Bryant - Course 4. Tax Planning. 4. Tax Characteristics of Entities

Question 1

Select the factor that qualifies a person as an employee.

• Worker could suffer a loss or make a profit.
• Employee sets the work hours.
• Worker is not required to follow the employer’s instructions.
• Employer provides training and tools to the worker.

Answer 1

Employer provides training and tools to the worker.

Employees can receive training, but they cannot set their own work hours (generally) and must comply with employer directives.

Question 2

If all payments for their services are derived from direct sales rather than from the number of hours worked. An example is a licensed real estate agent.

Answer 2

A statutory nonemployee

Question 3

If a worker falls into one of these four categories:
* a driver who is paid on commission or is your agent,
* a life insurance sales agent,
* a person who works at home on materials or goods that you supply, or
* a salesperson who turns in orders for resale from wholesalers, retailers, contractors, or hotel or restaurant establishments.

Answer 3

A statutory employee

Question 4

If the person for whom the services are performed has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

Answer 4

An independent contractor

Question 5

If someone can control what services will be performed and how it will be done, even if the employee has freedom of action.

Answer 5

A common-law employee

Question 6

Employee versus Independent contractor

Answer 6

Generally, employees are distinguished from independent contractors under the tax law by applying a set of rules known as the 20 common law factors. If a sufficient number of these factors are present in an employment situation, this indicates that the employer has the right to control how the worker performs his work, and therefore the worker is an employee rather than an independent contractor. There isn’t a particular factor that influences this determination, and factors that are relevant in one situation may not be relevant in another.

Facts that provide evidence of the degree of control and independence fall into three categories:

Behavioral: Does the company have the right to control what the worker does and how the worker does his job?
Financial: Are the business aspects of the worker’s job controlled by the payer?
Type of Relationship: Are there written contracts or employee-type benefits? Will the relationship continue and is the work performed a key aspect of the business?

Question 7

Jean is planning on opening her own bed and breakfast establishment in the form of a sole proprietorship. Which of the following procedures will she need to complete? (Select all that apply)

• Set up the bed and breakfast establishment as a separate entity
• Obtain a business license required under the state law
• Obtain an employer identification number (EIN) from the IRS for her employees
• Obtain sufficient insurance to fulfill state requirements

Answer 7

Obtain a business license required under the state law
Obtain an employer identification number (EIN) from the IRS for her employees
Obtain sufficient insurance to fulfill state requirements

As a sole proprietor, Jean may be required to obtain a business license in the city in which she operates. If she has employees or is required to pay federal excise taxes, she must obtain an employer identification number (EIN) from the IRS. A sole proprietor is required to obtain sufficient insurance (although, the sufficient amount required could be $0), nor will the establishment be set up as a separate entity.

Question 8

Jean owns a bed and breakfast establishment as a sole proprietor. When she files the earnings of the establishment, she reports it under the business’ own tax identification number and on its own business tax forms.

• False
• True

Answer 8

False

The sole proprietorship is not a separate entity from its owner. This extends to the tax treatment of the business’ profits and loss as well. The business’ earnings are reported as part of the owner’s personal tax form under Schedule C.

Question 9

If a customer sues Jean for injuries obtained at Jean’s bed and breakfast that she owns as a sole proprietor, which of the following statements is true?

• The Bed and Breakfast will bear the settlement alone
• Jean will be personally liable for the settlement
• Jean will not be responsible for the settlement
• Jean’s personal property is not exposed to the suit

Answer 9

Jean will be personally liable for the settlement

The sole proprietorship is not a separate entity from its owner. Hence, the owner has to assume full responsibility for all business debts and liabilities. The owner’s personal property is not immune to the business’ debts and liabilities. This is the greatest disadvantage of a sole proprietorship.

Question 10

All tax-exempt organizations are non-profit organizations.

• False
• True

Answer 10

False.

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

Question 11

What are the advantages of establishing a C-corporation over other forms of business entities? (Select all that apply)

• Double taxation
• Additional options for raising capital
• Limited liability for owners
• Restrictions on the number and type of shareholders that can own stock

Answer 11

Additional options for raising capital
Limited liability for owners

Advantages of a C-corporation include limited liability for the amount invested by shareholders, and the ability to raise capital through debt or by issuing equity. A disadvantage includes double taxation since shareholders pay taxes on distributed dividends and companies pay corporate taxes. There are no restrictions on the number and type of shareholders that can own stock in a C-corporation.

Question 12

Which of the following statements concerning business entities are correct? (Select all that apply)

• A qualified personal service corporation must use the 21% maximum corporate tax rate to calculate its tax liability.
• Professionals may incorporate as professional corporations to take advantage of retirement and other tax advantages available to corporate employees.
• A trust is subject to the same tax rates as corporations.
• An association is a legally established entity.

Answer 12

A qualified personal service corporation must use the 21% maximum corporate tax rate to calculate its tax liability.
Professionals may incorporate as professional corporations to take advantage of retirement and other tax advantages available to corporate employees.

A trust is subject to the same tax rates as individuals, not corporations. An association is not a legally established entity it is a group of people joined together for a common purpose. Professionals may incorporate as professional corporations to take advantage of tax advantages available to corporate employees that aren’t available to self-employed individuals such as proprietors and partners. A qualified personal service corporation must use the 21% maximum corporate tax rate to calculate its tax liability.

Question 13

Match the following:
Personal Service Corporation
Personal Holding Company
Professional Corporation
C Corporation

• May be publicly traded or privately held.
• Income is derived from personal investments
• Shareholders are personally liable for their professional acts.
• May use the cash method of accounting.

Answer 13

Personal Service Corporation - May use the cash method of accounting.

Personal Holding Company - Income is derived from personal investments

Professional Corporation - Shareholders are personally liable for their professional acts.

C Corporation - May be publicly traded or privately held.

Question 14

Aubin purchased a stock for $10 on November 20, 2022, and exchanged it for $12 on May 10, 2023. What has she experienced?

• Short-term capital gain (STCG)
• Long-term capital gain (LTCG)
• Long-term capital loss (LTCL)
• Short-term capital loss (STCL)

Answer 14

Short-term capital gain (STCG)

Short-term capital gain (STCG) is the gain realized on the sale or exchange of a capital asset held for one year or less.

Question 15

What is the netting process procedural rules for capital gains for individuals and corportations?

Answer 15

Long-term capital gains (LTCGs) are netted against long-term capital losses (LTCLs).
Short-term capital gains (STCGs) are netted against short-term capital losses (STCLs).
A net long-term capital gain (NLTCG) is then offset against a net short-term capital loss (NSTCL).
A net long-term capital loss (NLTCL) is then offset against a net short-term capital gain (NSTCG).

If a corporation reports both a NLTCG and a NSTCG after the netting procedure is completed, both the NSTCG and the NLTCG are taxed at the same rates as ordinary income.

Question 16

After the netting process procedural rules for corportations have been applied, how are the net results taxed to the individual?

Answer 16

NSTCGs are netted against NLTCLs, and any excess amount is taxed at the same rates as ordinary income.

NLTCLs and NSTCLs cannot be deducted from ordinary income for corporations. (individuals can deduct up to $3,000 per year)

Question 17

If a corporation reports both a NLTCG and a NSTCG after the netting procedure is completed, at what rate is NSTCG and the NLTCG are taxed at?

Answer 17

If a corporation reports both a NLTCG and a NSTCG after the netting procedure is completed, both the NSTCG and the NLTCG are taxed at the same rates as ordinary income.

Question 18

How much NLTCLs and NSTCLs be deducted from ordinary income for corporations?

Answer 18

NLTCLs and NSTCLs cannot be deducted from ordinary income for corporations.

(individuals can deduct up to $3,000 per year)

Question 19

How much NLTCLs and NSTCLs be deducted from ordinary income for individuals?

Answer 19

NLTCLs and NSTCLs cannot be deducted from ordinary income for corporations.

Individuals can deduct up to $3,000 per year.

Question 20

What are the rules for Dividends-Received Deduction?

Answer 20

Percentage of Stock Owned Dividends - Received Deduction

Less than 20% = 50%
20% through 79.99% = 65%
80% or more = 100%

However, the 65% and 50% dividends-received deductions are subject to the following limitations:
The dividends-received deduction is limited to 65% (or 50%) of taxable income (computed without regard to the net operating loss (NOL) deduction or the dividends-received deduction and capital loss carrybacks to the limitation year).
The limitation based on 65% (or 50%) of taxable income does not apply if the corporation has an NOL for the current year after deducting the dividends-received deduction determined under the general rules.
The dividends-received deduction is not available if the stock is held 45 or fewer days out of the 91-day period that commences 45 days before the ex-dividend date.

Question 21

Main Corporation has a $400,000 NOL generated in 2019. Main Co.’s taxable income, dating back to 2014 has been:

Year Taxable Income
2014 $50,000
2015 $12,500
2016 $220,000
2017 $5,000
2018 $100,000
2019 $0
What is Main Corp.’s NOL carryforward that can be applied to offset future taxable income?

• $0
• $12,500
• $400,000
• $50,000

Answer 21

$12,500

The NOL of $400,000 from 2019 can be carried back five years to 2014. From there it can be used to offset taxable income. The NOL minus Taxable Income results in the NOL Carryforward that is applied to the following year:

Year NOL Taxable Income NOL Carryforward
2014 $400,000 $50,000 $350,000
2015 $350,000 $12,500 $337,500
2016 $337,500 $220,000 $117,500
2017 $117,500 $5,000 $112,500
2018 $112,500 $100,000 $12,500
2019 $12,500 $0 $12,500

Question 22

What is the Compensation Deduction Limitation?

Answer 22

A publicly held corporation is prohibited from taking a deduction for compensation in excess of $1 million paid to the CEO, CFO, or any of the three highest-paid employees, and an additional “five highest compensated employees” beyond the CEO, CFO, and the three highest-paid executive officers.

Question 23

What is the current corporate tax rate?

Answer 23

The current corporate tax rate is a flat 21%.

Question 24

What are the 2 corporate Penalty Taxes?

Answer 24

Accumulated Earnings Tax (Section 531)

Personal Holding Company (PHC) Tax (Section 541)

Question 25

What is the reason for imposing the penalty for Accumulated Earnings Tax (Section 531)?

Answer 25

To discourage companies from retaining excessive amounts of earnings if the funds are invested in non-operating assets. A primary purpose is to force dividend payments of excess earnings.

Question 26

What is the reason for imposing the penalty for Personal Holding Company (PHC) Tax (Section 541)?

Answer 26

To prevent closely held companies from converting an operating company into a passive investment company. A primary purpose is to force dividend payments of passive income.

Question 27

What is the reason for the nature of the tax formula for Accumulated Earnings Tax (Section 531)?

Answer 27

The tax base is taxable income plus or minus certain adjustments. The tax computation is inherently subjective because the accumulated earnings credit (which often reduces the tax base to zero) is based on the retention of earnings for the reasonable needs of the business, which is a subjective determination.

Question 28

What is the reason for the nature of the tax formula for Personal Holding Company (PHC) Tax (Section 541)?

Answer 28

The determination of whether a corporation is a personal holding company and the computation of the penalty tax is a mechanical process. Once the corporation is determined to be a PHC, the tax base is taxable income plus or minus certain adjustments.

Question 29

What is the reason for the computation of tax for Personal Holding Company (PHC) Tax (Section 541)?

Answer 29

Adjustments are made to taxable income for items such as the dividends-received deduction, the dividends-paid deduction, and the federal income tax liability to arrive at undistributed PHC income. The penalty tax (which is in addition to the regular tax liability) is 20% of undistributed PHC income.

Question 30

What is the reason for the computation of tax for Accumulated Earnings Tax (Section 531)?

Answer 30

Adjustments are made to taxable income for items such as the dividends-received deduction, the dividends-paid deduction, the federal income tax liability, and the accumulated earnings credit. The penalty tax (which is in addition to the regular tax liability) is 20% of accumulated taxable income.

Question 31

How can a company avoid the Accumulated Earnings Penalty Tax?

Answer 31

The accumulated earnings tax discourages companies from retaining excessive amounts of earnings if the funds are invested in assets unrelated to business needs.

Thus, a company may avoid the penalty tax if its earnings are reinvested in operating-type assets or retained for the reasonable needs of the business. If this tax was not imposed, closely held corporations might not pay dividends to their shareholders (thereby avoiding a double tax on the earnings). The retained earnings then could be reinvested in passive investments.

Reasonable needs of the business include:
* Reasonably anticipated expansion of the business and plant replacement
* Acquiring the assets or stock (other than portfolio investments) of another business
* Providing working capital for the business
* Establishing a sinking fund to retire corporate debt
* Making investments in or loans to suppliers or customers

Question 32

Accumulated Taxable Income Calculation?

Answer 32

Taxable income:

(+) Dividends-received deduction
(+) Net operating loss deduction
(-) Net capital losses
(-) Net long-term capital gains over net short-term capital losses (less federal income tax on such net gains)
(-) Federal income tax liability
(-) Charitable contributions exceeding the 10% limit
(-) Deductions for dividends paid or deemed paid
(-) Accumulated earnings credit **
—————

= Accumulated taxable income

Question 33

How much is the Accumulated earnings credit for Personal Service Corporations and non-personal Service Corporations?

Answer 33

Personal Service Corporations are allowed an accumulated earnings credit of $150,000 while non-personal service corporations are allowed a credit of $250,000.

Question 34

What are the 2 tests to be classified as a personal holding company?

Answer 34

A company must meet both of the following tests to be classified as a personal holding company:

More than 50% of the value of the outstanding stock is owned by five or fewer individuals at some time during the last six months of the tax year;
60% or more of adjusted ordinary gross income is personal holding company income. Personal holding company income consists of passive types of income including dividends, interest, and, under certain circumstances, rental income.

Question 35

What is the computation of Personal Holding Company Tax?

Answer 35

The personal holding company tax is the highest individual tax rate for dividends times undistributed personal holding income. Various adjustments are made to taxable income to arrive at the tax base. These adjustments are similar to those for the accumulated earnings tax.

Question 36

How can personal holding company tax be avoided?

Answer 36

The personal holding company tax may be avoided** if the company 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 37

A corporation may be capitalized with both equity securities (generally common or preferred stock) and long-term debt issued to the shareholders.

What is the advantages of issuance of debt in the capital structure?

Answer 37

The interest payments on the debt are deductible by the corporation, whereas dividends are not deductible.

Redemptions of stock may result in dividend income treatment to the shareholders unless certain requirements are met, whereas repayment of debt is a tax-free return of capital.

Question 38

If the corporation is too thinly capitalized (for example, excessive amounts of debt are issued relative to the amount of equity capital), the IRS may attempt to recharacterize the debt as equity and deny an interest deduction to the corporation.

What are the guidelines in IRC Section 385 for determining whether the debt is recharacterized as equity?

Answer 38

• The legal form of the instrument and actual adherence to its terms.
• Excessive debt-equity ratio.
• Proportionality of debt and shareholder’s equity interests.
• Convertibility of the debt into a stock of the corporation or contingent interest payments based on corporate earnings.

Under Section 385, the issuing corporation must characterize the instrument as debt or stock. The shareholders or debt-holders are prohibited from treating the instrument inconsistently with the issuer’s characterization unless they disclose the inconsistent treatment on their tax returns. The issuer’s characterization is not binding on the IRS.

Question 39

What is and describe Earnings and profits (E&P)?

Answer 39

Earnings and profits (E&P) measure a corporation’s economic ability to pay dividends from its current and accumulated earnings without impairment of capital.

This means that the corporation has generated an operating surplus on its capital.

If the corporation has no E&P, a distribution represents a tax-free return of capital, and possibly a capital gain, rather than a taxable dividend.

Question 40

Describe Current vs. Accumulated Earnings

Answer 40

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.

Question 41

When a corporation repurchases (redeems) some of its outstanding stock from a shareholder, the stock redemption is treated as?

Answer 41

• A taxable dividend (to the extent of E&P)
• An exchange of the stock, generally resulting in capital gain or loss treatment by the shareholder

Question 42

Which type of treatment prevents corporations from paying disguised dividends in the form of a stock redemption, taxable as a capital gain?

• Taxable dividend
• Exchange of stock
• Exchange of bond
• Outstanding shares

Answer 42

Taxable dividend treatment prevents corporations from paying disguised dividends in the form of a stock redemption, taxable as a capital gain.

Question 43

Stock redemption is treated as an exchange subject to capital gain or loss treatment (opposed to dividend) if any of the following 3 conditions or tests are met:

Answer 43

• The redemption is substantially disproportionate to the shareholder’s interest.
• The redemption is not essentially equivalent to a dividend.
• The redemption results in a complete termination of the shareholder’s interest.

Question 44

What does a complete termination of a shareholder’s stock interest qualify for? (Select all that apply)

• Capital gain
• Loss treatment
• Refund
• Ownership

Answer 44

Capital gain
Loss treatment

Under Section 302(b)(3), a complete termination of a shareholder’s stock interest also qualifies for capital gain or loss treatment.

Question 45

Two additional redemption rules cover special situations:

Explain Section 302(b)(4)

Answer 45

Section 302(b)(4) provides exchange (rather than dividend) treatment for noncorporate shareholder redemptions in a partial liquidation of the distributing corporation. To qualify, the distribution must be made pursuant to the termination of an active trade or business of the distributing corporation or be considered not essentially equivalent to a dividend at the corporate level.

Question 46

Two additional redemption rules cover special situations:

Explain Section 303

Answer 46

Section 303 permits the executor of an estate or a beneficiary to have stock in a closely held corporation redeemed, whereby the redemption is treated as an exchange (rather than as a dividend) provided certain conditions are met. The redemption amount is limited to the death taxes imposed and the amount of deductible funeral and administration expenses incurred.

Question 47

In a complete liquidation, what happens to the assets?

Answer 47

Either distributed in-kind to the shareholders in exchange for their stock or sold and converted to cash in exchange for their stock.

Question 48

Distribution of Assets Example:

Pursuant to a complete liquidation, Southern Corporation distributes the following assets to its shareholders:

Inventory: $10,000 basis, $20,000 FMV
Land held as an investment: $5,000 basis, $40,000 FMV, subject to a $30,000 liability
Marketable securities: $20,000 basis, $15,000 FMV

What does Southern Corporation recognize as ordinary income and capital gain/loss?

Answer 48

Southern Corporation recognizes $10,000 ($20,000 - $10,000) of ordinary income on the distribution of the inventory, $35,000 ($40,000 - $5,000) of capital gain on the distribution of the land, and $5,000 ($15,000 - $20,000) of capital loss on the distribution of the marketable securities.

Question 49

Tax Consequences of a Complete Liquidation Example:

Sun Corporation makes a liquidating distribution of land with a $70,000 adjusted basis and a $100,000 FMV to shareholder John, who surrenders his Sun stock to the corporation. Joan, another shareholder, receives $100,000 cash for her shares. John’s adjusted basis in the Sun stock is $40,000. Joan’s adjusted basis in her stock is $120,000.

What capital gain/loss does John and Joan recognize?
What is John’s tax basis of the land?

Answer 49

John recognizes a $60,000 ($100,000 - $40,000) capital gain.

Joan recognizes a $20,000 ($120,000 - $100,000) capital loss.

The tax basis of the land received by John is $100,000 (the land’s FMV on the distribution date).

Question 50

What is the limitation for Non-business bad debts counted as deductible as a short-term capital loss?

Answer 50

The use of long-term debt to capitalize a closely held C corporation is an excellent choice assuming that the corporation is profitable. However, if the corporation is not successful and goes bankrupt, the corporate debt owed to the shareholders becomes worthless and is treated by any non-corporate shareholders as a non-business bad debt. Non-business bad debts are deductible as a short-term capital loss, subject to the $3,000 per year limitation.

Question 51

How much may a shareholder deduct up to as an ordinary loss if corportation’s sock is considered Section 1244 became worthless?

Answer 51

As an alternative to using debt, the shareholders could capitalize the corporation using stock (equity). Assuming that the requirements are met, the corporation’s stock would be considered as a Section 1244 stock (small business corporation stock). Upon the Section 1244 stock becoming worthless, each shareholder may deduct up to $50,000 ($100,000 on a joint return) as an ordinary loss. The ability to deduct up to $100,000 against ordinary income is superior to the capital loss treatment that applies to non-business bad debts.

Question 52

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

• False
• True

Answer 52

False.

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

Question 53

Describe Dividend Policy

Answer 53

Dividends paid from E&P are fully taxable to shareholders and are not deductible by the corporation. Thus, in a closely held corporation where ownership and management are not separated, the parties may wish to increase salary payments to shareholder-employees rather than increase dividends. A similar type of incentive may be present for a shareholder; he or she may lease property to a corporation instead of transferring it to the corporation as a capital contribution. Even though the increased salary or rental payments are taxable to the shareholders (as are dividends), these payments are deductible as business expenses by the entity as long as the amounts paid are reasonable. This is an important way to avoid the double taxation of corporate income, which occurs if dividends are paid rather than compensation or rent.

Question 54

How can you use operating and capital loss carryovers?

Answer 54

A corporation should plan to use its net operating loss and capital loss carryovers. For example, the sale of appreciated business assets may result in recognition of Section 1231 gain that can offset capital loss carryovers because net Section 1231 gains receive capital gain treatment. Alternatively, the sale or disposition of assets may result in the recognition of ordinary income because of the depreciation recapture rules. This ordinary income can offset expiring NOLs.

Question 55

Describe charitable donations through corporations.

Answer 55

Many owners of closely held corporations prefer to make charitable donations through their controlled corporations rather than as individuals because the corporations can deduct the contributions. Otherwise, to fund the contributed amounts, the controlled corporation may have to make nondeductible dividend payments to the shareholders. Also, an accrual basis corporation may accelerate a charitable contribution deduction if the board of directors approves the contribution before year-end, and the corporation pays the pledge within 2½ months of the corporation’s tax year-end.

Question 56

Describe the Dividends-Received Deduction

Answer 56

Corporate shareholders may deduct the dividends received from other corporations in which there is ownership interest. This deduction is 100%, 65%, or 50% of taxable income unless the deduction creates or increases a net operating loss (NOL). The specific deductible amount is dependent on the percentage ownership in the other corporation that generated the dividend.

Percentage of Stock Ownership - Dividends-Received Deduction

Less than 20% = 50%

20% to 79.99% = 65%

Greater than 80% = 100%

A substantial scale-down of the dividends-received deduction may result if taxable income (other than the dividend income) is negative and if the final result is a small amount of taxable income being reported instead of an NOL. Therefore, if the limitation is expected to apply, the corporation should either accelerate deductions into the current year or postpone the recognition of income to a later year. Either action can result in the creation of an NOL that prevents the limitation on the dividends-received deduction from applying.

Question 57

For purposes of the accumulated earnings tax, all of the following are reasonable needs of the business EXCEPT which?

• Acquiring the assets or stock of another business.
• Retiring debts.
• Providing working capital for the business.
• Making loans to stockholders.

Answer 57

Making loans to stockholders.

Reasonable needs of businesses include: reasonably anticipated expansion of the business and plant replacement, acquiring the assets or stock of another business, providing working capital for the business, establishing a sinking fund to retire corporate debt, and making investments or loans to suppliers and customers, not stockholders.

Question 58

When a corporation repurchases (redeems) a portion of its outstanding stock from a shareholder, redemption is treated as either a taxable dividend or as an exchange of the stock, generally resulting in capital gain or loss treatment by the shareholder.

• False
• True

Answer 58

True

When a corporation repurchases (redeems) a portion of its outstanding stock from a shareholder, redemption is treated as: a taxable dividend (to the extent of E&P); an exchange of the stock, generally resulting in capital gain or loss treatment by the shareholder.

Question 59

In computing corporate net operating loss (NOL), which of the following is taken into consideration?

• Non-business deductions
• Capital gains and losses
• Dividend-received deductions
• Carryover, carryback deductions

Answer 59

Dividend-received deductions

The computation of a corporate net operating loss (NOL) does not involve making adjustments for non-business deductions and capital gains and losses as are required for individuals. In computing a corporation’s NOL, the full dividends-received deduction is allowed. However, no deduction is permitted for an NOL carryover or carryback from a preceding or succeeding year.

Question 60

First Corporation, which is in its fifth year of operations, has the following capital gains and losses in the current year:
LTCG $20,000
LTCL $4,000
STCG $16,000
STCL $40,000
Taxable income (exclusive of the capital gains and losses) is $60,000. What is First Corporation’s capital gain or loss position?

• Capital loss of $8,000
• Capital gain of $2,000
• Neither capital gain or capital loss
• Capital loss of $10,000

Answer 60

Capital loss of $8,000

NLTCG $16,000
NSTCL $24,000
————-
First Corporation thus has a net capital loss of $8,000.

Question 61

Short-term capital gain (STCG)

Answer 61

The gain realized on the sale or exchange of a capital asset held for one year or less.

Question 62

Short-term capital loss (STCL)

Answer 62

The loss realized on the sale or exchange of a capital asset held for one year or less.

Question 63

Long-term capital gain (LTCG)

Answer 63

The gain realized on the sale or exchange of a capital asset held longer than one year.

Question 64

Long-term capital loss (LTCL)

Answer 64

The loss realized on the sale or exchange of a capital asset held longer than one year.

Question 65

What is included in a partnership agreement?

Answer 65

In this agreement, the partners set out the terms of how the partnership will operate, how profits and losses are shared, and how income deductions and credits will be allocated to the partners.

Question 66

Define partnership

Answer 66

A partnership is an entity owned by two or more persons who have joined together to operate a business for profit. It is defined as “a syndicate, group, pool, joint venture, or other unincorporated organization” that carries on any business, financial operation, or venture. A partner is a member and can be an individual, corporation, trust or estate of such syndicate, group, pool, joint venture, or organization.

Question 67

Describe the 2 types of partnerships

Answer 67

In general partnerships, each partner has unlimited liability for partnership debts. Thus, these partners are at risk for more than their investment in the partnership.

In limited partnerships, at least one partner must be a limited partner. The general partners are liable for all partnership debts and the limited partners are liable only to the extent of their investment plus any amount they commit to contributing to the partnership if called upon.

Question 68

Define Limited Liability Partnerships (LLPs)

Answer 68

A limited liability partnership (LLP) is typically either a limited partnership or a general partnership that has registered as an LLP under the law of one or more states.

However, not all states recognize LLPs.

This form of partnership is particularly attractive to professional service partnerships, such as public accounting firms.

Question 69

How is a limited liability partnership (LLP) distinct from general partnerships and limited partnerships?

Answer 69

• Partners are liable for their own acts and the acts of individuals under their direction however they are typically not liable for the negligence, wrongful acts, or misconduct of other partners.
• If the LLP is also a general partnership, each partner has potential liability for partnership liabilities, such as wages owed to employees.
• State law may require an LLP to register and pay a fee each year and to carry a certain amount of liability insurance.
• The partners are not considered employees. However, general partners are subject to self-employment tax on their share of partnership income.
• If the partnership makes guaranteed payments to certain partners for services they perform for the partnership, those payments are taxable to the partners who receive them.

Question 70

Define Family Limited Partnerships (FLPs)

Answer 70

The family limited partnership (FLP) is a financial planning technique that enables a family to hold and manage its wealth, including the family business, with several generations of family members as partners.

The usual practice of formation is to establish the senior members of the family, who are likely to be the business owners, as general partners and name other members of the family as limited partners. Because a FLP can transfer the control of the business by appointing successor general partners, it can also be an effective business entity for estate planning purposes

Question 71

When creating a FLP, how must it be designed to accomplish a valid business or investment purpose?

Answer 71

• Conducting a family business, and
• Pooling family wealth and managing it in a coherent, structured way.

Question 72

What do Family Limited Partnerships (FLPs) allow families to do?

Answer 72

FLPs allow families to:
* Retain the control of the family business or investment assets by senior family members as general partners,
* Develop and implement a succession plan for transferring management of the business to the next generation,
* Transfer the family business or assets to future generations at the lowest permissible cost in estate and gift taxes, and
* Reduce the income tax liability on partnership income when it is allocated to limited partners in a tax bracket lower than the general partners’ bracket.

Question 73

What are the requirements for a corporation to qualify as an S corporation for federal tax purposes?

Answer 73

• Have no more than 100 shareholders,
• Be a domestic corporation,
• Have no shareholder who is a nonresident alien, and
• Have only one class of stock (S corporations cannot have common and preferred shares, but shares can be voting and non-voting stock).

Question 74

How are S corporations taxed?

Answer 74

Rules pertaining to an S corporation are located in Subchapter S of the IRC.

Legally, S corporations are the same as other corporations but for tax purposes, they are special corporations treated as flow-through entities.

S corporations are not taxed, and** income, deduction, loss, and credit items pass through to the shareholders. **Corporate tax rules will apply unless overridden by the Subchapter S provisions.

Question 75

Which statement about LLCs is true?

• LLCs are taxed like corporations.
• LLCs have a limited number of partners allowed.
• LLCs have a limited liability advantage that is similar to corporations.
• LLCs require a less formal creation process than general partnerships.

Answer 75

LLCs have a limited liability advantage that is similar to corporations.

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

Question 76

All of the following are tax consequences for LLCs that meet the federal income tax definition of a partnership, EXCEPT:

• The LLC will avoid double taxation on income.
• The members of an LLC will not be subject to self-employment tax.
• Health insurance premiums are 100% deductible for LLC members.
• The LLC is liable for payroll taxes on employee wages and excise taxes.

Answer 76

The members of an LLC will not be subject to self-employment tax.

Members of an LLC that meet the federal income tax definition of a partnership are subject to self-employment tax and can deduct health insurance premiums. An LLC is liable for payroll and excise taxes but avoids double taxation on income.

Question 77

Which of the following statement(s) regarding the liability of business owners is/are CORRECT? (Select all that apply)

• A sole proprietor has unlimited liability for business debts and judgments.
• A general partner’s business and personal assets are at risk to creditors.
• All members in an LLC typically enjoy limited liability.
• Shareholders of an S corporation do not have limited liability because the entity is a corporation under state law.

Answer 77

A sole proprietor has unlimited liability for business debts and judgments.
A general partner’s business and personal assets are at risk to creditors.
All members in an LLC typically enjoy limited liability.

Shareholders of an S corporation have limited liability as do members of an LLC. A sole proprietor or a general partner has unlimited personal liability for business debts and judgments.

Question 78

Which of the following are features of a partnership? (Select all that apply)

• Profits and losses are shared according to the partnership agreement.
• A partnership can be created without formality.
• A partner can be an individual, corporation, trust or estate.
• A partnership cannot have more than 100 shareholders.

Answer 78

Profits and losses are shared according to the partnership agreement.
A partnership can be created without formality.
A partner can be an individual, corporation, trust or estate.

An S corporation can only have 100 shareholders or less, but there are no restrictions on the number or types of partners in a partnership. A partnership can be created informally and profits and losses are divided according to the partnership agreement. A partnership is defined as a syndicate, group, pool, joint venture or unincorporated organization that carries on any business, financial operation or venture, and a partner is a member who can be an individual, corporation, trust or estate.

Question 79

Dean Accounting did not want to be liable for each partners’ conduct, so it converted to a different flow-through business entity. Identify the most suitable form of flow-through entity for Dean Accounting.

• Limited Liability Company
• Limited Liability Partnership
• S Corporation
• General partnership

Answer 79

Limited Liability Partnership

The LLP form limits legal liability. Under state LLP laws, partners are liable for their own acts and the acts of individuals under their direction. LLP partners are not liable for the negligence or misconduct of other partners. This entity is attractive to professional service partnerships, such as public accounting firms.

Question 80

Before the formation of a partnership, what items must be considered for tax implications?

Answer 80

• Basis of a partnership interest,
• Holding period for a partnership interest,
• Basis of partnership assets,
• Financial accounting considerations, and
• Organizational and syndication fees.

Question 81

Describe Section 721 (Nonrecognition Rules)

Answer 81

Section 721 (Nonrecognition Rules) prevents the recognition of gain or loss upon either the transfer of property in exchange for a partnership interest or subsequent transfers of property by the partners in exchange for a pro-rata increase in their partnership interests.

Without this nonrecognition provision, gain on a transfer of appreciated property would be recognized and the partners might not have sufficient liquidity (e.g., cash) to pay the tax.

In addition, the transfer of property to the partnership represents a mere change in ownership form, which is not a recognition event under the tax laws. Finally, the depreciation recapture rules do not apply if no gain is recognized under Section 721.

Question 82

What are the exceptions to Section 721?

Answer 82

• The Section 721 nonrecognition of gain or loss rules do not apply if the partner acts in a capacity other than a partner. For example, if a partner sells property to the partnership in an arms-length transaction, the sale would be taxable.
• If a partner contributes services instead of cash or property in exchange for an unrestricted partnership interest, the fair market value (FMV) of the services is taxed as compensation to the contributing partner because services do not qualify as property. This situation will often occur when partnerships are formed without adequate tax advice. If care is not taken at the inception of a partnership, an unanticipated and severe tax consequence will befall the partner who provides the service.
• The contributing partner recognizes gain if liabilities transferred to the partnership exceed the partner’s basis in the partnership. This is also a situation that can result in an unanticipated tax increase. Good planning can avoid or mitigate the impact of this rule.
• The contributing partner recognizes gain if the partnership is treated as an investment company had it been incorporated under Section 351.

Question 83

Describe Basis of Partnership Interest if the Section 721 nonrecognition rules apply

Answer 83

If the Section 721 nonrecognition rules apply, IRC 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.

If a contributing partner renders services to the partnership in exchange for a partnership interest, the contributing partner’s basis equals the amount of income recognized from rendering the services (i.e., the fair market value (FMV) of the services). The FMV basis is permitted because the partner recognizes ordinary income equal to the FMV of the services.

Question 84

Tina contributes a building worth $80,000 (adjusted basis of $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?

• $95,000
• $60,000
• $15,000
• $75,000

Answer 84

$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.

In Tina’s case, the $15,000 in services is added to the adjusted basis of $60,000 to determine her interest. $15,000 + $60,000 = $75,000.

Question 85

Describe the Section 752 Adjustment

Answer 85

A partner’s basis for his or her partnership interest includes the partner’s ratable share of partnership liabilities, as well as the basis attributable to any property and services, contributed to the partnership. In addition, the following rules apply if a partnership assumes a partner’s liability or if the partner transfers property to the partnership subject to liability:
* All partners treat an increase in partnership liabilities as a cash contribution, which increases their bases by their ratable share of the assumed liabilities.
* The partnership’s assumption of liability is treated as a cash distribution to the partner whose liability is assumed, which decreases his basis in the partnership.
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.

Question 86

Recourse debt is the term that is used when lenders have recourse back to the individual partners, should the partnership default on its obligation. Non-recourse debt is the term used to describe situations where the lenders do not have recourse with the partners, should the partnership default on its payments.

In order for the partners’ basis to be affected by non-recourse financing, where must the debt be obtained from (3 places)?

Answer 86

Bank
Government agency
Retirement or pension fund

Question 87

What is the Negative Basis Rule?

Answer 87

The basis of a partnership interest cannot be negative. Therefore, Section 731 requires recognition of a gain in situations where a negative basis would otherwise occur.

Question 88

Describe the Holding Period for Partnership Interest when contributing cash, property, or Section 1231 property

Answer 88

Depending on when a partner contributes cash, property, or Section 1231 property, the holding period for partnership interest can vary. For example:
* If a partner contributes only cash to the partnership in exchange for a partnership interest, the holding period begins on the date that the interest is acquired.
* If the partner contributes property, the holding period for the partnership interest generally includes the holding period of the contributed property.
* If the contributed property is other than a capital asset or Section 1231 property, the holding period begins on the date that the partnership interest is acquired.

Question 89

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

• The date of the partnership’s fiscal year.
• The date the interest is acquired by the partnership.
• The date the interest is acquired by Erica.
• The date the partnership received the cash.

Answer 89

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 90

What does IRC Section 723 provide?

Answer 90

IRC 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.

Without this rule, partners could increase the basis of their property for depreciation and subsequent sale purposes merely by contributing appreciated property to a partnership. Because the carryover basis rule applies, the partnership’s holding period for the property includes the period the property was held by the contributing partner.

Question 91

What are Financial Accounting Considerations regarding the carryover basis and nonrecognition rules?

Answer 91

Under Generally Accepted Accounting Principles (GAAP), the carryover basis and nonrecognition rules used in taxation do not apply.

For instance, if property is contributed to a partnership, its book value is recorded at the contributed property’s FMV. This GAAP treatment results in a difference between the tax bases and financial accounting book values of contributed assets.

Question 92

Financial Accounting Example:

Anwar contributes cash of $30,000 and Beth contributes land having a $30,000 FMV and a $20,000 adjusted basis to the AB Partnership. Each partner receives a 50% interest in the partnership. For financial accounting purposes, the land is recorded at $30,000. For tax purposes, the carryover basis of the land to the partnership is $20,000. No gain or loss is recorded for financial accounting purposes if the partnership later sells the land for $30,000. However, the partnership recognizes a $10,000 gain under the tax rules because the land’s adjusted basis for tax purposes is only $20,000. The $10,000 pre-contribution gain is allocated to Beth.

Answer 92

Anwar contributes cash of $30,000 and Beth contributes land having a $30,000 FMV and a $20,000 adjusted basis to the AB Partnership. Each partner receives a 50% interest in the partnership. For financial accounting purposes, the land is recorded at $30,000. For tax purposes, the carryover basis of the land to the partnership is $20,000. No gain or loss is recorded for financial accounting purposes if the partnership later sells the land for $30,000. However, the partnership recognizes a $10,000 gain under the tax rules because the land’s adjusted basis for tax purposes is only $20,000. The $10,000 pre-contribution gain is allocated to Beth.

Question 93

How much can a partnership deduct for the costs of organizing the partnership in the year the partnership begins?

Answer 93

A partnership can deduct up to $5,000 of the costs of organizing the partnership in the year the partnership begins business.

The deduction is limited to the lesser of
(1) the amount of organizational expenditures or
(2) $5,000, reduced by the amount by which such organizational expenditures exceed $50,000.

Any organizational expenditures exceeding the first year deduction can be deducted ratably over the 180-month period beginning with the month the partnership begins business. Organizational expenditures that qualify for this treatment include items such as the attorney’s fees for drafting the partnership agreement, the accountant’s fees for setting up the financial record system, and filing fees.

Question 94

How does a partnership treat syndicating fees?

Answer 94

The partnership must capitalize expenses attributable to syndicating the partnership. These expenses, however, are not amortizable.

Syndication fees are expenses incurred to promote and market partnership interests (usually associated with tax-sheltered limited partnership interests).

Examples of nondeductible syndication fees include brokerage and registration fees, legal fees of the underwriter and issuer, and printing costs associated with the prospectus and promotional materials.

Question 95

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

• Accounting fees
• Legal fees
• Printing costs of a prospectus
• Brokerage fees
• Filing fees

Answer 95

Accounting fees
Legal fees
Filing fees

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

Question 96

What permits partners some latitude to decide how income, deductions, losses, and credits are to be allocated among the individual partners?

Answer 96

IRC Section 704 permits partners some latitude to decide how income, deductions, losses, and credits are to be allocated among the individual partners. Special allocations are unique to partnerships and permit flexible arrangements among the partners for sharing specific income and loss items. A partner’s distributive share of such items is generally determined by the partnership agreement.

Question 97

What happens if any partner’s interest in the partnership changes during the year (e.g., due to the sale of a partnership interest or the entry of a new partner who contributes property to the partnership in exchange for an interest)?

Answer 97

If any partner’s interest in the partnership changes during the year (e.g., due to the sale of a partnership interest or the entry of a new partner who contributes property to the partnership in exchange for an interest),** all of the partners must determine their distributive share of the partnership income, deductions, losses, and credits according to their varying interests in the partnership during the year.**

Question 98

Describe basis adjustment for S corporation stock

Answer 98

Usually, a shareholder’s original basis for S corporation stock is either the amount paid for the stock or a substituted basis from a nontaxable transaction (e.g., a Sec. 351 tax-free corporate formation transaction). Adjustments are subsequently made for ordinary income (or loss) and separately stated items that flow through to the shareholders, as well as additional capital contributions by shareholders and distributions to shareholders.

Question 99

How is the distribution of cash or property from the partnership to a partner generally treated?

Answer 99

A distribution of cash or property from the partnership to a partner is generally treated as a** tax-free return of capital.** This treatment closely parallels the tax-free consequences resulting from a capital contribution of property made in exchange for a partnership interest under Section 721.

Question 100

Describe how Liquidating distribution vs Non-liquidating distribution are treated

Answer 100

Liquidating distribution: The partnership may desire to liquidate a partner’s entire interest due to retirement, death or other business reasons. In such cases, the liquidating distribution is treated as a sale or exchange of the partnership interest.

Non-liquidating distribution: A distribution may result in a reduction of a partner’s capital interest in the partnership. Property distributed to a partner in a non-liquidating distribution does not result in a taxable gain or loss to the partner unless the distribution includes cash or marketable securities in excess of the partner’s basis in his or her partnership interest.

Question 101

Which condition would prevent a corporation from qualifying as an S corporation?

• A corporation has an estate as a shareholder.
• A corporation is not a member of an affiliated group.
• A corporation has only one class of stock.
• A corporation has nonresident aliens as shareholders.

Answer 101

A corporation has nonresident aliens as shareholders.

To qualify as an S corporation, the corporation must not have a nonresident alien as a shareholder.

Question 102

What are the Qualification Requirements for a business to qualify as an S corporation?

Answer 102

To qualify as an S corporation, a business must meet the definition of a small business corporation. To meet this definition, the entity must have the following requirements:
* Must be a domestic (U.S.) corporation rather than a foreign corporation.
* Must not be an ineligible corporation.
* Must not have more than 100 shareholders.
* Must have only individuals, estates, certain kinds of trusts, and certain kinds of tax-exempt organizations as shareholders.
* Must not have a nonresident alien as a shareholder.
* Must issue only one class of stock.
All the above requirements must be met for the initial election to be made. Once an election is made, the requirements must be met on every day of each tax year that the S election is in effect. Otherwise, the election terminates.

Question 103

Select the maximum number of different individuals that can be considered shareholders in a single S corporation at one time.

• 50
• 100
• 150
• 200

Answer 103

200

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

Question 104

Subsidiaries of S Corporations

Answer 104

Although an S corporation may not have a corporate shareholder, it may own stock of a C corporation. If this stock ownership equals or exceeds 80%, however, the S corporation (parent) and the C corporation (subsidiary) are considered as an affiliated group under IRC Section 1504.

Starting in 1997, being a member of an affiliated group no longer terminates the S election. Nevertheless, an S corporation may not file a consolidated return with its 80%-owned subsidiaries.

Question 105

What is a Qualified Subchapter S Subsidiary (QSSS)?

Answer 105

In addition, an S corporation may have a Qualified Subchapter S Subsidiary (QSSS). The subsidiary is a QSSS if the parent S corporation owns 100% of the QSSS stock and elects to treat the QSSS as such. Under this election, the QSSS is not treated as a separate corporation for income tax purposes. Instead, all assets, liabilities, income, deductions, and credits of the QSSS are treated as those of the parent S corporation.

Question 106

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

• False
• True

Answer 106

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 107

What are the Election Requirements for S corporation status?

Answer 107

Election Requirements:
* File- All shareholders who own stock on the date the S election is filed must consent to the election. The election and consent are filed with the IRS on Form 2553.
* Consent - Shareholders who own stock during any part of the tax year must consent to the election if they own stock on any day preceding the election date.
* Election- A corporation may make the election in the tax year preceding the election year or on or before the fifteenth day of the third month of the election year.

Question 108

An election to be taxed as an S corporation becomes effective only as of the beginning of a tax year, but a termination can become effective before the end of a normal year. Some termination conditions to be aware of are:

Answer 108

Revocation of S corporation status,
Involuntary and inadvertent terminations, and
Election after termination.

Question 109

Revocation of S Corporation Status

Answer 109

An S election may be terminated either voluntarily by the shareholders or involuntarily if the corporation fails to continue to meet the requirements for a small business corporation (e.g., if on any day in any year the S corporation has more than 100 shareholders or issues a second class of stock). Voluntary revocation is permitted if consent is obtained from shareholders owning more than 50% of the corporation’s stock.

Question 110

Involuntary and Inadvertent Terminations

Answer 110

An S corporation may involuntarily lose its special tax status and revert to being a C corporation if it fails to meet the small business corporation requirements or if it has excessive (i.e., more than 25% of gross receipts) amounts of passive (investment) income for each year in a three-year period. However, if the IRS deems that the termination was inadvertent and the S corporation or its shareholders take the necessary steps within a reasonable time period to restore its small business corporation status, the S corporation status is considered to have been continuously in effect.

Question 111

If an S corporation terminates its election, the corporation may not re-elect S corporation status for how long?
* 1 year
* Never
* 5 years
* 3 years

Answer 111

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 re-election. For purposes of the five-year rule, tax years beginning before January 1, 1997 are not counted.

Question 112

S Corporation Operations
Income, gains, losses, deductions, and credits pass through to the S corporation’s shareholders in a manner similar to the partnership rules. Some common separately stated items include:

Answer 112

• Short-term and long-term capital gains and losses
• Section 1231 gains and losses
• Charitable contributions
• Credits
• Interest on investment indebtedness
• AMT adjustments and tax preference items
• Foreign taxes paid or accrued
• Dividends and other portfolio income

Question 113

When comparing income allocation requirements of a partnership and an S corporation, _ ______??______,
I. partnership income must be allocated based on percentage of stock owned on a daily basis
II. S corporations special allocations are permitted.
* I only
* II only
* Both I and II
* Neither I nor II

Answer 113

Neither I nor II

In the case of an S corporation, the income must be allocated based on percentage of stock owned on a daily basis. Partners have 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 114

Basis Adjustments

Answer 114

Under IRC Section 705, the basis of each partnership interest is adjusted to reflect the partner’s share of income and deduction items. This basis adjustment is necessary to ensure a single level of taxation of partnerships. Basis adjustments for income and deduction items are made currently regardless of whether an actual distribution is made to the partners.

In addition, each partner’s basis in the partnership interest is adjusted for capital contributions, withdrawals, and changes in liabilities that occur during the year.

Each partner’s basis is increased by the partner’s distributive share of partnership ordinary income and separately stated income and gain items. The basis of the partnership interest is increased whether the income is taxable to the partners or is tax-exempt.

A partner’s basis is decreased (but not below zero) by partnership distributions and by the partner’s distributive share of partnership ordinary loss, separately stated losses and deductions, and expenditures that are nondeductible in computing partnership ordinary income or loss (e.g., charitable contributions made by the partnership).

Question 115

Losses and Limitations

A shareholder’s deduction for ordinary losses and separately stated items cannot exceed his or her basis for the S corporation stock plus the debt basis for any shareholder loans made to the S corporation. The following rules apply when determining the deductibility of ordinary loss and separately stated loss items:

Answer 115

• A positive basis adjustment is made to the stock basis for ordinary income or separately stated income or gain items accruing during the year before the ordinary losses and separately stated loss and deduction items are used to reduce the stock basis.
• The shareholder’s deduction for pass-through losses is limited to the stock basis after the above positive adjustments and after distributions but before negative adjustments for losses and deductions and the shareholder’s debt basis.
• A shareholder’s pass-through loss first reduces the shareholder’s stock basis (but not below zero).
• If the loss exceeds the stock basis, the remaining pass-through loss then reduces the shareholder’s debt basis (but not below zero).
• If the loss exceeds both the stock and debt basis, the shareholder carries over the excess loss and deducts it in a subsequent year when the shareholder again has basis in stock or debt. The carryover basis is indefinite but does not transfer to another taxpayer if the shareholder disposes of all of the stock or if the shareholder dies. Furthermore, if the S election is terminated, the loss must be used against any basis of the former S corporation stock by the end of a one-year post-termination transition period.

Question 116

Restoration of Basis

Answer 116

If a shareholder’s debt basis in a loan made to the S corporation is reduced by a loss deduction, subsequent increases in basis resulting from S corporation income in a future year initially increase the debt basis until that basis reduction is fully restored. Any excess positive adjustment then increases the shareholder’s stock basis.

If the debt basis is not fully restored, gain results when the loan is repaid. If the loan is in the form of a note, the repayment results in a capital gain because the note constitutes a capital asset. However, ordinary income results if the loan is an unsecured advance.

Question 117

Passive Activity Loss Limitation

Answer 117

The passive activity loss limitations apply to partners who do not materially participate in the business of the partnership. The passive activity loss rules are applied at the partner level, that is, each partner must determine whether he or she materially participates in the partnership.

If a loss is determined to be passive, a partner may not deduct the loss against either earned income or portfolio income but may deduct the loss only against other passive income. These rules are highly significant and play a major role in determining the deductibility of partnership losses by partners.

Question 118

LIFO Recapture

Answer 118

If a C corporation converts to an S corporation, and had used the LIFO (Last-in-first-out) method of accounting for its inventories while a C corporation, the firm must recapture the LIFO reserve. If the FIFO (First-in-first-out) method of accounting for inventory is higher (usually it would be), the firm must pay tax on this LIFO recapture (the entire reserve) in four annual installments (the first installment is due the last year as a C corporation, and the remaining three as an S corporation).

Question 119

Distribution to Shareholders

Answer 119

Money or property distribution made by an S corporation to its shareholders is treated as a return of capital if the S corporation has no accumulated earnings and profits from pre-S corporation years. As such, the amount of money or FMV of the nonmoney property distributed to a shareholder reduces the basis of the shareholder’s S corporation stock. If distributions exceed the shareholder’s stock basis, the excess is treated as a capital gain if the stock is a capital asset.

The S corporation recognizes gain (but not loss) if it distributes nonmoney property to its shareholders. The distribution is treated as if the corporation sold the property to the shareholders at its FMV. 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.

Question 120

Distribution to Shareholder 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.

How much capital gain does S corporation recognizes?
How does it pass through to Sue?
What is the basis of the land to Sue?

Answer 120

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 121

Tax Year Restrictions

Answer 121

S corporations must use a calendar year unless a business purpose can be established for choosing a fiscal year-end.
These year-end restrictions prevent shareholders from deferring pass-through income for up to 11 months (e.g., if a January 31 fiscal year-end was permitted).

Also, like a partnership, an 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 122

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 _ ______??_______.

• 1 month
• 11 months
• 3 months
• 6 months

Answer 122

3 months

An S corporation may elect a maximum 3-month deferral if it agrees to make a special tax payment each year that approximates the deferral benefit.

Question 123

Treatment of Fringe Benefits

Answer 123

S corporation shareholders who own more than 2% of the outstanding stock are not eligible for tax-free corporate employee fringe benefits for the following statutory fringe benefits:
* The group term life insurance exclusion under Section 79 for premiums paid for a coverage of up to $50,000.
* The exclusion from income for premiums paid for accident and health insurance and medical reimbursement plans under Section 105 and Section 106.
* The exclusion for cafeteria plan benefits under Section 125.
* Employer-provided fringe benefits under Section 132.
* Meals and lodging furnished for the convenience of the employer under Section 119.
The fringe benefits listed above are included in the gross income of a more than 2% shareholder as a guaranteed payment. The amount of the payment is deductible by the corporation. Amounts received by a shareholder owning 2% or less of the S corporation’s stock are excluded by the shareholder and deductible by the corporation as they would be for employees of a C corporation.

Question 124

A partial list of fringe benefits not subject to special treatment includes:

Answer 124

• Stock options
• Qualified fringe benefits
• Nonqualified fringe benefits
• Compensation for injuries and sickness
• Educational assistance programs
• Dependent care assistance programs
• No additional-cost fringe benefits, qualified employee discounts, working condition fringe benefits, de minimis fringe benefits, and on-premises athletic facilities.

Question 125

Corporate Tax on Built-In Gains

Answer 125

A 21% corporate tax on built-in gains applies if a corporation that previously was a C corporation elects to be an S corporation. The built-in gains tax does not apply to a corporation that always has been an S corporation or that elected S corporation status before 1987. A built-in gain exists if the FMV of an asset exceeds its adjusted basis on the first day the S election is effective. If the corporation sells an asset with a built-in gain within the five-year period beginning on the effective date for the election, the S corporation is taxed on the built-in gain. Built-in losses existing on the first day of the S election period can be used to reduce built-in gains. Any appreciation on the asset that occurs after conversion from a C corporation to an S corporation is subject to the regular S corporation pass-through rules but is not taxed under the built-in gains tax. Any asset not held on the first day of the S corporation election period is also exempt from the built-in gains tax.

Question 126

Built-In Gains Tax 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).

How is the total gain of $175,000 treated?

Answer 126

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 127

Tax on Excess Net Passive Income

Answer 127

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.

Question 128

When would corporate form be preferred?

Answer 128

The corporate form may be preferred due to the availability of nontax attributes such as limited liability, the relative freedom to transfer ownership interests, and the ability to raise outside equity capital.

Question 129

If the owners expect operating losses in the initial years of operation, which organization form would be best?

Answer 129

If the owners expect operating losses in the initial years of operation, they may prefer the partnership form to either the C corporation or the S corporation form of organization.

In a C corporation, the operating losses do not benefit the shareholders directly and may be of no benefit if the corporation cannot generate sufficient profits in future years to offset the loss carryovers.

In a partnership, the losses pass through to the partners, limited by their basis for the partnership interest. The basis of a partner’s interest, however, includes his or her share of partnership liabilities.

In contrast, an S corporation’s ability to pass through losses is limited to the shareholder’s basis in the stock and any shareholder loans. Other S corporation liabilities, such as loans to the corporation, are not included in determining the shareholder’s loss limitation because the shareholders are not liable for such loans. Thus, the partnership form may provide its owners a greater opportunity to deduct losses than the S corporation form.

Question 130

When is an optional basis adjustment election under Section 754 usually desirable?

Answer 130

An optional basis adjustment election under Section 754 is usually desirable for an incoming partner whose partnership interest costs more than the tax basis of his or her share of the partnership’s assets. The excess amount is added to the new partner’s basis for his or her interest in the partnership’s assets. If the partnership made a Section 754 election in a prior year, the election continues in effect and automatically applies to the current year. However, if the election was not previously made, all of the partners must agree to make the election because it is made at the partnership level rather than by the individual partner.

Therefore, before a sale is consummated, an incoming partner should attempt to obtain assurances from the remaining partners that the partnership will agree to make the election in the current year if the election is not already in effect. Attaching a statement to a timely filed tax return for the year the transaction occurs constitutes the election.

Question 131

Grace is a financial planner hired by Joel to develop a financial plan. Joel owns a consulting business as a sole proprietor and is a general partner for a small publishing firm. Which of the following statements are correct about the debts of these entities that Joel owns an interest in? (Select all that apply)
* The consulting company’s debt is part of Joel’s personal debt.
* The consulting company’s creditors may place liens on his property.
* The publishing company’s debt may have increased Joel’s share of debt.
* Neither the consulting nor the publishing companies’ debts effects Joel’s personal debt.

Answer 131

The consulting company’s debt is part of Joel’s personal debt.
The consulting company’s creditors may place liens on his property.
The publishing company’s debt may have increased Joel’s share of debt.

Both the consulting company and the publishing company’s debt effects Joel’s personal debt obligations. It is likely that creditors require some sort of collateral from Joel’s personal property to secure loans for his business. An increase of borrowing by the partnership will result in an additional share of the debt for Joel.

Question 132

What is the basis of each partnership interest adjusted to reflect?
* Partner’s share of original contribution
* Partner’s share of income and deduction items
* Partner’s share of dividends
* Partner’s share of loans

Answer 132

Partner’s share of income and deduction items

Under Section 705, the basis of each partnership interest is adjusted to reflect the partner’s share of income and deduction items.

Question 133

Carl, partner with a $10,000 basis in the ABC Partnership, receives property having a FMV of $20,000 and a basis of $8,000 in a non-liquidating distribution. How much gain does Carl recognize?
* $10,000
* $12,000
* $0
* $28,000

Answer 133

$0

A partner recognizes gain only when the amount of cash distributed exceeds the basis of the partnership interest.

Question 134

An S corporation tax year is restricted to a calendar year unless the corporation establishes a business purpose for a fiscal year.
* False
* True

Answer 134

True

The tax year is restricted to a calendar year unless the corporation establishes a business purpose (e.g., a natural business cycle) for a fiscal year. Other special rules allow a tax year resulting in a maximum three-month deferral.

Question 135

Match the following:
Sole Proprietor
Corporation
Partnership

• A shareholder’s investment has no effect on their basis
• The basis for all or some of the partners will increase by their share of the debt
• Individual will be personally liable for repayment of the debt

Answer 135

Sole Proprietor - Individual will be personally liable for repayment of the debt

Corporation - A shareholder’s investment has no effect on their basis

Partnership - The basis for all or some of the partners will increase by their share of the debt

Question 136

Net Operating Losses (NOLs) generated in 2023 may be carried back _ ______??_______ years and carried forward _ ______??_______ years.
* two; twenty
* zero; unlimited
* five; unlimited
* ten; twenty

Answer 136

zero; unlimited

If you choose to carry back your NOL from 2023:
You cannot carry back your NOL, but you can carry it forward an indefinite number of years, and
Your NOL can offset only up to 80 percent of your taxable income before your 20 percent Section 199A deduction.

Question 137

The accumulated earnings tax rate is _ ______??_______ on excess accumulated earnings above a specified threshold.
* 20%
* 21%
* 15%
* 37%

Answer 137

20%

The accumulated earnings tax is imposed on a corporation’s accumulated taxable income for a particular year. The accumulated earnings tax rate is 20% on excess accumulated earnings above a specified threshold of $250,000 ($150,000 for a personal service corporation).

Question 138

Under IRC Section 731 basis of a partnership interest _ ______??_______.
* must be allocated
* cannot be negative
* may not be reduced
* does not include adjustments

Answer 138

cannot be negative

The basis of a partnership interest cannot be negative. Therefore, IRC Section 731 requires recognition of a gain in situations where a negative basis would otherwise occur.

Question 139

Select the characteristics of an S Corporation. (Select all that apply)
* Limited liability
* Double taxation
* Multiple-class shares
* Limited number of owners

Answer 139

Limited liability
Limited number of owners

C Corporation:
* Double taxation
* Multiple-Class Shares
* Separate entity
* Limited liability

S Corporation:
* Earnings Taxed Once
* Limited number of owners
* Separate Entity
* Limited liability

Question 140

Each of the following facts provides evidence of the degree of control and independence of a hired worker EXCEPT:
* Form of Compensation
* Type of Relationship
* Financial
* Behavioral

Answer 140

Facts that provide evidence of the degree of control and independence fall into three categories:
* Behavioral: Does the company have the right to control what the worker does and how the worker does his job?
* Financial: Are the business aspects of the worker’s job controlled by the payer?
* Type of Relationship: Are there written contracts or employee benefits? Will the relationship continue and is the work performed a key aspect of the business?

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

Question 141

If a worker is hired for a job and the employer has the right to control or direct only the result of the work and not the means and methods of accomplishing the result, the worker is BEST categorized as a(n) _ ______??_______.

• statutory nonemployee
• common-law employee
• statutory employee
• independent contractor

Answer 141

independent contractor

An independent contractor: If the person for whom the services are performed has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

The employer is not required to furnish an independent contractor with workers’ compensation coverage or fringe benefits.

Question 142

Which of the following are CORRECT regarding C corporations?
* There are no circumstances where creditors can pierce the corporate veil and seek payment from the shareholders.
* Shareholders have unlimited liability.
* There are no restrictions on the number or types of shareholders that can own stock in a C-corporation.
* Corporations usually prefer to obtain additional funds by issuing additional stock.

Answer 142

There are no restrictions on the number or types of shareholders that can own stock in a C corporation. This is one of the key advantages of a C corporation.

Question 143

A qualified personal service corporation (QPSC) must use the _ ______??_______ rate to calculate its tax liability.
* 37%
* 21%
* 15%
* 20%

Answer 143

21%

A qualified personal service corporation (QPSC) must use the 21% (2023) maximum corporate tax rate to calculate its tax liability.

Question 144

Sole proprietors may use which of the following as their tax identification number? (Select all that apply)
* Social Security Number (SSN)
* Employer Identification Number (EIN)
* Electronic Filing Identification Number (EFIN)
* Preparer Tax Identification Number (PTIN)

Answer 144

Social Security Number (SSN)
Employer Identification Number (EIN)

If a sole proprietorship has employees or is required to pay federal excise taxes, it must obtain an employer identification number (EIN) from the IRS. Otherwise, sole proprietors use their Social Security number (SSN) as their tax identification number.

Question 145

If a tax-exempt organization has unrelated business taxable income (UBTI) exceeding _ ______??_______ in 2023, it must pay income tax on that income.

• $2,500
• $1,000
• $600
• $4,300

Answer 145

$1000

If a tax-exempt organization has unrelated business taxable income (UBTI) exceeding $1,000 in 2023, it must pay income tax on that income. UBTI is defined as income from a business activity unrelated to the organization’s tax-exempt purpose.