CHAPTER 14

COMPARATIVE FORMS OF DOING BUSINESS
SOLUTIONS TO PROBLEM MATERIALS
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
1 Entity attributes Modified 1
2 Entity attributes Unchanged 2
!iability e"posure Unchanged
# Ethics problem $e%
& 'orporate ta" rates: marginal and effecti(e Modified &
) 'hoice of business entity: ta" and Unchanged )
nonta" factors
* 'hoice of business entity Unchanged *
+ 'hoice of business entity Modified +
, 'hoice of business entity Modified ,
1- Single (ersus double ta"ation Modified 1-
11 .lternati(e minimum ta" Modified 11
12 .lternati(e minimum ta"/ asset sales Unchanged 12
1 Ethics problem Unchanged 1
1# 0ringe benefits Unchanged 1#
1& 0ringe benefits Unchanged 1&
1) 1easonable compensation Unchanged 1)
1* Shareholder loans to corporation Unchanged 1*
1+ .(oiding double ta"ation: lease Unchanged 1+
rental payments
1, 1ental property or corporate asset Modified 1,
2- .ccumulated earnings ta" Modified 2-
21 Stoc2 redemption Unchanged 21
22 3ssue recognition Unchanged 22
2 3ssue recognition Unchanged 2
2# S corporation: maintaining or re(o2ing status Modified 2#
2& 1ecognition under 4 &1 and debt Modified 2&
(ersus e5uity
2) 1ecognition at time of contribution and basis Modified 2)
2* 6asis for o%nership interest Modified 2*
14-1
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Comparative Forms of Doing Business 14-2
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
2+ 'onduit (ersus entity concept Unchanged 2+
2, 'onduit (ersus entity concept Unchanged 2,
- 'ontributions7 profits7 and Modified -
distributions to o%ners
1 8istributions to o%ners Unchanged 1
2 Passi(e acti(ity losses Modified 2
6asis and at9ris2 rules: partnership Unchanged
(ersus corporation
# Special allocations Unchanged #
& .t9ris2 amount and basis Unchanged &
) Special allocations Unchanged )
* Special allocations Unchanged *
+ .sset sale (ersus stoc2 sale Modified +
, Sale of a business: sole proprietorship Unchanged ,
#- Sale of a business: partnership Unchanged #-
#1 Purchase of partnership Unchanged #1
#2 3ssue recognition Unchanged #2
# Purchase of a corporation Modified #
6ridge 8iscipline
Problem
1 Ta" and financial reporting of corporate Unchanged 1
formation
2 S corporation formation Unchanged 2
Partnership formation Unchanged
# .lternati(e minimum ta" Unchanged #
1esearch/
Problem
1 3nternet acti(ity Unchanged 1
2 3nternet acti(ity Unchanged 2
3nternet acti(ity Unchanged
# 3nternet acti(ity $e%
PROBLEM MATERIAL
1: a: S corporation and ' corporation ;S and '<: p: 1#9)
b: ' corporation ;'<: p: 1#9)
c: ' corporation ;'<: p: 1#9+
d: ' corporation ;'<: p: 1#91
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Comparative Forms of Doing Business 14-3
e: S corporation ;S<: pp: 1#9& and 1#9+
f: Sole proprietorship and partnership ;SP and P<: p: 1#9*
g: ' corporation ;'<: 'oncept Summary 1#91
h: Partnership ;P<7 S corporation ;S<7 and ' corporation ;'<: 'oncept Summary 1#91
i: Sole proprietorship7 partnership7 and S corporation ;SP7 P7 and S<: p: 1#91*
2: a: Partnership7 S corporation and ' corporation ;P7 S7 and '<:
b: Partnership and S corporation ;P and S<:
c: Partnership and S corporation ;P and S<:
d: Partnership and S corporation ;P and S<:
e: Partnership ;P<:
f: Partnership ;P<:
pp: 1#91) to 1#91,
: a: Since a sole proprietorship has unlimited liability7 the sole proprietorship and the
o%ners are liable for the remaining =2 million after the = million is paid by insurance:
Since the 0M> of the net assets is =+&-7--- ;=,&-7--- 9 =1--7---<7 the o%ner is liable
for the remaining =171&-7--- ;=27---7--- 9 =+&-7---<:
b: Since a partnership has unlimited liability7 the partnership and the partners are liable for
the remaining =2 million after the = million is paid by insurance: Since the 0M> of
the net assets is =+&-7--- ;=,&-7--- 9 =1--7---<7 the partners are liable for the
remaining =171&-7--- ;=27---7--- 9 =+&-7---<: The corporate characteristic of limited
liability applies to an !!':
c: . ' corporation has limited liability ;i:e:7 e5ual to the 0M> of the assets of =,&-7---<:
The plaintiff %ill share %ith the other creditors ;i:e:7 =1--7---< of the entity %ith
respect to claims against the =,&-7--- of assets: The shareholders of the ' corporation
ha(e no personal liability for the remaining corporate debts of =171&-7--- ;=27---7---
? =1--7--- 9 =,&-7---<:
d: Same response as in ;c< for an S corporation:
pp: 1#9# to 1#9*
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#: The first issue to be addressed is a business issue rather than an ethical issue: 1educing the
income ta" liability through sound business planning should be a goal of any business o%ner
or business entity:
The business issue to be addressed is %hether Ted@s alleged ta" 2no%ledge results in a
prudent business decision in restructuring the transaction as an asset sale rather than the sale
of o%nership interests: Unfortunately7 the re(ised transaction produces a negati(e cash flo%
effect for Ted in terms of the t%o9percent discount and in terms of the ta" costs of the sale
transaction:
0or the sole proprietorship7 regardless of the legal form of the sales transaction7 the sale is
treated as the sale of the indi(idual assets of the business for income ta" purposes: 0or the
partnership7 more beneficial ta" results can occur from a sale of partnership interests rather
than from a sale of the partnership assets: 0or the sale of partnership assets7 any ordinary
income property that is appreciated %ill produce ordinary income: The sale of a partnership
interest results in capital gain treatment7 e"cept for ordinary income associated %ith
unrealiAed recei(ables and substantially appreciated in(entory:
The second issue to be addressed is the reallocation of the sales proceeds bet%een the radio
station and the T> station: Since the reallocation reduces the proceeds to be recei(ed by
Uncle 0ran27 %ho %as not informed of the original offer7 an ethical issue definitely is present
and a legal issue may be present: 3n addition7 proceed reallocations bet%een the radio station
and the T> station should not be made if they are arbitrary and do not reflect the asset (alues:
'oncept Summary 1#91
&: a: The ta" liability of each of the corporations is as follo%s:
Red Corporation
1&B C =&-7--- D = *7&--
2&B C 2&7--- D )72&-
#B C &7--- D 17*--
=1&7#&-
White Corporation
1&B C = &-7--- D = *7&--
2&B C 2&7--- D )72&-
#B C 2#&7--- D +7--
&B C 22-7--- D 117---
=1-+7-&-
Blue Corporation
1&B C = &-7--- D = *7&--
2&B C 2&7--- D )72&-
#B C *2&7--- D 2#)7&--
&B C 2&7--- D 117*&-
=2*27---
or #B C =+--7--- D =2*27---
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Comparative Forms of Doing Business 14-5
Orange Corporation
#B C =1-7---7--- D =7#--7---
&B C 1&7---7--- D &72&-7---
B C 77 D 1--7---
=+7*&-7---
or &B C =2&7---7--- D =+7*&-7---
The effecti(e ta" rate for each of the corporations is as follo%s:
Red Corporation
=1&7#&-
D 1,:1B
=+-7---
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White Corporation
=1-+7-&-
D :**B
=2-7---
Blue Corporation
=2*27---
D #B
=+--7---
Orange Corporation
= +7*&-7---
D &B
=2&7---7---
The marginal ta" rate for each of the corporations is as follo%s:
1ed #B
Ehite ,B
6lue #B
Frange &B
b: The marginal ta" rate can be ,B ;#B ? &B< or +B ;&B ? B< as the result of the
phase9out of the benefits of the lo%er brac2ets: The effecti(e ta" rate %ill ne(er
e"ceed the statutory rate of &B:
pp: 1#9+ to 1#91-
): Smith7 1aabe7 and Maloney7 'P.s
&1,1 $atorp 6oule(ard
Mason7 FG #&-#-
March 1&7 2--2
.my and Heff 6arnes
&*-- 1edmont Gigh%ay
.le"andria7 >. 22--
8ear .my and Heff:
3 am responding to your re5uest for ad(ice on the business entity form to be selected for
operating the florist shop: 3n our con(ersation7 the inclination %as to conduct the business as
a partnership or as an S corporation: .fter paying salaries of =#&7--- to each of you7 the
profits of the business %ill be about =)-7---: The intent is to in(est the earnings in the
gro%th of the business rather than ma2e distributions:
3n selecting an entity form7 consideration should be gi(en to both ta" and nonta" factors: The
ta" conse5uences for the partnership form (ersus the S corporation form %ould be the same:
The salary of =#&7--- is included in your gross income7 and the partnership or S corporation
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Comparative Forms of Doing Business 14-7
%ould deduct the =,-7--- in calculating its ta"able income: 3n addition7 regardless of
%hether the entity is a partnership or an S corporation7 each of you %ould include one9half of
the =)-7--- proIected floral earnings in gross income:
. substantial difference does e"ist7 ho%e(er7 %ith respect to the nonta" factors: 3f the floral
shop is conducted as a general partnership7 there is unlimited liability: 'on(ersely7 if the
floral shop is conducted as an S corporation7 limited liability results: .lthough in many cases
shareholders of small businesses operating as S corporations are re5uired to guarantee
corporate debts7 the corporate form still pro(ides protection against contingent liabilities:
3n choosing bet%een the partnership and the S corporation form7 3 recommend the S
corporation form: Go%e(er7 you may %ant to consider the limited liability company ;!!'<
form: This legal form pro(ides limited liability7 the same ta" conse5uences as those of the
partnership form7 and greater fle"ibility than the S corporation form: 'all me at your
con(enience: 3 loo2 for%ard to resol(ing any 5uestions you ha(e regarding the business
entity form for your floral shop:
Sincerely7
'arlene Sims7 'P.
pp: 1#9) to 1#9,
*: Jary can benefit by passing the losses through and offsetting them against his other income:
Since he is the sole o%ner7 the t%o business forms a(ailable that %ill permit this are the sole
proprietorship and the S corporation: . benefit of the S corporation %hen compared %ith the
sole proprietorship is limited liability: pp: 1#9) to 1#9,
+: The three forms of business entity a(ailable to Hac2 are the sole proprietorship7 corporation7
and S corporation: The partnership is not a (iable option7 since Hac2 is to be the sole o%ner:
3n selecting the business form7 Hac2 should consider both ta" and nonta" factors:
$onta" factors to consider include the ability to raise capital and limited liability: The
corporate form normally pro(ides the greatest ease and potential for obtaining o%ner
financing: Go%e(er7 for Hac2 this does not appear to be an ad(antage7 %hen compared %ith
an unincorporated entity ;i:e:7 sole proprietorship<7 because he is to be the only o%ner: The
corporate form does ho%e(er7 in this case7 offer the ad(antage of limited liability:
3f Hac2 selects the sole proprietorship form7 the profits of the entity %ill be ta"ed to him:
Since Hac2 %ill be in the &B ta" brac2et7 the ta" liability on the proIected earnings of
=2--7--- for the initial year %ould be =*-7--- ;=2--7--- C &B<:
3f Hac2 selects the corporate form7 the earnings of the business %ill be ta"ed to the
corporation: The ta" liability on the proIected earnings of =2--7--- for the initial year %ould
be =)172&- K;=&-7--- C 1&B< ? ;=2&7--- C 2&B< ? ;=2&7--- C #B< ? ;=1--7--- C ,B<L:
3n addition7 to the e"tent that the corporation distributes part or all of the after9ta" earnings to
Hac2 as a di(idend7 double ta"ation %ould result: Fn the other hand7 if the corporation pays
Hac2 a salary7 Hac2 %ill be able to recei(e cash from the corporation %ithout double ta"ation:
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The total income ta" %ould increase7 ho%e(er7 as amounts recei(ed by Hac2 as salary %ill be
ta"ed at &B: This may be the best solution:
.nother solution %ould be to elect S corporation status: The earnings of the corporation
%ould be ta"ed to Hac2 rather than at the corporate le(el: Ehile the initial year7 the ta"
liability of =*-7--- %ould be higher than the ' corporation ta" liability of =)172&-7 the
potential for being subIect to double ta"ation %ould be a(oided: 0inally7 the ad(antage of
limited liability %ould be achie(ed:
pp: 1#9) to 1#9,
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Comparative Forms of Doing Business 14-9
,: a: 3f Sil(er is a ' corporation7 the corporate ta" liability is:
1&B C =&-7--- D = *7&--
2&B C 2&7--- D )72&-
#B C 2&7--- D +7&--
=2272&-
Since Sil(er %ill not distribute any di(idends7 the shareholders %ill ha(e no ta"
liability associated %ith it:
3f Sil(er is an S corporation7 the corporate ta" liability %ill be =- and the
shareholdersM ta" liability %ill be =-7--- ;=1--7--- C -B<: >ie%ed from an entity9
o%ner perspecti(e7 operating as a ' corporation %ill result in ta" sa(ings of =*7*&-
;=-7--- 9 =2272&-<: $ote that these sa(ings are based on the assumption that the
after9ta" earnings are rein(ested in the gro%th ;i:e:7 reasonable needs for purposes of
accumulated earnings ta"< of the business and that no distributions are made to the
shareholders:
b: 3f Sil(er is a ' corporation7 the corporate ta" liability is =2272&-: The ta" at the
shareholder le(el on the distribution of after9ta" earnings of =**7*&- is =272&
;=**7*&- C -B<: Therefore7 the combined corporation and shareholder ta" is
=#&7&*& ;=2272&- ? =272&<:
3f Sil(er is an S corporation7 the corporate ta" liability %ill be =- and the shareholder
ta" liability %ill be =-7---: The =1--7--- %ill be a distribution out of ... and thus
%ill be ta"9free to the shareholders:
>ie%ed from an entity9o%ner perspecti(e7 operating as an S corporation %ill result in
ta" sa(ings of =1&7&*& ;=#&7&*& 9 =-7---<:
pp: 1#9+ and 1#9,
1-: a: The corporate ta" liability on ta"able income of =--7--- is =1--72&- for the '
corporation:
= &-7--- C 1&B D = *7&--
2&7--- C 2&B D )72&-
2&7--- C #B D +7&--
2--7--- C ,BD *+7---
=1--72&-
Since the ta" liability on the =--7--- is assessed at the corporate le(el7 there %ill be
no di(idend distribution to Mabel and .lan: They %ill each recei(e a salary of
=1--7---:
b: The ta" liability is assessed at the shareholder le(el rather than at the corporate le(el
for the S corporation: Mabel and .lan %ill each ha(e a ta" liability of =&27&--
;=1&-7--- C &B< associated %ith their respecti(e shares of the corporate ta"able
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14-10 2003 Entities Volume/Solutions Manual
income of =--7---: Therefore7 the corporation %ill need to distribute =&27&-- each
to Mabel and .lan to pay their ta" liability: They also %ill recei(e their salary of
=1--7--- each:
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Comparative Forms of Doing Business 14-11
c: The combined entity/o%ner ta" liability in ;a< %ill be as follo%s:
' corporation =1--72&-
Shareholders on distribution 9-9
Shareholders on salaries ;=2--7--- C &B< *-7---
'ombined ta" liability =1*-72&-
The combined entity/o%ner ta" liability in ;b< %ill be as follo%s:
S corporation = 9-9
Shareholders ta"ed on S corporation earnings
;=--7--- C &B< 1-&7---
Shareholders on salaries ;=2--7--- C &B< *-7---
'ombined ta" liability =1*&7---
pp: 1#9+ and 1#9,
11: a: Parrott@s regular income ta" liability on ta"able income of =&7---7--- is calculated as
follo%s:
1&B C =&-7--- D =*7&--
2&B C 2&7--- D )72&-
#B C 2&7--- D +7&--
,B C 2&7--- D ,17)&-
#B C #7))&7--- D 17&+)71--
=17*--7---
The .MT of the corporation is calculated as follo%s:
Ta"able income = &7---7---
?Positi(e .MT adIustments including
.'E adIustment ;=#--7--- ? =),-7---< 17-,-7---
9 $egati(e .MT adIustments ;-7---<
?Ta" preferences )7---7---
D.lternati(e minimum ta"able income ;.MT3< =127-)-7---
9 E"emption K=#-7--- 9 2&B ;=127-)-7--- 9 =1&-7---<L 9-9
D.MT base =127-)-7---
C 1ate 2-B
DTentati(e .MT = 27#127---
9 1egular income ta" liability ;17*--7---<
D.MT = *127---
Thus7 if Parrott is a ' corporation7 its ta" liability is =27#127--- ;=17*--7--- regular
ta" ? =*127--- .MT<:
b: .n S corporation is a ta" reporter rather than a ta"payer: Thus7 Parrott %ill pass the
regular ta"able income7 the separately stated items7 and .MT attributes through to its
shareholders %ho %ill ma2e the regular ta" liability calculation and the .MT
calculation on their indi(idual income ta" returns:
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c: The results in a: %ill be the same: Ehether the ' corporation is closely9held is not
rele(ant: .n S corporation7 ho%e(er7 cannot ha(e &7--- shareholders: 3t %ould be
ta"ed as a ' corporation: The ans%er to b: then %ould be the same as the result in a:
pp: 1#9+ to 1#91-
12: '!3E$T !ETTE1
Smith7 1aabe7 and Maloney7 'P.s
&1,1 $atorp 6oule(ard
Mason7 FG #&-#-
.ugust 1)7 2--2
Ms: 'orey !ong%ell/Ta" 8irector
Pelican 'orporation
2-- 6rando 1o%
Jrand 3sle7 !. *-&&
8ear Ms: !ong%ell:
3 am responding to your in5uiry regarding %hether you should do a cash or
installment sale of your land and building: 6ased on the analysis belo%7 3 recommend that
you do an installment sale %hich %ill delay recognition of the gain on the sale and the
payment of ta": The analysis of the ta" conse5uences of the t%o options is presented belo%:
PelicanMs ta" liability for 2--2 and 2-- is as follo%s if the cash option is selected:
1egular 3ncome Ta" !iability
2--2 2--
Ta"able income before sale =)--7--- =)--7---
Jain from sale ;=&--7--- 9 =#--7---< 1--7--- 9-9
Ta"able income =*--7--- =)--7---
Ta" liability ;#B rate< =2+7--- =2-#7---
.MT
2--2 2--
Ta"able income before sale =)--7--- =)--7---
.MT gain from sale ;=&--7--- 9 =#2&7---< *&7--- 9-9
.MT3 =)*&7--- =)--7---
E"emption amount ;9-9< ;9-9<
.MT base =)*&7--- =)--7---
1ate C 2-B C 2-B
Tentati(e .MT =1&7--- =12-7---
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Comparative Forms of Doing Business 14-13
.MT = 9-9 = 9-9
PelicanMs ta" liability for 2--2 and 2-- is as follo%s if the installment option is selected:
1egular 3ncome Ta" !iability
2--2 2--
Ta"able income before sale =)--7--- =)--7---
Jain from sale ;=&--7--- 9 =#--7---< 9-9 1--7---
Ta"able income =)--7--- =*--7---
Ta" liability ;#B rate< =2-#7--- =2+7---
.MT
2--2 2--
Ta"able income before sale =)--7--- =)--7---
.MT gain from sale ;=&--7--- 9 =#2&7---< 9-9 *&7---
.MT3 =)--7--- =)*&7---
E"emption amount ;9-9< ;9-9<
.MT base =)--7--- =)*&7---
1ate C 2-B C 2-B
Tentati(e .MT =12-7--- =1&7---
.MT = 9-9 = 9-9
Since neither year is an .MT year under either option7 the normal planning attribute of
delaying the recognition of gain applies: Thus7 Pelican should select the installment option
%hich %ill delay the payment of ta"es: 3f you ha(e any 5uestions7 please call:
Sincerely7
Hac2 Hones
Partner
pp: 1#9, and 1#91-
1: .ndyMs belief that if the accumulated earnings ta" issue is satisfactorily resol(ed on the
current audit that it %ill not be raised on any subse5uent audits is unfounded: 3n terms of the
audit practices of the 31S7 there is no basis for this belief:
The other issue is .ndyMs responsibility for pro(iding the re(enue agent %ith information on
the changes in the e"pansion policy of his business: The accumulated earnings ta" is not a
self9assessing ta": .ndy has no responsibility to (olunteer information to the re(enue agent
regarding the change in policy: Go%e(er7 if 5uestions regarding this are raised by the
re(enue agent7 .ndy should be forthright in his responses:
3n terms of the present audit7 it is probably for a period that precedes the change in e"pansion
policy: Thus7 .ndyMs corporation should not ha(e an accumulated earnings ta" problem
associated %ith the period under e"amination: Go%e(er7 due to the change in e"pansion
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14-14 2003 Entities Volume/Solutions Manual
policy7 .ndy should e(aluate the corporationMs di(idend policy and compensation policy ;i:e:7
may %ant to increase his =2--7--- salary< in light of the accumulated earnings ta" ris2s:
p: 1#91
1#: a: 3f the farm is incorporated as a ' ;regular< corporation7 then the brothers as
shareholder9employees can 5ualify as employees: Thus7 the =27--- ;=2-7--- for
lodging and =127--- for meals< is e"cludible to the brothers under the 4 11, meals
and lodging e"clusion: 3f the farm is an S corporation7 the brothers are treated as are
partners ;see part b:<:
b: 3f the farm is not incorporated ;i:e:7 a partnership<7 the 31S position is that the brothers
do not satisfy the definition of an employee: Therefore7 they are not eligible for the
4 11, e"clusion and the =27--- must be included in their gross income:
'oncept Summary 1#92
1&: a: Partnership ' 'orporation S 'orporation
Ta"able income before cost of
certain fringe benefits =#--7--- =#--7--- =#--7---
9 8eductible fringe benefits ;2&7---< ;-&7---< ;2&7---<
Ta"able income =1)&7--- = ,&7--- =1)&7---
.ssuming that the fringe benefit plans are not discriminatory7 the potential e"ists for
the employer business entity to deduct the amounts paid for fringe benefits: Thus7
regardless of the entity form7 the amounts paid to a 5ualified pension plan ;G:1: 1-
plan for o%ner/employees of a partnership or an S corporation< are deductible by the
business entity: 0or the partners and S corporation shareholders7 the pension amount
is included in their gross income and then is eligible for deduction as a contribution to
an G:1: 1- plan: Jroup9term life insurance and meals and lodging are only
deductible by the ' corporation ;see part b:<:
0or beneficial fringe benefit treatment for group9term life insurance and meals and
lodging to be recei(ed7 the indi(idual must be an employee: Partners do not 5ualify
as employees7 and greater than 2B shareholders of an S corporation are treated the
same as partners in a partnership for fringe benefit purposes:
b: 0or beneficial fringe benefit treatment for group9term life insurance and meals and
lodging to be recei(ed7 the indi(idual must be an employee: Partners do not 5ualify
as employees7 and greater than 2B shareholders of an S corporation are treated the
same as partners in a partnership for fringe benefit purposes: Since partners and
greater than 2B S corporation shareholders do not 5ualify as employees7 they do not
5ualify for either 4 *, e"clusion treatment for group9term life insurance or 4 11,
e"clusion treatment for meals and lodging: Therefore7 the amounts paid by the
business entity for these fringe benefits are included in the gross income of the
partners and S corporation shareholders: 0or the corporate shareholders7 the amounts
paid are deductible by the corporation and e"cludible by the employee9shareholders:
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Comparative Forms of Doing Business 14-15
The pension plan contributions made for employees are e"cludible by the co(ered
employees: 3ncome %ill not be recogniAed by the employees until they recei(e
payments from the pension plan: 0or the o%ner/employees of a partnership or an S
corporation %ho ha(e contributions made to their G:1: 1- plans by the business
entity7 the amounts paid must be included in their gross income: Go%e(er7 this
inclusion can be offset by a corresponding deduction for adIusted gross income on the
indi(idualMs ta" return: Ehen benefits are paid from the G:1: 1- plan7 the recipient
includes the amount in his or her gross income:
'oncept Summary 1#92
1): a: Under option 17 0a%n7 3nc: can deduct salaries of =#--7---: Thus7 0a%n7 3nc:Ms ta"able
income %ill be =- ;=#--7--- 9 =#--7---<: $o di(idends %ill be distributed since there
are no after9ta" earnings: Jus %ill include =2#-7--- of salary in his gross income7 and
Hanet %ill include =1)-7--- of salary in her gross income:
Under option 27 0a%n7 3nc:7 can deduct salaries of =1&-7---: Thus7 0a%n7 3nc:Ms
ta"able income %ill be =2&-7--- ;=#--7--- 9 =1&-7---< and 0a%n7 3nc:Ms ta" liability
%ill be =+-7*&-:
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1&B C = &-7--- D = *7&--
2&B C 2&7--- D )72&-
#B C 1*&7--- D &,7&--
&B C 1&-7--- D *7&--
= +-7*&-
Jus %ill include =,-7--- of salary and =+#7)2& ;=1),72&- C &-B< of di(idend income
in his gross income: Hanet %ill include =)-7--- of salary and =+#7)2& ;=1),72&- C
&-B< of di(idend income in her gross income:
b: Under option 17 the salary payments reduce 0a%n7 3nc:Ms ta"able income to =-: Thus7
0a%n7 3nc:7 should be a%are of the possibility of the unreasonable compensation issue
being raised by the 31S:
pp: 1#911 and 1#912
1*: a: S%allo% %ill deduct interest e"pense each year of =)7--- ;=#--7--- C ,B<: Sandra
and 0ran %ill each report interest income of =1+7--- ;=2--7--- C ,B< each year:
b: S%allo% %ill not be allo%ed a deduction each year for the interest payments of
=)7---: 3nstead7 the payments %ill be labeled as di(idends: Sandra and 0ran %ill
each report di(idend income of =1+7--- each year: Ehen the loan is repaid in &
years7 assuming ade5uate earnings and profits7 Sandra and 0ran %ill each report
di(idend income of =2--7---:
pp: 1#911 and 1#912
1+: T.C 03!E MEMF1.$8UM
8.TE: .ugust 127 2--2
01FM: 6ob Thomas
SU6HE'T: 3ncorporating a Sole Proprietorship
!iane Ta"payer is going to incorporate her sole proprietorship: She o%ns land and a building
that has been used in her business: She %ants to 2no% %hether she should contribute the
land and building or lease it to the ne% corporation:
Fne of the issues that !iane needs to be concerned about is a(oiding double ta"ation: Fnce
she incorporates her sole proprietorship as a ' corporation7 the ' corporation is subIect to
ta"ation on its ta"able income: Then7 !iane is ta"ed on any after9ta" earnings distributed to
her as di(idends:
Fne %ay to a(oid or reduce the effect of double ta"ation is to reduce corporate ta"able
income: 3f !iane leases the land and building to the corporation7 the lease rental payments
;assuming they are reasonable< made by the corporation to !iane are deductible in
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calculating corporate ta"able income: $ote7 ho%e(er7 the corporation %ill forgo the
depreciation deduction it %ould ha(e recei(ed on the building:
pp: 1#911 and 1#912
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14-18 2003 Entities Volume/Solutions Manual
1,: 3f !a(ender ac5uires the shopping mall7 its ta" liability %ould increase as follo%s:
.dditional liability ;=)--7--- net rental income C #B< =2-#7---
The indi(idual ta" liabilities of Marci and Hennifer %ould not be affected by the shopping
mall ac5uisition by the corporation:
3f Marci and Hennifer ac5uire the shopping mall and lease it to the corporation7 their
combined ta" liabilities %ould increase as follo%s:
$et rental income =#--7---
9 8epreciation ;*7---<
D 3ncrease in their ta"able incomes =)7---
.dditional ta" liability ;=)7--- C +:)B< D = 1#-711+
.t the corporate le(el7 the corporate ta"able income %ould increase as follo%s:
$et rental income =)--7---
9 1ental payments to Marci and Hennifer ;#--7---<
D .dditional ta"able income =2--7---
.dditional ta" liability ;=2--7--- C #B< = )+7---
Thus7 under the option recommended by the 'P.7 the combined ta" liability of =2-+711+
;=1#-711+ ? =)+7---< is more than the =2-#7--- ta" liability under the corporate ac5uisition
option: Go%e(er7 !a(ender has been able to channel =#--7--- to Marci and Hennifer %ith
the amount being deductible in calculating !a(ender@s ta"able income:
pp. 1#911 and 1#912
2-: a:1ose7 3nc:@s corporate ta" liability is calculated as follo%s:
1&B C = &-7--- D = *7&--
2&B C 2&7--- D )72&-
#B C 2&7--- D 11-7&--
&B C 2&7--- D 117*&-
=1)7---
3n addition7 1ose may be subIect to the accumulated earnings ta": This ta" liability
could be as high as =1-17,-# ;=2)#7--- C +:)B<: The =2)#7--- represents the
after9ta" earnings of the corporation ;=#--7--- 9 =1)7---<:
b. 3n this case7 1ose %ould not be subIect to the accumulated earnings ta": Thus7 the
total corporate ta" liability %ould be =1)7---: The shareholders of 1ose %ould be
ta"ed on their di(idend income:
c. 1ose@s regular income ta" liability is =- because the S election results in the
corporation not being subIect to 0ederal income ta": The ta"able income of =#--7---
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is passed through to the shareholders@ ta" returns: The accumulated earnings ta" does
not apply to S corporations:
p: 1#91
21: a: Pigeon7 3nc:7 has a recogniAed gain of =)&7--- ;=*&7--- 0M> 9 =1-7--- adIusted
basis< on the distribution of the land to Tim:
Tim@s recogniAed gain on the receipt of the land is calculated as follo%s:
.mount realiAed =*&7---
6asis for stoc2 redeemed ;-7---<
1ealiAed gain =#&7---
1ecogniAed gain =#&7---
3f Tim@s holding period for the stoc2 is o(er one year7 the =#&7--- gain is classified as
a long9term capital gain: $ote that if the transaction had not 5ualified as a 4 -2
stoc2 redemption7 Tim %ould ha(e reported di(idend income of =*&7---:
b. Pigeon7 3nc: has a recogniAed gain of =)&7--- ;=*&7--- 0M> 9 =1-7--- adIusted basis<
on the distribution of the land to Tim: Go%e(er7 since Pigeon 3nc: is an S corporation7 the
=)&7--- is passed through and ta"ed to the shareholders:
Tim@s recogniAed gain on the receipt of the land is calculated as follo%s:
.mount realiAed =*&7---
6asis for stoc2 redeemed ;-7---<
1ealiAed gain =#&7---
1ecogniAed gain =#&7---
3f Tim@s holding period for the stoc2 is long9term7 the =#&7--- gain is classified as a
long9term capital gain:
pp: 1#91# and 1#91,
22: Since 8a(id and Tan7 3nc:@s obIecti(e is to a(oid double ta"ation7 the follo%ing need to be
addressed:
• Tan@s ta"able income can be reduced through compensation payments that are reasonable:
8oes the =#--7--- annual salary for 8a(id meet the re5uirements for reasonable
compensationN Might it be possible to increase the amount and still be considered
reasonableN
• 6ased on the data7 it appears that Tan is not distributing di(idends to 8a(id: Ehile such
a techni5ue can be used to a(oid or defer double ta"ation7 is the retention defensible in
terms of the accumulated earnings ta"N
• Eould an S corporation election be ad(isableN
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14-20 2003 Entities Volume/Solutions Manual
pp: 1#911 to 1#91&
2: S corporations can ha(e a ma"imum of *& shareholders: Married shareholders are counted as
one shareholder: Therefore7 Tammy and .rnold need to structure the property settlement so
that this re5uirement is not (iolated ;i:e:7 only one of them %ill remain a shareholder<: Ehen
there are enough shareholders that there may e(entually be a problem %ith this re5uirement7
a sound ta" strategy %ould include a right of first refusal pro(ision on the part of the
corporation or other shareholders %ith regard to transferring stoc2 outside the e"tant
shareholder group: pp: 1#91# and 1#91&
2#: 3f the S election is (oluntarily terminated7 another election for Eagle 'orporation cannot be
made for a fi(e9year period: Therefore7 the decision regarding re(o2ing the S election should
be considered a long9run7 rather than a short9run7 one: The re(ocation of the election can be
made only if a maIority of the shareholders consent: Thus7 $ell %ill need one of the other
shareholders to agree %ith her in order to (oluntarily re(o2e the election:
.ssuming that the S election is maintained and the earnings of =1&-7--- are distributed to the
shareholders7 the ta" liability associated %ith the distribution for each of the shareholders is
=1&7--- ;=&-7--- C -B<: 3f the S election is re(o2ed effecti(e for 2--27 the corporate ta"
liability is =#17*&-: The ta" liability for each of the shareholders on the di(idend distribution
of =)7-+ ;=1-+72&- < is =1-7+2& ;=)7-+ C -B<: Therefore7 the total corporate and
shareholder ta" liability %ould be computed as follo%s:
S 'orporation ' 'orporation

'orporate ta" liability = - = #17*&-
Shareholder ta" liability #&7--- 27#*&
= #&7--- = *#722&
1e(ocation of the S election combined %ith a policy of distributing all the earnings to the
three shareholders %ill result in a greater combined corporation/shareholder ta" liability of
=2,722& ;=*#722& 9 =#&7---<: Thus7 if all of the earnings are going to be distributed7 the S
election should be maintained:
pp. 1#91# and 1#91&
2&: a: $o gain or loss is recogniAed on the contribution of property by 6ob and 'arl to the
corporation: 0or 6ob7 there is no realiAed gain or loss: 'arlMs realiAed gain of
=11&7--- K=2#-7--- ;amount realiAed< 9 =12&7--- ;adIusted basis<L is not recogniAed
because the 4 &1 re5uirements are satisfied: Therefore7 the realiAed gain is deferred7
and 'arl has a carryo(er basis for his stoc2 of =+&7--- K=12&7--- ;adIusted basis< 9
=#-7--- ;mortgage assumed<L: 6obMs basis for his stoc2 is =2--7---: 8eer7 3nc:Ms
basis for the land is a carryo(er basis of =12&7---: Each shareholder has a basis for
his loan of =*&7---: 3n addition7 each shareholder has interest income each year of
=)7--- ;=*&7--- C +B< and 8eer7 3nc: deducts =127--- of interest e"pense each year:
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Comparative Forms of Doing Business 14-21
b: The asset contributions %ill be treated the same as in part a: 3f all of the debt is
reclassified as e5uity7 6obMs and 'arlMs basis for their stoc2 %ill each increase by
=*&7---: The interest payments of =127--- annually %ill be reclassified as di(idends
and %ill not be deductible by 8eer7 3nc:
c: T.C 03!E MEMF1.$8UM
8.TE: Hanuary &7 2--2
01FM: Seth .ddison
SU6HE'T: 'ontributions and !oans to 8eer7 3nc:
Today 3 met at lunch %ith 6ob 6entA to discuss the ta" conse5uences of the capital
contributions and loans to 8eer made by him and 'arl Pierce:
'apital contributions
.sset
6asis 0M>
6ob: 'ash =2--7--- =2--7---
'arl: !andO 12&7--- 2#-7---
O Mortgage of =#-7--- assumed by 8eer7 3nc:
!oans to 8eer7 3nc:
6ob =*&7---
'arl =*&7---
Maturity date: 1- years
3nterest rate: +B ;same as 0ederal rate<:
3 re(ie%ed %ith 6ob the follo%ing ta" conse5uences:
• 1ecognition of gain: Since 6ob and 'arl o%n all of the stoc27 the realiAed gain of
=11&7--- ;=2#-7--- 9 =12&7---< to 'arl is not recogniAed under 4 &1:
• 6asis for stoc2: 6ob@s is =2--7--- and 'arl@s is =+&7--- ;=12&7--- 9 =#-7---<:
• 6asis for assets: 8eer@s basis for its assets is as follo%s:
'ash =2--7---
!and =12&7---
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14-22 2003 Entities Volume/Solutions Manual
• .ssuming the loans made by 6ob and 'arl to 8eer are classified as loans7 8eer
can deduct =127--- of interest e"pense each year and 6ob and 'arl must each
include =)7--- of interest income in their gross income each year for the 1-9year
period: Each has a basis for their loan of =*&7---:
• 3f the 31S should reclassify the loans as e5uity ;i:e:7 thin capitaliAation issue<7 the
interest payments %ould be treated as di(idends: Thus7 8eer %ould lose its
=127--- interest deduction and 6ob and 'arl each %ould be recei(ing di(idend
income each year rather than interest income: 3f E P P is at least =1&-7--- at the
time of the loan repayment7 6ob and 'arl %ould each be re5uired to report
=*&7--- of di(idend income rather than treating the repayment as a return of
capital:
pp: 1#9117 1#9127 and 1#91)
2): a: $o gain or loss is recogniAed on the contribution of property to a partnership:
Therefore7 6obby@s realiAed gain of =)-7--- ;=1&-7--- 9 =,-7---< is not recogniAed:
6uddy@s basis for his partnership interest is =1&-7--- and 6obby@s basis for his
partnership interest is =,-7---: The recogniAed gain on the sale of the land is =*&7---
;=1)&7--- amount realiAed 9 =,-7--- adIusted basis< and is allocated to the partners
as follo%s:
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Comparative Forms of Doing Business 14-23
Pre9'ontribution Jain Post9'ontribution Jain
6uddy = 9-9 =*7&--
6obby )-7--- *7&--
b. $o gain or loss is recogniAed on the contribution of property to an S corporation if the
contributing shareholders satisfy the +-B control re5uirement: Therefore7 6obby@s
realiAed gain of =)-7--- ;=1&-7--- 9 =,-7---< is not recogniAed: 6uddy@s stoc2 basis
is =1&-7--- and 6obby@s is =,-7---: The recogniAed gain on the sale of the land is
=*&7--- ;=1)&7--- amount realiAed 9 =,-7--- adIusted basis< and is allocated to the
shareholders as follo%s:
6uddy =*7&--
6obby *7&--
c. $o gain or loss is recogniAed on the contribution of property to a ' corporation if the
contributing shareholders satisfy the +-B control re5uirement: Therefore7 6obby@s
realiAed gain of =)-7--- ;=1&-7--- 9 =,-7---< is not recogniAed: 6uddy@s stoc2 basis
is =1&-7--- and 6obby@s is =,-7---: The ' corporation has a recogniAed gain on the
sale of the land of =*&7--- ;=1)&7--- amount realiAed 9 =,-7--- adIusted basis<: This
recogniAed gain has no effect on 6uddy and 6obby:
d. .n e"change of the original parcel of land for another parcel of land could 5ualify for
deferral as a 41-1 li2e92ind e"change: Go%e(er7 since the business of the entity is
real estate de(elopment7 it appears that the land is in(entory: Section 1-1 deferral
treatment does not apply to in(entory: Thus7 structuring the disposition and
ac5uisition as an e"change %ould produce the same ta" conse5uences as the sale and
purchase option:
pp: 1#91) and 1#91*
2*: a: 3nitial basis under 4 &1 = 1+-7---
Effect of corporate earnings 9-9
Effect of corporate liability 9-9
.licia@s stoc2 basis Q regular corporation = 1+-7---
b: 3nitial basis under 4 &1 = 1+-7---
Effect of corporate earnings ;-B< #+7---
Effect of corporate liability 9-9
.licia@s stoc2 basis Q S corporation = 22+7---
c: 3nitial basis under 4 *21 = 1+-7---
Effect of partnership earnings ;-B< #+7---
Effect of partnership liability ;-B< 1+7---
.licia@s basis for partnership interest = 2#)7---
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14-24 2003 Entities Volume/Solutions Manual
pp: 1#91* to 1#921
2+: a: The conduit concept applies for the partnership: The effect of these transactions on
partnership ta"able income is =- since each of these transactions is reported separately
;i:e:7 Ras isR< on the partnersM ta" returns: Thus7 each partner reports his or her
distributi(e share of each of the follo%ing %ith the identity maintained:
• !T'J of =1-7--- ;=-7--- 9 =2-7---<
• 4 121 gain of =2&7--- ;=)&7--- 9 =#-7---<
• 8i(idend income of =+7---
The ta"9e"empt interest %ould be passed through to the partners on their respecti(e
Schedules S91: Since the conduit concept applies7 such interest is e"cludible in
calculating each partnerMs ta"able income:
b: The entity concept applies for the ' corporation: Thus7 each of these transactions7
e"cept for the ta"9e"empt income7 %ould affect the calculation of corporate ta"able
income: The dollar amount and classification of income is as follo%s:
• =1-7--- !T'J
• =2&7--- 4 121 gain
• =+7--- ordinary income
The =&7--- of municipal bond interest is e"cludible in calculating the corporate ta"able
income: The 36M di(idend 5ualifies for a *-B di(idends recei(ed deduction ;=&7)--<:
c: The treatment for the S corporation is similar to that for the partnership: The conduit
concept applies %ith these transactions producing no effect on the calculation of
corporate ta"able income:
Each of the shareholders %ill report his or her share of each item7 e"cept for the
municipal bond interest %hich is e"cludible from gross income7 based on the per
share/per day rule:
pp: 1#91* and 1#91+
2,: a .mber can ta2e her share ;=2--7--- C 2-B D =#-7---< of the losses to her indi(idual
ta" return: This reduces her basis for her partnership interest ;outside basis< to =)-7---
;=1--7--- 9 =#-7---<: Ger share of the distribution in year further reduces her
outside basis to =#&7--- K=)-7--- 9 ;=*&7--- C 2-B<L: She must report her share
;=1&-7--- C 2-B D =-7---< of the partnership profits on her indi(idual ta" return in
year #: This increases her outside basis to =*&7--- ;=#&7--- ? =-7---<: .mber has
no recogniAed gain or loss on the distribution in reduction of her o%nership interest in
year #: The distribution reduces her outside basis to =1&7--- ;=*&7--- 9 =)-7---<:
b: .mber can ta2e her share ;=2--7--- C 2-B D =#-7---< of the losses to her indi(idual
ta" return: This reduces her stoc2 basis to =)-7--- ;=1--7--- 9 =#-7---<: Ger share of
the distribution in year further reduces her stoc2 basis to =#&7--- K=)-7--- 9 ;=*&7---
C 2-B<L: She must report her share ;=1&-7--- C 2-B D =-7---< of the S corporation
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Comparative Forms of Doing Business 14-25
profits on her indi(idual ta" return in year #: This increases her stoc2 basis to =*&7---
;=#&7--- ? =-7---<: The redemption distribution 5ualifies as a stoc2 redemption %ith
.mber@s recogniAed gain being =#172&- K=)-7--- 9 ;=*&7--- C 2&B<L: .mber@s
remaining stoc2 basis is =&)72&- ;=*&7--- 9 =1+7*&-<:
c: The corporate losses of =2--7--- belong to the ' corporation rather than to the
stoc2holders: Thus7 .mber@s stoc2 basis of =1--7--- is not affected: Since the '
corporation has no EPP7 .mber@s share of the year distribution of =*&7--- reduces
her stoc2 basis to =+&7--- K=1--7--- 9 ;=*&7--- C 2-B<L: The =1&-7--- of earnings in
year # are ta"ed at the corporate le(el and ha(e no effect on .mber: The redemption
distribution 5ualifies as a stoc2 redemption %ith .mber@s recogniAed gain being
=+7*&- K=)-7--- 9 ;=+&7--- C 2&B<L: .mber@s remaining stoc2 basis is =)7*&-
;=+&7--- 9 =2172&-<:
pp. 1#91) to 1#91,
-: a: 1ecognition of gain Since Hohn and Maria control the ' corporation as pro(ided in
4 &17 there is no recogniAed gain: !i2e%ise7 there is no
recogniAed gain at the ' corporation le(el:
Friginal basis for stoc2
Hohn ;=+-7--- 9 =127---< = )+7---
Maria --7---
Effect of entity earnings
' 'orporation:
T3 =1-7---
Ta" !iability:
=&-7--- C 1&B D = *7&--
=2&7--- C 2&B D )72&-
=2&7--- C #B D +7&--
=-7--- C ,B D 117*--
= 7,&-
Hohn $o effect
Maria $o effect
Effect of distribution
8i(idend income
Hohn = &7---
Maria &27&--
Ta" !iability
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14-26 2003 Entities Volume/Solutions Manual
Hohn ;=&7--- C -B< = 1-7&--
Maria ;=&27&-- C -B< 1&7*&-
.dIusted basis for stoc2
Hohn = )+7---
Maria --7---
b: 1ecognition of gain Same as in ;a<:
Friginal basis for stoc2 Same as in ;a<:
Effect of entity earnings
S corporation: The ta"able income of =1-7--- is passed through to Hohn and
Maria as follo%s:
Hohn ;=1-7--- C #-B< = &27---
Maria ;=1-7--- C )-B< = *+7---
The .ccumulated .dIustments .ccount ;...< increases by =1-7---:
Hohn:Gis ta" liability is increased by =1&7)-- ;=&27--- C -B< and his stoc2 basis is
increased by =&27---:
Maria: Ger ta" liability is increased by =27#-- ;=*+7--- C -B< and her stoc2 basis
is increased by =*+7---:
Effect of distribution The distribution reduces the S corporation@s ... by =+*7&--7
Hohn@s stoc2 basis by =&7---7 and Maria@s stoc2 basis by
=&27&--:
.dIusted basis for stoc2
Hohn ;=)+7--- ? =&27--- 9 =&7---< = +&7---
Maria ;=--7--- ? =*+7--- 9 =&27&--< =2&7&--
c. The combined ' corporation/shareholder@s ta" liability is as follo%s:
' corporation = 7,&-
Hohn 1-7&--
Maria 1&7*&-
= )-72--
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Comparative Forms of Doing Business 14-27
The combined S corporation/shareholder@s ta" liability is as follo%s:
S corporation = 9-9
Hohn 1&7)--
Maria 27#--
= ,7---
.ssuming the earnings and distribution policy remain constant7 the annual ta"
liability sa(ings from electing S status is =2172--:
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14-28 2003 Entities Volume/Solutions Manual
' corporation combined ta" liability = )-72--
S corporation combined ta" liability ;,7---<
Ta" liability sa(ings = 2172--
The sa(ings result because the ' corporation and shareholders are subIect to double
ta"ation on =+*7&-- of the =1-7--- annual earnings: 3n addition7 the remaining
=+7&&- of undistributed after9ta" earnings may e(entually be subIect to a second layer
of ta"ation at the shareholder le(el:
pp: 1#9+7 1#9,7 and 1#91# to 1#91,
1: a: 1eturn of capital treatment applies to partnership distributions: The partners reduce
their basis in the partnership interest by the adIusted basis of the partnership property
recei(ed: This is limited to the partner@s basis in the partnership interest: .nita and
Gector@s adIusted basis for the land is =1#-7--- each:
1ecogniAed Jain Partnership 6asis
.nita =9-9 =2--7--- 9 =1#-7--- D =)-7---
Gector =9-9 =1&-7--- 9 =1#-7--- D =1-7---
b: 1eturn of capital treatment applies to S corporation distributions for S corporations
;assuming there is no accumulated E P P from ' corporation ta" years<: Go%e(er7
411;b< re5uires that the appreciation of =+-7--- ;=)-7--- 9 =2+-7---< on the land
be recogniAed by the S corporation: This amount then flo%s through and is ta"ed at
the shareholder le(el: The shareholders@ basis for their stoc2 is increased by the
amount of the recogniAed gain: .nita and Gector@s adIusted basis for the land is
=1+-7--- each:
1ecogniAed Jain 6asis for Stoc2
.nita =#-7--- =2--7--- ? =#-7--- 9 =1+-7--- D =)-7---
Gector =#-7--- =1&-7--- ? =#-7--- 9 =1+-7--- D =1-7---
c. 8i(idend treatment applies7 using the fair mar2et (alue of the land7 to ' corporation
distributions: There is no effect on the shareholders@ stoc2 basis: 3n addition7 411;b<
re5uires that the appreciation of =+-7--- ;=)-7--- 9 =2+-7---< on the land be
recogniAed by the ' corporation %ith the related ta"ation being at the ' corporation
le(el: .nita and Gector@s adIusted basis for the land is =1+-7--- each:
1ecogniAed Jain 8i(idend 3ncome Stoc2 6asis
.nita =9-9 =1+-7--- =2--7---
Gector 9-9 1+-7--- 1&-7---
d. . limited liability company is ta"ed as a partnership: Thus7 the ta" conse5uences to
.nita and Gector are the same as in a: abo(e:
p: 1#91,
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14-30 2003 Entities Volume/Solutions Manual
2: a: Tello%Ms ta"able income is calculated as follo%s:
.cti(e income =1,-7---
Portfolio income 1&7---
Passi(e acti(ity losses 9-9 O
Ta"able income =2-&7---
O The assumption is made that Tello% satisfies the three re5uirements for being
labeled a personal ser(ice corporation for 4 #), purposes: Therefore7 none of the
passi(e acti(ity losses can be offset against either the acti(e income or the portfolio
income:
b: Tello%Ms ta"able income is calculated as follo%s:
.cti(e income =1,-7---
Portfolio income 1&7---
Passi(e acti(ity losses ;1*-7---<O
Ta"able income = &7---
O The passi(e acti(ity losses can be offset against the acti(e income of a closely held
corporation if the corporation does not meet the stoc2 o%nership re5uirements under
the personal holding company pro(isions: 3f the corporation does meet the PG'
pro(isions re5uirements7 the ans%er is the same as in a:
p: 1#91,
: a: 1osaMs basis for her partnership interest prior to consideration of the loss is =12-7---
K=&-7--- ? 1-B of =*--7--- ;partnership debt<L: Go%e(er7 the loss pass9through from
the partnership %hich 1osa can deduct is limited to her at9ris2 basis of =)&7---
K=&-7--- ? 1-B of =1&-7--- ;recourse debt<L: .t the end of 2--27 1osaMs basis for her
partnership interest is =&&7--- K=&-7--- ? 1-B of =*--7--- ;partnership debt< 9
=)&7--- ;at9ris2 amount passed through<L: .lthough 1osaMs share of the partnership
loss is =,-7--- ;1-B C =,--7---<7 her basis is reduced only by the =)&7--- %hich
produces a ta" benefit: The =2&7--- ;=,-7--- 9 =)&7---< %hich 1osa cannot deduct in
2--2 can be used in future ta"able years7 once her at9ris2 basis is ade5uate to absorb it:
b: Since the entity concept applies7 none of the ' corporationMs loss can be deducted on
1osaMs ta" return: The basis for 1osaMs stoc2 at the end of 2--2 is =&-7---7 the amount
of her initial contribution:
pp: 1#91* to 1#92-
#: a: Special allocations are permitted for partnerships: Thus7 under the agreement for
sharing losses7 the =1--7--- loss %ill be allocated to the partners as follo%s:
Megan ;=1--7--- C 1-B< =1-7---
>ern ;=1--7--- C ,-B< ,-7---
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Comparative Forms of Doing Business 14-31
b: 3f the entity is a ' corporation7 the corporation has a =1--7--- loss on its ta" return:
There is no direct effect on the shareholders:
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14-32 2003 Entities Volume/Solutions Manual
c: 3f the entity is an S corporation7 special allocations are not permitted: The =1--7--- loss is
allocated to the shareholders based on the per share/per day rule:
Megan ;=1--7--- C )-B< =)-7---
>ern ;=1--7--- C #-B< #-7---
p: 1#921
&: a: The outside basis of each partner is calculated as follo%s:
.bby >elma
'ontribution = *&7--- = &-7---
1ecourse financing 1--7--- 1--7---
$onrecourse financing &-7--- &-7---
=22&7--- =2--7---
b: The at9ris2 basis of each partner is calculated as follo%s:
.bby >elma
'ontribution = *&7--- = &-7---
1ecourse financing 1--7--- 1--7---
=1*&7--- =1&-7---
pp: 1#91)7 1#91*7 and 1#91,
): Partnership ' 'orporation S 'orporation
a: Tes $o $o
b: Tes $o $o
c: Tes $o $o
d: Tes $o $o
e: Tes $o $o
pp: 1#91) and 1#921
*: a: Since the +-B control re5uirement of 4 &1 is not satisfied at the time SanIay
contributes the land to the ' corporation7 the basis of the land to the corporation is the
fair mar2et (alue of =1--7---: Therefore7 the sale of the land by the corporation for
=11-7--- produces a recogniAed gain for the corporation of =1-7--- K=11-7--- ;amount
realiAed< 9 =1--7--- ;adIusted basis<L: The sale produces no effect at the shareholder
le(el:
b: .s in part a:7 the sale of the land by the S corporation for =11-7--- produces a
recogniAed gain of =1-7---: Since the entity is an S corporation7 the recogniAed gain is
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Comparative Forms of Doing Business 14-33
passed through to the three shareholders based on their stoc2 o%nership: Therefore7
=7--- ;=1-7--- C -B< is reported on SanIayMs return and the balance of =*7--- is
reported on the returns of the other t%o shareholders:
c: The nonrecognition re5uirements of 4 *21 are satisfied at the time SanIay contributes
the land to the partnership: Therefore7 the partnershipMs basis for the land is a carryo(er
basis of =)-7---7 and the partnershipMs recogniAed gain is =&-7--- K=11-7--- ;amount
realiAed< 9 =)-7--- ;adIusted basis<L: Section *-#;c< re5uires that the precontribution
appreciation of =#-7--- be allocated to SanIay: The recogniAed gain balance of
=1-7--- is allocated among the three partners depending on the profit and loss sharing
ratio:
pp: 1#91) and 1#921
38. a: The basis for the stoc2 purchased by Emily and 0reda %ould be its cost of =,-+7---:
The basis of the assets to the corporation %ould not be affected7 since the corporation
is not in(ol(ed in the purchase/sale transaction:
Jeorge %ould ha(e a recogniAed gain of =#+7--- from the stoc2 sale and the gain
%ould be classified as a capital gain:
.mount realiAed =,-+7---
9 6asis for stoc2 ;&)-7---<
1ecogniAed gain =#+7---
b: Emily and 0reda %ould ha(e a basis for each of the assets purchased e5ual to the cost
;i:e:7 0M><: Since the 0M> of the listed assets is =*&-7---7 the =1&+7--- e"cess of
the purchase price o(er =*&-7--- %ill be assigned to good%ill: Jood%ill is amortiAed
o(er a period of 1& years for ta" purposes:
3f Emily and 0reda desire to conduct the business in corporate form7 they can
contribute the assets to a corporation in a ta"9free transaction under 4 &1: The basis
of the contributed assets to the corporation %ill be a carryo(er basis ;i:e:7 total basis of
=,-+7---<:
Pelican %ill be assigned the follo%ing recogniAed gain from the sale of the assets to
Emily and 0reda for =,-+7---:
1ecogniAed 'lassification
.sset Jain 'apital Frdinary
'ash = 9-9 = 9-9 = 9-9
.ccounts recei(able 9-9 9-9 9-9
3n(entory 1-7--- 9-9 1-7---
0urniture and fi"tures 2-7--- 9-9 2-7---O
6uilding &-7--- &-7---OO 9-9
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14-34 2003 Entities Volume/Solutions Manual
!and 11-7--- 11-7---OO 9-9
Jood%ill 1&+7--- 1&+7--- 9-9
=#+7--- =1+7--- =-7---
O 4 12#& recapture
OO 4 121 gain:
Jeorge7 as the shareholder7 is not in(ol(ed in the purchase/sale transaction: Thus7 this
transaction %ill produce no ta" conse5uences for Jeorge: !ogically7 ho%e(er7 the
corporation %ould li5uidate and distribute the a(ailable cash to Jeorge: Since
Pelican is in the #B ta" brac2et7 the corporate ta" liability associated %ith the asset
sale %ould be =11+72- ;=#+7--- C #B<: Therefore7 %hen Jeorge recei(es a
li5uidating distribution of =*+,7)+- ;=,-+7--- 9 =11+72-<7 he %ill recogniAe a capital
gain of =22,7)+- ;=*+,7)+- amount realiAed 9 =&)-7--- adIusted basis for stoc2<:
c: The basis for the stoc2 purchased by Emily and 0reda is its cost of =&&-7---: The
basis of the assets to the corporation %ould not be affected7 since the corporation is
not in(ol(ed in the purchase/sale transaction:
Jeorge %ould recei(e a recogniAed loss of =1-7--- from the stoc2 sale and the loss
%ould be classified as a capital loss:
.mount realiAed = &&-7---
9 6asis for stoc2 ;&)-7---<
1ecogniAed loss ;= 1-7---<
p: 1#92 and 'oncept Summary 1#91
,: a: .mount realiAed =2)-7---
!ess: adIusted basis ;1)-7---<
1ealiAed gain =1--7---
1ecogniAed gain =1--7---
E(en though !inda sold her business7 the transaction is treated as the sale of the
indi(idual assets: This is necessary to classify the recogniAed gain as capital or
ordinary:
.sset Frdinary 'apital and 4 121
.ccounts recei(able = 2&7--- = 9-9
Fffice furniture and fi"tures 27--- 9-9
6uilding 1&7---
!and 2-7---
Jood%ill +7---
Since the sales price e"ceeds the fair mar2et (alue of the listed assets by =+7---
;=2)-7--- 9 =2227---<7 the e"cess is treated as paid for good%ill:
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Comparative Forms of Doing Business 14-35
b: Huan has a basis for each of the listed assets of fair mar2et (alue7 and a basis for
good%ill of =+7---:
c: Prior to the 1e(enue 1econciliation .ct of 1,,7 the good%ill amortiAation could not
be deducted by Huan for ta" purposes: Thus7 if Huan %ere successful in negotiating
%ith !inda to ha(e the e"cess =+7--- labeled a payment for a co(enant not to
compete7 Huan could then deduct the =+7--- o(er the life of the co(enant: 0rom
!indaMs perspecti(e7 this %ould result in the =+7--- gain being classified as ordinary
income: .s a result of the 1e(enue 1econciliation .ct of 1,,7 both good%ill and a
co(enant not to compete are amortiAed and deducted o(er a 1&9year statutory period:
Thus7 from HuanMs perspecti(e7 the ta" conse5uences of assigning the =+7--- e"cess
payment to good%ill or to a co(enant are the same: Go%e(er7 the ta" conse5uences to
!inda still differ: That is7 gain on the co(enant is classified as ordinary income7
%hereas gain on the good%ill is classified as a capital gain: Thus7 if the co(enant has
no legal rele(ance to Huan7 he should negotiate %ith !inda for a price reduction %hich
reflects the ta" benefit of the alternati(e ta" on capital gains to !inda ;assuming there is
a benefit to !inda<: 'on(ersely7 if a co(enant %ould ha(e legal rele(ance to Huan7 then
at least part of the =+7--- should be assigned to a co(enant:
pp: 1#9217 1#9227 E"ample 1*7 and 'oncept Summary 1#91
#-: a: The sales are treated as the sales of o%nership interests: Thus7 each partner calculates
his or her recogniAed gain as follo%s:
Jail Garry
.mount realiAed =-*7--- =-*7---
9 6asis ;1--7---< ;1&-7---<
1ecogniAed gain =2-*7--- =1&*7---
The recogniAed gain is classified as long9term capital gain under 4 *#1 subIect to any
ordinary income recognition under 4 *&1 for RhotR assets: Since JG Partnership has no
unrealiAed recei(ables or substantially appreciated in(entory7 all of the gain is
classified as long9term capital gain:
The sale of the partnership interests by Jail and Garry results in the termination of JG
Partnership under 4 *-+;b<;1<;6< K%ithin a 129month period7 there is a sale or e"change
of at least &-B of the total interest in partnership capital and profitsL:
b: 3f the assets are appreciated7 an indi(idual purchasing an interest in a partnership
normally %ould prefer to purchase partnership assets rather than an o%nership interest:
This preference occurs because the basis of the assets %ill be e5ual to the amount paid
for them ;i:e:7 0M>< rather than ha(ing a carryo(er basis associated %ith the purchase
of a partnership interest: This negati(e result associated %ith the purchase of a
partnership interest can be offset for the ac5uiring partner if the partnership ma2es the
4 *&# election %hich acti(ates the special basis pro(isions under 4 *# for the
ac5uiring partner: Go%e(er7 there are a (ariety of reasons %hy the partnership may be
un%illing to ma2e this election:
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14-36 2003 Entities Volume/Solutions Manual
3n the case at hand7 the normal preference does not apply because the JG Partnership is
terminated: Thus7 regardless of the method of purchase7 the assets of the ne%
partnership ;i:e:7 S! Partnership< %ill ha(e a basis e5ual to the amount paid by Seith
and !iA ;i:e:7 0M><:
p: 1#92 and 'oncept Summary 1#91
#1: '!3E$T !ETTE1
Smith7 1aabe7 and Maloney7 'P.s
&1,1 $atorp 6oule(ard
Mason7 Fhio #&-#-
.ugust 1)7 2--2
Mr: Ted Ta"payer
&- !a2e Shore 8ri(e
Erie7 P. 1)&-1
8ear Ted:
3 am responding to your in5uiry regarding your purchase of the 'arp Partnership for
=#--7---: Tour outside basis is =2--7--- and S2ip@s outside basis is =2--7---:
Since you and S2ip ha(e ac5uired a greater than &- percent interest in capital and profits7 the
original 'arp Partnership terminates: 3t is sur(i(ed by a ne% 'arp Partnership o%ned by you
and S2ip: The basis of the partnership assets is the cost of =#--7---: Thus7 in this case7 a
4 *&# election is not necessary:
3f you ha(e any 5uestions7 please call:
Sincerely7
Hanet Thomas7 'P.
Partner
p: 1#92 and 'oncept Summary 1#91
#2: 0rom >ladimirMs perspecti(e7 the sale of 1uby7 3nc:7 should be structured so as to a(oid
double ta"ation: . sale of the stoc2 of 1uby7 3nc:7 to the in(estor group %ill achie(e this
obIecti(e: The sale of the assets by the corporation ;or the distribution of the assets to
>ladimir to sell< follo%ed by the li5uidation of the corporation %ould result in double
ta"ation: Thus7 >ladimir needs to recogniAe this difference in ta" conse5uences to effecti(ely
conclude the negotiations: p: 1#92 and 'oncept Summary 1#91
#: Smith7 1aabe7 and Maloney7 'P.s
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Comparative Forms of Doing Business 14-37
&1,1 $atorp 6oule(ard
Mason7 FG #&-#-
.ugust 1)7 2--2
Mr: 6ill E(ans
1-- >illage Jreen
'hattanooga7 T$ *#-
8ear Mr: E(ans:
3 am responding to the in5uiry regarding %hether you should negotiate to purchase the stoc2
or the assets of 8ane 'orporation:
0rom a ta" perspecti(e7 you should ac5uire the assets of 8ane 'orporation rather than the
stoc2: 6y purchasing the assets7 the basis for the assets %ill be the purchase price of
=*&-7---: Then contribute the assets to a ne% corporation under 4 &1 %ithout any
recognition: The basis of the assets to the corporation %ill be =*&-7---: 3f the stoc2 of 8ane
'orporation is purchased instead7 the basis for the stoc2 is the purchase price of =*&-7---:
Go%e(er7 the corporationMs basis for its assets %ould remain at =#1-7---: 3n order to step the
asset basis up to the purchase price of =*&-7---7 the corporation %ould need to ma2e a 4 +
election: Go%e(er7 the disad(antage of a 4 + election is that the corporation %ould ha(e a
recogniAed gain as a result of a deemed sale of its assets:
. nonta" ad(antage of the asset purchase is the a(oidance of legal responsibility for any
liabilities of 8ane 'orporation: .lthough 8ane has no recorded liabilities7 there is the
possibility of unrecorded or contingent liabilities:
3f 3 can be of further assistance7 please let me 2no%:
Sincerely7
1obert .mes7 'P.
Partner
T.C 03!E MEMF1.$8UM
8.TE: .ugust 127 2--2
01FM: 1obert .mes
SU6HE'T: Purchase of 8ane 'orporation by 6ill E(ans
6ill E(ans is going to purchase either the stoc2 of 8ane 'orporation or its assets: 6ill has
agreed %ith the seller that 8ane has a fair mar2et (alue of =*&-7---: 8aneMs adIusted basis
for its assets is =#1-7---: 6ill has re5uested our ad(ice on %hether he should negotiate to
purchase the stoc2 of 8ane or its assets:
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14-38 2003 Entities Volume/Solutions Manual
3f 6ill purchases the assets of 8ane7 his basis for the assets %ould be the purchase price of
=*&-7---: Ge then could contribute the assets to a ne% corporation %ithout any recognition
under 4 &1: The corporationMs adIusted basis for the assets %ould be =*&-7---:
3f 6ill purchases the stoc2 of 8ane7 his basis for the stoc2 %ould be =*&-7---: Go%e(er7
since 8ane is not in(ol(ed in the transaction7 the corporationMs basis for its assets %ould
remain at =#1-7---: 3n order to step the asset basis up to the purchase price of =*&-7---7
8ane %ould need to ma2e a 4 + election: Go%e(er7 the disad(antage of a 4 + election is
that the corporation %ould ha(e a recogniAed gain as a result of the deemed sale of its assets:
Thus7 from a ta" perspecti(e7 6ill should purchase the assets rather than the stoc2 of 8ane:
3n addition7 the asset purchase %ill a(oid any potential unrecorded or contingent liability
problem:
p: 1#92 and 'oncept Summary 1#91
BRIDGE DISCIPLINE PROBLEMS
0inancial .ccounting 6alance Sheet
1: a: .ssets !iabilities and F%ners E5uity
'ash =1--7---Mortgage on land = 2-7---
!and 12-7--- 'ommon stoc2 2--7---
=22-7--- =22-7---
Entity theory applies in constructing the financial accounting balance sheet: Thus7 the fair
mar2et (alues are used for the assets and the related common stoc2 account:
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Comparative Forms of Doing Business 14-39
Ta" 6alance Sheet
b: .ssets !iabilities and F%ners E5uity
'ash =1--7---Mortgage on land = 2-7---
!and #-7--- 'ommon stoc2 12-7---
=1#-7--- =1#-7---
'onduit theory applies in constructing the ta" balance sheet: Thus7 a carryo(er basis is used
for the assets and the related shareholders@ basis for their common stoc2:
c: 0inancial
.ccounting Ta"
.mount realiAed =1&-7--- =1&-7---
9 .dIusted basis ;12-7---< ;#-7---<
D 1ecogniAed gain =-7--- =11-7---
6ecause the assets %ere (alued at fair mar2et (alue at the time of the contribution to the
entity7 the =-7--- gain represents the appreciation occurring after the assets %ere
contributed to the entity: 6ecause the assets %ere (alued at a carryo(er basis at the time of
the contribution to the entity7 the =11-7--- gain represents both the appreciation ;=+-7---<
occurring at the time of the contribution to the entity and the appreciation ;=-7---<
occurring after the assets %ere contributed to the entity:
2: a:7 b:7 and c: 6oth the financial accounting and the ta" results are the same as in 1: abo(e:
The only difference is that the =11-7--- recogniAed gain for ta" purposes is ta"ed at the
shareholder le(el ;S corporation is a flo%9through entity< rather than at the corporate le(el as
in 1: abo(e:
0inancial .ccounting 6alance Sheet
: a: .ssets !iabilities and F%ners E5uity
'ash =1--7---Mortgage on land = 2-7---
!and 12-7--- Partners@ F%nership 3nterest 2--7---
=22-7--- =22-7---
Entity theory applies in constructing the financial accounting balance sheet: Thus7 the fair
mar2et (alues are used for the assets and the related partners@ o%nership interests:
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14-40 2003 Entities Volume/Solutions Manual
Ta" 6alance Sheet
b: .ssets !iabilities and F%ners E5uity
'ash =1--7---Mortgage on land = 2-7---
!and #-7--- Partners@ F%nership 3nterest 12-7---
=1#-7--- =1#-7---
'onduit theory applies in constructing the ta" balance sheet: Thus7 a carryo(er basis is used
for the assets and the related partners@ partnership interests:
c: 0inancial
.ccounting Ta"
.mount realiAed =1&-7--- =1&-7---
9 .dIusted basis ;12-7---< ;#-7---<
D 1ecogniAed gain =-7--- =11-7---
6ecause the assets %ere (alued at fair mar2et (alue at the time of the contribution to the
entity7 the =-7--- gain represents the appreciation occurring after the assets %ere
contributed to the entity: 6ecause the assets %ere (alued at a carryo(er basis at the time of
the contribution to the entity7 the =11-7--- gain represents both the appreciation ;=+-7---<
occurring at the time of the contribution to the entity and the appreciation ;=-7---<
occurring after the assets %ere contributed to the entity:
The =11-7--- recogniAed gain for ta" purposes is ta"ed at the partner le(el ;partnership is a
flo%9through entity<: Section *-#;c<;1<;.< re5uires that the =11-7--- gain be allocated to
Ha2e and 0ran as follo%s:
Ha2e 0ran
Precontribution gain = -=+-7---
Post9contribution gain 1&7--- 1&7---
=1&7--- =,&7---
3f Parchment is an !!' that has chec2ed the bo" to be ta"ed as a partnership7 then the
partnership ta" rules apply: So the results %ould be e"actly the same as those for an entity
that legally is a partnership:
#: a: 0or the first ta" year of a corporation7 a corporation is e"empt from the .MT: So
neither Teal nor !a(ender needs to ma2e an .MT calculation for their first ta" year:
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Comparative Forms of Doing Business 14-41
b: The 'ode contains a number of instances of beneficial ta" treatment for small
businesses: Fne such treatment appears in 4 &&;e< for small corporations: 3f a
corporation satisfies the statutory definition of a small corporation for this purpose7 the
corporation is e"empt from the .MT for ta" years subse5uent to the first ta" year:
!a(ender is a small corporation as defined in 4 &&;e<;1< %hereas Teal is not: Thus7
only Teal is subIect to the .MT:
c: The different ta" treatment for Teal and !a(ender is consistent %ith a theme in se(eral
code sections that small business deser(es beneficial ta" treatment %hen compared
%ith large business entities:
p: 1#91-
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RESEARCH PROBLEMS
1: The 3nternet .cti(ity research problems re5uire that the student access (arious sites on the
3nternet: Thus7 each student@s solution li2ely %ill (ary from that of the others:
Tou should determine the s2ill and e"perience le(els of the students before ma2ing the
assignment7 coaching them %here necessary so as to broaden the scope of the e"ercise to the
entire a(ailable electronic %orld:
Ma2e certain that you encourage students to e"plore all parts of the Eorld Eide Eeb in this
process7 including the 2ey ta" sites7 but also information found through the %eb sites of
ne%spapers7 magaAines7 businesses7 ta" professionals7 go(ernment agencies7 political outlets7
and so on: They should %or2 %ith 3nternet resources other than the Eeb as %ell7 including
ne%sgroups and other interest9oriented lists:
6uild interaction into the e"ercise %here(er possible7 as2ing the student to send and recei(e
e9mail in a professional and responsible manner:
2: See the 3nternet .cti(ity comment abo(e:
: See the 3nternet .cti(ity comment abo(e:
#: See the 3nternet .cti(ity comment abo(e:
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NOTES