Chapter 05 Solutions

# Chapter 05 Solutions - P roblem Solutions Chapter Five 18...

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Problem Solutions Chapter Five 18. Adam would prefer a dividend because he would have \$21,250 after tax [\$25,000 dividend – (\$25,000 × 15% tax rate)]. If he were paid a bonus, only \$18,000 after tax [\$25,000 bonus – (\$25,000 × 28% tax rate)] results. However, this ignores the effect of the payments on Sparrow Corporation. If Sparrow paid Adam a deductible bonus, it would save \$8,500 (\$25,000 deduction for bonus payment × 34% tax rate) in taxes. (There is no tax savings with a dividend payment.) Since Adam is \$3,250 better off with a dividend (\$21,250 after tax from a dividend – \$18,000 after tax with a bonus) and Sparrow is \$8,500 better off with a bonus, the two parties taken together are \$5,250 better off with a bonus (\$8,500 benefit from bonus for Sparrow – \$3,250 benefit from a dividend for Adam). As Adam is the sole shareholder of the corporation, he should choose the bonus alternative. Examples 28 and 29 19. The salaries paid to Holly and Terry are vulnerable to constructive dividend treatment since neither shareholder appears to have earned them. There is also a problem regarding the \$470,000 salary payment to Judy. Why is she receiving \$150,000 more than John when it appears they share equally in managing the company’s operations? Although Judy is not a shareholder, her relationship to Holly and Terry is enough of a tie-in to raise the unreasonable compensation issue. Furthermore, Pink Corporation has never distributed a dividend although it has substantial E & P. Given the dividend history and the salary disparities, the IRS might successfully argue that all of the salary paid to Terry and Holly, as well as the \$150,000 paid to Judy, is unreasonable. Example 30 24. Michele and Wally have dividend income of \$80,000 each {[\$100,000 (accumulated E & P) + \$60,000 (current E & P)] ÷ 2}. The dividend income will be subject to the 15%/0% tax rates on dividends. The remaining \$40,000 of the \$200,000 distribution reduces the basis (\$20,000 each) in the shareholders’ stock with any excess treated as a capital gain. Michele has a reduction in stock basis from \$11,000 to zero and a capital gain of \$9,000. Wally has a reduction in stock basis from \$26,000 to \$6,000. Example 1 25. a. Redbird reports the \$250,000 dividend as taxable income but has a dividends received deduction under § 243 of \$175,000 (70% × \$250,000). None of the other items affect taxable income. Thus, taxable income is \$575,000 (\$500,000 taxable income before dividends + \$250,000 dividend – \$175,000 dividends received deduction). b. Redbird Corporation’s E & P as of December 31 is \$915,000, computed as follows: \$150,000 (beginning balance in E & P) + \$575,000 (taxable Page 1 of 5

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income) + \$175,000 (dividends received deduction) + \$35,000 (tax- exempt interest) – \$20,000 (interest on indebtedness to purchase tax- exempt bonds). pp. 5-3 and 5-4
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Chapter 05 Solutions - P roblem Solutions Chapter Five 18...

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