Part 2 - Businesses - Unit 1 - Content Flashcards

Question

Natural Tax Year

Answer 1

- A business is always allowed to use a year other than a “required” tax year if it can establish a “substantial business purpose” for using a different tax year. - A seasonal business, such as a ski resort, may use a tax year that follows the natural cycle of the business itself. This is sometimes called a “natural tax year.” A “natural tax year” is a fiscal year in which the last two months of the year provide over 25% of the business’s gross receipts for the entire year. - A business may normally elect a fiscal year based on a genuine business purpose; however, it is not considered a “legitimate” business purpose to elect a particular fiscal tax year just so that partners or shareholders may defer income recognition. - Example: Donna and Thomas are clothing designers. They decide to form a 50/50 partnership in order to sell designer swimwear for men and women. Although Donna and Thomas are both individuals who report their personal income on a calendar year, they file Form 1128 in order to request a natural business year for their partnership. Their natural business year would end in September, after the summer is over, when most swimsuits for the year are sold. Their request for a natural business year is granted. They will file their partnership return with a fiscal year-end of September 30.

Answer 2

- A partnership or S corporation can also request to use a tax year other than its required tax year by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. This is known as a section 444 election, and it does not apply to any business that establishes a genuine business purpose for using a different tax year. - A business can request a section 444 election if it meets all of the following requirements: - It is not a member of a tiered structure. - It has not previously had a section 444 election in effect. - It elects a year that meets the deferral period requirement.

Answer 3

- An accounting method is a set of rules used to determine when and how income and expenses are reported. No single accounting method is required of all taxpayers. However, the taxpayer must use a system that properly reflects income and expenses, and it must be used consistently from year to year. Businesses generally report taxable income under one of the following accounting methods: - Cash method: Under the cash method, a taxpayer generally deducts expenses when they are paid. - Accrual method: Under the accrual method, a taxpayer generally deducts expenses as they are incurred, and income when it is earned. - Hybrid method (using elements of the methods above). - Special methods for farming businesses (covered later)

Answer 4

- Under the TCJA, all businesses (except tax shelters) are permitted to use the cash method of accounting if they meet the annual gross receipts test of $29 million, (in 2023) even if the business produces, manufactures, or sells inventory. - Average annual gross receipts are determined by adding the gross receipts for the three preceding tax years and dividing the total by three. If the business has been in existence for less than three years, then the applicable average gross receipts will be determined based on the applicable number of years in existence. - The most common accounting method is the cash method, which is used by most small businesses. The accrual method is used by most large corporations and is considered a more accurate method of recognizing income and expenses, because it reflects when taxable income is actually earned. The accrual method is required for publicly traded corporations (such as Coke, Nike, etc.). - Note: Large nonprofit entities are often required to use the accrual method because many of them receive government funding (such as federal grants) and must have audited financial statements.

Answer 5

- A business owner may use different accounting methods if he or she has two separate and distinct businesses. Two businesses will not be considered “separate and distinct” unless a separate set of books and records is maintained for each business. - Example: Anthony is a self-employed enrolled agent. He prepares returns from January through April every year. He is also a part-time baseball umpire who is usually booked on weekends to officiate baseball games for various amateur leagues. He reports his tax preparation business using the accrual method and his earnings as an umpire using the cash method. He keeps separate books and records for each business and files a separate Schedule C for each business. Anthony may choose to use different accounting methods because he has two distinct businesses with separate sets of records for each.

Answer 6

- There is an exception to the timing of the deductibility on prepaid expenses under the “12-month rule” under which the cash-basis taxpayer is not required to capitalize amounts paid for periods that do not extend beyond the earlier of the following: - 12 months after the benefit begins, or - The end of the tax year after the tax year in which payment is made. - Example: Lizbeth is a sole proprietor who rents retail space for her eyebrow threading business. She pays two years of rent in advance in order to receive a substantial discount from her landlord. She cannot use the 12-month rule because the benefit from her advance payment exceeds the 12-month time period. She must recognize the rent expense over the two-year period, regardless of which method of accounting she uses.

Answer 7

- When a business files its first tax return, it may choose any permitted accounting method. Subsequent changes, either in the overall accounting method or the treatment of a material item, generally require that the taxpayer obtain IRS approval. Prior approval is needed for: - Changes from cash to accrual or vice versa, unless the change is required by law. - Changes in the method used to value inventory, (inventory methods are covered in your book). - Changes in the method of depreciation or amortization. This includes situations where a taxpayer changes from an “impermissible method” of depreciation or misses depreciation on an asset altogether. - The taxpayer must file Form 3115, Application for Change in Accounting Method, to request a change in either an overall accounting method or the accounting treatment for an individual item. - Automatic changes in accounting methods do not require IRS consent. But both automatic and non-automatic changes are requested on Form 3115. - Example: Hagerman Farms, Inc. is a profitable C corporation that grows and produces animal feed. This year, the company exceeds $29 million in average annual gross receipts. It was using the cash method in the past year, but now is required to switch to the accrual method. This is an accounting method change that is mandated by law and does not require prior consent from the IRS. Hagerman Farms will switch to the accrual method of accounting and file the Form 3115 along with its corporate income tax return. The Form 3115 is filed in the first affected year that contains the change. - Note: Unclaimed depreciation, for closed as well as open years, is allowed through a Section 481(a) adjustment that reduces income in the year of change. If the entire adjustment is less than $25,000, a de minimis rule permits taxpayers to take 100% of the amount into account in the year of change (see IRS Rev. Proc. 96-31 for more information). - Example: Five years ago, Karen bought a residential rental condominium for $97,500. The land value was $15,000, and the building’s depreciable basis was $82,500. Karen self-prepared her own returns for several years and did not claim any depreciation on the rental. Karen visits an enrolled agent, Gordon, and he discovers the missed depreciation deductions that went on for many years. Gordon tells Karen that she can claim her missed depreciation by filing Form 3115. The unclaimed depreciation of $14,500 is treated as a negative adjustment on Schedule E, with the annotation of “§481(a) adjustment”.

Answer 8

- Cost of goods sold (COGS) is deducted from a business’s gross receipts to determine its gross profit. COGS is calculated by adding up the cost of goods available minus any ending inventory. COGS is also referred to as “cost of sales.” The following expenses related to inventory sold are included in the calculation of COGS: - The cost of products or raw materials, including freight - Storage costs of raw materials and finished products - Direct labor costs to produce the goods - Factory overhead The equation for cost of goods sold is as follows: Beginning Inventory + Inventory Purchases and Production Costs - Ending Inventory = Cost of Goods Sold (COGS) - Cost of goods sold is the direct costs attributable to the production (or purchase) of the goods or services sold by a business. In a manufacturing business, labor costs allocable to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into a finished, saleable product. - Example: In calculating COGS, Nathan’s Custom Shoes includes the cost of leather and thread in the shoes it manufactures, as well as wages for the workers who produce and assemble the shoes. Inventory does not include the cost of advertising for the shoes. COGS is recorded as an expense when the company sells its finished goods. - Example: Heritage Emporium, Inc. manufactures historical theater costumes. During the month of October, Heritage Emporium purchases extra raw materials to produce additional costumes for the Halloween holiday. All the materials and shipping costs associated with the inventory are capitalized rather than expensed. As the costumes are sold, Heritage Emporium expenses the costs associated with the inventory as cost of goods sold. At the end of each month, Heritage Emporium does a physical inventory count and adjusts COGS for any damaged or stolen inventory.

Answer 9

- The uniform capitalization rules (commonly referred to as UNICAP) provide detailed guidance regarding the direct costs and certain indirect costs related to the production of goods or the purchase of merchandise for resale that businesses must capitalize as part of the cost of inventory. - UNICAP rules apply to producers of tangible and intangible personal property, and producers of real property, as well as a business that acquires wholesale inventory for resale. - A business that wishes to change its accounting treatment of inventory must file Form 3115 and request a change to its accounting method.

Answer 10

- In general, only large businesses are subject to the uniform capitalization rules. - The Tax Cuts and Jobs Act modified the UNICAP rules for small and mid-sized businesses. - Businesses that do not exceed $29 million in gross receipts test in 2023 (based on average gross receipts for the prior three tax years) are not required to apply the uniform capitalization (UNICAP) rules. - Example: Bloomington Studios is a professional film studio with average gross receipts of $170 million per year. Bloomington Studios produces cartoons and movies for Hollywood. Even though the company does not produce any tangible products, film production is subject to the UNICAP rules, so Bloomington Studios must capitalize all of its costs, including set design, costumes, special effects, film editing, and salaries for actors and production workers. When a film is finally completed and released to the public for distribution, Bloomington Studios is allowed to deduct the production costs as COGS. - Example: Big Bargains Grocery, Inc. has six store locations and has $35 million in average gross receipts. Big Bargains Grocery employees take a physical inventory of each store at least once a month. During the physical inventory, store employees are required to record any damaged goods such as dented cans and ripped packaging. When the physical inventory is completed, each store manager does a final reconciliation, adjusting the books to reflect adjustments for expired food and damaged merchandise. If the business did not track its inventory, it would never know when products were stolen, damaged, or expired.

Answer 11

- If a business is subject to the UNICAP rules, inventory should include all of the following, if applicable: - Merchandise or stock in trade - Raw materials, work in process, finished products - Supplies that physically become a part of items for sale (labels, stickers, boxes, exterior packaging, etc.) - Purchased merchandise if the title has passed to the taxpayer, even if the merchandise is still in transit or the business does not have physical possession of it for another reason - Goods out on consignment, Goods held for sale in display rooms or booths located away from the taxpayer’s place of business - Intangible costs (examples include film or video production) - The following items are NEVER INCLUDED IN INVENTORY: - Goods the business has sold if the legal title (ownership) has passed to the buyer, - Goods consigned to the business (but not owned by the business), - Goods ordered for future delivery, if the business does not yet have the legal title; or - Land, buildings, and depreciable equipment that are used in the business are never included in the calculation of inventory.

Answer 12

- Regardless of a business’ size, the following expenditures and entity types are not subject to UNICAP: - Small businesses with average annual gross receipts under the threshold, - Hobby activities - Research and experimental expenditures, and marketing or advertising costs, regardless of business size. - Intangible drilling and development costs of oil and gas or geothermal wells, - Timber raised, harvested, or grown, and the underlying land, - Qualified creative expenses incurred as self-employed writers, musicians, artists, etc. - Loan originations, - Warranty costs and product liability costs, and - Property provided to customers in connection with providing services. The property must be de minimis and not be included in inventory in the hands of the service provider. An example would be a veterinarian who primarily provides veterinary services but carries a small amount of pet food and flea medication for sale to customers in their waiting room. - Example: Earnest Brownwood is a self-employed writer that reports his business activity on Schedule C. His last novel became a blockbuster bestseller and was optioned for a Hollywood picture. As a result, Earnest’s income from writing was over $30 million in the prior year. Earnest writes novels about real historical figures. He often travels to foreign locations to do his research. Although it often takes him several years to write a novel, all his research expenses are deductible as they are incurred. His qualified creative expenses do not have to be capitalized because self-employed writers are exempt from UNICAP, regardless of their gross receipts.

Answer 13

- Inventory “shrinkage” is a general term for lost, stolen, or damaged inventory. Shrinkage reduces a businesses’ ending inventory and thus increases COGS. The discrepancy may occur due to shoplifting, goods being damaged or lost, supplier fraud, or even a natural disaster. Sales do not affect the shrinkage calculation. - When a business incurs a casualty or theft loss of inventory, it has two options to record the loss. The business can: - Adjust its cost of goods sold, or - It can record the loss separately as a casualty or theft loss. - If the business deducts the loss separately, it must eliminate the affected inventory items from the cost of goods sold by making a downward adjustment to opening inventory or purchases. The business must avoid counting the loss twice. If the business expects an insurance reimbursement for the loss, it should not claim a loss to the extent it has a reasonable prospect of recovery. - Example: Cornerstone Computers, Inc. is a wholesale computer and electronics retailer. The business uses a point-of-sale inventory tracking system, but also does a periodic manual count. At the end of the year, the business has inventory records showing 20,000 computer laptop units on hand, but a physical count of the inventory shows only 19,850 units. Cornerstone Computers has an inventory discrepancy 150 (20,000 – 19,850). This is an example of inventory shrinkage, and might be due to shoplifting, inventory errors, or even employee theft. Cornerstone Computers will adjust its cost of goods sold, increasing the cost of goods sold to reflect the lost or stolen items.

Answer 14

- An unincorporated business with two or more owners is generally classified as a partnership for federal tax purposes. A partnership is a pass-through entity. - Income and loss is determined at the partnership level and are taxable to the individual partners. In this respect, a partnership is similar to a sole proprietorship, except that it is run by more than one person. A partnership must always have at least two partners, and at least one of them must be a general partner. - Unlike corporations, general partnerships do not require any formal legal documents in order to form. Partnerships that have some form of liability protections for some of the partners (such as limited partnerships and limited liability partnerships) do require formal documents – including those filed with the state. - A joint undertaking merely to share expenses is not a partnership. For example, a rental property owned by two people would generally not be classified as a business or a partnership.

Answer 15

- The term partnership agreement refers to any written document or oral agreement that bears on the underlying economic arrangement of the partners, including allocations of income, gain, loss, deductions, and credits. Examples of such documents include: - Loan and credit agreements - Assumption agreements - Indemnification agreements - Subordination agreements - Correspondence with a lender concerning terms of a loan - Loan guarantees - A partnership agreement can be modified during the tax year. However, the partnership agreement cannot be modified after the due date for filing the partnership return for the year, not including extensions. - Example: Pierre and Rodney are friends who run Battlefield Tools, LLC, a cash-basis, calendar-year partnership. They split the partnership’s proceeds 50/50. They decide to alter their partnership agreement in order to include an accountable plan for reimbursements, because they want the partnership to reimburse them for business mileage that they incur on their own vehicles. They have until the unextended due date of the partnership return (March 15) to change the partnership agreement. Filing for an extension does not give them additional time to change their partnership agreement.

Answer 16

- A corporation (although a corporation can be a partner in a partnership) - A joint-stock company or joint-stock association - An insurance company - Certain banks - A government entity - Any organization required to be taxed as a corporation by the IRS - Certain foreign organizations - Any tax-exempt (non-profit) organization - Any real estate investment trust (REIT) - Any organization classified as a trust or estate - Any other qualifying entity that elects to be classified as a corporation by filing Form 8832 (or Form 2553 for an S corporation)

Answer 17

- A partnership must file a tax return unless it has neither any income nor any expenditures that would be treated as a deduction or credit for the year. - A partnership reports its income or loss on Form 1065, U.S. Return of Partnership Income, which is due on the fifteenth day of the third month following the close of the tax year. - The partnership return must show the name and address of each partner and the partner’s distributive share of taxable income (or loss) on Schedule K-1 (Form 1065). The individual partner then reports their share of partnership income on Schedule E of Form 1040. - Most partnership returns are due on March 15. A six-month extension is allowed, with an extended due date of September 15. - The extension is requested on Form 7004, Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns and must be filed prior to the original due date.

Answer 18

- Beginning January 1, 2024, all partnerships are required to file Form 1065 and related forms and schedules electronically if they file 10 or more returns of any type during the tax year, including information returns, W-2s, excise tax returns, etc. If a partnership fails to do so, it will be subject to penalty unless it was unable to file electronically (e.g., because the e-filing was rejected, the return required paper attachments, etc.).

Answer 19

- Partners who work in a partnership are not employees and generally do not receive wages or Forms W-2. - Partners receive a Schedule K-1, which allows the individual partners to track their ownership stake and share of profits or losses. - General partners are considered self-employed and therefore, must pay estimated payments just like other self-employed individuals. - Limited partners are subject to self-employment tax only on guaranteed payments, such as salaries and professional fees for services rendered. - Example: Iron Horse Investments, LP is a limited partnership that has only two general partners, Gary and Laurie, and 75 limited partners, who are just passive investors. Gary and Laurie are the only ones who actually work in the business on a daily basis. Gary and Laurie are considered self-employed and will owe self-employment tax on the ordinary income that they receive from the partnership. However, during the year, Iron Horse Investments decides to paint its main office. The partnership reaches out to Steve, who is a limited partner, who also owns a commercial painting business. Steve agrees to paint the partnership’s office for a guaranteed payment of $4,000. This is a one-time gig, and Steve normally does not perform any services for the partnership. Steve receives a Schedule K-1 at the end of the year showing his share of distributive partnership income, but he will only owe self-employment tax on the amount of the guaranteed payment, because that was a payment for services performed.

Answer 20

- Schedules K-2 and K-3 are recently introduced schedules that replace and expand the foreign transaction section of Schedule K-1. All partnerships must complete these schedules unless a reporting exception applies. - Schedule K-2 and K-3 have a “domestic filing exception” that exempts partnerships from filing these schedules if certain criteria are met. - Example: Reggie and Pamela Stanton are married and file jointly. Both are U.S. citizens. Each own a 25% partnership interest in Stanton Consulting, LLP, a domestic partnership. Stanton Consulting, LLP invests in a regulated investment company (RIC) and receives a Form 1099-DIV from the RIC reporting $100 of foreign taxes paid on passive category foreign source income. The partnership does not have any foreign activity other than that from the RIC, so this is considered “minimal” foreign activity. Reggie and Pamela receive a notification from Stanton Consulting, LLP on an attachment to their Schedule K-1s that they will not receive the Schedule K-3 unless they request it. Reggie and Pamela do not request Schedule K-3 from Stanton Consulting for tax year. Stanton Consulting notified all of its other partners the same way. The partnership qualifies for the domestic filing exception, and, as such, Stanton Consulting does not need to complete Schedules K-2 or K-3.

Answer 21

- The two most common types of partnerships are general partnerships and limited partnerships. In a general partnership, all of the partners have unlimited liability for partnership debts. In a limited partnership, there must be at least one general partner and at least one limited partner. - Limited partners have no obligation to contribute additional capital to the partnership under state law and therefore do not have an economic risk of loss related to partnership liabilities. - In this respect, a limited partner is like an investor in a corporation. Limited partners generally cannot participate in the management or the day-to-day administration of the partnership. - A limited partnership (LP), and other types of partnerships with some form of liability protections, such as a limited liability partnership (LLP) and, in some states, a limited liability limited partnership (LLLP), is formed under state limited liability law. - Note: A general partnership is composed of only general partners. In other words, a general partnership cannot have limited partners. In order for a partner to have limited liability, formal documents have to be filed with the state, and a state-level entity must be formed.

Answer 22

- An LLP is more similar to a general partnership, in that all the partners can take an active role in managing the day-to-day affairs of the business, but partners can still have liability protections (similar to the liability protection that a limited partner might receive). - An LLP protects individual partners from liability for the malpractice of other partners. Most often, the owners of limited liability partnerships offer professional services (e.g., attorneys, engineers, architects, and doctors). - For example, LLP ownership in the State of California is limited to persons licensed to practice in the fields of public accountancy, law, engineering, or architecture. In order to form an LLP in California, the business must first register with the California Secretary of State. - Example: Casper and Brandon are licensed architects in the state of California. They form C&B Architects, LLP to offer architectural services to the public. They register their partnership with the Secretary of State and formed their LLP on July 1. The LLP allows Casper and Brandon to actively participate in the partnership’s management affairs, while still providing limited liability protection to each partner. Their first partnership return (Form 1065) will be due on March 15 of the following year.

Answer 23

- Unlike S corporations, which must report all income and expenses in proportion to stock ownership, partnerships have much more flexibility. - Partnership agreements can be written to reflect special allocations of income, gain, loss, or deductions, as long as the allocations have substantial economic effect, which is defined in IRS regulations. - For example, the partnership agreement may, with certain restrictions, allocate all of the depreciation deductions to one partner or specify that the partners share capital, profits, and losses in different ratios. - Example: Mary, who has design and sewing skills, forms a partnership with Cortney, who has the money to invest in developing a clothing line. Cortney contributes $100,000 of cash to the partnership. Mary and Cortney agree to split the business profits 20/80 until Cortney recovers her entire investment; thereafter, profits will be split 50/50. These special allocations are written into their partnership agreement. - Example: James and Kirk are licensed attorneys and form an LLP. James contributes only $1,000, and Kirk contributes $99,000. Due to James’ previous expertise in litigation and his existing political contacts, the partnership agreement provides that James will be allocated 40% of the business income. Thus, although James owns only 1% in partnership capital, his profit-sharing ratio is 40%. This income/loss allocation between is permissible because it correctly reflects the partner’s underlying economic arrangement.

Answer 24

- They may compensate the partner for services or for the use of capital, as if they were made to a person who is not a partner. Guaranteed payments are generally deducted by the partnership on Form 1065 as a business expense and reported to the partner receiving the guaranteed payment on their Schedule K-1. - The partner who receives a guaranteed payment reports the amount of the payment as ordinary income on Schedule E (Form 1040). Guaranteed payments are not subject to income tax withholding by the partnership. - If the partnership pays for the health insurance premiums for its partners, it deducts the expense on the partnership return as a guaranteed payment. - With regards to the Section 199A Qualified Business Income deduction, §199A excludes guaranteed payments made to a partner from qualified business income. This means that a partner cannot take a 199A deduction directly on their guaranteed payments (similar to how most employees cannot claim a 199A deduction on their wages). In other words, any amounts that are paid to a partner as guaranteed payments will reduce the amount of qualifying business income otherwise eligible for the QBI deduction. - Example: Irving is a general partner in the Brandenburg Partnership. Under the terms of his partnership agreement, he is entitled to a guaranteed payment of $10,000 per year, regardless of how profitable the partnership is. Irvin’s distributive share of partnership income is 10%. Brandenburg Partnership has $50,000 of ordinary income after deducting Irving’s guaranteed payment. He includes $15,000 of ordinary income ($10,000 guaranteed payment + $5,000 [$50,000 × 10%] for his distributive share) on his individual income tax return.

Answer 25

- The following items must be separately stated on a partnership’s return: - Net short-term & Long term capital gains and losses, - Charitable contributions - Dividends received from a corporation eligible for a dividends-received deduction - Foreign income taxes (paid or accrued) - Taxes paid to a U.S. possession (Guam, American Samoa, Puerto Rico, etc.) - Section 1231 gains and losses - Section 1250 depreciation recapture - Section 179 deduction - Any tax-exempt income and expenses related to the tax-exempt income - Investment income and related investment expenses - Rental income and any related expenses - Qualifying section 199A wages paid by the partnership (to employees) - Unadjusted Basis of assets immediately after acquisition (UBIA): Reporting UBIA on the partnership return is necessary for purposes of each partner calculating the 20% pass-through QBI deduction on their personal returns. - Example: Foster is a 25% partner in Omaha Architects, LLP, a partnership with three other individual partners. Omaha Architects makes $20,000 of charitable contributions during the year that are reported on the partnership tax return, Form 1065. As Omaha Architects is a pass-through entity, it does not receive a tax benefit from deductible contributions. Instead, Foster’s Schedule K-1 shows $5,000 as his share of the partnership’s charitable contributions, which he can potentially claim on his individual tax return.

Answer 26

- When a partnership is formed, or new partners are added, the partners contribute property or cash in exchange for their partnership interests. Generally, neither the partner nor the partnership recognizes gain or loss in connection with contributions, whether made in connection with the partnership’s formation or after it is operating. - When a partner contributes property (rather than money) to a partnership, the partner’s basis in their partnership interest as well as the partnership’s basis in the property is generally the same as the adjusted basis of the property contributed by the partner, including any gain recognized by the partner in connection with the contribution. - For example, if a partner contributes a building with an FMV of $175,000 and a basis of $65,000, with no debt, the basis of the building in the hands of the partnership would also be $65,000. This amount would also be the partner’s basis in his own partnership interest. The partner’s holding period for the property is also carried over. - Example: Reyna and Hamlin are both Certified Financial Planners. They come together to form Zenith Financial, LLP, an equal partnership to offer financial services. Reyna contributes an office building to the partnership that has an adjusted basis of $145,000 and an FMV of $300,000. The partnership will use the building as its main office. Hamlin contributes $125,000 in cash. The basis of Reyna’s partnership interest is $145,000, and the basis of Hamlin’s interest is $125,000. Even though the contributions to the partnership were not the same, they can still share partnership profits and losses equally.

Answer 27

- However, a partner’s contribution can result in gain or loss recognition in the following situations: - When property is contributed to a partnership that would be treated as an investment company if it were incorporated. - When contributed property is distributed to a different partner within seven years of the original contribution date. The contributing partner would recognize gain on the difference between the fair market value and the adjusted basis of the property as of the contribution date. The character of the gain or loss will be the same as would have resulted if the partnership had sold the property to the distributee partner. - When a partner contributes cash or property to a partnership and then receives an immediate distribution of different property (or cash). In this case, the transaction may be considered a “disguised sale.” If a contribution and distribution occur within two years of each other, the transfers are presumed to be a “disguised sale” unless the facts clearly indicate they are not. - Example: Benjamin transfers a factory building to Leeds Partnership and then, two months later, Leeds Partnership distributes $3,000,000 in cash to Benjamin. The factory building has a fair market value of $4,000,000 and a basis of $1,200,000. This transfer would likely be treated as a “disguised sale,” rather than a distribution. In this case, the transaction would not qualify for nonrecognition treatment, and Benjamin would be required to recognize income on the “sale” of the building to the partnership.

Answer 28

- A partner can acquire an interest in a partnership as compensation for services performed. If a partner receives a capital interest as compensation for services, the partner must recognize ordinary income equal to the fair market value of a partnership interest that is transferred in exchange for services. The amount is treated as a guaranteed payment. - Example: Dana is an attorney who contributes her legal services to a partnership in exchange for a 5% partnership interest. The fair market value of the partnership interest is $3,000. Dana is required to recognize $3,000 of ordinary income, and her basis in the partnership is $3,000.

Answer 29

- The amount of a partnership’s loss that a partner is potentially allowed to deduct on their tax return is normally dependent on (1) the partner’s basis in the partnership, and (2) the amount the partner has at-risk in the partnership (i.e., the “at-risk” limitation). - In general, a partner cannot deduct losses that exceed their partnership basis. Losses disallowed due to insufficient basis are carried forward until the partner can deduct them in a later year, typically when there is sufficient basis in the partnership. Debts incurred on behalf of the partnership can increase a partner’s individual basis. - For example, if a partner takes out a $50,000 loan to finance partnership operations and he or she personally guarantees the debt, the debt is considered part of their basis in the partnership for purposes of deducting partnership losses. - If a partner does not have any personal liability to satisfy the debt of a partnership, deductible losses may be limited by the at-risk rules. - Example: Gary and Danica are two friends who form West Lake Winery, LLC, a 50/50 partnership. Gary invests $10,000 in cash. Danica also invests $10,000 in cash, and she also personally guarantees a business loan of $80,000 on behalf of the partnership to purchase wine-making equipment. Danica is the only signatory on the loan because Gary’s credit is poor. West Lake Winery has a net loss of ($24,000) for the year, which is allocated equally to the partners ($12,000 in losses each). The at-risk limitations limit Gary’s deduction to $10,000, the amount of his investment, as he is not personally liable for the note. Danica’s losses are not limited, because her basis includes the debt basis of the loan ($80,000), for which she is personally liable. She is allowed to deduct her $12,000 loss in full. Gary’s disallowed losses must be carried over to the following year. - Example: Yellowstone Energy, LP is a limited partnership with over 100 partners. Raymond is a general partner, whereas Silvio is one of the limited partners. Yellowstone Energy has taken a recourse loan of $500,000 during the year to help fund its business operations. Raymond is a general partner, so he personally guarantees the loan. This may affect his partnership basis. Silvio is a limited partner and is simply an investor; he is not responsible for the borrowings of the business. Silvio’s basis is not affected by the loan or any other liabilities.

Answer 30

- Do not confuse the “at-risk limitation” with the “passive activity loss” rules. They are not the same thing. The at-risk rules deal with a partner’s investment in an activity, while the passive activity rules deal with a partner’s participation in an activity. They are also reported on different forms. - Form 6198, At-Risk Limitations, is for calculating profit or loss from an at-risk activity for the current year. Form 8582, Passive Activity Loss Limitations, is used to figure the amount of any passive activity loss (PAL) for the current tax year. - The at-risk rule limits the deductibility of losses to the partner’s basis, not including his or her share of most nonrecourse debt. This means that a partner is prohibited from taking losses based on partnership liabilities unless the partner would be forced to satisfy the debt with their personal assets. - This rule is intended to prevent abusive deductions from tax shelter activities. - Example #1 (profitable partnership): Jordan is a limited partner in the Crypted Partnership, LP, a business that mines different types of cryptocurrencies. He invested $5,000 to obtain his 5% partnership interest. As a limited partner, Jordan is not required to invest any additional capital, his legal liability is limited to his partnership investment and he is not involved in its day-to-day business. Jordan’s at risk limitation is $5,000, the amount of his initial investment. If the partnership had losses, this is the most he would be able to deduct. However, the partnership is very profitable in the current year, and Jordan’s Schedule K-1 from the partnership reflects his distributive share of the partnership’s income, which is $39,000. Because Jordan is a limited partner who does not take an active role in the business, his income from the limited partnership is viewed as passive income, which is not subject to self-employment tax. So he has the double benefit of (1) limited liability, as well as (2) avoiding self-employment tax on his partnership earnings. - Example #2 (unprofitable partnership): Emily is a limited partner in Arise Energy LP, a business that invests in different types of renewable energy. She owns a 1% partnership interest. Emily is also not involved in the partnership’s day-to-day business. Emily’s only other income for the year is $40,000 in wages. Arise Energy does poorly in the current year because a catastrophic storm wiped out its main offices. Emily’s Schedule K-1 from the partnership reflects her distributive share of the partnership’s losses, which are ($15,000). Emily cannot deduct any of the losses, because she cannot offset her wages (active income) with this passive activity loss. The ($15,000) loss is suspended and must be carried forward, until the partnership is profitable, or she disposes (sells) the activity.

Answer 31

- A partnership is not a taxable entity; its income and losses flow through and are reported on the partners’ individual tax returns. Partners are taxed on their distributive share of income, whether or not it is actually distributed. Partnership distributions may include the following: - Distributions of the partnership’s earnings for the current or prior years. - A withdrawal by a partner in anticipation of the current year’s earnings. - A complete or partial liquidation of a partner’s interest. - A distribution to all partners in complete liquidation of the partnership. - All partnership distributions are either current or liquidating. - A liquidating distribution terminates a partner’s entire interest in the partnership (generally either when a partner is no longer a partner in the partnership, or the partnership itself no longer continues to be in existence). A current distribution is one that does not terminate the partner's interest in the partnership. - A partnership distribution is not taken into account in determining the partner’s distributive share of the partnership’s income or loss.

Answer 32

- If the amount of a cash (or the cash portion of mixed cash and property) distribution exceeds a partner’s basis in the partnership, then the excess of the cash distribution over the partner’s basis will normally result in capital gain to the partner. - If a property distribution exceeds a partner’s basis in the partnership, this will usually not result in taxable gain, but the partner’s basis will be transferred into the asset(s) received in the distribution. - A partnership does not recognize any gain or loss because of distributions it makes to partners. - A partner who receives a current (nonliquidating) distribution cannot recognize a loss, but a partner that receives a liquidating distribution may recognize a loss if (1) the amount of cash and the partnership’s basis in non-cash assets distributed to the partner is less than the partner’s basis in the partnership right before the distribution, and (2) only cash and “hot assets” are distributed to the partner. - Example: Henry is a 10% partner in the Brockville Realty partnership. The basis of Henry’s partnership interest is $100,000 at the beginning of the year. He receives a distribution of $40,000 cash and a parcel of farmland that has an adjusted basis to the partnership of $80,000. Henry’s basis in the farmland is limited to $60,000 ($100,000 basis - $40,000, the cash he receives) since the total amount cannot exceed his partnership interest. After this distribution, his partnership basis would be zero, but he recognizes no gain on the distribution as the amount of the cash received is not in excess of his outside basis in the partnership. Later, if Henry decides to sell the farmland, then his basis for determining gain will be $60,000. Any gain on the land will be recognized when he eventually sells it.

Answer 33

- “Hot assets” are ordinary-income producing assets. The main two examples are inventory and accounts receivables. A gain or loss on a sale or exchange of unrealized receivables or inventory items a partner received in a distribution is generally treated as ordinary income or loss when later sold by the partner. - They receive this treatment because these are assets that would have generated ordinary income for the partnership if they were sold. - Example: Triple Crown Accountancy, LLP is a partnership with four equal partners, who are all licensed accountants. The partners have a major disagreement about the direction of the firm and decide to go their separate ways. Triple Crown Accountancy liquidates on December 10. The partnership does not distribute any cash to the partners, but it does distribute $30,000 in unrealized receivables to Dillon, one of the partners. The following year (In January) the clients pay the outstanding invoices (the unrealized receivables) and Dillon receives the money for the invoices. He must treat the income as ordinary income, just as if the income would have been received by the partnership itself.

Answer 34

- A partnership interest is a capital asset. As a result, a gain or loss on the sale or exchange of a partnership interest is normally treated as a capital gain or loss. - However, if the partnership holds certain section 751 “hot assets”, some or all of the gain or loss may be recharacterized as ordinary. - Gain or loss is calculated as the difference between the amount realized and the adjusted basis of the partner’s interest in the partnership. If the selling partner is relieved of partnership liabilities, he or she must include the liability relief as part of the amount realized for his or her interest.

Answer 35

- A partnership cannot deduct a loss on the sale or trade of property if the transaction is directly or indirectly between related parties. Under the related party transaction rules, an individual is considered to be the owner of a partnership interest directly or indirectly owned by his or her family members. - Members of a family, for this purpose, include siblings, half-siblings, spouses, ancestors, parents, and lineal descendants (children, grandchildren). - For the purposes of this rule, “related parties” does not include: ex-spouses, in-laws, aunts, uncles, stepsiblings, cousins, or stepparents. - Example: Mason and Addie are siblings. Addie is a 60% partner in the Crown Partnership, and Mason is a 55% partner in the Belkin Partnership. If one partnership sells property to the other at a loss, the loss will not be allowed because the partnerships are considered related parties, because the majority ownership in both partnerships is held by two closely-related family members (Mason and Addie). Losses will instead be suspended until the property is eventually disposed of in a non-related party transaction.

Answer 36

- When a partnership dissolves or stops doing business, it is called a partnership liquidation, and the partnership will normally pay off existing debts and liabilities and distribute to the partners any remaining assets. - A dissolution (or liquidation) marks the official ending of a partnership. A partnership may also dissolve when a partner dies, or when one partner drops out of the business. - In a partnership liquidation, the liquidating distributions are similar to regular distributions except that the partner may recognize a loss if the total of cash and the basis of certain qualifying property received is less than their basis in the partnership. - Example: Limestone Realty is having serious financial difficulties and decides to liquidate. Larissa is a 10% partner. Her basis right before the liquidation is $9,000. Limestone Realty distributes $1,550 in cash to Larissa, in complete liquidation of her interest. There are no other assets to distribute, and the partnership formally dissolves a week later. Larissa can recognize a $7,450 capital loss on the liquidating distribution ($9,000 basis – $1,550 cash received).

Answer 37

- Payments made by the partnership to a retiring partner or a deceased partner’s estate are considered a distribution, not a distributive share or a guaranteed payment. - A retiring or deceased partner is treated as a partner until his or her interest in the partnership has been completely liquidated. - The death of a partner will close the partnership’s tax year for that partner, but it generally does not close the partnership’s tax year for the remaining partners. A final Schedule K-1 will generally be issued to the deceased partner. - Example: John was a 5% partner in Greenway Consulting, LLP, a cash-basis, calendar-year partnership. John died on August 1. The distributive share of ordinary partnership income allocable to John through the date of his death was $40,000. For the entire year, 5% of the partnership’s income was $55,000. John’s daughter, Amy, inherits her late father’s partnership interest and takes over his role in the business effective on August 1. $40,000 of ordinary partnership income would be reported on John’s final income tax return (Form 1040) via the final K-1 issued to him by the partnership, and the remaining $15,000 of partnership income would be allocated to Amy on her Schedule K-1 from the partnership.

Answer 38

- A buy-sell agreement is a legal contract that binds the partnership to buy out the interest of a deceased partner; this type of agreement helps to ensure that the business will continue uninterrupted. - Example: Global Attorneys, LLP is a calendar year, cash-basis partnership law firm. When the partnership was formed, each partner signed a buy-sell agreement that stated in the event of one partner’s death, the deceased partner's estate would receive $400,000 in full payment for the partnership interest, based on the deceased partner’s share of the partnership’s property. During the year, William, a 20% partner, dies. William’s estate was paid $400,000 by Global Attorneys, LLP in accordance with the buyout agreement. The entire $400,000 will be treated as a distribution. With the 20% partnership now no longer in existence, the remaining partners’ interests will increase proportionately as a result.

Answer 39

- A partnership terminates when all its operations are discontinued and no part of any business, financial operation, or venture is continued by any of the partners in a partnership. The partnership’s tax year ends on the date of termination. - If the partnership is terminated before the end of its regular tax year, Form 1065 must be filed for the short tax year from the beginning of the tax year through the date of termination. The return is due on the fifteenth day of the third month following the date of termination. - Note: If an existing general partnership is later converted into an MMLLC classified as a partnership, the conversion does not terminate the partnership, and there is no sale, exchange, or termination of partnership interests. The partnership’s tax year does not close, and the MMLLC can continue to use the partnership’s existing employer identification number. - Example: Urban Engineering, LLP is a calendar-year partnership. The partnership is having financial difficulties, and the owners decide to dissolve the business. Urban Engineering terminates and stops doing business on May 3. Its final Form 1065 for the short tax year period of January 1 through May 3 is due on August 15, 2023, the fifteenth day of the third month following the end of the month of termination.

Answer 40

- If a partnership terminates and one of the former partners is insolvent and cannot pay their share of the partnership’s debts, the other partners may be forced to pay more than their share of the liabilities. If another partner pays any part of an insolvent partner’s share of the debts, the partner that actually pays the debt can take a bad debt deduction on their individual tax return. - Example: Chester and Dayna are 50/50 partners in Diamond Tutoring, LLC, a company that provides online tutoring services. The company is struggling, and Chester and Dayna decide to discontinue the business. The partnership is terminated, and it has $50,000 of liabilities to creditors after liquidating all of its assets. However, Chester has filed for personal bankruptcy and the court has declared him insolvent. Even though Dayna is a 50% partner, she assumes responsibility for the entire $50,000 of partnership debt, which she pays herself out of her own personal savings. She can claim a bad debt deduction on her Form 1040, in the amount of $25,000, equal to Chester’s share of the debt that she personally assumed.

Answer 41

- Most major companies are organized as C corporations, which are taxed under subchapter C of the Internal Revenue Code. A C corporation can own property in its own name, and it can be sued directly. The shareholders who own stock in a corporation do not own its individual assets. Individual shareholders are protected from legal liability, except in very unusual circumstances. - The IRS requires certain businesses to be taxed as corporations. The following businesses formed are automatically treated as corporations: - A business formed under a federal or state law that refers to it as a corporation - A business formed under a state law that refers to it as a joint-stock company or joint-stock association - Insurance companies and certain banks - A business owned by a state or local government - A business specifically required to be taxed as a corporation by the IRC (for example, certain publicly-traded partnerships) - Certain foreign businesses - Any other entity that elects to be taxed as a C corporation and files Form 8832, Entity Classification Election.

Answer 42

- Perpetual life and limited liability: A C corporation enjoys perpetual life and limited liability. - Double taxation: Earnings of a C corporation may be taxed twice: first at the corporate level and again at the shareholder level if they are distributed as dividends. Shareholders of a C corporation cannot deduct corporate losses. - Shareholder meetings: A corporation must maintain a list of all its shareholders and generally must conduct at least one shareholder meeting per year. - Organization: A C corporation must file a charter, issue stock, and be overseen by a board of directors. - Number of shareholders: A C corporation may have a single owner-shareholder or an unlimited number of shareholders. - Articles of incorporation: A corporation’s existence starts when articles of incorporation are filed with the state office that handles incorporations (usually the Secretary of State), along with any required filing fees. - Liquidation: If a C corporation liquidates, it will recognize gain or loss on the sale or distribution of its assets. Corporate shareholders then recognize gain or loss on the surrender of their stock to the corporation. - Stock: A C corporation may sell common and/or preferred stock with different voting rights. - Tax-free fringe benefits: A C corporation’s shareholder-employees can receive tax-free employee fringe benefits that are deductible by the corporation as a business expense. This applies to employees who are owners of the company as well as other employees.

Answer 43

- A domestic corporation in existence for any part of a tax year (including corporations in bankruptcy) must file an income tax return, regardless of its taxable income or activity. A C corporation files Form 1120, U.S. Corporation Income Tax Return. - There are some specialized forms for other types of corporations, such as foreign corporations, which must file Form 1120-F, or life insurance companies, which file Form 1120-L. - Tax-exempt organizations organized as corporations file Form 990 rather than Form 1120. - A corporation must generally file by the fifteenth day of the fourth month after the end of its tax year. This means that a calendar-year corporation generally must by April 15. - A six-month extension to October 15 is available by filing Form 7004.

Answer 44

- Corporations are required to make estimated tax payments if they expect their tax due to be $500 or more during the taxable year. - Unlike S corporations and partnerships, the late filing penalties assessed against a C corporation are assessed on the amount due (the same as individual taxpayers). If a corporation does not owe any tax for the year, or has an overall loss and no tax liability, then no late filing penalties will be assessed. - Corporations are required to use the Electronic Federal Tax Payment System, (also called EFTPS), to make all federal tax deposits, including estimated tax payments, payroll taxes, excise taxes, and corporate income tax installments are due on a quarterly basis, on the fifteenth day of the fourth, sixth, ninth, and twelfth months of the corporation’s taxable year. - For a calendar year corporation, estimates are due: - April 15-First Estimate - June 15-Second Estimate - September 15-Third Estimate - December 15-Fourth Estimate

Answer 45

- In general, each quarterly federal tax payment is 25% of the corporation’s “required annual payment,” which is the lesser of two amounts: - Current-year tax liability: 100% of the federal income tax reported on the return for the current taxable year of the payment - Prior-year safe harbor: 100% of a corporation’s federal income tax reported on the return for the preceding year - There is no penalty for underpayment of estimated tax if the tax is less than $500, or if each quarterly estimated tax payment is at least 25% of the corporation’s current-year tax. - Unlike individuals, corporations without a tax liability in the preceding year cannot use the 100% prior-year safe harbor amount to determine their required estimated tax payment. The safe harbor provision will also not apply in the following instances: - If the prior tax year was a short year (less than 12 months) - If the corporation did not file a return for the prior year

Answer 46

- If a corporation accidentally overpays its estimated tax, it may use Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax, to obtain a quick refund of its estimated tax payments. - Form 4466 must be filed before the corporation files its tax return. - Form 4466 may be used if a corporation’s overpayment is at least 10% of its anticipated tax liability and at least $500. - Example: Segal Holdings, Inc. is a C corporation that reports its income and loss using the cash method. Segal Holdings has been earning revenue steadily throughout the year and made regular estimated payments during the year based on its current-year tax liability. However, on December 19, 2023, Segal Holdings suffers a severe financial loss when a hurricane destroys its main office building (which was uninsured). After this catastrophic event, Segal Holdings expects to have a net operating loss for the year. The corporation files Form 4466 on January 10, 2024, to obtain a quick refund of the overpaid estimated tax that it paid in 2023. It does not have to wait until it files its Form 1120 in order to obtain a refund of its overpaid tax.

Answer 47

- C Corporations cannot pay any income tax using a paper check; there are no federal deposit coupons or estimated payment vouchers for corporations. - If a corporation owes a very small balance when it files its annual return (under $500) then the corporation can pay using Direct Debit when it e-files its corporate tax return. Otherwise, all payments must be made using EFTPS.

Answer 48

- On February 23, 2023, The Department of the Treasury and the Internal Revenue Service published final regulations amending the rules for filing returns and other documents electronically. - Starting January 1, 2024, corporations are now required to e-file their Form 1120 return, as well as any information returns if they file 10 or more information returns. - This amendment removes the asset threshold and significantly expands the number of corporations that must e-file for the moving forward. A waiver may be requested in cases of undue hardship. - Example: Superior Lumber Company, Inc. is a small C Corporation. The corporation is required to file two Forms W–2, nine Forms 1099–MISC, and seven Forms 1099-NEC. Because Superior Lumber Company is required to file over 10 information returns, the corporation is required to file all its information returns electronically, as well as its Form 1120.

Answer 49

- A C corporation pays tax on its earnings and can accumulate income. - Corporations pay a flat tax of 21% on all their profits. - The federal corporate AMT was repealed by the Tax Cuts and Jobs Act. However, the Inflation Reduction Act created the brand-new corporate alternative minimum tax (CAMT), which generally imposes a 15% minimum tax on the adjusted financial statement income of very large corporations. The CAMT generally applies to large corporations with average annual financial statement income exceeding $1 billion.

Answer 50

- The disadvantage that a C corporation has over other forms of business is that the earnings of a C corporation may be taxed twice–once at the corporate level and once at the shareholder level, through dividend distributions. A corporation does not receive a tax deduction for the distribution of dividends to its shareholders. - A C corporation’s income does not retain its character when it is distributed to shareholders. For example, if a C corporation earns rental income, it pays tax on this and any other sources of income at the corporate level. When the corporation’s after-tax income is distributed to shareholders, this portion does not retain its character as rental income. It is distributed merely as a dividend. - A corporation can have revenue from many different sources, including sales of products, services, and investment income. - Example: Spire Cutlery, Inc. is a C corporation that receives tax-exempt income from bonds. Spire Cutlery subsequently distributes income to its shareholders as taxable dividends. Even though a portion of the income was tax-exempt to Spire Cutlery, it does not retain its tax-exempt character when distributions are made to the shareholders. In contrast, in the case of an S corporation or a partnership, the income would have retained its character when it was passed through to the partners or S corporation shareholders.

Answer 51

- Corporations may be required to submit certain additional schedules along with their Form 1120. - These schedules are unique to C corporations and are primarily used for reconciling “book” or accounting differences with the deductions that are allowable under current tax law. - Differences in accounting rules for financial reporting (also called “book income”) and tax reporting can lead to differences in the amounts of income reported to shareholders and tax authorities. - Preparation of a C corporation’s income tax return includes a reconciliation of book income to taxable income. - Schedule M-1 and Schedule M-3 are both used to reconcile book-to-tax differences. - Schedule L is the balance sheet, based on the corporation’s books and records. - Very small corporations with less than $250,000 of gross receipts or total assets are not required to file Schedule M-1, or Schedule L. - Example: Indigo Shoes, Inc. is a small C Corporation that reports income and loss on the cash basis. Indigo Shoes had $196,000 in gross receipts during the tax year. The corporation’s total assets were $45,000 at the end of the year. Indigo Shoes, Inc. is not required to file a Schedule M-1, or a Schedule L. - Example: Seafoam Design, Inc. is a C Corporation that had $500,000 in gross receipts and $1 million in assets. Seafoam Design must file Schedule L. It may use the simpler, shorter, Schedule M-1 to reconcile the difference between its book income and taxable income. Seafoam Design does not have to file Schedule M-3. - Example: Groveland Manufacturing, Inc. is a large C corporation with $60 million in assets and $95 million in gross receipts for the year. The business must file Schedule L as well as Schedule M-3.

Answer 52

- A corporation is allowed to accumulate a reasonable portion of its earnings for possible expansion or other bona fide business reasons. However, a corporation may be subject to the accumulated earnings tax if it does not distribute enough of its profits to shareholders. This tax was instituted to prevent corporations from hoarding income in order to avoid income tax on distributions for its shareholders. - The accumulated earnings tax is levied at a rate of 20% of the excess amount accumulated. It is not automatically applied; it is assessed only after an audit. A corporation would have the opportunity to try to justify the amount of its accumulated earnings during an IRS examination. - An accumulation of $250,000 or less is generally considered reasonable for most businesses. However, for personal service corporations, the limit is $150,000. “Reasonable needs” of the business include the following: - Specific, definite, and feasible plans for the use of the earnings accumulation in the business. Specific examples include: - The expansion of the company to a new area or a new facility. - Acquiring another business through the purchase of stock or assets. - Providing for reasonable estimates of product liability losses. - The amount necessary to redeem the corporation’s stock included in a deceased shareholder’s gross estate, if the amount does not exceed the reasonably anticipated total estate and inheritance taxes and funeral and administration expenses incurred by the shareholder’s estate.

Answer 53

- A corporation is initially formed by a transfer of money, property, or services by prospective shareholders in exchange for stock in the corporation - Contributions to the capital of a corporation are generally not taxable transactions to the corporation, whether or not they are made by the shareholders. - A shareholder will not recognize gain when a cash contribution is made for stock. This is just like when a person purchases stock on the open market for cash. The shareholder’s basis in the stock is the amount of cash contributed.

Answer 54

- If stock is exchanged for services, the recipient of the stock recognizes taxable income based upon the fair market value of the stock received, and that amount is the taxpayer's basis in the stock. - Example: Danny is a web designer who provides web design services to Outriders Films, Inc. He agrees to accept 300 shares of stock as payment instead of cash. The stock is valued at $5,000. Danny must recognize ordinary income of $5,000 as payment for services he rendered to the corporation. His basis in the stock is $5,000. Several years later, Outriders Films becomes wildly successful, and Danny is able to sell his 300 shares for $150,000. Danny must report a $145,000 long term capital gain on the sale of the stock ($150,000 -$5,000 basis).

Answer 55

- The basis of property contributed to a corporation’s capital by anyone other than a shareholder is zero. - Example: The city of Phoenix, Arizona, gives Bellevue Motors Corporation a plot of land as an enticement to locate its new manufacturing facility there. The city hopes that Belview Motors will bring jobs to the area. Bellevue Motors accepts the land and accounts for the property as a contribution to capital. The land has a zero basis since the property was contributed by a non-shareholder (the city of Phoenix itself contributed the land).

Answer 56

- If a taxpayer transfers property to a corporation in exchange for stock, and immediately afterward, the taxpayer controls the corporation, the exchange may not be taxable. This rule applies both to individuals and to entities that transfer property to a corporation. It also applies to whether the corporation is being formed or is already in operation. - In order to be considered “in control” of a corporation immediately after a section 351 exchange, the transferors must own at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock immediately after the transfer. - Example: Guinevere owns an office building that she rents out to commercial tenants. Her basis in the building is $380,000. She organizes Muldoon Realty, Inc. when the building has a fair market value of $750,000. Guinevere transfers the building to Muldoon Realty for all its authorized capital stock. No gain is recognized by Guinevere or the corporation on the transfer.

Answer 57

- If a corporation transfers its stock in satisfaction of a debt, and the fair market value of its stock is less than the debt, the corporation has to recognize income to the extent of the difference. For example, if the stock is given to an individual to pay for a debt that is owed to the individual, the transfer does not qualify for nonrecognition treatment. - Example: Makeshift Motor Company is having financial difficulties. The company owes its freelance web designer, Tim, over $7,000 in delinquent invoices. Tim threatens to shut down the company’s web page, so Makeshift Motors offers to give 40 shares of stock to the web designer in order to satisfy the debt. Tim accepts the deal, and Makeshift Motors transfers 40 shares of stock with a FMV of $6,000 to Tim. The transfer does not qualify for nonrecognition treatment. Makeshift Motor Company is required to recognize $1,000 of taxable income from the transfer, because the corporation has a gain from the cancellation of indebtedness ($7,000 outstanding debt - $6,000 FMV of the stock).

Answer 58

- A C corporation figures and deducts a net operating loss (NOL) in a similar manner as an individual. Most businesses can now only carry their net operating losses forward. - Qualified farming corporations and casualty insurance companies can still carry back NOLs 2 years. - An NOL may only offset up to 80% of taxable income. - A corporation cannot increase its current year NOL by carrybacks or carryovers from other years in which it has a loss. A prior-year NOL may be carried forward indefinitely. - An NOL carryback or carryforward can only be used to reduce corporate income tax. If the corporation owes other taxes or penalties from a prior or in a future year, an NOL will not reduce the penalties.

Answer 59

- Unlike the favorable capital gains rates available to individuals, the capital gains of a C corporation are taxed at the same rate as its ordinary income. - In the case of a C corporation, capital losses are only deductible to the extent of capital gains. A C corporation is not allowed to offset capital losses against its other income the way individuals can (up to a limit). - A C corporation’s excess capital losses are carried to other years in the following order: - Three years prior to the loss year - Two years prior to the loss year - One year prior to the loss year - Any loss remaining is carried forward for five years (with a few exceptions). - When a corporation carries back or carries forward a capital loss, the loss is treated as a short-term capital loss. A C corporation cannot carry back capital losses to any previous year when it was an S corporation. - If, after carrying back a net capital loss three years and forward five years, any part of the capital loss still remains, it is lost forever, and the corporation cannot use the loss to offset any future capital gains. - Example: Sunburst Corporation incurred a capital loss of ($12,000) during the year. Sunburst Corporation had no capital gain income in the prior three tax years. The result is that Sunburst Corporation shall carry forward its ($12,000) capital loss up to five tax years in the future to offset future capital gains. After five years, any remaining unused capital losses will be lost. - Example: Hazlett Realty, Inc. converted from an S corporation to a C Corporation on January 1, 2023. During the year, Hazlett Realty incurs $13,000 in long-term capital losses. All of the company’s capital losses must be carried forward because the corporation was an S corporation in the prior year. The losses that are carried forward will be treated as short term losses and will reduce capital gains in future years.

Answer 60

- Unlike other business entities, C corporations can deduct a certain amount of charitable contributions made to qualified organizations. - The maximum allowable deduction is limited to 10% of a corporation's taxable income. - Donations in excess of these limits may be carried over and deducted in the following five years, subject to the same limitations. No carryback is allowed for charitable contributions. Any excess contributions not used within that five-year period are lost. - A corporation cannot deduct a carryover of excess contributions to the extent it increases a net operating loss carryover. If there is no taxable income, the corporation would not be able to deduct charitable contributions for that year. - The rules regarding what qualifies as a charitable organization and required supporting documentation are the same for corporations as they are for individuals. - Example: Turnkey Media, Inc. donated $35,000 in cash to the Sierra Wildlife Foundation, a qualified 501(c)(3) charity. Turnkey Media’s taxable income before figuring its charitable contribution deduction is $95,000. The corporation’s allowable charitable deduction is $9,500 ($95,000 × 10% = $9,500). Turnkey Media will have a $25,500 charitable contribution carryover to use in future years ($35,000 actual contribution - $9,500 allowable = $25,500 carryover).

Answer 61

- A corporation using the cash method can deduct charitable contributions in the year they are paid. - A corporation using the accrual method can deduct unpaid contributions if the board of directors authorized the contributions during the year, and the corporation pays the contributions by the due date for filing the corporation’s tax return (not including extensions). - A declaration with a statement that includes the date that the board of directors adopted the resolution must accompany the return. - Example: Healthline Medical, Inc. is a calendar-year, accrual-basis corporation. Healthline Medical’s board of directors approves a charitable contribution of $5,000 to the American Red Cross on December 15, 2023. Healthline Medical deducts the contribution on its 2023 corporate tax return. Healthline Medical, Inc. does not have to pay the contribution until April 15, 2024 (the due date for filing the corporation’s tax return).

Answer 62

- A corporation can deduct a percentage of certain dividends received from other corporations in which it has an ownership interest. - The dividends-received deduction (DRD) is designed to reduce the consequences of double taxation. Without this deduction, corporate profits could be taxed to the corporation that earned them, then to its corporate shareholders, and then again to the individual shareholders of the parent corporation. - Percentage of Stock Ownership --> Dividends Received Deduction: - Less than 20% --> 50% - 20%-80% --> 65% - Greater than 80% --> 100% - Example: Lauder Management, Inc. owns 10% of Klondike Corp. Lauder Management received $50,000 of dividends from Klondike Corp. Lauder Management has taxable income of $70,000 before considering its dividend income. Lauder Management is therefore allowed a 50% dividends-received deduction, figured as follows: $25,000 = ($50,000 × 50% DRD). Lauder Management’s taxable net income is $95,000 ($70,000 + [$50,000 - $25,000]).

Answer 63

- Under federal law, related companies and organizations are treated as a single, controlled group for certain tax purposes. A controlled group is a group of corporations that are related through common ownership, typically as either parent-subsidiary or brother-sister. - Eligible affiliated corporations can elect to file a consolidated return. - Members of controlled groups are also subject to the rules regarding related party transactions that may require deferral of recognition for losses or expenses incurred by one party. - A controlled group of corporations is entitled to only one $250,000 accumulated earnings tax credit. In addition, the employees of those businesses are considered the same employee pool for certain qualified plan requirements.

Answer 64

- A Parent-Subsidiary Controlled Group involves a parent corporation that owns at least 80% of the voting power of at least one other corporation (with possible additional corporations that are at least 80% owned by either the common parent or one of the subsidiary entities); although a foreign corporation would not be considered a member of a controlled group. - Example: Express Corporation is large C Corporation that owns two other, smaller corporations. Express Corporation owns 80% of the outstanding shares of A&B, Inc. Express Corporation also owns 90% of the shares of C&D Inc. A controlled group exists with all three companies. In this scenario, Express Corporation is the “parent company” of the other two, smaller, corporations. These companies can elect to file a single, consolidated corporate return (Form 1120). - Example: Sunshade Corporation owns: - 90% of the stock of Arch Corporation - 80% of the stock of Barstow Corporation - 65% of the stock of Crain Corporation - Unrelated parties own the remaining percentage of stock not owned by Sunshade Corporation. As Sunshade Corporation owns 80% or more of the stock of Arch and Barstow Corporations, it is the common parent of a parent-subsidiary group consisting of the three corporations. Crain Corporation is not a member of the controlled group because Sunshade Corporation’s ownership is less than 80%.

Answer 65

- A Brother-Sister Controlled Group involves situations in which five or fewer individuals, estates, or trusts own 80% or more of the combined voting power for multiple corporations and have identical common ownership within the individual corporations of at least 50%. - Unlike a parent-subsidiary controlled group, the focus in a brother-sister controlled group is on individual ownership. In other words, “effective control” requires collective ownership of more than 50% of the stock of each corporation, (but only to the extent such stock ownership is identical with respect to each corporation).

Answer 66

- Corporate distributions, typically in the form of dividends, occur when cash, stock, or other property is distributed to shareholders based on the shareholders’ ownership of the corporation’s stock. When a corporation earns profits, it may retain the profits in the business (as retained earnings) or pay all or a portion of the profits as dividends to shareholders. - Corporations can issue their own stock to raise capital. Issuing stock has NO IMPACT on a corporation’s net income. - Alternatively, when a corporation later issues a dividend to its shareholders, the corporation cannot deduct the dividend payments as an expense. - This is because if dividends were deductible by a corporation, the entity could effectively eliminate its tax liability every single year simply by distributing any taxable revenues to its shareholders.

Answer 67

- Dividends are most often paid in cash. However, a dividend can take the form of stock or other property. The most common kinds of corporate distributions are: - Ordinary dividends (either in cash or in property) - Capital gain distributions - Nondividend distributions - Distributions of stock or stock rights - The FMV of distributed property becomes the shareholder’s basis in the property. A distribution may be reduced by the following liabilities: - Any liability of the corporation the shareholder assumes - Any liability applicable to distributed property, such as mortgage debt the shareholder assumes in connection with the distribution of ownership in a building - Example: Andrew and Lenny are equal shareholders in Milano Foods, Inc. They each hold 50% of the corporation’s stock. At the end of the year, Andrew receives a distribution of $10,000 in cash, which is taxed to Andrew as a dividend. The corporation does not have enough available funds to make a similar cash distribution to Lenny, so Milano Foods distributes a cargo van to him that has a basis of $15,000 and an FMV of $10,000. Although the van’s fair market value is less than its basis, Milano Foods cannot recognize a loss on the distribution. The distribution amount is considered to be the van’s FMV, which is $10,000. This will be Lenny’s basis in the van.

Answer 68

- A corporation must furnish Form 1099-DIV, Dividends and Distributions, to each shareholder who receives a dividend of $10 or more during a calendar year by January 31. - The corporation is allowed to furnish Forms 1099-DIV to shareholders any time after April 30 of the year of the distributions if the corporation has made its final distributions for the calendar year.

Answer 69

- Accumulated earnings and profits are earnings and profits (E&P) that the corporation accumulated in a prior year and has not distributed to its shareholders. - Note: Any part of a distribution from current year earnings and profits or accumulated earnings and profits is reported as dividend income to the shareholder and is generally taxable as ordinary income to the shareholder rather than as capital gains. - If a corporation’s accumulated earnings and profits are reduced to zero, the remaining part of a distribution reduces the adjusted basis of the shareholder’s stock. This is referred to as a “non-dividend distribution,” and it is not taxable to the shareholder until his or her basis in the stock is fully recovered. - This nontaxable portion is considered to be a return of capital to the shareholder. In other words, non-dividend distributions mean that investors are getting back some of the money they originally invested in the company. - Example: John likes to invest in stock. Five years ago, he purchased 500 shares of SuperGood Software, Inc. for $8,000. On January 10, SuperGood Software, Inc. issues a non-dividend distribution of $8,900 to John. The first $8,000 of the distribution will reduce his stock basis to zero. Since his basis cannot be reduced below zero, the remaining $900 is taxable to John as a long-term capital gain.

Answer 70

- A distribution of property is treated as if the corporation had sold the property to the shareholder. A corporation (either a C corporation or an S corporation) recognizes a gain on a distribution of property to a shareholder if the FMV of the property is more than its adjusted basis. This gain adds to the corporation’s earnings & profits. - A corporation generally cannot recognize a loss on a distribution of property (i.e., where the property’s FMV is less than the adjusted cost basis). - However, a corporation is allowed to recognize losses when depreciated property is distributed to shareholders in complete liquidation (when the corporation ceases operations). - Example: Royal Manufacturing, Inc. distributes to an individual shareholder, Frank, $65,000 of cash, and a small building with a $35,000 adjusted basis and a $50,000 FMV. The transaction is treated as a sale to Royal Manufacturing. Royal Manufacturing must recognize a $15,000 taxable gain on the distribution of property because its FMV is more than its adjusted basis ($50,000 - $35,000 = $15,000).

Answer 71

- Stock distributions or stock dividends occur when a corporation issues additional shares of its own stock to shareholders, rather than paying a cash dividend or distributing property. Stock dividend distributions do not affect the market capitalization of a company, but a stock dividend generally reduces the per-share market price of the company’s stock. - Distributions by a corporation of its own stock or stock rights are tax-free to shareholders and not deductible by the corporation. However, they may be treated as taxable property distributions in rare situations, including when: - The shareholder has the choice to receive cash instead of stock. - The distribution gives cash or other property to some shareholders and an increase in the percentage interest in the corporation’s assets or earnings and profits to other shareholders. - The distribution is in convertible preferred stock. - The distribution gives preferred stock to some shareholders and common stock to other shareholders. - The distribution is paid based on ownership of preferred stock.

Answer 72

- A corporation must capitalize, rather than deduct, the expenses of issuing a stock dividend, such as printing, postage, and any fees for listing on stock exchanges. Typical costs associated with issuing stock include fees for attorneys, accountants, as well as underwriting costs. A corporation may not deduct or amortize costs incurred in connection with issuing its capital stock. - A corporation MAY NOT DEDUCT any of the costs incurred in connection with the initial public offering of stock (also called an “IPO”). - Instead, stock issuance costs are treated as a reduction in the proceeds of the stock sale. They are considered the equivalent of selling the stock at a discount; thus, they do not create an expense that could give rise to a deduction. - Note: An initial public offering (IPO) occurs when a private company issues stock to the public for the first time. This is also commonly referred to as “going public.” The proceeds from the sale of stock shares in an initial public offering provide the issuing company with investment capital. The money that is received by the corporation from a stock sale is not taxable income. Consequently, the costs incurred by the corporation to issue stock are not deductible and must be capitalized. It is equivalent for income tax purposes to the sale of stock at a discount.

Answer 73

- A constructive distribution, also called a constructive dividend, may occur when a corporation confers a personal benefit upon a shareholder. - This would make the transaction nondeductible to the corporation and, in many instances, taxable to the shareholder. Consequently, constructive distributions have a very undesirable income tax impact. Examples of constructive distributions include: - Payment of personal expenses: If a corporation pays personal expenses on behalf of a shareholder, the amounts should be classified as a distribution rather than expenses of the corporation. - Unreasonable compensation: If a corporation pays an employee-shareholder an unreasonably high salary considering the services actually performed, the excessive part of the salary may be treated as a distribution. - Unreasonable rents: If a corporation rents property from a shareholder and the rent is unreasonably higher than the shareholder would charge an unrelated party for the use of the property, the excessive part of the rent may be treated as a distribution. - Cancellation of a shareholder’s debt: If a corporation cancels a shareholder’s debt without repayment by the shareholder, the amount canceled may be treated as a distribution. - Property transfers for less than FMV: If a corporation transfers or sells property to a shareholder for less than its FMV, the excess may be treated as a distribution. - Below market or interest-free loans: If a corporation gives a loan to a shareholder on an interest-free basis or at a rate below the applicable federal rate, the uncharged interest may be treated as a distribution. - Example: Design Source, Inc. rents office space from a 75% shareholder, Timothy, who is the sole owner of the office building. The corporation pays Timothy $25,000 a month for its space. He charges other tenants $5,000 a month for offices with the same square footage. The excessive rent of $240,000 ($25,000 - $5,000 = $20,000 × 12 months) would likely be disallowed as an expense for Design Source and recharacterized as a constructive distribution to Timothy.

Answer 74

- A stock redemption occurs when a corporation buys back its own stock from a shareholder in exchange for cash or property. The stock acquired may then be canceled, retired, or held as Treasury stock. Common reasons why a corporation would redeem a shareholder’s stock include: - To make sure that ownership of the corporation remains with people that were chosen by current owners or by the original founders of the corporation; - To go private by redeeming all publicly traded shares - To increase the market price of the stock through lowering the amount of outstanding shares; - To eliminate hostile minority shareholders; - To retire preferred stock to reduce or eliminate the dividend payments; or - To avert a hostile takeover attempt - If the corporation pays cash to redeem stock, there is no taxable effect to the corporation. - However, if the corporation distributes property for a redemption (instead of cash), then it might have to recognize a gain, (but not a loss) as if the property were sold for the fair market value to the stockholder. (In this scenario, it would normally be advisable for the corporation to sell the property to an unrelated party, recognize a gain or a loss, and then use the cash proceeds from sale for redemption of the shareholder’s stock). - The corporation may not recognize a loss on a stock redemption unless: - The redemption occurs in a complete liquidation of the corporation, or - The redemption occurs on stock held by an estate. - Corporate expenditures incurred in a stock redemption are not deductible by the corporation as a business expense.

Answer 75

- In general, a “qualified” stock redemption must result in a substantial reduction in the shareholder’s ownership. For example, when a shareholder retires or leaves the company permanently, and the other shareholders choose to “buy out” the retiring shareholder’s interest. - A stock redemption by a C Corporation will generally not increase the basis of the stock owned by the remaining shareholders. - Instead, the corporation’s E&P (earnings and profits) is reduced in a qualified stock redemption by the ratable share of E&P attributable to the stock redeemed. - By reducing the corporation’s earnings and profits, this will also reduce the amount of income that would ultimately be taxable to the remaining shareholders. - Example: Micro Devices, Inc. has four unrelated shareholders: Donald, Sandy, Randall, and Jennifer. Randall, a 25% percent shareholder, has a disagreement with the other owners and quits the company. Randall’s 25% stock interest has a fair market value of $400,000. Randall threatens to sell his company stock to an unrelated party. In order to avoid this scenario, Micro Devices, Inc. redeems all of Randall’s stock on his departure for $400,000. For Randall, the stock redemption is treated as a sale, and he will either have a capital gain or loss, just as if he had sold his stock on the open market. The three remaining shareholders, Donald, Sandy, and Jennifer, now own all the outstanding stock. Their individual stock basis would remain the same, although the percentage of the stock ownership of the remaining shareholders would increase. Micro Devices, Inc. would reduce its E&P.

Answer 76

- A corporate liquidation is considered at two levels, the shareholder level, and the corporate level. “Liquidating distributions” are distributions received by a shareholder during a complete or partial dissolution of a corporation. When a corporation dissolves, it redeems all of its stock in a series of distributions. - Complete liquidation occurs when the corporation ceases its activities and distributes any remaining assets to its shareholders. - A corporate dissolution or liquidation must be reported on Form 966, Corporate Dissolution or Liquidation, within 30 days after the resolution or plan is adopted to dissolve the corporation or liquidate any of its stock.

Answer 77

- When a corporation distributes property in a complete liquidation, the transaction is treated as if the corporation sold the distributed assets at their fair market value. The corporation recognizes gain or loss on the liquidation in an amount equal to the difference between the FMV and the adjusted basis of the assets distributed. - Amounts received by the shareholder in complete liquidation of a corporation are treated as full payment in exchange for the shareholder’s stock. Shareholders will normally recognize either capital gain or capital loss from a liquidating distribution, based on the difference between the FMV of the assets received from the corporation less the shareholder’s basis in the corporate stock. - A corporation must file an income tax return for the year it goes out of business, even if it has no income or business activity in that year. - If the dissolution is effective on any day other than the last day of the corporation’s tax year, the final tax return is due on the fifteenth day of the fourth month following the close of its short tax year. - Example: Melon Corporation, Inc. ceases all of its business operations and plans to dissolve. The company distributes a building to one of its shareholders as part of a complete liquidation. The adjusted basis of the building is $600,000, and its fair market price is $500,000. Melon Corporation can recognize a loss of $100,000.

Answer 78

- The rules governing S corporations are found in subchapter S of the Internal Revenue Code. An S corporation has similarities to both a C corporation and a partnership. Like a partnership, an S corporation is a pass-through entity and is generally not taxed on its earnings. Instead, income and losses pass through to shareholders. - Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on corporate income. - S corporations do have some drawbacks. They are less flexible than partnerships. For example, in a partnership, the partners can have different allocations for income and loss based on their partnership agreement. - With an S Corporation, profits and losses must be passed through to the shareholders based on their percentage of stock ownership. Shareholders can’t make any special agreements or arrangements for allocating profits and losses in an imbalanced manner. Unlike C corporations, an S corporation can only have one class of stock (although differences in voting rights are permitted). - S corporations also have very strict limits on the number of shareholders and the type of shareholders that the company can have. A C Corporation does not have any shareholder restrictions. There are some instances in which an S corporation is forced to pay tax on its earnings, like a C corporation, although these instances are rare. - An S corporation generally may choose to use either the cash or the accrual method of accounting, but it does have a required tax year.

Answer 79

- An S corporation generally may choose to use either the cash or the accrual method of accounting, but it does have a required tax year. Generally an S corporation must have IRS permission to use a fiscal year. - An S corporation may always use a calendar year, or any other tax year for which it establishes a bona fide business purpose. A new S corporation must use Form 2553, Election by a Small Business Corporation, to elect a tax year.

Answer 80

- The main requirements for S corporation status are: - It must be a domestic corporation. - It cannot have more than 100 shareholders. - Shareholders generally must be U.S. citizens or U.S. residents, (if individuals), or certain kinds of trusts, banks, estates, or certain tax-exempt corporations. Corporate shareholders and partnerships are generally excluded. However, certain tax exempt corporations, including 501(c)(3) corporations, may be S corporation shareholders. In contrast, an S corporation is allowed to own a partnership interest or own stock in a C corporation. - Nonresident aliens cannot be direct shareholders in an S corporation. - An S corporation can only have one class of stock, but that stock can have differences in voting rights. The difference in voting rights allows one group of shareholders to retain voting control, while allowing other shareholders to benefit from corporate earnings. However, all the stock of an S corporation must possess identical rights to distribution and liquidation proceeds. - Profits and losses must be allocated to shareholders in proportion to each one’s interest in the business. - All shareholders of an S corporation must give consent for the S election.

Answer 81

- For the 100-shareholder limit, related persons can be considered one shareholder. Spouses are automatically treated as a single shareholder. A family, defined as a group of individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, is considered a single shareholder as long as any family member elects such treatment. - When a shareholder dies, the deceased shareholder’s spouse and the estate are still considered one shareholder for the shareholder limit. - However, spouses cannot be considered a single shareholder if they divorce, or if the marriage is dissolved for any other reason than death. Therefore, a shareholder’s divorce can potentially increase the number of shareholders to a number in excess of the 100-shareholder limit. - If an S corporation fails to meet this restriction, the S election is considered terminated, and the S corporation ceases to be an S corporation and is instead taxed as a C corporation.

Answer 82

- An S corporation must generally be owned only by individuals, trusts, or estates. S Corporations cannot be owned by another S corporation, a C corporation, or a partnership. - However, an S corporation is allowed to have another S corporation as a wholly-owned subsidiary; this is called a qualified Subchapter S subsidiary, also referred to as “QSSS” or “Q-Sub.” For example, if one S corporation acquires another S corporation, the acquired S corporation can be treated as a subsidiary by filing a proper election using Form 8869. - The acquired S corporation is called the “subsidiary,” while the purchasing corporation is called the “parent” corporation. If a proper Q Sub election is not filed, then the acquired corporation will be treated as a C corporation for tax purposes.

Answer 83

- An S corporation files its tax return on Form 1120-S. Allocated amounts of income, deductions, and credits pass through to individual shareholders and are reported on Schedule K-1. - The return must be signed and dated by an authorized corporate officer or, in certain instances, by a fiduciary, such as a receiver, trustee, or assignee, on behalf of the corporation. - An S corporation is always required to file a tax return, regardless of income or loss. The filing requirement ends only when the corporation is legally dissolved. - The tax return is due on the fifteenth day of the third month following the tax year-end. For a calendar-year S corporation, the tax return is due March 15. A six-month extension of time to file can be requested using Form 7004.

Answer 84

- To become an S corporation, a corporation (or other eligible entity) must file an election on Form 2553, Election by a Small Business Corporation. - The filing must be made no later than the 15th day of the 3rd month after the start of its tax year for the election to be effective at the beginning of the year. - Example #1: (No prior tax year): Milltown Minerals, Inc. is a newly formed corporation that incorporated on January 9, 2024. In order to elect to be an S-Corporation beginning with its first tax year, Milltown Minerals must file Form 2553 anytime between January 9 and March 24 (within 2 months and 15 days after the start of its first tax year). Because the corporation had no prior tax year, and was not incorporated until January, any S corporation election made before January 9 would not be valid. - Example #2 (Prior tax year): American Copiers, Inc. is a calendar-year C corporation that has been filing Form 1120 for the past five years. American Copiers wishes to convert to an S corporation and make an S election for the tax year beginning January 1, 2024. In order to be an S corporation beginning January 1, 2024, the corporation must file Form 2553 on or before March 15, 2024. Because the corporation was already in existence and had been filing as a C corporation in the past, it can also make the election at any time during the prior tax year (2023) to make it effective for the following year (2024).

Answer 85

- If the S election is made during the corporation’s tax year for which it first takes effect, each individual shareholder who holds stock during the year must also consent to the election. This is true even if the person may have sold or transferred his or her stock before the election is made. - Example: Harrison, Silvia, and Nicholas are all equal shareholders in Salem Hardware, Inc., a calendar year C corporation. On January 5, 2023, Nicholas decides to retire from the business. Nicholas sells all his shares in Salem Hardware to Martha, his cousin, completing the stock sale on February 1, 2023. Two weeks later, on February 14, 2023, Harrison, Silvia, and Martha vote to elect S corporation status. The corporation must file Form 2553 on or before March 15, 2023 to make it effective for 2023, and all the current shareholders must agree to the election. In addition, Nicholas must also consent to, and sign, the S election (Form 2553) even though he is no longer a current shareholder and sold all his stock before the election was made. This is because Nicholas was still a shareholder at the beginning of the year that the corporation wants to make the election.

Answer 86

- Note that the same rule DOES NOT hold true for S Corp conversions to a C Corporation. - Example: Larry, Tim and Karen are shareholders in Jumbo Candies Inc., an S corporation that has been in existence for three years. Larry owns 55% of the corporate stock, and Tim and Karen own the remainder. Larry decides that he wants to convert Jumbo Candies, Inc. to a C corporation. Larry may choose to convert to a C corporation because he owns more than 50% of the stock. He does not need the other two shareholders’ consent.

Answer 87

- All the income of an S corporation must be allocated to the shareholders, even if it is not distributed. Income, gains, losses, deductions, and credits are allocated to each shareholder on a pro-rata basis. The shareholder then reports the items on his or her tax return. Some of the items that pass through to shareholders on a pro-rata basis and retain their character must be separately stated on an S corporation’s tax return. These include: - Net income or loss from rental real estate activity (rental income) - Portfolio income or loss (interest income, dividend income, and royalty income, etc.) - Capital gains or losses - Section 1231 gain or loss - Charitable contributions - Section 179 expense deduction - Foreign taxes paid or accrued - Any business credits - Investment interest expense - Tax preference and adjustment items needed to figure a shareholder’s AMT - Nonbusiness bad debts - Unlike a C corporation, an S corporation is not eligible for a dividends-received deduction. - Example: Diamond Toys, Inc. is an S corporation with a single shareholder named Noah. Diamond Toys has $100,000 of gross receipts; $40,000 wage expense to Noah, its shareholder; $15,000 of charitable contributions; $10,000 of rental losses; and $8,000 of capital gains. Its ordinary business income is $60,000 ($100,000 gross receipts - $40,000 wages). The other items are all separately stated on Form 1120-S and are not used to determine the corporation’s ordinary income or loss.

Answer 88

- S corporation shareholders must pay taxes on their share of the corporation’s current year income, regardless of whether the amounts are distributed. - The taxable amount of each distribution is contingent upon a shareholder’s stock basis, and it is the shareholder’s responsibility to track his individual basis. - Distributions from an S corporation must be paid to all shareholders on the same date as pro-rata distributions based on the shareholders’ individual ownership percentages.

Answer 89

- The amount of an S corporation distribution is equal to the sum of cash and the fair market value of the property received by a shareholder. If an S corporation distributes appreciated property, the distribution is treated as a sale to the shareholder. - To the extent the FMV of the property exceeds the corporation’s adjusted basis, the corporation would recognize gain. The gain passes through to the shareholders and increases the basis of their stock. No loss is recognized if the FMV of the distributed property is less than the corporation’s basis.

Answer 90

- S corporations generally are not subject to taxation since they are primarily pass-through entities. However, in certain cases, S corporations are subject to taxes. A subchapter S corporation may have to pay income tax due to: - Excess net passive investment income - Built-in gains - Investment credit recapture - LIFO recapture - Except for the investment credit recapture provision, these taxes normally only apply to corporations, which were once C corporations, and then converted to S corporations at a later date. If the corporation has always been an S corporation since its inception, these taxes generally will not apply.

Answer 91

- An S corporation may wish to pay little or no salary or wages to employees or officers who are also shareholders, instead choosing to issue distributions of corporate profits instead. S corporation distributions are subject only to regular income tax. Unlike wages, distributions are not subject to withholding or payroll taxes. - However, the IRS wants companies to pay their fair share of payroll taxes, and therefore requires that S corporation shareholders who are also employees take adequate compensation for any services performed. This means that S corporations must pay employee-shareholders reasonable wages before making distributions. - If an S corporation is not paying “reasonable compensation” to a shareholder-employee, the IRS may reclassify distributions to the shareholder as wages, subject to employment taxes. Therefore, an S corporation will be at risk if it attempts to avoid paying employment taxes by having its officers treat their compensation as cash distributions, payments of personal expenses, or loans rather than as wages. - The regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and receives no compensation. Such an officer would not be considered an employee for tax purposes. - Example: Lawrence was the sole shareholder and employee of an S corporation. He was an experienced accountant with a master’s degree in business administration. His firm had annual revenues of $1.5 million. Lawrence paid himself an annual salary of $24,000 and received distributions from the firm of $400,000. The IRS concluded Lawrence was deliberately paying himself a low salary to avoid employment taxes and required that $150,000 of the distributions be reclassified as salary. Additional employment taxes, penalties, and interest were assessed on the reclassified payments.

Answer 92

- If a shareholder sells or disposes of their stock in an S corporation, it is treated in the same manner as the sale of stock in a C corporation. The shareholder reports the sale of the stock on Schedule D. The gain or loss that is recognized by the shareholder is the difference between the shareholder’s basis and the sale price of the stock. - If a shareholder in an S corporation terminates their interest in a corporation during the tax year, the corporation, with the consent of all affected shareholders (including those whose interest is terminated), may elect to allocate income and expenses as if the corporation’s tax year consisted of two separate short tax years, the first of which ends on the date of the shareholder’s termination. - To make this election, the corporation must attach a statement to a timely filed original or amended Form 1120-S for the tax year for which the election is made and state that it is electing to treat the tax year as if it consisted of two separate tax years. The statement must also explain how the shareholder’s entire interest was terminated (e.g., sale or gift), and state that the corporation and each affected shareholder consented to the election. - A single statement may be filed for all terminating elections made for the tax year. If this election is made, “SECTION 1377 (a (2) ELECTION MADE” should be written at the top of each affected shareholder’s Schedule K-1. - Example: Fairborn Realty, Inc. is an S corporation that operates on a calendar-year basis. Fairborn Realty has two equal shareholders, Hugo and David. Fairborn Realty has a $10,000 loss for the first six months of the year (from January 1-June 30). On July 1, Hugo sells his entire stock interest in Fairborn Realty to Laura, an unrelated person. There are no more items of income or loss for the rest of the year. Fairborn Realty makes a Section 1377(a)(2) election on its tax return. The $10,000 loss would be allocated to the short taxable year ending June 30 (in other words, the first part of the year, when Hugo and David were still shareholders). Hugo and David would each be entitled to $5,000 of the loss, which would be reported on their respective Schedules K-1. Since Fairborn had no other activity for the rest of the year, Laura would not have any income or loss allocated to her.

Answer 93

- Once the S election is made, it stays in effect until terminated. In addition to the ways already discussed, the election will terminate automatically in any of the following cases: - The corporation no longer qualifies as a small business corporation. - For each of three consecutive tax years, the corporation - Has accumulated earnings and profits, and - Derives more than 25% of its gross receipts from passive investment income. - The corporation creates a second class of stock (such as preferred stock and common stock). - The shareholders willingly revoke the S election. - When an S election is terminated, two short tax years are created for the corporation. Income and loss must be allocated on a pro-rata basis between the period the corporation operated as an S corporation and the period as a C corporation that was created when the S election was terminated. - Example: Adventure Capitalist, Inc. is a calendar-year S corporation with three equal shareholders, Christopher, Elijah, and Meghan. Elijah and Meghan want to revoke the S election in order to become a C corporation, so they can broaden their investor base to include foreign shareholders. Christopher does not want to revoke the election. Together, Elijah and Meghan own more than 50% of the corporation’s stock (they each own a third). Therefore, they can revoke the S election without Christopher’s consent. Elijah and Meghan prepare and sign a formal revocation statement and mail it into the IRS, and their status as an S corporation will be revoked. After the revocation, the corporation will be treated as a C corporation.

Answer 94

- Sometimes a corporation will inadvertently terminate its election. For an “inadvertent termination,” a corporation’s S election terminates effective on the date that the company commits the act that triggers the ineligibility. - An S corporation election can be inadvertently terminated in several ways. For example, when a married couple divorces, and the two ex-spouses cause the shareholder limit to exceed 100. The date of the event would be the “termination date.” - Another common terminating event is when an S corporation makes disproportionate distributions—for example, distributing cash to some shareholders, but not to others. This could potentially be viewed as creating a second class of stock and terminating S status. A terminating event will be considered inadvertent if the event was not within the control of the corporation, and the shareholders did not plan to terminate the election. - In the past, S corporations with inadvertent terminations were forced to request a private letter ruling, which was costly. However, the IRS recently released Revenue Procedure 2022-19, which permits S corporations to remedy most inadvertent terminations of S corporation without having to request a private letter ruling. - Great podcast on this by Tony Nitti: https://taxodyssey.libsyn.com/6-reasons-an-s-corporation-wouldnt-need-a-plr

Answer 95

- The IRS now permits automatic relief (without having to request a PLR) under the following six circumstances: - One-class-of-stock requirement - Disproportionate shareholder distributions - Certain errors or omissions on Form 2553 or Form 8869 - A missing administrative acceptance letter (called the “Notice of Acceptance”) for an S election or QSub election - The filing of a federal income tax return inconsistent with an S election or QSub election (S Corporations file a Form 1120-S, and a QSub is included on the “parent” corporation’s Form 1120-S). - Correcting one or more non-identical governing provisions. - The IRS will no longer provide private letter rulings in scenarios covered by this Revenue Procedure. - If the status of an S corporation is terminated, either because the shareholders elect to become a C corporation or because a terminating event has occurred, the S corporation normally cannot elect to become an S corporation again within the next five years (60 months). However, the IRS may choose to waive the five-year restriction.

Answer 96

- Dunbar Consulting Inc. is a calendar-year S corporation. The corporation inadvertently terminates its S status during the year. Ramon, a 10% shareholder, was a U.S. resident alien at the beginning of the year. On March 3, Ramon became a nonresident alien by voluntarily abandoning his LPR status (Legal Permanent Residence) and surrendering his green card. Because some of its corporate stock was owned by a nonresident alien, the S election is terminated. The S corporation shareholders immediately correct the problem, by transferring all of Ramon’s stock to a permitted shareholder. Dunbar Consulting must request a private letter ruling for termination relief. The PLR fee is $38,000, which must be submitted with the request. The IRS receives the company’s request, and agrees the termination was inadvertent. Therefore, the S corporation’s “S status” is considered to have been continuously in effect, and no termination is deemed to have occurred. Only a single S corporation tax return will need to be filed for the tax year. (Based on PLR Number: 201150024).

Answer 97

- For Part 1 of the EA exam, you must understand compensation and fringe benefits from the employee’s perspective. For Part 2, you must know how these benefits are treated from the employer’s perspective. - Employee compensation can take many different forms. “Compensation” usually refers to regular wages, but it can also include other incentives, such as fringe benefits, stock options, and other company benefits.

Answer 98

- Transfers of property to an employee can also be considered compensation. If an employer transfers property (for example, a vehicle, equipment, or other property) to an employee, the employee must recognize the property as taxable compensation on the date of the transfer. - Wages paid in any medium other than cash is computed based on the fair market value of such items at the time of payment. - In other words, the fair market value of the property transferred to the employee is what is used to compute the wages. The business will recognize a gain or loss on the transfer equal to the difference between the fair market value and its basis in the property. - Example: ABC Manufacturing is having cash flow difficulties. The company offers one of its employees a used truck in lieu of his weekly salary. The employee gladly accepts the truck. The amount that must be recognized by the employee is the FMV of the vehicle on the date of transfer. The company, on the other hand, must treat the transfer as a sale. - Note: If an employee’s wages are paid in property rather than money, the employer is responsible for ensuring that the amount of the payroll tax required to be withheld is available for payment in money (Rev. Rul. 2004-37).

Answer 99

- A fringe benefit is an extra benefit supplementing an employee’s salary. It is a type of non-cash compensation that may be offered by a business to make positions more desirable for employees. There are many types of fringe benefits that employers are allowed to offer their employees on a tax-free basis. - Examples include: medical and dental insurance, use of a company car for business-related errands, subsidized meals, and employee discounts. Some fringe benefits may be partially taxable. Examples of taxable fringe benefits include: - Off-site athletic facilities and health club memberships, - Concert and athletic event tickets, - Intangible property such as vacations, stocks, or securities, - The value of employer-provided life insurance over $50,000, - Any cash benefit or benefits in the form of a credit card or gift card (an exception applies for occasional meal money or transportation fare to allow an employee to work beyond normal hours), - Transportation benefits, if the value of a benefit for any month is more than a specified non-taxable limit, - Employer-provided vehicles, if they are used for personal purposes or commuting. - Note: Because of the Tax Cuts and Jobs Act, most entertainment expenses are no longer deductible. Therefore, the cost of entertainment provided to an employee is no longer a non-taxable fringe benefit. There is an exception for entertainment expenses that are directly for the benefit of employees, (i.e., occasional office parties or company picnics that include all the staff).

Answer 100

- A “cafeteria plan” is a written benefit plan that provides employees an opportunity to choose between receiving at least one taxable benefit, such as cash, and one qualified (nontaxable) benefit. It is called a “cafeteria plan” because employees are allowed to choose between different types of benefits or elect to receive an amount in cash. - A cafeteria plan is the only way an employer can offer employees a choice between taxable and nontaxable benefits without the choice causing all the benefits to become taxable. A plan offering only a choice between taxable benefits is not a cafeteria plan. - Employees generally contribute a portion of their salaries on a pre-tax basis to pay for a portion of the qualified benefits. Having a salary reduction option is typically deemed sufficient to satisfy the requirement to provide a taxable option, even though the amounts are withheld on a pre-tax basis. The plan may make benefits available to employees, their spouses, and their dependents. - Note: A major disadvantage of a cafeteria plan is that these plans are costly and time consuming to administer. Large employers must pay for annual nondiscrimination testing. For smaller employers, a “simple cafeteria plan” is available, which enables employers with 100 or fewer employees to bypass annual nondiscrimination testing. - Example: Bluebell Accounting, Inc. offers a cafeteria plan to its 95 employees. The cafeteria plan includes options such as health insurance, dental and vision insurance, retirement savings and more. Samantha is a full time auditor for Bluebell Accounting. Samantha gets to choose the types of healthcare options she wants and decline the ones she doesn’t. Samantha declines the health coverage, because she already has coverage that she likes through her husband’s employer. She does choose to enroll in the Dependent Care FSA, and the life insurance coverage. The Dependent Care FSA (DCFSA) is a pre-tax benefit account she can use to pay for daycare. Because the amounts contributed to her FSA are pre-tax, it can substantially reduce Samantha’s income taxes, as well as her Social Security and Medicare taxes.

Answer 101

- Nondiscrimination testing was put into place to ensure all employees benefit from the company retirement plans and cafeteria plans, not just highly paid executives. The IRS requires employers to make sure their cafeteria plans do not favor highly compensated employees over the rest of the company’s employees. - If a cafeteria plan favors either “highly compensated employees” (HCEs) or “key employees” as to eligibility to participate, contributions, or benefits, the employer must include in their taxable income the value of taxable benefits they could have selected. - This is intended to discourage employers from offering tax-free benefits to their owners or highly compensated executives while ignoring lower-paid employees. - The IRS uses a process called “family attribution” in order to make the determination of who qualifies as either an HCE or a key employee, which means that an employee can be determined to be an HCE or key employee merely by familial relationship. An employee who is a spouse, child, grandparent or parent of someone who is a 5% (or greater) owner of the business, is also automatically considered an “owner” under the family attribution rules.

Answer 102

- Example: McCarthy Construction, Inc. sponsors a cafeteria plan. The company has 200 employees, including 20 executives which are considered highly compensated employees. During the year, the president of McCarthy Construction decides to change their cafeteria plan and only offer their health care FSA to the executives, excluding all the lower-paid workers. A health care FSA cannot discriminate in favor of highly compensated employees (HCEs) as to eligibility to participate. Therefore, the company’s plan fails discrimination testing. Unless corrections are made, all the health benefits offered to the executives will become taxable to them as wages.

Answer 103

- Accident and Health Benefits - Adoption Assistance Programs - Group Term Life Insurance: Group-term life insurance is a nontaxable fringe benefit, but only up to a certain amount. The cost of the first $50,000 of group-term life insurance coverage a company pays on behalf of an employee is excludable from the employee’s taxable income. If the company pays for more than $50,000 of coverage, the excess benefit must be included in the employee’s taxable income. - Some employers only pay for the first $50,000 of group-term life insurance coverage and then offer additional coverage at the employee’s expense. If the employee pays for the additional life insurance coverage after $50,000, the amounts that the employee pays are not counted as taxable income to the employee. - Group term life insurance on an employee’s dependents can be offered as a de minimis fringe benefit if the coverage offered is $2,000 or less. If the dependent or spousal life insurance benefit is greater than $2,000, then the Fair Market Value of the entire benefit must be included in the employee’s income.

Answer 104

- An HSA is a type of health savings account that is owned by the employee. This means that the employee has complete control over the funds, and any contributions an employer makes to an HSA become the employee’s property and cannot be withdrawn by the employer. Contributions to an HSA are typically used to pay medical expenses of the account owner, spouse, and any dependent. - An employer’s contribution amount to an employee’s HSA must be comparable for all employees who have comparable coverage during the same period, or there will be an excise tax equal to 35% of the amount the employer contributed to all employees’ HSAs (i.e., the plan cannot discriminate in favor of highly compensated employees). - However, an employer is allowed to make larger HSA contributions for a non-highly compensated employee than for a highly compensated employee (i.e., the plan may discriminate against highly compensated employees).

Answer 105

- No contributions can be made to an individual’s HSA after he or she becomes enrolled in Medicare. Any excess contributions to an HSA are subject to a 6% penalty tax unless corrected by the deadline (generally the HSA owner’s filing due date, plus extensions). - Example: Hillary, who is single with no dependents, has always participated in an HSA offered by her employer. Hillary turns age 65 on January 10, and promptly enrolls in Medicare. She ceases to be an eligible individual for HSA purposes when she becomes enrolled in Medicare. Therefore, she is no longer eligible to participate in the HSA. Hillary is unaware of this rule, so she accidentally contributes $3,000 to her HSA, meaning to use the amounts for medical expenses later in the year. Hillary must withdraw the excess HSA contribution before the due date of her tax return, or she will be subject to an excise tax of 6%.

Answer 106

- An FSA and an HSA are not the same thing! Flexible spending accounts (FSA) and health savings accounts (HSA) are both fringe benefits that can reduce an employee’s income tax liability. However, an HSA is always paired with a high-deductible health plan, and the funds in an HSA are immediately vested, meaning that the HSA funds belong to the employee, not the employer. An HSA is also “portable.” The account “moves” with the employee if they change employers or leave the workforce.

Answer 107

- An FSA (flexible spending account) is a form of cafeteria plan benefit that reimburses employees for expenses incurred for certain qualified benefits. Through the use of FSAs, participants can pay their out-of-pocket costs using pre-tax dollars. - This type of plan is a voluntary agreement to reduce an employee’s salary in return for an employer-provided fringe benefit. The reimbursements from the FSA to the employee are tax-free. - The most common type of FSAs are dependent care FSAs (DCFSA), and health care FSAs (HCFSA). - Dependent Care FSA: A Dependent Care FSA is limited to $5,000 per calendar year, per family ($2,500 if MFS). The FSA must be provided for a qualifying person’s care to allow the employee to work. The exclusion cannot exceed the smaller of the earned income of either the employee or, if married, the employee’s spouse. DCFSA funds are tax-free if the amounts are used for qualifying daycare expenses. A “qualifying dependent” is generally a child under age 13, a disabled spouse, or a dependent parent in eldercare. - Health Care FSA: Health FSAs are commonly funded by employees through voluntary salary reduction contributions, and employers may also contribute. Contributions to an FSA are not includible in the employee’s wages, and reimbursements from an FSA that are used to pay qualified medical expenses are not taxed.

Answer 108

- FSAs are sometimes referred to as having a “use-it-or-lose-it” rule. Normally, employers are allowed two choices: - A limited carryover, which allowed participants to carry over part of their unused health care FSA balances remaining at the end of a plan year. - Or, a company may also choose to allow an employee a grace period of up to two-and-a-half months from the end of the plan year to use the remaining balance. - FSA plans can elect either the carryover or grace period option but not both. These options are solely at the employer’s discretion. - At the end of the grace period, all unspent funds would be forfeited back to the employer. - Example: Mandy is widowed and works as a secretary for Grady Manufacturing, Inc. Mandy has a DCFSA (dependent care FSA) which she uses to pay for her 8-year-old son’s daycare so she can work. Mandy directs her employer to withhold the maximum of $5,000 in her DCFSA, so she can use the amounts to pay for her son’s daycare. The amount is deducted from her paycheck each pay period. The amounts are reimbursed tax-free if used for qualifying daycare expenses.

Answer 109

- The 21st Century Cures Act (Cures Act) provides a method for small employers to reimburse individual health coverage premiums up to a dollar limit through a “Qualified Small Employer Health Reimbursement Arrangement” (QSEHRA). - A QSEHRA is not a group health plan. Employers with fewer than 50 full-time employees that do not offer a group health plan are able to offer a QSEHRA. - A QSEHRA can only be funded by the employer, and no employee contributions are permitted. The arrangement provides for reimbursement of the medical expenses incurred by the employee or the employee’s family members. The employee’s coverage does not need to be provided by the employer. - QSEHRAs are subject to annual limits. Employers are permitted to set a lower QSEHRA limit, as long as the limit is consistent for all eligible employees. - Example: Successful Sports, LLC is a retail sports memorabilia shop. The business has 11 full-time employees. The business is not subject to ACA requirements. Rather than offering a group health plan, the business owners decide to set up a QSEHRA, and offer to reimburse the employee’s out-of-pocket health insurance premiums instead. Successful Sports selects a flat, $425 monthly reimbursement amount for all the employees and limits the reimbursement to health insurance premiums. The reimbursements are deductible by Successful Sports as a business expense, and not taxable to the employees.

Answer 110

- A “working condition fringe” benefit is a type of fringe benefit employers offer employees so they can perform their jobs. This can be any property or service provided to an employee to the extent that, if the employee paid for the property or service, the amount paid would be deductible as a business expense. - There are many different types of “working condition” fringe benefits that are deductible to the employer and not taxable to the employee, and this can vary, depending on the specific industry. - A common working condition benefit is an employee’s use of a company car for business purposes. A company car may be partially taxable if the employee uses it for commuting or other personal use. - However, there is an exception for “qualified nonpersonal-use” vehicles. These are vehicles that an employee is unlikely to use more than minimally for personal purposes because of its design. Examples include fire trucks, police cars, hearses, school buses, cement mixers, and tractors. Also, any vehicle designed to carry cargo of over 14,000 pounds is automatically qualified as a “nonpersonal-use” vehicle. - Example: Heaton is employed as a full-time accountant with Carville Public Accountants. His accounting firm provides all the accountants with a yearly subscription to an accounting trade journal, the Journal of Forensic Accountancy. The subscription costs $245 per year. The amounts are not included in Heaton’s income, and fully deductible by his employer as a business expense. - Example: Phillip is a professional welder. His employer, Texas Welding Services, Inc., provides personal protective equipment for all of its employees. This includes a welding helmet, face shield, coveralls with fire-resistant sleeves, and safety goggles for every welder. None of this safety equipment is taxable, because it is required for the employees to do their jobs. - Example: Officer Samuel Jones is a police officer in a small town. Each officer in the district has an assigned car. Officer Jones is required to take his police car home. In the case of an emergency, he uses the car to respond to the scene and support his department. The police car is clearly marked as a police vehicle. Therefore, the officer’s limited personal use of the vehicle is not a taxable benefit.

Answer 111

- An employer-provided cell phone is another common working condition benefit. There must be a substantial business reason to provide the employee a cell phone; it cannot simply be used to boost an employee’s morale, to attract a prospective worker, or as a means of providing additional compensation to an employee. - Example: Janelle is an executive for TrenchCoat Media, Inc., an advertising firm in New York. Janelle frequently visits clients at their business locations. She uses her employer-paid cell phone to keep in touch with clients and her employer while she is out of her office. Her company provided cell phone is a non-taxable fringe benefit.

Answer 112

- A business can reimburse employees for business-related expenses on a tax-free basis. The requirements of an accountable plan are applied on an employee-by-employee basis. There are two types of reimbursement plans: - Accountable Plans: Amounts paid under an accountable plan are deductible by the employer, but they are not taxable wages and are not subject to income tax withholding or payment of Social Security, Medicare, and FUTA taxes. - Nonaccountable Plans: Amounts paid under a nonaccountable plan are taxable to employees as wages and are subject to all employment taxes and withholding. Generally, there are no substantiation requirements for a nonaccountable plan. - For reimbursements to qualify as nontaxable under an accountable plan, the employee must follow strict guidelines in order to have the expenses reimbursed. An accountable plan requires employees to: - Have incurred the expenses while performing services as employees. - Adequately account for the expenses within a reasonable period of time. - Provide documentary evidence of travel, mileage, and other employee business expenses. - Return any excess reimbursement or allowance to the employer within a reasonable period of time, if paid in advance. A cash advance must be reasonably calculated to equal the anticipated expense, and the employer must make the advance within a reasonable period of time. - Sample accountable plan from Intuit: https://proconnect.intuit.com/taxprocenter/wp-content/uploads/2017/09/a21e5-accountableplanagreement.pdf - Example/Accountable Plan: Victoria is a medieval history professor at Sandpoint University. The university has a written accountable plan. Victoria was invited to speak at a history conference in a different state. She submits all of the expenses that she incurred while at the conference. The university reimburses Victoria’s mileage, up to the current IRS standard mileage rate, as well as for lodging and other travel expenses as it related to the conference. However, the university did not reimburse Victoria’s other expenses: amenities such as movies, in-room bars, and a spa manicure, which she enjoyed in the evening after the conference. Those expenses were personal in nature. - Example/Non-Accountable Plan: Electra is a sales representative who works for Simulant Pharmaceuticals, Inc. Electra uses her own vehicle to travel to doctor’s offices and hospitals while making sales calls. Simulant Pharmaceuticals gives Electra a $500 auto allowance per month ($6,000 total for the year) to cover her automobile expenses. Electra does not have to provide any proof of her expenses to her employer. Electra is being reimbursed under a nonaccountable plan. Her employer must include the $6,000 on Electra’s Form W-2 as if it were wages. The full amount would be deductible to the business as wages, but subject to payroll taxes and withholding.

Answer 113

- Special rules allow employers to grant “employee achievement awards” that are excludable from an employee’s wages if the awards are tangible personal property (i.e., the awards cannot be made in cash or gift cards, or any cash equivalents), subject to certain deduction limits. Employers may generally exclude the value of awards given for length of service or safety achievement. - “Qualified plan awards” are employee achievement awards under a written plan that does not discriminate in favor of highly compensated employees. An employer’s deduction and the tax-free amount for each employee are limited each year to the following: - $400 for awards that are not “qualified plan” awards. - $1,600 for all awards, if an employee receives both qualified and non-qualified awards during the year. - Example: White Lumber, Inc. gives a set of golf clubs to Royce, as an employee award for outstanding sales achievement. Royce is a highly paid executive. The fair market value of the golf clubs is $750. Only the company’s top executives are allowed to receive sales awards. Because the sales awards are only available to the highest-paid employees, the award is treated as a “nonqualified plan” award. The amount of the award that must be included in taxable wages to the employee is $350 ($750 - $400). White Lumber, Inc. can deduct $400 as a business expense, with the excess being deductible as wages (and therefore subject to all payroll taxes). If the award had been available to all the company’s employees, then the entire amount would have been deductible as a business expense, and the executive (Royce) would not have to report any taxable amount. - Example: Lasalle Motors, Inc. is an auto manufacturer. Lasalle Motors offers each employee a nice silver watch when they reach 10 years of service with the company. All the employees are eligible for length-of-service awards, even the lowest-paid workers. Each watch is worth $650, and the same watch is given to all employees that have been with the company for 10 years. Osmund has worked for Lasalle Motors for the required 10 years, and he receives a silver watch upon completing 10 years with the company. The watch is not taxable to Osmund, and it is deductible as a business expense to LaSalle Motors.

Answer 114

- The value of an employee’s use of a health club or athletic facilities may be excluded from wages, but only if the facility is on premises that the employer owns or leases. If the employer pays for a gym membership or a fitness program provided to the employee at an off-site location, the value must be included in the employee’s compensation. - Example: Austin Children’s Hospital has a small, on-site gymnasium which is available for employees to use. There are several treadmills and a set of free-weights that hospital employees may use, either on their break or after their shift ends. The gym helps employees reduce stress, and exercise helps keep the employees healthy. The use of the on-site gym is not taxable to the employees, and the hospital can deduct the cost of the gym equipment.

Answer 115

- An employer may exclude from taxable wages the value of meals and lodging it provides to employees if they are provided: - On the employer’s business premises, such as in an employer’s cafeteria, and/or - For the employer’s convenience. - Under the TCJA, meals provided to an employee by the employer (for example, food and beverages provided at no charge through a cafeteria operated by the employer) on the employer’s property are not taxable to the employee, but the employer only receives a 50% deduction. - In regards to lodging, employer-provided lodging is generally 100% deductible by the employer and not taxable to the employee. Lodging can be provided to the employee, the employee’s spouse, and the employee’s dependents, and still not be taxable. The exclusion from taxation does not apply if the employee can choose to receive additional pay or a cash allowance instead of free lodging. - Example: Alaskan Drilling, Inc. employs several employees at a remote drilling site. Due to the inaccessibility of facilities for the employees who are working at the job site to obtain lodging and the prevailing weather conditions, Alaskan Drilling furnishes lodging to all its employees at the site in order to carry on the drilling project. The company may exclude the value of the lodging that it provides to its employees from their wages. The costs associated with the lodging facilities would be fully deductible by the company. - Example: Snowcap Ski Resort, Inc. offers free employee housing to all its full-time seasonal and year-round employees at all the ski areas it owns. The free housing is also extended to include the employee’s spouse and dependents. The on-site housing is mandatory, because it allows the employees to be on-call 24/7 for any emergency, such as an avalanche, which can be a real threat to skiers. Since the on-site housing is for the convenience of the employer, and also for the safety of the resort’s patrons, it is nontaxable to the employees and deductible by the employer. - Example: Summit Property Management, Inc. employs fifteen full-time employees. The company pays for tea, coffee, and granola bars for the employee break room. These foods and beverages are considered a de minimis benefit, and not taxable to the employees. Summit can deduct 50% of the cost of these food and beverage expenses.

Answer 116

- Educational Assistance: An educational assistance program is a separate written plan that allows an employer to provide educational assistance to employees for the cost of tuition, fees, books, supplies, and equipment. In general, there are two types of tax-free educational assistance: - Job-related education (under IRC section 132) and - Non job-related education (under IRC Section 127) - Job-related education can be a “working condition benefit” if the education maintains or improves job-related skills needed in the employee’s present job. The amounts would be non-taxable to the employee, and fully deductible by the employer if the education: - Maintains or improves skills required by the individual’s current employment, trade or business, or - Meets the express requirements of the employer, or the requirements of applicable law or regulations, imposed as a condition to the individual’s retention of salary, status or employment. - Examples would include: continuing education courses for an enrolled agent or a CPA to maintain their license. Or a notary course for a bookkeeper who is employed at a tax preparation firm. - Non-job-related education is also called an “educational assistance plan” or an “employer educational program” (EAP). In this case, the education does not need to be job-related in order to be deductible. However, this type of assistance requires a written plan, it must meet non-discrimination requirements, and the amounts are limited to $5,250 per year. If an employer pays more than $5,250, the excess is taxed as wages to the employee. - An educational assistance plan can cover tuition, fees, and the cost of books, supplies and tools. - The CARES Act allowed payments toward an employee’s student loan as an eligible educational assistance plan expense. This provision was extended through tax year 2025. Both federal student loans and private student loans are eligible. The $5,250 annual cap applies to both the student loan repayments as well as other educational assistance (including tuition reimbursements). - The cost of meals, lodging, or transportation are not qualifying expenses. - Example: Judith is a full-time employee of Chessmore Advisory, Inc. an investment advisory firm. With her employer’s permission, Judith enrolls in an online program at her local college to earn a certificate in Financial Services Management. The certificate is directly related to her job and will improve her skills as an employee. Judith submits her receipts for her tuition and required textbooks to her employer, totaling $4,200. Chessmore Advisory reimburses the full amount of her educational costs. The amounts are not taxable to Judith and not subject to any limits. Chessmore Advisory may deduct the costs as a regular business expense.

Answer 117

- Employee Discounts: Employers can exclude from wages the price reductions they give to employees on services or property they offer to customers in the normal course of business, up to the following limits: - For a discount on services, 20% of the price charged nonemployee customers for the service. - For a discount on merchandise or property, the company’s gross profit percentage multiplied by the price nonemployee customers pay. - In order to be an excluded benefit, the discount has to be offered to all employees, regardless of compensation. Employee discounts do not apply to discounts on real property or discounts on investment property, (such as company stock). - Example: Surat Clothiers is a clothing boutique that sells fine men’s suits. The business offers all their employees a 20% discount on all the clothing in the store. The employee discount is an excludable benefit and is not taxable to the employees.

Answer 118

- An employer can exclude from an employee’s taxable income the value of a service provided to the employee if it does not create a substantial additional cost for the business. - Typically, no-additional-cost services are excess capacity services, such as airline, bus, or train tickets; hotel rooms; or telephone services provided free or at a reduced price to employees working in those lines of business. - Example: Pablo works as a full-time personal trainer for Gorilla Gym. Since Pablo is an employee, Gorilla Gym offers Pablo a free gym membership at the gym. These benefits would be tax-free to Pablo because they do not create any substantial additional costs for Gorilla Gym. - Example: Greta works as a flight attendant for Northbound Airlines. The airline allows all its current employees and their spouses to fly for free by using a standby travel program. When a regularly scheduled flight has empty seats, airline employees are allowed to fly at no charge. Greta flies for free to Cancun, Mexico, with her husband. The value of the airline ticket may be excluded from her wages.

Answer 119

- Under the TCJA, moving expenses are no longer deductible as a business expense. Employers who reimburse employees for their moving expenses must now include the moving expense reimbursements in employees’ wages, subject to income and employment taxes. This is true even if the expenses are substantiated and reimbursed under an accountable plan. - Example: Bright Star Estates wants to hire Dustin to lead its new marketing department. Dustin lives in another state, and only agrees to accept the position if Bright Star pays for all his moving expenses. The company agrees to pay Dustin’s moving expenses as a condition of his employment contract. Dustin incurs $7,000 in moving expenses, consisting of $6,000 for moving his household goods, $800 for airfare at the time of the move, and $200 in meals while he is in transit. The employer reimburses Dustin for all these expenses. Bright Star must include the entire reimbursement as wages on Dustin’s Form W-2. The amounts are deductible to Bright Star, but the entire amount is subject to payroll tax and income tax withholding, just like any other wage expense.

Answer 120

- The TCJA eliminated the employer’s deduction for employee transportation fringe benefits (parking benefits and mass transit). Although the deduction is not allowed to employers, the exclusion from income for employees continues. In other words, a company can still offer tax-free transportation and parking benefits to its employees, but the company cannot deduct the expense. - An employee’s use of a company-owned vehicle for business purposes (if properly documented) is not considered taxable income to the employee. However, driving a company vehicle for personal use is a taxable noncash fringe benefit. - There is an exception for situations in which the employer is ensuring the employee’s safety, or when the employee is required to use a company vehicle for commuting because the employee works in a public safety profession. - Example: Paramount Brokers is a professional brokerage firm in Los Angeles, CA. As a condition of employment, all employees are offered free transit passes, which are valued at $270 per month. The transit passes are not taxable to the employee. However, Paramount Brokers cannot deduct the cost of the transit passes as a business expense. - Example: Connolly is a bus driver for Smallville Elementary School. Connolly is required to use the school bus during work hours, including his lunch breaks, because sometimes he is required to pick up and drop off sick students during the day. Connolly takes the bus to the sandwich shop during his scheduled lunch hour, because he is required not to leave the bus during his shift. Connolly’s minimal personal use of the vehicle is not considered a taxable benefit. - Example: Brentwood Electronics, Inc. has a pickup truck that it allows its employees to use while they are on call. The pick-up is not a police, fire, or public safety vehicle. Carlton, a company supervisor, is allowed to drive the pick-up home, because he is “on-call” during the weekends. The vehicle is not a qualified nonpersonal use vehicle; thus, the commuting is a non-cash taxable fringe benefit. A small amount of additional wages is added to Carlton’s Form W 2 to account for his personal use of the truck.

Answer 121

- The Affordable Care Act mandates that certain employers provide health insurance for full-time workers. All employers that are ALEs (or “applicable large employers”) are subject to the employer-shared responsibility provisions. This includes for-profit entities, most nonprofit organizations, and government entities. The IRS commonly uses these acronyms: - ACA: Affordable Care Act - ALE: Applicable Large Employer: an employer with 50 full-time employees (or a combination of full-time and part-time employees that is the hourly equivalent to 50 full-time employees). - FTE: Full-time employee - MEC: Minimum Essential Coverage.

Answer 122

- The ACA employer provisions remain in full effect. Only the individual mandate was repealed. Applicable Large Employers who do not offer minimum essential coverage to their employees will face penalties. Unlike the individual shared responsibility payment, the employer shared responsibility penalty is subject to IRS lien and levy enforcement actions. - Employers with 50 or more employees are subject to the “Employer Shared Responsibility” provisions. In other words, the Affordable Care Act penalizes employers with a monetary penalty if the employer does not offer coverage which meets minimum value and affordability standards. - For ACA purposes, a “full-time employee” is an individual employed on average at least 30 hours per week, or at least 130 hours in a calendar month. An employer that meets the 50 full-time employee threshold is referred to as an “Applicable Large Employer” or ALE. - Employers with fewer than 50 full-time employees are not subject to the Affordable Care Act’s employer shared responsibility provisions.

Answer 123

- The general rule is that if an employer offers group health coverage to any full-time employees, the employer must offer coverage to all full-time employees. - The employer has the option to offer coverage to part-time employees but is not required to do so. If an employer offers coverage to any part-time employees, then all the part-time employees must be offered the same coverage. Employers must treat all employees who average 30 hours a week as full-time employees. - The ACA “employer mandate” is a requirement that all businesses with 50 or more full-time equivalent employees (FTE) offer and/or provide health insurance to “substantially all” of their full-time employees and dependents up to age 26. “Dependents” include children up to age 26, excluding stepchildren and foster children. - If the employer does not offer health coverage, and is required to, the company may be subject to penalties. These penalties are officially referred to as “Employer Shared Responsibility Payments.”

Answer 124

- For ACA purposes, an employer health plan meets the “minimum value” standard if both of the following apply: - The insurance is designed to pay at least 60% of the total cost of medical services, - The insurance benefits include substantial coverage of physician and inpatient hospital services. - Employers may not impose enrollment waiting periods that exceed 90 days for health plans. Employers are not required to offer dental or vision coverage, although they can voluntarily do so, if they wish. - If the employer offers health coverage, and the employee subsequently declines the coverage, then the employer will not be subject to a penalty. In other words, the ACA does not penalize an employer for employees who decline an offer of coverage. - Example: Pearland Mortgage Company has 650 full-time employees. Pearland offers health coverage to all of its full-time employees and their dependents. The coverage offers minimum value. Only 540 of Pearland’s employees actually enroll in coverage. The rest of the company’s employees decline the coverage. The company is compliant with ACA provisions.

Answer 125

- There are two types of ACA penalties that apply to large employers: - 4980H(a) Penalty: Failure to Offer Minimum Essential Coverage: This is the penalty for NOT OFFERING health insurance. An employer may be liable for this penalty if they are classified as an applicable large employer and do not offer minimum essential coverage to at least 95% of their full-time employees (and their dependents) and at least one employee receives the Premium Tax Credit. For 2023, the penalty amount is $240 per month ($2,880 if for an entire year) for each month that a full-time employee (without regard to whether each employee received a Premium Tax Credit) is not provided with minimum essential coverage—after excluding the first 30 full-time employees from the calculation. - 4980H(b) Penalty: Failure to Offer Coverage that Provides Minimum Value: An ALE may be liable for this penalty if the employer DOES offer health insurance, but at least one full-time employee receives the Premium Tax Credit. ALEs must offer coverage that provides minimum value and is affordable to all full-time employees each month. If the coverage is not affordable to the employee or doesn’t provide minimum value (or if an employee did not receive an offer of coverage), then the 4980H(b) penalty may apply. This penalty is based solely on the number of full-time employees who receive the Premium Tax Credit. The penalty in 2023 is $360 per month ($4,320 if for an entire year) for each month that a full-time employee received the Premium Tax Credit and was not provided with insurance as detailed above. To be liable for the 4980H(b) penalty, at least one of the employers’ full-time employees must receive a Premium Tax Credit. Only full-time employees, not full-time equivalents, are counted for purposes of calculating this penalty. - 4980H(a) Penalty: Example: Anchorage Engineering, Inc. employs 150 full-time employees throughout 2023. The company misunderstood the ACA mandate and did not think that they had to offer health insurance, so they did not offer it to any of their employees. During the year, one employee applies for health insurance through the federal Healthcare Marketplace and receives the Advance Premium Tax Credit. Anchorage Engineering, Inc. is audited by the IRS and assessed a $345,600 penalty ($2,880 × [150 full-time employees – 30 the first thirty full-time employees]). - 4980H(b) Penalty: Example: Ashland Software, Inc. employs 52 full-time employees and 10 part-time employees. The part-time employees work fewer than 10 hours a week. Ashland Software offers health insurance to all its full-time employees but does not offer coverage to its part-time employees. Sally has been working for Ashland Software for several months. She was working part-time but was migrated to a full-time position at the beginning of the year. After she became full-time, the human resources department made a mistake and did not offer Sally enrollment in the company’s group health care plan. Sally went onto the healthcare Marketplace and obtained health coverage. She received a subsidy. As an ALE, Ashland Software would become liable for a penalty for its mistake, but only for the one employee (Sally) that received a subsidy. The maximum penalty that Ashland Software would be assessed would be $4,320 in 2023.