Chapter 22 S Corporations Discussion Questions: 1. [LO 1] In general terms, how are C corporations different from and similar to S corporations? S corporations either are incorporated under state law, have the same legal protections as C corporations, and have elected S corporation status, or they are non-corporate business entities who have elected to be treated as a corporation, and then elected S corporation status. S corporations are governed by the same corporate tax rules that apply in the organization, liquidation, and reorganization of C corporations. Unlike a C corporation, an S corporation is a flow-through entity and shares many tax similarities with partnerships. For example, basis calculations for S corporation shareholders and partners are similar, the income or loss of an S corporation flows through to its owners, and distributions are generally not taxed to the extent of the owner’s basis. 2. [LO 1] What are the limitations on the number and type of shareholders an S corporation may have? How are these limitations different from restrictions on the number and type of shareholders C corporations or partnerships may have? Only U.S. citizens or residents, certain trusts, and certain tax-exempt organizations may be shareholders, no corporations or partnerships. In addition, S corporations may have no more than 100 shareholders; family members and their estates count as one shareholder for purposes of the shareholder limit test. Family members include a common ancestor (not more than 6 generations removed) and her lineal descendants and their spouses (or former spouses). C corporations and partnerships do not have a limit on the amount or type of shareholders or partners. 3. [LO 1] Why can’t large, publicly traded corporations be treated as S corporations? A publicly traded corporation could not elect S corporation status because it would not likely satisfy the maximum 100-shareholder limit required of S corporations. 4. [LO 1] How do the tax laws treat family members for purposes of limiting the number of owners an S corporation may have? Family members and their estates count as one shareholder for the 100-shareholder limit. Family members include a common ancestor (not more than 6 generations removed) and her lineal descendants and their spouses (or former spouses). Under this broad definition, great-grandparents, grandparents, parents, children, brothers and sisters, grandchildren, great-grandchildren, aunts, uncles, cousins and the respective spouses are family members for this purpose. 5. [LO 1] Super Corp. was organized under the laws of the state of Montana. It issued common voting stock and common nonvoting stock to its two shareholders. Is Super Corp. eligible to elect S corporation status? Why or why not? Assuming that the voting and nonvoting stock shares have equal distribution and liquidation rights, Super Corp. may elect S corporation status. While the law specifies that S corporations can have only one class of stock, differences in voting power are permitted as long as distribution and liquidation rights are identical. 6. [LO 1] Karen is the sole shareholder of a calendar-year-end C corporation she formed last year. If she elects S corporation status this year on February 20, when will the election become effective and why? What if she had made the election on March 20? January 1, current year; since the election was made on or before the 15th day of the third month of the year the status can take effect as of the beginning of the year. If Karen had waited until March 20th, the election would not take effect until the beginning of the next year. 7. [LO 1] JB Corporation is a C corporation owned 80 percent by Jacob and 20 percent by Bauer. Jacob would like JB to make an S election, but Bauer is opposed to the idea. Can JB elect to be taxed as an S corporation without Bauer’s consent? Explain. No, JB will not be able to make the S election unless all the owners, including Bauer, consent to become an S corporation. 8. [LO 1] In what circumstances could a calendar-year C corporation make an election on February 1, year 1, to be taxed as an S corporation in year 1 but not have the election effective until year 2? If the corporation did not meet all the S corporation requirements for each day of the current year before it made the S election, the election would not be effective until the subsequent year. Likewise, if one or more shareholders who held the stock in the corporation during the current year and before the S corporation election was made did not consent to the election (for example, a shareholder disposes of his stock in the corporation in the election year before the election is made and fails to consent to the S election), the election would not be effective until the following year. 9. [LO 2] Theodore, Alvin, and Simon are equal shareholders of Timeless Corp. (an S corporation). Simon wants to terminate the S election, but Theodore and Alvin disagree. Can Simon unilaterally elect to have the S election terminated? If not, what would Simon need to do to have the S election terminated? Simon cannot voluntarily terminate the S election because he does not own more than 50 percent of the corporation. However, Simon could have the S election “involuntarily” terminated by selling some of his stock to an ineligible shareholder (such as a corporation, partnership or nonresident alien) or by contributing his stock to a partnership. 10. [LO 2] Juanita is the sole shareholder of Belize Corporation (a calendar-year S corporation). She is considering revoking the S election. It is February 1, year 1. What options does Juanita have for timing the effective date of the S election revocation? Juanita can choose to have the election terminated as of the beginning of year 1 as long as the termination is made by March 15th (calendar year S corporation). If the election is made after March 15th the effective date would be the beginning of the following year; however, she can choose a specific termination date as long as it is on or after the election date. 11. [LO 2] Describe the circumstances in which an S election may be involuntarily terminated. A failure to meet the S corporation requirements will result in the termination of the S election. This includes exceeding the 100-shareholder limit or ownership by ineligible shareholders (such as a corporation or nonresident alien). The S election will also be terminated if the corporation has excess passive investment income (over 25 percent of gross receipts) for three consecutive years and has prior earnings and profits from previous operation as a C corporation. 12. [LO 2] Describe a situation in which a former C corporation that elected to be taxed as an S corporation may have its S election automatically terminated, but a similarly situated corporation that has always been taxed as an S corporation would not. The S election is terminated when an S corporation has earnings and profits from prior C corporation operations and has passive investment income in excess of 25 percent of gross receipts for three consecutive years. The S election termination for excess passive investment income does not apply to an S corporation that has never been taxed as a C corporation. 13. [LO 2] When a corporation’s S election is terminated mid-year, what options does the corporation have for allocating the annual income between the S corporation short year and the C corporation short year? The allocation can be made using the daily method or the specific identification method. The daily method allocates income for the full year between the S and the C corporation years, using the number of days in each short year. The specific identification method uses the corporation’s normal accounting rules to allocate income to the actual period in which it was earned. Use of the specific identification method requires that all shareholders at any time during the S corporation short year and the shareholders on the first day of the C corporation short year to consent to the election using the specific identification method. However, an S corporation must use the specific identification method to allocate income between the short years (the per day allocation method is not allowed) if there is a sale or exchange of 50 percent or more of the corporation’s stock during the year. 14. [LO 2] On June 1, year 1, Jasper Corporation’s S election was involuntarily terminated. What is the earliest Jasper may be taxed as an S corporation again? Are there any exceptions to the general rule? Explain. Jan 1, year 6 would be the earliest that Jasper Corporation could reelect S corporation status. After terminating or voluntarily revoking S corporation status, the corporation must wait to reelect S corporation status until the beginning of the fifth tax year after the tax year in which it terminated the election. The IRS may consent to an earlier election under a couple of conditions: (1) if the corporation is now owned more than 50 percent by shareholders who were not owners at the time of termination, or (2) if the termination was not reasonably within the control of the corporation or shareholders with a substantial interest in the corporation and was not part of a planned termination by the corporation or shareholders. 15. [LO 3] Apple Union (AU), a C corporation with a March 31 year-end, uses the accrual method of accounting. If AU elects to be taxed as an S corporation, what will its year-end and method of accounting be (assuming no special elections)? AU can continue to use the accrual method of accounting, but the company’s year-end will change to December 31 because S corporations must use a calendar year end unless they can establish a business purpose for an alternative year end or a natural business year end. 16. [LO 3] Compare and contrast the method of allocating income or loss to owners for partnerships and for S corporations. S corporations, like partnerships, are flow-through entities, and thus their profits and losses flow through to their shareholders annually for tax purposes. Partnerships have considerable flexibility in making special profit and loss allocations to their partners. In contrast, S corporations must allocate profits and losses pro rata, based on the number of outstanding shares each shareholder owns on each day of the tax year. 17. [LO 3] Why must an S corporation report separately stated items to its shareholders? How is the character of a separately stated item determined? How does the S corporation report this information to each shareholder? An S corporation must separately state those items that are taxed differently than ordinary business income (loss) to shareholders so that the items are reported correctly and receive the appropriate tax treatment on each shareholder’s tax return. The character of a separately stated item is determined at the corporate level, and the information is reported to the shareholder on his or her specific schedule K-1. 18. [LO 3] How do S corporations report dividends they receive? Are they entitled to a dividends-received deduction? Why or why not? Dividends that are received by the S corporation are reported as a separately stated item to each owner. The S corporation is not entitled to the dividends-received deduction because the dividends flow directly through the company to the owner. Therefore, since the S corporation will not pay a tax on the dividend it would not qualify for the dividends-received deduction. 19. [LO 4] Shawn receives stock in an S corporation when it is formed in a tax-deferred transaction by contributing land with a tax basis of $50,000 and encumbered by a $20,000 mortgage. What is Shawn’s initial basis in his S corporation stock? The shareholder’s basis in stock received in forming an S corporation equals the tax basis of the property transferred, less any liabilities assumed by the corporation on the property contributed (“substituted basis”). Thus, Shawn’s initial basis in the S corporation would equal $30,000, which is the $50,000 carryover tax basis of the land minus the $20,000 mortgage assumed. 20. [LO 4] Why is a shareholder’s basis in an S corporation stock adjusted annually? The annual adjustment is required to prevent income or losses from being double-counted (i.e., double-taxed or double-deducted) by shareholders either when they sell stock or receive distributions, and to ensure that tax-exempt income and non-deductible expenses are not ultimately taxed or deducted. 21. [LO 4] What adjustments are made annually to a shareholder’s basis in S corporate stock and in what order? What impact do these adjustments have on a subsequent sale of stock? Adjustments to basis are made in the following order; increased for contributed capital, ordinary business income and separately stated income/gain items (including tax-exempt income); decreased for distributions made throughout the year, non-deductible expenses, and ordinary business losses and separately stated expense/loss items. These adjustments will determine the shareholder’s adjusted basis in the S corporation stock, which will be subtracted from sales price to determine the gain or loss on the sale of the stock. Reg. § 1.1367-1(g) allows a shareholder to elect to decrease basis by ordinary business losses and separately stated expense/loss items before decreasing basis by nondeductible expenses by attaching a statement to the shareholder's tax return. This election is advantageous because loss/expense deductions are limited to a shareholder's basis, and this election results in a higher basis limitation for deductible loss/expense items. 22. [LO 4] Can a shareholder’s basis in S corporation stock ever be adjusted to a negative number? Why or why not? As with a partnership, adjustments that decrease basis cannot reduce an S corporation shareholder’s tax basis below zero. This feature of the federal tax system makes sense because basis represents the shareholder’s investment in the stock of a corporation. Because it is not possible to have a negative investment, it is not possible to have a negative basis. 23. [LO 4] Describe the three hurdles a taxpayer must pass if he wants to deduct a loss from his share in an S corporation. What other loss limitation rule may impact the deductibility of losses from an S corporation? The three hurdles are tax basis, at-risk amount, and the passive activity loss rules. The tax basis hurdle disallows allocated losses to the extent that they exceed the shareholder’s stock and debt basis. While S corporation debt is not included in the stockholder’s stock basis, shareholders can create debt basis in an S corporation by loaning money directly to the S corporation. When a stockholder has stock and debt basis in an S corporation, the losses are first applied to the stock basis and second to the debt basis. The non-utilized losses are not necessarily lost but are suspended until the shareholder generates additional basis. The carryover period for the suspended loss is indefinite. However, if the shareholder sells the stock before creating additional basis, the suspended losses disappear unused. Losses are also limited to the” at-risk” amount. With one notable exception, an S corporation shareholder’s at-risk amount is the sum of her stock and debt basis. The primary exception relates to nonrecourse loans and is designed to ensure that shareholders only are deemed at risk when they have an actual risk of loss. Specifically, an S corporation shareholder taking out a nonrecourse loan to make a capital contribution (either cash or other property) to the S corporation generally creates stock basis in the S corporation but only increases her amount at risk by the net fair market value of her property, if any, used as collateral to secure the nonrecourse loan. IRC Sec. 465(b)(2)(B). The collateral’s net fair market value is determined at the loan date. Likewise, if the shareholder takes out a nonrecourse loan to make a direct loan to the S corporation, the loan creates debt basis, but only increases her amount at risk by the net fair market value of her property, if any, used as collateral to secure the nonrecourse loan. When the stock basis plus debt basis is different from the at-risk amount, S corporation shareholders apply the tax basis loss limitation first, and then the at-risk limitation. Losses limited under the at-risk rules are carried forward indefinitely until the shareholder generates additional at-risk amounts to utilize them or sells the S corporation stock. S corporation shareholders, just like partners, are subject to the passive-activity loss rules. There are no differences in the application of these rules for S corporations; the definition of a passive activity, the tests for material participation, the income and loss baskets, and the passive activity loss carryover rules are exactly the same. Thus, as in partnerships, the passive activity loss rules limit the ability of S corporation shareholders to deduct losses unless they are involved in actively managing the business. In addition, for losses that clear each of the three separate hurdles, S corporation shareholders are not allowed to deduct excess business losses. An excess business loss for the year is the excess of aggregate business deductions for the year over the sum of aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $518,000 for married taxpayers filing jointly and $259,000 for other taxpayers. In the case of S corporation business losses, the provision applies at the shareholder level. 24. [LO 4] Is a shareholder allowed to increase her basis in her S corporation stock by her share of the corporation’s liabilities, as partners are able to increase the basis of their ownership interest by their share of partnership liabilities? Explain. S corporation shareholders are not allowed to include any S corporation debt in their stock basis. This difference between S corporations and partnerships is attributable to the fundamental difference in liability exposure of S corporation shareholders versus partners. In particular, S corporation shareholders have limited liability with respect to S corporation debts whereas partners, in general, are liable for the debts of the partnership. 25. [LO 4] How does a shareholder create debt basis in an S corporation? How is debt basis similar and dissimilar to stock basis? The shareholder is able to create debt basis by lending money directly to the S corporation. Debt basis is similar to stock basis in the sense that a shareholder may deduct S corporation losses to the extent of both stock basis and debt basis. Debt basis is dissimilar to stock basis in that distributions are only nontaxable to the extent of stock basis. Thus, distributions received by a shareholder with debt basis but no stock basis are taxable. 26. [LO 4] When an S corporation shareholder has suspended losses due to the tax-basis or at-risk amount limitation, is he allowed to deduct the losses if the S corporation status is terminated? Why or why not? Suspended losses are generally not deductible after the S corporation status is terminated. However, there is a post-termination transition period (PTTP) that allows shareholders to utilize suspended losses. The transition period starts on first day after the last day of the tax year as an S corporation and ends the latter of (1) one year after the S corporations last day or (2) the due date for filing the last return of the S corporation (including extensions). This rule allows the shareholder to create additional stock basis (by making additional capital contributions) during the PTTP and to utilize suspended losses based on her stock basis (not her debt basis) at the end of the period. Any suspended losses utilized at the end of the PTTP reduce the shareholder’s basis in her stock. Any losses not utilized at the end of the period are lost forever. 27. [LO 4] When considering C corporations, the IRS checks to see whether salaries paid are too large. In S corporations, however, it usually must verify that salaries are large enough. Account for this difference. As a taxable entity, C corporations have a tax incentive to pay a shareholder/employee tax deductible salary instead of nondeductible dividends. In contrast, S corporations are flow-through entities and face different incentives. Specifically, because salary paid by S corporations is subject to payroll taxes whereas S corporation profits are not, there is an incentive for the S corporation to pay a shareholder/employee a lower salary and report higher S corporation profits to avoid the payroll taxes on the shareholder/employee’s salary. 28. [LO 4] How does the tax treatment of employee fringe benefits reflect the hybrid nature of the S corporation? S corporations are treated in part like C corporations and in part like partnerships with respect to tax deductions for qualifying employee fringe benefits. For shareholder-employees who own 2 percent or less of the entity, the S corporation receives C corporation tax treatment. That is, it gets a tax deduction for qualifying fringe benefits, and the benefits are nontaxable to all employees. For shareholder-employees who own more than 2 percent of the S corporation, it receives partnership treatment. That is, the S corporation receives a tax deduction, but the otherwise qualifying fringe benefits are taxable to the more-than-2-percent shareholder-employees. Fringe benefits taxable to this group include employer-provided health insurance (§106), group-term life insurance (§79), meals and lodging provided for the convenience of the employer (§119), and benefits provided under a cafeteria plan (§125). Examples of benefits that are nontaxable to more-than-2-percent shareholder-employees (and partners in a partnership) include employee achievement awards (§74), qualified group legal services plans (§120), educational assistance programs (§127), dependent care assistance programs (§129), no-additional-cost services (§132), qualified employee discounts (§132), working condition fringe benefits (§132), de minimis fringe benefits (§132), on-premises athletic facilities (§132), and medical savings accounts (§220).The tax treatment allows a certain fringe benefits to be nontaxable to the receiver who owns 2 percent or less of the S corporation, similar to C corporations, while withholding that nontaxable feature from owners of more than 2 percent of the company, similar to partnerships. 29. [LO 4] If a corporation has been an S corporation since inception, describe how its operating distributions to its shareholders are taxed to the shareholders. The distributions are nontaxable as long as they do not exceed the shareholder’s stock basis in the corporation. Amounts in excess of the stock basis are taxed as capital gains. 30. [LO 4] How are the tax consequences of a cash distribution different from those of a noncash property distribution to both the S corporation and the shareholders? S corporations do not recognize a gain on cash distributions and the distributions are tax free to the shareholder up to his or her stock basis. Amounts in excess of the stock basis are taxed as capital gains. For noncash property distributions, S corporations recognize gain as though they had sold the appreciated property for its fair market value just prior to the distribution. Shareholders who receive (and don’t receive) the distributed property recognize their distributive share of the deemed gain and increase their stock basis accordingly. On the other hand, S corporations do not recognize losses on distributions of property whose value has depreciated. For the shareholder, the amount of a property distribution is the fair market value of the property received (minus any liabilities the shareholder assumes on the distribution). The distribution is tax free to the shareholder up to his or her stock basis. Amounts in excess of the stock basis are taxed as capital gains. 31. [LO 5] What role does debt basis play in determining the taxability of operating distributions to S corporation shareholders? Debt basis plays no role in determining the taxability of operating distributions. Only stock basis is considered to determine the taxability of operating distributions. 32. [LO 5] What does the accumulated adjustments account represent? How is it adjusted year by year? Can it have a negative balance? The AAA represents the cumulative income or losses for the period the corporation has been an S corporation. It is calculated as: The beginning of year AAA balance + Separately stated income/gain items (excluding tax-exempt income) + Ordinary income - Separately stated losses and deductions - Ordinary losses - Nondeductible expenses that are not capital expenditures (except deductions related to generating tax-exempt income) - Distributions out of AAA = End of year AAA balance Unlike a shareholder’s stock basis, the AAA may have a negative balance. However, the reduction for distributions may not cause the AAA to go negative or to become more negative. Note that if current year income and loss items net to make a negative adjustment to the AAA, the net negative adjustment from these items is made to the AAA after any AAA reductions for distributions (that is, the reduction in AAA for distributions is made before the net negative adjustment for current year income and loss items). 33. [LO 5] If an S corporation with accumulated E&P makes a distribution, from what accounts (and in what order) is the distribution deemed to be paid? S corporation distributions are deemed to be paid from the following sources in the order listed: (1) The AAA account (to the extent it has a positive balance). (2) Existing accumulated earnings and profits from years when the corporation operated as a C corporation. (3) The shareholder’s stock basis. 34. [LO 5] Under what circumstances could a corporation with earnings and profits make a nontaxable distribution to its shareholders after the S election termination? §1371(e) provides for special treatment of any S corporation distribution in cash after an S election termination and during the post-termination transition period (PTTP): Such cash distributions are nontaxable to the extent they do not exceed the corporation’s AAA balance and the individual shareholder’s basis in the stock. The PTTP for post-termination distributions is generally the same as the PTTP for deducting suspended losses. For determining the taxability of distributions, the PTTP generally begins on the day after the last day of the corporation's last taxable year as an S corporation; it ends on the later of (a) one year after the last S corporation day or (b) the due date for filing the return for the last year as an S corporation (including extensions). In addition to the general rules that apply to PTTP distributions, there is a special rule that applies to distributions from an "eligible terminated S corporation" that occur after the PTTP. Specifically, distributions from an eligible terminated S corporation that occur after the PTTP are treated as paid pro rata from its accumulated adjustments account and from its earnings and profits. An eligible terminated S corporation is any C corporation which (i) was an S corporation on December 21, 2017, (ii) revoked its S corporation election during the two-year period beginning on December 22, 2017, and (iii) had the same owners on December 22, 2017 and on the revocation date (in identical proportions). Under these rules, distributions out of the corporation’s AAA balance would be nontaxable to the extent they do not exceed the shareholder’s basis in the stock. 35. [LO 5] How do the tax consequences of S corporation liquidating distributions differ from the tax consequences of S corporation operating distributions at both the corporate and shareholder levels? For operating distributions, S corporations recognize gain but not loss on property distributions and neither gain nor loss on cash distributions. Operating distributions are tax free to the shareholder up to his or her stock basis. Amounts in excess of the stock basis are taxed as capital gains. In contrast, with a liquidating distribution the S corporation recognizes gains or losses on each asset that is distributed and that gain or loss increases or reduces the owner’s stock basis. On the shareholder level, the owners recognize a gain or loss depending on their stock basis in relation to the value of property received. 36. [LO 6] When is an S corporation required to pay a built-in gains tax? The built-in gains tax applies only to an S corporation that has a net unrealized built-in gain at the time it converts from a C corporation. Further, for the built-in gains tax to apply, the S corporation must subsequently recognize net built-in gains during the built-in gains tax recognition period. The built-in gains tax recognition period is the first 5 years a corporation operates as an S corporation. 37. [LO 6] When is an S corporation required to pay the excess net passive income tax? If an S corporation previously operated as a C corporation and has accumulated earnings and profits at the end of the year from a prior C corporation year, it may be subject to the excess net passive income tax. The tax is levied on the S corporation’s excess net passive income and applies when the corporation’s passive investment income exceeds 25 percent of its gross receipts. 38. [LO 6]. Is the LIFO recapture tax a C corporation tax or an S corporation tax? Explain. The LIFO recapture tax is technically a C corporation tax that is paid in four annual installments. The first installment is due on or before the due date (not including extensions) of the corporation’s last C corporation tax return. The final three annual installments are due each year on or before the due date (not including extensions) of the S corporation’s tax return. 39. [LO 6] When must an S corporation make estimated tax payments? S corporations with a federal income tax liability of $500 or more due to the built-in gains or excess net passive investment income must estimate their tax liability for the year and pay it in four quarterly estimated installments. 40. [LO 6] On what form does an S corporation report its income to the IRS? When is the tax return due? What information does the S corporation provide to shareholders to allow them to complete their tax returns? Form 1120-S. The return is initially due on March 15th for calendar year taxpayers (the 3rd month and 15th day after the year-end for the S corporation), but the due date can be extended automatically up to 6 months. The S corporation provides each shareholder with a K-1 that outlines their share of business income/loss and separately stated items. 41. [LO 6] Compare and contrast S corporations, C corporations, and partnerships in terms of tax consequences at formation, shareholder restrictions, income allocation, basis calculations, compensation to owners, taxation of distributions, and accounting periods. Tax characteristic C corporation S corporation Partnership/LLC Forming or contributing property to an entity No gain or loss on contribution of appreciated or depreciated property if transferors of property have control (as defined in §351) after transfer. Same as C corporations. Same as C and S corporations except no control requirement (§721 applies to partnerships). Type of owner restrictions No restrictions Only individuals who are U.S. citizens or residents, certain trusts, and tax-exempt organizations. No restrictions Number of owner restrictions No restrictions Limited to 100 shareholders. (Family members and their estates count as one shareholder.) Must have more than one owner. Election Default status if corporation under state law. Must formally elect to have corporation taxed as S corporation. Default status if unincorporated and have more than one owner. Income and loss allocations Not allocated to shareholders. Income and loss flow through to owners based on ownership percentages. Income and loss flow through to owners but may be allocated based on something other than ownership percentages (special allocations). Entity debt included in stock (or partnership interest) basis No Generally, no. However, loans made from shareholder to corporation create debt basis. Losses may be deducted to extent of stock basis and then debt basis. Yes. All entity liabilities are allocated to basis of partners. Loss limitations Losses remain at corporate level. Losses flow through but subject to basis limitation, at-risk limitation, passive activity limitations, and excess business loss limitation. Same as S corporations. Self-employment Income status of ordinary Income allocations Not applicable Not self-employment income. May be self-employment income depending on partner’s status. Salary to owners permitted Yes Yes Generally, no. Salary-type payments are guaranteed payments subject to self-employment tax. Fringe benefits Can pay nontaxable fringe benefits to owners. Can pay nontaxable fringe benefits to owners who own two percent or less of stock. May not pay nontaxable fringe benefits to owners. Operating distributions: owner tax consequences Taxable as dividends to extent of earnings and profits. Generally, not taxable to extent of owner’s basis. Same as S corporations. Operating distributions: Entity tax consequences Gain on distribution of appreciated property; no loss on distribution of depreciated property. Same as C corporations. Generally, no gain or loss on distribution of property. Liquidating distributions Corporation and shareholders generally recognize gain or loss on distributions. Same as C corporations. Partnership and partners generally do not recognize gain or loss on liquidating distributions. Entity-level taxes Yes, based on corporate tax rate schedule. Generally, no, but may be required to pay built-in gains tax, excess passive investment income tax, or LIFO recapture tax if converting from C to S corporation. No Tax year Last day of any month or 52-53-week year. Generally, calendar year. Based on tax year of owners. Problems 42. [LO 1] Julie wants to create an S corporation called J’s Dance Shoes (JDS). Describe how the items below affect her eligibility for an S election. a. Because Julie wants all her shareholders to have an equal say in the future of JDS, she gives them equal voting rights and decides shareholders who take a more active role in the firm will have priority in terms of distribution and liquidation rights. While equal voting rights are permissible, distributions to owners must be made on a pro rata basis determined by stock ownership percentages (not the extent of participation in the business’s activities), thus JDS would not be eligible to make an S election. As an alternative, Julie could use salary to compensate shareholders actively participating in the business. b. Julie decides to incorporate under the state laws of Utah since that is where she lives. Once she gets her business up and running, however, she plans on doing extensive business in Mexico. These facts do not create a problem with the S election. The S election requirements mandate that the corporation be organized in the U.S., or under U.S. law, or the laws of any state in the U.S. The election does not preclude corporations from doing business outside of the U.S. 43. [LO1] {Research} Lucy and Ricky Ricardo live in Los Angeles, California. After they were married, they started a business named ILL Corporation (a C corporation). For state law purposes, the shares of stock in ILL Corp. are listed under Ricky’s name only. Ricky signed the Form 2553 electing to have ILL taxed as an S corporation for federal income tax purposes, but Lucy did not sign. Given that California is a community property state, is the S election for ILL Corp. valid? No, the election is not valid because under community property law, Lucy owns 50 percent of the ILL Corp. stock. Consequently, according to the federal tax laws she must also sign the form to elect to have ILL taxed as an S corporation. See J.M. Seely, 51 TCM 1087, Dec. 43,081(M), TC Memo. 1986-216. 44. [LO 1] Jane has been operating Mansfield Park as a C corporation and decides she would like to make an S election. What is the earliest the election will become effective under each of these alternative scenarios? a. Jane is on top of things and makes the election on January 1, 2020. Effective Jan. 1, 2020 b. Jane is mostly on top of things and makes the election on January 15, 2020. Effective Jan. 1, 2020 c. Jane makes the election on February 10, 2020. She needed a little time to convince a C corporate shareholder to sell its stock to a qualifying shareholder. That process took all of January, and she was glad to have it over with. Effective January 1, 2021. The Corporation did not meet all the requirements to be considered an S corporation from the beginning of the year (it had a C corporation as a shareholder), so the election won’t take effect until the following year. d. Jane makes the election on March 14, 2020. Effective Jan 1, 2020. Because she made the election within the first 2 ½ months of the year, the election can be retroactively effective at the beginning of the year. e. Jane makes the election on February 5, 2020. One of the shareholders refused to consent to the S election. He has since sold his shares (on January 15, 2020) to another shareholder who consented to the election. January 1, 2021. All shareholders who owned stock during 2020 before the S election was made must consent to the election for it to apply in 2020. Because that did not happen in this case, the election is not effective until January 1, 2021. 45. [LO 2] Missy is one of 100 unrelated shareholders of Dalmatian, an S corporation. She is considering selling her shares. Under the following alternative scenarios, would the S election be terminated? Why or why not? a. Missy wants to sell half her shares to a friend, a U.S. citizen, so they can rename their corporation 101 Dalmatians. Yes, the election would be terminated because an S corporation is not allowed to have more than 100 shareholders. b. Missy’s mother’s family wants to be involved with the corporation. Missy splits half her shares evenly among her aunt, uncle, grandfather, and two cousins. No, the election would not be terminated because all family members (including Missy) are lineal descendants of the grandfather (common ancestor) so they all count as one shareholder. In total, Dalmatian has 100 shareholders for tax purposes after the transfer. c. Missy sells half her Dalmatian stock to her husband’s corporation. Yes, the election would be terminated because corporations can’t be shareholders in an S corporation. 46. [LO 2] Cathy, Heathcliff, and Isabelle are equal shareholders in Wuthering Heights (WH), an S corporation. Heathcliff has decided he would like to terminate the S election. In the following alternative scenarios, indicate whether the termination will occur and indicate the date if applicable (assume no alternative termination dates are selected). a. Cathy and Isabelle both decline to agree to the termination. Heathcliff files the termination election anyway on March 14, 2020. The termination will not occur because Heathcliff does not own more than 50 percent of the stock of Wuthering Heights. In order to terminate the election, shareholders holding more than 50 percent of the stock must agree to the termination. b. Isabelle agrees with the termination, but Cathy strongly disagrees. The termination is filed on February 16, 2020. Because shareholders holding 67 percent of the stock agree to the termination, the S corporation election is terminated. Because the revocation was filed within the first 2 ½ months of the year, it is effective on January 1, 2020. c. The termination seems to be the first thing all three could agree on. They file the election to terminate on March 28, 2020. The termination/revocation is effective on January 1, 2021 because the revocation was not filed within the first 2 ½ months of the year. d. The termination seems to be the first thing all three could agree on. They file the election to terminate on February 28, 2020. The termination/revocation is effective on January 1, 2020 because the revocation was filed within the first 2 ½ months of the year. e. Knowing the other two disagree with the termination, on March 16, 2020 Heathcliff sells one of his 50 shares to his maid, who recently moved back to Bulgaria, her home country. The election is terminated on March 16, 2020 because as of that date, the S corporation no longer meets the S corporation requirements. It has a nonresident alien as a shareholder. 47. [LO 2] Assume the following S corporations, gross receipts, passive investment income, and corporate E&P. Will any of these corporations have its S election terminated due to excessive passive income? If so, in what year? All became S corporations at the beginning of year 1. a. Clarion Corp. Year Gross Receipts Passive Investment Income Corporate Earnings and Profits 1 $1,353,458 $250,000 $321,300 2 $1,230,389 $100,000 $321,300 3 $1,139,394 $300,000 $230,000 4 $1,347,039 $350,000 $100,000 5 $1,500,340 $400,000 $0 Clarion Corp. will not have its S election terminated. To be terminated, it must have C corporation earnings and profits and have passive income in excess of 25 percent of its gross receipts for three consecutive years. Here Clarion meets these requirements for years 3 and 4 but not year 5 because it has no C corporation earnings and profits. Year Gross Receipts Passive Investment Income Passive Income % of Gross Receipts Corporate Earnings and Profits 1 $1,353,458 $250,000 18.47% $321,300 2 $1,230,389 $100,000 8.13% $321,300 3 $1,139,394 $300,000 26.33% $230,000 4 $1,347,039 $350,000 25.98% $100,000 5 $1,500,340 $400,000 26.67% $0 b. Hanson Corp. Year Gross Receipts Passive Investment Income Corporate Earnings and Profits 1 $1,430,000 $247,000 $138,039 2 $700,380 $200,000 $100,000 3 $849,000 $190,000 $100,000 4 $830,000 $210,000 $80,000 5 $1,000,385 $257,390 $80,000 b. Hanson Corp. will not have its S election terminated because it did not have passive income in excess of 25 percent of its gross receipts for three consecutive years (even though it had C corporation E&P for all of those years). Year Gross Receipts Passive Investment Income Passive Income % of Gross Receipts Corporate Earnings and Profits 1 $1,430,000 $247,000 17.27% $138,039 2 $700,380 $200,000 28.56% $100,000 3 $849,000 $190,000 22.38% $100,000 4 $830,000 $210,000 25.30% $80,000 5 $1,000,385 $257,390 25.73% $80,000 c. Tiffany Corp. Year Gross Receipts Passive Investment Income Corporate Earnings and Profits 1 $1,000,458 $250,000 $0 2 $703,000 $300,480 $0 3 $800,375 $400,370 $0 4 $900,370 $350,470 $0 5 $670,000 $290,377 $0 c. Tiffany Corp. will not be subject to the excess passive income test because it does not have any C corporation E&P. d. Jonas Corp. Year Gross Receipts Passive Investment Income Corporate Earnings and Profits 1 $1,100,370 $250,000 $500 2 $998,000 $240,000 $400 3 $800,350 $230,000 $300 4 $803,000 $214,570 $200 5 $750,000 $200,000 $100 Jonas Corp. will have its S election terminated as of day 1 of year 6 because it had passive income in excess of 25 percent of its gross receipts, and it had C corporation earnings and profits for three consecutive years (years 3, 4, and 5). To avoid this problem, Jonas could have distributed its minimal E&P. Year Gross Receipts Passive Investment Income Passive Income % of Gross Receipts Corporate Earnings and Profits 1 $1,100,370 $250,000 22.72% $500 2 $998,000 $240,000 24.05% $400 3 $800,350 $230,000 28.74% $300 4 $803,000 $214,570 26.72% $200 5 $750,000 $200,000 26.67% $100 48. [LO 2] Hughie, Dewey, and Louie are equal shareholders in HDL, an S corporation. HDL’s S election terminates under each of the following alternative scenarios. When is the earliest it can again operate as an S corporation? a. The S election terminates on August 1, year 2, because Louie sells half his shares to his uncle Walt, a citizen and resident of Scotland. Assuming it qualifies for the S election, the soonest HDL can elect S status is January 1, year 7. This is the beginning of the fifth taxable year after the year in which the election was terminated (year 2). b. The S election terminates effective January 1, year 3, because on August 1, year 2, Hughie and Dewey voted (2 to 1) to terminate the election. January 1, year 8. This is the beginning of the fifth tax year after the year in which the election was terminated (year 3 was the year of the termination; then year 4, 5, 6, 7, and beginning of year 8 is the effective date). 49. [LO 3] Winkin, Blinkin, and Nod are equal shareholders in SleepEZ, an S corporation. In the conditions listed below, how much income should each report from SleepEZ for 2021 under both the daily allocation and the specific identification allocation methods? Refer to the following table for the timing of SleepEZ’s income. Period Income January 1 through March 15 (74 days) $125,000 March 16 through December 31 (291 days) 345,500 January 1 through December 31, 2021 (365 days) $470,500 a. There are no sales of SleepEZ stock during the year. In this case, because there was no change in ownership, there is no need to apply an allocation method (both give the same result). Each shareholder will report $156,833 of income ($470,500 total income for year x 1/3 ownership) b. On March 15, 2021, Blinkin sells his shares to Nod. Daily Allocation Method: Winkin $156,833; (1/3 ownership x 365/365 days x $470,500 income) Blinkin $31,796 (1/3 ownership x 74/365 days x $470,500 income) Nod $281,870 [$156,833 (1/3 ownership x 365/365 days x $470,500 income) + $125,037 (1/3 ownership acquired x 291/365 days x $470,500 income)] Specific Identification Method: Winkin $156,833 (1/3 ownership x 125,000) + (1/3 ownership x 345,500) Blinkin $41,667 (1/3 ownership x $125,000) + (0/3 ownership x $345,500) Nod $272,000 (1/3 ownership x $125,000) + (2/3 ownership x $345,500) c. On March 15, 2021, Winkin and Nod each sell their shares to Blinkin. Daily Allocation Method: Winkin $31,796 (1/3 ownership x 74/365days x $470,500) Nod $31,796 (1/3 ownership x 74/365 days x $470,500) Blinkin $406,907 [$31,796(1/3 ownership x 74/365 days x $470,500) + $375,111(3/3 ownership x 291/365 days x $470,500)] Specific Identification Method: Winkin $41,667 (1/3 ownership x $125,000) Nod $41,667 (1/3 ownership x $125,000) Blinkin $387,167 (1/3 ownership x $125,000 + (3/3 ownership x $345,500) Use the following information to complete problems 50 and 51: UpAHill Corporation (an S corporation) Income Statement December 31, year 1 and year 2 Year 1 Year 2 Sales revenue $175,000 $310,000 Cost of goods sold (60,000) (85,000) Salary to owners Jack and Jill (40,000) (50,000) Employee wages (15,000) (20,000) Depreciation expense (10,000) (15,000) Miscellaneous expenses (7,500) (9,000) Interest income (related to business) 2,000 2,500 Qualified dividend income 500 1,000 Overall net income $45,000 $134,500 50. [LO 3] Jack and Jill are owners of UpAHill, an S corporation. They own 25 and 75 percent, respectively. a. What amount of ordinary income and separately stated items are allocated to them for years 1 and 2 based on the information above? Assume that UpAHill Corporation has $100,000 of qualified property (unadjusted basis) in both years. Year 1: Ordinary Income $44,500 (includes $2,000 of interest income related to business); $11,125 ($44,500 x 25%) allocated to Jack and $33,375 ($44,500 x 75%) allocated to Jill Separately stated items: Qualified Dividend income $500; $125 ($500 x 25 %) allocated to Jack and $375 ($500 x 75%) allocated to Jill. Qualified Business Income of $44,500 (ordinary income of $44,500); $11,125 allocated to Jack; $33,375 allocated to Jill. Wages Allocated (employees + officers’ compensation) $55,000; $13,750 allocated to Jack ($55,000 wages x 25%); $41,250 allocated to Jill ($55,000 wages x 75%). Qualified property: $100,000; $25,000 allocated to Jack; $75,000 allocated to Jill. Year 2: Ordinary Income $133,500 (including $2,500 of interest income related to business); $33,375 ($133,500 x 25%) allocated to Jack and $100,125 ($133,500 x 75%) allocated to Jill Separately stated items: Qualified Dividend income $1,000; $250 ($1,000 x 25%) allocated to Jack and $750 ($1,000 x 75%) allocated to Jill. Qualified Business Income of $133,500 (ordinary income of $133,500); $33,375 allocated to Jack; $100,125 allocated to Jill. Wages Allocated (employees + officers’ compensation) $70,000; $17,500 allocated to Jack ($70,000 x 25%); $52,500 allocated to Jill ($70,000 wages x 75%). Qualified property: $100,000; $25,000 allocated to Jack; $75,000 allocated to Jill. b. Complete UpAHill’s Form 1120-S, Schedule K, for year 1. Qualified Business Income Statement UpAHill Corporation EIN 58-1111111 Qualified Business Income: Ordinary Income $44,500 W-2 wages: $55,000 UBIA of qualified property: $100,000 c. Complete Jill’s 1120-S, Schedule K-1, for year 1. Qualified Business Income Statement UpAHill Corporation EIN 58-1111111 Shareholder: Jill Qualified Business Income: Ordinary Income $33,375 W-2 wages: $41,250 UBIA of qualified property: $75,000 51. [LO 3, 4] Assume Jack and Jill, 25 and 75 percent shareholders, respectively, in UpAHill Corporation, have tax bases in their shares at the beginning of year 1 of $24,000 and $56,000, respectively. Also assume no distributions were made. Given the income statement above, what are their tax bases in their shares at the end of year 1? Jack will have a tax basis of $35,250 which is his original basis of $24,000 + $11,125 (his 25% share of the $44,500 ordinary income) + $125 (his share of the interest and dividends, respectively). Jill will have a new tax basis of $89,750 which is her original basis of 56,000 + 33,375 (her 75% share of the $44,500 ordinary income) + $375 (her share of the interest and dividends, respectively). Use the following information to complete problems 52 and 53: Falcons Corporation (an S corporation) Income Statement December 31, Year 1 and Year 2 Year 1 Year 2 Sales revenue $300,000 $430,000 Cost of goods sold (40,000) (60,000) Salary to owners Julio and Milania (40,000) (80,000) Employee wages (25,000) (50,000) Depreciation expense (20,000) (40,000) Section 179 expense (30,000) (50,000) Interest income (related to business income) 12,000 22,500 Municipal bond income 1,500 4,000 Government fines 0 (2,000) Overall net income $158,500 $174,500 Distributions $30,000 $50,000 52. [LO 3] Julio and Milania are owners of Falcons Corporation, an S corporation. Each owns 50 percent of Falcons Corporation. In year 1, Julio and Milani each received distributions of $15,000 from Falcons Corporation. a. What amount of ordinary income and separately stated items are allocated to them for year 1 based on the information above? Assume that Falcons Corporation has $200,000 of qualified property (unadjusted basis). Ordinary Income $187,000 (including $12,000 of interest income related to business); $93,500 ($187,000 x 50%) allocated to Julio and Milani each. Separately stated items: Section 179 expense $30,000; $15,000 allocated to Julio and Milani each. Municipal bond income $1,500; $750 allocated to Julio and Milani each. Nondeductible fines $0. Distributions $30,000; $15,000 to Julio and $15,000 to Milani. Qualified Business Income of $187,000 (ordinary income of $187,000); $93,500 allocated to Julio and Milani each. Wages Allocated (for purposes of qualified business income, employee wages + officer compensation) $65,000; $32,500 allocated to Julio ($65,000 wages x 50%); $32,500 allocated to Milani ($65,000 wages x 50%); Qualified property: $200,000; $100,000 allocated to Julio and Milani each. b. Complete Falcons Form 1120-S, Schedule K, for year 1. Qualified Business Income Statement Falcons Corporation EIN 58-1111111 Qualified Business Income: Ordinary Income $187,000 W-2 wages: $65,000 UBIA of qualified property: $200,000 c. Complete Julio’s 1120-S, Schedule K-1, for year 1. Qualified Business Income Statement Falcons Corporation EIN 58-1111111 Shareholder: Julio Qualified Business Income: Ordinary Income $93,500 W-2 wages: $32,500 UBIA of qualified property: $100,000 53. [LO 3] In year 2, Julio and Milani each received distributions of $25,000 from Falcons Corporation. a. What amount of ordinary income and separately stated items are allocated to them for year 2 based on the information above? Assume that Falcons Corporation has $200,000 of qualified property (unadjusted basis). Ordinary Income $222,500; $111,250 ($222,500 x 50%) allocated to Julio and Milani each. Separately stated items: Section 179 expense $50,000; $25,000 allocated to Julio and Milani each. Municipal bond income $4,000; $2,000 allocated to Julio and Milani each. Nondeductible fines $2,000; $1,000 allocated to Julio and Milani each. Qualified Business Income of $222,500 (ordinary income of $200,000 + $22,500 interest income related to business); $111,250 allocated to Julio and Milani each. Wages Allocated (for purposes of qualified business income, employee wages + officer compensation) $130,000; $65,000 allocated to Julio ($130,000 wages x 50%); $65,000 allocated to Milani (130,000 employee wages x 50%). Qualified property: $200,000; $100,000 allocated to Julio and Milani each. Distributions $50,000; $25,000 to Julio and $25,000 to Milani. b. Complete Falcons Form 1120-S, Schedule K, for year 2. Qualified Business Income Statement Falcons Corporation EIN 58-1111111 Qualified Business Income: Ordinary Income $222,500 W-2 wages: $130,000 UBIA of qualified property: $200,000 c. Complete Milani’s 1120-S, Schedule K-1, for year 2. Qualified Business Income Statement Falcons Corporation EIN 58-1111111 Shareholder: Milani Qualified Business Income: Ordinary Income $111,250 W-2 wages: $65,000 UBIA of qualified property: $100,000 54. [LO 4] Harry, Hermione, and Ron formed an S corporation called Bumblebore. Harry and Hermione both contributed cash of $25,000 to get things started. Ron was a bit short on cash but had a parcel of land valued at $60,000 (basis of $50,000) that he decided to contribute. The land was encumbered by a $35,000 mortgage. What tax bases will each of the three have in his or her or his stock of Bumblebore? Harry and Hermione have a basis equal to the cash they contributed ($25,000). Ron’s $15,000 basis is computed by starting with the $50,000 basis of the property contributed and then subtracting the $35,000 mortgage that Ron was relieved of when he contributed the property to the corporation. 55. [LO 4] Jessica is a one-third owner in Bikes-R-Us, an S corporation that experienced a $45,000 loss this year (year 1). If her stock basis is $10,000 at the beginning of the year, how much of this loss clears the hurdle for deductibility (assume at-risk limitation equals the tax-basis limitation)? If she cannot deduct the whole loss, what happens to the remainder? Is she able to deduct the entire loss if she sells her stock at year-end? Jessica is allocated $15,000 of loss ($45,000 x 1/3). However, she is allowed to deduct only $10,000 of the allocation because this is the amount of her stock basis in Bikes-R-Us. Jessica is allowed to deduct $10,000, the amount of her stock basis. The $5,000 she is not allowed to deduct is suspended until Jessica creates additional basis to absorb the loss. If Jessica sells the stock before creating additional basis, the loss disappears unused. 56. [LO 4] Assume the same facts as in the previous problem, except that at the beginning of year 1 Jessica loaned Bikes-R-Us $3,000. In year 2, Bikes-R-Us reported ordinary income of $12,000. What amount is Jessica allowed to deduct in year 1? What are her stock and debt bases in the corporation at the end of year 1? What are her stock and debt bases in the corporation at the end of year 2? Just as in the previous problem, Jessica is allocated a $15,000 loss. She is allowed to deduct $10,000 of the loss, which reduces her stock basis to $0. She then can deduct an additional $3,000 of the loss, reducing her debt basis to $0. She has a suspended $2,000 ($15,000 - $10,000 - $3,000) loss at the end of year 1. In year 2, Jessica’s $4,000 ($12,000 x 1/3) share of ordinary income restores Jessica’s debt basis to $3,000 and then increases her stock basis to $1,000. Jessica can then deduct the $2,000 loss carryover first against her $1,000 stock basis and then her $3,000 debt basis, reducing her stock basis to $0 and her debt basis to $2,000. 57. [LO 4] Birch Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, James, who has operated it as an S corporation since its inception. Last year, James made a direct loan to Birch Corp. in the amount of $5,000. Birch Corp. has paid the interest on the loan but has not yet paid any principal. (Assume the loan qualifies as debt for tax purposes.) For the year, Birch experienced a $25,000 business loss. What amount of the loss clears the tax-basis limitation, and what is James’s basis in his Birch Corp. stock and Birch Corp. debt in each of the following alternative scenarios? a. At the beginning of the year, James’s basis in his Birch Corp. stock was $45,000 and his basis in his Birch Corp. debt was $5,000. All $25,000 of the loss clears the tax basis limitation. James’s stock basis is reduced to $20,000 ($45,000 – 25,000 loss). His debt basis remains at $5,000. b. At the beginning of the year, James’s basis in his Birch Corp. stock was $8,000 and his basis in his Birch Corp. debt was $5,000. Of the $25,000 loss, $13,000 clears the tax basis limitation. James’s stock basis is reduced from $8,000 to $0, and his debt basis is reduced from $5,000 to $0. James has a suspended loss of $12,000 ($25,000 - $13,000). c. At the beginning of the year, James’s basis in his Birch Corp. stock was $0 and his basis in his Birch Corp. debt was $5,000. $5,000 clears the tax basis limitation. James’s stock basis remains at $0, and his debt basis is reduced from $5,000 to $0. James has a suspended loss of $20,000 ($25,000 – 5,000). 58. [LO4] {Research} Timo is the sole owner of Jazz Inc., an S corporation. On October 31, 2020, Timo executed an unsecured demand promissory note of $15,000 and transferred the note to Jazz (Jazz could require Timo to pay it $15,000 on demand). When Timo transferred the note to Jazz, his tax basis in his Jazz stock was zero. On January 31, 2021, Timo paid the $15,000 to Jazz as required by the promissory note. For the taxable year ending December 31, 2020, Jazz incurred a business loss of $12,000. How much of the loss clears the stock and debt basis hurdles for deductibility? $0. In 2020, Timo merely executed and transferred his demand note to Jazz Corp., and he did not make any payments on the note until the following year. Since Timo incurred no cost in executing the note, Timo’s basis in the note was zero. Thus, in 2020 there was no economic outlay to Jazz from Timo (in the form of a capital contribution or a loan). Consequently, his stock (and debt basis) at year end is $0, and he is not allowed to deduct any of Jazz’s 2020 loss. Timo’s stock basis does not increase until he transferred the cash to Jazz in 2021. See Rev. Rul. 81-187, 1981-2 CB 167. 59. [LO 4] Chandra was the sole shareholder of Pet Emporium, which was originally formed as an S corporation. When Pet Emporium terminated its S election on August 31, 2019, Chandra had a stock basis and an at-risk amount of $0. Chandra also had a suspended loss from Pet Emporium of $9,000. What amount of the suspended loss is Chandra allowed to deduct, and what is her basis in her Pet Emporium stock at the end of the post-termination transition period under the following alternative scenarios (assume Pet Emporium files for an extension to file its tax returns)? a. Chandra makes capital contributions of $7,000 on August 30, 2020, and $4,000 on September 14, 2020. Chandra is allowed to create stock basis to absorb the suspended loss until the end of the post termination transition period (PTTP). This ends on the later of (a) one year after the last S corporation day or (b) the due date for filing the return (including extensions). Because Chandra made $11,000 of contributions ($7,000 + $4,000) before September 15, 2020, (the end of the PTTP), she is allowed to increase her stock basis to $11,000 and then she is allowed to deduct the $9,000 suspended loss stock basis. This reduces her stock basis to $2,000 (her basis in Pet Emporium the C corporation going forward). b. Chandra makes capital contributions of $5,000 on September 1, 2020, and $5,000 on September 30, 2020. Because Chandra made a $5,000 contribution to Pet Emporium before September 15, 2020 ( the last day of the PTTP), she is allowed to increase her stock basis by the $5,000 and then she is allowed to deduct $5,000 of the $9,000 suspended loss, reducing her basis to $0 at the end of the PTTP. When she contributes $5,000 on September 30, 2020 (after the PTTP), she is allowed to increase the basis in her stock in Pet Emporium the C corporation. c. Chandra makes a capital contribution of $10,000 on August 31, 2020. Because Chandra made the $10,000 contribution before September 15, 2020, (the end of the PTTP) she is allowed to increase her S corporation stock basis to $10,000 and then deduct the entire $9,000 suspended loss. This reduces her stock basis to $1,000 which will be her stock basis in Pet Emporium the C corporation. d. Chandra makes a capital contribution of $10,000 on October 1, 2020. Because Chandra made the contribution after September 15, 2020, (the end of the PTTP), she is not allowed to deduct any of the suspended losses. Consequently, the suspended loss disappears unused and her basis at the end of the PTTP is $0. The $10,000 contribution on October 1, 2020 increases Chandra’s basis in Pet Emporium the C corporation to $10,000. 60. [LO 4] {Planning} Neil owns stock in two S corporations, Blue and Green. He actively participates in the management of Blue but maintains ownership in Green only as a passive investor. Neil has no other business investments. Both Blue and Green anticipate a loss this year, and Neil’s basis in his stock of both corporations is $0. All else equal, if Neil plans on making a capital contribution to at least one of the corporations this year, to which firm should he contribute in order to increase his chances of deducting the loss allocated to him from the entity? Why? Neil should contribute to Blue Corporation to increase his chances of deducting the loss. The reason is that any loss allocation from Blue will be deductible to the extent of his stock basis (and at-risk amounts). Because he participates in the activities of Blue Corporation the loss will not be subject to the passive activity loss restrictions. In contrast, if he contributes to Green Corporation, even though he has stock basis and at risk amounts he may still not be allowed to deduct the loss due to the passive activity loss limitations. To deduct a loss from Green Corporation, Neal will need to have passive income from other sources. 61. [LO4] {Planning} In the past several years, Shakira had loaned money to Shakira Inc. (an S corporation) to help the corporation keep afloat in a downturn. Her stock basis in the S corporation is now $0, and she has deducted $40,000 in losses, reducing her debt basis from $100,000 to $60,000. Things appear to be turning around this year, and Shakira Inc. repaid Shakira $20,000 of the $100,000 outstanding loan. What is Shakira’s income, if any, on the partial loan repayment? The $20,000 repayment must be pro-rated between the portion of the debt with remaining basis ($60,000) and the portion of the debt with no basis ($40,000). To the extent the repayment is attributable to the portion of the debt with no basis, Shakira must recognize a capital gain (the debt is a capital asset). In this situation 60 percent of the debt has basis ($60,000/$100,000) and 40 percent does not ($40,000/$100,000). Consequently, Shakira must recognize $8,000 of capital gain on the repayment ($20,000 payment x 40%). See Rev. Rul. 64-162, 1964-1 C.B. 304. 62. [LO4] Adam Fleeman, a skilled carpenter, started a home improvement business with Tom Collins, a master plumber. Adam and Tom are concerned about the payroll taxes they will have to pay. Assume they form an S corporation, and each earns a salary of $80,000 from the corporation; in addition, they expect their share of business profits to be $60,000 each. How much Social Security tax and Medicare tax (or self-employment tax) will Adam, Tom, and their corporation have to pay on their salary and profits? Each employee will have to have pay $6,120 ($80,000 x 7.65%) in FICA (Social Security and Medicare) employment taxes in 2020. The S corporation would also have to pay $6,120 of FICA taxes ($80,000 x 7.65%) on behalf of each employee ($12,240 total). Neither Adam nor Tom is required to pay FICA taxes on his share of the business profits (assuming they are paying themselves reasonable salaries). 63. [LO4] {Planning} Using the facts in problem 62, could Adam and Tom lower their payroll tax exposure if they operated their business as a partnership? Why or why not? If Adam and Tom operated the business as a partnership, because they are actively involved in the business activities, they would be subject to self-employment tax on any payments they receive for their services (guaranteed payments), and they would be subject to employment taxes on their shares of business profits. Consequently, they would have lower payroll tax exposure by operating as an S corporation. They need to make sure they are paying themselves reasonable salaries as S corporation shareholders or the IRS may deem their business profits to be salary to the extent required to make their salaries reasonable. 64. [LO4] This year, Justin B.’s share of S corporation income includes $4,000 of interest income, $5,000 of dividend income, and $40,000 of net income from the corporation’s professional service business activity. a) Assume that Justin B. materially participates in the S corporation. How much of his S corporation income is potentially subject to the net investment income tax? $9,000. Because Justin B. materially participates in the S corporation, the net income related to the business activity is not subject to the tax, but the interest and dividend would be investment income potentially subject to the tax. b) Assume that Justin B. does not materially participate in the S corporation. How much of his S corporation income is potentially subject to the net investment income tax? $49,000. Because Justin B. does not materially participate in the S corporation, the net income related to the business activity, interest income, and dividend would be investment income potentially subject to the tax. 65. [LO4] Friends Jackie (0.5 percent owner), Jermaine (1 percent owner), Marlon (2 percent owner), Janet (86 percent owner), and Tito (10.5 percent owner) are shareholders in Jackson 5 Inc. (an S corporation). As employees of the company, each receives health insurance ($10,000 per year benefit), dental insurance ($2,000 per year benefit), and free access to a workout facility located at company headquarters ($500 per year benefit). What are the tax consequences of these benefits for each shareholder and for Jackson 5 Inc.? Because they are 2 percent or less shareholders, Jackie, Jermaine, and Marlon would all receive the fringe benefits tax free. However, because Janet and Tito own more than 2 percent in Jackson 5, they would be taxed on the value of the benefits they received for the health and dental insurance. However, they would not be taxed on the benefit they receive for the workout facility located at company headquarters. The corporation would be allowed to deduct the cost of all of the benefits provided to the shareholders. 66. [LO 5] Maple Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, Brady, who immediately elected S corporation status. On December 31 of the current year, Maple distributed $30,000 cash to Brady. What are the amount and character of gain Brady must recognize on the distribution in each of the following alternative scenarios? a. At the time of the distribution, Brady’s basis in his Maple Corp. stock was $35,000. Brady would recognize $0 gain and his stock basis would be reduced from $35,000 to $5,000 ($35,000 original basis – 30,000 distribution). b. At the time of the distribution, Brady’s basis in his Maple Corp. stock was $8,000. Brady would recognize a $22,000 long-term capital gain (the distribution exceeds his basis by $22,000), and his stock basis would be reduced to $0. c. At the time of the distribution, Brady’s basis in his Maple Corp. stock was $0. Brady would recognize a $30,000 long-term capital gain (the distribution exceeds his stock basis by $30,000), and his stock basis would remain at $0. 67. [LO 5] Oak Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, Glover, and has always operated as a C corporation. However, at the beginning of this year, Glover made a qualifying S election for Oak Corp., effective January 1. Oak Corp. did not have any C corporation earnings and profits on that date. On June 1, Oak Corp. distributed $15,000 to Glover. What are the amount and character of gain Glover must recognize on the distribution, and what is his basis in his Oak Corp. stock in each of the following alternate scenarios? a. At the time of the distribution, Glover’s basis in his Oak Corp. stock was $35,000. $0 gain; basis in stock is $20,000 ($35,000 original basis minus $15,000 distribution). b. At the time of the distribution, Glover’s basis in his Oak Corp. stock was $8,000. $7,000 long-term capital gain; basis in stock is $0. c. At the time of the distribution, Glover’s basis in his Oak Corp. stock was $0. $15,000 long-term capital gain; basis in stock is $0. 68. [LO 5] On January 1, 2020, Janna has a tax basis of $15,000 in her Mimikaki stock (Mimikaki has been an S corporation since inception). In 2020, Janna was allocated $20,000 of ordinary income from Mimikaki. What are the amount and character of gain she recognizes from end-of-the-year distributions in each of the following alternative scenarios, and what is her stock basis following each distribution? a. Mimikaki distributes $10,000 to Janna. At the time of the distribution, Janna’s stock basis is $35,000 ($15,000 original basis plus $20,000 ordinary income allocation). On the distribution, Janna recognizes $0 gain, and the distribution reduces her stock basis to $25,000 ($35,000 stock basis minus $10,000 distribution). b. Mimikaki distributes $20,000 to Janna. At the time of the distribution, Janna’s stock basis is $35,000 ($15,000 original basis plus $20,000 ordinary income allocation). On the distribution, Janna recognizes $0 gain, and the distribution reduces her stock basis to $15,000 ($35,000 stock basis minus $20,000 distribution). c. Mimikaki distributes $30,000 to Janna. At the time of the distribution, Janna’s stock basis is $35,000 ($15,000 original basis plus $20,000 ordinary income allocation). On the distribution, Janna recognizes $0 gain and the distribution reduces her stock basis to $5,000 ($35,000 stock basis minus $30,000 distribution). d. Mimikaki distributes $40,000 to Janna. At the time of the distribution, Janna’s stock basis is $35,000 ($15,000 original basis plus $20,000 ordinary income allocation). On the distribution, Janna recognizes a $5,000 capital gain, and the distribution reduces her stock basis to $0. 69. [LO 5] Assume the following year 2 income statement for Johnstone Corporation, which was a C corporation in year 1 and elected to be taxed as an S corporation beginning in year 2. Johnstone’s earnings and profits at the end of year 1 were $10,000. Marcus is Johnstone’s sole shareholder, and he has a stock basis of $40,000 at the end of year 1. What is Johnstone’s accumulated adjustments account at the end of year 2, and what amount of dividend income does Marcus recognize on the year 2 distribution in each of the following alternative scenarios? Johnstone Corporation Income Statement December 31, Year 2 Year 2 (S corporation) Sales revenue $150,000 Cost of goods sold (35,000) Salary to owners (60,000) Employee wages (50,000) Depreciation expense (4,000) Miscellaneous expenses (4,000) Interest income 10,000 Overall net income $7,000 a. Johnstone distributed $6,000 to Marcus in year 2. AAA = $1,000; $0 dividend income on distribution because the distribution was out of Johnstone’s AAA. b. Johnstone distributed $10,000 to Marcus in year 2. AAA = $0; $3,000 dividend income. $7,000 of the distribution came from Johnstone’s AAA and reduced Marcus’s stock basis in Johnstone but the $3,000 in excess of the AAA is a dividend to the extent of Johnstone’s earnings and profits. Because Johnstone’s E&P was $10,000, all $3,000 of the excess is a dividend to Marcus. Johnstone’s E&P would be reduced to $7,000 at the end of year 2. c. Johnstone distributed $16,000 to Marcus in year 2. AAA = $0; Dividend income is $9,000. $7,000 of the distribution came from Johnstone’s AAA and reduced Marcus’s stock basis in Johnstone but the $9,000 in excess of the AAA is a dividend to the extent of Johnstone’s earnings and profits. Because Johnstone’s E&P was $10,000, all $9,000 of the excess is a dividend to Marcus. Johnstone’s E&P would be reduced to $1,000 at the end of year 2. d. Johnstone distributed $26,000 to Marcus in year 2. AAA = $0; Dividend income is $10,000. $7,000 of the distribution came from Johnstone’s AAA and reduced Marcus’s stock basis in Johnstone but the $19,000 in excess of the AAA ($26,000 minus $7,000) is a dividend to the extent of Johnstone’s earnings and profits. Because Johnstone’s E&P was $10,000, $10,000 of the excess is a dividend to Marcus. Johnstone’s E&P would be reduced to $0 at the end of year 2. The remaining $9,000 would reduce Marcus’s basis in his Johnstone stock. 70. [LO 5] At the end of the year, before distributions, Bombay (an S corporation) has an accumulated adjustments account balance of $15,000 and accumulated E&P of $20,000 from a previous year as a C corporation. During the year, Nicolette (a 40 percent shareholder) received a $20,000 distribution (the remaining shareholders received $30,000 in distributions). What are the amount and character of income or gain Nicolette must recognize from the distribution? What is her basis in her Bombay stock at the end of the year? (Assume her stock basis is $40,000 after considering her share of Bombay’s income for the year but before considering the effects of the distribution.) The distribution is a return of capital (reduction in basis) to Nicolette to the extent of Bombay’s accumulated adjustments account. Since Bombay’s AAA account balance is $15,000, the first $15,000 distributed to shareholders is deemed to come from the AAA account. Nicole’s proportionate share would be $6,000 ($15,000 x 40%). Thus, Nicole is not taxed on the first $6,000 of the distribution, and this reduces her stock basis to $34,000 ($40,000 stock basis minus $6,000 return of capital). The next $20,000 of distributions paid by Bombay comes from its E&P (its total E&P is $20,000). Nicole’s proportionate share is $8,000 ($20,000 x 40%). Thus, the next $8,000 of the distribution is a dividend to Nicole, which does not reduce her stock basis in the S Corporation. The final $6,000 received ($20,000 distribution less $6,000 paid from AAA and $8,000 paid from E&P) reduces Nicole’s basis in her stock to $28,000 ($34,000 - $6,000). 71. [LO 5] Pine Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, Connor, who has always operated it as a C corporation. However, at the beginning of this year, Connor made a qualifying S election for Pine Corp., effective January 1. Pine Corp. reported $70,000 of C corporation earnings and profits on the effective date of the S election. This year (its first S corporation year), Pine Corp. reported business income of $50,000. Connor’s basis in his Pine Corp. stock at the beginning of the year was $15,000. What are the amount and character of gain Connor must recognize on the following alternative distributions, and what is his basis in his Pine Corp. stock at the end of the year? a. Connor received a $40,000 distribution from Pine Corp. at the end of the year. Pine Corp.’s accumulated adjustments account was $0 at the beginning of the year, and it is increased to $50,000 by the business income it earned during the year. The $40,000 distribution comes entirely from its AAA. Connor’s stock basis at the beginning of the year was $15,000, and it is increased by $50,000 to $65,000 by Pine Corp.’s business income. The distribution reduces the stock basis to $25,000 ($65,000 minus $40,000 distribution). Connor is not taxed on the distribution. b. Connor received a $60,000 distribution from Pine Corp. at the end of the year. Pine Corp.’s accumulated adjustments account was $0 at the beginning of the year, and it is increased to $50,000 (before the distribution) by the business income it earned during the year. $50,000 of the $60,000 distribution comes from Pine Corp.’s AAA, reducing its AAA to $0. The remaining $10,000 of the distribution is out of Pine Corp.’s E&P (reducing its E&P to $60,000). Connor’s stock basis at the beginning of the year was $15,000 and it is increased by $50,000 to $65,000 by Pine Corp.’s business income. The $50,000 of the distribution that is out of Pine Corp’s AAA reduces Connor’s stock basis to $15,000 ($65,000 minus $50,000 distribution out of AAA). Connor is taxed on a $10,000 dividend (the $10,000 of the distribution that is out of Pine Corp.’s E&P). c. Connor received a $130,000 distribution from Pine Corp. at the end of the year. Pine Corp.’s accumulated adjustments account was $0 at the beginning of the year, and it is increased to $50,000 (before the distribution) by the business income it earned during the year. $50,000 of the $130,000 distribution comes from Pine Corp.’s AAA, reducing its AAA to $0. $70,000 of the remaining $80,000 is out of Pine Corp.’s E&P (reducing its E&P to $0). The remaining $10,000 of the distribution is a reduction of stock basis to Connor. Connor’s stock basis at the beginning of the year was $15,000 and it is increased by $50,000 to $65,000 by Pine Corp.’s business income. The $50,000 of the distribution that is out of Pine Corp’s AAA reduces Connor’s stock basis to $15,000 ($65,000 minus $50,000 distribution out of AAA). Connor is taxed on a $70,000 dividend (the $70,000 of the distribution that is out of Pine Corp.’s E&P). Finally, the remaining $10,000 reduces Connor’s stock basis to $5,000 ($15,000 minus $10,000 distribution in excess of AAA and E&P). d. Connor received a $150,000 distribution from Pine Corp. at the end of the year. Pine Corp.’s accumulated adjustments account was $0 at the beginning of the year and it is increased to $50,000 (before the distribution) by the business income it earned during the year. $50,000 of the $150,000 distribution comes from Pine Corp.’s AAA, reducing its AAA to $0. $70,000 of the remaining $100,000 is out of Pine Corp.’s E&P (reducing its E&P to $0). The remaining $30,000 of the distribution is a return of capital or capital gain to Connor. Connor’s stock basis at the beginning of the year was $15,000 and it is increased by $50,000 to $65,000 by Pine Corp.’s business income. The $50,000 of the distribution that is out of Pine Corp’s AAA reduces Connor’s stock basis to $15,000 ($65,000 minus $50,000 distribution out of AAA). Connor is taxed on a $70,000 dividend (the $70,000 of the distribution that is out of Pine Corp.’s E&P). Finally, the remaining $30,000 first reduces Connor’s stock basis to $0 ($15,000 minus $15,000 of the distribution in excess of AAA and E&P) and then creates $15,000 of long-term capital gain to Connor. 72. [LO 5] Carolina Corporation, an S corporation, has no corporate E&P from its years as a C corporation. At the end of the year, it distributes a small parcel of land to its sole shareholder Shadiya. The fair market value of the parcel is $70,000, and its tax basis is $40,000. Shadiya’s basis in her stock is $14,000. Assume Carolina Corporation reported $0 taxable income before considering the tax consequences of the distribution. a. What amount of gain or loss, if any, does Carolina Corporation recognize on the distribution? Carolina must recognize $30,000 gain ($70,000 fair market value minus $40,000 tax basis) on the distribution just as if it had sold the property for its fair market value. b. How much gain must Shadiya recognize (if any) as a result of the distribution, what is her basis in her Carolina Corporation stock after the distribution, and what is her basis in the land? Shadiya recognizes a total of $56,000 gain on the distribution. First, she is allocated the $30,000 gain on the distribution. This increases her stock basis from $14,000 to $44,000. Second, she recognizes a $26,000 gain because the $70,000 distribution exceeds her $44,000 stock basis by $26,000. Her ending stock basis is zero and her basis in the land is $70,000, its fair market value. c. What is your answer to (a) if the fair market value of the land is $25,000 rather than $70,000? Zero loss. Carolina Corporation is not allowed to deduct any loss on the distribution of depreciated property. d. What is your answer to (b) if the fair market value of the land is $25,000 rather than $70,000? Shadiya’s stock basis before the distribution is $14,000. The amount of the distribution is $25,000, the fair market value of the land. The first $14,000 of the distribution is nontaxable and reduces Shadiya’s basis to zero. The remaining $11,000 of the distribution in excess of her stock basis is taxed as capital gain to Shadiya. Her ending stock basis is zero, and her basis in the land is $25,000, its fair market value. 73. [LO5] Miley decided to terminate the S corporation election of her solely owned corporation on October 17, 2019 (effective immediately), in preparation for taking it public. Miley had previously elected S corporation status on January 1, 2018. At the time of the election, the corporation had an accumulated adjustments account balance of $150,000 and $450,000 of accumulated E&P from prior C corporation years, and Miley had a basis in her S corporation stock of $135,000. During 2020, Miley’s corporation reported $0 taxable income or loss. Also, during 2020 the corporation made distributions to Miley of $80,000 and $60,000. How are these distributions taxed to Miley assuming the following? a. Both distributions are in cash. The first was paid on June 15, 2020, and the second was paid on November 15, 2020. The June 15 distribution is nontaxable. The June 15 distribution is during the post-termination transition period, so it is nontaxable to the extent of the corporation’s accumulated adjustments account ($150,000) and Miley’s stock basis ($135,000). Because the second distribution is after the end of the PTTP (it ends on October 17, 2020) the distribution is treated as a distribution out of the corporation’s earnings and profits. So, Miley must recognize a $60,000 dividend on the November 15th distribution. b. Both distributions are in cash. The first was paid on June 15, 2020, and the second was paid on September 30, 2020. In this case, both distributions are during the PTTP so they are nontaxable to the extent of the corporation’s AAA and Miley’s stock basis. Because the total amount of the distributions is $140,000 and the corporation’s AAA is $150,000, both distributions are nontaxable to the extent of Miley’s stock basis of $135,000. The excess $5,000 distribution ($135,000 stock basis – $140,000 distribution) is taxable as a capital gain. c. Assume the same facts as in part (b), except the June 15 distribution was a property (noncash) distribution (fair market value of distributed property equal to basis). Because the June 15 distribution is not in cash it is a dividend to Miley to the extent of the corporation’s earnings and profits. Here Miley must recognize $80,000 of dividend income. The September 30 distribution is during the post-termination transition period so it is nontaxable to the extent of the corporation’s accumulated adjustments account ($150,000) and Miley’s stock basis ($135,000). 74. [LO 5] Alabama Corporation, an S corporation, liquidates this year by distributing a parcel of land to its sole shareholder, Mark Ingram. The fair market value of the parcel is $50,000, and its tax basis is $30,000. Mark’s basis in his stock is $25,000. a. What amount of gain or loss, if any, does Alabama Corporation recognize on the distribution? Alabama must recognize $20,000 gain ($50,000 fair market value minus $30,000 tax basis) on the distribution just as if it had sold the property for its fair market value. b. How much gain must Mark recognize (if any) as a result of the distribution, and what is his basis in the land? Mark recognizes a total of $25,000 gain on the liquidating distribution. First, he is allocated the $20,000 gain on the distribution that Alabama Corporation recognizes. This gain increases his stock basis from $25,000 to $45,000. Second, he recognizes a $5,000 gain because the $50,000 distribution exceeds his $45,000 stock basis by $5,000. Thus, Mark recognizes $25,000 of gain on the distribution ($20,000 gain allocated from Alabama Corporation plus $5,000 gain from the distribution in excess of his basis). His basis in the land is $50,000, its fair market value. c. What is your answer to part (a) if the fair market value of the land is $20,000 rather than $50,000? Alabama Corporation would recognize a $10,000 loss on the liquidating distribution ($20,000 FMV less $30,000 basis = $10,000 loss). d. What is your answer to part (b) if the fair market value of the land is $20,000 rather than $50,000? Mark would recognize a net loss of $5,000 on the liquidating distribution. First, he is allocated the $10,000 loss on the distribution that Alabama Corporation recognizes. This loss reduces his stock basis to $25,000 to $15,000. Second, he recognizes a $5,000 gain because the $20,000 distribution exceeds his $15,000 stock basis by $5,000. Thus, Mark recognizes a net loss of $5,000 ($10,000 loss allocated from Alabama Corporation plus $5,000 gain from the distribution in excess of basis). Mark’s basis in the land is $20,000, its fair market value. 75. [LO 6] Rivendell Corporation uses the accrual method of accounting and has the following assets as of the end of 2019. Rivendell converted to an S corporation on January 1, 2020. Asset Adjusted basis FMV Cash $40,000 $40,000 Accounts receivable 30,000 30,000 Inventory 130,000 60,000 Land 100,000 125,000 Totals $300,000 $255,000 a. What is Rivendell’s net unrealized built-in gain at the time it converted to an S corporation? Zero net unrealized built-in gain. It has an unrealized built-in loss of $45,000 ($25,000 built-in gain on the land but $70,000 built-in loss on the inventory). b. Assuming the land was valued at $200,000, what would be Rivendell’s net unrealized gain at the time it converted to an S corporation? $30,000 net unrealized built-in gain. This is the net of the $100,000 unrealized built-in gain on the land and the $70,000 built-in loss on the inventory. c. Assuming the land was valued at $125,000 but that the inventory was valued at $85,000, what would be Rivendell’s net unrealized gain at the time it converted to an S corporation? Zero net unrealized built-in gain. Rivendell has a net unrealized built-in loss of $20,000. This is the $25,000 built-in gain on the land but a $45,000 built-in loss on the inventory. 76. [LO 6] Virginia Corporation is a calendar-year corporation. At the beginning of 2020, its election to be taxed as an S corporation became effective. Virginia Corp.’s balance sheet at the end of 2019 reflected the following assets (it did not have any earnings and profits from its prior years as a C corporation). Asset Adjusted basis FMV Cash $20,000 $20,000 Accounts receivable 40,000 40,000 Inventory 90,000 200,000 Land 150,000 175,000 Totals $300,000 $435,000 In 2020, Virginia Corp. reported business income of $50,000 (this would have been its taxable income if it were still a C corporation). What is Virginia’s built-in gains tax in each of the following alternative scenarios? a. During 2020, Virginia Corp. sold inventory it owned at the beginning of the year for $100,000. The basis of the inventory sold was $55,000. Virginia’s net unrealized built-in gain at the time it converted to an S corporation is $135,000 ($110,000 built-in gain on inventory and $25,000 built-in gain on land). Its built-in gains tax is 21% multiplied by the least of (a) $45,000 which is its recognized built-in gain on the inventory for the year (b) $135,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $50,000 which is what its taxable income would have been if it were still a C corporation. So, Virginia Corporation’s built-in gains tax is 21% x $45,000 = $9,450. b. Assume the same facts as part (a), except Virginia Corp. had a net operating loss carryover of $24,000 from its time as a C corporation. Virginia’s net unrealized built-in gain at the time it converted to an S corporation is $135,000 ($110,000 built-in gain on inventory and $25,000 built-in gain on land). Its base for the built-in gains tax is the least of (a) $45,000 recognized built-in gain on the inventory), (b) $135,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $50,000 which is what its taxable income would have been if it were still a C corporation (exclusive of its net operating loss carryover). The base ($45,000) is then reduced by Virginia’s net operating loss of $24,000 from its time as a C corporation. Thus, Virginia Corporation’s base for the built-in gains tax is $21,000 ($45,000-$24,000), and its built-in gains tax is 21% x $21,000 = $4,410. c. Assume that same facts as part (a), except that if Virginia Corp. were a C corporation, its taxable income would have been $1,500. Virginia’s net unrealized built-in gain at the time it converted to an S corporation is $135,000 ($110,000 built-in gain on inventory and $25,000 built-in gain on land). Its built-in gains tax is 21% multiplied by the least of (a) $45,000, which is its recognized built-in gain on the inventory, (b) $135,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $1,500 which is what its taxable income would have been if it were still a C corporation. So, its built-in gains tax is 21% x $1,500 = $315. 77. [LO 6] Tempe Corporation is a calendar-year corporation. At the beginning of 2020, its election to be taxed as an S corporation became effective. Tempe Corp.’s balance sheet at the end of 2019 reflected the following assets (it did not have any earnings and profits from its prior years as a C corporation): Asset Adjusted basis FMV Cash $20,000 $20,000 Accounts receivable 40,000 40,000 Inventory 160,000 200,000 Land 150,000 120,000 Totals $370,000 $380,000 Tempe Corp.’s business income for the year was $40,000 (this would have been its taxable income if it were a C corporation). a. During 2020, Tempe Corp. sold all of the inventory it owned at the beginning of the year for $210,000. What is its built-in gains tax in 2020? Tempe’s net unrealized built-in gain at the time it converted to an S corporation is $10,000 ($40,000 built-in gain on inventory minus $30,000 built-in loss on the land). Its built-in gains tax is 21% multiplied by the least of (a) $40,000 which is its recognized built-in gain on the inventory, (b) $10,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $40,000 which is what its taxable income would have been if it were still a C corporation. So, its built-in gains tax is 21% x $10,000 = $2,100. b. Assume the same facts as in part (a), except that if Tempe Corp. were a C corporation, its taxable income would have been $7,000. What is its built-in gains tax in 2020? Tempe’s net unrealized built-in gain at the time it converted to an S corporation is $10,000 ($40,000 built-in gain on inventory minus $30,000 built-in loss on the land). Its built-in gains tax is 21% multiplied by the least of (a) $40,000 which is its recognized built-in gain on the inventory, (b) $10,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $7,000 which is what its taxable income would have been if it were still a C corporation. So, its built-in gains tax is 21% x $7,000 = $1,470. c. Assume the original facts except the land was valued at $140,000 instead of $120,000. What is Tempe Corp.’s built-in gains tax in 2020? Tempe’s net unrealized built-in gain at the time it converted to an S corporation is $30,000 ($40,000 built-in gain on inventory minus $10,000 built-in loss on the land). Its built-in gains tax is 21% multiplied by the least of (a) $40,000 which is its recognized built-in gain on the inventory, (b) $30,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $40,000 which is what its taxable income would have been if it were still a C corporation. So, its built-in gains tax is 21% x $30,000 = $6,300 78. [LO 6] Wood Corporation was a C corporation in 2019 but elected to be taxed as an S corporation in 2020. At the end of 2019, its earnings and profits were $15,500. The following table reports Wood Corp.’s (taxable) income for 2020 (its first year as an S corporation). Wood Corporation Income Statement December 31, 2020 Sales revenue $150,000 Cost of goods sold (35,000) Salary to owners (60,000) Employee wages (50,000) Depreciation expense (4,000) Miscellaneous expenses (4,000) Interest income 8,000 Qualified dividend income 2,000 Overall net income $7,000 What is Wood Corporation’s excess net passive income tax for 2020? $0. Wood’s passive and net passive investment income is $10,000 ($8,000 interest income + $2,000 dividend income). Its gross receipts are $160,000 ($150,000 sales revenue + $8,000 interest income + $2,000 dividend income). Because Wood’s passive investment income of $10,000 does not exceed $40,000 (25% of its gross receipts), Wood does not owe any excess net passive income tax for 2020. 79. [LO 6] Calculate Anaheim Corporation’s excess net passive income tax in each of the following alternative scenarios: a. Passive investment income, $100,000; expenses associated with passive investment income, $40,000; gross receipts, $120,000; taxable income if a C corporation, $40,000; corporate E&P, $30,000. $8,400, computed as follows: The excess net passive income tax is 21% multiplied by the lesser of: (1) $42,000 [($100,000 passive investment income minus $40,000 expenses associated with passive investment income) x ($100,000 – 25% x $120,000)/$100,000] or (2) $40,000 (Anaheim’s taxable income if it had been a C corporation). Thus, its excess net passive income tax is $8,400 (21% x 40,000). b. Passive investment income, $100,000; expenses associated with passive investment income, $70,000; gross receipts, $120,000; taxable income if a C corporation, $1,200; corporate E&P, $30,000. $252, computed as follows: The excess net passive income tax is 21% multiplied by the lesser of (1) $21,000 [($100,000 passive investment income minus $70,000 expenses associated with passive investment income) x (100,000 – 25% x $120,000)/$100,000] or (2) $1,200 (Anaheim’s taxable income if it had been a C corporation). Thus, its excess net passive income tax is $252 (21% x 1,200). c. Passive investment income, $100,000; expenses associated with passive investment income, $40,000; gross receipts, $120,000; taxable income if a C corporation, $40,000; corporate E&P, $0. $0 excess net passive income tax because Anaheim does not have any C corporation E&P. 80. [LO 5, 6] {Planning} Mark is the sole shareholder of Tex Corporation. Mark first formed Tex as a C corporation. However, in an attempt to avoid having Tex’s income double-taxed, Mark elected S corporation status for Tex several years ago. On December 31, 2020, Tex reports $5,000 of earnings and profits from its years as a C corporation and $50,000 in its accumulated adjustments account from its activities as an S corporation (including its 2020 activities). Mark discovered that for the first time Tex was going to have to pay the excess net passive income tax. Mark wanted to avoid having to pay the tax, but he determined the only way to avoid the tax was to eliminate Tex’s E&P by the end of 2020. He determined that, because of the distribution ordering rules (AAA first), he would need to have Tex immediately (in 2020) distribute $55,000 to him. This would clear out Tex’s accumulated adjustments account first and then eliminate Tex’s C corporation earnings and profits in time to avoid the excess net passive income tax. Mark was not sure Tex could come up with $55,000 of cash or property in time to accomplish his objective. Does Mark have any other options to eliminate Tex’s earnings and profits without first distributing the balance in Tex’s accumulated adjustments account? Yes, Mark could elect to have Tex distribute its earnings and profits before it distributes from its accumulated adjustments account. With this election, Tex would need to distribute only $5,000 to eliminate its E&P and avoid the excess net passive income tax. See §1368(e)(3)(A). The election is made by attaching a statement to a timely filed original or amended return for that tax year, on Form 1120S. See (Reg. §1.1368-1(f)(5)(iii). 81. [LO 6] {Planning} Farve Inc. recently elected S corporation status. At the time of the election, the company had $10,000 of accumulated earnings and profits and a net unrealized gain of $1,000,000 associated with land it had invested in (although some parcels had an unrealized loss). In the next couple of years, most of the income the company expects to generate will be in the form of interest and dividends (approximately $200,000 per year). However, in the future, the company will want to liquidate some of its current holdings in land and possibly reinvest in other parcels. What strategies can you recommend for Farve Inc. to help reduce its potential tax liability as an S corporation? First to eliminate its exposure to the excess net passive income tax, Farve may consider distributing its $10,000 of C corporation earnings and profits. If it has no C corporation earnings and profits it will not be subject to the excess net passive income tax. To limit its exposure to the built-in gains tax, Farve could sell parcels of land with built-in losses to offset parcels sold with built-in gains. To the extent Favre does not have parcels of land with built-in losses to offset the parcels with built-in gains, it could eliminate its exposure to the built-in gains tax entirely by waiting to sell the land with built-in gains until the built-in gains tax recognition period expires. 82. [LO 6] Until the end of year 0, Magic Carpets (MC) was a C corporation with a calendar year. At the beginning of year 1, it elected to be taxed as an S corporation. MC uses the LIFO method to value its inventory. At the end of year 0, under the LIFO method, its inventory of rugs was valued at $150,000. Under the FIFO method, the rugs would have been valued at $170,000. How much LIFO recapture tax must MC pay, and what is the due date of the first payment under the following alternative scenarios? a. Magic Carpets’ regular taxable income in year 0 was $65,000. $4,200 LIFO recapture tax ($20,000 x 21%). The LIFO recapture tax is paid in four installments of $1,050 each ($4,200/4). The first installment is due on April 15, year 1 (the unextended due date for the C corporation tax return). The remaining three installments are due on March 15 of years 2, 3, and 4 (the unextended due date for the S corporation tax returns). b. Magic Carpets’ regular taxable income in year 0 was $200,000. $4,200 LIFO recapture tax ($20,000 x 21%). The LIFO recapture amount is $20,000 ($170,000 FIFO inventory basis minus $150,000 LIFO inventory basis). This additional $20,000 is taxed at MC’s marginal tax rate of 21% (corporations are subject to a flat 21% tax rate). The LIFO recapture tax is paid in four installments of $1,050 each ($4,200/4). The first installment is due on April 15, year 1 (the unextended due date for the C corporation tax return). The remaining three installments are due on March 15 of years 2, 3, and 4 (the unextended due date for the S corporation tax returns). Comprehensive Problems 83. {Planning} Knowshon, sole owner of Moreno Inc., is contemplating electing S status for the corporation (Moreno Inc. is currently taxed as a C corporation). Provide recommendations related to Knowshon’s election under the following alternative scenarios: a. At the end of the current year, Moreno Inc. has a net operating loss of $800,000 carryover from 2019. Beginning next year, the company expects to return to profitability. Knowshon projects that Moreno will report profits of $400,000, $500,000, and $600,000 over the next three years. What suggestions do you have regarding the timing of the S election? Explain. Knowshon should delay making an S election until the beginning of year three when it has used up its NOL carryover as a C corporation. With a net operating loss carryover, Moreno’s income won’t be subject to taxation even though it is a C corporation. If Moreno becomes an S corporation before it uses its NOL carryover, the NOL will not be available to be utilized while Moreno is an S corporation. Only in the case where Moreno eventually reverts back to being a C corporation would the NOL become available to be utilized. b. How would you answer part (a) if Moreno Inc. had been operating profitably for several years and thus had no net operating loss? To shield Moreno’s income from double taxation, Knowshon should make the election as soon as possible (unless there are other nontax reasons not to make the election). In this situation, the earliest effective date for the election will be January 1 of the year after the current year. Before making the election, Knowshon should consider all factors associated with the election – not just losses. c. While several of Moreno Inc.’s assets have appreciated in value (to the tune of $2,000,000), the corporation has one property--some land in a newly identified flood zone—that has declined in value by $1,500,000. Knowshon plans on selling the loss property in the next year or two. Assume that Moreno does not have a net operating loss. What suggestions do you have for timing the sale of the flood zone property and why? If Knowshon is planning on making the S election, it may make sense to wait until after the election becomes effective to sell the land. This way, Moreno can reduce its exposure to the built-in gains tax. However, Knowshon should also consider the tax savings the loss property will generate if Moreno sells the property as a C corporation. The point is that Knowshon should consider the tax savings from the loss property if it is sold as a C corporation or as an S corporation. 84. {Planning} Barry Potter and Winnie Weasley are considering making an S election on March 1, 2021, for their C corporation, Omniocular. However, first they want to consider the implications of the following information: • Winnie is a U.S. citizen and resident. • Barry is a citizen of the United Kingdom but a resident of the United States. • Barry and Winnie each owns 50 percent of the voting power in Omniocular. However, Barry’s stock provides him with a claim on 60 percent of the Omniocular assets in liquidation. • Omniocular was formed under Arizona state law, but it plans on eventually conducting some business in Mexico. a) Is Omniocular eligible to elect S corporation status? If so, when is the election effective? All shareholders are eligible S corporation shareholders. However, it appears as though Omniocular has more than one class of stock because even though Barry and Winnie each have 50 percent of the voting power, Barry’s stock provides him with 60 percent of the assets in liquidation. Consequently, Omniocular is not eligible to make an S election. For the remainder of the problem, assume Omniocular made a valid S election effective January 1, 2021. Barry and Winnie each owns 50 percent of the voting power and has an equal claim on Omniocular’s assets in liquidation. In addition, consider the following information: • Omniocular reports on a calendar tax year. • Omniocular’s earnings and profits as of December 31, 2020 were $55,000. • Omniocular’s 2020 taxable income was $15,000. • Omniocular’s assets at the end of 2020 are as follows: *$110,000 under FIFO accounting. • On March 31, 2021, Omniocular sold the land for $42,000. • In 2021, Omniocular sold all the inventory it had on hand at the beginning of the year. This was the only inventory it sold during the year. Other Income/Expense Items for 2021 Sales Revenue $155,000 Salary to owners (50,000) Employee wages (10,000) Depreciation expense (5,000) Miscellaneous expenses (1,000) Interest income 40,000 Qualified dividend income 65,000 • Assume that if Omniocular were a C corporation for 2021, its taxable income would have been $88,500. b. How much LIFO recapture tax is Omniocular required to pay and when is it due? $6,300 LIFO recapture tax ($30,000 x 21%). The LIFO recapture amount is $30,000 ($110,000 FIFO inventory basis minus $80,000 LIFO inventory basis). This additional $30,000 is taxed at Omniocular’s marginal tax rate of 21%. The LIFO recapture tax is paid in four installments of $1,575 each ($6,300/4). The first installment is due on April 15, year 2021 (the unextended due date for the 2020 C corporation tax return). The remaining three installments are due on March 15 of years 2022, 2023, and 2024 (the unextended due date for the S corporation tax returns). Note that the LIFO recapture tax increases Omniocular’s tax basis in the inventory to $110,000. c. How much built-in gains tax, if any, is Omniocular required to pay? $3,150. Omniocular’s net unrealized built-in gain at the time it converted to an S corporation is $20,000 [$10,000 built-in gain on the land plus $15,000 built-in gain on inventory (after increasing basis to $110,000 due to LIFO recapture tax) minus $5,000 built-in loss on equipment]. Its built-in gains tax is 21% multiplied by the least of (a) $15,000 which is its recognized built-in gain on the inventory (b) $20,000 which is its net unrealized built-in gain when it converted to an S corporation (it had not recognized any of this amount previously), and (c) $88,500 which is what its taxable income would have been if it were still a C corporation. So, its built-in gains tax is 21% x $15,000 = $3,150. This tax passes through as an ordinary loss (the tax arose from the sale of inventory so the loss is ordinary to Omniocular’s shareholders). d. How much excess net passive income tax, if any, is Omniocular required to pay? $8,400. Omniocular’s passive and net passive investment income is $105,000 ($40,000 interest income + $65,000 qualified dividend income). Its gross receipts are $260,000 ($155,000 sales revenue + $40,000 interest income + $65,000 dividend income). Because Omniocular’s passive investment income exceeds 25% of its gross receipts it is subject to the excess net passive income tax. The amount of the tax is $8,400, computed as follows: The excess net passive income tax is 21% multiplied by the lesser of: (1) $40,000 [$105,000 net passive investment income x ($105,000 – 25% x $260,000)/$105,000] or (2) $88,500 (Omniocular’s taxable income if it had been a C corporation). Thus, its excess net passive income tax is $8,400 (21% x 40,000). Each item of passive income that flows through to the shareholders is reduced by a pro-rata portion of the excess net passive income tax. In this situation, Omniocular’s passive income is $40,000 of interest and $65,000 of qualified dividend income. Thus, the amount of interest that flows through to Omniocular’s shareholders is $36,800 [$40,000 – ($40,000/$105,000 x $8,400) and the amount of qualified dividend income that flows through to the shareholders is $59,800 [$65,000 – ($65,000/$105,000 x $8,400)] e. Assume Barry’s basis in his Omniocular stock was $40,000 on January 1, 2021. What is his stock basis on December 31, 2021? Barry is a 50 percent shareholder in Omniocular. His basis on December 31, 2021 is $52,225, computed as follows: Description Amount Description Basis on 1/1/2021 $40,000 Interest income 18,400 $36,800 (interest income reduced by portion of excess net passive income tax) x 50% (Barry is a 50 percent owner). Qualified dividend income 29,900 $59,800 (dividend income reduced by portion of excess net passive income tax) x 50% Business (loss) (see below) (12,075) ($24,150) x 50% Capital loss (on land sale) (24,000) ($48,000) x 50% Basis at year end $52,225 Business income (loss): Description Amount Sales revenue $155,000 COGS (adjusted to FIFO basis due to LIFO recapture tax) (110,000) Loss from built-in gains tax (3,150) Salaries to owners (50,000) Employee wages (10,000) Depreciation expense (5,000) Miscellaneous expenses (1,000) Business income (loss) ($24,150) For the following questions, assume that after electing S corporation status Barry and Winnie had a change of heart and filed an election to terminate Omniocular’s S election, effective August 1, 2022. • In 2022, Omniocular reported the following income/expense items: January 1 – July 31, 2022 (212 days) August 1 – December 31, 2022 (153 days) January 1 – December 31, 2022 Sales revenue $80,000 $185,000 $265,000 Cost of goods sold (40,000) (20,000) (60,000) Salaries to Barry and Winnie (60,000) (40,000) (100,000) Depreciation expense (7,000) (2,000) (9,000) Miscellaneous expenses (4,000) (3,000) (7,000) Interest income 6,000 5,250 11,250 Overall net income (loss) ($25,000) $125,250 $100,250 f. For tax purposes, how would you recommend Barry and Winnie allocate income between the short S corporation year and the short C corporation year if they would like to minimize double taxation of Omniocular’s income? They should allocate the income based on the number of days in the short year compared to the entire year (i.e., the daily method). This will allow them to shift income out of the short C corporation year and into the short S corporation year and thus subject less income to double taxation. g. Assume in part (f) that Omniocular allocates income between the short S and C corporation years in a way that minimizes the double taxation of its income. If Barry’s stock basis in his Omniocular stock on January 1, 2022, is $50,000, what is his stock basis on December 31, 2022? $79,114. If Omniocular allocates its income based on the number of days in the S corporation period and the C corporation period it will allocate $29,114 of income to Barry ($100,250 x 212/365 x 50% ownership). Thus, his stock basis will be $79,114 ($50,000 plus $29,114). h. When is the earliest tax year in which Omniocular can be taxed as an S corporation again? January 1, 2027. This is the beginning of the fifth year after the year in which the S election was terminated. 85. Abigail, Bobby, and Claudia are equal owners in Lafter, an S corporation that was a C corporation several years ago. While Abigail and Bobby actively participate in running the company, Claudia has a separate day job and is a passive owner. Consider the following information for 2020: • As of January 1, 2020, Abigail, Bobby, and Claudia each has a basis in Lafter stock of $15,000 and a debt basis of $0. On January 1, the stock basis is also the at-risk amount for each shareholder. • Bobby and Claudia also are passive owners in Aggressive LLC, which allocated business income of $14,000 to each of them in 2020. Neither has any other source of passive income (besides Lafter, for Claudia). • On March 31, 2020, Abigail lends $5,000 of her own money to Lafter. • Anticipating the need for basis to deduct a loss, on April 4, 2020, Bobby takes out a $10,000 loan to make a $10,000 contribution to Lafter. Bobby uses his automobile ($12,000 fair market value) as the sole collateral for his loan (nonrecourse). • Lafter has an accumulated adjustments account balance of $45,000 as of January 1, 2020. • Lafter has C corporation earnings and profits of $15,000 as of January 1, 2020. • During 2020, Lafter reports a business loss of $75,000, computed as follows: • Lafter also reported $12,000 of tax-exempt interest income. a. What amount of Lafter’s 2020 business loss of $75,000 are Abigail, Bobby, and Claudia allowed to deduct on their individual tax returns? What are each owner’s stock basis and debt basis (if applicable) and each owner’s at-risk amount with respect to the investment in Lafter at the end of 2020? Abigail: As a one-third owner, Abigail is allocated $25,000 of the $75,000 business loss. Of the $25,000 loss, Abigail is allowed to deduct $24,000. $24,000 of the $25,000 loss clears the debt and stock basis hurdles and the at-risk hurdle. Because the loss is not a passive loss to Abigail, she is allowed to deduct the amount that clears the at-risk hurdle. See computations below: Abigail Description Debt basis Stock basis At-risk January 1, 2020 $5,000 $15,000 $20,000* Share of tax-exempt income 4,000 4,000 Business loss clearing debt basis, and at-risk hurdles (5,000) ($19,000) ($24,000) December 31, 2020 $0 $0 $0 *Includes amounts in debt basis and stock basis. As indicated above, Abigail’s debt basis, stock basis, and at-risk amounts are $0 as of December 31, 2020. Abigail will suspend $1,000 at the stock/debt basis level. Bobby: As a one-third owner, Bobby is allocated $25,000 of the $75,000 business loss. Of the $25,000 loss, Bobby is allowed to deduct $19,000. All $25,000 of the loss clears the stock basis hurdle but only $19,000 of the $25,000 clears the at-risk amount hurdle. Finally, because the loss from Lafter is not a passive loss to Bobby, the passive loss restrictions do not apply. See computations below: Bobby Description Debt basis Stock basis At-risk January 1, 2020 $0 $15,000 $15,000 Capital contribution (from nonrecourse loan) 10,000 0* Share of tax-exempt income 4,000 4,000 Business loss clearing debt basis, and at-risk hurdles ($25,000) ($19,000) December 31, 2020 $0 $4,000 $0 *Because the contribution was funded by a nonrecourse loan, it is not included in the at-risk amount. As indicated above, Bobby’s stock basis is $4,000 on December 31, 2020 and her at-risk amount is $0 as of December 31, 2020. Bobby will suspend $6,000 of the loss at the at-risk level. Claudia: As a one-third owner, Claudia is allocated $25,000 of the $75,000 business loss. Of the $25,000 loss, Claudia is allowed to deduct $14,000. $19,000 of the loss clears the stock basis and at-risk amount hurdles. However, because the loss from Lafter is a passive loss to Claudia, she is allowed to deduct the loss to the extent she has passive income from other sources. In this case, she was allocated $14,000 of passive income from Aggressive LLC. Consequently, she is allowed to deduct $14,000 of the loss. See computations below: Claudia Description Debt basis Stock basis At-risk January 1, 2020 $0 $15,000 $15,000 Share of tax-exempt income 4,000 4,000 Business loss clearing debt basis, and at-risk hurdles ($19,000) ($19,000) December 31, 2020 $0 $0 $0 As indicated above, Claudia’s stock basis is $0 on December 31, 2020 and her at-risk amount is $0 as of December 31, 2020. Claudia will suspend $6,000 of the loss at the stock basis level and $5,000 of the loss at the passive activity level. During 2021, Lafter made several changes to its business approach and reported $18,000 of business income, computed as follows: • Lafter also reported a long-term capital gain of $24,000 in 2021. • Lafter made a cash distribution on July 1, 2021, of $20,000 to each shareholder. b. What amount of gain/income does each shareholder recognize from the cash distribution on July 1, 2021? To determine the taxability of the distribution we must determine Lafter’s earnings and profits (E&P) and accumulated adjustment accounts (AAA) at the end of the year (before considering the impact of the distribution on these amounts). At the end of 2020, before the distributions, Lafter’s E&P is $15,000. Its AAA is computed as follows: AAA balance on December 31, 2021 before the distributions is $12,000, computed as follows: Description Amount Explanation AAA balance 1/1/2020 $45,000 2020 business loss (75,000) AAA is not affected by tax-exempt income. AAA balance 1/1/2021 ($30,000) 2021 business income 18,000 2021 long-term capital gain 24,000 AAA balance 12/31/2021 before distributions $12,000 Distributions $60,000 $12,000 of the distributions are out of AAA AAA balance 12/31/2021 after distributions $0 Distributions can reduce AAA to $0 but not below. Of the $60,000 total distribution (3 x $20,000), $12,000 is out of AAA and is a return of capital, $15,000 is out of E&P and is a dividend, and the remaining $33,000 is a return of capital ($60,000 total minus $12,000 minus $15,000). Therefore, for each shareholder $5,000 of the $20,000 distribution is a dividend ($15,000/3) and $15,000 is a return of capital/capital gain ($12,000 + $33,000 = $45,000/3) depending on each shareholder’s stock basis before the distribution. The stock basis of each shareholder and the amount of capital gain each shareholder recognizes on the distribution is calculated as follows: Description Abigail Bobby Claudia Stock basis January 1, 2021 (see answer to part a) $0 $4,000 $0 Share of 2021 business income ($18,000 total) 6,000 6,000 6,000 Amount of income that must restore debt basis before stock basis (5,000) Share of 2021 long-term capital gain ($24,000) 8,000 8,000 8,000 Stock basis December 31, 2021 before distribution $9,000 $18,000 $14,000 Return of capital portion of distribution (portion not out of E&P) 15,000 15,000 15,000 Stock basis before required gain recognition on distribution (6,000) 3,000 (1,000) Capital gain recognized on distribution 6,000 0 1,000 Stock basis 12/31/2021 after distributions $0 $3,000 $0 In summary: Abigail recognizes $5,000 of dividend income on the distribution and $6,000 of long-term capital gain. Abigail has $0 basis in her Lafter stock and $5,000 of debt basis at year end. Bobby recognizes $5,000 of dividend income on the distribution. Bobby has $3,000 of basis in her Lafter stock at year end. Claudia recognizes $5,000 of dividend income on the distribution and $1,000 of long-term capital gain. Lafter’s E&P and AAA are reduced to $0. 86. While James Craig and his former classmate Paul Dolittle both studied accounting at school, they ended up pursuing careers in professional cake decorating. Their company, Good to Eat (GTE), specializes in custom-sculpted cakes for weddings, birthdays, and other celebrations. James and Paul formed the business at the beginning of 2020, and each contributed $50,000 in exchange for a 50 percent ownership interest. GTE also borrowed $200,000 from a local bank. Both James and Paul had to personally guarantee the loan. Both owners provide significant services for the business. The following information pertains to GTE’s 2020 activities. • GTE uses the cash method of accounting (for both book and tax purposes) and reports income on a calendar-year basis. • GTE received $450,000 of sales revenue and reported $210,000 of cost of goods sold (it did not have any ending inventory). • GTE paid $30,000 compensation to James, $30,000 compensation to Paul, and $40,000 of compensation to other employees (assume these amounts include applicable payroll taxes, if any). • GTE paid $15,000 of rent for a building and equipment, $20,000 for advertising, $14,000 in interest expense, $4,000 for utilities, and $2,000 for supplies. • GTE contributed $5,000 to charity. • GTE received a $1,000 qualified dividend from a great stock investment (it owned 2 percent of the corporation distributing the dividend) and it recognized $1,500 in short-term capital gain when it sold some of the stock. • On December 1, 2020, GTE distributed $20,000 to James and $20,000 to Paul. • GTE has qualified property of $300,000 (unadjusted basis). Required: a. Assume James and Paul formed GTE as an S corporation. • Complete GTE’s Form 1120-S page 1, Form 1120-S, Schedule K; and Paul’s Form 1120-S Schedule K-1 (note that you should use 2019 tax forms). • Compute the tax basis of Paul’s stock in GTE at the end of 2020. • What amount of Paul’s income from GTE is subject to FICA or self-employment taxes? • What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1? • What amount of tax does GTE pay on the $1,000 qualified dividend it received? Answer: GTE’s business income is $85,000 computed as follows: Description Amount Sales Revenue $450,000 Cost of goods sold (210,000) Compensation of officers (60,000) Other compensation (40,000) Rent expense (15,000) Advertising (20,000) Interest expense (14,000) Utilities (4,000) Supplies (2,000) Business income $85,000 GTE’s separately stated items are as follows: • Qualifying dividend of $1,000. • Short-term capital gain of $1,500. • Distribution of $20,000 to James. • Distribution of $20,000 to Paul. • $5,000 charitable contribution • Qualified Business Income of $85,000 • Wages to employees of $100,000 • Qualified property of $300,000 GTE’s Form 1120-S, page 1 Other Deductions, Line 19, Form 1120-S: Utilities $4,000 Supplies $2,000 Total $6,000 GTE’s 1120-S Schedule K Qualified Business Income Statement Good to Eat EIN 58-1111111 Qualified Business Income: Ordinary Income $85,000 W-2 wages: $100,000 UBIA of qualified property: $300,000 Paul’s 1120-S Schedule K-1. This includes 50% of all items on Schedule K. Qualified Business Income Statement Good to Eat EIN 58-1111111 Shareholder: Paul Qualified Business Income: Ordinary Income $42,500 W-2 wages: $50,000 UBIA of qualified property: $150,000 • Compute the tax basis of Paul’s stock in GTE at the end of 2020. Paul’s Tax Basis in GTE • What amount of Paul’s income from GTE is subject to FICA or self-employment taxes? Only Paul’s $30,000 salary is subject to FICA tax. • What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1? $0. Paul will not recognize any income or gain on the December 1 distribution. The entire distribution is a return of capital (return of basis). • What amount of tax does GTE pay on the $1,000 qualified dividend it received? $0. GTE is a flow-through entity so it does not pay any tax on the dividend it received. b. Assume James and Paul formed GTE as an LLC. • Complete GTE’s Form 1065, page 1; Form 1065, Schedule K; and Paul’s Form 1065, Schedule K-1 (note that you should use 2019 tax forms). • Compute the tax basis of Paul’s ownership interest in GTE at the end of 2020. • What amount of Paul’s income from GTE is subject to FICA or self-employment taxes? • What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1? • What amount of tax does GTE pay on the $1,000 qualified dividend it received? GTE’s business income is $85,000 computed as follows: Description Amount Sales Revenue $450,000 Cost of goods sold (210,000) Guaranteed payments (60,000) Other compensation (40,000) Rent expense (15,000) Advertising (20,000) Interest expense (14,000) Utilities (4,000) Supplies (2,000) Business income $85,000 GTE’s separately stated items are as follows: • Qualifying dividend of $1,000. • Short-term capital gain of $1,500. • Distribution of $20,000 to James. • Distribution of $20,000 to Paul. • Charitable contribution $5,000 • Qualified Business Income of $85,000 • Wages to employees of $40,000 (note that guaranteed payments to partners are not considered wages paid to employees) • Qualified property of $300,000 GTE’s Form 1065, page 1 is as follows: Other Deductions, Line 20, form 1065: GTE’s Form 1065 Schedule K is as follows: Paul’s Form 1065 Schedule K-1 is as follows: Qualified Business Income Statement Good to Eat EIN 58-1111111 Shareholder: Paul Qualified Business Income: Ordinary Income $42,500 W-2 wages: $50,000 UBIA of qualified property: $150,000 • Compute the tax basis of Paul’s ownership interest in GTE at the end of 2020. Paul’s Tax Basis in GTE LLC interest on December 31, 2020. • What amount of Paul’s income from GTE is subject to FICA or self-employment taxes? $72,500. Paul is subject to self employment taxes on the $30,000 guaranteed payment and on his $42,500 share of GTE’s business income because he works for GTE. • What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1? $0. The entire $20,000 distribution is a nontaxable return of capital. • What amount of tax does GTE pay on the $1,000 dividend it received? $0. Because GTE is a flow-through entity, it does not pay tax on the dividend. c. Assume James and Paul formed GTE as a C corporation. • Complete GTE’s Form 1120, page 1 (note that you should use the 2019 tax form). • Compute the tax basis of Paul’s stock in GTE at the end of 2020. • What amount of Paul’s income from GTE is subject to FICA or self-employment taxes? • What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1? • What amount of tax does GTE pay on the $1,000 qualified dividend it received? GTE’s Form 1120, page 1 is as follows: Other Deductions, Line 26, form 1120: • Compute the tax basis of Paul’s stock in GTE at the end of 2020. $50,000. Paul’s stock basis in GTE is equal to his $50,000 beginning contribution. The distribution was from GTE’s earnings and profits (taxable income in this case) and so does not represent a return of capital. • What amount of Paul’s income from GTE is subject to FICA or self-employment taxes? Only Paul’s salary of $30,000 is subject to FICA or self-employment tax. • What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1? Paul must recognize $20,000 of qualifying dividend income since the distribution came from E&P. • What amount of tax does GTE pay on the $1,000 qualified dividend it received? $105. GTE is allowed to deduct a 50 percent dividends-received deduction (it owns less than 20 percent of the corporation distributing the dividend) which reduces the taxable amount of the dividend to $500. The $500 is taxed at 21%. So, GTE pays $105 on the dividend ($500 x 21%). 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
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