Chap 3 - Small business Corporations (S Corps)

Question 1

S corporations

Answer 1

Small closely held corporations can elect to be treated like a partnership. In effect, all the earning and losses of the corporation are passed through to the shareholders. This eliminates the corporate tax, but the shareholders are taxed on their share of the corporate earnings regardless of if they were distributed.

Question 2

If an S corporation has no accumulated earnings and profits, the amount distributed to a shareholder:

a. Has no effect on the shareholder’s basis for the stock.
b. Must be returned to the S corporation.
c. Decreases the shareholder’s basis for the stock.
d. Increases the shareholder’s basis for the stock.

Answer 2

Decreases the shareholder’s basis for the stock.

Choice “c” is correct. If an S corporation has no accumulated earnings and profits, the amount distributed to a shareholder decreases the shareholder’s basis for the stock. The distribution is nontaxable to the extent of the shareholder’s basis.

Choice “b” is incorrect. The amount distributed to a shareholder does not need to be returned to the S corporation.

Choice “d” is incorrect. Distributions do not increase a shareholder’s basis.

Choice “a” is incorrect. Distributions have no effect on a shareholder’s basis if they are out of accumulated earnings and profits and are therefore taxable. They would also have no effect on a shareholder’s basis if the basis is already zero, which would result in the shareholder recognizing a gain to the extent of the distribution. In this case, we are not told whether or not the basis is already zero.

Question 3

Stahl, an individual, owns 100% of Talon, an S corporation. At the beginning of the year, Stahl's basis in Talon was $65,000. Talon reported the following items from operations during the current year:
 Ordinary loss	$ 10,000
 Municipal interest income	6,000
  Long-term capital gain	4,000
 Short-term capital loss	9,000
What was Stahl's basis in Talon at year-end?
	a.	$50,000
	b.	$55,000
	c.	$61,000
	d.	$56,000

Answer 3

$56,000.

Choice “d” is correct. Stahl’s basis would be computed as follows:
Beginning basis: $ 65,000
+ Income $6,000 (Tax-free income increases basis)
− Loss ($10,000)
− Net capital loss (5,000) - ($4,000 gain netted with $9,000 loss)
= $ 56,000

Computing a shareholders basis in S corp stock:
= initial basis
+ income items (separately and non separately stated items, taxable and tax exempt interest)
+ additional shareholder investments in corporation stock
- distribution to shareholders
- loss or expense items
= ending basis

Choice “a” is incorrect. This choice excludes the $6,000 of municipal interest income from the above calculation. Remember, both taxable and tax exempt items of income give the taxpayer additional basis.

Choice “b” is incorrect. This choice excludes both the municipal interest income and the net capital loss from the above calculation. Remember, both taxable and tax exempt and separately and non-separately stated items (stated on the K-1) of income or loss affect a shareholder’s basis.

Choice “c” is incorrect. This choice excludes the net capital loss from the above calculation. Remember, both separately and non-separately stated items (stated on the K-1) of loss affect a shareholder’s basis.

Question 4

Baker, an individual, owned 100% of Alpha, an S corporation. At the beginning of the year, Baker’s basis in Alpha Corp. was $25,000. Alpha realized ordinary income during the year in the amount of $1,000 and a long-term capital loss in the amount of $3,000 for this year. Alpha distributed $30,000 in cash to Baker during the year. What amount of the $30,000 cash distribution is taxable to Baker?

a. $0
b. $5,000
c. $4,000
d. $30,000

Answer 4

$4,000.

Choice “c” is correct. The order in which stock basis is increased or decreased is important. Because both the taxability of a distribution and the deductibility of a loss are dependent on stock basis, there is an ordering rule for computing stock basis.

Stock basis is adjusted annually, as of the last day of the S corporation year, in the following order:

1. Increased for income items and excess depletion;
2. Decreased for distributions;
3. Decreased for non-deductible, non-capital expenses and depletion; and
4. Decreased for items of loss and deduction.

When determining the taxability of a non-dividend distribution, the shareholder looks solely to his/her stock basis (debt basis is not considered).
In accordance with S-corporation ordering rules for calculation of basis, Baker’s stock basis in Alpha would be calculated as follows:
Initial stock basis $ 25,000
Increase for share of income 1,000
Basis before distribution $ 26,000

Results: $26,000 of the $30,000 distribution would be tax free return of basis; $4,000 would be taxable as capital gain; loss of $3,000 cannot be utilized in current year due to lack of basis.

Choice “a” is incorrect. Baker’s basis before distribution is less than the cash distributed so there would be some gain.

Choice “b” is incorrect. This choice does not take into account the current year activity of the S corporation in determining Baker’s basis.

Choice “d” is incorrect. Based upon the above rule, amounts distributed to the extent of the shareholder’s basis are not taxable.

Question 5

Lane Inc., an S corporation, pays single coverage health insurance premiums of $4,800 per year and family coverage premiums of $7,200 per year. Mill is a ten percent shareholder-employee in Lane. On Mill’s behalf, Lane pays Mill’s family coverage under the health insurance plan. What amount of insurance premiums is includible in Mill’s gross income?

a. $0
b. $4,800
c. $720
d. $7,200

Answer 5

$7,200.

Choice “d” is correct. $7,200 of insurance premiums (the amount of family coverage premiums, as indicated in the question) is includible in Mill’s gross income.

Rule: Fringe benefits paid by an S corporation are deductible by the S corporation only for non-shareholder employees and those employee-shareholders owning 2% or less of the S corporation. Other fringe benefits paid are deductible by the S corporation if included as part of gross income from the S corporation for the individual receiving the benefits (i.e., included as part of income on the shareholder’s W-2).

Choices “a”, “c”, and “b” are incorrect, per the above rule.

Question 6

Beck Corp. has been a calendar-year S corporation since its inception on January 2, Year 1. On January 1, Year 4, Lazur and Lyle each owned 50% of the Beck stock, in which their respective tax bases were $12,000 and $9,000. For the year ended December 31, Year 4, Beck had $81,000 in ordinary business income and $10,000 in tax-exempt income. Beck made a $51,000 cash distribution to each shareholder on December 31, Year 4. What was Lazur’s tax basis in Beck after the distribution?

a. $6,500
b. $1,500
c. $52,500
d. $57,500

Answer 6

$6,500.

Choice “a” is correct. Lazur’s tax basis after the distribution was $6,500.

Rule: The adjusted basis of S corporation stock goes up for undistributed earnings (including tax-exempt income) and vice-versa, as it would in a partnership.

Rule: Amounts distributed (including distributions not taxable as dividends) reduce the adjusted basis of the stock.

Lazur’s basis at 1/1/Year 4 $ 12,000
Add:
50% of ordinary income $40,500 [$81,000 × 50%]
50% of tax-exempt income $5,000 [$10,000 × 50%]
Less:
Distribution to Lazur ($51,000)
Basis at 12/31/Year 4 $ 6,500

Choices “b”, “c”, and “d” are incorrect, per the above rules.

Question 7

Village Corp., a calendar year corporation, began business in Year 1. Village made a valid S corporation election on December 5, Year 3, with the unanimous consent of its shareholders. The eligibility requirements for S status continued to be met throughout Year 4. On what date did Village’s S status become effective?

a. December 5, Year 3.
b. December 5, Year 4.
c. January 1, Year 4.
d. January 1, Year 3.

Answer 7

January 1, Year 4.

Choice “c” is correct.

Rule: In order to be effective for the current taxable year, the S corporation election must be made by the 15th day of the third month of the taxable year. If the election is made after that date, it becomes effective on the first day of the next taxable year, January 1, Year 4, in this case.

Choices “d”, “a”, and “b” are incorrect, per the above rules.

Question 8

A shareholder’s basis in the stock of an S corporation is increased by the shareholder’s pro rata share of income from:
Tax-exempt interest Taxable interest
a. Yes Yes
b. No Yes
c. Yes No
d. No No

Answer 8

Yes, Yes.

Choice “a” is correct.

Rule: Both tax-exempt and taxable interest income increase a shareholder’s basis in S corporation stock.

Choices “d”, “b”, and “c” are incorrect, per the above rule.

Question 9

Zinco Corp. was a calendar year S corporation. Zinco’s S status terminated on April 1, Year 1, when Case Corp. became a shareholder. During Year 1 (365-day calendar year), Zinco had nonseparately computed income of $310,250. If no election was made by Zinco, what amount of the income, if any, was allocated to the S short year for Year 1?

a. $0
b. $76,500
c. $155,125
d. $233,750

Answer 9

$76,500.

Choice “b” is correct. ($310,250/365) x 90 = $76,500.
Zinco will be taxed as an S corporation from January 1 to March 31, Year 1, and a C corporation from April 1 to December 31, Year 1. Absent the election to calculate the incomes of the S and C corporation portions of the year separately, Zinco’s income is allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year. Year 1 has 365 days, 90 of which occurred before April 1.

Choice “d” is incorrect. Absent the election to calculate the incomes of the S and C corporation portions of the year separately, Zinco’s income is allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year. This is the income allocated to the C corporation portion of the year.

Choice “c” is incorrect. Absent the election to calculate the incomes of the S and C corporation portions of the year separately, Zinco’s income is allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year, not on a 50/50 split.

Choice “a” is incorrect. Zinco’s income must be allocated on a per-share, per-day basis between the S and C corporation portions of the taxable year.

Question 10

Bristol Corp. was formed as a C corporation on January 1, Year 1, and elected S corporation status on January 1, Year 3. At the time of the election, Bristol had accumulated C corporation earnings and profits, which have not been distributed. Bristol has had the same 25 shareholders throughout its existence. In Year 6, Bristol’s S election will terminate if it:

a. Increases the number of shareholders to 100.
b. Has passive investment income exceeding 90% of gross receipts in each of the three consecutive years ending December 31, Year 5.
c. Takes a charitable contribution deduction.
d. Adds a decedent’s estate as a shareholder to the existing shareholders.

Answer 10

Has passive investment income exceeding 90% of gross receipts in each of the three consecutive years ending December 31, Year 5.

Choice “b” is correct. S corporations that are former C corporations with undistributed C corporation earnings and profits are restricted in the amount of passive investment income they can realize without terminating their S election. The restriction is 25% of total gross receipts from passive investment income. The S election is terminated if the S corporation has passive investment income greater than 25% of gross receipts for three consecutive years. After 3 years with 90% of its gross receipts from passive sources, Bristol will lose its S corporation status on the first day of its Year 6 taxable year.

Choice “a” is incorrect. An S corporation can have as many as 100 shareholders.

Choice “d” is incorrect. A decedent’s estate may be an S corporation shareholder.

Choice “c” is incorrect. S corporations pass their charitable contribution deductions through to their shareholders.

Question 11

As of January 1 of the current year, Kane owned all the 100 issued shares of Manning Corp., a calendar year S corporation. On the 41st day of the year, Kane sold 25 of the Manning shares to Rodgers. For the current year ended December 31 (a 365-day calendar year), Manning had $73,000 in nonseparately stated income and made no distributions to its shareholders. What amount of nonseparately stated income from Manning should be reported on Kane’s current year tax return?

a. $0
b. $54,750
c. $56,750
d. $16,250

Answer 11

$56,750.

Choice “c” is correct. The mid-year change of ownership causes Manning’s S corporation income to be allocated between the shareholders on a per-share, per-day basis. The first 40 days’ income is allocated 100% to Kane: 40 x ($73,000/365) = $8,000. 75% of the remaining 325 days’ income is allocated to Kane: 75% x 325 x ($73,000/365) = $48,750. The total income allocated to Kane is $56,750 ($8,000 + $48,750).

Choice “b” is incorrect. Manning’s income will be allocated on a per-share, per-day basis; although Kane owned 75% of the shares starting on April 1, he owned 100% of the shares through March 31.

Choice “d” is incorrect. This is the income that should be allocated to Rodgers; the question asks how much should be allocated to Kane.

Choice “a” is incorrect. The mid-year change of ownership causes Manning’s S corporation income to be allocated between the shareholders on a per-share, per-day basis.

Question 12

On February 10, Year 1, Ace Corp., a calendar-year corporation, elected S corporation status and all shareholders consented to the election. There was no change in shareholders in Year 1. Ace met all eligibility requirements for S status during the preelection portion of the year. What is the earliest date on which Ace can be recognized as an S corporation?

a. January 1, Year 2.
b. February 10, Year 1.
c. January 1, Year 1.
d. February 10, Year 2.

Answer 12

January 1, Year 1.

Choice “c” is correct.

Rule: An S election made by the 15th day of the third month of the taxable year is retroactively effective on the first day of the taxable year.

Choices “d”, “b”, and “a” are incorrect, per the above rule.

Question 13

An S corporation has 30,000 shares of voting common stock and 20,000 shares of non-voting common stock issued and outstanding. The S election can be revoked voluntarily with the consent of the shareholders holding, on the day of the revocation:
Shares of voting stock Shares of nonvoting stock
a. 7,500 5,000
b. 0 20,000
c. 20,000 0
d. 10,000 16,000

Answer 13

10,000 and 16,000.

26,000>25,000 (50,000 shares x 50%)

Choice “d” is correct. S corporation status can be revoked if shareholders owning more than 50% of the total number of issued and outstanding shares consent. The specific percentage of voting and nonvoting shareholders is not considered, just the total. Holders of more than 25,000 total shares must approve the revocation.

Choices “b”, “a”, and “c” are incorrect. S corporation status can be revoked if shareholders owning more than 50% of the total number of issued and outstanding shares consent. The specific percentage of voting and nonvoting shareholders is not considered, just the total.

Question 14

The Haas Corp., a calendar year S corporation, has two equal shareholders. For the current year, Haas had taxable income and current earnings and profits of $60,000, which included $50,000 from operations and $10,000 from investment interest income. There were no other transactions that year. Each shareholder’s basis in the stock of Haas will increase by:

a. $25,000
b. $50,000
c. $0
d. $30,000

Answer 14

$30,000.

Choice “d” is correct. The basis of a shareholder’s stock in an S corporation is increased by any item of income and decreased by any item of loss or deduction that passes through to the shareholder. Each shareholder reports ½ of $60,000 income as their basis.

Choice “b” is incorrect. The S corporation had $50,000 income from operations, of which ½ is reported by each shareholder. However, investment income must also be considered.

Choice “a” is incorrect. Investment income must also be considered.

Choice “c” is incorrect. The basis of a shareholder’s stock in an S corporation is increased by any item of income and decreased by any item of loss or deduction that passes through to the shareholder.

Question 15

Which of the following conditions will prevent a corporation from qualifying as an S Corporation?

a. One shareholder is a grantor trust.
b. One shareholder is an estate.
c. The corporation has both common and preferred stock.
d. The corporation has one class of stock with different voting rights.

Answer 15

The corporation has both common and preferred stock.

Choice “c” is correct. An S corporation can only have one class of stock outstanding. Common and preferred stock would constitute two classes of stock.

Choice “d” is incorrect. One class of stock with different voting rights is allowed for S corporations.

Choice “b” is incorrect. Individuals, estates, and certain trusts may be shareholders in an S corporation.

Choice “a” is incorrect. Grantor trusts, Section 678 trusts, qualified Subchapter S trusts (QSSTs), certain testamentary trusts, and voting trusts are allowed to be shareholders in an S corporation.

Question 16

Boles Corp., an accrual-basis calendar-year S corporation, has been an S corporation since its inception and is not subject to the uniform capitalization rules. In the current year, Boles recorded the following:
Gross receipts $ 50,000
Dividend income from investments 5,000
Supplies expense 2,000
Utilities expense 1,500
What amount of net business income should Boles report on its Form 1120S, U.S. Income Tax Return for an S corporation, Schedule K?
a. $48,000
b. $53,500
c. $53,000
d. $46,500

Answer 16

$46,500.

Choice "d" is correct. An S corporation reports both separately stated and non-separately stated (net business) items of income. The dividend income is a separately stated item and is not included in the calculation of net business income. Therefore, net business income is calculated as follows:
 Gross receipts	$ 50,000
 Supplies expense	(2,000)
  Utilities expense	(1,500)
 Net business income	$ 46,500

Choice “b” is incorrect. Dividend income is not included in net business income. Supplies expense is included in net business income.

Choice “c” is incorrect. Dividend income is not included in net business income. Utilities expense is included in net business income
.
Choice “a” is incorrect. Utilities expense is included in net business income.

Question 17

Boles Corp., an accrual-basis calendar-year S corporation, has been an S corporation since its inception and is not subject to the uniform capitalization rules. In Year 1, Boles recorded the following:
 Gross receipts	$ 50,000
  Dividend income from investments	5,000
 Supplies expense	2,000
  Utilities expense	1,500
On Bole's Year 1 S corporation Form Schedule K, Shareholders' Shares of Income, Credits Deductions, etc., what amount of income should be separately stated from business income?
	a.	$0
	b.	$50,000
	c.	$5,000
	d.	$48,000

Answer 17

$5,000.

Choice “c” is correct. An S corporation reports both separately stated and non-separately stated (net business) items of income. The dividend income is a separately stated item and is not included in the calculation of net business income.

Choice “b” is incorrect. Dividend income is a separately stated item and is not included in net business income. Gross Receipts are included in net business income.

Choice “d” is incorrect. Dividend income is a separately stated item and is not included in net business income. Supplies expenses and utilities expense would be deducted from net business income.

Choice “a” is incorrect. Dividend income is a separately stated item and is not included in net business income. Supplies expenses and utilities expense would be deducted from net business income.

Question 18

Which of the following entities may adopt any tax year end?

a. Trust.
b. C corporation.
c. Limited liability company.
d. S corporation.

Answer 18

C corporation.

Choice “b” is correct. C corporations may adopt any year end, provided the year end is approved by the IRS.

Choice “d” is incorrect. S corporations must generally adopt a calendar year end; however, certain S corporations may establish a valid business purpose for a different fiscal year by filing an election using Form 8716.

Choice “c” is incorrect. Limited liability companies generally elect to be taxed as partnerships. Partnerships must generally use the year end of the majority of its partners. If there is no majority, then the partnership must generally use a calendar year end.

Choice “a” is incorrect. All trusts (except tax-exempt trusts) must use a calendar year end.

Question 19

Evan, an individual, has a 40% interest in EF, an S corporation. At the beginning of the year, Evan’s basis in EF was $2,000. During the year, EF distributed $100,000 and reported operating income of $200,000. What amount should Evan include in gross income?

a. $38,000
b. $80,000
c. $118,000
d. $40,000

Answer 19

$80,000.

Choice “b” is correct. Like partnerships, S corporations report both separately and non-separately stated items of income and/or loss. Allocations to shareholders are made on a per-share, per-day basis in accordance with ownership percentage. Shareholders in an S corporation must include on their personal income tax return their distributive share of each separate “pass-through” item. Shareholders are taxed on these items, regardless of whether or not these items have been distributed to them during the year.

EF’s operating income $ 200,000
x Evan’s ownership % 40%
Gross income for Evan $ 80,000

Choice “a” is incorrect. This answer option incorrectly assumes that Evan’s gross income is calculated as 40% of the distribution for the year ($100,000 x 40% = $40,000) less the basis of $2,000 as of the beginning of the year ($40,000 - $2,000 = $38,000).

Choice “d” is incorrect. This answer option incorrectly assumes that Evan’s gross income is calculated as 40% of the distribution for the year ($100,000 x 40% = $40,000).

Choice “c” is incorrect. This answer option incorrectly assumes that Evan’s gross income is 1 - 40%, or 60%, of the corporation’s operating income for the year ($200,000 x 60% = $120,000), less the basis of $2,000 as of the beginning of the year ($120,000 - $2,000 = $118,000).

Question 20

Magic Corp., a regular C corporation, elected S corporation status at the beginning of the current calendar year. It had an asset with a basis of $40,000 and a fair market value (FMV) of $85,000 on January 1. The asset was sold during the year for $95,000. Magic’s corporate tax rate was 35%. What was Magic’s tax liability as a result of the sale?

a. $19,250
b. $0
c. $3,500
d. $15,750

Answer 20

$15,750.

Choice "d" is correct. A distribution or a sale of an S corporation's assets may result in a tax on any "built-in gain" at the corporate level. An unrealized "built-in gain" results when the following two conditions occur: (1) a C corporation elects S corporation status, and (2) the fair market value of the corporate assets exceeds the adjusted basis of corporate assets on the election date. The two conditions exist in the facts of the question. The net unrealized built-in gain is the excess of the fair market value of corporate assets over the adjusted basis of corporate assets at the beginning of the year in which the S corporation status is elected.
FMV at January 1  $ 85,000
Adjusted basis at January 1  $ (40,000)
Excess $ 45,000
× 35% tax rate *35%
Corporate tax liability = $ 15,750

Note: The gain to the corporation is a total of $55,000 ($95,000 − $40,000). An S corporation generally does not pay tax at the corporate level; however, in this case, there was built-in gain of $45,000 upon the election to become an S corporation, so the related C corporation tax must be paid upon the sale of the asset.

Choice “b” is incorrect. The gain to the corporation is a total of $55,000 ($95,000 − $40,000). An S corporation generally does not pay tax at the corporate level; however, in this case, there was built-in gain of $45,000 upon the election to become an S corporation, so the related C corporation tax must be paid upon the sale of the asset.

Choice “c” is incorrect. This choice incorrectly assumes that the tax is calculated as 35% of the difference between the sales price of the asset ($95,000) and the fair market value at the effective date of the S election ($85,000). [$95,000 − $85,000 = $10,000; $10,000 × 35% = $3,500].

Choice “a” is incorrect. This choice incorrectly uses the actual total gain on the sale (the sales price of $95,000 less the basis of $40,000) and then calculates the tax liability as 35% of that amount. [$95,000 − $40,000 = $55,000; $55,000 × 35% = $19,250].

Question 21

Commerce Corp. elects S corporation status as of the beginning of the current year. At the time of Commerce’s election, it held a machine with a basis of $20,000 and a fair market value of $30,000. In March of the current year, Commerce sells the machine for $35,000. What would be the amount subject to the built-in gains tax?

a. $15,000
b. $0
c. $10,000
d. $5,000

Answer 21

$10,000.

Choice “c” is correct. The built-in gain for the machine is $10,000, the difference, on the date of the election of S status, between the $20,000 adjusted basis of the machine to the C corporation and the $30,000 fair market value. That is the amount of the gain that occurred while the corporation was a C corporation, and it is also the amount that is subject to the built-in gains tax.

Choice “b” is incorrect. The $0 indicates that there is no built-in gain on the machine. There are a number of exceptions to the built-in gains tax, but none of them apply in this question.

Choice “d” is incorrect. The $5,000 is the amount of the gain recognized on the sale ($35,000 - $20,000 - $10,000) that is not built-in gain. The $5,000 gain occurred while the corporation was an S corporation and is not subject to the built-in gains tax.

Choice “a” is incorrect. The $15,000 is the total gain recognized on the sale ($35,000 - $20,000), not the amount of gain subject to the built-in gains tax.

Question 22

Sandy is the sole shareholder of Swallow, an S corporation. Sandy's adjusted basis in Swallow stock is $60,000 at the beginning of the year. During the year, Swallow reports the following income items:
 Ordinary income	        $ 30,000
 Tax-exempt income	$ 5,000
  Capital gains                $ 10,000
In addition, Swallow makes a nontaxable distribution to Sandy of $20,000 during the year. What is Sandy's adjusted basis in the Swallow stock at the end of the year?
	a.	$60,000
	b.	$70,000
	c.	$85,000
	d.	$80,000

Answer 22

$85,000.

Rules: The rules for determining a shareholder’s basis in S corporation stock follow:

Initial basis (or beginning of year)
+ Income items (separately and non-separately stated items)
+ Additional shareholder investments in corporation stock
- Distributions to shareholders
- Loss or expense items
= Ending basis

Choice “c” is correct.
Initial basis (or beginning of year amount) $60,000
Income items (separately and non-separately stated items) $45,000
Additional shareholder investments in corporation stock − $0
Distributions to shareholders ($20,000)
Loss or expense items − $0
Ending basis $ 85,000

Choice “a” is incorrect. This is only the amount of Sandy’s basis at the beginning of the year ($60,000). The income items and distributions also affect Sandy’s basis as of the end of the year.

Choice “b” is incorrect. This answer option includes the $60,000 basis at the beginning of the year plus the $10,000 in capital gains during the year, but it incorrectly excludes the ordinary and tax-exempt income from the year and the effect of the distributions during the year.

Choice “d” is incorrect. This answer option incorrectly excludes the $5,000 of tax-exempt income received by Swallow during the year.

Question 23

Which of the following can be an advantage of a limited liability company over an S corporation?

a. Appreciated property can be distributed tax-free to an owner.
b. Incentive stock options can be used to compensate owners.
c. Owners receive limited liability protection.
d. Double taxation of profits is avoided.

Answer 23

Appreciated property can be distributed tax-free to an owner.

Rule: IRC Section 311 controls the taxability of corporate distributions. An S corporation (and a C corporation) recognizes a gain on any distribution of appreciated property (a property dividend) in the same manner as if the asset had been sold to the shareholder at its fair market value.

Choice “a” is correct. An S corporation cannot distribute appreciated property to its shareholders without gain. In general, a partnership can distribute appreciated property tax-free to its partners (in general, a non liquidating distribution to a partner is nontaxable). Since a limited liability company (LLC) is taxed like a partnership (an LLC properly structured and with two or more owners is taxed like a limited partnership with no general partners), a limited liability company can distribute appreciated property to its owners tax-free.

Choice “c” is incorrect. Owners receive limited liability protection with both an S corporation and a limited liability company so there is no advantage for a limited liability company over an S corporation here.

Choice “b” is incorrect. Incentive stock options can be used to compensate owners with both an S corporation and a limited liability company. There is no entity restriction for these stock options, other than that they can be granted only by corporations. There is no advantage for a limited liability company over an S corporation here.

Question 24

Tap, a calendar-year S corporation, reported the following items of income and expense in the current year:
Revenue $ 44,000
Operating expenses 20,000
Long-term capital loss 6,000
Charitable contributions 1,000
Interest expense 4,000
What is the amount of Tap’s ordinary income?
a. $24,000
b. $19,000
c. $20,000
d. $13,000

Answer 24

$20,000.

Rule: IRC Section 1366 controls the pass-through of S corporation income items to shareholders. In general, items are divided into separately stated items (items that could potentially affect the tax liability of the shareholders) and non-separately stated items. Non-separately stated items are lumped together and constitute the S corporation’s ordinary income. Separately stated items are passed through to the shareholders (in a manner similar to partnerships) and retain their tax attributes to the shareholders.

Choice “c” is correct. Tap’s ordinary income is calculated as follows:
Revenue $ 44,000
Operating expenses (20,000)
Interest expense (4,000)
Ordinary income $ 20,000
The long-term capital loss and the charitable contributions are not included in Tap’s ordinary income. They are separately stated items and thus are passed through to the shareholders and retain their tax attributes.

Choice “d” is incorrect. The $13,000 would include both the long-term capital loss and the charitable contributions.

Choice “b” is incorrect. The $19,000 would include the long-term capital loss but not the charitable contributions.

Choice “a” is incorrect. The $24,000 would not include the interest expense.

Question 25

Stone Corp. has been an S corporation since inception. In each of Year 1, Year 2, and Year 3, Stone made distributions in excess of each shareholder’s basis. Which of the following statements is correct concerning these three years?

a. In Year 1 and Year 2 only, the excess distributions are taxed as capital gain.
b. In all three years, the excess distributions are taxed as capital gains.
c. In Year 1 only, the excess distributions are tax free.
d. In Year 3 only, the excess distributions are taxed as capital gain.

Answer 25

In all three years, the excess distributions are taxed as capital gains.

Rule: Per IRC Section 1368, the amount of any distribution to an S corporation shareholder is equal to the cash plus the fair market value of any other property distributed. How the distribution is taxed depends on whether the S corporation has C corporation accumulated earnings and profits (E&P). If the S corporation has never been a C corporation or if it has no C corporation accumulated E&P, the distribution is a tax-free recovery of capital to the extent it does not exceed the shareholder’s adjusted basis in the stock of the S corporation. When the amount of the distribution exceeds the shareholder’s adjusted basis of the stock, the excess is treated as a gain from the sale or exchange of property (normally a long-term capital gain).

Choice “b” is correct. In each of the years, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains.

Choice “a” is incorrect. In each of the years, and not just the first and second years, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains; they are not tax free.

Choice “c” is incorrect. In each of the years, and not just the first year, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains.

Choice “d” is incorrect. In each of the years, and not just the third year, Stone made distributions in excess of each shareholder’s basis. These distributions will normally be taxed as capital gains.

Question 26

Stone owns 100% of an S corporation and materially participates in its operations. The stock basis at the beginning of the year is $5,000. During the year, the corporation makes a distribution of $3,500 and passes through a loss from operations of $2,000 for the year. What loss can Stone deduct on Stone’s personal tax return?

a. $5,500
b. $1,500
c. $0
d. $2,000

Answer 26

$1,500 of the loss can be deducted on Stones personal tax return (5,000 basis - 3,500 distribution = $1,500).

Choice “b” is correct. An S Corporation shareholder’s basis is reduced by distributions to the shareholders as well as loss or expense items. However, loss deductions are limited to a shareholder’s adjusted basis in S corporation stock plus direct shareholder loans to the corporation. Any losses disallowed may be carried forward indefinitely and will be deductible as the shareholder’s basis is increased.
Beginning Basis $ 5,000
Less: Distributions to Shareholder $(3,500)
Less: Shareholder share of losses $(2,000)
$5,500
Excess $500 (5,500 loss - 5,000 basis) carried forward indefinitely.
Ending Shareholder Basis $ 0

Choice “c” is incorrect. Losses are deductible only to the extent of the shareholder’s basis.

Choice “d” is incorrect. The shareholder cannot deduct the full loss without a sufficient amount of basis in the S corporation stock.

Choice “a” is incorrect. The shareholder cannot have a negative basis as a result of distributions and losses.

Question 27

Absent an election to close the books, the allocation of nonseparately stated income or loss for an S corporation shareholder that changed his ownership interest during the year is computed based on which of the following ownership percentages?

a. Ownership percentage determined as an average of the beginning and ending ownership percentages.
b. Ownership percentage computed on a per-share per-day basis.
c. Ownership percentage at the end of the S corporation year.
d. Ownership percentage at the beginning of the S corporation year.

Answer 27

Ownership percentage computed on a per-share per-day basis.

Choice “b” is correct. Allocations to shareholders are made on a per-share, per-day basis.

Choice “c” is incorrect. Ownership in the S Corporation could change during the year.

Choice “d” is incorrect. Ownership in the S Corporation could change during the year.

Choice “a” is incorrect. Ownership in the S
Corporation could change during the year.

Question 28

Miyasyke, Inc., a calendar year S corporation, has 5 equal shareholders at the end of the tax year. Miyasyke had $75,000 of taxable income. Miyasyke made distributions to its shareholders of $32,000 each, for a total of $160,000. Each shareholder’s basis in the S corporation is $100,000 at the beginning of the tax year. What amount from Miyasyke should be included in each shareholder’s gross income?

a. $47,000
b. $32,000
c. $0
d. $15,000

Answer 28

$15,000 (75,000/5).

Choice “d” is correct. Each shareholder reports his/her pro rata share of the S corporation’s taxable income in his or her gross income. The distributions are not taxable to the extent the shareholders’ basis exceeds the distribution (and increased for any income reported by them during the year).

Choice “c” is incorrect. Each shareholder’s share of taxable income (non-separately stated) is reported in the shareholder’s gross income.

Choices “b” and “a” are incorrect. Choice “b” only includes the distribution, which is not taxable in this case as the shareholder’s basis exceeds the distribution. Choice “a” includes both the shareholder’s pro rata share of the taxable income and the distribution. The distribution is not taxable in this situation.

Question 29

A sole proprietorship incorporated on January 1 and elected S corporation status. The owner contributed the following assets to the S corporation:
Basis Fair market value
Machinery $7,000 $8,000
Building 11,000 100,000
Cash 1,000 1,000
Two years later, the corporation sold the machinery for $4,000 and the building for $110,000. The machinery had accumulated depreciation of $2,000, and the building had accumulated depreciation of $1,000. What is the built-in gain recognized on the sale?
a. $100,000
b. $6,000
c. $0
d. $99,000

Answer 29

$0.

Choice “c” is correct. An S corporation is subject to the “built-in gains” tax (as well as the “LIFO Recapture” tax and the “Passive Investment Income” tax) only if the S corporation had previously been a C corporation. In this question, the corporation elected “S” status on the day or incorporation; hence, the corporation was never a C corporation. So, the “built-in gains” tax doesn’t apply to the facts presented.

Choices “a”, “d”, and “b” are incorrect per the above rule.

Question 30

Which of the following items must be separately stated on Form 1120S, U.S. Income Tax Return for an S Corporation, Schedule K-1?

a. Section 1245 Gain.
b. Unearned revenue.
c. Mark-to-market income.
d. Gain or loss from the sale of collectibles.

Answer 30

Gain or loss from the sale of collectibles.

Choice “d” is correct. Gain or loss from the S corporation’s sale of collectibles is separately reported on the Schedule K-1 of IRS form 1120S.

Choice “c” is incorrect. The S corporation’s mark-to-market income is part of “ordinary business income (loss),” which is separately stated on the Schedule K-1 of IRS form 1120S. However, the various components of “ordinary business income,” such as mark-to-market income, are not separately stated on the K-1 of IRS form 1120S.

Choice “b” is incorrect. The S corporation’s unearned revenue is not separately stated but is a component of “ordinary business income” or “net rental real estate income (loss)” or “other net rental income (loss),” each of which is separately stated on the Schedule K-1 of IRS form 1120S. However, the various components (such as unearned revenue) of “ordinary business income,” “net rental real estate income (loss),” and “other net rental income (loss)” are not separately stated on the K-1 of IRS form 1120S.

Choice “a” is incorrect. The S corporation’s section 1245 gain (and section 1250 gain) is not separately stated but is a component of “ordinary business income” or “net rental real estate income (loss)” or “other net rental income (loss),” each of which is separately stated on the Schedule K-1 of IRS form 1120S. However, the various components (such as section 1245 gain) of “ordinary business income,” “net rental real estate income (loss),” and “other net rental income (loss)” are not separately stated on the K-1 of IRS form 1120S.

Question 31

For which of the following entities is the owner’s basis increased by the owner’s share of profits and decreased by the owner’s share of losses but is not affected by the entity’s bank loan increases or decreases?

a. S corporation.
b. Limited liability company.
c. Partnership.
d. C corporation.

Answer 31

S corporation.

Choice “a” is correct. The owner’s basis in an S Corporation is increased by the owner’s share of profits and decreased by the owner’s share of losses. It is not affected by any bank loans increased or decreased by the corporation. It is only increased by direct loans made to the corporation by the owner.

Choice “d” is incorrect. C Corporations are not flow through entities and the owner’s basis is not affected by profits, losses, or loans made by the corporation.

Choice “c” is incorrect. The owner’s basis in a partnership is increased by the owner’s share of profits and decreased by the owner’s share of losses. For a partnership, the basis is also affected by increases and decreases of bank loans.

Choice “b” is incorrect. Limited Liability Companies are taxed as C corporations or partnerships, which are both incorrect as per above.

Question 32

Frank is a 1/3 shareholder in an S corporation. At the beginning of the year, Frank’s basis in his S corporation stock was $10,000. Frank’s share of the S corporation items of income included $35,000 of income from operations; $1,000 of charitable contributions, and $1,000 of capital gains. During the year, Frank also contributed $15,000 of additional capital and received a $3,000 distribution from the S corporation. What is Frank’s basis at the end of the tax year?

a. $65,000
b. $57,000
c. $60,000
d. $46,000

Answer 32

$57,000.

Choice "b" is correct. Frank's basis is calculated as follows:
Beginning basis           $ 10,000
Add: Separate and non-separate items
           Income                $ 35,000
           Capital gains        $ 1,000
Additional contributions $ 15,000
Less: Distributions           $ (3,000)
Loss or expense items    $ (1,000)
Frank's ending basis         $ 57,000

Question 33

Carson owned 40% of the outstanding stock of a C corporation. During a tax year, the corporation reported $400,000 in taxable income and distributed a total of $70,000 in cash dividends to its shareholders. Carson accurately reported $28,000 in gross income on Carson’s individual tax return. If the corporation had been an S corporation and the distributions to the owners had been proportionate, how much income would Carson have reported on Carson’s individual return?

a. $188,000
b. $28,000
c. $160,000
d. $132,000

Answer 33

$160,000.

Choice “c” is correct. S Corporations work in a similar fashion to partnerships. The income is passed through to the shareholder and included in taxable income whether or not it is actually distributed. Therefore, Carson will report 40% of the $400,000 taxable income, or $160,000. The $28,000 distribution will not affect the taxable income, but will reduce Carson’s basis in the S Corporation stock.

Choice “b” is incorrect. This is simply the same answer as if the corporation were a C Corporation.

Choice “d” is incorrect. This is the correct answer of $160,000 reduced by the $28,000 distribution. The $28,000 will not reduce taxable income, but will reduce Carson’s basis in the S Corporation stock.

Choice “a” is incorrect. This is the correct answer of $160,000 increased by the $28,000 distribution. The $28,000 will not increase taxable income, but will reduce Carson’s basis in the S Corporation stock.

Question 34

Beech Corp., an accrual-basis, calendar-year S corporation, has been an S corporation since its inception. At the beginning of the current year, Gold owned 50% of the 100 issued shares of Beech stock, and had a $3,000 tax basis in the Beech stock. During the current year, Beech had $200,000 in net business income and $4,000 in Oak County municipal bond interest income. Beech made no distributions to its shareholders. What was Gold’s tax basis in Beech stock at year end?

a. $105,000
b. $102,000
c. $104,000
d. $103,000

Answer 34

$105,000.

Choice “a” is correct. A shareholder’s basis in an S corporation is increased by his or her proportionate share of all income, including tax-free income. Gold’s ending basis in Beech is $105,000. $3,000 beginning basis + $100,000 (50% of net business income) + $2,000 (50% of municipal bond interest income).

Choices “b”, “d”, and “c” are incorrect, per the above explanation.

Question 35

Which of the following increases the accumulated adjustments account of an S corporation?

a. Distribution to shareholders.
b. Charitable contributions.
c. Interest and dividends.
d. Capital contributions by the shareholders.

Answer 35

Interest and dividends.

Choice “c” is correct. The accumulated adjustments account (AAA) for an S corp is increased by separately stated and non-separately stated income and gains (except tax-exempt income and certain life insurance proceeds).

Choice “d” is incorrect. Capital contributions by shareholders do not increase AAA.

Choice “a” is incorrect. Distributions to shareholders would decrease AAA, not increase AAA.

Choice “b” is incorrect. Charitable contributions would decrease AAA, not increase AAA.

Question 36

The two equal shareholders of a C corporation are thinking of filing an election to have the company treated as an S corporation. Which of the following consequences is an advantage of this election?

a. The corporation’s tax-free fringe benefits for the shareholders will be deductible by the corporation.
b. The corporation’s capital losses can be claimed on the tax returns of the shareholders.
c. The shareholders of the S corporation will be taxed only on distributions from the corporation.
d. The corporation’s net operating loss carryovers from prior years are immediately deductible by the shareholders.

Answer 36

The corporation’s capital losses can be claimed on the tax returns of the shareholders.

Choice “b” is correct. Capital losses and all other items of income and loss flow through to the tax returns of the shareholders.

Choice “d” is incorrect. The net operating loss carryovers are not immediately deductible by the shareholders.

Choice “a” is incorrect. The tax-free fringe benefits of more-than-2-percent shareholders are not deductible by the corporation.

Choice “c” is incorrect. Shareholders of S corporations are taxed on their prorated share of all income and losses, not just what was distributed.

Question 37

Paige, a 25 percent shareholder in an S corporation, had a stock basis of $10,000 at the beginning of the year. The corporation had ordinary income of $200,000 for the year. There were no separately stated items. Paige received wages from the corporation of $25,000 and a distribution of $30,000. What was Paige’s basis in the stock at year-end?

a. $5,000
b. $30,000
c. $35,000
d. $0

Answer 37

$30,000.

Choice “b” is correct. Page is a 25 percent shareholder. So basis is increased by 25 percent of ordinary income, or $50,000 (25% × $200,000). Basis is decreased by the $30,000 distribution. The wages do not affect basis. Basis is $30,000 ($10,000 + $50,000 – $30,000 = $30,000).

Choices “d”, “a”, and “c” are incorrect, based on the above computation.

Question 38

A company terminated its S corporation status for the current tax year. When can the company reelect S status?

a. Cannot reelect in future.
b. Third year from the current tax year.
c. Fifth year from the current tax year.
d. Immediately.

Answer 38

Fifth year from the current tax year.

Choice “c” is correct. The rule is that an S corporation that terminates cannot reelect S status until the fifth year from the current year.

Choices “d”, “b”, and “a” are incorrect, based on the above explanation.

Question 39

An S corporation had the following income and expenses:
Sales  $240,000
Rent expense $25,000
Entertainment expense $5,000
Interest income $1,500
Contributions to qualifying charities $600
Section 179 expense $3,000
Depreciation expense $1,800
What would be reported as ordinary income on the corporation's income tax return?
	a.	$208,600
	b.	$206,100
	c.	$210,700
	d.	$213,200

Answer 39

$210,700.

Choice “c” is correct. Ordinary income is the net of all taxable and deductible ordinary business revenue and expenses not including separately stated items. Ordinary income is $240,000 sales – $25,000 rent expense – $2,500 entertainment expense – $1,800 depreciation expense = $210,700. Per tax law, only 50 percent of the $5,000 entertainment expense is deductible. The Interest income, charitable contributions, and section 179 expense are separately stated items. They flow through to the shareholder(s) separately on Schedule K-1 and are not part of ordinary income.

Choices “b”, “a”, and “d” are incorrect, based on the above explanation.

Question 40

Dove and Eagle formed a business entity in which they are equal owners. Dove contributed cash of $100,000, and Eagle contributed land with a basis of $40,000 and fair market value of $100,000. For its first year of operations, the entity had taxable income of $60,000 and made no distributions. At year-end, it had outstanding recourse liabilities to third parties of $10,000. Eagle had a basis of $70,000 in the entity at the end of the first year of operations. What type of entity was formed?

a. Limited liability company (LLC).
b. C corporation.
c. General partnership.
d. S corporation.

Answer 40

S corporation.

Choice “d” is correct. $70,000 is computed as follows. Eagle’s initial basis is the carryover basis of the land of $40,000. At the end of the year, it is then increased by the 50 percent ownership of the $60,000 taxable income, or $30,000. This is consistent with the basis rules of an S corporation.

Choice “b” is incorrect. Basis in a C corporation is not increased for a share of the taxable income. If this were a C corporation, the ending basis would be $40,000.

Choice “c” is incorrect. Basis in a general partnership is increased for the prorated share of taxable income and also the prorated share of the liabilities. If this were a general partnership, the ending basis would be $75,000 ($40,000 + $30,000 + $5,000).

Choice “a” is incorrect. Basis in an LLC is increased for the prorated share of taxable income and also the prorated share of the liabilities. If this were an LLC, the ending basis would be $75,000 ($40,000 + $30,000 + $5,000).

Question 41

What is the tax rate for an S corporation that pays tax on built-in gains?

a. The highest corporate income tax rate.
b. The income tax rate of the shareholder.
c. The highest individual income tax rate.
d. The calculated income tax rate of the corporation.

Answer 41

The highest corporate income tax rate.

Choice “a” is correct. The tax rate for the built-in gains tax is 35 percent, which is the highest corporate income tax rate.

Choices “d”, “b”, and “c” are incorrect, based on the above rule.

Question 42

HDF, a calendar-year corporation, began business in year 1. HDF made a valid S corporation election on December 1, year 2. Assuming the eligibility requirements for S corporation status continued to be met throughout year 3, on which of the following dates did HDF’s S corporation status become effective?

a. December 1, year 2.
b. December 1, year 3.
c. January 1, year 2.
d. January 1, year 3.

Answer 42

January 1, year 3.

Choice “d” is correct. An S corporation election made by the fifteenth day of the third month of the year (March 15th, year 2, in this case) can be retroactive to the beginning of the year (January 1, year 2, in this case). Any election made subsequent to that date is effective as of the first day of the next year (January 1, year 3, in this case). Since the election was made after March 15, year 2, the election will become effective on January 1, year 3.

Choices “c”, “a”, and “b” are incorrect per the explanation above.