24211_ch23_final_p001-014

24211_ch23_final_p001-014 - 23 S Corporations Solutions to...

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Unformatted text preview: 23 S Corporations Solutions to Problem Materials DISCUSSION QUESTIONS 23-1 a. No. An S corporation may not own stock in an S corporation, per se. The QSub (qualified subchapter S subsidiary) rules permit one S corporation to own another corporation if it owns 100 percent of the subsidiary S corporation's stock and elects to treat the subsidiary as a QSub. The QSub combines its income and deductions with those of the parent corporation. [See p. 23-4 and 1361(b)(2)(A).] Yes. When counting shareholders, stock owned by a husband and wife is treated as owned by one shareholder. This applies whether the stock is owned jointly or separately, as long as the couple is not divorced. Thus, this corporation has only 99 owners and falls below the general 100-shareholder eligibility requirement. [See p. 23-5 and 1361(b)(3).] Yes, but only if the trust is one of the five types of trusts permitted as shareholders. The one most applicable in this case is the voting trust. If the trust is established to exercise voting power for the children's stock, it may hold stock in the S corporation. Each child is treated as a separate shareholder. [See p. 23-5 and 1361(c)(2)(A).] Yes. The corporation may have only one class of stock issued and outstanding. Stock that is authorized but is unissued does not invalidate the election. (See p. 23-7.) This corporation does not exceed the 100 shareholder limit, since the family members are all treated as one shareholder. With this ownership rule, the corporation has only 71 shareholders. (See p. 23-6 and 1361(c)(1)) No, an S corporation can own stock in a C corporation or QSub. [See pp. 23-5 and 1361(b)(3).] No, a married couple counts as one shareholder. [See p. 23-6 and 1361(c)(2).] No, estates and resident aliens are eligible shareholders. [See p. 23-4 and 1361(c).] No, the two minor children will count as shareholders, but L will not. [See Example 3, p. 23-7 and 1361(c).] No, as a custodian, L is ignored. No, since there are no owners of the preferred stock, it is unissued and is consequently acceptable. [See p. 23-7 and 1361(c)(4).] No, the differences in voting rights are authorized by 1361(c)(4). (See p. 23-7.) No. This corporation would exceed the 100 shareholder limit, except that the family members are treated as one shareholder. With this rule, the corporation has only 61 shareholders. (See p. 23-6 and 1361(c)(1)) The termination rules do not apply in this case because an S corporation is allowed to own stock in a C corporation or QSub. [See pp. 23-4 and 1361(c)(6).] The termination is effective on December 29 because there are more than 100 shareholders on that date. (See pp. 23-6 and 23-11.) 23-1 b. c. d. e. 23-2 a. b. c. d. e. f. g. h. 23-3 a. b. 23-2 Chapter 23 S Corporations c. d. e. f. g. The election will terminate when the Englishman loses his status as a resident alien. (See p. 23-12.) The termination is effective the date of the exchange because two classes of stock have been issued at that point. (See p. 23-12.) The termination could be effective on January 1 of the year of the election if the election is made within the first 21=2 months of the year; otherwise the termination is prospective (effective January 1 next year). The corporation could specify any prospective date for the termination, on or after the date the corporation files the revocation statement with the OIRS [See p. 23-11 and 1362(d)(1).] The termination is effective June 5 because the C corporation is not an eligible shareholder. (See p. 23-12.) The termination will be effective January 1, 2012 because the passive income has exceeded 25 percent of gross receipts for three consecutive years and there is AE&P. (See Example 16 and pp. 23-14 and 23-15.) 23-4 Stock authorized and outstanding must be identical in rights and interest conveyed to shareholders. For example, rights refer to pro rata dividends and pro rata distributions on liquidation. But differences in voting rights are authorized by the Code. Therefore, the mother may exchange her assets for stock ownership equal to 40 percent of class A voting and 60 percent of class B nonvoting stock. If she then gives the nonvoting stock to her children, she maintains voting control and achieves her objective. (See Example 4 and p. 23-7.) Since the corporation is a calendar year corporation, the election must be filed by March 15. In addition, consent to the S election must be obtained from not only F, M, and T, who hold stock at the time of the election, but also from V, who held stock during a portion of the taxable year prior to the election. This consent allows V to be protected from allocations of income, losses, and other items. Without V's consent by March 15, 2011, the election will not be effective until 2012. (See Example 7 and pp. 23-10 and 23-11.) Yes, the election can be made for all of 2011 if it is done by March 15, 2011. [See p. 23-9 and 1362(b)(1) and (b)(2).] a. Probably. Consent from R must be obtained by the filing deadline unless the IRS grants an extension of time due to a holding that R's absence is "reasonable cause." Moreover, late election relief is routinely granted. [See Example 6, p. 23-10, and Reg 1.1362-6(b)(iii).] b. Yes, the sale is after the effective date and has no effect unless X can get support from other stockholders for a revocation. [See p. 23-11 and 1362(d)(1)(D).] a. The corporation's initial taxable year begins on the earliest date that the corporation issues shares, acquires property, or commences doing business as a corporation. Accordingly, the corporation must make its S election before 2 months and 15 days elapse from the earliest of these dates. ABC must make its S election by May 16, 2011, to take effect for the year beginning March 2, 2011, without availing itself of any relief provisions. (See Example 5 and p. 23-9.) The corporation could make an election to take effect for its taxable year beginning January 1, 2012. It would need to file the election on or before March 15, 2012. (See Example 5 and p. 23-10.) If ABC were a C corporation for the year in which it received the property in the 351 exchange, it would be subject to the built-in gain tax on any subsequent sale of any of these assets, if they were sold within the first ten S corporation years. (See pp. 23-51 through 23-54.) The extended due date for the corporation's 2011 tax return (September 15, 2012) has not yet elapsed. Therefore, the corporation can request relief for a late election with the IRS service center where the corporation files all other tax returns, pursuant to Rev. Proc. 2003-43. It must state the reason for the delay. If the service center accepts the election, the corporation is an S corporation for its 2011 taxable year. (See Example 6 and pp. 23-9 and 23-10.) This situation also qualifies for relief under Sec. 1362(b)(5). However, since the corporation did not apply for relief within the time periods prescribed by Rev. Proc. 2003-43, it must apply for a letter ruling with the IRS National Office. (See p. 23-10.) 23-5 23-6 23-7 b. c. d. e. 23-8 An intentional revocation must be made by the corporation. Shareholders holding more than one half the shares of stock must consent. (1) If made by the 15th day of the third month of the current taxable year (March 15 for a calendar year business), the election is effective on the first day of the taxable year unless the corporation specifies a prospective date. (2) If made after this two-month and 15-day period, the revocation is effective the following taxable year unless another day on or after the date of revocation is selected. If an effective date is one other than the first day of the following tax year, the corporation's taxable year is divided into two parts. It has an S short year ending the day before the termination date and a C short year for the remaining part of the year. Both an S corporation and a C corporation return must be Solutions to Problem Materials 23-3 filed, each reflecting the correct share of income, deductions, credits, etc. The two approved methods of determining these amounts are the (1) pro rata, or per-day, method and (2) the interim closing of the books method. The tax liability for the C short year must be determined by annualizing the C short year income. If the revocation takes effect on the beginning of a tax year, the corporation closes its S corporation books at the end of the tax year and files an S corporation return. At the beginning of the next taxable year, it must follow the rules and regulations concerning reporting and filing C corporation income and returns. A violation of eligibility requirements terminates the S corporation election on the date of the disqualifying event. However, the IRS may allow the corporation to continue its S status if the factor disqualifying the election is inadvertent and is corrected. A termination due to excessive passive income becomes effective at the beginning of the first year following the close of the third consecutive year in which the corporation had (1) passive investment income exceeding 25 percent of gross receipts, and (2) AE&P at the end of each of these three years from the time it was a C corporation. The results at the effective date are the same as for situation (2) above. [See Examples 9 through 16, pp. 23-11 through 23-15 and 1362(d).] 23-9 The corporation cannot revoke the election as of January 1, 2011 because a timely revocation cannot be filed (by the 15th day of the third month, which is March 15 for a calendar year corporation). The intention of this provision is to prevent corporations from waiting until the end of the tax year to determine the most advantageous filing status (i.e., as an S corporation or a C corporation). However, the corporation may revoke the S election for the remainder of the year. Similarly, S status is terminated immediately when any Subchapter S requirement is violated. For example, stock could be sold to an ineligible shareholder, such as a nonresident alien, corporation, or partnership. Thus, the shareholders should consider an appropriate method and time to cause one or more of the requirements to be violated to accomplish their objective. (See Examples 9, 10, 11 and pp. 23-11 through 23-12.) Passive investment income includes gross receipts from rents, not net income from rents. Rents are not passive income when significant services are provided. If (1) this is the third consecutive year the corporation has had gross rental income exceeding 25 percent of gross receipts, and (2) it also has had AE&P at the end of each year, then the excessive passive investment income test will be violated and the corporation will lose its S election as of the beginning of the next year. Steps that could be taken are to (1) increase other nonpassive income so that rent is a smaller portion of gross receipts, (2) perform substantial services to have rent removed from the category of passive income, (3) delay receipt of the last two months of rent until the beginning of the following tax year to lower the percentage of gross receipts that is rent (if a cash basis corporation), or (4) distribute all AE&P before the year end. For example, 30 percent/12 months 2.5 percent 10 months 25 percent. The corporation could also distribute all of its AE&P by election to bypass its AAA. (See Example 16 and pp. 23-14 and 23-15.) a. The salary is a deductible business expense for the S and C corporations always, but for the partnership only with a guaranteed payment to the partner. (See Example 18 and pp. 23-17 through 23-18.) Owners can be employees of the business and be paid salaries subject to FICA and withholding for the S and C corporate shareholders, but for partners only if the partner's capital interest does not exceed 5 percent. Partners whose capital interests exceed the 5 percent limit must pay self-employment tax on their share of partnership operating income because they are considered to be self-employed. (See Example 18 and pp. 23-17 through 23-18.) Fringe benefits for owner/employees are deductible for all C corporations. Fringe benefits for S shareholders owning 2 percent or less of the corporation's stock receive the same treatment. The S corporation is allowed a deduction for the cost of the qualifying employee benefits and the more than 2 percent shareholder/employee must include the amount in gross income. Although treated as wages subject to withholding taxes, any health insurance is not subject to the FICA or FUTA taxes. Partnerships are also allowed to deduct the cost of the fringe benefits provided to its partners. The cost of such benefits is treated as a deductible guaranteed payment by the partnership and included in the gross income of the partner. (See p. 23-18.) The shareholder-employee excludes the benefits from gross income if the employer is a C corporation. A shareholder-employee who owns no more than 2% of the S corporation may also claim the exclusion. In determining the 2% threshold, the shareholder-employee must observe the constructive ownership rules of 318. Thus the employee would be treated as owning any stock held by a family member or trust or estate of which the employee is a beneficiary. (See p. 23-18.) 23-10 23-11 b. c. d. 23-4 Chapter 23 S Corporations 23-12 The original character of all S corporation items flows through to be reported by shareholders on their own tax returns. The Schedule K-1 provides each shareholder with his or her dollar share and the character of income, expenses, gains, losses, and credits that may be subject to special treatment. (See Schedule K-1 at Exhibits 23-1 and 23-2 and pp. 23-21 through 23-27.) a. b. Dividend income received by an S corporation is separately stated and flows through to each shareholder pro rata as dividend income. (See pp. 23-21 and 23-27.) Accrued rental expense to a shareholder is deductible by the S corporation only when it is includible income to the shareholder. In the case of a cash-basis shareholder, the expense is not deductible until paid. (See Example 30, p. 23-37.) Net LTCGs flow through to each shareholder before short-term gains or losses are netted against them. LTCGs are combined with other shareholder capital gains and losses on their individual returns. The S corporation must also report gains subject to the 28% and 25% tax rates. (See Exhibit 23-2, p. 23-27.) The S corporation must recognize the gain to the extent the market value of the distributed asset exceeds the S corporation's basis in the asset. This gain flows through to the shareholders. The recipient shareholder has a basis in the asset equal to its market value. To the extent the market value exceeds the shareholder's basis in the S corporation's stock (increased by his or her share of the gain recognized by the corporation), the transaction is treated as a partial sale of stock. (See p. 23-56.) Yes. All reasonable salaries paid to family members are deductible business expenses and includible income to the children. (See p. 23-39.) Yes. However, special income allocation rules require that (1) all family members be compensated for their services, and (2) allocations to the children represent an equitable return on their capital. Two advantages of the S corporation form are that (1) shareholders are not required to participate in management, and (2) corporate stock may have different voting rights. [See p. 23-39, 1366(e), and Reg. 1.1366-3(a).] Yes. K may form a trust to hold the children's shares as long as the trust is a voting trust, a deemed grantor trust, QSST or ESBT. [See pp. 23-4 through 23-6 and 1361(c)(2)(A).] She can transfer nonvoting stock to her children or to one or more trusts. An S corporation may have only one class of stock. However, voting rights may differ among the shares of outstanding stock, as long as all economic rights per share are identical. (See p. 23-7.) Ability to remove property from a trust typically renders the trust to be a grantor trust. A grantor trust is transparent for tax purposes, and is specifically allowed to hold shares in an S corporation. Thus she could transfer shares to a trust in this manner. She would continue to be treated as the owner of all of the trust's property, including the S corporation shares, for income tax purposes. There is no special election required in order for a grantor trust to be an eligible shareholder. (See p. 23-5.) She could create a QSST for each child to hold shares of the S corporation. Each QSST would need to be for the exclusive benefit of one child for that child's life. Accordingly, no other person could get any income or property from the trust during the life of the child. The trustee must distribute (or be required to distribute) all of the trust's income annually to the child. The child, or parent or guardian, but not the trustee, would need to file an election to treat the trust as a QSST. As a result of this election, the child would include the trust's share of the income from the S corporation on his or her personal return each year. (See p. 23-5.) An ESBT would allow the trustee to distribute income between the children in a flexible manner. The trustee could accumulate income if that alternative is desirable. The trustee must elect to treat the trust as an ESBT. An ESBT must pay tax on its portion of the S corporation income. The tax is a flat rate of 35% on all ordinary income. Distributions are tax-free to the beneficiaries. (See p. 23-6.) 23-13 c. d. 23-14 a. b. c. 23-15 a. b. c. d. 23-16 Both stock and debt basis are used to determine the primary limit on a shareholder's ability to deduct his or her portion of losses that flow through at the end of the S corporation's taxable year. In general, all income distributions and losses serve to adjust the basis of a shareholder's stock. However, if losses exceed a shareholder's stock basis, the excess will reduce the shareholder's debt basis (but not below zero). In years subsequent to a debt basis reduction, the shareholder's portion of the corporation's income (less losses and distributions) will restore debt basis (but not beyond its initial amount). A shareholder may obtain debt basis by a direct loan of money to the S corporation. Contrast this rule with the partnership treatment, whereby partners may be allocated portions of the partnership's debts to outsiders. (See pp. 23-30 and 23-31.) Solutions to Problem Materials 23-5 23-17 a. b. When market value exceeds basis, the S corporation must recognize the gain on the asset distributed. This gain passes through to the owners. The basis to the owners of the property received is its FMV. In addition, owners must recognize gain when the FMV of the assets received exceeds their basis in the corporate stock (increased by their share of the gain recognized by the corporation). This is capital gain because it is treated as a sale of stock. [See Example 38, p. 23-47, and 1363(d).] When the property's basis exceeds its market value, there is a realized loss but no recognized loss. The basis of the property received is its fair market value on the date of the distribution. (See p. 23-47.) 23-18 Cash distributions, when there is no AE&P, are includible income only when they exceed a shareholder's basis in the S corporate stock (determined at the corporation's year end). In this situation, the shareholder's basis excludes receivables or other obligations due from the corporation. The character of the income is capital gain. In addition to potential capital gain recognition, shareholders receiving cash distributions from an S corporation with AE&P have dividend income to the extent the distribution is from AE&P. [See p. 23-40 and 1368(b).] The post-termination transition period (PTTP) was created to allow shareholders to transact certain S corporation activities after the S corporation no longer existed. The period begins the day after the S corporation's final S corporation tax year and ends on whichever occurs last: (1) one year later; (2) the due date for the S corporation return, including extensions; (3) 120 days after a closing agreement determining that the S corporation terminated in a prior year; or (4) 120 days after an audit that adjusts S corporation income. This period is used to make nontaxable cash distributions from AAA. It also can be used by shareholders to increase basis in stock that would allow the flow through of any net loss carryovers that were not available to the shareholder previously because the basis in the S corporation stock plus debt/ receivables was zero. (See pp. 23-48 and 23-49.) a. Advantages. Unlike partners, S shareholders 1. May be employees of their S corporation, with their salaries subject to FICA, and not subject to self-employment tax; 2. Typically have capital gain on the sale of an ownership interest or may qualify for 1244 ordinary loss; 3. Increase their basis in the S corporation for loss flow-through by debt owed to them personally by the S corporation; 4. Have no personal liability for S corporation debts unless they have guaranteed them; 5. Are not required to participate in the management of the business; 6. Are not subject to ordinary income when certain capital assets are sold to the S corporation, even if the seller owns more than 50 percent of the business. Disadvantages. Unlike S corporations, partnerships 1. Provide owners with the ability to contribute assets for an ownership interest tax-free, regardless of the contributing parties' percentage of ownership; 2. Do not usually recognize gain when appreciated assets are distributed to a partner, even if the partner has no basis in the partnership; 3. May have income, expenses, gains, losses, and credits specially allocated among owners; 4. May have the basis of their assets adjusted when an ownership interest is sold or when gain or loss is recognized by a partner as a result of partnership distributions; 5. Allow owners to include their share of partnership liabilities in their basis; 6. Have no restrictions on who may be an owner or on the number of owners; 7. May not lose their elections to be treated as partnerships; 8. Are not subject to any built-in gains tax or passive investment income tax; and 9. Are subject to distribution restrictions only for a donee partner, whereas S corporations are subject to rules requiring fair salaries, interest, etc. to all related parties. b. Advantages for the S corporation relative to a C corporation: 1. The original character of all S corporation items flows through to the owners, which provides benefits, particularly when the S corporation has net losses, as is often the case in the early years of operation; 2. Distributions from S profits are not taxed to shareholders unless their basis is zero, so double taxation is avoided; 3. Net capital gains and losses are passed through to the shareholders; and 4. Excess accumulated earnings are not subject to a penalty tax. 23-19 23-20 23-6 Chapter 23 S Corporations Advantages for the C corporation relative to an S corporation: 1. It has a separate graduated income tax rate schedule; 2. Owner/employee fringe benefits are excludable by the owner/employee; 3. Business income is not taxable to owners until distributed; 4. Corporate taxable years may differ from those of their owners; 5. There are no restrictions on the total number of owners; 6. State income taxes, bad debts, and charitable contributions are business deductions; and 7. There is a dividend deduction equal to 70 percent (80% if at least 20% of the distributing corporation's stock is owned and 100% if from an affiliated corporation) of dividend income. 8. The corporation may have more than one class of stock. (See Exhibit 23-6 and pp. 23-57 through 23-60.) PROBLEMS 23-21 The election is terminated if the corporation has passive investment income exceeding 25 percent of its gross income for three consecutive years and the corporation has AE&P at the end of each of these three consecutive years. In this case, the corporation computes its income as follows: Passive Interest $50,000 Dividends 5,000 Gain from prior installment sales Used car sales Totals $55,000 25% passive investment income ceiling Maximum passive investment income allowed if election is to be preserved. Total $ 50,000 5,000 30,000 40,000 $125,000 .25 $ 31,250 11- The interest income of $50,000 and the dividend income of $5,000 are both passive. Therefore the passive income exceeds the limit and the corporation loses its S election at the start of the next year. (See Example 16 and p. 23-15.) 23-22 a. S Inc. must file a Form 1120S, an S corporation income tax return, for the short period January 1, through July 31, and a Form 1120, a C corporation income tax return, for the short period August 1 through December 31. Both returns are due on March 15, 2012, the due date of the calendar year short period C corporation return. The returns may be extended until September 15. S must prorate its 11-month income of $432,000 between the S corporation and the C corporation returns, based on the number of days reflected on each return (since the interim closing method was not elected). S corporation income: C corporation income: c. $252,099 (213/365 $432,000) $179,901 (152/365 $432,000) b. Taxable income on the C corporation return will be $179,410 (152 days/365 days $432,000). In computing the tax liability, this amount must be annualized as follows: Step 1: Taxable income ($179,901 365/152) Tax liability on a 12-month basis $146,880 152/365 $61,166 tax liability for the short period August 1 -- December 31 $432,000 34% $146,880 Step 2: In this situation, annualization causes all of the C corporate income to be taxed at 34 percent. (See Examples 13 and 14 and p. 23-13.) Solutions to Problem Materials 23-7 23-23 a. If the partners incorporate, the corporation must pay employment taxes on their compensation. As a result, the corporation's ordinary taxable income would be calculated as follows: Partnership S Corporation Sales $ 400,000 $ 400,000 Operating Expenses (190,000) (190,000) Owners' Compensation (1) (200,000) (200,000) FICA Taxes (2) (15,300) FUTA Tax (3) (,868) AB's Ordinary income (loss) $ 10,000 $ (6,168) (1) The partners are personally subject to self-employment tax as follows: Per partner Compensation Per partner share of net income Total SE Ceiling for 2011 Tax rate Total SE Tax $100,000 5,000 $105,000 106,800 15.30% $ 16,065 (2) The Corporation and shareholders are subject to FICA as follows: Per shareholder Compensation FICA Ceiling for 2011 Tax rate Total FICA Withheld Employer FICA per shareholder (3) FUTA is imposed as follows: Maximum base for 2011 Rate Per shareholder $7,000 6.20% $ ,434 $100,000 106,800 7.65% $ 7,650 $ 7,650 Partners Shareholders b. Per Owner Compensation 50% of net income Less SE Tax Deduction Net income $100,000 5,000 (8,033) $ 96,968 $100,000 (3,084) -- $ 96,916 11c. There is probably little difference in the total tax liability if they incorporate or operate as a partnership. The personal liability issues are approximately equivalent between a corporation and a limited liability company. Incorporation would offer a tax advantage if the principals wanted to retain money in the business, or if they wanted to avail themselves of fringe benefits. If they incorporate the practice and make an S election, the income retained by the business would not be subject to self-employment tax, as it would be in a partnership. Similarly, their fringe benefits for health insurance would not be subject to selfemployment tax. At the levels of income given in this problem, the tax savings would not be substantial from incorporation. From a fringe benefit point of view, the best strategy would be to incorporate and not make an S election. If the practice were to operate as a C corporation, the fringe benefits would be completely deductible by the corporation and excludable by the shareholder-employees. 23-8 Chapter 23 S Corporations d. The limited liability company would allow the owners the same liability limits as they would have as shareholders in a corporation. The limited liability company is generally treated as a partnership for tax purposes. This combination of corporate protection for nontax purposes and flow through treatment for tax purposes is causing this entity to be a popular option for many businesses. (See p. 23-17 and Example 18) S Corporation 23-24 Sales Cost of goods sold Gross profit Salary to Z (includes insurance) Other expenses Net income (ordinary) $180,000 (70,000) $110,000 (12,500) (40,000) $ 57,500 (1) 1. Dividend income and net capital loss are items subject to special treatment and flow through to each shareholder to be treated as dividend income and capital loss on their personal returns. The life insurance is treated as part of Z's salary and qualifies as a deductible employee benefit for the S corporation. Z's A.G.I. Salary Business net income Business salary Dividend income Net capital loss A.G.I. $30,000 11,500 (2) 12,500 1,000 (2) (,800)(2) $54,200 (3) 2. 20% $57,500 $11,500; 20% $5,000 $1,000; and 20% $4,000 $800. 3. A cash distribution is not includible income to Z unless the distribution exceeds Z's basis. Then, the distribution is treated as a partial sale of a shareholder's interest. Z's Basis Beginning basis Flow-through of ordinary income Distributions Flow through of dividend income Flow through of capital loss Ending basis $10,000 12,500 (4) (4,000) (5) 1,000 (,800) $18,700 4. See (2) above: ($11,500 $1,000). Note that the $500 life insurance is treated as part of Z's salary. The salary does not affect basis because Z is considered to be an employee of the business. 5. 20% $20,000 $4,000. (See Exhibit 23-3; Examples 19 through 28; and pp. 23-28 through 23-36.) 23-25 Sales Cost of goods sold Gross profit Salary to Z Other expenses Net ordinary loss S Corporation $ 180,000 (130,000) $ 50,000 (18,000) (65,000) $ (33,000) Z's beginning basis Flow through income (dividend) distribution Basis before losses $10,000 1,600 ,000 $11,600 Solutions to Problem Materials 23-9 Total Passing to Z to Z Allowed this Year 72.50% Carried Forward 27.50% Charitable Ordinary loss Capital loss Total $ ,400 13,200 2,400 $16,000 $ ,290 9,570 1,740 $11,600 $ ,110 3,630 ,660 $4,400 Z's Federal Tax Return Salary from unrelated employer Salary from S corporation Dividend income from S corporation Ordinary loss from S corporation Capital loss from S corporation AGI $30,000 18,000 1,600 (9,570) (1,740) $38,290 If Z itemized deductions, she can claim $290 for her share of the S corporation's contributions. (See pp. 23-31 through 23-32 and Example 26) 23-26 a. The entire loss is deductible since M has sufficient stock and debt basis. Beginning Stock Basis Loan during year Add income for year: 1231 gain $20,000 10% Basis before loss Losses: Total 100,000 10,000 M's Portion 10,000 1,000 $ 7,500 5,000 2,000 $14,500 Ordinary Capital 11- (11,000) All of the loss is allowable, since M's basis exceeds the total. Her stock and debt basis are reduced as follows: Stock: Beginning basis Share of income Basis before loss Reduction for loss Ending basis Debt: Amount loaned Loss in excess of stock basis ($11,000 $9,500) Ending basis b. $ 7,500 2,000 $ 9,500 (9,500) $ ,000 $ 5,000 (1,500) $ 3,500 The $7,000 (10%) that flows to M increases the basis in the note back to $5,000 ($1,500), and the remaining $ 5,500 increases the basis of the stock from zero to $5,500. (See pp. 23-31 through 23-32 and Example 26). 23-10 Chapter 23 S Corporations 23-27 a. Note that the date of sale counts as an ownership day for the seller. For a non-leap year the computations are Days through March 15 Days in year Percent of year through March 15 Percent ownership through March 15 Weighted average through March 15 Days after March 15 Days in year Percent of year after March 15 Percent ownership after March 15 Weighted average after March 15 Total weighted average for V 74 365 20.2740% 25.0000% 5.0685% 291 365 79.7260% 15.0000% 11.9589% 17.0274% Total V Share Net ordinary Income Net capital loss $200,000 (10,000) $34,055 (1,703) b. Note that the date of sale counts as an ownership day for the seller. For a non-leap year the computations are Days through March 15 Days in year Percent of year through March 15 Percent ownership through March 15 Weighted average through March 15 74 365 20.2740% 25.0000% 5.0685% Total V Share Net ordinary Income Net capital loss $200,000 (10,000) $10,137 (,507) c. Percent ownership through March 15 Items though March 15 Net ordinary Income Net capital loss 25.0000% Total $60,000 (2,500) V Share $15,000 (,625) (See pp. 23-28 and 23-29, Examples 20 through 22) Solutions to Problem Materials 23-11 11-28 Basis January 1 Net income Cash distributed Decrease in debt Basis December 31 a. Partner b. S Owner $ 9,000 4,500 (6,000) (1,200) $ 6,300 $ 9,000 4,500 (6,000) (2,000) $ 5,500 H's 30 percent share of net income ($15,000 30% $4,500) increases basis, and cash received (presumably $20,000 30% $6,000) decreases basis. Partner H's basis is further decreased by the decrease in total liabilities ($62,000 $58,000 $4,000 30% $1,200). S shareholder H's basis in stock is not affected by the decrease in debt, but H's basis in the receivable from the corporation is reduced by $2,000. Basis in the receivable becomes important if losses are passed through to the shareholders and basis in stock is zero. (See pp. 23-28 and 23-29, Examples 20 through 22.) 23-29 a. Basis in stock Basis in debt Total basis 11Allowed Carry Forward $14,500 10,000 $24,500 Loss type: Ordinary ($32,000/$36,000 $24,500) Capital ($4,000/$36,000 $24,500) Total 11b. $32,000 4,000 $36,000 $21,778 2,722 $24,500 $10,222 1,278 $11,500 The deduction of $24,500 of allocated losses reduces Z's basis in his B stock and his basis in the note receivable to zero. (See Examples 24, 25 and 26 and pp. 23-33 through 23-35.) 23-30 Beginning basis Adjustments Ordinary income Tax exempt income Losses carried forward from prior year End 7,000 5,500 12,500 (11,500) 1,000 Stock Debt 0 0 2,500 2,500 0 10,000 9,000 1,000 (See Example 26 and pp. 23-33 through 23-35.) 23-12 Chapter 23 S Corporations 23-31 Items of income and expense are allocated to the shareholders according to their stock holdings. Any loss deduction, however, is limited to each shareholder's basis in his stock and any notes receivable from the corporation. Other liabilities of the corporation do not affect the shareholder's basis. Income and loss allocated to each shareholder: LJ RS Ordinary loss Long-term capital gain Tax-exempt interest Loss limitations: Beginning stock basis Long-term capital gain Tax-exempt interest Notes receivable basis Total $18,000 ,300 ,600 $12,000 ,200 ,400 $12,000 ,300 ,600 5,000 $17,900 $10,000 ,200 ,400 ,000 $10,600 As a result of the limitations, each shareholder reports the following items on his return: Ordinary loss Long-term capital gain Tax-exempt interest $17,900 ,300 ,600 $10,600 ,200 ,400 (See Examples 26 through 28 and pp. 23-32 through 23-36.) 23-32 a. Stock Note* b. Basis before loss Loss ($45,000 40% $18,000) Basis after loss Income ($20,000 40% $8,000) Basis after income $ 15,000 (15,000) $ 0 5,000 $ 5,000 $ 8,000 (3,000) $ 5,000 3,000 $ 8,000 *For the second year, 1367(b)(2) allows M to increase the basis in the debt for the excess of all positive adjustments over all negative adjustments to the stock basis. Here, the positive adjustments for M are $8,000 ($20,000 40%) and there are no negative adjustments (i.e., no distributions and no losses or separately stated deductions). As a result, M increases the debt basis by $3,000 (back to its original face value of $8,000) and the remaining $5,000 is allocated to the stock basis. (See Exhibit 23-3, Examples 24 through 28, and pp. 23-32 through 23-36.) 23-33 a. First Year: Stock Debt Basis Beginning Dividend Income Basis before loss Loss Basis Ending $30,000 $ 18,000 3,000 $ 21,000 (21,000) $ 0 $12,000 $12,000 (9,000) $ 3,000 Solutions to Problem Materials 23-13 b. Second Year: Stock Debt Basis Beginning Dividend Income Ordinary Income Basis Ending 11c. $ 0 $ 0 $ 3,000 1,200 6,000 $10,200 Even though repayment of the note is made during the year, all changes in basis are determined at the end of the year. Thus, the repayment exceeds X's basis in the note by $1,800 ($12,000 $10,200 from (b) above). Since the debt is a note, the $1,800 excess is capital gain. If the debt had been an open account, the $1,800 would have been ordinary income. X also reports $6,000 net ordinary income and $1,200 dividend income. X's basis in the stock remains at zero. (See Example 28; pp. 23-33 through 23-35.) Since the increases of the current year do not exceed the decreases to debt basis in the prior year, they are all allocated to debt basis. (See pp. 23-33 and 23-34 and Example 25.) 23-34 X recognizes a capital gain of $10,000 ($60,000 $50,000). The note payable to X does not affect the gain calculation on his stock, and it will presumably be paid off by the corporation in due course. (See pp. 23-55 and 23-56.) 23-35 a. In 2011, Tax Savings, as determined below, are $1,338: Proprietorship K S Corporation K Total Son Total Son Net income before salary Salary to K Net income before salary AGI Standard deduction Exemptions Taxable income Tax (rate schedule) (Current table not yet available) b. 60,000 ,000 60,000 60,000 60,000 8,400 7,300 44,300 6,048 60,000 (25,000) 35,000 0 900 0 0 0 25,000 24,500 49,500 8,400 7,300 33,800 4,473 10,500 10,500 ,950 ,000 9,550 1,014 c. There is no includible income if the son's transfer for the other 30 percent also takes place at this time. Contributions of assets solely for a corporate capital interest are nontaxable exchanges if the transferor owns at least 80 percent of the corporation. K may have to file a gift tax return if the value of the 30 percent interest given to her son is more than $12,000. K may be able to avoid or reduce gift tax if she spreads the gift over two or more years. K must relinquish control over her son's 30 percent ownership interest. Filing a gift tax return would support the transfer to the son as a gift, and is required if the value is more than $12,000. Although she may act for him as a guardian, trustee, or custodian, the courts often have viewed this as a continuation of control. The safer approach is to appoint an independent person, such as a bank, to fill this role. Two important advantages are that (1) K's son is not required to participate in management, and (2) the corporate stock could have different voting rights. Since a family relationship exists between K and her son, she must pay herself a reasonable salary covering services performed for the S corporation in order to prevent possible IRS reallocations. (See pp. 23-39 through 23-40 and Example 32.) 23-36 a. $180 1245 gain ($2,280 $2,100 $180, which is less than $7,900 accumulated depreciation) must be recognized by the S corporation; it then flows through to the owners. b. M's basis in the equipment is $2,280 FMV since this is a taxable distribution. c. M's basis in the stock is $8,828 [$11,000 ($180 60% $108) $2,280]. d. M's A.G.I. is increased by the $108 ($180 60%) recognized 1245 gain that flows through to her. [See Example 38, pp. 23-47, and 1366(b).] 23-14 Chapter 23 S Corporations 23-37 All answers and explanations are the same as they are for Problem 23-36 except c and d. c. M's basis in the stock is zero since the FMV of the equipment exceeds M's basis by $972 [$2,280 ($1,200 $108)]. d. When the FMV of assets distributed to an S shareholder exceeds that shareholder's basis in the stock, the distribution is treated as a partial sale of stock. Thus, shareholder M must recognize, in addition to the $108 discussed in c, $972 of capital gain. The increase to A.G.I. is $1,080 ($972 $108), assuming M has no capital losses. [See Example 38, p. 23-47, and 1366(b).] 23-38 There is $60,000 gain recognized by the corporation, $ 12,000 of which flows through to J. The distribution gives J a plat of land with a basis of $16,000 ($80,000 20%) at fair market value. J's basis in his stock is now $46,000 ($50,000 $12,000 $16,000). (See Example 38 and p. 23-47.) 23-39 Shareholder T U V Stock basis before distribution Corporate Gain on land Basis Distribution: Cash Land Desks Total Gain on distribution Stock basis after distribution 11- (See Example 38 and p. 23-47.) 23-40 Beginning balances Sales Cost of goods sold Operating expenses Salary to J Ordinary taxable income Tax-exempt income Capital gain Positive AAA adjustment Balance before distributions Distributions Balance before losses Nondeductible entertainment Expenses related to tax-exempt Capital loss Contribution Negative adjustment to AAA AAA balance before distribution Distribution Net negative adjustment Ending Balances $12,000 3,000 15,000 10,000 7,000 3,000 20,000 5,000 $ 0 $40,000 3,000 43,000 10,000 7,000 3,000 20,000 0 $23,000 $40,000 3,000 43,000 10,000 7,000 3,000 20,000 0 $23,000 Stock Basis AAA OAA AE&P $100,000 $ 300,000 (120,000) (50,000) (40,000) $ 90,000 13,000 7,000 $143,000 $ ,000 $4,000 90,000 13,000 7,000 $210,000 10,000 $200,000 (4,000) (3,000) (2,000) (5,000) 90,000 13,000 7,000 $ 97,000 $13,000 $4,000 10,000 (4,000) (3,000) (2,000) (5,000) (4,000) (3,000) (2,000) (5,000) $ (11,000) $229,000 (10,000) ,000 $219,000 $186,000 $10,000 $4,000 (See Examples 36 and 37 and pp. 23-45 through 23-47.) Solutions to Problem Materials 23-15 23-41 In order to determine the treatment of these distributions, the balances in the various retained earnings accounts must be determined. The balances are determined on the last day of the taxable year regardless of when the distributions are made. More importantly, the balances are those after positive adjustments and before adjustments for nondeductible and deductible items. The balances are: Stock Basis AAA OAA AE&P Balances before distributions a. $210,000 $229,000 $13,000 $4,000 The $100,000 distribution is all from AAA and represents a nontaxable return of capital, reducing the shareholder's basis to $110,000 and the AAA account to $129,000 as shown below. Capital Gain Stock Basis AAA OAA AE&P Balances before distributions Distribution $ 100,000 AAA (100,000) Ending balances $ 210,000 (100,000) $ 110,000 $ 229,000 (100,000) $ 129,000 $13,000 $4,000 $,000 $13,000 $4,000 b. The $220,000 distribution represents $220,000 of AAA. Distributions of AAA are nontaxable but only to the extent of the shareholder's basis. Therefore, of the $220,000 distributed, $210,000 is a nontaxable return of basis and the remaining $10,000 is capital gain. Note that because the distribution exhausts the shareholder's basis, the capital loss and the charitable contribution are not deductible and must be carried over. Capital Gain Dividend Stock Basis AAA OAA AEP Balances before distributions Distribution $ 220,000 AAA (220,000) Ending balances c. $ 210,000 $10,000 $10,000 (210,000) $ ,000 $ 229,000 (220,000) 9,000 $13,000 $4,000 $,000 $ $13,000 $4,000 The $260,000 represents $229,000 from AAA, $4,000 from Accumulated E&P, $13,000 from OAA, and $3,000 from paid-in capital. As a result, the shareholder must report a capital gain of $46,000 and a dividend of $ 4,000 as computed below. As above, the distribution exhausts the shareholder's basis, thereby preventing the deduction of the capital loss and the charitable contribution both of which can be carried over to the following year. Capital Gain Dividend Stock Basis AAA OAA AE&P Balances before distributions Distribution $ 260,000 AAA (229,000) Balances $ 31,000 AEP (4,000) Balance $ 27,000 OAA (13,000) Balance $ 14,000 Paid-in Capital (14,000) Ending balances $ 210,000 $19,000 $19,000 $19,000 13,000 $32,000 14,000 $46,000 (210,000) $ ,000 $ $ $ ,000 ,000 ,000 $ 229,000 (229,000) ,000 ,000 ,000 ,000 $ 13,000 $ 4,000 $ ,000 4,000 $4,000 $4,000 $4,000 $ $ $ $ $ 13,000 $ 13,000 (13,000) $ ,000 $ ,000 $ 4,000 (4,000) $ ,000 $ ,000 $ ,000 (See Examples 36 and 37 and pp. 23-45 through 23-47.) 23-42 a. b. The corporation must recognize a long-term capital gain of $25,000 on the distribution of the IM stock. J and G report their shares of ordinary income ($35,000 50% $17,500) and their shares of the capital gain on the stock ($25,000 50% $12,500). 23-16 Chapter 23 S Corporations AAA PTI AE& Total Beginning balance Net ordinary income Gain on stock Subtotal Distribution--G Distribution--J $ 50,000 35,000 25,000 $110,000 (55,000) (55,000) $ 0 $ 40,000 $30,000 $ 40,000 (20,000) (20,000) $ 0 $30,000 $30,000 $120,000 35,000 25,000 $180,000 (75,000) (75,000) $ 30,000 The distribution to the extent of AAA is allocated equally to J and G. Both cash and property distributions reduce PTI balances. Both shareholders have sufficient basis to prevent any of the distribution from being taxable as a gain from sale of stock. (See Example 36 and pp. 23-45 and 23-47.) 23-43 a. Corporate Accounts AAA PTI AE&P OAA b. Y's 70% c. Stock A.G.I. Basis Total Distributions Beginning balances Net ordinary income Excludable income $ 13,000 $ 2,000 $ 6,000 $ ,000 $ 12,000 $ 8,400 4,000 $ 25,000 $ 7,000 8,400 2,800 18,200 Cash distributions: 1. From AAA (25,000) Y's 70% $17,500 (17,500) 2. From PTI (2,000) Y's 70% $1,400 Non-taxable to extent of stock basis (,700) Remaining $700 taxable as capital gain ,700 3. Dividend from AE&P (6,000) Y's 70% $4,200 4,200 4. Return of capital - OAA $55,000 ($25,000 $2,000 $6,000) $22,000 (4,000) 70% from OAA is capital gain for Y since Y has 2,800 recovered her basis 5. Capital gain from paid-in capital Y's 70% of ($22,000 $4,000) $12,600 capital gain 12,600 Ending balances $ 0 $ 0 $ 0 $ 0 $28,700 $ 0 17,500 ,700 ,700 4,200 2,800 12,600 $38,500 Explanations: a. Cash distributions must follow a specific order: (1) to the extent of AAA, (2) to the extent of PTI, (3) to the extent of AE&P, (4) return of capital to the extent of shareholder basis (as adjusted by increases and decreases in OAA), and (5) capital gain from paid-in capital for all remaining amounts. (See Examples 36 and 37 and pp. 23-45 and 23-47.) b. The $22,000 in step 4 reduces OAA by its $4,000 balance and the stock accounts by $18,000 ($22,000 $4,000). Solutions to Problem Materials 23-17 Y has $4,200 ($6,000 70%) dividend income and $16,100 ($2,800 $12,600 $700) capital gain from cash distributed in excess of basis, assuming Y has no capital losses from other sources. (See Example 34 and pp. 23-43 and 23-44.) d. The $5,000 note is not included in basis and is never used except to allow losses to flow through. (See pp. 23-30 and 23-31.) e. The Schedule M-2 does not include Accumulated Earnings and Profits, Paid-in Capital, or Capital Stock. Thus, not all distributions are necessarily reported on Schedule M-2. c. (See Example 34 and pp. 23-43 and 23-44) 23-44 AAA a. Corporate Accounts PTI AE&P OAA b. Y's 70% c. Stock A.G.I. Basis Beginning balances Net ordinary income Gain on distribution Y's 70% is capital gain Excludable income $ 13,000 12,000 2,000 $ 2,000 $ 6,000 ,000 $ 8,400 1,400 4,000 $ 7,000 $ 8,400 1,400 2,800 $ 19,600 $ 27,000 Property distributions: 1. From AAA (27,000) Y's 70% $18,900 2. From PTI (2,000) 3. Dividend from AE&P (6,000) Y's 70% $4,200 4. Return of capital - OAA $55,000 ($27,000 $6,000) $22,000 (4,000) Y's 70% $4,000 $2,800, of which $700 is return of capital and $2,100 is capital gain since Y has recovered her basis 5. Capital gain from paid-in capital Y's 70% of ($22,000 $4,000) $12,600 capital gain Ending balances $ 0 $ 0 $ 0 $ 0 11- ,700 4,200 (18,900) (,700) 2,800 11,200 $28,700 $ 0 Explanations: a. Noncash distributions must follow a specific order: (1) to the extent of AAA, (2) from PTI, (3) to the extent of AE&P, (4) return of capital to the extent of shareholder basis (as adjusted by increases and decreases in OAA), and (5) capital gain for all remaining amounts. (See Example 36 and pp. 23-45 through 23-47.) b. Y's ordinary income, dividend income, and capital gains are the same as in 23-43. This is not always the result but occurs in this case since (1) the gain on the stock distributed was capital gain, and (2) total distributions absorb all of the corporation's AE&P and all of Y's basis in the stock. (See Example 37 and pp. 23-45 through 23-47.) 23-18 Chapter 23 S Corporations 23-45 a. b. The $20,000 cash distribution is deemed to be first from the corporation's $11,000 accumulated adjustments account. This AAA distribution is nontaxable and reduces M's basis in his D stock to $15,250 [$18,000 (25% $11,000 $2,750)]. The $9,000 balance of the distribution is from the accumulated earnings and profits account, and $2,250 (25% $9,000) is a taxable dividend to M. So M's $5,000 distribution is a $2,250 taxable dividend and a $ 2,750 nontaxable distribution. After the distribution, D has a zero balance in AAA (distributions cannot cause a negative AAA balance) and a $10,000 balance in its accumulated earnings and profits account. (See Example 34 and p. 23-44.) Corporate Accounts PTI AE&P Stock Basis M 23-46 AAA OAA J Beginning balances Net ordinary income Tax-exempt interest income Cash distributions: Step 1 Step 2 Step 3 Ending balances $ 8,000 12,000 $ 2,000 $ 3,000 $ ,000 $ 13,000 6,000* 1,000 (10,000) (1,000) ,000 $ 9,000 $ 8,500 6,000* 1,000 (10,000) (1,000) ,000 $ 4,500 2,000 (20,000) (2,000) ,000 ,000 (2,000)* $ 1,000 $2,000 *Items that are taxable income to M and J. a. b. c. The corporate account balances are shown. M and J have $6,000 net ordinary income each and $ 1,000 of dividend income each. (See Example 36 and p. 23-45.) Stock bases for M and J are shown. (See pp. 23-44 and 23-45.) 23-47 AAA Corporate Accounts PTI AE&P Stock Basis M OAA J Beginning balances Net ordinary income Capital gain Tax-exempt interest income Cash distributions: Step 1 Step 2 Step 3 Ending balances $ 8,000 12,000 1,000 $ 2,000 $ 3,000 $ ,000 2,000 (21,000) (2,000) ,000 $ ,000 (1,000) $ 2,000 $ 13,000 6,000 ,500 1,000 (10,500) (1,000) ,000 $ 9,000 $ 8,500 6,000 ,500 1,000 (10,500) (1,000) ,000 $ 4,500 $,00 0 $2,000 The distribution of land results in a $1,000 capital gain recognized and passed through to M and J, along with $6,000 ordinary income each and $1,500 of dividend income each. Noncash distributions reduce PTI under current IRS instructions. (See Example 36 and pp. 23-45 through 23-47.) 23-48 Gross receipts for the passive investment income test are $160,000, of which $60,000 is dividends and rents. Since the corporation has passive investment income exceeding 25 percent of its gross receipts [$60,000 is Solutions to Problem Materials 23-19 greater than (25% $160,000 $40,000)], and it has AE&P at the end of the taxable year, the tax on passive income is imposed. Excessive net passive income is computed as follows: Total gross receipts 25% of total Passive gross receipts ($20,000 $40,000) Not in excess of 25% gross receipts (25% $160,000) Excessive portion $160,000 40,000 $ 60,000 (40,000) $ 20,000 Net passive investment income Dividend Rent Total Gross receipts Directly connected expenses Net $20,000 (0) $20,000 $ 40,000 (25,000) $ 15,000 $ 60,000 (25,000) $ 35,000 Net passive investment income Times excessive % ($20,000 / 60,000) $35,000 ,,1/3 $11,667 $ 4,083 Tax at 35% Apportioned to rent and dividend income proportionate to net income from dividends and rents. Final pass-through to shareholders: Type income Dividend Rent Ordinary Gross receipts Directly connected expenses Net Apportioned passive income tax Net pass through total 1/3 to each shareholder (See Example 39 and pp. 23-50 and 23-51.) 23-49 a. $20,000 ,0(0) $20,000 (2,333) $17,667 $ 5,889 $ 40,000 (25,000) $ 15,000 (1,750) $ 13,250 $ 4,417 $100,000 (70,000) $ 30,000 ,0(0) $ 30,000 $ 10,000 Lesser of built-in gain or taxable income (NRBIG) Top corporate tax rate Tax Lesser of built-in gain or taxable income (NRBIG) Top corporate rate Tax $30,000 0.35 $10,500 $20,000 0.35 $ 7,000 b. The net unrealized built-in gain is $55,000 ($240,000 $185,000). The net recognized built-in gain for the current year is $30,000 in part a and $20,000 in part b. Note that there were no NOL carryforwards nor business tax credit carryforwards from C years. (See Examples 40 through 44 and pp. 23-54 through 23-58.) 23-20 Chapter 23 S Corporations 23-50 Adjusted Basis Fair Market Value Built-in Gain (Loss) Inventory Land Equipment $20,000 30,000 45,000 $95,000 $ 85,000 70,000 15,000 $170,000 $ 65,000 40,000 (30,000) $ 75,000 Although L recognizes a gain of $70,000 ($90,000 $20,000) on the sale of the inventory, L's built-in gain recognized is limited to the amount accrued to the inventory on the date of conversion from a C corporation to S status, $65,000. The built-in loss on the sale of the equipment is limited to $30,000 ($45,000 $15,000). L's pre limitation amount is $35,000 (the built-in gain of $65,000 less the built-in loss of $30,000. Tax on Net Built-in Gain: Net recognized built-in gain Top corporate tax rate Tax $35,000 0.35 $12,250 Note that there were no NOL carryforwards nor business tax credit carryforwards from C years. (See Examples 40 through 44 and pp. 23-51 through 23-54.) 23-51 a. b. c. T Corporation's LIFO recapture amount is $110,000 [the excess of the inventory's value under FIFO over its actual LIFO basis as of the end of T's last C corporation taxable year ($650,000 $540,000)]. The LIFO recapture tax is $38,500 ($110,000 35%). The LIFO recapture tax is payable in four equal installments, with the first $9,625 installment being due on the due date of T's last C corporation return and the subsequent payments being due on the due dates of T Corporation's first three S corporation returns. No interest is due if the required payments are paid on a timely basis, and there is no requirement that estimated tax payments be made with respect to any LIFO recapture tax due. The $150,000 difference in the inventory's FIFO value and the fair market value at the end of 2008 will be subject to the built-in gains tax as the inventory is sold. [See Example 45, p. 23-55, and 1363(d).] d. 23-52 Since the S corporation flow-through rules apply before the deduction for worthless stock or debt, E has an ordinary loss of $18,000 ($30,000 60%). This reduces E's basis in the stock to $52,000 ($70,000 $18,000). The loss on worthless securities is treated as a sale or exchange of a capital asset, occurring on the last day of the shareholder's tax year. The $52,000 deduction for E's worthless stock is a capital loss unless it qualifies as an ordinary loss under 1244. The worthless note is a personal loss, and therefore, all of it is a capital loss unless E can establish it as a business debt, in which case it would be an ordinary loss. However, a business debt for E is unlikely since the loans were to protect his investment. There are four possible outcomes for E given the above facts. 1 2 3 4 E's income $120,000 Loss from operations (18,000) Capital loss--worthless securities (3,000) Ordinary-- 1244 Ordinary--business debt (25,000) Capital loss--personal Net income $ 74,000 $120,000 (18,000) (52,000)* (25,000)** $ 25,000 $120,000 (18,000) ,000 $120,000 (18,000) (52,000)* (3,000) $ 99,000 (3,000) $ 47,000 Solutions to Problem Materials 23-21 Carryover (1) $52,000 $3,000 $49,000 capital loss (3) $25,000 $52,000 $3,000 $74,000 capital loss (4) $25,000 $3,000 $22,000 capital loss *This deduction assumes E files married joint. If E does not file married joint, only $50,000 qualifies as an ordinary loss, and the remaining $2,000 is capital loss and increases the capital loss carryover by $2,000 in each situation. (See p. 23-55.) **However, the deduction is treated as a miscellaneous itemized deduction, subject to the 2% AGI floor. See Graves v. Comm'r, TC Memo 2004-140. TAX RETURN PROBLEMS Completed Forms 1120S and Schedule K-1s (23-5323-54) are contained in the Instructor's Resource Guide and Test Bank for 2012. TAX RESEARCH PROBLEMS Solutions to the Tax Research Problems (23-5523-58) are contained in the Instructor's Resource Guide and Test Bank for 2012. ...
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This note was uploaded on 02/05/2012 for the course ACCT 110 taught by Professor Smith during the Spring '11 term at Adrian College.

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