V. Federal Taxation of Entities - 1.Corporate Taxation

Question 1

V. Federal Taxation of Entities

1. Corporate Taxation
2. Formation of a Corporation

III. Basis Issues

Answer 1

1. The corporation’s basis in the property received is: Shareholder’s basis in property + Gain recognized by shareholder
2. The shareholder’s basis in the stock received from the corporation is:

• Basis of all property transferred to the corporation
• • Gain recognized by shareholder
• − Boot received by shareholder
• − Liabilities assumed by corporations

Question 2

V. Federal Taxation of Entities

1. Corporate Taxation
2. Formation of a Corporation

V. Holding Period

Answer 2

1. The Shareholder’s Holding Period—For the stock may or may not include the amount of time the shareholder held the property just given to the corporation.
   
   1. Capital asset or Section 1231—Asset transferred to corporation—property holding period is tacked on to stock holding period.
   2. All other property—Holding period of property does not tack on. Holding period for stock begins on day after the transfer.
2. The Corporation’s Holding Period—In the property received always includes the period that the transferor held the property before the exchange.

Question 3

V. Federal Taxation of Entities

1. Corporate Taxation
2. Formation of a Corporation

Adams, Beck, and Carr organized Flexo Corp. with authorized voting common stock of $100,000. Adams received 10% of the capital stock in payment for the organizational services that he rendered for the benefit of the newly formed corporation. Adams did not contribute property to Flexo and was under no obligation to be paid by Beck or Carr.

Beck and Carr transferred property in exchange for stock as follows:

Adjusted basis Fair market value % of Flexo stock acquired

Beck 5,000 20,000 20%

Carr 60,000 70,000 70%

What amount of gain did Carr recognize from this transaction?

1. $40,000
2. $15,000
3. $10,000
4. $0

Answer 3

D.

The transaction would qualify as a tax-free event for Carr because it would be considered to be a Section 351 transfer. Under Section 351, no gain or loss is recognized if the property is transferred solely for the exchange of stock of the corporation, if immediately after the transfer the transferring taxpayer or taxpayers have control over the corporation. Control is defined as owning at least 80% of corporation’s voting stock and at least 80% of the corporation’s other classes of stock.

Since Beck and Carr together own 90% of the corporation immediately after the transfer, the transaction would be a tax-free event for both taxpayers.

Question 4

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Income

C. Special Rules

Answer 4

1. Accrual accounting is required except for small corporations (gross receipts less than $25 million), certain personal service corporations, and S corporations. Recurring expenses, however, must be paid within 8 1/2 months of the fiscal year-end to be deducted.
2. Passive loss rules
   
   1. Passive loss limits do not apply to corporations (except personal service corporations and certain “close” corporations).
   2. Closely held corporations can use passive losses to offset active corporate income but not portfolio income.
   3. Personal service corporations cannot offset passive losses against either active income or portfolio income.
3. Corporations are subject to a flat 21% tax rate beginning in 2018.
4. Beginning in 2018, personal service corporations are taxed at a flat 21% rate.

Question 5

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Income

Which of the following items should be included on the Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, of Form 1120, U.S. Corporation Income Tax Return, to reconcile book income to taxable income?

1. Cash distributions to shareholders
2. Premiums paid on key-person life insurance policy
3. Corporate bond interest
4. Ending balance of retained earnings

Answer 5

1. Cash distributions to shareholders do not reduce book or taxable income.
2. Premiums paid on key-person life insurance policies reduce book income but not taxable income, so this is a reconciling item for Schedule M-1.(Correct)

Question 6

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Income

On January 2 of this year, Big, an accrual-basis, calendar-year C corporation, purchased all of the assets of a sole proprietorship, including $300,000 of goodwill. Current-year federal income tax expense of $110,100 and $7,500 for goodwill amortization (based upon 40-year amortization period) were deducted to arrive at Big’s book income of $239,200. What is Big’s current-year taxable income (as reconciled on Schedule M-1)?

1. $239,200
2. $329,300
3. $336,800
4. $349,300

Answer 6

c.

The purpose of Schedule M-1 of Form 1120 U.S. Corporation Income Tax Return is to reconcile book income (loss) with income per the return. Federal income tax is not deductible for tax purposes so it must be added back to book income, giving $349,300 ($239,200 + $110,100). The goodwill is amortized over 15 years for tax purposes, or $20,000 per year ($300,000/15 years). Thus, the book goodwill amortization is added back and the tax goodwill is deducted. This results in taxable income of $336,800 ($349,300 + $7,500 − $20,000).

Question 7

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Income

Filler-Up is an accrual-basis, calendar-year C corporation. Filler-Up uses an allowance method for accounting for bad debts. The allowance for bad debts was $20,000 at the beginning of the year and $30,000 at the end of the year. During the year, Filler-Up wrote off $5,000 of uncollectible receivables and accrued an additional $15,000 of expenses for accounts estimated to be uncollectible. What is the Schedule M-1 adjustment on Filler-Up’s federal income tax return?

1. $10,000 decrease in taxable income.
2. $10,000 increase in taxable income.
3. $5,000 decrease in taxable income.
4. $5,000 increase in taxable income.

Answer 7

B.

The tax deduction for bad debts is limited to the amount allowed under the direct write-off method. Under the allowance method for bad debts (used for book purposes), Filler-Up recorded $15,000 in bad debt expenses for accounts estimated to be uncollectible. Filler-Up can deduct only $5,000 as bad debt expense for tax purposes. Therefore, Filler-Up must add $10,000 ($15,000 – $5,000) to book income as an M−1 adjustment.

Question 8

V. Federal Taxation of Entities

1. Corporate Taxation
2. Accounting Methods and Periods—Corporations

II. Tax Accounting Methods

Answer 8

Cash versus Accrual Accounting—In general, the following entities cannot use the cash method of accounting:

1. Regular C corporations
2. Partnerships that have regular C corporations as partners
3. Tax shelters (Note: The exceptions listed in item “4” below do not apply to tax shelters.)
   
   • Definition: Tax Shelter: An entity other than a C corporation for which ownership interests have been offered for sale in an offering required to be registered with Federal or State security agencies.
4. Notwithstanding the above, the following entities can use the cash method:
   
   1. Any corporation (or partnership with C corporation partners) whose annual gross receipts do not exceed $25 million. The test is satisfied for a prior year if the average annual gross receipts for the previous three-year period do not exceed $25 million. Once the test is failed, the entity must use the accrual method for all future tax years.
   2. Certain farming businesses
   3. Qualified personal service corporations

Question 9

V. Federal Taxation of Entities

1. Corporate Taxation
2. Special Corporate Deductions

Answer 9

II. Charitable Contributions

1. Rule: The deduction is the lower of: AB of property + 50% × (FMV − AB), or 2 × AB
2. The limit on the deduction is 10% of taxable income
3. Any excess charitable contribution (above the 10% limit) carries forward for five years (there is no carryback)

III. Dividends-Received Deduction

Ownership percentage Deduction percentage

Less than 20% 50%

20% or more, but less than 80% 65%

80% or more 100%

IV. Domestic Production Deduction (DPD)—Beginning in 2018, the DPD has been repealed.

Question 10

V. Federal Taxation of Entities

1. Corporate Taxation
2. Special Corporate Deductions

In the current year, Brown, a C corporation has gross income (before dividends) of $900,000 and deductions of $1,100,000 (excluding the dividends-received deduction). Brown received dividends of $100,000 from a Fortune 500 corporation (which it owned less than 20%) during the current year.

What is Brown’s net operating loss?

1. $100,000
2. $130,000
3. $150,000
4. $200,000

Answer 10

C.

Ignoring the dividend, Brown has a net operating loss (NOL) of $200,000. Brown must also include the $100,000 of dividends in income, reducing the NOL to $100,000. Brown also is permitted to take the dividends received deduction.

Since the dividend is received from a Fortune 500 corporation it is reasonable to assume that Brown owns less than 20% of the corporation, so the dividends received deduction is 50% of the dividends received, or $50,000. This increases the NOL to $150,000.

Note that the dividends received deduction is not limited to the taxable income of Brown since Brown has a loss before the dividends received deduction.

Question 11

V. Federal Taxation of Entities

1. Corporate Taxation
2. Special Corporate Deductions

Morris Corporation’s income tax return for 2019 shows deductions exceeding gross income by $75,000. Included in the tax return are the following items:

Net operating loss deduction (carryover from 2018) $13,400

Dividends received deduction 6,600

What is Morris’ net operating loss for 2019?

1. $75,000
2. $68,400
3. $61,600
4. $55,000

Answer 11

C.

The requirement is to determine the NOL for 2019 given that deductions in the tax return exceed gross income by $75,000. In computing the NOL for 2019, the DRD of $6,600 would be fully allowed, but the $13,400 NOL deduction (carryover from 2018) would not be allowed. $75,000 — $13,400 = $61,600.

Question 12

V. Federal Taxation of Entities

1. Corporate Taxation
2. Special Corporate Deductions

Soma Corp. had $600,000 in compensation expense for book purposes in 2019. Included in this amount was a $50,000 accrual for 2019 nonshareholder bonuses. Soma paid the actual 2019 bonus of $60,000 on March 1, 2020.

In its 2019 tax return, what amount should Soma deduct as compensation expense?

1. $600,000
2. $610,000
3. $550,000
4. $540,000

Answer 12

B.

While cash−based taxpayers deduct deferred compensation in the tax year that the compensation is actually paid to employees, accrual basis taxpayers deduct deferred compensation in the tax year that the liability to pay the compensation becomes fixed. The liability to pay the deferred compensation becomes fixed when: (1) all events have occurred to establish the liability to pay the compensation; (2) economic performance has occurred with respect to the liability; and (3) the amount can be determined with reasonable accuracy. In addition, accrual−basis taxpayers must pay the deferred compensation within the first 2 1/2 months of a tax year to deduct the compensation in the preceding year.

Assuming Soma Corp. fixed the liability to pay the compensation in 2019, the corporation may deduct all of the nonshareholder bonuses ($60,000) on its 2019 tax return because the bonuses were paid within the first 2 1/2 months of the end of its 2019 tax year. Since an additional $10,000 of bonuses were paid than accrued, this amount may be added to the corporation’s compensation expense, putting that expense at $610,000.

Question 13

V. Federal Taxation of Entities

1. Corporate Taxation
2. Special Corporate Deductions

In 2019, Best Corp., an accrual-basis calendar year C corporation, received $100,000 in dividend income from the common stock that it held in an unrelated domestic corporation.

The stock was not debt-financed and was held for over a year. Best recorded the following information for 2019:

Loss from Best’s operations($ 10,000)

Dividends received100,000

Taxable income (before dividends-received deduction)$ 90,000

========

Best’s dividends-received deduction on its 2019 tax return was

1. $100,000.
2. $65,000.
3. $50,000.
4. $45,000.

Answer 13

D.

If a C corporation owns less than 20% of a domestic corporation, 50% of dividends received or accrued from the corporation may be deducted.

A C corporation owning 20% or more but less than 80% of a domestic corporation may deduct 65% of the dividends received or accrued from the corporation. Similarly, C corporation owning 80% or more of a domestic corporation may deduct 100% of the dividends received or accrued from the corporation. However, the dividend received deduction is limited to a percentage of the taxable income of the corporation, unless the corporation sustains a net operating loss.

For this question, the taxable income limitation rule comes into effect:

When ownership is less than 80%, the dividends received deduction (DRD) equals the lesser of 50% or 65% of the dividends received (whichever applies), or 50% or 65% of taxable income computed (whichever applies) without regard to the DRD, any net operating loss (NOL) deduction, or capital loss carry back. The taxable income limitation rule does not apply however if the DRD creates or adds to a NOL.

If the corporation has a net operating loss, the dividend received deduction may be taken without limiting the deduction to a percentage of the corporation’s taxable income.

This response uses the correct deduction percentage for Best Corp.’s ownership percentage and correctly limits the dividend received deduction to a percentage of the corporation’s taxable income. The limit is calculated by multiplying taxable income (before the dividend received deduction), i.e., $90,000, by the correct dividend received deduction percentage, i.e., 50%.

Question 14

V. Federal Taxation of Entities

1. Corporate Taxation
2. Special Corporate Deductions

During 2019, Stark Corp. reported gross income from operations of $350,000 and operating expenses of $400,000. Stark also received dividend income of $100,000 (not included in gross income from operations) from an investment in a taxable domestic corporation in which it owns 10% of the stock. Additionally, Stark had a net operating loss carryover from 2018 of $30,000. What is the amount of Stark Corp.’s net operating loss for 2019?

1. $0
2. $(20,000)
3. $(30,000)
4. $(50,000)

Answer 14

A.

The requirement is to determine Stark Corp.’s net operating loss (NOL) for 2019. A NOL carryover from 2018 would not be allowed in computing the 2019 NOL. In contrast, a dividends received deduction (DRD) is allowed in computing a NOL since a corporation’s DRD is not subject to limitation if it creates or increases a NOL. Stark Corp. does not have an NOL. Taxable income before the NOL is $25,000. The $30,000 NOL cannot be used when computing the 2019 NOL.

Question 15

V. Federal Taxation of Entities

1. Corporate Taxation
2. Penalty Taxes

I. Accumulated Earnings Tax

Answer 15

1. An accumulated earnings tax of 20% is imposed on undistributed accumulated taxable income.
   
   1. Accumulated taxable income is computed by adjusting taxable income to reflect retained economic income.
   2. Dividend distributions reduce accumulated taxable income because income is not accumulated if dividends are paid out to shareholders.
   3. For purposes of the accumulated earnings tax, dividends include consent dividends and dividends paid within three-and-a-half months of year-end.
2. Adjustments
   
   1. Taxable income is reduced by (1) accrued income taxes, (2) excess charitable contributions, (3) net capital loss, (4) net capital gain after tax.
   2. Taxable income is increased by adding back (5) the dividends-received deduction and (6) any net operating loss or capital loss carryovers.
3. Accumulated Earnings Credit—The accumulated earnings credit is the greater of two numbers related to earnings and profits.
   
   1. One number is the amount of the current earnings and profits needed for the “reasonable needs” of the business.
   2. The second number is a flat $250,000 ($150,000 for service (e.g., health, law, accounting, engineering) corporations) less the accumulated earnings and profits at the close of preceding year.

Question 16

V. Federal Taxation of Entities

1. Corporate Taxation
2. Penalty Taxes

II. Personal Holding Company (PHC) Tax

Answer 16

1. PHC Tax—The PHC tax is imposed on undistributed PHC income.
   
   1. To reduce PHC income, dividends must be pro rata. (The dividends cannot be paid disproportionately.)
   2. For purposes of the PHC tax, dividends include dividends paid during the year, consent dividends, and dividends paid within 3½; months of year-end (limited to 20% of dividends actually paid during year).
   3. A deficiency dividend can also be paid to avoid the PHC tax.

Question 17

V. Federal Taxation of Entities

1. Corporate Taxation
2. Penalty Taxes

Kari Corp., a manufacturing company, was organized on January 2, 2019. Its 2019 federal taxable income was $400,000 and its federal income tax was $84,000.

What is the maximum amount of accumulated taxable income that may be subject to the accumulated earnings tax for 2019 if Kari takes only the minimum accumulated earnings credit?

1. $300,000
2. $150,000
3. $66,000
4. $0

Answer 17

C.

The accumulated earnings tax is a penalty tax imposed on corporations that accumulates earnings and profits for the purpose of avoiding income tax for its shareholders. The accumulated earnings tax is equivalent to 20% of the corporation’s accumulated taxable income.

Accumulated taxable income is composed of taxable income adjusted downward for federal income and excess profits taxes, charitable deduction in excess of the ceiling, net capital gains and losses, and taxes of foreign countries and U.S. possessions and upward for certain corporate deductions, net operating loss deduction and capital loss carryback or carryover.

When calculating the accumulated earnings tax, corporations are given a credit, the accumulated earnings credit, of $250,000 ($150,000 for certain service corporations) plus dividends paid within the first 3 1/2 months of the corporation’s tax year less accumulated earnings and profits at the end of the preceding tax year.

Hence, the maximum amount of accumulated taxable income that may be subject to the accumulated earnings tax for 2019 if Kari Corp. takes only the minimum accumulated earnings credit is $66,000. This amount is composed of $400,000 in taxable income less both a downward adjustment of $84,000 for federal income taxes and the $250,000 accumulated earnings credit.

Question 18

V. Federal Taxation of Entities

1. Corporate Taxation
2. Taxation of Related Corporations

Answer 18

1. Affiliated Groups—An “affiliated group” exists when one corporation owns at least 80% of the voting power of another corporation andholds shares representing at least 80% of its value. This test must be met on every day of the year.
2. Foreign corporations, exempt corporations, regulated investment companies, S corporations, and insurance companies are not eligible to consolidate
3. Controlled Groups—Controlled groups are parent-subsidiary corporations, brother-sister groups, and certain insurance companies.
4. A controlled group of corporations is entitled to one $250,000 accumulated earnings tax credit. A controlled group also receives only one Section 179 expense deduction.
   
   1. Parent-Subsidiary—The focus here is on corporate ownership. A parent-subsidiary controlled group exists if: Stock possessing at least 80% of the voting power of all classes of stock
   2. Brother-Sister—The focus here is on individual ownership. A brother-sister controlled group exists if: Two or more corporations are owned by five or fewer persons (individuals, estates, or trusts):
      
      1. Who have a common ownership of more than 50% of the total combined voting powers of all classes of stock entitled to vote, or more than 50% of the total value of shares of all classes of stock of each corporation, and
      2. Who possess stock representing at least 80% of the total combined voting power of all classes of stock entitled to vote, or at least 80% of the total value of shares of all classes of each corporation.
      3. The 80% test does not apply for determining brother-sister corporations in some circumstances, such as limiting the accumulated earnings credit.

Question 19

V. Federal Taxation of Entities

1. Corporate Taxation
2. Taxation of Related Corporations

Which of the following groups may elect to file a consolidated corporate return?

1. A brother/sister-controlled group
2. A parent corporation and all more-than-10%-controlled partnerships
3. A parent corporation and all more-than-50%-controlled subsidiaries
4. Members of an affiliated group

Answer 19

D.

By definition, members of an affiliated group are eligible to elect to file a consolidated tax return. In general, an affiliated group contains a parent corporation and other corporations that are owned at least 80% by other members of the affiliated group. Brother/sister controlled groups are not eligible to file a consolidated return.

Question 20

V. Federal Taxation of Entities

1. Corporate Taxation
2. Taxation of Related Corporations

With regard to consolidated tax returns, which of the following statements is correct?

1. Operating losses of one group member may be used to offset operating profits of the other members included in the consolidated return.
2. Only corporations that issue their audited financial statements on a consolidated basis may file consolidated returns.
3. Of all intercompany dividends paid by the subsidiaries to the parent, 70% are excludable from taxable income on the consolidated return.
4. The common parent must directly own 51% or more of the total voting power of all corporations included in the consolidated return.

Answer 20

A.

The primary advantages of filing a consolidated return are that:

(1) losses of one affiliated member offset gains of another member;
(2) intercompany dividends are excludable from taxable income; and
(3) intercompany profits are deferred until realized.

Since this response indicates that the operating losses of one group member may be used to offset operating profits of the other members, it is correct.

Question 21

V. Federal Taxation of Entities

1. Corporate Taxation
2. Distributions from a Corporation

I. Earnings and Profits

Answer 21

1. Additions to Taxable Income—Are made for exempt income or deductions that do not represent an economic outlay.
   
   1. Municipal interest and life insurance proceeds are added to taxable income because they are economic inflows excluded from taxable income.
   2. The dividends-received deduction does not represent an economic outlay, so it is added back to taxable income in computing E&P.
   3. Deductions claimed for carryovers from previous years (carryforwards) are added back to taxable income.
   4. Proceeds from corporate life insurance policy (less cash surrender value)
2. Some Expenditures are Not Deductible—But represent economic outlays. These expenditures reduce taxable income in computing E&P.
   
   1. The amount of federal income tax (net of credits) reduces taxable income in computing E&P because it represents an economic outlay.
   2. Related party losses
   3. Penalties, fines, lobbying expenses, life insurance premiums for a “key” man, entertainment expenses, and the disallowed portion of business meals.
3. Some Modifications to Taxable Income—Modifications are timing differences and can be positive or negative.
   
   1. The deferred portion of a gain from a current installment sale (but not other deferrals) is also added to taxable income because it represents an economic inflow. When the gain is recognized in later years, it reduces taxable income because it has already been included in E&P in the year of the sale.
   2. The amount of depreciation deducted in excess of straight-line is viewed as a form of deferral and it is added back to taxable income (like the installment gain, this is a timing adjustment that will reverse in later years). The Alternate Depreciation System (ADS) is used to compute depreciation for earnings and profits. See the “Section 1231 Assets—Cost Recovery” lesson for more details on ADS.
   3. The amount deducted under Section 179 for regular tax must be deducted ratably over five years for computing E&P. Bonus depreciation is not allowed for computing E&P.
   4. Net capital loss and the excess amount of charitable contributions

Question 22

V. Federal Taxation of Entities

1. Corporate Taxation
2. Distributions from a Corporation

D. Distributions generally reduce E&P

Answer 22

1. A distribution of appreciated property will first increase E&P by the amount of the gain recognized on the distribution.
2. Distributions cannot create a deficit in E&P—only losses(NOL) can create a deficit.

Example

If Corporation Mouse distributes property with a FMV of $1,000 and a basis of $1,200 to shareholder Cat and Cat assumes a liability attached to the property of $300, E&P is reduced by $900 ($1,200 − $300).

Distribution Current E&P Accumulated E&P

return of capital - -

Current first + +

Current first + -

Netting first - +

Question 23

V. Federal Taxation of Entities

1. Corporate Taxation
2. Distributions from a Corporation

III. Property Distribution

Answer 23

1. If the liability on the property exceeds the property’s fair market value, the FMV is treated as being equal to the liability.
   
   • Example
   • A corporation distributes property with an FMV of $10,000 and a basis of $3,000 to a shareholder, who assumes a liability of $12,000 on the property. The corporation recognizes a gain of $12,000 – $3,000 = $9,000
2. Amount distributed = FMV − Liabilities on property
3. Basis of the property to the shareholder is the fair market value.
4. Constructive dividends are also treated as distributions.

Question 24

V. Federal Taxation of Entities

1. Corporate Taxation
2. Distributions from a Corporation

Fox, the sole shareholder in Fall, a C corporation, has a tax basis of $60,000. Fall has $40,000 of accumulated positive earnings and profits at the beginning of the year and $10,000 of current positive earnings and profits for the current year. At year end, Fall distributed land with an adjusted basis of $30,000 and a fair market value (FMV) of $38,000 to Fox. The land has an outstanding mortgage of $3,000 that Fox must assume. What is Fox’s tax basis in the land?

1. $38,000
2. $35,000
3. $30,000
4. $27,000

Answer 24

A.

For dividends, the amount distributed is the fair market value of the property received less any liabilities assumed by the shareholder, or $35,000 ($38,000 − $3,000). Fox would have $35,000 of dividend income since earnings and profits is at least this amount. However, the basis in the property received as a taxable dividend is always the fair market value of the property, or $38,000.

Question 25

V. Federal Taxation of Entities

1. Corporate Taxation
2. Distributions from a Corporation

Which of the following items reported on a C corporation’s tax return would not require an adjustment to taxable income in computing current earnings and profits (E&P)?

1. Straight-line depreciation
2. Installment sale income
3. Amortization of organizational expenses
4. Meals and entertainment expenses

Answer 25

1. Correct! Depreciation for E&P purposes is straight line, so if the tax depreciation is straight line, then no adjustment is necessary.
2. The installment sale method is not allowed for computing E&P, which results in an adjustment to taxable income when computing E&P.
3. Organizational expenses cannot be amortized for E&P, which results in an adjustment to taxable income when computing E&P.
4. 100% of meals and entertainment are deductible for computing E&P (rather than 50% for meals and 0% for entertainment), which results in an adjustment to taxable income when computing E&P.

Question 26

V. Federal Taxation of Entities

1. Corporate Taxation
2. Distributions from a Corporation

As the result of an IRS audit of a C corporation and its sole shareholder, the IRS agent proposes that a portion of the shareholder’s salary is unreasonable. Because the corporation has significant earnings and profits, the agent has determined that the unreasonable portion of the salary is a dividend. Which of the following is correct regarding the impact of the proposed adjustment to both the corporation and its shareholder?

1. Full disallowance of salary expense, a corresponding increase in nondeductible dividends to the corporation, and no effect on the shareholder since both salaries and dividends are taxable income.
2. Partial disallowance of salary expense, a corresponding increase in nondeductible dividends to the corporation, and reclassification of the shareholder’s salary to dividend treatment.
3. Allowance of the full amount as salary expense to the corporation and reclassification of the unreasonable portion of the shareholder’s salary to dividend treatment.
4. Partial disallowance of salary expense, a corresponding increase in deductible dividends to the corporation, and no effect on the shareholder’s return since both salaries and dividends are taxable income.

Answer 26

B.

For a shareholder who also is an employee at the corporation, any disallowed salary will be treated as a dividend. Dividends are taxable to the shareholder and are not deductible for the corporation.

Question 27

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Redemptions and Liquidations

I. Redemptions—A redemption of stock occurs when a corporation repurchases stock from a shareholder. The redemption is generally treated by the shareholder as a sale of the stock that will trigger recognition of gain or loss. However, a redemption of stock can also be structured to have the identical effect of a dividend distribution. Hence, the tax rules are constructed to assure that redemptions, which have the effect of a dividend, are taxed as dividends rather than sales of stock.

Answer 27

• There are two advantages of redemption treatment. First, the shareholder is able to offset stock basis against the redemption proceeds. Second, any resulting gain is treated as capital gain, which is often advantageous as compared to dividend income.

Question 28

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Redemptions and Liquidations

II. Three Methods to Qualify—In order for a redemption to be taxed as a sale, it must qualify under one of three circumstances:

Answer 28

1. First—A redemption will be treated as a sale, if the distribution is not essentially equivalent to a dividend (NEED).

• Definition:
• Not Essentially Equivalent to a Dividend (NEED): This phrase has been interpreted to mean that there is a “meaningful” reduction in the shareholder’s rights, including voting rights and rights to earnings.

2. Second—A substantially disproportionate redemption will also qualify as a sale if the shareholder passes two tests: the control test and the reduced interest test.

• Definitions:
• Control Test:The shareholder must own less than 50% of the voting shares after the redemption.
• Reduced Interest Test: The shareholder must own less than 80% of the shares that were owned prior to the redemption.

3. Third—A complete termination of the shareholder’s interest in the corporation qualifies as a sale.

Question 29

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Redemptions and Liquidations

How does a noncorporate shareholder treat the gain on a redemption of stock that qualifies as a partial liquidation of the distributing corporation?

1. Entirely as a capital gain
2. Entirely as a dividend
3. Partly as a capital gain and partly as a return of capital
4. Entirely as a tax-free transaction

Answer 29

A.

1. Noncorporate shareholders treat the gain on a redemption of stock that qualifies as a partial liquidation of the distributing corporation as a capital gain, just as if they had sold their stock.
2. Corporate shareholders receive dividend treatment on a partial liquidation.

Question 30

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Redemptions and Liquidations

A corporation transferred fully depreciated machinery to an individual shareholder in a liquidating distribution. The original cost of the machinery was $6,000, and the fair market value at the date of the transfer was $5,000. If the shareholder’s basis in the corporation’s stock was $2,000, then the shareholder reports

1. $3,000 capital gain.
2. $3,000 ordinary income.
3. $5,000 ordinary income and $2,000 capital loss.
4. No gain and no loss.

Answer 30

A.

Shareholder’s gain is computed as the fair market value received ($5,000) less basis in stock ($2,000) = $3,000. The gain is capital since the stock is a capital asset.

Question 31

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Reorganizations

• Stock for asset reorgs are A and C
• Stock for stock reorgs are B
• Divisive reorgs are D

Answer 31

1. Type A (A+B=A)
   
   1. Stock for asset
   2. Statutory merger
   3. Target corporation must dissolve
   4. Voting or non-voting stock can be used by Acquiring
   5. At least 50% of the consideration given to Target by Acquiring must be stock
2. Type B
   
   1. Stock for Stock
   2. Acquiring must own at least 80%
   3. Only voting stock can be used by Acquiring
   4. No boot is allowed
3. Type C
   
   1. Stock for asset
   2. Does not have to be a statutory merger
   3. Only voting stock can be used by Acquiring
   4. Boot is allowed but it cannot exceed 20% of the consideration provided by Acquiring
   5. Acquiring must acquire substantially all of Target’s assets (90% of net asset value and 70% of gross asset value)

Question 32

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Reorganizations

In connection with a recapitalization of Yorktown Corporation, Robert Moore exchanged 1,000 shares of stock which cost him $95,000 for 1,000 shares of new stock worth $108,000 and bonds in the principal amount of $10,000 with a fair market value of $10,500.

What is the amount of Moore’s recognized gain?

Answer 32

1. Amount Realized:

• Stock 108,000
• Bonds-Boot 10,500
• 118,500
• Adjusted Basis (95,000)
• Realized Gain 23,500

2. Recognized Gain - Lower of:

1. Realized Gain 23,500
2. Boot received 10,500

3. The basis to the shareholder in the stock received is:

Basis in stock surrendered 95,000

+ Gain Recognized 10,500

• Boot Received (10,500)

95,000

Question 33

V. Federal Taxation of Entities

1. Corporate Taxation
2. Corporate Reorganizations

Which of the following statements correctly represents the tax effect of the liquidation of an 80% or more owned subsidiary?

1. The subsidiary can recognize a loss on depreciated assets transferred to minority shareholders.
2. Assets transferred to the parent of the liquidating corporation generally have a carryover basis.
3. The total basis of assets transferred to the parent of the liquidating corporation must be allocated among the various assets according to their fair market values.
4. The subsidiary recognizes gain on the distribution of appreciated assets to the parent.

Answer 33

B.

Assets transferred to the parent of the liquidating corporation generally have a carryover basis.