Tax Characteristics of Entities - Examples Flashcards
Sole Proprietorships
For Example: Frank recently left his job as an accountant at a large CPA firm with the idea of opening a practice specializing in tax compliance and planning. Frank wants to control the business himself and doesn’t want to take on any partners. Frank has decided to operate his business as a sole proprietorship, therefore, he and his practice will be considered as a single taxpayer.
The netting process: The rules for netting long- and short-term capital gains and losses, the treatment of Section 1231 (that is, a business’ fixed assets) gains and losses, and the long-term capital gain and loss holding periods are the same for both corporations and individuals.
For example, consider the following two case studies:
Gulf Corporation has the following capital gains and losses during the current year:
LTCG $15,000
LTCL $5,000
STCG $3,000
STCL $8,000
Gulf Corporation has a $10,000 NLTCG and a $5,000 NSTCL. The NLTCG is offset against the NSTCL, resulting in a $5,000 net capital gain that is taxed at the same rates as ordinary income.
Huge Corporation has the following capital gains and losses during the current year:
LTCG $5,000
LTCL $15,000
STCG $8,000
STCL $10,000
Huge Corporation has a $10,000 NLTCL and a $2,000 NSTCL. Neither net loss is deductible against ordinary income in computing its current year taxable income.
Dividends-Received Deduction
King Corporation has the following income and expense items during the current year:
Net income from operations $ 50,000
Dividend income from 20% (or more)-owned corporations $200,000
The dividends-received deduction determined under the general rule is $130,000 (0.65 x $200,000 dividends). The deduction limitation is $162,500 (0.65 x $250,000 (50,000 + 200,000) taxable income before the dividends-received deduction). Because the limitation ($162,500) exceeds the dividends-received deduction computed under the general rule ($130,000), the entire $130,000 dividends-received deduction is allowed.
Net Operating Losses
For example, Main Corporation’s NOL for the current year is computed from the following income and deduction items:
Operating Income $400,000
Plus: Dividends received from 20%-(or more) owned corporations $300,000
Gross Income $700,000
Minus: Business operating expenses ($600,000)
Dividends-received deduction (.65 × $300,000) ($195,000)
Net operating loss ($95,000)
Compensation Deduction Limitation - A publicly held corporation is denied a deduction for compensation paid to its chief executive officer and its four highest-compensated officers if the compensation amount for any individual exceeds $1 million per year
Acorn Corporation is a publicly held company listed on the New York Stock Exchange. During the current year, its chief executive officer, Richard, receives the following compensation from the corporation: Salary $1,200,000; commission-based compensation on sales generated by Richard, $400,000; payments to a qualified pension plan $25,000; and tax-free fringe benefits of $10,000. The commissions, payments to the qualified plan, and the tax-free fringe benefits are not subject to the $1 million annual deduction limitation for Richard’s compensation. Thus, $200,000 ($1,200,000- $1,000,000) of Richard’s salary is not deductible by Acorn Corporation, even though Richard is taxed on the entire $1,200,000.
Computation of Tax - The corporate income tax rate is a flat 21% of taxable income.
For example, Jackson Corporation’s taxable income is $150,200. Their tax is 21% of that amount or $31,542.
Accumulated Earnings Tax - Personal Service Corporations are allowed an accumulated earnings credit of $150,000 while non-personal service corporations are allowed a credit of $250,000.
Compact Corporation has taxable income of $100,000 in the current year. Compact’s federal income tax liability is $22,250, and the corporation paid $10,000 in dividends to its shareholders. Compact claims a dividends-received deduction of $80,000 on $100,000 of dividend income. Accumulated E&P at the beginning of the year retained for the reasonable needs of the business is $200,000, and Compact Corporation’s reasonable needs of the business at year-end amount to $220,000. The accumulated taxable income and the accumulated earnings credit are computed as follows:
Taxable income $100,000
Plus: Dividends-received deduction 80,000
Minus: Federal income tax liability (22,250)
Dividends-paid deduction (10,000)
Accumulated earnings credit, which equals the greater of:
(1) $ 250,000 (statutory exemption) - $200,000 (accumulated E&P at the beginning of the year) $50,000 or
(2) E&P retained for the increased reasonable needs of the business ($220,000 - $200,000) $ 20,000
(50,000)
Accumulated taxable income $ 97,750
The accumulated earnings tax is $19,550 (0.20 x $97,750) and is paid in addition to the corporation’s regular tax. Compact’s total federal tax liability is $41,800 ($22,250 + $19,550).
Personal Holding Company Tax -
For example, Crane Corporation has four shareholders who together own more than 50% of the value of the stock at all times during the year. In addition, 60% or more of adjusted ordinary gross income is personal holding company income (dividends, interest, etc.). Therefore, Crane is classified as a personal holding company for the current year because the stock ownership and income tests are met. Crane receives a $25,000 dividend for which a $20,000 dividends-received deduction is claimed and pays $18,750 of dividends to its shareholders. Crane has $200,000 of taxable income and a $61,250 regular tax liability.
Taxable income Adjustments: $200,000
Federal income tax liability (61,250)
Dividends-received deduction 20,000
Dividends-paid deduction (18,750)
————
Undistributed personal holding company income $140,000
Multiplied by: Personal holding company tax rate x 0.20
Personal holding company tax $ 28,000
Crane’s total federal tax liability is $89,250 ($61,250 + $28,000). The $28,000 personal holding company tax may be avoided if Crane pays all of the undistributed personal holding company income to its shareholders. Special rules allow personal holding companies to pay these dividends even after the corporation’s year-end. The shareholders then pay an income tax levy on the dividend distribution.
Current vs. Accumulated Earnings - Current year and accumulated earnings and profits (E&P) must be differentiated because the tax code provides specific tracing rules to determine whether a distribution is taxable as a dividend.
For example, a distribution to shareholders is deemed to be made first out of current E&P and therefore results in a taxable dividend even if accumulated E&P at the beginning of the year is negative. Accumulated E&P represents the total of all prior years’ undistributed E&P amounts as of the first day of the tax year. Distributions are deemed to be made out of accumulated E&P only after the current E&P (if any) is exhausted.
Pacific Corporation, a calendar-year taxpayer, has a $100,000 accumulated E&P deficit as of January 1. It reports $30,000 of current E&P. The corporation makes a $40,000 distribution to its shareholders. Of the $40,000 distribution, $30,000 is a taxable dividend to the extent of current E&P, and the remaining $10,000 is a tax-free return of capital (to the extent that Pacific’s shareholders have basis in their stock) because of the accumulated E&P deficit. The E&P deficit is not increased by the tax-free distribution.
Dividend Policy - Dividends paid from E&P are fully taxable to shareholders and are not deductible by the corporation. Thus
Mario and Nancy are equal owners of Texas Corporation, which is highly profitable and has substantial E&P. Mario and Nancy are the key officers and are each paid a $100,000 salary. A reasonable salary for each would be $150,000. To increase cash distributions to the owners, additional salary payments of $50,000 should be made to both Mario and Nancy because the corporation can deduct salary payments, whereas the dividend payments are not deductible. The salary payments result in only a single level of taxation, while the dividend payments result in double taxation. Consideration also should be given to payroll taxes because the additional $50,000 compensation may subject the employer and the two shareholders to additional payroll taxes (e.g., the 15% Medicare portion and the FICA tax). With the new 15% dividend tax rate, if Texas Corporation had small taxable income, the combination of the dividend tax and the corporate tax could be lower than Mario’s and Nancy’s personal tax rate plus the payroll taxes. The new tax law may make for more individualized corporate dividend - salary planning.
Basis of Partnership Interest - If the Section 721 nonrecognition rules apply, Section 722 provides a substituted basis rule for determining the basis of a partnership interest. Disregarding the effect of any liabilities, the basis of the contributing partner’s partnership interest equals the sum of money contributed plus the adjusted basis of other property transferred to the partnership.
For example, if Allen contributes business equipment having a $10,000 FMV and a $4,000 adjusted basis to the ABC Partnership in exchange for a 30% interest in the partnership, the basis of Allen’s partnership interest is $4,000 (a substituted basis) because he recognizes no gain or loss under Section 721.
Section 752 Adjustment - Under the general rules of Section 752, a partner’s basis in the partnership interest increases by the partner’s share of any changes in the partnership’s liabilities during the year.
For example, if total partnership liabilities (including accounts and notes payable, mortgages, bank loans, etc.) increase during the year from $100,000 to $200,000, the basis of a partner with a 50% interest in the partnership increases by $50,000 ($100,000 increase in liabilities x 0.50).
Negative Basis Rule - Section 731 requires recognition of a gain in situations where a negative basis would otherwise occur.
Becky transfers property having a $100,000 FMV and a $20,000 adjusted basis, which is subject to a $60,000 mortgage, in exchange for a one-third interest in the BCD Partnership. The partnership owes no other liabilities. Becky, Cindy, and Dan each have a one-third interest in the partnership. The $60,000 reduction in Becky’s individual liabilities is treated as a distribution of money. Thus, Becky must recognize a $20,000 gain because the distribution exceeds her $40,000 basis in the partnership interest. Becky’s basis in the partnership interest is zero after the distribution. The basis is computed as follows:
Adjusted basis of property transferred $20,000
Plus: Becky’s share of the mortgage assumed by the partnership ($60,000 x 1/3) $20,000
Minus: Decrease in Becky’s individual liabilities ($60,000)
Tentative basis of Becky’s partnership interest ($20,000)
Plus: Gain recognized by Becky (to the extent of negative basis) $20,000
Becky’s basis in the partnership interest $0
Holding Period for Partnership Interest - The holding period for partnership interest can vary
For example, In the current year, Johanna contributes business machinery to the JK Partnership in exchange for partnership interest. Johanna originally acquired the machinery in 1997. Because the machinery is Section 1231 property, Johanna’s holding period for her partnership interest begins in 1997 (the date she acquired the machinery). If Johanna had contributed inventory instead of machinery, the holding period would begin on the inventory contribution date.
Basis of Partnership Assets - Section 723 provides a carryover basis rule for property contributed to the partnership. The partnership’s basis in the property is the same as that of the transferor partner, even if the contributing partner recognizes gain.
For example, In the current year, Carlos contributes equipment with a $6,000 adjusted basis and an $8,000 Fair Market Value to the CDE Partnership and receives one-third interest in the partnership. Carlos acquires this equipment in 1997. CDE’s basis for the equipment is $6,000, its adjusted basis in the hands of the contributing partner. Carlos recognizes no gain due to the Section 721 non-recognition rules. CDE’s holding period for the equipment begins in 1997 because it includes Carlos’ holding period for the property.