Ch21TB

©2009 CCH. All Rights Reserved. Chapter 21

853

Chapter 21S Corporations

TRUE-FALSE QUESTIONS—CHAPTER 21To qualify as an S corporation there is no limit to the number of shareholders.1. A corporation with more than 50 shareholders will not qualify for the S election.2. Ace Trucking Co., Inc. is chartered in Michigan. It has 100 shares of common stock and 200 shares of preferred stock 3. outstanding which are held by three individuals who also live in Michigan. The corporation owns no subsidiaries. This corporation qualifi es for the S election. A corporation with two classes of stock cannot qualify under Subchapter S for the election not to be taxed.4. If a corporation fails to make a timely S election, an extension of time to make the election may be granted.5. A calendar year corporation that meets certain requirements and wishes not to be taxed as a corporation for 2009 must 6. make an S election by March 15, 2009. An S corporation cannot be subject to an income tax.7. An electing S corporation is entitled to the dividends received deduction.8. A shareholder’s stock basis in an S corporation is increased by his or her share of the corporation’s separately stated 9. and non-separately computed items of income. If a shareholder of an S corporation has a tax year different from that of the corporation, he or she must report any 10. distributions of current year’s taxable income in the year he or she actually receives the distribution. A corporation has been an S corporation for fi ve years and has accumulated earnings and profi ts. Its S election is 11. terminated in the year following the third consecutive year in which more than 25 percent of the corporation’s gross receipts for a tax year are excessive passive income. If an S corporation’s passive investment income is more that 25 percent of gross receipts for two consecutive 12. tax years and the corporation has pre-S corporation earnings and profi ts at the end of each of those years, the corporation’s S corporation status will be terminated. For 20X1, the books and records of Clover, Inc., a cash basis S corporation, refl ected the following:13.

Salary to Dad Clover, President and 50% shareholder $22,000Salary to Son Clover, janitor and 50% shareholder 60,000Loans to Dad Clover during 20X1, no repayments 30,000

Dad Clover worked 40-hour weeks for the entire year but said that the business could not afford to pay him a salary more than the $22,000. The IRS could reclassify the $30,000 and/or part of the son’s salary to Dad Clover, and assess income tax withholding as well as employment taxes on those amounts. An Electing Small Business Trust is an eligible shareholder for an S corporation.14. Corporation X began operations on January 1, 2009, and met all of the requirements to qualify as an S corporation. 15. On March 15, 2009, X fi led a valid Form 2553 to elect S corporation status. X cannot be treated as an S corporation until 2010. Billy Johnson sold his stock in Corporation Z, an S corporation, to Corporation N, a C corporation. This will not 16. terminate Z’s status as an S corporation. Any incorporated business can elect to be taxed as an S corporation.17. Since S corporations are corporations, they are subject to the accumulated earnings tax, personal holding company 18. tax, and alternative minimum tax. A corporation cannot elect S status if it has as a shareholder a corporation or partnership.19. A corporation that wants to elect and retain S corporation status can at no time have 100 shareholders.20. All members of the same family are treated as one shareholder in an S corporation.21. A corporation cannot qualify as an S corporation if it has more than one class of stock.22. A corporation eligible to be an S corporation is automatically treated as such by the IRS.23.

854 CCH Federal Taxation—Comprehensive Topics

Chapter 21 ©2009 CCH. All Rights Reserved.

A corporation’s S status can only be terminated by having all shareholders revoke the S election.24. Once fi led, an S corporation cannot rescind a revocation.25. An S corporation may accidentally revoke its S status by either no longer qualifying as a small business corporation 26. or by having accumulated E&P and excess passive investment income for three consecutive years. The IRS is more likely to accept an S corporation’s request to disregard an inadvertent termination if it believes that 27. the terminating event was not reasonably within the corporation’s control and was not part of a plan to terminate the corporation’s S status. Unlike the partnership rules, an S corporation is not allowed to specially allocate items of income, deduction, gain and 28. loss among its shareholders. The decision of whether to deduct or take a credit for foreign income taxes paid or accrued by the S corporation is 29. made by the S corporation. Nonseparately stated items are items of income and deduction subject to limitations applied at the shareholder-level.30. The character of any item of income, gain, loss, deduction, or credit included in a shareholder’s pro rata share is 31. determined at the shareholder-level and retain that character in the shareholder’s hands. An S corporation shareholder may deduct his or her pro rata share of the corporation’s items of loss and deduction 32. only to the extent that the amount of those items does not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation plus the adjusted basis of any S corporation indebtedness to the shareholder. Shareholders must reduce their adjusted basis in S corporation stock by their pro rata share of noncapital, 33. nondeductible expenses. S corporation shareholders cannot increase the adjusted basis of their stock by their share of the general liabilities of 34. the corporation, but do increase their basis by amounts they personally loan the corporation. Shareholders who receive a distribution during the year must wait until the end of the year to determine how the 35. amount they receive will be taxed. All S corporations are required to maintain an AAA to determine how distributions are taxed to its shareholders.36. With the consent of the majority of shareholders, an S corporation may elect to treat a distribution as coming from its 37. AAA fi rst and then from its accumulated E&P without consent of any of the shareholders. An election to treat a distribution as coming fi rst from accumulated E&P is effective until the entire balance of E&P is 38. distributed. The S corporation does not recognize loss on the distribution of property where the FMV is less than the corporation’s 39. adjusted basis in the property. Two-percent shareholders are treated as self-employed individuals and must include the value of fringe benefi ts in 40. their gross income unless an exclusion is available to self-employed individuals.

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MULTIPLE CHOICE QUESTIONS—CHAPTER 21Who pays tax on the income of an S corporation?41.

The S corporationa. The shareholdersb. The customersc. There is no tax imposed on S corporation incomed.

What is the maximum number of shareholders that an S corporation may have?42. 10a. 25b. 35c. 100d. None of the abovee.

Which of the following is not an eligible shareholder for an S corporation?43. Nonresident aliena. Qualifi ed Subchapter S Trustb. An estatec. None of the aboved.

Which type of stock will disqualify a corporation from becoming an S corporation?44. One class of stock but with different voting rightsa. A straight debt instrumentb. Stock which has preference in dividendsc. None of the aboved.

Which corporation will qualify for S corporation status?45. Corporation owning a subsidiarya. DISC corporationb. Possession corporationc. None of the aboved.

Which of the following information is not necessary on Form 2553--Election by Small Business Corporation?46. Shareholder namea. Shareholder social security numberb. Number of shares owned by shareholderc. Shareholder marital statusd. Date the shares were acquirede.

Which tax year is not allowed an S corporation?47. Calendar yeara. Fiscal year established by business purposeb. Fiscal year that is the same as all the principal ownersc. None of the aboved.

Which of the following taxes is not imposed on an S corporation?48. Built-in gains taxa. Excessive passive investment income taxb. Corporate taxc. Tax on early disposition of property on which the investment credit was claimed by the corporation as a previous d. C corporation



Jack Freeman, a calendar year taxpayer, owns 30 percent of an S corporation which closes its books on June 30 each 49. year. On November 30, 2009 and April 30, 2010, the S corporation pays a $40,000 cash dividend and has a taxable income for the year ending June 30, 2010 of $90,000. Jack, on his personal return would report income of:

$12,000 for 2009 and $12,000 for 2010a. $12,000 for 2009 and $15,000 for 2010b. $0 for 2009 and $27,000 for 2010c. $12,000 for 2009 and $27,000 for 2010d. $40,000 for 2009 and $50,000 for 2010e.

Michael Moore owns stock in an S corporation. The corporation sustained a net operating loss during the year. 50. Michael’s share of the loss is $5,000. His adjusted basis in the stock is $1,000. In addition, he has a loan outstanding to the corporation in the amount of $2,000. What amount, if any, is Michael entitled to deduct with respect to the loss?

$5,000a. $3,000b. $2,000c. $1,000d. None of the abovee.

What is Gerald Germain’s basis in an S corporation assuming he is the sole shareholder and his capital account has 51. a balance of $15,000, the corporation has $5,000 in liabilities, $2,000 in previously taxed income, and $1,000 in accumulated earnings and profi ts?

$23,000a. $22,000b. $18,000c. $17,000d. None of the abovee.

What is the only credit allowed against the tax on passive investment income?52. Dependent care credita. Investment creditb. General business creditc. Credit for special fuelsd. Business energy creditse.

Passive investment income includes all except:53. Interesta. Sales or exchanges of stock or securitiesb. Rentsc. Interest on deferred payment sales of property held for sale to customersd.

S corporation corporate level elections include all except:54. S election and/or change of accounting methoda. Election out of the installment sales provisionb. Deduction and recapture of certain mining exploration expensesc. Inventory valuationd.

Which of the following is not a separately stated item in the income computation of an S corporation?55. Long-term capital gaina. Charitable contributionsb. Interest incomec. Section 179 expensed. General business credite.

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The election on Form 2553 for S corporation status is effective for a tax year if it is fi led any time during the previous 56. tax year, or fi led in the tax year to which the election is to apply by:

The 15th day of the fi rst montha. The 15th day of the second monthb. The 15th day of the third monthc. The 15th day of the fourth monthd.

Sunnie purchased 50 percent of the shares of corporation H, a calendar year S corporation, for $7,000. She also 57. guaranteed a corporate loan of $6,000. For 2009, H had an operating loss of $22,000. What is the amount of H’s loss that Sunnie can deduct on her individual income tax return for 2009?

$11,000a. $10,000b. $7,000c. $0d.

Which one of the following items does not increase a shareholder’s basis in an S corporation?58. All income items of the S Corporation, including tax-exempt income, that are separately stated and passed a. through to the shareholder. Any nonseparately stated income of the S corporation.b. The amount of the deductions for depletion that is more than the basis of the property being depleted.c. Any expense of the S corporation that is not deductible in fi guring its income and no properly chargeable to a d. capital account.

Which of the following would not increase the basis of a shareholder’s stock in an S corporation:59. All separately stated income items of the S corporation, including tax- exempt income.a. Any nonseparately stated income of the S corporation.b. Capital gains tax paid by the shareholder.c. The amount of deductions for depletion that is more than the basis of the property being depleted.d.

On 1-1-X1, Mr. Vear purchased 50 percent of S Corporation Z’s only class of stock outstanding for $100,000. 60. On 12-1-X1, he purchased the other 50 percent of its stock. For 20X1, Z Corporation had a net operating loss of $255,500. How much of the loss can Mr. Vear deduct on his individual income tax return for 20X1?

$138,600a. $200,000b. $234,208c. $255,500d.

Income from an S corporation is taxed at:61. the shareholder level.a. the corporate level.b. both the shareholder level and the corporate level.c. None of the above.d.

Advantages of an S corporation include:62. limited liability.a. single level of taxation.b. not subject to the personal holding company tax.c. All of the above.d. None of the above.e.

Which of the following is not a requirement of a “small business corporation?”63. It must be a domestic corporation.a. It can never have more than 100 shareholders.b. It must use the reserve method of accounting.c. It can only have one class of stock.d.



All of the following are permitted shareholders of an S corporation except:64. estates.a. eligible trusts.b. nonresident aliens.c. certain tax-exempt organizations.d.

Which of the following trusts is eligible to be an S corporation shareholder?65. Electing small business trust.a. Eligible foreign trust.b. Qualifi ed subchapter S trust.c. Only a and c.d. All of the above trusts are eligible to be S corporation shareholders.e.

Which of the following count as a single S corporation shareholder?66. A husband and wife.a. A spouse and a spouse’s estate.b. Members of a family with a common ancestor.c. All of the above.d.

A corporation will be treated as having one class of stock if:67. all of its outstanding shares of stock confer identical rights to distribution and liquidation proceeds.a. there is no differences in voting rights.b. there is no differences in the timing of distributions.c. All of the above.d.

To become an S corporation, a corporation must:68. have once been a C corporation.a. elect to be treated as such.b. have at least 100 shareholders.c. Only c and b.d. All of the above.e.

An S corporation may lose its S status because:69. it issues a second class of stock.a. it has accumulated E&P and excess passive investment income for three consecutive years.b. the number of shareholders exceeds 100.c. All of the above.d.

An S corporation’s separately stated items must include all of the following except:70. gross income from business operations.a. tax credits.b. investment income expense.c. charitable contributions.d.

A shareholder’s adjusted basis in stock is used to determine:71. the extent to which a distribution made by the corporation to the shareholder is taxable.a. the amount of losses that shareholders may deduct in a given year.b. the shareholder’s realized gain or loss upon the sale or exchange of the stock.c. All of the above.d.

The accumulated adjustment account:72. represents the amount of the corporation’s earnings as a C corporation that has only been taxed at the corporate a. level. measures the accumulated undistributed net income of a corporation while it has been an S corporation.b. Both a. and b.c. None of the above.d.

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Passive investment income:73. includes gross receipts derived from royalties, rents, dividends, interest, and annuities.a. does not include interest on any obligation acquired in the ordinary course of the corporation’s trade or business b. or from its sale of inventory. does not include any recognized built-in gain or loss of the S corporation for any tax year during the recognition c. period. All of the above.d.

Which of the following statements about the built-in gains tax is true?74. The recognized gain is allocated pro rata to its shareholders, thereby imposing a tax on the gain at the a. shareholder-level. The built-in gains tax prevents an S corporation from escaping tax at the entity-level for unrealized gains from b. periods during its earlier years as a C corporation. Only amounts of appreciation generated during a corporation’s existence as a C corporation are subject to the c. built-in gains tax. All of the above.d.

The LIFO recapture amount is the difference between:75. the amount of the corporation’s inventory assets under the retail method and the amount of the corporation’s a. inventory assets under the LIFO method. the amount of the corporation’s inventory assets under the FIFO method and the amount of the corporation’s b. inventory assets under the LIFO method. the amount of the corporation’s inventory assets and fair market value.c. None of the above.d.

A calendar year corporation wishes to elect to be taxed as an S corporation. What is the last day that the corporation 76. can fi le an election to be effective for 2009?

December 31, 2008.a. March 15, 2009.b. April 15, 2009.c. December 31, 2009.d.

A corporation that elected S status in 20X2 has C corporation earnings and profi ts of $50,000 from its C corporation 77. years. During 20X5 the corporation’s gross receipts are $120,000, which includes $75,000 of interest income. Expenses related to the interest income are $10,000. The corporation’s excess passive investment income would be:

$45,000.a. $35,000.b. $39,000.c. $20,000.d.

An S corporation incurs an operating loss of $80,000 in 20X5 and makes no distributions to its shareholders during 78. the year. Before considering the current year operating loss, Abe, a shareholder that owns 50 percent of the S corporation stock, has a basis in his shares of S corporation stock of $30,000 and a $20,000 basis in a note from the corporation. How much of the $80,000 loss can he deduct on his 20X5 individual tax return?

$0.a. $20,000.b. $30,000.c. $40,000.d.

On January 1, 20X6, an S corporation has accumulated E&P of $55,000 from its years as a C corporation and has a 79. positive AAA balance of $15,000. The corporation’s sole shareholder, Betty, has a basis in her S corporation stock of $30,000. During 20X6, the corporation reports ordinary income of $10,000 and a $20,000 long-term capital gain. During 20X6, the corporation distributes $65,000 to Betty. The amount of the distribution that represents a taxable dividend is:

$0.a. $20,000.b. $50,000.c. $55,000.d.



On January 1, 20X6, an S corporation has accumulated E&P of $55,000 from its years as a C corporation and has a 80. positive AAA balance of $15,000. The corporation’s sole shareholder, Betty, has a basis in her S corporation stock of $30,000. During 20X6, the corporation reports ordinary income of $10,000 and a $20,000 long-term capital gain. During 20X6, the corporation distributes $65,000 to Betty. The balance in the corporation’s accumulated E&P at the end of 20X6 is:

$0.a. $5,000.b. $35,000.c. $55,000.d.

A calendar-year S corporation has a balance in its AAA and accumulated E&P of $3,000 and $20,000, respectively, 81. at the beginning of 20X9. During 20X9, the corporation has ordinary income of $10,000. Also during 20X9, the corporation makes a $15,000 distribution to its shareholders. What amount of the $15,000 distribution is taxed as dividend income to the shareholders?

$0.a. $2,000.b. $3,000.c. $5,000.d. $15,000.e.

A calendar-year S corporation has a balance in its AAA and accumulated E&P of $3,000 and $20,000, respectively, 82. at the beginning of 20X9. During 20X9, the corporation has tax-exempt income of $5,000 and ordinary income of $10,000. Also during 20X9, the corporation makes a $15,000 distribution to its shareholders. If a bypass election is properly made for 20X9, what amount of the $15,000 distribution is taxed as dividend income to the shareholders?

$0.a. $2,000.b. $3,000.c. $5,000.d. $15,000.e.

A calendar-year S corporation has a balance in its AAA and accumulated E&P of $3,000 and $20,000, respectively, 83. at the beginning of 20X4. During 20X4, the corporation has tax-exempt income of $5,000 and ordinary income of $10,000. Also during 20X4, the corporation makes a $15,000 distribution to its shareholders. If a bypass election is properly made for 20X4, what is the corporation’s balance in its AAA and accumulated E&P at the beginning of 20X5?

$13,000 and $5,000, respectively.a. $18,000 and $5,000, respectively.b. $0 and $18,000, respectively.c. $3,000 and $20,000, respectively.d.

A calendar-year S corporation has a $36,500 operating loss for 20X1. At the beginning of 20X1, S corporation had 84. two equal shareholders: A and B. On May 31, 20X1, A sells his shares of stock in the S corporation. How much of the $36,500 loss is allocable to A?

$0.a. $4,167.b. $7,550.c. $7,604.d. $15,100.e.

During 20X1, an S corporation has $30,000 of ordinary income and a $50,000 long-term capital gain. The corporation 85. distributes $48,000 to its sole shareholder during the year. What amount(s) will the sole shareholder report from the S corporation on his 20X1 income tax return?

Ordinary income $30,000; long-term capital gain $18,000.a. Ordinary income $18,000; long-term capital gain $30,000.b. Ordinary income $30,000; long-term capital gain $50,000.c. Ordinary income $0; long-term capital gain $48,000.d.

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Candie Deschamp sold her 20-percent interest in an S corporation on April 30. On November 30, the corporation, 86. which uses the calendar year as its tax year, sold land with an adjusted basis of $30,000 for $84,750. The corporation’s income from business operations was $109,500, of which $30,000 was earned while Candie held stock in the corporation. What is Candie’s share of the capital gain and income from business operations?

$0 of capital gain and $6,000 of ordinary incomea. $0 of capital gain and $7,200 of ordinary incomeb. $3,600 of capital gain and $6,000 of ordinary incomec. $3,600 of capital gain and $7,200 of ordinary incomed.

Jorge Calahan has S corporation stock with an adjusted basis of $5,000 and he has a $4,000 loan to the corporation 87. that was still outstanding. His pro rata share of business income for the year is $1,000, and his pro rata share of the corporation’s separately stated items of loss and deduction is $6,000. At the end of the year the corporation distributed $6,000 to Jorge. How much of the $6,000 of separately stated items of loss and deduction may Jorge deduct?

$0a. $4,000b. $5,000c. $6,000d.

Siddhu Coffee Roasters, Inc. is an S corporation. It has accumulated E&P, and for three consecutive years, more 88. than 25 percent of its gross receipts have consisted of passive investment income. In the current year, its passive investment income is $625,000, its deductions related to its passive investment income total $25,000, and its gross receipts total $1,000,000. What amount of tax on excess passive investment income does Siddhu have for the current year?

$0a. $122,400b. $126,000c. $131,250d.

Fenton Venetian Blinds, Inc. elected S status in the current year. While Fenton was a C corporation, it valued its 89. inventory using the LIFO method. On the day before the effective date of its S election, the LIFO value of its inventory was $75,000. If it had used FIFO to value its inventory, its inventory would have been valued at $125,000. Prior to making this valuation of its inventory, the corporation had determined that its taxable income was $350,000. How much additional tax will the corporation have to pay for its last year as a C corporation?

$17,000a. $17,500b. $42,500c. $50,000d.



SUPPLEMENTARY PROBLEMS—CHAPTER 21How much time does a corporation have to fi le for S status? 90. How is a shareholder’s pro rata share of S corporation income determined? 91. What is a shareholder’s deductible loss assuming his share of the corporate loss is $10,000, he purchased the stock at 92. the beginning of the year for $6,500, and he personally loaned the corporation $2,000? What are the three potential sources of Accumulated Earnings and Profi ts of an S corporation? 93. Is an S corporation required to annualize its income for a short tax year? 94. Smile, a calendar year S corporation since 2008, has two shareholders who each own 50 shares of stock, which each 95. shareholder purchased for $5,000. Mr. C, one of the shareholders, loaned Smile $2,000 on June 1, 2008, and $6,000 on May 1, 2009. Smile had $9,000 ordinary income on December 31, 2008. Both shareholders reported their share of the corporation’s income on their individual returns for 2008. For 2009, Smile reported an ordinary loss of $6,000. No distributions were made in 2008 or 2009 by the corporation. What is the adjusted basis of Mr. C’s stock on December 31, 2009? Describe three potential advantages and three potential disadvantages of organizing a business as an S corporation. 96. Describe the federal tax treatment of income from an S corporation to its shareholders. 97. In what situations might an S corporation involuntarily revoke its S corporation status? 98. When an S corporation distributes property to its shareholders how is that property valued? 99. S corporation shareholders increase their basis in the S corporation stock by their pro rata share of nontaxable 100. income. Similarly, they must reduce their adjusted basis in S corporation stock by their pro rata share of noncapital, nondeductible expenses. Provide one example of nontaxable income and a noncapital, nondeductible expense. Offer a reason why either rule exists.

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ANSWERS TO TRUE-FALSE QUESTIONS—CHAPTER 21False. Limited to 100 shareholders. 1. False. Can have up to 100 shareholders. 2. False. Can have only one class of stock. 3. True. 4. False. No extension of time for electing S status is allowed. 5. True. 6. False. An S corporation is subject to a possible tax on built-in capital gains and also a tax on excessive passive 7. income. False. S corporations not eligible for the dividends received deductions. 8. True. 9. False. Report share of an S corporation’s income in the year the corporation’s tax year ends. 10. True. 11. False. Must be three years. 12. True. 13. True. 14. False. Meet requirements for retroactive S classifi cation. 15. False. An S corporation cannot have a C corporation as a shareholder. 16. False. Only corporations that satisfy certain requirements can elect to be taxed as S corporations. 17. False. S corporations are not subject to those taxes. 18. True. 19. False. A corporation that wants to elect and retain S corporation status can at no time have more than 100 20. shareholders. False. All members of a family who have the same common ancestor may elect to be treated as one shareholder. 21. True. 22. False. A corporation eligible to be an S corporation must elect to be treated as such. 23. False. A corporation’s S status can be terminated voluntarily or involuntarily. More than 50 percent of the 24. shareholders must consent to a voluntary revocation. False. A corporation may rescind a revocation at any time before it becomes effective. 25. True. 26. True. 27. True. An S corporation’s shareholders are taxed on their pro rata share of the S corporation’s income, gains, losses, 28. deductions, and credits. False. The decision and election is made at the shareholder level. 29. False. Items subject to limitations at the shareholder level would be separately stated items. 30. False. These items are determined at the entity level and retain that character in the shareholder’s hands. (P1507.03) 31. True. 32. True. 33. False. S corporation shareholders do not increase the adjusted basis of their stock by their share of the general 34. liabilities of the corporation or by amounts they personal loan the corporation. True. 35. False. Only S corporations with accumulated E&P from their years as a C corporation are required to maintain an 36. AAA. False. With the consent of all shareholders who receive a distribution during the tax year, an S corporation may elect 37. to treat a distribution as coming fi rst from its accumulated E&P and then from its AAA. False. An election is irrevocable and effective only for the tax year for which it is made. 38. True. 39. True. 40.



ANSWERS TO MULTIPLE CHOICE QUESTIONS—CHAPTER 21b. Income from an S corporation is passed through to the shareholders and included on their personal returns. 41. d. The maximum number of shareholders that an S corporation may have is 100. 42. a. An S corporation may not have a nonresident alien as a shareholder. 43. c. Stock holding preferential treatment as to dividends will be treated as a second class of stock and render a 44. corporation ineligible for S corporation status. a. S corporations are allowed to own subsidiaries. 45. d. Shareholder marital status is not required on Form 2553. 46. c. Partnerships are allowed the same fi scal year as the principal partners but S corporations are not. 47. c. S corporations are not subject to the regular corporate income tax. 48. c. Income or loss of an S corporation is reported in the year which the S corporation tax year ends. Any dividends 49. paid by an S corporation only reduce taxpayer’s basis in the corporation and are not reported as income unless basis is reduced to zero. b. Any loans made to the corporation are added to the basis of the stock to arrive at basis in the S corporation. 50. d. The liabilities and accumulated earnings and profi ts are not included in the basis computation. Previously taxed 51. income is added to the capital balance. d. The credit for special fuels is the only credit allowed against the tax on passive income of an S corporation. 52. d. Passive income does not include interest on deferred payment sales of property held for sale to customers. 53. c. Shareholder elections include the deduction and recapture of certain mining exploration expenditures. 54. c. Interest income is not a separately stated item of an S corporation. 55. c. Form 2553 is due by the 15th day of the third month. 56. c. Loss is limited to basis. Guarantee of corporation loan does not add to basis. 57. d. A nondeductible expense decreases shareholder basis. 58. c. Shareholder paid capital gains tax does not affect basis. 59. a. ($255,500 x 11/12 x 1/2) + ($255,500 x 1/12) = $117,104 + $21,292 60. a. 61. d. 62. c. 63. c. 64. d. 65. d. 66. a. 67. b. 68. d. 69. a. 70. d. 71. b. 72. d. 73. d. 74. b. 75. b. 76. c. 77.

($75,000 - $10,000) x ($75,000 - ($120,000 x 25%)) $75,000

d. Abe is allocated $40,000 of the operating loss. He can utilize the entire $40,000 by reducing the adjusted basis in 78. his stock to $0 and reducing the basis in his indebtedness to the corporation to $10,000. b. The corporation’s AAA at the end of the year equals $45,000 ($15,000 + $10,000 + $20,000). The fi rst $45,000 is 79. deemed to come from AAA. The remaining $20,000 is treated as having come from accumulated E&P. c. The corporation’s AAA at the end of the year equals $45,000 ($15,000 + $10,000 + $20,000). The fi rst $45,000 80. is deemed to come from AAA. The remaining $20,000 is taxed as a dividend. This reduces the accumulated E&P balance to $35,000. b. The corporation’s AAA is increased by the $10,000 of ordinary income, thus increasing the AAA balance to 81. $13,000. Thus, only $2,000 of the $15,000 distribution is treated as having come from accumulated E&P. e. With a proper bypass election, the entire $15,000 is deemed to come fi rst from accumulated E&P. 82.

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a. With a proper bypass election, the entire $15,000 is deemed to come fi rst from accumulated E&P. This reduces the 83. corporation’s accumulated E&P to $5,000. The beginning balance in the AAA is increased by the $10,000 of ordinary income (but not the $5,000 of tax-exempt income). c. $36,500/365 days = $100 x 50% = $50 a day x 151 days = $7,550. 84. c. 85. d. The capital gain and business income has to be allocated to Candie on a pro rata basis. The allocation must 86. be made on the basis of the whole year because no election was made to terminate the S corpoation’s year when Candie sold her stock. The capital gain ($84,750 - $30,000 = $54,750) is allocated by dividing $54,750 by 365 and then multiplying the result by the number of days that Candie held the stock (120). Candie’s basis interest in her corporation stock is $3,600 (($54,750/365) x 120 x 20%). She is allocated $7,200 of business income ($109,500/365 x 120 x 20%). b. Jorge’s adjusted basis in his stock is increased by the $1,000 of business income. The $6,000 distribution reduces 87. his adjusted basis in the stock to zero. $4,000 of his separately stated items of loss and deduction can be deducted because the adjusted basis of his loan is $4,000. The remaining $2,000 cannot be deducted until basis is restored to his loan and/or stock. c. The tax on excess passive investment income is 35% multiplied by a corporation’s excess net passive income. 88. A corporation’s excess net passive income is calculated by multiplying its net passive income (passive investment income minus deductions related to that income) by a fraction whose numerator is its passive investment income minus 25% of the corporation’s gross receipts and whose denominator is the corporation’s passive investment income. Siddhu Coffee Roasters’ excess net passive income is $360,000 and its excess passive investment income tax is $126,000 ($360,000 x 35%).

Net PII: $625,000 - $25,000 = $600,000PII -- 25% gross receipts: $625,000 - ($1,000,000 x 25%) = $375,000Excess PII $600,000 x ($375,000/$625,000) = $360,000

a. The LIFO recapture amount is $125,000 - $75,000 = $50,000. After the corporation adds this $50,000 to its taxable 89. income, it will have to pay an additional $50,000 x 34% = $17,000 in federal income tax.



ANSWERS TO SUPPLEMENTARY PROBLEMS—CHAPTER 21A corporation must fi le for S corporation status on or before the fi fteenth day of the third month of the beginning of 90. the corporation’s tax year. Generally a shareholder’s pro rata share of S corporation income is determined on a per-share, per-day basis.91. His loss deduction is limited to $8,500. The loss is limited to the basis of the stock in the corporation plus the amount 92. of any loans made to the corporation. The three potential sources of accumulated earnings and profi ts are from: 93. (a.) Tax years prior to the corporation’s S election (b.) S corporation tax years prior to 1983 (c.) Acquisition of other corporations which results in a carryover of earnings and profi ts An S corporation is not required to annualize its income for a short tax year. The annualization process is for the 94. determination of the income tax. Since the S corporation is not taxed and the income is passed through to the shareholders, there is no need for annualization.

$5,000 Original Basis+2,000 Loan+6,000 Loan+4,500 Share of Income

-3,000 Share of Loss$14,500 Ending Basis

Possible advantages include: 95. single level of taxation • corporate losses fl ow-through to shareholder • no accumulated earnings tax, personal holdings tax, or alternative minimum tax • free transferability of stock • distributive share of S corporation income is not subject to self-employment tax •

Possible disadvantages include: limit on the number of shareholders • restrictions on who can be a shareholder • permitted only a single class of stock • fl ow-through percentage is pro rata • tax on built-in gains and excess passive investment income • LIFO recapture tax • tax on fringe benefi ts•

S corporation shareholders are taxed on their pro rata share of the S corporation’s income, gains, losses, deductions, 96. and credits. S corporations are required to compute and report their taxable income on Form 1120S. Since the activities of the S corporation fl ow through to its shareholders, some items of income, gain, deduction, loss, and credit must be separately stated from S corporation taxable income so that any limit that applies to the item at the shareholder-level can be applied on the shareholders’ respective income tax returns. A shareholder’s pro rata share of corporate items is reported to the shareholder on Schedule K-1. A corporation’s S election terminates if it ceases to be a small business corporation. An S corporation ceases to be 97. a small business corporation if a C corporation, partnership, nonresident alien, or other nonpermitted shareholder becomes a shareholder in the corporation. An S corporation also ceases to be a small business corporation if it issues a second class of stock, or if the number of shareholders exceeds 100. A corporation’s S election terminates if the corporation has accumulated E&P and reports excess passive income for 98. three consecutive tax years. An S corporation can have accumulated E&P either from its years as a C corporation or because it acquired a C corporation with accumulated E&P. When an S corporation distributes property to its shareholders, the property is valued at its fair market value (FMV), 99. which becomes the shareholder’s basis in the property. A shareholder’s adjusted basis in S corporation stock is increased by the shareholder’s pro rata share of municipal 100. interest income. This ensures that shareholders are never taxed on any tax-exempt interest that is earned by the S corporation and subsequently distributed to the shareholder. Similarly, the shareholder’s adjusted basis in the S corporation stock is decreased by the shareholder’s pro rata share of noncapital, nondeductible expenses (for example, illegal bribes, kickbacks, and other nondeductible payments, nondeductible fi nes and penalties, expenses and interest

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relating to tax-exempt income, disallowed losses from transactions between related persons, and the disallowed portion of meal and entertainment expenses). This ensures that the shareholder does not later benefi t from these nondeductible items by having a higher stock basis.



DIFFICULTY LEVEL RATINGS—CHAPTER 21The following table denotes the relative diffi culty level of each question. Teachers may wish to organize test

questions based on the diffi culty level of the particular class.True-False Question Ratings

Easy1. Easy2. Easy3. Easy4. Easy5. Easy6. Easy7. Easy8. Moderate9. Moderate10. Moderate11. Moderate12. Moderate13. Moderate14. Moderate 15. Moderate 16. Moderate 17. Easy 18. Easy 19. Moderate 20. Moderate 21. Easy 22. Easy 23. Moderate 24. Easy25. Moderate26. Moderate27. Moderate28. Moderate29. Moderate30. Moderate31. Easy32. Easy33. Easy34. Moderate35. Moderate36. Moderate37. Diffi cult38. Diffi cult39. Easy 40.

Multiple Choice Question RatingsEasy41. Easy42. Easy43. Easy44. Easy45. Easy46. Easy47. Easy48. Moderate49. Moderate50. Moderate51. Moderate52. Moderate53. Moderate54. Moderate55. Moderate56. Moderate57. Moderate 58. Moderate 59. Moderate 60. Easy 61. Easy 62. Easy 63. Moderate 64. Moderate 65. Easy 66. Moderate 67. Easy 68. Moderate 69. Easy70. Moderate71. Moderate72. Moderate73. Moderate74. Easy75. Moderate76. Diffi cult77. Moderate78. Diffi cult79. Diffi cult80. Diffi cult81. Moderate82. Moderate83. Diffi cult84. Moderate85. Moderate86. Moderate87. Moderate88. Moderate 89.

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Supplementary Problem RatingsEasy 90. Easy 91. Easy92. Easy93. Easy94.

Moderate95. Easy96. Moderate97. Easy98. Easy99. Diffi cult100.

Ch21TB

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