South Western Federal Taxation 2014 Corporations Partnerships Estates and Trusts 37th Edition Hoffman Solutions Manual

CHAPTER 13
COMPARATIVE FORMS OF DOING BUSINESS
SOLUTIONS TO PROBLEM MATERIALS
Status: Q/P
Question/ Learning Present in Prior
Problem Objective Topic Edition Edition
1 LO 1 Legal and tax forms Unchanged 1

2 LO 1, 3 Taxation of C corporation versus S Unchanged 2
corporation
3 LO 1 Limited liability company versus S Unchanged 3
corporation
4 LO 3 Tax rates: corporation versus individual Updated 4
5 LO 2, 3 Limited liability partnership Unchanged 5
6 LO 2 Limited liability: corporate general partner Unchanged 6
7 LO 2 Nontax factors and tax factors in choosing a Unchanged 7
business entity
8 LO 1, 2, 3 Limited liability and loss pass-throughs Unchanged 8
9 LO 3, 4, 7 S corporation versus C corporation status Unchanged 9
10 LO 3 Distribution policy: C corporation and S New
corporation
11 LO 3 Alternative minimum tax: direct versus New
indirect
12 LO 3 Alternative minimum tax: shifting income Unchanged 12
and deductions
13 LO 3 S corporation and limited liability company: Unchanged 13
state income tax treatment
14 LO 4 Fringe benefits and tax treatment Unchanged 14
15 LO 4 Double taxation and reasonable compensation Unchanged 15
16 LO 4 Avoiding double taxation: techniques Unchanged 16
17 LO 4 Avoiding double taxation: interest payments Unchanged 17
18 LO 4 Avoiding double taxation: no distributions Unchanged 18
19 LO 4 Accumulated earnings tax New
20 LO 4, 5 S corporation versus C corporation status Unchanged 20
21 LO 4 S corporation: qualification Unchanged 21
22 LO 5 Contribution of personal use assets to a Unchanged 22
corporation or a sole proprietorship
23 LO 5 Recognition under § 351 and § 721 Unchanged 23
24 LO 5 Special allocations Unchanged 24
25 LO 5 Basis for ownership interest: effect of entity Unchanged 25
liabilities
13-1
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13-2 2014 Corporations Volume/Solutions Manual
Status: Q/P
Question/ Learning Present in Prior
Problem Objective Topic Edition Edition
26 LO 5 Basis for ownership interest Unchanged 26

27 LO 5 S corporation as a taxpayer Unchanged 27
28 LO 5 Partnership and S corporation: distributions Modified 28
29 LO 5 Distributions: S corporations New
30 LO 6 Sale of an ownership interest: sale of New
corporate assets versus sale of stock
31 LO 6 Sale of an ownership interest: C corporation Modified 31
32 LO 2, 3, Entity attributes Unchanged 32
4, 5, 6
33 LO 5 Entity attributes Unchanged 33
34 LO 5, 6 Special allocations: § 754 election Modified 34
35 LO 2 Liability exposure Unchanged 35
36 LO 3 Corporate tax rates: marginal and effective New
37 LO 1, 2, 3 Choice of business entity: tax and nontax Unchanged 37
factors
38 LO 2, 3 Choice of business entity: tax and nontax New
factors
39 LO 3 Choice of business entity New
*40 LO 3 Single versus double taxation Unchanged 40
*41 LO 3 Alternative minimum tax Unchanged 41
*42 LO 3 Alternative minimum tax: installment sale Unchanged 42
43 LO 4 Fringe benefits Modified 43
44 LO 4 Fringe benefits Unchanged 44
*45 LO 4 Reasonable compensation Modified 45
46 LO 4 Shareholder loans to corporation Unchanged 46
*47 LO 4 Shareholder leasing property to corporation Unchanged 47
*48 LO 3, 4 Accumulated earnings tax Unchanged 48
*49 LO 4 Stock redemption versus sale to outsiders Unchanged 49
50 LO 4 S corporation: maintaining or revoking status Unchanged 50
51 LO 5 Recognition under § 351, basis, and allocation New
of gain
*52 LO 5 Recognition at time of contribution and basis Unchanged 52
*53 LO 5 Effects of contributions, profits, and New
liabilities on basis: different types
of entity
*54 LO 5 Transactions affecting different entity types New
55 LO 5 Distributions to owners Unchanged 55
*56 LO 5 Passive activity losses Unchanged 56
57 LO 5 Basis and at-risk rules: partnership Unchanged 57
58 LO 5 Limit on loss deductions: partnership New
versus C corporation
*59 LO 6 Asset sale versus stock sale Unchanged 59
*60 LO 6 Sale of sole proprietorship: tax New
consequences
61 LO 6 Sale of a business: partnership Unchanged 61
62 LO 6 Purchase of a business: C corporation New
*The solution to this problem is available on a transparency master.
Comparative Forms of Doing Business 13-3
Status Q/P
Research Present in Prior
Problem Topic Edition Edition
1 Stock redemption versus dividend Unchanged 1

2 S corporation shareholder and payroll taxes Unchanged 2
3 S corporation debt basis Unchanged 3
4 Partnership: share of profits Unchanged 4
5 Internet activity Unchanged 5
CHECK FIGURES
35.a. $4 million. 52.b. $0 recognized gain for Agnes and

35.b. $4 million. Becky, $50,000 recognized gain for
35.c. $925,000. Carol; stock basis: Agnes $100,000,
35.d. Same as c. Becky $40,000, Carol $50,000.
36.a. Red 34%, 22.13%; White 39%, 52.c. Same as b.
33.92%; Blue 34%, 34%; Orange 35%, 53.a. $40,000 stock basis.
35%. 53.b. $100,000 stock basis.
36.b. Phaseout benefits of lower brackets. 53.c. $122,500 partnership basis.
39.a. C corporation results in tax savings of 55.a. Sam $95,000 gain; Allison $240,000
$10,950. dividend income; Swift $65,000 gain.
39.b. S corporation results in tax savings of 55.b. Sam $95,000 gain; Allison $240,000
$1,267. basis reduction; Swift $65,000 gain
40.a. $0 for Mabel and Alan. passthrough.
40.b. $78,750 each. 56.a. $374,000.
40.c. $275,500; $280,000. 56.b. $49,000.
41.a. $2,514,000. 56.c. $54,000.
42. Select the cash option. 57.a. Jo $675,000; Velma $300,000.
43.a. $63,000 excludible. 57.b. Jo $625,000; Velma $250,000.
43.b. $63,000 gross income. 58.a. Deduct $65,000; basis $55,000.
44.a. Partnership $165,000; C Corporation 58.b. $900,000 loss to corporation; $0
$95,000; S Corporation $165,000. deduction to Rosa; Rosa’s basis
46.a. Parrott deducts interest expense $50,000.
$67,500; Abner reports interest income 59.a. Emily and Freda stock basis $908,000;
$40,500; Deanna reports interest George recognized capital gain
income of $27,000 each year. $348,000.
46.b. Parrott not allowed deduction; Abner 59.b. Emily and Freda have basis for listed
reports dividend income $40,500 each assets $750,000 and goodwill
year; Deanna reports dividend income $158,000; George recognized capital
of $27,000 each year. gain on liquidation $229,680.
48.a. $79,200 accumulated earnings tax and 59.c. Emily and Freda stock basis $550,000;
$272,000 regular tax liability for George recognized capital loss
Flower. $10,000.
48.b. $272,000 regular tax liability for 60.a. Linda recognized gain $100,000;
Flower. $27,000 ordinary income; $73,000
48.c. $0 regular tax liability for Flower. capital gain.
49.a. Grace yes; Frank no. 60.b. Juan basis of $260,000.
49.b. Grace yes; Frank yes. 61.a. Gail $207,000 LTCG; Harry $157,000
50. S election should be maintained. LTCG.
52.a. $0 recognized gain for Agnes and 61.b. Acquire the assets.
Becky, $50,000 recognized gain for 62. Acquire the assets.
Carol; outside basis: Agnes $108,000,
Becky $48,000, Carol $54,000.
DISCUSSION QUESTIONS
1. The principal legal forms for conducting a business entity are the sole proprietorship,
partnership, limited liability company, and corporation. The principal Federal income tax
forms are the same, except that the corporation is divided into the C corporation and the S
corporation. p. 13-2
2. A corporation is a separate legal entity, apart from its owners. If it is a C (regular) corporation
for Federal income tax purposes, the corporation is taxed on its earnings. If the corporate
earnings are distributed to the shareholders as dividends, the earnings are subject to a second
layer of taxation. A corporation that elects S corporation status receives tax treatment similar
to that of a partnership with the corporate earnings being taxed only at the shareholder level.
The tax law provides for S status to allow entities to choose the corporate form and avoid
double taxation. pp. 13-2 and 13-6 to 13-8
3. The business advantage of both the limited liability company and the S corporation is limited
liability. The tax advantage of the limited liability company is that it can be taxed under the
conduit concept available to the partnership. The tax advantage of the S corporation is that
generally it is taxed under the conduit concept similar to the partnership. Thus, only single
taxation applies to both forms. Furthermore, losses can be passed through from the entity and
deducted by the owners.
The limited liability company possesses the following advantages when compared with the S
corporation.
• Greater flexibility in terms of the number of owners, types of owners, special allocation
opportunities, and capital structure.
• Debt can be included in the owner’s basis.
• Less recognition of gain on contributions of appreciated property (§ 721 applies rather
than § 351).
• An ownership interest in an LLC is not necessarily a security.
p. 13-5 and Chapters 11 and 12
4. The maximum statutory rate for a C corporation and for an individual is 35%. However, at
certain levels of income the individual rates are lower than the corporate rates. For example,
in 2013 income between $146,400 and $250,000 is taxed at 28% or 33% for a married
taxpayer filing a joint return, whereas for a corporation the rate is 39%. In addition, at certain
levels of income, the individual rates are higher than the corporate rates. For example, in 2013
income between $500,000 and $10,000,000 is taxed to a corporation at 34%, whereas for a
married taxpayer filing a joint return, the rate is 35% (except for certain high-income
persons). So what is relevant is the actual rates that apply in a particular situation and not the
maximum statutory rates. Also double taxation may apply with corporations if dividend
distributions are made to shareholders. pp. 13-6 and 13-17
5. The motivation for the change in legal form is to limit liability. Under the general partnership
form, there is unlimited liability with the personal assets of each of the firm partners being
subject to the claims of the partnership creditors. Under the limited liability partnership form,
the personal assets of a particular partner are subject to the claims of the partnership creditors
for his or her actions. (Note in some states that even this amount is limited.) However, the
personal assets of a particular partner are not subject to the claims of partnership creditors for
the actions of other partners.
The income tax consequences associated with the general partnership form and the limited
liability form are the same. That is, the entity is not subject to taxation (i.e., the partnership is
a tax reporter and the partners are the taxpayers). Both profits and losses are passed through to
the partners.
p. 13-5 and Tax in the News on p. 13-4
6. The limited liability objective can be achieved by forming a limited partnership whose general
partner is a corporation. The liability of the limited partners is limited by statute. The owners
of the corporation have effectively limited their liability by having the corporation be the
general partner. Prior to the issuance of the check-the-box Regulations, it was necessary to
structure the entity carefully in order to avoid the limited partnership being classified as an
association and taxed as a corporation. Under the check-the-box Regulations, the limited
partnership cannot be reclassified as an association and taxed as a corporation. So this prior
pitfall no longer exists. pp. 13-4, 13-5, and Figure 13.1
7. a. Nontax factors are important to Samuel in selecting the business entity form for his
lawn-servicing business. The ability of the entity to raise capital as well as the
advantages of limited liability should be considered when selecting the form of
business entity. Additional factors which should be taken into account include: (1) the
estimated life of the business, (2) the number of owners and their roles in
the management of the business, (3) the ease of transfer of ownership interests, and (4)
the organizational formality required to establish the entity.
b. Tax factors are also important to Samuel. However, one cannot conclude which are
more significant to Samuel. Above all, business decisions should make economic
sense.
pp. 13-3 to 13-7
8. Abe can benefit by passing the losses through and offsetting them against his other income.
Since he is the sole owner, the three business forms available that will permit this are the sole
proprietorship, limited liability company (LLC), and the S corporation. A benefit of the S
corporation and the limited liability company when compared with the sole proprietorship is
limited liability. Once Abe’s business starts producing a profit, each of these three business
forms will result in single taxation (i.e., the entity is not subject to taxation and Abe is subject
to taxation). pp. 13-6 to 13-8
9. The S corporation and its owners are subject to single taxation and the C corporation and its owners
are subject to double taxation. As Sue suggests, one way to avoid double taxation is to reduce the
corporate taxable income to zero. However, one must be aware of the possibility of the IRS raising
the unreasonable compensation issue. To the extent that the IRS is successful, the salary is
reclassified as a dividend and double taxation is produced.
Sam is correct that being an S corporation does provide certain constraints in that the requirements
that must be satisfied in order to elect S status (e.g., number and types of shareholders, only one
class of stock) become maintenance requirements. For example, issuing preferred stock would result
in termination of the S election.
One approach would be for Sam to elect S corporation status presently. If at some time in the future
he cannot continue to satisfy the maintenance requirements, he would then become a C corporation.
During the period that the S corporation election is in effect, he would not have to be concerned
about double taxation.
Note that a tax advisor should not limit his or her analysis to the options provided by the client. Sam
should also consider the limited liability company (LLC).
pp. 13-6, 13-11, and Concept Summary 13.2

10. A C Corporation is subject to double taxation only if it makes distributions to the
shareholders. Since Paul’s corporation currently pays no dividends and does not intend to do
so in the future, double taxation is not present. In addition, the $60,000 salary paid to Paul
was deductible by the corporation in calculating its taxable income of $100,000.
By making the S election, Paul may have created a wherewithal to pay problem for himself.
He is taxed on the $100,000 even though he is receiving no dividends from the corporation.
Thus, he may have generated a cash flow problem. In addition, by making the S election, he
has increased the entity/owner tax liability for a C corporation from $22,250 [($50,000 ×
15%) + ($25,000 × 25%) + ($25,000 × 34%)] to that for an S corporation of $33,000
($100,000 × 33%). However, as the entity earnings increase each year, this $10,750 ($33,000
– $22,250) difference will decrease. Ultimately the C corporation tax could be greater than
the S corporation tax at the shareholder level.
pp. 13-6, 13-7, 13-11, and Example 7
11. All four of the entities, either directly or indirectly, are subject to the AMT. For the sole
proprietorship and the C corporation, the impact is direct (i.e., the AMT is calculated on the
owner of the sole proprietorship’s Form 1040 and on the C corporation’s Form 1120). For the
partnership and S corporation, the impact is indirect (i.e., the entities are conduits and the
AMT is calculated on the owners’ tax returns). pp. 13-7 and 13-8
12. Violet’s acceleration of income and deferral of deductions for a tax year in which it is subject
to the AMT can be beneficial. Since Violet is subject to the AMT for the current year, any
increase in net income is taxed at the 20% AMT rate. If such income were taxed next year, it
would be subject to a 34% regular corporate tax rate. p. 13-9
13. Both the S corporation and the limited liability company forms will permit Mary and Richerd
to pass the entity losses through to their Federal individual income tax returns. For state
income tax purposes, the limited liability company form also will accomplish this result.
However, not all states permit S corporation treatment. Thus, Mary and Richerd need to
ascertain if such treatment is available in the southeastern state. If S corporation treatment is
not available, then they should select the limited liability company form. If S corporation
treatment is available, they probably still should select the limited liability company form
because of the statutory restrictions that exist with S corporations (e.g., number and types of
owners and the capital structure). p. 13-9
14. The statement describes the most favorable type of fringe benefit available tax wise. For
example, meals and lodging which qualify under § 119 receive this tax treatment. However,
many fringe benefits (e.g., pension and profit sharing plans) provide an immediate deduction
for the employer, but only tax deferral for the employee. Thus, the employee is taxed in the
future when he or she actually receives the benefit. While not as favorable as a complete
exclusion, deferral treatment is a positive tax advantage. p. 13-10
15. a. Since David and Tan, Inc.’s objective is to avoid double taxation, the following need
to be addressed:
• Tan’s taxable income can be reduced through reasonable compensation payments.

Is the $400,000 annual salary for David reasonable? It might be possible to
increase this amount and still be reasonable!
• Based on the data, it appears that Tan is not distributing dividends to David.
While such a technique can be used to avoid or defer double taxation, is the
retention defensible in terms of the accumulated earnings tax?
• Would an S corporation election be advisable?
b. Yes, avoiding double taxation associated with Tan should be a goal of David and Tan.
This is consistent with the general goal of minimizing taxation.
pp. 13-10 to 13-14
16. The following payments to shareholders are deductible in calculating corporate taxable
income.
• Salary payments to shareholder-employees.
• Lease rental payments to shareholder-lessors.
• Interest payments to shareholder-creditors.
Because of the tax benefit that results, the IRS scrutinizes these types of transactions carefully
in terms of reasonableness. In addition, the interest payments may result in the IRS raising the
§ 385 thin capitalization issue.
pp. 13-10, 13-11, and Examples 10 and 11
17. The second approach (i.e., a combined capital contribution of $600,000 and loan of $300,000)
has two potential advantages. First, the annual interest payment of $16,500 ($300,000 × 5.5%)
on the loan is deductible by Beige, Inc. Second, the repayment of the loan by the corporation
does not result in income to Teresa.
The potential pitfall is that the IRS may consider the corporation to be thinly capitalized. This
could result in interest payments being reclassified as dividends (making them nondeductible
by the corporation). Furthermore, the loan repayment will be treated as a dividend to the
shareholder.
pp. 13-11, 13-12, and Example 11
18. Perhaps. In theory, this approach represents sound tax planning. However, it may not be
feasible for several reasons. First, the shareholders may not be willing to forgo distributions
from the corporation. Second, such a distribution policy could result in the imposition of an
accumulated earnings tax. pp. 13-12 and 13-13
19. The absence of dividends may result in the IRS assessing the accumulated earnings tax. If this
should occur, accumulated taxable income would be taxed at a 20% rate in 2013. The penalty tax
will not be assessed if Martin has reasonable needs for its accumulated earnings or, as a practical
matter, it is not a closely held corporation. Finally, the accumulated earnings tax does not apply to
S corporations. pp. 13-12, 13-13, Chapter 3, and Concept Summary 13.2
20. Operating as a C corporation would provide Arnold with greater flexibility in that he would
not have to be concerned with satisfying the qualification requirements under § 1361 in order
to elect S corporation status. Once the election is made, the qualification requirements become
maintenance requirements. The principal negative attribute of being a C corporation is the
potential for double taxation.
Factors to consider in making the S election include the following:
• Are all the shareholders willing to consent to the election?
• Can the qualification requirements under § 1361 be satisfied at the time of the election?
• Since the qualification requirements become maintenance requirements, can these

requirements continue to be satisfied?
• For what period will the conditions that make the election beneficial continue to prevail?
• Will the corporate distribution policy create wherewithal to pay problems at the
shareholder level?
pp. 13-13 and 13-14
21. a. S corporations can have a maximum of 100 shareholders. For this limitation, married
shareholders and certain family members are counted as one shareholder. Divorced
taxpayers are still counted as one shareholder. So after the divorce, there still are only
100 shareholders. When there are enough shareholders that there may eventually be
a problem with this requirement, a sound tax strategy would include a right of first
refusal provision on the part of the corporation or other shareholders with regard to
transferring stock outside the extant shareholder group.
b. The qualification requirements for S status must be maintained. That is, if any of
these requirements are not kept, the entity loses its S status and becomes a
C corporation. Therefore, if Tammy or Willy transfer some of the S corporation stock
to an unrelated person, Roadrunner becomes a C corporation since the 100 unrelated
shareholder limitation is exceeded.
p. 13-13, Chapter 12, and Concept Summary 13.2
22. The tax consequences to Sabrina and to the entities will be the same. The fair market value of
the SUV of $40,000 is less than Sabrina’s adjusted basis (i.e., cost) of $58,000 for the SUV.
Therefore, the adjusted basis of the SUV to the S corporation or to the C corporation is the
lower fair market value of $40,000. Sabrina’s realized loss of $18,000 (i. e, the value decline
while she held the SUV for personal use) is disallowed. The contribution of the SUV to
Sabrina’s sole proprietorship produces the same tax consequences as the contribution to her
wholly owned corporation. p. 13-15 and Concept Summary 13.2
23. a. Sections 721, 722, and 723 provide for the nonrecognition of realized gain or loss,
a carryover basis for the partner’s partnership basis, and a carryover basis for the
partnership’s basis for its assets contributed. Sections 351, 358, and 362 provide for
the same tax consequences on the contribution of property by a shareholder to a
corporation but only if the 80% control requirement is satisfied. If the 80% control
requirement is not satisfied, the shareholder’s realized gain or loss is recognized and
the basis for his or her stock is the fair market value at the date of the contribution.
The corporation’s basis for the contributed assets is the fair market value at the date of
the contribution.
b. Except as noted in part a., the same nonrecognition rules that apply for a C corporation
apply for an S corporation.
p. 13-15 and Concept Summary 13.2
24. Section 704(c) provides for a mandatory special allocation if a partner contributes an asset to
a partnership whose basis is not equal to the fair market value. The amount of the special
allocation for the contributing partner is the difference between the partner’s adjusted basis
for the asset and the fair market value. The purpose for the special allocation is to provide for
the eventual taxation of the value increment or decrement to the contributing partner, rather
than to have it shared among all the partners. Other elective special allocations are available if
they have substantial economic effect.
The concept of special allocations does not apply for the corporate form because of the entity
concept. The recognition of gains or losses and the taking of deductions occurs at the corporate
rather than at the shareholder level. S corporations use the per-share and per-day allocation method.
pp. 13-15, 13-16, 13-21, and Concept Summary 13.2
25. Changes in partnership liabilities increase or decrease a partner’s basis in the partnership
interest. This is appropriate because generally partners are liable for the entity liabilities if not
paid by the partnership.
Corporate liability changes do not have any effect on the shareholder’s basis in the stock. This
is appropriate because the shareholder has limited liability and is not liable for the debts of the
entity.
p. 13-16, 13-17, and Example 16
26. Item Effect on Basis
Shareholder in Shareholder in
Partner C Corporation S Corporation
Profits + no effect +
Losses – no effect –
Liability increase + no effect no effect
Liability decrease – no effect no effect
Contribution of assets + + +
Distribution of assets – no effect if –
classified as
a dividend
–
if classified
as a return
of capital
p. 13-16 and Example 16
27. The conduit concept generally applies to the S corporation. Therefore, the S corporation is a
tax reporter rather than a taxpayer, with the taxation occurring at the shareholder level.
However, there are several instances in which the S corporation is the taxpayer. Included are
the tax on built-in gains and the tax on certain passive investment income. p. 13-18 and
Concept Summary 13.2
28. a. The conduit concept applies in the case of a partnership. Therefore, the partnership is
merely a tax reporter and the partners are the taxpayers. The partners are taxed on their
respective shares of the earnings of the partnership rather than on the receipt of
distributions of earnings. Thus, Dexter has already been taxed on his share of the
partnership earnings.
b. If Warbler is an S corporation, the answer does not change because the conduit
concept also applies for S corporations.
pp. 13-17 and 13-18
29. The C corporation is treated as a separate taxable entity and is subject to double taxation. The
benefit of the S election is that the corporation generally is not subject to taxation. Similar to
the partnership, the earnings of an S corporation are passed through and taxed at the owner
level. Therefore, if the S corporation shareholder later receives a distribution of these
earnings, such earnings have already been taxed. pp. 13-18 and 13-19
30. If Sandra and Renee each sell their stock, they will be taxed on the realized gain (i.e., excess
of amount realized over the adjusted basis for the stock). Olive Corporation is not affected by
the sale.
If Olive sells the assets, pays its liabilities, and distributes the balance to the shareholders, the
recognized gain is passed through to the shareholders. The shareholders’ basis of their stock
is increased by the amount of the gain recognized. The shareholders are also taxed on the
excess of the amount distributed to them by Olive over the adjusted basis of their stock.
Consequently, both the stock sale and the asset sale produce the same amount of recognized
gain to Sandra and Renee. However, there may be a difference in its classification. Because
the stock is a capital asset, all of the recognized gain on the stock sale is a long-term capital
gain. This may not be the case on the asset sale, and some of the gain could be ordinary
income.
Another factor favoring the stock sale is that it is less complex and costly to carry out than the
asset sale.
31. From Vance’s perspective, the sale of Rose, Inc., should be structured to avoid double
taxation. A sale of the stock of Rose to the investor group achieves this objective. The sale of
the assets by the corporation (or the distribution of the assets to Vance to make the sale)
followed by the liquidation of the corporation results in double taxation. Thus, Vance needs to
recognize this difference in tax consequences in order to effectively conclude the negotiations.
pp. 13-26 and 13-27
32. a. S corporation and C corporation (S and C). p. 13-4
b. C corporation (C). pp. 13-3 and 13-4
c. C corporation (C). pp. 13-6 to 13-8

d. Sole proprietorship, partnership, and S corporation (SP, P, and S). p. 13-6
e. C corporation (C). p. 13-13

f. S corporation (S). Concept Summary 13.2
g. Sole proprietorship and partnership (SP and P). p. 13-5
h. C corporation (C). p. 13-26 and Concept Summary 13.1
i. Sole proprietorship, partnership, and S corporation (SP, P, and S). p. 13-16
j. Sole proprietorship and partnership (SP and P). p. 13-16
k. C corporation (C). p. 13-17
l. N.
m. S corporation (S). p. 13-18
33. a. Partnership, S corporation, and C corporation (P, S, and C).
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).
34. At least four factors should be considered when evaluating whether to make the election
under § 754 which will activate the operational provisions of § 743. These four factors are: (1)
the partnership must make the election, (2) the election could produce negative basis
adjustments if the adjusted basis exceeds the fair market value of the partnership assets at the
acquisition date, (3) the election also activates the optional adjustment to basis under § 734
that results from partnership distributions, and (4) the complexity of recordkeeping. pp. 13-21,
13-25, and Example 22
PROBLEMS
35. a. As a sole proprietorship has unlimited liability, the sole proprietorship and the owner
are liable for the remaining $4 million after the $6 million is paid by insurance. Since
the net FMV of the net assets is $725,000 ($925,000 – $200,000), the owner is liable
for the remaining $3,275,000 ($4,000,000 – $725,000).
b. Because a partnership has unlimited liability, the partnership and the partners are
liable for the remaining $4 million after the $6 million is paid by insurance. Since the
net FMV of the net assets is $725,000 ($925,000 – $200,000), the partners are liable
for the remaining $3,275,000 ($4,000,000 – $725,000).
c. A C corporation has limited liability (i.e., equal to the FMV of the assets of $925,000).
The plaintiff will share with the other creditors (i.e., $200,000) of the entity with
respect to claims against the $925,000 of assets. The shareholders of the C corporation
have no personal liability for the remaining corporate debts of $3,075,000 ($4,000,000
– $925,000).
d. Same response as in c. for an S corporation.
p. 13-5
36. a. The tax liability of each of the corporations is as follows:
Red Corporation
15% × $ 50,000 = $ 7,500

25% × 25,000 = 6,250
34% × 24,000 = 8,160
$21,910
White Corporation
15% × $ 50,000 = $ 7,500

25% × 25,000 = 6,250
34% × 255,000 = 86,700
5% × 230,000 = 11,500
$111,950
Blue Corporation
15% × $ 50,000 = $ 7,500

25% × 25,000 = 6,250
34% × 825,000 = 280,500
5% × 235,000 = 11,750
$306,000
or 34% × $900,000 = $306,000
Orange Corporation
34% × $10,000,000 = $ 3,400,000

35% × 30,000,000 = 10,500,000
3% × 3,333,333 = 100,000
$14,000,000
or 35% × $40,000,000 = $14,000,000
The effective tax rate for each of the corporations is as follows:

Red Corporation
$21,910 = 22.13%
$99,000
White Corporation
$111,950 = 33.92%
$330,000
Blue Corporation
$306,000 = 34%
$900,000
Orange Corporation
$14,000,000 = 35%
$40,000,000
The marginal tax rate for each of the corporations is as follows:
Red 34%
White 39%
Blue 34%
Orange 35%
b. The marginal tax rate can be 39% (34% + 5%) or 38% (35% + 3%) as the result of the
phaseout of the benefits of the lower brackets. The effective tax rate will never exceed
the statutory rate of 35%.
Chapter 2
37. Hoffman, Raabe, Smith, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
March 12, 2013
Amy and Jeff Barnes
5700 Redmont Highway
Washington, D.C. 20024
Dear Amy and Jeff:
I am responding to your request for advice on the business entity form to be selected for
operating the florist shop. In our conversation, the inclination was to conduct the business as a
partnership or as an S corporation. After paying salaries of $45,000 to each of you, the profits
of the business will be about $60,000. The intent is to invest the earnings in the growth of the
business rather than make distributions.
In selecting an entity form, consideration should be given to both tax and nontax factors. The
tax consequences for the partnership form versus the S corporation form would be the same.
The salary of $45,000 is included in your gross income, and the partnership or S corporation
would deduct the $90,000 in calculating its taxable income. In addition, regardless of whether
the entity is a partnership or an S corporation, each of you would include one-half of the
$60,000 projected floral earnings in gross income.
A substantial difference does exist, however, with respect to the nontax factors. If the floral
shop is conducted as a general partnership, there is unlimited liability. Conversely, if the floral
shop is conducted as an S corporation, limited liability results. Although in many cases
shareholders of small businesses operating as S corporations are required to guarantee
corporate debts, the corporate form still provides protection against contingent liabilities.
In choosing between the partnership and the S corporation form, I recommend the S
corporation form. However, you may want to consider the limited liability company (LLC)
form. This legal form provides limited liability, the same tax consequences as those of the
partnership form, and greater flexibility than the S corporation form. Call me at your
convenience. I look forward to resolving any questions you have regarding the business entity
form for your floral shop.
Sincerely,
Carlene Sims, CPA
pp. 13-2 to 13-6
38. The three forms of business entity available to Coleman and his spouse are the partnership, C
corporation, and S corporation. The sole proprietorship is not a viable option, since Coleman
and his spouse are to be the owners. In selecting the business form, Coleman should consider
both tax and nontax factors.
Nontax factors to consider include the ability to raise capital and limited liability. The
corporate form normally provides the greatest ease and potential for obtaining owner
financing. However, for Coleman and his spouse this does not appear to be an advantage,
when compared with an unincorporated entity (i.e., partnership), because he and his spouse
are to be the only owners. The corporate form does however, in this case, offer the advantage
of limited liability.
If Coleman and his spouse select the partnership form, the profits of the entity will be taxed to
the two owners. Since Coleman and his spouse will be in the 39.6% tax bracket, the tax
liability on the projected earnings of $300,000 for the initial year would be $118,800
($300,000  39.6%).
If Coleman and his spouse select the corporate form, the earnings of the business will be taxed
to the corporation. The tax liability on the projected earnings of $300,000 for the initial year
would be $100,250 [($50,000 × 15%) + ($25,000 × 25%) + ($25,000 × 34%) + ($200,000 ×
39%)]. In addition, to the extent that the corporation distributes part or all of the after-tax
earnings to Coleman and his spouse as a dividend, double taxation would result. On the other
hand, if the corporation pays salaries to Coleman and his spouse, they will be able to receive
cash from the corporation without double taxation. The total income tax would increase,
however, as amounts received by Coleman and his spouse as salary will be taxed at 35%. This
may be the best solution.
Another solution would be to elect S corporation status. The earnings of the corporation
would be taxed to Coleman and his spouse rather than at the corporate level. While the initial
year, their tax liability of $118,800 ($300,000 × 39.6%) would be higher than the C
corporation tax liability of $100,250, the potential for being subject to double taxation would
be avoided. Finally, the advantage of limited liability would be achieved.
pp. 13-3 to 13-6
39. a. If Plum is a C corporation, the corporate tax liability is:
15% × $50,000 = $ 7,500

25% × 25,000 = 6,250
34% × 5,000 = 1,700
$15,450
Since Plum will not distribute any dividends, the shareholders will have no tax
liability associated with it.
If Plum is an S corporation, the corporate tax liability will be $0 and the shareholders’
tax liability will be $26,400 ($80,000 × 33%). Viewed from an entity-owner
perspective, operating as a C corporation will result in tax savings of $10,950
($26,400 – $15,450). Note that these savings are based on the assumption that the
after-tax earnings are reinvested in the growth (i.e., reasonable needs for purposes of
accumulated earnings tax) of the business and that no distributions are made to the
shareholders.
b. If Plum is a C corporation, the corporate tax liability is $15,450. The tax at the
shareholder level on the distribution of after-tax earnings of $64,550 is $9,683
($64,550  15%), assuming the dividends are qualified dividends. Therefore, the
combined corporation and shareholder tax is $25,133 ($15,450 + $9,683).
If Plum is an S corporation, the corporate tax liability will be $0 and the shareholder
tax liability will be $26,400 ($80,000 × 33%). The $80,000 will be a distribution out
of AAA and thus will be tax-free to the shareholders.
Viewed from an entity-owner perspective, operating as a C corporation will result in
tax savings of $1,267 ($25,133 – $26,400).
pp. 13-6, 13-7, and Example 7
40. a. The corporate tax liability on taxable income of $450,000 is $153,000 for the
C corporation.
$ 50,000 × 15% = $ 7,500
25,000 × 25% = 6,250
25,000 × 34% = 8,500
235,000 × 39% = 91,650
115,000 × 34% = 39,100
$153,000
Since the tax benefits of the 15% and 25% brackets have been phased out, the tax
liability could be calculated as follows:
$450,000 × 34% = $153,000
Since the tax liability on the $450,000 is assessed at the corporate level, there will be
no dividend distribution to Mabel and Alan. They will each receive a salary of
$175,000.
b. The tax liability is assessed at the shareholder level rather than at the corporate level
for the S corporation. Mabel and Alan will each have a tax liability of $78,750
($225,000 × 35%) associated with their respective shares of the corporate taxable
income of $450,000. Therefore, the corporation will need to distribute $78,750 each to
Mabel and Alan to pay their tax liability. They also will receive their salary of
$175,000 each.
c. The combined entity/owner tax liability in a. will be as follows:
C corporation $153,000
Shareholders on distribution –0–
Shareholders on salaries ($350,000 × 35%) 122,500
Combined tax liability $275,500
The combined entity/owner tax liability in b. will be as follows:
S corporation $ –0–
Shareholders taxed on S corporation earnings
($450,000 × 35%) 157,500
Shareholders on salaries ($350,000 × 35%) 122,500
Combined tax liability $280,000
41. a. Owl’s regular income tax liability on taxable income of $6,250,000 is calculated as
follows:
15% × $ 50,000 = $ 7,500

25% × 25,000 = 6,250
34% × 25,000 = 8,500
39% × 235,000 = 91,650
34% × 5,915,000 = 2,011,100
$2,125,000
Since the tax benefits of the 15% and 25% brackets have been phased out, the tax liability
could be calculated as follows:
$6.25 million × 34% = $2,125,000
The AMT of the corporation is calculated as follows:
Taxable income $ 6,250,000
+ Positive AMT adjustments including ACE adjustment
($600,000 + $750,000) 1,350,000
– Negative AMT adjustments (30,000)
+ Tax preferences 5,000,000
= Alternative minimum taxable income (AMTI) $12,570,000
– Exemption [$40,000 – 25%($12,570,000 – $150,000)] (–0–)
= AMT base $12,570,000
× Rate 20%
= Tentative AMT $ 2,514,000
– Regular income tax liability (2,125,000)
= AMT $ 389,000
Thus, if Owl is a C corporation, its tax liability is $2,514,000 ($2,125,000 regular

income tax + $389,000 AMT).
b. An S corporation is a tax reporter rather than a taxpayer. Thus, Owl will pass the
regular taxable income, the separately stated items, and AMT attributes through to its
shareholders who will make the regular tax liability calculation and the AMT
calculation on their individual income tax returns.
c. The results in a. will be the same. Whether the C corporation is closely held is not
relevant. An S corporation, however, cannot have 5,000 shareholders. It would be
taxed as a C corporation. The answer to b. then would be the same as the result in a.
pp. 13-7 to 13-9
42. Falcon’s tax liability for 2013 and 2014 is as follows if the cash option is selected.
Regular Income Tax Liability
2013 2014
Taxable income before sale $400,000 $400,000
Gain from sale ($500,000 – $400,000) 100,000 –0–
Taxable income $500,000 $400,000
Tax liability (34% rate) $170,000 $136,000
AMT
2013 2014
AMT gain from sale ($500,000 – $425,000) 75,000 –0–
Other AMT adjustments and tax preferences 425,000 –0–
AMTI $900,000 $400,000
Exemption amount (–0–) (–0–)
AMT base $900,000 $400,000
Rate × 20% × 20%
Tentative AMT $180,000 $ 80,000
AMT $ 10,000 $ –0–

Falcon’s tax liability for 2013 and 2014 is as follows if the installment option is selected.
Regular Income Tax Liability
2013 2014
Gain from sale ($500,000 – $400,000) –0– 100,000
Taxable income $400,000 $500,000
Tax liability (34% rate) $136,000 $170,000

AMT
2013 2014
AMT gain from sale ($500,000 – $425,000) –0– 75,000
Other AMT adjustments and tax preferences 425,000 –0–
AMTI $825,000 $475,000
Exemption amount (–0–) (–0–)
AMT base $825,000 $475,000

Rate × 20% × 20%
Tentative AMT $165,000 $ 95,000
AMT $ 29,000 $ –0–
If the cash option is selected, the combined tax liability for the two years is $316,000
($180,000 in 2013 and $136,000 in 2014). If the installment option is selected, the combined
tax liability for the two years is $335,000 ($165,000 in 2013 and $170,000 in 2014). Thus,
Falcon saves $19,000 ($335,000 – $316,000) by selecting the cash option.
pp. 13-7, 13-8, and Chapter 3
43. a. If the farm is incorporated as a C (regular) corporation, then the sisters and the brother
as shareholder-employees can qualify as employees. Thus, the $63,000 ($45,000 for
lodging and $18,000 for meals) is excludible to the sisters and the brother under the
§ 119 meals and lodging exclusion. If the farm is an S corporation, the sisters and the
brother are treated as partners (see part b.).
b. If the farm is not incorporated (i.e., a partnership), the IRS position is that the sisters
and the brother do not satisfy the definition of an employee. Therefore, they are not
eligible for the §119 exclusion and the $63,000 must be included in their gross
income.
pp. 13-9, 13-10, and Example 9
44. a. Partnership C Corporation S Corporation
Taxable income before cost of
certain fringe benefits $400,000 $400,000 $400,000
– Deductible fringe benefits (235,000) (305,000) (235,000)
Taxable income $165,000 $ 95,000 $165,000
Assuming that the fringe benefit plans are not discriminatory, the potential exists for the
employer business entity to deduct the amounts paid for fringe benefits. Thus, regardless of
the entity form, the amounts paid to a qualified pension plan (H.R. 10 plan for
owner/employees of a partnership or an S corporation) are deductible by the business
entity. For the partners and S corporation shareholders, the pension amount is included in
their gross income and then is eligible for deduction as a contribution to an H.R. 10 plan.
Group-term life insurance and meals and lodging are only deductible by the C corporation
(see part b.).
For beneficial fringe benefit treatment for group-term life insurance and meals and
lodging to be received, the individual must be an employee. Partners do not qualify as
employees, and greater than 2% shareholders of an S corporation are treated the same
as partners in a partnership for fringe benefit purposes.
b. For beneficial fringe benefit treatment for group-term life insurance and meals and
lodging to be received, the individual must be an employee. Partners do not qualify as
employees, and greater than 2% shareholders of an S corporation are treated the same
as partners in a partnership for fringe benefit purposes. Since partners and greater than
2% S corporation shareholders do not qualify as employees, they do not qualify for
either § 79 exclusion treatment for group-term life insurance or § 119 exclusion
treatment for meals and lodging. Therefore, the amounts paid by the business entity
for these fringe benefits are included in the gross income of the partners and S
corporation shareholders. For the corporate shareholders, the amounts paid are
deductible by the corporation and excludible by the employee-shareholders.
The pension plan contributions made for employees are excludible by the covered
employees. Income will not be recognized by the employees until they receive
payments from the pension plan. For the owner/employees of a partnership or an S
corporation who have contributions made to their H.R. 10 plans by the business entity,
the amounts paid must be included in their gross income. However, this inclusion can
be offset by a corresponding deduction for adjusted gross income on the individual’s
tax return. When benefits are paid from the H.R. 10 plan, the recipient includes the
amount in his or her gross income.
pp. 13-9 and 13-10
45. a. Under option 1, Turtle can deduct salaries of $300,000. Thus, Turtle’s taxable income
will be $0 ($300,000 – $300,000). No dividends will be distributed since there are no
after-tax earnings. Britney will include $135,000 of salary in her gross income, Shania
will include $90,000 of salary in her gross income, and Alan will include $75,000 of
salary in his gross income.
Under option 2, Turtle can deduct salaries of $150,000. Thus, Turtle’s taxable income
will be $150,000 ($300,000 – $150,000) and Turtle’s tax liability will be $41,750.
15% × $ 50,000 = $ 7,500
25% × 25,000 = 6,250
34% × 75,000 = 25,500
5% × 50,000 = 2,500
$41,750
Britney will include $67,500 of salary and $36,083 [($150,000 – $41,750) × 1/3] of
dividend income in her gross income. Shania will include $45,000 of salary and
$36,083 ($108,250 × 1/3) of dividend income in her gross income. Alan will include
$37,500 of salary and $36,083 ($108,250 × 1/3) of dividend income in his gross
income.
b. Under option 1, the salary payments reduce Turtle taxable income to $0. Thus, Turtle
should be aware of the possibility of the unreasonable compensation issue being raised
by the IRS.
pp. 13-11 and 13-12
46. a. Parrott will deduct interest expense each year of $67,500 ($1,350,000 × 5%). Abner
will report interest income of $40,500 ($810,000 × 5%) each year and Deanna will
report interest income of $27,000 ($540,000 × 5%) each year.
b. Parrott will not be allowed a deduction each year for the interest payments of $67,500.
Instead, the payments will be labeled as dividends. Abner will report dividend income
of $40,500 each year and Deanna will report dividend income of $27,000 each year.
When the loan is repaid in 5 years, assuming adequate earnings and profits, Abner will
report dividend income of $810,000 and Deanna will report dividend income of
$540,000.
47. If Lavender acquires the shopping mall, its tax liability would increase as follows:
Additional liability ($500,000 net rental income × 34%) $170,000
The individual tax liabilities of Marci and Jennifer would not be affected by the shopping mall
acquisition by the corporation.
If Marci and Jennifer acquire the shopping mall and lease it to the corporation, their combined
tax liabilities would increase as follows:
Net rental income $300,000

– Depreciation (37,000)
= Increase in their taxable incomes $263,000
Additional tax liability ($263,000 × 35%) $ 92,050
At the corporate level, the corporate taxable income would increase as follows:
Net rental income $500,000
– Rental payments to Marci and Jennifer (300,000)
= Additional taxable income $200,000
Additional tax liability ($200,000 × 34%) $ 68,000
Thus, under the option recommended by the CPA, the combined tax liability of $160,050
($92,050 + $68,000) is slightly less than the $170,000 tax liability under the corporate
acquisition option (34% × $500,000). In addition, Lavender has been able to channel
$300,000 to Marci and Jennifer with the amount being deductible in calculating Lavender’s
taxable income.
p. 13-11
48. a. Flower, Inc.’s corporate tax liability is calculated as follows:
15% × $ 50,000 = $ 7,500
25% × 25,000 = 6,250
34% × 725,000 = 246,500
5% × 235,000 = 11,750
$272,000
In addition, Flower may be subject to the accumulated earnings tax. This tax liability
could be as high as $105,600 ($528,000 × 20%). The $528,000 represents the after-tax
earnings of the corporation ($800,000 – $272,000).
b. In this case, Flower would not be subject to the accumulated earnings tax. Thus, the
total corporate tax liability would be $272,000. The shareholders of Flower would be
taxed on their dividend income of $528,000 ($800,000 – $272,000).
c. Flower’s regular income tax liability is $0 because the S election results in the
corporation not being subject to Federal income tax. The taxable income of $800,000
is passed through to the shareholders’ tax returns. The accumulated earnings tax does
not apply to S corporations.
pp. 13-6, 13-7, 13-12, and 13-13
49. a. Grace’s redemption qualifies as substantially disproportionate under $ 302(b)(2).

Before the redemption, Grace owned 25% of the stock and after the redemption, she
owns only 11.1%. Therefore, she has had a greater than 20% reduction in her
proportionate stock ownership. As a result, she qualifies for return of capital treatment.
Amount realized $175,000

Basis [$150,000 × (125 shares  175 shares)] (107,143)
Recognized long-term capital gain $ 67,857
Frank’s redemption does not qualify as substantially disproportionate—after the

redemption, he does not own less than 50% of the stock. Therefore, he has dividend
income of $175,000 which is eligible for the beneficial 15% tax rate. His total stock
basis will not change (i.e., $350,000), but his basis per share will increase from $667
($350,000  525 shares) to $875 ($350,000 ÷ 400 shares).
b. The tax consequences to Grace of selling 125 shares to Chuck would be the same as in
a. above. However, Frank would now receive return of capital treatment rather than
dividend treatment. His recognized gain on selling 125 shares to Chuck is calculated
as follows:

Basis [($350,000 × (125 shares  525 shares)] (83,333)
Recognized long-term capital gain $ 91,667
c. Factors that would influence the form of the transaction (i.e., stock redemption versus
sale of stock to an outsider) include the following:
• External market for the stock.

• Willingness of Frank and Grace to permit an outsider to purchase stock in the
corporation.
• Frank’s preference for capital gain treatment (e.g., other capital losses available)
rather than dividend results.
• Frank’s preference for increasing gross income by only $91,667 instead of
$175,000.
50. If the S election is voluntarily terminated, another election for Clay Corporation cannot be
made for a five-year period. Therefore, the decision regarding revoking the S election should
be considered a long-run, rather than a short-run, one. The revocation of the election can be
made only if a majority of the shareholders consent. Thus, Nell will need one of the other
shareholders to agree with her in order to voluntarily revoke the election.
Assuming that the S election is maintained and the annual earnings of $180,000 are
distributed to the shareholders, the tax liability associated with the distribution for all the
shareholders is $59,400 ($180,000 × 33%). If the S election is revoked effective for 2012, the
corporate tax liability is $53,450. The tax liability for all of the shareholders on the dividend
distribution, assuming the dividends are qualified dividends, is $18,983 [($180,000 –
$53,450) × 15%]. Therefore, the total corporate and shareholder tax liability would be as
follows:
S Corporation C Corporation
Corporate tax liability $ –0– $53,450
Shareholder tax liability 59,400 18,983
$59,400 $72,433
Revocation of the S election combined with a policy of distributing all the earnings to the
three shareholders will result in a greater combined corporation/shareholder tax liability of
$13,033 ($72,433 – $59,400). Thus, if all of the earnings are going to be distributed, the S
election should be maintained.
51. a. No gain or loss is recognized on the contribution of property to a partnership.

Therefore, Evans’ realized gain of $400,000 ($600,000 amount realized – $200,000
adjusted basis) is not recognized. Basis in the partnership interest is $600,000 for
Phillip and $200,000 for Evans. The recognized gain on the sale of the land is
$452,000 ($652,000 amount realized – $200,000 adjusted basis) and is allocated to the
partners as follows:
Pre-contribution gain Post-contribution gain
Phillip $ –0– $26,000
Evans 400,000 26,000
b. No gain or loss is recognized on the contribution of property to an S corporation if the

contributing shareholders satisfy the 80% control requirement. Therefore, Evans’
realized gain of $400,000 ($600,000 amount realized – $200,000 adjusted basis) is not
recognized. Evans’ stock basis is $200,000 and Phillip’s is $600,000. The recognized
gain on the sale of the land is $452,000 ($652,000 amount realized – $200,000
adjusted basis) and is allocated to the shareholders as follows:
Phillip $226,000
Evans 226,000
c. No gain or loss is recognized on the contribution of property to a C corporation if the

contributing shareholders satisfy the 80% control requirement. Therefore, Evans’
realized gain of $400,000 ($600,000 amount realized – $200,000 adjusted basis) is not
recognized. Phillip’s stock basis is $600,000 and Evans’ is $200,000. The C
corporation has a recognized gain on the sale of the land of $452,000 ($652,000
amount realized – $200,000 adjusted basis). This recognized gain has no effect on
either Phillip or Evans.
d. An exchange of the original parcel of land for another parcel of land could qualify for
deferral as a § 1031 like-kind exchange. However, since the business of the entity is
real estate development, it appears that the land is inventory. If so, § 1031 deferral
treatment does not apply. Thus, structuring the disposition and acquisition as an
exchange produces the same tax consequences as the sale and purchase option.
pp. 13-15, 13-16, and Example 15
52. a. Section 721 provides that no gain or loss is recognized by the partners upon the
contribution of property to a partnership. Thus, neither Agnes nor Becky has any
recognized gain. Since Carol is contributing services rather than property, she has a
recognized gain of $50,000.
Section 722 provides for a carryover basis for the partners. The $20,000 mortgage
assumed by the partnership results in the adjustments indicated below. Thus, the
partner’s basis for the partnership interest is as follow:
Agnes ($100,000 + $8,000) $108,000

Becky ($60,000 – $20,000 + $8,000) 48,000
Carol ($50,000 + $4,000) 54,000
Section 723 provides for a carryover basis to the partnership for the assets received.
Cash $100,000
Land 60,000
Organization costs 50,000
b. Section 351 provides that no gain or loss is recognized upon the contribution of
property to a corporation if the shareholders control (i.e., at least 80%) the corporation
immediately after the transfer. Since the combined ownership of Agnes and Becky
(40% + 40% = 80%) satisfies this requirement, neither has any recognized gain. Since
Carol is contributing services rather than property, she has a recognized gain of
$50,000.
Section 358 provides for a carryover basis for the shareholders. Thus, the shareholder’s
basis for the stock is as follow:
Agnes $100,000
Becky ($60,000 – $20,000) 40,000
Carol 50,000
Section 362 provides for a carryover basis to the corporation for the assets received.
Cash $100,000
Land 60,000
Organization costs 50,000
c. Same tax consequences as in part b., above, since S status involves a corporation.
pp. 13-15 and 13-16
53. a. Initial basis under § 351 and § 358 $40,000

Effect of corporate earnings –0–
Effect of corporate liability –0–
Eloise’s stock basis: C corporation $40,000
b. Initial basis under § 351 and § 358 $ 40,000

Effect of corporate earnings ($200,000 × 30%) 60,000
Effect of corporate liability –0–
Eloise’s stock basis: S corporation $100,000
c. Initial basis under § 721 and § 722 $ 40,000

Effect of partnership earnings ($200,000 × 30%) 60,000
Effect of partnership liability ($75,000 × 30%) 22,500
Eloise’s basis for partnership interest $122,500
pp. 13-15 to 13-17
54. a. (1) Operations $ 92,000

Tax-exempt interest income (excludable) –0–
Long-term capital gain 60,000
Taxable income for C corporation $152,000
(2) Operations $ 92,000

Taxable income for S corporation $ 92,000
Separately stated items:

Tax-exempt interest income (excludable) $ –0–
Long-term capital gain $60,000
Each shareholder reports his or her share of the taxable income from operations of
$92,000 and of the long-term capital gain of $60,000. The tax-exempt interest of
$19,000 passes through to the shareholders but is excludible from gross income.
b. (1) For C corporation shareholders, the $200,000 distribution is a dividend
because it is paid out of earnings and profits. The earnings and profits of the
corporation at the end of the year is arrived at as follows:
Beginning balance $900,000

+ Taxable income 152,000
+ Tax-exempt interest 19,000
– Tax liability (42,530)*
– Dividend distribution (200,000)
= Ending E & P $828,470
*The corporate tax liability is $42,530 [($50,000 × 15%) + ($25,000 × 25%) +

($25,000 × 34%) + ($52,000 × 39%)].
(2) For the S corporation shareholders, the $200,000 distribution is treated as a
return of capital and reduces the shareholders’ stock basis.
pp. 13-17 to 13-19
55. a. Since the transaction qualifies as a substantially disproportionate distribution for Sam
under § 302(b)(2), he receives return of capital treatment.
– Basis for stock redeemed (25,000)
= Realized gain $ 95,000
= Recognized gain $ 95,000
The gain is classified as a capital gain.

As the land distributed is appreciated property, Swift has a recognized gain of $65,000
($120,000 – $55,000).
Because Allison’s redemption does not qualify for stock redemption treatment, she
must report the $240,000 received as dividend income. The $40,000 basis for the
shares surrendered by Allison is reallocated to her remaining shares.
b. The tax consequences to Sam of the stock redemption is the same as in part a. (i.e.,
$95,000 capital gain). Swift also has a recognized gain of $65,000 on the distribution
of the land to Sam. However, since Swift is an S corporation, the $65,000 recognized
gain is taxable at the shareholder level. Therefore, Sam must include in his gross
income his pro rata share of the $65,000, or $9,750 ($65,000 × 15%). The tax
consequences to Allison of the nonqualifying stock redemption will be to reduce her
stock basis by the $240,000. Allison must also include in her gross income her pro
rata share of the $65,000 recognized gain, or $39,000 ($65,000 × 60%).
pp. 13-17 and 13-18
56. a. Indigo’s taxable income is calculated as follows:
Active income $325,000
Portfolio income 49,000
Passive activity losses (–0–)*
Taxable income $374,000
*The assumption is made that Indigo satisfies the three requirements for being
labeled a personal service corporation for § 469 purposes. Therefore, none of
the passive activity losses can be offset against either the active income or
the portfolio income. The passive activity losses of $333,000 carry over.
b. Indigo’s taxable income is calculated as follows:

Active income $ 325,000
Passive activity losses (325,000)*
Taxable income $ 49,000
*The passive activity losses can be offset against the active income of a closely
held corporation if the corporation does not meet the stock ownership
requirements under the personal holding company provisions.
If the corporation does meet the PHC provisions requirements, the answer is the same
as in part a.
c. Active income $325,000
Passive activity losses (320,000)*
Taxable income $ 54,000
*All of the passive activity losses of $320,000 can be offset against active income.
Therefore, there is no passive activity loss carryover.
pp. 13-19 and 13-20
57. a. The outside basis of each partner is calculated as follows:

Jo Velma
Contribution $500,000 $125,000
Recourse financing 125,000 125,000
Nonrecourse financing 50,000 50,000
$675,000 $300,000
b. The at-risk basis of each partner is calculated as follows:

Jo Velma
Contribution $500,000 $125,000
Recourse financing 125,000 125,000
$625,000 $250,000
pp. 13-15, 13-16, 13-20, and Examples 19 and 20
58. a. Rosa’s basis for her partnership interest prior to consideration of the loss is $120,000
[$50,000 + 10% of $700,000 (partnership debt)]. However, the loss pass-through
which Rosa can deduct is limited to her at-risk basis of $65,000 [$50,000 + 10% of
$150,000 (recourse debt)]. At the end of 2013, Rosa’s basis for her partnership interest
is $55,000 [$50,000 + 10% of $700,000 (partnership debt) – $65,000 (at-risk amount
of loss passed through)]. Although Rosa’s share of the partnership loss is $90,000
(10% × $900,000), her basis is reduced only by the $65,000 which produces a tax
benefit. The $25,000 ($90,000 – $65,000) which Rosa cannot deduct can be used in
future taxable years as her at-risk basis is restored.
b. Because the entity concept applies, none of the C corporation’s loss of $900,000 can
be deducted by Rosa. The basis for Rosa’s stock at the end of 2013 remains
unchanged at $50,000.
pp. 13-17 to 13-21
59. a. The basis for the stock purchased by Emily and Freda would be its cost of $908,000.
The basis of the assets to the corporation would not be affected, since the corporation
is not involved in the purchase/sale transaction.
George would have a recognized gain of $348,000 from the stock sale and the gain would
be classified as a capital gain.
– Basis for stock (560,000)
Recognized gain $348,000
b. Emily and Freda would have a basis for each of the assets purchased equal to the cost
(i.e., FMV). Since the FMV of the listed assets is $750,000, the $158,000 excess of the
purchase price over $750,000 will be assigned to goodwill. Goodwill is amortized
over a period of 15 years for tax purposes.
If Emily and Freda desire to conduct the business in corporate form, they can contribute the
assets to a corporation in a tax-free transaction under § 351. The basis of the contributed
assets to the corporation will be a carryover basis (i.e., total basis of $908,000).
Pelican will be assigned the following recognized gain from the sale of the assets to Emily
and Freda for $908,000:
Classification
Recognized
Asset Gain Capital Ordinary
Cash $ –0– $ –0– $ –0–
Accounts receivable –0– –0– –0–
Inventory 10,000 –0– 10,000
Furniture and fixtures 20,000 –0– 20,000*
Building 50,000 50,000** –0–
Land 110,000 110,000** –0–
Goodwill 158,000 158,000 –0–
$348,000 $318,000 $30,000
*§ 1245 recapture
**§ 1231 gain
George, as the shareholder, is not involved in the purchase/sale transaction. Thus, this
transaction will produce no tax consequences for George. Logically, however, the
corporation would liquidate and distribute the available cash to George. Since Pelican is in
the 34% tax bracket, the corporate tax liability associated with the asset sale would be
$118,320 ($348,000 × 34%). Therefore, when George receives a liquidating distribution of
$789,680 ($908,000 – $118,320), he will recognize a capital gain of $229,680 ($789,680
amount realized – $560,000 adjusted basis for stock).
c. The basis for the stock purchased by Emily and Freda is its cost of $550,000. The
basis of the assets to the corporation would not be affected, since the corporation is not
involved in the purchase/sale transaction.
George would receive a recognized loss of $10,000 from the stock sale and the loss would
be classified as a capital loss.
Basis for stock (560,000)
Recognized loss ($ 10,000)
60. a. Amount realized $260,000

Less: Adjusted basis (160,000)
Realized gain $100,000
Recognized gain $100,000
Even though Linda sold her business, the transaction is treated as the sale of the
individual assets. This is necessary in order to classify the gain as capital or ordinary.
Asset Ordinary Capital and § 1231

Accounts receivable $25,000 $ –0–
Office furniture and fixtures 2,000 –0–
Building 15,000
Land 20,000
Goodwill 38,000
Because the sales price exceeds the fair market value of the listed assets by $38,000
($260,000 – $222,000), the excess is treated as paid for goodwill.
b. Juan has a basis for each of the listed assets of the fair market value, and a basis for
goodwill of $38,000.
c. Under existing rules, both goodwill and a covenant not to compete are amortized and
deducted over a 15-year period. Thus, from Juan’s perspective, the tax consequences
of assigning the $38,000 excess payment to goodwill or to a covenant are the same.
However, the tax consequences to Linda differ. If the gain is from a covenant, it is
classified as ordinary income, whereas if from goodwill, it is classified as a capital
gain. Thus, Juan might negotiate with Linda for a price reduction to provide her with
the tax benefit of capital gain.
Example 21 and Concept Summary 13.1

61. a. The sales are treated as the sales of ownership interests. Thus, each partner calculates
his or her recognized gain as follows:
Gail Harry
Amount realized $307,000 $307,000
– Basis (100,000) (150,000)
Recognized gain $207,000 $157,000
The recognized gain is classified as long-term capital gain under § 741 subject to any
ordinary income recognition under § 751 “hot” assets. Since GH Partnership has no
unrealized receivables or substantially appreciated inventory, all of the gain is
classified as long-term capital gain.
The sale of the partnership interests by Gail and Harry results in the termination of GH
Partnership. Under § 708(b)(1)(B), there is a sale or exchange of at least 50% of the
total interest in partnership capital and profits within a 12-month period.
b. If the assets are appreciated, an individual purchasing an interest in a partnership

normally would prefer to purchase the assets rather than an ownership interest. This
preference occurs because the basis of the assets will be equal to the amount paid for
them (i.e., FMV). With the purchase of a partnership interest, however, a carryover
basis results. This negative result associated with the purchase of a partnership interest
can be offset if the partnership makes the § 754 election. This activates the special
basis provisions under § 743 for the acquiring partner. However, there are a variety of
reasons why the partnership may be unwilling to make this election.
In the case at hand, the usual choices do not apply because the GH Partnership is
terminated. Regardless of the method of purchase, the assets of the new partnership
(i.e., KL Partnership) will have a basis equal to the amount paid by Keith and Liz (i.e.,
FMV).
pp. 13-24 to 13-26 and Concept Summary 13.1

62. Hoffman, Raabe, Smith, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
August 15, 2013

Mr. Maurice Allred
100 Aspen Green
Chattanooga, TN 37403
Dear Mr. Allred:
I am responding to the inquiry regarding whether you should negotiate to purchase the stock
or the assets of Jewel Corporation.
From a tax perspective, you should acquire the assets of Jewel Corporation rather than the
stock. By purchasing the assets, the basis for the assets will be the purchase price of $700,000.
Then contribute the assets to a new corporation under § 351 without any recognition. The
basis of the assets to the corporation will be $700,000. If the stock of Jewel Corporation is
purchased instead, the basis for the stock is the purchase price of $700,000. However, the
corporation’s basis for its assets would remain at $500,000.
A nontax advantage of the asset purchase is the avoidance of legal responsibility for any
liabilities of Jewel Corporation. Although Jewel has no recorded liabilities, there is the
possibility of unrecorded or contingent liabilities.
If I can be of further assistance, please let me know.

Sincerely,
Robert Ames,
CPA Partner
TAX FILE MEMORANDUM
DATE: August 10, 2013
FROM: Robert Ames
SUBJECT: Purchase of Jewel Corporation by Maurice Allred
Maurice Allred is going to purchase either the stock of Jewel Corporation or its assets.
Maurice has agreed with the seller that Jewel has a fair market value of $700,000. Jewel’s
adjusted basis for its assets is $500,000. Maurice has requested our advice on whether he
should negotiate to purchase the stock of Jewel or its assets.
If Maurice purchases the assets of Jewel, his basis for the assets would be the purchase price
of $700,000. He then could contribute the assets to a new corporation without any
recognition under § 351. The corporation’s adjusted basis for the assets would be $700,000.
If Maurice purchases the stock of Jewel, his basis for the stock would be $700,000. However,
since Jewel is not involved in the transaction, the corporation’s basis for its assets would
remain at $500,000.
Thus, from a tax perspective, Maurice should purchase the assets rather than the stock of
Jewel. In addition, the asset purchase will avoid any potential unrecorded or contingent
liability problem.
p. 13-26
Proposed solutions to the Research Problems are found in the Instructor’s Guide. Previously, these
items were a part of the Instructor’s Companion Site for the textbook.

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CHAPTER 13

COMPARATIVE FORMS OF DOING BUSINESS

SOLUTIONS TO PROBLEM MATERIALS

1 LO 1 Legal and tax forms Unchanged 1

26 LO 5 Basis for ownership interest Unchanged 26

1 Stock redemption versus dividend Unchanged 1

35.a. $4 million. 52.b. $0 recognized gain for Agnes and

pp. 13-6, 13-11, and Concept Summary 13.2

• Tan’s taxable income can be reduced through reasonable compensation payments.

• Since the qualification requirements become maintenance requirements, can these

pp. 13-17 and 13-18

p. 13-27 and Concept Summary 13.1

b. C corporation (C). pp. 13-3 and 13-4

c. C corporation (C). pp. 13-6 to 13-8

e. C corporation (C). p. 13-13

15% × $ 50,000 = $ 7,500

15% × $ 50,000 = $ 7,500

15% × $ 50,000 = $ 7,500

34% × $10,000,000 = $ 3,400,000

or 35% × $40,000,000 = $14,000,000

The effective tax rate for each of the corporations is as follows:

15% × $50,000 = $ 7,500

15% × $ 50,000 = $ 7,500

Thus, if Owl is a C corporation, its tax liability is $2,514,000 ($2,125,000 regular

AMT $ 10,000 $ –0–

Tax liability (34% rate) $136,000 $170,000

AMT base $825,000 $475,000

AMT $ 29,000 $ –0–

pp. 13-9 and 13-10

Net rental income $300,000

Additional tax liability ($263,000 × 35%) $ 92,050

Additional tax liability ($200,000 × 34%) $ 68,000

49. a. Grace’s redemption qualifies as substantially disproportionate under $ 302(b)(2).

Amount realized $175,000

Frank’s redemption does not qualify as substantially disproportionate—after the

Amount realized $175,000

• External market for the stock.

p. 13-13 and Example 14

51. a. No gain or loss is recognized on the contribution of property to a partnership.

b. No gain or loss is recognized on the contribution of property to an S corporation if the

c. No gain or loss is recognized on the contribution of property to a C corporation if the

Agnes ($100,000 + $8,000) $108,000

pp. 13-15 and 13-16

53. a. Initial basis under § 351 and § 358 $40,000

b. Initial basis under § 351 and § 358 $ 40,000

c. Initial basis under § 721 and § 722 $ 40,000

54. a. (1) Operations $ 92,000

(2) Operations $ 92,000

Separately stated items:

Beginning balance $900,000

*The corporate tax liability is $42,530 [($50,000 × 15%) + ($25,000 × 25%) +

= Recognized gain $ 95,000

The gain is classified as a capital gain.

b. Indigo’s taxable income is calculated as follows:

57. a. The outside basis of each partner is calculated as follows:

b. The at-risk basis of each partner is calculated as follows:

60. a. Amount realized $260,000

Recognized gain $100,000

Asset Ordinary Capital and § 1231

Example 21 and Concept Summary 13.1

b. If the assets are appreciated, an individual purchasing an interest in a partnership

pp. 13-24 to 13-26 and Concept Summary 13.1

August 15, 2013