners.
What is the amount and type of income
(loss) that you expect from other
sources?
For example, income (loss) from a partnership, S
corporation, or LLC will “flow through” to the owners.
Dividends from a C corporation must be reported on the
tax returns of the shareholders. Any income (loss) from
other sources will also be reported on the returns of the
owners. Thus, for planning purposes, it is important to
know all sources and types of income (loss) that the
owners will have.
Do you expect to have losses in the
early years of the business?
Losses of partnerships, S corporations, and LLCs flow
through to the owners and represent potential deductions
on their individual returns. Losses of a C corporation do
not flow through.
Will you withdraw profits from the
business or leave them in the business
so it can grow?
Profits from a partnership, S corporation, or LLC will
“flow through” to the owners, and will be subject to
taxation on their individual tax returns. Profits of a C
corporation must be reported on the tax returns of the
shareholders only if such profits are paid out to
shareholders as dividends. Thus, in the case of a
partnership, S corporation, or LLC, owners must pay tax
on profits before reinvesting funds back into the business.
In the case of a C corporation, the corporation must pay
tax on its profits.
In what state(s) will the business be
formed?
States assess business taxes (e.g., corporate income tax,
franchise tax) on various forms of entities, including
some that apply to S corporations, partnerships, and/or
LLCs.
2-1
2. (LO 1) C corporations are separate taxable entities. Cassowary Corporation will report the operating
income and tax-exempt income on its return (Form 1120), resulting in taxable income of $120,000
for the year. Shareholders are required to report income from a C corporation only to the extent of
dividends received; thus, Barbara reports no income from Cassowary for the year. An S
corporation is a tax reporting entity but (generally) not a taxable entity. Instead, its profit (loss)
and separately stated items flow through to the shareholders. Emu Corporation will report
ordinary business income of $120,000 and separately stated tax-exempt interest income of $8,000 on
its return (Form 1120S), with 40% of these amounts allocated to Barbara (Schedule K–1). Barbara
will report ordinary business income of $48,000 and tax-exempt interest income of $3,200 on her
individual return (Form 1040). The absence of dividend distributions from Emu Corporation does
not affect Barbara’s treatment of the income.
3. (LO 1, 7) Art should consider operating the business as a sole proprietorship (or a single-member LLC)
for the first three years. If he works 15 hours per week in the business, he will exceed the minimum
number of hours required to be a material participant (52 × 15 = 780) under the passive activity loss
rules. [An individual is treated as materially participating in an activity if he or she participates in the
activity for more than 500 hours during the year. Reg. § 1.469-5T(a)(1).] Therefore, he will be able to
deduct the losses against his other income. When the business becomes profitable, Art should consider
incorporating. If he reinvests the profits in the business, the value of the stock should grow accordingly,
and he should be able to sell his stock in the corporation for long-term capital gain.
4. (LO 1, 2)
a. If Catbird Company is an LLC: A single-member LLC is generally taxed as a proprietorship.
Thus, Janice will report the $100,000 operating income (Schedule C), $15,000 long-term
capital gain (Schedule D), and if she itemizes, $5,000 charitable contribution (Schedule A) on
her tax return. The $70,000 withdrawal would have no effect on Janice’s individual tax
return.
b. If Catbird Company is an S corporation: An S corporation is a tax reporting entity (Form
1120S), and its income, gains, deductions, and losses are passed through to and reported by
the shareholders on their tax returns. Separately stated items (e.g., long-term capital gain and
charitable contribution) retain their character at the shareholder level. Consequently, Janice
will report the $100,000 operating income (Schedule E), $15,000 long-term capital gain
(Schedule D), and if she itemizes, $5,000 charitable contribution (Schedule A) on her tax return.
The $70,000 withdrawal would have no effect on Janice’s individual tax return.
c. If Catbird Company is a C corporation: A C corporation is a separate taxable entity, and its
taxable income has no effect on the shareholders until such time a dividend is paid. When
dividends are paid, shareholders must report dividend income on their tax returns. Thus,
Catbird Company will report taxable income of $110,000 ($100,000 operating income +
$15,000 LTCG – $5,000 charitable contribution) on its Form 1120. Corporations receive no
preferential tax rate on long-term capital gains. Janice will report dividend income of $70,000
(Schedule B) on her individual tax return.
5. (LO 1, 2)
If Joel buys the warehouse and rents it to the corporation, he can charge the corporation the
highest amount of rent that is reasonable. The rental operation can help bail some profits out of
the corporation and avoid double taxation on corporate income. Joel would have rent income but
Manatee would have a deduction for rent expense.
The depreciation and other expenses incurred in connection with the warehouse will be
deductible by Joel, which should enable him to offset some or all of the rental income. If the
rental property produces a loss, Joel can use the loss to offset any passive activity income he might
have.
Upon future sale of the warehouse, Joel will not be subject to the § 291 additional depreciation
recapture provision that would be applicable to Manatee Corporation.
Any § 1231 gain resulting from the sale of the warehouse would qualify for the preferential tax
rate on long-term capital gains. C corporations do not receive any preferential tax rate on long-
term capital gains.
6. (LO 1) Yes, most states allow for single-member LLCs. Under the default rules of the check-the-
box Regulations, a single-member LLC is taxed as a sole proprietor. A single-member LLC can
elect to be taxed instead as a corporation by filing Form 8832 (Entity Classification Election).
7. (LO 1) The statement is correct. Because no Form 8832 was filed, the LLC will be taxed as a
partnership, the default classification for multi-member LLCs under the check-the-box Regulations.
A Form 8832 is required to be filed only if the taxpayer wants to elect to have the entity classified as
a corporation for Federal tax purposes.
8. (LO 2) A C corporation is relatively unrestricted as to the choice of accounting periods, and
generally may choose either a fiscal year or a calendar year. It is not necessary for a new C
corporation to obtain consent of the IRS with regard to its choice of an accounting period. Personal
service corporations, however, can elect a fiscal year only under one of the following circumstances:
A business purpose for the year can be demonstrated.
The year results in a deferral of not more than three months’ income. An election under § 444 is
required, and the PSC will be subject to the deduction limitations of § 280H.
Thus, Salmon Corporation can elect a March 31 fiscal year-end, but Scarlet Corporation would need
to satisfy the business purpose exception to qualify for a March 31 fiscal year-end.
9. (LO 2) In general, a corporation is not allowed to use the cash method of accounting for
Federal tax purposes. However, S corporations, qualified personal service corporations, and C
corporations engaged in the trade or business of farming or timber are exceptions to this rule.
Further, a C corporation with $5 million or less of average gross receipts over the past three years is
allowed to use the cash method.
a. Jade Corporation has $4.8 million of average gross receipts over the 2013–2015 period. Thus,
Jade satisfies the gross receipts exception and may use the cash method of accounting.
b. Lime Corporation, a PSC, may use the cash method of accounting without regard to its gross
receipts.
10. (LO 2) A corporation that uses the accrual method cannot claim a deduction for an expense
involving a related party (e.g., a more than 50% shareholder) until the recipient reports that amount
as income. Lupe, a cash basis taxpayer, must report the $100,000 bonus in 2017, the year he
receives the payment. Jasper Corporation may deduct the $100,000 bonus in 2017, the year Lupe
is required to report it as income.
11. (LO 2) Both corporations and individuals include recognized capital gains in their taxable income.
For a corporate taxpayer, there is no preferential tax rate applicable to long-term capital gains.
Instead, the capital gain is taxed at Parrot’s normal tax rate of 25%. The preferential tax rate of 15%
would apply to Jeanette’s long-term capital gain.
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12. (LO 2) John and Eagle Corporation each net the $10,000 LTCG against the $18,000 STCL,
resulting in an $8,000 net capital loss. John reports the capital transactions on his individual tax
return, deducts $3,000 of the net capital loss in the current year, and carries forward to next year a
$5,000 STCL for the remainder of the net capital loss. Eagle reports the capital transactions on its
corporate tax return, but none of the $8,000 net capital loss is deductible in the current year. Instead,
Eagle carries back an $8,000 STCL three years and, if necessary, forward five years, to be offset against
capital gains in such years.
13. (LO 2) For an individual taxpayer, there is no deprecation recapture under § 1250 with respect to
realty placed in service after 1986 and depreciated under the straight-line method. However, under
§ 291, a C corporation must treat a portion of gain recognized on the disposition of § 1250
property as depreciation recapture (ordinary income). The § 291 ordinary income amount is equal to
20% of the excess of the amount of depreciation recapture that would arise if the property was
§ 1245 property over the amount of depreciation recapture computed under § 1250 (without regard
to § 291). As a result, some of the gain recognized by a C corporation on the sale of the warehouse
will be ordinary income (and not § 1231 gain).
14. (LO 2)
a. If Osprey is a personal service corporation, it cannot deduct any of the passive activity
loss in the current year. A personal service corporation cannot offset a passive activity loss
against either active or portfolio income.
b. A closely held corporation that is not a personal service corporation can offset passive
activity losses against net active income but not against portfolio income. Therefore,
Osprey can deduct $100,000 of the passive activity loss in the current year. The remaining
$20,000 of passive activity loss is carried forward.
15. (LO 2) In order to be deductible by an accrual basis corporation in the year authorized by its
board of directors, a charitable contribution must be paid within 3 1/2 months of the end of
the year of authorization (April 15, 2017, in this case). Because payment was made within the
required time period, the charitable contribution is deductible in 2016.
16. (LO 2, 7) The following tax issues should be considered.
Is Orange an accrual method taxpayer and, if so, will the contribution be made by April 15,
2017, so as to obtain a deduction in 2016?
Will the contribution consist of property or cash?
If the contribution consists of property, what is the character of the property (capital gain or
ordinary income property) and amount of the contribution deduction?
What is the current year’s taxable income limitation on the deductibility of charitable
contributions?
In what tax year did the charitable contribution carryover originate and when does the 5-year
period for such carryover expire?
If the $45,000 sum of the current year’s contribution plus the carryover amount exceeds the
taxable income limitation, should the current year’s gift be deferred to the subsequent tax year?
17. (LO 2) The domestic production activities deduction is equal to 9% of the lesser of the
taxpayer’s (1) qualified production activities income or (2) taxable income. However, the deduction
cannot exceed 50% of the corporation’s W–2 wages related to qualified production activities income.
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18. (LO 2, 3, 7) As a general rule, an NOL is carried back 2 years and forward 20 years to offset
taxable income in such carryover years. However, a taxpayer can (irrevocably) elect to forgo the
carryback period and just carry the NOL forward. In determining whether Gold should make the
election, some of the relevant issues are:
What are Gold’s marginal tax rates for the carryback years?
o What effect, if any, would an NOL carryback have on the prior years’ tax computations?
What is Gold’s estimated future marginal tax rate?
o What is Gold’s estimated future taxable income?
o Are corporate income tax rates anticipated to change in the future?
Does Gold have immediate cash flow needs that would favor the carryback approach?
19. (LO 1, 3) Otter Corporation will be allowed a dividends received deduction equal to 70% of the
$15,000 dividend it received from Marmot (subject to taxable income limitation described in
Example 26). It will pay tax at the applicable corporate tax rate of 25% on the remaining portion
of the dividend. Gerald must include in income the entire $15,000 dividend he received from
Marmot, and he will pay tax at the 15% rate applicable to individuals.
20. (LO 3) A corporation that owns stock in another corporation is allowed a dividends received
deduction. The deduction percentage is based on the percentage of ownership that the recipient
corporation has in the corporation paying the dividend. Currently, with Mustard’s 15% ownership
interest in Burgundy, the deduction percentage is 70%. If the stock purchase increases Mustard’s
ownership interest in Burgundy to 20% or more, but less than 80%, then the deduction percentage
is 80%. If the stock purchase increases Mustard’s ownership interest in Burgundy to 80% or
more, then the deduction percentage is 100%.
21. (LO 3)
a. Organizational expenditures.
b. Organizational expenditures.
c. Organizational expenditures.
d. Startup expenditures.
e. Neither.
22. (LO 5) Plum Corporation and Ivory Corporation are members of a controlled group of corporations
(related corporations) and subject to a special income tax liability computation. The special
computation limits the amount of a controlled group’s taxable income that is taxed at rates lower
than 35% to that amount the corporations in the group would have if they were one corporation. As
a result, Omar’s plan will be ineffective in lowering the overall corporate income tax liability of the
two corporations.
23. (LO 6) Estimated tax payments are required if the corporation’s tax liability is expected to be $500 or
more. The required annual payment (which includes estimated AMT liability) is the lesser of (1)
100% of the corporation’s tax for the current year or (2) 100% of the corporation’s tax for the
preceding year (if that year was a 12-month tax year, the return filed showed a tax liability, and the
corporation is not a large corporation).
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24. (LO 6) The starting point on Schedule M–1 is net income per books. Additions and subtractions are
entered for items that affect net income per books and taxable income differently. An example of an
addition is Federal income tax expense, which is deducted in computing net income per books but is
disallowed in computing taxable income. An example of a subtraction is a charitable contributions
carryover that was deducted for book purposes in a prior year but deducted in the current year for tax
purposes.
ADDITIONS
c. Federal income tax per books.
d. Capital loss in excess of capital gain.
e. Charitable contributions in excess of taxable income limitation.
f. Premiums paid on life insurance policies covering executives (corporation is beneficiary).
SUBTRACTIONS
a. Life insurance proceeds received upon death of covered executive.
b. Tax depreciation in excess of book tax depreciation.
g. Domestic production activities deduction.
25. (LO 6) Corporations with total assets of $10 million or more are required to file Schedule M3; thus,
Woodpecker, with $8.5 million of assets, is not required to file the form. If a Schedule M3 is filed
by Woodpecker, the amortization is reported on line 28, Part III as follows: $40,000 book
amortization in column (a), $15,000 temporary difference in column (b), and $55,000 tax return
amortization in column (d).
COMPUTATIONAL EXERCISES
26. (LO 2)
a. Zero. Corporations can deduct capital losses against capital gains but not ordinary income.
Instead, net capital losses are first carried back to the three preceding years and then carried
forward for five years, to be offset against net capital gains in such carryover years.
b. $7,000. Of the $12,000 net capital loss, $5,000 is carried back to 2015 and deductible against
the $5,000 net capital gain of that year. The remaining $7,000 ($12,000 – $5,000) of the net
capital loss is carried forward to 2017. (Since a net capital loss is carried back only three
years, the 2016 loss cannot be carried back to tax year 2012.)
27. (LO 2)
a. $589,765. The gain is computed as follows: $1,500,000 amount realized – $910,235 adjusted
basis ($1,000,000 – $89,765 accumulated depreciation) = $589,765 recognized gain.
b. Section 1231 gain of $571,812 and § 1250 recapture (ordinary income) of $17,953. Under
§ 1250, recapture is limited to the excess of accelerated depreciation over straight-line
depreciation. However, under § 291, corporations have additional § 1250 recapture (ordinary
income) equal to 20% of the excess of the amount that would be treated as ordinary income if
the property was § 1245 property (i.e., the accumulated depreciation amount of $89,765) over
the amount that would be treated as ordinary income under § 1250 without regard to § 291
(i.e., $0). Thus, under § 291, Aqua has § 1250 recapture of $17,953 [20% × ($89,765 – $0)].
The remaining $571,812 of recognized gain ($589,765 – $17,953) is § 1231 gain.
28. (LO 2) $15,000. A closely held C corporation that is not a personal service corporation can offset a
passive activity loss against net active income, but not against portfolio income. Hummingbird can
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deduct only $40,000 of the $45,000 passive activity loss. Thus, Hummingbird’s taxable income is
$15,000 ($40,000 + $15,000 – $40,000).
29. (LO 2)
a. $27,000. The contribution qualifies for the increased deduction amount for certain inventory
gifts (i.e., contribution of inventory for use in the organization’s exempt function and such
use is the care of the needy). Thus, the deduction amount is equal to the lesser of (1) the sum
of the property’s basis plus 50% of the appreciation on the property [$24,000 + .50($30,000 –
$24,000) = $27,000] or (2) twice the property’s basis (2 × $24,000 = $48,000).
b. $32,000. This is a contribution of capital gain property; thus, the deduction amount is the
property’s fair market value. (Stock is intangible personal property; thus, the qualified
organization’s use of the stock is not relevant.)
c. $130,000. This is a contribution of capital gain property; thus, the deduction amount is the
property’s fair market value. (Tangible personal property that is put to a use related to the
qualified organization’s exempt function.)
30. (LO 3)
a. $70,000. The NOL rule applies, as deducting $70,000 (70% × $100,000 dividends received)
results in an NOL for Crane [$180,000 + $100,000 – $255,000 – $70,000 = ($45,000) NOL].
b. $154,000. The taxable income limitation applies to the amount of the deduction [70% ×
($300,000 + $230,000 – $310,000) = $154,000].
31. (LO 3) $3,650. Generally, the first $5,000 of organizational expenditures are expensed, and the
remaining costs are amortized over a 180-month period (beginning with the month the corporation
begins business). However, the $5,000 expensing amount is reduced dollar-for-dollar for the amount
of organizational expenditures in excess of $50,000. Thus, Cherry will deduct $1,000 [$5,000 –
($54,000 – $50,000)] plus $2,650 [($54,000 – $1,000) ÷ 180 × 9], or $3,650.
32. (LO 4)
a. $12,000 [(15% × $50,000) + (25% × $18,000)].
b. $3,680,000 [(34% × $10,000,000) + (35% × $800,000)].
c. $59,500 (35% × $170,000). Personal service corporations are subject to a flat rate of 35% on
taxable income.
PROBLEMS
33. (LO 1, 2)
a. Income, gains, deductions, and losses of a proprietorship are reported on the individual tax
return of the sole proprietor (Form 1040), regardless of whether any amounts are actually
withdrawn from the business during the year. Consequently, Roger reports the $45,000 net
operating profit ($220,000 operating income – $175,000 operating expenses) and $10,000 longterm
capital loss on his tax return. The LTCL will be subject to the capital loss
limitations applicable to individual taxpayers. Riflebird Company, as a proprietorship, files
no entity Federal income tax return for the year.
b. A C corporation is a separate taxable entity which files a corporate income tax return. Riflebird
Company will report taxable income of $45,000 ($220,000 operating income – $175,000
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222
operating expenses) on its Form 1120. A corporation cannot currently deduct a net capital loss.
Instead, the LTCL is subject to the corporate capital loss carryover rules (carried back three
years and forward five years, as STCL). Riflebird Company’s taxable income has no effect on
the shareholders until such time a dividend is paid. When dividends are paid, shareholders must
report dividend income on their tax returns. Therefore, Roger does not report Riflebird’s net
profit or long-term capital loss on his individual return.
34. (LO 1, 2)
a. Otter, a partnership, is not a taxpaying entity. Its profit (loss) and separate items flow through
to the partners. The partnership’s Form 1065 reports net profit of $110,000 ($320,000 income
– $210,000 expenses). The partnership also reports the $15,000 long-term capital gain as a
separately stated item on Form 1065. Ellie and Linda each receive a Schedule K1 reflecting
net profit of $55,000 and separately stated long-term capital gain of $7,500, which each
reports on her own return. The 0/15/20% preferential tax rate applies to the LTCG. The
withdrawals do not affect taxable income but decrease their basis in the partnership (but not
below zero).
b. Otter, an S corporation, is not a taxpaying entity. Its profit (loss) and separate items flow
through to the shareholders. The S corporation’s Form 1120S reports net profit of $110,000
($320,000 income – $210,000 expenses). The S corporation also shows the $15,000 long-
term capital gain as a separately stated item on Form 1120S. Ellie and Linda each receive a
Schedule K1 reporting net profit of $55,000 and separately stated long-term capital gain of
$7,500, which each reports on her own return (subject to capital loss limitation). The
0/15/20% preferential tax rate applies to the LTCG. The withdrawals do not affect taxable
income but decrease their basis in the S corporation (but not below zero).
c. Otter, a C corporation, is a taxpaying entity. Otter’s Form 1120 reports taxable income of
$125,000 ($320,000 income – $210,000 expenses + $15,000 LTCG). Corporations do not
received a preferential tax rate on LTCG income. Ellie and Linda report dividend income of
$25,000 each. The dividend income is subject to the 0/15/20% preferential tax rate.
35. (LO 1, 2)
a. Azure Company, as a C corporation, has taxable income of $350,000 and corporate income
tax of $119,000 [$350,000 × 34% (see Exhibit 2.1)]. The exclusion for municipal bond
interest applies to C corporations. Since Sasha received no dividends or salary from Azure
during the year, she is not currently taxed on any of the corporation’s income.
b. Since dividend distributions are not deductible, the income tax consequences to Azure
Company, a C corporation, are the same as in part a. above (i.e., corporate income tax of
$119,000). Sasha incurs income tax of $15,000 ($75,000 × 20%) with respect to the
dividends she received during the year.
c. The salary paid to Sasha is deducible by Azure Company, resulting in taxable income of
$275,000 ($350,000 net operating income – $75,000 salary) and corporate income tax of
$90,500 (see Exhibit 2.1). Sasha incurs income tax of $29,700 ($75,000 × 39.6%) with
respect to the salary she received during the year. (Payroll taxes on the salary would also
apply to Azure and Sasha.)
d. There is no Federal income tax applicable to businesses formed as sole proprietorships. Instead,
the income and expenses of a proprietorship retain their character and are reported on the
individual income tax return of the proprietor. Sasha therefore incurs income tax of $138,600
($350,000 net operating income × 39.6% marginal tax rate) with respect to Azure Company.
(Sasha would also be subject to self-employment tax on her net self-employment income.)
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e. The result would be the same as in part d. above. Sasha must pay tax on the net operating
income of Azure Company, regardless of the amount she withdraws. (Sasha would also be
subject to self-employment tax on her net self-employment income.)
36. (LO 1, 2)
a. An S corporation is not a taxable entity. Its profit (loss) and separately stated items flow
through to the shareholders. Taupe Corporation’s Form 1120S reports ordinary business
income of $420,000 and separately stated long-term capital gain of $30,000. Torsten receives
a Schedule K1 reporting ordinary business income of $420,000 and separately stated long-
term capital gain of $30,000. Torsten will report ordinary business income of $420,000 and
long-term capital gain of $30,000 on his individual income tax return (Form 1040), regardless
of how much of the income was withdrawn from Taupe. Torsten’s income tax liability with
respect to the income from Taupe is $172,320 [($420,000 ordinary business income × 39.6%
marginal tax rate) + ($30,000 LTCG × 20% preferential tax rate)].
b. A C corporation is a taxable entity, and Taupe Corporation’s Form 1120 reports taxable
income of $450,000 ($420,000 ordinary business income + $30,000 LTCG) and income tax
of $153,000 [$450,000 × 34% (see Exhibit 2.1)]. C corporations do not receive any
preferential tax rate with respect to long-term capital gains. The taxable income of a C
corporation has no effect on the shareholders until such time a dividend is paid. Therefore,
Torsten has no tax consequences in the current year with respect to Taupe Corporation.
37. (LO 1) If Purple Company is a proprietorship, Kirsten must report net income of $200,000, regardless
of the amount she withdraws. If the company is a C corporation, it must pay corporate tax on its taxable
income and Kirsten must report any dividends she receives from the company as income.
a.
Kirsten’s after-tax income is computed below:
Income from proprietorship
$200,000
Less deductions ($6,300 standard deduction + $4,050 exemption) (10,350)
Taxable income $189,650
Tax on $189,650 (see Appendix A for Tax Rate Schedules) $ 46,139
After-tax income ($200,000 – $46,139) $153,861
b. Tax on corporation’s net income of $200,000:
Tax on $200,000 (see Exhibit 2.1)
$ 61,250
Corporation’s after-tax income ($200,000 – $61,250)
Kirsten’s taxable income ($138,750 dividend – $6,300
standard deduction – $4,050 exemption)
$138,750
$128,400
Kirsten’s tax on $128,400 at rates applicable to
dividends [($37,650 × 0%) + .15($128,400 – $37,650)]
$ 13,613
Kirsten’s after-tax income ($138,750 – $13,613) $125,137
c.
The corporation will have taxable income of $61,250 ($200,000
compensation deduction – $138,750 salary). Kirsten will have taxable
net income before
income of $128,400
($138,750 – $6,300 standard deduction – $4,050 exemption). Her tax will be $28,989, and
her after-tax income will be $109,761 ($138,750 – $28,989).
38. (LO 2)
a. Wilson can claim an itemized deduction of $17,400 [$90,000 – $50,000 (insurance recovery)
– $100 (floor on personal casualty losses) – $22,500 (10% of $225,000 AGI)].
b. Wilson can deduct $40,000 [$90,000 – $50,000 (insurance recovery)]. Corporations are not
subject to the $100 floor or the 10%-of-AGI limitation.
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39. (LO 1, 4, 7)
a. Gross income $395,000
Ordinary deductions (245,000)
Taxable income (to owner of proprietorship)
Tax @ 33%
$150,000
$49,500
b. Gross income of corporation $395,000
Ordinary deductions (245,000)
Salary (100,000)
Taxable income
Corporate tax @ 15%
$ 50,000
$ 7,500
Gross income of shareholder
Salary
$100,000
Tax @ 33%
33,000
Total tax
$40,500
c. Gross income of corporation $395,000
Ordinary deductions (245,000)
Taxable income
Corporate tax [$22,250 + (39% × $50,000)]
$150,000
$41,750
d. Gross income of corporation $395,000
Ordinary deductions (245,000)
Salary (100,000)
Taxable income
Corporate tax @ 15%
$ 50,000
$ 7,500
Tax paid by shareholder
On salary ($100,000 × 33%)
$ 33,000
On dividend [($50,000 – $7,500) × 15%] 6,375 39,375
Total tax
$46,875
e. Hoffman, Raabe, Maloney, & Young, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 2, 2016
Mr. Robert Benton
1121 Monroe Street
Ironton, OH 45638
Dear Mr. Benton:
This letter is in response to your inquiry as to the Federal income tax effects of incorporating
your business. I have analyzed the tax results under both assumptions, proprietorship and
corporation. I cannot give you a recommendation until we discuss the matter further and you
provide me with some additional information. My analysis based on information you
have given me to date is presented below.
COMPUTATION 1
Total tax on $150,000 taxable income if you continue as a
proprietorship (33% tax rate) $49,500
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Total tax if you incorporate:
Individual tax on $100,000 salary @ 33% $33,000
Corporate tax on $50,000 corporate taxable income 7,500
Total $40,500
Although this analysis appears to favor incorporating, it is important to consider that there
will be additional tax on the $42,500 of income left in the corporation if you withdraw that
amount as a dividend in the future, as calculated below:
COMPUTATION 2
After-tax income left in corporation ($50,000 taxable
income – $7,500 corporate tax)
$42,500
Tax on $42,500 @ 15% $6,375
Total tax paid if you incorporate ($40,500 + $6,375)
$46,875
Comparison of computations 1 and 2 appears to support incorporating. If you incorporate and
recover the income left in the corporation as long-term capital gain from a sale of stock in the
future, the total tax cost of incorporating will be the same, as shown in computation 3 below.
COMPUTATION 3
After-tax income left in corporation ($50,000 taxable
income – $7,500 corporate tax)
$42,500
Tax on $42,500 @ 15% LTCG rate $6,375
Total tax paid if you incorporate ($40,500 + $6,375) $46,875
In summary, incorporating appears to be the most attractive option, whether you recover
income left in the corporation as capital gain or as dividend income. Keep in mind, however,
that there are important nontax and other tax considerations with respect to this decision. We
can discuss those issues at our next meeting.
Thank you for consulting my firm on this important decision. We are pleased to provide
analyses that will help you make the right choice.
Sincerely,
Jon Thomas, CPA
40. (LO 2, 4)
a. The salary for the deferral period (October 1 through December 31) must be at least
proportionate to the employee’s salary received for the prior fiscal year. The amount that
Carmine Corporation must pay Juan during the period October 1 through December 31, 2016,
to permit Carmine to continue to use its fiscal year without negative tax effects, is $84,000
($336,000 × 3/12).
b. Carmine Corporation, a PSC, is subject to a tax rate of 35% on all of its taxable income. The
corporation would pay tax of $33,250 ($95,000 × 35%) for the tax year ending September 30,
2016. To illustrate the negative tax impact of classification as a PSC, compare this amount
to the $20,550 (see Exhibit 2.1) a corporation that is not a PSC would pay on taxable
income of $95,000.
2-12 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-26
41. (LO 2)
a. Under the cash method of accounting, the salaries are deductible in the year that they are
paid by Broadbill. Thus, Broadbill deducts $440,000 ($220,000 × 2), the amount of salaries
paid by the corporation in 2016. The $40,000 of salaries paid by Broadbill in 2017 is
deductible by the corporation in 2017.
b. An accrual method corporation cannot claim a deduction for an accrual with respect to a
related party (e.g., more-than-50% shareholder). Instead, the deduction is deferred until such
time the recipient reports that amount as income. Thus, Broadbill deducts $460,000 [$220,000
(salary paid in 2016 to related party Marcia) + $240,000 (salary paid and accrued to unrelated
party Zack)]. The $20,000 of Marcia’s 2016 salary that is accrued by Broadbill on December
31, 2016, is deductible by the corporation in 2017 (the year it is paid to Marcia).
42. (LO 1, 2, 4)
a. Under the check-the-box Regulations, a single-member LLC is treated as a sole proprietorship
unless corporate status is elected by filing a proper Form 8332 (Entity Classification Election).
If Lemon Company is a proprietorship, then $10,500 ($70,000 × 15%) of individual income tax
results in the current year for Jonathan. The income (or loss) of a proprietorship is reported on
the proprietor’s individual return (Form 1040). Individuals in the 33% marginal tax bracket
receive a preferential tax rate of 15% on LTCGs.
b. If Lemon is a C corporation, then $12,500 of corporate income tax results in the current year.
Corporations do not receive a preferential tax rate for LTCGs, and such income is taxed at the
normal corporate rates resulting in a tax of $12,500 [($50,000 × 15%) + ($20,000 × 25%)].
43. (LO 2, 4)
a. $105,000 taxable income = $480,000 (operating income) – $390,000 (operating expenses) +
$55,000 (LTCG) – $40,000 (STCL). The tax on $105,000 of taxable income is $24,200
[($50,000 × 15%) + ($25,000 × 25%) + ($25,000 × 34%) + ($5,000 × 39%)]. Corporations
include LTCGs in taxable income and do not receive a preferential tax rate with respect to
such income.
b. $90,000 taxable income = $480,000 (operating income) – $390,000 (operating expenses) +
$15,000 (LTCG) – $15,000 (STCL). No deduction is allowed for the $25,000 net capital loss.
Instead, the net capital loss is carried back three years and forward five years. The tax on
$90,000 of taxable income is $18,850 [($50,000 × 15%) + ($25,000 × 25%) + ($15,000 × 34%)].
44. (LO 2)
a. If Goshawk is a proprietorship, only $21,000 of the $40,000 long-term capital loss can be
deducted in the current year. The loss will offset the short-term capital gain of $18,000 first;
then, an additional $3,000 of the loss may be utilized as a deduction against ordinary income.
The remaining $19,000 net capital loss is carried forward to next year and years thereafter
until completely deducted. The capital loss carryover retains its character as long term.
b. If Goshawk is a C corporation, only $18,000 of the long-term capital loss can be deducted in
the current year. The loss deduction is limited to the amount of capital gains ($18,000
STCG). A corporation cannot claim a net capital loss as a deduction against ordinary income.
The $22,000 net capital loss can be carried back to the three preceding years to reduce any
net capital gains in those years. (The loss is carried back three years and forward five years.)
Any loss not offset against net capital gains in the three previous years can be carried forward
for five years, to offset capital gains in those years. The long-term capital loss will be treated
as a short-term capital loss as it is carried back and forward.
2-12 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-27
45. (LO 2)
a. Net short-term capital gain $ 15,000
Net long-term capital loss (105,000)
Net capital loss ($ 90,000)
Gorilla cannot deduct the net capital loss of $90,000 on its 2016 return, but must carry it back to
the three preceding years, applying it against net capital gains in 2013, 2014, and 2015, in that
order. The net capital loss is carried back or forward as a short-term capital loss.
b. 2016 net capital loss ($90,000)
Offset against
2013 (net long-term capital gains) $18,000
2014 (net short-term capital gains) 25,000
2015 (net long-term capital gains) 20,000
Total carrybacks $63,000
c. $27,000 ($90,000 – $63,000) STCL carryforward to 2017, 2018, 2019, 2020, and 2021, in
that order.
d. These transactions are netted with the taxpayer’s other capital transactions for 2016.
Assuming these are the only capital transactions in 2016, the taxpayer offsets $15,000 of capital
gains against the capital losses and deducts an additional $3,000 in capital losses. The remaining
$87,000 ($105,000 – $15,000 – $3,000) is carried forward indefinitely (as long- term capital
loss).
46. (LO 2)
a. Under § 291, a corporation will incur an additional amount of depreciation recapture
(ordinary income) upon a disposition of § 1250 property for a gain. The § 291 adjustment is
equal to 20% of the excess of the amount of depreciation recapture that would arise if the
property was § 1245 property over the amount of deprecation recapture computed under
§ 1250 (without regard to § 291). The solution follows Example 14 in the text.
First, determine the recognized gain:
Sales price
$ 850,000
Less adjusted basis:
Cost of property $ 650,000
Less cost recovery (287,492) (362,508)
Recognized gain
$ 487,492
Second, determine the § 1245 recapture potential. This is the lesser of $487,492 (recognized
gain) or $287,492 (cost recovery claimed).
Third, determine the normal § 1250 recapture amount:
Cost recovery taken $ 287,492
Less straight-line cost recovery
§ 1250 ordinary income
Fourth, determine the additional § 291 amount:
§ 1245 recapture potential Less §
1250 recapture amount Excess §
1245 recapture potential
(287,492)
$ –0–
$287,492
(–0–)
$287,492
Apply § 291 percentage 20%
Additional ordinary income under § 291 $ 57,498
2-14 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-28
Heron Corporation’s recognized gain of $487,492 is accounted for as follows:
Ordinary income under § 1250 $ –0–
Ordinary income under § 291 57,498
§ 1231 gain 429,994
Total recognized gain $487,492
b. Heron Company, as a sole proprietorship, is not subject to § 291; instead, the normal
depreciation recapture rules apply with respect to the gain recognized on the sale of the
realty. The realty is § 1250 property and there is no recapture of depreciation under that
provision when straight-line depreciation is used. As such, the entire gain of $487,492 is treated
as § 1231 gain on the tax return of the proprietor of Heron.
47. (LO 2)
a. A closely held C corporation that is a personal service corporation is subject to the passive
activity loss rules and, as a result, Plum cannot deduct any of the $75,000 passive activity loss
in the current year. Therefore, Plum’s taxable income is $430,000 ($410,000 net active
income + $20,000 portfolio income – $0 passive activity loss).
b. A closely held C corporation that is not a personal service corporation is subject to the
passive activity loss rules, but it can deduct a passive activity loss against net active income
(but not portfolio income). Thus, Plum’s taxable income is $355,000 [$410,000 (net active
income) + $20,000 (portfolio income) – $75,000 (passive activity loss)].
48. (LO 2) The total amount of Aquamarine’s charitable deduction for the year is $118,500. The painting
is capital gain property, but it is tangible personal property which was not used for a purpose related to
the qualified organization’s exempt function. Thus, the amount of the contribution is limited to the
painting’s basis, or $15,000. The Apple stock is capital gain property and the amount of the contribution
is the stock’s fair market value, or $90,000. The canned groceries are ordinary income property but the
donation qualifies for the enhanced deduction for corporate contributions of inventory. As such, the
amount of the contribution of the inventory is equal to the lesser of (1) the sum of the property’s basis
plus 50% of the appreciation on the property, or (2) twice the property’s basis. Thus, the amount of the
contribution of the canned groceries is $13,500 [$10,000 (basis) + 0.5($17,000 –
$10,000)].
49. (LO 2, 7) Hoffman, Raabe, Maloney, & Young, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 10, 2016
Mr. Joseph Thompson
Jay Corporation
1442 Main Street
Freeport, ME 04032
Dear Mr. Thompson:
I have evaluated the proposed alternatives for your 2016 year-end contribution to the University of
Maine (University). I recommend that you sell the Brown Corporation stock and donate the
proceeds to the University. The four alternatives are discussed below.
2-14 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-29
Donation of cash, the unimproved land, or the Brown Corporation stock each will result in a $200,000
charitable contribution deduction. Donation of the Maize Corporation stock will result in only a
$140,000 charitable contribution deduction.
Contribution of the Brown Corporation stock will result in a less desirable outcome from a tax
perspective. However, you will benefit in two ways if you sell the stock and give the $200,000 in
proceeds to the University. Donation of the proceeds will result in a $200,000 charitable contribution
deduction. In addition, sale of the stock will result in a $160,000 long-term capital loss. If Jay
Corporation had capital gains of at least $160,000 and paid corporate income tax in the past three
years, the entire loss can be carried back and Jay will receive tax refunds for the carryback years. If
Jay Corporation had no capital gains in the carryback years, the capital loss can be carried forward
and offset against capital gains of the corporation for up to five years.
Jay Corporation should make the donation in time for the ownership to change hands before the end
of the year. Therefore, I recommend that you notify your broker immediately so there will be no problem
in completing the donation on a timely basis.
I will be pleased to discuss my recommendation in further detail if you wish. Please call me if you
have questions. Thank you for consulting my firm on this matter. We look forward to serving you in
the future.
Sincerely,
Richard Stinson, CPA
Note to instructor: The land and stock are “unrelated use property” but they are not “tangible personal
property.”
50. (LO 2, 7) Gray Corporation should defer the gift of the land until 2017. This would allow Gray to
fully deduct in 2016 the carryover contribution amount of $75,000. If, instead, Gray gifted the land
in 2016, the corporation would lose any otherwise allowable deduction as to the $75,000 carryover
amount. This occurs because current year gifts are applied against the taxable income limitation
before application of any carryover amounts. Thus, the taxable income limitation for 2016 would be
completely exhausted by the gift of land in 2016. Since 2016 represents the fifth and last year of
the carryover period, a gift of the land in 2016 precludes any deduction for the $75,000. A gift of
appreciated land held for more than one year as an investment results in a charitable deduction equal
to the land’s fair market value (subject to the taxable income limitation).
Assuming a gift of the land in 2017
2016 taxable income limitation: 10% × $1,000,000 = $100,000.
2016 charitable contribution deduction: $75,000 (carryover from 2011 gift).
2017 taxable income limitation: 10% × $1,200,000 = $120,000.
2017 charitable contribution deduction: $120,000 (gift of land; excess contribution of $130,000 is
carried forward for up to five years).
Assuming a gift of the land in 2016
2016 taxable income limitation: 10% × $1,000,000 = $100,000.
2016 charitable contribution deduction: $100,000 (gift of land; excess contribution of $150,000 is
carried forward for up to five years). Carryover from 2011 gift ($75,000) disappears, as 2016 is
the last year of the carryover period.
2017 taxable income limitation: 10% × $1,200,000 = $120,000.
2017 charitable contribution deduction: $120,000 (carryover from 2016 gift; remaining $30,000 of
carryover from 2016 gift carries over to 2018).
2-16 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-30
51. (LO 2, 7) Hoffman, Raabe, Maloney, & Young, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 17, 2016
Mr. Dan Simms, President
Simms Corporation
1121 Madison Street
Seattle, WA 98121
Dear Mr. Simms:
On December 12 you asked me to advise you on the timing of a contribution by Simms Corporation
to the University of Washington. My calculations show that the corporation will maximize its tax
savings by making the contribution in 2016.
If the corporation makes the contribution in 2016, it can deduct $25,000 as a charitable contribution,
which will save $9,750 (39% tax rate × $25,000 deduction) in Federal income tax. However, if the
corporation makes the contribution in 2017, the percentage limitations applicable to corporations will
limit the 2017 deduction to $10,000 ($100,000 projected profit × 10% limit). The corporation will
save $3,400 (34% tax rate × $10,000 deduction) in taxes as a result of this deduction. The corporation
may carry the remaining $15,000 forward for five years or until exhausted. If the corporation
continues at the 2017 profit level, it will save an additional $5,100, for a total tax savings of $8,500.
This analysis makes it clear that the corporation will save $1,250 more ($9,750 – $8,500) if it makes
the contribution in 2016. In addition, all of the savings will occur in 2016. If the corporation makes
the contribution in 2017, its tax savings will be split among several years. My advice is that the
corporation should make the contribution immediately so ownership of the stock can be transferred
by December 31.
Sincerely,
Alicia Gomez, CPA
52. (LO 2)
a. White’s domestic production activities deduction is equal to 9% of the lesser of:
taxable income (before DPAD) of $900,000, or
qualified production activities income of $1.2 million.
The tentative deduction is $81,000 ($900,000 × 9%). Because W2 wages attributable to
QPAI were $200,000, the wage limitation ($200,000 × 50% = $100,000) does not apply.
Therefore, White’s DPAD is $81,000.
b. The wage limitation now applies and White’s DPAD is $75,000 ($150,000 × 50%).
53. (LO 2, 3)
a. The key to this question is the relationship between the dividends received deduction and the
net operating loss deduction. The dividends received deduction is limited to a percentage of
taxable income of the corporation unless taking the full dividends received deduction would
cause or increase an NOL. In this case the dividends received deduction is limited to 70% of
taxable income.
2-16 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-31
Gross income:
From operations $660,000
Dividends 240,000 $900,000
Less: Expenses from operations
(720,000)
Income before the dividends received deduction
$180,000
Dividends received deduction (70% × $180,000)
(126,000)
Taxable income
$ 54,000
The dividends received deduction is limited to 70% of taxable income (before the dividends
received deduction) because taking 70% of $240,000 ($168,000) would not create a net
operating loss.
b. If Swallow Corporation owns 26% of Brown Corporation’s stock, the percentage for
calculating the dividends received deduction would be 80%. Under
taking the full dividends received deduction would create an NOL.
these circumstances,
Gross income:
From operations $660,000
Dividends 240,000 $ 900,000
Less: Expenses from operations (720,000)
Income before the dividends received deduction $ 180,000
Dividends received deduction (80% × $240,000) (192,000)
Net operating loss ($ 12,000)
The dividends received deduction is not limited to 80% of taxable income (before the
dividends received deduction) because taking 80% of $240,000 ($192,000) creates a net
operating loss.
54. (LO 3) Following the procedure used in Example 26 in the text, proceed as follows:
Step 1
Almond
Corporation
Blond
Corporation
Cherry
Corporation
70% × $100,000 (dividend received)
70% × $100,000 (dividend received)
70% × $100,000 (dividend received)
$70,000
$70,000
$70,000
Step 2
70% × $200,000 (taxable income before DRD)
70% × $50,000 (taxable income before DRD)
70% × $90,000 (taxable income before DRD)
$140,000
$35,000
$63,000
Step 3
Lesser of Step 1 or Step 2 $70,000
$63,000
Generates a net operating loss (use Step 1) $70,000
Consequently, the dividends received deduction for Almond Corporation is $70,000 under the general
rule. Blond Corporation also claims a dividends received deduction of $70,000 because a net
operating loss results when the Step 1 amount ($70,000) is subtracted from 100% of taxable income
before DRD ($50,000). Cherry Corporation, however, is subject to the taxable income limitation and
is allowed only $63,000 as a dividends received deduction.
2-18 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-32
55. (LO 3)
a. For 2016, the deduction for organizational expenditures is $5,422 {$5,000 (amount that can
be immediately expensed) + [($43,000 – $5,000) ÷ 180 months 2 months]}. Except for the
expenses related to the printing and sale of the stock certificates, all other expenses qualify
for the § 248 amortization election. Thus, organizational expenditures total $43,000 ($21,000
+ $3,000 + $19,000). To qualify for the election, the expenditure must be incurred before the
end of the taxable year in which the corporation begins business. Since the legal fees were
incurred in 2016, the $19,000 qualifies as organizational expenditures.
b. Organizational expenditures now total $52,000 ($21,000 + $3,000 + $28,000). Since
organizational expenditures exceed $50,000, the $5,000 first-year expensing limit is reduced
to $3,000 [$5,000 – ($52,000 – $50,000)]. Thus, the 2016 deduction for organizational
expenditures is $3,544 {$3,000 (amount immediately expensed) + [($52,000 – $3,000) ÷
180 months 2 months]}.
56. (LO 3) All $41,500 of the expenditures are startup expenditures. Egret can elect under § 195 to
currently write off the first $5,000 and to amortize the remaining amount of such expenditures
over a 180-month period beginning with the month in which it begins business (i.e., July 1, 2016).
Thus, Egret’s deduction in 2016 for startup expenditures is $6,217 {$5,000 + $1,217 [($41,500 –
$5,000) ÷ 180 months 6 months]}. Egret makes the § 195 election simply by claiming the
deduction on its 2016 tax return. (If Egret decides to forgo the § 195 election, the $41,500 must
be capitalized and is deductible only when the corporation ceases to do business and liquidates.)
57. (LO 4)
Purple Corporation:
Tax on—$65,000
Tax on $50,000 × 15% $ 7,500
Tax on $15,000 × 25% 3,750
Total tax $ 11,250
Azul Corporation:
Tax on—$290,000
Tax on $100,000 $ 22,250
Tax on $190,000 × 39% 74,100
Total tax $ 96,350
Pink Corporation:
Tax on—$12,350,000
Tax on $10 million
$3,400,000
Tax on $2,350,000 × 35% 822,500
Total tax $4,222,500
Turquoise Corporation:
Tax on $19,000,000 × 35% $6,650,000
Teal Corporation (a personal service corporation):
Tax on $130,000 × 35% $ 45,500
2-18 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-33
58. (LO 5) Since Red and White are members of a controlled group of corporations, and since they
did not consent to an apportionment plan, the marginal tax brackets are apportioned equally to
the two entities. As such, Red Corporation’s income tax liability is $42,325 [($25,000 × 15%) +
($12,500 × 25%) + ($12,500 × 34%) + ($80,000 × 39%)], and White Corporation’s income tax
liability is $69,625 [($25,000 × 15%) + ($12,500 × 25%) + ($12,500 × 34%) + ($150,000 ×
39%)]. (Note that the combined tax liability of $111,950 for the two corporations is equal to the
tax liability they would have incurred if they were taxed as one corporation with their combined
taxable income of $330,000.)
59. (LO 6) Grouse, a large corporation, may use the prior year’s tax liability exception only for purposes of
its first estimated tax payment for 2016. Any shortfall from not using the current year’s (2016) tax
liability for the first installment must be paid in conjunction with the second installment payment. As
such, Grouse’s installment payment dates and amounts are as follows:
Payment Amount
April 15, 2016 $ 59,500*
June 15, 2016 212,500 **
September 15, 2016 136,000
December 15, 2016 136,000
Total $544,000
*Based on preceding year’s tax, for first installment only: [$700,000 taxable income × 34% (see
Exhibit 2.1)] = $238,000 ÷ 4 = $59,500.
**Based on current year’s tax, for remaining installments: [$1,600,000 taxable income × 34% (see
Exhibit 2.1)] = $544,000 ÷ 4 = $136,000. Second installment must include shortfall from first
installment: [$136,000 + ($136,000 – $59,500)] = $212,500.
60. (LO 6) Emerald’s net income per books is reconciled to taxable income as follows:
Net income per books (after tax)
Plus:
$257,950
Items that decreased net income per books
but did not affect taxable income:
+ Federal income tax per books 41,750
+ Excess of capital losses over capital gains 6,000
+ Interest on loan to purchase tax-exempt bonds 1,500
+ Premiums paid on life insurance policy on life
of Albatross’s president 7,800
Subtotal $315,000
Minus:
Items that increased net income per books
but did not affect taxable income:
– Tax-exempt interest income
– Life insurance proceeds received as a result
(15,000)
of the death of the corporate president (150,000)
Taxable income $150,000
2-20 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-34
61. (LO 6) Sparrow’s net income per books is reconciled to taxable income as follows:
Net income per books (after tax)
Plus:
$174,100
Items that decreased net income per books
but did not affect taxable income:
+ Federal income tax per books
86,600
+ Excess of capital loss over capital gains 9,400
+ Interest paid on loan incurred to purchase
tax-exempt bonds 1,100
+ Nondeductible meals and entertainment 5,500
Subtotal $276,700
Minus:
Items that increased net income per books
but did not affect taxable income:
– Tax-exempt interest income (4,500)
– Excess of MACRS over book depreciation (7,200)
Taxable income $265,000
62. (LO 6) Dove’s unappropriated retained earnings per books, as of December 31, 2016, is determined as
follows:
Balance at beginning of year $ 796,010
Plus:
Net income (loss) per books 386,250
Subtotal $ 1,182,260
Minus:
Cash dividend distributions (150,000)
Balance at end of year $ 1,032,260
63. (LO 6) Pelican, Inc., reports the meals and entertainment expenditures on line 11, Part III as
follows: book expense of $10,000 in column (a), permanent difference of ($5,000) in column (c),
and tax return deduction of $5,000 in column (d). This problem illustrates reporting procedures when
book expenses are greater than tax return deductions. It also illustrates the reporting of permanent
differences.
64. (LO 6) Pelican, Inc., reports the fines and penalties on line 12, Part III as follows: book expense of
$50,000 in column (a), permanent difference of ($50,000) in column (c), and tax return deduction
of $0 in column (d). Further, Pelican, Inc., reports the depreciation on line 31, Part III as follows:
book expense of $245,000 in column (a), temporary difference of $65,000 in column (b), and tax
return deduction of $310,000 in column (d). This problem illustrates the Schedule M3 reporting
when book expenses are both more than and less than tax return deductions. It also illustrates the
reporting of both temporary and permanent differences.
65. (LO 6) These amounts must be reported on line 32, Part III as follows: $190,000 book bad debt
expense in column (a), ($130,000) temporary difference in column (b), and $60,000 tax return bad
debt expense in column (d). This problem illustrates reporting procedures when book expenses are
greater than tax return deductions. It also illustrates the reporting of temporary differences.
2-20 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-35
66. (LO 2, 3, 7) Organizational expenditures and startup expenditures were incurred in January, February,
and March. For both types of expenditures, the corporation can elect to expense the first $5,000
of qualifying expenditures and amortize the remaining balance over a period of 180 months. Don and
Steve should identify the organizational and startup expenditures that qualify, and decide whether
to make the elections. Since the elections are deemed to be made, a decision to forgo either
would require a statement to that effect attached to the corporation’s return.
The corporation must choose cost recovery methods and decide whether to elect immediate expensing
under § 179. It is also necessary to select an accounting method. The accrual method will be required
for sales and purchases of inventory, but the hybrid method may be chosen as the overall method.
This would allow use of the cash method for all items other than purchases and sales.
The corporation has a great deal of flexibility in selecting a fiscal or calendar year. The golf retail
business is generally seasonal in nature, so the corporation should consider electing a November 30,
January 31, or February 28 fiscal year.
If Don and Steve are family members (e.g., brothers) as defined under § 267 and the corporation
selects the accrual method of accounting, the accrued bonuses will not be deductible until the year of
payment. If the payment date is not changed, the deduction for bonuses will be disallowed, which
could result in underpayment of estimated payments, which would result in a penalty.
RESEARCH PROBLEMS
1. A PSC [as defined under § 441(i)(2)] must use the calendar year for reporting purposes, unless the
PSC can establish, to the satisfaction of the IRS, a business purpose for a fiscal year-end. [§ 441(i)(1);
a fiscal year can also be elected under the provisions of § 444.] Approval of the IRS to adopt (or change
to) a fiscal year under the business purpose exception is obtained by filing Form 1128, “Application to
Adopt, Change, or Retain a Tax Year” [Reg. §§ 1.441-1(c)(2)(i), 1.441-3(b)(1), and
1.442-1(b)(1)]. In determining whether a PSC has established a business purpose for a fiscal year,
consideration will be given to all of the facts and circumstances relating to the adoption of the fiscal
year, including the tax consequences resulting from such adoption [Reg. § 1.442-1(b)(2)].
Reasons sufficient to satisfy the business purpose standard:
Fiscal year coincides with the entity’s natural business year. [Reg. § 1.442-1(b)(2)] In general, a
natural business year exists if, for each of the three most recent 12-month periods that end with
the last month of the requested fiscal year, 25% or more of the entity’s gross receipts were
derived in the last two months of such requested fiscal year. (In addition to the 25% gross receipts
test, a natural business year can also be established under the annual business cycle test and the
seasonal business test.) [See Rev.Proc. 2002-39, 2002-1 C.B. 1046.] In some cases, a PSC
satisfying the 25% gross receipts test will be deemed to have established a business purpose and
obtain automatic IRS consent. [See Rev.Proc. 2006-46, 2006-2 C.B. 859.]
Reasons insufficient to satisfy the business purpose standard:
Deferral of income to shareholders [§ 441(i); Reg. § 1.442-1(b)(2)];
The use of a particular year for regulatory or financial accounting purposes;
The hiring patterns of a particular business;
The use of a particular year for administrative purposes;
2-22 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-36
The fact that a particular business involves the use of price lists, model years, or other items that
change on an annual basis;
The use of a particular year by related entities; and
The use of a particular year by competitors [Rev.Proc. 2002-39, 2002-1 C.B. 1046].
2. TAX FILE MEMORANDUM
Date: September 17, 2016
From: Leticia Ramirez
Subject: Startup expenditures of John’s Premium Steakhouse, Inc.
Today, I talked with John Dobson regarding the tax treatment of startup expenditures related to the
opening of a new restaurant. Mr. Dobson recently formed John’s Premium Steakhouse, Inc., with a
contribution of cash in exchange for 100% of the corporation’s stock. The corporation has since entered
in leases for a building and restaurant equipment. Mr. Dobson requested guidance on the tax treatment
of the various operating expenses the corporation expects to incur prior to the opening of the
restaurant.
At issue: What is the correct tax treatment of startup expenditures?
Conclusion: Section 195 governs the deductibility of startup expenditures. Under § 195(c)(1),
“startup expenditures” include amounts paid or incurred in connection with (1) investigating the
creation or acquisition of an active business or (2) creating an active business. In addition, startup
expenditures must be amounts that would be deductible as business expenses (under § 162) if
incurred in connection with the operation of an existing active business. Startup expenditures that
John’s Premium Steakhouse might incur include rent or lease expense, licensing fees, utilities,
employee salaries and benefits (e.g., for training and other work performed during the pre-opening
period), advertising, and food costs (e.g., testing menu items during the pre-opening period). Startup
expenditures do not include amounts paid for the purchase of depreciable property. Startup expenditures
also do not include organizational expenditures, but such amounts are deductible (under
§ 248) in the same manner as startup expenditures.
Under § 195(b), a taxpayer can elect to deduct the first $5,000 of startup expenditures and amortize
the remainder of expenditures over the 180-month period beginning with the month the business begins.
The $5,000 expensing amount is reduced to the extent startup expenditures exceed $50,000. Under
Reg. § 1.195-1(b), the election to deduct startup expenditures is deemed made by claiming the proper
deduction amount on the corporation’s tax return for the year in which the business begins.
(Alternatively, the corporation can forgo the election by including with the tax return a statement that
clearly indicates an election to capitalize startup expenditures. Capitalized expenditures are deductible
when the corporation ceases business and liquidates.)
The determination of when a business begins is important for two reasons. First, startup expenditures
are not deductible until such time the business begins. Second, once a business has begun, the startup
phase is done and further operating expenditures are deductible as trade or business expenses (under
§ 162). The IRS is authorized to prescribe regulations on when a business begins under § 195, but to
date no such regulations have been issued [§ 195(c)(2)(A)]. However, the deduction for
organizational expenditures has the same commencement of business requirement [see § 248(a)], and
Reg. § 1.248-1(d) provides that a “corporation begins business when it starts the business operations
for which it was organized.” Further, the courts have held that for purposes of § 195, a taxpayer is not
2-22 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-37
engaged in a business until such time the business has begun to operate as a going concern and
performed the activities for which it was formed. See, Richmond Television Corp. v. U.S., 65-1 USTC
¶9395, 15 AFTR 2d 880, 345 F.2d 901 (CA-4, 1965), vacated and remanded on other grounds, 86
S.Ct. 233 (USSC, 1965); and Yuri G. Glotov, 93 TCM 1339, T.C.Memo 2007-147. In the case of
John’s Premium Steakhouse, the startup phase would terminate and the active business would
commence when the restaurant begins serving meals to customers in the normal course of business.
3. TAX FILE MEMORANDUM
Date: May 2, 2016
From: Jonathan Smith
Subject: Tern Corporation
Facts: Tern Corporation, a calendar year C Corporation, is solely owned by Jessica Ramirez. Tern’s
only business since its incorporation in 2013 has been land surveying services. In Tern’s state of
incorporation, land surveying can be performed only by a licensed surveyor. Jessica, Tern’s only
employee, is a licensed surveyor. Jessica is not a licensed engineer. Upon audit of Tern’s 2013 and
2014 tax returns, the IRS asserted tax deficiencies stemming from its conclusion that the corporation
was a personal service corporation subject to the flat tax rate of 35%. Jessica believes that the IRS’s
determination is incorrect and she has requested advice on how to proceed.
At issue: Is Tern Corporation a personal service corporation under § 448(d)(2) and therefore subject
to the flat tax rate of 35%?
Conclusion: Section 11(b)(2) provides that the taxable income of a qualified personal service
corporation, as defined in § 448(d)(2), is subject to a flat tax rate of 35%. Under § 448(d)(2), a “qualified
personal service corporation” means any corporation that satisfies both a function test and an ownership
test. The function test requires that “substantially all of the activities” of the corporation involve the
performance of services in one of eight specified fields, including engineering [§ 448(d)(2)(A)].
The ownership test requires, in general, that substantially all of the stock of the corporation is owned
by employees (or retired employees) performing services for the corporation [§ 448(d)(2)(B)]. Since
Jessica owns 100% of Tern Corporation and is the corporation’s only employee, the ownership
test is not in question.
Temp. Reg. § 1.448-1T(e)(4)(i) provides that the field of engineering includes surveying. Further, the
provision notes that the “substantially all of the activities” requirement is satisfied if 95% or more of
the time spent by employees of the corporation is devoted to the performance of services in a
designated field (e.g., engineering). Thus, Tern is a personal service corporation as defined under Temp.
Reg. § 1.448-1T(e)(4)(i). In a recent case directly on point with our facts, a corporate taxpayer in the
business of land surveying was held to be a personal service corporation as defined by
§ 448(d)(2). In Kraatz & Craig Surveying Inc. [134 T.C. 167 (2010)], the taxpayer argued that Temp.
Reg. § 1.448-1T(e)(4)(i) was invalid in that it included surveying in the engineering field. The Tax
Court rejected that argument, however, by noting, in part, that the underlying legislative language
supported the regulation’s interpretation. [See, e.g., H. Rep. No. 99-841, 99th Cong., 2d Sess., 1986,
p. 285.] [The Tax Court also rejected the taxpayer’s argument that state law is determinative of what
is included in the field of engineering for purposes of § 448(d)(2).] Thus, the IRS’s determination that
Tern Corporation is a personal service corporation subject to the flat tax of 35% is correct and the tax
deficiency should be paid. In the future, an attempt should be made to reduce or eliminate Tern’s taxable
income through increased compensation payments to Jessica.
2-24 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-38
Research Problems 4 to 7
The Internet Activity research problems require that students utilize online resources to research and answer the
questions. As a result, solutions may vary among students and courses. You should determine the skill and
experience levels of the students before assigning these problems, coaching where necessary. Encourage students
to explore all parts of the Web in this research process, including tax research databases, as well as the websites of
the IRS, newspapers, magazines, businesses, tax professionals, other government agencies, and political outlets.
Students should also work with resources such as blogs, Twitter feeds, and other interest-oriented technologies to
research their answers.
2-24 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-39
CHECK FIGURES
26.a. Zero. 42.a. $10,500.
26.b. $7,000. 42.b. $12,500.
27.a. $589,765. 43.a. $105,000 taxable income; $24,200 tax.
27.b. Section 1231 gain of $571,812 and § 1250 43.b. $90,000 taxable income; $18,850 tax.
recapture of $17,953. 44.a. $21,000 deducted; $19,000 carried
28. $15,000.
forward.
29.a. $27,000. 44.b. $18,000 deducted; $22,000 carried back 3
29.b. $32,000.
years and forward 5 years.
29.c. $130,000. 45.a. Offset short-term capital gain of $15,000
30.a. $70,000.
against net long-term capital loss of
30.b. $154,000.
$105,000. The $90,000 net capital loss
31. $3,650.
must be carried back 3 years against net
32.a. $12,000.
capital gains.
32.b. $3,680,000. 45.b. Total carryback $63,000.
32.c. $59,500. 45.c. $27,000; carry forward to 2017, etc.
33.a. Roger will report profit $45,000 and long- 45.d. Deduct $18,000 in 2016, $87,000 carried
term capital loss $10,000.
forward indefinitely.
33.b. Riflebird taxable income $45,000 and 46.a. Ordinary income of $57,498 and § 1231
$10,000 STCL carryback. Roger no
gain of $429,994.
consequences. 46.b. Section 1231 gain of $487,492.
34.a. Each partner reports $55,000 net profit 47.a. $430,000.
and long-term capital gain $7,500. 47.b. $355,000.
34.b. Same as part a. 48. $118,500.
34.c. Corporation reports $125,000 income. 49. Sell Brown stock and donate proceeds.
Shareholders each report $25,000 50. Gift land in 2017.
dividend income. 51. 2016.
35.a. Azure tax of $119,000; Sasha $0 tax. 52.a. $81,000.
35.b. Azure tax of $119,000; Sasha $15,000 tax. 52.b. $75,000.
35.c. Azure tax of $90,500; Sasha $29,700 tax. 53.a. $54,000.
35.d.
35.e.
36.a.
Azure tax of $0; Sasha $138,600 tax.
Azure tax of $0; Sasha $138,600 tax.
Taupe tax of $0; Torsten tax of $172,320.
53.b.
54.
($12,000).
Almond $70,000; Blond $70,000; Cherry
$63,000.
36.b. Taupe tax of $153,000; Torsten $0 tax. 55.a. $5,422.
37.a. After-tax income $153,861. 55.b. $3,544.
37.b. After-tax income $125,137. 56. $6,217.
37.c.
38.a.
38.b.
After-tax income $109,761.
$17,400 itemized deduction.
$40,000.
57. Purple $11,250; Azul $96,350; Pink
$4,222,500; Turquoise $6,650,000; Teal
$45,500.
39.a. $49,500. 58. Red $42,325; White $69,625.
39.b. $40,500. 59. April 15, $59,500; June 15, $212,500;
39.c. $41,750.
September 15, $136,000; December 15,
39.d. $46,875.
$136,000.
40.a. $84,000. 60. Taxable income of $150,000.
40.b. $33,250. 61. Taxable income of $265,000.
41.a. $440,000. 62. $1,032,260.
41.b. $460,000.
2-26 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-40
SOLUTION TO ETHICS & EQUITY FEATURE
Pushing the Envelope on Year-End Planning (p. 2-19). Currently, Lark Corporation’s dividends received
deduction is $98,700, as limited by the taxable income limitation ($497,000 – $556,000 + $200,000 =
$141,000 taxable income before the dividends received deduction × 70% = $98,700). The NOL rule does not
currently apply since subtracting $140,000 ($200,000 × 70%) does not yield a negative number. However, if
the tax department’s recommendation is implemented and deductible expenditures are increased by $1,001 by
year end, the NOL rule would apply: $141,000 – $1,001 = $139,999 revised taxable income before the
dividends received deduction – $140,000 dividends received deduction = ($1) NOL. Thus, an additional
$1,001 of deductible expenditures would increase Lark’s dividends received deduction by $41,300 ($140,000
– $98,700). There is nothing unethical about this year-end tax planning strategy. As long as the additional
expenditures satisfy the requirements for a trade or business deduction, the strategy should be successful in
taking advantage of the NOL rule. If Congress is concerned about year-end tax planning techniques such as
this, it certainly has the authority to amend the dividends received deduction provisions (see, e.g., holding
period and debt-financed stock restrictions). Until such time, however, taxpayers should not be faulted for
taking advantage of legitimate tax saving opportunities.
SOLUTIONS TO ROGER CPA REVIEW QUESTIONS
Detailed answer feedback for Roger CPA Review questions is available on the instructor companion site
1. d
2. b
3. d
4. a
5. c
6. b
7. d
2-26 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-41
TAX RETURN PROBLEMS
Problem 1: Pet Kingdom Corporate Tax Return
2-28 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-42
Corporations: Introduction and Operating Rules
2-29
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Corporations: Introduction and Operating Rules
2-31
2-32 2017 Corporations Volume/Solutions Manual
2-32 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-32
Corporations: Introduction and Operating Rules
2-33
2-34 2017 Corporations Volume/Solutions Manual
2-34 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-34
Corporations: Introduction and Operating Rules
2-35
2-36 2017 Corporations Volume/Solutions Manual
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Corporations: Introduction and Operating Rules
2-37
2-38 2017 Corporations Volume/Solutions Manual
(a) Name of officer
(b) Social security number
(c) Percent of
time devoted to
business
Percent of stock owned
(f) Amount of
compensation
(d) Common (e) Preferred
1 Janet Morton
123-45-6789
100.00%
50.00%
%
262,500
Kim Wonq
987-65-4321
100.00%
50.00%
%
262 500
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
2
525,000
3
4
525,000
Form 1125-E
Compensation of Officers
(Rev December 2013)
... Attach to Form 1120, 1120-C, 1120-F, 1120-REIT, 1120-RIC, or 11205
OMB No. 1545-2225
Department of the Treasury
Internal Revenue Service
..,.. Information about Form 1125-E and its se arate instructions is at www.irs. ov/form1125e.
Name Employer identification number
Pet Kin dam Inc. 11-1111111
Note. Complete Form 1125-E only if total receipts are $500,000 or more. See instructions for definition of total receipts
2 Total compensation of officers .
3 Compensation of officers claimed on Form 1125-A or elsewhere on return
4 Subtract line 3 from line 2. Enter the result here and on Form 1120, page 1, line 12 or the
appropriate line of your tax return .
For Paperwork Reduction Act Notice, see separate instructions.
HTA
Form 1125-E (Rev 12-2013)
2-38 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-38
Corporations: Introduction and Operating Rules
2-39
2-40 2017 Corporations Volume/Solutions Manual
2-40 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-40
Pet Kingdom, Inc 11-1111111
Line 6, Sch L (1120) - Other Current Assets
1
2
3
Certificates of De~osit 1
Beoinnino
End
400000
400,000
Federal Income Tax Refund Due 2
3,977
Total other current assets 3
400000
403,977
Line 9 Sch L 1120 - Other Investments
End
1 Stock Investments
1 1,125,000
2 Total other investments 2 1,125000
Line 14, Sch L 1120 - Other Assets
1 Other Assets
Be End
1 128,500
2 Total other assets 2 128,500
Line 18, Sch L 1120 - Other Current Liabilities
Be innin End
1 Other Current Liabilities
1 175,000 155000
2 Total other current liabilities 2 175000 155,000
© 2015 Universal Tax Systems Inc and/or its affiliates and licensors All rights reserved
2-40 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-42
Corporations: Introduction and Operating Rules
2-41
2-42 2017 Corporations Volume/Solutions Manual
Problem 2: Kingfisher Corporate Tax Return
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Corporations: Introduction and Operating Rules
2-43
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Corporations: Introduction and Operating Rules
2-45
2-46 2017 Corporations Volume/Solutions Manual
2-46 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-46
Form 1125-A
(Rev December 2012)
Department of the Treasury
Internal Revenue Serv ce
Cost of Goods Sold
•
•
Attach to Form 1120, 1120-C, 1120-F, 11205, 1065, or 1065-B.
Information about Form 1125-A and its instructions is atwww.irs.gov/form1125a.
OMB No. 1545-2225
Name
Kinafisher Corooration
Employer identification number
11-1111111
1
900 000
2
1 032 000
3
4
5
6
1 932 000
7
1 012 000
8
920 000
1 Inventory at beginning of year .
2 Purchases.
3 Cost of labor
4 Additional section 263A costs (attach schedule).
5 Other costs (attach schedule).
6 Total. Add lines 1 through 5
7 Inventory at end of year .
8 Cost of goods sold. Subtract line 7 from line 6 Enter here and on Form 1120, page 1, line 2
or the appropriate line of your tax return (see instructions)
9 a Check all methods used for valuing closing inventory:
(i)D Cost
(ii)[RJ Lower of cost or market
(iii)D Other (Specify method used and attach explanation.) •
b Check if there was a writedown of subnormal goods
. ... • D
c Check if the LIFO inventory method was adopted this tax year for any goods (if checked attach Form 970) .
d If the LIFO inventory method was used for this tax year enter amount of closing inventory
computed under LIFO
e If property is produced or acquired for resale do the rules of section 263A apply to the entity (see instructions)?.
Was there any change in determining quantities, cost or valuations between opening and closing inventory? If
"Yes," attach explanation.
For Paperwork Reduction Act Notice, see instructions.
HTA
•D
rt•
rt-
Form 1125-A(Rev12-2012)
2-46 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-47
2-48 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-48
(a) Name of officer
(b) Social security number
(c) Percent of
time devoted to
business
Percent of stock owned
(f) Amount of
compensation
(d) Common (e) Preferred
1 Nancy Trout
123-45-6789
100.00%
50.00%
%
160,000
Delores Lake
987-65-4321
100.00%
50.00%
%
160 000
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
%
2
320,000
3
4
320,000
Form 1125-E
Compensation of Officers
(Rev. December 2013)
... Attach to Form 1120, 1120-C, 1120-F, 1120-REIT, 1120-RIC, or 11205
OMB No. 1545-2225
Department of the Treasury
Internal Revenue Service
..,.. InformationaboutForm 1125-E and its se arate instructionsis at www.irs. ov/form1125e.
Name Employer identification number
11-1111111
Note. Complete Form 1125-E only if total receipts are $500,000 or more. See instructions for definition of total receipts.
2 Total compensation of officers .
3 Compensation of officers claimed on Form 1125-A or elsewhere on return
4 Subtract line 3 from line 2. Enter the result here and on Form 1120, page 1, line 12 or the
appropriate line of your tax return .
For Paperwork Reduction Act Notice, see separate instructions.
HTA
Form 1125-E (Rev 12-2013)
2-48 2017 Corporations Volume/Solutions Manual Corporations: Introduction and Operating Rules 2-49
2-50 2017 Corporations Volume/Solutions Manual
NOTES
CHAPTER 2
CORPORATIONS: INTRODUCTION AND
OPERATING RULES
LECTURE NOTES
OVERVIEW
For Federal income tax purposes, the distinctions among forms of business organization are
critical. This chapter discusses the tax treatment of sole proprietorships, partnerships, regular
corporations, and limited liability companies. Main topics include: (1) tax treatment of various
business forms, (2) an introduction to the income taxation of corporations, (3) determining the
corporate income tax liability, (4) procedural matters, and (5) tax planning.
SUMMARY OF CHANGES IN THE CHAPTER
The following are notable changes in the chapter from the 2016 Edition. For major changes, see
the Preface to the Instructor’s Edition of the text.
Added a Concept Summary comparing the tax attributes of various forms of business
entities.
Added a Concept Summary on Schedule M–1 (Form 1120).
Added a new Tax in the News feature and a new Global Tax Issues feature.
Updated text to reflect new filing due dates for corporations.
Updated text and examples throughout the chapter.
The Big Picture
Samantha Johnson owns Skylark Bakery, a sole proprietorship, which generates an annual
operating profit of $100,000. In addition, the bakery earns annual dividends of $5,000 from
investing excess working capital in the stock of publicly traded corporations. Samantha is in
the 33% marginal tax rate bracket irrespective of the bakery. In the past, Samantha has
withdrawn $50,000 annually from the bakery.
If Samantha conducts the business as a regular C corporation, what would be the annual
income tax savings (or cost)? For purposes of this analysis, use the 2016 tax rates and ignore
any employment tax or state tax considerations.
2.1 TAX TREATMENT OF VARIOUS BUSINESS FORMS
1. Business forms include sole proprietorships, partnerships (covered in Chapters 10 and
11), trusts and estates (covered in Chapter 20), S corporations (covered in Chapter 12),
regular corporations, and limited liability companies.
2-2 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-2
Chapter 2 – Corporations: Introduction and Operating Rules
Sole Proprietorships
2. A sole proprietorship is not a taxable entity separate from its owner. Net income or loss
from the proprietorship is computed on Schedule C and reported as part of the
proprietor’s income on Form 1040. Thus, the proprietor pays tax on the profits of the
proprietorship.
3. The proprietor reports all of the net profit from the business, regardless of the amount
actually withdrawn during the year.
4. Income and expenses retain their character when reported by the proprietor.
Example: Sweet operates a candy store as a sole proprietorship. He earned a profit of
$75,000 during the year and withdrew $40,000 from the proprietorship. Sweet must
report the $75,000 as net income from the proprietorship on his personal tax return.
Partnerships
5. Partnerships are tax-reporting, but not taxpaying, entities. A partnership reports its
income on Form 1065.
6. Each partner receives a Schedule K–1 that reports the partner’s share of ordinary business
income (loss) along with each separately reported pass-through item. Schedule K–1 items
are reported on each partner’s tax return. (Example 2)
Corporations
7. There are two types of corporations for tax purposes: corporations governed by
Subchapter C (C corporations) and corporations governed by Subchapter S
(S corporations).
8. S corporations have the following characteristics:
a. Generally do not pay Federal income taxes.
b. Similar to partnerships in that operating income (loss) flows through to the
shareholders. Like partnerships, all income and expense items are not aggregated
when computing ordinary business income (loss). Certain items retain their
separate character.
c. Income and expense items “pass through” to shareholders, who report their share
of the partnership items on their own returns. Items are allocated to shareholders
according to their stock ownership interests.
9. Regular C corporations are subject to entity-level taxation. Other characteristics include:
2-3 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-3
Chapter 2 – Corporations: Introduction and Operating Rules
a. C corporation reports its income and expenses on Form 1120.
b. Dividends paid are not deductible by the corporation.
Example: A C corporation has revenues of $80,000, has operating expenses of
$60,000, and paid dividends of $10,000. Net income for the year is $20,000, since
the dividends are not deductible by the corporation.
c. When a corporation distributes its income, the shareholders report dividend
income on their own returns. Since the corporation pays tax on corporate income,
this entity-level tax, along with the tax paid by shareholders on the distribution of
that income as a dividend, results in income earned by a C corporation being
subject to “double taxation.” (Examples 3 and 4)
10. Taxation of Dividends.
a. Closely held corporations may attempt to avoid the double taxation by disguising
a dividend distribution as some other purported transaction.
(1) One common way is to pay excessive compensation to shareholder-
employees.
(2) The IRS scrutinizes compensation and other economic transactions (e.g.,
salaries, interest, or rents) between closely held corporations and their
shareholders for reasonableness.
b. Dividend eligibility for the capital gains rates alleviates some of the double
taxation effect.
(1) The current tax rate applicable to qualified dividend income (and long-
term capital gains) is 15% or, for taxpayers in the 39.6% marginal tax
bracket, 20% (0% for taxpayers in the 10% or 15% marginal tax brackets).
(2) A 3.8% Medicare surtax applies to net investment income in excess of
modified adjusted gross income of $200,000 ($250,000 if married filing
jointly), thus increasing the double taxation of dividend income for high-
income taxpayers.
ADDITIONAL LECTURE RESOURCE
According to the Tax Policy Blog, the official blog of the Tax Foundation (“U.S. Corporate
Revenue Is Low Because High Taxes Have Shrunk the Corporate Sector,” September 18, 2014,
William McBide):
2-4 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-4
Chapter 2 – Corporations: Introduction and Operating Rules
“Pass-through businesses are subject to just one layer of tax, the individual income tax, while C
corporations face double taxation due to the corporate tax and shareholder taxes on dividends
and capital gains. The U.S. corporate tax rate is the highest in the developed world, at 39%
including state corporate taxes.
Pass-through businesses have grown dramatically such that more than 90% of U.S. businesses
are pass-through entities, mainly S corporations, partnerships and sole proprietorships. While the
number of pass-through businesses has been growing, the number of C corporations has been
shrinking over the last 27 years. The Tax Reform Act of 1986 reduced the corporate tax rate, but
reduced the individual tax rate further, and raised taxes on corporations in other ways. That
marked the peak of U.S. C corporations, at 2.6 million in 1986. As of 2011 (most recent data),
there are now 1 million fewer corporations, at 1.6 million. In contrast, S corporations grew from
about 800 thousand in 1986 to 4.2 million in 2011, and partnerships grew from 1.7 million to 3.3
million.”
11. Comparison of Corporations and Other Forms of Doing Business.
a. Consideration of tax factors requires an examination of corporate rate structure
(Exhibit 2.1).
(1) The marginal tax rate for corporations ranges from 15% to 35%. The
marginal rates for individuals range from 15% to 39%. Therefore, in many
cases, the tax burden will be greater if a business is operated as a
corporation.
(2) In other cases, when the corporate marginal tax rate is lower than the
individual marginal rate, the corporate form of doing business presents tax
savings opportunities. (Example 6) Be sure to consider the double taxation
effect (including the preferential rate for dividend income) and the
character of business income, employment taxes, and other tax issues.
(Example 7)
b. With a C corporation.
(1) Tax attributes of the income and expense items do not pass through to the
shareholders. As a result, if the business is expected to generate tax-
favored income (e.g., tax-exempt income or long-term capital gains), one
of the other (non-C corporation) forms of business may be desirable.
(2) Since C corporation losses have no effect on the taxable income of the
shareholders, one of the non-C corporation forms of business may be
desirable if business losses are anticipated. (Example 8)
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c. The combined corporation-employee payroll tax burden should be compared with
the self-employment tax associated with the proprietorship and partnership forms
of business.
(1) Income of a proprietorship subject to self-employment tax. Deduction
available to individual for part of self-employment taxes paid.
(2) Wages paid to a shareholder-employee of a C or S corporation are subject
to payroll taxes.
d. At the entity level:
(1) State corporate income taxes and/or franchise taxes are applicable to
corporations.
(2) No entity-level Federal taxes on S corporations, limited liability
companies, or partnerships. But can be state income or franchise taxes.
(3) State income tax laws may not have rate preference for dividends from
corporate distributions.
12. Nontax Considerations.
a. Nontax considerations may override tax considerations. Factors to consider
include:
Limited liability for corporate shareholders. Unlimited liability for sole
proprietors and general partners in partnerships.
Ability to raise large amounts of capital using the corporate form.
Free transferability of ownership interests in corporation.
Continuity of life for the corporate form of business.
Centralized management of a corporation. Limited partnerships may also
have centralized management, which is essential for the smooth operation
of a widely held business.
Limited Liability Companies
13. A limited liability company (LLC) offers a very important nontax advantage (unlimited
liability) plus the tax advantage of being treated as a partnership (or proprietorship, in the
case of a single-member LLC) and avoiding the double taxation problem associated with
C corporations.
a. All 50 states and the District of Columbia recognize LLCs.
b. States vary in the corporate characteristics allowed to LLCs.
c. LLC owners are called members.
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14. Entity Classification.
The IRS eased the entity classification problem by issuing check-the-box Regulations.
a. Regulations enable taxpayers to choose the tax status of a business entity without
regard to its corporate or noncorporate characteristics.
b. Under these Regulations, an unincorporated entity with more than one owner is
by default classified as a partnership.
c. An unincorporated entity with only one owner is, by default, classified as a
disregarded entity (DRE) and treated as a sole proprietor.
d. If an entity wants to use its default status, it simply files the appropriate tax return.
e. Under the default rules, if no election is made, multi-owner entities are treated as
partnerships and single-owner entities are sole proprietorships. New entities using
a default classification should not file Form 8332.
f. If the entity wants to use a status other than the default status, or if it wants to
change its status, Form 8832 (Entity Classification Election) is used to “check the
box” (Reg. §§ 301.7701–1 through –4 and –7).
(1) An LLC can therefore be taxed as a C corporation or S corporation.
(2) Since LLCs are not treated as being incorporated under state law, they
default to partnership or DRE status.
g. The “check-the-box” election is not available to entities incorporated under state
law or that are required to be treated as corporations under Federal law (i.e.,
publicly traded partnerships).
2.2 AN INTRODUCTION TO THE INCOME TAXATION OF CORPORATIONS
An Overview of Corporate versus Individual Income Tax Treatment
15. There are similarities and differences between the taxation of corporations and
individuals. See Exhibit 2.2—Tax Formulas.
16. Similarities:
a. Gross income is computed in much the same manner for corporations and
individuals.
(1) Both are entitled to exclusions from income. Corporate taxpayers are
allowed fewer exclusions.
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b. Tax rules applying to property transactions of corporations and noncorporate
taxpayers are similar.
(1) The definition of capital assets (§ 1221) does not differ across taxpayers.
(2) Deferral on like-kind exchanges and involuntary conversion are also
available to both types of taxpayers.
(3) The exclusion permitted by § 121 (the sale of a personal residence) does
not apply to corporations. This last point seems simple enough, but
consider the following example:
Example: Ed is employed as general manager of Green Brewing
Corporation. In this capacity, Ed is in charge of quality control, a feature
highly touted by Green in advertising to its customers. To maintain
constant quality control, Ed is required to live in a residence owned by
Green and located adjacent to its brewery. If Green sold this residence for
a gain, it may not use § 121 to exclude such gain. Had the residence been
owned by Ed (and not Green Brewing Corporation), § 121 would be
available to Ed.
(4) Disallowance of losses on sales of property to related parties and on wash
sales of securities applies to both individuals and corporations.
c. Business deductions for corporations parallel those available to individuals.
(1) No distinction between business and nonbusiness interest or business and
nonbusiness bad debts for corporations.
d. Credits that are personal in nature (child care, earned income) are naturally not
available to corporations.
17. Dissimilarities:
a. Different tax rates apply to corporations and individuals.
b. All allowable corporate deductions are treated as business deductions.
(1) AGI has no relevance to corporations.
(2) Corporations have no itemized deductions, no standard deduction, and no
personal and dependency exemptions.
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Specific Provisions Compared
18. See Concept Summary 2.2 for a comparison of the income taxation of individuals and
corporations.
Accounting Periods and Methods
19. Accounting Periods.
a. C corporations generally may choose a calendar year or a fiscal year for reporting
purposes.
b. Corporations can have different tax years for their shareholders.
c. A PSC must generally use a calendar year [§ 441(i)]. However, it may elect a
fiscal year if:
(1) It can show a business purpose (i.e., a natural business year); or
(2) The PSC year results in a deferral of not more than three months’ income.
An election under § 444 is required, and the PSC will be subject to the
deduction limitations of § 280H. Under the latter provision, a PSC’s
deduction for shareholder-employee salaries will be limited if payment of
those salaries is disproportionately postponed beyond December 31.
(Examples 9 and 10)
(3) A PSC has as its principal activity the performance of personal services,
and such services are substantially performed by shareholder-employees.
The performance of services must be in the fields of health, law,
engineering, architecture, accounting, actuarial science, performing arts, or
consulting [§ 448(d)(2)(A) and Reg. § 1.441–3(d)(1)].
ADDITIONAL LECTURE RESOURCE
PSC Substantially All Activity Test. As to the function requirement, Temp. Reg. § 1.448–
1T(e)(4) provides that the “substantially all” test is met if 95% or more of the time spent by
employees of the corporation is devoted to performing services in qualifying fields. A case
addressing the function requirement is Grutman-Mazler Engineering, Inc., 95 TCM 1551,
T.C.Memo. 2008–140.
Similarly, Temp. Reg. § 1.448–1T(e)(5) establishes a 95% or more threshold for satisfying the
stock ownership requirement. For a case addressing the ownership requirement, see Robertson
Strong & Apgar Architects, PC, T.C. Summary Opinion 2007–48.
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ADDITIONAL LECTURE RESOURCE
What Year-End Do Corporations Use? McDonald’s Corporation and Ford Motor Corporation,
along with the majority of corporations, have a calendar year-end. Best Buy and Macy’s, both
retailers, have January year-ends, closing out their books after the rush of the busy holiday
season. Vail Resorts, Inc., which operates ski resorts in Colorado, Minnesota, and Utah, has a
July 31 year-end, the slowest time of the year for its business.
20. Accounting Methods.
a. The cash method of accounting, available to individuals, is not available to most
regular corporations (§ 448). Cash method is allowed for:
(1) S corporations.
(2) Qualified PSCs.
(3) Corporations with average annual gross receipts of $5 million or less for
the most recent three-year period.
b. Regardless of these exceptions, most individuals and corporations that maintain
inventory for sale to customers are required to use the accrual method of
accounting for determining sales and cost of goods sold.
(1) As a matter of administrative convenience, the IRS will permit many
taxpayers to use the cash method for determining sales and cost of goods
sold.
(2) This includes any entity with average annual gross receipts of not more
than $1 million for the most recent three-year period, and some entities
with average annual gross receipts of not more than $10 million for the
same three-year period (Rev.Proc. 2001–10, 2001–1 C.B. 272 and
Rev.Proc. 2002–28, 2002–1 C.B. 815).
c. If a corporation uses the accrual method of accounting, and it has an accrual
outstanding at the end of any taxable year with respect to a related party, it
cannot claim a deduction until the related party reports the amount as income
[§ 267(a)(2)]. (Example 11)
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ADDITIONAL LECTURE RESOURCE
Related-Party Limitation. The § 267(a)(2) limitation on deducting accrued expense paid to
related parties affects many closely held corporations, particularly those that are family owned.
For purposes of the more-than-50% shareholder test, an individual is deemed to own the stock
owned, directly or indirectly, by family members (i.e., siblings, spouse, ancestors, and lineal
descendants) [§ 267(c)]. When a corporation’s stock is only owned by family members, each
shareholder will be a related party under the more-than-50% test. For many family-owned
(accrual basis) corporations then, § 267(a)(2) will affect the deductibility of many different types
of accrued expenditures (e.g., salary, bonus, interest, rent, and lease).
Example: Three brothers (cash-basis, calendar year taxpayers) own all of the stock in Brown
Corporation (accrual-basis, calendar year taxpayer) and are its principal employees. After a
particularly profitable year, in December 2016, Brown declares a bonus payable to each of its
employees. Brown also accrues interest owed on amounts borrowed from its shareholders. The
bonuses and interest are not paid until January 2017. Under the stock attribution rules of § 267,
each of the brothers is deemed to own 100% of the stock of Brown. As a result, the bonuses
attributable to the brothers and all of the interest are not deductible by Brown Corporation until
2017.
Return to the Big Picture
(Example 11) Samantha incorporates her business as Skylark Bakery, Inc., a calendar year,
accrual method C corporation. Samantha, a cash method taxpayer, owns 100% of the
corporation’s stock at the end of 2015. On December 31, 2015, Skylark Bakery has accrued a
$10,000 bonus to Samantha. Samantha receives the bonus in 2016 and reports it on her 2016
tax return. Because of the special rule dealing with cash-basis-related parties, Skylark Bakery
cannot claim a deduction for $10,000 until 2016.
Capital Gains and Losses
21. Differences exist in corporate and individual taxpayers’ treatment of capital gains and
losses.
a. Net capital gains of corporations are not eligible for lower rates, as are net capital
gains of individuals.
b. Corporate capital losses may only offset capital gains while individuals may
deduct up to $3,000 of losses in excess of capital gains.
c. Excess corporate capital losses are carried back three and forward five years to
offset capital gains, while capital losses of individuals are carried forward
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indefinitely. When corporations carry over capital losses, they are treated as short
term. For individuals, capital losses retain their original status as long term or
short term [§ 1211(a) and 1212(a)]. (Examples 12 and 13)
Recapture of Depreciation
22. § 291 requires additional § 1250 depreciation recapture by corporations.
a. The corporation will have additional ordinary income equal to 20% of the excess
of the amount of depreciation recapture that would arise if the property was
§ 1245 property over the amount of depreciation recapture computed under
§ 1250.
b. The result is a recharacterization of what would otherwise be § 1231 gain as
ordinary income. (Example 14)
Passive Activity Losses
23. Passive activity loss limitations apply to individuals, closely held C corporations, and
personal service corporations (PSCs).
a. For S corporations and partnerships, the passive activity loss rules are applied at
the owner level.
b. A corporation is closely held if, at any time during the last half of the taxable
year, more than 50% of the value of the corporation’s outstanding stock is owned,
directly or indirectly, by or for not more than five individuals.
(1) Closely held C corporations can offset passive activity losses against net
active income, but not portfolio income.
c. PSCs generally cannot deduct passive activity losses against either active income
or portfolio income. (Example 15)
Charitable Contributions
24. Corporations are subject to limitations on their charitable contributions.
a. For accrual-basis corporations, there is an exception to the rule that deductions for
charitable contributions are allowed only for the year in which payment is made.
Corporations may deduct charitable contributions in the year preceding payment
if the contribution is authorized by the board of directors by the end of that year
and is paid on or before the fifteenth day of the third month of the next year.
(Example 16)
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Example: ABC Corporation uses the accrual method of accounting and the
calendar year as its tax year. The board of directors authorizes a cash contribution
on November 3, 2016, that the corporation pays on March 10, 2017. The
corporation can deduct the contribution in 2016. If the contribution is not paid
until April 1, 2017, the corporation cannot deduct the contribution until 2017.
b. The general rule that measures the amount of the deduction as fair market value on
the date of the donation for long-term capital gain property and adjusted basis (or
fair market value, if lower) for ordinary income property (appreciated property that,
if sold, would not result in long-term capital gain) applies to corporations as well as
individuals. However, there are exceptions to the general rule. (Example 18)
(1) If a corporation contributes tangible personal property and the charitable
organization puts it to an unrelated use, the deduction is limited to the
basis of the property. (Examples 19 and 20)
(2) Contributions of capital gain property to certain private nonoperating
foundations are limited to the basis of the property donated.
(3) Contributions of inventory by corporations to charities for use in their
exempt purpose and solely for the care of the ill, needy, or infants, or
where the property is used for research purposes under specified
conditions are subject to special rules. The deduction is measured by the
adjusted basis of the property plus 50% of the appreciation on the
property. (Examples 17 and 21)
Example: Rose Instruments, Inc., a scientific equipment manufacturer,
donates inventory (basis of $30,000, fair market value of $70,000) to a
qualified nonprofit university that will use the equipment in its scientific
research endeavors. The amount of the charitable contribution is $50,000
[$30,000 basis + 0.5($70,000 fair market value – $30,000 basis)], which is
less than the ceiling of $60,000 (2 × $30,000 basis).
c. The annual deduction for corporations is limited to 10% of taxable income
computed without regard to the charitable contribution deduction, net operating
loss or capital loss carrybacks, dividends received deduction, and domestic
production activities deduction.
(1) Any contribution in excess of the 10% limitation is carried forward for
five years.
(2) Any carryforward must be added to subsequent contributions and is
subject to the 10% limit. The current year’s contributions must be
deducted first, with carryover amounts from previous years deducted in
order of time. (Examples 22 and 23)
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ADDITIONAL LECTURE RESOURCE
Charitable Contributions of Inventory. The Regulations provide guidance on determining
whether inventory is related to a qualified organization’s exempt purpose or function. The
Regulations also elaborate on the requirement that the corporate donor receive a written
statement from the qualified organization regarding the use and disposition of donated inventory
[§ 170(e)(3)(A)(iii)], as well as the determination of inventory basis (Reg. § 1.170A–4A). In
some cases, the disposition of inventory by a donee within three years of the date of contribution
will result in recapture (gross income) to the corporation, equal to the excess of the corporation’s
charitable deduction for the inventory over its basis in such property [§ 170(e)(7)]. For a recent
ruling where the enhanced inventory deduction was disallowed due to inadequate substantiation,
see NSAR 2011380IF (August 15, 2011).
Domestic Production Activities Deduction
25. Domestic production activities deduction (DPAD) is based on the income from
manufacturing activities (§ 199) (see Chapter 3 for a detailed discussion).
a. DPAD is the lower of the following (Example 24):
9% of qualified production activities income.
9% of taxable income (modified adjusted gross income for individuals).
50% of W–2 wages related to the qualified production activities income.
ADDITIONAL LECTURE RESOURCE
What Business Activities Are Eligible for the DPAD? Many taxpayers think that they must be
in a manufacturing business in order to be eligible for the DPAD. Not true! According to IRC
§ 980D, some of the industries that qualify include any qualified film produced by a taxpayer in
the United States; electricity, natural gas, or potable water produced in the United States;
construction performed in the United States; and engineering or architectural services performed
in the United States for construction projects located in the United States [§ 199(c)(4)].
Unfortunately, the sale of food and beverages prepared by the taxpayer at a retail establishment
does not apply.
Net Operating Losses
26. Individual and corporate taxpayers may have net operating losses (NOLs) that can be
carried back two years and forward 20 years to offset taxable income.
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a. Corporations do not adjust their tax losses for capital losses, because they are not
permitted a deduction for net capital losses.
b. Corporations do not make adjustments for nonbusiness deductions or for personal
exemptions as individuals do.
c. Corporations include their dividends received deduction in computing the NOL.
(Example 25)
d. Like individuals, corporations may elect to forgo the carryback period.
Deductions Available Only to Corporations
27. The dividends received deduction (DRD) is for dividend distributions received from
other domestic corporations. Dividends from foreign corporations generally do not
qualify—see § 245(a).
a. The purpose of DRD is to mitigate (or eliminate) the triple taxation of corporate-
source income.
b. The amount of the DRD is determined as follows:
Percentage of Ownership
by Corporation Shareholder
Deduction
Percentage
Less than 20% 70%
20% or more but less than 80% 80%
80% or more and payor corporation is a member
of an affiliated group with the payee corporation 100%
Example: During all of the current year, Silver Corporation (a calendar taxpayer)
owned 4% of Bronze Corporation and 21% of Copper Corporation. Dividends
received are $50,000 from Bronze Corporation and $100,000 from Copper
Corporation. Presuming the percentage of taxable income limitation does not
apply, DRD = $115,000 [(70% × $50,000) + (80% × $100,000)].
c. The DRD is limited to a percentage of its taxable income.
(1) Computed without regard to the NOL deduction, DPAD, DRD, and any
capital loss carryback to the current tax year.
(2) The percentage of taxable income limitation corresponds to the deduction
percentage.
Example: Assume the same facts as in the preceding example. The taxable
income percentage limitation for Silver Corporation is 70% for Bronze
Corporation dividends and 80% for Copper Corporation dividends.
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d. The taxable income limitation does not apply if the DRD would create or increase
a net operating loss for the current taxable year or in the case of the 100% DRD
available to members of an affiliated group.
e. In working with this myriad of rules, the following steps are useful:
Multiply the dividends received by the deduction percentage.
Multiply the taxable income by the deduction percentage.
DRD is limited to the lesser of step 1 or step 2, unless deducting the
amount derived in step 1 results in an NOL. If so, the amount derived in
step 1 should be used. This is referred to as the NOL rule (Example 26).
f. Dividends on stock held for 45 days or less during the 91-day period surrounding
the ex-dividend date (90 days during the 181-day period surrounding the ex-
dividend date if preferred stock) will not qualify for the DRD [§ 246(c)].
(Example 27)
g. The DRD is reduced to the extent of portfolio indebtedness (any indebtedness
directly attributable to investment in stock).
(1) The amount of the reduction is limited to the allocable amount of the
corporation’s interest deduction on the portfolio indebtedness. For
determining whether indebtedness is “directly attributable” to stock
investment, see, e.g., OBH, Inc. v. U.S., 2005–2 USTC ¶50,627, 96
AFTR2d 6801, 397 F Supp.2d 1148 (D.Ct. Neb., 2005) and Rev.Rul.
88–66, 1988–2 C.B. 35.
(2) The reduction in the DRD cannot exceed the amount of the interest
deduction allocable to the dividend.
ETHICS & EQUITY
Pushing the Envelope on Year-End Planning. Lark Corporation anticipates $141,000 of 2016
taxable income before considering the dividends received deduction. Its potential dividends
received deduction of $140,000 ($200,000 dividend × 70%) would be limited to $98,000 (70%
of $140,000 taxable income). Incurring an additional $1,001 of expenses would result in the
dividends received deduction producing a loss, and avoiding the limitation, reducing its taxable
income by an additional $42,000.
Accelerating $1,001 of deductible expenses to 2016 would be good, and ethical, tax planning as
long as those expenses meet the requirements for deductibility under Lark’s accounting method
and do not constitute a sham. This may be fairly easy to do if Lark is a cash-basis taxpayer (e.g.,
by simply paying additional accounts payable). It may be more of a challenge if it is an accrual-
basis taxpayer given the late date. However, it is probably still possible to accelerate an expense
and still meet the all-events and economic performance tests (e.g., by accelerating maintenance
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and/or repairs, purchasing supplies or a depreciable asset, or making a charitable contribution).
Accelerating or deferring the timing of real economic events for tax purposes is a common tax-
planning technique.
28. Organizational Expenditures Deduction.
a. Organizational expenditures include legal services incident to organization,
necessary accounting services, expenses of temporary directors and organizational
meetings, and fees paid to the state for incorporation.
(1) Costs connected with the issuing and selling of stock and other securities,
or with transferring assets to a corporation, are not organizational costs.
They reduce the amount of capital raised and are not deductible.
b. No deduction is available for organizational expenses unless the taxpayer makes
an election under § 248. Under § 248, the taxpayer may, starting in the month in
which the business begins:
(1) Immediately deduct the first $5,000 of organizational costs, reduced dollar
for dollar for the amount these expenses exceed $50,000 and
(2) Amortize the remainder of such expenses over a 180-month period.
(Example 28)
c. Example: Fox Corporation had $51,000 of organizational expenditures in the
current year. Fox can elect to expense $4,000 [$5,000 – ($51,000 – $50,000)] of
this amount and amortize the $47,000 balance ($51,000 – $4,000) over 180
months.
d. In order for a corporation to qualify for this election, expenditures must be
incurred before the end of the taxable year in which the corporation begins
business. A corporation is deemed to make an election under § 248 to deduct
organizational expenditures for the taxable year in which it begins business.
(1) No separate statement or specific identification of the deducted amount as
organizational expenditures is required.
(2) Generally, a corporation begins business when it starts the business
operation for which it was organized [Reg. § 1248–1(d)].
e. A corporation may choose to forgo the deemed election by clearly electing on a
timely filed return to capitalize organizational expenditures for the taxable year in
which the business begins. In this case, the organizational expenditures are not
deductible until the corporation ceases to do business and liquidates.
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f. Startup expenses (§ 195) (investigation and operating expenses incurred before
the business begins producing income) are different from organizational costs.
However, the amortization, immediate expensing, and deemed election rules that
apply to organizational costs also apply to startup costs.
ADDITIONAL LECTURE RESOURCE
Determination of When Corporation Begins Business. According to Reg. § 1.248–1(d): The
deduction allowed under Section 248 must be spread over a period beginning with the month in
which the corporation begins business. The determination of the date the corporation begins
business presents a question of fact which must be determined in each case in light of all the
circumstances of the particular case. The words “begins business,” however, do not have the
same meaning as “in existence.” Ordinarily, a corporation begins business when it starts the
business operations for which it was organized; a corporation comes into existence on the date of
its incorporation. Mere organizational activities, such as the obtaining of the corporate charter,
are not alone sufficient to show the beginning of business. If the activities of the corporation
have advanced to the extent necessary to establish the nature of its business operations, however,
it will be deemed to have begun business. For example, the acquisition of operating assets that
are necessary to the type of business contemplated may constitute the beginning of business.
2.3 DETERMINING THE CORPORATE INCOME TAX LIABILITY
Corporate Income Tax Rates
29. Corporations compute their Federal income tax liability using the rate structure contained
in § 11(b) (the rate schedule is illustrated in Exhibit 2.1 and the inside front cover of the
text). Corporate tax rates are not indexed for inflation. (Example 30)
a. An additional surtax of 5% is imposed on taxable income over $100,000, but such
tax is not to exceed $11,750.
(1) Consequently, the tax savings from the lower rates [i.e., 15% (on the first
$50,000) and 25% (on the next $25,000)] is completely phased out once
taxable income reaches $335,000 (Example 31).
(2) PSCs are taxed at a flat 35% rate [§ 11(b)(2)].
b. At $10 million, the corporate rate goes to 35% and at $15 million, an additional
3% surtax applies (which brings the total rate to 38% for that bracket). At
$18,333,333, the surtax is no longer imposed.
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Return to the Big Picture
(Example 30) Assume that Samantha incorporates her business as Skylark Bakery, Inc., a
calendar year C corporation. The corporation pays Samantha a salary of $50,000 for the
current year. Skylark Bakery has taxable income of $51,500 [$100,000 operating profit +
$5,000 dividends − $50,000 salary expense – $3,500 dividends received deduction ($5,000 ×
70%)]. Its income tax liability is $7,875, determined as follows:
Tax on $50,000 at 15% $7,500
Tax on $1,500 at 25% 375
Tax liability $7,875
Alternative Minimum Tax
30. Corporations (other than “small corporations”) are subject to an alternative minimum tax
(AMT) that is similar to the AMT of individuals. Most adjustments and preferences are
the same as for individuals, but the rates and exemption amounts are different. See
Chapter 3 for a detailed discussion of the AMT.
Tax Liability of Related Corporations
31. A controlled group of corporations (related corporations) is entitled to one $250,000
accumulated earnings tax credit and one $40,000 exemption for the AMT and is limited
to taxable income in each of the first two brackets as though the group was one
corporation [§ 1561(a)]. (Examples 32 and 33) Controlled groups include parent-
subsidiary corporations, brother-sister groups, combined groups, and certain insurance
companies.
a. If these restrictions did not exist, the shareholders of a corporation could gain
significant tax advantages by splitting a single corporation into multiple
corporations.
2.4 PROCEDURAL MATTERS
Filing Requirements for Corporations
32. Corporations must file a tax return (Form 1120 or Form 1120S) on or before the fifteenth
day of the third month following the close of the tax year. Corporations receive an
automatic extension of six months by filing Form 7004 by the due date of the return.
a. Return is due even if the corporation has no taxable income.
2-19 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-19
Chapter 2 – Corporations: Introduction and Operating Rules
b. Corporations that were not in existence throughout the entire annual accounting
period are required to file a return for the portion of the year they were in
existence.
c. A corporation is relieved of filing a tax return only when it ceases to do business
and retains no assets [§ 6012(a)(2) and Reg. § 1.6012–2(a)].
Estimated Tax Payments
33. Corporations must make estimated tax liability payments unless the liability is less than
$500.
a. Required annual payment (including any AMT liability) is equal to the lesser of:
(1) 100% of the current year’s tax.
(2) 100% of the prior year’s tax (prior year exception).
b. Estimated payments can be made in four installments due on or before the
fifteenth day of the fourth month, the sixth month, the ninth month, and the
twelfth month of the corporate taxable year (§ 6655).
(1) Therefore, for a calendar year corporation, estimated payments are due
April 15, June 15, September 15, and December 15.
(2) A corporation failing to pay its required estimated payments will be
subjected to a nondeductible penalty on the amount by which the
installments are less than the tax due.
There are exceptions to this underpayment penalty.
The penalty is imposed on each installment. A corporation must
pay one-fourth of its required annual payment by the due date of
each installment.
c. Corporations having taxable income of at least $1 million in any of the prior three
years (a “large” corporation) can use the prior year exception only for the first
installment payment. Any shortfall of this payment must be remedied in the
second installment payment. (Example 34)
Example: Blue Corporation has a $1 million tax liability for the current year and
an $800,000 tax liability for the prior year. Using the prior year exception, Blue
Corporation’s first installment payment is $200,000 ($800,000 ÷ 4). Second
installment payment is $300,000 [($1 million tax ÷ 4) + ($250,000 required
quarterly payment using the current year tax – $200,000 paid as first installment)].
Third and fourth installment payments are $250,000 each.
2-20 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-20
Chapter 2 – Corporations: Introduction and Operating Rules
Schedule M–1—Reconciliation of Income (Loss) per Books with Income per Return
34. Schedule M–1 of Form 1120 reconciles the net income per financial accounting (i.e., per
books) with taxable income per the tax return. That is, Schedule M–1 reports the book to
tax differences for the year.
a. Schedule M–1 is required for corporations with total assets less than $10 million.
b. The starting point in the reconciliation process is net income (loss) per books.
(1) The following are entered as additions:
Federal income tax per books.
The excess of capital losses over capital gains.
Income that is reported in the current year for tax purposes but is
not reported in computing net income per books (e.g., prepaid
income).
Various expenses that are deducted in computing net income per
books but are not allowed in computing taxable income (e.g.,
charitable contributions in excess of the 10% ceiling applicable to
corporations).
(2) The following are entered as subtractions:
Income reported for financial accounting purposes but not included
in taxable income (e.g., tax-exempt interest).
Deductions taken on the tax return but not expensed in computing
net income per books (e.g., DPAD).
(3) The result is taxable income before the dividends received deduction and
the NOL deduction. (Example 35)
Schedule M–2—Analysis of Unappropriated Retained Earnings per Books
35. Schedule M–2 reconciles unappropriated retained earnings at the beginning of the year
with unappropriated retained earnings at year-end. (Example 36)
a. Corporations with less than $250,000 of gross receipts and less than $250,000 in
assets do not have to complete Schedule L (balance sheet) and Schedules M–1
and M–2.
Schedule M–3—Net Income (Loss) Reconciliation for Corporations with Total Assets of
$10 Million or More
36. Corporations with at least $10 million in total assets on their financial statements must
report much greater detail relative to financial and taxable income (loss) differences on
Schedule M–3. This form is a response to the financial scandals.
2-21 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-21
Chapter 2 – Corporations: Introduction and Operating Rules
a. Any corporation required to file a Schedule M–3 does not file a Schedule M–1.
b. Objectives of Schedule M–3 are the following:
(1) Create greater transparency between financial statements and tax returns.
(2) Identify corporations engaging in aggressive tax practices by highlighting
transactions that create book/tax differences.
37. Schedule M–3 has three parts.
a. Part I is financial information and the net income (loss) reconciliation.
(1) Financial net income (loss) sources come from the SEC Form 10-K,
financial statements, or the corporation’s books and records. (Example 37)
(2) Any income statement restatements or adjustments for the current or past
five years should be included.
b. Part II reconciles net income (loss) per income statement of includible
corporations with taxable income on the return. Corporations included in the
financial reporting group may differ from the tax reporting group. (Example 38)
c. Part III reconciles expense and deduction items. (Examples 39 and 40)
(1) Lists 36 expense and deduction items to reconcile.
(2) Differences between financial and tax amounts must be classified as being
temporary or permanent.
Effect of Taxes on the Financial Statements
38. For tax years beginning in 2014 and later, Schedule UTP must be filed by corporations
with $10 million or more in assets. In general, it requires reporting tax positions taken on
a current (or prior) year’s Federal tax return and for which the corporation recorded a
reserve for Federal income tax in its audited financial statements. See Chapter 14 for a
discussion on financial reporting of tax positions.
Form 1120 Illustrated
39. The illustrative example is useful in introducing the corporate Form 1120.
Consolidated Returns
40. Corporations that are members of a parent-subsidiary affiliated group may be able to file
a consolidated income tax return for a taxable year. See Chapter 8.
2-22 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-22
Chapter 2 – Corporations: Introduction and Operating Rules
2.5 TAX PLANNING
Corporate versus Noncorporate Forms of Business Organization
41. The decision to use the corporate tax form must consider both tax and nontax issues.
Close attention should be paid to:
a. Operating as a C corporation results in the imposition of the corporate tax rate.
Corporate taxable income is taxed twice. Dividends are not deductible by the
corporation, and qualified dividends paid to an individual are subject to a lower
tax rate.
b. The difference in the Federal tax brackets between an individual and a corporation
may not be substantial. Several state and local governments impose higher taxes
on corporations than on individuals. Consequently, the tax ramifications of
incorporating can be determined only on a case-by-case basis.
c. Corporate source income loses its identity as it passes through to the shareholders.
d. It may be difficult for shareholders to recover some or all of their investment in
the corporation without an ordinary income result.
e. Corporate losses cannot be passed through to the shareholders.
f. The corporate form provides shareholders with the opportunity to be treated as
employees for tax purposes if the shareholders render services to the corporation.
Operating the Corporation
42. Effective tax planning before year-end can cause income to be shifted to the next tax year
and can produce deductions by incurring expenses in the current year. Focus on the
following issues:
a. Charitable contributions. Accrual-basis corporations can claim a deduction for
contributions in the year preceding payment if certain conditions are met.
b. Timing of capital gains and losses. Offset gains on sale of capital assets with
capital losses. Monitor any already realized capital losses so they do not expire
before they can be used.
c. Net operating losses. In some situations, electing to forgo an NOL carryback may
generate greater tax savings. (Example 41)
d. Dividends received deduction. Consideration should be given to the proper timing
of income and deductions to bring the NOL rule into play. (Example 42)
2-23 SWFT 2017: Corp., Part., Est. & Trusts/Instructor’s Guide with Lecture Notes 2-23
Chapter 2 – Corporations: Introduction and Operating Rules
e. Organizational expenditures. Corporations formed late in the year should consider
adopting a fiscal year to make sure that organizational expenditures are incurred
in the first taxable year of the corporation. (Example 43)
f. Shareholder-employee payment of corporate expenses. Decide if corporate
expenses should be kept at the corporate level or shifted to the shareholder-
employee.
Return to the Big Picture
Conducting Skylark Bakery as a corporation would save Samantha $9,375 in income taxes
annually, computed as follows:
Total income tax if the bakery is operated as a
sole proprietorship, with an operating profit of $100,000
$33,750
If the bakery is operated as a regular corporation:
Tax on corporate taxable income of $51,500
$ 7,875
Tax on Samantha’s salary of $55,000 (33% rate) 16,500
Total income tax when operated as a C corporation $24,375
Difference
$ 9,375
Note: See the text for computations of tax and corporate taxable income.
The above results occur when a high-income individual taxpayer takes advantage of the lower
marginal tax rates of corporations. Other issues, such as employment tax considerations and the
taxation of dividend distributions (income and Medicare surtax), also should be considered.
Further, other potential entity options, such as the LLC and S corporation, should be evaluated.
What If?
What if the bakery in the first year it becomes a corporation generates a $10,000 short-term
capital loss (STCL) on the disposition of some of its stock investments? Regular corporations
can only deduct capital losses against capital gains; thus, the $10,000 STCL would not be
deductible currently and would be carried forward for up to five years. If the bakery is operated
as a sole proprietorship, Samantha would report the capital loss on her individual return. She
could use the $10,000 STCL to offset any capital gains she may have and deduct up to $3,000
of the loss against ordinary income.
RESEARCH PROBLEMS
Solutions to end-of-chapter Research Problems are located in the Solutions Manual.
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1. In general, what is the filing deadline for a C corporation in 2016?
a. March 15
b. April 15
c. The 15
th
day of the 3
rd
month after year end
d. The 15
th
day of the 4
th
month after year end
a. Incorrect. In general, a C corporation is required to file its tax return by the 15
th
day of the
4
th
month after its year end, which would be April 15 for a calendar year corporation.
b. Incorrect. In general, a C corporation is required to file its tax return by the 15
th
day of the
4
th
month after its year end, which would be April 15 for a calendar year corporation.
c. Incorrect. In general, a C corporation is required to file its tax return by the 15
th
day of the
4
th
month after its year end, which would be April 15 for a calendar year corporation.
d. Correct! In general, a C corporation is required to file its tax return by the 15
th
day of the 4
th
month after its year end, which would be April 15 for a calendar year corporation.
2. Keckye Co. is a calendar year C Corporation. When is Keckye’s 2016 tax return due?
a. March 15, 2017
b. April 15, 2017
c. June 15, 2017
d. October 15, 2017
a. Incorrect. In general, a C corporation is required to file its tax return by the 15
th
day of the
4
th
month after its year end, which would be April 15 for a calendar year corporation.
b. Correct! In general, a C corporation is required to file its tax return by the 15
th
day of the 4
th
month after its year end, which would be April 15 for a calendar year corporation.
c. Incorrect. In general, a C corporation is required to file its tax return by the 15
th
day of the
4
th
month after its year end, which would be April 15 for a calendar year corporation.
d. Incorrect. In general, a C corporation is required to file its tax return by the 15
th
day of the
4
th
month after its year end, which would be April 15 for a calendar year corporation.
3. Keckye Co. is a C corporation with a fiscal year-end of September 30. When is Keckye’s 2016 tax
return due?
a. March 15, 2017
b. April 15, 2017
c. December 15, 2016
d. January 15, 2017
a. Incorrect. A C corporation is required to file its tax return by the 15
th
day of the 3
rd
month
after its year end, which would be March 15 for a calendar year corporation. A corporation
with a September 30 year-end would be required to file by December 15.
b. Incorrect. A C corporation is required to file its tax return by the 15
th
day of the 3
rd
month
after its year end, which would be March 15 for a calendar year corporation. A corporation
with a September 30 year-end would be required to file by December 15.
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c. Correct! A C corporation is required to file its tax return by the 15
th
day of the 3
rd
month
after its year end, which would be March 15 for a calendar year corporation. A corporation
with a September 30 year-end would be required to file by December 15.
d. Incorrect. A C corporation is required to file its tax return by the 15
th
day of the 3
rd
month
after its year end, which would be March 15 for a calendar year corporation. A corporation
with a September 30 year-end would be required to file by December 15.
4. Identify which of the following cannot function as a pass-through entity for tax purposes.
a) Sole proprietorship
b) Limited Liability Company
c) Partnership
d) S-Corporation
a) Correct! A pass-through entity is one that is a separate entity responsible for filing its own
tax return but not subject to tax. Instead, its ordinary income and each category of its
special income, deductions, gains, and losses are included in, or passed through to, the tax
returns of the owners. A sole proprietorship does not file a separate information return but
is rather included in the tax return of the proprietor.
b) Incorrect. A pass-through entity is one that is a separate entity responsible for filing its own
tax return but not subject to tax. Instead, its ordinary income and each category of its
special income, deductions, gains, and losses are included in, or passed through to, the tax
returns of the owners. A sole proprietorship does not file a separate information return but
is rather included in the tax return of the proprietor.
c) Incorrect. A pass-through entity is one that is a separate entity responsible for filing its own
tax return but not subject to tax. Instead, its ordinary income and each category of its
special income, deductions, gains, and losses are included in, or passed through to, the tax
returns of the owners. A sole proprietorship does not file a separate information return but
is rather included in the tax return of the proprietor.
d) Incorrect. A pass-through entity is one that is a separate entity responsible for filing its own
tax return but not subject to tax. Instead, its ordinary income and each category of its
special income, deductions, gains, and losses are included in, or passed through to, the tax
returns of the owners. A sole proprietorship does not file a separate information return but
is rather included in the tax return of the proprietor.
5. The following chart shows ownership percentages of Devon Corp. in X, Y and Z Corporations,
and dividends received by Devon from these corporations in 2016.
Devon’s Ownership % Dividend Received
X Corp.
15%
$100,000
Y Corp.
20%
$120,000
Z Corp.
30%
$200,000
Devon is a calendar-year corporation and received no other dividends in 2016. What amount of
dividend income must be included by Devon on its 2016 corporate tax return?
a) $126,000
b)
$114,000
c)
$94,000
d)
$106,000
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a) Incorrect. A corporation is entitled to reduce its income by a dividends received deduction
equal to a percentage of dividends received, with the percentage determined by ownership.
When ownership is below 20%, as with X Corp. there is a 70% dividends received deduction
making 30% of the $100,000 in dividends received, or $30,000, taxable. When ownership is
at least 20% but is below 80%, as is the case with both Y and Z, the dividends received
deduction is 80%, making 20% of the $320,000 in dividends received, or $64,000, taxable.
Total taxable dividends will be $30,000 + $64,000 or $94,000.
b) Incorrect. A corporation is entitled to reduce its income by a dividends received deduction
equal to a percentage of dividends received, with the percentage determined by ownership.
When ownership is below 20%, as with X Corp. there is a 70% dividends received deduction
making 30% of the $100,000 in dividends received, or $30,000, taxable. When ownership is
at least 20% but is below 80%, as is the case with both Y and Z, the dividends received
deduction is 80%, making 20% of the $320,000 in dividends received, or $64,000, taxable.
Total taxable dividends will be $30,000 + $64,000 or $94,000.
c) Correct! A corporation is entitled to reduce its income by a dividends received deduction
equal to a percentage of dividends received, with the percentage determined by ownership.
When ownership is below 20%, as with X Corp. there is a 70% dividends received deduction
making 30% of the $100,000 in dividends received, or $30,000, taxable. When ownership is
at least 20% but is below 80%, as is the case with both Y and Z, the dividends received
deduction is 80%, making 20% of the $320,000 in dividends received, or $64,000, taxable.
Total taxable dividends will be $30,000 + $64,000 or $94,000.
d) Incorrect. A corporation is entitled to reduce its income by a dividends received deduction
equal to a percentage of dividends received, with the percentage determined by ownership.
When ownership is below 20%, as with X Corp. there is a 70% dividends received deduction
making 30% of the $100,000 in dividends received, or $30,000, taxable. When ownership is
at least 20% but is below 80%, as is the case with both Y and Z, the dividends received
deduction is 80%, making 20% of the $320,000 in dividends received, or $64,000, taxable.
Total taxable dividends will be $30,000 + $64,000 or $94,000.
6. Crimson Corp. was organized as a calendar year corporation in January 2016, incur- ring
$51,000 in qualified organizational expenses, and began business in March 2016. What
is the maximum amount Crimson may deduct for organizational expenditures on its
2016 corporate tax return?
a. $4,000
b) $6,611
c) $6,350
d) $7,133
a) Incorrect. Up to $5,000 in qualifying organizational expenses are deductible in the year
incurred, with the amount reduced by the amount by which total organizational expenses
exceed $50,000. With a total of $51,000, Crimson could deduct $4,000. In addition, the
remaining $47,000 is amortized over 15 years, or 180 months, beginning in the period in
which the entity commences operations. Since Crimson began operations in March 2016,
amortization would be for 10 months or 10/180 x $47,000 =$2,611 and total deductible
organizational expenses will be $4,000 + $2,611 or $6,611.
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b) Correct! Up to $5,000 in qualifying organizational expenses are deductible in the year
incurred, with the amount reduced by the amount by which total organizational expenses
exceed $50,000. With a total of $51,000, Crimson could deduct $4,000. In addition, the
remaining $47,000 is amortized over 15 years, or 180 months, beginning in the period in
which the entity commences operations. Since Crimson began operations in March 2016,
amortization would be for 10 months or 10/180 x $47,000 =$2,611 and total deductible
organizational expenses will be $4,000 + $2,611 or $6,611.
c) Incorrect. Up to $5,000 in qualifying organizational expenses are deductible in the year
incurred, with the amount reduced by the amount by which total organizational expenses
exceed $50,000. With a total of $51,000, Crimson could deduct $4,000. In addition, the
remaining $47,000 is amortized over 15 years, or 180 months, beginning in the period in
which the entity commences operations. Since Crimson began operations in March 2016,
amortization would be for 10 months or 10/180 x $47,000 =$2,611 and total deductible
organizational expenses will be $4,000 + $2,611 or $6,611.
d) Incorrect. Up to $5,000 in qualifying organizational expenses are deductible in the year
incurred, with the amount reduced by the amount by which total organizational expenses
exceed $50,000. With a total of $51,000, Crimson could deduct $4,000. In addition, the
remaining $47,000 is amortized over 15 years, or 180 months, beginning in the period in
which the entity commences operations. Since Crimson began operations in March 2016,
amortization would be for 10 months or 10/180 x $47,000 =$2,611 and total deductible
organizational expenses will be $4,000 + $2,611 or $6,611.
7. When preparing Schedule M-1 of Form 1120, which of the following must be added to net
income per books in order to compute taxable income?
a) 100% of meals and entertainment expense
b) Municipal bond interest
c) Excess of tax vs. book depreciation
d) Accrued bad debt expense
a) Incorrect. To convert from book income to taxable income, bad debt expense, accrued in
the period of sale, will have to be added back since it is not deductible until the account is
written off. Half, not 100%, of meals and entertainment expense would be added back to
book income to calculate taxable income.
b) Incorrect. To convert from book income to taxable income, bad debt expense, accrued in
the period of sale, will have to be added back since it is not deductible until the account is
written off. Municipal bond interest is not taxable and would be deducted from, not added
to, book income to determine taxable income.
c) Incorrect. To convert from book income to taxable income, bad debt expense, accrued in
the period of sale, will have to be added back since it is not deductible until the account is
written off. The excess of tax over book depreciation is deducted from book income, not
added to it.
d) Correct! To convert from book income to taxable income, bad debt expense, accrued in the
period of sale, will have to be added back since it is not deductible until the account is
written off. Half, not 100%, of meals and entertainment expense would be added back to
book income to calculate taxable income. Municipal bond interest is not taxable and would
be deducted from, not added to, book income to determine taxable income. The excess of
tax over book depreciation is deducted from book income, not added to it.
C H A P T E R
2
Corporations: Introduction and
Operating Rules
Corporations, Partnerships,
Estates & Trusts
The Big Picture (slide 1 of 2) The Big Picture (slide 2 of 2)
• Samantha Johnson owns Skylark Bakery
– Currently, the bakery is operated as a sole
proprietorship and generates an annual operating
profit of $100,000
• In addition, the bakery earns annual dividends of
$5,000 from investing excess working capital
– These stock investments typically are held for a
minimum of three to four months
• Due to income from other business ventures and
investments, Samantha is in the 33% marginal
tax rate bracket irrespective of the bakery
The Big Picture (slide 1 of 2) The Big Picture (slide 2 of 2)
• In the past, Samantha has withdrawn $50,000 annually
from the bakery
– She sees this as reasonable payment for her services
• Samantha has asked you about the tax consequences of
conducting the business as a regular (C) corporation
– Based on the given information, what would be the annual
income tax savings (or cost) of operating the bakery as a
corporation?
• For purposes of this analysis, use the 2016 tax rates and ignore any
employment tax or state tax considerations
• Read the chapter and formulate your response
Various Business Forms Sole Proprietorship
• Business operations can be conducted in a
number of different forms including
– Sole proprietorships
– Partnerships
– Trusts and estates
– S corporations (also called Subchapter S corps)
– Regular corporations (also called C corps)
– Limited liability companies
Various Business Forms Sole Proprietorship
• Not a separate taxable entity
• Income reported on owner’s Sch. C
Partnership (slide 1 of 2)
The Big Picture – Example 1
Sole Proprietorships
• Return to the facts of The Big Picture on p. 2-1
• Samantha, the sole proprietor of Skylark Bakery,
reports the $100,000 operating profit from the
business on Schedule C of her individual tax
return
– Even though she withdrew only $50,000, Samantha
reports all of the $100,000 operating profit from the
business on Form 1040, where she computes taxable
income for the year
• She also reports dividend income of $5,000 on
Partnership (slide 1 of 2)
Schedule B of Form 1040
Partnership (slide 1 of 2)
• Separate entity, but does not pay tax
– Files information return (Form 1065)
• Most income and expense items are aggregated
in computing the ordinary business income
(loss) of the partnership
– Certain income and expense items are reported
separately to the partners
– e.g., Interest and dividend income, long term capital
gain, charitable contributions and investment
expenses
Partnership (slide 2 of 2) S Corporation
• Partnership ordinary business income (loss) and
separately reported items are allocated to
partners according to their profit and loss
sharing ratios
– Each partner receives a Schedule K–1
• Reports partner’s share of partnership ordinary business
income (loss) and separately stated items
– Each partner reports these items on his or her own
tax return
Partnership (slide 2 of 2) S Corporation
• Separate entity, only pays special taxes (e.g., built-in
gains)
– Files information return Form 1120S
• Similar to partnership taxation
– Ordinary business income (loss) flows through to the
shareholders to be reported on their separate returns
– Certain items flow through to the shareholders and retain their
separate character when reported on the shareholders’ returns
• The S corporation ordinary business income (loss) and
the separately reported items are allocated to the
shareholders according to their stock ownership interests
C Corporation Dividends
• C corporations are subject to an entity-level
Federal income tax which results in what is
known as a double taxation effect
– C corporation reports its income and expenses and
computes tax on the taxable income reported on its
Form 1120
• Uses tax rate schedule applicable to corporations
– When corporation distributes its income, the
corporation’s shareholders report dividend income on
their own tax returns
• Thus, income that has already been taxed at the corporate
level is also taxed at the shareholder level
C Corporation Dividends
• Double taxation stems, in part, from the fact that
dividend distributions are not deductible by the
corporation
• To alleviate some of the double taxation effect, Congress
reduced the tax rate applicable to dividend income of
individuals
– Generally, dividends are taxed at the same marginal rate
applicable to a net capital gain
• Thus, individuals otherwise subject to the 10% or 15% marginal tax
rate pay 0% tax on qualified dividends received
• Individuals subject to the 25, 28, 33, or 35 percent marginal tax
rates pay a 15% tax on qualified dividends
• Individuals subject to the 39.6% marginal tax rate pay a 20% tax on
qualified dividends
Medicare Surtax Corporate Income Tax Rates
• Beginning in 2013, § 1411 imposes a 3.8%
Medicare surtax on a taxpayer’s net investment
income in excess of modified adjusted gross
income of $200,000 ($250,000 if married filing
jointly)
– Thus, for high-income taxpayers, the double taxation
of dividend income is increased by this surtax
Medicare Surtax Corporate Income Tax Rates
Nontax Issues in Selecting
Entity Form (slide 1 of 3)
Nontax Issues in Selecting
Entity Form (slide 2 of 3)
• Liability
– Sole proprietors and some partners have unlimited
liability for claims against the entity
• Capital-raising
– Corporations and partnerships to a lesser extent can
raise large amounts of capital for entity ventures
Nontax Issues in Selecting
Entity Form (slide 2 of 3)
Nontax Issues in Selecting
Entity Form (slide 2 of 3)
• Transferability
– Corporate stock is easily sold, but partners must
approve partnership interest transfer
• Continuity of life
– Corporations exist indefinitely
Nontax Issues in Selecting
Entity Form (slide 3 of 3)
Nontax Issues in Selecting
Entity Form (slide 2 of 3)
• Centralized management
– Corporate actions are governed by a board of
directors
– Partnership operations may be conducted by each
partner without approval by other partners
Limited Liability Companies (LLC)
Entity Classification
Prior to 1997 (slide 1 of 2)
• LLCs have proliferated since 1988 when IRS
ruled it would treat qualifying LLCs as
partnerships
– Major nontax advantage
• Allows owners to avoid unlimited liability
– Major tax advantage
• Allows qualifying business to be treated as a partnership for
tax purposes, thereby avoiding double taxation associated
with C corporations
Limited Liability Companies (LLC)
Entity Classification
Prior to 1997 (slide 1 of 2)
• Sometimes difficult to determine if entity will be
taxed as a corporation
– If entity has a majority of corporate characteristics, it
is taxed as a corporation
– Most entities have the following characteristics:
• Associates
• Objective to carry on business and share profits
Entity Classification
Prior to 1997 (slide 2 of 2)
Entity Classification
After 1996 (slide 1 of 2)
• If entity has a majority of the following relevant
corporate characteristics it is treated as a
corporation:
– Continuity of life
– Centralized management
– Limited liability to owners
– Free transferability of ownership interests
Entity Classification
Prior to 1997 (slide 2 of 2)
Entity Classification
After 1996 (slide 1 of 2)
• Check-the-box Regulations
– Allows taxpayer to choose tax status of entity without
regard to corporate or noncorporate characteristics
– Entities with > 1 owner can elect to be classified as
partnership or corporation
– Entities with only 1 owner can elect to be classified as
sole proprietorship or as corporation
Entity Classification
After 1996 (slide 2 of 2)
Comparison of Corporate and Individual
Tax Treatment (slide 21 of
3)
• Check-the-box Regulations (cont’d)
– If no election is made, multi-owner entities treated as
partnerships, single person businesses treated as
sole proprietorships
– Election is not available to:
• Entities incorporated under state law
• Entities required to be corporations under federal law (e.g.,
certain publicly traded partnerships)
Entity Classification
After 1996 (slide 2 of 2)
Comparison of Corporate and Individual
• Similarities
Tax Treatment (slide 22 of
3)
– Gross Income of a corporation and individual are very
similar
• Includes compensation for services, income from trade or
business, gains from property, interest, dividends, etc
• Corp taxpayers are allowed fewer exclusions
• Nontaxable exchange treatment is similar
– Business deductions of a corporation and individual
also are very similar
Comparison of Corporate and Individual
Comparison of Corporate and Individual
Tax Treatment (slide 23 of
3)
Tax Treatment (slide 2 of 3)
• Dissimilarities
– Different tax rates apply
– All deductions of corp are business deductions
• Corp does not calculate AGI
• Corp does not deduct standard deduction, itemized
deductions, or personal and dependency exemptions
• Corp does not reduce casualty and theft loss by $100
statutory floor and 10% of AGI
Comparison of Corporate and Individual
Tax Treatment (slide 3 of 3)
T
ax Formulas
Corporations Individuals
Income (broadly conceived)
(Exel usi ons)
Gross income
(Deductions except for NOL and DRD)*
Taxable income before NOL and DRD
(Net operating loss deduction)
(Dividends received deduction)
Taxable income
Tax on taxable income
(Tax credits)
Income (broadly conceived)
(Exclusions)
Gross income
(Deductions for AGI)**
Adjusted gross income
(Greater of itemized or standard deductions)
(Personal and dependency exemptions)
Taxable income
Tax on taxable income
(Tax credits)
Tax due (or refund)
Tax due (or refund)
*NOL= net operating loss; DRD = dividends received deduction.
'*'* AGI = adjusted gross income.
24
Specific Provisions Compared
• In comparing the income taxation of individuals
and corporations the following areas warrant
special discussion:
– Accounting periods and methods
– Capital gains and losses
– Recapture of depreciation
– Passive losses
– Charitable contributions
– Domestic production activities deduction
– Net operating losses
– Special deductions available only to corporations
Accounting Periods and Methods
(slide 1 of 2)
• Accounting periods
– Most C corporations can use calendar year or fiscal
year ending on last day of a calendar month (or 52-53
week year)
– S corps and Personal Service Corporations (PSC) are
limited in available year ends
The Big Picture – Example 11
Accounting Periods and Methods
(slide 2 of 2)
• Accounting methods
– Cash method can’t be used by C corp. unless:
• In farming or timber business
• Qualified PSC
• “Ave. Annual Gross receipts” ≤ $5,000,000
– As a matter of administrative convenience, the IRS
will permit
• Entities with ave. annual gross receipts of $1 million or less
for the most recent 3 year period to use the cash method
(even if buying and selling inventory)
• Certain entities with ave. annual gross receipts greater than
$1 million but not more than $10 million for the most recent 3
year period to use the cash method
The Big Picture – Example 11
Accrual Method Of Accounting And
Cash Basis Related Parties (slide 1 of 2)
• Return to the facts of The Big Picture on p. 2-1
• Assume that Samantha incorporates her
business as Skylark Bakery, Inc., a calendar
year, accrual method C corporation.
– Samantha, a cash method taxpayer, owns 100% of
the corporation’s stock at the end of 2016
The Big Picture – Example 10
Capital Gains and Losses (slide 1 of 2)
Accrual Method Of Accounting And
Cash Basis Related Parties (slide 2 of 2)
• On December 31, 2016, Skylark Bakery has
accrued a $10,000 bonus to Samantha
– Samantha receives the bonus in 2017 and reports it
on her 2017 tax return
• Skylark Bakery cannot claim a deduction for the
$10,000 until 2017
The Big Picture – Example 10
Capital Gains and Losses (slide 1 of 2)
• Individuals
– Net capital gains subject to the following preferential
tax treatment
• Net short-term gains subject to regular tax rates
• Net long-term gains max tax rate 20%
– Net capital losses deductible up to $3,000 with
remainder carried to future years
• Carryovers do not lose their identity but remain either long
term or short term
Capital Gains and Losses (slide 2 of 2) Depreciation Recapture
• Corporations
– No special tax rates apply to capital gains
• Entire gain is included in income subject to normal corporate
tax rates
– Corp cannot take a deduction for net capital losses
• Capital losses can be used only to offset capital gains
• Unused capital losses are carried back 3 years and carried
forward for 5 years
– All carried over losses are treated as short-term
Capital Gains and Losses (slide 2 of 2) Depreciation Recapture
• In general, the recapture rules under §§ 1245 and 1250
are equally applicable to both individual and corporate
taxpayers
– However, corporations may have more depreciation recapture
(ordinary income) on the disposition of § 1250 property than
individuals
• Under § 291, a corporation has additional ordinary
income equal to 20% percent of the excess of
– Depreciation recapture that would arise if property was § 1245
property over depreciation recapture computed under § 1250
(without regard to § 291)
Passive Losses
Charitable Contributions
(slide 34 of
5)
• Passive loss rules apply to:
– Individuals and personal service corps
• Cannot offset passive losses against active or portfolio
income
– S corps and partnerships
• Passive income and loss flows through to owners and rules
applied at owner level
– Closely held C corps
• May offset passive losses against active income, but not
portfolio income
Passive Losses
Charitable Contributions
(slide 35 of
5)
• Both corporate and noncorporate taxpayers may
deduct charitable contributions in year paid
– Exception for accrual basis corporations allows
deduction in year preceding payment if:
• Authorized by the board of directors by the end of that year,
and
• Paid within 3 ½ months of year end
Charitable Contributions
Charitable Contributions
(slide 2 of 5)
(slide 2 of 5)
• Amount deductible for property contributions
depends on type of property contributed
• Long-term capital gain property deduction = fair
market value of property
– Exception: Corp may only deduct basis if tangible
personal property contributed and not used by charity
in its exempt function
Charitable Contributions
Charitable Contributions
(slide 3 of 5)
(slide 3 of 5)
• Long-term capital gain property deduction = fair
market value of property (cont’d)
– Exception: Deduction for property contribution to
certain private nonoperating foundations is limited to
basis in property
Charitable Contributions
Charitable Contributions
(slide 4 of 5)
(slide 4 of 5)
• Ordinary income property deduction = basis in
property
– Exception: Basis plus 50 % of appreciation can be
deducted if inventory or research property is
contributed which is used by charity as required by
Code
• Deduction is limited to twice the property’s basis
Charitable Contributions
Charitable Contributions
(slide 5 of 5)
(slide 5 of 5)
• Corporate charitable contribution deduction is
limited to 10% of taxable income before:
– Charitable contribution deduction
– NOL or capital loss carryback
– Dividends received deduction, and
– Domestic production activities deduction
• Contributions in excess of 10% limit can be
carried forward for 5 years
Net Operating Loss
Domestic Production
Activities Deduction
• The American Jobs Creation Act of 2004 created
a new deduction based on the income from
manufacturing activities
– The domestic production activities deduction is based
on the following formula:
• 9% × Lesser of
– Qualified production activities income
– Taxable (or adjusted gross) income
• The deduction cannot exceed 50% of an employer’s W–2
wages related to qualified production activities income
Net Operating Loss
• Net operating losses of corporations and
individuals may be:
– Carried back two years
– Unused portion carried forward 20 years
• Unlike individuals, a corporation does not:
– Adjust its tax loss for capital losses, since a
corporation cannot deduct net capital losses
– Make adjustments for any nonbusiness deductions
• A corporation is allowed to include the dividends
received deduction (discussed below) in
computing its NOL
Dividends Received Deduction
Dividends Received Deduction
(slide 1 of 3)
(slide 2 of 3)
• If corporation owns stock in another corporation
and receives dividends, a portion of dividends
may be deducted from income:
Dividends Received Deduction
Dividends Received Deduction
(slide 2 of 3)
(slide 2 of 3)
• The dividends received deduction is limited to a
percentage of the taxable income of a corporation
– For this purpose, taxable income is computed without regard to
• The NOL deduction
• The domestic production activities deduction
• The dividends received deduction
• Any capital loss carryback to the current tax year
– The percentage of taxable income limitation corresponds to the
deduction percentage
– However, the taxable income limitation does not apply if the
corporation has an NOL for the current taxable year
Dividends Received Deduction
Dividends Received Deduction
(slide 43 of
3)
(slide 2 of 3)
The following steps are useful in calculating the
dividends received deduction
1. Multiply dividends received by deduction
percentage
2. Multiply taxable income by deduction
percentage
3. Subtract 1. from taxable income
-If entity has income before DRD, but DRD creates
NOL, amount in 1. is DRD (the NOL rule)
-If DRD does not create NOL, deduction is limited to
lesser of 1. or 2.
DRD Examples
Organizational Expenditures
DRD Examples
Organizational Expenditures
(slide 1 of 2)
• A corporation may elect to amortize
organizational expenses over a 180-month
period beginning with the month in which the
corporation begins business
• A special exception allows the corporation to
immediately expense the first $5,000 of these
costs
• Phased out on a dollar-for-dollar basis when these expenses
exceed $50,000
Organizational Expenditures
Organizational Expenditures
(slide 2 of 2)
• Organizational expenditures include the following:
– Legal services incident to organization
– Necessary accounting services
– Expenses of temporary directors and of organizational meetings
of directors and shareholders
– Fees paid to the state of incorporation
• Expenditures connected with issuing or selling shares of
stock or other securities or with the transfer of assets to
a corporation do not qualify
– Such expenditures reduce the amount of capital raised and are
not deductible at all
Organizational Expenditures
Organizational Expenditures
Example
(slide 2 of 2)
• Wren Corp. incurs $53,000 of organizational
costs
– Wren can expense $2,000 of this amount
[$5,000 - ($53,000 - $50,000)]
– The $51,000 balance is amortized over 180 months
Start-up Expenditures
(slide 1 of 2)
• Start-up expenditures include:
– Various investigation expenses involved in entering a
new business
• e.g., Travel, market surveys, financial audits, legal fees
– Also includes operating expenses, such as rent and
payroll, that are incurred by a corporation before it
actually begins to produce any gross income
Start-up Expenditures
Start-up Expenditures
(slide 1 of 2)
(slide 2 of 2)
• At the election of the taxpayer, such
expenditures can be treated in the same manner
as organizational expenditures
– Up to $5,000 can be immediately expensed (subject
to the dollar cap and excess-of-$50,000 phaseout)
– Any remaining amounts are amortized over a period
of 180 months
Corporate Tax Formula
Gross income
Less: Deductions (except charitable, Div. Rec’d, NOL
carryback, STCL carryback)
Taxable income for charitable limitation
Less: Charitable contributions (
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