6

Penalty Taxes on
Corporate Accumulations

Solutions to Tax Research Problems

TAX RESEARCH PROBLEMS

6-41 a. Section 1033 provides for nonrecognition of gain on certain involuntary conversions. Condemnations
are included in the term involuntary conversion, as are sales following the threat of condemnation. To
qualify for nonrecognition, the taxpayer must replace the property with similar or related-use property.
The taxpayer could purchase control of a corporation that owns qualified replacement property. The
qualified replacement property must be acquired by the end of the second taxable year following the
close of the taxable year in which the involuntary conversion takes place.
The Holts are interested in investing the proceeds in a three-year CD. This will violate the
replacement period. The longest replacement period is two years and eleven months, assuming that the
conversion took place during the first month of a tax year.
Failure to replace on time will result in the realized gain on the conversion being recognized. The
type of gain will be dependent on the property. Specifically, H Corporation might have ordinary
income as a result of § 1250 and § 1245 depreciation recapture.
b. It is very likely that H Corporation will be a personal holding company. There are two tests: the
ownership test and the income test. Because the corporation is owned by William and Wilma alone, it
will always meet the ownership test. Because the only revenue following the condemnation will be
interest income, which is personal holding company income, the corporation will meet the income test.
The corporation cannot rely on the exclusion contained in § 543 to avoid the tax. This section
provides for a subtraction in arriving at adjusted ordinary gross income for interest on condemnation
awards. That refers to the interest paid as part of the settlement. It does not apply to interest earned
on the temporary investment of the condemnation proceeds.
The easiest way for the corporation to avoid paying the penalty tax is to pay dividends. Dividends
reduce the undistributed personal holding company income. Therefore, if the corporation distributes
all this income as dividends, no penalty tax will accrue.
Another possible way to avoid the personal holding company tax would be for the corporation to
invest the funds in securities yielding nontaxable interest. To be personal holding company income, the
item must be included in adjusted ordinary gross income. Because nontaxable interest is excluded, it is
not personal holding company income.
c. We need to know the Holts’ basis in the stock. Since § 331 treats the liquidation as a sale at the
shareholder level, the basis and holding period of the stock are needed to determine the gain or loss on
the liquidation and the resultant tax. We also need to know if the corporation owned any assets (other
than cash) that would be distributed to the Holts. Under § 336, the corporation recognizes gains and
losses on the distribution of its assets. If there are losses, information about the date and method of
acquisition is also needed to determine if the loss is limited by § 336(d)(1) or (2).

6-1
6-2 Chapter 6 Penalty Taxes on Corporate Accumulations

6-42 Issue: Did Cotton, Inc. accumulate earnings for the purpose of avoiding income tax to Stacey?

5- The accumulated earnings tax is imposed on corporations formed or availed of for the purpose of avoiding
the tax on its shareholders. Section 533(a) states that the fact that E&P of a corporation is permitted to
accumulate beyond the reasonable needs of the business is determinative of the purpose to avoid income
tax with respect to its shareholders. Thus, Cotton, Inc. must show that its failure to pay dividends is
attributable to funds being retained for reasonable business needs. Section 537(a) provides that the
reasonable needs of the business include reasonably anticipated needs of the business. Reg. § 1.537-1(b)(1)
states that in order for a corporation to justify an accumulation of E&P for reasonably anticipated future
needs, there must be an indication that the future needs of the business require such accumulation, and the
corporation must have specific, definite, and feasible plans for the use of such accumulation. When the
future needs of the business are uncertain or vague, or when the execution is postponed indefinitely, an
accumulation cannot be justified on the grounds of reasonably anticipated needs of the business. The
reasonably anticipated needs are to be based on the facts as of the close of the tax year. Cotton, Inc. must
demonstrate that earnings are retained for reasonable business needs and that future needs are evidenced
by specific and definite plans.

5- Sub-issues: The corporation has accumulated funds because of (1) fear of losing the company, (2) decreased
profits from foreign competition, and (3) modernization due to OSHA. Is this action justified according to
the statutory reasonable needs test?

1. Fear of losing the company: For AET purposes, the “economic history of the country and this company
is both pertinent and illuminating” [Dill Manufacturing Co., 39 B.T.A. 1031 (1939)]. Judicial opinion is
that expectations should be reasonable in light of the evidence: “Eloquent but unsupported assertions
do not take the place of testimony or proof [Smoot Sands & Gravel Corp., 274 F.2d 495, 60-1 USTC
{9241, 5 AFTR2d 626 (CA-4, 1960)]. In Hardin v. U.S., 461 F.2d 864, 72-1 USTC {9464, 29 AFTR2d
72-1446 (CA-5, 1972), a bakery’self-insurance reserve was not a reasonable need: “at best they can
establish only that such reserves might have been necessitated in the event of some hypothetical disaster
that might have entailed substantial plant replacement costs. In the absence of any evidence supporting
the reasonableness of that hypothesis, neither corporation could have retained earnings merely for the
purpose of providing for some theoretical contingency that might never have transpired. Bare
possibilities do not amount to reasonable business needs.” Similarly, a downturn in the housing
industry was not sufficient cause for a lumber company to reserve for losses. Rather, evidence must
demonstrate that losses are reasonably anticipated [Suwannee Lumber Manufacturing Co., 39 TCM
572, T.C. Memo 1979-477; also see C. E. Hooper, Inc., 539 F.2d 1276, 76-2 USTC {9538, 38 AFTR2d
76-5417 (Ct. Cls., 1976); and R. Gsell & Co., 34 T.C. 41 (1960)].
The question of what is reasonable is generally interpreted by the courts according to the prudent
businessman rule. “The issue is whether a reasonable businessman would have set aside the above sums
to meet the obligations described” [A. F. Gallun & Sons v. U.S., 510 F.Supp. 630, 81-1 USTC {9471, 47
AFTR2d 81-1157]. The rationalizations for the accumulations should be similar to those of a prudent
businessman confronted with the same problems (Halby Chemical Co., Inc. v. U.S., 67-2 USTC {9500,
19 AFTR2d 1589). If sound testimony is presented, the court may bow to experienced
management’judgment concerning the reasonableness of specific issues: “we may be guided by the dicta
that we should hesitate to substitute our judgment for that of petitioner’managers” [Syracuse Stamping
Co., 4 TCM 371 (1945)].
Thus, Stacey must show that her fear of losing the company is reasonable with supporting evidence
such as industry statistics, market surveys, financial ratios, or economic trends. One apparent valid
explanation of Stacey’ fear and her retaining earnings is competition.
2. Competition: Several cases recognize legitimate accumulation of funds for the potential detrimental
effects of competition. For example, a paper manufacturer’accumulations were considered reasonable
by Circuit Judge Moore: “I am convinced… that Mohawk in its use and preservation of its earnings
was motivated by a desire to maintain and improve its plant and equipment, and in this way to be able
to compete successfully in the highly competitive specialty paper industry with its several competitors
then current (1959–91961) and in the future” [Mohawk Paper Mills, Inc. v. U. S., 67-1 USTC {9108,
18 AFTR2d 6111 (D.Ct., N.Y.); see also, Empire Steel Castings, Inc., 33 TCM 155, T.C.Memo 1974-
034; Marie’Shoppe, Inc., 36 TCM 1548, T.C. Memo 1977-381; Hardins Bakeries Corp. v. Martin, Jr.,
293 F. Supp. 1120, 67-1 USTC {9253, 19 AFTR2d 647 (D.Ct., Miss); Smokeless Fuel Co., 2 TCM 794,
T.C. Memo 1943-425; and F. E. Watkins Motor Co., 31 T.C. 288 (1958)].
 Solutions to Tax Research Problems 6-3

Although these cases suggest that Cotton, Inc. may reserve funds in response to foreign competition,
Reg. § 1.537-1(b)(1) requires that Cotton have specific and definite plans for the use of the funds. The
courts appear to accept less formal documentation for closely held corporations. While examining
the reasonably anticipated demands for funds, the Tax Court stated: “a closely held corporation cannot
be held to the same strict formalities of large public corporations” [Bremerton Sun Publishing Co., 44 T.C.
566 (1965)]. “Furthermore, in weighing the proof, consideration must be given to the fact that Mohawk is
and has been not only a family corporation but in many ways a one-man corporation. Decisions which, in
the case of industrial giants, might well be found recorded in engineering committee minutes, reports,
directors’ minutes, and countless interoffice memoranda would not necessarily be recorded formally in a
situation in which one man had the responsibility of operating a company with limited funds and often on
a hand to mouth basis” [Mohawk Paper Mills, Inc.; see also, Empire Steel; Shaw-Walker Co. v. Comm.,
390 F.2d 205, 68-1 USTC {9211, 21 AFTR2d 655 (CA-6, 1968); Smokeless Fuel Co.; and Walton Mill, 31
TCM 75, T.C. Memo 1972-025]. Primarily, the evidence and testimony in Mohawk convinced the court
of the taxpayer’intentions, albeit informal.
However, in other cases, lack of evidence supporting the taxpayer’contentions has led the court to
enforce the specific and definite requirements even in a closely held corporation. But petitioner’plans for
diversification to protect itself were not “in such stages of planning that would justify accumulation of
earnings. The most that can be said is several proposals were considered” [Henry Van Hummell, Inc. v.
Comm., 364 F.2d 746, 66-2 USTC {9610, 18 AFTR2d 5500 (CA-10, 1966); see also, Smoot Sand &
Gravel Corp.; R. C. Tway, 60-1 USTC {9240, 5 AFTR2d 849 (D.Ct., Ky); and C. E. Hooper, Inc.]. A
textile manufacturer was denied accumulations for a water-jet loom (technology to stay competitive). As
the Court said, “there must be something more than a mental conception of a plan by the petitioner’chief
executive for us to conclude that such a plan was actually in existence as of a given date.” The Court
concluded that “anticipation of a need is not equivalent to a plan of acquisition” (Cadillac Textiles, Inc.,
34 TCM 265, T. C. Memo 1975-046).
The appellate courts appear less demanding for a specific and definite plan than does the Tax Court.
Stacey should provide evidence of Cotton, Inc.’need to modernize to stay ahead of competition, in
specific terms (i.e., type of equipment, cost, industry trends, etc.).
3. OSHA Modernization: Accumulation of funds in order to comply with federal regulations generally has
been accepted as a reasonable business need as long as enforcement is likely. A coal mining equipment
manufacturer was permitted to accumulate a reasonable estimate of funds necessary to meet the
requirements of the 1969 Mine Safety Act even though enforcement was uneven [Wilcox
Manufacturing, 38 TCM 378, T.C. Memo 1979-092; see also, A. F. Gallun and Sons Corp. v. U.S., 510
F. Supp. 630, 81-1 USTC {9471, 47 AFTR2d. 81-1157 (D.Ct. Wis. EPA); Mohawk Paper (stream
pollution)]. It must be likely that compliance costs will be incurred; otherwise, accumulations will not
be accepted. “There was no anticipated need to maintain capital for pollution or environmental
controls in general and there is no evidence that Suwannee anticipated any cost relating to any violation
until actually cited” [Suwannee Lumber Mfg. Co.; see also, Doug Long, Inc., 72 T.C. 158 (1979)].
Cotton, Inc. must show that it is likely to incur OSHA compliance costs in specific terms and provide
reasonable estimates.
Stacey’s last defense against the AET (in the event the aforementioned reasons fail) is to show that the
purpose of Cotton’failure to distribute its earnings was not an attempt to avoid shareholder income tax. The
Supreme Court ruled that the avoidance of shareholder tax must not be one of the purposes of the
accumulation. It is not necessary that it be the dominant purpose (Donruss Co. v. U.S., 393 U. S. 297, 69-1
USTC {9167 23 AFTR2d. 69-418). The subjective intent issue should be pursued as a last resort only. Reg.
§ 1.533-1(a)(2) provides that the presence of such intent depends on the existing circumstances. One factor
that may exemplify the forbidden purpose is the corporation’dividend policy. Cotton’failure to distribute its
earnings should be justified on the basis of reasonable business needs in order to avoid the intent issue and the
presumption of the forbidden purpose due to undistributed earnings. (See Snow Mfg. Co., 86 T.C. 260.)
 6
Penalty Taxes on
Corporate Accumulations

Test Bank

True or False

1. Corporations are required to compute and pay the accumulated earnings tax by the due date of the tax return.

2. The accumulated earnings tax is paid instead of the regular corporate tax plus the alternative
minimum tax.

3. In calculating accumulated taxable income, both the accumulated earnings credit and dividends-paid
deduction are subtracted from adjusted taxable income.

4. The accumulated earnings credit for a manufacturing company is the smaller of (a) retention for
reasonable business needs minus net capital gains, or (b) $250,000 minus previous accumulations.

5. The dividends-paid deduction for accumulated earnings tax purposes consists solely of dividends paid
during the tax year and dividends paid within 21=2 months of the close of the tax year (“throwback
dividends”).

6. If a corporation does not have a reasonable business need, it may not accumulate income in excess of
$250,000 without the imposition of the accumulated earnings tax.

7. The Bardahl formula may be used to determine whether actual working capital exceeds required
working capital for purposes of the accumulated earnings tax.

8. The IRS generally determines actual working capital based on current market value whenever there is
a significant difference between historical cost and current market value.

9. For personal holding company tax purposes, a corporation meets the income requirement if
60 percent or more of the corporation’s adjusted ordinary gross income is personal holding company
income.

10. To be a personal holding company, the corporation must have been formed or availed of for the
purpose of avoiding tax on the shareholders.

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6-6 Chapter 6 Penalty Taxes on Corporate Accumulations

11. The dividends-paid deduction for personal holding company tax and accumulated earnings tax is
computed the same way.

12. Any corporation that has accumulated taxable income is subject to the accumulated earnings tax.

13. Accumulations of earnings for working capital constitutes a reasonable business need.

14. A corporation whose only source of income is rental income will not be subject to the personal
holding company penalty tax.

15. For purposes of the personal holding company provisions, gross income minus capital gains, § 1231
gains and depreciation, property taxes, interest expense, and rents paid related to gross rental income
equal ordinary gross income.

16. A corporation’s “adjusted income from rents” will not be added to personal holding company income
(PHCI) if the total of dividends paid, consent dividends, and throwback dividends is less than the
amount by which nonrental PHCI exceeds 10 percent of ordinary gross income.

17. A corporation need not worry about the personal holding company penalty, since a deficiency
dividend will eliminate all amounts due the government.

18. If an attorney incorporates her practice, all amounts received for legal services will be personal
holding company income.

19. One way to reduce a corporation’s exposure to the accumulated earnings tax is for the corporation to
invest in additional assets related to reasonable business needs.

20. Court decisions have found the reasonable possibility of business reversals to be justification for not
imposing the accumulation of earnings penalty tax.

Multiple Choice

21. Which one of the following is not used as a method of avoiding double taxation?
a. Multiple corporations
b. Excessive compensation for services to the corporation by shareholder
c. Issuance of debt in lieu of stock
d. Leasing of property to the corporation by shareholder
e. None of the above
22. In computing the accumulated earnings tax, it is necessary to compute “adjusted taxable income.”
Which one of the following is not added to taxable income to arrive at adjusted taxable income?
a. Dividends-received deduction
b. Net operating loss deduction that is reflected in taxable income
c. Net capital gains
d. Capital loss carryovers from other years that are reflected in taxable income
23. In calculating adjusted taxable income for accumulated earnings tax purposes, which one of the
following is not subtracted from taxable income?
a. Regular Federal income taxes for the year
b. Dividends-paid deduction
c. Charitable contributions in excess of allowable deduction
d. Net capital loss
e. Net capital gains
 Test Bank 6-7

24. B Corporation, a retail shoe store, operates on a calendar year and has paid no dividends for three
years. Using the following information, calculate the accumulated earnings credit for B Corporation:

Estimated reasonable needs for the current year $200,000

Prior accumulations 100,000
Net capital gain 15,000
Taxes attributed to capital gain 5,100

a. $85,000
b. $90,100
c. $100,000
d. $150,000
e. $250,000
25. B Corporation, a service company, operates on a calendar year and has paid no dividends for three
years. What would its accumulated earnings credit be?

Estimated reasonable needs for the current year $200,000

Prior accumulations 100,000
Net capital gain 15,000
Taxes attributed to capital gain 5,100

a. $85,000
b. $90,100
c. $100,000
d. $150,000
e. $250,000
26. Which one of the following is not part of the dividends-paid deduction for accumulated earnings tax
purposes?
a. Dividends paid within 21=2 months after the close of the tax year (“throwback dividends”)
b. Dividends paid during the year
c. Deficiency dividends
d. Consent dividends paid on the last day of the year
e. None of the above
27. The minimum credit in calculating the accumulated earnings credit for a corporation that is not a
service company and which has $375,000 in prior accumulations is
a. $0
b. $125,000
c. $225,000
d. $250,000
e. An amount that cannot be determined from the information given
28. Section 533, Accumulated Earnings Tax, provides that a corporation is deemed to have been formed
or availed of for the purpose of avoiding tax on shareholders if
a. The corporation is a holding or an investment company.
b. The corporation has accumulations in excess of the designated minimum credit.
c. The corporation has invested in assets unrelated to the corporation’s business.
d. The corporation has paid no dividends.
e. The corporation has 10 or fewer shareholders.
6-8 Chapter 6 Penalty Taxes on Corporate Accumulations

29. Which one of the following is not always exempt from the accumulated earnings tax?
a. Personal holding companies
b. Tax-exempt corporations
c. Passive foreign investment companies
d. Publicly held corporations
e. None of the above
30. In which case did the Supreme Court hold that the penalty tax could apply in situations when the
primary reason for accumulations was not tax avoidance?
a. Union Offset
b. Golconda Mining Corp.
c. Alphatype Corp.
d. Trico Products
e. Donruss
31. Which one of the following is not normally considered a reasonable need for retaining income?
a. Product liability losses
b. Retirement of debt
c. Plant replacement
d. Stock redemption from minority shareholder
e. Business expansion
32. Section 537(a)(1) of the Internal Revenue Code states that accumulations for reasonable business
needs include “reasonably anticipated needs” of the business. Which of the following is true regarding
“reasonably anticipated needs” for accumulations?
a. The corporation must have specific plans for use of the accumulation.
b. The funds must be spent soon after the close of the year.
c. The expenditure cannot be postponed indefinitely.
d. Both a. and c.
e. Both b. and c.
33. Which one of the following ratios is not calculated for use in the Bardahl formula?
a. Working capital ratio
b. Accounts payable turnover ratio
c. Inventory turnover ratio
d. Accounts receivable turnover ratio
e. None of the above
34. Which of the following is not considered an operating expense for purposes of the Bardahl formula?
a. Taxes
b. Rent
c. Salaries
d. Depreciation
e. Selling expenses
35. Which one of the following is not exempt from the personal holding company tax?
a. S corporations
b. Tax-exempt corporations
c. Surety companies
d. Lending and finance companies
e. All of the above are exempt
 Test Bank 6-9

36. A personal holding company will always meet the ownership test if more than percent of the value of
the corporation’s outstanding shares of stock are owned by five or fewer persons at any time during
the last half of the tax year.
a. 25 percent
b. 35 percent
c. 40 percent
d. 50 percent
e. 80 percent
37. To determine stock ownership by attribution for purposes of the personal holding company tax, stock
is attributed from which of the following?
a. Spouse and children
b. Brother and sister
c. Proportionate share of any stock owned by a partnership
d. Both a. and b.
e. Choices a., b. and c.
38. G Corporation, which has $15,000 in passive income, will need to have an adjusted ordinary gross
income (AOGI) of greater than what amount in order to “fail” the personal holding company income
test?
a. $25,000
b. $22,500
c. $20,000
d. $15,000
e. $10,000
39. All of the following guidelines regarding stock attribution as it relates to the personal holding
company ownership test are true except:
a. Stock options held by the taxpayer, but not yet exercised, are not considered owned by the
taxpayer.
b. Convertible securities are considered outstanding stock.
c. Stock attributed from a partner to the taxpayer cannot be reattributed to another partner.
d. Stock attributed from one family member to another cannot be reattributed to yet another family
member.
e. Stock owned by an estate is considered as proportionately owned by the beneficiaries.
40. Which of the following is subtracted from gross income to arrive at ordinary gross income (OGI)?
a. Capital losses
b. Section 1231 gains
c. Charitable contributions in excess of the amount deductible
d. Interest on tax refunds
e. None of the above
41. Use the following information about Q Corporation, an apartment rental company with three
shareholders.
Interest income $15,000
Gross rental income 16,000
Depreciation, property taxes, and interest expense related to rental income 18,000
Maintenance and utilities related to rental income 4,000
Dividends paid during the current year 7,000

What is the adjusted ordinary gross income for Q Corporation?

a. $13,000
b. $9,000
c. $(6,000)
d. $15,000
e. $31,000
6-10 Chapter 6 Penalty Taxes on Corporate Accumulations

42. Use the following information about Q Corporation, an apartment rental company with three
shareholders.
Interest income $15,000
Gross rental income 30,000
Depreciation, property taxes, and interest expense related to rental income 18,000
Maintenance and utilities related to rental income 4,000
Dividends paid during the current year 7,000
What is Q Corporation’s adjusted income from rents?

a. $8,000
b. $12,000
c. $26,000
d. $30,000
e. None of the above
43. Which of the following is not usually considered personal holding company income?
a. Dividends received by the corporation
b. Interest income of the corporation (paid on certificates of deposit)
c. Copyright royalties paid to the corporation if their sum is more than 50 percent of ordinary gross income
(OGI)
d. Income from estates and trusts taxable to the corporation
44. G Corporation has $75,000 gross rental income. Expenditures related to the rental income include
$10,000 depreciation, $2,000 property taxes, and $8,000 repairs. Adjusted income from rents is
a. $55,000
b. $65,000
c. $63,000
d. $73,000
e. $67,000
45. The amount of rental income that, unless the relief measure applies, would be treated as personal
holding company income for a corporation whose primary business activity is the collection of rents
from rental property is known as
a. Net rental income
b. Adjusted ordinary gross income
c. Adjusted income from rents
d. Rental personal holding company income
e. Adjusted gross rental income
46. Nonrental personal holding company income always includes
a. Dividends received
b. Taxable interest income
c. All mineral, oil, and gas royalties
d. All of the above
e. Both a. and b.
47. To determine whether adjusted income from rents is to be added to personal holding company
income, two specific tests must be performed. Adjusted income from rents is not added to personal
holding company income if both tests are met. The tests are known as the “50 percent test” and the
“10 percent test.” What information is used in performing the “50 percent test,” in addition to
adjusted income from rents?
a. Ordinary gross income and dividends paid
b. Adjusted ordinary gross income
c. Nonrental personal holding company income
d. Adjusted gross rental income
e. Rental income net of depreciation and taxes
 Test Bank 6-11

48. To determine whether adjusted income from rents is to be added to personal holding company
income, two specific tests must be performed. Adjusted income from rents is not added to personal
holding company income if both tests are met. The tests are known as the “50 percent test” and the
“10 percent test.” What information is used in performing the “10 percent test”?
a. Dividends paid
b. Nonrental personal holding company income
c. Ordinary gross income
d. Both b. and c.
e. All of the above
49. The personal holding company tax rate for the current year is
a. 15 percent of undistributed PHCI
b. 28 percent of undistributed PHCI
c. 34 percent of undistributed PHCI
d. 35.5 percent of distributed PHCI
e. 38.6 percent of undistributed PHCI
50. F Corporation, a personal holding company, has $200,000 of adjusted taxable income before the
dividends-paid deduction. F paid $60,000 of dividends during the current tax year. What is the
maximum amount of “throwback” dividends (paid within 21=2 months from F’s tax year-end) that F
can elect to include in the prior year’s dividends-paid deduction?
a. $140,000
b. $60,000
c. $28,000
d. $12,000
51. P Corporation is a PHC. It has undistributed PHC income of $100,000 before subtracting dividends.
During the tax year, it paid dividends of $30,000 to shareholders. It paid another $30,000 during the
21=2 months following the end of the tax year. The amount of undistributed personal holding company
income is
a. $40,000
b. $64,000
c. $70,000
d. $88,000
e. $100,000
52. Y Corporation has determined that it must pay personal holding company tax for its 2011 calendar
tax year. Y Corporation has $600,000 in adjusted taxable income, has paid dividends of $30,000 in
2011, and has paid $10,000 in dividends by March 15, 2012. What is Y Corporation’s personal
holding company tax?
a. $84,600
b. $157,920
c. $159,600
d. $168,000
e. $223,334
53. In which case did the court rule that the amount of required working capital, determined by the
Bardahl formula, could be increased by 75 percent because of the possibility of increased labor and
other operating costs due to inflation?
a. Goodall
b. Colonial Amusement Corp.
c. Delaware Trucking Co. Inc.
d. Union Offset
e. Ted Bates Co.
6-12 Chapter 6 Penalty Taxes on Corporate Accumulations

54. In which case did the court find that documentation is necessary to avoid the accumulated earnings tax
where a corporation asserts that its working capital accumulations were for a legitimate business need?
a. Goodall
b. Colonial Amusement Corp.
c. Delaware Trucking Co. Inc.
d. Union Offset
e. Ted Bates Co.
55. To “fail” the passive income test and thereby avoid personal holding company status, a corporation
can do any of the following except
a. Generate less adjusted ordinary gross income.
b. Switch investments from dividend-paying stocks to growth stocks.
c. Increase shareholder compensation by the amounts that otherwise would be invested to generate
personal holding company income.
d. Replace personal holding company income with tax-exempt income, capital gains, or § 1231
gains.
e. Increase operating income without increasing passive income.
 6
Penalty Taxes on
Corporate Accumulations

Solutions to Test Bank

True or False

1. False. The accumulated earnings tax is a penalty tax that generally arises because of an IRS audit.
(See p. 6-3.)

2. False. The accumulated earnings tax does not replace these taxes but is an addition to these taxes.
(See p. 6-3 and § 531.)

3. True. This is the last step before reaching the accumulated taxable income figure. (See Exhibit 6-1,
pp. 6-10 and 6-11, and § 535.)

4. False. The accumulated earnings credit is the greater of the two. [See Exhibit 6-2, Example 5, pp. 6-12
through 6-14, and § 535(c).]

5. False. The dividends-paid deduction also includes consent dividends and the portion of distributions paid
as a result of liquidation, partial liquidation, or redemption of stock that is chargeable to earnings and
profits. [See Exhibit 6-3; pp. 6-14 and 6-15; and §§ 561(a)(1), 562(b)(1), 563(a), and 565.]

6. False. The accumulation also must occur with an intent of avoiding income taxation of the shareholders
before the tax is imposed. [See pp. 6-4 and 6-5 and § 532(a).]

7. True. If the actual working capital exceeds required working capital, then the excess is considered an
indication of unreasonable accumulations. (See p. 6-7.)

8. True. The IRS follows the decision of the Supreme Court made in the Ivan Allen Co. case: Actual working
capital is to be determined by current value anytime there is a significant difference between cost and
market value. (See p. 6-8.)

9. True. The income test is met if 60 percent of AOGI is made up of PHC income. However, the ownership
test also must be met before the entity will be classified as a PHC. (See pp. 6-17 and 6-18 and § 542.)

10. False. All the corporation has to do is meet both the ownership and income test. (See p. 6-17 and § 542.)

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6-14 Chapter 6 Penalty Taxes on Corporate Accumulations

11. False. PHCs are also entitled to a dividend carryover, and the amount of dividends paid within
21=2 months of year-end are limited to the smaller of undistributed PHC income, or 20 percent of the
dividends actually paid during the year. (See pp. 6-14 and 6-15, and 6-25 and 6-26, and §§ 561 and 563.)

12. False. A corporation must be formed or availed of for the purpose of avoiding the tax on the shareholders
before the accumulated earnings tax is applied. In addition, personal holding companies are specifically
exempt. (See p. 6-3.)

13. True. Accumulations for working capital needs are reasonable needs of the business. (See p. 6-7.)

14. True. The corporation will not have any personal holding company income. The rent will exceed
50 percent of AOGI, and there is no undistributed PHC income other than rent. Therefore, the rent is
excluded from the definition of PHC income. (See pp. 6-22 through 6-24.)

15. False. Ordinary gross income is calculated by subtracting only capital gains and § 1231 gains from gross
income. [See Exhibit 6-4, p. 6-19 and § 543(b)(1).]

16. False. The “adjusted income from rents” will be added to PHCI unless both the dividends test and the test
to determine whether adjusted income from rents is 50 percent or more of AOGI are passed. (See pp. 6-22
through 6-24.)

17. False. The deficiency dividend can eliminate the PHC tax but not interest and penalty due the
government. (See p. 6-26 and § 547.)

18. False. It will be PHC income only if the client maintains the right to designate who will perform the
services or if the services are so unique that only the shareholder could perform the services. (See pp. 6-24
and 6-25.)

19. True. However, the taxpayer must be careful to avoid passive investments or investments that could be
considered unrelated to the corporation’s existing or projected business. (See pp. 6-5 and 6-6.)

20. True. The court specifically addressed this issue in Ted Bates Co. and in Goodall. (See pp. 6-28 and 6-29.)

Multiple Choice

21. a. The use of multiple corporations would increase the number of times income might be taxed. (See
pp. 6-2 through 6-4.)

22. c. Net capital gains are subtracted from taxable income. (See Exhibit 6-1, pp. 6-10 and 6-11 and § 535.)

23. b. The dividends-paid deduction is added to adjusted taxable income. (See Exhibit 6-1, pp. 6-10 and 6-11,
and § 535.)

24. d. A comparison between two calculations must be made in the determination of the accumulated earnings
credit. According to the general rule, the credit is $90,100 ($200,000
$100,000
$15,000 þ $5,100).
According to the minimum credit rule, the credit is $150,000 ($250,000
$100,000). The accumulated
earnings credit is always the greater of the two. [See Exhibit 6-2, pp. 6-12 through 6-14, and §§ 535(c)(1)
and 535(c)(2).]

25. b. In this case, the minimum credit of $50,000 ($150,000 minus prior accumulations of $100,000) is less than
the accumulations credit calculated according to the general rule of $90,100 ($200,000
$100,000

$15,000 þ $5,100). [See Exhibit 6-2, pp. 6-12 through 6-14, and §§ 535(c)(1) and 535(c)(2).]

26. c. Deficiency dividends are used to reduce undistributed PHC income. (See Exhibit 6-3; pp. 6-14 and 6-15;
and §§ 561, 563, and 565.)

27. a. Since the $250,000 minimum credit is reduced by prior accumulations, the minimum credit will always
be zero for non-PHC corporations that have more than $250,000 in accumulations. (See Example 6
and pp. 6-12 through 6-14.)
 Solutions to Test Bank 6-15

28. a. Section 533 specifically provides that a corporation that is a mere holding or an investment company is
deemed to have been formed to avoid the tax on shareholders. (See pp. 6-3 through 6-5.)

29. d. Although publicly held corporations are usually protected from the accumulated earnings tax, the tax
has been applied to such corporations whose management was dominated by a small group of
shareholders who benefitted from control of dividend policy. (See p. 6-3 and § 532.)

30. e. The Donruss decision makes it difficult to prove that closely held corporations were not formed in order
to avoid the penalty tax. (See p. 6-4.)

31. d. Only stock redemptions of a deceased shareholder in conjunction with § 303 are considered as part of
the reasonable business needs. (See pp. 6-5 through 6-7 and § 537.)

32. d. The regulations state that the funds do not have to be expended in a short time after the close of
the year, but that the expenditure cannot be put off indefinitely. [See p. 6-5, § 537(a)(1), and Reg.
§ 1.537-1(b).]

33. a. The Bardahl formula uses the inventory turnover ratio, accounts receivable turnover ratio, and
accounts payable turnover ratio. (See pp. 6-7 through 6-10.)

34. d. The operating expenses used are those that require payment in cash. Therefore, depreciation is not
considered. (See p. 6-7.)

35. e. In addition, banks, life insurance companies, foreign personal holding companies, and certain other
types of corporations are exempt from the PHC tax. [See p. 6-16 and § 542(c).]

36. d. Therefore, any corporation with fewer than 10 shareholders will always meet the PHC ownership test
because the stock owned by any five or fewer persons will always equal more than 50 percent of the
total stock. [See p. 6-16 and § 542(a)(2).]

37. e. Stock is attributed for personal holding company tax purposes from both family members and
partnerships. [See p. 6-17 and § 544(a)(2).]

38. a. To “fail” the income test for PHC status, a corporation’s PHCI must be less than 60 percent of its
AOGI. The $15,000 in passive income is 60% of $25,000. [See p. 6-18, and § 542(a)(a).]

39. a. Stock options are treated as being owned by the taxpayer for purposes of the PHC ownership test.
[See p. 6-17 and §§ 544(a)(3), 544(a)(5), and 544(b).]

40. b. Only capital gains and § 1231 gains are subtracted from gross income to arrive at OGI. Capital losses
and § 1231 losses are not considered when computing either gross income or OGI. [See Exhibit 6-4,
pp. 6-18 and 6-19, and § 543(b).]

41. d. AOGI is calculated for Q Corporation by subtracting the $18,000 of depreciation, property taxes, and
interest expense related to rental income from the $31,000 of OGI (interest income and gross rental
income in this example). However, these deductions may not exceed the $16,000 of gross rental income.
Thus: $31,000
$16,000 = $15,000. (See Example 11 and pp. 6-22 through 6-24.)

42. b. Adjusted income from rents is calculated by subtracting depreciation, property taxes, interest expense,
and rents paid (a total of $18,000) from gross rental income ($30,000). (See Example 11 and pp. 6-22
through 6-24.)

43. c. There are two other conditions that must be met, but generally if copyright royalties exceed 50 percent
of OGI they are not treated as PHCI. (See Exhibit 6-8 and pp. 6-21 through 6-25.)

44. c. The only items subtracted from gross rental income to arrive at “adjusted income from rents” are
depreciation, property taxes, interest expense, and rents paid ($75,000
$10,000
$2,000 = $63,000).
(See Exhibit 6-6 and pp. 6-22 through 6-24.)
6-16 Chapter 6 Penalty Taxes on Corporate Accumulations

45. c. Personal holding company income equals adjusted income from rents. [See Exhibit 6-6, p. 6-23, and
§ 543(b)(2).]

46. e. Dividends and interest are always included in PHCI, but, depending on a PHC’s line of business,
mineral, oil, and gas royalties may not be included in PHCI. (See Exhibit 6-8, p. 6-24.)

47. b. The “50 percent test” determines whether the adjusted income from rents is 50 percent or more of
AOGI. (See Example 11 and pp. 6-22 and 6-24.)

48. e. The “10 percent test” determines whether the total of dividends paid, dividends considered paid, and
consent dividends is greater than or equal to PHCI reduced by 10 percent of OGI. (See Example 11 and
pp. 6-22 through 6-24.)

49. a. The rate is set to equal the highest individual tax rate on dividends. (See p. 6-25 and § 541.)

50. d. The deduction for “throwback” dividends (paid during the 21=2 month period after the end of the tax
year) is limited to 20 percent of the dividends paid during the tax year ($60,000  20 percent =
$12,000). (See p. 6-26.)

51. b. The deduction for dividends paid in the 21=2 month period is limited to 20 percent of the dividends paid
during the tax year. Therefore, the dividend deduction is $36,000 ($30,000  20 percent = $6,000 þ
$30,000) and the UPHCI is $64,000 ($100,000
$36,000). (See p. 6-25.)

52. a. The PHC tax is calculated as follows:

Adjusted taxable income $600,000

Minus: Dividends paid in 2011 (30,000)
Minus: 2012 throwback dividends (limited to 20% of 2011 dividends) (6,000)
UPHCI $564,000
Times: PHC tax rate 15%
PHC tax $ 84,600

(See Example 13 and pp. 6-25 through 6-27.)

53. c. The court made this ruling in Delaware Trucking Co., Inc. Acceptance of this need, however, depends
on the taxpayer’s ability to establish that increased operating costs due to inflation are likely. (See
pp. 6-29 and 6-30.)

54. d. The court ruled in Union Offset that even if an accumulation is for a legitimate business need,
documentation regarding that need is required to prevent imposition of the penalty. (See p. 6-29.)

55. a. Generating less AOGI would increase the ratio of PHCI to AOGI. (See pp. 6-31 and 6-32.)
 6
Penalty Taxes on
Corporate Accumulations

Comprehensive Problems

1. Profit Corporation has accumulated $500,000 of earnings as of the end of last year. For the current year, its
income statement shows the following:

Revenue from operations $1,000,000

Dividend income ,100,000
Total $1,100,000
Less:
Cost of goods sold $700,000
Administration expenses 50,000
Charitable contribution 200,000 (,950,000)
Net Income $ ,150,000

Profit Corporation has plans for expansion that will require $300,000. It paid a dividend during the year of
$50,000.
a. Compute Profit’taxable income for the year.
b. Compute Profit’income tax for the year.
c. Compute Profit’accumulated taxable income for the year.
d. Compute Profit’accumulated earnings tax for the year.
e. Other than increasing dividends, can Profit avoid the penalty tax?

6-17
6-18 Chapter 6 Penalty Taxes on Corporate Accumulations

2. T Corporation, owned by individual A, has the following for 2011:

Sales $500,000
Cost of goods sold 450,000
Other operating expenses 40,000
Dividend income 100,000
Interest income 80,000
Rental income 300,000
Rental expenses:
Depreciation 80,000
Interest on mortgage 100,000
Property taxes 40,000
Dividends paid during 2011 50,000
Dividends paid on 2/1/2012 50,000
a. Calculate ordinary gross income.
b. Calculate adjusted ordinary gross income.
c. Calculate adjusted income from rentals.
d. Calculate personal holding company income.
e. Calculate the personal holding company tax.
 Solutions to Comprehensive Problems 6-19

Solutions to Comprehensive Problems

1. a. Revenue from operations $1,000,000

Less: Cost of goods sold $700,000
Administrative expenses 50,000 (,750,000)
Income from Operations $ ,250,000
Dividends received $100,000
Less: Dividends-received deduction 70,000 ,030,000
Charitable contributions—maximum , (35,000)
Taxable income $ ,245,000

b. 15%
$ 50,000 $ 7,500

25%
$ 25,000 6,250
34%
$170,000 57,800
5%
$145,000 7,250
Tax $78,800

c. Taxable income $ 245,000

Add: Dividends-received deduction 70,000
Subtotal $ 315,000
Less: Excess charitable contribution (165,000)
Federal income tax (78,800)
Adjusted taxable income $ 71,200
Accumulated earnings credit ,0*
Dividend paid deduction (50,000)
Accumulated taxable income $ 21,200

*The credit is zero because prior accumulation exceeds both $250,000 and the needs of the business.

d. Accumulated taxable income $21,200

Tax rate 15%
Tax $3,180

e. It is unlikely that the Bardahl formula will show that the actual working capital does not exceed the
needed working capital. Profit might be able to show that the accumulations were not intended to
avoid tax at the shareholder level.

2. a. Gross income from sales $ 50,000

Dividend income 100,000
Interest income 80,000
Rental income 300,000
OGI $530,000

b. OGI $ 530,000
Less: Depreciation (80,000)
Interest (100,000)
Property taxes (40,000)
AOGI $ 310,000

c. Rental income $ 300,000

Less: Expenses (220,000)
Adjusted income from rents $ 80,000
6-20 Chapter 6 Penalty Taxes on Corporate Accumulations

Since adjusted income from rents does not exceed 50 percent of AOGI, it is personal holding
company income.

d. Dividends $100,000
Interest 80,000
Rents 80,000
$260,000

Since this exceeds 60 percent, T is a personal holding company.

e. Sales $ 500,000
Less: Cost of goods sold (450,000)
Operating expenses (40,000)
Operating income $ 10,000
Add: Interest income 80,000
Dividends $100,000
Less: Deduction (70,000) 30,000
Rental income 80,000
Taxable income $ 200,000

Tax 15%
$ 50,000 ¼ $ 7,500

25%
$ 25,000 ¼ 6,250
34%
$125,000 ¼ 42,500
5%
$100,000 ¼ 5,000
$ 61,250

Taxable income $ 200,000

Add: Dividends-received deduction 70,000
$ 270,000
Less: Income tax (61,250)
Dividend paid:
2011 $50,000
2012 (max) $10,000 (60,000)
Undistributed PHC income $ 148,750.00
Rate 15%
Tax $ 22,312.50