Chapter 2: Corporations: Introduction and Operating Rules

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CHAPTER 2

CORPORATIONS: INTRODUCTION AND OPERATING RULES

SOLUTIONS TO PROBLEM MATERIALS

Question/Problem Topic

Status:PresentEdition

Q/P inPriorEdition

1 Tax and nontax factors in entity selection New2 Partnership capital gain and withdrawals Unchanged 23 Corporation versus proprietorship Unchanged 34 Corporate tax versus partnership tax Unchanged 4*5 Corporate versus individual taxation New6 Expenses to avoid double taxation Unchanged 67 Unreasonable compensation Unchanged 78 Taxation of dividends and salary New9 Check-the-box rules Unchanged 9

10 Benefits of LLC Unchanged 1011 Fiscal year election for corporation New12 Cash method of accounting limitations Unchanged 1213 Accrual method required Unchanged 1314 Capital loss treatment of corporation and

individualUnchanged 14

*15 Capital gain treatment for corporations, individ-uals, and LLC

New

16 LTCL of individuals and corporations Unchanged 1617 Passive loss rules: closely held C corporations

and PSCs contrastedUnchanged 17

18 Passive loss deduction for closely heldcorporation and personal service corporation

Unchanged 18

19 Tax treatment of charitable contributions forcorporate and noncorporate taxpayers

Unchanged 19

20 Production activities deduction New21 Organizational and start-up expenses Unchanged 2122 Dividends received deduction New23 Organizational expenditures and start-up

expendituresUnchanged 23

24 Start-up expenditures Unchanged 2425 Tax liability of related corporations Unchanged 25

2-1


Question/Problem Topic


Q/P inPriorEdition

26 Schedules M-1 and M-3 New27 Differences between taxable income and

accounting incomeUnchanged 27

28 Schedule M-3 Unchanged 2829 Compare LTCL treatment for corporations and

for proprietorshipsUnchanged 29

30 Tax treatment of income and distributions frompartnership, S and C corporations

New

31 Corporation net income taxation, cash distribu-tion to owner versus proprietorship with cashdistribution, new rules on dividend taxation

New

32 Taxation of corporation versus proprietorship Unchanged 32*33 Taxation of corporation versus proprietorship New34 Comparison of deduction for casualty loss for

individual and corporate taxpayersUnchanged 34

*35 Tax liability determination as proprietorship orcorporation

Unchanged 35

36 Salary requirements for use of fiscal year bypersonal service corporation

New

37 Capital loss of corporation Unchanged 3738 Salary deduction under cash and accrual

accountingUnchanged 38

39 Comparison of treatment of capital losses forindividual and corporate taxpayers

Unchanged 39

40 Capital gains and losses of a corporation;carryback/carryover

New

41 Passive loss of closely held corporation; PSC Unchanged 4142 Charitable contributions of corporation

compared with individual taxpayerUnchanged 42

43 Corporate charitable contribution Unchanged 4344 Charitable contributions of corporation;

carryoverNew

45 Timing of charitable contributions deduction ofaccrual basis corporation

Unchanged 45

46 Production activities deduction New*47 Dividends received deduction New*48 Dividends received deduction Modified 4949 Organizational expenses Unchanged 50*50 Organizational expenses Unchanged 51*51 Determine corporate income tax liability Modified 5252 Filing requirements for Form 1120-A Unchanged 56*53 Schedule M-1, Form 1120 Modified 5754 Schedule M-1, Form 1120 Unchanged 5855 Schedule M-3, Form 1120 New56 Schedule M-3, Form 1120 New57 Schedule M-3, Form 1120 New58 Schedule M-3, Form 1120 New59 Tax issues involved in starting a new business

in the corporate formUnchanged 59

2-2 2007 Corporations Volume/Solutions Manual


Tax ReturnProblems Topic


Q/P inPriorEdition

1 Corporation income tax (Form 1120) New2 Corporation income tax (Form 1120) New

ResearchProblem

1 Dividends received deduction Unchanged 12 Charitable contribution deduction New3 Expenditures incurred on behalf of corporation Unchanged 34 Internet activity Unchanged 45 Internet activity Unchanged 5

*The solution to this problem is available on a transparency master.

Corporations: Introduction and Operating Rules 2-3


CHECK FIGURES

29.a. Andrew will report profit $20,000and capital loss $5,000.

29.b. Andrew’s income is not increased.30.a. Each partner reports $200,000 net

profit and LTCG of $60,000.30.b. Same as a.30.c. Corporation reports $520,000

income. Shareholder reports$80,000 dividend income.

32.a. Losses not passed through toshareholder.

32.b. Deduct $153,000.33.a. After-tax income $87,234.50.33.b. After-tax income $72,540.33.c. After-tax income $68,406.34.a. $33,900.34.b. $45,000.35.a. $36,050.35.b. $29,450.35.c. $23,420.35.d. $33,658.36.a. $80,000.36.b. $35,000.37.a. $50,000.37.b. $62,000.38. $65,000 for Hugh, $60,000 for

Sam.39.a. $8,000 deducted 2006; $7,000

carried forward to 2007.39.b. $5,000 deducted 2006; $10,000

carried back to 2003, then 2004,etc.

40.a. Offset short-term capital gain of$60,000 against net long-term cap-ital loss of $380,000. The $320,000net long-term loss is carried back 3years and forward 5 years.

40.b. Total carryback $280,000.40.c. $40,000; carry forward 2007, etc.41. Offset $45,000 of passive loss

against active income. No offset ifa PSC.

42.a. $12,000.42.b. $12,500.44.a. $19,350.45. 2006.46.a. $6,000.46.b. $12,000.47.a. $36,000.47.b. ($8,000).48. Green $35,000; Orange $210,000;

Yellow $224,000.49.a. $5,072.49.b. $5,092.49.c. $5,072.49.d. $5,092.50. $5,566.51. Violet $4,800; Indigo $92,450;

Orange $113,900; Blue$1,473,900; Green $7,000,000.

52. Jay no; Shrike no; Martin yes.53. $120,000.54. $100,000.



DISCUSSION QUESTIONS

1. You should ask questions that will enable you to assess both tax and nontax factors thatwill affect the entity choice. Some relevant questions are addressed in the following table,although there are many additional possibilities.

Question Reason for the question

What type of business are you going tooperate?

This question will provide information thatmay affect the need for limited liability,ability to raise capital, ease of transferringinterests in the business, how long thebusiness will continue, and how the busi-ness will be managed.

What amount and type of income (loss) doyou expect from the business?

Income from a business will eventually bereported on the tax returns of the owners.

What is the amount and type of income(loss) that you expect from other sources?

For example, income (loss) from a part-nership, S corporation, or LLC will ‘‘flowthrough’’ to the owners. Dividends from aC corporation must be reported on the taxreturns of the shareholders. Any income(loss) from other sources will also bereported on the returns of the owners.Thus, for planning purposes, it is impor-tant to know all sources and types ofincome (loss) that the owners will have.

Do you expect to have losses in the earlyyears of the business?

Losses of partnerships, S corporations,and LLCs flow through to the owners andrepresent potential deductions on theirindividual returns. Losses of a C corpora-tion do not flow through.

Will you withdraw profits from thebusiness or leave them in the business so itcan grow?

Profits from a partnership, S corporation,or LLC will ‘‘flow through’’ to the owners,and will be subject to taxation on theirindividual tax returns. Profits of a C corpo-ration must be reported on the tax returnsof the shareholders only if such profits arepaid out to shareholders as dividends.Thus, in the case of a partnership, S cor-poration, or LLC, owners must pay tax onprofits before plowing funds back into thebusiness. In the case of a C corporation,the corporation must pay tax on its profits.

pp. 2-2 to 2-7

2. George must report $75,000 income on his tax return, and Mike is not required to reportincome from the corporation on his tax return. Proprietorship profits flow through to theowner and are reported on the owner’s individual income tax return. Shareholders arerequired to report income from a corporation only to the extent of dividends received. Mikedid not receive a dividend. pp. 2-2 and 2-4

3. Art should consider operating the business as a sole proprietorship for the first three years.If he works 15 hours per week in the business, he will exceed the minimum number ofhours required to be a material participant (52 � 15 = 780). Therefore, he will be able todeduct the losses against his other income. When the business becomes profitable, Art



should consider incorporating. If he reinvests the profits in the business, the value of thestock should grow accordingly, and he should be able to sell his stock in the corporation forlong-term capital gain. pp. 2-2 to 2-4

4. Losses of sole proprietorships are passed through to their owners, but losses (operating orcapital) of regular corporations are not. Capital losses of sole proprietorships retain theircharacter when reported by the proprietor.

The capital loss of the sole proprietorship is passed through to Lucille, and she is allowedto report it on her tax return as a capital loss. She can offset the loss against capital gainsor deduct it against ordinary income (up to $3,000) if she has no capital gains for the year.The capital loss of Mabel’s corporation is reported on the tax return of the corporation,which is a separate taxable entity. It has no effect on her taxable income.

The operating loss is passed through to Lucille, and she is allowed to deduct it on her taxreturn (subject to at-risk and passive loss limitations). The operating loss of the corporationhas no effect on Mabel’s tax return.

pp. 2-2 to 2-4 and 2-12

5. Conner should report the information on his individual tax return as follows:

If SE is Conner should report

a. A proprietorship $90,000 profit on Schedule C, $3,000 capital losson Schedule D (with a $9,000 carryover). The$45,000 withdrawal would have no impact onConner’s individual tax return.

b. A C corporation $45,000 dividend (profit withdrawn from SE).Neither the $90,000 profit nor the $12,000 capitalloss would flow through.

c. An S corporation $90,000 profit and $12,000 capital loss would flowthrough from SE to Conner and be reported on hisindividual tax return. The capital loss would becombined with any personal capital gains (losses),and would be subject to the $3,000 limit. The$45,000 withdrawal would have no impact onConner’s individual tax return.

6. If Tanesha buys the warehouse and rents it to the corporation, she can charge thecorporation the highest amount of rent that is reasonable. The rental operation can helpher to bail some profits out of the corporation and avoid double taxation on corporateincome. The depreciation and other expenses incurred in connection with the warehousewill be deductible by Tanesha, which should enable her to offset some or all of the rentalincome. If the rental property produces a loss, Tanesha can use the loss to offset any pas-sive income she might have. If Tanesha has the corporation buy the warehouse, the reve-nue and expenses related to the building will be included in the computation of corporateincome. If there is a profit, Tanesha can bail it out as a dividend, which will be taxed at a15% rate. pp. 2-5, 2-6, and 2-33

7. To the extent a salary paid to a shareholder/employee is considered reasonable, thecorporation is allowed a deduction, which reduces corporate taxable income. To the extenta salary payment is not considered reasonable, the payment is treated as a dividend,which does not reduce taxable income. The shareholder/employee is taxed on both salaryand dividends. Therefore, double taxation has occurred on $60,000. p. 2-5



8. Al will be subject to a 15% rate on the $20,000 that ABC pays him as a dividend, but ABCwill not be allowed to deduct the amount in computing corporate taxable income. Jay willreport the additional $20,000 that JKL pays him as salary and will be taxed at his marginalrate of 35%. JKL will be allowed to deduct the salary payment in computing corporatetaxable income. p. 2-5

9. The check-the-box rules permit a qualifying entity to elect to be taxed either as a partnershipor as a corporation. The election is made by filing Form 8832. If Ed and Barbara do not fileForm 8832, the entity will be treated as a partnership by default. pp. 2-8 and 2-9

10. The primary nontax advantage of an LLC is limited liability. The primary tax advantage isthat Erica can elect to have the LLC treated as a partnership rather than a corporation, thusavoiding the problem of double taxation. pp. 2-7 and 2-8

11. As owner-employees, Hank and Charlie offer services in the area of performing arts, so HCis a personal service corporation. HC appears to have a business year that ends on January31. Although a PSC is not normally allowed to adopt a fiscal year, HC should be able todemonstrate a business purpose for electing a January 31 fiscal year-end. Example 10

12. A corporation that uses the accrual method cannot claim a deduction for an accrual owedto a related party until the recipient reports that amount as income. Paul, a cash basistaxpayer, must report the income in the year he receives the payment from the corporation.The corporation may deduct the expense in the year Paul is required to report the income(i.e., the year he receives the payment). p. 2-11

13. Businesses that maintain inventory for sale to customers are required to use the accrualmethod of accounting for determining sales and cost of goods sold. Therefore, RoseCorporation would be required to use the accrual method, at least for transactionsinvolving inventory. p. 2-10

14. Kathy may use her $25,000 LTCL to offset any capital gains she has during the year. If shehas losses in excess of gains, she may deduct up to $3,000 of the losses as a deductionfor AGI, and any remaining losses may be carried forward indefinitely.

Eagle Corporation may use the capital loss to offset any capital gains realized during the year.Any excess losses may be carried back three years and forward five years. When carriedback or forward, a long-term capital loss is treated as a short-term loss. pp. 2-11 and 2-12

15. The reporting rules and applicable tax rates are summarized in the following table.

If Alpha is The gain would be reported The tax rate would be

a. A proprietorship By Janice on Sch. D, Form 1040 15%

b. An S corporation By Alpha on Form 1120S; flow-through to Janice on Schedule K-1

15%

c. A C corporation By Alpha on Form 1120 Applicable corporate taxrate

d. An LLC By Janice or Alpha—a onemember LLC can elect to be taxedas a sole proprietorship or as acorporation—see items a. and c.above

See items a. or c. above



16. John may deduct up to $3,000 of his net capital loss in computing taxable income for thecurrent year and may carry the remaining $4,000 forward for an indefinite period. He canuse the capital loss carryover to offset capital gains in the carryforward years, or he candeduct up to $3,000 per year from ordinary income if he has no capital gains. FoxCorporation cannot deduct any of the loss in the year incurred. However, Fox can carry theloss back three years and forward five years until the entire loss is offset against capitalgains in the carryback or carryforward years. Examples 13 and 14

17. Falcon can deduct none of the passive loss. A personal service corporation cannot offset apassive loss against either active or portfolio income. p. 2-12

18. A closely held corporation that is not a personal service corporation can offset a passiveloss against active income, but not against portfolio income. Hummingbird can deduct only$30,000 of the $60,000 passive loss. Example 15

19. Individuals cannot deduct contributions until they are actually made. Therefore, Andreamust wait until 2007 to deduct the contribution. Aqua Corporation, whose board ofdirectors authorized the contribution in 2006, can deduct the contribution in 2006,assuming the pledge is paid on or before March 15, 2007. p. 2-13 and Example 16

20. Presumably the corporation qualified for the production activity deduction. The rate for thededuction, which is three percent for 2006, increases to six percent for 2007 through 2009.See Example 23 and related discussion.

It is also possible that the controller expects the corporation’s tax rate to decrease in 2007,which would result in a lower corporate tax on the $200,000 income.

21. Martin Corporation should elect to forgo the NOL carryback if profits in the two precedingyears were small and if higher profits are expected in the future. Carrying an NOL back tolow profit years will generate a smaller tax savings than carrying the loss forward to highprofit years. Before electing to forgo an NOL carryback, a corporation should be able topredict with confidence that future profits will be higher. p. 2-34 and Example 37

22. Otter Corporation will be allowed to exclude 80% of its $240,000 dividend (subject topossible limitations described in Example 25). It will pay tax at the applicable corporate taxrate on the portion of the dividend not excluded. Gerald must include the entire $240,000dividend and will pay tax at the 15 percent rate applicable to individuals. Example 3

23. Scarlet Corporation’s organizational expenses include (a) expenses of temporary directorsattending organization meetings and (c) legal expenses incurred for drafting of corporatecharter and bylaws. Start-up expenses include (b) investigation expenses incurred in con-nection with acquisition of a new business and (e) cost of market survey incurred beforeScarlet started producing income. Expenses incurred in printing stock certificates are nei-ther organizational expenses nor start-up expenses. The printing expenses cannot bededucted but reduce the amount of the capital realized from the sale of stock. p. 2-18

24. Expenses incurred before any revenue is produced by a business are treated as start-upexpenditures under § 195. A taxpayer may elect to expense $5,000 of such expenses andamortize the balance over a period of 180 months or longer, rather than capitalize suchcosts permanently. Therefore, Teal can elect to deduct $5,000 in 2007. p. 2-19

25. George’s plan will not reduce corporate income taxes. Palmetto, Poplar, and Spruce wouldbe related corporations and would be subject to special rules for computing the corporateincome tax. Therefore, the total corporate tax liability would remain unchanged. Examples29 and 30 and related discussion



26. Both schedules reconcile the differences between taxable income and financial net income(book income). Schedule M-3 applies to corporations with $10 million or more of totalassets. Schedule M-1 applies to corporations that are not required to file Schedule M-3.Schedule M-3 requires much more detail than Schedule M-1. Corporations that are notrequired to file Schedule M-3 may do so voluntarily. pp. 2-22 to 2-26

27. The starting point on Schedule M-1 is net income per books. Additions and subtractionsare entered for items that affect net income per books and taxable income differently. Anexample of an addition is Federal income tax expense, which is deducted in computing netincome per books but is disallowed in computing taxable income. An example of asubtraction is a charitable contributions carryover that was deducted for book purposes ina prior year but deducted in the current year for tax purposes.

ADDITIONS

b. Travel and entertainment expenses in excess of deductible limitsc. Book depreciation in excess of allowable tax depreciationd. Federal income tax per bookse. Charitable contributions in excess of deductible limitsf. Premiums paid on life insurance policy on key employeei. Interest incurred to carry tax-exempt bonds

SUBTRACTIONS

a. Charitable contributions carryover from previous yearg. Proceeds of life insurance paid on death of key employeeh. Tax-exempt interest

p. 2-22 and Example 31

28. The government’s objectives were (1) to create greater transparency between corporatefinancial statements and tax returns, and (2) to identify corporations that engage in aggres-sive tax practices. p. 2-24

PROBLEMS

29. a. Revenues, expenses, gains, and losses of a proprietorship flow through to the pro-prietor. Consequently, Andrew reports the $20,000 net profit and $5,000 capitalloss on his individual tax return.

b. Shareholders are required to report income from a corporation only to the extent ofdividends received. Therefore, Andrew does not report the net profit or capital losson his individual return.

pp. 2-2 and 2-4

30. a. Woodchuck, a partnership, is not a taxpaying entity. Its profit (loss) and separateitems flow through to the partners. The partnership’s Form 1065 reports net profit of$400,000 ($1,000,000 income� $600,000 expenses). The partnership also reportsthe $120,000 long-term capital gain as a separately stated item on Form 1065.Charlotte and Catherine both receive a Schedule K-1 reporting net profit of$200,000 and separately stated long-term capital gain of $60,000. Each partnerreports net profit of $200,000 and long-term capital gain of $60,000 on her ownreturn. The withdrawals do not affect taxable income for the partners but decreasetheir basis in the partnership. Example 2



b. Woodchuck, an S corporation, is not a taxpaying entity. Its profit (loss) and sepa-rate items flow through to the shareholders. The S corporation’s Form 1120Sreports net profit of $400,000 ($1,000,000 income � $600,000 expenses). TheS corporation also reports the $120,000 long-term capital gain as a separatelystated item on Form 1120S. Charlotte and Catherine both receive a Schedule K-1reporting net profit of $200,000 and separately stated long-term capital gain of$60,000. Each partner reports net profit of $200,000 and long-term capital gain of$60,000 on her own return. The withdrawals do not affect taxable income for thepartners but decrease their basis in the S corporation. Example 2

c. Woodchuck, a C corporation, is a taxpaying entity. Woodchuck’s Form 1120reports net operating profit of $400,000 ($1,000,000 income� $600,000 expenses)and also reports the $120,000 long-term capital gain. Charlotte and Catherinereport dividend income of $80,000 each. The dividend income will be subject to amaximum individual tax rate of 15%. pp. 2-4, 2-5, and Example 2

31. If Mesquite Company is a corporation, the $200,000 net profit is taxable at the corporate level,resulting in corporate tax of $61,250 [$22,250+ .39($200,000 � $100,000)]. Sheryl will paytax of $20,812.50 on the dividend income ($138,750 � 15%). Total taxes amount to$82,062.50 ($61,250+ $20,812.50). If Mesquite Company is a proprietorship, Sheryl mustpay tax of $70,000 ($200,000 � 35%). In the case of a corporation, FICA taxes would addto the tax burden of the corporation and the individual. In the case of the proprietorship, theindividual would be subject to self-employment taxes. pp. 2-2 to 2-5 and Examples 5 and 6

32. Losses of a C corporation are not passed through to the shareholders. The corporationmay carry net operating losses to other years (back two years, forward twenty). Capitallosses of corporations are not deductible in the year incurred, but can be carried back threeyears or forward five years.

Operating losses of a proprietorship are deductible if the proprietor is a material participant.Net capital losses are passed through to the proprietor and are subject to the $3,000 limitation.

a. The corporation’s losses are subject to the NOL and capital loss carryback provi-sions. The losses are not passed through to the shareholder.

b. Chris is a material participant in Orange Company. Chris has enough other incometo be in the 35% bracket, so he will not be in a net operating loss situation afterdeducting the loss from Orange Company. He can deduct $153,000 ($150,000operating loss+ $3,000 capital loss).

pp. 2-6 and 2-12

33. Lambert Company has net income of $110,000 ($150,000 revenue � $40,000 expenses).If the company is a proprietorship, Ron must report this amount as income, regardless ofthe amount he withdraws. If the company is a corporation, it must pay corporate tax on theincome and Ron must report any dividends he receives from the company as income.

a. Ron’s after-tax income is computed below:Income from proprietorship ($150,000� $40,000) $ 110,000Less deductions ($5,150 standard deduction+ $3,300

exemption) (8,450)

Taxable income $ 101,550

Tax on $101,550 (see Appendix A for Tax Rate Schedules) $22,765.50

After-tax income ($110,000� $22,765.50) $87,234.50



b. Tax on corporation’s net income of $110,000:

Tax on $100,000 $22,250Tax on $10,000@ 39% 3,900

Tax liability $26,150

Corporation’s after-tax income ($110,000� $26,150) $83,850

Ron’s taxable income ($83,850 dividend� $5,150standard deduction� $3,300 exemption) $75,400

Ron’s tax on $75,400 at 15% rate applicable todividends $11,310

Ron’s after-tax income ($83,850� $11,310) $72,540

c. The corporation will have $26,150 taxable income ($150,000 revenue � $83,850salary � $40,000 other expenses). Ron will have taxable income of $75,400($83,850 � $5,150 standard deduction � $3,300 exemption). His tax will be$15,444, and his after-tax income will be $68,406 ($83,850� $15,444).

pp. 2-2 to 2-5

34. a. Dakota can deduct $33,900 [$75,000� $30,000 (insurance recovery)� $100 (flooron personal casualty losses)� $11,000 (10% of AGI)] if she itemizes deductions. IfDakota does not itemize, she would not have a deduction.

b. Dakota can deduct $45,000 [$75,000 � $30,000 (insurance recovery)]. Corpora-tions are not subject to the $100 floor or the 10% limitation.

p. 2-9

35. a. Gross income $200,000Ordinary deductions (97,000)

Taxable income (to owner of proprietorship) $103,000

Tax@ 35% $36,050

b. Gross income of corporation $200,000Ordinary deductions (97,000)Salary (70,000)


Corporate tax $ 4,950Gross income of shareholderSalary $ 70,000

Tax@ 35% 24,500

Total tax $29,450

c. Gross income of corporation $200,000Ordinary deductions (97,000)

Taxable income $103,000

Corporate tax $23,420



d. Gross income of corporation $200,000Ordinary deductions (97,000)Salary (70,000)


Corporate tax $ 4,950

Tax paid by shareholderOn salary ($70,000� 35%) $ 24,500On dividend [($33,000� $4,950)� 15%] 4,208

28,708

Total tax $33,658

e. Hoffman, Raabe, Smith, and Maloney, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 1, 2006

Mr. Robert Benton1121 Monroe StreetIronton, OH 45638

Dear Mr. Benton:

This letter is in response to your inquiry as to the tax effects of incorporating yourbusiness in 2007. I have analyzed the tax results under both assumptions, proprie-torship and corporation. I cannot give you a recommendation until we discuss thematter further and you provide me with some additional information. My analysisbased on information you have given me to date is presented below.

COMPUTATION 1

Total tax on $103,000 taxable income if you continue as aproprietorship $36,050

Total tax if you incorporate:Individual tax on $70,000 salary @ 35% $24,500Corporate tax on $33,000 corporate taxable income 4,950

Total $29,450

Although this analysis appears to favor incorporating, it is important to consider thatthere will be additional tax on the $28,050 of income left in the corporation if youwithdraw that amount as a dividend in the future, as calculated below:

COMPUTATION 2

Income left in corporation ($33,000 taxable income�$4,950 corporate tax) $28,050

Tax on $28,050@ 15% $ 4,208

Total tax paid if you incorporate ($29,450+ $4,208) $33,658



Comparison of computations 1 and 2 appears to support incorporating. If you incor-porate and recover the income left in the corporation as long-term capital gain inthe future, the total tax cost of incorporating will be the same, as shown in computa-tion 3 below.

COMPUTATION 3

Income left in corporation ($33,000 taxable income�$4,950 corporate tax) $28,050

Tax on $28,050@ 15% LTCG rate $ 4,208

Total tax paid if you incorporate ($29,450+ $4,208) $33,658

In summary, incorporation appears to be the most attractive option, whether yourecover income left in the corporation as capital gain or as dividend income. Keepin mind, however, that there are important nontax considerations with respect tothis decision. We can discuss those issues at our next meeting.

Thank you for consulting my firm on this important decision. We are pleased to pro-vide analyses that will help you make the right choice.

Sincerely,

Jon Thomas, CPA

pp. 2-2 to 2-5 and 2-20

36. a. The salary for the deferral period (September through December) must be at leastproportionate to the employee’s salary received for the fiscal year. The amount thatMarion Corporation must pay Marion during the period September 1 throughDecember 31, 2006, to permit the continued use of its fiscal year without negativetax effects is $80,000 ($240,000� 4/12). Example 11

b. Marion Corporation, a PSC, is subject to a tax rate of 35% on all of its net profit. Thecorporation would pay tax of $35,000 ($100,000 � 35%). To illustrate the negativetax impact of classification as a PSC, compare this amount to the $22,250 that acorporation that is not a PSC would pay. p. 2-20

37. A corporation cannot deduct a net capital loss in the year incurred. The net loss can becarried back for three years and offset against capital gain in the carryback years. If thecapital loss is not used in the carryback years, it can be carried forward for five years.Capital gains of corporations are included in taxable income and are not subject to the 20%maximum rate that applies to individuals.

a. $400,000 (operating income) � $350,000 (operating expenses) = $50,000 taxableincome. No capital loss deduction is allowed.

b. $400,000 (operating income) � $350,000 (operating expenses) + $12,000 (netcapital gain) = $62,000 taxable income.

pp. 2-11 and 2-12

38. Under the accrual method of accounting, Egret would deduct $65,000 ($60,000� $20,000+$25,000) of the salary paid to Hugh, since he did not ownmore than 50% of the corporation’s



stock. It would deduct $60,000 of Sam’s salary under the accrual method of accounting,since Sam owned more than 50% of the corporation’s stock. p. 2-10

39. a. Of the $15,000 long-term capital loss, $8,000 can be deducted in 2006. The losswill offset the capital gains of $5,000 first; then, an additional $3,000 of the loss maybe utilized as a deduction against ordinary income. The remaining $7,000 of loss iscarried forward to 2007 and years thereafter until completely deducted.

b. Only $5,000 of the loss may be deducted in 2006. The loss deduction is limited to theamount of capital gains ($3,000 STCG + $2,000 LTCG). A corporation may notclaim any capital losses as a deduction against ordinary income. The remaining$10,000 loss can be carried back to the three preceding years to reduce any capitalgains in those years. [The loss is carried back first to the tax year 2003.] Anyremaining loss not offset against capital gains in the three previous years can becarried forward for five years only, to offset capital gains in those years. The long-termcapital loss will be treated as a short-term capital loss as it is carried back and forward.

Examples 13 and 14

40. a. Net short-term capital gain $ 60,000Net long-term capital loss (380,000)

Excess net long-term loss ($320,000)

The excess capital losses of $320,000 are not deductible on the 2006 return, butmust be carried back to the three preceding years, applying them to 2003, 2004, and2005, in that order. Such long-term capital losses are carried back or forward asshort-term capital losses.

b. 2006 excess loss ($320,000)

Offset against2003 (net short-term capital gains) $ 80,0002004 (net long-term capital gains) 60,0002005 (net long-term capital gains) 140,000

Total carrybacks ($280,000)

c. $40,000 ($320,000 � $280,000) STCL carryover to 2007, 2008, 2009, 2010, and2011, in that order.

d. Doris would net these transactions with all other capital transactions for 2006.Assuming these were her only capital transactions in 2006, she would offset$60,000 of capital losses against the capital gains and deduct an additional $3,000in capital losses on her return. The remaining $317,000 ($380,000 � $60,000 �$3,000) would be carried forward indefinitely.

pp. 2-11 and 2-12

41. If Condor is a closely held corporation and not a PSC, it may offset $45,000 of the $80,000passive loss against the $45,000 of active business income. However, it may not offset theremaining $35,000 against portfolio income. Example 15

If Condor were a PSC, it could not offset the passive loss against either active or portfolioincome. p. 2-12

42. a. When a corporation contributes inventory that is used in a manner related to theexempt purpose of the charity to which the inventory is donated, the amount of the



deduction is equal to basis plus one half of the appreciation, in this case $12,000[$10,000+ 50%($14,000� $10,000)]. p. 2-14 and Example 20

b. Normally, corporate contributions of long-term capital gain property are measuredby the fair market value of the asset, $14,000. In this case the deduction will be lim-ited to $12,500, 10% of taxable income. The remaining $1,500 ($14,000 �$12,500) may be carried forward for five years. pp. 2-13 and 2-14

43. Hoffman, Raabe, Smith, and Maloney, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 6, 2006

Mr. Joseph ThompsonJay Corporation1442 Main StreetFreeport, ME 04032

Dear Mr. Thompson:

I have evaluated the proposed alternatives for your 2006 year-end contribution to the Uni-versity of Maine. I recommend that you sell the Brown Corporation stock and donate theproceeds to the University. The four alternatives are discussed below.

Donation of cash, the unimproved land, or the Brown stock each will result in a $120,000charitable contribution deduction. Donation of the Maize Corporation stock will result inonly a $20,000 charitable contribution deduction.

Contribution of the Brown Corporation stock will result in a less desirable outcome from atax perspective. However, you will benefit in two ways if you sell the Brown stock and givethe $120,000 in proceeds to the University. Donation of the proceeds will result in a$120,000 charitable contribution deduction. In addition, sale of the stock will result in a$50,000 long-term capital loss. If Jay had capital gains of at least $50,000 and paid corpo-rate income tax in the past three years, the entire loss can be carried back and Jay willreceive tax refunds for the carryback years. If Jay had no capital gains in the carrybackyears, the capital loss can be carried forward and offset against capital gains of the corpo-ration for up to five years.

Jay Corporation should make the donation in time for the ownership to change handsbefore the end of the year. Therefore, I recommend that you notify your broker immediatelyso there will be no problem in completing the donation on a timely basis.

I will be pleased to discuss my recommendation in further detail if you wish. Please call meif you have questions. Thank you for consulting my firm on this matter. We look forward toserving you in the future.

Sincerely,

Richard Stinson, CPA

pp. 2-13 to 2-15

44. a. Taxable income for purposes of applying the 10% charitable contributions limitationdoes not include the dividends received deduction or capital loss carryback. For



purposes of the 10% limitation, Taxable income is $193,500 ($300,000� $120,000+$13,500). The maximum charitable contribution allowed for the year, therefore, is$19,350 (10%� $193,500).

b. The excess $4,650 not allowed ($24,000 contribution � $19,350 allowed) can becarried over to the following year.

p. 2-15 and Example 21

45. Hoffman, Raabe, Smith, and Maloney, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 6, 2006

Mr. Dan Simms, PresidentSimms Corporation1121 Madison StreetSeattle, WA 98121

Dear Mr. Simms:

On December 3 you asked me to advise you on the timing of a contribution by Simms Cor-poration to the University of Washington. My calculations show that the corporation willmaximize its tax savings by making the contribution in 2006.

If the corporation makes the contribution in 2006, it can deduct $20,000 as a charitablecontribution, which will save $7,800 (39% tax rate � $20,000 deduction) in Federal incometax. However, if the corporation makes the contribution in 2007, the percentage limitationsapplicable to corporations will limit its 2007 deduction to $10,000 ($100,000 projected profit�10% limit). The corporation will save $3,400 (34% tax rate � $10,000 deduction) in taxesas a result of this deduction. The corporation may carry the remaining $10,000 forward anddeduct the amount in 2008. If the corporation continues at the 2007 profit level, it will savean additional $3,400 in tax in 2008, for a total tax savings of $6,800.

This analysis makes it clear that the corporation will save $1,000 more ($7,800� $6,800) ifit makes the contribution in 2006. In addition, all of the savings will occur in 2006. If the cor-poration makes the contribution in 2007, its tax savings will be split between 2007 and2008. My advice is that the corporation should make the contribution immediately so own-ership of the stock can be transferred by December 31.

Sincerely,

Alicia Gomez, CPA

pp. 2-14 and 2-15

46. a. Lynx’s production activities deduction for 2006 is 3% of the lesser of

l taxable income of $200,000, or

l qualified production income of $250,000.

The tentative deduction is $6,000 ($200,000 � 3%). Because W-2 wages were$35,000, the wage limitation does not apply. Therefore, Lynx’s final productionactivities deduction for 2006 is $6,000. p. 2-16



b. Lynx’s production activities deduction for 2006 is 6% of the lesser of

l taxable income of $200,000, or

l qualified production income of $250,000.

The tentative deduction is $12,000 ($200,000 � 6%). Because W-2 wages were$35,000, the wage limitation does not apply. Therefore, Lynx’s final productionactivities deduction for 2007 is $12,000. p. 2-16

47. a. The key to this question is the relationship between the dividends received deduc-tion and the net operating loss deduction. The dividends received deduction (DRD)is limited to a percentage of taxable income of the corporation (unless taking the fulldividends received deduction would cause or increase an NOL). In this case andwith an 18% stock ownership, the dividends received deduction is limited to 70% oftaxable income.

Gross income from operations $ 440,000Less: Expenses from operations (480,000)Dividends 160,000

Taxable income before the dividends received deduction $ 120,000Dividends received deduction (70%� $160,000)* (84,000)


*Computation of the DRD limitation:

Step 1

Multiply the dividends received by the deduction percentage[$160,000� 70% (based on 18% ownership)] $112,000

Step 2

Multiply the taxable income before the DRD by thededuction percentage ($120,000� 70%) $ 84,000

Step 3

Lesser of Step 1 or Step 2 unless full DRD generates NOL $ 84,000

The dividends received deduction is limited to 70% of taxable income because tak-ing 70% of the $160,000 dividend received ($112,000) would not create a net oper-ating loss ($120,000� $112,000= $8,000 net income).

b. The dividends received deduction (DRD) is limited to a percentage of taxableincome of the corporation (unless taking the full dividends received deductionwould cause or increase an NOL). With a 75% stock ownership, the full 80% divi-dends received deduction creates an NOL, as shown below.



Gross income from operations $ 440,000Less: Expenses from operations (480,000)Dividends 160,000

Taxable income before the dividends received deduction $ 120,000Dividends received deduction (80%� $160,000)* (128,000)

Taxable income (NOL) ($ 8,000)

*Computation of the DRD limitation:

Step 1

Multiply the dividends received by the deduction percentage[$160,000� 80% (based on 75% ownership)] $128,000

Step 2

Multiply the taxable income before the DRD by the deductionpercentage ($120,000� 80%) $ 96,000

Step 3

Lesser of Step 1 or Step 2 unless full DRD generates NOL $128,000

The dividends received deduction is not limited to 80% of taxable income becausetaking 80% of the $160,000 dividend received ($128,000) would create a net operat-ing loss ($120,000� $128,000= $8,000 net loss).

Example 25

48. Following the procedure used in Example 25 in the text, proceed as follows:

GreenCorporation

OrangeCorporation

YellowCorporation

Step 1

70%� $50,000 (dividend received) $35,00070%� $300,000 (dividend received) $210,00070%� $400,000 (dividend received) $280,000

Step 2

70%� $100,000 (taxable income) $70,00070%� $150,000 (taxable income) $105,00070%� $320,000 (taxable income) $224,000

Step 3

Lesser of Step 1 or Step 2 $35,000 $224,000Generates a net operating loss $210,000

Consequently, the dividends received deduction for Green Corporation is $35,000 underthe general rule. Orange Corporation claims a dividends received deduction of $210,000because a net operating loss results when the Step 1 amount ($210,000) is subtracted



from 100% of taxable income ($150,000). Yellow Corporation, however, is subject to thetaxable income limitation and is allowed only $224,000 as a dividends received deduction.

pp. 2-17, 2-18, and Example 25

49. a. $5,000 (amount that can be immediately expensed) + [($18,000 � $5,000) ‚ 180months] = $5,072. To qualify for the election, the expenditure must be incurredbefore the end of the taxable year in which the corporation begins business. Amorti-zation does not apply to the $3,600 of expenses that were incurred after the end ofthe taxable year.

b. $5,000 (amount that can be immediately expensed) + [($21,600 � $5,000) ‚ 180months] = $5,092.

c. $5,072 [same as a.]. The corporation’s method of accounting is of no consequencein determining organizational expenditures that qualify for the election to amortize.

d. $5,092. [same as b.]

pp. 2-18, 2-19, and Examples 26 and 39

50. Qualifying organizational expenditures include these items:

Expenses of temporary directors and of organizational meetings $12,000Fee paid to the state of incorporation 3,000Accounting services incident to organization 15,000Legal services for drafting the corporate charter and bylaws 21,000

Total $51,000

Since an appropriate and timely election under § 248 was made, the amount that Hum-mingbird Corporation may write off for the tax year 2006 is determined as follows:

$4,000+ [($51,000� $4,000) ‚ 180 months� 6 (months in tax year)] = $4,000+[ $261 (per month amortization)� 6 months] = $5,566.

Only $4,000 of the $5,000 immediate expensing is allowed as the total expenses of$51,000 exceed $50,000 by $1,000. The $4,000 immediately expensed reduces theamount left to be amortized to $47,000 ($51,000� $4,000).

pp. 2-18 and 2-19

51. Violet Corporation:

Tax on $32,000 is $4,800 ($32,000� 15%).

Indigo Corporation:

Tax on—$280,000Tax on $100,000 $22,250Tax on $180,000� 39% 70,200

Total tax $92,450



Orange Corporation:

Tax on—$335,000Tax on $100,000 $ 22,250Tax on $235,000� 39% 91,650

Total tax $ 113,900

Blue Corporation:

Tax on—$4,335,000Tax on $335,000 $ 113,900Tax on $4,000,000� 34% 1,360,000

Total tax $1,473,900

Green Corporation:

Tax on—$20,000,000Tax on $20,000,000� 35% $7,000,000

p. 2-6 and Examples 27 and 28

52. Corporations Jay and Shrike may not file Form 1120-A. Sales for Jay exceed $500,000; Shrikeis amember of a controlled group. Martin Corporationmay file Form 1120-A. pp. 2-21 and 2-22

53. Net income per books is reconciled to taxable income as follows:

Net income per books (after tax) $ 209,710Plus:Items that decreased net income per books

but did not affect taxable income:+ Federal income tax liability 30,050+ Excess of capital losses over capital gains 4,200+ Interest paid on loan incurred to purchase

tax-exempt bonds 2,800+ Premiums paid on policy on life of president

of the corporation 5,240

Subtotal $ 252,000Minus:Items that increased net income per books

but did not affect taxable income:� Interest income from tax-exempt bonds (22,000)� Life insurance proceeds received as a result

of the death of the corporate president (110,000)


Example 31



54. Net income per books is reconciled to taxable income as follows:

Net income per books (after tax) $172,750Plus:Items that decreased net income per books

but did not affect taxable income:+ Federal income tax liability 22,250+ Excess of capital losses over capital gains 6,000+ Prepaid rent 10,000+ Interest paid on loan incurred to purchase

tax-exempt bonds 3,000+ Premiums paid on policy on life of president

of the corporation 10,000

Subtotal $ 224,000Minus:Items that increased net income per books

but did not affect taxable income:� Interest income from tax-exempt bonds (5,000)� Rent taxed in 2005 (15,000)� Life insurance proceeds received as a result

of the death of the corporate president (100,000)� Excess depreciation (4,000)


pp. 2-22, 2-23, and Example 31

55. PGW will enter $120 million on Schedule M-3, Part I, line 4 (worldwide consolidated netincome) and CGW’s net income of $22 million on line 5a (net income from nonincludibleforeign entities). This results in net income per income statement of includible corporations(Part 1, line 11) of $98 million. Example 33

56. PGW must report these items on Schedule M-3, Part II, line 9 [Income (Loss) from U.S.partnerships]. The corporation reports $5,000,000 (book income) on line 9, column (a).PGW reports income per tax return of $3,900,000 ($2,500,000 + $3,500,000 �$2,000,000 � $100,000) in column (d) of line 9, and a permanent difference of $1,100,000in column (c). Example 34

57. PGWmust report the amortization on line 28, Part III as follows: $50,000 book amortizationin column (a), $25,000 temporary difference in column (b), and $75,000 tax returnamortization in column (d). This problem illustrates the Schedule M-3 reporting when bookexpenses are less than tax return deductions. It also illustrates the reporting of temporarydifferences. Example 35

58. These amounts must be reported on line 32, Part III as follows: $100,000 book bad debtexpense in column (a), $75,000 temporary difference in column (b), and $25,000 tax returnbad debt expense in column (d). This problem illustrates reporting procedures when bookexpenses are greater than tax return deductions. It also illustrates the reporting oftemporary differences. Example 36

59. Organizational expenditures and start-up expenditures were incurred in January andFebruary. The corporation can elect to expense the first $5,000 of qualifying expendituresand amortize the balance over a period of 180 months or more. Don and Steve shouldidentify the organizational expenditures that qualify for this election, and decide whether tomake the election.



The corporation must choose cost recovery methods and decide whether to elect immedi-ate expensing under § 179. It is also necessary to select an accounting method. Theaccrual method will be required for sales and purchases of inventory, but the hybrid methodmay be chosen as the overall method. This would allow use of the cash method for all itemsother than purchases and sales.

The corporation has a great deal of flexibility in selecting a fiscal or calendar year. The golfretail business is generally seasonal in nature, so the corporation should consider electinga November 30, January 31, or February 28 fiscal year.

The accrued bonuses will not be deductible if not paid by the close of the tax year. If thepayment date is not changed, the deduction for bonuses will be disallowed, which couldresult in underpayment of estimated payments, which would result in a penalty.

pp. 2-10, 2-11, and 2-34

TAXRETURNPROBLEMS

1.

2.

The answers to the Tax Return Problems and the Research Problems are incorporated into the2007 Corporations Volume of the Instructor ’s Guide with Lecture Notes to Accompany WESTFEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATE & TRUSTS.


Chapter 2: Corporations: Introduction and Operating Rules

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Transcript of Chapter 2: Corporations: Introduction and Operating Rules