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Interactive Self-Study CPE/CE Course

2013 Tax Year


Business
Entities
CPE/CE
4 Credit Hours
Corporations, Partnerships, & LLCs
TheTaxReview Business Entities Overview i
Business Entities Self-Study CPE/CE
Copyright 2013 Tax Materials, Inc.
All Rights Reserved
Course Overview
Program Content: This course provides continuing professional education (CPE/CE) for tax professionals to address taxation,
basis, and reporting issues for C corporations, S corporations, partnerships, and exempt organizations. Prob-
lems with organization and administration of these business entities are examined by use of court decisions
that illustrate how tax rules apply in real-life situations, with focus on distributions from the business entity
to individuals with an ownership interest.
Publication Date: September 2013.
Expiration Date: The Final Exam must be completed online within one year from your date of purchase or shipment. See
the Final Examination Instructions on the next page for information regarding nal exam completion.
Field of Study: Taxes.
Program Level: Overview. This course provides a general overview of the subject area from a broad perspective. It is
appropriate for tax professionals at all organization levels.
Recommended Participants: Tax professionals who prepare individual income tax returns are encouraged to participate in this course.
Prerequisites: Individuals who have prepared Form 1040 tax returns.
Advance Preparation: No advanced preparation is needed to complete this course.
Type of Delivery Method: Interactive self-study.
CPE/CE Credit Hours: 4 Credit Hours. One 50-minute period equals one CPE/CE Credit Hour.
Passing Grade: Participants who answer a minimum of 70% correct on the nal exam will receive a Certicate of Completion.
See the Final Examination Instructions on the next page for further information regarding passing require-
ments and acquiring the Certicate of Completion.
Record Retention: As an IRS-approved provider of continuing education, Tax Materials, Inc. will report successful completion
of this course to the IRS. According to the IRS, at some point in the future, you will be able to view your
completed continuing education credits through your online PTIN account.
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Tax Materials, Inc. is registered with the National Association of State Boards of Accountancy (NASBA) as
a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of
accountancy have nal authority on the acceptance of individual courses for CPE credit. Complaints regard-
ing registered sponsors may be submitted to the National Registry of CPE Sponsors through its website:
www.learningmarket.org. National Registry of CPE Sponsors ID Number 109322
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program sponsors may be submitted to NASBA through its website: www.learningmarket.org.
Our sponsor number is 054
In accordance with the standards set forth in Circular 230, section 10.6, CPE/CE credits have been granted
based on a 50-minute hour. IRS Program Number is 7VT8K-T-00004-13-S
Tax Materials, Inc. has been approved by the California Tax Education Council to offer the Business Entities
Self-Study CPE/CE Course 6193-CE-0010, which provides 4 hours of federal credit and 0 hours of state credit
towards the annual continuing education requirement imposed by the State of California. A listing of ad-
ditional requirements to register as a tax preparer may be obtained by contacting CTEC at P.O. Box 2890,
Sacramento, CA, 95812-2890, toll-free by phone at 1-877-850-2832, or on the internet at www.ctec.org.
CTEC Course ID Number 6193-CE-0010

ii Overview TheTaxReview Business Entities


Business Entities Self-Study CPE/CE
Helpful Hint: Attempt to relate your tax preparation experience with the information you are studying. By doing
so, you will increase retention and maximize your results. Also, utilize the Notes sections to jot down reminders
and information that will be helpful to you in your tax practice.
Follow the instructions below:
1) Start each chapter by reading the Learning Objectives.
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a) Key Facts: Information that is particularly pertinent to the Learning Objective.
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c) Notes: Many of the main points of the chapter are highlighted. Review the notes and try to relate the
content with your experience.
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answers to the correct ones on the pages that follow.
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TheTaxReview Business Entities Table of Contents iii
Learning Objectives / Table of Contents
Chapter
1 C Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1-A Dene requirements for nontaxable transfers to corporations under IRC section 351.
1-B Determine how recent court decisions affect treatment of loan disbursements and repayments to
Ccorporations.
1-C Determine whether distributions from C corporations are taxable or nontaxable.
2 S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2-A File Form 2553, Election by a Small Business Corporation, and apply the proper Revenue Procedure
to request relief for a late election.
2-B Compute taxable income from S corporation distributions and determine the effect on a
shareholders stock basis.
2-C Recognize the potential of S corporation termination because of shareholder revocation, failure of
qualication, or violation of passive income restrictions.
3 Partnerships and LLCs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
3-A Identify separately stated items of partnership income or loss and report those items properly on
Schedule K-1, Form 1065, U.S. Return of Partnership Income.
3-B Identify recourse and nonrecourse liabilities and determine the effect on a partner or LLC
members ownership basis.
3-C Determine gain or loss on current distributions or liquidating distributions made to a partner or LLC
member.
4 Exempt Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
4-A Determine whether an entity qualies as a tax-exempt organization under Internal Revenue Code
section 501(c)(3), based on organizational structure, operation, and purpose.
4-B Identify the ling requirements and required disclosures for a tax-exempt organization.
4-C Identify unrelated business income and requirements for ling Form 990-T, Exempt Organization
Business Tax Return.
Final Exam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
iv Table of Contents TheTaxReview Business Entities
TheTaxReview Business Entities Chapter 1 1
CPE/CE
Learning Objectives
Successful completion of this course will enable the participant to:
1-A Dene requirements for nontaxable transfers to corporations under IRC
section 351.
1-B Determine how recent court decisions affect treatment of loan disburse-
ments and repayments to C corporations.
1-C Determine whether distributions from C corporations are taxable or
nontaxable.
Glossary Terms
Section 351. If the conditions of IRC section 351 are met, no gain or loss results
when a person transfers property, including cash, to a C corporation.
Bona de loan. A loan involving a business entity and one of its owners must
have characteristics of an arms-length transaction, including a true debtor/
creditor relationship, to be recognized as a bona de loan for tax purposes.
Earnings and prots. An accounting concept used to determine the amounts
available for dividend distribution to shareholders of a C corporation. Distri-
butions up to the amount of a C corporations earnings and prots are gener-
ally taxable to the shareholders. Distributions in excess of earnings and prots
are treated as a return of capital.
Learning Objective 1-A
Dene requirements for nontaxable transfers to corporations under IRC
section 351.
General Rule for Contributions of Capital to a Corporation
Contributions to the capital of a corporation are paid-in capital. The contri-
butions, whether cash or property, are not taxable to the corporation. The na-
ture of the contribution will determine the basis for the corporation and the
shareholder.
Contributions of cash. A shareholder does not recognize gain or loss upon a
cash contribution in exchange for stock. The shareholders basis in stock is the
amount of cash contributed.
Contributions of property. The basis of property contributed to the capital of
a corporation is the same as the basis the shareholder had in the property,
increased by any gain the shareholder recognized on the exchange. This
amount is also the shareholders basis in the corporations stock. Exception:
See Nontaxable TransfersSection 351, page 2.
KEY FACT
1
C Corporations
2 Chapter 1 TheTaxReview Business Entities
NOTES Services in exchange for stock. The fair market value of services rendered
in exchange for corporate stock is taxable to the service provider. The taxable
amount is the shareholders basis in the stock.
Contributions by non-shareholders. Contributions to capital made by non-
shareholders (such as land contributed by a municipality) have a basis to the
corporation of zero. If a corporation receives a cash contribution from a person
other than a shareholder, the corporation must reduce the basis of any prop-
erty acquired with that contribution during the 12-month period following the
date of the contribution by the amount of the contribution (not below zero).
Nontaxable TransfersSection 351
General rule. No gain or loss shall be recognized if property is transferred
to a corporation by one or more persons solely in exchange for stock in such
corporation, and immediately after the exchange such person or persons are in
control of the corporation.
Alex transfers property worth $35,000 and renders services valued at $3,000
to a corporation in exchange for stock valued at $38,000. Right after the ex-
change, he owns 85% of the outstanding stock. No gain is recognized on the
exchange of the property under section 351. However, Alex recognizes ordi-
nary income of $3,000 as payment for services he rendered to the corporation.
Control dened. The term control means the ownership of stock possessing
at least 80% of the total combined voting power of all classes of stock entitled to
vote and at least 80% of the total number of shares of all other classes of stock
of the corporation.
Notes:
The term one or more persons may include individuals, trusts, estates, part-
nerships, associations, or corporations.
Money is treated as property for purposes of section 351.
Services do not qualify as property for purposes of section 351.
Technical know-how, such as trade secrets or processes, may be considered
property for purposes of section 351, depending on the importance of the
underlying services.
Bill and Gary buy property for $100,000, each contributing $50,000. Years later,
they organize a corporation and transfer the property to the corporation. The
property is the only capital contributed to the corporation. The fair market
value of the property at the time of the transfer was $300,000. Under section
351, no gain is realized on the transfer by Bill, Gary, or the corporation. Bill
and Gary each have a basis in the corporation of $50,000.
Te fair market value o services
rendered in echange for corporate
stock is taxable to the service
provider.
EXAMPLE
Te term control means the
ownership o stock posesing at least
80% o the toal combined voing
power o all clases o stock entitled
to voe and at least 80% o the toal
number o shares o all oher clases
o stock o the corporation.
EXAMPLE
TheTaxReview Business Entities Chapter 1 3
NOTES
Bill and Gary transfer property with a basis of $100,000 ($50,000 each) to a
corporation in exchange for stock with a fair market value of $300,000. This
represents 75% of each class of stock of the corporation, as the other 25% was
already issued to someone else. Because they did not meet the 80% owner-
ship threshold immediately after the exchange, Bill and Gary each recognize
a taxable gain of $100,000 (FMV of stock for each of $150,000 minus $50,000
basis of each).
Nonqualied transactions. Section 351 treatment does not apply to the fol-
lowing situations.
Transfers to investment companies.
Transfers in a bankruptcy or similar proceeding in exchange for stock used to
pay creditors.
Stock is received in exchange for the corporations debt or security interest in
the corporations debt.
Immediately after the exchange. Simultaneous exchanges are not necessary
to meet the qualications for purposes of section 351. Control of the corpora-
tion immediately after the exchange includes agreements where the rights
of the parties have been previously dened, and execution of the agreement
proceeds in a timely manner consistent with the agreement.
Transfer must be solely in exchange for stock. If the transferor receives prop-
erty other than stock in the exchange (referred to as boot), gain is realized
to the extent of the money or other property received. Boot includes debt
obligations issued by the corporation.
Nonqualied preferred stock. Transfer of nonqualied preferred stock is
treated as boot and does not count for purposes of the 80% control qualica-
tion for a section 351 transfer. The term nonqualied preferred stock means
preferred stock if:
The holder of the stock has the right to require the issuer or a related person
to redeem or purchase the stock,
The issuer or a related person is required to redeem or purchase the stock,
The issuer or a related person has the right to redeem or purchase the stock
and, as of the issue date, it is more likely than not that such right will be exer-
cised, or
The dividend rate on such stock varies in whole or in part (directly or indi-
rectly) with reference to interest rates, commodity prices, or other similar
indices.
Group control. A group of investors can combine to meet the 80% control
requirement. However, minimal transfers of property by shareholders do not
qualify if the reason is merely to qualify other individuals for a section 351
transfer. Regulations refer to property which is of relatively small value in
comparison to the value of the stock. Revenue Procedure 77-37 explains that
the property transferred will not be considered of relatively small value if the
EXAMPLE
KEY FACT
4 Chapter 1 TheTaxReview Business Entities
NOTES fair market value of the property transferred is equal to, or in excess of, 10%
of the fair market value of the stock and securities already owned (or to be re-
ceived for service) by such person.
Assumption of liabilities in a section 351 exchange. In most areas of tax law,
liability relief is treated the same as if cash had changed hands. However, in a
section 351 transfer, a corporation can assume liability without triggering gain
if the liability is less than the contributors adjusted basis. The shareholders
basis in stock is reduced by the amount of liability transferred.
If the liability assumed by the corporation is more than the contributing share-
holders adjusted basis, the excess is treated as gain.
BasisSection 351 Transfer
Shareholders Basis in Stock Corporations Basis in Property
Adjusted basis of property
+ Gain recognized
+ Cash paid
Cash received
FMV of property received
Liabilities transferred
Adjusted basis of property in hands of
the shareholder
+ Gain recognized by the shareholder on
the transfer
Alan transferred property to a corporation in a section 351 exchange. The
propertys FMV was $20,000, and Alans adjusted basis in the property was
$8,000. The property was subject to a liability of $6,000, which was transferred
to the corporation. Alans basis in the stock received is $2,000 ($8,000 adjusted
basis of property contributed minus $6,000 liability transferred).
Assume the same facts as Example #1, above, except the property was subject
to a liability of $10,000. Because Alans adjusted basis in the property was
$8,000, he would report a gain of $2,000 on the transaction. Alans basis in the
stock received would be $0.
Relief of liability not required to trigger gain. Assumption of liability by
the corporation does not necessarily mean the shareholder must be relieved
of liability. In Seggerman, the corporation assumed liabilities associated with
contributed assets. However, the taxpayers remained personally liable for the
debts as secondarily liable guarantors. The liability was greater than the ba-
sis of property contributed. Therefore, even though the taxpayers were not re-
lieved of liability, the amount was subtracted from basis and gain was recog-
nized. (Seggerman, 7th Cir., October 24, 2002)
Holding period. The holding period for stock received in a section 351 transfer
includes the time the shareholder held the property before the exchange. The
corporations holding period for the contributed property includes the time the
property was held by the shareholder.
EXAMPLE #1
EXAMPLE #2
Te holding period for stock received
in a section 351 transfer includes
the time the shareholder held the
property before the echange.
TheTaxReview Business Entities Chapter 1 5
NOTES
In Slota vs. Commissioner, taxpayers set up a corporation for their farming op-
eration. The taxpayers received income from crop sales and USDA payments
and deposited those elements of income into their personal account. They sub-
sequently transferred the income amounts to their corporate account. When
ling their tax return, the taxpayers assigned the income to their corporate
return, which, because of corporate expenses, resulted in zero taxable income
for the corporation. The taxpayers asserted they contributed the crops and
the USDA payments to the corporation and, therefore, the corporation earned
the income. The IRS contended the amounts transferred to the corporation
were income from personal business and not property and, therefore, should
be taxed as personal income instead of corporate income. The court agreed
with the IRS, stating the taxpayers failed to show they transferred the crops or
underlying land to the corporation. The taxpayers may not avoid paying tax on
income by transferring income to a newly organized corporation in a section
351 transaction. (Slota, T.C. Summary 2010-152).
Reporting a Section 351 Transfer
Both the corporation and every signicant transferor (stockholder who owns
either 5% or more of a public company or 1% or more of a privately held com-
pany) involved in a section 351 transfer must attach a statement to their income
tax returns.
Signicant transferor. A signicant transferor is anyone who transfers prop-
erty to a corporation under section 351, and if immediately after the exchange
owns at least 5% (by vote or value) of the total outstanding stock of a publicly
traded company, or at least 1% (by vote or value) of the total outstanding stock
of a privately held company.
Required statement. Every signicant transferor receiving stock in a section
351 exchange must attach to his or her tax return for the taxable year of the
exchange a statement detailing certain information regarding the exchange.
Corporations transferring stock must also attach a similar statement to their
tax return.
Filed with the shareholders return. Shareholders must attach a statement
to the income tax return for the taxable year of the exchange that contains the
following information.
1) Description of the property transferred in exchange for stock and the cost or
other basis of the property transferred.
2) With respect to stock received in the exchange, information on:
The kind of stock and preferences, if any,
The number of shares of each class received, and
The fair market value per share of each class at the date of the exchange.
3) With respect to securities received in the exchange, information on:
The principal amount and terms, and
The fair market value at the date of exchange.
4) The amount of money received, if any.
COURT CASE
Every signicant transferor receiving
stock in a section 351 echange
must atach to his or her tax return
for the taxable year o the echange
a statement detailing certain
information regarding the echange.
Corporations transfering stock must
also atach a similar statement to
their tax return.
6 Chapter 1 TheTaxReview Business Entities
NOTES 5) With respect to other property received:
A complete description of each separate item,
The fair market value of each separate item at the date of exchange, and
In the case of a corporate shareholder, the adjusted basis of the other prop-
erty in the hands of the controlled corporation immediately before the dis-
tribution of such other property to the corporate shareholder in connec-
tion with the exchange.
6) With respect to liabilities assumed by the corporation, information on:
The nature of the liabilities,
When and under what circumstances created,
The corporate business reason for assumption by the corporation, and
Whether such assumption eliminates the transferors primary liability.
Filed with the corporations return. Every corporation distributing stock in
a section 351 exchange must attach a statement to its income tax return for the
taxable year of the exchange that contains the following information.
1) A complete description of all property received from the transferors.
2) The basis of the exchanged property in the hands of the transferors on the
date of the exchange.
3) The following information with respect to the capital stock of the corporation:
The total issued and outstanding capital stock immediately prior to and
immediately after the exchange, with a complete description of each class
of stock,
The classes of stock and number of shares issued to each transferor in the
exchange, and the number of shares of each class of stock owned by each
transferor immediately prior to and immediately after the exchange, and
The fair market value of the capital stock as of the date of exchange which
was issued to each transferor.
4) The following information with respect to securities of the corporation:
The principal amount and terms of all securities outstanding immediately
prior to and immediately after the exchange,
The principal amount and terms of securities issued to each transferor in
the exchange, with information showing each transferors holdings of se-
curities of the corporation immediately prior to and immediately after the
exchange,
The FMV of the securities issued to the transferors on the date of the ex-
change, and
Information as to whether the securities issued in the exchange are subor-
dinated in any way to other claims against the corporation.
5) The amount of money, if any, which passed to each of the transferors in con-
nection with the transaction.
6) With respect to other property which passed to each transferor:
A complete description of each separate item,
The FMV of each separate item at the date of exchange, and
In the case of a corporate transferor, the adjusted basis of each separate
item in the hands of the corporation immediately before the distribution
of such other property to the corporate transferor in connection with the
exchange.
TheTaxReview Business Entities Chapter 1 7
NOTES 7) The following information as to the transferors liabilities assumed by the
corporation in the exchange:
The amount and a description of each liability,
When and under what circumstances created, and
The corporate business reasons for assumption by the corporation.
Learning Objective 1-B
Determine how recent court decisions affect treatment of loan
disbursements and repayments to C corporations.
C Corporation Loans to Shareholders
In many cases, little thought is given to tax consequences when a C corporation
advances or loans funds to a shareholder. Even when the transaction is intend-
ed as a loan, documentation is quite often lacking. Lack of proper documenta-
tion opens the door for the IRS to assert that the payment to the shareholder
was actually a disguised dividend or compensation, rather than a loan.
Even with clear documentation that the transaction is a loan, there can still be
unfavorable tax consequences when the terms of the loan are not followed or
too little or no interest is charged.
Shareholder Loans to C Corporation
When a shareholder invests in a C corporation, the investment is usually char-
acterized as a contribution to capital, which is not taxable to the corporation
nor deductible by the shareholder. Later withdrawals from the corporation are
typically treated as a dividend, taxable to the shareholder and not deductible
to the C corporation.
When a shareholder makes a loan to a C corporation, instead of a contribution
to capital, the following tax advantages are gained.
Repayment of the loan principal to the shareholder is nontaxable, as opposed
to a taxable dividend distribution. The shareholder pays no tax on the re-
payment received and the payment by the C corporation is not a deductible
expense. The shareholder is able to recover part of their investment in the
Ccorporation without triggering any taxes.
The interest payments to the shareholder are deductible by the C corpora-
tion. This allows a shareholder to withdraw cash from the corporation with-
out double taxation. The shareholder will pay income tax on the interest pay-
ments; however, the interest payment is not subject to payroll taxes.
IRS Market Segment Specialization Program Audit Technique
GuideShareholder Loans
The IRS issued Market Segment Specialization Program Audit Technique
GuideShareholder Loans to assist its examiners in auditing corporations to
determine whether a bona de shareholder loan exists. Although the guide
focuses on corporate loans to shareholders, many of the factors it considers in
determining whether an actual loan exists apply equally to shareholder loans
to corporations.
Even with clear documentation that
the transaction is a loan, there can
still be unfavorable tax consequences
when the terms o the loan are no
followed or too litle or no interest is
charged.
8 Chapter 1 TheTaxReview Business Entities
NOTES The guide directs the examiner to ask the question: is there a bona de debt?
The primary determination as to whether or not debt is a bona de debt hinges
on the question: When the loan was made, was there a genuine intent that
the borrowed funds be repaid? Over many years, a set of common law factors
has evolved. The guide recommends the following key determining factors be
considered.
The extent to which the shareholder controls the corporation.
Whether security was given.
Is the shareholder in a position to repay the loan?
Adequate earnings and prots.
Certicate of indebtedness is given to the corporation.
Is there a repayment schedule or an attempt to repay?
Is there a set maturity date?
Whether the corporation charges interest.
Whether the corporation has made systematic efforts to obtain repayment.
Magnitude of the advances.
Whether a ceiling exists to limit the amount the corporation can advance.
Dividend history of the company.
The guide instructs the reader to view the above factors as a whole. Any fac-
tor on its own is not determinative and the list is not all inclusive. The purpose
for analyzing the above factors is to determine the parties intent at the time of
distribution.
Is There a Debtor/Creditor Relationship?
The courts also focus on whether the parties to the transaction intended to cre-
ate a bona de debtor/creditor relationship. The courts have noted that wheth-
er the transfer of funds between a shareholder and a C corporation constitute
bona de debt is a question of fact which must be decided on the basis of all
relevant facts and circumstances in each case.
Shareholder loan to a C corporation. When presented with the issue of
whether a purported loan from a shareholder to a C corporation is debt or eq-
uity, the courts have generally weighed the following factors and provided the
following explanations:
Names given to the documents. The issuance of a stock certicate indicates a capi-
tal contribution. The issuance of a note is indicative of bona de debt. However,
in a closely held corporation, labels attached to transfers through bookkeeping
entries have limited signicance unless the labels are supported by objective
evidence.
Presence or absence of xed maturity date. The presence of a xed maturity date
indicates a xed obligation to repay, a characteristic of a debt obligation. The
absence of the same on the other hand would indicate that the repayment was
somehow tied to the fortunes of the business, indicative of an equity advance.
Source of repayments. If it is impossible to estimate when a monetary transfer
will be repaid because the repayment is contingent upon future prots, a cap-
ital investment is indicated. When a debtors repayment is contingent upon
earnings, the lender is acting more like a capital investor hoping to make a
Te primary determination as to
whether or no debt is a bona de
debt hinges on the question: When
the loan was made, was there a
genuine intent that the borowed
funds be repaid?
In a closely held corporation, labels
atached to transfers through
bookkeeping entries have limited
signicance unles the labels are
supported by obective evidence.
TheTaxReview Business Entities Chapter 1 9
NOTES prot, not as a creditor expecting to be repaid regardless of the companys suc-
cess or failure.
The right to enforce repayment. An essential element in determining whether a
shareholder intended to enforce repayment of the advance is whether a good-
faith intent on the part of the recipient of the funds to make repayment and
good-faith intent on the part of the shareholder to enforce payment exists.
Increase in management participation. If a shareholder makes a monetary transfer
to a corporation, and as a result receives an increased right to participate in the
management of the corporation, such participation tends to demonstrate that
the advance was not a bona de debt, but rather a capital investment.
Status equal to or inferior to other creditors. Whether a monetary transfer is sub-
ordinated to an outside creditor bears on whether a shareholder was acting as
a creditor or an investor. In addition, failure to demand timely repayment ef-
fectively subordinates the shareholder-corporation debt to the rights of other
creditors who receive payment in the interim.
Intent of the parties. The inquiry of a court in resolving the debt-equity issue is
primarily directed at ascertaining the intent of the parties.
Thinor adequate capitalization. A monetary transfer to a corporation appears
to be a capital contribution if the corporation is thinly capitalized. When look-
ing at a corporations debt to equity ratio, the courts typically look to industry
averages as a guide.
The identity of interest between creditor and shareholder. This factor generally com-
pares the equity ownership of stockholders with their position as creditors in
order to determine whether there is an identity of interest between the two
positions. This factor does not apply in sole shareholder situations.
Source of interest payments. This factor is essentially the same as the third factor,
the source of repayments. The focus, however, is on how the parties treated the
interest. A true lender is concerned with interest. When shareholders transfer
sums to a corporation and do not insist that the corporation make interest pay-
ments, it indicates that the shareholders expect to be paid out of future earn-
ings or through increased market value of their equity interest.
Ability to obtain loans from outside lending institutions. Would an outside lender
have loaned the funds in the same form and on the same terms? However, the
mere fact that a loan could not be obtained from an unrelated source does not
preclude the existence of a bona de loan.
Use of the funds by the corporation. Generally, the fact that an advance is used to
satisfy the daily operating needs of a corporation indicates a bona de indebt-
edness, whereas a monetary transfer resembles equity if it is used to acquire
capital assets.
Failure to repay on the due date. A true lender is also concerned with the repay-
ment of the loan. When a shareholder transfers funds to a corporation and
does not receive repayment on the due date, it indicates that the shareholder is
acting as an equity investor, not a lender.
10 Chapter 1 TheTaxReview Business Entities
NOTES
C corporation loan to a shareholder. When presented with the issue of wheth-
er a disbursement to a shareholder was a loan, a distribution, or compensa-
tion, the courts weigh many of the same factors listed on page 8. The critical
question is the same. What was the intent of the parties? Was there a genuine
intent that the borrowed funds would be repaid? Key factors the court consid-
ers include:
Whether the promise to repay is evidenced by a note or other instrument,
Whether interest was charged,
Whether a xed schedule for repayments was established,
Whether collateral was given to secure the loan,
Whether repayments were made,
Whether the shareholder had a reasonable prospect of repaying the loan
and whether the corporation had sufcient funds to advance the loan, and
Whether the parties conducted themselves as if the transaction were a loan.
Ernie is a shareholder of Power Wash, Inc., a C corporation. Ernie borrowed
$5,000 from Power Wash, Inc. and executed a promissory note for $5,000 with
5% interest. The note did not specify a maturity date or repayment amount.
Ernie and Power Wash, Inc. initiated bi-weekly payroll deductions of $100
per pay period that will pay off the loan within a couple of years. The lack of
maturity date or repayment schedule has generally not been held against a
taxpayer by the courts. The pattern of systematic payroll deductions and that
the loan will be repaid within a couple of years is evidence that the $5,000 is
a bona de debt.
Marcus is a shareholder of Painters, Inc., a C corporation. On December 1,
2013 Marcus borrowed $5,000 from Painters, Inc. and executed a promissory
note for $5,000 with 5% interest due on December 1, 2014. Marcus made no
interest or principal payments and on December 1, 2014 renewed the note
with Painters, Inc. for $5,000 plus the accrued interest of $250. The terms of
the renewed note are $5,250 principal, 5% interest, and due date of December
1, 2015. On December 1, 2015, Marcus again renewed the note, plus accrued
interest, for $5,512.50 principal, 5% interest, and due date of December 1, 2016.
The courts have viewed the pattern of setting a maturity date and annually
renewing the note, but never repaying the loan, indicative of a disguised divi-
dend and not a bona de debt.
KEY FACT
EXAMPLE
EXAMPLE
TheTaxReview Business Entities Chapter 1 11
NOTES
The taxpayers husband, who was deceased at the time of the court case,
was the sole shareholder of a C corporation. The taxpayers husband was the
key employee and responsible for managing the business. The taxpayer was
also employed by the corporation. The corporation had a line of credit from
an outside lender which was secured by all the companys assets, in addition
to property owned by the taxpayer and her husband. When the corporation
started having cash ow problems, it tried to obtain additional loans from the
outside lender. The outside lender declined to loan any additional funds until
the previous loans were repaid. The taxpayers husband then decided to use
personal funds to help his corporation and was advised by his CPA to treat
the advances as loans instead of capital investments. The taxpayers husband
also asked the taxpayer to loan funds to his corporation. The taxpayer was
hesitant as she knew the corporation was struggling nancially; however, she
believed, if necessary, her husband would repay the loans so she decided to
loan funds to the corporation.
The taxpayer and her husband made a number of loans to the corporation with
varying amounts of documentation. The in-house accountant was instructed
to record all advances from the personal accounts of the taxpayers husband
as shareholder loans on the corporate books, and the CPA also reported those
transactions as shareholder loans on the corporate income tax returns. Formal
loan documents were not executed for most of the transactions. The corpora-
tion did not make any payments on any of the funds advanced. No interest was
charged and no security was given for the shareholder loans. Also, prior to
the taxpayers husbands death, he did not seek repayment of the shareholder
loans. After the taxpayers husband died, the corporation ceased its opera-
tions. On the corporations nal tax return, it reported $218,489 as income from
forgiveness. The taxpayer led an amended tax return reporting a business
bad debt loss of $218,489 from the shareholder loans made. The IRS disallowed
the taxpayers ordinary loss treatment of the $218,489 business bad debt de-
duction and instead allowed the taxpayer a $218,489 capital loss.
The issue for the court to decide was whether the monetary transfers made
by the taxpayer and her husband to the corporation were capital contributions
or bona de debts. The court applied the factors listed in Shareholder loan to
a C corporation, page 8. The court noted a number of items that indicated the
advances were capital contributions and not bona de debt. No xed maturity
date existed and there was no xed repayment schedule. Despite knowing
the corporation was struggling, and that there was not sufcient cash ow to
repay them, the taxpayer and her husband advanced funds to the corporation.
Even though the notes were demand notes, the court found clear evidence
that the taxpayer and her deceased husband would not have demanded pay-
ment if it would have imperiled the nancial condition of the corporation, and
a demand for repayment or interest was never made. The court further noted
that the taxpayer and her deceased husband knew the extent of the corpora-
tions nancial problems and knew that transferring funds to the corporation
Continued on next page
COURT CASE
12 Chapter 1 TheTaxReview Business Entities
NOTES
Court Case continued
was risky. Knowing this, the taxpayer and her deceased husband still chose to
make the transfers. Although the transfers were treated as debt on the corpo-
rate books, the court did not believe the taxpayer and her husband intended,
or could have intended, the transfers to be bona de debt. The court held that
the transfers did not constitute bona de debt and should be treated as capital
contributions. (Tedford, T.C. Summary 2004-132)
The taxpayer was the sole shareholder and president of a C corporation. Dur-
ing the year, the taxpayer received a salary from the corporation. The taxpayer
also received miscellaneous checks totaling $72,000 from the corporation that
he did not report as income. The taxpayer treated the miscellaneous checks as
repayments of loans previously advanced to the corporation. The IRS argued
that the $72,000 of disbursements were dividend distributions and taxable to
the taxpayer.
The corporations tax return shows a zero balance on its balance sheet under
the item loans from shareholders. The corporation does maintain a handwrit-
ten ledger entitled shareholder cash loans to corporation which lists several
loans at various interest rates. None of the loans in the ledger are corroborated
by a formal promissory note with principal and interest rates corresponding
to the amounts recorded in the ledger.
The taxpayer presented, as evidence of his shareholder loans to the corpo-
ration, two promissory notes. A line of credit promissory note (rst note) for
$1,000,000, dated September 1, 1995, bearing interest at 5% and payable on
demand. This note lists the taxpayer as the borrower and the corporation as
the lender. The second promissory note (second note) dated March 22, 1996
was for $337,500, payable on demand, bearing interest at 9.5%, or 12% if pay-
ment is not made upon demand. The second note is unsecured and is not
listed in the corporations handwritten ledger of shareholder loans. Attached
to the second note is a copy of a personal note between the taxpayer and a
bank. The taxpayers bank loan is for the principal sum of $337,500, charges
interest identical to the second note but has a stated maturity of April 1, 1999,
and is secured by real estate owned by the taxpayer. The taxpayer stated
that he borrowed the funds from the bank to loan to the corporation since his
personal funds were depleted.
The court was not persuaded that the promissory notes presented by the
taxpayer represent true indebtedness of the corporation. The rst note clearly
states that the borrower is the taxpayer and the lender is the corporation.
The taxpayer argued that the names of the parties are reversed but there is
no record that links the rst note explicitly to any actual monetary advance
by the taxpayer to the corporation. Neither the corporation nor the taxpayer
presented any record for any alleged advancements, repayment or accruals
of interest regarding funds lent pursuant to the rst or second note. The notes
Continued on next page
COURT CASE
TheTaxReview Business Entities Chapter 1 13
NOTES
Court Case continued
are not listed in the corporations handwritten ledger or listed on the corpora-
tions balance sheet. The taxpayer was unable to substantiate the claim that
the $72,000 of miscellaneous checks received were repayments of loans or
that any loans existed from the taxpayer to the corporation.
Even if the taxpayer had presented consistent and credible evidence that the
cash repayments were repayments of prior loans to the corporation, the court
stated it would have concluded, based on the facts and circumstances of this
case, that those prior loans were in reality equity contributions and not debt.
The court applied the factors listed in Shareholder loan to a C corporation,
page 8. The court found the factors weighed in favor of reclassifying any al-
leged loans from the taxpayer to the corporation as equity investments. Also,
when comparing the second note to the taxpayers note with the bank, the
second note had no stated maturity date and was not secured, which put the
taxpayer in a riskier position than the bank. The court viewed this as further
supporting the argument of a capital contribution. The court concluded that
any alleged loans from the taxpayer to the corporation were equity contribu-
tions to risk capital rather than true debt. Thus the disbursements totaling
$72,000 were dividend distributions taxable to the taxpayer. (HJ Builders, Inc.,
T.C. Memo 2006-278)
The taxpayers were sole shareholders of two C corporations. Each corporate
balance sheet reported outstanding shareholder loans for the years in ques-
tion. When requested under audit, the taxpayers did not produce any written
agreements or promissory notes evidencing any of the amounts reported as
loans to or by the corporations. Neither taxpayer charged interest on any
amount lent to his or her separate corporation. None of the amounts reported
as loans were collateralized, and the amounts reported as repayments were
not made pursuant to a schedule or any other specic term. The taxpayers
and the corporations did not record the amount of any loan between them,
or otherwise keep track of it accurately. During the years under audit, the
taxpayers received distributions from their corporations which they recorded
as loan repayments. The IRS disagreed with the characterization, arguing that
all the distributions were actually constructive dividends.
The court agreed with the IRS. The court recognized that closely held corpo-
rations may sometimes be lax in formalizing their dealings with each other;
however, the court rejected the taxpayers claims as unsupported. The court
found the taxpayers did not establish their intent at the time of any of the dis-
tributions to be that the distribution was a repayment of a shareholder loan or
the making of a loan to a shareholder. At the time of any of the distributions,
the taxpayers failed to establish that the requisite bona de debtor/creditor
relationship existed. (Knutsen-Rowell, Inc. et al, T.C. Memo 2011-65)
COURT CASE
14 Chapter 1 TheTaxReview Business Entities
NOTES
Learning Objective 1-C
Determine whether distributions from C corporations are taxable or
nontaxable.
General Rules for Taxation of Non-Liquidating Distributions
C corporations may distribute money, stock, or other property to shareholders.
The following general rules hold for non-liquidating distributions.
Distributions of earnings and prots (E&P) are taxable to the recipient as
dividends.
Distributions in excess of E&P are nontaxable up to the amount of a share-
holders basis in the C corporation stock.
Distributions in excess of E&P, and in excess of a shareholders stock basis,
represent gain from the sale or exchange of property (capital gain). The hold-
ing period for long- or short-term treatment is determined by how long the
shareholder owned the stock.
The C corporation, not the shareholder, determines whether the distribution is
a dividend. The corporation les Form 5452, Corporate Report of Nondividend
Distributions, as part of making this determination. The corporation does not
deduct dividends paid to shareholders.
Earnings and Prots (E&P)
E&P is an accounting concept used for purposes of properly determining:
Taxable dividends.
Taxable distributions when a C corporation converts to an S corporation.
Taxable liquidation proceeds.
E&P is used to identify distributions that represent return on a shareholders
investment. Distributions in excess of E&P represent a return of capital.
Earnings and prots are composed of current-year E&P and accumulated E&P.
Note: E&P represents the amount that can be distributed to shareholders with-
out depleting capital. E&P is not the same as net income.
Current-year E&P. A worksheet for computing current-year E&P is provided
as part of Form 5452, Corporate Report of Nondividend Distributions. The general
idea is to determine how much money and property might be available for
distribution, without totally ignoring the effects of depreciation. Current-year
E&P can be computed using the following steps.
1) Compute current-year taxable income using the normal rules for income
and deductions, but without any Section 179 expense or depreciation deduc-
tions that may have been claimed on the tax return.
2) If the Section 179 expense was claimed on the tax return, compute deprecia-
tion on the affected asset over ve years using the straight-line method.
3) Compute all other depreciation using ADS life and straight-line method.
KEY FACT
KEY FACT
TheTaxReview Business Entities Chapter 1 15
NOTES 4) Add the following items to income.
Refunds of federal income tax received during the year.
Tax-exempt income, including nontaxable life insurance proceeds paid to
the C corporation.
Dividends received deductions used to compute taxable income.
Any carryovers used to compute current-year taxable income (such as NOL
deductions, excess charitable contributions, and capital losses).
Deferred gains on current-year installment sales.
Cancelled debt not included in current-year taxable income.
5) Subtract the following items from income.
Federal income taxes paid or accrued in the current year.
Expenses of producing tax-exempt income in the current year.
Any other current-year nondeductible items, such as nes, penalties, politi-
cal contributions and lobbying expenses, certain life insurance premiums,
including interest on debt, current excess capital losses, current excess
charitable contributions, and meals and entertainment expenses.
Note: The lists of additions and subtractions in the Internal Revenue Code and
Treasury Regulations are not comprehensive.
Accumulated E&P. Current-year E&P, if not distributed to shareholders, be-
comes accumulated E&P. Since distributions can be made in excess of current
E&P, it is possible for current E&P to be negative. Accumulated E&P is deter-
mined by the C corporation at the beginning of each tax year.
Nontaxable income earned by a C corporation increases E&P since it repre-
sents a shareholders return on investment.
Jill is the sole shareholder in Pail Corporation, a C corporation that manu-
factures buckets. Jills basis in her Pail Corporation stock is $55,000. In 2013,
Pail Corporation had E&P of $40,000 available for distribution, which includes
$2,400 in nontaxable municipal bond interest. Any 2013 distribution to Jill of
$40,000 or less will be fully taxable to her as dividends, even though the dis-
tribution could include E&P attributable to nontaxable bond interest.
Distributions less than current-year E&P. If total distributions during the
year do not exceed current-year E&P (calculated at the close of the year with-
out subtracting distributions made during the year), then all distributions
made during the year are treated as distributions of current-year E&P. Such
distributions are taxable to the shareholder as dividends.
Distributions in excess of current-year E&P. If total distributions for the
year exceed current-year E&P (calculated at the close of the year without sub-
tracting distributions made during the year), then part or all of each distribu-
tion is treated as a distribution of accumulated E&P. The portion attributable
to E&P is taxable to the shareholder as dividends. The calculation depends on
whether the C corporation has current-year E&P.
KEY FACT
EXAMPLE
16 Chapter 1 TheTaxReview Business Entities
NOTES
The corporation has current-year E&P. Allocate distributions for the year as
follows:
1) Divide current-year E&P by total distributions for the year. Since total
distributions exceed E&P, the result is a fraction less than one but greater
than zero.
2) Multiply each distribution made during the year by the fraction from the rst
step. The result is the amount of the distribution to be treated as having
come from current-year E&P. Starting with the rst distribution made during
the year, the remainder of each distribution will be treated as having come
from accumulated E&P.
The corporation does not have current-year E&P. Allocate distributions for
the year as follows:
1) If current-year E&P is less than zero, prorate the negative balance to the
date of each distribution made during the year. Skip this step if current E&P
is exactly zero.
2) Determine the available accumulated E&P for each distribution date during
the year by subtracting the amounts obtained in the rst step, if any. Treat
each distribution as a distribution from these adjusted accumulated E&P
amounts.
If the second step in either case reduces accumulated E&P to zero, then the
remaining part of each distribution reduces the adjusted basis of the stock
held by the shareholders. To the extent that the balance exceeds the adjusted
basis of the stock, it is treated as gain from the sale or exchange of property.
Jack is the sole shareholder in Pumper Corporation, a C corporation that makes
water pumps. At the beginning of 2013, Pumper Corporations accumulated
E&P is $20,000. During the year, the corporation made an $8,000 distribution to
Jack on June 30 and again on December 31. The treatment of the $16,000 total
2013 distributions depends on whether Pumper Corporation had E&P in 2013.
Case #1: Suppose Pumper Corporations 2013 E&P is $10,000.
1) Current-year E&P divided by distributions is $10,000 $16,000, or 0.625.
2) Each $8,000 distribution consists of $5,000 ($8,000 0.625) in current-year
E&P and $3,000 in accumulated E&P.
Pumper Corporation has distributed all of its current-year E&P and $6,000 of
its accumulated E&P. The remaining $14,000 of accumulated E&P is available
for distribution in future years. Continued on next page
CASE #1
CASE #2
EXAMPLE
TheTaxReview Business Entities Chapter 1 17
NOTES
Example continued
Case #2: Suppose Pumper Corporations 2013 E&P is ($14,000), that is, negative
$14,000.
1) ($14,000) is prorated by assigning ($7,000) to each distribution date.
2) Determine the available accumulated E&P on each distribution date as
follows:
June 30, 2013 Distribution:
Accumulated E&P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000
Prorated current-year E&P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,000)
Accumulated E&P available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000
Amount of distribution treated as dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,000)
December 31, 2013 Distribution:
Accumulated E&P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000
Prorated current-year E&P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,000)
Accumulated E&P available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)
Amount of distribution treated as dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0
Nondividend amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000
2013 year-end accumulated E&P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)
The nondividend amount paid on December 31 is nontaxable to the extent that
it does not exceed Jacks basis in Pumper Corporations stock. The amount
in excess of his basis, if any, is treated as gain from the sale or exchange of
property.
In Case #2 of the example, above, suppose Jacks basis in Pumper Corpora-
tions stock is $5,500. The $16,000 distributed to Jack in 2013 consists of an
$8,000 dividend, $5,500 return of capital, and $2,500 gain from the sale or ex-
change of property. Jacks stock basis is reduced to zero.
Constructive Dividends
The IRS may examine C corporations with E&P and reclassify distributions
to shareholders as constructive dividends. Often the IRS must rst determine
that amounts paid by the corporation (or not paid by a shareholder) are actu-
ally distributions instead of corporate expenses. The corporation does not de-
duct constructive dividends.
If distributions made to a shareholder have previously been reported as non-
taxable to the shareholder, amounts reclassied as constructive dividends
become taxable to the shareholder.
The following examples illustrate how constructive dividends can occur.
Below-market loans. The corporation lends money to a shareholder but charg-
es interest below the applicable federal rate, or no interest at all. The amount
of interest that should have been charged may be treated as a distribution to
the shareholder.
EXAMPLE
KEY FACT
18 Chapter 1 TheTaxReview Business Entities
NOTES Cancellation of shareholder debt. The corporation cancels a debt owed to the
corporation by a shareholder. The amount cancelled is treated as a distribu-
tion to the shareholder.
Transfers of property for less than fair market value. The corporation sells, ex-
changes, or otherwise transfers property to a shareholder, but the sharehold-
er pays less than the FMV of the property. If the shareholder is not a corpora-
tion, the excess of FMV over price paid may be treated as a distribution to the
shareholder.
Unreasonable rents. The corporation rents property from a shareholder, but
the amount of rent is unreasonably more than the shareholder would charge
an unrelated party. The excessive part of the rent may be treated as a distribu-
tion to the shareholder.
Unreasonable salaries. The corporation pays an employee who is also a share-
holder a salary that is unreasonably high in relation to the services actually
performed by the shareholder-employee. The excessive part of the wages
may be treated as a distribution to the shareholder.
Personal expenses. The corporation pays a shareholders personal expenses or
otherwise fails to meet the requirements for deducting expenses paid in be-
half of a shareholder. The amount paid may be treated as a distribution to the
shareholder.
During the tax years 2003 2005, a C corporation paid and deducted all the
expenses and reported the income from an activity that the Tax Court deter-
mined was the sole shareholders hobby. The hobby activity existed before the
corporation was formed and was unrelated to the business of the corporation.
Not only were the hobby expenses disallowed as an expense to the corpora-
tion, but the amounts paid by the corporation were reclassied by the IRS as
constructive dividends to the shareholder.
The Court also determined that the corporations prot-sharing plan did not
constitute a qualied prot-sharing plan under IRC section 401(a). Contribu-
tions made by the corporation to the plan during the years in question were not
deductible by the corporation, but were reclassied as constructive dividends
to the shareholder.
In each of the years under examination, the corporation paid wages to a friend
of the shareholder in connection with the hobby activity. Those wages became
part of the constructive dividends. The potential existed for the wage amounts
to be taxed three times: to the corporation (since the deduction for the wages
was disallowed), to the shareholder (as constructive dividends), and to the
friend (as wages). The Court did not address this possibility. (DKD Enterprises,
T.C. Memo 2011-29)
General Rule for Distributions of Stock and Stock Rights
Distributions by a C corporation of its own stock (stock dividends) and rights
to acquire corporate stock (stock options) are generally not taxable to the
recipient and are not reported on the recipients tax return.
COURT CASE
TheTaxReview Business Entities Chapter 1 19
NOTES Exceptions: Distributions of stock dividends and stock options are taxable to the
recipient when the effect on all shareholders is not uniform. This will occur if
any of the following apply.
The recipient or any other shareholder has the choice to receive cash or other
property instead of the stock or stock rights.
The distribution gives cash or other property to some shareholders and an
increase in percentage interest in corporate assets or E&P to other share-
holders, or the distribution is convertible preferred stock with the same end
results.
The distribution gives preferred stock to some common stock shareholders
and common stock to other common stock shareholders.
The distribution is on preferred stock, with certain exceptions.
The basis of stock dividends or options received from a C corporation in a
taxable distribution is their fair market value on the date distributed. The basis
of stock owned by the shareholder before the distribution does not change.
Distributions in Redemption of Stock
When a C corporation makes a distribution in full or partial redemption for
stock, the shareholder reports the distribution as a sale of the stock.
Liquidating Distributions
Distributions made during a C corporations partial or complete liquidation
are not made out of E&P but are at least partly return of capital. Liquidating
distributions reduce shareholder basis in corporate stock.
Relationship of liquidating distributions to shareholder basis.
If the shareholders basis is less than the amount of liquidating distribution,
the difference is a capital gain.
If the shareholders basis equals the liquidating distribution, no gain or loss
is recognized by the shareholder.
If the shareholders basis is more than the liquidating distribution, the share-
holder may have a capital loss. The loss can be reported on the shareholders
tax return only after the nal distribution has been received, resulting in the
redemption or cancellation of the stock.
A shareholder was able to prove to the Tax Court that a distribution of Ccor-
poration property was received in a de facto liquidation rather than as a non-
liquidating distribution. Even though the shareholder had failed to report the
distribution on his original tax return, he was able to treat the distribution as a
redemption of his corporate stock. He was allowed capital gain treatment for
the amount in excess of his stock basis, resulting in a considerably smaller de-
ciency than originally determined by the IRS. (Rendina, T.C. Memo 1996-392)
KEY FACT
COURT CASE
20 Chapter 1 TheTaxReview Business Entities
NOTES
Chapter 1 Self-Quiz
Instructions
Test your knowledge and comprehension of information presented in Chapter 1.
True/False
1) Mark transferred property to a corporation and immediately after the ex-
change his percentage of stock ownership was exactly 80%. Marks owner-
ship percentage meets the control test for purposes of section 351.
True False
2) When a shareholder makes a loan to a C corporation instead of an equity
contribution, certain tax advantages are gained.
True False
3) A shareholder les Form 5452, Corporate Report of Nondividend Distributions,
in order to determine how a distribution from a C corporation is to be taxed
on his or her personal return.
True False
Multiple Choice
1) For each of the following scenarios, the transfer qualies under section 351.
Which of the following statements about transfers to a corporation is true?
a) Fred transfers property with a FMV of $50,000 and a basis of $20,000.
Freds basis in the stock is $50,000.
b) Wilma transfers cash in the amount of $100,000 and services valued at
$20,000 in exchange for stock valued at $120,000. Wilmas basis in the stock
is $100,000.
c) Barney transfers property with a FMV of $50,000, basis of $20,000, and debt
on the property of $15,000 to a corporation. Barneys basis in the stock is
$35,000.
d) Betty transfers property with a FMV of $40,000, basis of $30,000, and debt
on the property of $10,000 to a corporation. In addition, she transfers
$10,000 cash. Bettys basis in the stock is $30,000.
2) All the following factors are considered when evaluating whether a share-
holder loan to a C corporation has the characteristics of a bona de debt or
an equity contribution except:
a) Intent of the parties.
b) Absence of a xed maturity date.
c) Failure to pay on the due date.
d) The management position of the shareholder.
TheTaxReview Business Entities Chapter 1 21
NOTES 3) Stan is the sole shareholder in QRS Corporation, a C corporation that does
plumbing repairs. His basis in company stock is $21,500. In June 2013, Stan
received a distribution of $10,000 from QRS Corporation. In December 2013,
the corporation forgave a loan of $15,000 made to Stan so he could buy a boat.
QRS Corporation had $17,000 E&P available for distribution in 2013. What
does Stan report on his individual tax return? What are his basis in QRS
Corporation stock and QRS Corporations E&P at the beginning of 2014?
a) Stan reports $17,000 in dividends and reduces his basis in QRS Corpora-
tion stock to $13,500. QRS Corporations E&P at the beginning of 2014 is $0.
b) Stan reports $10,000 in dividends and reduces his basis in QRS Corpora-
tion stock to $6,500. QRS Corporations E&P at the beginning of 2014 is
$7,000.
c) Stan reports $25,000 in dividends and increases his basis in QRS Corpora-
tion stock to $29,500. QRS Corporations E&P at the beginning of 2014 is $0.
d) Stan reports $21,500 in dividends and reduces his basis in QRS Corpo-
ration stock to $0. QRS Corporations E&P at the beginning of 2014 is
$13,500.
22 Chapter 1 TheTaxReview Business Entities
NOTES
Chapter 1 Self-Quiz Answers
True/False
1) Mark transferred property to a corporation and immediately after the ex-
change his percentage of stock ownership was exactly 80%. Marks owner-
ship percentage meets the control test for purposes of section 351.
True Correct. Under section 351, control means ownership of 80%
or more of the corporations stock.
False Incorrect. Under section 351, control means ownership of 80%
or more of the corporations stock. The percentage of ownership
does not need to be greater than 80%.
2) When a shareholder makes a loan to a C corporation instead of an equity
contribution, certain tax advantages are gained.
True Correct. The repayment of loan principal is a nontaxable event.
The shareholder pays no tax on the repayment of loan princi-
pal, and the payment by the C corporation is not a deductible
expense. Making a loan instead of an equity contribution allows
the shareholder to recover part of their funds advanced to the
Ccorporation without triggering any taxes.
False Incorrect. Withdrawals from a C corporation are typically treat-
ed as dividends, taxable to the shareholder and not deductible
by the C corporation. When funds advanced to a C corporation
are treated as a loan instead of an equity contribution, the prin-
cipal repayments are tax-free and the payment of interest is a
means to withdraw cash from the C corporation without double
taxation.
3) A shareholder les Form 5452, Corporate Report of Nondividend Distributions,
in order to determine how a distribution from a C corporation is to be taxed
on his or her personal return.
True Incorrect. Form 5452 includes the corporations calculation of earn-
ings and prots. This form is led by the C corporation, not by
shareholders.
False Correct. The classication of distributions is done at the corpo-
rate level, not at the individual level.
Multiple Choice
1) For each of the following scenarios, the transfer qualies under section 351.
Which of the following statements about transfers to a corporation is true?
a) Fred transfers property with a FMV of $50,000 and a basis of $20,000. Freds
basis in the stock is $50,000.
Incorrect. Freds basis in the stock is the same basis he had in the property
transferred. Freds basis is $20,000.
TheTaxReview Business Entities Chapter 1 23
NOTES b) Wilma transfers cash in the amount of $100,000 and services valued at
$20,000 in exchange for stock valued at $120,000. Wilmas basis in the stock
is $100,000.
Incorrect. The fair market value of services Wilma provides in exchange
for stock is taxable to Wilma. The taxable amount is included in
the basis of the stock. Her basis is $120,000 ($100,000 cash plus
$20,000 services).
c) Barney transfers property with a FMV of $50,000, basis of $20,000, and debt
on the property of $15,000 to a corporation. Barneys basis in the stock is
$35,000.
Incorrect. Liabilities transferred reduce the basis of the stock. Barneys ba-
sis is $5,000 ($20,000 basis in the property minus $15,000 debt).
d) Betty transfers property with a FMV of $40,000, basis of $30,000, and debt on
the property of $10,000 to a corporation. In addition, she transfers $10,000
cash. Bettys basis in the stock is $30,000.
Correct. Bettys basis is the original basis of the property minus the lia-
bility transferred plus the cash transferred. ($30,000 basis minus
$10,000 debt = $20,000 plus $10,000 cash).
2) All the following factors are considered when evaluating whether a share-
holder loan to a C corporation has the characteristics of a bona de debt or
an equity contribution except:
a) Intent of the parties.
Incorrect. The intent of the shareholder and the C corporation at the time
the loan is made is one of the primary factors in determining
whether or not the debt is a bona de debt.
b) Absence of a xed maturity date.
Incorrect. The absence or presence of a xed maturity date is a factor that
is considered. The presence of a xed maturity date is a charac-
teristic of debt obligations, while the absence of a xed maturity
date is indicative of an equity contribution.
c) Failure to pay on the due date.
Incorrect. One of the factors considered is whether the loan is repaid on
the due date. A true lender is concerned with the repayment of
the loan. When a shareholder does not receive repayment on
the due date, it indicates the shareholder is acting as an equity
investor, not a lender.
d) The management position of the shareholder.
Correct. The management position of a shareholder is not a factor con-
sidered in evaluating shareholder loans. However, increased
management rights given to a shareholder as a result of a loan is
one of the factors. The increased right to participate in manage-
ment tends to demonstrate that the advance was not a bona de
debt but an equity contribution.
24 Chapter 1 TheTaxReview Business Entities
NOTES 3) Stan is the sole shareholder in QRS Corporation, a C corporation that does
plumbing repairs. His basis in company stock is $21,500. In June 2013, Stan
received a distribution of $10,000 from QRS Corporation. In December 2013,
the corporation forgave a loan of $15,000 made to Stan so he could buy a boat.
QRS Corporation had $17,000 E&P available for distribution in 2013. What
does Stan report on his individual tax return? What are his basis in QRS
Corporation stock and QRS Corporations E&P at the beginning of 2014?
a) Stan reports $17,000 in dividends and reduces his basis in QRS Corpora-
tion stock to $13,500. QRS Corporations E&P at the beginning of 2014 is $0.
Correct. QRS Corporations forgiveness of Stans debt is treated as a dis-
tribution. Thus Stans distributions for 2013 total $25,000. The
rst $17,000 is a distribution of E&P and is taxable as dividends.
QRS Corporations E&P is now reduced to zero. The remaining
$8,000 reduces Stans stock basis from $21,500 to $13,500.
b) Stan reports $10,000 in dividends and reduces his basis in QRS Corpora-
tion stock to $6,500. QRS Corporations E&P at the beginning of 2014 is
$7,000.
Incorrect. The $10,000 distribution is taxable as dividends and reduces
E&P to $7,000. But the debt forgiveness must also be treated as
a distribution. Distributions are applied rst against E&P and
then against stock basis. This incorrect calculation erroneously
applied the $15,000 debt forgiveness against stock basis rst.
c) Stan reports $25,000 in dividends and increases his basis in QRS Corpora-
tion stock to $29,500. QRS Corporations E&P at the beginning of 2014 is $0.
Incorrect. The $15,000 debt forgiveness is treated as a distribution. Stans
total distributions are $25,000, which is $8,000 more than QRS
Corporations E&P. Distributions are taxable as dividends up to
the amount of E&P. The excess should be subtracted from corpo-
rate stock basis, not added.
d) Stan reports $21,500 in dividends and reduces his basis in QRS Corpora-
tion stock to $0. QRS Corporations E&P at the beginning of 2014 is $13,500.
Incorrect. QRS Corporations forgiveness of Stans debt is treated as a dis-
tribution. Thus Stans distributions for 2013 total $25,000. Distri-
butions are taxable as dividends up to the amount of E&P. This
incorrect calculation erroneously applied the distributions to
stock basis rst and subtracted the $3,500 difference from E&P.
TheTaxReview Business Entities Chapter 2 25
CPE/CE
2
S Corporations
Learning Objectives
Successful completion of this course will enable the participant to:
2-A File Form 2553, Election by a Small Business Corporation, and apply the
proper Revenue Procedure to request relief for a late election.
2-B Compute taxable income from S corporation distributions and determine
the effect on a shareholders stock basis.
2-C Recognize the potential of S corporation termination because of share-
holder revocation, failure of qualication, or violation of passive income
restrictions.
Glossary Terms
One-class-of-stock rule. To qualify for S corporation status, the corporation
may have only one class of stock with regard to rights to dividends and liquida-
tion proceeds.
Accumulated adjustments account (AAA). An S corporation account that
represents the accumulation of undistributed S corporation income.
Other adjustments account. An S corporation account that tracks tax-exempt
income and related expenses, and federal taxes.
Learning Objective 2-A
File Form 2553, Election by a Small Business Corporation, and apply the
proper Revenue Procedure to request relief for a late election.
General Rules for Filing Form 2553
An eligible corporation makes the election to be taxed as an S corporation by
ling Form 2553, Election by a Small Business Corporation. The effective date of
the election is indicated on line E, Form 2553.
Form 2553 must be completed and led no later than two months and 15 days
after the rst day of the tax year the election is to take effect (March 15 for a
calendar year corporation).
An existing corporation may le Form 2553 at any time during the tax year
immediately preceding the date the election is to take effect.
Each shareholder who owns stock on the date the election is led must con-
sent to the election and sign Form 2553 or separate consent statement. If Form
2553 is led on or after the effective date, all shareholders who owned stock at
any time between the effective date and date of ling must consent and sign.
There are special signature rules for shareholders who are minor children,
estates or trusts, and those with community, joint, or other shared interest.
26 Chapter 2 TheTaxReview Business Entities
NOTES
Cue Corporation has been in existence for ten years and qualies to make the
S corporation election. Cue Corporation has a window of 14 months and 15
days in which to make the election. (12 months preceding the effective date
and the two months and 15 days after the effective date).
Exceptions to General Rules for Filing Form 2553
An eligible non-corporate entity (such as a partnership or LLC) may elect to be
taxed as an S corporation. Such an entity that les Form 2553 is deemed also to
have made the election to be taxed as a corporation. This eliminates the need to
le Form 8832, Entity Classication Election.
IRS procedures may allow a late election when a corporation (or non-corporate
entity electing to be taxed as a corporation) misses the deadline for ling Form
2553.
Who May File Form 2553 and Elect S Corporation Status?
A corporation (or other eligible entity) may le Form 2553 to elect be an S cor-
poration only if it meets all the following tests.
It is a domestic corporation (or a domestic entity eligible to elect treatment as
a corporation). Individual shareholders may not be resident aliens.
It has no more than 100 shareholders, limited to individuals, estates, and cer-
tain tax-exempt organizations and trusts. All members of a family and their
estates may be treated as one shareholder. A family is dened as a common
ancestor and all lineal descendents, together with current and former spous-
es of the common ancestor and the lineal descendents.
It has only one class of stock, disregarding differences in voting rights. Gener-
ally this requirement is met if all outstanding shares of corporate stock con-
fer to all the shareholders identical rights to any distribution and liquidation
proceeds.
It is not one of the following ineligible corporations.
1) An insurance company.
2) A nancial institution that uses the reserve method of accounting for bad
debts.
3) A DISC or former DISC (domestic international sales corporation).
4) A corporation claiming the Puerto Rico and possessions tax credit.
Examples of eligible shareholders. The following may be S corporation
shareholders: individuals who are U.S. citizens or residents, decedents es-
tates, bankruptcy estates, 501(c)(3) organizations, employee stock option plans,
qualied pension plans and qualied prot-sharing plans, qualied subchap-
ter Strusts (QSSTs), and electing small business trusts (ESBTs).
Examples of ineligible shareholders. The following may not be S corpora-
tion shareholders: partnerships, corporations (including single-member LLCs
electing to be taxed as corporations), charitable remainder trusts, IRAs, SEPs,
SIMPLE plans, and state and local governments.
EXAMPLE
An eligible non-corporate entity
(such as a partnership or LLC) may
elect to be taxed as an S corporation.
TheTaxReview Business Entities Chapter 2 27
NOTES
A timely-led Form 2553 is generally mailed or faxed directly to the IRS. Ad-
dresses and fax numbers are provided in the instructions for Form 2553. Proof
of mailing or fax should be retained. The IRS will notify the corporation whether
the election has been accepted and when it will take effect.
Relief for Late S Corporation Elections
If Form 2553 is led more than two months and 15 days after the rst day of the
tax year, it is late and the election generally will be effective for the following
tax year. Relief for a late S corporation election (and entity classication elec-
tion, if applicable) may be available if the corporation can show that failure to
le on time was due to a reasonable cause. Form 2553 includes a section for
describing the reasonable cause. If an otherwise eligible corporation fails to
meet any requirements discussed, below, relief for a late S corporation election
may be available under other Revenue Procedures or through a Private Letter
Ruling.
No Form 2553; Form 1120S Not Filed (Rev. Proc. 2007-62)
This simplied method applies only for elections effective for tax years ending
on or after December 31, 2007, and when no more than six months have passed
since the unextended due date for the initial Form 1120S.
Revenue Procedure 2007-62 allows a qualifying corporation (or other eligible
entity) to request simultaneous relief for a late S corporation election and for a
late entity classication election, if applicable, when the elections are intended
to be effective on the same date.
All the following requirements must be met.
1) The corporation (or other eligible entity) has not yet led a tax return for the
tax year beginning on the date indicated on Form 2553.
2) The corporation (or other eligible entity) fails to qualify for S corporation
election and, if applicable, for election to be taxed as a corporation solely
because Form 2553 was not timely led.
3) The corporation (or other eligible entity) has reasonable cause for its failure
to timely make the election.
4) No taxpayer whose liability would be affected by the S corporation election
has reported inconsistently with the S corporation election.
5) No more than six months have passed since the unextended due date of
Form 1120S for the tax year beginning on the date indicated on Form 2553.
Requesting relief and making the election. The request for relief is made by
ling a completed Form 2553 as an attachment to the corporations (or other
eligible entitys) initial Form 1120S.
This must be done no later than six months after the due date of the initial
Form 1120S (excluding extensions).
Form 2553 includes space for an explanation of the reasonable cause. No ad-
ditional statements or attachments are required.
KEY FACT
If Form 2553 is led more than two
months and 15 days afer the rst
day o the tax year, it is late and the
election generally will be eective for
the following tax year.
28 Chapter 2 TheTaxReview Business Entities
NOTES
Tar-Dee LLC uses a calendar year and wants to be taxed as an S corporation.
Tar-Dee LLC meets all the requirements for electing to be taxed as a corpora-
tion and for electing S corporation status, and has selected March 1, 2013 as
the date the election is to take effect. Tar-Dee LLC fails to le Form 2553 by
the due date of May 15, 2013 because the members thought their lawyer was
ling the form. In thinking the lawyer had led Form 2553, Tar-Dee LLC has
reasonable cause for its failure to timely le Form 2553. Tar-Dee LLC may use
the procedures of Revenue Procedure 2007-62 by ling its initial Form 1120S
and Form 2553 no later than September 15, 2014. If Tar-Dee LLC les these
forms after March 15, 2014 without rst obtaining an extension of time to le
Form 1120S, the usual late-ling penalties will apply.
Late Election Relief: No Form 2553, but Form 1120S Filed
If Form 1120S has been led without an S corporation election, relief for a late
election may be available. Two cases are described here. The procedures for re-
questing relief and making the election are the same for both situations.
Form 1120S Filed, No IRS Complaints (Rev. Proc. 97-48)
An otherwise eligible corporation that has not led Form 2553, but has been
ling Form 1120S without IRS complaint, can receive automatic relief under
Revenue Procedure 97-48. All the following requirements must be met.
1) The corporation has led Form 1120S consistent with the intent to be an
Scorporation.
2) The corporation fails to qualify as an S corporation solely because Form 2553
was not timely led.
3) The corporation has reasonable cause for its failure to timely make the
election.
4) No taxpayer whose liability would be affected by the S corporation election
has ever reported inconsistently with the S corporation election.
5) Neither the corporation nor any of its shareholders received notication
from the IRS regarding any problem with S corporation status within six
months of the date on which the initial Form 1120S was timely led.
Form 1120S Filed, IRS Notice Received (Rev. Proc. 2003-43)
An otherwise eligible corporation that has not led Form 2553, but has led
Form 1120S, may be able to request relief under Revenue Procedure 2003-43
even if an IRS notice regarding S corporation status has been received. All the
following requirements must be met.
1) The initial form 1120S was led within six months of the original unextended
due date.
2) The corporation fails to qualify as an S corporation solely because Form 2553
was not timely led.
3) The corporation has reasonable cause for its failure to timely make the
election.
EXAMPLE
If Form 1120S has been led without
an S corporation election, relief for a
late election may be available.
TheTaxReview Business Entities Chapter 2 29
NOTES 4) No taxpayer whose liability would be affected by the S corporation election
has ever reported inconsistently with the S corporation election.
5) Less than 24 months have passed since the original due date of Form 2553.
Requesting relief and making the election. In both cases, the request for re-
lief is made by ling a completed Form 2553 at any time during the period that
the corporation intended to be an S corporation (Rev. Proc. 97-48), or within 24
months of the original due date for Form 2553 (Rev. Proc. 2003-43).
As applicable, write at the top of Form 2553 Filed Pursuant to Rev. Proc.
97-48 or Filed Pursuant to Rev. Proc. 2003-43.
Describe the reasonable cause in the space provided on Form 2553.
Form 2553 must be signed by a corporate ofcer and by each shareholder
who owned shares at any time during the period that the corporation in-
tended to be an S corporation.
Attach a declaration signed by a corporate ofcer stating that the corporation
intended to be an S corporation.
Attach a declaration signed by each shareholder stating that the shareholder
reported income on all affected returns consistent with S corporation status
for all affected years.
The signed declarations must state Under penalties of perjury, to the best of my
knowledge and belief, the facts presented in support of this election are true, correct,
and complete.
Private Letter Ruling Option
If none of the Revenue Procedures applies, or if the IRS has denied a corpora-
tions request for relief for a late election, a Private Letter Ruling may be re-
quested. Any request for a Private Letter Ruling must be accompanied by the
appropriate user fee. User fees for requests begin at $275. When the corpora-
tion is selecting a non-calendar tax year as part of the late election ruling, ad-
ditional fees may apply. Relief obtained under any of the Revenue Procedures
does not involve a user fee.
Learning Objective 2-B
Compute taxable income from S corporation distributions and determine
the effect on a shareholders stock basis.
S Corporation Distributions
Generally, S corporation distributions, with the exception of taxable dividend
distributions, are considered a return of capital and reduce a shareholders ba-
sis in the stock of the corporation. The part of any distribution that is more than
the shareholders basis is treated as a gain from the sale or exchange of prop-
erty. The corporations distributions may be in the form of cash or property.
S corporation distributions are not treated as dividends except in certain cases
in which the corporation has accumulated earnings and prots from years be-
fore it becomes an S corporation. Accumulated earnings and prots generally
represent earnings that were taxed to the C corporation but were never distrib-
uted to the shareholders.
If none o the Revenue Procedures
applies, or if the IRS has denied a
corporations request for relief for a
late election, a Private Leer Ruling
may be requested.
Accumulated earnings and prots
generally represent earnings that
were taxed to the C corporation
but were never distributed to the
shareholders.
30 Chapter 2 TheTaxReview Business Entities
NOTES
S Corporation Shareholder Stock Basis
An S corporation shareholders basis determines the following.
1) The allowance of nontaxable distributions of cash or property, and
2) The deductibility of ow-through losses and deductions.
A shareholders stock basis is increased by:
Stock purchases and additional contributions.
Flow-through income, including tax-exempt income.
Stock basis is decreased by:
Distributions of cash or property.
Flow-through losses.
Flow-through deductions.
Nondeductible corporation expenses.
A shareholders stock basis can never be reduced below zero. Any losses in-
curred while the shareholders basis is zero are suspended until basis is restored.
Basis of S Corporation Stock Upon Conversion From C Corporation
The basis of a C corporation shareholders stock becomes the beginning basis
in stock when the corporation converts to S status. Earnings and prots carried
over from a C corporation do not add to basis. In some cases, it may be advan-
tageous to distribute E&P before converting to S status. See Deemed Dividends,
page 33.
S Corporations With No Earnings and Prots
All distributions from an S corporation are treated as return of capital if the
Scorporation has no earnings and prots. An S corporation will generally not
have earnings and prots unless the corporation was once a C corporation. An
S corporation may also have earnings and prots as the result of an acquisition
involving the carryover of accumulated earnings and prots from the acquired
corporation, such as in a tax-free reorganization.
Amount applied against basis. All distributions of cash or property and ow-
through deductions are applied rst against the shareholders stock basis. If
there is sufcient stock basis to absorb the distribution amounts, there is no
taxable income to the shareholder. The shareholders stock basis is then re-
duced by the amount of the distribution.
Amount in excess of basis. If a distribution of cash or property exceeds the
shareholders stock basis, the excess is treated as a taxable capital gain. These
distributions are taken into consideration before ow-through losses and
deductions.
Order of adjustments in stock basis. To calculate a shareholders stock basis
when determining the taxability of a distribution, certain adjustments must
rst be made. An S corporation shareholders basis is adjusted in the following
order.
1) Increased for income items, including separately and non-separately stated
items and tax-exempt income (plus the excess of the deductions for deple-
tion, other than oil and gas depletion, over the basis of the property subject
to depletion),
Te basis o a C corporation
shareholders stock becomes the
beginning basis in stock when the
corporation converts to S status.
Earnings and prots caried over
fom a C corporation do no add to
basis.
All distributions o cash or property
and flow-through deductions
are applied rst against the
shareholders stock basis. If there is
sucient stock basis to absorb the
distribution amounts, there is no
taxable income to the shareholder.
TheTaxReview Business Entities Chapter 2 31
NOTES 2) Decreased for distributions (distributions in excess of stock basis result in tax-
able capital gain),
3) Decreased for nondeductible expenses (and the depletion deduction for any
oil and gas property held by the corporation, but only to the extent the share-
holders pro-rata share of the propertys adjusted basis exceeds that deduc-
tion), and
4) Decreased for deductible losses passing through to the shareholder, whether
separately or non-separately stated.
Bert is 100% shareholder of Writers, Inc., an S corporation. Berts stock basis is
$3,500. Writers, Inc. makes a cash distribution to Bert in the amount of $4,000.
The distribution consists of a $3,500 nontaxable return of capital and a $500
taxable capital gain. Berts stock basis after the distribution is zero.
Election to switch order of basis adjustments. An election is available to
reduce an S corporation shareholders basis by pass-through losses before
nondeductible expenses (switching items #3 and #4, above). This election can
result in a higher allowable deduction for the tax year. The election applies to
all subsequent years and requires IRS permission to reverse.
S Corporations With Earnings and Prots
If the S corporation was previously a C corporation, any income accumulated
prior to its S corporation election is subject to C corporation distribution rules.
An S corporation with earnings and prots (E&P) must maintain an accumu-
lated adjustments account to determine the taxability of distributions to share-
holders. The existence of accumulated earnings and prots may indicate that a
distribution is a taxable dividend.
Although keeping an accumulated adjustments account is not required for
Scorporations with no earnings and prots, it is recommended.
Accumulated Adjustments Account (AAA)
The accumulated adjustments account represents the accumulation of undis-
tributed S corporation income. Distributions to shareholders are not taxable
to the extent of the balance in the accumulated adjustments account. The
taxation of distributions in excess of the accumulated adjustments account
depends on whether the corporation has accumulated earnings and prots.
Increases in AAA. AAA is increased by the following items.
Separately stated items of income (except tax-exempt income), loss, deduc-
tion, or credit.
Non-separately stated income.
The excess of deductions for depletion, other than oil or gas depletion, over
the basis of the property subject to depletion.
The increases are taken into account before any of the following decreases.
EXAMPLE
An S corporation with earnings and
prots (E&P) must maintain an
accumulated adjustments account
to determine the taxability o
distributions to shareholders.
Although keeping an accumulated
adjustments account is no required
for S corporations with no earnings
and prots, it is recommended.
KEY FACT
32 Chapter 2 TheTaxReview Business Entities
NOTES Decreases in AAA. AAA is decreased rst by ordinary distributions up to the
amount in AAA. It is then decreased by the following items, in order:
Nondeductible corporate expenses and expenses not chargeable to a capital
account.
The total of the shareholders deductions for depletion of oil or gas property
held by the corporation.
Separately stated items of loss or deduction.
Non separately computed loss.
On January 1, 2012, Shannon formed Chalker, Inc., an S corporation. For tax
year 2012, the S corporation passed through income of $16,000 that Shannon
reported on her individual income tax return. The income was a positive ad-
justment to the accumulated adjustments account. Shannon did not receive
any distributions in 2012.
In 2013, Shannon took a distribution of $15,000 from Chalker, Inc. Since the
accumulated adjustments account had a balance of $16,000, the distribution
was not taxable to Shannon. The distribution caused a negative adjustment
to the accumulated adjustments account, which had a balance of $1,000 after
the distribution.
Corporate account. The accumulated adjustments account belongs to the
Scorporation and does not belong to any specic shareholder. A new share-
holder who purchases stock in an S corporation also purchases a share of the ac-
cumulated adjustments account and is eligible to receive tax-free distributions.
The accumulated adjustments account can have a below-zero balance from
losses but not from distributions. The decit is made up by positive adjust-
ments in future years.
Other Adjustments Account (OAA)
The other adjustments account is adjusted for tax-exempt income (and related
expenses) and federal taxes attributable to a C corporation tax year.
Ordering Rules for S Corporation Distributions
Tax Effect on Shareholder Effect on Stock Basis
1) Accumulated adjustments
account.
Not taxable. Negative adjustment.
2) Earnings and prots. Taxable dividend. No adjustment.
3) Other adjustment account. Not taxable. Negative adjustment.
4) Return of capital. Not taxable up to basis in stock. Negative adjustment.
5) Excess of basis in stock. Capital gain. No adjustment.
Election to distribute earnings and prots rst. An S corporation can elect
to alter the ordering rules and distribute earnings and prots rst and amounts
from the accumulated adjustments account second.
EXAMPLE
Te accumulated adjustments
account can have a below-zero
balance fom loses but no fom
distributions. Te decit is made
up by positive adjustments in future
years.
TheTaxReview Business Entities Chapter 2 33
NOTES
Deemed Dividends
An S corporation may elect to distribute all or part of its C corporation earnings
and prots through a deemed dividend. The election is considered to be an
election to distribute earnings and prots rst (see page 32). The amount of the
deemed dividend is considered as distributed to the shareholders in propor-
tion to their stock ownership, then immediately contributed by the sharehold-
ers back to the corporation, all on the last day of the corporations taxable year.
Shareholders pay tax on a deemed distribution, and the amount increases the
basis in stock.
In certain cases, it can be advantageous to declare a deemed dividend.
Kurt owns 100% of Trumpet, Inc., a C corporation. Trumpet has $25,000 of un-
distributed earnings and prots when Kurt converts to S status in 2012. Kurts
basis in the stock of the C corporation was $7,200 before the conversion.
After the conversion, the corporation passes through a loss of $15,000. Kurts
deductible loss is limited to his basis, which is $7,200. The remaining $7,800 in
losses carries over and will not be deductible until Kurt increases his stock
basis. The loss does not reduce earnings and prots.
If Kurt had taken a deemed dividend of $7,800, earnings and prots would be
reduced without a net taxable effect. The deemed dividend would have been
taxable to Kurt, but he would have been able to claim the offsetting loss.
Previously Taxed Income (PTI)
Certain S corporations have an account called previously taxed income. The
previously taxed income account contains undistributed S corporation earn-
ings from pre-1983 S corporation years. For scal years beginning after May
25, 2007, previously taxed income reduces earnings and prots for any electing
Scorporation. The effect is that earnings and prots are exhausted earlier.
Note that for any benet to arise from this law, a corporation would have had to
have been an S corporation at some point prior to 1983, a C corporation at some
point after then, and an S corporation again after May 25, 2007.
Post Termination Transition Period (PTTP)
When a corporation terminates S corporation status, rules for distributions
generally revert to C corporation rules. However, a post termination transition
period applies special rules for distributions to be treated as if the distributions
were made by an S corporation. For the duration of the post termination transi-
tion period, distributions from the accumulated adjustments account and the
other adjustments account retain their tax-free character, up to the sharehold-
ers adjusted basis in S corporation stock.
Also see Election to distribute earnings and prots rst, page 32.
Duration. The post termination transition period begins the day after termina-
tion of S corporation status and ends on the later of:
1) The day that is one year after the date of termination, or
2) The due date for ling the last S corporation return (including extensions).
Shareholders pay tax on a deemed
distribution, and the amount
increases the basis in stock.
EXAMPLE
For the duration o the post
termination transition period,
distributions fom the accumulated
adjustments account and the
oher adjustments account retain
their tax-fee character, up to the
shareholders adjusted basis in
S corporation stock.
34 Chapter 2 TheTaxReview Business Entities
NOTES
Learning Objective 2-C
Recognize the potential of S corporation termination because of shareholder
revocation, failure of qualication, or violation of passive income restrictions.
Termination of S Corporation Status
An S corporation election will terminate, and the corporation will revert to
Ccorporation taxation, upon the occurrence of any one of the following events.
1) Shareholders revoke the election,
2) The corporation fails to qualify as an S corporation, or
3) The corporation violates the passive income restrictions (for corporations
with E&P).
If a corporations S election terminates on a day other than the rst day of its
tax year, the corporation will have two short tax years, and an allocation of
income and expenses between the S corporation year and the C corporation
year may be necessary.
Shareholder Revocation
The S corporation election may be revoked with the consent of shareholders
holding more than 50% of the shares of stock of the corporation. A revocation
made on or before the 15th day of the third month of the taxable year is effec-
tive as of the rst day of the taxable year (March 15 for a calendar year corpora-
tion). Revocation made after the 15th day of the third month of the tax year is
effective for the following taxable year.
A calendar year corporation decides to revoke its S election in 2013. If the
revocation is led on or before March 15, 2013, the corporation will be treated
as an S corporation beginning on January 1, 2013. If the corporation les its
revocation anytime from March 16, 2013 to March 15, 2014, it will be treated
as an S corporation beginning on January 1, 2014.
Revocation can be made for a prospective date which is on or after the date the
revocation is made.
A calendar year corporation decides to revoke its S election effective June 30,
2013. It must le its revocation statement and consents, stating the intended
revocation date of June 30, on or before June 30, 2013.
Corporation statement. The corporation les a statement of revocation, signed
by an ofcer who is authorized to sign Form 1120S, with the IRS Service Center
where the original election was led. Include the following information.
A statement that the corporation is revoking its S corporation election under
IRC section 1362(a).
The corporations name, address, and EIN.
The number of shares of outstanding stock.
KEY FACT
Te S corporation election may
be revoked with the consent o
shareholders holding more than
50% o the shares o stock o the
corporation.
EXAMPLE
EXAMPLE
TheTaxReview Business Entities Chapter 2 35
NOTES The effective date of the revocation.
The shareholders consent statements.
Shareholder statement. A statement signed by the shareholder, under pen-
alty of perjury, which includes:
The name, address, and EIN of the consenting shareholder.
The number of shares owned by the shareholder.
The date the shareholder acquired the stock.
The shareholders tax year end.
The name and EIN of the S corporation.
The election to which the shareholder consents.
The shareholders consent statement should be attached to the corporations
election revocation statement.
Rescission of revocation. A revocation may be rescinded by an S corpora-
tion at any time prior to the date it becomes effective. A rescission requires the
consent of each person who consented to the revocation, as well as each person
who became a shareholder after the revocation was made.
Failure to Qualify as a Small Business Corporation
If any event occurs which would have prevented the corporation from mak-
ing an S election in the rst place, the election automatically terminates. For
example, transferring stock to an ineligible shareholder, or the transfer of stock
resulting in too many shareholders, will terminate an S election. If the election
is terminated due to a specic event that causes the corporation to fail to meet
the denition of a small business corporation, the termination is effective as of
the date on which the failure occurred.
Reorganization. An S election generally will not be terminated due to a reor-
ganization if the corporation continues to meet the S corporation eligibility re-
quirements. Reorganizations frequently involve the transfer of corporate stock
to intermediary parties who are deemed to hold the stock momentarily before
transferring it to the ultimate shareholder. The IRS has privately ruled that hav-
ing such shareholders does not cause the termination of the S corporations
election.
Comment: Attempts to terminate an S corporation election by violating eligi-
bility rules may be overturned on the premise that such action would violate
the shareholders duciary duty to the corporation.
A U.S. appellate court ruled that a minority shareholder could not transfer his
S corporation stock to an ineligible entity because the transfer would termi-
nate the S companys S status. Under state law, the shareholder owed the
corporation and other shareholders a duciary duty of utmost good faith and
loyalty. The court held that the shareholders proposed transfer was motivated
by self-interest, there was no legitimate business purpose for the transaction
to the company, and the company would be irreparably harmed by the loss
of its S corporation status. Therefore, the court found the transaction to be
a breach of the shareholders duciary responsibility and disallowed it. (A.W.
Chesterton Company, Inc., 1st Cir., Oct. 14, 1997)
A revocation may be rescinded by an
S corporation at any time prior to the
date it becomes eective.
If any event occurs which would
have prevented the corporation fom
making an S election in the rst
place, the election automatically
terminates.
COURT CASE
36 Chapter 2 TheTaxReview Business Entities
NOTES
Passive Investment Violation
An S corporation election shall terminate if passive investment income exceeds
25% of gross receipts for three consecutive taxable years, and the corporation
has accumulated earnings and prots from periods when the corporation was
a C corporation. The termination will occur on the rst day of the taxable year
after the 3-year period.
Earnings and prots. A corporation will only be subject to this rule if it was a
C corporation prior to electing S status. A corporation which has never been a
C corporation will not have earnings and prots and will not be subject to this
rule. See Earnings and Prots, page 14.
Passive investment income. For purposes of this provision, passive income
includes income from royalties, rents, dividends, interest, and annuities. Pas-
sive income does not include:
Royalties derived in the ordinary course of a trade or business of franchising
or licensing property,
Rents derived in the active trade or business of renting property, or
Interest on any obligation acquired from the sale of a capital asset or the per-
formance of services in the ordinary course of business.
Royalties. Royalties received by a corporation are derived in the ordinary
course of a trade or business of franchising or licensing property only if,
based on all the facts and circumstances, the corporation either created the
property or performed signicant services or incurred substantial costs with
respect to the development or marketing of the property.
Trade Winds, Inc. is a calendar year S corporation with accumulated earn-
ings and prots. In 2012, the corporation had gross receipts of $75,000. Of this
amount, $5,000 is from royalties with respect to a trademark, $8,000 is from
royalties from a patent owned by the corporation, and $62,000 is gross receipts
from operations. Trade Winds, Inc. created the trademark but did not create the
patent or perform signicant services or incur substantial costs with respect to
the development or marketing of the patent. Because the corporation created
the trademark, the royalty payments with respect to the trademark are derived
in the ordinary course of business and are not included within the denition
of royalties for purposes of determining the corporations passive investment
income. However, the royalties derived from the patent are included as pas-
sive income because the corporation did not create it or perform substantial
services or incur substantial costs with respect to developing or marketing it.
The corporations passive investment income percentage for 2012 is 10.67%
($8,000 $75,000). Since this does not exceed 25% of the corporations gross
receipts, the 3-year period does not begin to run.
Rents. Rents received by a corporation are derived in an active trade or busi-
ness of renting property only if, based on all the facts and circumstances, the
corporation provides signicant services or incurs substantial costs in the rent-
al business.
An S corporation election shall
terminate if pasive investment
income eceeds 25% o gros receipts
for three consecutive taxable
years, and the corporation has
accumulated earnings and prots
fom periods when the corporation
was a C corporation.
Roalties received by a corporation
are derived in the ordinary course
o a trade or busines o fanchising
or licensing property only if, based
on all the facts and circumstances,
the corporation either created the
property or performed signicant
services or incured substantial costs
with respect to the development or
marketing o the property.
EXAMPLE
TheTaxReview Business Entities Chapter 2 37
NOTES Stock or securities. Sales of stock or securities are no longer classied as pas-
sive investment income for purposes of assessing taxes on an S corporation.
Comment: An S corporation that earns passive income and has accumulated
E&P may want to consider making a dividend distribution sufcient to elimi-
nate the accumulated E&P. This would avoid possible termination due to pas-
sive income restrictions and also avoid the possible tax on excess net passive
income. See Deemed Dividends, page 33.
Inadvertent Termination
If an inadvertent S corporation termination occurs, and the corporation takes
steps to correct the terminating event within a reasonable time after the dis-
covery, the IRS may allow the corporation to continue to operate as an S cor-
poration. The corporation has the burden of establishing that the termination
was inadvertent. A termination may be found to be inadvertent if the event was
not reasonably within the control of the corporation and was not part of a plan
to terminate the election, or the event took place without the knowledge of the
corporation. Permission from the IRS is required to disregard an inadvertent
termination. The corporation and all shareholders must consent to any adjust-
ments the IRS may require for the period.
Status of corporation. The status of the corporation after the terminating
event is determined by the IRS. Inadvertent termination relief may be grant-
ed retroactively for all years for which the terminating event or circumstance
is effective, in which case the corporation is treated as if its election had not
terminated. Alternatively, relief may be granted only for the period in which
the corporation was eligible for S treatment, in which case the corporation is
treated as a C corporation during the period for which the corporation was not
eligible for its intended status.
An ineligible shareholder acquired shares of stock in a corporation that had
a valid S election in place, thus terminating the S election. Upon discovering
the existence of the ineligible shareholder, an eligible shareholder acquired
all of the ineligible shareholders stock. The corporation claimed that the cir-
cumstances resulting in the termination of its S election were inadvertent
and were not motivated by tax avoidance or retroactive tax planning. The
corporation and its shareholders all agreed to make any adjustments consis-
tent with S corporation treatment as may be required. The IRS concluded that
the termination of the corporations S election was inadvertent and allowed
the corporation to continue to be treated as though no termination had taken
place. (Ltr. Rul. 201117015)
A termination may be found to be
inadvertent if the event was no
reasonably within the control o the
corporation and was no part o a
plan to terminate the election, or
the event took place without the
knowledge o the corporation.
Inadvertent termination relief may
be granted retroactively for all years
for which the terminating event or
circumstance is eective, in which
case the corporation is treated as if
its election had no terminated.
LETTER RULING
38 Chapter 2 TheTaxReview Business Entities
NOTES
Five-Year Waiting Period for Reinstatement
If an S corporation election is terminated, whether by shareholder revocation,
by ceasing to qualify, or by violating the passive income restrictions, a 5-year
waiting period applies during which the corporation cannot re-elect S corpora-
tion status without IRS consent.
IRS consent. In certain circumstances, the IRS may permit a corporation to
make a new election before the 5-year period expires. The corporation has the
burden of establishing that under the relevant facts and circumstances, permis-
sion should be granted. The fact that more than 50% of the stock in the corpora-
tion is owned by persons who did not own any stock in the corporation on the
day of the termination tends to establish that consent should be granted. In the
absence of this fact, consent is ordinarily denied unless the corporation shows
that the event causing termination was not reasonably within the control of the
corporation or shareholders having substantial interest in the corporation and
was not part of a plan to terminate the election.
An S corporation had its S status terminated when it created a second class
of stock. Subsequently, the corporation converted its two classes of stock into
one class of common stock and requested permission to re-elect S corpora-
tion status prior to the termination of the 5-year waiting period. As of the date
of the second S election, more than 50% of the stock in the corporation was
owned by persons who did not own any stock in the corporation on the date
of the termination. Permission was granted to the corporation to elect to be an
Scorporation prior to the end of the 5-year waiting period. (Ltr. Rul. 201117020)
An S corporation terminated its S election by recapitalizing its stock into com-
mon stock and employee stock option plan (ESOP) convertible preferred stock.
All shareholders subsequently sold their convertible stock to the corporations
ESOP with two of the shareholders electing to defer the gain from the sale
under IRC section 1042. At the time of the re-election request, the ESOP held
all of the corporations stock. While an ESOP is an eligible shareholder of an
S corporation, only C corporation shareholders may defer the gain from the
sale of stock to an ESOP under IRC section 1042. Therefore, the IRS denied
the corporations request for re-election prior to the expiration of the 5-year
statutory waiting period even though the redemption of stock had caused a
more than 50% ownership change. (Ltr. Rul. 200851003)
Automatic consent after certain terminations. A corporation may, without
requesting the IRS consent, make a new S election before the 5-year waiting
period under the following conditions.
The corporation revoked its election effective on the rst day of the rst tax-
able year for which its S election was to be effective, or
The corporation failed to meet the denition of a small business corpora-
tion on the rst day of the rst taxable year for which its election was to be
effective.
Te corporation has the burden o
establishing that under the relevant
facts and circumstances, permiion
should be granted.
LETTER RULING
LETTER RULING
TheTaxReview Business Entities Chapter 2 39
NOTES
Chapter 2 Self-Quiz
Instructions
Test your knowledge and comprehension of information presented in Chapter 2.
True/False
1) A corporation may le Form 2553 up to 24 months after the original due date
and still qualify for late election relief, as long as no corporate tax returns
have been led and Form 2553 includes all required information.
True False
2) A distribution from an S corporation with no earnings and prots is always
treated as a capital gain by the shareholder.
True False
3) Under no circumstances will a former S corporation be able to reinstate its
S status until the 5-year waiting period expires.
True False
Multiple Choice
1) Which of the following is a true statement about Form 2553?
a) Form 2553 must always be mailed separately or faxed to the IRS.
b) If a corporation has received no IRS notices regarding a missing Scorpo-
ration election, the corporation does not need to show reasonable cause
for failing to le Form 2553.
c) Form 2553 is due six months after the unextended due date for the initial
Form 1120S.
d) If Form 2553 is being led late, it must be signed by all shareholders who
owned stock at any time since the effective date of the S corporation
election.
2) On January 1, 2013, Picture This, Inc., an S corporation, has accumulated
earnings and prots of $5,000 and a balance in the accumulated adjustments
account of $3,000. The corporations sole shareholder, Brian, has stock basis
in the corporation of $2,000. The corporation earns income during the year of
$1,000 and incurs losses of $2,500. At the beginning of the year, Picture This,
Inc. made a distribution to Brian of $2,000. The corporation has not made the
election to distribute earnings and prots rst. Which of the following state-
ments is true?
a) The entire distribution will be taxable as a dividend.
b) Brian has a suspended loss of $1,500.
c) The corporations earnings and prots account at the end of the year is
$3,000.
d) The corporations AAA account at the end of the year is zero.
40 Chapter 2 TheTaxReview Business Entities
NOTES 3) Which of the following events will result in the termination of a corpora-
tions S election?
a) An S corporation without earnings and prots has passive investment in-
come comprising 30% of its gross receipts.
b) An S corporation is involved in a reorganization which involves the trans-
fer of its stock to intermediary parties prior to transferring it to the ulti-
mate shareholders.
c) 50% of the shareholders of an S corporation sign statements of revocation
and attach them to the corporations statement of revocation.
d) An S corporation issues a second class of stock.
TheTaxReview Business Entities Chapter 2 41
NOTES
42 Chapter 2 TheTaxReview Business Entities
NOTES
Chapter 2 Self-Quiz Answers
True/False
1) A corporation may le Form 2553 up to 24 months after the original due date
and still qualify for late election relief, as long as no corporate tax returns
have been led and Form 2553 includes all required information.
True Incorrect. If the corporation has not yet led Form 1120S, Form
2553 may be used to request relief and make the S corporation
election if it is led with the initial Form 1120S no later than six
months after the due date for that Form 1120S (excluding exten-
sions). The longest amount of time this deadline could be after
the due date for Form 2553 is 15 months.
False Correct. The 24-month time limitation for ling Form 2553 ap-
plies in the case when Form 1120S has already been led and all
other requirements are met.
2) A distribution from an S corporation with no earnings and prots is always
treated as a capital gain by the shareholder.
True Incorrect. Only distributions in excess of the shareholders stock
basis are taxable to the shareholder as capital gains. Distribu-
tions are tax-free up to the amount of the shareholders basis in
stock.
False Correct. All distributions from an S corporation with no earn-
ings and prots are applied rst against the shareholders stock
basis. If there is sufcient stock basis to absorb the distribution
amounts, there is no taxable income to the shareholder.
3) Under no circumstances will a former S corporation be able to reinstate its
S status until the 5-year waiting period expires.
True Incorrect. Generally, if an S election is terminated, a 5-year wait-
ing period is required before the corporation may re-elect S cor-
poration status. However, there are certain circumstances under
which the IRS will grant permission to make the election before
the 5-year period expires.
False Correct. In certain circumstances, the IRS may permit a corpo-
ration to make a new election before the 5-year period expires.
The corporation has the burden of establishing that permission
should be granted.
Multiple Choice
1) Which of the following is a true statement about Form 2553?
a) Form 2553 must always be mailed separately or faxed to the IRS.
Incorrect. Under Revenue Procedure 2007-62, a corporation that has not
led Form 2553, but has been ling Form 1120S without receiv-
ing an IRS notice, may le Form 2553 with Form 1120S. Form 2553
need not be separately led or faxed to the IRS in this case.
TheTaxReview Business Entities Chapter 2 43
NOTES b) If a corporation has received no IRS notices regarding a missing S corpo-
ration election, the corporation does not need to show reasonable cause
for failing to le Form 2553.
Incorrect. All procedures for ling a late S corporation election and re-
questing relief require that reasonable cause be described on
Form 2553.
c) Form 2553 is due six months after the unextended due date for the initial
Form 1120S.
Incorrect. Form 2553 is due two months and 15 days after the date the elec-
tion is to take effect.
d) If Form 2553 is being led late, it must be signed by all shareholders who
owned stock at any time since the effective date of the S corporation
election.
Correct. For an election led on or after the effective date of the S corpo-
ration election, Form 2553 must be signed by all shareholders or
former shareholders who owned stock at any time during the
period beginning on the effective date.
2) On January 1, 2013, Picture This, Inc., an S corporation, has accumulated
earnings and prots of $5,000 and a balance in the accumulated adjustments
account of $3,000. The corporations sole shareholder, Brian, has stock basis
in the corporation of $2,000. The corporation earns income during the year of
$1,000 and incurs losses of $2,500. At the beginning of the year, Picture This,
Inc. made a distribution to Brian of $2,000. The corporation has not made the
election to distribute earnings and prots rst. Which of the following state-
ments is true?
a) The entire distribution will be taxable as a dividend.
Incorrect. The distribution would only be a taxable dividend to the extent
it was taken from earnings and prots. According to the order-
ing rules, the distribution is treated as coming out of the AAA
prior to earnings and prots. Distributions to shareholders are
tax-free to the extent of the balance in AAA. AAA is increased by
income before deducting the distribution, thus, the balance in
AAA is $4,000 ($3,000 beginning balance + $1,000 income) prior
to the distribution of $2,000.
b) Brian has a suspended loss of $1,500.
Correct. A shareholders stock basis can never be reduced below zero. Af-
ter taking into account the distribution to Brian and the income
for the year, Brians stock basis is $1,000 ($2,000 beginning bal-
ance $2,000 distribution + $1,000 income). $1,000 of the $2,500
loss will be taken in the current year and the remaining $1,500
will be suspended until basis is restored.
c) The corporations earnings and prots account at the end of the year is
$3,000.
Incorrect. Unless an election is made to distribute earnings and prots
rst, the earnings and prots account is only reduced by a dis-
tribution after AAA has been used up. Here, the distribution did
44 Chapter 2 TheTaxReview Business Entities
NOTES not reduce AAA to zero; therefore, earnings and prots were
unchanged.
d) The corporations AAA account at the end of the year is zero.
Incorrect. The AAA can have a below-zero balance from losses but not
from distributions. By the ordering rules, the distribution re-
duced AAA prior to the losses; therefore, the negative balance
was caused by the losses, not the distribution, and is allowable.
The decit will be made up in future years.
3) Which of the following events will result in the termination of a corpora-
tions S election?
a) An S corporation without earnings and prots has passive investment in-
come comprising 30% of its gross receipts.
Incorrect. An S corporation without earnings and prots is not subject to
the passive investment rule.
b) An S corporation is involved in a reorganization which involves the trans-
fer of its stock to intermediary parties prior to transferring it to the ulti-
mate shareholders.
Incorrect. Reorganizations frequently involve the transfer of corporate
stock to intermediary parties who are deemed to hold the stock
momentarily before transferring it to the ultimate shareholder.
The IRS has privately ruled that having such shareholders does
not cause the termination of the S corporations election if the
corporation otherwise qualies.
c) 50% of the shareholders of an S corporation sign statements of revocation
and attach them to the corporations statement of revocation.
Incorrect. The S corporation election may be revoked with the consent of
shareholders holding more than 50% of the shares of stock of the
corporation.
d) An S corporation issues a second class of stock.
Correct. If any event occurs which would have prevented the corporation
from making the S election in the rst place, the election auto-
matically terminates. An S corporation is specically prohibited
from having more than one class of stock.
TheTaxReview Business Entities Chapter 3 45
CPE/CE
Learning Objectives
Successful completion of this course will enable the participant to:
3-A Identify separately stated items of partnership income or loss and report
those items properly on Schedule K-1, Form 1065, U.S. Return of Partnership
Income.
3-B Identify recourse and nonrecourse liabilities and determine the effect on
a partner or LLC members ownership basis.
3-C Determine gain or loss on current distributions or liquidating distribu-
tions made to a partner or LLC member.
Glossary Terms
Separately stated items. Separately stated items are items of income or loss
owing through from a partnership or S corporation that may be subject to
special limits or computations on the partner or shareholders individual re-
turn. Separately stated items are not included in the business entitys net busi-
ness income or loss.
Nonrecourse liability. A partnership liability is a nonrecourse liability if no
partner or related person has an economic risk of loss for that liability.
Current distribution. A distribution from a partnership that does not com-
pletely retire a partners interest in the partnership.
Learning Objective 3-A
Identify separately stated items of partnership income or loss and report
those items properly on Schedule K-1, Form 1065, U.S. Return of Partnership
Income.
Separately Stated Items
A partnership is not a taxpaying entity. The partners report the partnerships in-
come, gain, loss, deductions, and credits on their own individual tax returns. Al-
though a partnership does not pay tax, the partnership computes taxable income
and determines the character of the income, gain, loss, deductions, and credits.
The ordinary income or loss of a partnership is computed in the same manner
as in the case of an individual, except that:
1) Items described in IRC section 702(a) shall be separately stated, and
2) The following deductions are not allowed to the partnership.
a) Personal exemptions,
b) Foreign taxes paid or accrued,
c) Charitable contributions,
d) Net operating loss deduction,
e) Personal itemized deductions, and
f) Depletion with respect to oil and gas wells.
3
Partnerships and LLCs
46 Chapter 3 TheTaxReview Business Entities
NOTES Separately stated items are those items that may be subject to special calcula-
tions or have limitations that may differ on the tax returns of each individual
partner. The character of the separately stated items in the hands of the part-
ners is determined as if each item was realized directly from the source or in-
curred in the same manner as incurred by the partnership. For example, capital
gains and losses and charitable contributions are separately stated items since
they could affect each partner differently, depending on the partners individ-
ual tax situation.
The items described in IRC section 702(a) that each partner is required to take
into account separately are:
Net short-term capital gains and losses,
Net long-term capital gains and losses,
Section 1231 gains and losses,
Charitable contributions,
Dividends eligible for the dividends received deduction,
Taxes paid or accrued to a foreign country or a U.S. possession, and
Other items of income, gain, loss deduction, or credit as provided in the
regulations.
Examples provided in the regulations include recoveries of bad debts, prior
taxes and delinquency amounts, nonbusiness expenses, intangible drilling and
development costs, and soil and water conservation expenses. The examples
included in the regulations are not all inclusive. IRS regulation 1.702-1(a)(8)(ii)
states that each partner must also take into account separately the partners
distributive share of any partnership item which, if separately taken into ac-
count by any partner, would result in an income tax liability for that partner, or
for any other person, different from that which would result if that partner did
not take the item into account separately.
The ordinary business income or loss from the trade or business activities of a
partnership is calculated after separating out all the items which are required
to be separately stated. Partnership ordinary business income or loss is then
combined with separately stated items on the individual partners income tax
return.
Schedule K-1 (Form 1065)
The partnership uses Schedule K-1 (Form 1065) to report each partners share
of the partnerships income, deductions, credits, and other information. Sched-
ule K-1 includes the ordinary income or loss from trade or business activities
of the partnership and all other items of partnership income or loss that are
required to be separately stated.
Ordinary business income (loss). The ordinary business income (loss) from
trade or business activities is reported on line 1, Schedule K-1. If the partner-
ship has more than one trade or business, it will attach a statement identifying
the income or loss from each activity.
Separately stated items are those
items that may be subect to special
calculations or have limitations that
may dier on the tax returns o each
individual partner.
KEY FACT
TheTaxReview Business Entities Chapter 3 47
NOTES
Fish or Cut Bait Partnership reports the following income and deductions for
the year.
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 Administrative expenses . . . . . . . $ 15,000
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 Depreciation expense . . . . . . . . . . . . $ 7,000
Section 179 deduction . . . . . . . $ 5,000 Charitable contributions . . . . . . . . $ 3,000
The ordinary business income from Fish or Cut Bait Partnerships trade or busi-
ness is $18,000 ($80,000 $40,000 $15,000 $7,000). The Section 179 deduction
of $5,000 and charitable contributions of $3,000 are separately stated items.
Jerry has a 50% ownership interest in Fish or Cut Bait Partnership in Exam-
ple #1. The partnership issues Jerry a Schedule K-1, which reports ordinary
partnership business income of $9,000 ($18,000 partnership income 50%),
along with a Section 179 deduction of $2,500 and charitable contribution of
$1,500.
The partnership ordinary business income is combined with the Section 179
deduction on Schedule E, Form 1040, and partnership income of $6,500 is re-
ported on line 17, Form 1040 ($9,000 partnership ordinary business income
minus $2,500 separately stated Section 179 deduction). The charitable contri-
bution passed through to Jerry on Schedule K-1 is reported as a charitable
contribution on Schedule A, Itemized Deductions, of Jerrys Form 1040.
Net rental real estate income (loss). Net rental real estate income (loss) from
Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corpora-
tion, is reported on line 2, Schedule K-1. If the partnership has more than one
rental real estate activity, it will attach a statement identifying the income or
loss from each activity.
Other net rental income (loss). Net rental income (loss) from other than a
rental real estate activity is reported on line 3, Schedule K-1. If the partnership
has more than one rental activity, it will attach a statement identifying the in-
come or loss from each activity.
Guaranteed payments. Guaranteed payments are payments made to partners
for services performed. The guaranteed payment is determined without regard
to the partnership income. Guaranteed payments are reported as a deduction
from ordinary income of the partnership and also as a separately stated item to
the partner. Guaranteed payments include payments for salaries, health insur-
ance, and certain nonqualied deferred compensation plans and are reported
on line 4, Schedule K-1.
Interest income. Line 5, Schedule K-1 includes only taxable portfolio inter-
est. Taxable portfolio interest includes interest from all sources except interest
exempt from tax and interest on tax-free covenant bonds. Interest income from
credit bonds to holders of tax credit bonds is included and a statement with
additional information attached to Schedule K-1.
Ordinary dividends. Taxable ordinary dividends, including qualied divi-
dends, are reported on line 6a, Schedule K-1.
EXAMPLE #1
EXAMPLE #2
Guaranteed payments are reported
as a deduction fom ordinary
income o the partnership and also
as a separately stated item to the
partner.
48 Chapter 3 TheTaxReview Business Entities
NOTES Qualied dividends. Qualied dividends received from domestic corpora-
tions and qualied foreign corporations are reported on line 6b, Schedule K-1.
Royalties. Royalties received by the partnership are reported on line 7, Schedule
K-1.
Net short-tem capital gain (loss). The net gain or (loss) on capital assets held
one year or less from Schedule D (Form 1065) is reported on line 8, Schedule
K-1.
Net long-term capital gain (loss). The net gain or (loss) on capital assets held
more than one year from Schedule D (Form 1065) is reported on line 9a, Sched-
ule K-1.
Collectibles (28%) gain (loss). The amount of net long-term capital gain or
(loss) that is attributable to collectibles is reported on line 9b, Schedule K-1. A
collectibles gain or (loss) is any long-term gain or deductible long-term loss
from the sale or exchange of a collectible that is a capital asset. Collectibles
include works of art, rugs, antiques, metal (such as gold, silver, or platinum
bullion), gems, stamps, coins, alcoholic beverages, and certain other tangible
property.
Unrecaptured section 1250 gain. There are three types of unrecaptured sec-
tion 1250 gain. The partnership will report unrecaptured section 1250 gain from
the sale or exchange of its business assets on line 9c, Schedule K-1. If there
is unrecaptured section 1250 gain from the sale or exchange of an interest in
another partnership or from an estate, trust, real estate investment company
(REIT), or regulated investment company (RIC), there will be an attachment
to Schedule K-1 providing the amount and type of each unrecaptured section
1250 gain.
Net section 1231 gain (loss). The net section 1231 gain or (loss) from Form
4797 is reported on line 10, Schedule K-1. If the partnership has more than one
rental, trade, or business activity, identify on an attachment to Schedule K-1 the
amount of section 1231 gain or (loss) from each separate activity.
Other income (loss). Any other item of income or (loss) not included on lines
1 through 10, Schedule K-1, is reported on line 11, Schedule K-1. Other income
or (loss) items include the following:
Other portfolio income (loss) (code A). The partnership will report portfo-
lio income, other than interest, ordinary dividend, royalty, and capital gain
(loss) income, by attaching a statement reporting the type of other portfolio
income.
Involuntary conversions (code B). Net gain or (loss) from involuntary conver-
sions due to a casualty or theft.
Section 1256 contracts and straddles (code C). The partnership will report any
net gain or (loss) from section 1256 contracts.
Mining exploration costs recapture (code D). The partnership will provide
a schedule that shows the information needed to recapture certain mining
exploration costs.
Cancellation of debt (code E). If cancellation of debt is reported to the part-
nership on Form 1099-C, the partnership will report each partners distribu-
tive share on line 11 using code E.
A collectibles gain or (los) is any
long-term gain or deductible long-
term los fom the sale or echange
o a collectible that is a capital aset.
TheTaxReview Business Entities Chapter 3 49
NOTES Other income (loss) (code F). Amounts with code F are other items of income,
gain, or (loss) not included in lines 1 through 10 or reported on line 11 using
codes A through E. The partnership should provide a description and the
amount of each item. Examples include recoveries of tax benet items, gains
from the disposition of farm recapture property, gambling gains and (losses),
and gain from the sale or exchange of qualied small business stock.
Section 179 deduction. Section 179 expense deduction is reported on line 12,
Schedule K-1. If the partnership has more than one rental, trade, or business
activity, identify on an attachment to Schedule K-1 the amount of Section 179
deduction from each separate activity. Line 12 will not be completed for any
partner that is an estate or trust and not eligible for the Section 179 expense
deduction.
Other deductions. Line 13, Schedule K-1, other deductions include:
Cash contributions (code A). Cash contributions subject to the 50% adjusted
gross income (AGI) limitation.
Cash contributions (code B). Cash contributions subject to the 30% AGI
limitation.
Noncash contributions (code C). Noncash contributions subject to the 50%
AGI limitation. For all noncash contributions, the partnership must attach a
copy of its Form 8283 to the Schedule K-1 of each partner if the deduction for
any item or group of similar items of contributed property exceeds $5,000,
even if the amount allocated to any partner is $5,000 or less. The amount of
food inventory contributions should not be reported using code C. These
contributions should be reported separately on an attached statement.
Noncash contributions (code D). Noncash contributions subject to the 30%
AGI limitation.
Capital gain property to a 50% organization (30%) (code E). Capital gain
property contributions subject to the 30% AGI limitation.
Capital gain property (20%) (code F). Capital gain property contributions
subject to the 20% AGI limitation.
Contributions (100%) (code G). Qualied conservation contributions of prop-
erty used in agriculture or livestock production.
Investment interest expense (code H). Interest expense properly allocable to
debt on property held for investment purposes. Property held for investment
purposes includes property that produces income (unless derived in the
ordinary course of a trade or business) from interest, dividends, annuities,
or royalties, and gains from the disposition of property that produces those
types of income or is held for investment. Investment interest expense does
not include interest expense allocable to a passive activity.
Deductions: royalty income (code I). Deductions related to royalty income.
IRC section 59(e)(2) expenditures (code J). Deductions related to circulation
expenditures, research and experimental expenditures, intangible drilling
and development costs, and mining exploration and development costs.
Deductions: portfolio (2% oor) (code K). Deductions related to portfolio in-
come that is subject to the 2% of AGI limitation.
Deductions: portfolio (other) (code L). Other deductions related to portfolio
income.
Other income (los) (code F).
Te partnership should provide a
description and the amount o each
item.
50 Chapter 3 TheTaxReview Business Entities
NOTES Amounts paid for medical insurance (code M). Amounts paid during the tax
year for insurance that constitutes medical care for the partner (including
the partners spouse, dependents, and children under age 27 who are not
dependents).
Educational assistance benets (code N). Amounts paid during the tax year
for educational assistance benets paid to a partner.
Dependent care benets (code O). Amounts paid during the tax year for
dependent care benets paid on behalf of each partner.
Preproductive period expenses (code P).
Commercial revitalization deduction from rental real estate activities (codeQ).
Pensions and IRAs (code R). Payments for a partner to an IRA, qualied plan,
or simplied employee pension (SEP) or SIMPLE IRA plan.
Reforestation expense deduction (code S).
Domestic production activities information (codes T and U).
Employers Form W-2 wages (code V)
Other deductions (code W). Amounts listed with code W include deductions,
such as penalty on early withdrawal of savings, amounts paid that would be
allowed as an itemized deduction on the partners income tax return and are
not listed above, and interest expense allocated to debt nanced distributions.
Self-employment earnings (loss). Line 14, Schedule K-1, codes A through C,
provides information necessary for each partner to calculate their share of self-
employment tax.
Credits. Line 15, Schedule K-1, provides information on the partnerships tax
credits.
Low-Income Housing Credit (section 42(j)(5) from pre-2008 buildings (code A).
Low-Income Housing Credit (other) from pre-2008 buildings (code B).
Low-Income Housing Credit (section 42(j)(5) from post-2007 buildings (code C).
Low-Income Housing Credit (other) from post-2007 buildings (code D).
Qualied rehabilitation expenditures (rental real estate) (code E).
Other rental real estate credits (code F).
Other rental credits (code G).
Undistributed capital gains credit (code H).
Alcohol and cellulosic biofuel fuels credit (code I).
Work Opportunity Credit (code J).
Disabled access credit (code K).
Empowerment Zone Credit and renewal community employment credit
(code L).
Credit for increasing research activities (code M).
Credit for employer Social Security and Medicare taxes paid on certain
employee tips (code N).
Backup withholding (code O).
Other credits (code P).
Foreign transactions. Line 16, Schedule K-1, codes A through N and Code Q, pro-
vides the necessary information to compute the Foreign Tax Credit or deduction.
Alternative minimum tax (AMT) items. Line 17, Schedule K-1, codes A
through F, lists income and deductions that are adjustments or tax preferences
for the AMT calculation.
TheTaxReview Business Entities Chapter 3 51
NOTES Tax-exempt income and nondeductible expenses. Line 18, Schedule K-1.
Tax-exempt interest income (code A). Tax-exempt interest income, including
any exempt-interest dividends received from a mutual fund or other regu-
lated investment company.
Other tax-exempt income (code B). All other tax-exempt income except tax-
exempt interest.
Nondeductible expenses (code C). Nondeductible expenses paid or incurred
by the partnership. These do not include separately stated deductions shown
elsewhere on Schedule K-1, capital expenditures, or items, the deduction for
which is deferred to a later tax year.
Distributions. Line 19, Schedule K-1, codes A through C, list cash, marketable
securities, and other property distributed to the partners.
Other information. Line 20, Schedule K-1, codes A through Y, provides part-
ners all other information needed to prepare their income tax returns. Exam-
ples of other information include investment income, investment expenses, re-
capture of certain credits, recapture of Section 179 deduction, and disposition
of property with Section 179 deductions.
Learning Objective 3-B
Identify recourse and nonrecourse liabilities and determine the effect on a
partner or LLC members ownership basis.
General Rule for a Partners Basis in a Partnership
Partners basis (outside basis). A partners basis in a partnership interest that
is acquired by the contribution of money or property is the amount of money
and the partners adjusted basis in the property at the time of the contribution.
Special rules apply in the case of investment partnerships where gain may be
recognized at the time of contribution of the property by the partner contribut-
ing the property.
Basis increases. A partners basis is increased by the following:
The partners additional contributions to the partnership, including an
increased share of, or assumption of, partnership liabilities.
The partners distributive share of taxable and nontaxable partnership
income.
The partners distributive share of the excess of the deductions for depletion
over the basis of the depletable property, unless the property is oil or gas
wells whose basis has been allocated to partners.
Basis decreases. A partners basis is decreased (but never below zero) by the
following:
The money (including a decreased share of partnership liabilities or an as-
sumption of the partners individual liabilities by the partnership) and ad-
justed basis of property distributed to the partner by the partnership.
The partners distributive share of the partnership losses (including capital
losses).
Tese do no include separately
stated deductions shown
elsewhere on Schedule K-1, capital
ependitures, or items, the deduction
for which is defered to a later tax
year.
52 Chapter 3 TheTaxReview Business Entities
NOTES The partners distributive share of nondeductible partnership expenses that
are not capital expenditures. This includes the partners share of any Section
179 expenses, even if the partner cannot deduct the entire amount on his or
her individual income tax return.
The partners deduction for depletion for any partnership oil and gas wells,
up to the proportionate share of the adjusted basis of the wells allocated to
the partner.
Partners liabilities assumed by the partnership. If contributed property is
subject to a debt, or if a partners liabilities are assumed by the partnership,
the basis of that partners interest is reduced (but not below zero) by the liabil-
ity assumed by the other partners. This partner must reduce his or her basis
because the assumption of the liability is treated as a distribution of money
to that partner. The other partners assumption of the liability is treated as a
contribution by them of money to the partnership.
Susan acquired 20% interest in a partnership by contributing property with an
adjusted basis of $80,000 and a $40,000 mortgage. The partnership assumed
payment of the mortgage. Susans basis in the partnership is decreased by
the assumption of liability by the other partners.
Adjusted basis of contributed property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000
Minus: Portion of mortgage assumed by other partners
(80% $40,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Basis of Susans partnership interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,000
Assume the same facts as Example #1, except the contributed property had
a mortgage of $120,000. The basis of Susans partnership interest would be
zero. The difference of the mortgage assumed by the other partners and her
basis would be treated as capital gain for Susan. However, this gain would
not increase the basis of her partnership interest.
Portion of mortgage assumed by other partners
(80% $120,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,000
Minus: Adjusted basis of contributed property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Gain realized by Susan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,000
Book value of partners interest. The adjusted basis of a partners interest is
determined without considering any amount shown in the partnership books
as a capital, equity, or similar account.
Keith contributes to his partnership property that has an adjusted basis of
$4,000 and a fair market value of $10,000. His partner, Lynn, contributes $10,000
cash. Each partner has increased his or her capital account by $10,000, which
will be reected in the partnership books. However, the adjusted basis for
Keith is only $4,000 and the adjusted basis for Lynn is $10,000.
If contributed property is subect to
a debt, or if a partners liabilities
are asumed by the partnership,
the basis o that partners interest
is reduced (but no below zero) by
the liability asumed by the oher
partners.
EXAMPLE #1
EXAMPLE #2
KEY FACT
EXAMPLE
TheTaxReview Business Entities Chapter 3 53
NOTES Determination of basis. The adjusted basis of a partners partnership inter-
est is ordinarily determined at the end of the partnerships tax year. However,
if there has been a sale or exchange of all or part of the partners interest, or a
liquidation of his or her entire interest in a partnership, the adjusted basis is
determined on the date of the sale, exchange, or liquidation.
Effect of Partnership Liabilities on Basis
A partners basis in a partnership interest includes the partners share of part-
nership liabilities if the liability:
1) Creates or increases the partnerships basis in any of its assets,
2) Gives rise to a current deduction to the partnership, or
3) Is a nondeductible, noncapital expense of the partnership.
Increases. If a partners share of partnership liabilities increases, or a part-
ners individual liabilities increase because he or she assumes partnership
liabilities, the increase is treated as a contribution of money by the partner to
the partnership.
Decreases. If a partners share of partnership liabilities decreases, or a part-
ners individual liabilities decrease because the partnership assumes his or her
individual liabilities, the decrease is treated as a distribution of money to the
partner by the partnership.
Assumption of liability. A partner or related person is considered to assume
a partnership liability only to the extent that:
1) The partner is personally liable for the debt,
2) The creditor knows that the liability was assumed by the partner or related
person,
3) The creditor can demand payment from the partner or related person, and
4) No other partner or person related to another partner will bear the economic
risk of loss on that liability immediately after the assumption.
Related person. Related persons for these rules include, but are not limited
to, the following.
An individual and his or her spouse, ancestors, and lineal descendants.
An individual and a corporation if the individual directly or indirectly owns
80% or more in value of the outstanding stock of the corporation.
Two corporations that are members of the same controlled group.
A grantor and duciary of any trust.
A partnership and a person owning, directly or indirectly, 80% or more of the
capital or prots interests.
Transfer of property subject to liability. If property contributed to a partner-
ship by a partner or distributed by the partnership to a partner is subject to a
liability, the transferee is treated as having assumed the liability to the extent it
does not exceed the fair market value of the property.
Te adjusted basis o a partners
partnership interest is ordinarily
determined at the end o the
partnerships tax year.
KEY FACT
If property contributed to a
partnership by a partner or
distributed by the partnership to
a partner is subect to a liability,
the transferee is treated as having
asumed the liability to the eent
it does no eceed the fair market
value o the property.
54 Chapter 3 TheTaxReview Business Entities
NOTES
Recourse and Nonrecourse Liabilities
Partners share of recourse liabilities. A partnership liability is a recourse
liability to the extent that any partner or a related person has an economic risk
of loss. A partners share of a recourse liability equals his or her economic risk
of loss for that liability. A partner has an economic risk of loss if that partner,
or a related person, would be obligated to make a net payment to the creditor
or a contribution to the partnership if the partnership were constructively liq-
uidated. A partner who is the creditor for a liability of the partnership has an
economic risk of loss in that liability.
Constructive liquidation. Generally, in a constructive liquidation, the following
events are treated as occurring at the same time.
All partnership liabilities become payable in full.
All the partnerships assets have a value of zero, except for property contrib-
uted to secure a liability.
All property is disposed of by the partnership in a fully taxable transaction
for no consideration except relief from liabilities for which the creditors right
to reimbursement is limited solely to one or more assets of the partnership.
All items of income, gain, loss, or deduction are allocated to the partners.
The partnership liquidates.
Andy and Barney form a cash basis general partnership with cash contribu-
tions of $20,000 each. Under the partnership agreement, they share all partner-
ship prots and losses equally. The partnership borrows $60,000 to purchase
depreciable business equipment. The debt is included in each partners basis
in the partnership because incurring it creates an additional $60,000 of basis
in the partnerships depreciable property.
If Andy is required to pay the creditor in the event the partnership defaults,
he has an economic risk of loss in the liability. His basis in the partnership
would be $80,000 ($20,000 cash + $60,000 debt), while Barneys basis would
be $20,000.
Limited partner. A limited partner generally has no obligation to contribute
additional capital to the partnership and therefore does not have an economic
risk of loss in partnership recourse liabilities. Thus, absent some other factor,
such as the guarantee of a partnership liability by the limited partner or the
limited partner making the loan to the partnership, a limited partner generally
does not have a share of partnership recourse liabilities.
Partners share of nonrecourse liabilities. A partnership liability is a non-
recourse liability if no partner or related person has an economic risk of loss
for that liability. A partners share of nonrecourse liabilities is generally pro-
portionate to his or her share of partnership prots. However, this rule may
not apply if the partnership has taken deductions attributable to nonrecourse
liabilities or the partnership holds property that was contributed by a partner.
A partners share o a recourse
liability equals his or her economic
risk o los for that liability.
KEY FACT
EXAMPLE
A partnership liability is a
nonrecourse liability if no partner or
related person has an economic risk
o los for that liability.
TheTaxReview Business Entities Chapter 3 55
NOTES Under general basis rules, both recourse and nonrecourse liabilities will in-
crease a partners basis in the partnership, but only recourse liabilities will in-
crease a partners at-risk basis. Since the at-risk rules limit deductible losses to
the amount at risk in the activity, recourse liabilities are more relevant.
Learning Objective 3-C
Determine gain or loss on current distributions or liquidating distributions
made to a partner or LLC member.
General Rule for Distributions Made to a Partner or LLC Member
A distribution to a partner or LLC member will be either (1) a current distribu-
tion that does not completely retire the partners interest in the partnership,
or (2) a liquidating distribution that does retire the partners interest in the
partnership.
Tax effects on partnership. A partnership does not recognize gain on a distri-
bution of money or property to a partner.
Tax effects of distributions on partners. A partner pays tax on income at the
time the income is earned, not when the income is distributed. Therefore,
distributions to partners are generally not taxable. Exception: A distribution
of money is taxable if the amount of the distribution exceeds the partners
adjusted basis in the partnership interest.
A partner generally will not recognize a loss on a distribution of property. How-
ever, a loss may be recognized as a result of a liquidating distribution if money
and/or unrealized receivables or inventory are distributed. See Payments for
unrealized receivables and inventory items, page 58.
Sylvester and Adrianne are partners in a partnership. Each partner receives a
current distribution of $5,000 in cash. Sylvesters adjusted basis in his partner-
ship interest is $6,000. Adriannes adjusted basis in her partnership interest
is $3,000. The $5,000 distribution to Sylvester is not taxable, but does reduce
his basis to $1,000 ($6,000 minus $5,000 distribution = $1,000 adjusted basis).
Adrianne has a capital gain of $2,000 ($5,000 distribution against $3,000 basis).
Current Distributions
A current distribution is any distribution that does not completely retire a part-
ners interest in the partnership. A current distribution can either reduce the
partners capital account or can reduce the partners ownership interest in the
partnership.
Gain. Gain will not be recognized by a partner in a current distribution unless
money is distributed. Gain is recognized only if the amount of money received
exceeds the partners adjusted basis in the partnership.
Loss. A loss will not be recognized by a partner on a current distribution.
A partnership does no recognize
gain on a distribution o mone or
property to a partner.
KEY FACT
EXAMPLE
56 Chapter 3 TheTaxReview Business Entities
NOTES Basis of property received in a current distribution. A partners basis for
property (other than money) received in a current distribution is the partner-
ships adjusted basis in the property. The propertys basis is limited to the part-
ners adjusted basis in the partnership reduced by any money received in the
same transaction.
Liquidating Distributions
A liquidating distribution retires a partners interest in the partnership. A se-
ries of payments made as part of a liquidation plan are all treated as liquidat-
ing distributions.
Gain. A partner will recognize gain on a liquidating distribution to the extent
that money distributed exceeds the partners adjusted basis in his or her part-
nership interest.
Loss. A loss on a liquidating distribution can be recognized if cash, unrealized
receivables, or inventory items are received by the partner. If any other prop-
erty is distributed to the partner, the partner cannot recognize a loss.
The IRS challenged a noncash distribution to a partner in liquidation of his
interest. The partnership purchased real estate shortly before the liquidation
and distributed the property to the retiring partner. The partner claimed non-
recognition of gain since no cash was distributed. The IRS maintained the real
estate served no purpose other than to provide the partner with a noncash
distribution and denied the partner nonrecognition of gain under IRC section
731. It was further discovered that this purchase was entirely orchestrated by
the retiring partner himself, even to the extent of selecting the property. (Ltr.
Rul. 200650014)
Liabilities. Assumption of liabilities by a partner is treated as payment of
money to the partnership. Assumption of liabilities results in an increase in the
partners basis. Conversely, a relief of liabilities is treated as money paid to the
partner. The partners basis is decreased by the amount of liabilities relieved.
Sale of partnership interest. The sale or exchange of a partners interest in
a partnership generally results in capital gain or loss. However, payment for
unrealized receivables and inventory are treated as ordinary income or loss.
Gain or loss is the difference between the amount realized and the adjusted
basis of the partners interest in the partnership. If the selling partner is re-
lieved of any liabilities, that partner must include the liability relief as part of
the amount realized.
A los on a liquidating distribution
can be recognized if cash, unrealized
receivables, or inventory items are
received by the partner.
KEY FACT
TheTaxReview Business Entities Chapter 3 57
NOTES
Fred became a partner in the Alphabet Partnership by contributing $5,000 in
cash on the formation of the partnership. The adjusted basis of his partnership
interest at the end of 2012 was $20,000, which includes his $15,000 share of
partnership liabilities. The partnership has no unrealized receivables or inven-
tory items. In 2013, Fred sold his interest in the partnership for $10,000 in cash.
Fred realizes $25,000 from the sale ($10,000 cash payment plus $15,000 liability
relief). Fred reports $5,000 capital gain on his Form 1040 ($25,000 realized less
$20,000 basis).
Disguised sale rules. A transfer of property (other than money or an obliga-
tion to contribute money) by the partner to the partnership, and a transfer of
money or other consideration by the partnership to the partner, is treated as
a sale by the partner to the partnership if:
1) The transfer of money or other consideration would not have been made
but for the transfer of property, and
2) In cases where the transfers are not made simultaneously, the subsequent
transfer is not dependent on the entrepreneurial risks of partnership
operations.
For purposes of disguised sale rules if, within a two-year period, a partner
transfers property to a partnership, and the partnership transfers money or
other consideration to the partner, the transfers are presumed to be a disguised
sale unless the facts and circumstances clearly establish otherwise.
Facts and circumstances. The presence of some or all of the following facts
and circumstances may indicate that a disguised sale has taken place.
1) The timing and amount of a subsequent transfer are determinable with rea-
sonable certainty at the time of an earlier transfer,
2) The transferor has a legally enforceable right to the subsequent transfer,
3) The partners right to receive the transfer of money or other consideration
is secured in any manner, taking into account the period during which it is
secured,
4) Any person has made or is legally obligated to make contributions to the
partnership in order to permit the partnership to make the transfer of money
or other consideration,
5) Any person has loaned, or has agreed to loan, the partnership the money or
other consideration required to enable the partnership to make the transfer,
taking into account whether any such lending obligation is subject to contin-
gencies related to the results of partnership operations,
6) The partnership has incurred, or is obligated to incur, debt to acquire the
money or other consideration necessary to permit it to make the transfer,
taking into account the likelihood that the partnership will be able to incur
that debt,
7) The partnership holds money or other liquid assets, beyond the reasonable
needs of the business, that are expected to be available to make the transfer,
EXAMPLE
KEY FACT
58 Chapter 3 TheTaxReview Business Entities
NOTES 8) Partnership distributions, allocations, or control of partnership operations is
designed to effect an exchange of the burdens and benets of ownership of
property,
9) The transfer of money or other consideration by the partnership to the part-
ner is disproportionately large in relationship to the partners general and
continuing interest in partnership prots, and
10) The partner has no obligation to return or repay the money or other con-
sideration to the partnership, or has such an obligation, but it is likely to
become due at such a distant point in the future that the present value of
that obligation is small in relation to the amount of money or other consid-
eration transferred by the partnership to the partner.
Certain distributions treated as sales or exchanges. When a partnership
distributes the following items, the distributions may be treated as a sale or
exchange of property rather than a distribution.
Unrealized receivables or substantially appreciated inventory items distrib-
uted in exchange for any part of the partners interest in other partnership
property, including money.
Other property (including money) distributed in exchange for any part of a
partners interest in unrealized receivables and/or substantially appreciated
inventory items.
Property distributed to satisfy guaranteed payments. Revenue Ruling 2007-40
provides that a partnership must recognize gain or loss as if the property had
been sold at FMV and may treat the amount as a guaranteed payment.
Sale or exchange treatment does not apply to distributions of property to the
partner who contributed the property to the partnership, or payments made
to a retiring partner or successor in interest of a deceased partner that are the
partners distributive share of partnership income.
Substantially appreciated inventory items. Inventory items are considered
to have appreciated substantially in value if, at the time of the distribution,
the total FMV is more than 120% of the partnerships adjusted basis for the
property. However, if a principal purpose for acquiring inventory property is
to avoid ordinary income treatment by reducing the appreciation to less than
120%, that property is excluded.
Payments for unrealized receivables and inventory items. If a partner re-
ceives money or property in exchange for any part of a partnership interest, the
amount due to his or her share of the partnerships unrealized receivables or
inventory items results in ordinary income or loss. This amount is treated as if
it were received for the sale or exchange of property that is not a capital asset.
This treatment applies to the unrealized receivables part of payments to a retir-
ing partner or successor in interest of a deceased partner only if that part is not
treated as paid in exchange for partnership property. See Liquidation at partners
retirement or death, page 59.
KEY FACT
If a partner receives mone or
property in echange for any part
o a partnership interest, the
amount due to his or her share
o the partnerships unrealized
receivables or inventory items results
in ordinary income or los.
TheTaxReview Business Entities Chapter 3 59
NOTES Unrealized receivables. Unrealized receivables include any rights to payment
not already included in income for the following items.
Goods delivered, or to be delivered, to the extent the payment would be
treated as received for property other than a capital asset.
Services rendered or to be rendered.
Unrealized receivables also include the amount of gain that would be treated
as ordinary income, such as section 1245 or section 1250 property.
Determining gain or loss. The income or loss realized by a partner upon the
sale or exchange of its interest in unrealized receivables and inventory items
is the amount that would have been allocated to the partner if the partnership
had sold all its property for cash at FMV in a fully taxable transaction immedi-
ately prior to the partners transfer of interest in the partnership.
Liquidation at partners retirement or death. Payments made by the part-
nership to a retiring partner or successor in interest of a deceased partner in
return for the partners entire interest in the partnership may have to be allo-
cated between payments in liquidation of the partners interest in partnership
property and other payments. The partnerships payments include an assump-
tion of the partners share of partnership liabilities treated as a distribution of
money.
For income tax purposes, a retiring partner or successor in interest of a de-
ceased partner is treated as a partner until his or her interest in the partnership
has been completely liquidated.
Liquidating payments. Payments made in liquidation of the interest of a re-
tiring or deceased partner in exchange for his or her interest in partnership
property are considered a distribution, not a distributive share or guaranteed
payment that could give rise to a deduction for the partnership.
Unrealized receivables and goodwill. Payments made for the retiring or de-
ceased partners share of the partnerships unrealized receivables or goodwill
are not treated as made in exchange for partnership property if both of the fol-
lowing tests are met.
1) Capital is not a material income-producing factor for the partnership. Capi-
tal is a material income-producing factor if a substantial part of the gross
income of the business comes from the use of capital (such as investments in
inventory, plants, machinery, or equipment).
2) The retiring or deceased partner was a general partner in the partnership.
However, this rule does not apply to payments for goodwill to the extent that
the partnership agreement provides for a reasonable payment to a retiring
partner for goodwill.
Gain or loss on distribution. Upon the receipt of the distribution, the retiring
partner or successor in interest of a deceased partner will recognize gain only
to the extent that any money distributed is more than the partners adjusted
basis in the partnership. The partner will recognize a loss only if the distribu-
tion is in money, unrealized receivables, and inventory items. No loss is recog-
nized if any other property is received.
For income tax purposes, a retiring
partner or succesor in interest o
a deceased partner is treated as a
partner until his or her interest in
the partnership has been completely
liquidated.
60 Chapter 3 TheTaxReview Business Entities
NOTES Other payments. Payments made by the partnership to a retiring partner or
successor in interest of a deceased partner that are not made in exchange for
an interest in a partnership property are treated as distributive shares of part-
nership income or guaranteed payments. This rule applies regardless of the
time over which the payments are to be made. It applies to payments made
for the partners share of unrealized receivables and goodwill not treated as
distributions.
If the amount is based on partnership income, the payment is taxable as a
distributive share of partnership income. The payment retains the same char-
acter when reported by the recipient that it would have had if reported by the
partnership.
If the amount is not based on partnership income, it is treated as a guaranteed
payment. The recipient reports guaranteed payments as ordinary income.
These payments are included in income by the recipient for his or her tax
year that includes the end of the partnership tax year for which the payments
are a distributive share or in which the partnership is entitled to deduct them
as guaranteed payments.
Former partners who continue to make guaranteed periodic payments to
satisfy the partnerships liability to a retired partner after the partnership is
terminated can deduct the payments as a business expense in the year paid.
The taxpayer, a lawyer, claimed payments received from his rm after retire-
ment were capital gain rather than ordinary income. The Tax Court held that
the payments made in place of a retirement plan for the rms partners were
guaranteed payments reportable as ordinary income. The payments were re-
lated to years worked for the rm and not in any way related to the size of the
partners interest or the prots of the law rm. (Wallis, T.C. Memo 2009-243)
Distribution of inventory. If a partner receives a distribution of unrealized
receivables or inventory, gain or loss on subsequent sale by the partner is or-
dinary gain or loss. Exception: If the partner sells inventory items held for more
than ve years after the distribution, the type of gain or loss depends on how
the items are being used on the date of sale. The gain or loss is capital gain or
loss if the property is a capital asset in the partners hands at the time sold.
Sandra receives, through dissolution of her partnership, inventory that has
a basis of $19,000. Within ve years, she sells the inventory for $24,000. The
$5,000 gain is taxed as ordinary income. If Sandra had held the inventory for
more than ve years, her gain would have been capital gain, provided the
inventory was a capital asset in her hands at the time of sale.
COURT CASE
If the partner sells inventory items
held for more than ve years afer
the distribution, the type o gain or
los depends on how the items are
being used on the date o sale.
EXAMPLE
TheTaxReview Business Entities Chapter 3 61
NOTES
Chapter 3 Self-Quiz
Instructions
Test your knowledge and comprehension of information presented in Chapter 3.
True/False
1) The partnerships only reporting of guaranteed payments to partners is as a
separately stated item.
True False
2) A nonrecourse debt is shared by both limited partners and general partners.
True False
3) The basis of Emmetts partnership interest is $20,000. He receives a current
distribution of $8,000 cash and property that has an adjusted basis to the
partnership of $16,000. Emmetts basis for the distributed property is limited
to $12,000.
True False
Multiple Choice
1) All of the following are items of partnership income or loss that are required
to be separately stated to each partner except:
a) Bad debt deduction.
b) Section 179 deduction.
c) Charitable contributions.
d) Long-term capital gain.
2) Which of the following scenarios about a partners basis in a partnership
interest is true?
a) George receives his distributive share of partnership income. His basis in
the partnership is decreased.
b) Jane acquires 50% of a partnership interest by contributing property with
a basis of $20,000 and a liability of $10,000 to the partnership. The partner-
ship assumes the liability. Her basis in the partnership is $25,000.
c) Judith is a 50% owner in a partnership interest. She assumes a liability
of $10,000 from the partnership. Her basis in the partnership interest is
increased by $10,000.
d) Elroy contributes property with a basis of $5,000 and a value of $10,000 to
a partnership. In addition, he contributes $5,000 in cash. His basis in the
partnership is $15,000.
62 Chapter 3 TheTaxReview Business Entities
NOTES 3) Which of the following scenarios for a partnership distribution is true?
a) Floyd receives a distribution from his partnership of $5,000 cash. He has a
basis in the partnership of $6,000. Floyd must pay tax on the distribution
because cash distributions are considered guaranteed payments.
b) Otis receives property as a current distribution from his partnership. Otis
has an adjusted basis in the partnership interest of $20,000. The property
has a basis of $30,000. Otis new basis in the property is $30,000.
c) Gomer has a basis in a partnership interest of $15,000. He receives a liqui-
dating distribution of $5,000 cash and is relieved of his portion of partner-
ship liability of $15,000. Gomer does not have to pay tax on the $5,000 cash
because it is below his basis in the partnership.
d) Howard has an adjusted basis in a partnership interest of $30,000. Upon
retiring from the partnership, he receives $25,000 in cash, terminating his
partnership interest. Howard can claim a capital loss of $5,000.
TheTaxReview Business Entities Chapter 3 63
NOTES
Chapter 3 Self-Quiz Answers
True/False
1) The partnerships only reporting of guaranteed payments to partners is as a
separately stated item.
True Incorrect. Payments to partners for services are guaranteed pay-
ments which are included with the partnerships ordinary de-
ductions when computing ordinary business income or loss.
Guaranteed payments are also separately reported to the ap-
propriate partner on their Schedule K-1.
False Correct. Guaranteed payments to partners include payments
for salaries, health insurance, and certain nonqualied deferred
compensation plans. The guaranteed payments are reported as
a separately stated item to each partner and also as a deduction
from the ordinary income of the partnership.
2) A nonrecourse debt is shared by both limited partners and general partners.
True Correct. Neither a limited partner nor a general partner has an
economic risk of loss for a nonrecourse debt. Therefore, all part-
ners share in nonrecourse liabilities.
False Incorrect. A limited partner generally has no obligation to con-
tribute additional capital to the partnership and therefore
does not have an economic risk of loss in partnership recourse
liabilities.
3) The basis of Emmetts partnership interest is $20,000. He receives a current
distribution of $8,000 cash and property that has an adjusted basis to the
partnership of $16,000. Emmetts basis for the distributed property is limited
to $12,000.
True Correct. Emmetts basis in the property is limited to his adjust-
ed basis in the partnership. His adjusted basis is $12,000 (origi-
nal basis of $20,000 minus $8,000 cash received).
False Incorrect. The partnership basis in the property does not carry
forward with the property when it is distributed to Emmett.
Multiple Choice
1) All of the following are items of partnership income or loss that are required
to be separately stated to each partner except:
a) Bad debt deduction.
Correct. A bad debt deduction is a component of a partnerships total
deductions in computing ordinary business income or loss from
trade or business activities. However, recoveries of bad debts are
required by the regulations to be separately stated.
64 Chapter 3 TheTaxReview Business Entities
NOTES b) Section 179 deduction.
Incorrect. A partnership can claim the Section 179 expense deduction;
however, the Section 179 deduction does not reduce the part-
nerships ordinary income. The Section 179 deduction is an item
that is required to be separately stated to each partner.
c) Charitable contributions.
Incorrect. Charitable contributions are one of the items specically men-
tioned in IRC section 702(a) that are required to be separately
stated.
d) Long-term capital gain.
Incorrect. Capital gains and losses are items that are required to be sepa-
rately stated since they could affect each partner differently, de-
pending on the partners individual tax situation.
2) Which of the following scenarios about a partners basis in a partnership
interest is true?
a) George receives his distributive share of partnership income. His basis in
the partnership is decreased.
Incorrect. A partners basis is increased by the partners distributive share
of partnership income.
b) Jane acquires 50% of a partnership interest by contributing property with
a basis of $20,000 and a liability of $10,000 to the partnership. The partner-
ship assumes the liability. Her basis in the partnership is $25,000.
Incorrect. The basis of Janes interest in the partnership is reduced by the
liability assumed by other partners. The other partners assumed
$5,000 debt ($10,000 liability 50% ownership). Janes basis in
the partnership is reduced to $15,000 ($20,000 basis minus $5,000
liability assumed by other partners).
c) Judith is a 50% owner in a partnership interest. She assumes a liability of
$10,000 from the partnership. Her basis in the partnership interest is in-
creased by $10,000.
Correct. A partner who assumes partnership liabilities is treated as mak-
ing a contribution of money to the partnership. This increases
the partners basis in the partnership interest.
d) Elroy contributes property with a basis of $5,000 and a value of $10,000 to
a partnership. In addition, he contributes $5,000 in cash. His basis in the
partnership is $15,000.
Incorrect. Elroys basis is $10,000 ($5,000 basis in the property plus $5,000
cash). His capital account within the partnership will reect the
fair market value of the property, plus his cash contribution.
However, his basis is determined by the cash contributed, plus
the basis in the property contributed.
TheTaxReview Business Entities Chapter 3 65
NOTES 3) Which of the following scenarios for a partnership distribution is true?
a) Floyd receives a distribution from his partnership of $5,000 cash. He has a
basis in the partnership of $6,000. Floyd must pay tax on the distribution
because cash distributions are considered guaranteed payments.
Incorrect. A distribution of money is taxable if the amount of the distri-
bution exceeds the partners adjusted basis. Floyds basis is re-
duced to $1,000 and the $5,000 is not taxable.
b) Otis receives property as a current distribution from his partnership. Otis
has an adjusted basis in the partnership interest of $20,000. The property
has a basis of $30,000. Otis new basis in the property is $30,000.
Incorrect. The propertys basis is limited to the partners adjusted basis in
the partnership. The new basis for Otis is $20,000.
c) Gomer has a basis in a partnership interest of $15,000. He receives a liqui-
dating distribution of $5,000 cash and is relieved of his portion of partner-
ship liability of $15,000. Gomer does not have to pay tax on the $5,000 cash
because it is below his basis in the partnership.
Incorrect. Relief of liability is treated as money paid to the partner. Gomers
basis is reduced by the amount of liability relieved. His adjusted
basis is zero (original basis of $15,000 minus $15,000 relief of li-
ability) and the $5,000 cash is taxable.
d) Howard has an adjusted basis in a partnership interest of $30,000. Upon
retiring from the partnership, he receives $25,000 in cash, terminating his
partnership interest. Howard can claim a capital loss of $5,000.
Correct. A capital loss can be recognized for a liquidating distribution of
money.
66 Chapter 3 TheTaxReview Business Entities
TheTaxReview Business Entities Chapter 4 67
CPE/CE Exempt Organizations
4
Learning Objectives
Successful completion of this course will enable the participant to:
4-A Determine whether an entity qualies as a tax-exempt organization under
Internal Revenue Code section 501(c)(3), based on organizational structure,
operation, and purpose.
4-B Identify the ling requirements and required disclosures for a tax-exempt
organization.
4-C Identify unrelated business income and requirements for ling Form
990-T, Exempt Organization Business Tax Return.
Glossary Terms
Unrelated business income. Unrelated business income that is not substan-
tially related to an exempt organizations exempt purposes is subject to taxa-
tion on Form 990-T, Exempt Organization Business Tax Return.
Organizational test. Under IRC section 501(c)(3), an exempt organization must
be organized as a corporation, trust, or unincorporated association with organiz-
ing documents limiting the organization to performance of exempt purposes.
Operational test. A substantial portion of an exempt organizations activities
must further its exempt purpose.
Learning Objective 4-A
Determine whether an entity qualies as a tax-exempt organization under
Internal Revenue Code section 501(c)(3) based on organizational structure,
operation, and purpose.
Tax-Exempt Qualications
A nonprot organization must be organized and operated exclusively for one
or more exempt purposes. To qualify for exempt status under the Internal Rev-
enue Code, the entity must continually meet the following requirements.
1) Serve some type of common good.
2) Not be a for-prot entity.
3) Not have net earnings that benet the members of the organization.
4) Not exert political inuence.
Nonprot Components
There are three key components for an organization to be exempt from federal
income tax under section 501(c)(3) of the IRC.
1) Organizational test.
2) Operational test.
3) Exempt purpose.
68 Chapter 4 TheTaxReview Business Entities
NOTES
Organizational Test
A 501(c)(3) organization must be organized as a corporation, trust, or unincor-
porated association. An organizations organizing documents (articles of in-
corporation, trust documents, articles of association) must limit its purpose to
those described in section 501(c)(3). See Common Types of Nonprots, page 70.
The organizational documents must not expressly permit unrelated activities
that do not further the organizations exempt purposes, and they must perma-
nently dedicate the organizations assets to exempt purposes.
The organizational test may be met if the purposes stated in the articles of
organization are limited in some way by reference to section 501(c)(3).
The requirement that the organizations purposes and powers must be lim-
ited by the articles of organization is not satised if the limit is contained only
in the bylaws or other rules or regulations.
The organizational test is not satised by statements of the organizations of-
cers that it intends to operate only for exempt purposes.
The test is not satised by the fact that the actual operations are for exempt
purposes.
An entitys articles of organization state that it is formed exclusively for literary
and scientic purposes within the meaning of section 501(c)(3). These articles
appropriately limit the organizations purposes. The organization meets the
organizational test.
An organization, by the terms of its articles, is formed to engage in research
without any further description or limitation. The organization will not be prop-
erly limited as to its purposes since not all research is scientic. The organiza-
tion does not meet the organizational test.
In interpreting an organizations articles, the law of the state where the orga-
nization was created is controlling. If an organization contends that the terms
of its articles have a different meaning under state law than their generally ac-
cepted meaning, such meaning must be established by a clear and convincing
reference to relevant court decisions, opinions of the state attorney general, or
other appropriate state authorities.
Dedication and distribution of assets. Assets of a tax-exempt organization
must be permanently dedicated to an exempt purpose. This means that should
an organization dissolve, its assets must be distributed for an exempt purpose
or to the Federal Government or to a state or local government for a public pur-
pose. If the assets could be distributed to members or private individuals or for
any other purpose, the organizational test is not met.
Operational Test
An organization will be regarded as operated exclusively for one or more ex-
empt purposes only if a substantial portion of its activities further its exempt
purpose. Certain other activities are prohibited or restricted including, but not
limited to:
Te organizational documents
must no epresly permit unrelated
activities that do no further the
organizations eempt purposes, and
the must permanently dedicate
the organizations asets to eempt
purposes.
EXAMPLE
EXAMPLE
If the asets could be distributed
to members or private individuals
or for any oher purpose, the
organizational test is no met.
An organization will be regarded as
operated eclusively for one or more
eempt purposes only if a substantial
portion o its activities further its
eempt purpose.
TheTaxReview Business Entities Chapter 4 69
NOTES The organization must not participate in the political campaigns of candi-
dates for local, state, or federal ofce.
The organization must restrict its lobbying activities to an insubstantial part
of its total activities. An organization does not qualify for section 501(c)(3) sta-
tus if a substantial part of its activities is attempting to inuence legislation.
The organizations earnings must not inure to the benet of any private
shareholder or individual.
The organization must not operate for the benet of private interests such
as those of its founder, the founders family, its shareholders or persons con-
trolled by such interests.
The organization must not operate for the primary purpose of conducting a
trade or business that is not related to its exempt purpose, such as a schools
operation of a factory.
The organization must not have purposes or activities that are illegal or vio-
late fundamental public policy.
A nonprot corporation organized to audit structural steel fabricators was
denied tax-exempt status from the IRS. As its primary activity, the corpora-
tion inspects the quality control procedures used in facilities of fabricators
applying for American Institute of Steel Construction (AISC) certication. The
certication program was established by AISC at the request of public and
private owners and developers who desired a reliable method for selecting
competent fabricators. The corporation claims it is operated exclusively for the
charitable purposes of lessening the burdens of government and encouraging
safe construction for the benet of the general public. The court held that the
corporation furthers private interests and is therefore not operated exclusively
for exempt charitable purposes. The IRS denial of tax-exempt status was
upheld. (Quality Auditing Company, Inc., 114 T.C. No. 31)
Exempt Purpose
To be tax exempt, an organization must have one or more exempt purposes
stated in its organizing document. Section 501(c)(3) of the IRC lists the follow-
ing exempt purposes: charitable, educational, religious, scientic, literary, fos-
tering national or international sports competition, preventing cruelty to chil-
dren or animals, and testing for public safety.
Charitable. The term charitable is used in its generally accepted legal sense.
Such term includes relief of the poor, advancement of religion, advancement
of education or science, erection or maintenance of public buildings or monu-
ments, lessening the burdens of government, and promotion of social welfare
by organizations designed to accomplish any of these purposes.
Educational. The term educational relates to the instruction or training of the
individual for the purpose of improving or developing his or her capabilities,
or the instruction of the public on subjects useful to the individual and bene-
cial to the community.
COURT CASE
70 Chapter 4 TheTaxReview Business Entities
NOTES Public interest. An organization is not organized or operated exclusively for
one or more of these exempt purposes unless it serves a public rather than a
private interest. Thus, to meet the requirements of the exempt purposes test,
it is necessary for the organization to establish that it is not organized or op-
erated for the benet of private interests such as designated individuals, the
creator or his or her family, shareholders of the organization, or persons con-
trolled, directly or indirectly, by such private interests.
Hidden Talent, Inc. is an art museum. The corporations principal activity is
exhibiting art created by a group of unknown but promising local artists. The
corporations activity is promoting the arts. All the art exhibited is offered
for sale at prices set by the artist. Each artist whose work is exhibited has a
consignment arrangement with the corporation. When art is sold, the museum
retains 10% of the selling price to cover the costs of operating the museum and
gives the remaining 90% to the artist. The artists in this situation directly ben-
et from the exhibition and sale of their art. As a result, the principal activity
of the corporation serves the private interests of these artists. Therefore, the
corporation is in violation of the restriction on private benet. Hidden Talent,
Inc. is not operated exclusively for exempt purposes.
Comment: As an alternative to applying for exemption, an organization may
obtain many of the benets of 501(c)(3) status by afliating with an existing
charity that acts as its agent. It is important to note that the existing charity
must be given full control and authority over the program.
Private Foundations
The counterparts to public charities are private foundations. While public
charities generally have broad public support, a private foundation is usually
funded by an individual, family, or a corporation. Establishing a private foun-
dation can give the donor a current tax benet while allowing the donor to
maintain some control over assets.
Charitable organizations described in IRC section 501(c)(3) are presumed to be
private foundations unless notication is made to the IRS. Notication is made
when the application for exempt status is led with the IRS. See Applying for
501(c)(3) Status, page 71. Exempt organizations that are not private foundations
include churches, educational institutions, hospitals and medical research or-
ganizations, charitable organizations receiving a major portion of their support
from the general public or United States, and governmental units.
Common Types of Nonprots
The most common types of exempt organizations are formed for charitable,
educational, or religious purposes.
Charitable Organizations
Charitable organizations conduct activities that promote:
Relief for the poor, the distressed, or the underprivileged.
Advancement of religion.
To meet the requirements o the
eempt purposes test, it is necesary
for the organization to establish that
it is no organized or operated for the
benet o private interests such as
designated individuals, the creator
or his or her family, shareholders
o the organization, or persons
controlled, directly or indirectly, by
such private interests.
EXAMPLE
Charitable organizations described
in IRC section 501(c)(3) are
presumed to be private foundations
unles noication is made to the
IRS.
Te most common types o eempt
organizations are formed for
charitable, educational, or religious
purposes.
TheTaxReview Business Entities Chapter 4 71
NOTES Advancement of education or science.
Erection or maintenance of public buildings, monuments, or works.
Lessening the burdens of the government.
Lessening neighborhood tensions.
Eliminating prejudice and discrimination.
Defending human and civil rights secured by law.
Combating community deterioration and juvenile delinquency.
Educational Organizations
Educational organizations include:
Schools, such as a primary or secondary school, a college, or a professional or
trade school.
Organizations that conduct public discussion groups, forums, panels, lectures,
or similar programs.
Organizations that present a course of instruction by means of correspon-
dence or through the use of television or radio.
Museums, zoos, planetariums, symphony orchestras, or similar organizations.
Nonprot day care centers.
Youth sports organizations.
Religious
The term church includes synagogues, temples, mosques, and similar types
of organizations. Although the IRC excludes these organizations from the re-
quirement to le an application for exemption, many churches voluntarily le
applications for exemption. Such recognition by the IRS assures the church
leaders, members, and contributors that the church is tax exempt under sec-
tion 501(c)(3) and qualies for related tax benets. Other religious organiza-
tions that do not carry out the functions of a church, such as mission orga-
nizations, speakers organizations, nondenominational ministries, ecumenical
organizations, or faith-based social agencies, may qualify for exemption. These
organizations must apply for exemption from the IRS.
Examples of qualifying nonprot organizations include:
Nonprot old-age homes,
Parent-teacher associations,
Charitable hospitals or other charitable organizations,
Alumni associations,
Schools,
Chapters of the Red Cross,
Boys or Girls Clubs, and
Churches.
Applying for 501(c)(3) Status
Form 1023, Application for Recognition of Exemption Under Section 501(c)
(3) of the Internal Revenue Code. Most organizations seeking recognition of
exemption from federal income tax under section 501(c)(3) must use Form 1023.
Oral requests for recognition of exemption will not be considered by the IRS. A
user fee between $400 and $850 generally applies, based on the organizations
Oral requests for recognition o
eemption will no be considered by
the IRS.
72 Chapter 4 TheTaxReview Business Entities
NOTES gross receipts, and payment must accompany the application. Form 1023 con-
tains instructions and checklists for required information which will include
the following:
The organizations employer identication number,
A conformed copy of the organizing documents,
A full description of the proposed activities of the organization, and
Financial statements showing receipts and expenditures for the current year
and the preceding four years or a proposed 3-year budget if the organization
has not yet begun operations.
The IRS may request additional information necessary to clarify the nature
of the organization. Organizations that submit a complete application will re-
ceive an acknowledgement from the IRS. Others will receive a letter requesting
more information or returning an incomplete application.
An organization is not required to le Form 1023 if:
It is a church, synagogue, temple, or mosque.
It is an integrated auxiliary of a church or association of churches.
Its gross annual receipts are not more the $5,000. An organization must le Form
1023 within 90 days of the end of the year in which it exceeds this threshold.
Even though the above organizations are not required to le Form 1023 to be
tax exempt, these organizations may choose to le Form 1023 in order to receive
a determination letter that recognizes their section 501(c)(3) status and speci-
es whether contributions to them are tax deductible.
Nonprot Responsibilities
Federal tax law imposes the following responsibilities on organizations receiv-
ing 501(c)(3) status.
Recordkeeping. Section 501(c)(3) organizations are required to keep books
and records detailing all activities, both nancial and nonnancial. Informa-
tion on its sources of support is crucial to determining an organizations private
foundation status.
Disclosure requirements. A 501(c)(3) organization must make certain docu-
ments available for public inspection. The organization must make available
their three most recent annual returns (Form 990 or Form 990-EZ), their ap-
plication (Form 1023), and any letter or other document issued by the IRS con-
cerning the application.
Written substantiation and disclosure. Organizations that are tax exempt
under section 501(c)(3) must meet certain requirements for documenting
charitable contributions. The federal tax law imposes two general disclosure
requirements.
1) A donor must obtain a written acknowledgement from a charity for any
single contribution of $250 or more before the donor can claim a charitable
contribution on his or her federal income tax return,
2) A charitable organization must provide a written disclosure to a donor who
makes a payment in excess of $75 partly as a contribution and partly for
goods and services provided by the organization.
Even though the above organizations
are no required to le Form 1023 to
be tax eempt, these organizations
may choose to le Form 1023 in
order to receive a determination
leer that recognizes their section
501(c)(3) status and species
whether contributions to them are
tax deductible.
TheTaxReview Business Entities Chapter 4 73
NOTES
Learning Objective 4-B
Identify the ling requirements and required disclosures for a tax-exempt
organization.
Filing Requirements and Required Disclosures for Tax-Exempt
Organizations
Most exempt organizations (including private foundations) must le vari-
ous returns and reports at some time during, or following the close of, their
accounting period.
Annual Information Returns
Organizations exempt from income tax generally must le an annual informa-
tion return or submit an annual electronic notice depending on the organiza-
tions gross receipts and total assets. Form 990 series returns are required to be
led by most tax-exempt organizations, except church and government-afli-
ated organizations. Form 990 is the IRS primary tool for gathering information
about tax-exempt organizations, for educating organizations about tax law re-
quirements and ensuring their compliance. Organizations use it to inform the
public about their programs. In addition, most states rely on Form 990 to per-
form charitable and other regulatory oversight, and to satisfy state income tax
ling requirements for organizations claiming exemption from state income
tax.
Which Form to File
Tax-Exempt Organization File Form
Gross receipts normally up to $50,000 990-N (may choose to le 990-EZ or 990)
Gross receipts less than $200,000, and
Total assets less than $500,000
990-EZ or 990
Gross receipts at least $200,000, or
Total assets at least $500,000
990
Private foundation 990-PF
Gross receipts. Gross receipts are the total amounts the organization received
from all sources during its annual accounting period, without subtracting any
costs or expenses.
Total assets. Total assets are the amount reported by the organization on its
balance sheet as of the end of the year, without reduction for liabilities.
Form 990-N, e-Postcard
Most small tax-exempt organizations whose annual gross receipts are nor-
mally $50,000 or less ($25,000 for tax years ending after December 31, 2007 and
before December 31, 2010) are required to electronically submit Form 990-N,
also known as the e-Postcard, unless they choose to le a complete Form 990 or
Form 990-EZ instead.
There is no paper version of Form 990-N. Form 990-N asks for the organiza-
tions employer identication number (EIN), tax year, legal name and mailing
Form 990 series returns are required
to be led by most tax-eempt
organizations, ecept church and
government-aliated organizations.
Form 990 is the IRS primary tool
for gathering information about
tax-eempt organizations, for
educating organizations about tax
law requirements and ensuring their
compliance.
Tere is no paper version o Form
990-N.
74 Chapter 4 TheTaxReview Business Entities
NOTES address, any other names the organization uses, name and address of a princi-
pal ofcer, website address if the organization has one, and conrmation that
the organizations annual gross receipts are $50,000 or less.
Filing. Gain access to Form 990-N by going directly to the ling site at http://
epostcard.form990.org.
Due date. The e-Postcard is due every year by the 15th day of the fth month
after the close of the tax year (May 15 for calendar-year organizations). An or-
ganization cannot le the e-Postcard until after the tax year ends.
A calendar year 501(c)(3) tax-exempt organization has gross receipts of
$35,000 in 2013. The organization may electronically le Form 990-N any time
from January 1, 2014 through May 15, 2014.
Penalty. There is no penalty assessment for late ling the e-Postcard, but an or-
ganization that fails to le required e-Postcards (or information returns Forms
990 or 990-EZ) for three consecutive years will automatically lose its tax-exempt
status. The revocation of the organizations tax-exempt status will not take
place until the ling due date of the third year. To regain its exempt status, an
organization will have to reapply for recognition as a tax-exempt organization.
Effect of losing tax-exempt status. If an organizations tax-exempt status is
automatically revoked, it is no longer exempt from federal income tax. Con-
sequently, it may be required to le one of the following federal income tax
returns and pay applicable income taxes.
Form 1120, U.S. Corporation Income Tax Return, due by the 15th day of the 3rd
month after the end of the organizations tax year, or
Form 1041, U.S. Income Tax Return for Estates and Trusts, due by the 15th day of
the 4th month after the end of your organizations tax year.
An automatically revoked organization is not eligible to receive tax-deduct-
ible contributions and will be removed from the cumulative list of tax-exempt
organizations.
Forms 990 and 990-EZ
Exempt organizations, other than private foundations, must le their annual
information returns on Form 990 or Form 990-EZ, unless excepted from ling
or allowed to submit Form 990-N, described on page 73.
An organizations completed Form 990 or 990-EZ is generally available for pub-
lic inspection. Some members of the public rely on Form 990 or 990-EZ as the
primary or sole source of information about a particular organization. How the
public perceives an organization in such cases may be determined by informa-
tion presented on its return. Therefore, the return must be complete, accurate,
and fully describe the organizations programs and accomplishments.
EXAMPLE
An organization that fails to le
required e-Postcards (or information
returns Forms 990 or 990-EZ)
for three consecutive years will
automatically lose its tax-eempt
status.
KEY FACT
TheTaxReview Business Entities Chapter 4 75
NOTES Form 990, Return of Organization Exempt From Income Tax. Form 990 must
be led by an organization exempt from income tax (including an organiza-
tion that has not applied for recognition of exemption) if it has either gross
receipts greater than, or equal to, $200,000 or total assets greater than, or equal
to, $500,000 at the end of the tax year. This includes organizations described in
section 501(c)(3), other than private foundations.
Form 990-EZ. Form 990-EZ is a shortened version of Form 990. It is designed for
use by small exempt organizations and nonexempt charitable trusts. Organiza-
tions with gross receipts less than $200,000, and total assets less than $500,000
at the end of the year, are eligible to le Form 990-EZ, a four-page form. If an
organization does not meet both these conditions, it must le Form 990.
Exceptions: The following organizations are not required to le Form 990-EZ or
Form 990.
Certain political organizations.
Certain church, church afliated organizations, church-operated schools,
and other religious-type organizations.
Certain private foundations le Form 990-PF. See Form 990-PF, below.
Pension plans exempt under IRC section 401 use Form 5500, Annual Return/
Report of Employee Benet Plan.
Exempt organizations that are not required to le Form 990 may be required to
le Form 990-T, Exempt Organization Business Tax Return. See Exception: Unrelated
Business Income, page 79.
Form 990-PF
All private foundations exempt under section 501(c)(3) must le Form 990-PF, Re-
turn of Private Foundation or Section 4947(a)(1) Trust Treated as a Private Foundation.
Electronic Filing
Forms 990, 990-EZ and 990-PF may all be led electronically. An organiza-
tion may be required to le these forms with related forms, schedules, and
attachments, electronically under certain circumstances. If an organization is
required to le a return electronically but does not, the organization is con-
sidered to have not led its return. The IRS may waive the requirement to le
electronically in cases of undue hardship.
Form 990. An organization with $10 million or more in total assets must le
Form 990 electronically if it les at least 250 returns in a calendar year, includ-
ing income, excise, employment tax, and information returns.
A tax-exempt organization has $10 million in total assets and 245 employees. It
must le Form 990 electronically because each Form W-2 and quarterly Form
941 is considered a separate return. This organization would le a total of 250
returns (245 W-2s, four 941s, and one 990).
Form 990-PF. A private foundation is required to le Form 990-PF electroni-
cally if it les at least 250 returns during the calendar year.
If an organization is required to le
a return electronically but does no,
the organization is considered to
have no led its return.
EXAMPLE
76 Chapter 4 TheTaxReview Business Entities
NOTES Waiver. The IRS may waive the requirement to le electronically in cases of
undue hardship. The criteria for undue hardship are situations where the or-
ganization cannot meet electronic ling requirements due to technology con-
straints or where compliance with the requirement would result in undue -
nancial burden on the ler.
Due Date
The due date for ling Form 990, 990-EZ, or 990-PF is the 15th day of the fth
month after the close of the organizations tax year (May 15 for calendar-year
organizations). In the case of liquidation, termination, or if the organization
was dissolved, the return is due by the 15th day of the fth month after the date
of liquidation, termination, or dissolution.
Extension of time to le. Form 8868, Application of Extension of Time to File an
Exempt Organization Return, is used to request an automatic three-month exten-
sion. The same form is used to request a second 3-month extension, which is
not automatic.
Penalties
Failure to le. Generally, an exempt organization that fails to le a required
return (except Form 990-N) must pay a penalty of $20 per day for each day the
failure continues. The same penalty will apply if the organization does not give
all the information required on the return or does not give the correct infor-
mation. The maximum penalty for any one return is the smaller of $10,000, or
5% of the organizations gross receipts for the year. For an organization with
gross receipts of over $1 million for the year, the penalty is $100 per day up to
a maximum of $50,000.
Responsible person. If the organization does not le a complete return, or
does not furnish correct information, the IRS will send the organization a letter
that includes a xed time to fulll the requirements. After that period expires,
the person failing to comply will be charged a penalty of $10 a day. The maxi-
mum penalty on all persons for failures with respect to any one return shall not
exceed $5,000.
Reasonable cause exception. No penalty will be imposed if reasonable cause
for failure to le timely can be shown.
A not-for-prot corporation argued that its inability to timely le its return was
due to the destruction of its records during relocation. However, the corpora-
tions bookkeeper had failed to make any effort to salvage waterlogged boxes
containing nancial records and had simply disposed of them. In addition, the
corporation delayed ling the returns until 20 months after they were due. The
court ruled that the corporation had failed to establish reasonable cause and
found that its failure to le its returns in a timely manner was due to willful
neglect. The court upheld the IRS assessment of late ling penalties. (Ameri-
can Friends of Yeshivat Ohr Yerushalayim, Inc., U.S. District Court, E.D. New
York, July 29, 2009)
Te criteria for undue hardship are
situations where the organization
canno meet electronic ling
requirements due to technology
constraints or where compliance
with the requirement would result
in undue nancial burden on the
ler.
COURT CASE
TheTaxReview Business Entities Chapter 4 77
NOTES Loss of exempt status. Organizations that fail to meet their annual ling re-
quirements for three consecutive years will lose their exemption status as of
the ling due date of the third year. Organizations that lose their tax-exempt
status must le income tax returns and pay income taxes.
Employment Tax Returns
Every employer, including an organization exempt from federal income tax,
which pays wages to employees is responsible for withholding, depositing,
paying, and reporting federal income tax, Social Security and Medicare (FICA)
taxes, and federal unemployment (FUTA), unless that employer is specically
excepted by law from those requirements or if the taxes clearly do not apply.
FICA and FUTA tax exceptions. Payments for services performed by a minis-
ter of a church in the exercise of the ministry, or a member of a religious order
performing duties required by the order, are generally not subject to FICA or
FUTA taxes.
FICA tax exemption election. Churches and qualied church-controlled or-
ganizations can elect exemption from employer FICA taxes by ling Form 8274,
Certication by Churches and Qualied Church-Controlled Organizations Electing
Exemption From Employer Social Security and Medicare Taxes.
FUTA tax exception. Payments for services performed by employees of reli-
gious, charitable, educational, or other section 501(c)(3) organizations that are
generally subject to FICA taxes if the payments are $100 or more for the year,
are not subject to FUTA taxes.
Other Information Returns
In addition to annual Form 990 series lings and employment tax returns, an
organization receiving charitable donations may be required to le certain in-
formation returns relating to donations received.
Donee Information Returns
Dispositions of donated property. If an organization receives charitable de-
duction property, and within three years sells, exchanges, or otherwise disposes
of the property, the organization must le Form 8282, Donee Information Return.
An organization is not required to le Form 8282 if the property is valued at
$500 or less or the property is consumed or distributed for charitable purposes.
Appraisal summary. If the value of the donated property exceeds $5,000, the
donor must get a qualied appraisal for contribution of property. A written ap-
praisal is not needed if the property is:
Nonpublicly traded stock of $10,000 or less,
A vehicle (including a car, boat, or airplane) if the deduction is limited to the
gross proceeds from its sale,
Intellectual property,
Certain securities,
Inventory and other property donated by a corporation that are qualied
contributions for the care of the ill, the needy, or infants, or
Any donation of stock in trade, inventory, or property held primarily for sale
to customers in the ordinary course of trade or business.
Organizations that lose their tax-
eempt status must le income tax
returns and pay income taxes.
Payments for services performed by a
minister o a church in the eercise
o the ministry, or a member o a
religious order performing duties
required by the order, are generally
no subect to FICA or FUTA taxes.
In addition to annual Form 990
series lings and emploment tax
returns, an organization receiving
charitable donations may be
required to le certain information
returns relating to donations
received.
78 Chapter 4 TheTaxReview Business Entities
NOTES The donee organization is not a qualied appraiser for the purpose of valuing
donated property.
Form 8283. For noncash donations over $5,000, the donor must attach Form
8382, Noncash Charitable Contributions, to his or her tax return to support the
charitable deduction. The donee must sign Part IV, Section B, Form 8283, un-
less the donation is of publicly traded securities. The person who signs for the
donee must be an ofcial authorized to sign the donees tax or information re-
turns or a person specically authorized to sign by that ofcial. A copy of Form
8283 must be given to the donee.
Information Provided to Donors
In some situations, a donor must obtain certain information from a donee orga-
nization to obtain a deduction for a charitable contribution. In other situations,
the donee organization is required to provide information to the donor. For
example, a charitable organization must give a donor a disclosure statement
for a quid pro quo contribution over $75. A donor cannot deduct a charitable
contribution of $250 or more unless the donor has a written acknowledgement
from the charitable organization. In some circumstances, an organization can
meet both requirements with the same written document.
Quid pro quo contributions. A quid pro quo contribution is a payment a do-
nor makes to a charity partly as a contribution and partly for goods or services.
A charitable organization must provide a written disclosure statement to do-
nors of a quid pro quo contribution over $75.
A donor gives a charity $100 and receives a concert ticket valued at $40. The
donor has made a quid pro quo contribution. The charitable contribution part
of the payment is $60. Even though the deductible part of the payment is not
more than $75, a disclosure statement must be led because the donors pay-
ment (quid pro quo contribution) is more than $75.
The written disclosure statement must inform the donor that the deductible
amount of the contribution is limited to the excess of any money contributed
over the fair market value of the goods or services provided by the charity and
provide the donor with a good faith estimate of the fair market value of the
goods or services that the donor received.
Acknowledgment of charitable contributions of $250 or more. A donor can
deduct a charitable contribution of $250 or more only if the donor has a written
acknowledgment from the charitable organization. The donor is responsible
for requesting and obtaining the written acknowledgment from the donee.
Acknowledgment of vehicle contribution. If an exempt organization re-
ceives a contribution of a qualied vehicle with a claimed value of more than
$500, the donee organization is required to provide a contemporaneous written
acknowledgment to the donor. Any donee organization that provides a written
acknowledgment to a donor is required to report the information contained in
the acknowledgment to the IRS.
In some circumstances, an
organization can meet boh
requirements with the same writen
document.
EXAMPLE
A donor can deduct a charitable
contribution o $250 or more
only if the donor has a writen
acknowledgment fom the
charitable organization.
TheTaxReview Business Entities Chapter 4 79
NOTES
Report of Cash Received
An exempt organization that receives, in the course of its activities, more than
$10,000 cash in one transaction (or two or more related transactions) that is not
a charitable contribution must report the transaction to the IRS on Form 8300,
Report of Cash Payments Over $10,000 Received in a Trade or Business.
Online Information for Form 990
The IRS website has a link to education, workshops, and seminars that walks in-
dividuals through key reporting issues common to exempt organizations. Follow
the link from the IRS home at www.irs.gov/Charities-&-Non-Prots.
Learning Objective 4-C
Identify unrelated business income and requirements for ling Form 990-T,
Exempt Organization Business Tax Return.
General Rule for Taxation of Exempt Organizations
An exempt organization is not taxed on income derived from an activity that is
substantially related to the charitable, educational, or other purpose that is the
basis for the organizations exemption, even if the activity is a trade or business.
Exception: Unrelated Business Income
If an activity conducted by an exempt organization generates unrelated busi-
ness income, except that the activity provides funds to carry out the organiza-
tions exempt purpose, then the organization is subject to tax on its income
from that unrelated trade or business.
Unrelated business income (UBI). An exempt organization has unrelated busi-
ness income if the income meets all three tests.
1) It is derived from a trade or business, and
2) The trade or business activity is regularly carried on, and
3) The trade or business activity is not substantially related to the
organizations exempt purposes.
Reporting Unrelated Business Income
Form 990-T, Exempt Organization Business Tax Return, is used to report unrelated
business income, claim allowable deductions, and compute tax, if any. The tax
on UBI is intended to neutralize the tax difference between nonprot and for-
prot companies. Without the tax, exempt organizations would have an ad-
vantage when competing with for-prot companies in pursuing income from
a trade or business.
Any exempt organization with gross income of $1,000 or more from the con-
duct of a regularly conducted unrelated trade or business must le Form 990-T.
Gross income is gross receipts minus cost of goods sold.
Form 990-T is due no later than the 15th day of the fth month following the
end of the organizations tax year (May 15 for calendar-year organizations).
KEY FACT
80 Chapter 4 TheTaxReview Business Entities
NOTES All unrelated business activities of an exempt organization are reported on a
single Form 990-T.
Form 990-T is a stand-alone form. When required, it is led in addition to Form
990, 990-EZ, or 990-PF, and is led separately from those forms.
Test 1: Trade or Business
A trade or business is any activity carried on for the production of income from
selling goods or performing services. When a trade or business activity is part
of a larger group of similar activities that may or may not be related to the or-
ganizations exempt purpose, the activity does not lose its identity as a trade or
business.
A hospital pharmacy furnishes supplies to the hospital and patients of the
hospital as part of its exempt purpose. Sales of pharmaceutical supplies to
the general public are considered a trade or business even though the sales
are part of the pharmacys other activities.
Test 2: Regularly Carried On
A business activity of an exempt organization is considered to be regularly car-
ried on if:
The activity occurs frequently or with continuity, and
The activity is pursued in a manner similar to comparable commercial activi-
ties of nonexempt organizations.
A hospital auxiliary operates a sandwich stand for two weeks each year at the
state fair. This annual activity is not considered the regular conduct of a trade
or business by the auxiliary. The sandwich stand does not compete with similar
facilities that a nonexempt organization would operate year-round. Operating
a sandwich stand in a shopping mall every Saturday, year-round, would be
the regular conduct of a trade or business.
Test 3: Not Substantially Related
A trade or business activity is not substantially related to an organizations
exempt purpose if it does not contribute importantly to the organizations ex-
empt purpose, other than providing funds so that the exempt purpose can be
carried out.
Any income-producing activity that does not directly further an organizations
exempt purposes could generate unrelated business income.
KEY FACT
EXAMPLE
EXAMPLE
KEY FACT
TheTaxReview Business Entities Chapter 4 81
NOTES
Characteristics of Unrelated Business Income
The following factors help determine whether an activitys contributions are
important to the organizations tax-exempt purposes and when an activity may
be an unrelated trade or business.
1) Size and extent of the activity involved. The size and extent of the busi-
ness activity is considered in relation to the nature and extent of the exempt
function that it is intended to serve. If an activity is conducted on a scale
larger than reasonably necessary to perform an exempt purpose, it does not
contribute importantly to the accomplishment of the exempt purpose. The
part of the activity that is more than needed to accomplish the exempt pur-
pose is an unrelated trade or business.
An exempt organization publishes a periodical that contains information and
other content related to its exempt purpose. The periodical is freely distributed
to the general public. The organization also solicits, sells, and publishes com-
mercial advertising in the periodical. The portion of the commercial advertising
activity that exceeds what is needed to fund the periodical for the organiza-
tions exempt purpose is an unrelated trade or business.
2) Selling products of exempt functions. The selling of products that result
from the performance of exempt functions is not an unrelated trade or busi-
ness if the product is sold in substantially the same state it was in when the
exempt functions are completed.
An exempt organization maintains an experimental dairy herd for scientic
purposes. The sale of milk and cream produced in the ordinary course of oper-
ating the project is not an unrelated trade or business. But sales of ice cream
made from the milk and cream are an unrelated trade or business unless the
ice cream manufacturing activity contributes importantly to the accomplish-
ment of an exempt purpose of the organization.
3) Dual use of assets or facilities. When an exempt organization has assets
or facilities necessary for the accomplishment of its exempt purposes, the
commercial use of the assets or facilities for commercial activities may be an
unrelated trade or business.
An exempt organization operates a childrens science museum, including a
theater auditorium designed for showing educational lms. The auditorium is a
principal feature of the museum and operates continuously while the museum
is open to the public. If the exempt organization regularly shows motion pic-
tures to the public when the museum is closed and charges admission, then
that activity is an unrelated trade or business.
EXAMPLE
EXAMPLE
EXAMPLE
82 Chapter 4 TheTaxReview Business Entities
NOTES 4) Exploitation of exempt functions. Exempt organizations may create good-
will or other intangibles that can be exploited in a commercial way. The com-
mercial exploitation is an unrelated trade or business unless it contributes
importantly to the accomplishment of the exempt purpose.
An exempt scientic organization exploits its excellent reputation in the eld
of biological research by regularly selling endorsements of laboratory equip-
ment to manufacturers. If these endorsements do not contribute importantly
to the accomplishment of the organizations exempt purposes, then the sale
of endorsements is an unrelated trade or business.
Excluded Trade or Business Activities
A number of activities are specically excluded from being classied as an un-
related trade or business. The following are some of the most common.
Volunteer workforce. A trade or business in which uncompensated workers
perform substantially all of the work is not an unrelated trade or business.
Convenience of members. A trade or business carried on by an exempt organi-
zation primarily for the convenience of its members, students, patients, of-
cers, or employees is not an unrelated trade or business. For example, a dor-
mitory laundry operated by a college is not an unrelated trade or business.
Sponsorship activities. Soliciting and receiving sponsorship payments is not an
unrelated trade or business if payments received can only buy an acknowl-
edgement of the sponsors name, logo, or product line, but cannot be used to
advertise the sponsors products or services.
Selling donated merchandise. A trade or business that consists of selling mer-
chandise, substantially all of which the exempt organization received as gifts
or donations, is not an unrelated trade or business. This exception can apply
to local and national thrift stores, as well as to exempt organizations that con-
duct yard sales in which substantially all merchandise sold was donated.
Distribution of low cost articles. Exempt organizations sometimes give away in-
cidental items such as greeting cards in an effort to encourage the recipient
to make a donation. Contributions received as a result of distributing low cost
articles are not an unrelated trade or business. For 2013, the term low cost
means $10.20 or less.
Convention or trade show activity. An exempt organization may regularly con-
duct activities in conjunction with a convention, annual meeting, or trade
show in order to promote the products and services of the exempt organiza-
tion or its community or to educate attendees about the organizations is-
sues. Income received because of such an activity is not an unrelated trade or
business. For example, booth rental fees charged to exhibitors at an exempt
organizations annual meeting are not an unrelated trade or business.
Traditional bingo. Income received by an exempt organization from the con-
duct of traditional bingo games is not an unrelated trade or business if it is
legal under state and local law, and if wagers are placed, winners are deter-
mined, and prizes are awarded in the presence of all players. However, if
EXAMPLE
TheTaxReview Business Entities Chapter 4 83
NOTES for-prot organizations can legally conduct traditional bingo games in a par-
ticular jurisdiction (such as an entire state), then bingo games conducted by
exempt organizations in that jurisdiction are an unrelated trade or business.
Other Income Excluded From Unrelated Business Income
Royalty income. A royalty is any payment made to use intangible property
rights, such as a trademark, trade name, copyright or prominent persons
name, photo, or facsimile signature. Royalties include payments for the right
to publish books, videos, computer programs, etc., but do not include pay-
ment for services of any kind. Royalties are not UBI.
Interest, dividend, and other investment income. Income that comes from routine
investments, including annuities and capital gain on stock held by the ex-
empt organization, is not UBI.
Rents from real property. If the exempt organization wholly owns the real prop-
erty and does not provide additional services as part of the rental, then in-
come from the rental activity is not UBI. This exclusion does not apply to
rents from personal property or rents from debt-nanced real property.
Gain or loss from the sale of property. Gain or loss from the sale of non-invento-
ry property owned by the exempt organization is not UBI. This exclusion does
not apply to gain or loss from the sale of inventory.
A university alumni associations exempt purposes were to advance the cause
of higher education, promote the interests and increase the usefulness of
the university, and encourage good fellowship among its members. The as-
sociation fullled its purposes by communicating with alumni and sponsoring
continuing educational activities and social events. Through news articles and
discussions with representatives from other organizations, the alumni associa-
tion became aware of afnity credit card programs and solicited proposals
from several banks. A plan was selected and the alumni association entered
into an agreement with the bank. The alumni association established the af-
nity credit card program in order to keep alumni aware of their ties to the
university, keep the universitys name before the public, provide a low-cost
credit card to alumni and other university supporters, and provide revenue
for its programs without placing undue demands on its staff. In exchange for
payments from the bank, the associations mailing list was provided to the
bank and the association endorsed the credit card program. The IRS said that
income from the afnity credit card program was unrelated business income
for the alumni association, but the Tax Court disagreed. The court determined
that the payments from the afnity credit card program were royalties and
therefore could not be classied as unrelated business income. (Alumni As-
sociation of the University of Oregon, Inc., T.C. Memo 1996-63)
COURT CASE
84 Chapter 4 TheTaxReview Business Entities
NOTES
Chapter 4 Self-Quiz
Instructions
Test your knowledge and comprehension of information presented in Chapter 4.
True/False
1) A private foundation cannot be tax-exempt under section 501(c)(3) because
it is operated for the benet of private interests.
True False
2) Martha gives $100 to a charity and receives a set of books as a thank you. The
charity must issue a written disclosure statement informing Martha of the
fair market value of the books.
True False
3) Form 990-T, Exempt Organization Business Income Tax Return, is led as an at-
tachment to Form 990, Form 990-EZ, or Form 990-PF.
True False
Multiple Choice
1) Which of the following articles of organization will satisfy the organizational
test under IRC section 501(c)(3)?
a) An organizations articles state that its purpose is to receive contributions
and pay them over to organizations that are described in section 501(c)(3).
b) The articles state that the organization is formed for charitable, philan-
thropic, and benevolent purposes.
c) The articles state that an organization is formed to promote American
ideals.
d) The articles expressly empower the organization to carry on social activi-
ties for charitable activities.
2) Which of the following tax-exempt organizations may not le Form 990-EZ?
a) A nonprot organization with gross receipts of $40,000.
b) A nonprot organization with $150,000 in gross receipts and $200,000 in
total assets, but which elects not to le its return electronically.
c) A nonprot organization with gross receipts of $100,000 and total assets of
$300,000.
d) A private foundation with gross receipts of $150,000 and total assets of
$450,000.
TheTaxReview Business Entities Chapter 4 85
NOTES 3) Which of the following activities could generate UBI?
a) An exempt organization primarily engages in activities that further its
exempt purposes. It owns publication rights to a book that does not relate
to any of the organizations exempt purposes. The organization transfers
publication rights to a commercial publisher in return for royalties.
b) An exempt civic organization publishes and sells a quarterly magazine
devoted to promoting the organizations exempt purposes. In order to
add additional revenue, the organization sells advertising spots to local
businesses. The advertising spots are commercial in nature and need not
refer to the civic organization.
c) An exempt vocational school operates a handicraft shop that sells articles
made by students in their regular course of instruction. The students are
paid a percentage of the sales price.
d) An exempt school owns tennis courts and locker rooms, which it uses
during the regular school year during its educational program. During
summer vacation, the school leases these facilities for a xed fee to an
unrelated individual who runs a summer tennis club.
86 Chapter 4 TheTaxReview Business Entities
NOTES
Chapter 4 Self-Quiz Answers
True/False
1) A private foundation cannot be tax-exempt under section 501(c)(3) because
it is operated for the benet of private interests.
True Incorrect. The term private foundation refers to the source of the
funding of an organization, not to its organizational or opera-
tional purpose. A private foundation is generally funded by an
individual, family, or corporation. It can qualify for tax-exempt
status as long as it meets the organizational, operational, and
exempt purpose tests.
False Correct. Charitable organizations described in IRC section
501(c)(3) are presumed to be private foundations unless noti-
cation is made to the IRS that they are not. Private foundation
refers to its source of funding, not its purpose.
2) Martha gives $100 to a charity and receives a set of books as a thank you. The
charity must issue a written disclosure statement informing Martha of the
fair market value of the books.
True Correct. The charitable organization must provide a written dis-
closure statement stating that the deductible amount of Mar-
thas contribution is limited to the excess of the money contrib-
uted over the fair market value of the books, and it must state a
good faith estimate of the fair market value of the books.
False Incorrect. The charitable organization must provide a written dis-
closure statement to donors of a quid pro quo contribution over
$75. The written disclosure statement must inform Martha that
the deductible amount of the contribution is limited to the ex-
cess of any money contributed over the fair market value of the
goods or services provided by the charity and provide Martha
with a good faith estimate of the fair market value of the books
she received.
3) Form 990-T, Exempt Organization Business Income Tax Return, is led as an at-
tachment to Form 990, Form 990-EZ, or Form 990-PF.
True Incorrect. Form 990-T is a stand-alone form and is led by itself.
False Correct. Form 990-T is required in addition to Form 990, 990-EZ,
or 990-PF, and is led separately from those forms.
Multiple Choice
1) Which of the following articles of organization will satisfy the organizational
test under IRC section 501(c)(3)?
a) An organizations articles state that its purpose is to receive contributions
and pay them over to organizations that are described in section 501(c)(3).
Correct. The organizational test may be met if the purposes stated in the
articles of organization are limited in some way by reference to
section 501(c)(3).
TheTaxReview Business Entities Chapter 4 87
NOTES b) The articles state that the organization is formed for charitable, philan-
thropic, and benevolent purposes.
Incorrect. The term charitable has a generally accepted legal meaning
which would be sufcient by itself; however, the terms philan-
thropic and benevolent have no generally accepted legal mean-
ing. Therefore, the stated purposes may, under the laws of the
state, permit activities that are broader than those intended by
the exemption law.
c) The articles state that an organization is formed to promote American
ideals.
Incorrect. Without any limitation or provision restricting such purposes to
accomplishment only in a charitable manner, the purposes will
not be sufciently limited. Such purposes are vague and may be
accomplished other than in an exempt manner.
d) The articles expressly empower the organization to carry on social activi-
ties for charitable activities.
Incorrect. Even if the articles state that the organization will be operated
exclusively for charitable purposes, the organizations power is
not sufciently limited to prevent it from engaging in non-ex-
empt activities.
2) Which of the following tax-exempt organizations may not le Form 990-EZ?
a) A nonprot organization with gross receipts of $40,000.
Incorrect. A tax-exempt organization with gross receipts of less than
$50,000 is eligible to le the Form 990-N, e-Postcard, but it may
elect to le either Form 990 or Form 990-EZ instead.
b) A nonprot organization with $150,000 in gross receipts and $200,000 in
total assets, but which elects not to le its return electronically.
Incorrect. Form 990-EZ may be led electronically, but is not required to be
led electronically. Only tax-exempt organizations with at least
$10 million in total assets, ling at least 250 returns in a year, are
required to le their returns electronically.
c) A nonprot organization with gross receipts of $100,000 and total assets of
$300,000.
Incorrect. A nonprot organization may le Form 990-EZ as long as its
gross receipts are less than $200,000 and its total assets are less
than $500,000.
d) A private foundation with gross receipts of $150,000 and total assets of
$450,000.
Correct. A private foundation is required to le Form 990-PF and may not
le Forms 990-N, 990-EZ, or 990.
88 Chapter 4 TheTaxReview Business Entities
NOTES 3) Which of the following activities could generate UBI?
a) An exempt organization primarily engages in activities that further its ex-
empt purposes. It owns publication rights to a book that does not relate
to any of the organizations exempt purposes. The organization transfers
publication rights to a commercial publisher in return for royalties.
Incorrect. Royalty income is specically excluded from the denition of
UBI. If the exempt organization itself had printed, publicized,
and sold the book, then income from book sales could be UBI
since the book is unrelated to the organizations exempt pur-
poses and income earned in this way is not royalty income.
b) An exempt civic organization publishes and sells a quarterly magazine
devoted to promoting the organizations exempt purposes. In order to add
additional revenue, the organization sells advertising spots to local busi-
nesses. The advertising spots are commercial in nature and need not refer
to the civic organization.
Correct. Income from the magazine sales is related to the organizations
exempt purpose, but the activity of selling advertising does not
contribute importantly to the civic organizations exempt pur-
pose. Income from these advertising sales could be UBI.
c) An exempt vocational school operates a handicraft shop that sells articles
made by students in their regular course of instruction. The students are
paid a percentage of the sales price.
Incorrect. The production of articles by the students is part of the vocation-
al schools exempt purpose, and the sale of these articles does
not generate UBI. If the handicraft shop also sells items made at
home by local residents who work to the shops specications,
that income could be UBI. The locally produced items are not
part of the schools exempt purpose.
d) An exempt school owns tennis courts and locker rooms, which it uses dur-
ing the regular school year during its educational program. During sum-
mer vacation, the school leases these facilities for a xed fee to an unre-
lated individual who runs a summer tennis club.
Incorrect. The leasing activity is income derived from renting real property
and is excluded from the denition of UBI. If, as part of the lease,
the employees of the school provide services to the summer ten-
nis club, such as collecting membership fees and scheduling
court time, then the leasing activity could generate UBI. Fur-
nishing services as part of the lease does not further the schools
exempt purpose.
TheTaxReview Business Entities Final Exam 89
CPE/CE
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Multiple Choice
Circle the correct answer.
1) Jerry transfers property with an adjusted basis of $20,000 and FMV of $50,000
into a corporation in a qualied exchange under IRC section 351. As part of the
transaction, the corporation assumes a liability attached to the property in the
amount of $8,000. What is Jerrys recognized gain on the transaction?
a) $0
b) $8,000
c) $30,000
d) $38,000
2) Eleanor transferred $50,000 into Ellie, Inc., which was shown on the corpo-
rate books as a loan. The year after the transfer, the corporation repaid Elea-
nor $15,000. The corporations accumulated earnings and prots were $10,000.
Upon examination, the IRS determined a bona de loan did not exist, and the
$50,000 transfer to the corporation was a contribution to capital. Of the $15,000
distribution to Eleanor, how much is taxable?
a) $0
b) $5,000
c) $10,000
d) $15,000
3) How are constructive dividends reported by a shareholder?
a) Capital gains.
b) Taxable dividends.
c) Nontaxable return of capital.
d) Capital contribution.
4) Early Days Partnership wants to be taxed as an S corporation. What form(s)
must be led to make the S corporation election?
a) By ling Form 8832, Entity Classication Election, the partnership is deemed
to have led the election to be taxed as an S corporation.
b) A partnership cannot elect to be taxed as an S corporation.
c) The partnership must le Form 8832, Entity Classication Election, then Form
2553, Election by a Small Business Corporation.
d) If the partnership les Form 2553, Election by a Small Business Corporation,
the entity is deemed to have made the election to be taxed as a corporation
and no additional form is necessary.
Final Exam
Go to www.thetaxbook.com and click on
Take CPE/CE Final Exams to take the Final Exam. Do not mail.
90 Final Exam TheTaxReview Business Entities
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5) Bart is a partner in Bartsco Partnership. The following item from Bartsco is
reported as a separately stated item on Barts Schedule K-1.
a) Net sales.
b) Depreciation expense.
c) Administrative expenses.
d) Charitable contributions.
6) Concession Stand, a qualied charitable organization, is dissolving. What op-
tions are available for Concession Stand to distribute assets remaining in the
organization upon dissolution?
a) Remaining assets may be distributed back to individuals who made
contributions to capital.
b) Remaining assets may be distributed for an exempt purpose or to the
federal government or to a state or local government for a public purpose.
c) Remaining assets may be reclassied as non-exempt subject to unrelated
business income tax (UBIT).
d) All of the above.
7) An exempt organization is subject to unrelated business income tax (UBIT) if:
a) The organization derives income from a trade or business.
b) The organization regularly carries on a trade or business activity.
c) The organization carries on a trade or business activity not substantially
related to the organizations exempt purpose.
d) All of the above.
8) The following item is deductible by a C corporation.
a) Shareholder wages.
b) Dividends.
c) Repayments of principal on a loan from a shareholder.
d) Principal amount of loan to a shareholder.
9) Nontaxable income earned by a C corporation has the following effect.
a) Nontaxable income does not increase a corporations earnings and prots.
b) Nontaxable income does increase a corporations earnings and prots.
c) Nontaxable income is not reported as business income by the
Ccorporation, but is passed through to shareholders.
d) Otherwise nontaxable income is taxable if earned by a C corporation.
10) When a C corporation makes a distribution in full or partial redemption for
stock, how does the shareholder report the distribution?
a) The distribution is reported as a sale.
b) The value of the stock distributed reduces the shareholders basis in
remaining stock.
c) The shareholder reports the distribution as a taxable dividend.
d) The distribution is treated as a stock dividend.
TheTaxReview Business Entities Final Exam 91
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11) An S corporation cannot have more than the following number of shareholders.
a) 25 shareholders.
b) 50 shareholders.
c) 75 shareholders.
d) 100 shareholders.
12) Eligible S corporation shareholders include:
a) Charitable remainder trusts.
b) Partnerships.
c) Decedents estates.
d) IRAs.
13) When a corporation terminates S corporation status, the post termination tran-
sition period begins. What is the maximum duration of the post termination
transition period?
a) 60 days.
b) 90 days.
c) One year.
d) The post termination transition period is extended until all assets of the
corporation have been distributed.
14) In court case A.W. Chesterton Company, Inc., an S corporation shareholder at-
tempted to terminate an S corporations status by:
a) Transferring stock to an ineligible shareholder.
b) Selling stock to investors to exceed the maximum number of eligible
shareholders.
c) Exercising stock options that violated the one-class-of-stock rule.
d) Rescinding his original consent to the S corporation election.
15) If an S corporation election is terminated, how long must the S corporation wait
until re-electing S corporation status?
a) One year.
b) Five years.
c) Ten years.
d) An S corporation is not allowed to re-elect S corporation status if its
original election was terminated.
16) Dog Days, Inc, an S corporation, has 10 shareholders. Some of the shareholders
wish to revoke the S election. For the revocation to take effect, what is the mini-
mum number of shareholders needed to sign consent statements?
a) 4 shareholders.
b) 5 shareholders.
c) 6 shareholders.
d) 7 shareholders.
92 Final Exam TheTaxReview Business Entities
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17) Which of the following information returns for tax-exempt organizations may
only be led electronically since there is not a paper version?
a) Form 990-PF.
b) Form 990-N.
c) Form 990-EZ.
d) Form 990.
18) Organizations qualifying under IRC section 501(c)(3) are required to keep the
following:
a) Financial books and records.
b) Nonnancial books and records.
c) Financial and nonnancial books and records.
d) Written acknowledgment for a contribution of $200.
19) Bahston Corporation is looking at the requirements to elect S corporation
status. How many shareholders must consent for the election to be effective?
a) 50%.
b) More than 50%.
c) More than 80%.
d) 100%.
20) Gain from the sale of an interest in a partnership held more than one year is
generally taxable at:
a) Long-term capital gain rates.
b) Short-term capital gain rates.
c) Qualied dividend rates.
d) Ordinary income rates.
TheTaxReview Business Entities Final Exam 93
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Final Examination Instructions
Expiration Date Reminder: The Final Exam must be completed online within one year from your date
of purchase or shipment. CPE/CE credits are not available more than one year after your date of
purchase or shipment.
All Final Exams are administered online at www.thetaxbook.com. It is recommended that you review
the Final Exam at the end of the course before taking it online. Final Exams mailed in will not be graded.
Follow the instructions below:
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2) Click on Take CPE/CE Final Exams, where you will nd a location to log in to the Final Exam.
3) Enter your User Name in the self-study CPE/CE login location. The email address associated with
your account at Tax Materials, Inc. is your User Name. If you do not have an email address, or
have not provided one, please call our toll-free number at 1-866-919-5277 to be assigned a User
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4) Enter your Password. The zip code associated with your account is your password. If you are
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5) Select the Business Entities Exam and click the Take Exam button.
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on your Certicate of Completion should you achieve a score of 70% or higher.
Take the Final Exam. Read the questions carefully and answer them to the best of your ability. At
the bottom of the exam, click on Submit Answers when nished. You will instantly know if you
have passed the test. If you failed, you are able to retake the test. If you passed, the Certicate
of Completion will be available for you to print.
94 Final Exam TheTaxReview Business Entities
TheTaxReview Business Entities Index 95
CPE/CE Index
A
AAA, 25, 31
Accumulated adjustments account, 25, 31
Accumulated E&P, 15
Annual information returns exempt
organizations, 73
Applying for 501(c)(3) status, 71
Appraisal summary exempt organizations, 77
Appreciated inventory items partnerships
and LLCs, 58
B
Basis in a partnership, 51
Basis S corporation shareholders, 30
Basis section 351, 4
Bona de loan, 1
Business income exempt organizations, 79
C
C corporation loans to shareholders, 7
Capital contributions to corporations, 1
Chapter 1 C corporations, 1
Chapter 1 self-quiz, 20
Chapter 2 S corporations, 25
Chapter 2 self-quiz, 39
Chapter 3 partnerships and LLCs, 45
Chapter 3 self-quiz, 61
Chapter 4 exempt organizations, 67
Chapter 4 self-quiz, 84
Constructive dividends, 17
Contributions of capital to corporations, 1
Control section 351, 2
Conversion from C corporation
Scorporations, 30
Corporations, 1
Corporations loans to shareholders, 7
Course completion instructions, ii
Course overview, i
CPE/CE credit hours, i
Creditor/debtor relationship, 8
Current distributions partnerships and
LLCs, 45
D
Debtor/creditor relationship, 8
Deemed dividends S corporations, 33
Distributions from C corporations, 15
Distributions of stock, 18
Distributions partnerships and LLCs, 55
Distributions S corporations, 29
Dividends constructive, 17
Dividends from S corporations, 33
Donee information returns exempt
organizations, 77
E
E&P, 14
Earnings and prots, 1, 14
Educational organizations, 71
Election S corporation, 25
Electronic ling exempt organizations, 75
Eligible shareholders S corporations, 26
Employment tax returns exempt
organizations, 77
e-Postcard, 73
Examination instructions, ii
Exempt organizations, 67
Exempt purpose, 69
Expiration date, i
F
Final exam, 89
Final examination instructions, ii, 93
Five-year waiting period S corporations, 38
Form 990, 75
Form 990-EZ, 75
Form 990-N, 73
Form 990-PF, 75
Form 990-T, 79
Form 2553, 25
Form 8283, 78
G
Group control section 351, 3
H
Holding period section 351, 4
I
Inadvertent termination S corporations, 37
Information returns exempt organizations, 73
Inventory items partnerships and LLCs, 58
L
Late election S corporations, 27
Learning objectives, iii
Liabilities partnerships and S corporations,
53
Liabilities section 351, 4
Liquidating distributions corporations, 14
Liquidating distributions partnerships and
LLCs, 56
LLCs, 45
Loan bona de, 1
Loans to shareholders, 7
N
NASBA, i
National Association of State Boards of
Accountancy, i
Non-liquidating distributions corporations, 14
Nonprot organizations, 67
Nonqualied preferred stock, 3
Nonrecourse liabilities, 45, 54
Nontaxable transfers corporations, 2
O
One-class-of-stock rule, 25
Operational test exempt organizations, 67, 68
Ordering rules for S corporation distributions,
32
Organizational test exempt organizations,
67, 68
Other adjustments account, 25, 32
Outside basis, 51
Overview, i
P
Partners basis, 51
Partnerships, 45
Passing grade, i
Passive investment violation S
corporations, 36
Post termination transition period, 33
Preferred stock section 351, 3
Prerequisites, i
Previously taxed income S corporations, 33
Private foundations, 70
Program content, i
PTI, 33
PTTP, 33
Publication date, i
96 Index TheTaxReview Business Entities
INDEX
Q
QAS, i
Quality Assurance Service, i
Quid pro quo exempt organizations, 78
R
Recommended participants, i
Recordkeeping exempt organizations, 72
Record retention, i
Recourse liabilities, 54
Redemption of stock, 19
Relief for late S corporation election, 27
Religious organizations, 71
Revocation of S corporation status, 34
S
S corporation distributions, 29
S corporation distributions ordering rules, 32
S corporation election, 25
S corporation one-class-of-stock rule, 25
S corporation passive investment
violation,36
S corporation relief for late election, 27
S corporation termination, 34
S corporations, 25
S corporations basis in shareholder stock, 30
Sanctioning bodies, i
Schedule K-1 (Form 1065), 46
Section 179 deduction partnerships and
LLCs, 49
Section 351, 1
Section 351 exchanges, 2
Self-employment earnings partnerships and
LLCs, 50
Separately stated items, 45
Services in exchange for stock, 2
Shareholder revocation S corporations, 34
Shareholders S corporations, 26
Signicant transferor section 351, 5
Stock, 18
Stock distributions, 18
Stock in exchange for services, 2
Substantially appreciated inventory items
partnerships and LLCs, 58
T
Tax-exempt income partnerships and
LLCs,51
Termination of S corporation status, 34
U
Unrealized receivables partnerships and
LLCs, 59
Unrelated business income, 67, 79
TheTaxReview Business Entities Course Evaluation 97
Course Evaluation
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with 5 as the highest.
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