Tax Characteristics of Entities - Examples

Question 1

Sole Proprietorships

Answer 1

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.

Question 2

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.

Answer 2

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.

Question 3

Dividends-Received Deduction

Answer 3

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.

Question 4

Net Operating Losses

Answer 4

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)

Question 5

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

Answer 5

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.

Question 6

Computation of Tax - The corporate income tax rate is a flat 21% of taxable income.

Answer 6

For example, Jackson Corporation’s taxable income is $150,200. Their tax is 21% of that amount or $31,542.

Question 7

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.

Answer 7

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).

Question 8

Personal Holding Company Tax -

Answer 8

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.

Question 9

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.

Answer 9

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.

Question 10

Dividend Policy - Dividends paid from E&P are fully taxable to shareholders and are not deductible by the corporation. Thus

Answer 10

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.

Question 11

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.

Answer 11

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.

Question 12

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.

Answer 12

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).

Question 13

Negative Basis Rule - Section 731 requires recognition of a gain in situations where a negative basis would otherwise occur.

Answer 13

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

Question 14

Holding Period for Partnership Interest - The holding period for partnership interest can vary

Answer 14

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.

Question 15

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.

Answer 15

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.

Question 16

Special Allocations - The special allocation provisions restrict the partners’ freedom to shift tax benefits among individual partners.

Answer 16

For example, the special allocation must have substantial economic effect, and must be made for property contributed by the partners when determining the allocation of depreciation deductions and the amount of gain or loss recognized when the partnership eventually sells the property. Essentially, the allocation of the depreciation deductions and the amount of recognized gain or loss must take into account the difference between the partnership’s basis for the contributed property and the property’s fair market value at the time of the contribution.

Question 17

Limitation on Losses - Section 704(d) limits deductibility of the losses to the partner’s adjusted basis in his or her partnership interest as determined at the end of the partnership’s tax year.

Answer 17

Consider the following case: Ellen, who has a 50% interest in the EF Partnership, has a $10,000 basis in her partnership interest at the end of the current tax year (before deducting her share of losses). The EF Partnership incurs a $50,000 ordinary loss this year, and Ellen’s share of the loss is $25,000 ($50,000 x 0.50). Ellen can only deduct $10,000 in the current year. The remaining $15,000 of loss carries over to future years. The deductible loss of $10,000 reduces Ellen’s partnership basis to zero at the end of the current year.

Question 18

Transaction between Partner and Partnership - Sometimes a partner may independently engage in transactions with the partnership, but since the partner and the partnership are not truly independent parties, abuse of this provision is possible.

Answer 18

For example, the partners might want to recognize losses by selling certain assets at a loss to the partnership while still retaining those assets in the partnership. Alternatively, a partner may wish to sell certain depreciable business assets (Section 1231 property) at a gain taxable to the partner at favorable capital gains rates while the partnership receives a stepped-up FMV basis in the assets for depreciation purposes. Section 707(b) forestalls such potential abuses by disallowing losses and by providing ordinary income (rather than capital gain) treatment under the following circumstances:
* Losses are disallowed on sales or exchanges between a partner and the partnership if the partner owns more than 50% interest in the partnership. A loss is also disallowed if a sale or exchange of property occurs between two partnerships in which the same partners own more than a 50% interest.
* Gains are treated as ordinary income (rather than a capital gain) if the partner owns (directly or indirectly) more than a 50% interest in the partnership and if the exchanged asset is not a capital asset in the transferee’s hands. Again, Section 267 constructive ownership rules apply to attribute ownership of interests held by related parties in order to meet the 50% test.

Question 19

Recognition of Gain or Loss - Capital gain or loss generally arises from the sale of a partnership interest because the interest is a capital asset in the hands of the selling partner.

Answer 19

For example, on October 1, Jesse sells his interest in the JK Partnership to Paula, an outsider, for $150,000 cash plus the release from $30,000 of partnership liabilities. Jesse’s basis in his partnership interest is $74,000 before taking into account his distributive share of partnership income for the period ending on the sale date and his share of any increase in partnership liabilities during the same period. For the current year, Jesse’s share of the partnership income for the period up to the date of sale is $20,000, and his share of increased partnership liabilities is $6,000. Thus, Jesse’s basis in his partnership interest is $100,000 ($74,000 basis on January 1 + $20,000 share of partnership income and a $6,000 share of increased partnership liabilities). The amount realized on the sale is $180,000 ($150,000 selling price + $30,000 liabilities). Thus, Jesse recognizes an $80,000 gain on the sale, which is capital gain unless ordinary income is triggered under Section 751.

Question 20

Section 751 - Under Section 751, ordinary income rather than capital gain treatment may result if a partnership has unrealized receivables or inventory items when a partnership interest is sold. Thus, this rule prevents a partner from converting ordinary income into capital gain by selling or liquidating the partnership interest.

Answer 20

For example, Joy’s basis in her partnership interest is $100,000, and the amount realized on its sale is $180,000, which results in an $80,000 gain. The cash method of accounting partnership has accounts receivable with a zero basis, a $30,000 fair market value (FMV). Joy’s share of these receivables is $10,000. Thus, $10,000 of the amount realized on the sale of the partnership interest is attributed to Joy’s share of the accounts receivable. Because her share of the receivables has a zero basis, a $10,000 FMV ($10,000-0) of the gain is ordinary income to Joy as though she sold her share of the receivables. The remaining $70,000 ($170,000-$100,000) of gain from the sale of Joy’s partnership interest is a capital gain.

Question 21

The S corporation - One Hundred Shareholder Limitation

Answer 21

For example, ABC Corporation, a qualifying S corporation, has 100 shareholders, including Brad and Bonnie, who are married and are counted as one shareholder. Brad dies and wills his stock to his two best friends, who do not already own ABC stock. Before the distribution of the stock from the estate, the estate and Bonnie are counted as one shareholder, and the S corporation remains qualified under the 100-shareholder limitation. ABC is disqualified as an S corporation when the stock is distributed to the two friends because the corporation then has 101 shareholders.

Question 22

The S corporation - One Class of Stock Restriction

Answer 22

For example, Dale is the sole owner of an S corporation. For estate tax planning purposes, Dale desires to make gifts of certain shares of the corporation’s stock to his children while still retaining control over the company. S corporation common stock with limited or no voting rights may be issued to Dale in exchange for a capital contribution. Dale can subsequently make gifts of this new stock to his children without disqualifying the S election.

Question 23

The S corporation - Election Requirements

Answer 23

For example, Circle Corporation, a C corporation, uses the calendar year as its tax year. To file an S election for 20X2, the election may be filed anytime in 20X1 or during the period that starts on January 1, 20X2 and ends on March 15, 20X2. If Circle Corporation makes the election on March 31, 20X2, the corporation remains a C corporation in 20X2 and becomes an S corporation in 20X3. However, if Circle Corporation can show reasonable cause for making the late election, the IRS may allow the election to be effective for 20X2.

Question 24

The S corporation - Involuntary and Inadvertent Terminations

Answer 24

For example a calendar year S corporation adds a one hundred and first shareholder on June 4. The S corporation status terminates on June 3. The corporation files a short-period S corporation tax return for the period January 1 through June 3 and files a C corporation tax return for the period from June 4 through December 31. Income or loss is prorated to the two tax returns on a daily basis. However, if the termination is deemed to be inadvertent and the violation of the 100-shareholder requirement is corrected within a reasonable time period, the S corporation status is considered to have been continuously in effect. In this case, no C corporation tax return is required. A single S corporation tax return will be filed for the year.

Question 25

The S corporation - Distribution to Shareholders -The gain then passes through to the shareholders whose basis for their S corporation stock is increased. The distributed property’s FMV reduces the shareholders’ S corporation stock basis.

Answer 25

For example, Austin Corporation, an electing S corporation, distributes land (a capital asset) to its sole shareholder Sue. The land has a $10,000 basis and a $90,000 fair market value. The S corporation recognizes an $80,000 capital gain, which passes through to Sue and increases the basis of her Austin stock. The basis of the land to Sue is $90,000 (its fair market value).

Question 26

The S corporation - Corporate Tax on Built-In Gains -A built-in gain exists if the FMV of an asset exceeds its adjusted basis on the first day the S election is effective.

Answer 26

For example, Beach Corporation, an accrual method taxpayer incorporated four (4) years ago, elects to be taxed as an S corporation as of January 1 of last year. On January 1 of last year, Beach owned land with a $50,000 basis and a $200,000 FMV. Beach sold the land this year for $225,000. Thus, Beach reports a total gain of $175,000 ($225,000 - $50,000). The first $150,000 of post-conversion appreciation is subject to the built-in gains tax at the corporate level and flows through to the shareholders. The remaining $25,000 of post-conversion appreciation also is subject to the regular S corporation pass-through rules but is not subject to the built-in gains tax. In addition, the built-in gains tax that is paid by the corporation flows through as a loss to the shareholders.

Question 27

The S corporation - Tax on Excess Net Passive Income -A 21% excess net passive income tax applies when an S corporation has passive investment income for the tax year that exceeds 25% of its gross receipts and, at the close of the tax year, the S corporation has accumulated Subchapter C E&P. Subchapter C E&P is the earnings and profits the corporation earned when it was taxed as a C corporation.

Answer 27

For example, Acorn Corporation made an S election last year after having been a C corporation for several years. Acorn has accumulated Subchapter C E&P at the end of the current year. During the current year, Acorn’s excess net passive income is $10,000, made up of dividends and interest. The excess net passive income tax is $2,100 ($10,000 x 0.21). The tax reduces (on a pro rata basis) the passive income items (for example, dividends and interest) that pass through to its shareholders.