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17Sole CHAPTER proprietorships- non-taxable entity separate from the individual who owns the proprietorship, the owner of a sole proprietorship reports all business income and expenses of proprietorship on Sched C of 1040. Ex if Sam has operating income of 100k but withdraws 50k, she still reports 100k regardless of withdrawal. Partnerships- not subject to federal income tax, required to file form 1065 which reports partnerships business activities. Each partner receives a Sched K-1 that reports partners share of ordinary business income and separate reported income and expenses. Ex. Jon & Bob= equal partners; business 500k of GI and 350k of expenses. They sold land for LTCG of 60k, Jon withdrew 40k and Bob 45k. Ordinary income of 500-350= 150k. Company also reports 60k LTCG. Each report 75k for business income and state LTCG of 30k on his own return. S corporations- do not pay federal income tax are similar to partnerships in that ordinary business income or loss flows through to the shareholders to be reported on separate returns and they do not aggregate all income and expense items in computing business income/loss. According to stock ownership interests. C corporations- are subject to entity level federal tax which results in a double taxation effect, it reports its income and expenses on form 1120 and computes tax on the taxable income using rate schedule to corporations. When a corporation distributes its income, the corps shareholders report dividend income on their own tax returns, therefore income taxed at a corporate level is also taxed at the shareholder level. Ex/ J Corp has T.I of 100k, it pays corp tax of 22,250 leaving 77,750 which is distributed as a dividend to single shareholder who has T.I of 68k (77,750- 5950 s.d- 3800 exemption). Looking at chart his tax is 4898 + the corps 22250 makes the combined tax 27148. If it was sole prop; 100k- 5950-3800) 90250 and pays tax of 18731 which is a savings of 8417 compared to C corps. Dividends are not deductible by the c corporation, therefore taxable to shareholders. Qualified dividend income is taxed at same preferential rate as LTCG- 15% (0 for ppl in two lower tax brackets). Tax attributes of income and expense items of a C corp do not pass through the corp entity to shareholders. Losses of a C corp are treated differently than losses of a proprietorship, partnership or S corp. Losses on propriep may be deductible by the owner, partnerships losses are passed through the partners and S corps are passed through to the shareholders, C corps have no effect on the taxable income of the shareholders. Limited liability company- qualify as partnerships it allows its owners to avoid unlimited liability which is primary non tax consideration in choosing this business. Unlimited liability is creditors of the business may file claims not only against the assets of the business but also against the personal assets of propriep or partners. The tax advantage of LLC can be treated as partnerships or propriep for tax purposes which avoids the double taxation associated with C corps. Corporation characteristics- continuity of life, centralized management, limited liability and free transferability of interests. Capital gains receive no favorable tax rate on LTCG and is taxed at normal corporate tax rates. Capital Losses- corporate tax payers are not permitted to claim any net capital losses as a deduction against ordinary income, they can only be used to offset capital gains, however they can carry back net capital losses to three preceding years, carryforwards are allowed 5 years or 3 years back, the loss is treated as short term capital loss for carry over years. Passive loss- apply to individual taxpayers and to closely held C corps and PSCs to prevent taxpayers from incorporating to avoid the passive loss limitations. In order to be closely held, if at any time during half the year it has to be more than 50% of the corps value of outstanding stock is owned by at most 5 ppl. PSC- performance of personal services performed by shareholder-employees, more than 10% of the stock is held by shareholder-employees. Passive losses can not be offset vs either active or portfolio income. Closely C corps can offset vs active income but not portfolio income. Domestic production activities deduction DPAD- 9% of the lower of qualified production activities or taxable income but can not exceed 50% of an employers w-2 wages related to qualified production activities. Ex Elk corp has T.I of 360k and qualified production activities income of 380k so 360k * .09= 32,400. The wages were 70k*.50= 35,000 so limitation does not apply . Net Operating Losses NOL- if a ciro may be carried back for 2 years and forward 20 years to offset taxable income for those years and it is allowed to include dividends received deduction in computing NOL. Ex. Blue corp has G.I of 200k and deductions of 300k excluding dividends received. Blue received 100k of dividends from fox which it holds 5% stock interest. 200k- 300k=(100k) 100k*.7= 70k taxable loss is = 100k + 70k= 170k. Assume they carry back 2 yrs and have T.I of 40k. 40k+ (-170k)= -130k taxable income for 2010 after NOL carryback. Dividends received deduction- purpose is to mitigate multiple taxation of corporate income, no deduction is allowed unless the corp has held the stock for more than 45 days. If less than 20%= 70% deduction percentage, 20%or more but less than 80%= 80%, more than 80%= 100%. APLIA: 1. Barbara owns 40% of the stock of Cassowary Corporation (a C corporation) and 40% of the stock of Emu Corporation (an S corporation). During 2012, each corporation has operating income of $120,000 (after income tax expense) and tax-exempt interest income of $8,000. Neither corporation pays any dividends during the year. How is this information reported by the corporations and Barbara for 2012? Since C corporations are separate taxable entities, Cassowary Corporation will the operating income and tax-exempt income. An S corporation is a tax reporting entity. Therefore, Barbara will report ordinary business income of $ 48k (120k*.4) and 3200 ( 8k *.4) 2. Art, an executive with Azure Corporation, plans to start a part-time business selling products on the Internet. He will devote about 15 hours each week to running the business. Art's salary from Azure places him in the 35% tax bracket. He projects substantial losses from the new business in each of the first three years and expects sizable profits thereafter. Art plans to leave the profits in the business for several years, sell the business, and retire. From a tax standpoint, Art should initially consider operating as a sole proprietorship or as a single member LLC this would allow him to deduct the losses vs other income, when business becomes profitable he should consider incorporating. 3. Samantha is the sole owner of Blue Company. In 2012, Blue had operating income of $200,000, a short-term capital loss of $10,000, and tax-exempt interest income of $3,000. Samantha withdrew $50,000 of profit from Blue. If Blue Company is an LLC, a single-member LLC is taxed as a proprietorship. Thus, Samantha will report the $200,000 operating income (Schedule C), $10,000 short-term capital loss (Schedule D), and $3,000 tax-exempt interest (Form 1040, page 1) on her tax return. The $50,000 withdrawal would have no effect on Samantha's individual tax return. If Blue Company is an S corporation, it is a tax reporting entity (Form 1120S), and its income, gains, deductions, and losses are passed through to and reported by the shareholders on their tax returns. Separately stated items, e.g., tax-exempt income and capital losses, retain their character at the shareholder level. Consequently, Samantha will report the $200,000 operating income (Schedule E), $10,000 short-term capital loss (Schedule D), and $3,000 tax-exempt interest (Form 1040, page 1) on her tax return. The $50,000 withdrawal would have no effect on Samantha's individual tax return. If Blue Company is a C corporation, it is a separate taxable entity, and its taxable income has no effect on the shareholders until such time as a dividend is paid. When dividends are paid, shareholders must report dividend income on their tax returns. Thus, Blue Company will report taxable income of $200,000 on its Form 1120. Corporations can deduct capital losses only to the extent of capital gains. The $10,000 net capital loss (STCL) will be carried back three years and forward five years. The tax-exempt interest income is excluded from Blue's gross income. Samantha will report dividend income of $50,000 (Schedule B) on her individual tax return . 4 In 2012, Jeanette, an individual in the 35% marginal tax bracket, recognized a $50,000 long-term capital gain. Also in 2012, Parrot Corporation, a C corporation in the 35% marginal tax bracket, recognized a $50,000 long-term capital gain. Neither taxpayer had any other property transactions in the year. What tax rates are applicable to these capital gains? Capital gains and losses result from the taxable sales or exchanges of capital assets. Whether these gains and losses are long term or short term depends upon the holding. Both corporations and individuals include recognized capital gains in their taxable income. Individuals generally pay a preferential tax rate of 15% on net capital gains (i.e., excess of net long-term capital gain over net short-term capital loss). Corporations, however, receive no favorable tax rate on longterm capital gains, and such income is taxed at the normal corporate tax rates. Since there is no preferential tax rate applicable to long-term capital gains for corporations, the capital gain is taxed at Parrot's normal tax rate of 35%. The preferential tax rate of 15% would apply to Jeanette's long-term capital gain. 5. John (a sole proprietor) and Eagle Corporation (a C corporation) each recognize a short-term capital gain of $6,000 and a long-term capital loss of $8,000 on the sale of capital assets. Neither taxpayer had any other property transactions during the year. John reports the capital transactions on his individual tax return and deducts a $7,000 net capital loss in the current year- False. Generally, individual taxpayers can deduct up to $3,000 of such net losses against other income. John reports the capital transactions on his individual tax return and is limited to a $2,000 net capital loss in the current year- True. Generally, individual taxpayers can deduct up to $3,000 of such net losses against other income. Any remaining capital losses can be carried forward to future years until absorbed by capital gains or by the $3,000 deduction. John nets the $6,000 STCG against the $8,000 LTCL, resulting in a $2,000 net capital loss- True. Each year, a taxpayer's short-term gains and losses are combined, and long-term gains and losses are combined. The result is a net short-term capital gain or loss and a net long-term capital gain or loss. Eagle Corporation nets the $6,000 STCG against the $8,000 LTCL, resulting in a $2,000 net capital loss- True. Each year, a taxpayer's short-term gains and losses are combined, and longterm gains and losses are combined. The result is a net short-term capital gain or loss and a net long-term capital gain or loss. Eagle reports the capital transactions on its corporate tax return- True. For corporations, capital losses can be used only as an offset against capital gains. Eagle is limited to a $3,000 net capital loss deduction in the current year- False. Eagle reports the capital transactions on its corporate tax return, but none of the $7,000 net capital loss is deductible in the current year. Instead, Eagle carries back a $7,000 STCL three years and, if necessary, forward five years, to be offset against capital gains in such years. All of the $7,000 net capital loss is deductible in the current year- false. Eagle carries back a $2,000 STCL three years and, if necessary, forward five years, to be offset against capital gains in such years- True Unlike individuals, corporate taxpayers are not permitted to claim any net capital losses as a deduction against ordinary income. Capital losses, therefore, can be used only as an offset against capital gains. Corporations may, however, carry back net capital losses to three preceding years. Any remaining net operating losses may be carried forward. 6. Egret Corporation, a calendar year C corporation, was formed on March 7, 2012, and opened for business on July 1, 2012. After its formation but prior to opening for business, Egret incurred the following expenditures: Accounting- $7,000, Advertising- 14,500, Employee payroll- 11,000, Rent- 8,000, Utilities-1,000. Startup expenses also include operating expenses, such as rent and payroll, that are incurred by a corporation before it actually begins to produce any gross income. At the election of the taxpayer, such expenditures are deductible in the same manner as organizational expenditures. Thus, up to $5,000 can be immediately expensed (subject to the phaseout) and any remaining amounts amortized over a period of 180 months. All $41,500 of the expenditures are startup expenditures. Egret can elect under 195 to currently write off the first $5,000 and to amortize the remaining amount of such expenditures over a 180-month period beginning with the month in which it begins business (i.e., July 1, 2012). Thus, Egret's deduction in 2012 for startup expenditures is $6,217 {$5,000 + $1,217 [($41,500 $5,000) 180 months x 6 months]}*. Egret makes the 195 election simply by claiming the deduction on its 2012 tax return. (If Egret decides to forgo the 195 election, the $41,500 must be capitalized and is deductible only when the corporation ceases to do business and liquidates.)* $41,500 - $5,000 = $36,500 $36,500 /180 months = $202.78 per month, $202.78 x 6 months = $1,216.78, rounded to $1,217.00, $5,000 + $1,217 = $6.217. Quiz- 1. Jaime is the sole proprietor of a small business. In 2010, the business sold a capital asset for a loss of $20,000. Jaime is allowed to report the capital loss on his individual income tax return for 2010- TRUE. 2. Eliza is a 50% shareholder in Beta, a C corporation. Beta earned net income of $100,000 during the year, and Eliza received a distribution of $20,000 from the corporation. Eliza must report $20,000 of income on her individual Federal income tax return (Form 1040)- TRUE. 3. Harold owns a 40% interest in a partnership that earned $50,000 in the current year. He also owns 40% of the stock in an S corporation that earned $50,000 during the year. The partnership did not make any distributions, and the corporation distributed $5,000 to him. Harold must pay income tax on $40,000 of income- TRUE. 4. Manuel is the sole shareholder of Alpha, Inc. In 2010, Alpha had net income of $200,000. Manuel, who is in the 35% tax bracket, received a dividend of $100,000 from Alpha. He will pay a tax of $35,000 on the dividend- FALSE. 5. Omega Corporation had taxable income of $200,000 which includes a long-term capital gain of $20,000 in 2010. The maximum amount of tax applicable to the capital gain is $7,800 ($20,000 X 39%)- TRUE . 6. Topaz Corporation had $145,000 operating income and $30,000 operating expenses during the year. In addition, Topaz had a $30,000 shortterm capital gain and a $40,000 short-term capital loss. Compute Topaz's taxable income for the year= 115,000. 7. Theta Corporation, a closely held corporation (not a PSC), had $120,000 of active income, $110,000 of portfolio income, and a $240,000 passive loss during the year. How much of the passive loss is deductible? 120,000 . 8. Sigma Corporation owns 80% of the stock of Epsilon Corporation, which pays it a dividend of $100,000. Sigma Corporation also owns 20% of the stock of Intergalactic Corporation, which pays it a $40,000 dividend. Assuming the taxable income limitation does not apply, how much is Sigma Corporation's dividend received deduction for the year? 132,000. 9. Zeta, Inc., a calendar year taxpayer, suffers a casualty loss of $45,000. Zeta recovered insurance of $30,000. How much of the casualty loss will be a tax deduction to Zeta, Inc.? 15,000. Chapter 18Section 351 a transfer of property to a corporation in exchange for stock constitutes a taxable sale or exchange of property. The amount of gain or loss is measured by the difference between the value of the stock received and the tax basis of the property transferred. When a taxpayer exchanges property for other property of a like kind, 1031 provides that gain (or loss) on the exchange is not recognized because a substantive change in the taxpayer's investment has not occurred until the exchange item was sold. For example, when a business is incorporated, the owner's economic status remains the same; only the form of the investment has changed. The investment in the business assets carries over to the investment in corporate stock. Section 351 exist because congress believes that tax rules should not impede business judgment. However, the taxpayer must recognize some or all of the realized gain when receiving boot (i.e., property of an unlike kind, such as cash). For example, if a taxpayer exchanges a truck used in a business for another truck to be used in the business and also receives cash, the taxpayer has the wherewithal to pay an income tax on the cash involved. If a taxpayer transfers property to a corporation and receives cash or property other than stock, gain (but not loss) is recognized to the extent of the lesser of the gain realized or the boot received (i.e., the amount of cash and the fair market value of other property received). Any gain recognized is classified (e.g., ordinary, capital) according to the type of assets transferred. EX: Amanda and Calvin form Quail Corporation. Amanda transfers property with an adjusted basis of $30,000, fair market value of $60,000, for 50% of the stock, worth $60,000. Calvin transfers property with an adjusted basis of $70,000, fair market value of $60,000, for the remaining 50% of the stock. The transfers qualify under 351. Amanda has an unrecognized gain of $30,000, and Calvin has an unrecognized loss of $10,000. Both have a substituted basis in the stock in Quail Corporation. Amanda has a basis of $30,000 in her stock, and Calvin has a basis of $70,000 in his stock. Therefore, if either Amanda or Calvin later disposes of the Quail stock in a taxable transaction (e.g., a sale), this deferred gain/loss will then be fully recognizeda $30,000 gain to Amanda and a $10,000 loss to Calvin. Section 351 is mandatory if a transaction satisfies the provision's requirements. The three requirements for non-recognition of gain or loss under 351 are that property is transferred in exchange for stock and the property transferors are in control of the corporation after the exchange. Therefore, if recognition of gain or loss is desired, the taxpayer must plan to fail to meet at least one of these requirements. Property- assets defined that include unrealized receivables but not services rendered. Non-recognition of gain occurs only when the shareholder receives stock. Stock for this purpose includes common and most preferred. However, it does not include nonqualified preferred stock, which possesses many of the attributes of debt. Does not include stock rights or stock warrants. any corporate debt or securities (e.g., long-term debt such as bonds) received are treated as boot because they do not qualify as stock. Therefore, the receipt of debt in exchange for the transfer of appreciated property to a controlled corporation causes recognition of gain. For the transaction to qualify as nontaxable under 351, the property transferors must be in control of the corporation immediately after the exchange. Control means that the person or persons transferring the property must have at least an 80 percent stock ownership in the corporation. EX: Jack exchanges property, basis of $60,000 and fair market value of $100,000, for 70% of the stock of Gray Corporation. The other 30% of the stock is owned by Jane, who acquired it several years ago. The fair market value of Jack's stock is $100,000. Jack recognizes a taxable gain of $40,000 on the transfer because he does not have control of the corporation after his transfer and his transaction cannot be integrated with Jane's for purposes of the control requirement. To be a member of the group and to aid in qualifying all transferors under the 0 percent control test, the person contributing services must transfer property having more than a relatively small value compared to the services performed. EX: Tyrone and Seth formed Blue Corporation three years ago. Both Tyrone and Seth transferred appreciated property to Blue in exchange for 50 shares each in the corporation. The original transfers qualified under 351, and neither Tyrone nor Seth was taxed on the exchange. In the current year, Tyrone transfers property (worth $90,000, adjusted basis of $5,000) for 50 additional Blue shares. Tyrone has a taxable gain of $85,000 on the transfer. The exchange does not qualify under 351 because Tyrone does not have 80% control of Blue Corporation immediately after the transferhe owns 100 shares of the 150 shares outstanding, or a 662/3% interest. When liabilities are assumed by another party, the party who is relieved of the debt is treated as having received cash or boot. Section 357(a) provides, however, that when the acquiring corporation assumes a liability in a 351 transaction, the liability is not treated as boot received for gain recognition purposes. EX: Dan transfers real estate (basis of $40,000 and fair market value of $90,000) to a controlled corporation in return for stock in the corporation. However, shortly before the transfer, Dan mortgages the real estate and uses the $20,000 proceeds to meet personal obligations. Thus, along with the real estate, the mortgage is transferred to the corporation. In this case, the assumption of the mortgage lacks a bona fide business purpose. Consequently, the release of the liability is treated as boot received, and Dan has a taxable gain on the transfer of $20,000. EX2: Andre transfers land and equipment with adjusted bases of $35,000 and $5,000, respectively, to a newly formed corporation in exchange for 100% of the stock. The corporation assumes the liability on the transferred land in the amount of $50,000. Without 357(c), Andre's basis in the stock of the new corporation would be a negative $10,000 [$40,000 (bases of properties transferred) + $0 (gain recognized) $0 (boot received) - $50,000 (liability assumed)]. Section 357(c), however, requires Andre to recognize a gain of $10,000 ($50,000 liability assumed - $40,000 bases of assets transferred). As a result, the stock has a zero basis in Andre's hands. The basis of property received by the corporation generally is determined under a carryover basis rule. This rule provides that the property's basis to the corporation is equal to the basis in the hands of the transferor increased by the amount of any gain recognized on the transfer by the transferor-shareholder. When a corporation receives money or property in exchange for capital stock (including treasury stock), neither gain nor loss is recognized by the corporation. if the property is transferred to a corporation by a nonshareholder in exchange for goods or services, the corporation must recognize income. EX: A city donates land worth $400,000 to Teal Corporation as an inducement for Teal to locate in the city. The receipt of the land produces no taxable income to Teal, and the land's basis to the corporation is zero. If, in addition, the city gives the corporation $100,000 in cash, the money is not taxable income to the corporation. However, if the corporation purchases property with the $100,000 of cash within the next 12 months, the basis of the acquired property is reduced by $100,000. Any excess cash that is retained and not used by Teal is handled according to the ordering rules noted previously. Significant tax differences exist between debt and equity in the capital structure. The advantages of issuing long-term debt instead of stock are numerous. Interest on debt is deductible by the corporation, while dividend payments are not. Further, loan repayments are not taxable to investors unless the repayments exceed basis. A shareholder's receipt of property from a corporation, however, cannot be tax-free as long as the corporation has earnings and profits. If stocks and bonds are capital assets in their owner's hands, losses from their worthlessness are governed by 165(g)(1). Under this provision, a capital loss materializes as of the last day of the taxable year in which the stocks or bonds become worthless. One way to recognize partial worthlessness is to dispose of the stocks or bonds in a taxable sale or exchange. But even then, the investor loss is disallowed if the sale or exchange is to a related party as defined under 267(b) (e.g., parents and children are related, but aunts, uncles, and cousins are not considered related). When stocks the or bonds are not capital assets, worthlessness yields an ordinary loss. For example, if the stocks or bonds are held by a broker for resale to customers in the normal course of business, they are not capital assets. Usually, however, stocks and bonds are held as investments and, as a result, are capital assets. Under certain circumstances involving stocks and bonds of affiliated corporations, an ordinary loss is allowed upon worthlessness. A corporation is an affiliate of another corporation if the corporate shareholder owns at least 80 percent of the voting power of all classes of stock entitled to vote and 80 percent of each class of nonvoting stock. Further, to be considered affiliated, the corporation must have derived more than 90 percent of its aggregate gross receipts for all taxable years from sources other than passive income. Passive income for this purpose includes items such as rents, royalties, dividends, and interest. Business bad debts are deducted as ordinary losses, while nonbusiness bad debts are treated as short-term capital losses. A business bad debt can generate a net operating loss, but a nonbusiness bad debt cannot. A deduction is allowed for the partial worthlessness of a business debt, but nonbusiness debts can be written off only when they become entirely worthless. Nonbusiness bad debt treatment is limited to noncorporate taxpayers. However, all of the bad debts of a corporation qualify as business bad debts. In an exception to the capital treatment that generally results, 1244 permits ordinary loss treatment for losses on the sale or worthlessness of stock of so-called small business corporations. The ordinary loss treatment for 1244 stock applies to the first $1 million of capital-ized value of the corporation's stock. If more than $1 million of the corporation's stock is issued, the entity designates which of the shares qualify for 1244 treatment. The amount of ordinary loss deductible in any one year from the disposition of 1244 stock is limited to $50,000 (or $100,000 for taxpayers filing a joint return with a spouse). If the amount of the loss sustained in the taxable year exceeds these amounts, the remainder is considered a capital loss. Special treatment applies if 1244 stock is issued by a corporation in exchange for property that has an adjusted basis above its fair market value immediately before the exchange. For purposes of determining ordinary loss upon a subsequent sale, the stock basis is reduced to the fair market value of the property on the date of the exchange. The holder of qualified small business stock may exclude 50 percent of any gain from the sale or exchange of such stock. However, under the American Recovery and Reinvestment Tax Act of 2009, the exclusion increases to 75 percent for qualified small business stock acquired after February 17, 2009, and from legislation in 2010, the exclusion increases to 100 percent for qualified stock acquired after September 27, 2010, and before 2012. To qualify for the exclusion, the taxpayer must have held the stock for more than five years and must have acquired the stock as part of an original issue. Only noncorporate shareholders qualify for the exclusion. A qualified small business corporation is a C corporation whose aggregate gross assets did not exceed $50 million on the date the stock was issued and must be actively involved in a trade or business. OUIZ: Sadie incorporates her sole proprietorship with assets having a fair market value of $80,000 and an adjusted basis of $100,000. Even though 351 applies, Sadie may recognize her realized loss of $20,000. FALSE 2 For 351 purposes, stock warrants are included in the definition of "stock." FALSE. 3 In order to retain the services of Paige, a key employee in Byron's sole proprietorship, Byron contracts with Paige to make her a 30% owner. Byron incorporates the business receiving in return 100% of the stock. Three days later, Byron transfers 30% of the stock to Paige. Under these circumstances, 351 will apply to the incorporation of Byron's business. FALSE. 4. A person who performs services for a corporation in exchange for stock will be treated as a member of the transferring group even if that person only transfers a relatively small amount of property to the corporation. FALSE 5. When a taxpayer incorporates her business, she transfers several liabilities to the corporation. If one of the liabilities is personal in origin, only that liability will be treated as boot. FALSE 6. Matthew and Gabriella form Epsilon Corporation. Matthew transfers property (basis of $50,000 and fair market value of $40,000) while Gabriella transfers land (basis of $25,000 and fair market value of $30,000) and $10,000 in cash. Each receives 50% of Epsilon Corporation's stock, which is worth a total of $80,000. As a result of these transfers: Neither Matthew nor Gabriella has any recognized gain or loss. 7. Cadence transfers property worth $500,000, basis of $100,000, to Alpha Corporation for 80% of the stock in Alpha, worth $400,000, and a long-term note, executed by Alpha Corporation and made payable to Cadence, worth $100,000. Cadence recognizes a gain of $100,000 on the transfer. 8. Willa transferred land worth $400,000, with a tax basis of $100,000, to Zeta Corporation, an existing entity, for 600 shares of its stock. Zeta Corporation has two other shareholders, Jasper and Jonah, each of whom holds 100 shares. With respect to the transfer: Willa has a basis of $400,000 in her 600 shares in Zeta Corporation. 9. Mackenzie incorporates her sole proprietorship, transferring it to newly formed Omega Corporation. The assets transferred have an adjusted basis of $300,000 and a fair market value of $400,000. Also transferred was $50,000 in liabilities, $5,000 of which was personal and the balance of $45,000 being business related. In return for these transfers, Mackenzie receives all of the stock in Omega Corporation. Mackenzie's basis in the Omega Corporation stock is $300,000 10. Lucia transferred equipment (adjusted basis of $100,000 and fair market value of $500,000) to Gamma Corporation. In return, Lucia received 80% of Gamma Corporation's stock (worth $320,000) and an automobile (fair market value of $60,000). In addition, there is an outstanding mortgage of $120,000, held for 5 years, on the building that Gamma Corporation assumed. With respect to this transaction: Lucia's recognized gain is $80,000. CHAPTER 19To the extent that a distribution is made from corporate earnings and profits (E & P), the shareholder is deemed to receive a dividend, taxed as ordinary income or as preferentially taxed dividend income. Generally, corporate distributions are presumed to be paid out of E&P and are treated as dividends unless the parties to the transaction can show otherwise. Distributions not treated as dividends (because of insufficient E & P) are nontaxable to the extent of the shareholder's stock basis, which is reduced accordingly. The excess of the distribution over the shareholder's basis is treated as a gain from the sale or exchange of the stock. EX: At the beginning of the year, Amber Corporation (a calendar year taxpayer) has E & P of $15,000. The corporation generates no additional E & P during the year. On July 1, the corporation distributes $20,000 to its sole shareholder, Bonnie, whose stock basis is $4,000. In this situation, Bonnie recognizes dividend income of $15,000 (the amount of E & P distributed). In addition, she reduces her stock basis from $4,000 to zero, and she recognizes a taxable gain of $1,000 (the excess of the distribution over the stock basis). The notion of earnings and profits (E & P) is similar in many respects to the accounting concept of retained earnings. Both are measures of the firm's accumulated capital (E & P includes both the accumulated E & P of the corporation since February 28, 1913, and the current year's E & P). A difference exists, however, in the way these figures are calculated. The computation of retained earnings is based on financial accounting rules, while E & P is determined using rules specified in the tax law. E & P fixes the upper limit on the amount of dividend income that shareholders must recognize as a result of a distribution by the corporation. In this sense, E & P represents the corporation's economic ability to pay a dividend without impairing its capital. Thus, the effect of a specific transaction on E & P may often be determined by assessing whether the transaction increases or decreases the corporation's capacity to pay a dividend. To determine current E & P, it is necessary to add all previously excluded income items back to taxable income. Included among these positive adjustments are interest on municipal bonds, excluded life insurance proceeds (in excess of cash surrender value), and Federal income tax refunds from tax paid in prior years. EX: A corporation collects $100,000 on a key employee life insurance policy (the corporation is the owner and beneficiary of the policy). At the time the policy matured on the death of the insured employee, it possessed a cash surrender value of $30,000. None of the $100,000 is included in the corporation's taxable income, but $70,000 is added to taxable income when computing current E & P (i.e., amount collected on the policy net of its cash surrender value). The collection of the $30,000 cash surrender value does not increase E & P because it does not reflect an increase in the corporation's dividend-paying capacity. Instead, it represents a shift in the corporation's assets from life insurance to cash., ALSO DIVIDENDS RECEIVED DEDUCTION AND DPAD ARE ADDED BACK. Negative adjustments are subtracted which include the nondeductible portion of meal and entertainment expenses; related-party losses; expenses incurred to produce tax-exempt income; Federal income taxes paid; nondeductible key employee life insurance premiums (net of increases in cash surrender value); and nondeductible fines, penalties, and lobbying expenses. Accumulated E & P is the total of all previous years' current E & P (since February 28, 1913) reduced by distributions made from E & P in previous years. When a positive balance exists in both the current and accumulated E & P accounts, corporate distributions are deemed to be made first from current E & P and then from accumulated E & P. When distributions exceed the amount of current E & P, it becomes necessary to allocate current and accumulated E & P to each distribution made during the year. EX: Green Corporation uses a June 30 fiscal year for tax purposes. Carol, Green's only shareholder, uses a calendar year. On July 1, 2012, Green Corporation has a zero balance in its accumulated E&P account. For fiscal year 20122013, the corporation suffers a $5,000 deficit in current E & P. On August 1, 2012, Green distributes $10,000 to Carol. The distribution is dividend income to Carol and is reported when she files her income tax return for the 2012 calendar year on or before April 15, 2013. Because Carol cannot prove until June 30, 2013, that the corporation has a deficit for the 20122013 fiscal year, she must assume that the $10,000 distribution is fully covered by current E&P. When Carol learns of the deficit, she can file an amended return for 2012 showing the $10,000 as a return of capital. When current E & P is positive and accumulated E&P has a deficit balance, accumulated E & P is not netted against current E & P. Instead, the distribution is deemed to be a taxable dividend to the extent of the positive current E&P balance. when current E & P is positive and accumulated E&P has a deficit balance, accumulated E & P is not netted against current E & P. Instead, the distribution is deemed to be a taxable dividend to the extent of the positive current E&P balance. All corporations treat dividends as ordinary income and are permitted a dividends received deduction (see Chapter 17). In contrast, individuals apply reduced tax rates on qualified dividend income through 2012 while nonqualified dividends are taxed as ordinary income. Under current law, dividends that meet certain requirements are subject to a 15 percent tax rate for most individual taxpayers from 2003 through 2012. Individuals in the 10 or 15 percent rate brackets were subject to a 5 percent rate on dividends paid from 2003 through 2007. Beginning in 2008, dividends are exempt from tax for these lower-income taxpayers. Dividends paid to shareholders who hold both long and short positions in the stock do not qualify. Second, the stock on which the dividend is paid must be held for more than 60 days during the 121-day period beginning 60 days before the exdividend date. PROPERTY DIVIDENDS- When a corporation distributes property rather than cash to a shareholder, the amount distributed is measured by the fair market value of the property on the date of distribution. As with a cash distribution, the portion of a property distribution covered by existing E & P is a dividend, and any excess is treated as a return of capital until stock basis is recovered. If the fair market value of the property distributed exceeds the corporation's E&P and the shareholder's basis in the stock investment, a capital gain usually results. EX: Red Corporation owns 10% of Tan Corporation. Tan has ample E & P to cover any distributions made during the year. One distribution made to Red Corporation consists of a vacant lot with an adjusted basis of $75,000 and a fair market value of $50,000. Red has a taxable dividend of $50,000, and its basis in the lot is $50,000. Corporate distributions reduce E & P by the amount of money distributed or by the greater of the fair market value or the adjusted basis of property distributed, less the amount of any liability on the property. E & P is increased by gain recognized on appreciated property distributed as a property dividend. EX: Crimson Corporation distributes property (basis of $10,000 and fair market value of $20,000) to Brenda, its shareholder. Crimson recognizes a $10,000 gain. Crimson's E & P is increased by the $10,000 gain and decreased by the $20,000 fair market value of the distribution. Brenda has dividend income of $20,000 (presuming sufficient E & P). Deficits can arise only in corporate losses. EX: Teal Corporation has accumulated E & P of $10,000 at the beginning of the current tax year. During the year, it has current E & P of $15,000. At the end of the year, it distributes cash of $30,000 to its sole shareholder, Walter. Teal's E & P at the end of the year is zero. The accumulated E & P of $10,000 is increased by current E & P of $15,000 and reduced by $25,000 because of the dividend distribution. The remaining $5,000 of the distribution to Walter does not reduce E & P because a distribution cannot generate a deficit in E & P. Instead, the remaining $5,000 reduces Walter's stock basis and/or produces a capital gain to Walter. As a general rule, stock dividends are excluded from income if they are pro rata distributions of stock or stock rights, paid on common stock. Five exceptions to this general rule exist. These exceptions deal with various disproportionate distribution situations. If stock dividends are not taxable, the corporation's E & P is not reduced. If the stock dividends are taxable, the distributing corporation treats the distribution in the same manner as any other taxable property dividend. Stock redemptions- When a shareholder sells stock to an unrelated third party, the transaction typically is treated as a sale or exchange whereby the amount realized is offset by the shareholder's stock basis and a capital gain (or loss) results. In such cases, the Code treats the proceeds as a return of the shareholder's investment. In a stock redemption , where a shareholder sells stock back to the issuing corporation for cash or other property, the transaction can have the effect of a dividend distribution rather than a sale or exchange. This is particularly the case when the stock of the corporation is closely held. In a sale of stock to an unrelated third party, the shareholder's ownership interest in the corporation is diminished. In the case of many stock redemptions, however, there is little or no change to the shareholder's ownership interest. In general, if a shareholder's ownership interest is not diminished as a result of a stock redemption, the Code will treat the transaction as a dividend distribution (return from the shareholder's investment). Noncorporate shareholders generally prefer to have a stock redemption treated as a sale or exchange rather than as a dividend distribution. For individual taxpayers, the maximum tax rate for long-term capital gains is currently 15 percent (0 percent for taxpayers in the 10 or 15 percent marginal tax bracket). The preference for qualifying stock redemption treatment is based on the fact that such transactions result in the tax-free recovery of the redeemed stock's basis and capital gains that can be offset by capital losses. In a nonqualified stock redemption, the entire distribution is taxed as dividend income (assuming adequate E & P), which, although generally taxed at the same rate as long-term capital gains, cannot be offset by capital losses. Stock Attribution- related parties are defined to include the following family members: spouses, children, grandchildren, and parents. Attribution also takes place from and to partnerships, estates, trusts, and corporations (50 percent or more ownership required in the case of regular corporations. Section 311 provides that corporations recognize gain on all nonliquidating distributions of appreciated property as if the property had been sold for its fair market value. When distributed property is subject to a corporate liability, the fair market value of that property is treated as not being less than the amount of the liability. Losses are not recognized on nonliquidating distributions of property. Therefore, a corporation should avoid distributing loss property (fair market value less than basis) as consideration in the redemption of a shareholder's stock. However, the corporation could sell the property in a taxable transaction in which it can recognize a loss and then distribute the proceeds. EX: To carry out a redemption, Blackbird Corporation distributes land (basis of $80,000, fair market value of $300,000) to a shareholder's estate. Blackbird has a recognized gain of $220,000 ($300,000 - $80,000). If the land is subject to a liability of $330,000, Blackbird has a recognized gain of $250,000 ($330,000 - $80,000). If the value of the property distributed was less than its adjusted basis, the realized loss would not be recognized. In a qualifying stock redemption, the E & P of the distributing corporation is reduced by an amount not in excess of the ratable share of the corporation's E & P attributable to the stock redeemed. Distributions of stock and securities of a controlled corporation to the shareholders of the parent corporation will be free of any tax consequences if they fall under 355. QUIZ: A distribution from a corporation to a shareholder will always be treated as a dividend for tax purposes. FALSE 2. A distribution from a corporation to a shareholder will only be treated as a dividend for tax purposes if the distribution is paid out of current or accumulated earnings and profits. TRUE 3. Evergreen Corporation distributes land with a fair market value of $200,000 to its sole shareholder. Evergreen's tax basis in the land is $50,000. Assuming sufficient earnings and profits, the amount of dividend reported by the shareholder is $200,000 . TRUE 4. A stock redemption is always treated as a sale or exchange for tax purposes. FALSE 5. Brothers and sisters are considered "family" under the stock attribution rules that apply to stock redemptions . FALSE 6. Assume taxable income is the starting point for computing E & P. During 2010, Sagittarius Corporation had a capital loss of $60,000 and a capital gain of $30,000. The net capital loss of $30,000 could not be deducted in arriving at Sagittarius's taxable income for 2010. The $30,000 was carried over to 2011 and fully deducted in that year. The excess capital loss of $30,000 would reduce Sagittarius Corporation's E & P in 2010. 7. A corporation sells property (basis of $175,000) to its sole shareholder for $125,000, the fair market value of the property. With respect to the sale, The corporation does not recognize a tax loss but reduces its E & P account $50,000. 8. Libra Corporation has a deficit in accumulated E & P of $200,000. For 2011, it has current E & P of $80,000. On December 31, 2011, Libra distributes $95,000 to its sole shareholder, Krista. Krista has a basis of $10,000 in her stock in Libra Corporation . Krista has dividend income of $80,000, reduces her stock basis to zero, and has a capital gain of $5,000. 9. On January 1, Scorpio Corporation (a calendar year taxpayer) has accumulated E & P of $200,000. During the year, Scorpio incurs a net loss of $300,000 from operations that accrues ratably. On June 30, Scorpio distributes $115,000 to Laura, its sole shareholder. How much of the $115,000 represents ordinary dividend income to Laura? $0. 10. Aquarius Corporation has E & P of $300,000. It distributes land with a fair market value of $125,000 (adjusted basis of $50,000) to its sole shareholder, Javier. The land is subject to a liability of $25,000 that Javier assumes Javier has a taxable dividend of $100,000. SAMPLE QUESTIONS: 1. Herman and Henry are equal partners in Badger Enterprises, a calendar year partnership. During the year, Badger Enterprises had $305,000 gross income and $230,000 operating expenses. Badger made no distributions to the partners. Badger must pay tax on $75,000 of income. FALSE 2. Quail Corporation is a C corporation with net income of $300,000 during 2010. If Quail paid dividends of $50,000 to its shareholders, the corporation must pay tax on $300,000 of net income. Shareholders must report the $50,000 of dividends as income. TRUE 3. Eagle Company, a partnership, had a long-term capital gain of $15,000 during the year. Aaron, who owns 40% of Eagle, must report $6,000 of Eagles long-term capital gain on his individual tax return. TRUE 15k *.4= 6k 4. Under the check-the-box Regulations, a single-member LLC that fails to elect to be treated as a corporation will be taxed as a sole proprietorship. TRUE 5. Tina incorporates her sole proprietorship with assets having a fair market value of $100,000 and an adjusted basis of $110,000. Even though 351 applies, Tina may recognize her realized loss of $10,000. FALSE 6. Adam transfers inventory with an adjusted basis of $120,000, fair market value of $300,000, for 85% of the stock of Hernon Corporation. In addition, he receives cash of $30,000. Adam recognizes a capital gain of $30,000 on the transfer. FALSE 7. Gabriella and Juanita form Luster Corporation, each receiving 50 shares of its stock. Gabriella transfers cash of $50,000, while Juanita transfers secret process (basis of zero and a fair market value of $50,000). Neither Gabriella nor Juanita recognizes gain as a result of these transfers. TRUE 8. In a 351 transaction, if a transferor receives consideration other than stock, the transaction can be taxable. TRUE 9. Juanita owns 45% of the stock in a C corporation that had a profit of $120,000 in 2010. Carlos owns a 45% interest in a partnership that had a profit of $120,000 during the year. The corporation distributed $20,000 to Juanita, and the partnership distributed $20,000 to Carlos. Which of the following statements relating to 2010 is incorrect? a. Juanita must report $20,000 of income from the corporation. b. The corporation must pay corporate tax on $120,000 of income. c. Carlos must report $20,000 of income from the partnership. d. The partnership is not subject to a Federal entity-level income tax. e. None of the above. 10. Ted is the sole shareholder of a C corporation, and Sue owns a sole proprietorship. Both businesses were started in 2010, and each business sustained a $5,000 net capital loss for the year. Which of the following statements is correct? a. Teds corporation can deduct the $5,000 capital loss in 2010.= NONE b. Teds corporation can deduct $3,000 of the capital loss in 2010.= NONE c. Sue can carry the capital loss back three years and forward five years.= NONE d. Sue can deduct the $5,000 capital loss against ordinary income is 2010. = NONE 11.Jane and Walt form Yellow Corporation. Jane transfers equipment worth $950,000 (basis of $200,000) and cash of $50,000 to Yellow Corporation for 50% of its stock. Walt transfers a building and land worth $1,050,000 (basis of $400,000) for 50% of Yellow stock and $50,000 cash. a. Jane recognizes no gain; Walt recognizes a gain of $50,000. ... View Full Document

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