Comprehensive Problem

ACCT 5327

Comprehensive Problem

Solution

Organizational Structure

Mike / Susan / Henry / Kevin / Angela / Maria
(5,000) / (3,500) / (1,500) / (2,000) / (2,000) / (2,000)
Moonrise
Basis / $1,250,000 / Basis / 1,080,000
LunaCA / Tidal Wave
Tangible assets $6,000,000
Goodwill 750,000
Liabilities $5,500,000
Common stock 1,250,000 / Basis / $3,000,000
Orbital
(German Disregarded Entity)

1. Calculate projected consolidated U.S. taxable income and net U.S. income tax payable after taxes for the Moonrise group under the following assumptions:

Moonrise / LunaCA / Tidal Wave / Orbitala / Consolidated
Sales / $8,000,000 / $10,000,000 / $3,600,000 / $3,584,000 / $25,184,000
Cost of goods / (3,000,000) / (4,100,000) / (900,000) / (768,000) / (8,768,000)
Gross Profit / $5,000,000 / $5,900,000 / $2,700,000 / $2,816,000 / 16,416,000
Dividends (portfolio) / 100,000 / 50,000 / 0 / 0 / 150,000
Capital gain (loss) / (80,000) / 42,000 / 12,000 / 0 / 0
Operating expenses / (2,200,000) / (3,000,000) / (2,000,000) / (896,000) / (8,096,000)
Administrative exp / (1,350,000) / (800,000) / (850,000) / (256,000) / (3,256,000)
Goodwill amortization / 0 / (50,000) / 0 / 0 / (50,000)
Subtotal / 1,496,000b / 2,142,000 / (138,000) / 1,664,000 / 5,164,000
Charitable contributions / (350,000) / (100,000) / 0 / (450,000)
Dividends rec’d ded / (70,000) / (35,000) / 0 / 0 / (105,000)
Subtotal / 1,076,000 / 2,007,000 / (138,000) / 1,664,000 / 4,609,000
Section 199 deduction / (92,505)c / (172,545)c / 0 / 0 / (265,050)
Taxable Income / 983,495 / 1,834,455 / (138,000) / 1,664,000 / 4,343,950
Taxable income / 983,495 / 1,834,455 / (138,000) / 1,664,000 / 4,343,950
U.S. tax rate / .34
U.S. income tax before credits / 334,388 / 623,715 / (46,920)d / 565,760 / 1,476,943
Foreign tax credit / 0 / 0 / 0 / (160,000) / (160,000)
U.S. income tax after credits / 334,388 / 623,715 / (46,920) / 405,760 / 1,316,943

a Orbital amounts translated into dollars using average exchange rate (1.28:1). Note that technically, Orbital’s figures should be included with Tidal Wave’s since Orbital is a disregarded entity 100% owned by Tidal Wave.

b includes deductible portion of capital loss only.

c allocated based on positive income from domestic production activities

d Tidal Wave’s share of U.S. income tax includes that assessed on income generated by Orbital, the disregarded entity. Thus, the actual share of income tax allocable to Tidal Wave = $358,840. We therefore do not need to (indeed we cannot) allocate the positive tax liability between the three entities with positive income as we did early in the semester.

2. Prepare the entry to account for the group's consolidated income tax accrual for the current year.

Income tax expense $1,468,103

Income tax payable $1,468,103

Note that both figures above reflect the $8,840 refund that Moonrise will receive from carrying back the excess capital loss. If the loss could not be carried back (e.g., because Moonrise did not have positive capital gain income in the prior period), the company would record a deferred tax asset of $8,840, and its income tax payable would be $1,476,943.

3. How much U.S. income tax would the group have saved if it had opted to treat Orbital as a corporation (rather than a disregarded entity) this year?

Now, only the incomes from Moonrise, LunaCA and Tidal Wave would be included, and the numbers would be as follows:

Moonrise / LunaCA / Tidal Wave / Consolidated
Sales / $8,000,000 / $10,000,000 / $3,600,000 / $21,600,000
Cost of goods / (3,000,000) / (4,100,000) / (900,000) / (8,000,000)
Gross Profit / $5,000,000 / $5,900,000 / $2,700,000 / 13,600,000
Dividends (portfolio) / 100,000 / 50,000 / 0 / 150,000
Capital gain (loss) / (80,000) / 42,000 / 12,000 / 0
Operating expenses / (2,200,000) / (3,000,000) / (2,000,000) / (7,200,000)
Administrative exp / (1,350,000) / (800,000) / (850,000) / (3,000,000)
Goodwill amortization / 0 / (50,000) / 0 / (50,000)
Subtotal / 1,496,000b / 2,142,000 / (138,000) / 3,500,000
Charitable contributions / (272,222) / (77,778)c / 0 / (350,000)
Dividends rec’d ded / (70,000) / (35,000) / 0 / (105,000)
Subtotal / 1,153,778 / 2,029,222 / (138,000) / 3,045,000
Section 199 deduction / (99,338)c / (174,712)c / 0 / (274,050)d
Taxable Income / 1,054,440 / 1,854,510 / (138,000) / 2,770,950
U.S. tax rate / .34
U.S. income tax before credits / 358,510 / 630,533 / (46,920)d / 942,123
Foreign tax credit / 0 / 0 / 0 / 0
U.S. income tax after credits / 341,502 / 600,621 / 0 d / 942,123

b includes deductible portion of capital loss only.

c allocated based on positive income from domestic production activities

d Now the disregarded entity is ignored. The group may allocate a negative share of income tax to Tidal Wave as in the allocation of income tax before credits. Alternatively, it may allocate a zero share to Tidal Wave, in which case, the income tax allocation between Moonrise and LunaCA will be as indicated in the allocation of income tax after credits. Only one of these allocations is correct—we would have to read the tax allocation agreement to determine which one is right.

4. How would its income tax accrual have changed in number 3 above?

Now, the income tax accrual would have to record U.S. income tax payable on the German income and the future foreign tax credit to be received:

Income tax expense $1,468,103

Deferred tax asset-FTC 160,000

Deferred tax asset-ch contr 30,940a

Deferred tax liability 565,760

Income tax payable 1,102,123b

a The Section 199 deduction will be reduced in the year in which the contributions carryforward is claimed. This reduction is built into the deferred tax asset. (In effect, the 199 deduction reduces the tax rate at which the contributions carryforward will be deducted—91% of 34% = 30.94%). Do not worry about this issue for purposes of the exam.

b Income tax payable equals $942,123 + $160,000 - $8,840 (capital loss carryback)

5. Assume that Orbital was treated as a foreign corporation and that it distributed €500,000 to Tidal Wave at a time when the exchange rate was €1:$1.30. What would be consolidated taxable income and tax liability now?

Tidal Wave will recognize foreign-source income with respect to the dividend as follows:

Actual dividend (€500,000 * 1.30) $650,000

Gross-up (([(€500/€1,250a]* €125)*1.28) 64,000

Taxable dividend $714,000

b Orbital’s E&P is reduced by the nondeductible charitable contribution (€50,000).

The additional dividend income would increase the charitable contributions deduction. It would not increase the 199 deduction. The consolidated group would be entitled to a $64,000 foreign tax credit.

6. Assume that Moonrise decides to sell its LunaCA stock before year end for $18,000,000. Further assume that prior to this year, LunaCA's aggregate "share" of consolidated taxable income was $7,500,000 and that its share of aggregate consolidated tax liability (which it paid itself) was $2,500,000. How much gain will Moonrise recognize in connection with the sale?

Tax basis in LunaCA:

Beginning basis (Sec. 351 basis) $1,250,000

Income:

Prior years $7,500,000

Current year (from #3 above) $1,854,510

Distribution ( 650,000)

Tax basis at date of sale $9,954,510

Selling price 18,000,000

Gain on sale $8,045 490

We can ignore LunaCA’s share of consolidated tax liability because it paid those taxes itself. Also note that the $650,000 dividend is coincidentally the same as the translated, pre-gross-up distribution that Tidal Wave received from Orbital. These are not the same distribution: this is a coincidence.

7. Compute Moonrise's E&P as of the end of the current year, assuming that all members of the consolidated group pay their own share of income taxes each year. For this purpose, note that each maintains its E&P separately (i.e., E&P is not consolidated). Be sure to account for gain recognized (if any) on sale of the LunaCA stock.

We don’t know Moonrise’s prior year earnings & profits, but we can compute its current E&P as follows:

Share of earnings $1,054,440

Gain on sale of LunaCA $8,045,490

Add nontaxable income:

Distribution from LunaCA 650,000

Less nondeductible expenses & losses:

Excess capital loss (carried back) ( 26,000)

Excess charitable contributions ( 77,778)

Federal income tax ( 341,502)

Additional income tax on stock sale ( 2,735,466)

Add back noneconomic deductions:

Dividends received deduction 70,000

Sec. 199 deduction 99,338

Current E&P $6, 738,521

8. Assume that Mike wants to retire soon. The other shareholders have agreed to have Moonrise redeem all of Mike's shares in the company for $5,000,000 upon his retirement. Assuming he does not retain any interest in Moonrise, how much tax will he owe on redemption of his shares at this price if the redemption occurs before December 31, 2012?

Mike’s original tax basis in his Moonrise shares was $300,000:

Moonrise stock $300,000

Liabilities transferred to MR 400,000

Property transferred to MR $700,000

He received 8,000 shares, giving him a tax basis per share of $37.50 per share. He later transferred 3,000 shares by gift to Susan and Henry, leaving him with 5,000 shares. His tax basis in the transferred shares was also transferred (to Susan and Henry). Thus, the tax basis of his remaining Moonrise shares is $187,500 (5,000 shares times $37.50 per share).

A qualified redemption of all his shares for $5,000,000 before 12/31/2012 will generate a taxable gain of $4,812,500. At the current 15% tax rate on capital gains, he will owe $721,875 in federal income tax.

9. How much tax would he owe if the redemption were to occur in 2013 under the assumption that the capital gains rate increases to 20 percent next year? How much tax would he owe if the redemption takes place next year and he retains a position on the board of directors of Moonrise?

If a qualified redemption of all his shares takes place next year, he will recognize the same $4,812,500 long-term capital gain. However, the tax rate will now be 20% (presumably). Thus, his tax liability would increase to $962,500.

If he retains a seat on the board of directors, the redemption will not be a complete termination of his interest. He will be deemed to own the 3,000 shares owned by Susan. His interest before and after the redemption would be as follows:

Pre-redemption / Post-redemption
Shares owned directly / 5,000 / 0
Shares owned from Susan / 3,000 / 3,500
Total direct & indirect ownership / 8,000 / 3,500
Total shares outstanding / 16,000 / 11,000
Percentage ownership / 50% / 31.81%

Thus, even though the family attribution rules are not waived, the redemption will qualify for sale treatment as a disproportionate redemption and he will owe only $962,500 on the transaction in 2013. Note that had the redemption not been qualified, it would be taxed as a dividend. If a non-qualified redemption in the amount of $5,000,000 occurred in 2013, he would owe $2,170,000 income tax (39.6% plus 3.8% ACA tax on the dividend).