Corporations: Introduction, Operating Rules, and Related Corporations2-1

Corporations: Introduction, Operating Rules, and Related Corporations2-1

CHAPTER 2

CORPORATIONS: INTRODUCTION,

OPERATING RULES, AND RELATED CORPORATIONS

SOLUTIONS TO PROBLEM MATERIALS

Discussion Questions

1. / Tax Factors / Partnership / S Corporation / C Corporation
Who pays tax on the entity’s income? / Partners / Shareholders /

Corporation

Are operating losses passed through to owners? / Yes / Yes / No
Are capital gains (losses) reported on owners’ tax returns as such? / Yes / Yes / No
Are distributions of profits taxable to owners? / No (generally) / No (generally) / Yes
Nontax Factors / Partnership / S Corporation / C Corporation
Limited liability? / No / Yes / Yes
Free transferability of ownership interests? / No / Yes / Yes

pp. 2-2 to 2-7

2.George must report $75,000 income on his tax return, and Mike is not required to report income from the corporation on his tax return. Proprietorship profits flow through to the owner and are reported on the owner’s individual income tax return. Shareholders are required to report income from a corporation only to the extent of dividends received. Mike did 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 of hours required to be a material participant (52 X 15 = 780). Therefore, he will be able to deduct 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 the stock should grow accordingly, and he should be able to sell his stock in the corporation for long-term capital gain. pp. 2-2 to 2-4

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

The capital loss of the sole proprietorship is passed through to Lucille, and she is allowed to report it on her tax return as a capital loss. She can offset the loss against capital gains or 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 tax return (subject to at-risk and passive loss limitations). The operating loss of the corporation has no effect on Mabel’s tax return.

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

5.Harry must report $60,000 of Purple Corporation income and may deduct $3,000 of the $8,000 loss on his Federal income tax return. He may carry forward the $5,000 unused LTCL and treat it as LCTL in the future. S corporations are similar to partnerships in that net profit or loss flows through to the shareholders to be reported on their separate returns. The $30,000 withdrawal has no impact on Harry’s taxable income. pp. 2-4 and 2-12

6.If Tanesha buys the warehouse and rents it to the corporation, she can charge the corporation the highest amount of rent that is reasonable. The rental operation can help her to bail some profits out of the corporation and avoid double taxation on corporate income. The depreciation and other expenses incurred in connection with the warehouse will be deductible by Tanesha, which should enable her to offset some or all of the rental income. If the rental property produces a loss, Tanesha can use the loss to offset any to a related party until the recipient reports that amount as income. passive income she might have. pp. 2-5 and 2-35

1. A corporation that uses the accrual method cannot claim a deduction for an accrual owed Paul, a cash basis taxpayer, 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

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

Eagle Corporation may use the capital loss to offset any capital gains incurred during the year. Any excess losses may be carried back three years and forward five years. When carried back or forward, a long-term capital loss is treated as a short-term loss. pp. 2-12 and 2-13

15.Judy reports the long-term capital gain on her individual tax return, and it is subject to a maximum tax rate of 15 percent. Link does not receive special tax treatment for its long-term capital gain. Therefore, the corporation’s gain will be taxed at 35 percent. p. 2-12

25.George’s plan will not reduce corporate income taxes. Palmetto, Poplar, and Spruce would be related corporations and would be subject to special rules for computing the corporate income tax. Therefore, the total corporate tax liability would remain unchanged. Examples 29 and 30 and related discussion

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

Additions

b.Travel and entertainment expenses in excess of deductible limits

c.Book depreciation in excess of allowable tax depreciation

d.Federal income tax per books

e.Charitable contributions in excess of deductible limits

f.Premiums paid on life insurance policy on key employee

i.Interest incurred to carry tax-exempt bonds

j.Capital losses in excess of capital gains

Subtractions

a.Charitable contributions carryover from previous year

g.Proceeds of life insurance paid on death of key employee

h.Tax-exempt interest

p. 2-27 and Example 36

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

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

pp. 2-2 and 2-4

37. A corporation cannot deduct a net capital loss in the year incurred. The net loss can be carried back for three years and offset against capital gain in the carryback years. If the capital 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 taxable income. No capital loss deduction is allowed.

b.$400,000 (operating income) – $350,000 (operating expenses) + $12,000 (net capital gain) = $62,000 taxable income.

pp. 2-12 and 2-13

42.a.When a corporation contributes inventory that is used in a manner related to the exempt 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. 2-15 and Example 20

b.Normally, corporate contributions of long-term capital gain property are measured by the fair market value of the asset, $14,000. In this case the deduction will be limited to $12,500, 10% of taxable income. The remaining $1,500 ($14,000 – $12,500) may be carried forward for five years. pp. 2-14 and 2-15

50.a.$5,000 (amount that can be immediately expensed) + [($18,000 – $5,000) ÷ 180 months] = $5,072. To qualify for the election, the expenditure must be incurred before the end of the taxable year in which the corporation begins business. Amortization does not apply to the $3,600 of expenses that were incurred after the end of the taxable year.

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

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

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

pp. 2-19, 2-20, and Examples 26 and 39

51.Qualifying organizational expenditures include these items:

Expenses of temporary directors and of organizational meetings$12,000

Fee paid to the state of incorporation3,000

Accounting services incident to organization15,000

Legal 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 Hummingbird Corporation may write off for the tax year 2005 is determined as follows:

$4,000 + [($51,000 – $4,000) ÷ 180 months X 6 (months in tax year)] = $4,000 + [$261 (per month amortization) X 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 the amount left to be amortized to $47,000 ($51,000 – $4,000).

pp. 2-19 and 2-20

52.Violet Corporation:

Tax on $38,000 is $5,700 ($38,000 X 15%).

Indigo Corporation:

Tax on—$180,000

Tax on $100,000$22,250

Tax on $80,000 X 39% 31,200

Total tax$53,450

Orange Corporation:

Tax on—$335,000

Tax on $100,000$ 22,250

Tax on $235,000 X 39% 91,650

Total tax$113,900

Blue Corporation:

Tax on—$4,620,000

Tax on $335,000$ 113,900

Tax on $3,285,000 X 34% 1,116,900

Total tax$1,230,800

Green Corporation:

Tax on—$18,500,000

Tax on $18,500,000 X 35%$6,475,000

p. 2-6 and Examples 27 and 28

50.a.$5,000 (amount that can be immediately expensed) + [($18,000 – $5,000) ÷ 180 months] = $5,072. To qualify for the election, the expenditure must be incurred before the end of the taxable year in which the corporation begins business. Amortization does not apply to the $3,600 of expenses that were incurred after the end of the taxable year.

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

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

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

pp. 2-19, 2-20, and Examples 26 and 39

÷

51.Qualifying organizational expenditures include these items:

Expenses of temporary directors and of organizational meetings$12,000

Fee paid to the state of incorporation3,000

Accounting services incident to organization15,000

Legal 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 Hummingbird Corporation may write off for the tax year 2005 is determined as follows:

$4,000 + [($51,000 – $4,000) ÷ 180 months X 6 (months in tax year)] = $4,000 + [$261 (per month amortization) X 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 the amount left to be amortized to $47,000 ($51,000 – $4,000).

pp. 2-19 and 2-20

52.Violet Corporation:

Tax on $38,000 is $5,700 ($38,000 X 15%).

Indigo Corporation:

Tax on—$180,000

Tax on $100,000$22,250

Tax on $80,000 X 39% 31,200

Total tax$53,450

Orange Corporation:

Tax on—$335,000

Tax on $100,000$ 22,250

Tax on $235,000 X 39% 91,650

Total tax$113,900

Blue Corporation:

Tax on—$4,620,000

Tax on $335,000$ 113,900

Tax on $3,285,000 X 34% 1,116,900

Total tax$1,230,800

Green Corporation:

Tax on—$18,500,000

Tax on $18,500,000 X 35%$6,475,000

p. 2-6 and Examples 27 and 28