Chapter 15 Business Entities Overview Discussion Questions 1. [LO 1] What are the most common legal entities used for operating a business? How are these entities treated similarly and differently for state law purposes? Corporations, limited liability companies (LLCs), general and limited partnerships, and sole proprietorships. These entities differ in terms of the formalities that must be observed to create them, the legal rights and responsibilities conferred on them and their owners, and the tax rules that determine how they and their owners will be taxed. Corporations and LLCs are similar in the sense that state laws protect all owners/members from personal legal liability. Further, corporations, LLCs, and partnerships are recognized as business entities for state law purposes. 2. [LO 1] How do business owners create legal entities? Is the process the same for all entities? If not, what are the differences? The process of creating legal entities differs by entity type. Business owners legally form corporations by filing articles of incorporation in the state of incorporation while business owners create limited liability companies by filing articles of organization in the state of organization. General partnerships may be formed either with or without written partnership agreements, and they typically can be formed without filing documents with the state. However, limited partnerships are usually organized by written agreement and must typically file a certificate of limited partnership to be recognized by the state. 3. [LO 1] What is an operating agreement for an LLC? Are operating agreements required for limited liability companies? If not, why might it be important to have one? An operating agreement is a written document among the owners of an LLC specifying the owners’ legal rights and responsibilities for dealing with each other. Generally, operating agreements are not required by law for limited liability companies; however, it might be important to have one to spell out the management practices of the new entity as well as the rights and responsibilities of the owners. 4. [LO 1] Explain how legal business entities differ in terms of the liability protection they afford their owners. Corporations and LLCs offer owners limited liability. General partners and sole proprietors may be held personally responsible for the debts of the general partnership and sole proprietorship. However, limited partners are not responsible for the partnership’s liabilities. 5. [LO 1] Did the tax lax law changes effective in 2018 increase or decrease the amount of the double tax on C corporation income? Explain. Decreased. Prior to 2018, the top corporate tax rate was 39 percent. After 2017, the corporate tax rate is a flat 21%. Consequently, the first level of tax (and the consequently, the double tax) on C corporation taxable income has been significantly reduced. 6. [LO 1] Why is it a nontax advantage for corporations to be able to trade their stock on the stock market? Having the ability to issue stock in the stock market provides corporations with a source of capital typically not available to other types of entities. In addition, going public provides a mechanism for shareholders of successful closely-held corporations to sell their stock on an established exchange. 7. [LO 1] How do legal corporations protect shareholders from liability? If you formed a small corporation, would you be able to avoid repaying a bank loan from your community bank if the corporation went bankrupt? Explain. A corporation is solely responsible for its liabilities. One exception to this is for payroll tax liabilities. Shareholders of closely-held corporations may be held responsible for payroll tax liabilities. If a corporation were to go bankrupt, the bank may have priority in possessing the corporation’s assets but it could not force the shareholders to satisfy the outstanding bank loan. The shareholders may lose their investment in the corporation but the shareholders’ personal assets would be safe from the bank. 8. [LO 1, LO 2] Other than corporations, are there other legal business entities that offer liability protection? Are any of them taxed as flow-through entities? Explain. Yes. Limited liability companies provide their members with liability protection similar to that provided by corporations to their shareholders. Limited partnerships protect limited partners, but not general partner(s), from partnership liabilities. All of these alternatives to corporations are taxed as flow-through entities. Limited liability companies are either taxed as partnerships (if there are at least two members), sole proprietorships (if there is only one individual member), or as disregarded entities (if there is only one corporate member). Limited partnerships are generally taxed as partnerships. 9. [LO 2] In general, how are unincorporated business entities classified for tax purposes? Unincorporated business entities are taxed as either partnerships, sole proprietorships, or disregarded entities (an entity that is considered to be the same entity as the owner). Unincorporated business entities (including LLCs) with more than one owner are taxed as partnerships. Unincorporated entities (including LLCs) with only one individual owner such as sole proprietorships and single-member LLCs are taxed as sole proprietorships. 10. [LO 2] Can unincorporated legal business entities ever be treated as corporations for tax purposes? Can legal corporations ever be treated as flow-through entities for tax purposes? Explain. Treasury regulations permit owners of unincorporated legal business entities to elect to have the entities treated as C corporations. Shareholders of certain eligible legal corporations may elect to have the entities receive flow-through tax treatment as S corporations. 11. [LO 2] What are the differences, if any, between the legal and tax classifications of business entities? A business entity may be legally classified as a corporation, limited liability company (LLC), a general partnership (GP), a limited partnership (LP), or a sole proprietorship under state law. However, for tax purposes a business entity can be classified as either a separate taxpaying entity or as a flow-through entity. Separate taxpaying entities pay tax on their own income. In contrast, flow-through entities generally don’t pay taxes because income from these entities flows through to their business owners who are responsible for paying tax on the income. C corporations are separate taxpaying entities and, if elected, some flow-through entities may be treated as separate taxpaying entities. Flow-through entities are usually taxed as either partnerships, sole proprietorships, or disregarded entities. 12. [LO 2] What types of business entities does the U.S. tax system recognize? Although there are more types of legal business entities, there are really only four categories of business entities recognized by the U.S. tax system: C corporations (treated as separate taxpaying entities), S corporations, partnerships, and sole proprietorships (treated as flow-through entities). 13. [LO 3] For flow-through business entities with individual owners, how many times is flow-through entity income taxed, who pays the tax, and what is the tax rate? Flow-through business entity income is taxed once to the individual owner at the individual’s tax rate. The top individual marginal tax rate is 37 percent. Individuals may also be subject to the 3.8 percent net investment income tax on income from an entity in which they are a passive investor. For sole proprietorships and entities taxed as partnerships, owners participating in the entity’s business activities may be subject to self-employment tax and the additional Medicare tax on the income from the flow-through entity. The income could be taxed entirely at 15.3 percent, entirely at 2.9 percent, or part at 15.3 percent and part at 2.9 percent. The additional Medicare tax rate is 0.9 percent. Further, when the owner qualifies for the qualified business income (QBI) deduction, the taxpayer is allowed to deduct 20 percent of the qualified business income (reduced by the taxpayer’s self-employed health insurance deduction, self-employment tax deduction, and deduction for contribution to qualified self-employed retirement plan) allocated to them from the entity. This reduces the tax rate to 29.6 percent (37 percent × (1 - 0.2) on flow-through income before the net investment income tax, self-employment tax, and additional Medicare tax. 14. [LO 3] What is the qualified business income deduction, and how does it affect the tax rate on flow-through business entity income? Owners of partnerships, S corporations, and sole proprietorships are allowed to deduct 20 percent of the qualified business income allocated to them from the entities (reduced by the deductible portion of self-employment taxes, (2) the self-employed health insurance deduction, and (3) the deduction for contributions to qualified self-employed retirement plans). The deduction applies only to qualified business income generated in the United States. In general, qualified business income is income from nonservice business (not investment) activities. There are limitations to the deduction imposed at the owner level. Taxpayers who qualify claim the deduction as a from AGI deduction that is not an itemized deduction. Thus, taxpayers can claim the deduction even when they claim the standard deduction. Because this is a 20 percent deduction, it effectively reduces the tax rate on flow-through entity income by 20 percent. Said another way, the tax rate is 80 percent of what it would be without the deduction. Consequently, a taxpayer with a marginal rate of 37 percent on the flow through income would pay tax at 29.6 percent on the income after factoring in the deduction [37 percent × (1 - 0.2)] 15. [LO 3] Doug is considering investing in one of two partnerships that will build, own, and operate a hotel. One is located in Canada and one is located in Arizona. Assuming both investments will generate the same before-tax rate of return, which entity should Doug invest in when considering the after-tax consequences of the investment? Assume Doug’s marginal rate is 37 percent, he will be a passive investor in the business, and he will report the flow-through income from either entity on his tax return. Explain (ignore any foreign tax credit issues). Doug should invest in the partnership building and operating the hotel in Arizona rather than Canada. The primary reason for this is that the partnership income from the Arizona hotel qualifies for the qualified business income deduction while the partnership income from the Canada hotel will not because the income is not generated in the U.S. Thus, the taxable income from the Arizona partnership will be 80 percent of the taxable income from the Canada partnership, due to the 20 percent qualified business income deduction. 16. [LO 3] Is business income allocated from a flow-through business entity to its owners self-employment income? Explain. Whether business income allocated from a flow-through business entity to its owners is self-employment income depends on the type of entity and the owner’s involvement in the entity’s business activities. Business income allocated from an S corporation to its shareholders is not self-employment income to the shareholders. In contrast, a sole proprietorships income is self-employment income to the sole proprietor. For entities taxed as a partnership, the more involved the owner is in working for the business, the more likely the business income allocation will be treated as self-employment income. 17. [LO 3] Who pays the first level of tax on a C corporation’s income? What is the tax rate applicable to the first level of tax? A C corporation files a tax return and pays taxes on its taxable income (first level of tax). For tax years beginning after 2017, corporations pay tax at a flat 21 percent on their income. 18. [LO 3] Who pays the second level of tax on a C corporation’s income? What is the tax rate applicable to the second level of tax and when is it levied? A corporation’s shareholders are responsible for the second level of tax on corporate income. The applicable rate for the second level of tax depends on whether corporations retain their after-tax earnings and on the type of shareholder(s). The shareholders pay tax either when they receive dividends at the dividend tax rate or when they sell their stock at the capital gains tax rate (either long-term or short-term, depending on how long they held the stock). The maximum tax rate on long-term capital gains and qualified dividends is 20 percent. Individual shareholders may also be required to pay the 3.8% net investment income tax on capital gains and dividends, depending on their income level. Corporate shareholders may be eligible for a dividends received deduction on dividends received from stock ownership. This deduction reduces the effective tax rate on dividends for corporate shareholders. Institutional and tax-exempt shareholders also have special rules on the taxation of dividends and capital gains. 19. [LO 3] Is it possible for shareholders to defer or avoid the second level of tax on corporate income altogether? Briefly explain. Yes. The second level of tax is deferred to the extent corporations don’t pay dividends and shareholders defer selling their shares. However, if a corporation retains earnings for the purpose of avoiding the second level or tax rather than to invest in the business, it may be subject to the accumulated earnings tax of 20 percent. This is a penalty tax that eliminates the tax incentive for retaining earnings strictly to avoid the double tax. The second level of tax can be avoided entirely to the extent corporations retain after-tax income and shareholders hold the stock until death. At death, in the hands of the heirs, the stock would take a basis equal to its fair market value and the gain built into the stock would disappear. 20. [LO 3] How does a corporation’s decision to pay dividends affect its overall tax rate? The overall tax rate on a corporation’s income includes the corporate tax rate on its income and the tax rate paid by shareholders on either distributed earnings or stock sales. Therefore, the overall tax rate increases with the proportion of earnings distributed as dividends to shareholders. The shareholder may choose to delay recognizing the second level of tax as it relates to stock sales because the shareholder can control the timing of that tax. 21. [LO 3] Is it possible for the overall tax rate on corporate taxable income to be lower than the tax rate on flow-through entity taxable income? If so, under what conditions would you expect the overall corporate tax rate to be lower? Yes, this is particularly true under tax legislation effective beginning in 2018 that made corporate tax rates significantly lower than individual tax rates. The overall tax rate on corporate taxable income is more likely to be lower than the overall rate on flow-through entity income the more corporations retain rather than distribute their after-tax earnings. Further, the overall corporate tax rate is likely to be lower than the tax rate on flow-through income when the flow-through owner does not qualify for the qualified business income deduction and/or when the flow-through income is subject to the 3.8 percent net investment income tax or the self-employment tax. Finally, the overall corporate tax rate is more likely to be lower than the rate on flow-through income when the corporate shareholder is taxed at a 15 percent or 0 percent rate on dividends and capital gains and when the shareholder is not subject to the 3.8 percent net investment income on dividends and capital gains. 22. [LO 3] Assume Congress increases individual tax rates on ordinary income while leaving all other tax rates unchanged. How would this change affect the overall tax rate on corporate taxable income? How would this change affect overall tax rates for owners of flow-through business entities? The overall tax rate on corporate taxable income would remain constant because Congress did not change the corporate rate, dividend rate, or capital gains rate. The tax rate for flow-through entities would increase because their individual owners would have a higher tax liability on the business income. 23. [LO 3] Assume Congress increases the dividend tax rate to the ordinary tax rate while leaving all other tax rates unchanged. How would this change affect the overall tax rate on corporate taxable income? The overall corporate income tax rate would increase because the second level tax to shareholders on the dividend distributions would increase. The overall tax rate would also increase because individual shareholders would be taxed at a higher rate due to the increase in the dividend rate. 24. [LO 3] Evaluate the following statement: “When dividends and long-term capital gains are taxed at the same rate, the overall tax rate on corporate income is the same whether the corporation distributes its after-tax earnings as a dividend or whether it reinvests the after-tax earnings to increase the value of the corporation.” This statement is incorrect because it ignores the time value of money. Although (qualified) dividends and long-term capital gains are currently taxed at the same rate for individual shareholders, this does not mean the present value of capital gains taxes paid when shares are sold will equal dividends taxes paid when dividends are received. As shareholders increase the holding period of their shares, capital gains taxes on share appreciation attributable to reinvested dividends are deferred, and the present value of these capital gains taxes will decline relative to taxes paid currently on dividends. 25. [LO 3] If XYZ Corporation is a shareholder of BCD Corporation, how many times will the BCD’s before-tax income potentially be taxed? Has Congress provided any tax relief for this result? Explain. Three times. Taxes are paid first by BCD and then by XYZ when it receives BCD’s dividends. XYZ shareholders will also pay taxes on dividends received from XYZ. Thus, the before-tax income of BCD will be taxed at least three times if both BCD and XYZ pay out all of their after-tax earnings as dividends. This potential for triple taxation is mitigated somewhat by the dividends received deduction XYZ would receive on BCD’s dividends. The dividends received deduction is 50%, 65%, or 100% depending on the level of the shareholder corporation’s ownership in the distributing corporation’s stock. 26. [LO 3] How many times is income from a C corporation taxed if a retirement fund is the owner of the corporation’s stock? Explain. The income from a C corporation owned by a retirement fund is taxed twice: once at the corporate level and another time at the retirees’ level. The retirement fund isn’t taxed on the earnings received, but those earnings are taxed to the retirees when the earnings are eventually distributed out of the retirement fund to the retiree. 27. [LO 3] For tax purposes, how is the compensation paid to an S corporation shareholder similar to compensation paid to an owner of an entity taxed as a partnership? How is it different? Compensation paid to an S corporation shareholder is similar to compensation paid to an owner of an entity taxed as a partnership in the following ways: the compensation is paid to the owner in exchange for the owner providing services to the entity, the compensation is deducted by the entity to calculate the entity’s business income, the compensation is taxed to the owner as ordinary income. Finally, neither form of compensation is eligible for the qualified business income deduction. The compensation is different because the compensation paid to an S corporation shareholder is employee compensation and the compensation paid to an owner of a flow-through entity is self-employment income. Consequently, the S corporation shareholder pays the employee’s portion of the FICA tax and the S corporation pays the employer’s portion. The owner of an entity taxed as a partnership is solely responsible for paying all of the self-employment tax on the compensation received. Nevertheless, the combined rate of the employer plus employer’s portion of the FICA tax is the same as the self-employment tax rate. 28. [LO 3] Why might it be a good tax planning strategy for an S corporation with one shareholder to pay a salary to the shareholder on the low end of what the services are potentially worth? Compensation to an S corporation shareholder is paid as employee compensation. Consequently, the S corporation and the shareholder employee must pay FICA tax on the compensation. Further, the compensation is not eligible for the qualified business income deduction. Paying compensation on the low end reduces the income that is subject to FICA tax and is ineligible for the qualified business income deduction and it increases the business income of the entity which is not subject to FICA tax and is potentially eligible for the qualified business income deduction. 29. [LO 3] When a C corporation reports a loss for the year, can shareholders use the loss to offset their personal income? Why or why not? No. Because C corporations are treated as separate entities for tax purposes, their losses do not flow through to shareholders. The losses stay at the corporate level. 30. [LO 3] Is a current-year net operating loss of a C corporation available to offset income from the corporation in other years? Explain. Yes. While NOLs provide no tax benefit to a corporation in the year the corporation experiences the NOL, they may be used to reduce corporate taxes in other years. C corporations may carry back NOLs incurred prior to 2018 two years and then forward 20 years to offset up to 100 percent of the income of the C corporations in those years. For NOLs incurred after 2017, C corporations can carry net operating losses forward indefinitely (no limit) but they may not carry them back. Further, the net operating loss deduction can only offset 80 percent of taxable income before the deduction in a given year. 31. [LO 3] Would a corporation with a small amount of current-year taxable income (before the net operating loss deduction) and a large net operating loss carryover have a tax liability for the current year? Explain. It depends. If the net operating loss was incurred in a tax year ending before 2018, the net operating loss deduction would reduce current year taxable income to zero and the corporation would not have a tax liability. In contrast, if the net operating loss was incurred in a year ending after 2017, it could offset only 80% of the taxable income before the net operating loss deduction. Consequently, the corporation would have a tax liability equal to 21 percent of the income remaining after the net operating loss deduction (16.8 percent of the income before the NOL deduction). 32. [LO 3] In its first year of existence, SMS, an S corporation, reported a business loss of $10,000. Michelle, SMS’s sole shareholder, reports $50,000 of taxable income from sources other than SMS. What must you know in order to determine whether she can deduct the $10,000 loss against her other income? Explain. Because an S corporation is a flow-through entity, the business loss from SMS is allocated to Michelle. However, the loss must clear certain limitations in order for Michelle to deduct this loss against her other income. First, Michelle may deduct the loss to the extent of her tax basis in her SMS stock. The second limitation is the “at-risk” amount. In general, the at-risk amount is similar to her basis in her SMS stock so the at-risk limitation will likely not be any more binding than the basis limitation. If SMS has adequate basis and at-risk amounts she can deduct the loss if she is involved in working for SMS. If Michelle is a passive investor in SMS, the loss is a passive activity loss and Michelle may only deduct the loss to the extent she has income from other passive investments (businesses in which she is a passive investor). 33. [LO 3] ELS, an S corporation, reported a business loss of $1,000,000. Ethan, ELS’s sole shareholder, is involved in ELS’s daily business activities, and he reports $1,200,000 of taxable income from sources other than ELS. What must you know in order to determine how much, if any, of the $1,000,000 loss Ethan may deduct in the current year? Explain. Because an S corporation is a flow-through entity, the business loss from ELS is allocated to Ethan. However, the loss must clear certain limitations in order for Ethan in order for him to deduct this loss against his other income. First, Ethan may deduct the loss to the extent of his tax basis in his ELS stock. The second limitation is the “at-risk” amount. In general, the at-risk amount is similar to his basis in his ELS stock so the at-risk limitation will likely not be any more binding than the basis limitation. Because Ethan is involved in ELS business activities, he is not considered to be a passive investor in ELS. Consequently, the passive activity loss limitations do not apply. However, Ethan is likely limited by the excess business loss limitation. We need to know Ethan’s filing status to know how much he can deduct in the current year. If Ethan’s filing status is married filing jointly, he can deduct $518,000 of the loss this year and include the remaining $482,000 loss in his net operating loss calculation for the year and carry it forward (subject to the 80 percent deduction limitation). If Ethan’s filing status is not married filing jointly, he could deduct $259,000 of the loss this year and include the remaining $741,000 loss in his net operating loss calculation for the year and carry it forward (subject to the 80 percent deduction limitation). 34. [LO 3] Why are S corporations less favorable than C corporations and entities taxed as partnerships in terms of owner-related limitations? S corporations may not have more than 100 shareholders and they may not have corporations, partnerships, nonresident aliens, or certain trusts as shareholders. The only ownership restriction for C corporations and partnerships is that C corporations must have a least one shareholder and a partnership (or entity taxed as a partnership) must have at least two owners. 35. [LO 3] Are C corporations or flow-through entities (S corporations and entities taxed as partnerships) more flexible in terms of selecting a tax year-end? Why are the tax rules in this area different for C corporations and flow-through business entities? C corporations provide greater flexibility when selecting tax year-ends. Generally, corporations can choose a tax year that ends on the last day of any month of the year. In contrast, S corporations must typically adopt a calendar year-end while partnerships are generally required to adopt year-ends consistent with the partners’ year-ends. The tax laws attempt to require flow-through entities to have the same year-end as their owners to limit the owners’ ability to defer reporting income. C corporation income does not flow through to owners so the year-end does not matter from a tax perspective. 36. [LO 3] Which tax entity types are generally allowed to use the cash method of accounting? The tax laws restrict the entities that may use the cash method. C corporations are generally required to use the accrual method of accounting. However, smaller C corporations may use the cash method. For 2020, C corporations with average annual gross receipts of $26 million or less may use the cash method of accounting. S corporations and entities taxed as partnerships generally may use the cash method of accounting. The cash method provides a tax advantage for entities because it allows the entities to have better control of when they recognize income and expenses. 37. [LO 3] According to the tax rules, how are profits and losses allocated to owners of entities taxed as partnerships (partners or LLC members)? How are they allocated to S corporation shareholders? Which entity permits greater flexibility in allocating profits and losses? For entities taxed as partnerships (partnerships or LLCs with more than one member), the entity profits and losses are allocated according to the LLC operating/partnership agreement. The agreement may provide for special allocations that are different from owners’ actual ownership percentages. In contrast, S corporation profits must be allocated to shareholders pro rata according to their ownership percentages. Thus, entities taxed as partnerships provide for greater flexibility in allocating profits and losses. 38. [LO 3] Compare and contrast the FICA tax burden of S corporation shareholder-employees and LLC members (assume the LLC is taxed as a partnership) receiving compensation for working for the entity (guaranteed payments) and business income allocations to S corporation shareholders and LLC members assuming the owners are actively involved in the entity’s business activities. How does your analysis change if the owners are not actively involved in the entity’s business activities? Shareholder-employees of S corporations pay FICA tax (and possibly the additional 0.9% Medicare tax depending on the salary level) on the shareholder’s salary. However, the shareholder’s allocation of the S corporation’s business income for the year is not subject to FICA, self-employment tax, or the additional 0.9% Medicare tax. If shareholders materially participate in the entity’s business activities, the income allocations are not subject to the 3.8% net investment income tax. Income allocations to shareholders who do not materially participate in the entity’s business activities may be subject to the net investment income tax, depending on the shareholder’s income level. Members of LLCs taxed as partnerships pay self-employment tax on any guaranteed payments they receive and on their share of business income from the LLC if they are actively involved in the LLC’s business activities. The tests for making this determination are not absolute so there is a diversity in practice in terms of applying this test. An LLC member may also pay the 0.9% additional Medicare tax on guaranteed payments and business-income allocations, depending on the member’s income level. Further, an LLC member who does not significantly participate in the entity’s business activity does not pay self-employment tax on the member’s share of operating income from the LLC. However, the member’s share of business income may be subject to the net investment income tax, depending on the member’s income level. 39. [LO 3] Explain how liabilities of an LLC (taxed as a partnership) or an S corporation affect the amount of tax losses from the entity that limited liability company members and S corporation shareholders may deduct. Do the tax rules favor LLCs or S corporations? LLC liabilities are included as part of a member’s tax basis in the entity while S corporation liabilities (other than loans from the shareholder) are not included in an S corporation shareholder’s tax basis in their stock. This distinction is important because the amount of loss a member or shareholder may deduct is limited to his or her tax basis in either his or her LLC interest or stock. Thus, in this regard, tax rules favor LLCs. 40. [LO 3] Compare the entity-level tax consequences for C corporations, S corporations, and business entities taxed as partnerships for both nonliquidating and liquidating distributions of noncash property. Do the tax rules tend to favor one entity type more than the others? Explain. Both C corporations and S corporations recognize gain on nonliquidating distributions of appreciated property. Neither C corporations nor S corporations recognize loss on nonliquidating distributions of depreciated property (the loss disappears unused by anyone). Entities taxed as partnerships do not recognize gain on nonliquidating distributions of appreciated property and they do not recognize loss on nonliquidating distributions of depreciated property (the loss carries over to the partner). Thus, the tax rules associated with nonliquidating distributions of noncash property favor partnerships over C corporations and S corporations. For liquidating distributions, C corporations and S corporations both recognize gain and loss (with certain exceptions) when distributing noncash property. Partnerships do not recognize gain or loss on liquidating distributions on noncash property (the loss carries over the receiving partner). Thus, the tax rules for liquidating distributions of noncash property favor entities taxed as partnerships over C corporations and S corporations. 41. [LO 3] If business entities taxed as partnerships and S corporations are both flow-through entities for tax purposes, why might an owner prefer one form over the other for tax purposes? List separately the tax factors supporting the decision to operate a business entity as either an entity taxed as a partnership or as an S corporation. Although business entities taxed as partnerships and S corporations are both taxed as flow-through entities, several differences exist between the two entity types. Advantages of S corporations include the ability for shareholders to work as employees of the business and not pay employment taxes on income allocations (self-employment and FICA tax benefit), and the ease of selling their stock. In contrast, the potential advantages to operate as a partnership are more numerous and include 1) no restrictions on the number and type of allowable owners, 2) few restrictions on tax-deferred contributions, 3) special allocations are allowed, 4) owner basis for entity debt, 5) generally no gain recognition on nonliquidating and liquidating distributions of appreciated property and 6) ease of converting to other entity types. These advantages are summarized in the following table: Note: X represents which entity is more favorable on that particular tax characteristic. S Corporations Entities Taxed as Partnerships Tax Characteristics: Limitations on number and type of owners X Contributions to entity X Special allocations X FICA and self-employment taxes X Additional Medicare tax X Amount of tax basis in ownership interest X Deductibility of entity losses X Selling ownership interest X Distributions of appreciated property (nonliquidating and liquidating) X Converting to other entity types X 42. [LO 3] What are the tax advantages and disadvantages of converting a C corporation into an LLC taxed as a partnership? The major disadvantage of converting a C corporation into an LLC taxed as a partnership is that the appreciation in corporate assets must be taxed once at the corporate level and again at the shareholder level as part of the conversion to an LLC. After converting to an LLC, the potential advantage will be that the entity avoids the double tax going forward. However, with the cut in corporate tax rates effective beginning in 2018, it is not necessarily true that C corporation income is taxed at a higher rate than flow-through income. Clearly, in the absence of a large NOL carry forward to absorb the gain (or 80 percent of the gain for NOLs incurred in tax years beginning after 2017), the present value of this advantage is typically overwhelmed by the taxes that must be paid at the time of conversion. Thus, in general, making the S election is a more viable method for converting a C corporation into a flow-through entity than by converting it into an entity taxed as a partnership. Problems 43. [LO 1] {Research} Visit your state’s official website and review the information there related to forming and operating business entities in your state. Write a short report explaining the steps for organizing a business in your state and summarizing any tax-related information you found. The items students mention are likely to vary from state to state but should include a description of the formalities required to organize an entity in the state as well as a general description of the federal (and perhaps state) rules applicable to the entity. 44. [LO 3] Kiyara (single) is a 50 percent shareholder of Jazz Corporation (an S Corporation). Kiyara does not do any work for Jazz Corp. Jazz Corp. reported $300,000 of business income for the year (2020). Before considering her business income allocation from Jazz Corp. and the self-employment tax deduction (if any), Kiyara’s adjusted gross income was $250,000 (all employee salary). Answer the following questions for Kiyara. a. Assuming the income allocated to Kiyara is qualified business income, what is Kiyara’s deduction for qualified business income? b. What is Kiyara’s net investment income tax liability (assume no investment expenses)? c. What is Kiyara’s self-employment tax liability? d. What is Kiyara’s additional Medicare tax liability (include all earned income in computing the tax)? a. $30,000 ($300,000 × 50% qualified business income allocated to Kiyara × 20% QBI deduction rate). b. $5,700. Because Kiyara does not do any work for Jazz Corp., the $150,000 business income allocated to her ($300,000 × 50%) is passive income and thus investment income for purposes of the net investment income tax. Kiyara’s net investment income tax is $5,700 which is 3.8% × the lesser of 1) $150,000 or 2) $200,000 ($400,000 minus $200,000 AGI threshold). Note that the problem says to assume $0 investment expenses so net investment income equals gross investment income. c. $0. Kiyara doesn’t have any self-employment income. d. $450. [.009 × ($250,000 salary minus $200,000 threshold)]. Kiyara’s only earned income is her $250,000 salary. 45. [LO 3] Mason (single) is a 50 percent shareholder in Angels Corp. (an S Corporation). Mason receives a $180,000 salary working full time for Angels Corp. Angels Corp. reported $400,000 of taxable business income for the year (2020). Before considering his business income allocation from Angels and the self-employment tax deduction (if any), Mason’s adjusted gross income is $180,000 (all salary from Angels Corp.). Answer the following questions for Mason. a. Assuming the business income allocated to Mason is qualified business income, what is Mason’s deduction for qualified business income? b. What is Mason’s net investment income tax liability (assume no investment expenses)? c. What is Mason’s self-employment tax liability? d. What is Mason’s additional Medicare tax liability? a. $40,000 ($400,000 × 50% qualified business income allocated to Mason × 20% QBI deduction rate). b. $0. Because Mason works for Angel Corp. the income allocated to him from Angel is not passive income and is therefore not subject to the net investment income tax. c. $0. Because Angel is an S corporation, the Angel business income allocated to Mason is not self-employment income and is therefore not subject to self-employment tax. d. $0. Mason’s salary of $180,000 is below the $200,000 threshold for paying the tax so he does not owe any additional Medicare tax. Note that because Angel is an S corporation, the Angel business income allocated to Mason is not subject to the additional Medicare tax. 46. [LO 3] Sarah (single) is a 50 percent owner in Beehive LLC (taxed as a partnership). Sarah does not do any work for Beehive. Beehive LLC. reported $600,000 of taxable business income for the year (2020). Before considering her 50 percent business income allocation from Beehive and the self-employment tax deduction (if any), Sarah’s adjusted gross income is $150,000 (all employee salary). Answer the following questions for Sarah. a. Assuming the business income allocated to Sarah is qualified business income, what is Sarah’s deduction for qualified business income? b. What is Sarah’s net investment income tax liability (assume no investment expenses)? c. What is Sarah’s self-employment tax liability? d. What is Sarah’s additional Medicare tax liability? a. $60,000 ($600,000 × 50% qualified business income allocated to Beehive × 20% QBI deduction rate). b. $9,500. Because Sarah does not do any work for Beehive Corp., the $300,000 business income allocated to her ($600,000 × 50%) is passive income and thus investment income for purposes of the net investment income tax. Sarah’s net investment income tax is $9,500 which is 3.8% × the lesser of 1) $300,000 or 2) $250,000 ($450,000 AGI minus $200,000 AGI threshold). Her AGI consists of the $150,000 salary plus the $300,00 business income allocation. Also, the problem says to assume $0 investment expenses so net investment income equals gross investment income. c. $0. The Beehive income allocated to Sarah is not self-employment income because she doesn’t do any work for Beehive. Consequently, the income is not subject to self-employment tax. The salary is subject to FICA but not self-employment tax because she is an employee. d. $0. Sarah’s salary of $150,000 is below the $200,000 threshold for paying the tax. Note that the Beehive income allocated to Sarah is not earned income and is not subject to the additional Medicare tax. 47. [LO 3] Omar (single) is a 50 percent owner in Cougar LLC (taxed as a partnership). Omar works half time for Cougar and receives a guaranteed payment of $50,000. Cougar LLC reported $450,000 of business income for the year (2020). Before considering his 50 percent business income allocation from Cougar and the self-employment tax deduction (if any), Omar’s adjusted gross income is $210,000 (includes $50,000 guaranteed payment from Cougar and $160,000 salary from a different employer). Answer the following questions for Omar. a. Assuming the business income allocated to Omar is qualified business income, what is Omar’s deduction for qualified business income? b. What is Omar’s net investment income tax liability (assume no investment expenses)? c. What is Omar’s self-employment tax liability (exclude the guaranteed payment)? d. What is Omar’s additional Medicare tax liability? a. $44,397 [($450,000 × 50% qualified business income allocated to Omar minus $3,013 self-employment tax deduction on $225,000 QBI) × 20% QBI deduction rate). The $3,013 self-employment tax deduction is computed as $6,026 self-employment tax on business income allocation (see answer to c) × 50%. Only the self-employment tax deduction on the business income allocation reduces QBI because the business income was included in QBI while the guaranteed payment was not (so the self-employment tax on the guaranteed payment does not reduce QBI). b. $0. Because Omar works half-time Cougar LLC, the business income allocated to him from Cougar is not passive income and is therefore not subject to the net investment income tax. c. $6,026. The applicable self-employment tax rate on Omar’s net earnings from self-employment is 2.9% because Omar’s employee compensation is greater than the $137,700 cutoff for the 15.3% rate. The self-employment tax on Omar’s business income allocation is $6,026 ($450,000 × 50% × .9235 × .029). Note that the self-employment tax on Omar’s guaranteed payment is $1,339 ($50,000 × .9235 × .029). Thus, including the guaranteed payment, Omar's self-employment tax liability is $7,365 ($6,026 + $1,339). d. $1,926 [($160,000 employee compensation + $253,963 net earnings from self-employment minus $200,000 threshold) × .009]. Omar’s net earnings from self-employment is computed as [($225,00 business income allocation + $50,000 guaranteed payment) × .9235]. 48. [LO 3] Andrea would like to organize SHO as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 11 percent annual before-tax return on a $200,000 investment. Andrea’s marginal income tax rate is 35 percent and her tax rate on dividends and capital gains is 15 percent. Andrea will also pay a 3.8 percent net investment income tax on dividends and capital gains she recognizes. If Andrea organizes SHO as an LLC, Andrea will be required to pay an additional 2.9 percent for self-employment tax and an additional .9 percent for the additional Medicare tax. Further, she is eligible to claim the deduction for qualified business income. Assume that SHO will pay out its all of its after-tax earnings every year as a dividend if it is formed as a C corporation. a. How much cash after taxes would Amanda receive from her investment in the first year if SHO is organized as either an LLC or a C corporation? b. What is the overall tax rate on SHO’s income in the first year if SHO is organized as an LLC or as a C corporation? a. LLC Description C Corp. Description (1) Pretax earnings $22,000 11% × $200,000 $22,000 11% × $200,000 (2) Entity level tax rate 0% 21% (3) Entity level tax -0- 4,620 (1) × (2) (4) Earnings after-entity-level tax $22,000 (1) – (3) $17,380 (1) – (3) (5) QBI deduction (4,341) [(4) – (6)] × 20% NA (6) Deduction for 50 percent of SE tax (295) (1) × .9235 × .029 × .5 NA (7) Net income taxable to owner 17,364 (4) + (5) + (6) 17,380 (4) distributed as dividend (8) Income tax paid by owner 6,077 (7) × .35 2,607 (7) × .15 (9) Self-employment tax 589 (1) × .9235 × .029 NA (10) Additional Medicare tax/Net investment income tax 183 (1) × .9235 × .009 additional Medicare tax 660 (7) × .038 net investment income tax (11) Owner-level tax $6,849 (8) + (9) + (10) $3,267 (8) + (10) After-tax cash flow $15,151 (1) – (11) $14,113 (7) – (11) b. LLC C Corp. Overall tax rate 31.13% (11)/(1) 35.85% [(3) + (11)]/(1) 49. [LO 3] Jacob is a member of WCC (an LLC taxed as a partnership). Jacob was allocated $100,000 of business income from WCC for the year. Jacob’s marginal income tax rate is 37 percent. The business allocation is subject to 2.9 percent of self-employment tax and .9 percent additional Medicare tax. a. What is the amount of tax Jacob will owe on the income allocation if the income is not qualified business income? b. What is the amount of tax Jacob will owe on the income allocation if the income is qualified business income (QBI) and Jacob qualifies for the full QBI deduction? a. $40,014, computed as follows: Amount Description (1) Business income allocation $100,000 (2) Deduction for 50 percent of SE tax (1,339) (1) × .9235 × .029 × .5 (3) QBI deduction 0 Income doesn’t qualify (4) Net income taxable business income 98,661 (1) + (2) + (3) (5) Income tax paid by owner 36,505 (4) × .37 (6) Self-employment tax 2,678 (1) × .9235 × .029 (7) Additional Medicare tax 831 (1) × .9235 × .009 additional Medicare tax Owner-level tax $40,014 (5) + (6) + (7) b. $32,713, computed as follows: Amount Description (1) Business income allocation $100,000 (2) Deduction for 50 percent of SE tax (1,339) (1) × .9235 × .029 × .5 (3) QBI deduction (19,732) [(1) – (2)] × 20% (4) Net income taxable business income 78,929 (1) + (2) + (3) (5) Income tax paid by owner 29,204 (4) × .37 (6) Self-employment tax 2,678 (1) × .9235 × .029 (7) Additional Medicare tax 831 (1) × .9235 × .009 additional Medicare tax Owner-level tax $32,713 (5) + (6) + (7) 50. [LO 3] Amanda would like to organize BAL as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Amanda’s marginal income tax rate is 37 percent and her tax rate on dividends and capital gains is 23.8 percent (including the 3.8 percent net investment income tax). If Andrea organizes BAL as an LLC, she will be required to pay an additional 2.9 percent for self-employment tax and an additional .9 percent for the additional Medicare tax. Also, she is eligible to claim a full deduction for qualified business income on BAL’s income. Assume that BAL will distribute half of its after-tax earnings every year as a dividend if it is formed as a C corporation. a. How much would cash after taxes would Amanda receive from her investment in the first year if BAL is organized as either an LLC or a C corporation? b. What is the overall tax rate of on BAL’s income in the first year if BAL is organized as an LLC or it is organized as a C corporation? a. LLC Description C Corp. Description (1) Pretax earnings $40,000 8% × $500,000 $40,000 8% × $500,000 (2) Entity level tax rate 0% 21% (3) Entity level tax -0- 8,400 (1) × (2) (4) Earnings after-entity-level tax $40,000 (1) – (3) $31,600 (1) – (3) (5) Deduction for 50 percent of SE tax (536) (1) × .9235 × .029 × .5 NA (6) QBI deduction (7,893) [(4) – (5)] × 20% NA (7) Net income taxable to owner 31,571 (4) + (5) + (6) 15,800 (4) × 50% distributed as dividend (8) Income tax paid by owner 11,681 (7) × .37 3,160 (7) × .20 (9) Self-employment tax 1,071 (1) × .9235 × .029 NA (10) Additional Medicare tax/Net investment income tax 332 (1) × .9235 × .009 additional Medicare tax 600 (7) × .038 net investment income tax (11) Owner-level tax $13,084 (8) + (9) + (10) $3,760 (8) + (10) After-tax cash flow $26,916 (1) – (11) $12,040 (7) – (11) b. LLC C Corp. Overall tax rate 32.71% (11)/(1) 30.4% [(3) + (11)]/(1) Note that while the overall tax rate is lower for BAL if it’s organized as a C Corp., Amanda ends up with less cash in year 1 if BAL is organized as a C corporation because BAL retained half of its after-tax income. 51. [LO 3] Sandra would like to organize LAB as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Sandra’s marginal income tax rate is 37 percent and her tax rate on dividends and capital gains is 23.8 percent (including the 3.8 percent net investment income tax). If Sandra organizes LAB as an LLC, she will be required to pay an additional 2.9 percent for self-employment tax and an additional .9 percent for the additional Medicare tax. LAB’s income is not qualified business income (QBI) so Sandra is not allowed to claim the QBI deduction. Assume that LAB will distribute all of its after-tax earnings every year as a dividend if it is formed as a C corporation. a. How much cash after taxes would Sandra receive from her investment in the first year if LAB is organized as either an LLC or a C corporation? b. What is the overall tax rate on LAB’s income in first year if LAB is organized as an LLC or it is organized as a C corporation? a. LLC Description C Corp. Description (1) Pretax earnings $40,000 8% × $500,000 $40,000 8% × $500,000 (2) Entity level tax rate 0% 21% (3) Entity level tax -0- 8,400 (1) × (2) (4) Earnings after-entity-level tax $40,000 (1) – (3) $31,600 (1) – (3) (5) Deduction for 50 percent of SE tax (536) (1)× .9235 × .029 × .5 NA (6) QBI deduction 0 Does not qualify NA (7) Net income taxable to owner 39,464 (4) + (5) + (6) 31,600 (4) × 100% distributed as dividend (8) Income tax paid by owner 14,602 (7) × .37 6,320 (7) × .20 (9) Self-employment tax 1,071 (1) × .9235 × .029 NA (10) Additional Medicare tax/Net investment income tax 332 (1) × .9235 × .009 additional Medicare tax 1,201 (7) × .038 net investment income tax (11) Owner-level tax $16,005 (8) + (9) + (10) $7,521 (8) + (10) After-tax cash flow $23,995 (1) – (11) $24,079 (7) – (11) b. LLC C Corp. Overall tax rate 40.01% (11)/(1) 39.8% [(3) + (11)]/(1) 52. [LO 3] Tremaine would like to organize UTA as either an S Corporation or a C corporation. In either form, the entity will generate a 9 percent annual before-tax return on a $1,000,000 investment. Tremaine’s marginal income tax rate is 37 percent, and his tax rate on dividends and capital gains is 23.8 percent (including the net investment income tax). If Tremaine organizes UTA as an S corporation, he will be allowed to claim the deduction for qualified business income. Also, because Tremaine will participate in UTA’s business activities, the income from UTA will not be subject to the net investment income tax. Assume that UTA will pay out 25 percent of its after-tax earnings every year as a dividend if it is formed as a C corporation. a. How much cash after taxes would Tremaine receive from his investment in the first year if UTA is organized as either an S corporation or as a C corporation? b. What is the overall tax rate on UTA’s income in the first year if UTA is organized as an S corporation or as a C corporation? c. What is the overall tax rate on UTA’s in the first year if it is organized as an S corporation, but UTA’s income is not qualified business income? d. What is the overall tax rate on UTA’s income if it is organized as an S corporation, UTA’s income is not qualified business income, and Tremaine is a passive investor in UTA? a. S Corp. Description C Corp. Description (1) Pretax earnings $90,000 9% × $1,000,000 $90,000 9% × $1,000,000 (2) Entity level tax rate 0% 21% (3) Entity level tax -0- 18,900 (1) × (2) (4) Earnings after-entity-level tax $90,000 (1) – (3) $71,100 (1) – (3) (5) QBI deduction 18,000 (4) × 20% NA (6) Net income taxable to owner 72,000 (4) - (5) 17,775 (4) × .25 distributed as dividend (7) Owner level marginal tax rate 37% 23.8% 20% div. + 3.8% net investment income tax (8) Owner-level tax $26,640 (6) × (7) $4,231 (6) × (7) After-tax cash flow $63,360 (1) – (8) $13,544 (6) – (8) b. LLC Corp. Overall tax rate 29.6% (8)/(1) 25.7% [(3) + (8)]/(1) c. 37 percent. If the income is not qualified business income, the full amount of income will be taxed at 37%. d. 40.8 percent (37 percent + 3.8 percent net investment income tax) 53. [LO 3] {Tax Forms} Marathon Inc. (a C corporation) reported $1,000,000 of taxable income in the current year. During the year it distributed $100,000 as dividends to its shareholders as follows: • $5,000 to Guy, a 5 percent individual shareholder. • $15,000 to Little Rock Corp., a 15 percent shareholder (C corporation). • $80,000 to other shareholders. a. How much of the dividend payment did Marathon deduct in determining its taxable income? b. Assuming Guy’s marginal ordinary tax rate is 37 percent, how much tax will he pay on the $5,000 dividend he received from Marathon Inc. (including the net investment income tax)? c. What amount of tax will Little Rock Corp. pay on the $15,000 dividend it received from Marathon Inc. (50 percent dividends received deduction)? d. Complete Form 1120 Schedule C for Little Rock Corp. to reflect its dividends received deduction (use the most recent Form 1120 Schedule C available). e. On what line on page 1 of Little Rock Corp.’s Form 1120 is the dividend from Marathon Inc. reported, and on what line of Little Rock Corp.’s Form 1120 is its dividends received deduction reported? a. $0. A corporation is not allowed to deduct dividend distributions it makes to its shareholders. b. $1,190. Guy would pay tax on the dividend at a 23.8% tax rate (20% + 3.8% net investment income tax). Total dividend $5,000 × 23.8% = $1,190. c. $1,575 tax. $15,000 dividend – $7,500 dividends received deduction = $7,500 taxable portion of dividend × 21% corporate tax rate = $1,575. d. See Schedule C below. e. Little Rock Corp will report the $15,000 dividend on Form 1120, page 1, line 4. Little Rock Corp. will report its $7,500 dividends received deduction on Form 1120, page 1, line 29b (assuming 2020 form is same structure as 2019 form). 54. [LO 3] {Research} After several years of profitable operations, Javell, the sole shareholder of JBD Inc., a C corporation, sold 22 percent of her JBD stock to ZNO Inc., a C corporation in a similar industry. During the current year, JBD reports $1,000,000 of after-tax income. JBD distributes all of its after-tax earnings to its two shareholders in proportion to their shareholdings. How much tax will ZNO pay on the dividend it receives from JBD? What is ZNO’s tax rate on the dividend income (after considering the DRD)? [Hint: see IRC §243] ZNO will pay $16,170 on the dividend and its tax rate on the dividend is 7.35 percent. According to IRC §243(a), corporations are generally entitled to a 50 percent dividends received deduction. Subsection (c) provides for a 65 percent dividends received deduction when a corporation owns 20 percent or more of the dividend-paying corporation. In this situation, ZNO is entitled to a 65 percent dividends received deduction on dividends received from JBD because ZNO owns 22 percent of JBD. ZNO’s tax liability from the dividend it receives from JBD is calculated as follows: Amount Description (1) JBD’s after-tax income $1,000,000 (2) Dividend paid to ZNO 220,000 22% × (1) (3) Dividends received deduction $143,000 (2) × 65% (4) ZNO’s taxable dividend (net of DRD) 77,000 (2) – (3) (5) ZNO’s tax rate 21% (6) ZNO’s tax on dividend $16,170 (4) × (5) ZNO’s overall tax rate on dividend 7.35% (6)/(2) 55. [LO 3] Mackenzie is considering conducting her business, Mac561, as either in LLC or an S corporation. Assume her marginal ordinary income tax rate is 37 percent, her marginal FICA rate on employee compensation is 1.45 percent, her marginal self-employment tax rate is 2.9 percent, and any employee compensation or self-employment income she receives is subject to the .9 percent additional Medicare tax. Also, assume Mac561 generated $200,000 of business income before considering the deduction for compensation Mac561 pays to Mackenzie and Mackenzie can claim the qualified business income deduction on Mac561’s business income. Determine Mackenzie’s after-tax cash flow from the entity’s business income and any compensation she receives from the business under the following assumptions: a. Mackenzie conducted Mac561 as a single-member LLC. Amount Description (1) Business income $200,000 (2) QBI deduction (39,464) [(1) – (3)] × 20% (3) Deduction for 50 percent of SE tax (2,678) (1)× .9235 × .029 × .5 (4) Net income taxable business income 157,858 (1) + (2) + (3) (5) Income tax paid by owner 58,407 (4) × .37 (6) Self-employment tax 5,356 (1) × .9235 × .029 (7) Additional Medicare tax 1,662 (1) × .9235 × .009 additional Medicare tax (8) Total tax $65,425 (5) + (6) + (7) After-tax cash flow $134,575 (1) – (8) b. Mackenzie conducted Mac561 as an S corporation and she received a salary of $100,000. All business income allocated to her is also distributed to her. Amount Description (1) Business income before comp. $200,000 (2) Salary (100,000) (3) FICA deduction (1,450) (2) × .0145 employer’s portion (4) Business income allocation and distribution to owner 98,550 (1) + (2) + (3) (5) QBI deduction (19,710) (4) × 20% (6) Net taxable business income 78,840 (4) + (5) (7) Income tax on net business income (29,171) (6) × .37 (8) Salary received 100,000 (2) (9) Income tax on salary (37,000) (8) × .37 (10) Additional Medicare tax on salary (900) (8) × .009 (11) FICA tax paid (1,450) (2) × .0145 employee’s portion After-tax cash flow $130,029 (4) + (7) + (8) + (9) + (10) + (11) c. Mackenzie conducted Mac561 as an S corporation and she received a salary of $20,000. All business income allocated to her is also distributed to her. Amount Description (1) Business income before comp. $200,000 (2) Salary (20,000) (3) FICA deduction (290) (2) × .0145 employer’s portion (4) Business income allocation and distribution to owner 179,710 (1) + (2) + (3) (5) QBI deduction (35,942) (4) × 20% (6) Net taxable business income 143,768 (4) + (5) (7) Income tax on net business income (53,194) (6) × .37 (8) Salary received 20,000 (2) (9) Income tax on salary (7,400) (8) × .37 (10) Additional Medicare tax on salary (180) (8) × .009 (11) FICA tax paid (290) (2) × .0145 employee’s portion After-tax cash flow $138,646 (4) + (7) + (8) + (9) + (10) + (11) d. Which entity/compensation combination generated the most after-tax cash flow for Mackenzie? What are the primary contributing factors favoring this combination? The S corporation with the low ($20,000) salary was the best. The factors favoring this were (1) a small amount of payroll tax on the low salary (2) a relatively large QBI deduction because of the low salary, and (3) none of the relatively large business income allocation was subject to FICA or self-employment tax. The IRS could potentially evaluate the salary Mackenzie performed and determine that it was unreasonably low. If so, the IRS could possibly reclassify some of the business income as salary. The single member LLC was a close second because it provided for a larger QBI deduction. However, this advantage was offset by the fact that the entire income was subject to self-employment tax (92.35 percent of it, anyway). 56. [LO 3] SCC corporation (a C corporation) has a net operating loss (NOL) carryover to 2020 in the amount of $30,000. How much tax will SCC pay in 2020 if it reports taxable income from operations of $20,000 before considering loss carryovers under the following assumptions? a. The NOL originated in 2017. None. SCCs’ loss in 2017 of ($30,000) will be available to offset up to 100 percent of the income generated by SCC in 2020. Since SCC earned $20,000 of taxable income in 2020 before any loss carryovers, it can use ($20,000) of the loss carryover from 2017 to offset its entire taxable income and will pay no tax. SCC will have a ($10,000) loss carryover for another 17 years. b. The NOL originated in 2018. $840 ($4,000 taxable income after NOL deduction × 21 percent). The year 2018 loss is carried forward indefinitely but it can only offset 80 of taxable income (before the NOL deduction) for a given year. In this case, the NOL deduction is limited to $16,000 ($20,000 taxable income before NOL × .8). Consequently, SCC’s taxable income in 2020 after the NOL deduction is $4,000. SCC will have a $14,000 loss carryover ($30,000 - $16,000 used in 2020) that will not expire. 57. [LO 3] Willow Corp. (a C corporation) reported taxable income before the net operating loss deduction (NOL) in the amount of $100,000 in 2020. Willow had an NOL carryover of $90,000 to 2020. How much tax will Willow Corp. pay in 2020, what is its NOL carryover to 2021, and when will the NOL expire under the following assumptions? a. $50,000 of the NOL was generated in 2016 and $40,000 of the NOL was generated in 2017. Tax is $2,100 and NOL carryover is $0. The expiration date is not applicable because there is no NOL. Description (1) 2020 taxable income before NOL $100,000 (2) 2016 NOL carryforward ($50,000) (3) 2017 NOL carryforward ($40,000) (4) Taxable income reported 10,000 (1) + (2) + (3) (5) Tax rate 21% Flat corporate tax rate Taxes paid in year 3 $2,100 (4) × (5) b. $50,000 of the NOL was generated in 2018 and $40,000 was generated in 2019. Tax is $4,200 and NOL carryover is $10,000. The NOL does not expire. It is carried forward indefinitely. The NOL carryover to 2020 is $90,000. The taxable income in 2020 before the NOL deduction is $100,000. The NOL deduction can offset only $80% of the $100,000. Consequently, 2020 taxable income will be $20,000 ($100,000 minus $80,000). The tax liability on the $20,000 is $4,200 ($20,000 × 21%). Because $80,000 of the $90,000 NOL was used to offset income in 2020, $10,000 of NOL carryover remains and is carried forward indefinitely to offset up to 80% of taxable income in a future year (it doesn’t matter but the NOL carryover originated in 2019 - the oldest (2018) NOL is used to offset income first). The NOL carryover does not expire. 58. [LO 3] Damarcus is a 50 percent owner of Hoop (a business entity). In the current year, Hoop reported a $100,000 business loss. Answer the following questions associated with each of the following alternative scenarios. a. Hoop is organized as a C corporation and Damarcus works full time as an employee for Hoop. Damarcus has a $20,000 basis in his Hoop stock. How much of Hoop’s loss is Damarcus allowed to deduct this year against his other income? $0. Losses of C corporations do not flow through to shareholders. b. Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus works full time for Hoop (he is not considered to be a passive investor in Hoop). Damarcus has a $20,000 basis in his Hoop ownership interest, and he also has a $20,000 at-risk amount in his investment in Hoop. Damarcus does not report income or loss from any other business activity investments. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year? $20,000. $50,000 of Hoop’s loss is allocated to Damarcus. However, because his basis and at-risk amounts are $20,000, he is allowed to deduct only $20,000 of the loss. The remaining $30,000 is suspended until Damarcus increases his basis and at-risk amount. The passive activity limitations do not apply because Damarcus is not considered to be a passive investor in Hoop. c. Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus does not work for Hoop at all (he is a passive investor in Hoop). Damarcus has a $20,000 basis in his Hoop ownership interest, and he also has a $20,000 at-risk amount in his investment in Hoop. Damarcus does not report income or loss from any other business activity investments. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year? $0. $50,000 of Hoop’s loss is allocated to Damarcus. However, because Damarcus is a passive investor and he does not have any other sources of passive income he is not allowed to deduct any of the loss allocated to him this year. d. Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus works full time for Hoop (he is not considered to be a passive investor in Hoop). Damarcus has a $70,000 basis in his Hoop ownership interest, and he also has a $70,000 at-risk amount in his investment in Hoop. Damarcus does not report income or loss from any other business activity investments. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year? $50,000. Damarcus had adequate basis and at-risk amounts to absorb the loss and the passive activity limits do not apply because he is not a passive investor in Hoop. Consequently, Damarcus can deduct all of the loss allocated to him. e. Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus does not work for Hoop at all (he is a passive investor in Hoop). Damarcus has a $20,000 basis in his Hoop ownership interest, and he also has a $20,000 at-risk amount in his investment in Hoop. Damarcus reports $10,000 of income from another business activity in which he is a passive investor. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year? $10,000. Damarcus has $20,000 basis and $20,000 of at-risk amounts to absorb $20,000 of the loss. However, because Damarcus is a passive investor in Hoop, he is allowed to deduct only $10,000 of the loss. He is allowed to deduct $10,000 because he has $10,000 of passive activity income. If Damarcus had $30,000 passive activity income, he would have been able to deduct only $20,000 of the loss because that is the basis and at-risk amount he had. 59. [LO 3] Danni is a single 30 percent owner of Kolt (a business entity). In the current year, Kolt reported a $1,000,000 business loss. Answer the following questions associated with each of the following alternative scenarios: a. Kolt is organized as a C corporation and Danni works 20 hours a week as an employee for Kolt. Danni has a $200,000 basis in her Kolt stock. How much of Kolt’s loss is Danni allowed to deduct this year against her other income? $0. Losses of C corporations do not flow through to shareholders. b. Kolt is organized as an LLC taxed as a partnership. Thirty percent of Kolt’s loss is allocated to Danni. Danni works 20 hours a week on Kolt business activities (she is not considered to be a passive investor in Kolt). Danni has a $400,000 basis in her Kolt ownership interest, and she also has a $400,000 at-risk amount in her investment in Kolt. Dannie does not report income or loss from any other business activity investments. How much of the $300,000 loss allocated to her from Kolt is Danni allowed to deduct this year? $259,000. Danni has adequate basis and at-risk amounts to absorb the loss and the passive activity limits do not apply because she is not a passive investor in Kolt. However, because Danni is single, her loss deduction is limited to $259,000. The remainder is considered an excess business loss and is not deductible this year. c. Kolt is organized as an LLC taxed as a partnership. Thirty percent of Kolt’s loss is allocated to Danni. Danni is not involved in Kolt business activities. Consequently, she is considered to be a passive investor in Kolt. Danni has a $400,000 basis in her Kolt ownership interest, and she also has a $400,000 at-risk amount in her investment in Kolt. Danni does not report income or loss from any other business activity investments. How much of the $300,000 loss allocated to her from Kolt is Danni allowed to deduct this year? $0. Even though Danni has adequate basis and at-risk amounts, she does not have any source of passive income. Therefore, she is not allowed to deduct any of the loss this year. 60. [LO 3] {Research} Mickey, Mickayla, and Taylor are starting a new business (MMT). To get the business started, Mickey is contributing $200,000 for a 40 percent ownership interest, Mickayla is contributing a building with a value of $200,000 and a tax basis of $150,000 for a 40 percent ownership interest, and Taylor is contributing legal services for a 20 percent ownership interest. What amount of gain is each owner required to recognize under each of the following alterative situations? [Hint: Look at IRC §§351 and 721.] a. MMT is formed as a C corporation. b. MMT is formed as an S corporation. c. MMT is formed as an LLC. a. Under §351, Mickey and Mickayla do not recognize any gain. However, because Taylor is contributing services (and services are not property) Taylor must recognize $100,000 of ordinary income on the receipt of the $100,000 worth of stock she receives from MMT ($200,000 + $200,000 = $400,000 ÷ 80% = $500,000 × 20% = $100,000). b. Same answer as part a. Under §351, Mickey and Mickayla do not recognize any gain. However, because Taylor is contributing services (and services are not property) Taylor must recognize $100,000 of ordinary income on the receipt of the $100,000 worth of stock she receives from MMT. c. Under §721, neither Mickey nor Mickayla recognize any gain on the transfer. However, because Taylor has a twenty percent interest in MMT, she recognizes $100,000 of ordinary income on the transaction. 61. [LO 3] {Research} Dave and his friend Stewart each owns 50 percent of KBS. During the year, Dave receives $75,000 compensation for services he performs for KBS during the year. He performed a significant amount of work for the entity, and he was heavily involved in management decisions for the entity (he was not a passive investor in KBS). After deducting Dave’s compensation, KBS reports taxable income of $30,000. How much FICA and/or self-employment tax is Dave required to pay on his compensation and his share of the KBS income if KBS is formed as a C corporation, an S corporation, or a limited liability company (ignore the .9 percent additional Medicare tax)? Description C Corporation S Corporation LLC Explanation (1) FICA $5,738 $5,738 $0 $75,000 salary 7.65% (not applicable for the LLC) (2) Self-employment income from entity compensation 0 0 $75,000 (3) Self-employment income from portion of entity business income 0 0 $15,000 $30,000 × 50% (4) Total Self –employment income 0 0 90,000 (2) +(3) (5) Net earnings from self-employment 0 0 83,115 (4) × .9235 (6) Self-employment tax 0 0 12,717 (5) × 15.3% Total FICA/Self-employment tax paid by Dave $5,738 $5,738 12,717 (1) + (6) 62. [LO 3] {Research} Rondo and his business associate, Larry, are considering forming a business entity called R&L, but they are unsure about whether to form it as a C corporation, an S corporation, or an LLC taxed as a partnership. Rondo and Larry would each invest $50,000 in the business. Thus, each owner would take an initial basis in his ownership interest of $50,000 no matter which entity type is formed. Shortly after the formation of the entity, the business borrowed $30,000 from the bank. If applicable, this debt will be shared equally between the two owners. a. After taking the loan into account, what is Rondo’s tax basis in his R&L stock if R&L is formed as a C corporation? b. After taking the loan into account, what is Rondo’s tax basis in his R&L stock if R&L is formed as an S corporation? c. After taking the loan into account, what is Rondo’s tax basis in his R&L ownership interest if R&L is formed as an LLC and taxed as a partnership? a. $50,000. C corporation shareholders do not include entity debt in the tax basis of their stock in the corporation. b. $50,000. S corporation shareholders do not include entity debt in the tax basis of their stock in the corporation. c. $65,000 ($50,000 + $15,000). The owner of an LLC includes his share of the LLC’s liabilities in his ownership interest. Here Rondo includes $15,000 in his basis (his share of the $30,000 LLC debt). 63. [LO 3] {Research} Kevin and Bob have owned and operated SOA as a C corporation for a number of years. When they formed the entity, Kevin and Bob each contributed $100,000 to SOA. Each has a current basis of $100,000 in his SOA ownership interest. Information on SOA’s assets at the end of year 5 is as follows (SOA does not have any liabilities): Assets FMV Adjusted Basis Built-in Gain Cash $200,000 $200,000 $0 Inventory 80,000 40,000 40,000 Land and building 220,000 170,000 50,000 Total $500,000 At the end of year 5, SOA liquidated and distributed half of the land, half of the inventory, and half of the cash remaining after paying taxes (if any) to each owner. Assume that, excluding the effects of the liquidating distribution, SOA’s taxable income for year 5 is $0. a. What are the amount and character of gain or loss SOA will recognize on the liquidating distribution? b. What are the amount and character of gain or loss Kevin will recognize when he receives the liquidating distribution of cash and property? Recall that his stock basis is $100,000 and he is treated as having sold his stock for the liquidation proceeds. a. By making a liquidating distribution, SOA is treated as though it sold its assets for their fair market value. On the distribution, SOA will recognize ordinary income of $40,000 on the distribution of the inventory (the built-in gain) and $50,000 of Sec. §1231 gain/ordinary income (depending on accumulated depreciation) on the distribution of the land and building. b. $140,550 long-term capital gain. SOA must pay tax on the $90,000 of income it recognizes in the distribution. Because the corporate tax rate is 21%, it pays $18,900 tax on the distribution ($90,000 × 21%). The tax payment reduces SOA’s cash to $181,100 ($200,000 - $18,900). The fair market value of the assets SOA distributes to its shareholders is $481,100 ($500,000 total value minus $18,900 taxes). One-half of the $481,100 ($240,550) is distributed to Kevin. Consequently, Kevin’s long-term capital gain on the distribution is $140,550 ($240,550 received minus $100,000 basis in his stock). The gain is long-term capital gain because the stock is a capital asset and Kevin held the stock for more than a year before the liquidating distribution. Comprehensive Problems 64. {Planning} {Research} Daisy Taylor has developed a viable new business idea. Her idea is to design and manufacture cookware that remains cool to the touch when in use. She has had several friends try out her prototype cookware, and they have consistently given the cookware rave reviews. With this encouragement, Daisy started giving serious thought to starting up a business called “Cool Touch Cookware” (CTC). Daisy understands that it will take a few years for the business to become profitable. She would like to grow her business and perhaps at some point “go public” or sell the business to a large retailer. Daisy, who is single, decided to quit her full-time job so that she could focus all of her efforts on the new business. Daisy had some savings to support her for a while, but she did not have any other source of income. She was able to recruit Kesha and Aryan to join her as initial equity investors in CTC. Kesha has an MBA and a law degree. She was employed as a business consultant when she decided to leave that job and work with Daisy and Aryan. Kesha’s husband earns close to $300,000 a year as an engineer (employee). Aryan owns a very profitable used car business. Because buying and selling used cars takes all his time, he is interested in becoming only a passive investor in CTC. He wanted to get in on the ground floor because he really likes the product and believes CTC will be wildly successful. While CTC originally has three investors, Daisy and Kesha have plans to grow the business and seek more owners and capital in the future. The three owners agreed that Daisy would contribute land and cash for a 30 percent interest in CTC, Kesha would contribute services (legal and business advisory) for the first two years for a 30 percent interest, and Aryan would contribute cash for a 40 percent interest. The plan called for Daisy and Kesha to be actively involved in managing the business, while Aryan would not be. The three equity owners’ contributions are summarized as follows: Daisy Contributed FMV Adjusted Basis Ownership Interest Land (held as investment) $120,000 $70,000 30% Cash $30,000 Kesha Contributed Services $150,000 30% Aryan Contributed Cash $200,000 40% Working together, Daisy and Kesha made the following five-year income and loss projections for CTC. They anticipate the business will be profitable and that it will continue to grow after the first five years. Cool Touch Cookware 5-Year Income and Loss Projections Year Income (Loss) 1 ($200,000) 2 ($80,000) 3 ($20,000) 4 $60,000 5 $180,000 With plans for Daisy and Kesha to spend a considerable amount of their time working for and managing CTC, the owners would like to develop a compensation plan that works for all parties. Down the road, they plan to have two business locations (in different cities). Daisy would take responsibility for the activities of one location and Kesha would take responsibility for the other. Finally, they would like to arrange for some performance-based financial incentives for each location. To get the business activities started, Daisy and Kesha determined CTC would need to borrow $800,000 to purchase a building to house its manufacturing facilities and its administrative offices (at least for now). Also, in need of additional cash, Daisy and Kesha arranged to have CTC borrow $300,000 from a local bank and to borrow $200,000 cash from Aryan. CTC would pay Aryan a market rate of interest on the loan, but there was no fixed date for principal repayment. Required: Identify significant tax and nontax issues or concerns that may differ across entity types and discuss how they are relevant to the choice of entity decision for CTC. Several issues or concerns exist in forming a new business and choosing an entity. Some of the non-tax issues are: • The time and cost to organize the entity. Corporations (both taxable and S corporations) generally are more cumbersome to form. General partnerships tend to be among the easier entities to form. • Corporations and LLCs provide better liability protection for their owners than do general partnerships. In this case, Daisy is concerned about the riskiness of the business and may want to consider this factor. • Daisy, Kesha, and Aryan seem concerned about flexibility in the business structure. That is, they want to be able to provide Daisy and Kesha performance-based compensation based on how their business locations perform. Typically, these issues favor entity formation as a partnership. • Finally, Daisy is planning for the future with an initial public offering. IPOs are most easily accomplished with a C corporation, although it is fairly simple to convert partnerships and LLCs into legal corporations and C corporations for tax purposes to accomplish an IPO. Some of the tax issues or concerns include: • Based on the given ownership percentages, the scenario fails the 80-percent control test since Kesha contributes only services. Thus, it is a taxable transaction if a C or S corporation is formed unless Kesha contributes property in addition to services. • Daisy, Kesha, and Aryan would like to be able to utilize any losses to reduce their individual tax liabilities in the early years of the business. Flow-through entities provide the most favorable organizational form for this purpose. More specifically, LLCs (taxed as partnerships) and partnerships allow owners to benefit by increasing their tax basis by the business debt so that they may be able to deduct larger losses than can S corporation shareholders. • The projected losses appear to be small enough that if CTC is a flow-through entity, losses flowing through to the owners will not be subject to the excess business loss limitation. • Once the business becomes profitable in year 4, using an LLC, partnership or S corporation subjects the income to one level of tax instead of two levels if the entity is formed as a C corporation. However, because C corporation tax rates are significantly lower than individual tax rates, Daisy will need to analyze the relative tax burden depending on entity type. • The business income appears to qualify as qualified business income which, at least through 2025, would provide a QBI deduction to Daisy, Kesha and Aryan if they form the business as a flow-through entity for tax purposes. This effectively reduces the tax rate applicable to the flow-through entity income. • If CTC is formed as a C corporation, Daisy, Kesha, and Aryan may be required to pay the 3.8% net investment tax on dividends distributed by CTC. Further, if the entity is organized as an LLC or S corporation, business income allocated to the individual investors may be subject to the 3.8% net investment income tax if the investors do not materially participate in the business. • The owners may be concerned about paying the lowest possible FICA and self-employment taxes. In general, C corporations and S corporations are favored because the employee/shareholder only pays 7.65 percent (1/2) of the FICA tax on any salary (note that they may be required to pay the .9 percent additional Medicare tax on the salary depending on their income level and other sources of earned income). In addition, S-corporation shareholders do not pay self-employment tax (or the .9 percent additional Medicare tax) on the business income allocated to them. In contrast, owners of entities taxed as partnerships owners must pay self-employment tax (and potentially the .9 percent additional Medicare tax) on their business income allocations (if they work for the business). • If the owners want the flexibility of special allocations to reward the owners, entities taxed as partnerships provide the more favorable form. • If Daisy, Kesha, and Aryan would like to consider adding new owners to the business, operating as a C corporation or S corporation may be costly because of the 80 percent control test applicable to contributions to the business. In general, contributions to LLCs and partnerships usually do not cause owners to recognize income on the contributions regardless of whether it is the initial contribution or a later addition of an owner. 65. {Research} Cool Touch Cookware (CTC) has been in business for about 10 years now. Daisy and Kesha are each 50 percent owners of the business. They initially established the business with cash contributions. CTC manufactures unique cookware that remains cool to the touch when in use. CTC has been fairly profitable over the years. Daisy and Kesha have both been actively involved in managing the business. They have developed very good personal relationships with many customers (both wholesale and retail) that, Daisy and Kesha believe, keep the customers coming back. On September 30 of the current year, CTC had all of its assets appraised. Below is CTC’s balance sheet, as of September 30, with the corresponding appraisals of the fair market value of all of its assets. Note that CTC has several depreciated assets. CTC uses the hybrid method of accounting. It accounts for its gross margin-related items under the accrual method, and it accounts for everything else using the cash method of accounting. Assets Adjusted Tax Basis FMV Cash $150,000 $150,000 Accounts receivable 20,000 15,000 Inventory* 90,000 300,000 Equipment 120,000 100,000 Investment in XYZ stock 40,000 120,000 Land (used in the business) 80,000 70,000 Building 200,000 180,000 Total Assets $700,000 $935,000** Liabilities Accounts payable $ 40,000 Bank loan 60,000 Mortgage on building 100,000 Equity 500,000 Total liabilities and equity $700,000 *CTC uses the LIFO method for determining the adjusted basis of its inventory. Its basis in the inventory under the FIFO method would have been $110,000. **In addition, Daisy and Kesha had the entire business appraised at $1,135,000, which is $200,000 more than the value of the identifiable assets. From January 1 of the current year through September 30, CTC reported the following income: Daisy and Kesha are considering changing the business form of CTC. Required: a. Assume CTC is organized as a C corporation. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an S corporation. [Hint: see IRC §§1374 and 1363(d).] b. Assume CTC is organized as a C corporation. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an LLC. Assume CTC converts to an LLC (taxed as a partnership) by distributing its assets to its shareholders, who then contribute the assets to a new LLC. [Hint: see IRC §§331, 336, and 721(a).] c. Assume that CTC is a C corporation with a net operating loss carryforward as of the beginning of the year in the amount of $2,000,000. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an LLC (taxed as a partnership). Assume CTC converts to an LLC by distributing its assets to its shareholders, who then contribute the assets to a new LLC. [Hint: see IRC §§172(a), 331, 336, and 721(a).] a. The following significant issues should be considered when converting CTC from a C corporation to an S corporation: • CTC may be subject to the built-in gains tax under IRC §1374 if CTC sells any of its appreciated assets. • According to IRC §1363(d), the difference between CTC’s LIFO inventory basis of $90,000 and what would have been its FIFO basis of $110,000 must be reported as ordinary income on the last return CTC files as a C corporation. • CTC would need to switch to a calendar year-end under IRC §1378(b) if it had been using a month other than December as its C corporation year-end. • As an S corporation, CTC would become subject to limits on the number and type of shareholders under IRC §1361(b). As a result, CTC would be unable to go public or operate certain types of businesses. • Because S corporations are flow-through entities, CTC’s dividends, interest, and long-term capital gains, and business income and losses will flow-through to Daisy and Kesha and will thus be taxed only once. However, business income may be taxed at higher individual rates than it would be taxed at the corporate rate. However, CTC’s income will now only be taxed once. • By converting to an S corporation, CTC’s income would be income that would be considered qualified business income. This means the owners would be allowed to claim the deduction for qualified business income on income allocations from CTC. This reduces the effective tax rate on the CTC income as a flow-through entity. • Passive owners may be subject to the net investment income tax on business income allocations. b. The following significant issues should be considered when converting CTC from a C corporation to an LLC: • Because LLCs are flow-through entities, CTC’s dividends, interest, and long-term capital gains and losses will flow through to Daisy and Kesha and thus will be taxable only once. However, business income may be taxed at higher individual rates that it would be taxed at the corporate rate. However, CTC’s income would only be taxed once as a flow-through entity. • Converting CTC into an LLC will trigger a deemed liquidation of CTC corporation resulting in gains and losses being recognized and taxed at both the corporate and shareholder level under IRC §336 and IRC §331. Given the appreciation in CTC’s assets, these taxes are likely to be significant if not prohibitive. • After converting to an LLC, CTC’s operations and its owners will be subject to state LLC statutes rather than state corporation laws. This will likely have an impact on the rights, responsibilities, and legal arrangement among the owners as well as the rights of outsiders with respect to CTC and its owners. • CTC must switch to a calendar year-end if it had previously been using some other year-end. • Owners who work for the business may be subject to self-employment tax and the additional Medicare tax on business income allocations. • Passive owners may be subject to the net investment income tax on business income allocations. c. Most of the considerations mentioned in part b. remain relevant except for the following items: • CTC’s $2,000,000 net operating loss carryforward will eliminate only $348,000 (80% - because it is a post 2017 NOL) of the $435,000 gain on liquidation ($1,135,000 fair market value of CTC assets less $700,000 tax basis in CTC assets) CTC would otherwise have to report under IRC §336. Unfortunately, the remaining net operating loss carryforward disappears with the corporation because it is a corporate tax attribute. • Although CTC’s net operating loss will reduce corporate level taxes on liquidation, Daisy and Kesha must pay capital gains taxes on the difference between the fair market of CTC’s assets and the tax basis they have in their CTC shares under IRC §331. These taxes, although lower than the combined liquidation taxes described in part (b), would still likely deter Daisy and Kesha from converting CTC to an LLC. Solution Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
Download
Close
Close
