Tax Characteristics of Entities - Review Questions

Question 1

Do you think the following statement, “All tax-exempt organizations are nonprofit organizations,” is true or false?

Choose the best answer.

False
True

Answer 1

False

Nonprofit status is a state law concept. Nonprofit status may make an organization eligible for certain benefits, such as state sales, property, and income tax exemptions. Although most federal tax-exempt organizations are nonprofit organizations, organizing as a nonprofit organization at the state level does not automatically grant the organization exemption from federal income tax.

Question 2

The CARES Act allows NOLs arising in 2021 or later to be carried back 5 years and carried forward indefinitely to offset capital gains.

True.
False.

Answer 2

False.

The CARES Act allows NOLs in 2018, 2019, and 2020 to be carried back 5 years and carried forward indefinitely to offset capital gains for those years. Starting in 2021, NOLs are subject to an 80% cap on the deduction and cannot be carried back, but can be carried forward indefinitely.

Question 3

In the current year, Chicago, Inc. had operating income of $750,000. They also own 30% of River North, Inc. and recently received a $250,000 dividend payment. Throughout the year, they incurred operating expenses of $900,000. What is their net operating loss for the current year and how much can they carry back or forward?

Choose the best answer.

1) $62,500 NOL, carried forward indefinitely
2) $62,500 NOL, carried back two years, then forward indefinitely
3) $62,500 NOL, carried back five years, then forward indefinitely
4) $100,000 NOL, carried forward indefinitely

Answer 3

1) $62,500 NOL, carried forward indefinitely

Gross income = $1 million ($750,000 operating income + $250,000 dividend payment). Their operating expenses are $900,000 and their dividends-received deduction is $162,500 (.65 x $250,000). As such, their net operating loss is $62,500. The loss cannot be carried back, as The TCJA of 2017 eliminated the two-year carryback option that was available until December 31, 2017. Prior to 2018, NOLs could only be carried forward for 20 years. Now, NOLs can be carried forward indefinitely.

Question 4

Which types of compensation are not taken into account for purposes of the $1 million limitation? (Check all that are true.)

1) remuneration payable on a commission basis
2) compensation based on individual performance goals (if approved by certain outside directors and shareholders)
3) payments to a qualified retirement plan
4) taxable employee benefits, such as employer-provided health care benefits

Answer 4

1) remuneration payable on a commission basis
2) compensation based on individual performance goals (if approved by certain outside directors and shareholders)
3) payments to a qualified retirement plan

The following types of compensation are not taken into account for purposes of the $1 million limitation:

remuneration payable on a commission basis
compensation based on individual performance goals (if approved by certain outside directors and shareholders)
payments to a qualified retirement plan, and
tax-free employee benefits, such as employer-provided health care benefits.

Question 5

Ajax Inc., a C-Corporation which is not a personal service corporation, has the following items of income and expense:

Taxable income - $715,000
Dividends paid - $62,500
Federal income tax - $129,800
Accumulated earnings and profits at the end of the preceding year - $210,000

Calculate the Accumulated Earnings Penalty

Choose the best answer.

1) $40,905
2) $55,905
3) $96,540
4) $87,405

Answer 5

3) $96,540

Since Ajax is not a personal service corporation, they are allowed to accumulate up to $250,000 of accumulated earnings. (Current year accumulated earnings plus prior year accumulated earnings less the allowed amount) × .20 = the accumulated earnings tax.

Current year accumulated earnings =$715,000 − $62,500 − $129,800 = $522,700.
Now add beginning accumulated earnings and subtract the allowance for a non-personal service corporation: $522,700 + $210,000 − $250,000 = $482,700.
Now multiply by 20% to determine the tax: $482,700 × .20 = $96,540.

Question 6

Non-business bad debts are deductible as a long-term capital loss, subject to the $3,000 per year limitation.

Choose the best answer.

True
False

Answer 6

False

Non-business bad debts are deductible as a short-term capital loss, subject to the $3,000 per year limitation.

Question 7

The following exercise will ask you to compare C corporations and S corporations. Match characteristics to each type of corporation. Some characteristics may be attributable to both types of corporations.

C Corporation vs. S Corporation

Characteristics C Corporation S Corporation
Double Taxation
Earnings Taxed Once
Limited Liability
Limited Number of Owners
Multiple-class Shares
Separate Entity

Answer 7

Characteristics C Corporation S Corporation
Double Taxation Y N
Earnings Taxed Once N Y
Limited Liability Y Y
Limited Number of Owners N Y
Multiple-class Shares Y N
Separate Entity Y Y

Question 8

Which of the following statements is true about LLCs?

Choose the best answer.

1) They have similar limited liability advantage as corporations
2) They are taxed similar to corporations
3) They require a less formal creation process than general partnerships
4) There are a limited number of partners allowed

Answer 8

1) They have similar limited liability advantage as corporations

LLCs having similar liability advantages as corporations and tax advantage of partnerships. The creation of the entity is more complex and formal than general partnerships. Unlike S corporations, LLCs do not have a limited number of partners.

Question 9

Tina contributes a building worth $80,000 (adjusted basis $60,000) and $15,000 in services to a partnership for an interest in the partnership. What is Tina’s basis in the partnership interest?

Choose the best answer.

1) $15,000
2) $60,000
3) $75,000
4) $95,000

Answer 9

3) $75,000

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.

Question 10

Erica contributes cash to the XYZ partnership in exchange for interest in that partnership. When does the holding period begin for Erica?

Choose the best answer.

1) The date of the partnership’s fiscal year
2) The date the partnership receives the cash
3) The date the interest is acquired by Erica
4) The date the interest is acquired by the partnership

Answer 10

3) The date the interest is acquired by Erica

If a partner contributes only cash to the partnership in exchange for a partnership interest, the holding period begins on the date the interest is acquired.

Question 11

Which of the following are considered organizational expenses for a partnership? (Select all that are true.)

1) Legal fees
2) Accounting fees
3) Filing fees
4) Printing costs of a prospectus
5) Brokerage fees

Answer 11

1) Legal fees
2) Accounting fees
3) Filing fees

Organizational expenses include legal and accounting fees incident to organizing the partnership, filing fees, and other expenses.

Question 12

Why do partners increase the basis of their partnership interests by their share of tax-exempt income?

Answer 12

Increasing the basis ensures that the tax-exempt income will retain its tax-free character when the income is subsequently distributed in the form of cash or the partner’s interest in the partnership is sold or exchanged

Question 13

Partnership interest is considered a _____ _____.

Answer 13

Capital Asset

A partnership interest is a capital asset similar to a corporate security.

Question 14

Which of the following conditions would prevent a corporation from qualifying as an S corporation?

Choose the best answer.

1) A corporation that has an estate as a shareholder.
2) A corporation that is not a member of an affiliated group.
3) A corporation that has only one class of stock.
4) A corporation that has nonresident aliens as shareholders.

Answer 14

4) A corporation that has nonresident aliens as shareholders.

In order to qualify as an S corporation, the corporation must not have a nonresident alien as a shareholder.

Question 15

At any one time, how many different individuals could be shareholders in a single S corporation?

Answer 15

The S corporation could have as many as 200 shareholders if the group consisted of 100 married couples.

Question 16

An S corporation can have both voting and nonvoting common stock as long as the shares of stock have identical rights to shares in the profits and assets of the corporation.

True.
False.

Answer 16

True.

Treasury regulations allow that a corporation is treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.

Question 17

If an S corporation terminates its election, the corporation may not re-elect S corporation status for how long?

Choose the best answer.

1) 5 years
2) 1 year
3) never
4) 3 years

Answer 17

1) 5 years

If an S corporation terminates its election, the corporation may not re-elect S corporation status for five years unless the IRS consents to an early reelection. For purposes of the five-year rule, tax years beginning before January 1, 1997 are not counted.

Question 18

Compare the manner in which income of an S corporation is allocated among the shareholders to the manner in which partnership income is allocated among the partners.

Answer 18

In the case of an S corporation, the income must be allocated based on the percentage of stock owned on a daily basis. Partners have a much greater flexibility. The partnership agreement serves as the basis for allocation, with special allocations being permitted. No special allocations are permitted for an S corporation.

Question 19

Two years ago, Deb Yager and Joan Collins formed an S-corporation. They each owned a 50% interest. Deb contributed $75,000 cash, while Joan contributed $50,000 cash, as well as $25,000 of appreciated securities. Joan’s basis in those securities was $22,000. After the first year, the S-corporation generated $50,000 of profit. Each shareholder received a $10,000 cash distribution at that time. The business then suffered a loss of $12,000 in the second year. Because of the firm’s poor cash position, there were no cash distributions to the shareholders at the end of the second year. How much was Joan’s basis in the S-corporation after the second year?

Choose the best answer.

1) $59,000
2) $62,000
3) $81,000
4) $84,000

Answer 19

4) $84,000

$50,000 cash + $25,000 securities = $75,000 initial basis. Please note that appreciated securities are an exception to tax free formation in that the individual contributing the securities to the entity must recognize the gain on the transfer (treated as a sale).

After Year 1 = $75,000 + $25,000 (1/2 of $50,000 profit) - $10,000 cash distribution = $90,000

After Year 2 = $90,000 - $6,000 (1/2 of pass through loss) = $84,000.

Question 20

The maximum deferral an S corporation may elect if it agrees to make a special tax payment each year that approximates the deferral benefit is ____ month(s).

Answer 20

Three-Month

A S corporation may elect a maximum three-month deferral if it agrees to make a special tax payment each year that approximates the deferral benefit.

Question 21

Paul owns a business that produces $50,000 of annual profits. If the business were incorporated, it could justify the retention of all of its earnings and pay little or no dividends. Paul also has $400,000 of taxable income from other sources. Should Paul organize the business as an S corporation or as a C corporation?

Answer 21

C corporation

Although many factors could be involved, one important tax factor is that Paul’s income from the business could be taxed as high as the 37 % marginal tax rate if it is an S corporation. The tax rate on the C corporation is a flat 21% on all net income. Double taxation would result, however, if the profits were withdrawn as a dividend payment or as a capital gain when the stock was sold.

Question 22

Which one of the following is a valid requirement for an S-corporation election?

1) There may be no more than 175 shareholders.
2) There may be no more than two classes of stock.
3) A simple majority of shareholders must consent to the election.
4) All shareholders must be U.S. citizens or residents or be one of certain qualifying trusts.

Answer 22

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

Question 23

Which one of the following is not a special tax faced by corporations going from C to S status?

1) Corporate conversion tax
2) LIFO recapture
3) Built-in gains tax
4) Excess net passive income tax

Answer 23

1) Corporate conversion tax

Corporate conversion tax is not a real tax but the others are all possible taxes that a S-Corp would be subject to if the company converted from a C to a S corporation.

Question 24

Steve Jones and Darrel Thompson both have significant net worth and are currently in the 37% marginal income tax bracket. They have formed an environmental waste consulting business. They want to form a business that will protect their net worth in case the business fails or it becomes involved in lawsuits, but they also would like to be able to share ownership with other family members if the business is successful. Furthermore, it is anticipated that the business will experience a loss the first year. The business entity will have to borrow funds upon its inception, in order to sustain the first year operating losses. Which business form would be most appropriate for Steve and Darrel?

1) General partnership
2) Limited Liability Company (taxed as a partnership)
3) C-corporation
4) S-corporation

Answer 24

2) Limited Liability Company (taxed as a partnership)

The general partnership would expose the owners to liability. The C corp cannot pass through the losses for a tax advantage like the S-corp and the LLC can. The LLC would be preferred over the S-Corp due to partnership taxation. The debt that the entity borrows will be added to their basis to give them an advantage as it relates to the at-risk rules.

Question 25

Two years ago, Susan Smith and Jane Jones formed an S-corporation, in which they each owned a 50% interest. Susan contributed $50,000 in cash, while Jane contributed $30,000 in cash, as well as $20,000 of appreciated securities. Jane’s basis in those securities was $12,000. After the first year, the S-corporation generated $40,000 of profit. Each shareholder received a $15,000 cash distribution at that time. The business then suffered a loss of $6,000 in the second year of operation. Because of the firm’s poor cash position, each shareholder received a nominal cash distribution of $1,000 at the end of the second year. How much was Jane’s basis in the S-corporation after the second year?

1) $34,000
2) $42,000
3) $50,000
4) $51,000

Answer 25

4) $51,000

$30,000 cash + $20,000 appreciated securities + $20,000 50% pass-through of profit − $15,000 distribution − $3,000 50% of pass-through of loss − $1,000 distribution = $51,000. Please note the FMV of securities is used since the shareholder must pay an $8,000 gain upon the disposition.

Question 26

Which of the following are considered advantages of partnerships or LLCs taxed as a partnership?

leverage
tax conduit
special allocations
substantial economic effect

I and II only
II and IV only
I, II and III only
I, II, III and IV

Answer 26

I, II and III only

Substantial economic effect is what owners must adhere to when special allocations are made and is not generally considered an advantage.