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H Chapter Three H TAXABLE ENTITIES, TAX FORMULA, INTRODUCTION TO PROPERTY TRANSACTIONS SOLUTIONS TO PROBLEM MATERIALS DISCUSSION QUESTIONS 3-1 The three classes of taxable entities under the Federal income tax system are: 1. Individuals; 2. Regular corporations; and 3. Fiduciaries (Estates and Trusts). In addition to the taxable entities, the partnership files an information return showing its income, deductions, gains, and losses, and how they are allocated among the partners. An S corporation, or electing small business corporation, usually pays no Federal income tax and is treated similar to a partnership. (See p. 3-2.) 3-2 The net taxable income of a corporation is subject to Federal income taxation. Any portion of the net profit remaining that is distributed to its shareholders as dividends is taxed at the shareholder level. The corporation is not entitled to a deduction for this dividend paid. This is thought by some to be double taxation because they believe the same income is taxed twice. (See pp. 3-5 and 3-6.) 3-3 A fiduciary that makes no current distributions is taxable on its entire net taxable income. When a fiduciary makes distributions, they are generally taxable to the beneficiaries to the extent of the trust’s or estate’s taxable income. Any distributions in excess of the entity’s income are considered distributions of capital, known as corpus, and are tax free. It is important to note that the trust or estate is entitled to a deduction for the amount of distributions that are taxable to the beneficiary(ies). Therefore, the income is not taxed twice. (See Example 4 and 5 p. 3-8.) 3-4 The annual return of a partnership (Form 1065) merely provides information about the income, deductions, gains, losses, and credits of the partnership, and information about how they are allocated among the partners. Since the partnership is never subject to tax on its income, the return can properly be referred to as an information return. The same is generally true of the S corporation tax return (Form 1120S), but in some instances penalty taxes must be paid. (See Example 7 and p. 3-10.) 3-5 The question is not specific as to whether the income of the partnership is derived from a trade or business or not. a. The guaranteed compensation paid to Y is subject to income tax and self-employment taxes. b. Y’s share of net income of $22,000 is subject to income tax. It is also subject to self-employment tax if it was earned in a trade or business. If it was not trade or business income (e.g., rents), the income would not be subject to self-employment tax. (See p. 3-10.) 3-1
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3-6 a. K’s salary, assuming it is reasonable in amount, is treated as a salary for income tax and payroll tax purposes. It is therefore subject to both income tax withholding and F.I.C.A.
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