Principles of Taxation for Business and

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

Chapter 10 Sole Proprietorships, Partnerships, LLCs, and S Corporations

Questions and Problems for Discussion

1. A sole proprietorship is not a legal entity but merely a business activity carried on by an
individual. The proprietor is personally liable to the business creditors. The net profit or loss from
the activity is part of the proprietor’s taxable income. Because a sole proprietorship has no
separate identity from its proprietor, it can’t be described as a passthrough entity.

2. Mrs. Liu should use the marginal rate applying to the next dollar of taxable income on Form 1040.

3. If the $17,000 business loss exceeds the total of Mr. Pitt’s other income items for the year
(salary, dividends, interest, etc.), the excess qualifies as a net operating loss, which he can
carryback as a deduction to his two prior taxable years.

4. Firm Q remitted $13,400 employer payroll tax (which it deducted as a business expense) and
$13,400 employee payroll tax withheld from the compensation paid to its employees during the
year.

5. The employee payroll tax is extremely convenient because the responsibility for computing and
paying the tax is on the employer, not the employee. However, the payroll tax rate structure is
regressive: 7.65 percent on a base amount of annual compensation + 1.45 percent on
compensation in excess of the base. In 2010, the employee payroll tax on $50,000 compensation
is $3,825 for an average rate of 7.65 percent. The employee payroll tax on $200,000
compensation is $11,070 for an average rate of 5.54 percent. Thus, the employee payroll tax is
often criticized as vertically inequitable.

6. The self-employment tax is based on net earnings from self-employment, which is essentially the
profit that sole proprietors earn from their business. Individuals pay their self-employment tax at
the same time and in the same manner as they pay income tax.

7. The income tax deduction for one-half of self-employment tax corresponds to the employer’s
deduction for employer payroll tax. The nondeductible one-half of self-employment tax
corresponds to the nondeductible employee payroll tax.

8. a. General partners have unlimited personal liability for all recourse debts of their partnership.

b. Limited partners have no personal liability for the debts of their partnership. However, Tom,
Angela, and Peter all cannot be limited partners because a limited partnership must have at
least one general partner.

c. The members of an LLC have no personal liability for the debts of their company.

d. The shareholders of an S corporation have no personal liability for the debts of their
corporation.

9. Any item recognized by a passthrough entity that is subject to a special rule, limitation, or
treatment in the computation of individual or corporate taxable income or tax liability must be
separately stated. This separate accounting allows each owner to apply the special rule,
limitation, or treatment to that owner’s share of the item.

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

10. Each partner in Soya Partnership must combine its share of Soya’s Section 1231 loss with all
other Section 1231 gains and losses realized during the year to determine that partner’s net
Section 1231 gain or loss. The rule that a net Section 1231 loss is deductible as an ordinary loss
and a net Section 1231 gain is treated as a capital gain can be applied only at the partner (rather
than the partnership) level.

11. The different uses of cash have no effect on the federal income tax liabilities of Mr. A and Mr. Z.
Both will pay tax on the income generated by their sole proprietorships, regardless of the amount
of cash flow generated or the use to which the owners put such cash flow.

12. a. As a shareholder, Mr. Bates has limited liability for creditor claims against UPF. In other
words, the creditor cannot demand repayment of the corporate debt from Mr. Bates.

b. The creditor can demand repayment of the entire $120,000 debt from Mr. Bates. If Mr. Bates
pays the debt, he can seek restitution from the other general partners for their proportionate
shares.

c. As a limited partner, Mr. Bates has limited liability for creditor claims against UPF.

d. As a member of a LLC, Mr. Bates has limited liability for creditor claims against UPF.

13. a. Mr. Yang’s basis in his sole proprietorship is the aggregate basis of the tangible and
intangible assets used in the business activity.

b. Mr. Yang’s basis is his adjusted basis in his intangible partnership interest, which equals his
initial basis (contributed cash and property or cost basis of a purchased interest) adjusted for
increases and decreases in his investment over time.

c. Mr. Yang’s basis is his adjusted basis in his corporate stock, which equals his initial basis
(contributed cash and property or cost basis of purchased stock) adjusted for increases and
decreases in his investment over time.

14. Corporation ABC must compute its adjusted basis in its interest in KK Partnership as of the date
of sale. This adjusted basis must include ABC’s share of partnership items attributable to the
portion of KK’s taxable year during which ABC was a partner (January 1 through October 9). The
partnership may not be able to compute such share until after the closing of the year on
December 31.

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

Application Problems

1. a. Schedule C would reflect net profit of $26,800 as shown on the following Schedule C:

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

b. Schedule SE would reflect $3,787 of SE tax, as shown on the following Schedule SE:

2. a. Rhea’s home office deduction is computed as follows.

Annual rent $48,000
Housekeeping service 5,200
Renter’s insurance 2,000
Total apartment expense $55,200
Percentage of square footage used as office .15
Expenses allocated to office $8,280

Rhea’s home office deduction is $8,280.

b. Rhea’s home office deduction is limited to $4,000 (net profit before the deduction).

3. a. Colin’s home office deduction is computed as follows.

Annual housing expenses $19,055
Percentage of square footage used as office .10
Expenses allocated to office 1,905
MACRS depreciation (10% [$185,000  39 years]) 474
Home office deduction $2,379

Net profit before home office deduction $75,000

Home office deduction (2,379)
Net profit $72,621

b. Net profit before home office deduction $1,800

Home office deduction (limited to profit before deduction) (1,800)
Net profit -0-

4. a. BDF’s 2010 payroll tax is $4,590 ($60,000 × 7.65%).

b. BDF’s 2010 payroll tax is $9,522 ([$106,800 × 6.2%] + [$200,000 × 1.45%]).

5. a. BDF’s 2011 payroll tax would be $4,590 (no change from 2010).

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

b. BDF’s 2011 payroll tax would be $9,720 ([$110,000 × 6.2%] + [$200,000 × 1.45%]).

6. a. Mrs. Singer’s 2009 self-employment tax is $7,271, and her income tax deduction is $3,636.

b. Mrs. Singer’s 2009 self-employment tax is $5,941, and her income tax deduction is $2,971.

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

c. Mrs. Singer’s 2009 self-employment tax is $588, and her income tax deduction is $294.

7. a. Only the $120,000 profit from operations is subject to self-employment tax.

b. Self-employment tax = $16,457 = $106,800 * 12.4% + $120,000 * 92.35% * 2.9%

c. Net profit from operations $120,000

Ordinary gain on asset sale 17,000
Interest income on working capital 960
Before-tax income from bookstore activities $137,960
One-half self-employment tax (8,229)
Taxable income from bookstore activity $129,731

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

8. a. Net profit from JC’s practice $32,000

One-half self-employment tax (2,261)
Taxable income from practice $29,739
Tax rate .25
Income tax $7,435

Before-tax income $32,000

Self-employment tax (4,522)
Income tax (7,435)
After-tax income $20,043

b. JC’s self-employment tax is 38 percent of the federal tax burden on her business income
($4,522 SE tax  $11,957 total tax).

9. a. Social Security tax ($33,000  6.2%) $2,046

Medicare tax ($33,000  1.45%) 479
Employer payroll tax on Ben’s salary $2,525

b. Salary payment to Ben $33,000

Employer payroll tax on salary 2,525
Unemployment tax 400
Jane’s before-tax cost of salary/tax payments $35,925 $35,925
Income tax savings from deduction ($35,925 × 35%) (12,574)

Reduction in Jane’s SE tax $962

Income tax cost of reduced deduction for 50% SE tax
($481 × 35%) (168)
Net tax savings from SE tax reduction (794)

Jane’s after-tax cost of hiring Ben $22,557

10. a. As equal general partners, AB and YZ each include half the partnership’s recourse debt in
their initial bases.
AB’s contributed cash $500,000
AB’s share of recourse debt 125,000
AB’s initial basis in its partnership interest $625,000

YZ’s basis in contributed land $430,000

YZ’s share of recourse debt 125,000
YZ’s initial basis in its partnership interest $555,000

b. Because YZ is a limited partner, it is not responsible for any of the partnership’s recourse
debt. As the general partner, AB is responsible for repayment (i.e. has unlimited liability) and
consequently can include the entire partnership debt in basis.
AB’s contributed cash $500,000
AB’s share of recourse debt 250,000
AB’s initial basis in its partnership interest $750,000

YZ’s basis in contributed land $430,000

YZ’s share of recourse debt -0-
YZ’s initial basis in its partnership interest $430,000

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

11. FGH Partnership’s $600,000 ordinary business income is allocated equally to Triad LLC and
Beta. However, since these two partners are both passthrough entities, the $300,000 allocated to
each is passed through and reported by the following taxpayers.
Mr. T (40% × $300,000) $120,000
Mrs. U (35% × $300,000) 105,000
V Inc. (25% × $300,000) 75,000
Ms. B 300,000
$600,000

12. a. Rochelle’s taxable income will increase by the $25,000 of ordinary income. Rochelle will
combine the $3,000 Section 1231 loss with any Section 1231 gains or losses from other
sources. Ultimately, the loss will reduce her taxable income by $3,000. The nondeductible
expenses and cash distribution will have no impact on her taxable income. Thus, the net
impact of the partnership activity on Rochelle’s taxable income is an increase of $22,000.

b. Tax cost = $22,000 * 35% = $7,700 cash outflow. Cash distribution of $5,000 is a cash
inflow. Net cash outflow of $2,700 ($5,000 - $7,700).

13. Gross receipts from sales $670,000

Cost of goods sold (460,000)
Operating expenses (96,800)
50% meals and entertainment (3,120)
KLMN’s ordinary business income $110,080

KLMN’s Section 1231 loss on the equipment sale and charitable contribution are separately
stated items.

14. a. Mr. T has the following shares.

Ordinary business income $11,008
Separately stated items: Section 1231 loss (1,350)
Charitable contribution (150)
Nondeductible expense (312)

b. Mr. T’s adjusted basis at beginning of year $45,000

Increased by ordinary business income 11,008
Decreased by: Cash distribution (1,000)
Section 1231 loss (1,350)
Charitable contribution (150)
Nondeductible expense (312)
Mr. T’s adjusted basis at end of year $53,196

c. Mr. T’s adjusted basis would increase to $55,996 ($53,196 + 10% [$28,000 increase in
partnership debt]).

15. a. Ordinary income = $270,000 = $500,000 - $200,000 - $30,000

Separately stated items:
Long-term capital gain $9,000
Nondeductible expenses 2,000
Distributions 100,000

b. Ordinary income, $135,000; Long-term capital gain, $4,500; Nondeductible expenses,

$1,000; Distributions, $50,000

c. $139,500 = $135,000 ordinary income + $4,500 capital gain

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

d. $123,500 = $25,000 beginning basis + $135,000 ordinary income +$4,500 capital gain -
$1,000 nondeductible expenses - $50,000 distribution +$10,000 share of debt increase

16. a. Schedule K:

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

b. Jayanthi’s Schedule K-1:

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

17. Partner X Partner Y

Initial basis in partnership interest $50,000 $10,000*
Deduction for $21,000 share of loss (21,000) (10,000)
Adjusted basis at beginning of next year $29,000 -0-

* Adjusted basis of contributed business assets

18. AV’s net Section 1231 loss is computed as follows.

Section 1231 loss on sale of equipment $(17,000)
Share of LLC Section 1231 gain 4,000
Net Section 1231 loss $(13,000)

AV’s net capital loss is computed as follows.

Capital loss on sale of securities $(5,000)
Share of LLC capital loss (1,200)
Net capital loss $(6,200)

Without the items from the LLC, AV has a $17,000 deductible Section 1231 loss and a $5,000
nondeductible capital loss. With the items from the LLC, it has a $13,000 deductible Section 1231
loss and a $6,200 nondeductible capital loss. Thus, the LLC items increased AV’s taxable income
by $4,000.

19. a. Ordinary income before guaranteed payments $95,000

Deduction for guaranteed payments (48,000)
Ordinary business income $47,000

Bonnie’s and George’s 50% share $23,500

b. Bonnie’s self-employment income is $71,500 ($48,000 guaranteed payment + $23,500 share

of ordinary business income). George’s self-employment income equals her $23,500 share of
ordinary business income.

c. Ordinary income before guaranteed payments $32,000

Deduction for guaranteed payments (48,000)
Ordinary business loss $(16,000)

Bonnie’s and George’s 50% share $(8,000)

Bonnie’s self-employment income is $40,000 ($48,000 guaranteed payment – $8,000 share

of business loss), while George has no self-employment income.

20. Zelda’s adjusted basis at beginning of 2009 $95,000

Increased by: 60% share of dividends and interest 8,760
60% share of capital gain 3,720
Basis before loss deduction $107,480
a. Decreased by limited deduction for
60% share of business loss (107,480)
b. Zelda’s adjusted basis at end of 2009 -0-

c. If Zelda received a $5,000 cash distribution from the partnership, her basis before the loss
deduction would be only $102,480, and the deduction for her share of the business loss is
limited to $102,480.

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

21. a. Zelda can deduct her $18,520 loss carryforward from 2009. Consequently, she will report a
$14,320 business loss ($4,200 2010 income - $18,250 loss carryforward) and $10,800
dividend and interest income on her 2010 Form 1040.

Zelda’s adjusted basis at beginning of 2010 -0-

Increased by: 60% share of business income 4,200
60% share of dividends and interest 10,800
60% share of partnership debt 12,600
Basis before loss deduction $27,600
Decreased by deduction for 2009 loss carryforward
($126,000 − $107,480) (18,520)
b. Zelda’s adjusted basis at end of 2010 $9,080

22. a. Ms. P’s initial cost basis in her partnership interest $20,000
Increased by share of partnership debt 12,000
Decreased by share of ordinary loss (28,000)
Ms. P’s adjusted basis on January 1, 2011 $4,000

Ms. P can deduct her entire $28,000 share of loss on her 2010 return.

b. Amount realized on sale ($2,000 cash + $12,000 debt relief) $14,000

Adjusted basis (4,000)
Gain recognized on sale of partnership interest $10,000

23. a. Leo can deduct $23,000 of his $30,000 allocated share of BLS’s 2008 operating loss.
BLS Stock BLS Note
Leo’s initial basis $15,000 $8,000
Decreased by limited loss deduction (15,000) (8,000)
b. Adjusted basis at end of 2008 -0- -0-

24. a. Leo is allocated $20,400 of 2009 income from BLS, so he can deduct his $7,000 loss
carryforward from 2008. Consequently, he will include $13,400 S corporation income in 2009
taxable income.
BLS Stock BLS Note
Leo’s basis at beginning of 2009 -0- -0-
Increased by 2009 income allocation 12,400 8,000
Decreased by 2008 loss carryforward (7,000) _____
b. Adjusted basis at end of 2009 $5,400 $8,000

c. In this case, Leo is allocated $11,000 of 2009 income from BLS, only $4,000 of which is
included in his 2009 taxable income.
BLS Stock BLS Note
Leo’s basis at beginning of 2009 -0- -0-
Increased by 2009 income allocation 3,000 8,000
Decreased by 2008 loss carryforward (3,000) (4,000)
d. Adjusted basis at end of 2009 -0- $4,000

25. Because his adjusted basis in the note surrendered in only $4,000, Leo must recognize a $4,000
capital gain on the receipt of the $8,000 repayment.

26. a. Evan’s cash withdrawal from the S corporation is not taxable to him, nor it the payment
deductible by the S corporation.

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

b. If the payments are recharacterized as salary, the S corporation is permitted a deduction,

lowering its taxable income. Evan must report salary income. The net effect on Evan’s
taxable income and income tax liability should be zero, since he is the sole shareholder of the
S corporation.

c. If the $50,000 per year is treated as salary, both the S corporation and Evan have unpaid
payroll tax of $3,825 per year, for a total potential underpayment of $22,950 ($3,825 * 2 * 3
years).

Issue Recognition Problems

1. Will the marginal tax rate on Ellie and her husband’s joint return for next year (and the rate
applying to Ellie’s business profits) increase because Ellie’s husband will earn a salary?

2. Does Javier owe employee payroll tax on his entire salary plus self-employment tax on his entire
net earnings from self-employment? Does Javier have an annual base amount of compensation
subject to either Social Security tax or self-employment tax (but not both), or does he have an
annual base amount subject to both Social Security and self-employment tax?

3. Is Mrs. Chou also considered to be self-employed so that some of the net profit from the business
should be attributed to her for self-employment tax purposes?

4. Does Travis’ use of his home office to house the family library violate the “exclusive use” test for
a home office deduction?

5. Should AF Partnership allocate a portion of its capital gain to Lola, even though she was not a
partner on the date the gain was realized? How does AF Partnership allocate 15 percent of its
income between Lola and R Corporation? What is Lola’s adjusted basis in her partnership
interest on April 12?

6. Did Fred adjust his basis in the limited partnership interest for his share of annual partnership
income? Has Fred received cash distributions equaling the total partnership income on which he
paid tax for the last nine years?

7. Is the exchange of a partnership interest for an interest in a newly formed LLC a taxable or
nontaxable exchange?

8. Does the state of incorporation (and every other state in which the corporation will conduct
business) treat an S corporation as a nontaxable passthrough entity for state income tax
purposes?

9. What happens to Mr. Yang’s carryforward of his DK loss when he sells his entire interest in the
partnership? Can Mr. Yang deduct $7,500 of his loss carryforward because he recognized a
$7,500 gain on the sale of the partnership interest? Does the loss carryforward transfer to the
purchaser of the partnership interest?

10. Which share of loss (ordinary or capital) does Paula deduct first? Because Paula can deduct only
$6,200 of her partnership losses, how does she allocate the deduction between her shares of
ordinary loss and capital loss?

11. Does Marcus recognize his final monthly 2009 guaranteed payment as taxable income in 2009 or
2010? Does the partnership deduction for the payment depend on the year in which Marcus
recognizes the payment as income?

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Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

12. Can David increase the basis in his DES stock by his $8,900 allocation of tax-exempt interest so
that he can deduct his entire $4,700 ordinary loss allocation?

13. How should WW account for the $21,000 payment made on its shareholders’ personal behalf?
Should Mr. and Mrs. West treat the corporate payment on their personal behalf as taxable
compensation from WW or as a nontaxable cash distribution that reduces the basis in their WW
stock?

14. Can the other six individuals prevent a termination of NS’s S corporation election? Is the NS
stock subject to a buy-sell agreement or similar restriction that prevents the individual from giving
shares to a nonqualifying shareholder?

15. Can BR recognize the $125,000 loss realized on the sale of land to a partnership in which it is a
partner? Are BR and the limited partnership related parties for purposes of the loss disallowance
rule? Does BR indirectly own a 100 percent interest in the partnership because all other partners
are BR shareholders?

16. In which taxable year does Corporation L report its $100,000 share of JKL Partnership’s 2009
business income? Is Corporation L’s $100,000 share allocated between the corporation’s fiscal
year ending on June 30, 2009, and its fiscal year ending on June 30, 2010?

17. Can FG deduct a $15,500 ordinary abandonment loss because it relinquished its equity interest
in the limited partnership?

Research Problems

1. Rev. Rul. 66-95, 1966-1 CB 169, provides the authority for the solution to this research problem.
The first step is the computation of Don Ferris’s guaranteed payment, which the partnership can
deduct in the computation of taxable income.
Taxable income before deduction of guaranteed payment $107,200
.50
Don Ferris’s share before guarantee $53,600
Minimum guarantee $75,000
Share (53,600)
Guaranteed payment $21,400

The second step is the computation of F&L’s taxable income.

Taxable income before deduction of guaranteed payment $107,200
Guaranteed payment (21,400)
Taxable income $85,800

The last step is the computation of Don and Lou’s shares of taxable income.
Don Ferris Lou Lindberg Total
Taxable income $53,600 $32,200 $85,800

2. This research problem is based on the facts in Tracy Lee Milian v. Commissioner, TC Memo
1999-366, in which the court held that a police officer was liable for self-employment tax on his
earnings as an off-duty security guard. The police officer was acting as an independent
contractor rather than a police department employee, even though he wore his police uniform
and used police equipment. As a security guard, he was not under policy department control,
even though the policy department approved his off-duty work. Because the facts of Max Coen’s
situation so closely resemble the facts in the Milian case, the IRS would certainly conclude that
Max’s $4,100 wages from the school district are net earnings from self-employment.

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3. According to Section 1362(d)(2), Herold’s S election terminated on October 10, 2009. Per
Section 1362(e)(1), the corporation must file its final Form 1120S for the period January 1-
October 9 (S short year) and its first Form 1120 for the period October 10-December 31 (C short
year). Section 1362(e)(2) requires that Herold’s 2009 taxable income be pro rated between the
two returns based on the number of days in each short year. Here is the pro ration.
(282 days [Jan. 1-Oct. 9] ÷ 365) × $592,030 = $457,404 income on Form 1120S
(83 days [Oct. 10-Dec. 31] ÷ 365) × $592,030 = $134,626 income on Form 1120

Section 1362(e)(5) requires that the corporate tax on Herold’s C short year income be computed
on an annualized basis. Thus, the corporate tax rates are applied to $592,030 annual income to
result in a full year’s tax of $201,290. This amount is then multiplied by the ratio of the number of
days in the C short year to the number of days in the full year. Based on this annualization,
Herold’s tax for its C short year is $45,773 ([83 ÷ 365] × $201,290.

4. Because Sandy has a zero adjusted basis in her worthless note, Section 166(b) provides that her
bad debt deduction is zero. Because she also has a zero adjusted basis in her worthless stock,
Section 166(g)(1) provides that her capital loss realized on the deemed sale of this stock is also
zero. Reg. Sec. 1.1366-2(a)(5) provides that if an S corporation shareholder disposes of all of her
stock, any loss carryforward attributable to the Section 1366(d) basis limitation is permanently
disallowed. Thus, Sandy can never deduct her $7,400 ordinary loss carryforward. In summary,
Sandy has no 2008 tax consequences from the worthlessness of her investment in Lindlee Inc.

Tax Planning Cases

1. Mr. and Mrs. Janus should clearly document that they used the $80,000 borrowed funds (plus
$5,000 from their savings account) to buy the new equipment for their restaurant. By doing so,
the interest on the debt is a fully deductible business expense on their Schedule C. If they used
borrowed funds to buy the two automobiles, the interest paid on such funds would be a
nondeductible personal expense.

2. Eve and Frank should not withdraw any funds from the partnership in 2009 because they need to
keep their initial investments intact to deduct the partnership’s operating loss on their 2009 Form
1040s.
Eve’s Basis Frank’s Basis
Initial cash invested in the partnership $30,000 $30,000
Partnership debt included in basis 25,000 25,000
Basis before loss deduction $55,000 $55,000
Share of 2009 operating loss (50,000) (50,000)
Basis at end of 2009 $5,000 $5,000

If the partners withdraw their initial cash contributions in December 2009, they can deduct only
$25,000 of their share of loss. The $25,000 nondeductible loss would carry forward as a
deduction against 2010 income. However, the deferral of a $25,000 ordinary deduction for one
year decreases the tax savings from the deduction in NPV terms. For example, at a 7 percent
discount rate, the deferral of the deduction for one year reduces the tax savings from $8,750
($25,000  35%) to $8,181 ($8,750  .935 discount factor). Of course, Eve and Frank must weigh
the tax savings against the opportunity cost of delaying their cash withdrawals from December to
January.

3. a. In each case, Amisha’s net cash flow from the loan in year 0 is ($26,000).
Cash loaned to Sultan ($40,000)
Tax savings from deduction of loss

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against debt basis ($40,000 × 35%) 14,000

Net cash flow in year 0 ($26,000)
The $49,000 share of undistributed corporate income in years 1 and 2 increased Amisha’s
basis in her Sultan note to $40,000 and her stock basis to $9,000. The repayment of the loan
in year 2 resulted in $42,470 net cash flow ($40,000 repayment + $3,800 interest - $1,330 tax
cost [$3,800 interest income × 35%]).
PV of year 0 net cash flow ($26,000)
PV of year 2 net cash flow
($42,470 × .890 discount factor) 37,798
NPV of cash flows $11,798

b. The $19,100 share of undistributed corporate income in years 1 and 2 increased Amisha’s
basis in her Sultan note to $19,100. The repayment of the loan in year 2 triggered a $20,900
capital gain taxed at 15%. Consequently, the repayment resulted in $39,335 net cash flow
($40,000 repayment - $3,135 capital gain tax + $3,800 interest - $1,330 tax cost [$3,800
interest income × 35%]).
PV of year 0 net cash flow ($26,000)
PV of year 2 net cash flow
($39,335 × .890 discount factor) 35,008
NPV of cash flows $9,008

c. Amisha’s share of corporate losses in years 1 and 2 had no effect on the zero basis in her
Sultan note. Consequently, when Sultan defaulted on repayment, Mrs. NG did not realize any
tax loss on the worthlessness of the note. The NPV of the cash flows associated with her loan
is ($26,000).

4. Investment A:

Year 0 Year 1 Year 2 Year 3

Purchase/Sale $(50,000) $60,000
Dividends $4,000 $4,000 4,000
Tax on dividends (600) (600) (600)
Tax on gain (1,500)
Net cash flow $(50,000) $3,600 $3,600 $61,900

NPV at 4% = $11,819

Investment B:
Year 0 Year 1 Year 2 Year 3
Purchase/Sale $(50,000) $90,000
Tax on annual income $(3,500) $(3,500) (3,500)
Tax on gain (1,500)
Net cash flow $(50,000) $(3,500) $(3,500) $85,000

NPV at 4% = $18,963

Note: tax basis of S corporation stock prior to sale is $80,000 ($50,000 +$30,000 earnings)

Based on these projections, Marla should choose Investment B, the S corporation stock.

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