Chapter 17

Question 1

Corporation definition

Answer 1

A corporation is essentially a legal entity created under state law for the purpose of conducting a business or philanthropic activity. Under traditional principles of state corporation law, there are four legal characteristics that distinguish a corporation from other forms of business operation. These four corporate characteristics are as follows:
• limited liability,
• transferability of interest,
• centralized management, and
• continuity of life.

Question 2

Limited Liability

Answer 2

An organization possesses limited liability if the organization’s creditors cannot proceed against its individual owners personally in satisfaction of a corporate debt. This feature is one of the best-known reasons for choosing the corporate form.

Question 3

Transferability of interest

Answer 3

Transferability of interest generally means that a shareholder of a corporation can transfer interest in the profits, assets, and control of the business freely and without restraint. If each shareholder, without the consent of the other shareholders of the organization, can transfer the corporate interest to a person who is not a shareholder, there is free transferability of interest.

Question 4

Centralized management

Answer 4

Centralized management exists if the operating authority is concentrated in one person or
a relatively small class within the group as opposed to the sharing of management decisions commonly found in partnerships. If any person or group of persons (which does not include all of the members) has continuing, exclusive authority to make the decisions necessary to the management and daily operation of the business, there is centralized management.

The group in which that authority is legally vested is called the board of directors.

Question 5

Continuity of life

Answer 5

Continuity of life means that death, disability, incapacity, addition of a new shareholder, or withdrawal of an old shareholder will not cause legal dissolution of the business.

Question 6

closely held corporation

Answer 6

A close corporation or closely held corporation is one that has no shares of its stock available for purchase by or in the hands of the general public.

Question 7

S corp qualification

Answer 7

To qualify for S corporation status, the following requirements must be met:
• An S corporation can have only one class of stock.
• An S corporation must have no more than 100 shareholders. Members of the same family are treated as one shareholder
An S corporation can have no shareholder other than an individual, an estate, or certain types of trusts (except for qualified Subchapter S subsidiary corporations).
• An S corporation must be a domestic corporation, one that is incorporated in the United States.
• An S corporation may not have nonresident alien shareholders.

Question 8

Taxation of an S Corp

Answer 8

An S corporation does not pay corporate tax on its income. The result is that the shareholders are taxed on the taxable (i.e., ordinary) income of the corporation in proportion to their stock ownership. If the corporation has a loss, it can be deducted directly by the shareholders.

Question 9

When to use an S Corp tax election

Answer 9

The S corporation election is used in a number of situations. For example, if you expected high initial losses in your first year or two of business operations, you would want to pass through the corporation’s losses since you are all in high individual income tax brackets, so that you could use them against your own income tax liability.

Question 10

When to use an S Corp tax election

Answer 10

An S corporation election might also be indicated where business owners want to take advantage of limited liability but do not want to incur a double taxation when income earned and taxed by the corporation is later distributed to its shareholders.

Question 11

When to use an S Corp tax election

Answer 11

By an irrevocable and unqualified gift of shares of stock, a taxpayer can arrange to split income with another family member. Thus it is possible to transfer income to lower income tax rate- bracket donees. By getting stock into the hands of various family members, it is possible to shift income to other taxpayers even though the income may be used to satisfy support or other family obligations that the donor would otherwise have to pay with after-tax dollars.

Question 12

NONRECOGNITION PROVISION FOR TRANSFER TO A CORPORATION CONTROLLED BY TRANSFEROR(S)

Answer 12

This nonrecognition provision must meet certain basic requirements. When a person or persons transfer property to a corporation solely in exchange for the corporation’s own stock (other than certain “nonqualified” preferred stock), and the transferor(s) control the corporation immediately after the transfer, no gain will be recognized on the appreciated property or securities contributed to the new corporation.

Question 13

There are three formal requirements that must be satisfied to obtain an exception to the general rule so that there will be no recognition of a gain.

Answer 13

1) First, there must be one or more persons transferring property (which may include cash) to the newly formed corporation.
2) Second, the transfer must be solely in exchange for stock in the corporation.
3) The third requirement for nonrecognition is that the transferor(s) (the person or persons transferring cash and/or property to the corporation in return for stock of the corporation) must be in control immediately after the exchange.

Question 14

Are the expenses of forming a corporation currently deductible in determining corporate taxable income?

Answer 14

There are a number of such expenses incurred in the organization of the corporation. For example, there are state filing fees and legal expenses in obtaining the charter, costs for accounting services incident to the organization, and fees paid for drafting the corporation charter and bylaws as well as for the terms of the original stock certificates.
A corporation can recover the cost of these organizational expenditures through amortization deductions.

In other words, the corporation can deduct these costs in even amounts over a period of 180 months beginning with the month in which the corporation begins business. In most cases this would be after the corporation is legally formed.

Question 15

Raising capital in a corporation - Bonds

Answer 15

Bonds may be a favored means of raising corporate capital. One reason for this is that a corporation will obtain a deduction for the interest paid on the indebtedness. By contrast, no deduction is allowed for dividends paid on either preferred or common stock. As long as a corporation can earn money at a higher rate (with the cash raised by issuing the bond) than it costs the corporation (in interest necessary to service the debt), it usually makes sense for the corporation to borrow money. This concept is known as “leverage.”

Question 16

Thinly capitalized

Answer 16

Thin capitalization refers to the ratio of debt to equity. Where a corporation is heavily capitalized by debt claims, it is considered to be thinly capitalized.
If a corporation is thinly capitalized:
- corporate deductions for interest payments to shareholders are disallowed
- receipt of interest payments by shareholder-creditors are reclassified and treated as dividends
- when the corporation pays off its debt to the shareholders, that payment is taxed as a dividend. This means that instead of treating the amount received as a tax-free repayment of a debt, the shareholder-creditor must report the payment as a dividend
- money that the corporation purportedly was accumulating to pay off the debt is now potentially subject to the accumulated-earnings tax

Question 17

A corporation would report its federal income tax on IRS Form 1120.

Answer 17

True

Question 18

Corporate deductions

Answer 18

A corporation is entitled to two types of deductions: ordinary deductions and special deductions.

Question 19

dividends-received deduction.

Answer 19

Type of “Special” corporate deduction

Question 20

Reasonable Definition

Answer 20

Reasonable” means only the amount that would ordinarily be paid for similar services by corporations like Bradwell under similar circumstances.

Question 21

Corporate Charitable Deductions

Answer 21

The Internal Revenue Code permits a charitable deduction for contributions by a corporation. However, the deduction is limited to a maximum of 10 percent of the corporation’s taxable income. (Certain adjustments are made to taxable income before the 10 percent maximum deduction is computed).

Question 22

Accumulated Earnings Tax

Answer 22

The accumulated-earnings tax is a tax imposed on every corporation that is formed or used for the purpose of avoiding personal income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being distributed.
Accumulations of $250,000 or less will automatically be considered to be for the reasonable needs of the business. Accumulations of $150,000 or less will be considered to be for the reasonable needs of the business in the case of professional service corporations.23 However, if Bradwell is profitable and begins to accumulate amounts in excess of $250,000, it should be prepared to show a bona fide business reason for not distributing these earnings in the form of dividends.

Question 23

Personal Holding Company

Answer 23

Yes. A personal holding company is a device stockholders have used to place income with a corporation to prevent themselves from being taxed on a personal level. The formulation of a personal holding company generally has taken two forms—the “incorporated-talent” form and the “incorporated-wallet” form.