Tax 2-5 Identify requirements for a valid S corporation election.

Question 1

S Corporations

Question 10 of 30

S corporation shareholders have the ability to deduct losses to the extent of

their original contribution of capital to the business.

their adjusted basis in the stock adjusted for corporate loans personally guaranteed.

their adjusted basis in the stock adjusted for money they have directly loaned to the corporation.

(LO 2-5, pg 51)

Answer 1

their adjusted basis in the stock adjusted for money they have directly loaned to the corporation.

A shareholder’s basis and ability to deduct losses from an S corporation are determined by the shareholder’s adjusted basis in the stock, increased by loans he or she has made to the corporation (basis in debt).

Question 2

S Corporations

Question 11 of 30

Which one of the following is not a feature of a limited liability company (LLC)?

limited liability to all members

automatic transfer of management rights without the majority approval of the remaining members

conduit taxation

(LO 2-4, pg 57)

Answer 2

automatic transfer of management rights without the majority approval of the remaining members

In an LLC, there is a prohibition against the transfer of management rights without majority approval of the remaining members.

Question 3

S Corporations

Question 13 of 30

Which of the following forms of business is not a conduit for tax purposes?

sole proprietorship

general partnership

C corporation

S corporation

(LO 2-4)

Answer 3

C corporation

Sole proprietorships, general partnerships, and S corporations are all conduit entities for tax purposes. Only a C corporation is a separate taxable entity.

Question 4

S Corporations

Question 23 of 30

Which one of the following is correct regarding a shareholder’s basis in an S corporation?

The basis is increased if the shareholder actually loans funds directly to the S corporation.

The basis is increased if the shareholder guarantees a loan for the S corporation.

Basis is increased by net income and distributions that flow through to the shareholder.

(LO 2-4, 45)

Answer 4

The basis is increased if the shareholder actually loans funds directly to the S corporation.

The stockholder’s basis is increased if the stockholder loans funds directly to the S corporation. A stockholder typically has basis in stock, and may have basis in debt as well.

The shareholders of an S corporation are allowed to count as basis only that debt created by a direct loan from the shareholder to the corporation.

Question 5

S Corporations

Question 29 of 30

Which one of the following is a requirement for an election to be taxed as an S corporation for a particular year?

The election must be filed on or before the fifteenth day of the fourth month of the tax year.

All shareholders must consent in writing to the election.

The corporation may have no more than 35 shareholders.

(LO 2-5, pg 50)

Answer 5

All shareholders must consent in writing to the election.

To be taxed as an S corporation for a given year, all shareholders must consent in writing to such election and the election must be filed by the fifteenth day of the third month (generally March 15th) of the taxable year. Also, the corporation may have no more than 100 shareholders.

Question 6

S Corporations

Question 30 of 30

Which one of the following is correct regarding an S corporation?

The S corporation may have two classes of stock.

All shareholders must elect to revoke the S corporation election.

The shareholders in an S corporation enjoy limited liability.

(LO 2-5, pg 50)

Answer 6

The shareholders in an S corporation enjoy limited liability.

As with a C corporation, shareholders do have limited liability.

Question 7

S Corporations

Identify income tax characteristics and advantages of a sole proprietorship.

2-5

Answer 7

A sole proprietorship is a conduit. The Schedule C is part of the individual income tax return, and the income or loss is a part of the AGI. The net income of the sole proprietorship is subject to the self-employment tax. There are no tax consequences on the formation or liquidation of a sole proprietorship. A proprietor has the ability to set up his own retirement plan; any losses generally may offset other income, and there is an above-the-line deduction for health and a portion of long-term care insurance.

Question 8

S Corporations

Identify nontax disadvantages generally associated with a sole proprietorship.

2-5

Answer 8

unlimited personal liability for business debts or lawsuits

capital structure is typically dependent on the resources of the proprietor

lack of continuity of business life

Question 9

S Corporations

Identify tax and nontax characteristics of a partnership.

2-5

Answer 9

conduit entity—income or loss is reported on the partners’ personal income tax returns;

generally no tax on formation or liquidation of the partnership;

joint and several liability—unlimited personal liability for business debts or lawsuits;

capital structure is typically dependent on the resources of the partners;

lack of continuity of business life

Question 10

S Corporations

In some situations, a partnership has the disadvantage of causing income recognition to the partners upon formation. Identify three situations in which income recognition may occur.

2-5

Answer 10

if appreciated securities are contributed to a partnership that is considered an exchange fund partnership

if a partner contributes services and receives an interest in capital

if the partnership relieves a partner of debt

Question 11

S Corporations

In some situations, a partnership has the disadvantage of causing the recognition of income upon liquidation. When will income be recognized in the liquidation of a partnership?

2-5

Answer 11

When Section 751 assets (“hot assets”) are distributed disproportionately to the partners. The so-called hot assets are unrealized receivables, appreciated inventory, and recapture on cost recovery property. The common denominator between all three of these items is that they can be recognized as ordinary income. The hot assets do not cause automatic income recognition upon liquidation of the partnership. Income recognition occurs only if a partner receives either more or less than her proportionate share of such assets. The rationale for such a rule is that each partner should receive a proportionate share of the ordinary income items. If there were no such rule, a high-bracket partner and a low-bracket partner could distribute assets upon liquidation in such a manner as to ensure that the high-bracket taxpayer received none of the ordinary income property, while the low-bracket taxpayer received all of the ordinary income. When liquidating a partnership, care must be exercised to ensure that unwanted tax consequences do not occur through a disproportionate distribution of hot assets.

Question 12

S Corporations

Identify a nontax advantage and disadvantage of limited partnerships.

2-5

Answer 12

Advantage—limited personal liability for the limited partners

Disadvantage—no service limited partners, limited partners cannot have day-to-day control or they lose limited partnership status

Question 13

S Corporations

Partnerships may allow special items of deduction between partners. Explain why special allocations are an advantage of a partnership.

2-5

Answer 13

This may allow particular tax items to flow through to the partners who are most able to use them.

Question 14

S Corporations

Briefly explain how a partner’s basis in a partnership is determined, and explain the importance of basis in a partnership.

2-5

Answer 14

The partner’s basis is equal to the partner’s contributions of cash to the partnership, the contribution of property (measured in adjusted basis), increased by the partners’ proportionate share of recourse and nonrecourse debt, increased by flow-through of income, and decreased by flow-through of loss and distributions. Payment of loan principal on the debt results in a decrease of the partners’ basis. A partner may deduct her distributive share of partnership losses only up to the amount of her basis in the partnership at the end of the tax year.

Question 15

S Corporations

Identify and explain tax and nontax characteristics and advantages generally associated with a C corporation.

2-5

Answer 15

separate taxable entity; ability to create a separate taxable entity to retain earnings at a potentially lower tax rate limited liability; liability generally is limited to capital contributed transferability of interest; easy to transfer ownership of the corporation through the sale of stock raising additional business capital; generally easy to raise capital through the sale of stock, or borrowing continuity of life; the C corporation’s existence is not affected by transfer of ownership, death, bankruptcy, or disability of a shareholder management characteristics; centralized management, mere ownership of stock does not give the owner the right to participate in management employee fringe benefits; many benefits (group term life insurance up to $50,000, health and accident insurance, disability insurance, pension or profit sharing plans) may be deductible to the corporation, but are not taxable to the employee

Question 16

S Corporations

Identify and explain tax and nontax disadvantages generally associated with a C corporation.

2-5

Answer 16

Tax—potential for double taxation—the net income of the corporation is subject to income tax; the dividends distributed are not deductible at the corporate level, but are taxable (generally at preferential tax rates) to the shareholders

Nontax—corporate formalities; large amounts of paperwork; generally more expensive to run; limited ability to operate out of state; less management flexibility; possible oppression of minority shareholders

Question 17

S Corporations

Explain how the accumulated earnings tax rules can be a disadvantage to a C corporation.

2-5

Answer 17

They prevent the corporation from retaining excess accumulations, forcing those accumulations to be distributed as dividends.

Question 18

S Corporations

Explain the disadvantage of classifying a C corporation as a personal service corporation.

2-5

Answer 18

The benefit of the corporate graduated tax rate is denied, and the first dollar of taxable income is taxed at the highest corporate marginal rate of 35%. The mere fact that a corporation is considered a qualified personal service corporation should not be the sole reason for deciding against a C corporation. The availability of fringe benefits, limited personal liability, and a variety of other considerations may still lead to the selection of a C corporation. However, the opportunity to retain income within the corporation at lower tax rates is not available. Note that the PSC classification is relevant to the C corporation only.

Question 19

S Corporations

Section 1244 stock is considered to be an advantage of a corporation.

Briefly describe the requirements for stock to be classified as Section 1244 stock.

2-5

Answer 19

The issuing corporation (C or S) must be domestic. The stock must have been issued for money or other certain property. The stock must be held by the individual who was the original purchaser. The treatment applies only to the first $1 million of stock issued.

Question 20

S Corporations

Section 1244 stock is considered to be an advantage of a corporation. Why is the ability to issue Section 1244 stock an advantage?

2-5

Answer 20

The loss from Section 1244 stock is treated as an ordinary loss for up to $100,000 annually on a joint return ($50,000 annually on any other return), rather than as a capital loss, which is limited to a $3,000 annual deduction. Excess losses in a given year are treated as capital losses.

Question 21

S Corporations

Forming as an S corporation is of particular advantage to a new business. Identify the major advantages an S corporation offers a new business.

2-5

Answer 21

The ability to pass the losses of the company through to the shareholders. Limited liability for the shareholders is attractive for a start-up business

Question 22

S Corporations

After the start-up period has passed, an S corporation often becomes a disadvantage, regardless of whether the new business is successful.

Identify the disadvantage of an S corporation to an unprofitable business after the start-up period.

2-5

Answer 22

Losses are deductible only to the extent of basis in a shareholder’s stock and debt. After several years of deducting losses, the shareholder’s basis is likely to be exhausted, and the losses would no longer be deductible.

Question 23

S Corporations

The basis in an S corporation is an important concept. How is basis calculated and why is it important?

2-5

Answer 23

The shareholder in an S corporation has basis in stock and basis in debt. The basis in stock is equal to the shareholder’s contributions of cash to the partnership, the contribution of property (measured in adjusted basis), increased by shareholder’s flow-through of income, and decreased by flow-through of loss and distributions. The basis in debt is the amount of money that the shareholder has personally loaned to the S corporation, reduced by any principal repayment from the corporation to the shareholder. A shareholder may deduct his distributive share of S corporation losses only up to the amount of his basis.

Question 24

S Corporations

An S corporation is unique in that there are certain requirements that must be met to qualify for S status. Identify the requirements for S status.

2-5

Answer 24

The corporation must be domestic. There may be only one class of stock, although differences in voting rights are allowed. There may be no more than 100 shareholders; members of a family (broadly defined) may elect to be treated as a single shareholder. All shareholders must be U.S. citizens or residents. All shareholders must be individuals or certain qualified trusts or estates. All shareholders must consent to the election (a husband and wife are treated as a single shareholder for this purpose).

Question 25

S Corporations

A disadvantage of an S corporation is the strict requirements to maintain the S status.

Identify occurrences that serve to involuntarily revoke the S status.

2-5

Answer 25

failure to meet the requirements for S corporation status, e.g., excess amounts of passive income if the corporation was a C corporation with earnings and profits, second class of stock; more than allowed number of shareholders

Question 26

S Corporations

Explain how an involuntary revocation of the S status can be a disadvantage.

2-5

Answer 26

The corporation will incur taxes rather than the net income flowing through to the shareholders. Losses would be trapped at the corporate level and would not flow through to the shareholders.

Question 27

S Corporations

The limited liability company (LLC) and the limited liability partnership (LLP) have grown in popularity over the past several years.

Briefly discuss the characteristics of an LLC.

2-5

Answer 27

The LLC is a statutory entity in which a “member’s” liability is limited to the investment in the entity (similar to a corporation). It is a conduit entity (similar to a partnership). State laws vary on whether an LLC must have more than one member and whether the LLC may provide personal services (such as medical, engineering, or legal services). A single member LLC is a “disregarded entity“ that files a Schedule C. An LLC with two or more members is, by default, treated as a partnership for federal income tax purposes. The LLC may, under the check-the-box regulations, elect to be treated as a corporation.

Question 28

S Corporations

Briefly discuss the characteristics of an LLP.

2-5

Answer 28

The LLP is also a statutory entity in that state law controls certain features. It is a conduit entity, similar to a partnership. The partners may be jointly and severally liable for contractual liability, as in a general partnership. They are also personally liable for their own malpractice or other torts (negligence, for example). However, they generally are not personally liable for the malpractice or torts of their partners.

Question 29

S Corporations

Briefly discuss the rules related to the self-employed health insurance deduction.

2-5

Answer 29

The self-employed health insurance deduction allows sole proprietors, partners in a partnership, and greater-than-2% shareholders in an S corporation to deduct health and accident insurance premiums as an adjustment to income. The insurance may cover the taxpayer, spouse, dependent, and any child of the taxpayer under age 27 at the close of the tax year. Generally, the insurance plan must be established under the taxpayer’s business. There is no deduction allowed for any month in which the taxpayer (or spouse) is eligible to participate in any employer-provided spouse) is eligible to participate in any employer-provided subsidized health plan.

Question 30

S Corporations

Example. In 2015, BuilderCo, a developer of corporate office space and a calendar-year taxpayer, began construction of a new 100,000 square foot office building, named Eco-View, that uses new technology to reduce the building’s use of energy in the lighting, heating, cooling, ventilation, and hot water supply systems. Eco-View is completed and placed in service in March 2016. As long as energy and power cost reduction requirements are met (see above) and BuilderCo has not taken energy efficient commercial building deductions in any earlier years, BuilderCo can take a tax deduction of up to

2-5

Answer 30

$180,000 ($1.80 × 100,000 square feet) in 2016.

Question 31

S Corporations

For property placed in service after 2005 and before 2017, taxpayers may claim a deduction for expenses incurred in creating energy efficient commercial buildings. The maximum energy efficient commercial building deduction is equal to $_ . _ _ per building square foot (it is 60¢ per building square foot for certain separate building systems), less the total amount of this deduction allowed for the building in prior years.

2-5

Answer 31

$1.80

The deduction is designed to act as an incentive for building owners to upgrade existing systems and for new structures to be designed in an energy efficient manner. This deduction is available whether a building is new or used. Among other requirements, the property must be depreciable or amortizable; the
equipment must be installed on or in any building located in the United States as part of:

1. the interior lighting systems,
2. the heating, cooling, ventilation, and hot water systems, or
3. the building envelope.

In addition, the property must be certified as being installed as part of a plan designed to reduce the annual energy and power costs with respect to the interior lighting systems, heating, cooling, ventilation, and hot water systems of the building by 50% or more.

Question 32

Practice Test 2

S Corporations

17. Which one of the following is a requirement for a valid S corporation election?
    a. There may be no more than 75 shareholders.
    b. There may be no more than two classes of stock.
    c. A simple majority of shareholders must consent to the election.
    d. All shareholders must be U.S. citizens or residents or be one of certain qualifying trusts.

(LO 2–5)

Answer 32

d. All shareholders must be U.S. citizens or residents or be one of certain qualifying trusts.

For a valid S corporation election, all shareholders must be U.S. citizens or residents or be certain qualifying trusts. There may be no more than 100 shareholders, and there may be no more than one class of stock, although differences in voting rights are allowed within the single class of stock. Also, to elect S corporation status, all shareholders must consent to the S corporation election.