Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.

3d Date: 15th April 2006 Time: 18:56 User ID: 40223

CHAPTER 2 CORPORATIONS: INTRODUCTION AND OPERATING RULES SOLUTIONS TO PROBLEM MATERIALS

Question/ Problem 1 2 3 4 *5 6 7 8 9 10 11 12 13 14 *15 16 17 18 19 20 21 22 23 24 25

Topic Tax and nontax factors in entity selection Partnership capital gain and withdrawals Corporation versus proprietorship Corporate tax versus partnership tax Corporate versus individual taxation Expenses to avoid double taxation Unreasonable compensation Taxation of dividends and salary Check-the-box rules Benefits of LLC Fiscal year election for corporation Cash method of accounting limitations Accrual method required Capital loss treatment of corporation and individual Capital gain treatment for corporations, individuals, and LLC LTCL of individuals and corporations Passive loss rules: closely held C corporations and PSCs contrasted Passive loss deduction for closely held corporation and personal service corporation Tax treatment of charitable contributions for corporate and noncorporate taxpayers Production activities deduction Organizational and start-up expenses Dividends received deduction Organizational expenditures and start-up expenditures Start-up expenditures Tax liability of related corporations 2-1

Status: Present Edition New Unchanged Unchanged Unchanged New Unchanged Unchanged New Unchanged Unchanged New Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged Unchanged New Unchanged New Unchanged Unchanged Unchanged

Q/P in Prior Edition 2 3 4 6 7 9 10 12 13 14

16 17 18 19 21 23 24 25

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-2

2007 Corporations Volume/Solutions Manual Status: Present Edition New Unchanged Unchanged Unchanged New New Unchanged New Unchanged Unchanged New Unchanged Unchanged Unchanged New Unchanged Unchanged Unchanged New Unchanged New New Modified Unchanged Unchanged Modified Unchanged Modified Unchanged New New New New Unchanged 41 42 43 45 37 38 39 32 34 35 Q/P in Prior Edition 27 28 29

Question/ Problem 26 27 28 29 30 31 32 *33 34 *35 36 37 38 39 40 41 42 43 44 45 46 *47 *48 49 *50 *51 52 *53 54 55 56 57 58 59

Topic Schedules M-1 and M-3 Differences between taxable income and accounting income Schedule M-3 Compare LTCL treatment for corporations and for proprietorships Tax treatment of income and distributions from partnership, S and C corporations Corporation net income taxation, cash distribution to owner versus proprietorship with cash distribution, new rules on dividend taxation Taxation of corporation versus proprietorship Taxation of corporation versus proprietorship Comparison of deduction for casualty loss for individual and corporate taxpayers Tax liability determination as proprietorship or corporation Salary requirements for use of fiscal year by personal service corporation Capital loss of corporation Salary deduction under cash and accrual accounting Comparison of treatment of capital losses for individual and corporate taxpayers Capital gains and losses of a corporation; carryback/carryover Passive loss of closely held corporation; PSC Charitable contributions of corporation compared with individual taxpayer Corporate charitable contribution Charitable contributions of corporation; carryover Timing of charitable contributions deduction of accrual basis corporation Production activities deduction Dividends received deduction Dividends received deduction Organizational expenses Organizational expenses Determine corporate income tax liability Filing requirements for Form 1120-A Schedule M-1, Form 1120 Schedule M-1, Form 1120 Schedule M-3, Form 1120 Schedule M-3, Form 1120 Schedule M-3, Form 1120 Schedule M-3, Form 1120 Tax issues involved in starting a new business in the corporate form

49 50 51 52 56 57 58

59

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules Status: Present Edition New New

2-3 Q/P in Prior Edition

Tax Return Problems 1 2 Research Problem 1 2 3 4 5

Topic Corporation income tax (Form 1120) Corporation income tax (Form 1120)

Dividends received deduction Charitable contribution deduction Expenditures incurred on behalf of corporation Internet activity Internet activity

Unchanged New Unchanged Unchanged Unchanged

1 3 4 5

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

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-4

2007 Corporations Volume/Solutions Manual CHECK FIGURES

29.a. 29.b. 30.a. 30.b. 30.c. 32.a. 32.b. 33.a. 33.b. 33.c. 34.a. 34.b. 35.a. 35.b. 35.c. 35.d. 36.a. 36.b. 37.a. 37.b. 38. 39.a. 39.b.

Andrew will report profit $20,000 and capital loss $5,000. Andrews income is not increased. Each partner reports $200,000 net profit and LTCG of $60,000. Same as a. Corporation reports $520,000 income. Shareholder reports $80,000 dividend income. Losses not passed through to shareholder. Deduct $153,000. After-tax income $87,234.50. After-tax income $72,540. After-tax income $68,406. $33,900. $45,000. $36,050. $29,450. $23,420. $33,658. $80,000. $35,000. $50,000. $62,000. $65,000 for Hugh, $60,000 for Sam. $8,000 deducted 2006; $7,000 carried forward to 2007. $5,000 deducted 2006; $10,000 carried back to 2003, then 2004, etc.

40.a.

40.b. 40.c. 41. 42.a. 42.b. 44.a. 45. 46.a. 46.b. 47.a. 47.b. 48. 49.a. 49.b. 49.c. 49.d. 50. 51. 52. 53. 54.

Offset short-term capital gain of $60,000 against net long-term capital loss of $380,000. The $320,000 net long-term loss is carried back 3 years and forward 5 years. Total carryback $280,000. $40,000; carry forward 2007, etc. Offset $45,000 of passive loss against active income. No offset if a PSC. $12,000. $12,500. $19,350. 2006. $6,000. $12,000. $36,000. ($8,000). Green $35,000; Orange $210,000; Yellow $224,000. $5,072. $5,092. $5,072. $5,092. $5,566. Violet $4,800; Indigo $92,450; Orange $113,900; Blue $1,473,900; Green $7,000,000. Jay no; Shrike no; Martin yes. $120,000. $100,000.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules DISCUSSION QUESTIONS 1.

2-5

You should ask questions that will enable you to assess both tax and nontax factors that will affect the entity choice. Some relevant questions are addressed in the following table, although there are many additional possibilities. Question What type of business are you going to operate? Reason for the question This question will provide information that may affect the need for limited liability, ability to raise capital, ease of transferring interests in the business, how long the business will continue, and how the business will be managed. Income from a business will eventually be reported on the tax returns of the owners. For example, income (loss) from a partnership, S corporation, or LLC will flow through to the owners. Dividends from a C corporation must be reported on the tax returns of the shareholders. Any income (loss) from other sources will also be reported on the returns of the owners. Thus, for planning purposes, it is important to know all sources and types of income (loss) that the owners will have. Losses of partnerships, S corporations, and LLCs flow through to the owners and represent potential deductions on their individual returns. Losses of a C corporation do not flow through. Profits from a partnership, S corporation, or LLC will flow through to the owners, and will be subject to taxation on their individual tax returns. Profits of a C corporation must be reported on the tax returns of the shareholders only if such profits are paid out to shareholders as dividends. Thus, in the case of a partnership, S corporation, or LLC, owners must pay tax on profits before plowing funds back into the business. In the case of a C corporation, the corporation must pay tax on its profits.

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

Do you expect to have losses in the early years of the business?

Will you withdraw profits from the business or leave them in the business so it can grow?

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 owners 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 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 15 = 780). Therefore, he will be able to deduct the losses against his other income. When the business becomes profitable, Art

3.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-6

2007 Corporations Volume/Solutions Manual 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 Mabels 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 Mabels 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 a. A proprietorship Conner should report $90,000 profit on Schedule C, $3,000 capital loss on Schedule D (with a $9,000 carryover). The $45,000 withdrawal would have no impact on Conners individual tax return. $45,000 dividend (profit withdrawn from SE). Neither the $90,000 profit nor the $12,000 capital loss would flow through. $90,000 profit and $12,000 capital loss would flow through from SE to Conner and be reported on his individual tax return. The capital loss would be combined with any personal capital gains (losses), and would be subject to the $3,000 limit. The $45,000 withdrawal would have no impact on Conners individual tax return.

b.

A C corporation

c.

An S corporation

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 passive income she might have. If Tanesha has the corporation buy the warehouse, the revenue and expenses related to the building will be included in the computation of corporate income. If there is a profit, Tanesha can bail it out as a dividend, which will be taxed at a 15% rate. pp. 2-5, 2-6, and 2-33 To the extent a salary paid to a shareholder/employee is considered reasonable, the corporation is allowed a deduction, which reduces corporate taxable income. To the extent a 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 salary and dividends. Therefore, double taxation has occurred on $60,000. p. 2-5

7.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules 8.

2-7

Al will be subject to a 15% rate on the $20,000 that ABC pays him as a dividend, but ABC will not be allowed to deduct the amount in computing corporate taxable income. Jay will report the additional $20,000 that JKL pays him as salary and will be taxed at his marginal rate of 35%. JKL will be allowed to deduct the salary payment in computing corporate taxable income. p. 2-5 The check-the-box rules permit a qualifying entity to elect to be taxed either as a partnership or as a corporation. The election is made by filing Form 8832. If Ed and Barbara do not file Form 8832, the entity will be treated as a partnership by default. pp. 2-8 and 2-9 The primary nontax advantage of an LLC is limited liability. The primary tax advantage is that Erica can elect to have the LLC treated as a partnership rather than a corporation, thus avoiding the problem of double taxation. pp. 2-7 and 2-8 As owner-employees, Hank and Charlie offer services in the area of performing arts, so HC is a personal service corporation. HC appears to have a business year that ends on January 31. Although a PSC is not normally allowed to adopt a fiscal year, HC should be able to demonstrate a business purpose for electing a January 31 fiscal year-end. Example 10 A corporation that uses the accrual method cannot claim a deduction for an accrual owed to a related party until the recipient reports that amount as income. 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 Businesses that maintain inventory for sale to customers are required to use the accrual method of accounting for determining sales and cost of goods sold. Therefore, Rose Corporation would be required to use the accrual method, at least for transactions involving inventory. p. 2-10 Kathy may use her $25,000 LTCL 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 realized 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. 2-11 and 2-12

9.

10.

11.

12.

13.

14.

15.

The reporting rules and applicable tax rates are summarized in the following table. If Alpha is a. A proprietorship b. An S corporation c. A C corporation The gain would be reported By Janice on Sch. D, Form 1040 By Alpha on Form 1120S; flowthrough to Janice on Schedule K-1 By Alpha on Form 1120 By Janice or Alphaa one member LLC can elect to be taxed as a sole proprietorship or as a corporationsee items a. and c. above The tax rate would be 15% 15% Applicable corporate tax rate See items a. or c. above

d. An LLC

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-8 16.

2007 Corporations Volume/Solutions Manual John may deduct up to $3,000 of his net capital loss in computing taxable income for the current year and may carry the remaining $4,000 forward for an indefinite period. He can use the capital loss carryover to offset capital gains in the carryforward years, or he can deduct up to $3,000 per year from ordinary income if he has no capital gains. Fox Corporation cannot deduct any of the loss in the year incurred. However, Fox can carry the loss back three years and forward five years until the entire loss is offset against capital gains in the carryback or carryforward years. Examples 13 and 14 Falcon can deduct none of the passive loss. A personal service corporation cannot offset a passive loss against either active or portfolio income. p. 2-12 A closely held corporation that is not a personal service corporation can offset a passive loss against active income, but not against portfolio income. Hummingbird can deduct only $30,000 of the $60,000 passive loss. Example 15 Individuals cannot deduct contributions until they are actually made. Therefore, Andrea must wait until 2007 to deduct the contribution. Aqua Corporation, whose board of directors 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 Presumably the corporation qualified for the production activity deduction. The rate for the deduction, 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 corporations tax rate to decrease in 2007, which would result in a lower corporate tax on the $200,000 income.

17. 18.

19.

20.

21.

Martin Corporation should elect to forgo the NOL carryback if profits in the two preceding years were small and if higher profits are expected in the future. Carrying an NOL back to low profit years will generate a smaller tax savings than carrying the loss forward to high profit years. Before electing to forgo an NOL carryback, a corporation should be able to predict with confidence that future profits will be higher. p. 2-34 and Example 37 Otter Corporation will be allowed to exclude 80% of its $240,000 dividend (subject to possible limitations described in Example 25). It will pay tax at the applicable corporate tax rate on the portion of the dividend not excluded. Gerald must include the entire $240,000 dividend and will pay tax at the 15 percent rate applicable to individuals. Example 3 Scarlet Corporations organizational expenses include (a) expenses of temporary directors attending organization meetings and (c) legal expenses incurred for drafting of corporate charter and bylaws. Start-up expenses include (b) investigation expenses incurred in connection with acquisition of a new business and (e) cost of market survey incurred before Scarlet started producing income. Expenses incurred in printing stock certificates are neither organizational expenses nor start-up expenses. The printing expenses cannot be deducted but reduce the amount of the capital realized from the sale of stock. p. 2-18 Expenses incurred before any revenue is produced by a business are treated as start-up expenditures under 195. A taxpayer may elect to expense $5,000 of such expenses and amortize the balance over a period of 180 months or longer, rather than capitalize such costs permanently. Therefore, Teal can elect to deduct $5,000 in 2007. p. 2-19 Georges 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

22.

23.

24.

25.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules 26.

2-9

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 total assets. 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 not required to file Schedule M-3 may do so voluntarily. pp. 2-22 to 2-26 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. c. d. e. f. i. SUBTRACTIONS a. g. h. p. 2-22 and Example 31 Charitable contributions carryover from previous year Proceeds of life insurance paid on death of key employee Tax-exempt interest Travel and entertainment expenses in excess of deductible limits Book depreciation in excess of allowable tax depreciation Federal income tax per books Charitable contributions in excess of deductible limits Premiums paid on life insurance policy on key employee Interest incurred to carry tax-exempt bonds

27.

28.

The governments objectives were (1) to create greater transparency between corporate financial statements and tax returns, and (2) to identify corporations that engage in aggressive tax practices. p. 2-24

PROBLEMS 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. 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.

b.

pp. 2-2 and 2-4 30. a. Woodchuck, a partnership, is not a taxpaying entity. Its profit (loss) and separate items flow through to the partners. The partnerships Form 1065 reports net profit of $400,000 ($1,000,000 income $600,000 expenses). The partnership also reports the $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 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 the partners but decrease their basis in the partnership. Example 2

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-10 b.

2007 Corporations Volume/Solutions Manual Woodchuck, an S corporation, is not a taxpaying entity. Its profit (loss) and separate items flow through to the shareholders. The S corporations Form 1120S reports net profit of $400,000 ($1,000,000 income $600,000 expenses). The S corporation also reports the $120,000 long-term capital gain as a separately stated item on Form 1120S. 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 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 the partners but decrease their basis in the S corporation. Example 2 Woodchuck, a C corporation, is a taxpaying entity. Woodchucks Form 1120 reports 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 Catherine report dividend income of $80,000 each. The dividend income will be subject to a maximum individual tax rate of 15%. pp. 2-4, 2-5, and Example 2

c.

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 pay tax 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 must pay tax of $70,000 ($200,000 35%). In the case of a corporation, FICA taxes would add to the tax burden of the corporation and the individual. In the case of the proprietorship, the individual would be subject to self-employment taxes. pp. 2-2 to 2-5 and Examples 5 and 6 Losses of a C corporation are not passed through to the shareholders. The corporation may carry net operating losses to other years (back two years, forward twenty). Capital losses of corporations are not deductible in the year incurred, but can be carried back three years 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. b. The corporations losses are subject to the NOL and capital loss carryback provisions. The losses are not passed through to the shareholder. Chris is a material participant in Orange Company. Chris has enough other income to be in the 35% bracket, so he will not be in a net operating loss situation after deducting the loss from Orange Company. He can deduct $153,000 ($150,000 operating loss + $3,000 capital loss).

32.

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 of the amount he withdraws. If the company is a corporation, it must pay corporate tax on the income and Ron must report any dividends he receives from the company as income. a. Rons after-tax income is computed below: Income from proprietorship ($150,000 $40,000) Less deductions ($5,150 standard deduction + $3,300 exemption) Taxable income Tax on $101,550 (see Appendix A for Tax Rate Schedules) After-tax income ($110,000 $22,765.50) $ 110,000 (8,450) $ 101,550 $22,765.50 $87,234.50

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules b.

2-11

Tax on corporations net income of $110,000: Tax on $100,000 Tax on $10,000 @ 39% Tax liability Corporations after-tax income ($110,000 $26,150) Rons taxable income ($83,850 dividend $5,150 standard deduction $3,300 exemption) Rons tax on $75,400 at 15% rate applicable to dividends Rons after-tax income ($83,850 $11,310) $22,250 3,900 $26,150 $83,850 $75,400 $11,310 $72,540

c.

The corporation will have $26,150 taxable income ($150,000 revenue $83,850 salary $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 (floor on personal casualty losses) $11,000 (10% of AGI)] if she itemizes deductions. If Dakota does not itemize, she would not have a deduction. Dakota can deduct $45,000 [$75,000 $30,000 (insurance recovery)]. Corporations are not subject to the $100 floor or the 10% limitation.

b. p. 2-9 35. a.

Gross income Ordinary deductions Taxable income (to owner of proprietorship) Tax @ 35% Gross income of corporation Ordinary deductions Salary Taxable income Corporate tax Gross income of shareholder Salary Tax @ 35% Total tax Gross income of corporation Ordinary deductions Taxable income Corporate tax

$200,000 (97,000) $103,000 $36,050 $200,000 (97,000) (70,000) $ 33,000 $ 4,950 $ 70,000 24,500 $29,450 $200,000 (97,000) $103,000 $23,420

b.

c.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-12 d.

2007 Corporations Volume/Solutions Manual

Gross income of corporation Ordinary deductions Salary Taxable income Corporate tax Tax paid by shareholder On salary ($70,000 35%) On dividend [($33,000 $4,950) 15%] Total tax

$200,000 (97,000) (70,000) $ 33,000 $ 4,950 $ 24,500 4,208 28,708 $33,658

e.

Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 December 1, 2006 Mr. Robert Benton 1121 Monroe Street Ironton, OH 45638 Dear Mr. Benton: This letter is in response to your inquiry as to the tax effects of incorporating your business in 2007. I have analyzed the tax results under both assumptions, proprietorship and corporation. I cannot give you a recommendation until we discuss the matter further and you provide me with some additional information. My analysis based on information you have given me to date is presented below. COMPUTATION 1 Total tax on $103,000 taxable income if you continue as a proprietorship Total tax if you incorporate: Individual tax on $70,000 salary @ 35% Corporate tax on $33,000 corporate taxable income Total $36,050 $24,500 4,950 $29,450

Although this analysis appears to favor incorporating, it is important to consider that there will be additional tax on the $28,050 of income left in the corporation if you withdraw 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) Tax on $28,050 @ 15% Total tax paid if you incorporate ($29,450 + $4,208) $28,050 $ 4,208 $33,658

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules

2-13

Comparison of computations 1 and 2 appears to support incorporating. If you incorporate and recover the income left in the corporation as long-term capital gain in the future, the total tax cost of incorporating will be the same, as shown in computation 3 below. COMPUTATION 3 Income left in corporation ($33,000 taxable income $4,950 corporate tax) Tax on $28,050 @ 15% LTCG rate Total tax paid if you incorporate ($29,450 + $4,208) $28,050 $ 4,208 $33,658

In summary, incorporation appears to be the most attractive option, whether you recover income left in the corporation as capital gain or as dividend income. Keep in mind, however, that there are important nontax considerations with respect to this decision. We can discuss those issues at our next meeting. Thank you for consulting my firm on this important decision. We are pleased to provide 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 least proportionate to the employees salary received for the fiscal year. The amount that Marion Corporation must pay Marion during the period September 1 through December 31, 2006, to permit the continued use of its fiscal year without negative tax effects is $80,000 ($240,000 4/12). Example 11 Marion Corporation, a PSC, is subject to a tax rate of 35% on all of its net profit. The corporation would pay tax of $35,000 ($100,000 35%). To illustrate the negative tax impact of classification as a PSC, compare this amount to the $22,250 that a corporation that is not a PSC would pay. p. 2-20

b.

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. b. $400,000 (operating income) $350,000 (operating expenses) = $50,000 taxable income. No capital loss deduction is allowed. $400,000 (operating income) $350,000 (operating expenses) + $12,000 (net capital 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 own more than 50% of the corporations

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-14

2007 Corporations Volume/Solutions Manual stock. It would deduct $60,000 of Sams salary under the accrual method of accounting, since Sam owned more than 50% of the corporations stock. p. 2-10

39.

a.

Of the $15,000 long-term capital loss, $8,000 can be deducted in 2006. The loss will offset the capital gains of $5,000 first; then, an additional $3,000 of the loss may be utilized as a deduction against ordinary income. The remaining $7,000 of loss is carried forward to 2007 and years thereafter until completely deducted. Only $5,000 of the loss may be deducted in 2006. The loss deduction is limited to the amount of capital gains ($3,000 STCG + $2,000 LTCG). A corporation may not claim 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 capital gains in those years. [The loss is carried back first to the tax year 2003.] Any remaining loss not offset against capital gains in the three previous years can be carried forward for five years only, to offset capital gains in those years. The long-term capital loss will be treated as a short-term capital loss as it is carried back and forward.

b.

Examples 13 and 14 40. a. Net short-term capital gain Net long-term capital loss Excess net long-term loss $ 60,000 (380,000) ($320,000)

The excess capital losses of $320,000 are not deductible on the 2006 return, but must be carried back to the three preceding years, applying them to 2003, 2004, and 2005, in that order. Such long-term capital losses are carried back or forward as short-term capital losses. b. 2006 excess loss Offset against 2003 (net short-term capital gains) 2004 (net long-term capital gains) 2005 (net long-term capital gains) Total carrybacks ($320,000) $ 80,000 60,000 140,000 ($280,000)

c. d.

$40,000 ($320,000 $280,000) STCL carryover to 2007, 2008, 2009, 2010, and 2011, in that order. 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 $3,000 in 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 $80,000 passive loss against the $45,000 of active business income. However, it may not offset the remaining $35,000 against portfolio income. Example 15 If Condor were a PSC, it could not offset the passive loss against either active or portfolio income. p. 2-12 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

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules

2-15

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 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. 2-13 and 2-14 Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 December 6, 2006 Mr. Joseph Thompson Jay Corporation 1442 Main Street Freeport, ME 04032 Dear Mr. Thompson: I have evaluated the proposed alternatives for your 2006 year-end contribution to the University of Maine. I recommend that you sell the Brown Corporation stock and donate the proceeds to the University. The four alternatives are discussed below. Donation of cash, the unimproved land, or the Brown stock each will result in a $120,000 charitable contribution deduction. Donation of the Maize Corporation stock will result in only a $20,000 charitable contribution deduction. Contribution of the Brown Corporation stock will result in a less desirable outcome from a tax perspective. However, you will benefit in two ways if you sell the Brown stock and give the $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 corporate income tax in the past three years, the entire loss can be carried back and Jay will receive tax refunds for the carryback years. If Jay had no capital gains in the carryback years, the capital loss can be carried forward and offset against capital gains of the corporation for up to five years. Jay Corporation should make the donation in time for the ownership to change hands before the end of the year. Therefore, I recommend that you notify your broker immediately so 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 me if you have questions. Thank you for consulting my firm on this matter. We look forward to serving 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 limitation does not include the dividends received deduction or capital loss carryback. For

43.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-16

2007 Corporations Volume/Solutions Manual 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 be carried over to the following year.

p. 2-15 and Example 21 45. Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 December 6, 2006 Mr. Dan Simms, President Simms Corporation 1121 Madison Street Seattle, WA 98121 Dear Mr. Simms: On December 3 you asked me to advise you on the timing of a contribution by Simms Corporation to the University of Washington. My calculations show that the corporation will maximize its tax savings by making the contribution in 2006. If the corporation makes the contribution in 2006, it can deduct $20,000 as a charitable contribution, which will save $7,800 (39% tax rate $20,000 deduction) in Federal income tax. However, if the corporation makes the contribution in 2007, the percentage limitations applicable 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 taxes as a result of this deduction. The corporation may carry the remaining $10,000 forward and deduct the amount in 2008. If the corporation continues at the 2007 profit level, it will save an 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) if it makes the contribution in 2006. In addition, all of the savings will occur in 2006. If the corporation makes the contribution in 2007, its tax savings will be split between 2007 and 2008. My advice is that the corporation should make the contribution immediately so ownership of the stock can be transferred by December 31. Sincerely, Alicia Gomez, CPA pp. 2-14 and 2-15 46. a. Lynxs production activities deduction for 2006 is 3% of the lesser of
l

taxable income of $200,000, or 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, Lynxs final production activities deduction for 2006 is $6,000. p. 2-16

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules b. Lynxs production activities deduction for 2006 is 6% of the lesser of
l

2-17

taxable income of $200,000, or 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, Lynxs final production activities deduction for 2007 is $12,000. p. 2-16 47. a. The key to this question is the relationship between the dividends received deduction 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 full dividends received deduction would cause or increase an NOL). In this case and with an 18% stock ownership, the dividends received deduction is limited to 70% of taxable income. Gross income from operations Less: Expenses from operations Dividends Taxable income before the dividends received deduction Dividends received deduction (70% $160,000)* Taxable income *Computation of the DRD limitation: Step 1 Multiply the dividends received by the deduction percentage [$160,000 70% (based on 18% ownership)] Step 2 Multiply the taxable income before the DRD by the deduction percentage ($120,000 70%) Step 3 Lesser of Step 1 or Step 2 unless full DRD generates NOL $ 84,000 $ 84,000 $112,000 $ 440,000 (480,000) 160,000 $ 120,000 (84,000) $ 36,000

The dividends received deduction is limited to 70% of taxable income because taking 70% of the $160,000 dividend received ($112,000) would not create a net operating loss ($120,000 $112,000 = $8,000 net income). b. The dividends received deduction (DRD) is limited to a percentage of taxable income of the corporation (unless taking the full dividends received deduction would cause or increase an NOL). With a 75% stock ownership, the full 80% dividends received deduction creates an NOL, as shown below.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-18

2007 Corporations Volume/Solutions Manual Gross income from operations Less: Expenses from operations Dividends Taxable income before the dividends received deduction Dividends received deduction (80% $160,000)* Taxable income (NOL) *Computation of the DRD limitation: Step 1 Multiply the dividends received by the deduction percentage [$160,000 80% (based on 75% ownership)] Step 2 Multiply the taxable income before the DRD by the deduction percentage ($120,000 80%) Step 3 Lesser of Step 1 or Step 2 unless full DRD generates NOL $ 440,000 (480,000) 160,000 $ 120,000 (128,000) ($ 8,000)

$128,000

$ 96,000

$128,000

The dividends received deduction is not limited to 80% of taxable income because taking 80% of the $160,000 dividend received ($128,000) would create a net operating 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: Green Corporation Step 1 70% $50,000 (dividend received) 70% $300,000 (dividend received) 70% $400,000 (dividend received) Step 2 70% $100,000 (taxable income) 70% $150,000 (taxable income) 70% $320,000 (taxable income) Step 3 Lesser of Step 1 or Step 2 Generates a net operating loss $35,000 $210,000 $224,000 $70,000 $105,000 $224,000 $35,000 $210,000 $280,000 Orange Corporation Yellow Corporation

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

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules

2-19

from 100% of taxable income ($150,000). Yellow Corporation, however, is subject to the taxable 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) 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. $5,000 (amount that can be immediately expensed) + [($21,600 $5,000) 180 months] = $5,092. $5,072 [same as a.]. The corporations method of accounting is of no consequence in determining organizational expenditures that qualify for the election to amortize. $5,092. [same as b.]

b. c. d.

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 Fee paid to the state of incorporation Accounting services incident to organization Legal services for drafting the corporate charter and bylaws Total $12,000 3,000 15,000 21,000 $51,000

Since an appropriate and timely election under 248 was made, the amount that Hummingbird 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 the amount 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$280,000 Tax on $100,000 Tax on $180,000 39% Total tax $22,250 70,200 $92,450

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-20

2007 Corporations Volume/Solutions Manual Orange Corporation: Tax on$335,000 Tax on $100,000 Tax on $235,000 39% Total tax Blue Corporation: Tax on$4,335,000 Tax on $335,000 Tax on $4,000,000 34% Total tax Green Corporation: Tax on$20,000,000 Tax on $20,000,000 35% p. 2-6 and Examples 27 and 28 $7,000,000 $ 113,900 1,360,000 $1,473,900 22,250 91,650 $ 113,900 $

52. 53.

Corporations Jay and Shrike may not file Form 1120-A. Sales for Jay exceed $500,000; Shrike is a member of a controlled group. Martin Corporation may file Form 1120-A. pp. 2-21 and 2-22 Net income per books is reconciled to taxable income as follows: Net income per books (after tax) Plus: Items that decreased net income per books but did not affect taxable income: + Federal income tax liability + Excess of capital losses over capital gains + Interest paid on loan incurred to purchase tax-exempt bonds + Premiums paid on policy on life of president of the corporation Subtotal Minus: Items that increased net income per books but did not affect taxable income: Interest income from tax-exempt bonds Life insurance proceeds received as a result of the death of the corporate president Taxable income Example 31 $ 209,710

30,050 4,200 2,800 5,240 $ 252,000

(22,000) (110,000) $ 120,000

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

Corporations: Introduction and Operating Rules 54. Net income per books is reconciled to taxable income as follows: Net income per books (after tax) Plus: Items that decreased net income per books but did not affect taxable income: + Federal income tax liability + Excess of capital losses over capital gains + Prepaid rent + Interest paid on loan incurred to purchase tax-exempt bonds + Premiums paid on policy on life of president of the corporation Subtotal Minus: Items that increased net income per books but did not affect taxable income: Interest income from tax-exempt bonds Rent taxed in 2005 Life insurance proceeds received as a result of the death of the corporate president Excess depreciation Taxable income pp. 2-22, 2-23, and Example 31 55. $172,750

2-21

22,250 6,000 10,000 3,000 10,000 $ 224,000

(5,000) (15,000) (100,000) (4,000) $ 100,000

PGW will enter $120 million on Schedule M-3, Part I, line 4 (worldwide consolidated net income) and CGWs net income of $22 million on line 5a (net income from nonincludible foreign entities). This results in net income per income statement of includible corporations (Part 1, line 11) of $98 million. Example 33 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 $1,100,000 in column (c). Example 34 PGW must report the amortization on line 28, Part III as follows: $50,000 book amortization in column (a), $25,000 temporary difference in column (b), and $75,000 tax return amortization in column (d). This problem illustrates the Schedule M-3 reporting when book expenses are less than tax return deductions. It also illustrates the reporting of temporary differences. Example 35 These amounts must be reported on line 32, Part III as follows: $100,000 book bad debt expense in column (a), $75,000 temporary difference in column (b), and $25,000 tax return bad debt expense in column (d). This problem illustrates reporting procedures when book expenses are greater than tax return deductions. It also illustrates the reporting of temporary differences. Example 36 Organizational expenditures and start-up expenditures were incurred in January and February. The corporation can elect to expense the first $5,000 of qualifying expenditures and amortize the balance over a period of 180 months or more. Don and Steve should identify the organizational expenditures that qualify for this election, and decide whether to make the election.

56.

57.

58.

59.

Path: K:/TL-WFT-05-0802/Application/TL-WFT-05-0802-002_V2-SM.3d Date: 15th April 2006 Time: 18:56 User ID: 40223

2-22

2007 Corporations Volume/Solutions Manual The corporation must choose cost recovery methods and decide whether to elect immediate expensing under 179. It is also necessary to select an accounting method. The accrual method will be required for sales and purchases of inventory, but the hybrid method may be chosen as the overall method. This would allow use of the cash method for all items other than purchases and sales. The corporation has a great deal of flexibility in selecting a fiscal or calendar year. The golf retail business is generally seasonal in nature, so the corporation should consider electing a 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 the payment date is not changed, the deduction for bonuses will be disallowed, which could result 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 the 2007 Corporations Volume of the Instructor s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATE & TRUSTS.