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Solutions Manual Pearson’s Federal Taxation 2024 Corporations, Partnerships, Estates & Trusts

Luke E. Richardson Mitchell Franklin

Chapter C:1 Tax Research Note: To do the online research problems for this chapter, textbook users must have access to an Internet-based tax service at their institution. Solutions are provided using CHECKPOINT, when applicable. In some cases, solutions using other tax services may differ.

Discussion Questions C:1-1 In a closed-fact situation, the facts have occurred, and the tax advisor’s task is to analyze them to determine the appropriate tax treatment. In an open-fact situation, by contrast, the facts have not yet occurred, and the tax advisor’s task is to plan for them or shape them so as to produce a favorable tax result. p. C:1-2. C:1-2 According to the AICPA’s Statements on Standards for Tax Services, the tax practitioner owes the client the following duties: (1) to inform the client of (a) the potential adverse consequences of a tax return position, (b) how the client can avoid a penalty through disclosure, (c) errors in a previously filed tax return, and (d) corrective measures to be taken; (2) to inquire of the client (a) when the client must satisfy conditions to take a deduction and (b) when information provided by him or her appears incorrect, incomplete, or inconsistent on its face; and (3) not to disclose tax-related errors without the client’s consent. pp. C:1-31 through C:1-33. C:1-3 When tax advisors speak about “tax law,” they refer to the IRC as elaborated by Treasury Regulations and administrative pronouncements and as interpreted by federal courts. The term also includes the meaning conveyed by committee reports. p. C:1-7. C:1-4 Committee reports concerning tax legislation explain the purpose behind Congress’ proposing the legislation. Transcripts of hearings reproduce the testimonies of the persons who spoke for or against the proposed legislation before the Congressional committees. Committee reports are sometimes used to interpret the statute. p. C:1-7. C:1-5 Committee reports can help resolve ambiguities in statutory language by revealing Congressional intent. They are indicative of this intent. pp. C:1-7 and C:1-8. C:1-6 The Internal Revenue Code of 1986 is updated for every statutory change to Title 26 subsequent to 1986. Therefore, it includes the post-1986 tax law changes enacted by Congress and today reflects the current state of the law. p. C:1-8. C:1-7 No. Title 26 deals with all taxation matters, not just income taxation. It covers estate tax, gift tax, employment tax, alcohol and tobacco tax, and excise tax matters. p. C:1-8. C:1-8 a. Subsection (c). It discusses the tax treatment of property distributions in general (e.g., amount taxable, amount applied against basis, and amount exceeding basis).

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b. Because Sec. 301 applies to the entire chapter, one should look throughout that entire chapter (Chapter 1 of the IRC – which covers Sec. 1 through Sec. 1400U-3) for any exceptions. One special rule – Sec. 301(e) – is found in Sec. 301. This special rule explains the tax treatment of dividends received by a 20% corporate taxpayer. Section 301(f) indicates some of the important special rules found in other IRC sections. c. Legislative. Section 301(e)(4) authorizes the issuance of Treasury Regulations as may be necessary to carry out the purposes of the subsection. pp. C:1-9 through C:1-10. C:1-9 Researchers should note the date on which a Treasury Regulation was adopted because the IRC may have been revised subsequent to that date. That is, the regulation may not interpret the current version of the IRC. Discrepancies between the IRC and the regulation occur when the Treasury Department has not updated the regulation to reflect the statute as amended. p. C:1-9. C:1-10 a. Proposed regulations are not authoritative, but they do provide guidance concerning how the Treasury Department interprets the IRC. Temporary regulations, which are binding on the taxpayer, often are issued after recent revisions to the IRC so that taxpayers and tax advisers will have guidance concerning procedural and/or computational matters. Final regulations, which are issued after the public has had time to comment on proposed regulations, are considered to be somewhat more authoritative than temporary regulations. pp. C:1-9 and C:1-10. b. Interpretative regulations make the IRC’s statutory language easier to understand and apply. They also often provide computational illustrations. In the case of legislative regulations, Congress has delegated the rulemaking on a specific topic (either narrow or broad) to the Treasury Department. However, after the Mayo Foundation case, both types of regulations will have the same authoritative weight. p. C:1-10. C:1-11 Prior to 2011, courts gave more authority to legislative regulations than to interpretive regulations. However, after the Supreme Court decision in Mayo Foundation, courts will hold both interpretive and legislative regulations to the same standard and will overturn them only in very limited cases. p. C:1-10. C:1-12 Under the legislative reenactment doctrine, a Treasury Regulation is deemed to have been endorsed by Congress if the regulation was finalized before a related IRC provision was amended by Congress and in the interim, Congress did not amend the statutory provision to which the regulation relates. p. C:1-10. C:1-13 a. Revenue rulings are not as authoritative as court opinions, Treasury Regulations, or the IRC. They represent interpretations by an interested party, the IRS. p. C:1-12. b. If the IRS audits the taxpayer’s return, the IRS likely will contend that the taxpayer should have followed the ruling and, therefore, owes a deficiency. p. C:1-12. C:1-14 a. The Tax Court, the U.S. Court of Federal Claims, or the U.S. district court for the taxpayer’s jurisdiction. p. C:1-14.

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b. The taxpayer might consider the precedent, if any, existing within each jurisdiction. The taxpayer might prefer to avoid expending cash to pay the proposed deficiency. If so, the taxpayer would want to litigate in the Tax Court. If the taxpayer would like to have a jury trial address questions of fact, he or she should opt for the U.S. district court. pp. C:1-14 through C:1-19, p. C:1-21, and p. C:1-23. c. Appeals from Tax Court and U.S. district court decisions are made to the circuit court of appeals for the taxpayer’s geographical jurisdiction. U.S. Court of Federal Claims decisions are appealable to the Court of Appeals for the Federal Circuit. Appeals from any of the circuit courts of appeals may be brought to the U. S. Supreme Court. pp. C:1-20 through C:1-21. C:1-15 No. A taxpayer may not appeal a case litigated under the Tax Court’s Small Cases Procedure. p. C:1-17. C:1-16 Tax Court regular and memo decisions have about the same precedential value. Decisions issued under the Small Cases Procedure of the Tax Court have little or no precedential value. pp. C:1-15 and C:1-17. C:1-17 Yes. The IRS can acquiesce (or nonacquiesce) in any federal court decision that is adverse to the IRS if the IRS decides to do so. In many cases the IRS does not acquiesce or nonacquiesce. p. C:1-17. C:1-18 In both the AFTR and USTC: decisions of U.S. district courts, U.S. bankruptcy courts, U.S. Court of Federal Claims, circuit courts of appeal, and the U.S. Supreme Court. Tax Court decisions are reported in neither of the two reporters. pp. C:1-16 and C:1-17 through C:1-22. C:1-19 Prior to 2009, revenue rulings appeared in the weekly Internal Revenue Bulletin (I.R.B.), and twice each year the decisions published in the I.R.B. were bound together and published in the Cumulative Bulletin (C.B.). For pre-2009 rulings, the I.R.B citation was temporary and was replaced by a citation to the C.B. After 2008, the IRS no longer publishes the Cumulative Bulletin. Therefore for current rulings, the initial I.R.B. citation is final. p. C:1-12. C:1-20 According to the Golsen Rule, the Tax Court will not follow a decision it made earlier, but rather will follow a decision of the circuit court of appeals to which the case under consideration is appealable. As an example, assume that the Tax Court, in a case involving a First Circuit taxpayer, ruled for the taxpayer. The issue had not been litigated earlier. Then, a U.S. district court in Georgia decided a case involving the same issue in favor of another taxpayer. The Eleventh Circuit, however, reversed the decision. Now a taxpayer from the Eleventh Circuit litigates the same issue in the Tax Court. Under the Golsen Rule, the Tax Court will follow the Eleventh Circuit’s decision favoring the government. The Tax Court need not follow an appeals court decision if a case was litigated by a taxpayer whose appeal would have been made to any circuit other than the Eleventh. p. C:1-21. C:1-21 a. The precedent binding upon a California taxpayer would be the Tax Court case. The Tax Court has national jurisdiction. pp. C:1-21 and C:1-23. b. Under the Golsen Rule, the Tax Court will depart from its earlier decision and follow the Fifth Circuit’s decision favoring the government. p. C:1-21. Copyright © 2024 Pearson Education, Inc.

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C:1-22 a. b. c. d. e.

Congressional Record Internal Revenue Bulletin Tax Court of the United States Reports Federal Register, Internal Revenue Bulletin, and/or Cumulative Bulletin Federal Supplement, American Federal Tax Reports (only tax-related), United States Tax Cases (only tax-related). f. Not found in an “official” publication; published by tax services pp. C:1-7, C:1-12 through C:1-14, and C:1-17 through C:1-19. C:1-23 A tax advisor might find the provisions of a tax treaty useful where a U.S. taxpayer engages in transactions in a foreign country. The United States has tax treaties with over 55 countries. p. C:1-24. C:1-24 Citators (1) trace the history of the case in question and (2) list other authorities that have cited such case. p. C:1-30. C:1-25 Revenue rulings, revenue procedures, and judicial decisions. p. C:1-29. C:1-26 Keyword, index, or citation are the three ways to search in tax service databases. p. C:126. C:1-27 a. • • • • • • • b. • • •

The principal primary sources found in CHECKPOINT are as follows: IRC Treasury Regulations Court opinions Revenue rulings and procedures Letter rulings Committee reports Tax treaties The principal secondary sources found in CHECKPOINT are as follows: Federal Tax Coordinator United States Tax Reporter Warren, Gorham & Lamont journals and treatises

Secondary sources will differ among the tax services. pp. C:1-26 through C:1-29. C:1-28 The features (i.e., icons, templates, and command buttons) will vary depending upon the particular tax service/Internet site accessed. Just about all commercial tax databases can be searched by keyword and citation. Some can be searched by table of contents and topic. Most noncommercial tax databases can be searched by keyword. Some can be searched by citation and table of contents. The advantages of using a commercial tax service (as opposed to a noncommercial service) are broader database scope, greater historical coverage, and more efficient search engines. The principal disadvantage is cost. Copyright © 2024 Pearson Education, Inc.

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Because of their relative disadvantages, the noncommercial sites should not be regarded as a substitute for a commercial tax service. Access is non-uniform. The scope and breadth of their databases are limited. pp. C:1-26 through C:1-28. C:1-29 The CPA should have a good faith belief that his or her position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. p. C:1-31. C:1-30 Under the AICPA’s Statements on Standards for Tax Services (SSTSs), a tax preparer is not obligated (1) to verify client provided information if the information is not suspicious on its face and (2) to update professional advice based on developments following its original conveyance. p. C:1-31. C:1-31 This answer lists six requirements. Under Circular 230, the practitioner is expected to: (1) base the advice on reasonable assumptions, (2) consider relevant facts and circumstances, (3) identify the facts relevant to the advice, (4) be properly skeptical of representations by the taxpayer and others, (5) relate applicable law and authority to the facts, and (6) not base an opinion on the chances that a transaction will be identified by IRS and subject to audit. p. C:1-30. C:1-32 Circular 230 is a government issued document that dictates rules for practicing before the IRS. The Statements on Standards for Tax Services (SSTSs) are ethical standards issued by the AICPA aimed at tax practitioners. Circular 230 applies only to federal tax issues, and the SSTSs apply to both federal and state issues. Circular 230 only applies to income taxes, and the SSTSs apply to all types of taxes. Finally, Circular 230 does not provide the same depth of ethical guidance found in the SSTSs. p. C:1-30.

Problems C:1-33 a. Yes. According to Secs. 71(a) and (b), the wife includes $25,000 per year. Also, the divorce agreement must explicitly state that the husband has no liability to make payments after the wife’s death. See Sec. 71(b)(1)(D) and Temp. Reg. Sec. 1.71-1T(b), Q-11. b. Yes. The husband deducts $25,000 per year according to Secs. 215(a) and (b). According to Sec. 62(a)(10), the alimony is deductible for AGI. c. For alimony agreements after December 31, 2018, Secs. 71 and 215 are repealed. pp. C:1-8 and C:1-26 through C:1-29. C:1-34 a. Legislative. According to Sec. 385(a), “The Secretary is authorized to prescribe such regulations as may be necessary or appropriate. . . .” b. Yes. Section 385(a) states that the regulations will be applicable “for purposes of this title.” “This title” is Title 26 of the federal statutes. Because Title 26 encompasses all tax statutes, the regulations would be relevant for estate tax purposes. pp. C:1-8 through C:1-10 and C:1-26 through C:1-29. C:1-35 a. Both rulings hold that contributions to a fund formed to acquire a portrait of a former judge and donated to a governmental agency are deductible under Sec. 170. pp. C:1-12 and C:1-13. b. Private letter rulings cannot be cited as precedence and apply only to the taxpayer for whom the IRS issued the ruling. pp. C:1-12 and C:1-13. Copyright © 2024 Pearson Education, Inc.

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c. Revenue rulings can be cited as precedence, and they are relied on by both taxpayers and the IRS for guidance in particular factual situations. pp. C:1-12 and C:1-13. C:1-36 Sections 355 and 856. The official IRS publication is the Internal Revenue Bulletin, which eventually is incorporated into the Cumulative Bulletin. pp. C:1-12 and C:1-29. C:1-37 Results might vary as the online service adds or deletes documents, but as of this writing: a. 443. b. 203. c. 87. C:1-38 The following results were obtained using CHECKPOINT. Results using other tax services may vary. a. 14. b. 8 using ‘home office’ without quotations, 4 with quotes around the term. c. The results after refining for “home office” are more relevant primarily because 280A also covers issues related to rental and vacation homes and refining the results omits these references. The search within results output produced revenue rulings related to home office issues, and the first result is to a revenue ruling explaining how the IRS would interpret an important Supreme Court case addressing home office deductions. pp. C:1-26 through C:1-28. C:1-39 a. Acquiescence. See AOD 1986-030, 1986-1 C.B. 1. b. No. The acquiescence was only with respect to whether a transfer to the taxpayer’s spouse is a taxable disposition. pp. C:1-17 and C:1-29. C:1-40 a. Acquiescence. See AOD 2016-02. b. The AOD addressed whether the limitation on home mortgage deductions applied on a per property or per taxpayer business. pp. C:1-17 and C:1-29. C:1-41 a. Nonacquiescence. See AOD 1988-014, 1988-2 C.B.1. b. Yes. In 2003, the Commissioner withdrew the 1988 AOD and acquiesced. See AOD 2003-001, 2003-2 I.R.B. pp. C:1-17 and C:1-29. C:1-42 a. Yes. The case was reviewed by the court. No. It was not a unanimous decision. Judges Korner, Swift, and Gerber did not participate. Judge Simpson dissented. pp. C:1-26 through C:1-29. b. Yes. The decision was entered under Rule 155. p. C:1-17. c. Yes. The case was reviewed by the Sixth Circuit Court of Appeals. pp. C:1-26 through C:1-29. C:1-43 a. Yes. The case was reviewed by the court. The decision was not unanimous. Judge Quealy dissented. Judge Tannenwald issued a concurring opinion with which five judges agreed. Judge Chabot issued a dissenting opinion with which three judges agreed, and Judge Nims issued a dissenting opinion with which three judges agreed. pp. C:1-26 through C:1-29. b. No. The decision was not entered under Rule 155. p. C:1-17. Copyright © 2024 Pearson Education, Inc.

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c. Yes. The case was reviewed by the Sixth Circuit Court of Appeals in 1982. pp. C:126 through C:1-29. C:1-44 a. National Cash Register Co. v. U.S., 400 F.2d 820, 22 AFTR 2d 5562, 68-2 USTC ¶9576 (6th Cir., 1968). b. Thomas M. Dragoun, 1984 RIA T.C. Memo ¶84,094 (T.C. Memo 1984-94), 47 TCM 1176. c. U.S. v. John M. Grabinski, 558 F. Supp. 1324, 52 AFTR 2d 83-5169, 83-2 USTC ¶9460 (DC MN, 1983). d. U.S. v. John M. Grabinski, 727 F.2d 681, 53 AFTR 2d 84-710, 84-1 USTC ¶9201 (8th Cir., 1984). e. Rebekah Harkness v. U.S., 469 F.2d 310, 30 AFTR 2d 72-5754, 72-2 USTC ¶9740 (Ct. Cl., 1972). Note that during this period, Court of Claims decisions were published in the Federal Reporter, Second Series. Alternatively, you could give the citation 199 Ct. Cls. 721, which references the Court of Claims Reporter. In the CHECKPOINT citator the name of the case is simply Harkness. f. Hillsboro National Bank v. CIR, 460 U.S. 370, 51 AFTR 2d 83-874, 83-1 USTC ¶9229 (USSC, 1983). g. Rev. Rul. 78-129, 1978-1 C.B. 67. pp. C:1-17 through C:1-22. C:1-45 a. Rev. Rul. 99-7, 1999-1 C.B. 361. b. Frank H. Sullivan, 1 B.T.A. 93 (1924). c. Tate & Lyle, Inc., 103 T.C. 656 (1994). d. Ralph L. Rogers v. U.S., 539 F. Supp. 104, 49 AFTR 2d 82-1160, 82-1 USTC ¶9246 (DC OH, 1982). e. Norman Rodman v. CIR, 542 F.2d 845, 38 AFTR 2d 76-5840, 76-2 USTC ¶9710 (2nd Cir., 1976). pp. C:1-17 through C:1-22. C:1-46 a. Circuit Court of Appeals for the Ninth Circuit; page 1198 of Volume 648 of the Federal Reporter, Second Series and page 81-5353 of Volume 48 of the American Federal Tax Reports, Second Series. b. U. S. Court of Federal Claims; page 455 of Volume 14 of the Claims Court Reporter and paragraph (not page) 9231 of Volume 1 of the 1988 U. S. Tax Cases. c. Supreme Court; page 13 of Volume 309 of the United States Supreme Court Reports and page 816 of Volume 23 of the American Federal Tax Reports. d. A U.S. District Court in Texas; page 76 of Volume 441 of the Federal Supplement and page 78-335 of Volume 41 of the American Federal Tax Reports, Second Series. e. Not a court decision; page 72 of Volume 1 of the 1983 Cumulative Bulletin. f. Circuit Court of Appeals for Sixth Circuit; page 474 of Volume 568 of the Federal Reporter, Second Series and paragraph (not page) 9199 of Volume 1 of the 1978 U.S. Tax Cases. pp. C:1-16 and C:1-22. C:1-47 a. A facelift as a deductible medical expense is discussed in ¶K-2109 of the Federal Tax Coordinator. Solutions using other tax services will differ. b. Section 213. Copyright © 2024 Pearson Education, Inc.

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c. Generally no. Section 213(d)(9) (effective for tax years beginning after 1990) provides that the cost of cosmetic surgery is not deductible except in certain narrow circumstances. pp. C:1-28 and C:1-29. C:1-48 No. The regulation does not reflect the amendments to Sec. 302 made by P.L. 96-589, P.L. 97-248, P.L. 98-369, and P.L. 111-325. A caution to this effect appears at the beginning of the regulation. pp. C:1-26 through C:1-29. C:1-49 a. Casualty losses from termite damage are discussed in ¶M-1743 (Federal Tax Coordinator) and Ann ¶1655.3020 (U.S. Tax Reporter). b. Authorities include: Rev. Rul. 63-232, 1963-2 C.B. 97; Henry L. Sutherland, 1966 PH T.C. Memo ¶66,155, 25 TCM 822; and Martin A. Rosenberg v. CIR, 42 AFTR 2d 303, 52-2 USTC ¶9377 (8th Cir., 1952). The first two authorities denied a deduction and the third allowed a deduction. Textbook users may find additional authority. pp. C:1-28 and C:1-29. C:1-50 a. More than 35% of the excess of the value of the decedent’s gross estate over the sum of allowable Sec. 2053 and 2054 deductions. b. No. The regulation indicates the test is more than (1) 35% of the gross estate or (2) 50% of the taxable estate. It does not reflect the P.L. 94-455 or P.L. 97-34 amendments to the IRC. A caution to this effect appears before the beginning of the reprint of the regulations. pp. C:1-26 through C:1-29. C:1-51 a. b. c. d. e. p. C:1-25.

645. 572-3rd - Accounting Methods – Adoptions and Changes. 570- 2nd - Accounting Methods – General Principles. 568-4th.. 367. 523-2nd.

C:1-52 “Fireman, Allowed; uniform” is discussed at ¶L-3806. Note: The CHECKPOINT source document does not use the gender neutral phrase “firefighter.” The revenue ruling dealing with this topic is Rev. Rul. 70-474, 1970-2 C.B. 34. pp. C:1-27 and C:1-28. C:1-53 a. b. c.

13. 12 issues are listed in the findings of fact. Yes. The Fourth Circuit reviewed the case. pp. C:1-28 and C:1-29.

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a. 27. No. According to the headnote to the opinion, the decision dealt with one issue,

b. deductions. c. C:1-55 a. b. c.

No. The decision has not been cited unfavorably. pp. C:1-28 and C:1-29. 1972. The deductibility of the cost of a customer list under Sec. 162. The government. The cost was not currently deductible. Copyright © 2024 Pearson Education, Inc.

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d. No. The decision was not reviewed at the trial level. e. Yes. The decision was appealed to the Sixth Circuit Court of Appeals. f. Yes. The CHECKPOINT citator lists nine citations to the Tax Court Memorandum decision and 13 citations to the CA6 decision. pp. C:1-26 through C:1-29. C:1-56 a. To file a tax return electronically, one must (1) purchase the requisite software from a commercial vendor or download it from a designated Internet site; (2) obtain a Personal Identification Number (PIN) from the IRS; (3) either prepare a tax return offline and upload, or prepare the return online; and (4) transmit the return to the IRS. b. The taxpayer can transmit funds electronically in one of three ways: (1) by authorizing an electronic funds withdrawal from a checking or savings account; (2) by authorizing payment by credit card; or (3) by mailing to the IRS a check or money order using a payment voucher. c. Electronic filing (1) allows the taxpayer to file a return from any personal computer; (2) is more accurate than manual filing; (3) offers the safety and security of direct deposit; (4) offers the convenience of filing a tax return early and delaying payment up to the due date, and (5) allows one to file federal and state tax returns simultaneously. p. C:1-28. C:1-57 a. b. c. p. C:1-28.

“Request for Copy of Tax Return.” “Corporation Claim for Deduction for Consent Dividends.” “Excise Tax on Greenmail.”

C:1-58 a. b. c. p. C:1-28.

“Request for Copy of Individual Tax Return.” “Corporation Income and Franchise Tax Return.” “Partnership Income Tax Return.”

C:1-59 The latest data as of this writing was for January 2022. a. 8 (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming). b. 1 (New Hampshire). c. 9.9%. d. North Dakota, 2.9%. p. C:1-28.

Comprehensive Problem C:1-60 STEP ONE: In performing a keyword (intuitive) search in CHECKPOINT, type “depreciate garbage dump” and select the Federal Tax Coordinator Analysis. You will find the annotation ¶L-7922 Air space and pits used as dumps as depreciable property. This source cites John Sexton 42 TC 1094 (1964), where a taxpayer purchased an open-pit mine to be used as a dump. The Tax Court held for the taxpayer and allowed the depreciation. The Tax Court reasoned that “rights in space have been recognized as property subject to transfer separately from the land” and concluded that these rights should be depreciable in the Copyright © 2024 Pearson Education, Inc.

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taxpayer’s business. The Tax Court also held that the difference between the property’s cost and salvage value was a reasonable measure of the amount to be depreciated and that a depreciation method based on the depreciable cost divided by quantity dumped was reasonable. The facts in Sexton are analogous to our client’s case. STEP TWO: Check the status of the case by checking the citator. The reasoning is followed in Kendrick & Barbara Sanders, 75 TC 157 (1980) and distinguished from A, Duda & Sons v. U.S., 40 AFTR 2d 77-5911 (CA, 1977). STEP THREE: Consult the AOD database to see if the IRS issued an Action on Decision for Sexton. In A.O.D. 1969 WL 21099, the IRS acquiesced in the result but disagreed with the Tax Court’s reasoning. The IRS believed the depreciation should be premised on the land’s having a determinable useful life rather than on the concept of air space separate from the land itself. The IRS, however, acquiesced without qualification to the taxpayer’s units-of-production method of calculating depreciation. STEP FOUR: Conclude that Mr. Stench can depreciate the difference between the dump’s site’s cost and salvage value at the end of its useful life ($20,000), and he should elect the units of production method to calculate the annual amount deductible. pp. C:1-26 through C:1-29.

Tax Strategy and Critical Thinking Problem C:1-61 Choose Alternative 2; file the lawsuit in the Tax Court. HPU is likely to lose a lawsuit filed in the U. S. district court (Alternative 1) because that court is bound by district court precedent adverse to the taxpayer. Likewise, HPU is likely to lose a lawsuit filed in the Court of Federal Claims (Alternative 3) because that court is bound by circuit court precedent adverse to the taxpayer. On the other hand, in the Tax Court (Alternative 2) the tax return position taken by HPU has a realistic possibility of being sustained on its merits. In a case involving HPU, the Tax Court would not be bound by the other circuit court’s precedent, which is adverse to the taxpayer because of the Golsen Rule. Rather, the Tax Court would be bound by HPU’s own circuit court precedent, which, based on the specific facts of the problem, is nonexistent because HPU’s circuit court has merely offered dictum, which is not binding. However, if the Tax Court issues a ruling consistent with the circuit court’s second proposition, namely, that by opening the home improvement center, HPU is merely “improving customer access to its existing products,” HPU will win the lawsuit, and its deduction will be sustained. pp. C:1-21 and C:1-23.

Case Study Problem C:1-62 Statements on Standards for Tax Services (SSTS) No. 3 states that a CPA “may in good faith rely, without verification, on information furnished by the taxpayer or by third parties” (Para. 2). Thus, you may accept Mal’s information at face value. His increase in AGI of over $30,000 may explain his increase in charitable contributions of approximately $10,000. In the second scenario the provision from SSTS No. 3 that a CPA “should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to a member” would be pertinent. Recently, the IRS audited Mal’s return, and Mal lacked substantiation for about 75 percent of the charitable contributions he had Copyright © 2024 Pearson Education, Inc.

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claimed. (He may have made the contributions, but he could not prove that he did.) Further, the round amount ($25,000) reported by Mal suggests that Mal may be estimating what he contributed. You probably should request to see substantiation (canceled checks, etc.) for the contribution(s) claimed. For charitable contributions of $250 or greater, no deduction is allowed unless the donee organization substantiates the contribution with a contemporaneous, written acknowledgement. Mal needs to be made aware of this rule for his current year’s return. All cash contributions, regardless of amount, must be documented with a bank record or written communication from the charity. The communication must include the name of the charity, date, and amount. p. C:1-32.

Tax Research Problems C:1-63 a. The primary issue is whether the amounts Thomas A. Curtis, M.D. Inc. paid to Ellen Curtis as compensation during fiscal years 1988 and 1989 were reasonable. b. Neither party was totally victorious. In fiscal year 1988, Ellen Curtis was paid $410,500. The amount held to be reasonable compensation by the Tax Court for 1988 was $227,000. In fiscal year 1989, Ellen Curtis was paid $510,500. The amount held to be reasonable compensation by the Tax Court for 1989 was $239,000. The amount held to be compensation, however, is more than the $100,000 and $105,000 the IRS asserted was reasonable compensation. c. The plaintiff is the corporation because it is the party that claimed a deduction for the compensation. The IRS is attempting to disallow the corporation’s deduction for part of the compensation paid. The disallowance of the deduction will have little effect on the two individuals since the amounts received will be either salary or dividends depending on the outcome of the case. d. Ellen Barnert married Dr. Thomas Curtis in 1984. e. Ms. Curtis worked approximately 60 to 70 hours supervising all departments set up within the corporation and the independent contractors, including scheduling and staffing of all the corporation’s offices. Ms. Curtis was a registered nurse. She had a bachelor’s degree in science and took worker’s compensation courses at the University of Southern California Law School. She had worked as a nurse for a number of years and managed an ambulatory hospital system. f. In fiscal year 1989, Ellen Curtis was paid $510,500. The Tax Court held $239,000 to be reasonable compensation in 1989. g. The corporation paid no dividends in either fiscal year. h. The case is appealable to the Ninth Circuit. i. The five factors mentioned in determining reasonable compensation according to Elliott’s are: (1) the employee’s role in the company, (2) external comparison of the employee’s salary with those paid by similar companies for similar services, (3) character and condition of the company, (4) conflict of interest in the employee’s relationship to the corporation, and (5) the internal consistency in the company’s treatment of payments to employees. C:1-64 Judicial authority exists to exclude the Medicare payments from the amount the mother is treated as having provided for her own support. The IRS agrees with this authority; therefore, if the IRS audits the client’s return, the IRS will not argue that Josh’s mother provided the majority of her own support. (This information should be included in the client letter.) The work papers should include a discussion of the authorities summarized below. Section 152(a) provides that one of the tests for claiming another as a dependent is to provide over onehalf of such person’s support. (Note: Josh’s mother’s gross income of $2,000 is not too high in Copyright © 2024 Pearson Education, Inc.

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the current year for her to be claimed his dependent assuming all other requirements are met.) If he provides over one-half of her support, he also may deduct any medical expenses he pays on her behalf. Section 152 does not define “support.” Regulation Sec. 1.152-1(a)(2) states that support includes “food, shelter, clothing, medical and dental care, education, and the like.” It also provides that in determining the amount an individual contributes to his own support, one must count the cost of support items paid for from “income, which is ordinarily excludable from gross income, such as benefits received under the Social Security Act.” In Alfred H. Turecamo v. CIR, 39 AFTR 2d 77-1487, 77-1 USTC ¶9415 (2nd Cir., 1977), the court held that hospital costs paid by Basic Medicare do not constitute support the ill person furnishes for himself or herself. After studying the legislative history of the Medicare statute, the court could find no valid basis “for distinguishing between hospital benefits received under Part A of Medicare [Basic Medicare] and either private insurance proceeds or supplemental benefits received under Part B [of Medicare].” In Rev. Rul. 70-341, 1970-2 C.B. 31, the IRS ruled that Basic Medicare payments on a person’s behalf must be treated as contributions by such person toward his own support. Such treatment was in contrast to that of Supplemental Medicare, which the IRS viewed as in the nature of insurance proceeds, and not self-support. Revenue Ruling 64-223, 1964-2 C.B. 50, held that amounts paid by an insurance company for medical costs are disregarded in the support test. In Rev. Rul. 79-173, 1979-1 C.B. 86, however, the IRS revoked Rev. Rul. 70-341. Thus, the IRS currently treats Basic Medicare payments consistently with Supplemental Medicare and ignores amounts received from either source for purposes of the support test. In Archer v. Comm. 73 T.C. 963 (1980), the court held that both Medicare and Medicaid are disregarded in the support test. C:1-65 In determining whether the property is used “too much” for personal purposes so that Sec. 280A applies, use of the residence by Amy or by family members constitutes personal use, as does use by persons who pay less than fair rental value (Sec. 280A(d)(2)). Use by Amy when performing repairs and maintenance full-time is totally disregarded (Sec. 280A(d)(2)). For purposes of allocating the expenses attributable to rental use, however, all the days on which the property is rented for fair rental value are considered, even if the property is rented to family members on some of these days (Prop. Reg. Sec. 1.280A-3(c)). The total number of days rented at fair rental value – the numerator of the fraction used in the allocation – is determined as follows: Days rented to sister Days rented to cousin Days rented to three families Total

8 4 120 132

The denominator for allocating interest and taxes is in dispute. Per Prop. Reg. Sec. 1.280 A-3(d)(3), the denominator is the total number of days of actual use (exclusive of use by the owner for performing repairs). Thus, the denominator would be 146 (12 + 8 + 4 + 2 + 120). Case law supports using as the denominator the number of days in the year, or 365 days in this case for allocating interest and taxes. Dorrance D. Bolton v. CIR 51 AFTR 2d 83-305, 82-2 USTC ¶9,699, Copyright © 2024 Pearson Education, Inc.

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(9th Cir., 1982), affirming 77 T.C. 104 (1981), and Edith G. McKinney v. CIR 52 AFTR 2d 83-6281, 83-2 USTC ¶9,665 (10th Cir., 1983). For allocating repairs, insurance, and depreciation, this ratio is the number of days rented at fair rental value divided by the total number of days of actual use, or 132/148. However, there is a conflict between Sec. 280A(e) and Prop. Reg. §1.280A-3(d)(3). The proposed regulation excludes repair days from the denominator, but the IRC is silent. Excluding the repair days results in a denominator of 146. C:1-66 a. The principal issue in both cases was whether the corporation could deduct amounts paid as compensation to the spouse (ex-spouse) of a sole shareholder. This issue, in turn, depended on whether such compensation was “reasonable” under the circumstances. b. The Tax Court considered a number of factors, including (1) the employee’s qualifications and training, (2) the nature, extent, and scope of her duties, (3) responsibilities and hours involved, (4) the size and complexity of the business, (5) the results of the employee’s efforts, (6) the prevailing rates for comparable employees in comparable businesses, (7) the scarcity of other qualified employees, (8) the ratio of compensation to the gross and net income of the business, (9) the salary policy of the employer to other employees, and (10) the amount of compensation paid to the employee in prior years. c. The facts of these cases are similar in the following respect: in both cases, the taxpayers were corporations that claimed a deduction for payments made to the spouse or ex-spouse of a sole shareholder. The facts are different in these respects: (1) In Summit the IRS contended that only a portion of the salary payments were nondeductible; in J.B.S., it argued that none of the salary payments were deductible. (2) In Summit, the spouse performed extensive services for the firm; in J.B.S., the ex-spouse appears to have performed no services. (3) In Summit, the court took into consideration the corporation’s rising profits; in J.B.S., the court did not. (In fact, the latter opinion does not mention the firm’s profits or loss position). (4) In Summit, the payments did not appear to be motivated by tax avoidance. (Because the corporation paid substantial dividends to its sole shareholder, the payments to the spouse did not appear to be “disguised dividends”). In J.B.S., the payments did appear to be motivated by tax avoidance. (Testimony indicated that some tax positions had been taken to minimize the corporation’s tax liability.) C:1-67 The memorandum should supply the following answers: a. Revenue Proc. 2023-1, 2023-1 I.R.B. 1 and Rev. Proc. 2023-4, 2023-1 I.R.B. 162 govern requests for determination letters. b. Form 5300, “Application for Determination for Employee Benefit Plan,” must be filed with the request. c. The following information must be provided in the request: 1 Complete statement of facts and other information 2. Copies of all contracts, wills, deeds, agreements, instruments, other documents pertinent to the transaction, and foreign laws 3. Analysis of material facts 4. Statement regarding whether same issue is in an earlier return and additional information required for §301.9100 requests 5. Statement regarding whether same or similar issue was previously ruled on or whether a request involving it was submitted or is currently pending Copyright © 2024 Pearson Education, Inc.

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Statement regarding interpretation of a substantive provision of an income or estate tax treaty 7. Statement regarding involvement of a transactional party located in a foreign country 8. Letter from Bureau of Indian Affairs relating to a letter ruling request for recognition of Indian tribal government status or status as a political subdivision of an Indian tribal government. 9. Statement of supporting authorities 10. Statement of contrary authorities 11. Statement identifying pending legislation 12. Statement identifying information to be deleted from the public inspection copy of letter ruling or determination letter 13. Signature by taxpayer or authorized representative 14. Authorized representatives 15. Power of attorney and declaration of representative 16. Penalties of perjury statement 17. Number of copies of request to be submitted 18. Sample format for a letter ruling request 19. Checklist for letter ruling requests d. Actions that must accompany the filing include payment of appropriate user fee and notification of interested parties.

“What Would You Do In This Situation?” Solution Ch. C:1, p. C:1-34. In this context, you have two professional duties: first, a duty of confidentiality to each client, and second, a duty to verify information that appears to be incorrect on its face. According to Statement No. 3 of the Statements on Standards for Tax Services, a CPA who is required to sign a tax return should consider information actually known to the CPA from the tax return of another client if (1) that information is relevant to the former return, (2) its consideration is necessary to properly prepare that return, and (3) the use of such information does not violate any rule of confidentiality. Here, (1) the information relating to each return is relevant to the other; (2) its consideration is necessary to properly prepare the other return; and (3) the use of such information does not violate any rule of confidentiality, so long as the information is not disclosed to the other client. Your considering the tax return information should lead you to believe that it is incorrect on its face; therefore, you have a duty to verify it. Accordingly, without revealing the basis for your belief, you should request from each client documentary evidence of its respective claim. Such evidence should consist of a paid invoice, a canceled check, a signed or certified receipt, a bill of lading, or any other document that indicates the essential terms of the contract of sale.

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Chapter C:2 Corporate Formations and Capital Structure Discussion Questions C:2-1 Various. A new business can be conducted as a sole proprietorship, partnership, C corporation, S corporation, LLC, or LLP. Each form has tax and nontax advantages and disadvantages. See pages C:2-2 through C:2-8 for a listing of the tax advantages and disadvantages of each form. A comparison of the C corporation, S corporation, and partnership alternative business forms appears in Appendix F. pp. C:2-2 through C:2-8. C:2-2 Alice and Bill should consider forming a corporation and making an S corporation election. An S corporation election will permit the losses incurred during the first few years to be passed through to Alice and Bill and be used to offset income from other sources. The corporate form affords them limited liability. As an alternative to incorporating, Alice and Bill might consider setting up a limited liability company that is taxed as a partnership and also has limited liability. pp. C:2-6 through C:2-8. C:2-3 Yes, several alternative classifications. The only default tax classification for the LLC is a partnership. Because the LLC has two owners, it cannot be taxed as a sole proprietorship. The entity can elect to be taxed as a C corporation or an S corporation. If the entity makes such an election, Sec. 351 applies to the deemed corporate formation. The entity would have to make a separate election to be treated as an S corporation. pp. C:2-8 and C:2-9. C:2-4 The default tax classification for White Corporation is a C corporation. However, White can be treated as an S corporation if it makes the necessary election. Following an S corporation election, the entity’s income will be taxed to its owners, thereby avoiding double taxation. The S corporation election is made by filing Form 2553 within the first 2½ months of the corporation’s existence (see Chapter C:11). pp. C:2-6 and C:2-7. C:2-5 The only default tax classification for the LLC is a sole proprietorship. Because the LLC has only a single owner, it cannot be treated as a partnership. Thus, the default classification is a “disregarded entity” taxed as a sole proprietorship. The entity can elect to be taxed as a C corporation or an S corporation. If the entity makes such an election, Sec. 351 applies to the deemed corporate formation. pp. C:2-8 and C:2-9. C:2-6 Possible arguments include: PRO (Corporate formations should be taxable events): 1. A corporate formation is an exchange transaction; therefore, parties to the exchange should recognize gains and losses. 2. Making a corporate formation a taxable event increases tax revenues. 3. Simplification is achieved by eliminating one of the two options - whether a transaction is taxable or not. This change will make administration of the tax laws easier. Copyright © 2024 Pearson Education, Inc.

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This change eliminates the need for taxpayers to structure transactions to avoid Sec. 351 to recognize gains and/or losses.

CON (No change should occur to current law): 1. A change in current law would hurt start-up corporations by reducing their capital through the income tax paid by transferors on an asset transfer. 2. No economic gains or losses are realized. Just a change in the form of ownership (direct vs. indirect) has occurred. Therefore, it is not appropriate to recognize gains and losses at this time. 3. With taxation, corporations will have to raise more capital because transferors of noncash property will have less capital to invest and because money must be diverted to pay taxes. 4. Taxpayers are prevented from recognizing losses under the current system, thereby increasing revenues to the government. 5. With taxation, businesses would be deterred from incorporating because of the tax consequences, and therefore economic growth in the U.S. would be adversely affected. pp. C:2-9 and C:2-10. C:2-7 The following tax consequences, if Sec. 351 applies: Neither the transferor nor the transferee corporation recognizes gain or loss when property is exchanged for stock. Unless boot property (i.e., property other than qualified stock) is received, the transferor’s realized gain or loss is deferred until he or she sells or exchanges the stock received. If boot property is received, the recognized gain is the lesser of (1) the amount of money plus the FMV of the non-money boot property received or (2) the realized gain. The transferor recognizes no losses even if boot property is received. The transferor’s basis in the stock received references his or her basis in the property transferred and is increased by any gain recognized and is reduced by the amount of money plus the FMV of the nonmoney boot property received and the amount of any liabilities assumed by the transferee corporation. The basis of the boot property is its FMV. The transferee corporation recognizes no gain on the transfer. The transferee corporation’s basis in the property received is the same basis that the transferor had in the property transferred increased by any gain recognized by the transferor. pp. C:2-16 through C:2-21. C:2-8 For purposes of Sec. 351, the following items are considered to be property: Money and almost any other kind of tangible or intangible property, including installment obligations, accounts receivable, inventory, equipment, patents, trademarks, trade names, and computer software. Property does not include services, an indebtedness of the transferee corporation that is not evidenced by a security, or interest on an indebtedness that accrued on or after the beginning of the transferor’s holding period for the debt. pp. C:2-12 and C:2-13. C:2-9 “Control” is defined as follows: Transferors as a group must own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock. The nonvoting stock ownership is tested on a class-by-class basis. pp. C:2-13 through C:2-16. C:2-10 The IRS has interpreted the phrase as follows: Sec. 351 requires the transferors to control the transferee corporation immediately after the exchange but does not specify how long this control must be maintained. The transferors, however, must not have a prearranged plan to dispose of their Copyright © 2024 Pearson Education, Inc.

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stock outside the control group. If they have such a plan, the IRS may not treat the transferors as in control immediately after the exchange. p. C:2-16. C:2-11 No. The Sec. 351 requirements are not met because Peter is not considered a transferor of property. Even though he transferred $1,000 of money, this property is of nominal value--less than 10% of the value of the stock he received for services ($49,000). Therefore, only John and Mary are deemed to have transferred property and, since they own only 66-2/3% of the stock of New Corporation, they are not in control. The 10% minimum is specified in Rev. Proc. 77-37 and applies only for advance ruling purposes. The shareholders may choose to engage in the transaction without an advance ruling, report it as nontaxable, and run the risk of being audited, with the result that the IRS treats the transaction as taxable. Alternatively, they might restructure the transaction by having Peter provide a larger amount of cash to the corporation and take more shares of stock. Another option would be for Peter to provide fewer services with the increased amount of cash and still receive 100 shares of stock. p. C:2-14. C:2-12 No. Section 351 does not require that the shareholders receive stock equal in value to the property transferred. Section 351 would apply to the transfer by Susan and Fred if all other requirements are met. However, Fred probably will be deemed to have made a gift of 25 shares of stock, paid compensation of $25,000, or repaid a $25,000 debt to Susan by transferring the Spade stock. p. C:2-15. C:2-13 Yes. Section 351 applies to property transfers to an existing corporation. For the exchange to be tax-free, the transferors must be in control of the corporation immediately after the exchange. In this example, Carl is not in control since he owns only 75 out of 125 shares, or 60% of the North stock. Therefore, the Sec. 351 requirements are not met. To qualify under Sec. 351, Carl can transfer enough property to acquire a total of 200 shares out of 250 (200 shares held by Carl and 50 shares held by Lynn) outstanding shares. In this situation, Carl would own exactly 80% of North stock (250 shares x 0.80 = 200 shares). A less expensive alternative would be for Lynn to transfer property equal to or exceeding $10,000 (50 shares owned x $2,000 per share x 10% minimum) to be considered a transferor. pp. C:2-14 and C:2-15. C:2-14 The transferor’s basis in stock received in a Sec. 351 exchange is determined as follows (Sec. 358(a)): Adjusted basis of property transferred to the corporation Plus: Any gain recognized by the transferor Minus: FMV of boot (other than money) received from the corporation Money received from the corporation The amount of any liabilities assumed by the transferee corporation Adjusted basis of stock received For purposes of calculating stock basis, liabilities assumed by the transferee corporation are considered money and reduce the shareholder’s basis in any stock received (Sec. 358(d)). Copyright © 2024 Pearson Education, Inc.

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The shareholder’s holding period for the stock includes the holding period of any capital assets or Sec. 1231 assets transferred. If the shareholder transfers any other property (e.g., inventory), the holding period for any stock received begins on the day after the exchange date. This rule can cause some shares of transferee corporation stock to have two different holding periods. The shareholder’s basis for any boot property is its FMV, and the holding period begins on the day after the exchange date (Sec. 358(a)(2)). pp. C:2-18 and C:2-19. C:2-15 Two sets of circumstances may require recognition of gain when liabilities are transferred. • First, all liabilities assumed by a controlled corporation are considered boot if the principal purpose of the transfer of any portion of such liabilities is tax avoidance or if no bona fide business purpose exists for the transfer (Sec. 357(b)). • Second, if the total amount of liabilities transferred to a controlled corporation exceeds the total adjusted basis of all property transferred by the transferor, the excess liability amount is treated as a gain taxable to the transferor without regard to whether the transferor had actually realized gain or loss (Sec. 357(c)). Under the second set of circumstances, the transferor recognizes gain, but the excess liabilities are not considered to be boot. Section 357(c)(3) provides special rules for cash basis transferors who transfer excess liabilities to a corporation. pp. C:2-22 through C:2-25. C:2-16 The IRS likely would consider the following two factors: (1) The transferor’s reason for incurring the liability (e.g., did the liability relate to the transferor’s trade or business). (2) The length of time from when the liability was incurred to the transfer date. If the transferor incurred the liability in connection with his or her trade or business, a Sec. 357(b) “problem” probably would not exist even if the transferor incurred the liability shortly before the transfer date. p. C:2-23. C:2-17 If Mark receives no boot, depreciation is not recaptured (Secs. 1245(b)(3) and 1250(d)(3)). The recapture potential is transferred to Utah Corporation along with the property. If Mark does receive boot and must recognize gain, the recognized gain is treated as ordinary income but not in an amount exceeding the recapture potential. Any remaining recapture potential is transferred to Utah. If Utah sells the property at a gain, it must recapture depreciation deducted by Mark and not recaptured at the time of the transfer, as well as depreciation that it has claimed. Depreciation in the year of transfer must be allocated between the transferor and transferee according to the number of months each party has held the property. The transferee is considered to have held the property for the entire month in which the property was transferred. pp. C:2-25 through C:2-27. C:2-18 The assignment of income doctrine could apply to a transfer of unearned income. However, the assignment of income doctrine does not apply to a transfer of accounts receivable by a cash method transferor in a Sec. 351 exchange if (1) the transferor transfers substantially all the assets and liabilities of a business and (2) a business purpose exists for the transfer. (See Rev. Rul. 80-198, 1980-2 C.B. 113.) p. C:2-27.

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C:2-19 In enacting Sec. 385, Congress mandated that the following factors be taken into account in determining whether an amount advanced to a corporation should be characterized as debt or equity capital: • Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest, • Whether the debt is subordinate to or preferred over other indebtedness of the corporation, • The ratio of debt to equity of the corporation, • Whether the debt is convertible into the stock of the corporation, and • The relationship between holdings of stock in the corporation and holdings of the interest in question. Although Congress enacted Sec. 385 in an attempt to provide statutory guidelines for the debt/equity question, the lack of interpretative regulations (other than those addressing narrow, specific areas) has required taxpayers, the IRS, and the courts to continue to use these statutory factors and other factors identified by the courts in ascertaining whether an instrument is debt or equity. For example, see O.H. Kruse Grain & Milling v. CIR, 5 AFTR 2d 1544, 60-2 USTC ¶9490 (9th Cir., 1960) cited in footnote 47 of the text, which lists additional factors the courts might consider. In addition, the Treasury Department indicated in Notice 94-47, 1994-1 C.B. 357, that it will carefully scrutinize instruments that combine tax treatment for debt with significant equity characteristics. Eight factors were listed that may be considered. pp. C:2-27 and C:2-28. C:2-20 Advantages of using debt include: Interest is deductible (subject to limitations) by the payor while a dividend payment is not deductible, and the repayment of an indebtedness generally is treated as a return of capital while a stock redemption often is treated as a dividend. Disadvantages of using debt include that dividend payments are eligible for a dividends-received deduction when received by a corporate shareholder; stock can be received tax-free as part of a corporate formation and/or reorganization while the receipt of debt usually is treated as boot; a distribution of stock to shareholders can be a nontaxable stock dividend while a distribution of a debt usually results in dividend income; and worthless stock results in an ordinary loss under Sec. 1244 while a worthless debt instrument generally results in a capital loss. pp. C:2-29 and C:2-30. C:2-21 Ordinary loss treatment. The principal advantage of satisfying the Sec. 1244 small business stock requirements is the ordinary loss treatment available for individual shareholders and certain partnerships reporting up to $50,000 (or $100,000 if married and filing jointly) of losses incurred on a sale or exchange of the stock. Ordinary loss treatment is available only if the loss is incurred by a qualifying shareholder who acquired the stock from the small business corporation; the corporation was a small business corporation at the time it issued the stock (i.e., a corporation whose aggregate money and other property received for stock is less than $1 million); the corporation issued the stock for money or property (other than stock or securities); and the issuing corporation derived more than 50% of its aggregate gross receipts from active sources during the most recent five tax years ending before the date when the stock was sold or exchanged. pp. C:2-32 and C:2-33.

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C:2-22 The two advantages of business bad debt treatment are (1) a business bad debt deduction can be claimed for partial worthlessness and (2) a business bad debt can be deducted as an ordinary loss. A nonbusiness bad debt can be deducted only in the year in which total worthlessness occurs. No partial write-offs of nonbusiness bad debts are permitted. A nonbusiness bad debt can be deducted only as a short-term capital loss. These losses can offset capital gains or be deducted by individuals up to $3,000 in a tax year. No limit exists on business bad debt deductions and, if such losses exceed income, they can be carried over as part of a net operating loss. To claim a business bad debt deduction, the holder must show that the dominant motivation for the loan was related to the taxpayer’s business and was not related to the taxpayer’s investment activities. pp. C:2-33 and C:2-34. C:2-23 To recognize gain or loss. Shareholders might avoid Sec. 351 treatment if, in transferring property, they realize a gain or loss that they want to recognize. They may be able to avoid Sec. 351 treatment by violating one or more of its requirements, for example, by selling the property to the corporation for cash, by selling the property to a third party who contributes it to the corporation, or by receiving sufficient boot to recognize the gain. pp. C:2-34 through C:2-36. C:2-24 The reporting requirements are as follows: Every person who receives stock, securities, or other property in a Sec. 351 exchange must attach a statement to his or her tax return for the period that includes the date of the exchange. The statement must include all the facts pertinent to the exchange (see Reg. Sec. 1.351-3(a)). Similarly, the transferee corporation must attach a statement to its tax return for the year in which the exchange took place (see Reg. Sec. 1.351-3(b)). The transferee’s statement requires a description of the property and liabilities received from the transferors and the stock and property transferred to the transferors in exchange for the property. p. C:2-36.

Issue Identification Questions C:2-25 Mary and Peter should consider the following tax issues: • Does the property transfer meet the Sec. 351 requirements? • Have Peter and Mary transferred property? Does Peter’s controlling Trenton Corporation prior to the transfer change the tax result? • Are the transferors in control of the corporation immediately after the transfer? • Do the transferors receive transferee corporation stock? • What is each shareholder’s recognized gain? • What is each shareholder’s basis in his or her stock? • What is each shareholder’s holding period for his or her stock? • Does Trenton recognize gain when it issues its stock? • What is Trenton’s basis in the property received from Mary? • What is Trenton’s holding period for the property received from Mary? The property transfer meets all the Sec. 351 requirements. Peter and Mary are considered to own all 195 of the Trenton shares immediately after the exchange. Peter’s contribution of cash for stock is not considered to be a nominal amount according to IRS rules relating to the issuance of private letter rulings (i.e., it equals or exceeds 10% of the value of Peter’s prior stock holdings). Thus, his stock is counted towards the 80% minimum stock ownership for control. Mary recognizes no gain on the asset transfer and takes a $50,000 basis in the Trenton shares she receives. The Copyright © 2024 Pearson Education, Inc.

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holding period for the Trenton shares includes her holding period for the property transferred. Trenton recognizes no gain when it issues its stock and takes a $50,000 basis in the property. pp. C:2-16 through C:2-21. C:2-26 Carl and his son should consider the following tax issues: • Does the property transfer meet the Sec. 351 requirements? • Have Carl and his son transferred property? • Are the transferors in control of the corporation immediately after the transfer? • Do the transferors receive transferee corporation stock? • Does the property contribution/receipt of stock as described in the facts reflect the true nature of the transaction? Or, has a deemed gift or other event occurred? • What is each shareholder’s recognized gain? • What is each shareholder’s basis in his stock? • What is each shareholder’s holding period in his stock? • If a deemed gift has been made, is it a taxable gift from Carl to his son? (This question could be rewritten for events other than a gift (e.g., repayment of a loan.)) • What is Cook Corporation’s basis in the property received from Carl? • What is Cook’s holding period for the property received from Carl? The contribution is nontaxable because it meets all the Sec. 351 requirements, and Carl and Carl, Jr. own all the Cook stock. Carl, Jr. receives a disproportionate amount of stock relative to his $20,000 capital contribution. It appears that the transaction should be recast so that Carl is deemed to receive 80 shares of stock, each valued at $1,000. He then gifts 30 shares to Carl, Jr. The deemed gift leaves each shareholder with 50 shares of stock. Neither shareholder recognizes any gain, and Carl takes a $50,000 adjusted basis in the 80 shares he receives. He recognizes no gain on the transfer of 30 shares to Carl, Jr., and $18,750 [(30/80) x $50,000] of his basis accompanies the deemed gifted shares. Carl’s basis in his remaining 50 shares is $31,250 ($50,000 - $18,750). Carl, Jr’s basis in his 50 shares is $38,750 ($20,000 + $18,750). pp. C:2-9 through C:2-21. C:2-27 Bill should consider the following tax issues: • Was the stock sold to a related party (Sam), as defined by Sec. 267(b)? If so, Bill cannot recognize the loss, and the remaining issues need not be examined. If not, then… • Is the stock a capital asset? • Is Bold a qualifying small business corporation? • If so, does the stock qualify for Sec. 1244 stock treatment? • If Sec. 1244 stock, what is Bill’s marital and filing status? • Has Bill’s basis in the stock changed relative to its initial acquisition cost? • What is the amount and character of Bill’s recognized loss? Bill’s stock sale results in the realization of a $65,000 ($100,000 - $35,000) long-term capital loss. If the purchaser is a related party, Sec. 267(a) precludes Bill from recognizing the loss. Because Bill is the original holder of the stock, the loss may be characterized as ordinary under Sec. 1244, assuming the various requirements of that provision are satisfied. pp. C:2-32 and C:2-33.

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Problems C:2-28 With the given facts (and ignoring employment and self-employment taxes), the sole proprietorship and the S corporation with distributions result in the lowest total tax, as determined in the following analysis:

Entity Level: Income before salary Salary deduction Taxable income Entity level tax Lucia: Pass-through income QBI deduction Salary income Dividend income Total income to Lucia Lucia’s tax Total Tax

Sole Proprietorship

C Corporation with Salary

C Corporation with Dividend

S Corporation with Salary

S Corporation with Distribution

$50,000 -0$50,000 $ -0-

$50,000 (20,000) $30,000 $ 6,300

$50,000 -0$50,000 $10,500

$50,000 (20,000) $30,000 $ -0-

$50,000 -0$50,000 $ -0-

$50,000 (10,000) -0-0$40,000 $ 8,800a

20,000 -0$20,000 $ 4,400b

-020,000 $20,000 $ 3,000c

$30,000 (6,000) 20,000 -0$44,000 $ 9,680d

$50,000 (10,000) -0-0$40,000 $ 8,800e

$ 8,800

$10,700

$13,500

$ 9,680

$ 8,800

-0-

$40,000 x 0.22 = $8,800 $20,000 x 0.22 = $4,400 c $20,000 x 0.15 = $3,000 d $44,000 x 0.22 = $9,680 e $40,000 x 0.22 = $8,800 b

The sole proprietorship and S corporation with distributions organizational forms allow for the qualified business income (QBI) deduction. Also, the corporate tax rate (21%) is close to the individual’s tax rate (22%), so the C corporation form along with the double taxation of distributed income in the form of a dividend causes that form to be disadvantageous. The C corporation with salary, while reducing double taxation, does not provide a QBI deduction or a reduced tax rate on salary, so this option also has disadvantages. The S corporation with salary has the disadvantage of reducing the amount of income subject to the QBI deduction. Given different facts, such as a higher individual tax rate, the outcomes of this analysis could change. pp. C:2-2 through C:2-8.

C:2-8

C:2-29 a. None. Dick does not recognize his $10,000 realized loss. b. $60,000 basis in Triton shares received. Dick’s holding period is deemed to begin three years ago when Dick originally purchased the land. c. None. Evan does not recognize his $15,000 realized loss. d. $45,000 basis in Triton shares received. Evan’s holding period is deemed to begin four years ago when Evan originally purchased the machinery. e. Fran recognizes $20,000 of ordinary income. f. $20,000 basis in Triton shares received. Fran’s holding period begins the day after the exchange date in the current year. g. Triton takes a $50,000 basis in the land and a $30,000 basis in the machinery. Because of the loss property limitation rule, the bases of these assets are reduced to their respective FMVs, assuming the parties do not elect to reduce stock basis. Thus, both assets have a holding period that begins the day after the transfer in the current year. The services, if capitalized, would have a $20,000 basis and a holding period starting in the current year. pp. C:2-16 through C:2-22. C:2-30 a. $20,000 gain. The Sec. 351 requirements have not been met because 30% of the stock is issued for services. Therefore, Ed recognizes $20,000 ($35,000 - $15,000) of capital gain. b. $35,000 basis in Jet shares received. Ed’s holding period begins on the day after the exchange date. c. Fran recognizes a $10,000 ($35,000 - $45,000) Sec. 1231 loss. d. $35,000 basis in Jet shares received. Fran’s holding period begins on the day after the exchange date. e. George recognizes $30,000 of ordinary income. f. $30,000 basis in Jet shares received. George’s holding period begins the day after the exchange date. g. Jet Corporation takes a $35,000 basis in the land and a $35,000 basis in the machinery. Its holding period for each asset begins the day after the exchange date. The services, if capitalized, would have a $30,000 basis. h. Because the Sec. 351 requirements would now have been met, the answers change as follows: a. Ed recognizes no gain or loss. b. $15,000 basis in the Jet shares received. Ed’s holding period is deemed to begin four years ago when he originally purchased the land. c. Fran recognizes no loss. d. $45,000 basis in the Jet shares received. Fran’s holding period is deemed to begin four years ago when she originally purchased the machinery. e. George recognizes $25,000 of ordinary income. f. $30,000 ($5,000 cash + $25,000 FMV of services) basis in the Jet shares received. George’s holding period begins the day after the exchange date. g. Jet’s basis in the land and machinery are $15,000 and $35,000, respectively. The loss property limitation rule limits the corporation’s basis in the machinery to its FMV. Jet’s holding period for the land is deemed to begin four years ago when Dick originally purchased the land. The holding period for the machinery also begins four years ago when Fran purchases it (Reg. Sec. 1.362-4(c)(3)(i)). The services, if capitalized, would have a $25,000 basis. pp. C:2-16 through C:2-22. Copyright © 2024 Pearson Education, Inc.

C:2-9

C:2-31 a. The control requirement is not met. Transferors of property receive only 75% and thus do not have 80% control. b. The control requirement is met. Robert transferred more than a nominal amount of property. The 80% control requirement has been met since all of Robert’s stock is counted for this purpose. c. The control requirement is not met. Sam owns only 33-1/3% of the Vast stock immediately after the exchange. No stock ownership is attributed from Sam’s parents to Sam. d. The control requirement is met. Charles and Ruth own 100% of the Tiny stock. The transfers do not have to be simultaneous. e. The control requirement is not met. Charles had a prearranged plan to sell a sufficient amount of shares to fail the control test. Only if Sam were considered to be a transferor (i.e., the sale took place as part of a public offering) would the transaction meet the requirements of Sec. 351. pp. C:2-13 through C:2-16. C:2-32 a. The control requirement is met. The property transferred by Fred is not considered to be nominal relative to the value of stock received for services. Therefore, Fred and Greta are considered to own 100% of the New stock. b. The control requirement is not met. For advance ruling purposes, Maureen’s shares are not counted towards determining whether the control requirement has been met because the property she contributed was nominal (i.e., does not meet the 10% property minimum of Rev. Proc. 77-37) compared to the value of the stock received for services. The taxpayer may choose to enter into the transaction without an advance ruling, report it as nontaxable, and run the risk of being audited, with the result that the IRS treats the transaction as taxable. Alternatively, Maureen can contribute additional property so that the amount of property equals or exceeds the 10% minimum. The minimum property contribution is $4,545 [$4,545 = 0.10 x ($50,000 - $4,545)]. The $4,545 amount is found by solving the following equation for Property: Property = 0.10 x ($50,000 Property), which solves to Property = (0.10 x $50,000)/1.1. pp. C:2-13 and C:2-14. C:2-33 Veronica needs to receive 1,000 additional shares in exchange for $25,000 worth of silver bullion. The 200 shares currently held by Veronica equal 40% of the 500 shares outstanding. To avoid recognizing a gain, Veronica must be “in control” of Poly-Electron immediately after the exchange. Control implies ownership of at least 80% of the total number of Poly-Electron shares outstanding. The number of additional shares that Veronica must acquire to achieve control can be calculated as follows, where A = additional shares needed: (200 + A) / (500 + A) = 0.80 200 + A = 0.80 x (500 + A) 200 + A = 400 + 0 .80 A 0.20 A = 200 A = 1,000 additional shares Thus, with the additional 1,000 shares, Veronica will have 80% control after the exchange (i.e., 1,200 / 1,500 = 80%.) If each share is worth $25, the value of silver bullion that Veronica must contribute is $25,000 (1,000 shares x $25). Having achieved control, Veronica’s exchange will qualify for nontaxable treatment under Sec. 351. p. C:2-13. Copyright © 2024 Pearson Education, Inc.

C:2-10

C:2-34 a. No. The exchange does not qualify as nontaxable under Sec. 351 because Al and Bob do not control West Corporation. (Al owns only 1,000/1,300 = 76.9% of the voting common stock while Bob owns 100% of the nonvoting preferred stock). Al recognizes $25,000 of gain on the transfer of the patent. His basis in his West stock is $25,000. Bob recognizes no gain or loss because he contributed cash. His basis in the preferred stock is $25,000. Carl recognizes $7,500 of ordinary income. His basis in his West stock is $7,500. West recognizes no gain or loss on the exchange. Its basis for the assets is: cash, $25,000; patent, $25,000; and services, $7,500. b. Nontaxable. The exchange now qualifies as nontaxable under Sec. 351 because Al and Bob together own 1,200/1,500 = 80% of the voting common stock and 100% of the nonvoting preferred stock. Al recognizes no gain or loss, and his basis in his West stock is zero. Bob recognizes no gain or loss, and his basis in his West stock is $25,000. The common stock has a $5,000 (200 x $25) FMV, and the preferred stock has a $20,000 (200 x $100) FMV, and those amounts would be allocated to the basis of each type of stock since the stock FMVs equals their bases in this situation. Carl recognizes $7,500 of ordinary income, and his basis in his West stock is $7,500. The consequences to West are the same as in Part a, except the basis for the patent is zero instead of $25,000. c. Nontaxable. The exchange apparently would qualify under Sec. 351. Assuming the $800 of cash contributed is acceptable under Rev. Proc. 77-37 because it meets the 10% property minimum for advance ruling purposes, Al and Bob would recognize no gain or loss. Carl would recognize $6,700 of ordinary income. The consequences to West are the same as in Part b except the cash contributed by Carl takes an $800 basis and the services generate $6,700 of taxable income. pp. C:2-13 and C:2-14. C:2-35 Cash

Equipment

Building

Land

Total

FMV of assets Fraction of total value

$ 5,000 0.030303

$90,000 0.545455

$40,000 0.242424

$30,000 0.181818

$165,000 1.0000

FMV of stock received Plus: Boot property Total proceeds Minus: Adj. basis of assets Gain (loss) realized

$ 3,788 1,212 $ 5,000

$68,182 21,818 $90,000

$30,303 9,697 $40,000

$22,727 7,273 $30,000

$125,000 40,000 $165,000

( 5,000) $ -0-

( 60,000) $30,000

( 51,000) ($11,000)

( 24,000) $ 6,000

(140,000) $ 25,000

Allocation of boot Gain recognized

$ 1,212 $ -0-

$21,818 $21,818

$ 9,697 $ -0-

$ 7,273 $ 6,000

$ 40,000 $ 27,818

$27,818 gain recognized: Gain on equipment, ordinary income (recapture on Sec. 1245 property) Gain on land, Sec. 1231 gain Total gain recognized

C:2-11

$21,818 6,000 $27,818

$40,000 basis in common stock: Adj. basis of property transferred Minus: FMV of boot received Plus: Gain recognized by transferor Basis in common stock Basis in nonqualified preferred stock

$140,000 (40,000) 27,818 $127,818 $ 40,000

$165,000 total basis in the property received: Cash Equipment Building Land Total

Tom’s Basis $ 5,000 60,000 51,000 24,000 $140,000

Recog. Gain $ -021,818 -06,000 $27,818

Reduction* Total $ -0$ 5,000 -081,818 (2,818) 48,182 -030,000 $(2,818) $165,000

*Total adjusted basis = $167,818 ($140,000 + $27,818); total FMV = $165,000. Thus, the reduction under Sec. 362(e)(2) = $2,818 ($167,818 - $165,000). Reg. Sec. 1.362-4(g)(2)(ii), adjusted basis includes the increase for gain recognized by the shareholder. pp. C:2-16 through C:2-22. C:2-36 $15,000. Ann must recognize $15,000 ($25,000 - $10,000) of gain on the exchange. To comply with the advance ruling requirements of Rev. Proc. 77-37, Fred must receive more than a nominal amount of stock in exchange for his property. If Fred obtained additional stock worth at least 10% of the value of the stock he already owned (i.e., at least five shares of stock in exchange for $5,000), his stock likely would be counted for control purposes, and the Sec. 351 requirements would be met. Ann may choose to enter into the transaction without increasing her property contribution so as to acquire at least 80% of Zero’s stock or without having Fred increase his contribution to at least $5,000, proceed without an advance ruling, and report the transaction as being nontaxable. Ann and Fred then run the risk of being audited and the IRS’s arguing the transaction is taxable. pp. C:2-14 and C:2-15. C:2-37 $4,000. Lucy recognizes $4,000 ($12,000 - $8,000) gain on the exchange because she owns less than 80% of the stock immediately after the exchange [(50+10)/110=54.5%]. To qualify under Sec. 351: (1) Lucy could contribute additional property for enough additional stock to obtain 80% control. To meet the 80% control requirement, she would have to purchase an additional 150 shares to own 200 shares (of the 250 shares outstanding). (2) Marvin could exchange enough property as part of the same transaction to qualify as a transferor under Sec. 351. For advance ruling purposes under Rev. Proc. 77-37, Marvin would have to contribute at least $6,000 for an additional five shares of stock to be considered a transferor of property. The taxpayers may choose to engage in the transaction without Lucy’s and Marvin’s increasing their property contributions, proceed without an advance ruling, and report it as being nontaxable. However, they would run the risk of being audited and the IRS’s arguing the transaction is taxable. pp. C:2-14 and C:2-15. Copyright © 2024 Pearson Education, Inc.

C:2-12

C:2-38 a. None. Neither Jerry nor Frank recognizes any gain or loss on the exchange because the Sec. 351 requirements have been met. b. $44,000. Because the exchange is disproportionate, Frank probably could be deemed to have made a gift of 25 shares of Texas stock to Jerry. Jerry’s basis in his 75 shares is $44,000 ($28,000 basis in property transferred by Jerry + $16,000 basis in the 25 shares received from Frank). This calculation presumes that no gift taxes are paid on the transfer. If gift taxes are paid, a second basis adjustment may be needed for the portion of the gift tax attributable to the appreciation. c. $16,000. Frank’s basis in his 25 Texas shares is $16,000 [$32,000 basis in property transferred x (25/50)]. p. C:2-15. C:2-39 a.

$20,000 capital gain: Amount realized Minus: Basis in land Realized gain Boot received (NQPS) Gain recognized (capital in character)

$170,000 ( 30,000) $140,000 $ 20,000 $ 20,000

b. $30,000. Basis of common stock and qualified preferred stock: $30,000 + $20,000 $20,000 = $30,000. This basis must be allocated to the common and qualified preferred stock based on their relative fair market values.

Basis of common stock: $100,000 x $30,000 = $20,000 $150,000 Basis of qualified preferred stock: $50,000 x $30,000 = $10,000 $150,000 Basis of nonqualified preferred stock: $20,000 (FMV). Basis of land to Temple Corporation: $50,000 = $30,000 + $20,000

pp. C:2-16 through C:2-19. C:2-40 a. None for Karen and Larry; $7,000 capital gain to Joe. Karen and Larry recognize no gain or loss under Sec. 351 because they receive only stock. Joe recognizes a $7,000 ($15,000 $8,000) capital gain because he receives only notes and therefore does not qualify for Sec. 351 treatment. b. Joe’s basis in the notes is $15,000. Karen’s basis in the stock is $18,000. Larry’s basis in the stock is $25,000. c. Gray Corporation’s basis in the land is $15,000. Gray’s basis in the equipment is $18,000. The $10,000 of depreciation recapture potential is inherited by Gray because Karen does not recognize a gain on the asset transfer. pp. C:2-16 through C:2-19. C:2-41 a. $4,000 gain. Nora realizes a $7,000 gain [($18,000 + $4,000) - $15,000] and must recognize a gain of $4,000, the amount of the boot (note) received. Of the $4,000 gain, $3,000 is ordinary income recaptured under Sec. 1245. The remaining $1,000 is a Sec. 1231 gain. b. $4,000 and $15,000. Nora’s basis in the note is $4,000, its FMV. Nora’s basis in the stock is $15,000 ($15,000 + $4,000 gain - $4,000 FMV of note). Copyright © 2024 Pearson Education, Inc.

C:2-13

c. $19,000. Needle Corporation’s basis in the machinery is $19,000 ($15,000 + $4,000 gain recognized). pp. C:2-16 through C:2-21 and C:2-25 through C:2-27. C:2-42a. $3,000 of ordinary income: Jim realizes a $3,500 [($5,000 + $1,000 + $2,000) $4,500] gain and recognizes a $3,000 gain. Because the $2,000 education loan assumed by Gold Corporation has no apparent business purpose, all liabilities transferred to Gold are treated as boot under Sec. 357(b). All of Jim’s gain is ordinary income recaptured under Sec. 1245. b. $4,500. Jim’s basis in his stock is $4,500 ($4,500 + $3,000 - $3,000). c. Jim’s holding period for the additional shares includes his holding period for the automobile. d. $7,500. Gold’s basis in the automobile is $7,500 ($4,500 + $3,000). pp. C:2-22 and C:2-23. C:2-43 a.

$3,000 of ordinary income, determined as follows: Stock (FMV) received $17,000 Release from liability 28,000 Amount realized $45,000 Minus: Basis of property transferred Machinery $15,000 Money 10,000 (25,000) Realized gain $20,000 Liability assumed $28,000 Minus: Basis of all property transferred ( 25,000) Recognized gain (Sec. 357(c)) $ 3,000 The gain is treated as ordinary income under Sec. 1245 recapture rules. b. Zero basis: Property transferred $25,000 Minus: Boot received (including liability) ( 28,000) Plus: Gain recognized 3,000 Basis in Moore stock $ -0c. $18,000 basis: Barbara’s basis in the machine $15,000 Plus: Barbara’s recognized gain 3,000 Moore corporation’s total basis in machinery $18,000 d. Sam recognizes no gain or loss. e. $17,000 basis, the amount of money he contributed to Moore for the stock. f. Barbara’s stock has a split holding period because she received the stock in exchange for Sec. 1231 property and cash, which is neither a capital asset nor Sec. 1231 property. Sam’s holding period starts on the day after the exchange date. g. Sec. 351 would not apply, so the answers would change as follows: a. $20,000 ordinary income. Barbara would recognize $20,000 of ordinary income recaptured under Sec. 1245. b. $17,000 basis. Barbara’s basis in the stock would be $17,000, its FMV. c. $35,000 basis. Moore’s basis in the machinery would be $35,000, its FMV. d. $17,000 ordinary income. Sam would recognize $17,000 of ordinary income from compensation. Copyright © 2024 Pearson Education, Inc.

C:2-14

e. f.

$17,000 basis. Sam’s basis in the Moore stock would be $17,000, its FMV. Both Barbara’s and Sam’s holding period for their stock would start on the day after the exchange date because the transaction did not qualify under Sec. 351, thereby making Sec. 1223(1) inapplicable.

pp. C:2-23 and C:2-24. C:2-44 a. $3,000 gain recognized. Jerry realizes an $18,000 [($15,000 + $35,000) - $32,000] gain and recognizes a $3,000 ($35,000 - $32,000) gain because the liabilities exceed the property’s basis (Sec. 357(c)). b. Zero basis. Jerry’s basis in his Emerald stock is zero ($32,000 + $3,000 - $35,000). c. $35,000 basis. Emerald’s basis in the property is $35,000 ($32,000 + $3,000). d. a. No gain or loss. Jerry recognizes no gain or loss because the liabilities are not considered boot and do not exceed the basis of property contributed. b. $17,000 basis. Jerry’s basis in his Emerald stock is $17,000 ($32,000 $15,000). c. $32,000 basis. Emerald’s basis in the property is $32,000. pp. C:2-22 through C:2-25. C:2-45 a. No gain or loss recognized. Ted realizes a $70,000 ([$60,000 + $35,000 + $15,000] [$5,000 + $35,000]) gain, but Ted recognizes no gain or loss. Section 357(c)(3) precludes Ted from recognizing a gain because of his “excess” liability situation (i.e., liabilities that total $50,000 exceeding the $40,000 total bases of the assets). This result occurs because the $35,000 of cash basis current liabilities do not count for purposes of the excess liability calculation. b. $25,000 basis. Ted’s basis in the stock received is $25,000 ($40,000 - $15,000). No reduction in basis is required for liabilities assumed by the transferee corporation under Sec. 357(c)(3) or under Sec. 358(d)(2). c. $40,000 basis. The corporation’s basis in the assets is the same $40,000 basis that Ted had ($5,000 in the cash, zero in the accounts receivable, and $35,000 in the equipment). d. The corporation. The corporation must recognize the income from the receivables when it collects on them. The corporation also can deduct the current liabilities when it pays them (Rev. Rul. 80-198, 1980-2 C.B. 13). pp. C:2-24 and C:2-25. C:2-46 a. $10,000 of ordinary income. Mary realizes a $50,000 ($110,000 - $60,000) gain but recognizes a $10,000 gain (amount of boot received). The gain is treated as ordinary income under the Sec. 1245 recapture rules. b. $60,000 basis. Mary’s basis in the Green common stock is $60,000 ($60,000 + $10,000 - $10,000). Her holding period for the stock is deemed to begin three years ago when she purchased the machine. Mary’s basis in the nonqualified preferred stock (boot) is $10,000, its FMV. Her holding period for the NQPS begins on the day after the exchange date. c. Green recognizes no gain or loss. d. $70,000 basis. Green’s basis in the machine is $70,000 ($60,000 basis to Mary + $10,000 gain recognized by Mary). Green’s holding period is deemed to begin three years ago when Mary purchased the machine. pp. C:2-17 through C:2-21, C:2-25, and C:2-26. Copyright © 2024 Pearson Education, Inc.

C:2-15

C:2-47 a. Since this transfer occurred after December 22, 2017, Ace Corporation recognizes $500,000 of ordinary income because the City of Omaha is a governmental entity. b. Ace Corporation takes a $500,000 basis in the land. c. Ace reports $600,000 of ordinary income. When it purchases the equipment, Ace takes a $250,000 basis in the equipment, its cost. d. Alternative facts: a. Because the nonshareholder contributor is not a customer, potential customer, governmental entity or civic organization, Ace Corporation recognizes no income. b. Ace Corporation takes a zero basis in the land. c. Ace recognizes no income when it receives the cash. The basis of the equipment purchased with the $100,000 contribution is its $250,000 purchase price minus the $100,000 of contributed cash, or $150,000. pp. C:2-31 and C:2-32. C:2-48 a. Kobe recognizes a $70,000 dividend, which is taxed at the applicable capital gains tax rate, and Bryant Corporation reports taxable income of $110,000. Bryant may not deduct the dividend paid to Kobe. b. Kobe recognizes interest income of $10,000, which is taxed at his ordinary tax rate. The principal repayment is not taxable to Kobe. Bryant reports taxable income of $100,000 because it gets a $10,000 deduction for the interest paid to Kobe. pp. C:2-27 through C:2-30. C:2-49 a. $100,000 ($75,000 + $25,000) capital loss to each shareholder. The $75,000 loss with respect to the stock investments is capital in character for both Tom and Vicki because they did not purchase the stock from the corporation. Because the $25,000 debts are secured by bonds, the worthless security rules of Sec. 165(g)(1) apply and their losses will be capital in character. b. STCL to Vicki; ordinary loss to Tom. If the liability were not secured by bonds, Vicki’s loan would be related solely to her stock investment and should be treated as a nonbusiness bad debt that is deductible as a short-term capital loss (up to $3,000 a year after netting capital losses against capital gains). An argument can be made that Tom’s loss would relate to an attempt to maintain his employment with Guest Corporation and, therefore, has a substantial business purpose. Such a loss would be deductible as an ordinary loss if the dominant motive for making the loan were related to his employment activities. c. Limited ordinary loss on stock; capital loss on bonds. The loss with respect to the stock investment would be ordinary in character under Sec. 1244 for both Tom and Vicki up to the $100,000 annual limit for the couple because they purchased the stock directly from Guest. The $50,000 loss exceeding the $100,000 Sec. 1244 limit would be capital in character. The worthless security rules of Sec. 165(g)(1) still would apply to the $25,000 losses on the bond investments. These losses would be capital in character. pp. C:2-32 through C:2-34. C:2-50 Harry: Ordinary loss of $50,000 under Sec. 1244 and LTCL of $75,000. Susan: LTCL of $175,000. Big Corporation: $125,000 LTCL. pp. C:2-32 through C:2-34. C:2-51 a. $50,000 ordinary loss and $2,000 LTCL. Lois’s loss is $52,000 ($28,000 - $80,000 basis), of which $50,000 (the limit for a single taxpayer) is ordinary under Sec. 1244. The remaining $2,000 is a long-term capital loss. b. $42,000 ordinary loss and $10,000 LTCL. Lois’s loss still would be $52,000 ($28,000 - $80,000 basis). However, for purposes of computing the Sec. 1244 loss, Lois’s basis in the stock Copyright © 2024 Pearson Education, Inc.

C:2-16

would be $70,000. Therefore, the ordinary loss under Sec. 1244 would be $42,000 ($28,000 $70,000). The remaining $10,000 would be a long-term capital loss. pp. C:2-32 and C:2-33. C:2-52 $52,000 LTCL. The entire loss is capital in character because Sue was not the original owner of the stock; therefore, the stock is no longer Sec. 1244 stock. pp. C:2-32 and C:2-33. C:2-53 a. Donna recognizes no gain when she transfers the land to Development Corporation. Development’s basis in the land will be $150,000. All gain on the subsequent sale will be ordinary income to Development. This alternative results in the pre-contribution gain that accrued prior to Donna’s transfer and the post-contribution profit earned from subdividing the land being taxed at a 21% tax rate. b. Donna could transfer the land to Development in exchange for stock and $330,000 of debt instruments. In this case, Donna would recognize $330,000 of long-term capital gain and Development’s basis in the land would be $480,000. The $330,000 of pre-contribution capital gain (net of any capital losses that Donna has recognized) is taxed at the applicable capital gains tax rate (in this case, 23.8%, including the 3.8% net investment tax). The step-up in basis permits Development to use the additional basis to offset income earned from subdividing the land that otherwise would be taxed at a 21% tax rate. Note: The basic scenario apparently would permit Donna’s gain to be reported using the installment method. However, sale of the land by a related person (a corporation controlled by Donna) within two years of the transfer date precludes deferral of the installment gain (Sec. 453(e)). pp. C:2-34 through C:2-36.

Comprehensive Problems C:2-54 a. Yes. The transaction meets the requirements of Sec. 351. Transferors of property (Alice, Bob, and Carla) own 88.2% (750/850 = 0.882) of the Bear stock. b. Alice recognizes a $10,000 gain, the amount by which the $60,000 mortgage assumed by Bear Corporation exceeds the $50,000 basis ($12,000 + $38,000) of all the assets transferred by Alice. The character is Sec. 1231 gain, of which some would be Sec. 1250 gain because of depreciation claimed on the building. Bob recognizes $10,000 of gain (the lesser of his realized gain of $15,000 or the boot received of $10,000). The gain is treated as ordinary income recaptured under Sec. 1245. Carla recognizes no gain or loss even though she received cash because she realized a $5,000 loss. Dick recognizes $10,000 of ordinary income as compensation for his services. Bear recognizes no gain or loss on issuing its stock or the note. c. Alice’s basis in her stock is zero ($12,000 + $38,000 - $60,000 liabilities + $10,000 gain). Her holding period for the stock includes her holding period for the land and building. Bob’s stock basis is $25,000 ($25,000 + $10,000 gain - $10,000 boot). His holding period for his stock includes his holding period for the equipment. Carla’s basis for her stock is $10,000 ($15,000 $5,000 boot). Her holding period for the stock includes her holding period for the van. Dick’s basis in his stock is $10,000. His holding period begins on the day after the exchange date. d. Bear’s basis in the assets received is: land $15,000 [$12,000 + (0.30 x $10,000)] and building $45,000 [$38,000 + (0.70 x $10,000)]. (The gain is allocated between the land and building according to the two assets’ relative FMVs as prescribed by the Sec. 357 Treasury Regulations.) The holding period for the land and building includes the time Alice held these properties. Equipment basis is $35,000 ($25,000 + $10,000). Holding period includes the time that Bob owned the properties. The van’s basis is $10,000, limited to its FMV, and the van’s holding period includes Copyright © 2024 Pearson Education, Inc.

C:2-17

the time Carla held it (Reg. Sec. 1.362-4(c)(3)(i)). If Bear and Carla elect, Bear can take a $15,000 basis in the van, but Carla’s basis in her stock would be limited to $5,000, its FMV. The accounting services are deductible by Bear if incurred after operations have begun. If the expenses are preoperating expenses, they should be amortizable under Sec. 248. C:2-55 Transferor shareholders

FMV common stock received FMV qualified preferred stock received FMV nonqualified preferred stock received Cash received Liability assumed Total amount realized Adjusted basis of property transferred Gain (loss) realized Gain (loss) recognized

----Ed---For Property

--------------Fay-------------For For Inventory Land

$40,000 9,000 6,000 -0-0$55,000 (36,000) $19,000 $ 6,000

$22,000

$ 11,000

16,000 2,000 $40,000 (14,000) $26,000 $16,000

8,000 1,000 $ 20,000 (50,000) $(30,000) $ -0-

Ed’s $6,000 gain recognized is ordinary income because of depreciation recapture, and Fay’s $16,000 gain recognized is ordinary income because she transferred inventory. Basis of nonqualified preferred stock: Ed’s basis in the nonqualified preferred stock received is its $6,000 FMV. The holding period of the stock begins the day after the exchange. Basis of qualified stock: Basis of property transferred Plus: Gain recognized Minus: Boot received: Nonqualified preferred stock Cash Liability assumed Total basis of qualified stock

Fay

$36,000 6,000

$64,000 16,000

(6,000) -0-0$36,000

(24,000) (3,000) $53,000

C:2-18

Check: FMV qualified stock received Minus: Gain deferred Plus: Loss deferred Total basis of qualified stock

$49,000 (13,000) -0$36,000

$33,000 (10,000) 30,000 $53,000

Allocation of Ed's qualified stock basis (by relative FMV): Common stock: $40,000/$49,000 x $36,000 = $29,388 Qualified preferred stock: $9,000/$49,000 x $36,000 = $6,612 The basis of each class of qualified stock includes Ed’s holding period for the equipment transferred. Fay's stock: Each share has a split holding period, with two-thirds considered beginning the day after the exchange, and one-third including Fay’s holding period for the land. See Rev. Rul. 85-164, 1985-2 C.B. 117. Corporation No gain (loss) recognized Basis of property received: Transferred (carryover) basis Gain recognized by shareholder Basis reduction under §362(e)(2) Total

Equipment

Inventory

Land

$36,000 6,000 -0$42,000

$14,000 16,000 -0$30,000

$50,000 -0(20,000)* $30,000

Holding period: Includes the transferor’s holding period for each property. *Total FMV of property transferred by Fay ($40,000 + $20,000) Total adjusted basis of property transferred by Fay ($14,000 + $16,000 + $50,000)** Reduction under §362(e)(2) [all to loss property, the land]

$ 60,000 (80,000) $(20,000)

**Under Reg. §1.362-4(g)(2)(ii), the transferee corporation’s basis for this calculation takes into account all applicable provisions of the tax law and, therefore, includes any gain recognized by the shareholder. Also see Reg. §1.362-4(h) Ex. (6). Thus, the inventory basis for this purpose is $30,000 ($14,000 + $16,000). If the corporation and Fay make a §362(e)(2)(C) election, Fay reduces her stock basis by $20,000 to $33,000, and the corporation takes a $50,000 carryover basis in the land. See Reg. §1.362-4(d)(2).

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Tax Strategy and Critical Thinking Problems C:2-56 a. The circumstances vary for the shareholders, who may or may not be pleased with this result. They have avoided the requirements of Sec. 351, which allows Eric to recognize a $150,000 capital loss. Although Florence has to recognize $25,000 of ordinary income, Wildcat can depreciate the machinery’s FMV of $25,000. If Eric can use the $150,000 loss to offset capital gains from other sources, he may be happy with this result. If Florence is in a low tax bracket, she might not mind that she has to recognize $25,000 of ordinary income. However, if Eric has no capital gains and cannot use the $150,000 capital loss, avoiding Sec. 351 may not be a desirable result. This is especially true if Wildcat plans to subdivide the land and sell it, thereby generating ordinary income in the near future. If Sec. 351 applied, Wildcat’s basis in the land would be limited under the Sec. 362(e)(2) reduction rules to $50,000, its FMV. However, Eric and Wildcat Corporation could make an election under Sec. 362(e)(2)(C) so that the land would have a $200,000 carryover basis to Wildcat and, therefore, much less income for Wildcat to report in future years. In such case, Eric’s basis would be limited to his stock’s FMV of $50,000 rather than the $200,000 basis in the property contributed. If he is not planning to sell his stock anytime soon, this reduction might not matter. Also Florence could avoid recognizing $25,000 of ordinary income on the machinery. On the other hand, the machinery would have a zero basis to Wildcat, and therefore Wildcat would not be allowed any depreciation on the machinery. As far as George is concerned, it makes no difference to him whether Sec. 351 applies or not. The result to him is the same either way. b. If the shareholders decide that meeting the Sec. 351 requirements would produce a greater tax benefit, they can proceed in several ways. For example: 1. The corporation could give George 150 shares of stock worth $15,000 and $10,000 of bonds. In such case Eric and Florence would own more than 80% (750/900 = 0.83) of the stock. 2. Florence and Eric each could contribute an additional $15,000 for 150 shares of stock. In such case, Eric and Florence would own more than 80% (1,050/1,300 = 0.808) of the stock. 3. George could contribute $2,500 of cash in addition to his services for 25 more shares. Thus, he would be a property contributor allowing all his shares to count in the 80% test. In such case, Eric, Florence, and George would own 100% of the stock. C:2-57 a.

Advantages of Alternative a: 1. Simplicity. Each person gets stock equal to her contribution to capital and will share in any appreciation in value in proportion to her contribution. 2. Paula recognizes no gain on the transaction because she received no boot. 3. The stock will be Sec. 1244 stock so, if Paula or Mary sells the stock at a loss or the business becomes bankrupt, at least some of the loss will be an ordinary loss. 4. The corporation, with the shareholders’ consent, can elect S corporation status for the first two years, so the losses flow through to the shareholders to offset income from other sources. Later, the corporation, with the shareholders’ consent, can revoke the S corporation election to become a regular C corporation. Copyright © 2024 Pearson Education, Inc.

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Disadvantages of Alternative a: 1. All distributions to Paula and Mary (above reasonable salaries) will be taxed as dividends to the shareholders and are not deductible by the corporation, although the dividends are subject to preferential tax rates. 2. Mary may want additional assurance that she will have preference in getting her investment back before the corporation pays any dividends. Since Paula has a majority ownership, she can decide when and if the corporation pays any dividends. 3. Paula may not want to share ownership with Mary. She might prefer that Mary’s investment be treated as a loan so that all future appreciation accrues to her (Paula). b.

Advantages of Alternative b: 1. Paula recognizes no gain on the transaction. 2. Mary is assured of a return of her investment on whatever terms are specified in the debt instrument, plus interest income at the stated market rate for ten years (provided the corporation does not go bankrupt). 3. Even if the corporation becomes bankrupt, Mary will have first call on any assets before Paula since Mary is a creditor. 4. Paula owns all the stock and benefits from the company’s appreciation in value. 5. Paula’s stock is Sec. 1244 stock. 6. The corporation, with Paula’s consent, can elect S corporation status for the first two years, which allows Paula to use losses to offset income from other sources. 7. The corporation gets a deduction for the interest paid to Mary, subject to limitations. 8. Mary’s income is limited to the note interest. She is not taxed on the return of her principal. Disadvantages of Alternative b: 1. Mary may want to participate in the anticipated growth of the company. She might prefer some stock in addition to some notes. 2. All distributions to Paula (above salary) are taxed as dividends and are not deductible by the corporation, although the dividends are subject to a preferential tax rate. 3. In the event of bankruptcy, Mary’s loss is capital in character.

Advantages of Alternative c: 1. Both Paula and Mary share in any stock appreciation. 2. The interest paid to Paula and Mary is deductible by the corporation, subject to limitations. Their income does not include any principal payments. 3. The stock is Sec. 1244 stock, so Mary and Paula each would have an ordinary loss for at least part of their investment. 4. The corporation, with the shareholders’ consent, can elect S corporation status and pass through losses during the first two years. Later, the corporation, with the shareholders’ consent, can revoke the S corporation election.

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Disadvantages of Alternative c: 1. For Paula, receipt of the note would be considered the receipt of boot, and she would have to recognize gain to the extent of $100,000 FMV of the note received, possibly over the ten-year period under the installment method. 2. Paula might not want to share ownership with Mary. 3. Mary might prefer a more secure return of her investment as in Alternative b even if she cannot participate in future growth of the corporation. 4. The IRS might try to reclassify the debt as equity, thereby changing its tax characteristics and possibly jeopardizing the S corporation election, if one has been made. d.

Advantages of Alternative d: 1. Paula recognizes no gain on the exchange. 2. All stock is Sec. 1244 stock. 3. Paula owns all the common stock and is entitled to the company’s appreciation in value. If she is willing to share some of this appreciation, the preferred stock could be made participating preferred stock. Disadvantages of Alternative d: 1. Mary has no assured return because the corporation might not pay dividends. However, she is more assured of payment than with common stock since the stock is cumulative. 2. Mary does not participate in the growth of the corporation. However, if they agree, the preferred stock can be participating. 3. The corporation cannot elect S corporation status because it has issued more than one class of stock. 4. All distributions to Paula and Mary (above any salaries) are taxable to them as dividends and not deductible by the corporation, although the dividends are subject to a preferential tax rate. In general, no one plan is ideal. Paula and Mary must take into consideration the following factors: 1. How much of the future appreciation in growth is Paula willing to share with Mary? 2. How much assurance does Mary want that she will have first claim on assets to repay her investment? How willing is she to be a minority shareholder or would she rather be a creditor? 3. How large a risk exists that the corporation will go bankrupt so that Paula and Mary want their ownership stakes to be Sec. 1244 stock? 4. How willing is Paula to recognize gain on the corporate formation?

C:2-58 a. A pass-through entity. In light of the nursery’s projected losses over the next two years, Paula and Mary might consider organizing the business as an S corporation, a general partnership, a limited partnership, or a limited liability company. With respect to all these forms, losses generated at the entity level would pass through to Paula’s and Mary’s separate returns. As a result, Paula and Mary could use a pro rata share of the entity’s loss to offset income they earn over the next two years. In the case of a C corporation, losses generated at the entity level would carry Copyright © 2024 Pearson Education, Inc.

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over to offset the corporation’s income in other years. Paula and Mary could not use C corporation losses to offset income they earn individually over the next two years. In either case, any NOL carryover to a post-2020 year would be subject to the 80% of taxable income limitation in the carryover years. Regarding the pass-through entity, this form would have the added advantage of providing the owners a qualified business income deduction should the entity become profitable in the future. b. As a type of partnership. To achieve their various business and investment objectives, and in light of their proposed use of debt and equity, Paula and Mary might structure the partnership as either a limited partnership or as a general partnership that makes a special allocation. A limited partnership would give either investor the opportunity to trade her general partnership right to manage the business (analogous to common stock ownership) for a limited partnership right to a fixed rate of return (analogous to preferred stock ownership). A limited partnership also would give either investor the opportunity to become a general creditor of the partnership (analogous to a corporate bondholder). In the case of a general partnership, so long as the special allocation has substantial economic effect (see Chapter C:9) this business form would give either investor the opportunity to trade her general partnership right to residual profits (analogous to common stock ownership) for a more limited right to a fixed rate of return (analogous to preferred stock ownership). It also would give either investor the opportunity to become a general creditor of the partnership (analogous to a corporate bondholder). Although the general partner in either partnership form would have unlimited liability, a limited liability company taxed by default as a general partnership would afford all its members limited liability.

Case Study Problems C:2-59 Listed below are the major points that should be covered in the memorandum to Bob. The student should incorporate those points into a properly structured memorandum using good form with proper grammar and punctuation. In the client memorandum, before discussing the tax advantages and disadvantages of incorporating, the student might discuss the nontax advantages of incorporating (e.g., limited liability, ease of transferring ownership interest, etc.). With the popularity of limited liability companies (LLCs), some consideration should be given to this business form. All states have adopted LLC legislation. Because most of Bob’s business will be done within a single state, interstate activities and the lack of a common body of LLC rules among states will not be an issue. The adoption of the final check-the-box regulations means that C corporation tax treatment is not limited to incorporated entities. Some discussion of the tax implications of the check-the-box regulations for an existing entity (a proprietorship) should be mentioned in the memorandum. Incorporation 1.

A corporate formation in which Bob receives only stock is nontaxable. Bob will recognize no gain or loss on the asset transfer. The transfer of property by either of the new investors should be properly timed since nontaxable transfers to existing corporations are difficult to Copyright © 2024 Pearson Education, Inc.

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accomplish because of the 80% control requirement. Timing is less important if the new investors are contributing cash and their contributions are to be made after Bob’s contribution. 2.

Bob likely will desire to continue to use the calendar year as the corporation’s tax year because there appears to be little advantage of changing to a fiscal year.

Bob likely will desire to continue the cash method of accounting as the corporation’s overall method of accounting because of its simplicity, assuming the small business exception under Sec. 448 applies if he operates the business as a C corporation.

Bob will continue to use the same depreciation method and convention once he transfers the building and equipment to the corporation. The depreciation recapture potential carries over from the proprietorship to the corporation. Depreciation for the year of transfer should be divided between Bob and the corporation.

The income from collecting the accounts receivable and accounts payable items that represent deductible expenses are reported by the corporation. The income is recognized when the corporation collects the receivables. The expenses are deducted when the corporation pays the liability.

Consideration should be given to an S corporation election. A C corporation may trigger double taxation if the earnings are distributed as a dividend, although the dividends will be taxed at the applicable capital gains rate. The S corporation election will permit all the earnings to be taxed at the individual tax rates and avoid the possibility of double taxation. The qualified business income deduction also may apply.

By retaining C corporation status, Bob would be permitted to exclude 100% of the gain recognized on the sale or exchange of qualified small business corporation stock that has been held for more than five years. Even if the stock were held less than five years, but more than one year, Bob’s gain would be taxed at the applicable capital gains rate. This advantage is not available to an S corporation whose shareholders instead increase the basis of their stock by the amount of any earnings retained in the business.

The salary paid to Bob should be reviewed to make sure it is reasonable. The employment taxes paid on the salary are about the same as the self-employment tax liability incurred with the sole proprietorship.

Consideration should be given to the availability of fringe benefits for Bob from either the C or S corporation business form. In general, the treatment of these fringe benefits—accident and health benefit premiums, etc.—are treated like guaranteed payments or salary for partners and 2%-or-more-shareholders of an S corporation. (See Chapter C:11.)

10.

Consideration should be given to a retirement plan for Bob. He can make deductible contributions to an IRA, or perhaps establish a qualified plan if he makes the S corporation election. Copyright © 2024 Pearson Education, Inc.

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Capital Structure 1.

The simplest capital structure is to have solely common stock issued to Bob and/or either of the other individuals who are interested in investing in the business. Common stock may be attractive to the individual who desires to be active in the business. Bob may prefer to issue preferred stock or debt to the individual who is interested only in investing in the business. The preferred stock could provide a guaranteed dividend payment for the investor. Preferred stock, however, may prevent an S corporation election.

The preferred or common stock should qualify for Sec. 1244 treatment. Section 1244 permits an ordinary loss to be claimed on the sale, exchange, or worthlessness of the stock.

The use of debt will permit the payment of a deductible interest payment to the debt holder, subject to limitations. The receipt of debt as part of the incorporation transaction will trigger the recognition of part or all of the transferor’s realized gain.

The use of debt will permit the repayment to be partially or totally nontaxable. Unlike stock, which need not be retired, debt usually is retired at a designated maturity date.

Bob should consider whether he should transfer the building and equipment to the corporation as part of the incorporation transaction. Some tax advantages may exist with Bob retaining title to the property and leasing it to the corporation. Keeping the property outside the business and leasing it to the corporation also prevents the possible taking of the property by the corporation’s creditors if financial difficulties arise.

Although the above discussion has been couched in terms of using a corporation or an LLC primarily to obtain tax advantages, one probably also should explain that LLCs and partnerships can be taxed as a C corporation under the check-the-box regulations. This change will provide greater flexibility for selecting the business entity form. Depending on the length of the assignment, the student might compare the partnership, corporation, and LLC forms of doing business because it is not entirely obvious from the facts that the corporate form is superior to the partnership form. C:2-60 Among the information that the transferor must provide the IRS are statements about the property transferred and its adjusted basis to the transferor. In addition, a statement about the liabilities transferred to the corporation including the nature of the liabilities, when and why they were created, and the corporate business reason for the transfer must be attached to the transferor’s return for the year of the transfer (see Reg. Sec. 1.351-3(a)). Similar information must be attached to the transferee corporation’s tax return for the year of transfer (see Reg. Sec. 1.351-3(b)). From the facts of the problem, the funds obtained from placing the mortgage on the building and land apparently has been used for personal purposes. Withdrawals from a sole proprietorship, however, are not a taxable event for Eric Wright. The transfer of the mortgage to the corporation, however, may be a taxable event if the IRS can prove that the acquisition or assumption of the liability by the corporation had a tax avoidance motive or lacked the necessary business purpose. In such a situation, all the liabilities assumed and acquired by the corporation would be boot property. On the Copyright © 2024 Pearson Education, Inc.

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other hand, a factor in favor of the taxpayer not being subject to Sec. 357(b) is that one year has passed between the time the mortgage was taken out and the time it was transferred to the corporation. The tax practitioner should thoroughly research the issue before reaching a conclusion. Should he or she find Sec. 357(b) is applicable, he or she should not agree to the client’s position since the AICPA’s Statement on Standards for Tax Services (SSTS) No. 1, Tax Return Positions, Para. 5a holds that a CPA should not recommend to a client that a position be taken with respect to the tax treatment of any item on a return unless the CPA has a good faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. Eric’s situation may lie in a gray area but, if sufficient authority exists for saying the necessary business purpose is present and a position based on that authority has a realistic possibility of being sustained, the CPA may prepare Eric’s return and not report any gain under Sec. 357(b). If the position has only a reasonable basis, SSTS No. 1, Paragraph 5b, would prevent the CPA from signing either Eric’s personal return or the corporate return unless the liability also is appropriately disclosed on the two returns. Thus, even if the position is disclosed, the CPA may not sign the return if the position does not have at least a reasonable basis. Statements on Standards for Tax Services are available on the AICPA’s website at http://www.aicpa.org.

Tax Research Problems C:2-61 The memorandum should explain why the transaction meets the requirements of Sec. 351. Under Reg. Sec. 1.351-1(a)(3), stock underwriters may be disregarded for purposes of Sec. 351 if the underwriter is an agent of the corporation or the underwriter’s ownership of the stock is transitory. If a person acquires stock from an underwriter in exchange for cash in a qualified underwriting transaction, the person who acquires the stock is treated as transferring cash directly to the corporation in exchange for the stock and the underwriter is disregarded. C:2-62 The memorandum should point out that the transfers of property to a controlled corporation are nontaxable only if the transferors control the transferee corporation immediately after the exchange (Sec. 351(a)). Section 368(c) defines control in terms of two 80% tests. Regulation Sec. 1.351-1(a) outlines some of the requirements of the control test but does not directly address the question of a prearranged binding agreement whereby one transferor sells one-half of his stock to someone who is not a transferor. Example (1) of Reg. Sec. 1.351-1(b) permits a transfer to qualify under Sec. 351 where transferee corporation stock is transferred by gift from a controlling transferor to his son, who also is a transferor, immediately after the exchange. Regulation Sec. 1.3511(a)(1)(ii) permits a shareholder to be ignored as a transferor when the amount of stock issued directly for property is of relatively small value in comparison to the value of the stock already owned or to be received by the person who transferred the property. Under Rev. Rul. 79-194, 1979-1 C.B. 145, the control requirement of Sec. 351(a) is to be determined after any sales or transfers occur. In Situation 1 of this ruling, the control requirement is satisfied when part of the 80% stock interest in a newly created corporation that was acquired by a transferor corporation was sold to a group of investors who had acquired the other 20% stock interest in the original transaction. In this situation, the shift in ownership occurred among individuals who were transferors, and the recipients owned a substantial amount of the corporation’s stock. Copyright © 2024 Pearson Education, Inc.

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In a second situation, described in Rev. Rul. 79-194, the control requirement was not met upon completion of a sale under a similar agreement, whereby a transferor who originally had acquired 99% of the stock sold one-half the stock of the new corporation to a second transferor who had originally acquired only 1% of the stock. The IRS held that the control requirement was not met because the 1% shareholder received stock of small value in the original transfer relative to the amount received in total and, therefore, was not considered to be a transferor. In the current case, it must be determined whether Bob has received a substantial part of the Stone Corporation stock or not. Revenue Procedure 77-37, 1977-2 C.B. 568, Sec. 3.07, indicates that ownership of 10% of the stock to be owned is not “of small value” and therefore should be considered a substantial part of the stock. Under this authority, the control requirement should be met and the transaction should be permitted to qualify under Sec. 351. C:2-63 The memorandum should explain that, as long as the additional 25 shares to be received by Greta do not have any other rights attaching to them, they are considered to be stock for purposes of Sec. 351. Thus, Greta will not have to recognize any income when she receives her contingent shares. Revenue Ruling 57-586, 1957-2 C.B. 249, addressed negotiable certificates issued to a shareholder in connection with a nontaxable reorganization representing a contingent interest in additional shares of the acquiring corporation’s stock that would be issued along with cash dividends if certain occurrences took place. The ruling held that the certificates were “other” property and fell under the boot rules. Two later court cases and several revenue rulings have changed this position substantially. First, in June M. Carlberg v. U.S., 6 AFTR 2d 5316, 60-2 USTC ¶9647 (8th Cir., 1960), the Eighth Circuit Court of Appeals held that certificates of contingent interest issued to the taxpayerstockholder in a corporate reorganization permitting her to obtain reserved shares, which were not to be issued pending the determination of liabilities of one of the merging corporations, were stock rather than other property. In James C. Hamrick, 43 T.C. 21 (1964), the Tax Court held that a taxpayer’s contractual right to receive additional stock, contingent upon the earnings of the corporation exceeding a specified amount, is the equivalent of stock within the meaning of Sec. 351. The receipt of additional shares in later years pursuant to the original incorporation agreement was held not to result in the recognition of gain by the transferor. The IRS held in Rev. Rul. 66-112, 1966-2 C.B. 68, that, because the contingent contractual rights were not specifically marketable and could give rise only to the receipt of additional stock by a transferor, both the stock and the control tests of Sec. 351 were satisfied. The IRS has acquiesced to the Hamrick decision (1966-2 C.B. 2). Revenue Ruling 66-112 also distinguished the facts at hand from those in Rev. Rul. 57-586.

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Revenue Ruling 67-90, 1967-1 C.B. 79, provides that a contingent contractual right to receive only additional voting stock provided for in a plan of reorganization satisfies the “solely for voting stock” requirement for a Type B reorganization where the number of additional shares of stock to be issued is determined by a formula based upon the future market price of the shares of the acquiring corporation. Revenue Procedure 77-37, 1977-2 C.B. 568, places certain restrictions on contingent stock that will be issued as part of a reorganization when a taxpayer is requesting a private letter ruling on the transaction. These restrictions do not apply to a Sec. 351 transaction. Revenue Procedure 83-59, 1983-2 C.B. 575, as modified by subsequent “no rule” area revenue procedures, requires a representation be made about contingent shares that are to be issued as part of a request for a private letter ruling on a Sec. 351 transaction, but it does not place any limit on the portion of the stock that can be considered to be contingent. C:2-64 Yes. John can avoid recognizing the $175,000 gain according to Ninth Circuit and Second Circuit holdings. In Peracchi v. CIR, 81 AFTR 2d 98-1754, 98-1 USTC ¶50, 150 (9th Cir., 1998), the Ninth Circuit reversed the decision of the Tax Court and held that an unsecured promissory note contributed to a corporation by its sole shareholder had a basis equal to its face amount. A similar result was reached in Lessinger v. CIR, 63 AFTR 2d 89-1055, 89-1 USTC ¶9254 (2nd Cir., 1989). Therefore, if John contributes a $175,000 promissory note to Newco in addition to the assets, the basis of assets contributed includes the face value of the note and is $475,000 ($250,000 + $175,000). Because the liabilities do not exceed the basis of assets contributed, John recognizes no gain. C:2-65 The client letter should address two questions. First, if Leticia, Monica, and Nathaniel advance funds to Lemona Corporation, will the advance be recharacterized as equity instead of debt? Second, will the unavailability of alternative financing at “reasonable rates” be significant in any decision to recharacterize? If the IRS and/or the courts recharacterize the advance as equity, the IRS and/or the courts would treat any “interest” paid to the three investors as “dividends,” nondeductible by Lemona. Furthermore, the IRS and/or the courts might treat the advance as nonbusiness related, i.e., as intended to safeguard the investors’ initial equity investment. In the latter event, if Lemona later became insolvent, and the three investors were unable to recoup the full amount of the advance, their loss would be treated as nonbusiness bad debt. Because the loss would be capital in character, it would be deductible only to the extent of $3,000 (per year) in excess of any capital gains. No relief for partial losses would be afforded the investors. The key statutory authority that governs the characterization of an investor advance to a corporation is Sec. 385. Under Sec. 385, the Treasury Secretary is authorized to issue regulations for determining whether an interest in a corporation should be treated as equity or indebtedness. Factors to be considered in the determination include, • Whether there is a written, unconditional promise to pay a sum certain in money • Whether the interest is subordinate to any corporate indebtedness • The corporation’s debt to equity ratio • Convertibility of the interest into corporate stock • The relationship between stockholdings and the interest in question Copyright © 2024 Pearson Education, Inc.

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Based on Factors 2, 3, and 5, the three investors’ interest in Lemona resembles equity more than debt. The interest is subordinate to other Lemona obligations; the corporation’s debt to equity ratio is extraordinarily high (25:1 before the note issuance); and the relationship between the interest in question and the investors’ pre-existing stockholdings is proportionate. On the other hand, based on Factors 1 and 4, the three investors’ interest resembles debt more than equity. The interest is evidenced by a note (i.e., a written, unconditional promise to pay a sum certain in money), and it is not convertible into Lemona stock. In Rudolph A. Hardman, 60AFTR 2d 87-5651, 82-7 USTC ¶9523 (9th Cir., 1987), the Ninth Circuit Court of Appeals cited 11 factors for distinguishing debt from equity for purposes of Sec. 385: • The names given to certificates evidencing indebtedness • The presence or absence of a maturity date • The source of repayments • The right to enforce payment of principal and interest • Participation in management • The investor’s status relative to corporate creditors • The intent of the parties • Thin capitalization • Identity of interest between creditor and stockholder • Payment of interest out of “dividend” funds • The ability of the corporation to obtain funds from outside lenders In the client letter, and to the extent possible, the student should evaluate the three investors’ corporate interest in terms of each of these factors. In Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC ¶9438 (5th Cir., 1967), a closely held corporation attempted to procure financing from outside lenders, but because of prohibitive interest rates, instead issued 7%, 15-year notes to its existing shareholders in exchange for cash advances of $138,400. The debt was subordinate to other corporate obligations. The corporation was not entitled to pay dividends on its stock until it had paid all past accrued interest on the notes. The corporation issued the notes on a pro rata basis and was thinly capitalized. On its tax return, the corporation deducted “interest” payments on the notes, but the IRS disputed this tax treatment. The IRS argued that based on all the facts and circumstances, the capital advanced by the shareholders was equity, not debt. Therefore, payments on the securities were dividends and nondeductible. In the client letter, the student should draw an analogy between the facts and issues of the Tomlinson case and those of the case in question. The student also should cite factual dissimilarities that might undermine application of the Tomlinson holding to the present case. From the analysis, he or she should derive a cogent conclusion that addresses the two central issues.

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“What Would You Do In This Situation?” Solution Ch. C:2, p. C:2-31. The IRS is likely to carefully scrutinize any issuance of debt to determine whether it should be treated as debt or equity or some combination of each. The Treasury Department has been given the authority under Sec. 385 to write regulations to distinguish between debt and equity, and also to allow an issue to be treated partly as debt and partly as equity. Thus far, the Treasury Department has not issued final Sec. 385 regulations, except for some specific situations not germane here. As a result, taxpayers must rely on judicial decisions as an indication of how a particular issue will be treated. Section 385 suggests factors that should be considered in determining whether an amount advanced to a corporation should be treated as debt or equity. In addition, O.H. Kruse Grain and Milling v. CIR, 5 AFTR 2d 1544, 60-2 USTC ¶9490 (9th Cir., 1960), lists additional factors the courts might consider. The Treasury Department indicated in Notice 94-47, 1994-1 C.B. 357, that it will carefully scrutinize instruments that combine tax treatment for debt with significant equity characteristics. Eight factors were listed that may be considered. As a CPA, you should inform your client of the risk that the proposed debt issue may be challenged by the IRS and partly or totally reclassified as equity. The fact that many large corporations already have issued debt instruments with extremely long maturities is a point in your client’s favor. If the corporation decides to go ahead with the issue, you would be justified in recommending the interest deductions if there exists a realistic possibility of the deductions being sustained upon examination. You also may recommend the deductions if a reasonable basis exists, and the taxpayer makes adequate disclosures. See Statement on Standards for Tax Services No. 1, Tax Return Positions.

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Chapter C:3 The Corporate Income Tax Discussion Questions C:3-1 Fiscal year or calendar year. Unless High Corporation is an S corporation or a personal service corporation, High can select a tax year ending on the last day of any month (i.e., a fiscal year or a calendar year). pp. C:3-2 through C:3-4. C:3-2 Yes. Port Corporation may change its annual accounting period without prior approval of the IRS if it satisfies the requirements of Rev. Proc. 2006-46, 2006-2 C.B. 859, as listed on page C:3-4 of the text. If Port does not satisfy these requirements, it can request approval of a change in accounting period by filing a Form 1128 on or before the fifteenth day of the third month following the close of the short period resulting from the change. p. C:3-4. C:3-3 Stan and Susan need to choose an accounting period. They generally can select either a calendar year or a fiscal year. A fiscal year can permit an income deferral. However, if they elect S corporation status, they generally are required to use a calendar year. Stan and Susan need to select an accounting method. They are required to use the accrual method for sales-related items because inventories are a material income producing factor but may want to use the cash method for other items (i.e., the hybrid method) as long as they are eligible. Stan and Susan need to select an accounting method for valuation of their inventory, i.e., LIFO, FIFO, etc. They may want to investigate which method is best for their particular type of inventory. Because the price of digital circuits has declined in recent years, the LIFO method does not appear to be a logical choice. Stan and Susan need to determine whether they will make an election to deduct up to $5,000 each and amortize the balance of organizational expenditures and/or start-up expenditures. An election is advisable because the election cannot be made retroactively if, upon audit, the IRS reclassifies deducted expenses as organizational expenditures. These elections are deemed made automatically under Reg. Secs. 1.248-1 and 1.195-1. Stan and Susan need to decide what method they will use to write off their research and development expenses, i.e., expense in year incurred or defer and amortize over 60 months or more. They also need to be aware that R&D expenditures made after 2021 will not be deductible at all and will have to be amortized over 60 months. Stan and Susan need to determine whether they want to make an S election to pass through start-up losses. Stan and Susan need to determine whether they want to capitalize the corporation with debt as well as equity, and, if so, how much debt and how much equity they will use. pp. C:3-2 through C:3-5. C:3-4 Corporations and individuals compute capital gains and losses the same way. However, corporations cannot deduct capital losses from ordinary income. A corporation can carry a capital loss back three years and over five years to offset capital gains. Individuals only can carry such losses over, although the carryover period is indefinite. Corporations also do not have a preferential tax rate for net capital gains that is lower than the top ordinary income rate as individuals do. pp. C:3-6 and C:3-7. Copyright © 2024 Pearson Education, Inc.

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C:3-5 Organizational expenditures include outlays incident to the creation of a corporation, chargeable to the corporation’s capital account, and of a character that would be amortizable if the corporation had a limited life. The corporation can elect under Sec. 248 to deduct the first $5,000 of the expenditures incurred in the corporation’s first tax year and to amortize the remainder over a period of 180 months starting with the month in which the corporation begins business operations. This election is deemed made automatically under Reg. Sec 1.248-1. pp. C:3-8 and C:3-9. C:3-6 Start-up expenditures are ordinary and necessary business expenses paid or incurred to investigate the creation or acquisition of an active trade or business, to create an active trade or business, or to conduct an activity engaged in for profit or the production of income before the time the activity becomes an active trade or business. A corporation can elect under Sec. 195 to deduct the first $5,000 of the expenditures and to amortize the remainder over a period of 180 months starting with the month in which an active trade or business begins. This election is deemed made automatically under Reg. Sec 1.195-1. pp. C3:9 and C:3-10. C:3-7 For tax years beginning after December 31, 2017, the deductibility of business interest in a given year is limited to the sum of the following amounts: business interest income, 30% of adjusted taxable income, and floor plan financing interest for motor vehicles. Any amount disallowed because of the above limitation carries over indefinitely. However, small corporations (those meeting the $29 million (in 2023) gross receipts test for small businesses) are exempt from this limitation. Business interest does not include investment interest, and business income does not include investment income. For C corporations, adjusted taxable income means taxable income computed without regard to: (1) income, gain, deduction, or loss not allocable to a trade or business; (2) business interest or business interest income; or the NOL deduction. pp. C:3-10 and C:3-11. C:3-8 Under Sec. 170, charitable contributions for corporations differ from those allowed to individuals in three ways: (1) the timing of the deduction, (2) the amount of the deduction permitted for the contribution of certain nonmoney property, and (3) the maximum deduction permitted in any given year. Accrual method corporations can deduct certain contributions that remain unpaid at year-end. Such an election is not available to individuals. A corporate taxpayer can deduct a larger amount for health-related and scientific-research property donated from inventory than is permitted an individual taxpayer. A corporation’s charitable contributions deduction is limited to 10% of adjusted taxable income, which differs from the series of limits that apply to individuals. pp. C:3-11 through C:3-14. C:3-9 Year 1 if paid on March 9; Year 2 if paid on April 20. Carver Corporation can deduct the contribution in Year 1 if it pays it on March 9 of Year 2. However, if Carver pays it on April 20 of Year 2 (after the March 15 of Year 2 deadline for a calendar year taxpayer), it cannot deduct the contribution in Year 1 but must deduct it in Year 2. pp. C:3-11 and C:3-12. C:3-10 If the property qualifies as scientific research property under Sec. 170(e)(4), Zero Corporation’s deduction is $2,012 {$1,225 + [0.50 x ($2,800 - $1,225)]} because the tentative deduction amount is less than twice the property’s adjusted basis ($2,450 = $1,225 x 2). Otherwise, the charitable contributions deduction is $1,225. pp. C:3-12 and C:3-13. C:3-11 Under Sec. 243, corporations are allowed a dividends-received deduction to partially or fully mitigate the effects of multiple taxation of corporate earnings. Dividends received by a domestic Copyright © 2024 Pearson Education, Inc.

C:3-2

corporation from another domestic corporation (other than S corporations) qualify for the special 50%, 65% or 100% deduction. Dividends from a greater than 10%-owned foreign subsidiary also are eligible for a 100% Sec. 245A dividends-received deduction. Ineligible for the dividendsreceived deduction are distributions that receive capital gain treatment (e.g., liquidating distributions), dividends on stock held 45 days or less, and dividends on debt-financed stock. pp. C:3-14 through C:3-18. C:3-12 The dividends-received deduction on debt-financed stock is disallowed to prevent a corporation from deducting interest paid on money borrowed to purchase the stock, while paying little or no tax on the dividends received on the stock. Otherwise, the corporation could gain an arbitrage advantage by acquiring debt-financed stock. p. C:3-18. C:3-13 Carry over to future years indefinitely. In carryover years, the NOL deduction might be limited to 80% of taxable income before the NOL deduction if the NOL carryover exceeds that limit. p. C:3-18. C:3-14 Various loss limitations. Section 267(a)(1) denies a deduction for losses realized on the sale or exchange of property between a corporation and a shareholder who owns more than 50% (in value) of the corporation’s stock (i.e., a controlling shareholder). The purchasing party can use the loss later to reduce his or her recognized gain on a subsequent sale or exchange of the property. Section 267(a)(2) denies a deduction for accrued expenses and interest on certain transactions involving a corporation and a controlling shareholder that use different accounting methods when the payee will include the item in gross income at a date that is later than when it is accrued by the payor. The payor deducts the expense at the time the payee includes it in gross income. pp. C:3-20 and C:3-21. C:3-15 $42,000 tax liability. In tax years beginning after 2017, the corporation is subject to a flat 21% tax rate. p. C:3-5. C:3-16 $15,750 = 75,000 × 0.21. Personal service corporations are taxed at a flat 21% rate in tax years beginning after 2017. p. C:3-5. C:3-17 Brother-sister controlled groups, parent-subsidiary controlled groups, and combined controlled groups. A group of two or more corporations is a brother-sister controlled group, under the 50%-80% definition, if five or fewer individuals, trusts, or estates own (1) at least 80% of the voting power of all classes of voting stock (or at least 80% of the total value of the outstanding stock) of each corporation, and (2) more than 50% of the voting power of all classes of stock (or more than 50% of the total value of the outstanding stock) of each corporation, taking into account only the stock ownership that each person has that is identical with respect to each corporation. A shareholder’s identical ownership is the percentage of stock the shareholder owns in common in each of the corporations. For some situations, the corporations are a brother-sister controlled group if the five or fewer shareholders meet the 50%-only definition. A parent-subsidiary controlled group is a group of two or more corporations where one corporation (the parent corporation) owns directly at least 80% of the voting power of all classes of voting stock, or 80% of the total value of all classes of stock, of a second corporation (the subsidiary corporation). The group can contain more than one subsidiary corporation. If the parent corporation, the subsidiary corporation, or any other members of the controlled group together own at least 80% of the voting power of all classes of voting stock, Copyright © 2024 Pearson Education, Inc.

C:3-3

or 80% of the total value of all classes of stock of another corporation, that other corporation is included in the parent-subsidiary controlled group. For purposes of the Sec. 179 expense dollar limitation, however, a parent subsidiary group is considered a controlled group if the ownership is more than 50%, rather than at least 80% (see Sec. 179(d)(6) and (7)). A combined controlled group is a group of three or more corporations where the following criteria are met: (1) each corporation is a member of a parent-subsidiary controlled group or a brother-sister controlled group and (2) at least one of the corporations is (a) the parent corporation of a parent-subsidiary controlled group and (b) a member of a brother-sister controlled group. pp. C:3-21 through C:3-25. C:3-18 Minimum accumulated earnings credit, Sec. 179 expense limitation, and the general business credit. Controlled groups must apportion these tax benefits among its members to prevent them from avoiding limitations through the use of multiple related corporations. Items requiring apportionment include the $250,000 minimum accumulated earnings credit, the amount of depreciable assets that can be expensed under Sec. 179, and the $25,000 general business credit limitation. For brother-sister corporations, the 50%-only definition applies to the minimum accumulated earnings credit while the Sec. 179 expense and the $25,000 general business credit limitations are subject to the 50%-80% definition. p. C: 3-25. C:3-19 The advantages of a consolidated tax return are: income of a profitable member can be offset by losses of another member; capital gains of one member can be offset by capital losses of another member; and profits or gains reported on intercompany transactions are deferred. The disadvantages are: the election is binding, losses on intercompany transactions are deferred, Sec. 1231 losses of one member offset Sec. 1231 gains of another member, losses of an unprofitable member may limit deductions or credits of a profitable member, and additional administrative expenses are incurred in preparing and filing the consolidated return. pp. C:3-26 and C:3-27. C:3-20 The substitution of fringe benefits for salary permits the owner-employee to exclude these amounts from personal taxation while the corporation obtains a deduction for the expenditure. Thus, the owner-employee can make certain expenditures out of pre-tax dollars that otherwise might be nondeductible personal expenditures payable out of after-tax dollars (e.g., group term life insurance premiums). p. C:3-29. C:3-21 A determination that part of the compensation paid to an owner-employee is unreasonable in amount for purposes of Sec. 162(a)(1) means that the corporation loses its tax deduction for that portion of the payment. Generally, the unreasonable compensation is taxed as compensation income to the owner-employee despite the disallowance to the corporation. (See also hedge agreements in Chapter C:4.) pp. C:3-28 and C:3-29. C:3-22 A corporation must pay estimated taxes if it expects its tax liability to exceed $500. The payments are due April 15, June 15, September 15, and December 15 for a calendar year corporation unless the fifteenth falls on a weekend or holiday, in which case amounts paid on the next business day are considered as paid on the due date. Regarding an April 15 due date, the filer also must consider Emancipation Day, which is an observed holiday in Washington, D.C. on April 16. If April 16 falls on Saturday, the observed holiday is the preceding Friday. If it falls on Sunday, the observed holiday is the succeeding Monday. For a fiscal year corporation, the due dates are the fifteenth day of the fourth, sixth, ninth, and twelfth months of the tax year. pp. C:3-29 and C:3-30. Copyright © 2024 Pearson Education, Inc.

C:3-4

C:3-23 Underpayment and late filling penalties. A large corporation is one whose taxable income was $1 million or more in any of its three immediately preceding tax years. A large corporation cannot base its estimated payment on last year’s liability. It must base its estimated payments on the current year’s liability. However, a large corporation can use the prior year’s liability for its first estimated tax installment, but it must repay the benefit of the reduced payment with its second installment. pp. C:3-30 and C:3-31. C:3-24 Underpayment and late filing penalties. A nondeductible penalty applies if a corporation does not deposit its required estimated tax installment on or before the due date for that installment. The IRS assesses interest if any remaining tax due is not paid by the original due date for the corporate tax return. In addition to interest, a late payment penalty (failure-to-pay penalty) applies if the corporation fails to pay the tax on time (see Chapter C:15). If the corporation requests an extension of time to file its tax return, the amount of tax shown on the request for extension (Form 7004) or the amount of tax paid by the original due date must be at least 90% of the tax shown on its Form 1120 to avoid a late payment penalty. pp. C:3-30 through C:3-32. C:3-25 A corporation must file a tax return each year whether it has any taxable income or not. If the corporation is no longer in existence, it does not have to file a tax return. If it was in existence for only a portion of the year, it must file a short-period return for the portion of the year it was in existence. p. C:3-33. C:3-26 April 15 or March 15 depending on the tax year involved. The due date for a calendar year corporate tax return is the fifteenth day of the fourth month after the end of the corporation’s tax year, or April 15. If the due date falls on a weekend or holiday, the return is due on the next business day. Regarding an April 15 due date, the filer also must consider Emancipation Day, which is an observed holiday in Washington, D.C. on April 16. If April 16 falls on Saturday, the observed holiday is the preceding Friday. If it falls on Sunday, the observed holiday is the succeeding Monday. The corporation can obtain a six-month extension for filing the tax return if the corporation files Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns). [Note: For June 30 year-end corporations before 2026, the extension period is seven months.] p. C:3-33. C:3-27 1. Some book income is not taxable. 2. Some gross income is not included in book income for the current period. 3. Some financial accounting expenses are not deductible for tax purposes. 4. Some deductions allowed for tax purposes are not expenses in determining book income for the current period. pp. C:3-34 and C:3-35.

C:3-5

Issue Identification Questions C:3-28 • • • • •

•

Is the property received cash or a noncash asset? If a noncash asset, are any liabilities assumed or acquired by the shareholder? Does the distribution come from the distributing corporation’s E&P? What is X-Ray’s gross income? Is either X-Ray or Yancey a foreign corporation? What is the appropriate dividends-received deduction percentage? • Does the overall dividends-received deduction limitation restrict the availability of the deduction? • Does one of the other special limitations on the dividends-received deduction apply (e.g., 45-day rule or debt-financed stock)? If X-Ray receives noncash property, what is the basis of the property to X-Ray?

Because X-Ray owns 10% of Yancey Corporation, it normally is entitled to a $50,000 (0.50 x $100,000) dividends-received deduction under Sec. 243. However, several limitations may apply. If X-Ray’s taxable income before the dividends-received deduction is less than $100,000, but at least $50,000, the deduction is limited, under Sec. 246, to 50% of its taxable income before the dividends-received deduction. If X-Ray’s taxable income after the dividends-received deduction is negative (i.e., an NOL), the dividends-received deduction limitation does not apply. In addition, if (1) X-Ray has held the Yancey stock for 45 days or less, (2) the Yancey stock is debt-financed, or (3) Yancey is a foreign corporation, X-Ray will receive either a reduced or no dividends-received deduction. See Secs. 245, 246, and 246A. pp. C:3-14 through C:3-18. C:3-29 • •

•

What is Williams Corporation’s realized loss? What is Williams’s recognized loss? • Does the sale of property to a shareholder at a loss trigger the application of the Sec. 267 related party rules? • Is Barbara related to any other Williams’ shareholders (e.g., spouses, siblings, or other entities) whose attribution of stock ownership causes her stock ownership to exceed 50% of Williams’ outstanding stock? • If a loss is disallowed, can the transaction be restructured to permit recognition of the loss? What is Barbara’s basis for the truck? Does it reflect an adjustment for the disallowed loss?

The primary issue is whether Barbara is a related party to Williams Corporation under the Sec. 267 rules. If so, the loss on the sale of the truck is disallowed. In this case, because Barbara does not own more than 50% of the Williams stock, she is not a related party, and Williams may deduct a $20,000 ($25,000 - $5,000) loss. The loss is a Sec. 1231 loss if Williams used the truck in the conduct of its trade or business. However, if Barbara’s spouse, siblings, or other parties or entities related to her own more than 25% of the stock, Barbara constructively owns more than 50% of Williams, and the loss will be disallowed under Sec. 267. pp. C:3-20 and C:3-21.

C:3-6

C:3-30 •

•

What is the tax liability for Pencil Corporation? For Eraser Corporation? • Are Pencil and Eraser C corporations? S corporations? • Are Pencil and Eraser members of a controlled group? • Are Mary and Don related parties for purposes of the controlled group stock ownership tests? • Are Pencil and Eraser personal service corporations? What amounts (if any) are Pencil and Eraser paying to Don and Mary? • Have the taxpayers divided up the payments among the three entities (Pencil, Eraser, and the joint return) to minimize their tax liabilities? • Can the taxpayers adjust their salaries and/or fringe benefits to reduce their total tax costs? If Pencil and/or Eraser are C corporations, would an S election be advisable?

The primary issue is the appropriate corporation classification for Pencil and Eraser Corporations. If both corporations are C corporations, they constitute a controlled group under Sec. 1563 and must apportion the benefit of certain items. Two other important issues are: (1) can either one of the corporations benefit from an S election and (2) what amount of salaries and fringe benefits should Don and Mary withdraw from each of the two corporations to maximize the corporate and shareholder benefits. The last two points are too complicated to arrive at a definitive answer with the limited facts given here. pp. C:3-21 through C:3-29. C:3-31 • • • • •

How much will future interest deductions be limited by the 30% limitation on net business interest? How much will future NOL deductions be limited by the 80% limitations on NOL deductions? How are the limitations calculated? How will the business interest limitation interact with the NOL deduction limitation? What kind if carryovers will arise as a result of these limitations?

The business interest deduction is limited to 30% of adjusted taxable income before the NOL deduction, so that limitation will apply first. Any excess interest carries over to the next year and future years indefinitely. The NOL deduction limitation applies after the business interest deduction limitation, so any reduction of taxable income from that limitation will, in turn, reduce the amount of taxable income to which the 80% limitation applies and hence will reduce the amount of the NOL deduction. Any remaining NOL carries over indefinitely. Thus, Epsilon faces some serious limitations on the deductibility of its interest expense and NOL carryovers. pp. C:3-10 and C:3-11.

C:3-7

Problems C:3-32 Asset Land Building Total

Sec. 1231 $35,000 49,000 $84,000

Type of Gain Ordinary $ 6,000 $ 6,000

Total $35,000 55,000 $90,000

These amounts are calculated as follows: Land: Sales price Minus: Basis (original cost) Sec. 1231 gain on land

$ 60,000 ( 25,000) $ 35,000

Building: Sales price Minus: Basis (original cost) $200,000 Minus: Depreciation ( 30,000) Recognized gain Recapture amount on building as if Sec. 1245 property: Lesser of: $30,000 (depreciation claimed) or $55,000 (recognized gain) Times: Sec. 291 percentage Ordinary income under Sec. 291 Sec. 1231 gain on building: Recognized gain Minus: Ordinary income on building Sec. 1231 gain on building

$225,000 ( 170,000) $ 55,000

$ 30,000 x 0.20 $ 6,000 $ 55,000 ( 6,000) $ 49,000

p. C:3-7.

C:3-8

C:3-33 Taxable income is $910,000. The character of income and losses is determined as follows: $125,000a 21,000b $146,000 $ 10,000 84,000 (15,000) $ 79,000 (24,000) $ 55,000

Sec. 1245 depreciation recapture on equipment Sec. 291 depreciation recapture on building Total depreciation recapture (ordinary income) Sec. 1231 gain on equipment ($135,000 - $125,000) Sec. 1231 gain on building ($105,000 - $21,000) Sec. 1231 loss on land Net Sec. 1231 gain Sec. 1231 lookback recapture (ordinary income) Remaining net Sec. 1231 gain (treated as long-term capital gain) a

Lesser of $125,000 accumulated depreciation or $135,000 gain. Hypothetical Sec. 1245 recapture is $105,000 (lesser of $120,000 accumulated depreciation or $105,000 gain). Thus, Sec. 291 recapture is $105,000 x 0.20 = $21,000.

Taxable income is calculated as follows: Ordinary income from operations Total ordinary income from recapture ($146,000 + $24,000) Net Sec. 1231 gain (treated as long-term capital gain) $55,000 Long-term capital loss on securities (35,000) Taxable income

$720,000 170,000 20,000 $910,000

Because the net Sec. 1231 gain is treated as long-term capital gain, the corporation has sufficient gains to offset the long-term capital loss on the securities. p. C:3-7. C:3-34 a. Delta Corporation can elect to deduct $5,000 of organizational expenditures under Sec. 248 and amortize the remainder over 180 months. Delta also can elect to deduct $5,000 of start-up expenditures under Sec. 195 and amortize the remainder over 180 months. These elections are deemed automatic under Treasury Regulations. Date 1/30 5/15 5/30 5/30 6/1 6/5 6/10 6/15 7/15

Expense Travel expense Legal expense Commission to stockbroker Director’s fees Expense of transferring building to Delta Accounting fees Training expense Rent expense Rent expense

Amount $2,000 2,500 4,000 2,500 3,000 1,500 5,000 1,000 1,000

C:3-9

Treatment Start-up expense Organizational expense Reduction of capital Organizational expense Capitalized as part of building cost Organizational expense Start-up expense Start-up expense Sec. 162 expense

b. Organizational expenditures total $6,500, and Delta can deduct $5,033 [$5,000 + ($1,500/180 months x 4 months)] in the first year. c. Start-up expenditures total $8,000, and Delta can deduct $5,067 [$5,000 + ($3,000/180 months x 4 months)] in the first year. pp. C:3-8 through C:3-10. C:3-35 a.

$30,000 charitable contributions deduction (limited), determined as follows:

Property Basis ABC stock (capital gain property) $18,000 Inventory (scientific research property) {$17,000 + [0.50 x ($22,000 - $17,000)]} 17,000 Antique vase (capital gain property-tangible personal property put to unrelated use) 10,000 Total before limitation Deduction is limited to $300,000 x 0.10 = $30,000. b.

FMV $25,000

Deduction Amount $25,000

22,000

19,500

18,000

10,000 $54,500

$24,500 charitable contributions carryover, determined as follows: Total contribution allowable before limitation Minus: Amount deducted in current year Contributions carryover to next five years

$54,500 (30,000) $24,500

pp. C:3-11 through C:3-14. C:3-36 a.

$40,000 charitable contributions deduction (limited), determined as follows:

Property XYZ stock (capital gain property) ABC stock (capital gain property) PQR Stock (short-term capital gain) Total contribution amount

Basis $25,000 2,000 12,000

FMV $19,000 16,000 18,000

Deduction $19,000 16,000 12,000 $47,000

The charitable contributions deduction is limited to $40,000 ($400,000 x 0.10). b.

$7,000 charitable contributions carryover, determined as follows:

Total contribution allowable before limitation Minus: Amount deducted in current year Contributions carryover to next five years

$47,000 (40,000) $ 7,000

c. Blue would have been better off selling the XYZ stock first, recognizing the $6,000 ($19,000 - $25,000) loss, and then donating the sales proceeds to the school. Under the original plan, Blue forfeited the loss recognition. pp. C:3-11 through C:3-14. Copyright © 2024 Pearson Education, Inc.

C:3-10

C:3-37 a.

Year 1: Contribution limitation: = $180,000 x 0.10 = $18,000 Carryover to Year 2: $20,000 - $18,000 = $2,000 Year 2: Contribution limitation: $125,000 x 0.10 = $12,500 Year 2 charitable contributions deduction consists of $12,000 (Year 2 contribution) plus $500 (part of carryover from Year 1) b.

$1,500 carryover to Year 3, determined as follows: Year 1 contribution Amount used in Year 1 Carryover used in Year 2 Carryover to Year 3

$ 20,000 ( 18,000) ( 500) $ 1,500

The entire carryover is from Year 1. pp. C:3-13 and C:3-14. C:3-38 a.

$6,000 charitable contributions deduction; $5,000 carryover, determined as follows: Gross profit on sales Dividends from less-than-20%-owned corporations Gross income Minus: Operating expenses Adjusted taxable income Charitable contributions deduction limitation ($60,000 x 0.10) Contributions carryover ($11,000 - $6,000)

$120,000 40,000 $160,000 ( 100,000) $ 60,000 $ 6,000 $ 5,000

$34,000 taxable income, calculated as follows: Adjusted taxable income Minus: Charitable contributions deduction Dividends-received deduction ($40,000 x 0.50) Taxable income

$ 60,000 ( 6,000) ( 20,000) $ 34,000

The dividends-received deduction limitation ($54,000 x 0.50 = $27,000) does not apply because $20,000 is less than the $27,000 limitation. pp. C:3-13 through C:3-15 and C:3-19. C:3-39 Gross profit on sales Dividends Gross income Minus: Operating expenses Taxable income before dividendsreceived deduction Dividends-received deductiona Taxable income (NOL)

Part a $220,000 100,000 $320,000 (218,000)

Part b $220,000 100,000 $320,000 ( 234,000)

Part c $220,000 100,000 $320,000 ( 272,000)

$102,000 ( 50,000) $ 52,000

$ 86,000 (43,000) $ 43,000

$ 48,000 ( 50,000) $( 2,000) b

C:3-11

Dividends-received deduction equals the lesser of: (1) 50% of dividends or $ 50,000 $ 50,000 $ 50,000 (2) 50% of taxable income before dividends-received deduction 51,000 43,000 N/A b Income limitation does not apply because the dividend-received deduction creates an NOL. d.

Revised answers:

Taxable income before the dividends-received deduction Dividends-received deduction from 20%owned corporationc Dividends-received deduction from less-than-20%-owned corporationd Taxable income (NOL)

Part a

Part b

Part c

$102,000

$86,000

$ 48,000

( 45,500)

( 15,000) $ 41,500

( 8,000) $32,500

( 15,000) $( 12,500)

$ 45,500

$45,500

66,300

$55,900

N/A

$ 15,000

$15,000

16,000

8,000

N/A

Dividends-received deduction from the 20%-owned corporation equals the lesser of: (1) 65% of the dividend or (2) 65% of taxable income before the 65% dividends-received deduction d

Dividends-received deduction from the lessthan-20%-owned corporation equals the lesser of: (1) 50% of the dividend or (2) 50% of taxable income reduced by the entire dividend from the 20%-owned corporation pp. C:3-14 through C:3-16.

C:3-40 Beta has dividend income of $10,000 but, under Sec. 246, gets no dividends-received deduction because it held the stock 45 days or less. Beta also has a short-term capital loss of $10,000 ($190,000 - $200,000). pp. C:3-17 and C:3-18.

C:3-12

C:3-41 a. Cheers may deduct all the interest paid on the loan. Corporations are not subject to the Sec. 163(d) investment interest deduction limitation rules. Also, Cheers has enough taxable income to avoid the 30% limitation on any business interest deduction under Sec. 163(j). b. Cheers must include all $40,000 of dividends received from Beer in its income. Under Sec. 246, its regular dividends-received deduction is $20,000 ($40,000 x 0.50). However, under Sec. 246A, the dividends-received deduction percentage is reduced by 80% to 10% [50% x (1.00 - 0.80)] because Cheers debt-financed 80% of the stock purchase. The allowed dividends-received deduction is $4,000 ($40,000 x 0.10). p. C:3-18. C:3-42 a.

$55,000 NOL, calculated as follows: Gross income from operations Dividends Gross income Minus: Operating expenses NOL before dividends-received deduction Minus: Dividends-received deduction ($50,000 x 0.50) NOL for 2023

$150,000 50,000 $200,000 (230,000) $(30,000) ( 25,000) $(55,000)

b. $16,000 in 2024 and $39,000 in 2025. In 2024, Ace’s NOL deduction is limited to 80% of taxable income, or $16,000 ($20,000 x 0.80), leaving $39,000 ($55,000 - $16,000) to carry over to 2025. In 2025, 80% of Ace’s taxable income is $80,000, so Ace can deduct the entire $39,000 remaining NOL carryover in 2025 without limitation. c. $17,000 in 2024 and $43,000 in 2025. In 2024, Ace first deducts the $5,000 NOL carryover from the pre-2018 tax year. The deduction in 2024 for the 2023 NOL carryover then is limited to 80% of taxable income after the deduction for the pre-2018 NOL carryover, or $12,000 [($20,000 - $5,000) x 0.80], leaving $43,000 ($55,000 - $12,000) to carry over to 2025. Ace’s total NOL deduction in 2024 is $17,000 ($5,000 + $12,000). In 2025, 80% of Ace’s taxable income is $80,000, so Ace can deduct the entire $43,000 remaining NOL carryover from 2023 without limitation. pp. C:3-18 and C:3-19. C:3-43 a.

$11,200. Delta’s taxable income for 2024 is calculated as follows: Operating gross profit Minus: Operating expenses Taxable income before business interest deduction Minus: Business interest deduction (limited to $80,000 x 0.30) Taxable income before NOL deduction Minus: NOL deduction (limited to $56,000 x 0.80) Taxable income

$200,000 (120,000) $ 80,000 (24,000) $ 56,000 (44,800) $ 11,200

b. $6,000 interest; $55,200 NOL. Delta has a $6,000 ($30,000 - $24,000) business interest carryover to 2025 and a $55,200 ($100,000 - $44,800 NOL carryover to 2025. pp. C:3-10, C:3-11, and C:3-18.

C:3-13

C:3-44 a.

$58,000 taxable income, calculated as follows:

Gross income from operations $180,000 Dividends from less than 20%-owned corporations 100,000 Gross income $280,000 Minus: Operating expenses (150,000) Taxable income before NOL, dividends-received, or charitable contributions deduction $130,000 Minus: Charitable contributions deduction ( 12,000)a Dividends-received deduction ( 50,000)b Taxable income before NOL deduction $ 68,000 NOL deduction ( 10,000)c Taxable income $ 58,000 a Charitable contributions deduction limitation: [($130,000 - $10,000) x 0.10]. Deduction is lesser of $20,000 FMV of contribution or $12,000 limit. b Dividends-received deduction: $100,000 x 0.50 = $50,000 tentative deduction. Limitation 0.50 x ($130,000 - $12,000) = $59,000. Deduction is lesser of $50,000 or $59,000 limitation. c NOL deduction is not limited because 80% of taxable income before the NOL deduction is $54,400 ($68,000 x 0.80), which is greater than the NOL carryover. b. Beta has an $8,000 ($20,000 - $12,000) charitable contributions deduction carryover to the next five years. p. C:3-19. C:3-45 a. Union’s realized loss: $6,000 = $18,000 - $24,000. Union does not recognize the loss because Jane is the controlling shareholder of the corporation. b. Jane’s realized gain: $15,000 = $28,000 - ($18,000 - $5,000). Jane’s recognized gain: $9,000 = $15,000 - $6,000 disallowed loss from Part a. c. Jane’s realized and recognized loss is: $3,000 = $10,000 - ($18,000 - $5,000). The $6,000 loss disallowed in Part a is permanently lost. pp. C:3-20 and C:3-21. C:3-46 Next year. Value cannot deduct the payment until the year it pays it (and Brett includes it in gross income) because Brett is a cash basis taxpayer and a controlling shareholder [Sec. 267(a)(2)]. Thus, the payment is deductible next year. pp. C:3-21. C:3-47 a.

$90,000 taxable income; $18,900 tax, calculated as follows: Gross profit from operations Plus: Net capital gain Total income Minus: Operating expenses Taxable income Tax liability ($90,000 x 0.21)

$150,000 1,000* $151,000 ( 61,000) $ 90,000 $ 18,900

*($8,000 - $15,000) + ($10,000 - $2,000) = $1,000.

C:3-14

$89,000 taxable income; $18,690 tax, calculated as follows:* Gross profit from operations Minus: Operating expenses Taxable income Tax liability ($89,000 x 0.21)

$150,000 ( 61,000) $ 89,000 $ 18,690

*Western has a net capital loss of $2,000 [($8,000 - $15,000) + ($10,000 - $5,000)]. Western may carry this loss back three years and over five years. pp. C:3-5 through C:3-7. C:3-48 Year 1: Taxable income, $140,000; tax liability, $29,400. Year 2: Taxable income, $441,000; tax liability, $92,610. These amounts are calculated as follows: Year 1: Gross profit on sales Minus: Operating expenses Net operating income Long-term capital gain Short-term capital loss allowed ($4,000 carries over) Taxable income Tax liability ($140,000 x 0.21)

$240,000 (100,000) $140,000 8,000 (8,000) $140,000 $ 29,400

Year 2: Gross profit on sales Minus: Operating expenses Net operating income Long-term capital gain Short-term capital loss carryover Taxable income Tax liability ($441,000 x 0.21)

$600,000 (165,000) $435,000 10,000 (4,000) $441,000 $ 92,610

pp. C:3-5 through C:3-7. C:3-49 If a regular corporation: (a) $10,500 = $50,000 x 0.21 (b) $105,000 = $500,000 x 0.21 (c) $10,500,000 = $50,000,000 x 0.21 If a personal service corporation, same as above. p. C:3-5.

C:3-15

C:3-50 a.

$57,000 taxable income; $11,970 tax, calculated as follows: Gross profits Dividends (more than 20%-owned corporations) Gross income Minus: Operating expenses Adjusted taxable income Minus: Charitable contributions deduction (limit: $85,000 x 0.10) Taxable income before the dividends-received deduction Minus: Dividends-received deduction ($30,000 x 0.65) Taxable income Tax liability ($57,000 x 0.21)

$120,000 30,000 $150,000 ( 65,000) $ 85,000 ( 8,500) $ 76,500 ( 19,500) $ 57,000 $ 11,970

b. Pace has a $1,500 ($10,000 - $8,500) charitable contributions carryover to the next five years and a $15,000 ($10,000 + $5,000) capital loss that it can carry back three years and over five years as a short-term capital loss. pp. C:3-5 and C:3-13 through C:3-16. C:3-51 $96,250 taxable income; $20,213 tax, calculated as follows: Gross profits on sales Capital gain net income ($40,000 + $25,000) Dividends from more-than-20%-owned corporation Gross income Minus: Operating expenses Dividends-received deduction ($15,000 x 0.65) NOL carryover from the preceding year (not limited) Taxable income Tax liability ($96,250 x 0.21)

$ 80,000 65,000 15,000 $160,000 ( 45,000) ( 9,750) ( 9,000) $ 96,250 $ 20,213

pp. C:3-5 through C:3-7 and C:3-13 through C:3-16. C:3-52 a. A brother-sister group under either the 50%-80% definition or the 50%-only definition. b. Jones and Kane are a brother-sister group under the 50%-only definition but not a controlled group under the 50%-80% definition. The 80% test is failed because Mary owns no stock in Kane Corporation. Tom owns more than 50% of both Jones and Kane stock. c. A parent-subsidiary group. Link Corporation is the 80% parent of Model; Link and Model together own 90% of Name. d. A combined-controlled group. Oat and Peach Corporations are brother-sister corporations under either definition. Oat Corporation is the parent of Rye Corporation. Seed Corporation is a group member because Oat and Rye together own 90% of Seed. Therefore, the Oat-Rye-Seed group is a parent-subsidiary group. Because Oat belongs to both groups, all four corporations are a combined controlled group. pp. C:3-21 through C:3-25.

C:3-16

C:3-53 Option 3 results in the lowest overall tax at $71,652. In all three options, individual taxable income is $222,300 ($250,000 - $27,700 standard deduction). In Option 1, $89,250 of taxable income is subject to the 0% preferential tax rate, and the remaining $133,050 is subject to the 15% preferential tax rate. In Option 2, $125,000 is subject to the 15% preferential tax rate, and the remaining $97,300 is subject to ordinary tax rates. In Option 3, all $222,300 of taxable income is subject to ordinary tax rates. Corporate taxable income is $400,000 in Option 1, $275,000 ($400,000 - $125,000 salary) in Option 2, and $150,000 ($400,000 - $250,000 salary) in Option 3. (Ignoring payroll taxes.) Tax liabilities are calculated as follows: Option 1: Corporation ($400,000 x 0.21) Individual [($89,250 x 0.0) + ($133,050) x 0.15)] Total tax

$ 84,000 19,958 $103,958

Option 2: Corporation ($275,000 x 0.21) Individual [($125,000 x 0.15) + ($10,294 + 0.22 x ($97,300 - $89,450)] Total tax

$ 57,750 30,771 $ 88,521

Option 3: Corporation ($150,000 x 0.21) Individual [$32,580 + 0.24 x ($222,300 - $190,750)] Total tax

$ 31,500 40,152 $ 71,652

Thus, Option 3 results in the lowest overall tax liability. pp. C:3-27 and C:3-28. C:3-54 The savings associated with the $3,000 of nontaxable fringe benefits equals $3,000 times Elizabeth’s marginal tax rate. The disadvantage of paying fringe benefits is that they generally cannot be restricted to key personnel or shareholder-employees but must cover virtually all employees. Because Elizabeth is the sole shareholder of Omega Corporation it may be less expensive for her to pay the cost of the fringe benefit personally. p. C:3-29. C:3-55 a. Four payments as follows: $57,750, $152,250, $105,000, 105,000. Using the current year tax, the minimum estimated tax payment for each quarter of 2023 will be $105,000 ($420,000 ÷ 4). Because Zeta Corporation is a large corporation, its estimated tax payments other than its first payment for the year cannot be based on the prior year’s tax liability. If Zeta uses the prior year’s tax for the first payment, only $57,750 ($231,000 ÷ 4) will be due for that payment. The second payment must be $152,250 [$105,000 + ($105,000 - $57,750)] to make up the shortfall in the first payment. The remaining two payments are $105,000 each. A smaller estimated tax payment might be possible if the annualized income or seasonal exception applies. b. Zeta’s 2023 tax return is due on April 15, 2024. c. Generally, remaining taxes would be due on April 15, 2024, but Zeta should owe no additional taxes when it files the tax return because its estimated tax payments of $420,000 should exactly equal the $420,000 tax liability. However, if the estimated tax payments turn out to be less than the actual tax liability, Zeta must pay the additional taxes no later than April 15, 2024. Copyright © 2024 Pearson Education, Inc.

C:3-17

d. Zeta may obtain an automatic six-month extension of time to file until October 15, 2024. This extension to file does not extend the time for the payment of the tax (if any), which still is due by April 15, 2024. However, the corporation will not be penalized if it pays at least 90% of its total tax liability by the unextended due date, although it will be charged interest on any unpaid balance. pp. C:3-29 through C:3-32. C:3-56 a. $5,250. Because Wright is not a large corporation, its minimum estimated tax payments are the lesser of: 1. $21,000 (2022 tax) ÷ 4 = $5,250 each quarter. or 2. $126,000 (2023 tax) ÷ 4 = $31,500 each quarter. Thus, quarterly payments of $5,250 on April 15, June 15, September 15, and December 15 of 2023 are sufficient to avoid under payment penalties. If any of these dates fall on a weekend or holiday, a payment made on the next business day is considered to have been made on the due date. b. Wright’s 2023 tax return is due on April 15, 2024. However, Wright may obtain an automatic six-month extension of time to file until October 15, 2024. c. All remaining taxes are due on April 15, 2024. The additional taxes owed will be $105,000 ($126,000 - $21,000). However, the corporation will not be penalized if it pays at least 90% of its total tax liability by the unextended due date, although it will be charged interest on any unpaid balance. d. $31,500. Now, 25% of 2022’s tax becomes $42,000 ($168,000 x 0.25). Therefore, Wright will pay estimated tax payments based on its estimated 2023 tax, which will be $31,500 on each quarterly payment date. If the forecast is accurate, Wright will owe no additional taxes when it files the return. pp. C:3-29 through C:3-32.

C:3-18

C:3-57 a. Rocket Corporation, Inc. Worksheet to Convert Book Income to Taxable Income For the Year ended December 31

Account Title Sales Dividends Interest (a) Gain on stock sale Life ins. proc. (b) Cost of sales Salaries and wages Bad debts Payroll taxes Interest (c) Contributions (d) Depreciation Other expenses (e) Fed. inc. taxes (f) NI/TI before spec. ded. (h) Totals

(a) (b) (c) (d)

(e) (f) (g)

Book Income

Adjustments

Taxable Income (before special deductions)

Dr.

Cr. 3,230,000 10,000 18,000 9,000 100,000

2,000,000 500,000 13,000 62,000 12,000 50,000 70,000 40,000 108,465 511,535 3,367,000 3,367,000

Cr.

3,230,000 10,000 15,000 9,000 0

3,000 100,000

1,000 4,200 25,000

128,000

Cr.

5,000 108,465 9,335 128,000

2,000,000 500,000 13,000 62,000 11,000 45,800 95,000 35,000 502,200 3,264,000

0 0 3,264,000

Municipal bond interest is excluded from taxable income under Sec. 103. Life-insurance proceeds are excluded from taxable income under Sec. 101 if paid as a result of the insured’s death. Interest on debt incurred to carry tax-exempt obligations is not deductible. Allowable charitable contributions deduction: Gross income $3,264,000 Minus: Deductions (other than NOL) (2,716,000) NOL deduction (90,000) Base for calculation of charitable contributions limitation) $ 458,000 Times: 10% allowable deduction 0.10 Charitable contributions deduction limitation $ 45,800 Rocket has a $4,200 ($50,000 - $45,800) charitable contributions carryover. Life insurance premiums are not deductible if the corporation is the beneficiary. Federal income taxes are not deductible when determining taxable income. Taxable income before char. contr. and NOL ded. ($458,000 + $90,000) $548,000 Minus: Charitable contributions deduction (45,800) Taxable income before spec. ded. (Form 1120, Line 28) $502,200 Minus: Special deductions: Dividends-received deduction ($10,000 x 0.65) (6,500) NOL deduction (90,000) Taxable income $405,700 Copyright © 2024 Pearson Education, Inc.

C:3-19

Tax provision reconciliation. Federal income tax expense ($516,500 x 0.21)

$108,465

Federal income taxes payable ($405,700 x 0.21) Net income before federal income taxes Permanent differences: Nondeductible interest Nondeductible insurance premiums Municipal interest Life insurance proceeds Dividends-received deduction Net income after permanent differences Temporary differences: Disallowed charitable contributions Depreciation NOL carryover Taxable income

$ 85,197 $620,000

pp. C:3-33 through C:3-35 and C:3-44.

C:3-20

1,000 5,000 (3,000) (100,000) (6,500) $516,500 4,200 (25,000) (90,000) $405,700

C:3-58 a.

Schedule M-1 of Form 1120 (numbers refer to lines of schedule):

1. 2. 3. 4. 5.

Net income per books Federal income tax expense per books Excess capital losses Income subject to tax not recorded on books Expenses recorded on books not deducted in this return: a. Depreciation $ -0b. Excess charitable contributions 4,000 c. Interest on loan to purchase tax-exempt bonds 7,000 d. Insurance premium 9,000 Total of lines 1 through 5 Income on books not in this return: a. Tax-exempt interest $10,000 Deductions in this return not on books: a. Depreciation 40,000 Total of lines 7 and 8 Income (line 28, page 1) [Line 6 less line 9]

6. 7. 8. 9. 10.

$581,760 156,240 8,000 -0-

20,000 $766,000

( 50,000) $716,000

See solution to Problem C:3-68 for Form 1120, Schedule M-1. b.

Tax provision reconciliation: Net income before federal income taxes Permanent differences: Nondeductible interest on loan Nondeductible insurance premium Tax-exempt interest income Net income after permanent differences Temporary differences: Excess capital loss Excess charitable contributions Depreciation Taxable income a

$738,000 7,000 9,000 ( 10,000) $744,000a 8,000 4,000 ( 40,000) $716,000b

Federal income tax expense = $744,000 x 0.21 = $156,240. Same as line 10 in Schedule M-1 because of no special deductions (i.e., no dividends-received or NOL deductions). b

pp. C:3-33 through C:3-35 and C:3-44.

C:3-21

C:3-59 Schedule M-2 of Form 1120 (numbers refer to lines of schedule): 1. Balance at beginning of year 2. Net income per books 3. Other increases 4. Total of lines 1, 2, and 3 5. Distributions: a. Cash $23,000 b. Stock -0c. Property -06. Other decreases: Contingency reserve 60,000 7. Total of lines 5 and 6 8. Balance at end of year (line 4 less line 7) pp. C:3-37. C:3-60 Step 1: Identify temporary differences. Beginning of Year: Net basis of: Installment note receivable Fixed assets Liability for warranties

Book

Tax

$ -0360,000 -0-

Difference

-0320,000 -0-

-040,000 -0-

Carryovers: Net operating loss carryover Capital loss carryover End of Year: Net basis of: Installment note receivable Fixed assets Liability for warranties

$15,000 -0Book

Tax

Difference

$ 30,000 280,000 12,000

$ 21,000 192,000 -0-

$ 9,000 88,000 12,000

Carryovers: Net operating loss carryover Capital loss carryover

-020,000

Steps 2 - 3: Prepare roll forward schedules and apply tax rates. DTAs: NOL carryover Capital loss carryover Liab. for warranties Total Times: Tax rate DTA

Beg. of Year $15,000 -0-0$15,000 0.21 $ 3,150

End of Year $ -020,000 12,000 $32,000 0.21 $ 6,720

C:3-22

Change $(15,000) 20,000 12,000 $ 17,000 $ 3,570

$246,500 259,574 -0$506,074

( 83,000) $423,074

DTLs: Installment note Fixed assets Total Times: Tax rate DTL

Beg. of Year $ -040,000 $40,000 0.21 $ 8,400

End of Year $ 9,000 88,000 $97,000 0.21 $20,370

Change $ 9,000 48,000 $ 57,000 $ 11,970

Steps 4 - 5: No valuation allowance or uncertain tax position adjustment needed. Step 6: Federal income taxes payable. Gross profit Minus: Tax depreciation Interest expense ($18,000 - $2,000) Other business expenses State income taxes Taxable income before NOL Minus: NOL deduction Taxable income

$800,000 $128,000 16,000 220,000 27,000

Federal income taxes payable ($394,000 x 0.21)

(391,000) $409,000 (15,000) $394,000 $ 82,740*

*Given the facts of this problem, this amount also is the current federal income tax expense for book purposes. Step 7: Total federal income tax expense. Current federal income tax expense (from Step 6) Deferred income tax expense Total federal income tax expense

$82,740 8,400* $91,140

*$11,970 - $3,570 from Steps 2 - 3 Step 8: Journal entry. Current federal income tax expense Deferred income tax expense Deferred tax asset Deferred tax liability Federal income taxes payable

82,740 8,400 3,570 11,970 82,740

C:3-23

Step 9: Tax provision reconciliation. Net income before income taxes Minus: State income taxes Net income before federal income taxes Permanent differences: Nondeductible interest Penalties and fines Municipal interest Net income after permanent differences Temporary differences: Warranty expense Capital loss Depreciation Installment sale NOL carryover Taxable income

$450,000 (27,000) $423,000

Federal income tax expense ($434,000 x 0.21)

$ 91,140

State effective tax rate ($27,000/$450,000) Federal effective tax rate ($91,140/$450,000) Total effective tax rate ($118,140/$450,000)

6.00% 20.25% 26.25%

Federal income taxes payable ($394,000 x 0.21)

$ 82,740

2,000 10,000 (1,000) $434,000 12,000 20,000 (48,000) (9,000) (15,000) $394,000

Step 10: Effective tax rate reconciliation. Statutory tax rate State income tax (net) [6% x (1 – 0.21)] Nondeductible interest ($2,000/$450,000 x 21%) Penalties and fines ($10,000/$450,000 x 21%) Municipal interest [($1,000)/$450,000 x 21%] Total effective tax rate

21.00% 4.74% 0.09% 0.47% (0.05)% 26.25%

Step 11: Partial financial statement presentation. Net deferred tax liability ($20,370 DTL - $6,720 DTA)

$ 13,650

Net income before federal income taxes Minus: State income tax expense Federal income tax expense Net income

$450,000 (27,000) (91,140) $331.860

pp. C:3-37 through C:3-49.

C:3-24

C:3-61 a.

Deferred tax asset = $20,000 x 0.21 = $4,200. Valuation allowance = $8,000 x 0.21 = $1,680.

Current federal income tax expense = $500,000 x 0.21 = $105,000. Deferred federal income tax expense (benefit) = $4,200 - $1,680 = ($2,520). Total federal income tax expense = $105,000 - $2,520 = $102,480. Federal income taxes payable = $500,000 x 0.21 = $105,000.

Journal entry: Current federal income tax expense Deferred tax asset Deferred federal income tax expense (benefit) Valuation allowance Federal income taxes payable

105,000 4,200 2,520 1,680 105,000

Tax provision reconciliation: Operating income Capital loss Net income before federal income taxes Permanent differences: Capital loss carryover > 50% likely to be unrealized Net income after permanent differences Temporary differences: Capital loss carryover ≥ 50% likely to be realized Taxable income

$500,000 (20,000) 480,000 8,000 488,000a 12,000 $500,000b

Total federal income tax expense = $488,000 x 0.21 = $102,480. Effective tax rate = $102,480/$480,000 = 21.35%. b Federal income taxes payable = $500,000 x 0.21 = $105,000. Effective tax reconciliation: Federal statutory rate Increase due to valuation allowance ($8,000/$480,000 x 21%) Effective tax rate Note that the valuation allowance increases the effective tax rate. pp. C:3-39 and C:3-40.

C:3-25

21.00% 0.35% 21.35%

C:3-62 a.

Liability for unrecognized tax benefits = $30,000 x 0.21 = $6,300. Total federal income tax expense = ($1,000,000 + $30,000) x 0.21 = $216,300. Deferred federal income tax expense = $25,000 x. 0.21 = $5,250. Current federal income tax expense = $216,300 - $5,250 = $211,050. Increase in deferred tax liability = $25,000 x. 0.21 = $5,250. Federal income taxes payable = $975,000 x 0.21 = $204,750. Journal entry: Current federal income tax expense Deferred federal income tax expense Deferred tax liability Liability for unrecognized tax benefits Federal income taxes payable

211,050 5,250 5,250 6,300 204,750

Although not required for the problem, the tax provision reconciliation is as follows: Net income before federal income taxes Permanent differences: Unrecognized expense Net income after permanent differences Temporary differences Base for current federal income expense Unrecognized expense deducted for tax Taxable income a

$1,000,000 30,000 $1,030,000a (25,000) $1,005,000b (30,000) $ 975,000c

Total federal income tax expense = $1,030,000 x 0.21 = $216,300. Current federal income tax expense = $1,005,000 x 0.21 = $211,050. c Federal income taxes payable = $975,000 x 0.21 = $204,750. b

pp. C:3-40 and C:3-41.

C:3-26

Comprehensive Problem C:3-63 a. Equipment 1: Sales Price $ 80,000 Cost $180,000 Minus: Depreciation for 2021 (0.1429 x $180,000) $25,722 Depreciation for 2022 (0.2449 x $180,000) 44,082 Depreciation for 2023 (0.1749 x $180,000 x 0.5) 15,741 Total depreciation ( 85,545) Adjusted basis at time of sale ( 94,455) Sec. 1231 ordinary tax loss on sale of Equipment 1 $ (14,455) Equipment 2: Cost Minus: Sec. 179 expense in 2023 MACRS basis Depreciation (Sec. 179 expense) for 2023

$334,000 (334,000) $ -0$334,000

b. Sales $950,000 Minus: Cost of goods sold (450,000) Gross profit $500,000 Plus: Dividends received on Invest Corporation stock 3,000 LTCG on sale of Invest Corporation stock $ 30,000 Minus: Capital loss carryover ( 6,000) Net capital gain 24,000 Minus: Depreciation ($15,741 + $334,000) $349,741 Bad debt deduction 15,000 Other operating expenses: 105,500 Loss on sale of Equipment 1 14,455 Total expenses and loss (484,696) Taxable income before special deductions (Form 1120, Line 28) $ 42,304 Minus: Dividends-received deduction ($3,000 x 0.50) $ 1,500 NOL deduction [limited to ($42,304 - $1,500) x 0.80] 32,643 Total special deductions ( 34,143) Taxable income $ 8,161 Tax liability ($8,161 x 0.21) $ 1,714 c. Net income per books Plus: Federal income taxes per books Excess book over tax bad debt expense ($22,000 - $15,000) Excess book over tax loss ($70,000 - $14,455) Minus: Excess tax over book depreciation ($349,741 - $24,200) Capital loss carryover Taxable income before special deductions (Form 1120, Line 28)

C:3-27

$246,200 65,100 7,000 55,545 (325,541) ( 6,000) $ 42,304

Tax Strategy and Critical Thinking Problems C:3-64 a. Barton Corporation’s tax on $800,000 is $168,000 ($800,000 x 0.21). Mike and Elaine’s tax in 2023 is $35,455, calculated as follows: Salary Minus: Standard deduction Taxable income

$225,000 ( 27,700) $197,300

Tax calculated at 2023 married filing jointly rates is as follows: $35,455 = $30,427 + 0.24 x ($197,300 - $190,750). b. Mike and Elaine are in the 24% marginal tax rate bracket, and Barton Corporation is in the 21% marginal tax bracket. Therefore, they apparently would incur an additional 3% (24% 21%) cost by Mike’s taking additional salary. Specifically, the corporation would get a tax benefit of the deduction at a 21% tax rate while Mike would pay tax on the incremental salary at 24%. Moreover, both Mike and Barton Corporation would have to pay incremental payroll taxes of 1.45% each on any additional salary, for a total percentage of 2.6% [1.45% + 1.45% x (1 - 0.21)], thereby causing a 5.6% (3% + 2.6%) total additional tax cost. c. The Bartons would not save net taxes by having Barton Corporation pay a salary to Elaine Barton. Any payments to her would be taxed at 24% instead of 21%, for an additional cost of 3%, and, moreover, would result in substantial payroll taxes for the corporation and for Elaine. Specifically, the total payroll tax burden would be 13.7% [7.65% + 7.65% x (1 - 0.21)] per year, for a total increased cost of 16.7% (3% + 13.7%). Thus, paying Elaine a salary instead of increasing Mike’s salary results in a significantly higher tax cost. C:3-65 a.

Rho’s taxable income is $22,750 and tax is $4,778, calculated as follows:

Dividends received from Divvy Corporation Operating loss Taxable income before the dividends-received deduction Minus: Dividends-received deduction (limited to $65,000 x 0.65) Taxable income Tax liability ($22,750 x 0.21)

$100,000 (35,000) $ 65,000 (42,250) $ 22,750 $ 4,778

The tentative dividends-received deduction of $65,000 ($100,000 x 0.65) does not create an NOL because taxable income would be exactly zero. Therefore, the limitation applies. Consequently, Rho’s dividends-received deduction is reduced by $22,750 ($65,000 - $42,250) of what it could have been without the limitation imposed. b. Rho could consider two strategies to take advantage of the full $65,000 ($100,000 x 0.65) tentative dividends-received deduction. First, Rho could engage in transactions to increase current year operating income by $35,000, for example, by selling assets or accelerating income recognition. This strategy produces the following result: Copyright © 2024 Pearson Education, Inc.

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Dividends received from Divvy Corporation Operating income (loss) Taxable income before the dividends-received deduction Minus: Dividends-received deduction Taxable income Tax liability ($35,000 x 0.21)

$100,000 -0$100,000 (65,000) $ 35,000 $ 7,350

Note that this strategy increases taxable income before the dividends-received deduction by $35,000 but increases the tax by only $2,572 ($7,350 - $4,778). Thus, the marginal tax rate on the additional $35,000 of income is 7.35% ($2,572/$35,000 x 100) rather than 21%. Alternatively, Rho could engage in transactions to generate one more dollar of operating loss, for example, by accelerating business deductions. This strategy produces the following result: Dividends received from Divvy Corporation Operating loss Taxable income before the dividends-received deduction Minus: Dividends-received deduction Net operating loss

$100,000 (35,001) $ 64,999 (65,000) $ (1)

Thus, Rho can claim the entire tentative dividends-received deduction without limitation because it creates a net operating loss. The key idea in both alternatives is to plan tax strategies that avoid being in the limitation zone for the dividends-received deduction.

Tax Form/Return Preparation Problems C:3-66 (See Instructor’s Resource Manual) C:3-67 (See Instructor’s Resource Manual) C:3-68 (See Instructor’s Resource Manual) C:3-69 (See Instructor’s Resource Manual)

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Case Study Problems C:3-70 a. According to Statements on Standards for Tax Services (SSTS) No. 6, Susan should inform Winter Park Corporation’s management that an error has been found and should recommend that Winter Park file an amended return. She may give this recommendation orally. She may not inform the IRS of the error without permission from Winter Park’s management. b. According to SSTS No. 6, if Susan represents Winter Park and discovers the error with regard to the NOL, she should inform the client promptly and recommend that the client disclose the error. However, she may not disclose the error to the IRS agents unless the client agrees. If the client does not agree to disclose the error, Susan should consider withdrawing from representing the client in the audit proceeding and perhaps consider whether she should continue a professional relationship with the client. c. Susan should recommend that Winter Park file an amended return. If Winter Park does not agree to file an amended tax return, Susan should not prepare or sign the current year’s tax return. According to SSTS No. 1, a CPA should not prepare or sign a return if the CPA knows that the return takes a position the CPA could not recommend. As with the earlier returns, Susan should not disclose the error to the IRS. Statements on Standards for Tax Services are available on the AICPA's website at http://www.aicpa.org. C:3-71 The memorandum to Phil Nickelson should address the following points at a minimum: 1.

The firm should determine whether the Center for Restoration of Waters is on the IRS’s list of qualified charitable organizations. If not, the IRS will disallow the charitable contributions deduction should it audit the return.

Charitable contributions in any tax year are deductible up to 10% of the corporation’s adjusted taxable income. Excess contributions are deductible over a five-year carryover period.

The possibility of accruing charitable contributions to obtain a larger charitable contributions deduction limitation should be considered if the corporation is an accrual method of accounting taxpayer.

The automobiles, boats, and real estate are all possible ordinary income properties because they are depreciable assets, and the depreciation recapture would trigger ordinary income if sold. In the case of depreciated property, the deduction probably is limited to the remaining adjusted basis of the property. The deduction available, for example, when an automobile or computer that has been fully depreciated is donated will be zero. If the ordinary income property’s adjusted basis exceeds its FMV, however, the deduction is limited to the FMV. Moreover, if the donee sells the vehicle for less than its FMV, the deduction is further limited to the amount of sales proceeds. The ordinary income possibility for buildings under the MACRS rule is quite small since buildings generally are depreciated using the straightline method. Copyright © 2024 Pearson Education, Inc.

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5. 6.

Property that has declined in value should not be donated. Instead, the corporation should consider selling the property, collecting the cash, deducting the loss, and donating the cash. When drafting the gift agreement, the corporation should obtain some assurance that the donated property will be used pursuant to the Center’s tax-exempt purpose. If not, the amount of the corporation’s charitable contributions deduction will be reduced for the amount of capital gain income that would have been recognized had the property been sold. In addition, some protection against the asset being sold to obtain cash also should be included in the gift agreement.

The cost of obtaining an appraisal of donated property is not considered to be a charitable contribution. Instead, the appraisal cost is deductible under Sec. 162. The corporation must file Form 8283 in the case of noncash contributions exceeding $500.

The memo should contain an invitation such as the following: Perhaps we should meet and discuss any contributions you plan to make beforehand to determine exactly how much you will be allowed to deduct for tax purposes.

Tax Research Problems C:3-72 Under Sec. 6655(d)(1), a corporation can avoid a penalty for failure to pay required estimated tax installments if the total amount of all estimated tax payments made on or before the last day prescribed for the payment of an installment equals or exceeds the lesser of the amount that would have been required if the estimated tax were (1) 100% of the tax shown on the return for the current tax year (Year 2) or (2) 100% of the tax shown on the corporation’s return for the preceding tax year (Year 1). According to Rev. Ruls. 86-58, 1986-1 C.B. 365, and 78-256, 1978-1 C.B. 438, additions to tax for underpayment of estimated tax for the year are computed by reference to the corporation’s original return unless the corporation files an amended return on or before the due date of the original return (including extensions). In the situation at hand, additions to tax for underpayment of Wicker’s Year 2 estimated taxes are computed by reference to the corporation’s original Year 1 return showing a $20,000 liability because Wicker did not file the amended tax return until April 20 of Year 2 (one month after the due date for the return with no extension requested). If Wicker relies on Sec. 6655(d)(1) to avoid additions to tax for Year 2, it must make estimated tax payments based on the tax liability shown on the original return filed for Year 1, or an amended return filed by the due date for the original return (including extensions). Consequently, Wicker must base its estimated tax payments for Year 2 on the $20,000 tax liability reported on the original Year 1 return if it is going to use the prior year exception. Alternatively, it could rely on having paid 100% of the current tax year liability (Year 2).

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C:3-73 The points listed below are the major ones the memorandum to the tax manager should cover. The student should prepare the memorandum using proper form with good grammar and punctuation. 1.

Under Sec. 170(e), the total amount of Bowen’s charitable contributions is as follows: Property Donated Bates stock Cash to Red Cross Pledge to Girl Scouts Total

Deduction Allowed $110,000 FMV [Sec. 170(e)(1)] 30,000 40,000 [Sec. 170(a)(2)] $180,000

However, under Sec. 170(b)(2) for 2023, Bowen is limited to a deduction of $80,000 (0.10 x $800,000 adjusted taxable income). The remaining $100,000 ($180,000 - $80,000) carries over to the succeeding five years. Assuming, however, that Bowen earns $800,000 of adjusted taxable income in the next two years and makes no additional contributions in those years, it will deduct $80,000 of the carryover next year and the remaining $20,000 in the following year. 2.

Under ASC 720-25, contributions of noncash property are recorded at their FMV. Therefore, the Bates stock is recorded as a $110,000 contribution. For book purposes, the difference between FMV and book value of $65,000 ($110,000 - $45,000) is recorded as a gain on the disposal of the stock. The pledge to the Girl Scouts is recorded immediately if the pledge is unconditional and depends only on the passage of time. Therefore, Bowen should record, for book purposes, total contributions of $180,000.

The $100,000 difference between the total contributions allowed for book purposes ($180,000) and for tax purposes ($80,000) will be a $100,000 positive adjustment item on Schedule M-1 or M-3 of Bowen’s current year corporate tax return. If Bowen deducts an $80,000 carryover next year and a $20,000 carryover in the following year, it will report negative Schedule M-1 or M-3 adjustments of $80,000 and $20,000, respectively, in those carryover years. The current year Schedule M-1 or M-3 also will show a negative adjustment for the $65,000 income recognized for book purposes but not for tax purposes. For book purposes, Bowen also will report a $21,000 ($100,000 x 0.21) deferred tax asset for the charitable contributions carryover, possibly subject to a valuation allowance.

The above results assume that Bowen makes the election in the current year to deduct the amount pledged to the Girl Scouts in the year accrued, 2023 in this case. If Bowen does not make the election, it still will deduct $80,000 in the current year but will have a carryover of $60,000 ($140,000 - $80,000) instead of $100,000. The deduction next year still will be $80,000 consisting of the $40,000 Girl Scout contribution deemed made next year and $40,000 of the $60,000 carryover. The remaining $20,000 carryover will be deducted in the following year for tax purposes.

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“What Would You Do In This Situation?” Solution Ch. C:3, p. C:3-8. The electrical contractor made a number of payments of a questionable nature in the tax year. These payments include $400,000 of kickbacks paid to people working for general contractors who award electrical subcontracts and $100,000 of payments made to individuals in the electrician’s union. Section 162(a) permits a deduction for a trade or business expense that is reasonable, ordinary, and necessary. Section 162(c)(1), however, disallows a deduction for any payment made, directly or indirectly, to an official or employee of any government. Section 162(c)(2) disallows a deduction for any payment made, directly or indirectly, to any person if the payment is an illegal bribe, illegal kickback, or other illegal payment under any law of the United States, or under any law of a state (but only if such law is generally enforced), which subjects the payor to a criminal penalty or to a loss of license or privilege to engage in a trade or business. One would need to look at whether these payments are illegal under federal, state, and local law because both private and government electrical work was involved. Such payments are likely to result in a loss of one’s electrical contracting license or privilege to engage in his or her trade or business. According to the facts in the case, these payments are illegal. Because they are illegal, one would need to look further at whether the laws concerning the making of these payments are “generally enforced.” If such rules are not enforced, then one might make a case that these payments are “necessary and customary” payments in our client’s line of business. Additional research should be undertaken with respect to the enforcement of the applicable laws. Substantial authority needs to be obtained that these payments are, in fact, common among the electrical contractors in the client’s general area of operation to avoid the Sec. 6662 substantial underpayment penalty. Alternatively, the CPA might consider recommending a disclosure, either on the tax return or in a statement attached to the return, the relevant facts affecting the tax treatment for the transaction and that a reasonable basis exists for such treatment. Because of the dollar amounts involved, the CPA needs to be careful about other taxpayer and tax return preparer penalties that might be levied in addition to the additional taxes, interest, and substantial understatement penalty that otherwise are imposed.

C:3-33

Chapter C:4 Corporate Nonliquidating Distributions Discussion Questions C:4-1 A corporation computes current E&P on an annual basis under Sec. 312 by making adjustments to taxable income so that the resulting amount represents the corporation’s economic ability to pay dividends out of the current year’s earnings. The specific adjustments required are outlined in Table C:4-1. Accumulated E&P is the sum of the current E&P (less distributions made out of current E&P) balances for all previous years reduced by the sum of (1) all previous current E&P deficits and (2) any distributions that have been made out of accumulated E&P. pp. C:4-3 and C:4-4. C:4-2 Distinguishing between current and accumulated E&P is necessary because distributions are deemed to come first out of current E&P and then out of accumulated E&P. Thus, if current E&P is positive, any distributions will be dividends to the extent of the current E&P even if accumulated E&P is negative. Also, if E&P is insufficient to cover all distributions, distributions are deemed to come pro rata out of current E&P and then in chronological order out of accumulated E&P. pp. C:4-6 through C:4-8. C:4-3 a. The distribution is a $100,000 dividend payable out of current E&P. b. First, $60,000 of the distribution is a dividend from current E&P. Second, $25,000 is a return of capital that reduces the shareholder’s stock basis to zero. Third, the remaining $15,000 is a capital gain. The $50,000 accumulated E&P deficit remains. c. First, $25,000 of the distribution is a return of capital that reduces the shareholder’s stock basis to zero. Second, the remaining $75,000 is a capital gain. A $120,000 ($60,000 + $60,000) accumulated E&P deficit remains. d. The distribution is a $100,000 dividend payable out of accumulated E&P. None of the current E&P deficit reduces accumulated E&P since the distribution is made on January 1. If the corporation makes the distribution on October 1, the answers to Parts a through c are the same. However, in Part d, accumulated E&P as of October 1 is $40,000 ($100,000 beginning balance - $60,000 current deficit as of October 1) so that $40,000 of the distribution is a dividend. Allocation of the current E&P deficit to the pre-October 1 period is accomplished by multiplying $80,000 times 9/12ths. (Alternatively, the actual number of days could be used, in which case the accumulated E&P deficit would be $59,836 ($80,000 x 273/365) in a non leap-year tax year.) Of the remaining $60,000, $25,000 is a return of capital that reduces the shareholder’s stock basis to zero, and the remaining $35,000 is a capital gain. pp. C:4-6 through C:4-8. C:4-4 a. FMV. The distribution amount is the FMV of all property received. If the shareholder assumes or acquires a liability in connection with the distribution, it reduces the amount of the distribution (but not below zero). b. The distribution amount is a dividend to the extent it is paid out of the current and accumulated E&P of the corporation. Copyright © 2024 Pearson Education, Inc.

C:4-1

c. FMV. The basis of any property received is its FMV. Any liability assumed or acquired by the shareholder in connection with the distribution does not reduce the property’s basis. d. The holding period for the property begins on the day after the distribution date. The answers would not change if they were made to a corporate shareholder because Sec. 301 (c) applies the same dividend rules to each type of shareholder. However, a corporation shareholder may be eligible for the dividends-received deduction. pp. C:4-8 and C:4-9. C:4-5 a. b. c. d.

The tax-exempt interest is added to taxable income to compute current E&P. The dividends-received deduction is added to taxable income. The capital loss carryover is added to taxable income. The federal income taxes are deducted from taxable income. p. C:4-4.

C:4-6 Yes. It is possible. Taxable income or loss must be adjusted under Sec. 312 to compute current E&P. If, for example, Badger had $12,000 of tax-exempt income, or if it had a $12,000 positive adjustment for depreciation, its current E&P could be $4,000 or more. If it were $4,000, the $2,500 distribution would be taxed to shareholders as a dividend, and a $1,500 accumulated E&P balance would remain. pp. C:4-6 through C:4-8. C:4-7 Yes. It matters if the corporation has a current E&P deficit and positive accumulated E&P. In such case, the amount of the current E&P deficit accrued on the distribution date reduces the accumulated E&P, and only the remainder is available for paying out dividends. It also matters if the corporation makes more than one distribution during the year, and there is insufficient E&P for all distributions to be treated as dividends. In such case, current E&P is allocated ratable to all distributions, but accumulated E&P is allocated on a FIFO basis to each distribution. These allocations are particularly important if the corporation’s stock changes hands during the year. pp. C:4-6 through C:4-8. C:4-8 Yes. The corporation should sell the building to a third party and report a $40,000 loss ($120,000 FMV - $160,000 basis) and then distribute the proceeds to its shareholders. If the corporation distributes the property to the shareholders first, the loss cannot be recognized when determining taxable income by either the corporation under Sec. 311(a) or its shareholders because the shareholders take a FMV basis in the property. If the property is distributed, the $160,000 adjusted basis of the building reduces the distributing corporation’s E&P and therefore the taxability of future distributions. pp. C:4-9 through C:4-11. C:4-9 Same tax result either way. From a tax perspective, it makes no difference whether the property is distributed first and then sold or sold first and the proceeds distributed to the shareholder. Either way, the corporation must recognize a $40,000 gain ($160,000 FMV - $120,000 basis) on the disposition/distribution of the building, and the shareholders have a $160,000 dividend. The shareholder’s basis in the building is $160,000. pp. C:4-9 through C:4-11.

C:4-2

C:4-10 A constructive dividend is the manner in which the IRS or the courts might characterize an excessive corporate payment to a shareholder to reflect the true economic benefit conferred upon the shareholder. Such dividends are most likely to arise in the context of a closely held corporation. Examples of constructive dividends include excessive compensation paid to a shareholder-employee or excessive lease payments made to a shareholder-lessor. pp. C:4-11 through C:4-13. C:4-11 Stock dividends generally are nontaxable because they do not add to the property the shareholder already owns, nor do they reduce the property of the corporation. As a general rule, the distribution is taxable whenever a stock dividend changes or has the potential to change the shareholder’s proportionate interest in the distributing corporation. pp. C:4-13 and C:4-14. C:4-12 A stock redemption is the acquisition by a corporation of its own stock for consideration. Some reasons for a redemption are listed on page C:4-16. Some redemptions that substantially change the shareholder’s proportionate interest closely resemble a sale of stock to a third party and are treated as a sale or exchange, while others that do not produce such a change are essentially equivalent to a dividend and are taxed as a dividend. p. C:4-16. C:4-13 If the redemption is treated as a sale, Andrew recognizes a $2,000 capital gain ($10,000 $8,000). Alternatively, if the redemption is not treated as a sale, Andrew recognizes a $10,000 dividend to the extent of Field Corporation’s current and accumulated E&P. In the dividend case, Andrew’s $8,000 basis in the redeemed stock is added to his basis in his remaining stock. The applicable capital gains tax rate would apply to either the $2,000 capital gain or the $10,000 dividend. p. C:4-17. C:4-14 A redemption is treated as a sale if the redemption satisfies any of the following conditions under Sec. 302(b) and Sec. 303: • It is substantially disproportionate. • It is a complete termination of the shareholder’s interest. • It is not essentially equivalent to a dividend. • It is a partial liquidation of the distributing corporation in redemption of part or all of a noncorporate shareholder’s stock. • It is made to pay death taxes. p. C:4-17. C:4-15 The purpose of the attribution rules is to prevent shareholders from either taking advantage of these favorable tax rules or avoiding unfavorable tax rules by deeming family members or related entities to own stock that the shareholder may not actually own. Attribution rules fall into four categories: family attribution, attribution from entities, attribution to entities, and option attribution. pp. C:4-18 through C:4-20. C:4-16 No. The transaction would not be a partial liquidation under Sec. 302(b)(4) because the assets will have been acquired by Ace Corporation in a taxable transaction within the past five years (unless Ace is willing to retain the assets and operate the business for at least five years prior to the partial liquidation). pp. C:4-23 through C:4-25.

C:4-3

C:4-17 Such a Sec. 303 redemption usually results in the shareholder’s recognizing little or no gain or loss because the estate or beneficiary’s basis in the stock redeemed is the stock’s FMV on the date of death (or alternate valuation date). Because the stock is redeemed soon after the date of death, the stock’s value at the time of redemption is likely to approximate the stock’s basis. pp. C:4-25 and C:4-26. C:4-18 A corporation must recognize gain under Sec. 311(b) when it distributes appreciated property in redemption of its stock. It does not recognize any loss when it distributes property that has declined in value. Also, the excess of FMV over the property’s E&P basis increases the distributing corporation’s E&P (and taxes on the corporation’s gain decrease E&P). As with an ordinary dividend, the amount that increases the E&P balance may be different from the gain that increases taxable income. The E&P account also is reduced. The amount of the reduction depends on whether the redemption is treated as a sale or exchange or as a dividend. If the redemption is treated as a sale or exchange, the corporation must reduce its E&P by the portion of the current and accumulated E&P balances attributable to the redeemed stock. That is, E&P is reduced by a percentage that equals the fraction of the outstanding stock redeemed. The remainder of the distribution reduces the capital account. If the redemption does not qualify for sale or exchange treatment, the corporation must reduce its E&P as it does for any other nonliquidating distribution not involving a stock redemption. p. C:4-27. C:4-19 A preferred stock bailout is a plan devised by shareholders to use preferred stock to withdraw earnings from a corporation as a capital gain rather than as a dividend. The specific steps of the plan are described on page C:4-28. Section 306 prevents a shareholder from realizing tax benefits by denying capital gain treatment in certain sales or exchanges and redemptions. It operates by causing certain preferred stock held by a distributee to be tainted. When the tainted (or Sec. 306) stock is sold or redeemed, part or all of the gain or income recognized is treated as a dividend or a “deemed” dividend rather than a true capital gain. Nevertheless, dividends and capital gains are both taxed at the applicable capital gains rate. pp. C:4-27 through C:4-30. C:4-20 An IRS determination that part of the compensation paid an owner-employee is unreasonable in amount means that the corporation loses its tax deduction for that portion of the payment. Generally, the unreasonable compensation is taxed as a dividend to the owner-employee. The dividend is subject to the applicable capital gains tax rate. The corporation still loses the deduction for the reclassified amount, however. The double taxation associated with dividend treatment can be avoided by having the owner-employee enter into a hedge agreement to repay any salary amounts determined to be unreasonable in amount. The shareholder is taxed on the salary payment in the year in which he or she receives the compensation, and the shareholder claims a deduction in the year he or she repays the excess amount to the corporation. pp. C:4-11 through C:4-13, C:4-33, and C:4-34. C:4-21 A bootstrap acquisition is an arrangement whereby a seller sells part of his stock to a purchaser and has the corporation redeem the remainder of his stock. The advantage of this arrangement is that the purchaser needs less cash to make the purchase. The consequence to the seller is the same as though he had sold all his stock to the purchaser because the redemption qualifies for sale treatment as long as the sale and redemption are all part of an integrated plan to terminate the seller’s entire interest. pp. C:4-34 and C:4-35. Copyright © 2024 Pearson Education, Inc.

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Issue Identification Questions C:4-22 The following tax issues should be considered: • Because the two cash distributions exceed E&P, what portion of each distribution comes out E&P? • What portion of each shareholder’s distribution is a return of capital? • What portion of the return of capital distribution(s) reduces the basis of the shareholder’s stock? • What portion of each shareholder’s return of capital distribution is a capital gain? • Is the recognized capital gain long-term or short-term? A key issue is to what extent Marsha’s distribution is treated as a dividend. Dye Corporation has $12,000 of current and accumulated E&P, so only $12,000 can be a dividend to either Barbara or Marsha. Current E&P is allocated ratably to Barbara and Marsha ($4,000 each), and accumulated E&P is allocated on a first-in, first-out basis so the remaining $4,000 of E&P is allocated to Marsha. Therefore, Marsha has an $8,000 dividend and a $2,000 return of capital. Barbara has a $4,000 dividend and a $6,000 return of capital. Any amount received by Marsha or Barbara after recovering their stock basis is a capital gain. The return of capital distribution reduces the basis of Marsha’s stock investment and will result in a corresponding increase (decrease) in the capital gain (capital loss) reported on her sale of the Dye stock to Barbara. pp. C:4-3 through C:4-8. C:4-23 The following issues should be considered: • What reasons might cause the sale price to be $125,000 below the apparent prevailing market price? • What gain or loss does Spring Harbor recognize on the sale? • What is Spring Harbor’s E&P balance? • Do the related party rules apply to the sale? • If the $125,000 shortfall is treated as a dividend, • At what rate is the dividend taxed? • What gain or loss does Spring Harbor recognize on the distribution? • What is the shareholder’s gross income? • What is the shareholder’s basis in the land? • What is the shareholder’s holding period for the land? • What is the distributing corporation’s gain or loss on the distribution? • What effect does the distribution have on the distributing corporation’s E&P? A key issue is whether Spring Harbor can recognize a $25,000 loss on the sale of the land to Neil for $275,000 ($275,000 sale price - $300,000 adjusted basis). It appears that Sec. 267 will prevent the recognition of the loss since, under Sec. 267(b), Neil and Spring Harbor are related parties. An additional issue is whether Neil has received a constructive dividend. If similar land has sold recently for $400,000, it appears that the sale price should have been $400,000 instead of $275,000. The $125,000 difference between the actual sales price and the price paid for similar land, therefore, should be considered a constructive dividend taxed at the applicable capital gains rate. Classifying the difference as a constructive dividend causes Spring Harbor to recognize a $100,000 ($400,000 $300,000) capital gain on the deemed land sale under Sec. 311(b) when appreciated property is distributed. It also will trigger a $21,000 ($100,000 x 0.21) income tax liability that will reduce E&P. Neil will take a $400,000 basis in the land. The distribution will reduce E&P by $125,000. pp. C:4-8 through C:4- 13. Copyright © 2024 Pearson Education, Inc.

C:4-5

C:4-24 The following issues should be considered: • What is Penny’s stock ownership before and after the redemption? • Are any shares attributed to Penny from her mother? • Can Penny elect to waive the family stock ownership attribution rules? • What is the amount and character of Penny’s gain or income on the stock redemption? • What is Penny’s basis in the 30 shares of stock she received as a gift from her mother? • If the distribution is treated as a dividend, how is Penny’s basis in her stock affected? • What is Penny’s mother’s basis in her stock after the redemption (i.e., is any of Penny’s remaining basis transferred to her mother)? • Does the corporation recognize any gain on the repurchase of the shares? • What is the corporation’s basis for the shares repurchased? • What effect does the redemption have on Price Corporation’s E&P? A key issue is whether the redemption should be treated as a sale or a dividend. Penny is deemed to own the shares owned by her mother. Therefore, she is deemed to have owned 70 shares before the redemption (70/100 = 70% of the Price stock) and 40 shares after the redemption (40/70 = 57% of the Price stock). Thus, the redemption is not substantially disproportionate under Sec. 302(b)(2). Another issue is whether Penny can have the family attribution rules waived under Sec. 302(b)(3). A problem is that she received her shares as a gift from her mother. If Penny can show that tax avoidance was not the principal purpose for the gift of the Price stock, she can sign a waiver, and the redemption will be treated as a sale. In such case, she recognizes a $19,000 ($35,000 $16,000) LTCG taxed at the applicable capital gains rate. E&P will be reduced by 30% of the current and accumulated E&P, or $30,000 (0.30 x $100,000). If a waiver of the family attribution rules is not possible, Penny will most likely have a $35,000 dividend, also taxed at the applicable capital gains rate. It is not likely that the Sec. 302(b)(1) “not essentially equivalent to a dividend” rules will apply since Penny still maintains majority stock ownership in Price following the redemption. If the distribution is treated as a dividend, her basis for all 30 shares will be reallocated to her mother since she is the individual whose stock ownership precluded the redemption from receiving capital gain treatment. E&P will be reduced by the $35,000 distributed to Penny. The corporation’s basis in the redeemed shares is not important since the corporation recognizes no gain or loss when it issues new or treasury stock (Sec. 1032). pp. C:4-16 through C:4-23. C:4-25 The following issues should be considered: • What is Gumby’s Pizza’s E&P balance immediately preceding the distribution? • If $50,000 in cash is withdrawn from the business, will it be treated as a dividend to George? • Will the $50,000 withdrawn from the business be considered to have been received as part of George’s stock sale? • Can the tax results for the transaction be improved if George has some of his stock redeemed for the $50,000 cash?

C:4-6

• • •

Would the tax consequences of the transaction be different if the $50,000 is withdrawn from the business either before or as part of the stock sale? Can the $50,000 payment be classified as payment of back wages to George? Would such an amount be deductible by the corporation? What is the amount and character of the gain recognized on George’s sale of the stock?

A key issue is whether the $50,000 George receives from Gumby’s Pizza constitutes a dividend or part of the amount he receives for his stock. If Gumby redeems 25% of his stock for $50,000 in cash as part of the same transaction in which his remaining stock is sold to Mary for $150,000, quite likely he can treat the entire $200,000 as received in exchange for his stock under the bootstrap redemption rules. In such case, he has a $130,000 ($200,000 - $70,000) capital gain. However, if he receives $50,000 from Gumby’s before entering into the sale agreement with Mary, he will have a $50,000 dividend and then an $80,000 ($150,000 - $70,000) capital gain on a later sale of his stock to Mary. In either case, the total $130,000 is taxed at the applicable capital gains rate. It is not likely that Gumby can treat the $50,000 payment as additional compensation (e.g., a bonus or payment made because of lower-than-normal salary payments made in prior years) and then deduct the payment in computing its corporate tax liability. A possibility might be to treat the $50,000 as paid to George in exchange for a covenant not to compete for a certain period of time. Such payment generally is treated as ordinary income to the recipient but is deductible by the payer over a 15-year period under Sec. 197. pp. C:4-3 through C:4-8, C:4-33, and C:4-34.

Problems C:4-26 $67,000 of current E&P, at a minimum, determined as follows: Dividends per quarter (150,000 x $0.15) Times: Number of quarters Total E&P needed Minus: Accumulated E&P at beginning of year Minimum amount of current E&P needed

$22,500 4 $90,000 (23,000) $67,000

Accordingly, $90,000 of current year dividends would be paid first out of the $67,000 projected balance in the current E&P account, then out of the $23,000 existing balance in the accumulated E&P account. pp. C:4-3 through C:4-8.

C:4-7

C:4-27 a.

$28,220 taxable income for 2023, calculated as follows: Gross profit from operations Dividends Interest Net capital gain ($8,000 - $1,200) Total income (Form 1120, Line 11) Minus: Administrative expenses $110,000 Bad debts 5,000 Depreciation 86,000 Charitable contribution [limited to ($85,800 - $40,000) x 0.10] Dividends-received deduction ($20,000 x 0.65) NOL deduction (carryover) Taxable income

$250,000 20,000 10,000 6,800 $286,800 (201,000) $ 85,800 ( 4,580)* $ 81,220 ( 13,000) ( 40,000) $ 28,220

*Charitable contribution carryover to next year = $3,500 from prior year + $3,420 ($8,000 - $4,580) from current year. b.

$227,424 of current E&P, calculated as follows: Taxable income Plus: Municipal bond interest $ 12,000 Life insurance proceeds 100,000 Excess depreciation ($86,000 - $42,000) 44,000 NOL deduction (carryover) 40,000 Dividends-received deduction 13,000 Minus: Excess charitable contribution ($8,000 - $4,580) $ 3,420 Penalties 450 Taxes ($28,220 x 0.21) 5,926 Current earnings and profits

pp. C:4-3 through C:4-6.

C:4-8

$ 28,220

209,000

( 9,796) $227,424

C:4-28 $409,000 of current E&P, calculated as follows: Taxable income Plus: Dividends-received deduction ($80,000 x 0.50) NOL deduction (carryover) Excess depreciation Minus: Long-term capital loss Fines and penalties Federal income taxes ($500,000 x 0.21) Current earnings and profits

$500,000 $ 40,000 20,000 40,000

100,000

$ 80,000 6,000 105,000

(191,000) $409,000

pp. C:4-3 through C:4-6. C:4-29 Beginning of Year 2: ($8,000). The $2,000 distribution in Year 1 is a return of capital and does not affect the E&P deficit. Beginning of Year 3: ($20,000) [($8,000) - $12,000] Beginning of Year 4: ($15,000) [($20,000) + ($10,000 - $5,000)] Beginning of Year 5: ($15,000) [($15,000) + ($14,000 - $14,000)] (The $3,000 distribution exceeding current E&P is a return of capital and does not reduce the accumulated E&P deficit.) p. C:4-3. C:4-30 a. $40,000 dividend to Connie; $15,000 out of current E&P and $25,000 out of accumulated E&P; $10,000 is a return of capital that reduces Connie’s basis to zero; the excess $2,000 is taxable as a capital gain. Accumulated E&P at the beginning of next year is zero. b. $30,000 is a dividend to Connie; $10,000 is a return of capital that reduces Connie’s basis to zero; the excess $12,000 is taxable as a capital gain. Accumulated E&P deficit at the beginning of next year remains at ($20,000). c. Clover’s accumulated E&P as of April 1 (of a non-leap year) is $50,000 - [($73,000 ÷ 365) x 90] = $32,000. Therefore, $32,000 is taxable as a dividend; $10,000 is a return of capital that reduces Connie’s stock basis to zero; and the remaining $10,000 distribution is taxable as a capital gain. Accumulated E&P deficit at the beginning of next year is ($55,000) [$50,000 - $18,000 pro rata deficit $32,000 dividend - $55,000 remaining deficit]. d. $10,000 is a return of capital that reduces Connie’s basis to zero; the excess $42,000 is taxable as a capital gain. Accumulated E&P deficit at the beginning of next year is ($35,000). pp. C:4-6 through C:4-8.

C:4-9

C:4-31 a. Pete recognizes a dividend of $40,000, and Cheryl recognizes a dividend of $80,000. Total E&P is $160,000, so E&P is sufficient for all distributions to Pete and Cheryl to be treated as dividends. b. Pete recognizes a dividend of $22,000 [($40,000/$120,000) x $66,000], and Cheryl recognizes a dividend of $44,000 [($80,000/$120,000) x $66,000]. Because both distributions occurred on the same date, current and accumulated E&P of $66,000 are allocated pro rata to each shareholder. The remaining $18,000 to Pete is treated as a return of capital that reduces his stock basis to $7,000. The remaining $36,000 to Cheryl reduces her stock basis to $4,000. pp. C:4-3 through C:4-8. C:4-32 a. Individual

Date

Amount

Current E&P

Charles Donald Total

3/1 9/1

$ 60,000 90,000 $150,000

$16,000 24,000 $40,000

Accumulated E&P

Dividend

Return of Capital

$30,000 -0$30,000

$46,000 24,000 $70,000

$14,000 66,000 $80,000

Thus, Charles has $46,000 of dividend income and a $14,000 return of capital, which reduces his basis in the Pearl stock from $80,000 to $66,000. The basis reduction increases Charles’s capital gain on the sale to $59,000 [$125,000 - ($80,000 - $14,000)]. Donald has a $24,000 dividend and a $66,000 return of capital, which reduces his stock basis at year-end from $125,000 to $59,000. b. Individual

Date

Amount

Current E&P

Accumulated E&P

Dividend

Return of Capital

Charles Donald Total

3/1 9/1

$ 60,000 90,000 $150,000

$ 40,000 60,000 $100,000

$ -0-0$ -0-

$ 40,000 60,000 $100,000

$20,000 30,000 $50,000

The return of capital distributions reduce Charles’ basis in his Pearl stock from $80,000 to $60,000 and Donald’s basis from $125,000 to $95,000. This basis reduction increases Charles’s capital gain on the sale to $65,000 [$125,000 - ($80,000 - $20,000)].

C:4-10

c. Individual

Date

Amount

Current E&P

Accumulated E&P

Dividend

Charles Donald Total

3/1 9/1

$ 60,000 90,000 $150,000

$ -0-0$ -0-

$60,000a 35,700b $95,700

$60,000 35,700 $95,700

Return of Capital $

-054,300 $ 54,300

59 x ($36,500) = ($5,900) E&P deficit for 1/1 through 2/28. 365 Note: Had this been a leap year, the denominator in the fraction would have been 366 and the numerator would have reflected an additional day in February. Acc. E&P on 3/1 = $120,000 - $5,900 = $114,100 available. b

243 x ($36,500) = ($24,300) E&P deficit for 1/1 through 8/31. 365 Note: Had this been a leap year, the denominator in the fraction would have been 366 and the numerator would have reflected an additional day in February. Acc. E&P on 9/1 = $120,000 - $24,300 - $60,000 = $35,700 Charles reports a $45,000 capital gain ($125,000 - $80,000) on the stock sale because the distribution does not affect his stock basis. The return of capital distribution reduces Donald’s stock basis from $125,000 to $70,700 ($125,000 - $54,300). pp. C:4-6 through C:4-8. C:4-33 a. $48,000 dividend. Dina recognizes a taxable dividend of $48,000 ($56,000 - $8,000). b. $56,000 basis. Dina’s basis in the land is $56,000, its FMV. c. $16,000 capital gain. Sedgwick Corporation recognizes a $16,000 [($48,000 net FMV + $8,000 release from liability) - $40,000] capital gain on the distribution. d. $35,360 net reduction. Sedgwick’s E&P is increased by the $16,000 E&P gain, which is the excess of the land’s FMV over its E&P adjusted basis. (Note that the E&P gain and the tax gain are the same in this problem.) E&P is decreased by the $48,000 ($56,000 FMV - $8,000 mortgage) net amount of the distribution and by the $3,360 (0.21 x $16,000) of federal income taxes imposed on the gain, or a net reduction of $35,360. pp. C:4-8 through C:4-11. C:4-34 a. $20,000 dividend. Arlene recognizes a taxable dividend of $20,000. The amount of the property (land) distribution is zero because the liability reduces the FMV, but not below zero. This result occurs under either interpretation of FMV, i.e., whether actual FMV or the greater liability is used (see Part b). b. Two alternatives for the basis exist. One alternative is that the basis of the land is $50,000, or the property’s actual FMV. Proponents of this approach argue that Sec. 311(b)(1) applies only for gain recognition purposes. The other alternative is that the land’s basis is $60,000 or the FMV determined under Sec. 311(b)(1). See Footnote 9 in text. c. $45,000 capital gain. Stowe Corporation must recognize a $45,000 ($60,000 deemed FMV - $15,000 tax basis) capital gain on the distribution. pp. C:4-8 through C:4-11.

C:4-11

C:4-35 a. $170,000 dividend. Calvin recognizes a dividend of $170,000 ($250,000 FMV $80,000 mortgage assumed), since Quick Corporation has E&P exceeding the amount distributed. b. $250,000 basis. Calvin’s basis in the building is $250,000. c. $100,000 gain. Quick recognizes a gain of $100,000 ($250,000 FMV - $150,000 adjusted basis) for taxable income purposes. Because the building was used in Quick’s business, $6,000 ($30,000 x 0.20) of the gain is ordinary income recaptured under Sec. 291. The remaining $94,000 ($100,000 - $6,000) is Sec. 1231 gain. d. A $101,000 net decrease is determined as follows: Quick’s E&P is increased by the E&P gain of $90,000 ($250,000 FMV-$160,000 E&P adjusted basis) and reduced by the $170,000 net amount of the distribution and by $21,000 ($100,000 x 0.21) in federal income taxes on the $100,000 gain recognized for taxable income purposes, thereby resulting in a net decrease of $101,000. pp. C:4-8 through C:4-11. C:4-36 a. Susan recognizes $200,000 of dividend income and takes a $200,000 basis in the land. Zeta Corporation recognizes a $75,000 Sec. 1231 gain. Zeta’s E&P is increased by $75,000 and reduced by the land’s $200,000 FMV and by the $15,750 ($75,000 x 0.21) of federal income taxes on the gain. b. Susan recognizes $60,000 ($200,000 - $140,000) of dividend income and takes a $200,000 basis in the land. Zeta recognizes a $75,000 Sec. 1231 gain. Zeta’s E&P is increased by $75,000 and reduced by the land’s $60,000 ($200,000 - $140,000) net FMV and by the $15,750 ($75,000 x 0.21) of federal income taxes on the gain. c. Susan recognizes $25,000 of dividend income and takes a basis of $25,000 in the inventory. Zeta recognizes $7,000 of ordinary income. Zeta’s E&P is increased by $7,000 and reduced by the inventory’s $25,000 FMV and by the $1,470 ($7,000 x 0.21) of federal income taxes on the gain. d. Susan recognizes $450,000 of dividend income and takes a $450,000 basis in the building. Zeta recognizes a $300,000 ($450,000 - $150,000) gain for taxable income purposes of which $15,000 ($75,000 x 0.20) is ordinary income under Sec. 291 and $285,000 ($300,000 - $15,000) is Sec. 1231 gain. For E&P purposes, the basis of the building is $165,000 ($225,000 - $60,000). The E&P gain (excess of FMV over E&P adjusted basis) is $285,000 ($450,000 - $165,000). Zeta’s E&P is increased by $285,000 and reduced by the building’s $450,000 FMV and by the $63,000 ($300,000 x 0.21) of federal income taxes on the gain. e. Susan recognizes $8,000 of dividend income and takes an $8,000 basis in the automobile. Zeta recognizes $2,240 of ordinary gain ($8,000 - $5,760) for taxable income purposes. For E&P purposes, the basis of the automobile is $6,800 ($12,000 - $5,200). The E&P gain (excess of FMV over E&P adjusted basis) is $1,200 ($8,000 - $6,800). Zeta’s E&P is increased by $1,200 and reduced by the automobile’s $8,000 FMV and by the $470 ($2,240 x 0.21) of federal income taxes on the gain. f. Susan recognizes $35,000 of dividend income and takes a $35,000 basis in the obligation. Zeta recognizes a $10,500 Sec. 1231 gain on the distribution from sale of property in a prior year (the character of the gain depends on the character of the property sold when the obligation was received). Zeta’s E&P is reduced by the obligation’s $35,000 FMV and by the $2,205 ($10,500 x 0.21) of federal income taxes on the gain. E&P is not increased by the E&P gain on the installment obligation because E&P was increased by the entire gain in the year of sale. pp. C:4-8 through C:4-11.

C:4-12

C:4-37 a. $220,000 ($500,000 paid - $280,000 reasonable compensation) would be nondeductible by the corporation and a constructive dividend to Wilma. b. $400,000 would likely be a constructive dividend to Harry. c. $290,000, which is the net FMV of the property sold ($350,000 - $60,000). Because Wilma paid only $150,000, she has a constructive dividend of $140,000 ($290,000 - $150,000). King Corporation recognizes a total gain of $260,000 ($350,000 FMV - $90,000 basis) on the sale of a portion of the building and the distribution of the remainder of the building. d. $15,000 constructive dividend. Harry recognizes a constructive dividend of $15,000 per year. King’s rent expense is reduced by $15,000. e. $65,000 constructive dividend. Wilma has a constructive dividend of $65,000 ($250,000 - $185,000). King’s basis in the land is reduced from $250,000 to $185,000. f. $8,000 constructive dividend. Harry and Wilma have a constructive dividend of $8,000. King’s deductions for its airplane use are reduced by $8,000. pp. C:4-11 through C:4-13. C:4-38 The $200,000 in disallowed salary and bonuses will be nondeductible by Forward Corporation and taxable as a dividend to Alvin. Forward will lose its salary deduction for a tax cost of $42,000 ($200,000 x 0.21). Assuming a 23.8% (20% + 3.8%) capital gains tax rate, Alvin will save $26,400 [$200,000 x (0.37 - 0.238)] because of the difference between his ordinary tax rate and the applicable tax rate on the dividend income. This solution assumes a 23.8% capital gains tax rate because Alvin’s capital gains rate is 20%, and his income exceeds the $200,000 (or $250,000) AGI threshold, thereby triggering the additional 3.8% tax on net investment income. Thus, the net tax cost is $15,600 ($42,000 - $26,400). pp. C:4-12 and C:4-13. C:4-39 a. None. The stock dividend is nontaxable under Sec. 305(a). b. $2,454.55 gain. Robert’s basis in each share is $909.09 ($100,000 ÷ 110 shares). His gain on the sale is computed as follows: Amount received on sale $7,000.00 Minus: Basis of five shares (5 x $909.09) (4,545.45) Recognized gain $2,454.55 c. $95,454.55 basis. Total basis in the 105 remaining shares is $95,454.55 ($100,000 $4,545.45), or $909.09 per share. Robert’s holding period for all shares begins six years ago when he acquired the original 100 shares. Thus, the holding period for the new shares includes the holding period for the original shares. pp. C:4-13 through C:4-15. C:4-40 a. None. Tillie recognizes no income when she receives the preferred stock. Tillie’s basis in her common and preferred stock is: Basis for 100 preferred shares: $100,000 x $ 10,000 = $ 5,263.16 $190,000 Basis for 1,000 common shares: $100,000 x $180,000 = $94,736.84 $190,000 b. $2,368.42 LTCG. Tillie recognizes a long-term capital gain of $2,368.42 ($5,000 $2,631.58) on the sale of one-half of the preferred stock. Copyright © 2024 Pearson Education, Inc.

C:4-13

c. $94,736.84 basis. Tillie’s basis in her common stock is $94,736.84. Tillie’s basis in her remaining preferred stock is $2,631.58. Her holding period for the preferred shares includes the five-year holding period of the common stock. pp. C:4-13 through C:4-15. C:4-41 a. Zero. Jim recognizes no income when he receives the rights. b. $1,166.67 LTCG. Because the value of the rights ($15) is more than 15% of the value of the underlying stock ($75), the basis of the stock must be allocated to the stock and the right. Jim’s basis in his stock is: $10,000 x ($75/$90) = $8,333.33 ($41.67 per share). Jim’s basis in his rights is $10,000 x ($15/$90) = $1,666.67 ($8.33 per right). Jim recognizes a long-term capital gain of $1,166.67 ($2,000 - $833.33) when he sells the 100 rights. c. None. Jim recognizes no gain when he exercises the rights. Their basis is added to the basis of the stock purchased with the rights ($6,000 + $833.33 = $6,833.33). d. $700 STCG. Jim recognizes a gain of $700 [(60 x $80) - (60 x $68.33)] on the stock sale. The gain is a short-term capital gain since the holding period begins on the September 10 exercise date. e. $11,066.66 basis. Jim’s basis in his remaining shares is as follows: Jim’s original 200 shares: $8,333.33 ($10,000 - $1,666.67). Jim’s 40 remaining shares purchased with the rights: $2,733.20 (40 shares x $68.33). pp. C:4-14 and C:4-15. C:4-42 Under the constructive ownership rules of Sec. 318, George’s stock will be attributed to: a, his wife; b, his father; e, his daughter; and g, his grandfather. pp. C:4-18 through C:4-20. C:4-43 Under the constructive ownership rules of Sec. 318, Lara owns 194 shares: 60 shares directly 10 shares through LMN Partnership (0.20 x 50 shares) 70 shares through LST Partnership (0.70 x 100 shares) 0 shares through Lemon Corporation 54 shares through Lime Corporation (0.60 x 90 shares) Thus, total deemed constructive ownership is 194 shares. pp. C:4-18 through C:4-20. C:4-44 Because Paul still owns 100% of Presto Corporation’s stock, the redemption is treated as a dividend under Sec. 301. Paul recognizes a $30,000 dividend to be taxed at the applicable capital gains rate. His $2,500 ($10,000 x 25/100) basis in the redeemed shares is added to his $7,500 ($10,000 - $2,500) basis in his remaining 75 shares, so his basis in the remaining 75 shares is $10,000. Presto’s E&P is reduced by the amount distributed, or $30,000. pp. C:4-18 through C:4-20, C:4-26, and C:4-27. C:4-45 a. $20,000 dividend; $46,000 total basis ($287.50 per share). Ethel owns 50% of the Benton stock before the redemption and 53.33% (160/300) after the redemption. Therefore, Ethel treats the redemption as a dividend and must recognize $20,000 (40 shares x $500) of dividend income. Ethel’s remaining 160 shares have a total basis of $46,000 (200 shares x $230 each) or $287.50 per share.

C:4-14

Fran owns 25% of the Benton stock before the redemption and 23.33% (70/300) after the redemption. The 23.33% is not less than 80% of Fran’s prior percentage ownership. Therefore, the redemption is not substantially disproportionate. Thus, unless Fran can establish that the redemption is not essentially equivalent to a dividend under Sec. 302(b)(1), she treats the redemption as a dividend distribution and must recognize $15,000 (30 shares x $500) of dividend income. Fran’s remaining 70 shares have a total basis of $23,000 (100 shares x $230 each), or $328.57 ($23,000/70) per share. Georgia owns 12.5% of the Benton stock before the redemption and 6.67% (20/300) after the redemption. Therefore, the redemption is substantially disproportionate and Georgia treats the redemption as a sale of stock under Sec. 302(b)(2) and recognizes a long-term capital gain of $8,100 [30 x ($500 - $230)]. Georgia’s remaining 20 shares have a basis of $230 each. b. Same as Part a for Ethel and Fran; $15,000 dividend to Georgia. If Ethel is Georgia’s mother, Ethel is considered to own 62.5% of the Benton stock (250/400) before the redemption and 60% (180/300) after the redemption. Therefore, Ethel still would have to treat the redemption distribution as a dividend. Georgia also is considered to own 62.5% before the redemption and 60% after the redemption and will be considered to have received a dividend. Thus, the tax consequences to Ethel and Fran do not change from Part a. However, Georgia must report a dividend of $15,000 (30 shares x $500) instead of a capital gain of $8,100 as in Part a. Georgia’s remaining 20 shares have a total basis of $11,500 (50 shares x $230 each), or $575 ($11,500/20) per share. pp. C:4-16 through C:4-23. C:4-46 In Part a, more than 2,700 shares (or at least 2,701 shares). In Part b, more than 2,267.5 shares (or at least 2,268 shares). a. Olsen’s percentage ownership before the redemption is 64.21% (6,100/9,500). To qualify as “substantially disproportionate,” the redemption must pass both the 50% test and the 80% test. Specifically, Olsen’s percentage ownership after the redemption must be less than 50% and be less than 80% of his prior percentage ownership, in this case 51.368% (64.21% x 0.80). With these facts, the 50% test (< 50%) is more binding than is the 80% test (< 51.368%). Thus, if the redemption meets the 50% test, it also will meet the 80% text. To meet the 50% test, the corporation must redeem more than 2,700 shares (or at least 2,701 shares) from Olsen, calculated as follows, where R = number of shares redeemed: (6,100 - R) / (9,500 - R) < 0.50 6,100 - R < 0.50 x (9,500 - R) 6,100 - R < 4,750 - 0.5 R 1,350 < 0.5 R 2,700 < R R > 2,700 shares Proof assuming 2,701 shares redeemed: Olsen owns 3,399 (6,100 - 2,701) shares out of 6,799 (9,500 - 2,701) after the redemption. His ownership percentage after the redemption is 49.993% (3,399/6,799), which is less than 50% and less than 51.368%, thereby meeting both tests.

C:4-15

b. In this situation, Olsen’s percentage ownership before the redemption is now 61.053% (5,800/9,500). As in Part a, to qualify as “substantially disproportionate,” the redemption must pass both the 50% test and the 80% test. Specifically, Olsen’s percentage ownership after the redemption must be less than 50% and be less than 80% of his prior percentage ownership, in this case 48.842% (61.053% x 0.80). With these facts, the 80% test (< 48.842%) is more binding than is the 50% test (< 50%). Thus, if the redemption meets the 80% test, it also will meet the 50% text. To meet the 80% test, the corporation must redeem more than 2,267.5 shares (or at least 2,268 shares) from Olsen, calculated as follows, where R = number of shares redeemed: (5,800 - R) / (9,500 - R) < 0.48842 5,800 - R < 0.48842 x (9,500 - R) 5,800 - R < 4,640 - 0.48842 R 1,160 < 0.51158 R 2,267.5 < R R > 2,267.5 shares Proof assuming 2,268 shares redeemed: Olsen owns 3,532 (5,800 - 2,268) shares out of 7,232 (9,500 - 2,268) after the redemption. His ownership percentage after the redemption is 48.838% (3,532/7,232), which is less than 50% and less than 48.842%, thereby meeting both tests. pp. C:4-20 and C:4-21. C:4-47 Sale treatment. The redemption is treated as a sale of stock by Amy, Beth, and Carla. Each recognizes a $15,000 ($20,000 - $5,000) capital gain on their redeemed shares. All these shareholders have a $1,000 per share basis for their remaining shares. Delta Corporation recognizes a $20,000 dividend because its stock ownership percentage does not change and because the redemption does not qualify for exchange treatment under Sec. 302(b)(4). Delta’s basis in its remaining 20 shares is $25,000, or $1,250 per share. Delta is entitled to a 65% dividends-received deduction for the distribution. pp. C:4-23 through C:4-25. C:4-48 a. A redemption of stock held by John’s estate will not qualify as a sale under Sec. 302 because, if less than all 400 shares, the estate would own 100% percent of the stock before and after the redemption. If the corporation redeems all 400 shares, the transaction would be a complete liquidation under Sec. 331 (see Chapter C:6). If the corporation redeems less than all 400 shares, however, a portion of the redemption can qualify for sale treatment under Sec. 303. The value of the stock in the gross estate ($10 million) is more than 35% of the adjusted gross estate, $5.6 million [0.35 x ($16,500,000 - $500,000)]. Thus, the estate is eligible for Sec. 303 treatment. The maximum qualified redemption under Sec. 303 is $2.22 million ($500,000 deductible funeral and administrative expenses + $1,720,000 estate taxes). b. The redemption qualifies under Sec. 303. However, only $2.22 million qualifies for sale treatment under Sec. 303. This $2.22 million represents 74 shares redeemed at $30,000 per share. The total basis of these 74 shares is $1.85 million ($25,000 x 74 shares). Thus, on this part of the redemption, the estate will report a $370,000 capital gain [$2,220,000 redemption proceeds $1,850,000 basis). Assuming sufficient earnings and profits, the remaining $780,000 ($3,000,000 $2,220,000) of the redemption proceeds is taxed as a dividend to the estate at the applicable capital gains rate for qualified dividends. The $650,000 ($25,000 x 26 shares) basis of these remaining shares is added back to the basis of the 300 shares not redeemed. pp. C:4-17, C:4-18, and C:4-25 through C:4-27. Copyright © 2024 Pearson Education, Inc.

C:4-16

C:4-49 a. $8,000 reduction. Ann’s percentage ownership before the redemption is 40%, and after the redemption it is 33.33% (30/90 shares). Eighty percent of the prior ownership is 32% (40% x 0.80). Therefore, the redemption does not qualify as substantially disproportionate. However, the redemption may or may not qualify as not essentially equivalent to dividend and thus may or may not qualify for sale treatment. If the redemption qualifies for sale treatment, White’s E&P is reduced by 10%, the percentage of stock that was redeemed. Thus, it is reduced by $8,000 (0.10 x $80,000), which is less than the $20,000 redemption proceeds. The remaining $12,000 of redemption proceeds reduces the balance in the capital account. b. $20,000 reduction. If the redemption does not qualify for sale treatment, White’s E&P is reduced by $20,000, the amount of redemption proceeds. pp. C:4-26 and C:4-27. C:4-50 a. Because this redemption is a complete termination of interest, Alan recognizes a gain of $40,000 ($100,000 - $60,000 basis). Barbara and Dave each retain a basis of $60,000 in their remaining shares. Time’s E&P is reduced by $80,000 (100/300 shares x $240,000). Time’s tax basis paid-in capital is reduced by $20,000 ($100,000 redemption amount - $80,000). b. If Barbara is Alan’s mother, Alan is considered to own 200/300 =66 2/3% before the redemption and 100/200 = 50% after the redemption. This redemption is not substantially disproportionate. Therefore, the redemption could be treated as a $100,000 dividend to Alan. If so, Barbara’s basis in her shares is increased by Alan’s basis in the 100 shares surrendered, so her basis is $120,000 ($60,000 + $60,000); Dave’s basis remains at $60,000; and Time’s E&P is reduced by $100,000, the amount of the dividend to Alan. However, the IRS in Rev. Rul 75-502, 1975-2 C.B. 111, held that a redemption was not essentially equivalent to a dividend where a shareholder’s interest dropped from 57% before the redemption to 50% after the redemption. Hence, the shareholder received sale treatment on the redemption. Because the facts in Alan’s situation are similar to those in Rev. Rul. 75-502, he probably can assert that the redemption of his stock is not essentially equivalent to a dividend and claim sale treatment similar to Part a. See Part c, for yet another option. c. If Alan agrees not to obtain any interest in Time for ten years, the family attribution rules can be waived. Therefore, the redemption could be treated as a sale, and Alan could recognize a $40,000 gain. Barbara and Dave each retain a $60,000 basis in their remaining shares. Time’s E&P is reduced by $80,000 [(100/300) x $240,000]. Time’s tax basis paid-in capital is reduced by $20,000 ($100,000 redemption amount - $80,000). pp. C:4-16 through C:4-23. C:4-51 a.

Redemption is treated as a sale: Before the redemption: 30 + 7.5 = 37.5 shares (37.5%) After the redemption: 5 + 7.5 = 12.5 shares (16.67%) The redemption is treated as a sale since it is substantially disproportionate. Bea has a capital gain of $25,000 ($30,000 - $5,000). Excel Corporation’s E&P is reduced by $25,000 (0.25 x $100,000). Excel’s tax basis paid-in capital is reduced by $5,000 ($30,000 redemption amount - $25,000). b. Redemption may be treated as a dividend: Before the redemption: 30 + 7.5 = 37.5 shares (37.5%) After the redemption: 20 + 7.5 = 27.5 shares (30.55%) Generally, this redemption potentially is treated as a $12,000 dividend to Bea because the 80% test is not met (0.80 x 37.5% = 30.00%). Alternatively, sale or exchange treatment may be available under Sec. 302(b)(1) since Bea goes from one minority position to another, possibly making the Copyright © 2024 Pearson Education, Inc.

C:4-17

redemption not essentially equivalent to a dividend. If so, she recognizes a $10,000 ($12,000 $2,000) long-term capital gain. If the transaction is a dividend, Excel’s E&P is reduced by $12,000 (amount distributed). If it is a sale, E&P is reduced by $10,000 (0.10 x $100,000), and tax basis paid-in capital is reduced by $2,000 ($12,000 redemption amount - $10,000). c. Redemption is treated as a sale: Before the redemption: 25 + 15 = 40 shares (40%) After the redemption: 15 shares (20%) The redemption is treated as a sale because it is substantially disproportionate. Carl must recognize a $26,000 ($30,000 - $4,000) capital gain. Excel has a $25,000 (0.25 x $100,000) reduction in its E&P, and a $5,000 reduction in its tax basis paid-in capital. This redemption also qualifies as a complete termination if the family attribution rules are waived. d. The redemption is treated as a sale. Carl’s estate must recognize a $2,000 gain ($30,000 - $28,000 FMV of the Excel stock on Carl’s date of death). Excel again has a $25,000 reduction in its E&P, and a $5,000 reduction in its tax basis paid-in capital. e. Redemption is treated as a sale: Before the redemption: 20 shares (out of 100) (20%) After the redemption: 0 shares (out of 80) (0%) The redemption is either a complete termination or substantially disproportionate. (No stock is attributed from Tetra Corporation to Andrew because Andrew owns less than 50% of the Tetra stock.) Andrew must recognize a $21,000 ($24,000 - $3,000) capital gain. Excel must recognize an $18,000 ($24,000 - $6,000) gain on the distribution of the land. Its E&P is increased by $18,000 minus the $3,780 ($18,000 x 0.21) of federal income taxes attributable to the gain and decreased by $22,844 [0.20 x ($100,000 + $18,000 - $3,780)], which is the lesser of pro rata E&P or the $24,000 distribution. Tax basis paid-in capital is reduced by $1,156 ($24,000 - $22,844). f. Redemption is treated as a dividend: Before the redemption: 25 + 75 = 100 shares (100%). After the redemption: 75 shares (out of 75) (100%). As a result of the attribution rules, Carl owns 100% of Excel stock before and after the redemption. Thus, the substantially disproportionate requirements are not met as they were in Part c. To qualify for sale treatment, Carl must have the family attribution rules waived. If Carl does so, he will recognize a $26,000 ($30,000 - $4,000) capital gain. Excel has a $25,000 (0.25 x $100,000) reduction in E&P, and a $5,000 reduction in its tax basis paid-in capital. pp. C:4-16 through C:4-27. C:4-52 a. Redemption potentially is treated as a dividend, but also possibly as a sale. Under the constructive ownership rules of Sec. 318, Alice owns 690 shares of Holston Corporation as follows: Shares owned directly Attribution from Carol, her daughter Attribution from the ABC Partnership (200 shares x 40%) Attribution from Carol after Carol’s attribution from the ABC Partnership (200 shares x 30%) Attribution from David after David’s attribution from the Gleason Family Trust (300 shares x 50%) Total shares directly or constructively owned by Alice

C:4-18

300 100 80 60 150 690

Alice has no attribution from Bob, her brother, or from Franklin Corporation because she owns less than 50% of the Franklin stock. Alice’s percentage ownership before and after the redemption of 100 shares is as follows: Before the redemption: 690/2,000 = 34.5% After the redemption: 590/1,900 = 31.05% 80% of her prior percentage ownership: 80% x 34.5% = 27.6% Although Alice’s ownership percentage after the redemption (31.05%) is less than 50%, it is not less than 80% of her prior percentage ownership (27.6%). Therefore, the redemption fails to be substantially disproportionate under Sec. 302(b)(2). The redemption also fails to be a complete termination or a partial liquidation. Consequently, the redemption receives dividend treatment unless the reduction from 34.5% to 31.05% is deemed to be a meaningful reduction, making the redemption not essentially equivalent to a dividend under Sec. 302(b)(1). Not passing the substantially disproportionate tests, therefore, injects uncertainty into the outcome. If a dividend, Alice recognizes an $80,000 dividend, and Holston Corporation reduces its E&P by $80,000. Alice’s remaining 200 shares have a total basis of $75,000 or $375 per share. Alternatively, if Alice can sustain sale treatment, she recognizes a $55,000 ($80,000 proceeds $25,000 basis) long-term capital gain, and the corporation reduces its E&P by $5,000 ($100,000 x 100/2,000). Alice’s remaining 200 shares have a $50,000 total basis or $250 per share. b. Redemption definitely is treated as a sale. Alice’s percentage ownership before and after the redemption of 200 shares is as follows: Before the redemption: 690/2,000 = 34.5% After the redemption: 490/1,800 = 27.22% 80% of her prior percentage ownership: 80% x 34.5% = 27.6% Alice’s ownership percentage after the redemption (27.22%) is less than 50%, and it is less than 80% of her prior percentage ownership (27.6%). Therefore, the redemption qualifies as substantially disproportionate under Sec. 302(b)(2) and receives sale treatment. Consequently, Alice recognizes a $110,000 ($160,000 proceeds - $50,000 basis) long-term capital gain, and the corporation reduces its E&P by $10,000 ($100,000 x 200/2,000). Alice’s remaining 100 shares have a $25,000 total basis or $250 per share. pp. C:4-16 through C:4-27. C:4-53 a. $100,000 dividend. Bailey recognizes a dividend of $100,000 subject to the applicable capital gains rate. Checker Corporation reduces its E&P by $100,000, the amount of the dividend. b. $100,000 dividend. Bailey has a dividend of $100,000, which is ordinary income. However, Bailey is entitled to a 65% dividends-received deduction. Checker reduces its E&P by $100,000, the amount of the dividend. c. $60,000 LTCG. Bailey recognizes a long-term capital gain of $60,000 ($100,000 $40,000 basis). Checker reduces its E&P by $70,000 (25% of the $280,000 balance) because she surrendered 25% of the outstanding stock in a redemption qualifying as a sale. d. The results are the same as Part c. Bailey recognizes a $60,000 long-term capital gain, and Checker reduces its E&P by $70,000. e. LTCG if an individual; dividend if a corporation. If Bailey is an individual, she would prefer long-term capital gain treatment. Although capital gains and dividends are both taxed at applicable capital gains rate, she deducts her basis in her stock in calculating her $60,000 of capital gain, whereas dividend treatment does not allow the deduction of basis so she would have to report $100,000 of dividends. Furthermore, she may be able to offset some or all of her capital gains Copyright © 2024 Pearson Education, Inc.

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with capital losses. If Bailey is a corporation, it normally would prefer dividend treatment. A dividend would increase Bailey’s taxable income by $35,000 ($100,000 - $65,000 DRD). A capital gain would increase taxable income by $60,000, with no special rate on capital gains for corporations. However, if the corporation realized a $60,000 capital loss, it could offset the loss against the $60,000 capital gain. In such case, Bailey Corporation might prefer the capital gain. pp. C:4-16 through C:4-27. C:4-54 a. $100,000 deemed dividend and $80,000 capital gain to Fran. The preferred stock is Sec. 306 stock. Fran’s basis in the preferred and common stock is allocated as follows: Preferred:

$150,000 x $60,000 = $20,000 $450,000

Common:

$300,000 x $60,000 = $40,000 $450,000

When Fran sells the preferred stock, $100,000 (the E&P at the time the stock was distributed) is a deemed dividend to Fran, $20,000 is a return of capital, and $80,000 is a capital gain. Star Corporation makes no adjustment to its E&P. b. $100,000 is a deemed dividend and $10,000 is a return of capital. Fran’s remaining $10,000 basis is added to her basis in the common stock, so the common stock basis is $50,000 ($40,000 + $10,000). Star makes no adjustment to its E&P. c. $175,000 dividend and $5,000 capital gain to Fran. Under the Sec. 301 rules, $175,000 is a dividend [up to the amount of E&P in the year of the redemption ($100,000 + $75,000)]; Fran’s $20,000 basis in the preferred shares is recovered tax-free; and the remaining $5,000 of the distribution is a capital gain. Star’s E&P is reduced by $175,000. pp. C:4-28 through C:4-30. C:4-55 a. $50,000 dividend. The sale is recast as a redemption of Razzle stock issued as a result of Bob’s capital contribution of the Dazzle stock to Razzle. The Sec. 302 stock ownership is tested by looking at Bob’s ownership of the Dazzle stock. • Bob’s ownership of Dazzle stock before the redemption: 60% of Dazzle stock. • Bob’s ownership after the redemption: 30 shares directly and 80% x 30 shares indirectly = 54 shares = 54% of Dazzle stock. The redemption is treated as a $50,000 dividend to Bob because the combined E&P of Dazzle and Razzle is $65,000 ($25,000 + $40,000). b. $6,000 and $14,000, respectively. Bob’s basis in his remaining Dazzle stock is $6,000 (30/60 x $12,000). Bob’s basis in his Razzle stock is increased to $14,000 by his $6,000 basis in the redeemed Razzle stock. c. Reduction of $40,000 and $10,000, respectively. Razzle’s E&P is reduced by the first $40,000 of the distribution, and Dazzle’s E&P is reduced by the remaining $10,000 ($50,000 $40,000) of the distribution. d. $6,000 basis. Razzle’s basis in its Dazzle shares is $6,000, the same as Bob’s pre-sale basis.

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e. $44,000 capital gain. If Bob owned only 50% of the Razzle stock before the sale, Bob owns 60% of the Dazzle stock before and 45% after the sale [30 shares + (50% x 30 shares)], so the redemption is treated as a sale under Sec. 302(b)(2). Bob recognizes a capital gain of $44,000 ($50,000 - $6,000 basis). pp. C:4-30 through C:4-32. C:4-56 a. $40,000 dividend. The sale is recast as a redemption. Because Jane still owns more than 50% of Parent after the redemption, [100 shares directly and 20 (50% x 80% x 50) shares indirectly out of 200 outstanding shares], or 60% of Parent’s stock, the $40,000 is taxed as a dividend to Jane. b. $15,000 basis. Jane’s basis in her remaining 100 shares of Parent stock is $15,000. c. $40,000 reduction. Subsidiary’s E&P is reduced to $20,000 ($60,000 - $40,000). d. $40,000 basis. Subsidiary’s basis in the Parent shares is $40,000. e. $70,000 capital gain. The recast redemption is substantially disproportionate {75% before the redemption and 70 [50 + 20 (25% x 80% x 100)] shares, or 35%, after the redemption}. Therefore, Jane recognizes a capital gain of $70,000 [$80,000 - (100/150 x $15,000)]. pp. C:4-32 and C:4-33. C:4-57 a. Jana will recognize $450,000 ($750,000 - $300,000) of capital gain on her sale of 75 shares of Stone Corporation stock to Michael. She will recognize an additional $150,000 ($250,000 - $100,000) of capital gain on the redemption of her remaining shares by Stone. Michael will take a stock basis of $750,000, the amount paid for the 75 shares purchased. Stone will recognize no gain or loss on the redemption if the redemption is for cash. If Stone uses property to redeem Jana’s stock, it will recognize gain (but not loss) on the property used as though the property was sold. Because the redemption of one-fourth of the Stone stock is treated as a sale, the corporation’s E&P will be reduced by $150,000, which is one-fourth of the available E&P. b. The results are the same even though the redemption takes place before the sale. As long as the redemption and sale are part of one transaction, the redemption will qualify as a sale. pp. C:4-34 and C:4-35. C:4-58 Solution appears on next page.

C:4-21

Comprehensive Problem C:4-58 a. Sigma Corporation’s $119,880 taxable income and $31,295 total tax liability are calculated as follows: Income: Operating gross profit Long-term capital gain Total income Deductions: Salary to Brian Payroll tax on Brian’s salary Depreciation Other operating expenses Total deductions Taxable income Income tax ($119,880 x 0.21) Sigma’s portion of payroll tax Total corporate tax liability

$290,000 30,000 $320,000 $ 80,000 6,120 25,000 89,000 200,120 $ 119,880 $ 25,175 6,120 $ 31,295

Brian’s $126,150 taxable income and $24,981 total tax liability are calculated as follows (using the 2023 standard deduction and tax rate schedule for a single individual): Salary income Dividend income AGI Minus: Standard deduction Taxable income

$ 80,000 60,000 $140,000 ( 13,850) $126,150

Ordinary taxable income ($126,150 - $60,000 dividend income)

$66,150

Tax on ordinary taxable income [$5,147 + ($66,150 - $44,725) x 0.22] Tax on dividend income (0.15 x $60,000) Total income tax Brian’s portion of payroll tax Total tax on Brian

$ 9,861 9,000 $18,861 6,120 $24,981

Total corporate and individual tax ($31,295 + $24,981)

$56,276

C:4-22

Sigma Corporation’s current E&P before ($105,705) and after ($45,705) the dividend distribution are calculated as follows: Taxable income Plus: Tax-exempt income Excess of tax depreciation over E&P depreciation ($25,000 - $21,000) Total additions Minus: Federal income taxes Current E&P before dividend distribution Minus: Dividend distribution Current E&P after dividend distribution b.

$119,880 $ 7,000 4,000 11,000 (25,175) $105,705 (60,000) $ 45,705

Brian’s $149,889 taxable income and $51,251 total tax liability are calculated as follows: Operating gross profit Minus: Business deductions: Depreciation Other operating expenses Total deductions Net income from business Plus: Long-term capital gain Minus: One-half self-employment tax AGI Minus: Standard deduction QBI deductiona Total deductions Taxable income

$290,000 $ 25,000 89,000 (114,000) $176,000 30,000 ( 12,289) $193,711 $ 13,850 29,972 ( 43,822) $149,889

Ordinary taxable income ($149,889 - $30,000 LTCG)

$119,889

Tax on ordinary income [$16,290 + ($119,889 - $95,375) x 0.24] Tax on long-term capital gain ($30,000 x 0.15) Total income tax Self-employment taxb Total tax

$ 22,173 4,500 $ 26,673 24,578 $ 51,251

The QBI deduction is not a deduction for AGI. The calculation is not covered until Chapter C:9, so students should take the amount in the problem as given. However, it is calculated as the lesser of ($176,000 - $12,289) x 0.20 = $32,742 or ($176,000 - $12,289 - $13,850) x 0.20 = $29,972. b $176,000 net income from business x 0.9235 = $162,536; ($160,200 x 0.124) + ($162,536 x 0.029) = $24,578.

C:4-23

In the sole proprietorship case, long-term capital gains are taxed once at the individual’s preferential capital gains tax rate (e.g., 15% in Brian’s situation), tax-exempt income is excluded from gross income, and operating profits are taxed once at the individual’s ordinary tax rate. In the C corporation case, long-term capital gain is taxed once at the corporation’s ordinary tax rate and again at the shareholder’s applicable capital gains tax rate (e.g., 15% in Brian’s situation) when distributed as a dividend. Tax-exempt income is excluded from the corporation’s gross income but is taxed at the shareholder’s ordinary tax rate when distributed as a dividend. Operating profits are taxed once at the corporation’s ordinary tax rate and again at the shareholder’s capital gain tax rate when distributed as a dividend. c.

Tax Strategy and Critical Thinking Problem C:4-59 a. John would have a $50,000 dividend. Jamaica Corporation would reduce its E&P by $50,000. b. John would have a $50,000 dividend and a $50,000 basis in the XYZ stock. Jamaica would recognize a $40,000 gain on the XYZ stock. Jamaica’s E&P would be increased by $40,000 assuming taxable income basis and E&P basis are equal and reduced by the $8,400 ($40,000 x 0.21) of federal taxes on the gain and by the XYZ stock’s $50,000 FMV, for a net reduction of $18,400 ($40,000 - $8,400 - $50,000). The disadvantage of this choice is that the corporation must recognize $40,000 and pay tax of $13,600 even though it has not sold the stock and has not received any cash. c. John would have a dividend of $50,000 and a $50,000 basis in the ABC stock. Jamaica’s E&P would be reduced by the $72,000 E&P adjusted basis of the stock to Jamaica. The disadvantage of this choice is that, if the stock is distributed to John, neither John nor Jamaica can ever take the $22,000 loss that Jamaica sustained on this stock before the distribution. d. John would recognize a $50,000 dividend ($81,000 FMV - $31,000 liability assumed). Jamaica would recognize $59,000 of ordinary income under Sec. 1245, the amount by which the $81,000 FMV exceeds Jamaica’s tax basis in the equipment distributed. Jamaica’s E&P would be increased by the $41,000 ($81,000 FMV - $40,000 E&P adjusted basis) E&P gain and reduced by the equipment’s net FMV of $50,000 ($81,000 FMV - $31,000 liability) and by the $12,390 ($59,000 x 0.21) tax on the gain, for a net reduction of $21,390 ($41,000 - $50,000 $12,390). The disadvantage of this choice is similar to that in Part b. Jamaica must recognize a $59,000 gain even though it has not sold the equipment and has not received any cash. e. John would recognize a $50,000 dividend and take a $50,000 basis in the installment obligation. Jamaica would recognize an $18,000 capital gain in the year it distributes the obligation. Its E&P would be increased by the $18,000 gain (assuming taxable income basis and E&P basis are equal) and decreased by the obligation’s $50,000 FMV and by the $3,780 ($18,000 x 0.21) of federal tax on the gain, for a net reduction of $35,780 ($18,000 - $50,000 - $3,780). The disadvantage of this choice is that Jamaica’s gain on the installment obligation is accelerated to the year of distribution instead of spread over the term of the note. f. No. It would not make any difference if John’s stock were redeemed for the property listed. Because John owns all the Jamaica stock, any redemption will be treated as a dividend to the extent of Jamaica’s E&P. g. Best option: cash; worst option: ABC stock. The best option probably would be cash so that Jamaica would not have to recognize any gain. The worst option probably would be the ABC stock because the loss of $22,000 on the stock could never be recognized by John or Jamaica. This Copyright © 2024 Pearson Education, Inc.

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option should be avoided. Of the property distributions resulting in gains, the installment obligation seems least objectionable because it triggers the least gain recognition to the corporation. However, John recognizes a $50,000 dividend currently, but the receipt of cash will be spread over the remaining term of the installment obligation. h. Yes. If John’s 100 shares represented one third of Jamaica’s outstanding shares, unrelated parties owned the remaining 200 shares, and Jamaica exchanged all of John’s shares for each of the properties listed, the distribution would be treated as a redemption in complete termination of John’s interest. Consequently, the following tax consequences would ensue. From the corporation’s perspective, Jamaica would increase its E&P by the excess of the FMV of any appreciated property distributed over that property’s E&P adjusted basis. It then would reduce its E&P by one third (i.e., 100 shares/300 shares), not to exceed the actual distribution amount. Any distribution exceeding the one-third amount would reduce Jamaica’s tax basis paid-in capital. From the shareholder’s perspective, John would recognize gain or loss equal to difference between the distribution amount and the aggregate adjusted bases of the stock surrendered. The character of the gain or loss would depend on the nature of the distributed property in John’s hands (i.e., how he used such property). John’s basis in any noncash property received would be the property’s FMV. The holding period for that property would be the day after the exchange date. i. Yes. If John were an investor, treating the distribution as a sale would be preferable to treating the distribution as a dividend because John could offset his other capital gains with any losses recognized in the sale, and his other capital losses with any gains recognized in the sale. Also, with sale treatment, he recognizes only the gain or loss and not the entire amount of the distribution as a dividend.

Case Study Problems C:4-60 The points listed below should be mentioned in the memorandum to the three sisters. The student should prepare a properly formatted memorandum with good grammar and punctuation. Purchase Transaction 1.

Amy will report a $60,000 ($100,000 - $40,000) long-term capital gain on the sale of the Theta stock to Beth and/or Meg. She might consider an installment sale, which will defer the recognition of the gain over the payment period and provide some interest income for Amy.

The purchasing shareholder(s) will take a $100,000 cost basis in the new block of stock and may control up to two-thirds of the Theta stock. Beth and Meg instead may purchase onehalf of Amy’s stock so that they are equal shareholders immediately following the sale.

The sale transaction does not result in any reduction of the Theta’s earnings and profits.

A sale transaction might be preferred since it does not require an outlay of any of Theta’s assets. If Beth and/or Meg encounter difficulties in raising the required $100,000, a properly structured bootstrap acquisition could be used where Theta redeems some of the shares and Beth and/or Meg purchase the remaining shares.

C:4-25

Redemption Transaction 1.

Amy will report a $60,000 long-term capital gain on the redemption. No attribution of stock occurs from either Beth or Meg to Amy because under the family attribution rules stock ownership is not attributed between siblings. Therefore, the redemption of Amy’s stock is considered a complete termination of Amy’s interest under Sec. 302(b)(3).

The two sisters may prefer to have the corporation redeem the shares because each sister will control one-half of the outstanding stock after the redemption. The redemption also does not require any economic outlay by any of the three shareholders.

The stock redemption will result in a $50,000 ($150,000 x 1/3) reduction in Theta’s earnings and profits, and a $50,000 reduction in paid-in capital.

C:4-61 The client letter should address the following issues: If Maria has a good faith belief that her position relating to the compensation amounts has a realistic possibility of being sustained administratively or judicially on its merits, if challenged, then according to Statements on Standards for Tax Services (SSTS) No. 1, Tax Return Positions, she may recommend that such a position be taken on the tax return. If she does not have such a good faith belief, she nevertheless may recommend the position if there is a reasonable basis for the position and she advises the taxpayer to disclose that position on the return. If she does not have such a good faith belief, and the position is not disclosed on the return, she should not recommend the position be taken, and she should not prepare or sign the return. Statements on Standards for Tax Services are available on the AICPA's website at http://www.aicpa.org. The advice Maria gives regarding the deductibility of the compensation should be written and supported by adequate work papers. Although oral advice may serve a client’s needs appropriately in routine matters, SSTS No. 7, Form and Content of Advice to Taxpayers, Para. 6, recommends written communications in important, unusual, or complicated transactions. The client letter should indicate what kind of support exists for the current and prior years’ compensation amounts, what kinds of audit risk exists, and the possible consequences of a subsequent audit.

Tax Research Problems C:4-62 In drafting the letter, the student should follow the basic steps in the tax research process. The letter should set forth the facts, identify key issues, discuss Sec. 302 and other applicable law, analyze the facts in terms of the law, derive logical conclusions, and present sound recommendations. A key issue that the student should address is whether the management of WEA facilities by a company wholly owned by Weymouth, in consideration for 20% of WEA’s revenues, violates Sec. 302(c)(2)(A)(ii) and Weymouth’s agreement with the IRS. Contractually, under the Widells’ proposal, Fortunelle will provide management services for WEA in return for arm’s length compensation. However, through his 100% ownership of Fortunelle, Weymouth may be deemed to have reacquired an interest in WEA. Facts that may be significant in determining the outcome include the following: Copyright © 2024 Pearson Education, Inc.

C:4-26

• • • • • •

Weymouth’s family relationship with WEA’s shareholders His past equity interest in WEA His past WEA management role His 100% ownership interest in Fortunelle Fortunelle’s proposed management role Fortunelle’s proposed revenue-sharing arrangement

Section 302(b)(3) provides that, if a redemption is in complete redemption of all the stock of the corporation owned by the shareholder, the redemption will be treated as a sale. Therefore, any gain or loss realized by the shareholder will be capital in character. Under Sec. 318(a)(1)(A), for purposes of Sec. 302, corporate stock owned by parents is attributed to their children. Under Sec. 302(c)(2)(A), the Sec. 318(a)(1)(A) attribution rules may be waived if the shareholder meets all the following conditions: i. Immediately after the distribution, the shareholder retains no interest in the corporation (including an interest as officer, director, or employee) other than an interest as a creditor, ii. The shareholder does not acquire any such interest within ten years from the date of the distribution, and iii. The shareholder files an agreement to notify the IRS if he or she acquired such interest. Under the terms of the Widells’ proposal, it appears that Weymouth will have met all three conditions. First, immediately after the corporate distribution of the WEA property, Weymouth retained no interest in WEA. Second, Weymouth will not have acquired an interest within ten years from the date of the distribution. (Fortunelle as a legal entity, not Weymouth as an individual, will have provided management services in an independent contractor capacity.) Third, Weymouth filed an agreement to notify the IRS if he acquires any interest. Weymouth, however, might not have satisfied condition (ii). Because of (1) his 100% ownership of Fortunelle, (2) the nature of the services that Fortunelle would provide for WEA, and (3) the proposed revenue-sharing arrangement, Weymouth might be deemed to have reacquired an interest in WEA, both as an owner and as an officer, within the ten-year period. Therefore, the Sec. 318(a)(1)(A) family attribution rules might not be waived, the redemption will not have been in complete redemption of all WEA stock owned by Weymouth, and the distribution would not have qualified for sale treatment. In Rev. Rul. 70-104, 1971 C.B. 66, the IRS ruled that a father’s performance of services for a corporation pursuant to a consulting agreement gives rise to an interest in the corporation for Sec. 302 waiver purposes. On the other hand, in Estate of Milton S. Lennard, 61 T.C. 554 (1974), the Tax Court ruled that a corporation’s employing a former shareholder did not give rise to an interest for Sec. 302 waiver purposes where (1) the former shareholder was employed as an independent contractor, (2) the corporation determined operating policy, (3) the corporation could terminate the employment at will, and (4) the compensation was reasonable in amount relative to the services performed.

C:4-27

The facts of the present case are analogous to those of Chertkof v. Commissioner, 48 AFTR 2d 81-5194, 81-1 USTC ¶9462 (4th Cir, 1981). In Chertkof, a closely held family corporation distributed real estate to the principal owner’s son in complete redemption of the son’s equity interest. At the time of the distribution, the son had the Sec. 318 family attribution rules waived by executing with the IRS an agreement not to reacquire an equity interest within ten years and to notify the IRS if he did so. As a result of the waiver, the distribution was treated as a sale, and the son recognized capital gain. Following the distribution, the son organized his own real estate company and capitalized it with the distributed real estate. Years later, the son’s wholly owned company entered into an agreement to manage the real estate of the family corporation in consideration for a percentage of its annual revenues. Contending that the real parties to the agreement were the son and the closely held family corporation, the Fourth Circuit Court of Appeals held that the son effectively had reacquired an interest in the family corporation and that this reacquisition violated Sec. 302(c)(2)(A)(ii). Consequently, the Sec. 318(a)(1)(A) family attribution rules effectively were not waived, the redemption was not in complete redemption of the son’s equity interest, and the son should have recognized a dividend, not capital gain. C:4-63 The memorandum should point out that Sec. 274 requires a corporation to meet strict substantiation requirements to deduct travel and entertainment expenses. Note, however, that entertainment expenses incurred after December 31, 2017, are disallowed. These substantiation requirements can be found in Reg. Secs. 1.274-1 and -2. If the corporation does not meet these requirements, the outlays are nondeductible under Sec. 162. The question here is whether these disallowed expenses are considered a dividend to Charles who incurred the expenses. In Henry Schwartz Corp., 60 T.C. 728 (1973), a corporation was denied travel and entertainment expense deductions because it failed to adequately substantiate the costs as required by Sec. 274(d). It was obvious in this case that some of these expenses were for the corporate business and thus were ordinary and necessary expenses. To the extent the outlay was ordinary and necessary to the corporation’s business; the expenses were not considered a dividend to the shareholder even though they were disallowed to the corporation. The IRS originally acquiesced in the Henry Schwartz Corp. decision (1974-2 C.B. 4) concerning the portion of the disallowed expenses that were a constructive dividend. It subsequently has nonacquiesced (1981-2 C.B. 3). Thus, the IRS likely will consider the $10,000 expense to be a dividend to Charles. Charles might prevail in omitting the $10,000 from gross income if he litigated the matter in the Tax Court based on the Henry Schwartz Corp. decision. Additional support for the taxpayer’s position may come from Palo Alto Town & Country Village, Inc. v. CIR, 41 AFTR 2d 78-517, 78-1 USTC ¶9200 (9th Cir., 1977), where the appeals court held that the test for a constructive dividend was twofold; “not only must the expenses be nondeductible to the corporation, but also they must represent some economic gain or benefit to the owner-taxpayer.”

C:4-28

C:4-64 Listed below are the major points that should be covered in the memorandum to the tax manager. The student should prepare the memorandum using proper form with good grammar and punctuation. 1.

Under Sec. 311(b)(1), Benson Corporation must recognize gain on the distribution of Parcel A to Scott Brown. The amount of the gain is $35,000 ($75,000 - $40,000) and its character is capital. However, under Sec. 311(a), the corporation recognizes no loss on the distribution of Parcel B to Lynn Brown.

Under Sec. 312, Benson must reduce its E&P by the FMV ($75,000) of Parcel A and by the E&P adjusted basis ($120,000) of Parcel B. Note that the recognized gain of $35,000 on Parcel A was included in Benson’s taxable income and therefore increased Benson’s E&P net of applicable tax [i.e., $35,000 - (0.21 x $35,000) = $27,650]. If Benson’s E&P basis did not equal its taxable income basis, Benson would further adjust E&P to reflect the difference between the taxable income gain and the E&P gain.

Under ASC 845-10-30-1, Benson must record both the gain on Parcel A ($35,000), and the loss on Parcel B ($45,000). The dividend is then recorded as a debit to retained earnings and a credit to property dividends at an amount equal to the property’s FMV. The entries then would be: At date of declaration: Investment in land Gain on appreciation of land Loss on depreciation of land Investment in land Retained earnings (property dividends declared) Property dividends payable

35,000 35,000 45,000 45,000 150,000 150,000

At date of distribution: Property dividends payable Investment in land 4.

150,000 150,000

Schedule M-1 of Form 1120 would report the difference between the $10,000 loss reported for book purposes and the $35,000 gain reported for tax purposes, which is the $45,000 loss disallowed for tax purposes.

C:4-65 No. There does not appear to be any compensatory intent for the bonus payments to John and Jean. Rather, the bonus payments appear to be “disguised dividends.” Therefore, these payments are likely to be treated as dividends to John and Jean and no deduction will be allowed to Plum Corporation. See O.S.C. & Associates, Inc. v. Comm., 84 AFTR 2d 99-5735, 99-2 USTC Copyright © 2024 Pearson Education, Inc.

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¶50,765 (9th Cir., 1999). In this case with similar facts, the Ninth Circuit affirmed the Tax Court in declaring that compensation based on gross profits and proportional to stock holdings were disguised dividends. The Court held that it was irrelevant whether the compensation or any part of it might have represented reasonable compensation. The method of calculation of the bonuses was not based on the value of services performed but was structured to distribute profits in proportion to stock holdings. C:4-66 The memorandum should explain that Sec. 162(a)(1) permits a taxpayer to deduct a reasonable allowance for salaries or other compensation for personal services actually rendered that is paid or incurred during the tax year. Regulation Sec. 1.162-8 holds that, “The income tax liability of the recipient in respect of an amount ostensibly paid to him as compensation, but now allowed to be deducted as such by the payor, will depend upon the circumstances of each case.” Such amounts may be taxed to the recipient as a dividend. But, “in the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in gross income of the recipient.” In the case at hand, it seems likely that Sara will be required to include all the amounts paid to her as compensation, despite the disallowance of a deduction for the “unreasonable” part of the payments by the corporation. The IRS is unlikely to reclassify the excess compensation as a dividend because, under current law, dividends for the years in question would be taxed at the applicable capital gains rate. The IRS is likely to follow the Sterno case (Sterno Sales Corp. v. U.S., 15 AFTR 2d 979, 65-1 USTC ¶9419 (Ct. Cl. 1965)) where the Court ruled that the taxpayer could not treat excess compensation as a dividend just because it was more advantageous than compensation. The Court required the taxpayer to treat the excess amounts as compensation because that was how they were classified when paid to the taxpayer. Revenue Ruling 69-115, 1969-1 C.B. 50, holds that shareholder-employees of a closely held corporation are entitled to deduct as a business expense in the year of repayment the portion of the salaries they received that were declared unreasonable compensation. Only the amounts they were legally obligated to repay under an agreement with the corporation can be deducted. The obligation to repay the salaries must be enforceable under state law. No deduction is available for any amounts that are voluntarily repaid. Also see Vincent E. Oswald, 49 T.C. 645 (1968), acq. 1968-2 C.B. 2, where the Tax Court held that a repayment was denied a deduction for amounts the shareholder voluntarily repaid prior to the adoption of a by-laws amendment requiring such repayments. Amounts were deductible, however, when paid after the corporation adopted a by-laws agreement requiring repayment of nondeductible compensation payments. In the case at hand, the unreasonable compensation equals: Year 1, $50,000; Year 2, $75,000; and Year 3, $115,000. All the compensation is taxed in the tax year in which it is received. Only the portion of the compensation repaid after the adoption of the by-laws amendment on December 15, Year 2 can be deducted. This amount should be: Year 1, $0; Year 2, $3,125 (1/24 x $75,000); and Year 3, $115,000. One could treat a ratable share of the repayment as being deductible in each of the five years in which a payment is made so that one-fifth of the Year 2 and Year 3 amounts [$23,625 = 0.20 x ($3,125 + $115,000)] is deductible in Year 5 through Year 9.

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“What Would You Do In This Situation?” Solution Ch. C:4, p. C:4-35. You should first alert your clients that this issue is subject to scrutiny. You also should advise your clients of the parameters used by the IRS on this issue. These would include, but not be limited to, the contractual arrangements entered into by members of the firm, the existence of other payments characterized as dividends (if any), and the revenue paid out during the year in proportion to the estimated fair market value of the services rendered by the individual members of the firm. You should examine the formula used to derive the bonus payment. Was it based on the percentage of revenue earned by each shareholder, or was it based on his or her percentage of ownership in the professional corporation? You also should determine the tax consequences to the corporation and the shareholders. Paying some dividends instead of all salary may not be costly because dividends are taxed at the applicable capital gains rate. Also, dividends are not subject to payroll taxes. Therefore, even though the corporation cannot deduct dividend payments, the difference in overall tax between salary payments and dividend payments may not be great. In any event, the final position you take should be in accordance with Paragraph 5a of the AICPA’s Statement on Standards for Tax Services No. 1, Tax Return Positions. Your position should be based on a good faith belief that it has a realistic possibility of being sustained administratively or judicially on its merits. Statements on Standards for Tax Services are available on the AICPA's website at http://www.aicpa.org.

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Chapter C:5 Other Corporate Tax Levies Discussion Questions C:5-1 Carlos could reduce his income taxes by transferring ownership of his investments to his corporation, but such is not always true. The corporation would have to be treated as a C corporation. If it were treated as an S corporation, the investment income would pass through to Carlos and be taxed at the same rate as if he held the investments himself. Although C corporation income is double taxed (first at the corporate level and again at the shareholder level), the two tax rates may be less than Carlos’ marginal tax rate on ordinary income. The first part of the double tax is the 21% corporate income tax, which may be less than or greater than Carlos’ marginal tax rate on ordinary income. The second part of the double tax is the 0%, 15%, or 20% tax rate on an individual’s qualified dividends, which is less than Carlos’ marginal tax rate on ordinary income. This second tax at the shareholder level can be deferred if the corporation does not pay a dividend to Carlos for many years, thereby allowing the investments to grow at a greater rate in the meantime. If Carlos’ investments generate long-term capital gains rather than ordinary income, there would not be a tax benefit in holding his investments in a C corporation. Such investment income would be taxed to the corporation at a 21% rate but would be taxed at a 0%, 15%, or 20% rate if Carlos were to own the investments himself. Even without the second part of the double tax, the tax effect is heavier when holding the investments in a C corporation. If Carlos’ investments generate qualified dividends, there may be a tax benefit for holding his investments in a C corporation since only half of them will be taxed at the 21% rate due to the 50% dividends-received deduction. In all of these circumstances, Carlos also should consider the 3.8% tax on net investment income if his AGI is large enough to subject him to that tax. pp. C:5-2 and C:5-3. C:5-2 Congress enacted the personal holding company (PHC) tax to deter the use of C corporations to shelter passive, investment, and personal services income. If an individual in a higher tax bracket earns such income through a C corporation rather than directly, it is taxed at a 21% rate rather than the individual’s tax rate. The second part of the double tax on C corporation income (i.e., at the shareholder level) mitigates this advantage, but it is deferred if the C corporation retains its earnings rather than paying dividends. The PHC tax is a penalty tax imposed on closely-held C corporations whose income is largely from passive or investment sources or from personal services. By allowing dividends paid to reduce it, the PHC tax provides a disincentive for using C corporations to shelter such income. Congress enacted the accumulated earnings tax rules for similar reasons. This penalty tax is imposed on C corporations that accumulate earnings rather than paying dividends so its shareholders can avoid the second part of the double tax (this tax avoidance purpose is presumed if the corporation accumulates earnings beyond its reasonable business needs). This consideration of the purpose for accumulating earnings and the corporation’s reasonable business needs differs from the PHC tax, whose applicability is based on mechanical rules. Like the PHC tax, the accumulated earnings tax allows dividends paid to reduce it, providing a disincentive for using C corporations to shelter income. pp. C:5-2, C:5-3, and C:5-12. Copyright © 2024 Pearson Education, Inc.

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C:5-3 Exempt from both the PHC tax and accumulated earnings tax in parts b and d. a. Not exempt from the PHC tax and not exempt from the accumulated earnings tax. However, a closely held corporation likely meets the stock ownership requirement. If it also meets the passive income requirement, it qualifies as a PHC and thus is exempt from the accumulated earnings tax. b. An S corporation is exempt from both the PHC tax and the accumulated earnings tax. c. Not exempt from the PHC tax and not exempt from the accumulated earnings tax. d. A tax-exempt organization is exempt from both the PHC tax and the accumulated earnings tax. e. A publicly held corporation is not necessarily exempt from the PHC tax, but it usually is so exempt because most likely it will fail the stock ownership requirement. A publicly held corporation is not exempt from the accumulated earnings tax, but because it is publicly held, it probably is not “formed or availed of for the purpose of avoiding the income tax with respect to its shareholders . . . by permitting earnings and profits to accumulate instead of being divided or distributed.” f. Not exempt from the PHC tax and not exempt from the accumulated earnings tax. g. A limited liability company (LLC) that does not elect to be taxed as a corporation under the check-the-box regulations is not treated as a corporation and thus does not qualify as a personal holding company and is not subject to the accumulated earnings tax. An LLC that elects to be taxed as a corporation is not automatically exempt from the PHC tax and accumulated earnings tax (unless it elects to be treated as an S corporation; see Part b). pp. C:5-4, C:5-12, and C:5-13. C:5-4 Carolina’s president first should determine whether the company meets the stock ownership requirement. If the company is widely held (i.e., five or fewer individuals do not directly or indirectly own more than 50% of the corporation), the stock ownership requirement is not met, and Carolina cannot be a personal holding company. However, if the stock ownership requirement is met, the company must compute its adjusted ordinary gross income (AOGI). The president should be aware that, for purposes of the passive income requirement, AOGI excludes any capital gains and Sec. 1231 gains. Thus, Carolina can avoid being a personal holding company even if it recognizes a large capital gain this year provided its other investment income that is personal holding company income does not exceed 60% of AOGI. pp. C:5-3 through C:5-5. C:5-5 Items a and b are included in PHCI. Items c and i are not included in PHCI. The other items can be excluded from PHCI if the appropriate exclusion or conditions apply. See Table C:5-1 for a summary of the exclusions. a. Included in PHCI. b. Included in PHCI. c. Not included in PHCI. d. Excluded from PHCI if the appropriate exclusion or conditions apply. e. Excluded from PHCI if the appropriate exclusion or conditions apply. f. Excluded from PHCI if the appropriate exclusion or conditions apply. g. Excluded from PHCI if the appropriate exclusion or conditions apply. h. Excluded from PHCI if the appropriate exclusion or conditions apply. i. Not included in PHCI. pp. C:5-5 through C:5-8. Copyright © 2024 Pearson Education, Inc.

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C:5-6 a. Eligible for the dividends-paid deduction for both the PHC tax and accumulated earnings tax for the current year. b. Eligible for the dividends-paid deduction for both the PHC tax and accumulated earnings tax for the current year. c. Eligible for the dividends-paid deduction for both the PHC tax and accumulated earnings tax for the current year. d. Not eligible for the dividends-paid deduction because it is a nontaxable stock dividend (see Chapter C:4). e. Eligible for the dividends-paid deduction for the current year for the PHC tax if Grayson elects throwback treatment. The throwback dividend is limited to the lesser of undistributed PHC income or 20% of the dividends paid during the year. If Grayson does not elect throwback treatment, the dividend is eligible for the dividends-paid deduction for the next year for the PHC tax. For the accumulated earnings tax, throwback treatment is required (without any limit), so the dividend is eligible for the dividends-paid deduction for the current year. pp. C:5-10, C:5-11, and C:5-20. C:5-7 Consent dividends are hypothetical dividends deemed to have been paid to shareholders on the last day of the corporation’s tax year. Any shareholder on such day can elect consent dividend treatment on or before the extended due date for the corporation’s tax return. A consent dividend increases the dividends-paid deduction, thus reducing the PHC tax or accumulated earnings tax. The deadline for electing a consent dividend is several months after the end of the corporation’s tax year, when its amount of undistributed PHC income or accumulated taxable income is better known. The corporation includes consent dividends in its dividends-paid deduction, thus reducing its PHC tax or accumulated earnings tax. The consent dividend also reduces the corporation’s E&P. A shareholder is treated as receiving a consent dividend on the last day of the corporation’s tax year, and it increases the shareholder’s basis in his or her stock. pp. C:5-10 and C:5-20. C:5-8 A deficiency dividend substitutes an income tax payment at the shareholder level for the personal holding company (PHC) penalty tax payment imposed at the corporate level. If a deficiency dividend were not paid, the PHC penalty tax would have to be paid, and then an income tax liability would arise when the earnings were subsequently distributed as a dividend. Under Sec. 547, three requirements must be satisfied with respect to a deficiency dividend: (1) a determination must be made that establishes the PHC tax liability amount, (2) a dividend must be paid within 90 days of establishing the PHC tax liability, and (3) a claim for a dividends-paid deduction must be filed within 120 days of the determination date. The payment of a deficiency dividend does not eliminate liability for interest and penalties that might be imposed with respect to the PHC penalty tax. A deficiency dividend is not available to avoid or reduce the accumulated earnings tax. pp. C:5-10 and C:5-11.

C:5-3

C:5-9 a. True. A PHC does not incur a PHC tax if its undistributed PHC income is zero or negative. b. False. Capital gains are not included in PHCI and AOGI, so they do not affect the passive income requirement. c. True. d. True. e. False. A deficiency dividend that is large enough to reduce UPHCI to zero eliminates only the PHC tax but does not eliminate the interest and penalties related to that tax. f. False. PHCs are exempt from the accumulated earnings tax. pp. C:5-3 through C:5-11. C:5-10 For a number of reasons, the personal holding company (PHC) tax does not raise substantial federal revenues. First, individuals whose small businesses would be PHCs if they organized them as C corporations instead may organize them as limited liability companies treated as partnerships or organize them as corporations and make an S election. Both entity forms are not subject to the PHC tax. Second, the PHC tax rules carve out a number of exceptions to the PHC income definition for selected forms of passive or investment income (for example, the rental income exclusion). Third, a corporation that retains PHC status can avoid the penalty tax by paying sufficient dividends to reduce undistributed PHC income to zero. Finally, the PHC tax rate is 20%, which is close to the 18.8% and 23.8% high-end preferential tax rates on dividends (including the 3.8% net investment tax). Therefore, the tax bite of the PHC tax is not as bad as its bark. pp. C:5-3 through C:5-11. C:5-11 According to the IRC, the accumulated earnings tax can apply to both publicly held and closely held corporations. However, the necessary tax avoidance purpose usually exists only with respect to closely held corporations where a shareholder group also is involved in the management of the corporation and can control its policies concerning the payment of dividends. Such a situation also could arise when management control for a publicly held corporation is held by a shareholder group that also has substantial stockholdings. pp. C:5-12 and C:5-13. C:5-12 Corporate level; avoidance does not have to be the sole motive. The tax avoidance scheme usually involves a reduction or elimination of the shareholder tax on the distribution of corporate earnings. The actions that avoid the tax liability usually take place at the corporate level and typically involve dealings between the corporation and its shareholders (e.g., corporate loans to the shareholders) or corporate investments of undistributed earnings in assets having no reasonable connection to the corporation’s business. According to the U. S. Supreme Court in The Donruss Company case, tax avoidance does not have to be the sole or dominant motive for the accumulation of earnings to have the accumulated earnings tax imposed. Tax avoidance only needs to be one of the motives. pp. C:5-12 through C:5-14. C:5-13 Hart Corporation could be subject to the personal holding company (PHC) tax or the accumulated earnings tax, but it is not subject to both of them because PHCs are exempt from the accumulated earnings tax. Hart is subject to the PHC tax if it meets the stock ownership and passive income requirements. It meets the stock ownership requirement because one individual (Angela) owns 100% of its stock. There is insufficient information to know whether the passive income requirement is met, but a start-up corporation often meets this requirement in its initial year because Copyright © 2024 Pearson Education, Inc.

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it often has little income that is not PHC income. Even if Hart meets the passive income requirement and thus qualifies as a PHC, it can avoid a PHC tax liability by paying dividends to Angela that are sufficient to reduce its undistributed PHC income to zero. To be subject to the accumulated earnings tax, Hart generally must accumulate earnings beyond its reasonable business needs. Because it is starting up, Hart likely has numerous reasonable business needs and thus may be able to justify the retention of any earnings. Even if it does not have many reasonable business needs, Hart’s potential accumulated earnings tax may be zero because it likely has low earnings in its initial year and a full $250,000 accumulated earnings credit available (Hart does not have any accumulated E&P at the end of the preceding year because it is newly formed). pp. C:5-3, C:5-4, and C:5-12 through C:5-14. C:5-14 Because Gamma Corporation has only a moderate need to reinvest its earnings in existing facilities or for expansion, it may have accumulated earnings beyond its reasonable business needs. If so, the tax law presumes that the purpose for accumulating earnings is the tax avoidance purpose that triggers the accumulated earnings tax. To reduce Gamma’s exposure to the accumulated earnings tax, its CFO should document Gamma’s reasonable business needs, making sure the plans for the earnings’ use are specific, definite, and feasible. These needs may include expanding Gamma’s business, acquiring a business, working capital, debt retirement, loans to suppliers or customers, potential product liability losses, stock redemption requirements, and business contingencies. Gamma can further reduce its accumulated earnings tax exposure by paying dividends to its shareholders. Even if Gamma is subject to the accumulated earnings tax, these payments will reduce the tax by increasing Gamma’s dividends-paid deduction. Gamma can eliminate any accumulated earnings tax exposure for future tax years by making an S corporation election (it also could eliminate any accumulated earnings tax exposure for the current tax year if Gamma makes the election in the first 2½ months of the current tax year; see Chapter C:11). If an S corporation election is not feasible, Gamma could convert its legal entity form from a corporation to a limited liability company. This conversion would maintain limited liability but eliminate any subsequent accumulated earnings tax exposure because Gamma would no longer be a corporation. The conversion, however, could generate current tax liabilities for Gamma and its shareholders because the corporation would be liquidating (see Chapter C:6). pp. C:5-12 through C:5-14 and C:5-26. C:5-15 The Bardahl formula estimates working capital needed for one operating cycle. An operating cycle is the sum of the inventory cycle and the accounts receivable cycle, reduced by the credit cycle. The average operating cycle (expressed as a portion of the year) is multiplied by a cash needs of the business factor for the year to derive the working capital requirements for one operating cycle. Comparing the corporation’s actual working capital to the estimated working capital needs indicates whether the corporation’s reasonable business needs include additional working capital. Calling this estimation a formula suggests mathematical precision, but the Bardahl formula’s applicability in practice is less precise because its inputs for a particular corporation’s facts and circumstances often are a matter of dispute. For example, the courts, the IRS, and taxpayers have in various instances based their Bardahl calculations on annual averages, monthly averages, peak month averages, and forecasted data. Depending on which set of calculations is accepted by the IRS and the courts, the estimated working capital needs amount can vary substantially. pp. C:5-16 through C:5-18. Copyright © 2024 Pearson Education, Inc.

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C:5-16 Operating companies can claim a credit equal to the greater of (1) $250,000 minus the accumulated E&P at the end of the preceding tax year or (2) the portion of current E&P (after reduction for the dividends-paid deduction and the net capital gain [reduced by federal income taxes on it]) retained to meet the reasonable needs of the business. Service companies are limited to the greater of $150,000 (minus accumulated E&P at the end of the preceding tax year) or the portion of current E&P (after reduction for the dividends paid deduction and the net capital gain, reduced by federal income taxes on it) retained to meet the reasonable needs of the business. Holding and investment companies are limited to $250,000 (minus accumulated E&P at the end of the preceding tax year) without the availability of the reasonable needs of the business alternative. pp. C:5-20 and C:5-21. C:5-17 a. True. b. False. The net capital gain (minus related federal income taxes) is a negative adjustment made to derive accumulated taxable income. c. False. A single accumulated earnings credit statutory exemption must be allocated among the members of a controlled group. d. False. The dividends-paid deduction does not reduce regular taxable income. e. True. f. False. Interest and penalties on the accumulated earnings tax are imposed from the date the return was originally due (without regard to any extensions). g. False. The accumulated earnings tax is not self-assessed by filing a tax return. pp. C:5-12 through C:5-21. C:5-18 a. PHC tax only. b. Accumulated earnings tax only. c. Accumulated earnings tax only. d. Both taxes. e. Both taxes. f. Neither tax. An accumulated earnings credit is allowed for the accumulated earnings tax, but it functions like a deduction and does not reduce the tax on a dollar-for-dollar basis. g. Accumulated earnings tax only. h. Both taxes. i. PHC tax only. j. PHC tax only. k. Neither tax. pp. C:5-13 through C:5-21. C:5-19 Agnew is unlikely to incur the book minimum tax if it goes public. A corporation is subject to this tax if its average annual adjusted financial statement income (AFSI) for any prior threetaxable-year period ending after December 31, 2021, exceeds $1 billion, and Agnew’s AFSI is likely much less than $1 billion. It is irrelevant whether Agnew’s stock is publicly traded. Agnew’s average annual AFSI for a three-taxable-year period may eventually exceed $1 billion, but its profits would have to be more than about ten times what they currently are. pp. C:5-22 through C:5-25.

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C:5-20 The book minimum tax is 15% of adjusted financial statement income (AFSI) exceeding the regular tax, and the regular tax is 21% of taxable income. In order for 15% of AFSI to exceed 21% of taxable income, AFSI needs to be greater than 140% of taxable income (AFSI ÷ TI > 0.21 ÷ 0.15). Blazic’s AFSI is only about 120% of taxable income, so its book minimum tax for the current year is zero. pp. C:5-22 through C:5-25.

Issue Identification Questions C:5-21 The following tax issues regarding Parrish Corporation’s first year of operations must be addressed: • • • • •

Will Parrish be deemed to be a PHC based on its first year income projections? Do the projections suggest that this will be a long-term problem? If Parrish would incur a PHC tax liability in its initial year of operation, what measures can be taken before year-end to avoid PHC status? Would Parrish benefit by making a timely S corporation election applicable to its initial tax year? To a later tax year? If Parrish is a PHC for its initial year of operation, what measures (e.g., current year dividends, throwback dividends, or deficiency dividends) can be taken after year-end to avoid liability for the PHC tax? If Parrish lacks sufficient cash to pay the dividend required to avoid PHC status, can a consent dividend eliminate the cash shortfall problem?

Projections indicate that 70% of Parrish’s gross income will consist of interest and dividends. The remaining 30% will consist of net rental income. Therefore, it appears that all of Parrish’s income is personal holding company income. Parrish meets the stock ownership requirement because five or fewer individuals own more than 50% of its stock (Robert and Kim own 100%). Thus, Parrish likely will be a personal holding company. Some consideration should be given to shifting investments to stocks with capital gains (instead of dividend potential) and shifting from corporate bonds to bonds earning tax-exempt interest. Parrish can attempt to change the nature of its activities to increase net rental income above 50% of AOGI and reduce the level of other PHCI earned (e.g., dividends and interest). If such changes are made, perhaps personal holding company status can be avoided in the initial tax year as well as in later years. Alternatively, other PHCI can be reduced by dividend payments so as to trigger the rental income exclusion. If PHC status cannot be avoided in the initial year, Parrish can pay sufficient dividends to minimize liability for the penalty tax, interest, and penalties. Alternatively, Parrish might consider making an S corporation election for its initial year and/or its second year. The built-in gains tax may pose a problem when the corporation retained C corporation status in its initial tax year and makes an S corporation election that begins with its second tax year. An S corporation election in the initial tax year can simplify the tax accounting that would be required by making the election in the second tax year or in a later tax year. pp. C:5-3 through C:5-11.

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C:5-22 The following tax issues regarding McHale Corporation’s earnings must be addressed: • Has McHale accumulated earnings beyond the reasonable needs of the business? • If so, was tax avoidance one of the directors’ motives for retaining the earnings? • What business needs can McHale’s management cite to justify the current and prior years earnings accumulation? To justify any future earnings accumulations? • What steps can McHale take to reduce its current accumulated earnings tax exposure? Its future accumulated earnings tax exposure? • Should McHale bring the accumulated earnings tax issue to the IRS’s attention? • Should an S corporation election be made to reduce future exposure to the accumulated earnings tax? McHale has a large E&P balance ($2 million currently), which is growing annually at a level of $300,000. Few dividends have been paid, and a substantial portion of the current year profit has been invested in portfolio securities or loaned to shareholders. The investment activities and loans indicate a possible accumulated earnings tax problem. Guidance should be given to McHale that “active business” investments should replace “portfolio” investments if the corporation is to avoid the accumulated earnings tax in future years. The corporation’s level of accumulated earnings is well past its $250,000 minimum accumulated earnings credit. Consequently, the corporation should document that the earnings are being retained to meet the reasonable needs of the business. No indication has been given whether such documentation exists although there is an indication that some of the investments are being made to protect against a business downturn, which is a legitimate use of corporate earnings. pp. C:5-12 through C:5-18.

Problems C:5-23 a. $200 more after-tax income. If Rick owns the investments himself, he will incur $8,160 ($20,000 x (0.37 + 0.038)) of tax, leaving him with $11,840 ($20,000 - $8,160) of after-tax income. If Rick’s C corporation owns the investments, the corporation will incur $4,200 ($20,000 x 0.21) of tax, leaving $15,800 ($20,000 - $4,200) to be paid as a dividend to Rick. He incurs $3,760 [$15,800 x (0.20 + 0.038)] of tax on the dividend, leaving him with $12,040 ($15,800 - $3,760) of after-tax income. Rick’s after-tax income thus is $200 ($12,040 - $11,840) more if he transfers the investments to his wholly-owned corporation rather than owning them himself. b. $2,170 less after-tax income. If Rick owns the investments himself, his after-tax income is $15,600 [$20,000 - ($20,000 x 0.22)]. If Rick’s C corporation owns the investments, the corporation’s after-tax income is $15,800 (see Part a), and Rick’s after-tax income is $13,430 [$15,800 - ($15,800 x 0.15)]. Rick’s after-tax income thus is $2,170 ($13,430 - $15,600) less if he transfers the investments to his wholly-owned corporation rather than owning them himself. c. Revised a. $756 more after-tax income. If Rick owns the investments himself, their value will grow 2.368% [4% x (1 – 0.37 – 0.038)] per year, resulting in $13,310 ($11,840 x 1.023685) after five years. If Rick’s C corporation owns the investments, their value will grow at 3.16% [4% x (1 – 0.21)] per year after corporate taxes, resulting in $18,459 ($15,800 x 1.03165) after five years. After receiving this amount as a qualified dividend and paying tax on it, Rick’s after-tax income is $14,066 [$18,459 - ($18,459 x (0.20 + 0.038))]. Rick’s after-tax income thus is $756 ($14,066 - $13,310) more if he transfers the investments to his wholly-owned corporation rather than owning them himself. Copyright © 2024 Pearson Education, Inc.

C:5-8

Revised b. $2,500 less after-tax income. If Rick owns the investments himself, their value will grow at an after-tax rate of return of 3.12% [4% x (1 – 0.22)] per year, resulting in $18,190 ($15,600 x 1.03125) after five years. If Rick’s C corporation owns the investments, their value will grow to $18,459 in the corporation after five years (see above), and Rick’s after-tax income is $15,690 [$18,459 - ($18,459 x 0.15)]. Rick’s after-tax income thus is $2,500 ($15,690 $18,190) less if he transfers the investments to his wholly-owned corporation rather than owning them himself. pp. C:5-2 and C:5-3. C:5-24 a. Duck is a personal holding company (PHC). The stock ownership and passive income requirements are both met. Stock ownership requirement: Zhao and any four of the nine other shareholders own 55% (19% + (4 × 9%)) of Duck’s stock. These five individuals own more than 50% of Duck’s stock, so the stock ownership requirement is met. Passive income requirement: Personal holding company income (PHCI) is 72.8% ($284,000 ÷ $390,000) of adjusted ordinary gross income (AOGI). This percentage is at least 60%, so the passive income requirement is met. b. Duck is not a PHC. The stock ownership requirement is not met. Any five of Duck’s shareholders own 50% (5 × 10%) of Duck’s stock. These five individuals do not own more than 50% of Duck’s stock, so the stock ownership requirement is not met. As in Part a, the passive income requirement is met, but Duck must meet both requirements to qualify as a PHC. c. Duck is a PHC. Zhao and any four of the nine other shareholders own 49.5% (9.1% + (4 × 10.1%)) of Duck’s stock, which is not more than 50% of Duck’s stock. However, any five of the other nine shareholders own 50.5% (5 × 10.1%) of Duck’s stock, which is more than 50% of its stock. Thus, Duck meets the stock ownership requirement and, as in Part a, meets the passive income requirement. p. C:5-4. C:5-25 a. PHC--Art is deemed to own all of Small’s stock under the Sec. 544 attribution rules. b. PHC--Art plus Phil, Robert, and Sue (the three individuals each are deemed to own onethird of the PRS Partnership’s stockholdings) are considered to own two-thirds of Small’s stock. c. PHC--Becky Whitaker is deemed to own all of Small’s stock (20% directly, 20% from her husband Art, 15% indirectly from the Trust, and 45% constructively from her sisters). p. C:5-4. C:5-26 Does not meet the passive income requirement, determined as follows: Gross income = $700,000 + $350,000 + $65,000 + $450,000 = $1,565,000 Ordinary gross income (OGI) = $1,565,000 – $65,000 = $1,500,000 Adjusted ordinary gross income (AOGI) = $1,500,000* Personal holding company income (PHCI) = $350,000 + $450,000 = $800,000 Passive income requirement: $800,000 ÷ $1,500,000 = 53.3%. The requirement is failed because 53.3% is not at least 60%. *The corporation does not have any adjustments that would cause AOGI to differ from OGI. pp. C:5-4 and C:5-5.

C:5-9

C:5-27 a. Meets the passive income requirement, determined as follows: Gross income = $125,000 + $160,000 + $18,000 + $5,000 + $800,000 + $190,000 = $1,298,000 Ordinary gross income (OGI) = $1,298,000 – $18,000 – $5,000 = $1,275,000 Adjusted ordinary gross income (AOGI) = $1,275,000 – $196,000 – $80,000 = $999,000 Adjusted income from rents (AIR) = $800,000 – $196,000 – $80,000 = $524,000 AIR included in personal holding company income (PHCI)? (1) $524,000 ÷ $999,000 = 52.5%, so AIR is at least 50% of AOGI (2) Nonrental PHCI = $160,000 + $190,000 = $350,000 10% of OGI = 0.10 × $1,275,000 = $127,500 $220,000 dividends-paid deduction is not at least $222,500 ($350,000 – $127,500, so this criterion for excluding AIR from PHCI is failed. Allen does not meet both criteria for excluding AIR from PHCI, so it includes AIR in PHCI. PHCI = $524,000 + $160,000 + $190,000 = $874,000 Passive income requirement: $874,000 ÷ $999,000 = 87.5%. The requirement is met because 87.5% is at least 60%. b. Does not meet the passive income requirement. As in Part a, gross income is $1,298,000, OGI is $1,275,000, AOGI is $999,000, AIR is $524,000, and AIR is at least 50% of AOGI. Unlike Part a, the dividends-paid deduction is at least the amount by which nonrental PHCI exceeds 10% of OGI ($226,000 ≥ $350,000 – $127,500). Allen meets both criteria for excluding AIR from PHCI. Its PHCI thus is $350,000 ($160,000 + $190,000), which is 35.0% ($350,000 ÷ $999,000) of AOGI. The passive income requirement is failed because 35.0% is not at least 60%. pp. C:5-4 through C:5-8. C:5-28 Meets the passive income requirement, determined as follows: Gross income = $40,000 + $5,000 + $10,000 + $2,000 + $80,000 = $137,000 Ordinary gross income (OGI) = $137,000 – $5,000 = $132,000 Adjusted ordinary gross income (AOGI) = $132,000* Copyright royalties included in personal holding company income (PHCI)? (1) $80,000 ÷ $132,000 = 60.6%, so copyright royalties are at least 50% of OGI (2) PHCI, other than copyright royalties = $10,000 + $2,000 = $12,000. This $12,000 is 9.1% of $132,000, so PHCI, other than copyright royalties, is less than or equal to 10% of OGI. (3) $25,000 ÷ $132,000 = 18.9%, so business expenses related to copyright royalties are not at least 25% of OGI. Jackson meets criteria (1) and (2) but fails criterion (3). Because it does not meet all three criteria, it includes copyright royalties in PHCI. PHCI = $10,000 + $2,000 + $80,000 = $92,000 Passive income requirement: $92,000 ÷ $132,000 = 69.7%. The requirement is met because 69.7% is at least 60%. *Jackson does not have any adjustments that would cause AOGI to differ from OGI. pp. C:5-4 through C:5-6.

C:5-10

C:5-29 Does not meet the passive income requirement, determined as follows: A key issue for applying the passive income requirement to Equus is whether its veterinary services income qualifies as income from personal service contracts and thus is personal holding company income (PHCI). Although Bonnie owns at least 25% of Equus’ stock, a person other than Equus does not have the right to designate the individual who is to perform the veterinary services (and the contracts do not designate the individual who is to perform the services). The veterinary services income thus is not PHCI, and the passive income requirement is applied as follows: Gross income = $200,000 + $120,000 + $10,000 + $18,000 = $348,000 Ordinary gross income (OGI) = $348,000 – $10,000 = $338,000 Adjusted ordinary gross income (AOGI) = $338,000* PHCI = $18,000 Passive income requirement: $18,000 ÷ $338,000 = 5.3%. The requirement is failed because 5.3% is not at least 60%. *Equus does not have any adjustments that would cause AOGI to differ from OGI. pp. C:5-4 through C:5-8. C:5-30 a. $42,000 = $200,000 x 0.21 b.

PHC tax = $21,600 = 0.20 x $108,000 UPHCI, with UPHCI calculated as follows: Taxable income $200,000 Plus: Dividends-received deduction ($50,000 x 0.50) 25,000 Minus: Federal income taxes ( 42,000) Dividends-paid deduction ( 75,000) Undistributed personal holding company income (UPHCI) $108,000

c. Before Moore Corporation files its tax return, it can eliminate its PHC tax liability by having its shareholders elect a consent dividend under Sec. 565 or a combination consent dividend and throwback dividend under Sec. 563 of at least $108,000. The throwback dividend is limited to 20% of the $75,000 actual dividends paid, or $15,000. After Moore files its income tax return, Moore can pay a deficiency dividend in the amount of $108,000, which will eliminate the PHC tax liability but not the interest and penalties owed. pp. C:5-8 through C:5-12, C:5-25, and C:5-26. C:5-31 a. PHC Tax = $33,550 = 0.20 x $167,750 UPHCI, with UPHCI calculated as follows: Taxable income $400,000 Minus: Federal income tax ( 84,000)a Plus: Dividends-received deduction 65,000b Minus: Net capital gain $175,000 Federal income tax ( 36,750)c (138,250) Dividends-paid deduction ( 75,000) Undistributed personal holding company income (UPHCI) $167,750 a $400,000 x 0.21 = $84,000. b $100,000 x 0.65 = $65,000. c $175,000 x 0.21 = $36,750.

C:5-11

b. Before Kennedy files its tax return, it can eliminate its PHC tax liability by having its shareholders elect a consent dividend or a combination consent dividend and throwback dividend of at least $167,750 (the throwback dividend is limited to 20% of the $75,000 actual dividends, or $15,000). After Kennedy files its tax return, a deficiency dividend in the amount of $167,750 will eliminate the PHC tax liability but not the interest and penalties owed. pp. C:5-8 through C:5-12, C:5-25, and C:5-26. C:5-32 a. Alpha is a PHC, determined as follows: Gross income = $750,000 + $200,000 + $50,000 + $200,000 = $1,200,000 OGI = $1,200,000 - $200,000 = $1,000,000 AIR = $750,000 – ($140,000 + $150,000 + $175,000) = $285,000 AOGI = $1,000,000 – ($140,000 + $150,000 + $175,000) = $535,000 PHCI = $285,000 + $200,000 = $485,000 Alpha can exclude AIR from PHCI if AIR is at least 50% of AOGI and if the dividends-paid deduction is at least the amount by which nonrental PHCI exceeds 10% of OGI. Alpha meets the 50% test because AIR is 53% ($285,000 ÷ $535,000) of AOGI, but it does not meet the dividendspaid deduction test. Alpha’s nonrental PHCI exceeds 10% of OGI by $100,000 [$200,000 - (0.10 x $1,000,000)], but the dividends-paid deduction is only $50,000. Thus, Alpha includes AIR in PHCI. Alpha is a personal holding company because it passes the stock ownership and passive income requirements: (1) Stock ownership requirement: two individuals own all the stock. (2) Passive income requirement: PHCI ($485,000)/AOGI ($535,000) = 90.65% b.

Regular tax liability = $79,800, calculated as follows: Gross income (see Part a) Minus: Rental related expenses Administrative expenses Dividends-received deduction Taxable income Regular income tax a

$1,200,000 ( 630,000) ( 90,000) ( 100,000)a $ 380,000 $ 79,800b

$200,000 x 0.50 = $100,000. $380,000 x 0.21 = $79,800.

PHC tax = $38,440, calculated as follows: Taxable income Plus: Dividends-received deduction Minus: Federal income taxes Net capital gain $200,000 Minus: Income taxes ( 42,000)* Dividends-paid deduction UPHCI PHC tax ($192,200 x 0.20) *$200,000 x 0.21 = $42,000. Copyright © 2024 Pearson Education, Inc.

C:5-12

$ 380,000 100,000 ( 79,800) ( 158,000) ( 50,000) $ 192,200 $ 38,440

Before Alpha files its tax return, it can eliminate the PHC tax liability by having its shareholders elect a consent dividend or a combination consent dividend and throwback dividend of at least $192,200 (the throwback dividend is limited to 20% of the $50,000 actual dividends, or $10,000). After it files the return, Alpha can pay a deficiency dividend that will eliminate the PHC tax liability but not the interest and penalties owed. pp. C:5-3 through C:5-12, C:5-25, and C:5-26. C:5-33 a. The IRS agent likely will argue that the sinking fund no longer is needed to repay the debt obligation. This amount is now available to be paid as a dividend and is presently invested in assets unrelated to operating activities and earning portfolio income. The lack of definite corporate plans at year-end regarding the use of these funds to purchase operating assets could hurt the company. The corporation might argue that temporary investments in stocks and bonds are not necessarily an indication that an unreasonable accumulation of earnings exists with a tax avoidance motive. An argument can be made that a general plan to purchase operating assets exists at yearend, and that the corporation was in the process of reviewing specific acquisition possibilities. The corporation should document these plans. b. The IRS agent likely will argue that the loans to Tess at a below-market interest rate serve as a substitute for a dividend payment. Their use and size (i.e., equal to one year’s net income) indicates a possible accumulated earnings tax problem and a tax avoidance motive. The agent also might point to facts, such as lack of any documentation regarding the loans, lack of enforcement of due dates for the loans, etc., that might exist as further evidence of a constructive dividend. The corporation might argue that the loans are temporary in nature and were made only because excess funds were available while the corporation waited to carry out other plans that could be documented. A plan for repaying the remaining loans and the use of the amounts so received in subsequent business activities might strengthen the corporation’s argument. c. The IRS agent likely will argue that the corporation’s substantial investment portfolio suggests excessive earnings accumulation. The corporate level of investments effectively serve as a substitute for dividend payments and Tess’s personal investments. The corporation should provide plans for using a large portion of the funds to support its operating activities in the near future, or to carry out other business-related activities. d. The IRS agent likely will argue that loans between members of the controlled group, all owned by Tess suggests excessive earnings accumulation for Tess’s benefit. The corporate loans are effectively a substitute for dividend payments and Tess’s personal loans or additional capital contributions to her other corporations. The corporation might argue that the loans are temporary and then provide written evidence of the indebtedness (e.g., a note) and that the note principal has been paid when due. Plans for using the funds to support Adobe’s operating activities would strengthen the taxpayer’s argument. Adobe might have legitimate business reasons for lending funds to Tess’s other corporations (e.g., they are important suppliers for Adobe). If so, Adobe should document the reasons. pp. C:5-13 through C:5-16. C:5-34 a.

Operating cycle = 72.89 days, determined as follows: Accounts receivable cycle: [0.50 x ($300,000 + $400,000)]/$3,200,000 = 0.1094 Inventory cycle: [0.50 x ($240,000 + $300,000)]/$1,500,000 = 0.1800 Credit cycle: [0.50 x ($150,000 + $200,000)]/($1,200,000 + $1,000,000 - $150,000 $100,000) = 0.0897 Operating cycle (as a decimal): 0.1094 + 0.1800 - 0.0897 = 0.1997 Operating cycle (in days): 0.1997 x 365 = 72.89 Copyright © 2024 Pearson Education, Inc.

C:5-13

Working capital = $469,295 = 0.1997 x ($1,500,000 + $1,000,000 - $150,000)

This answer will change if federal income taxes are included in operating expenses or if the peak balance for the accounts receivable, accounts payable and inventory amounts are used. (Note: students might be shown these two alternatives for comparisons.) c. One measure the corporation may take is to show that the numbers above do not reflect future conditions. For example, the simple average figures used in the above analysis might be replaced by peak figures for the current period or estimated figures for the following period(s). (Note: Students might be shown these two alternatives for comparisons.) Alternatively, specific uses for the additional working capital could be substantiated. pp. C:5-16 through C:5-18. C:5-35

Part a $ 50,000 250,000 200,000 150,000 130,000 20,000 200,000

1. Accumulated E&P 2. Lifetime minimum credit 2a. Current year minimum credit 3. Current year E&P 3a. Retained for business needs a 3b. E&P greater than business needs 4. Accumulated earnings credit (greatest of 2a or 3a)

Part b $50,000 150,000 b 100,000 150,000 130,000 20,000 130,000

Part c $200,000 250,000 50,000 100,000 100,000 -0100,000

The problem states that there are no current year capital gains, so there is no reduction for the net capital gain, net of federal income tax attributable to it. b Frank Corporation operates primarily in the field of accounting, so it uses $150,000 in this step (rather than $250,000). pp. C:5-20 and C:5-21. C:5-36 a.

Accumulated tax income = $261,300, calculated as follows: Taxable income Plus: Dividends-received deduction ($100,000 x 0.65) Charitable contributions from last year deducted as a carryover in the current year Subtotal Minus: Federal income taxes ($500,000 x 0.21) Dividends-paid deduction Net capital gaina $30,000 b Minus: Federal income taxes ( 6,300) Net capital gain adjustment

C:5-14

$500,000 65,000 25,000 $590,000 ( 105,000) ( 75,000) ( 23,700)

Accumulated earnings credit: (1) Greater of $250,000 minus accumulated E&P at end of preceding tax year ($125,000) or (2) Current E&P retained to meet reasonable needs of the business, minus net capital gain (net of federal income tax attributable to it) ($66,300)c Accumulated taxable income Times: Tax rate Accumulated earnings tax liability

( 125,000) $261,300 0.20 $ 52,260

Net capital gain includes only the long-term capital gain $30,000 x 0.21 = $6,300. c $90,000 - ($30,000 - $6,300). b

pp. C:5-18 through C:5-22. C:5-37 a.

Accumulated taxable income = $420,500, calculated as follows: Taxable income Minus: Federal income taxes ($700,000 x 0.21) Net capital gain minus federal income taxes [$100,000 - (0.21 x $100,000)] Dividends-paid deductiona Accumulated earnings credit: Increase in reasonable business needs $120,000b Minus: Net capital gain (net of taxes) (79,000) Plus: NOL carryover deducted currently Dividends-received deduction ($75,000 x 0.50) Accumulated taxable income

$ 700,000 (147,000) ( 79,000) (150,000) ( 41,000) 100,000 37,500 $420,500

The $100,000 dividend paid on February 10 of the following year is treated as if paid in the current year because it is paid on or before the fifteenth day of the fourth month following the current yearend (i.e., it is a throwback dividend). See Sec. 563. b

Calculation of accumulated earnings credit: 1. Accumulated E&P 2. Lifetime minimum credit 2a. Current year minimum credit 3. Current year E&P (after dividends) 3a. Retained for business needs 3b. E&P greater than business needs 4. Accumulated earnings credit (before $79,000 net capital gain adjustment)

$600,000 250,000 -0250,000 120,000 130,000 120,000

b. Accumulated earnings tax liability: $84,100 = $420,500 x 0.20. Thus, Howard’s total federal tax liability is $231,100 ($147,000 + $84,100). pp. C:5-18 through C:5-22. Copyright © 2024 Pearson Education, Inc.

C:5-15

C:5-38 $15,750,000 book minimum tax, determined as follows: Net income $2,500,000,000 Federal income tax expense 450,000,000 Book depreciation 330,000,000 Tax depreciation (375,000,000) Adjusted financial statement income $2,905,000,000 × 0.15 $ 435,750,000 Regular tax ($2,000,000,000 × 0.21) (420,000,000) Book minimum tax (not less than zero) $ 15,750,000 Yellow’s total tax for the current year is $435,750,000 ($420,000,000 + $15,750,000). pp. C:5-22 through C:5-25. C:5-39 $130 million adjusted financial statement income (AFSI) for Year 4. The $1 billion net loss for Year 3 carries forward indefinitely, but its use to reduce a year’s AFSI is limited to 80% of AFSI before this reduction. For Year 4, Euclid’s use of the Year 3 loss is limited to $520 million ($650,000,000 × 0.80). Euclid thus uses $520 million of the Year 3 loss and carries forward to Year 5 the remaining $480 million ($1,000,000,000 - $520,000,000) of it. Year 4 AFSI is $130 million ($650,000,000 - $520,000,000). pp. C:5-22 through C:5-25. C:5-40 a. Yes. The applicability of the book minimum tax is based on the corporation’s adjusted financial statement income (AFSI). A domestic C corporation is subject to the tax if its average annual AFSI for any prior three-taxable-year period ending after December 31, 2021, exceeds $1 billion. For 2023, there is only one such period (2020–2022), and Kiho’s average annual AFSI for it is $1.14 billion [($1,450,000,000 + $1,150,000,000 + $820,000,000) ÷ 3]. This average exceeds $1 billion, so Kiho is subject to the book minimum tax for 2023. b. Yes. Although Kiho’s average annual AFSI for the three taxable years preceding 2024 does not exceed $1 billion [($1,150,000,000 + $820,000,000 + $880,000,000) ÷ 3 = $950,000,000], it meets the $1 billion test for any prior three-taxable-year period ending after December 31, 2021 (i.e., 2020–2022). Kiho thus is subject to the book minimum tax for 2024. pp. C:5-22 through C:5-25. C:5-41 a. $393,756,250, determined as follows: Net income tax: 15% of adjusted financial statement income Regular tax (21% of taxable income) Book minimum tax (not less than zero) Regular tax Net income tax

$525,000,000 (483,000,000) $ 42,000,000 483,000,000 $525,000,000

General business credit limitation: Net income tax (NIT) 25% of NIT exceeding $25,000 General business credit limitation

$525,000,000 (131,243,750) $393,756,250

C:5-16

The $400 million of available general business credit exceeds the $393,756,250 limitation, so Brighton may claim $393,756,250 of it. b. $6,243,750 = $400,000,000 - $393,756,250. pp. C:5-22 through C:5-25. C:5-42 a. $33 million, determined as follows: 15% of adjusted financial statement income Regular tax (21% of taxable income) Book minimum tax (not less than zero)

$600,000,000 (567,000,000) $ 33,000,000

b. Zero, determined as follows: 15% of adjusted financial statement income Regular tax (21% of taxable income) Book minimum tax (not less than zero)

$615,000,000 (630,000,000) $ 0

c. $15 million. The $33 million book minimum tax for Year 1 is available as a minimum tax credit for Year 2. However, its use in Year 2 is limited to $15 million ($630 million regular tax exceeding $615 million (15% of AFSI)). Badger thus may claim a $15 million minimum tax credit for Year 2. d. $18,000,000 = $33,000,000 - $15,000,000. pp. C:5-22 through C:5-25.

Comprehensive Problem C:5-43 a. GI = rentals + dividends + taxable interest + STCG + LTCG $265,000 = $200,000 + $30,000 + $15,000 + $3,000 + $17,000 b. OGI = GI – STCG – LTCG $245,000 = $265,000 - $3,000 - $17,000 c. Adj. inc. from rents (AIR) = GI from rents – rental expenses* $127,000 = $200,000 - $30,000 - $32,000 - $11,000 *Depreciation, property taxes, interest, and rental expenses to extent not exceeding gross income from rents. d. AOGI = OGI - rental expenses (from Part c) $172,000 = $245,000 - $30,000 - $32,000 - $11,000 Alternatively, AOGI = Adj. inc. from rents + dividends + interest $172,000 = $127,000 + $30,000 + $15,000

C:5-17

e. Nonrental PHC income = dividend + interest $45,000 = $30,000 + $15,000 50% test:

Adj. inc. from rents AOGI

$127,000 = 73.8% $172,000

Thus, the 50% test is satisfied because 73.8% is at least 50%. 10% test:

Nonrental PHC income - 10% of OGI = ($30,000 + $15,000) - (0.10 x $245,000) = $20,500

The dividend paid ($15,000) does not equal or exceed the $20,500 minimum distribution that was calculated. Thus, the 10% test is not satisfied. Pass 50% test but fail 10% test. Therefore, adjusted income from rents is included in PHC income. PHC income = Nonrental PHC income + adj. inc. from rents $172,000 = $45,000 + $127,000 f. PHC income ÷ AOGI = $172,000 ÷ $172,000 = 100% Thus, the passive income requirement is met because 100% is at least 60%. Random has only two individual shareholders, so the stock ownership requirement is met. Both the stock ownership and passive income requirements are met. Therefore, Random is a PHC. g. Regular taxable income = $112,500; regular tax = $23,625, determined as follows: Rentals income $200,000 Dividends received 30,000 Taxable interest income 15,000 Capital gains 20,000 Gross income $265,000 Minus: Expenses related to rentals: Interest $ 30,000 Depreciation 32,000 Property taxes 11,000 Other Sec. 162 expenses 50,000 Total rental expenses $ 123,000 Plus: General and administrative expenses 10,000 (133,000) Taxable income before dividends-received deduction $132,000 Minus: Dividends-received deduction (65% x $30,000) (19,500) Taxable income $112,500 Regular tax ($112,500 x 0.21)

$ 23,625

C:5-18

UPHCI = $79,945; PHC tax = $15,989, determined as follows: Taxable income Plus: Dividends-received deduction Minus: Regular tax $ 23,625 Net capital gain minus tax* 13,430 Dividends-paid deduction 15,000 Undistributed PHC income (UPHCI) Times: Tax rate PHC tax

$112,500 19,500 ( 52,055) $ 79,945 0.20 $ 15,989

*$17,000 - ($17,000 x 0.21) = $13,430. NCG includes LTCGs but not STCGs. i. Before year-end, the corporation can pay an additional $5,500 ($20,500 - $15,000; see part e) dividend, thereby satisfying the 10% of OGI test and excluding adjusted income from rents from PHC income. The passive income requirement would then be computed as follows: Before: PHC income ÷ AOGI = $172,000 ÷ $172,000 = 100% After: PHC income ÷ AOGI = $45,000 ÷ $172,000 = 26.2% Because PHCI is now only 26.2% of AOGI, the corporation would not be a PHC. The IRC provides for a throwback dividend if paid within 3½ months after year-end. This remedy will not work in this case because the throwback dividend is limited to 20% of dividends paid during the year, or $15,000 x 0.20 = $3,000, which is not enough to enable the corporation to meet the 10% of OGI requirement. However, the shareholders could elect to “receive” $79,945 of consent dividends before the corporation files its tax return. This remedy is not restricted to 20% of the dividends paid during the year and can be accomplished any time before the tax return filing date, including extensions, thereby giving the corporation more than 3½ months to remedy the problem. Alternatively, if the IRS determines that the corporation owes the PHC tax after the corporation files the tax return, the corporation can eliminate the PHC tax by paying a $79,945 deficiency dividend. Payment of a deficiency dividend, however, does not eliminate the corporation’s liability for interest and penalties on the unpaid PHC tax. j. The corporation can avoid the PHC tax liability if it reduces the amount of dividend and taxable interest income earned to permit the exclusion of adjusted income from rents from the PHC income portion of the PHC income test. The inability to exclude adjusted income from rents from the PHC income test this year is due to the nonrental income exceeding 10% of OGI. Reducing the investments made in stock and debt obligations will reduce the dividend and taxable interest income. Possible investment alternatives for the funds currently invested in assets producing dividend and taxable interest income include additional rental properties, tax-exempt bonds, and investments that generate capital gains. k. A company that is a personal holding company is not subject to the accumulated earnings tax (Sec. 532(b)). The rules do not require the corporation to actually have paid the personal holding company tax. The corporation need only retain personal holding company status. If the corporation takes actions so that it no longer qualifies as a PHC, it may be subject to the accumulated earnings tax. pp. C:5-3 through C:5-12, C:5-25, and C:5-26. Copyright © 2024 Pearson Education, Inc.

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Tax Strategy and Critical Thinking Problems C:5-44 Galadriel and John face a couple of problems in their business. First, the corporation had cash constraints in the early years of the business. Now that the business has become established, the owners should evaluate their cash needs. If the owners are paying an unreasonably low salary merely to avoid paying income taxes on their withdrawals, the business may in fact have an accumulated earnings tax problem. That the IRS agent believes the couple had accumulated excessive amount of earnings within the business does not mean the IRS will assess an accumulated earnings tax. With the help of their CPA, the couple must document that the earnings retained in the business are earmarked for a particular business purpose(s). Business purposes that might be cited include: inventory build-up, entering new lines of business, establishing a second facility, etc. A well-developed business plan can support the argument for retaining earnings in the business instead of paying larger salaries or dividends. The CPA must carefully research and explain to the couple the possible tax cost of retaining earnings in the business without a good plan or timetable as to how and when the earnings would be used. The availability of adequate lines of credit to the couple’s business may be used to support the IRS agent’s position that part or all of the earnings that have been retained can be distributed as dividends without jeopardizing current and future operations. If this position is valid, the couple may begin to pay larger salaries and fringe benefits. If the accumulation is very large, the couple may increase salaries and fringe benefits so these amounts are closer to those of similar businesses of their size and type and then start paying dividends on their stockholdings. A long-term strategy to avoid the accumulated earnings tax might be to make an S corporation election. The election has a potential cost, however, because Sec. 1374 imposes a tax on post-conversion built-in gains if realized within five years of the conversion. pp. C:5-13 through C:5-15 and C:5-26. C:5-45 S&A Music, a C corporation, is taxed on the royalty income it earns from the music its owners have written. The corporation pays income taxes at a 21% tax rate. Because two individuals own all of S&A’s stock, S&A may be liable for the personal holding company (PHC) tax if its personal holding company income (PHCI) is 60% or more of the corporation’s adjusted ordinary gross income (AOGI). If the corporation is a PHC, a tax of 20% of its undistributed PHC income is imposed in addition to the regular income tax. Copyright royalty income can be excluded from PHCI if it is at least 50% of ordinary gross income (OGI), other personal holding company income is 10% or less of OGI, and business expenses are 25% or more of OGI. If the three tests are satisfied, copyright royalty income will not be PHCI, and S&A is unlikely to be deemed a PHC. To eliminate this potential problem in future years, the two shareholders might make an S corporation election. As an S corporation, the entity is a conduit and exempt from both the PHC tax and the accumulated earnings tax. A potential cost of such an election is that the entity’s income is taxed at the shareholders’ marginal tax rates that may exceed the 21% corporate tax rate. In addition, because the S&A Music has been a C corporation for a number of years, a built-in gains tax will apply for five years after the corporation makes the S corporation election. On the other hand, S corporation status prevents distributions of post-election earnings to shareholders from being taxed at both the entity and shareholder levels. Copyright © 2024 Pearson Education, Inc.

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Other ways Andrew and Steve can avoid the PHC tax include: • Liquidate the C corporation and form an LLC. Now may be an attractive time to liquidate, particularly if the corporation’s market value is expected to increase substantially in future years. • Make a stock offering to the public. If Andrew and Steve sell S&A Music shares to the public, the five or fewer individual shareholder requirement for PHC status will not have been met, and the PHC tax will not be imposed. The current time might not be good for making a stock sale, particularly if the company’s future is not as bright as the owners think it is. • Have the corporation distribute sufficient income to S&A’s shareholders as dividends to reduce the PHC tax base to zero. pp. C:5-3 through C:5-11, C:5-25, and C:5-26.

Case Study Problems C:5-46 a. The points presented in the analysis below should be included as part of the memorandum to Edward Eagle, Jr. regarding a potential personal holding company tax liability. The memorandum should be prepared using a proper format with good grammar and punctuation. The passive income requirement for the current year applies in the following manner: Gross income = $260,000 + $90,000 + $20,000 = $370,000 Ordinary gross income (OGI) = $370,000 Adjusted income from rents (AIR) = $260,000 - ($70,000 + $100,000 + $10,000) = $80,000 Adjusted ordinary gross income (AOGI) = $370,000 - ($70,000 + $100,000 + $10,000) = $190,000 Rentals inclusion: 50% test is not satisfied. AIR ($80,000) is less than 50% of AOGI ($190,000). Minimum needed AIR is $95,000 ($190,000 x 0.50). The 10% test also is not satisfied since other PHCI ($90,000 + $20,000 = $110,000) exceeds 10% of OGI (0.10 x $370,000 = $37,000) by $73,000 ($110,000 - $37,000), assuming the corporation pays only $40,000 of dividends in the current year. PHCI = $80,000 + $90,000 + $20,000 = $190,000. PHC requirements: Stock ownership requirement: The stock ownership requirement is met because family members own all the stock (under the Sec. 544 stock attribution rules, each child of Edward Eagle Sr. is considered as owning the stock actually owned by his or her siblings). Passive income requirement: $190,000 PHCI/$190,000 AOGI = 100%. The passive income requirement also is met. Therefore, Eagle Corporation will be a PHC in the current year and subject to the 20% PHC tax rate. b. The passive income requirement is the easier of the two PHC requirements to fail. Actions by the Eagle family that can bring this about include:

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1. Convert bonds and stocks into cash and invest in additional rental real estate so the adjusted income from rents exceeds 50% of AOGI. The conversion also will reduce the other PHCI. 2. Convert the bonds and stocks into cash and use the proceeds to reduce the interest expense incurred in the rental activities. The lower interest expense will increase the adjusted income from rents and can improve the taxpayer’s chances of passing the 50% test. 3. Convert part or all of the bonds or stocks into cash and invest in growth stocks that earn capital gains or tax-exempt bonds that earn nontaxable interest income. Both income categories are excluded from other PHCI. Such a strategy can keep the proportion of other PHCI at or below 10%. 4. An increased dividend payment of $33,000 ($110,000 - $37,000 - $40,000) over what is presently paid is required to pass the 10% test that allows adjusted income from rents to be excluded from PHCI (if the 50% test also is met). These dividends can be actual dividends paid during the year, consent dividends, throwback dividends paid after year-end, or some combination of the three. The needed dividend payment will be reduced if some of the stocks and bonds are converted into additional rental real estate investments, growth stocks, or tax-exempt debt obligations. Two other alternatives are possible. First, the corporation could make an S corporation election (with the shareholders’ consent), so long as no nonqualifying trusts own Eagle stock. Eagle’s income then would be taxed to the shareholders, and the PHC tax would be avoided. The S corporation election is more expensive than the C corporation option because the top individual tax bracket (currently 37%) exceeds Eagle’s 21% corporate tax rate. The S corporation election, however, avoids double taxation of the earnings. Because Eagle has been a C corporation for a number of years and has accumulated earnings and profits, as an S corporation it would be subject to an excess net passive income tax at the corporate level if its passive income exceeds 25% of its gross receipts. After three years of exceeding the 25% limit, its S corporation status would be terminated. To avoid the special tax and the possibility of terminating the status, a distribution of the accumulated earnings and profits would be needed. Alternatively, Eagle could be liquidated for income tax purposes. This alternative would require a distribution of the investment holdings and could result in a substantial tax levy at the corporate and shareholder levels (see Chapter C:6). Both alternatives most likely are less desirable than changing the income mix or dividend level for Eagle so as to fail the PHC income requirement. C:5-47a. You have a responsibility to advise the client, through the partner in charge of the Goss account, of the potential accumulated earnings tax liability in the current year. You also should advise them of the steps that can be taken to avoid the tax. b. No. You are not obligated to advise the IRS of a potential accumulated earnings tax liability because the accumulated earnings tax is not self-assessed. Accordingly, prior year returns need not be corrected (see Statements on Standards for Tax Services No. 6). c. The accumulated earnings tax liability can be avoided or eliminated through various measures.

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1. The $1.5 million in shareholder loans should be partially or fully repaid. The corporation could fund repayment through a dividend distribution or stock redemption, which would provide the owners with a source of funds to make the repayment. The potential cost is that the distribution would be taxable as a dividend to the shareholder(s). 2. Dividend payments should be increased to a rate comparable to that of similar corporations in the hanger industry. 3. Stock portfolio activities should be curtailed. Stock investments of a passive nature are a signal for an unreasonable accumulation of earnings. Perhaps the investments could be sold and the proceeds distributed to the shareholders, or the investments themselves could be distributed to the shareholders. The distribution likely would result in dividend treatment because the transaction may not qualify as a partial liquidation under Sec. 302(e). 4. Goss should develop a long-term business plan that sets forth realistic goals as to its future capital expenditure requirements and that justifies the need to retain earnings to fund its expansion. 5. An S corporation election should be considered to eliminate future accumulated earnings tax liability (see Chapter C:11). However, the higher individual tax rates and built-in gains tax may discourage the owners from making the S corporation election. The advantages of avoiding the double taxation of earnings and the accumulated earnings tax may or may not outweigh the disadvantages. The S corporation election also could trigger the built-in gains tax under Sec. 1374, which would increase the cost of post-election asset dispositions.

Tax Research Problems C:5-48 Section 542(a)(1) defines a personal holding company (PHC) as a corporation (1) 60% or more of whose adjusted ordinary gross income is personal holding company income and (2) more than one-half of whose stock is owned by five or fewer individuals at any time during the last half of its tax year. Camp Corporation satisfies the stock ownership requirement since all of its stock is owned by two individuals (Hal and Ruthie). Section 543(a)(1) defines personal holding company income (PHCI) to include interest. Meeting the second of the two requirements hinges on whether Camp is permitted to offset its interest income on the related party loans by the interest expense incurred to borrow such funds from a bank. Regulation Sec. 1.543-1(b)(2) states “the term ‘interest’ means any amounts, includible in gross income, received for the use of money loaned.” No mention is made of offsetting the interest income with any interest expense incurred. In Bell Realty Trust, 65 T.C. 766 (1976), a business trust that borrowed funds and lent them to a related party was not considered to be a conduit by the Tax Court. Interest income was included in the trust’s gross income, deemed to be PHCI (without any reduction for interest expense incurred), and included in adjusted ordinary gross income. The trust, which was taxable as a corporation, was deemed to be a PHC. Copyright © 2024 Pearson Education, Inc.

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In Blair Holding Company, 1980 PH T.C. Memo ¶80,079, 39 TCM 1255, the Tax Court issued a similar ruling regarding two brother-sister corporations. The corporation lending the money was not considered to be a conduit. The interest income was included in its gross income, considered to be PHCI, and included in adjusted ordinary gross income. As a result, the corporation was deemed to be a PHC. Thus, it appears that Camp may be a PHC in Year 1 because the $432,000 interest income from the $3.6 million lent to Vickers Corporation and the $40,000 of other passive income substantially exceed the $200,000 gross profit from operations. In later years, this problem may not exist if the operating profit rises to the $1 million level maintained prior to the slowdown in the auto industry. C:5-49 Section 532(a) holds that the accumulated earnings tax shall “apply to every corporation ... formed or availed of for the purpose of avoiding income tax with respect to its shareholders, or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed.” Section 533(a) provides that “the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.” Section 533(c)(1) permits the earnings accumulated for the reasonable needs of the business (as defined by Sec. 537(a)(1)) to be claimed as an accumulated earnings credit. The key question here is whether the excess earnings accumulation of Able Corporation can be offset by the reasonable needs of Baker Corporation’s business. Regulation Sec. 1.537-2(c)(3) states that “loans to another corporation, the business of which is not that of the taxpayer corporation, if the capital stock of such other corporation is owned, directly or indirectly, by the shareholder or shareholders of the taxpayer corporation and such shareholders are in control of both corporations” may indicate that earnings and profits of a corporation are being accumulated beyond the reasonable needs of the business. This appears to be the case here because William Queen, and not Able, owns Baker. Regulation Sec. 1.537-3(c) holds that “if one corporation owns the stock of another corporation and, in effect, operates the other corporation, the business of the latter corporation may be considered in substance, although not in legal form, the business of the first corporation.” Although Able lends money to Baker, it does not own or operate Baker at the 80% minimum level required in Reg. Sec. 1.537-3(c). The First Circuit Court of Appeals upheld the IRS’s position, articulated in Latchis Theatres of Keene, Inc. v. CIR, 45 AFTR 1836, 54-2 USTC ¶9544 (1st Cir., 1954), of not allowing earnings to be accumulated for the reasonable needs of sister corporations. This ruling has been followed in later decisions. Earnings have been permitted to be accumulated when the related corporation is a subsidiary, in particular one for which a consolidated tax return election has been made. (Special rules are found in Reg. Sec. 1.1502-43, which details the accumulated earnings tax rules for affiliated groups filing consolidated tax returns.) The Tax Court in Bremerton Sun Publishing Co., 44 T.C. 566 (1965), and J.P. Scripps Newspapers, 44 T.C. 453 (1965), however, has held that loans to commonly controlled corporations do not necessarily suggest that income has been accumulated unreasonably. Based on the facts and circumstances surrounding the loans, a CPA may be able to show that the loans are not indicative of an unreasonable earnings accumulation. Nor do they suggest a tax avoidance motive. Copyright © 2024 Pearson Education, Inc.

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As an alternative, William may create an Able and Baker parent-subsidiary (rather than brothersister) relationship by transferring either Able or Baker stock to the other corporation. The consolidated tax return rules may provide a way to avoid the personal holding company and/or the accumulated earnings tax that is not available to brother-sister corporations. The accountant should closely examine the consolidated tax regulations dealing with both of these taxes.

“What Would You Do In This Situation?” Solutions Ch. C:5, p. C:5-12. Two questions arise here: Is Taylor Corporation liable for the personal holding company (PHC) tax? If so, can Taylor take any action to reduce or eliminate the liability? No de minimis rule applies to the PHC tax. Taylor (and its CPAs) cannot escape the PHC tax if the company is, in fact, a personal holding company. The IRC provides no exception for small corporations. The current year corporate income tax liability is $6,300 [($50,000 - $20,000) x 0.21]. The PHC tax liability is $4,740 [($30,000 - $6,300) x 0.20], assuming the $6,300 of federal income tax is the only adjustment to taxable income when calculating UPHCI. The total tax liability, if the corporation owes the PHC tax, is $11,040 ($6,300 + $4,740). The corporation faces a 36.8% ($11,040/$30,000) average tax rate in its initial year of operation. The company and its CPAs might ignore the problem and hope that it goes away when the limitations period for the previous year’s tax return expires. Perhaps the IRS will overlook the fact that the corporation is a PHC. Failure to file Schedule PH with Form 1120 extends the limitations period from three to six years (Reg. Sec. 301.6501(f)-1). If the IRS catches the error, it will impose penalties and interest on the PHC tax amount from the due date for the return until the date the corporation pays the tax. Instead of paying the corporate level tax, the corporation could pay a deficiency dividend equal to its undistributed personal holding company income. The deficiency dividend is taxable to the corporation’s shareholders. Another alternative is to file an amended return and pay the PHC tax, interest, and penalties. Had the PHC problem been identified earlier, the corporation could have made an S corporation election for its initial tax year. The S corporation election would have permitted the corporation’s $30,000 of taxable income to pass through to its shareholders. As an S corporation, Taylor would be exempt from the PHC tax. It is too late for the corporation to make an S election for its initial tax year unless it can convince the IRS to accept a late election request. An S election might have been a good idea not only for the first year, but also for subsequent years. Now might be a good time to see if other issues were missed in the haste to submit a timely return. The first year is the critical year for making a number of elections. However, some elections must wait until the company begins business (for example, the Sec. 248 election to amortize organizational expenditures).

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Ch. C:5, p. C:5-19. The primary question here is what are the reasonable needs of the business to accumulate earnings? Section 537(b) defines reasonable needs of the business as (1) reasonably anticipated needs of the business, (2) Sec. 303 (death tax) redemption needs, (3) excess business holdings redemption needs, and (4) product liability loss reserves. Magnum’s need to maintain a large investment portfolio falls primarily into the first and fourth categories. The next three paragraphs present three reasons for accumulating earnings. A manufacturer of rifles and handguns, Magnum incurs product liability. The question is how does Magnum provide for the contingency of paying a large damage award? One possibility is insurance issued by a third party. Another possibility is self-insurance. Self insuring one’s activities justifies accumulating earnings. The amount of earnings a corporation can accumulate for selfinsurance must be reasonable in amount. Magnum also needs to retain earnings to replace existing manufacturing equipment and other fixed assets, expand current facilities, and meet working capital requirements. These requirements fall within “the reasonable needs of the business to accumulate earnings.” Nothing indicates that Magnum has ever engaged in capital expenditure planning whereby it documents its future facilities and equipment needs on a year-by-year basis. Such an undertaking on an annual basis could determine the firm’s needs. The cost of meeting these needs could be estimated and could justify its current earnings retention and investment policies. Business expansion and plant replacement are the most commonly asserted grounds for accumulating earnings and profits. In addition to the capital expenditure analysis, Magnum must examine the earnings needed for working capital purposes. This task can be done using the Bardahl formula described in Chapter C:5 or other documentation methods that would be acceptable. In determining whether the corporation has accumulated an unreasonable amount of earnings, the taxpayer (and unfortunately maybe the IRS) will want to value its investment portfolio. A number of methods may be used to value an investment portfolio. These methods are based on current market value, acquisition cost, or liquidation value. In Ivan Allen Co. v. U.S., 422 U.S. 617, 36 AFTR 2d 75-5200, 75-2 USTC ¶9557 (1975), the U.S. Supreme Court held that, in determining whether corporate earnings and profits have accumulated beyond the reasonable needs of the business, listed and readily marketable securities owned by the corporation and purchased out of E&P are taken into account, not at cost, but at their net liquidation value. The Ivan Allen decision means that Magnum’s earnings and profits for accumulated earnings tax purposes are much larger than that determined through historical cost methods because the investment portfolio has a much higher current valuation than the firm’s initial or historical cost even though the corporation has not realized asset appreciation. If the securities are readily marketable, the liquidation value should be a few percentage points below the portfolio’s market value. A secondary issue is Magnum’s incurring a personal holding company tax liability. Because of current investments in growth stocks, the corporation earns very little in dividends and interest (relative to manufacturing profits). The personal holding company tax might be a problem if gross profits from gun sales decline substantially in the future and this decline is combined with the company’s adopting a strategy to generate more interest and dividend income. The PHC tax is an Copyright © 2024 Pearson Education, Inc.

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issue for Magnum only if it qualifies as a PHC (i.e., it meets the stock ownership and passive income requirements). If it so qualifies, it is exempt from the accumulated earnings tax.

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Chapter C:6 Corporate Liquidating Distributions Discussion Questions C:6-1 A complete liquidation is defined by Reg. Sec. 1.332-2(c) as one or a series of distributions made by a liquidating corporation that completely cancels or redeems all of its stock in accordance with a plan of liquidation. A partial liquidation is defined by Sec. 302(e) as a distribution that (1) is not essentially equivalent to a dividend (when determined at the corporate level rather than at the shareholder level) and (2) is pursuant to a plan of liquidation and occurs within the tax year in which the plan is adopted or within the succeeding tax year. Generally, a partial liquidation involves the corporation either ceasing to conduct a trade or business (while still continuing to conduct a second trade or business) or contracting its business activities. In either case, the corporation remains in existence after the partially liquidating distribution. A complete liquidation is taxed under Secs. 331 and 336. A partial liquidation is taxed under Secs. 302(b)(4) and 311. The complete liquidation is taxed to the extent the shareholder recognizes a gain or loss, which is computed by comparing the FMV of the property received to the adjusted basis of the stock redeemed. When the shareholder receives a series of liquidating distributions, the distribution is taxed once the FMV of the property received exceeds the adjusted basis of the stock held. All basis is recovered first before the shareholder recognizes any gain. A partial liquidation results in exchange treatment for a noncorporate shareholder under Sec. 302(b)(4). A corporate shareholder is eligible for exchange treatment only if the distribution qualifies as an exchange under the stock redemption rules of Secs. 302(b)(1)-(b)(3). The shareholder recognizes a loss only when he or she receives the final liquidating distribution. pp. C:4-23 through C4-25 and C:6-4 through C:6-10. C:6-2 By being an LLC, Summit can avoid the corporate income tax. Other tax-related reasons for being an LLC include avoiding the shareholder-level tax on C corporation distributions, claiming the 20% qualified business income deduction, and passing the entity’s losses through to its shareholders. Making the change from a C corporation to an LLC requires the corporation be liquidated. The IRC imposes a tax at the corporate level and again at the shareholder level as the corporation distributes assets to the shareholders and the corporation’s existence terminates. The shareholders incur no tax when they contribute the assets to the LLC. Similar corporate and shareholder level taxes would be imposed if the shareholders contributed the Summit stock to the partnership and then the corporation liquidated into the partnership. The entity would not incur the tax costs of liquidating a C corporation had the business initially been formed as an LLC (instead of a C corporation). If instead, the corporation elected S corporation status, it would incur no tax upon the election. However, it might incur a tax on built-in gains if it sells assets within ten years of the election (see Chapter C:11). p. C:6-2. C:6-3 The cost of a corporate formation transaction usually is quite low because Sec. 351 permits appreciated property to be transferred to a corporation with no gain being recognized except to the extent the shareholder receives boot property. The shareholders generally recognize no loss on a corporate formation transaction even if they receive boot property. On the other hand, a liquidating corporation recognizes gain or loss on its noncash property distributions unless certain exceptions Copyright © 2024 Pearson Education, Inc.

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apply. The shareholders also recognize gain or loss upon receiving liquidating distributions in exchange for their stock. One common exception to the gain recognition requirement occurs when a corporation forms a controlled subsidiary corporation and then subsequently liquidates the corporation. In this situation, Secs. 332 and 337 permit both the liquidating corporation and its parent corporation to avoid recognizing gain or loss on the liquidation. pp. C:6-2 and C:6-3. C:6-4 Liquidation status continues from the time the plan of liquidation has been formally or informally adopted until the corporation ceases to be a going concern or until it has divested itself of all its property. Dissolution is a legal term that implies the corporation has surrendered the charter it originally received from the state. A corporation generally may complete its liquidation prior to undergoing dissolution. Dissolution may never occur if the corporation retains its charter to protect its corporate name from being acquired by another party. p. C:6-4. C:6-5 Ordinary dividend distributions require the distributing corporation to recognize gain (but not loss) when distributing noncash property as a dividend. The shareholder reports dividend income equal to the FMV of the property distributed when the distribution comes from earnings and profits (E&P). Stock redemptions also require the distributing corporation to recognize gain (but not loss) when distributing noncash property. The shareholder reports either dividend income or capital gain depending on the nature of the redemption transaction. The shareholder reports capital gains when the exchange provisions of Secs. 302(b)(1)-(4) apply. Complete liquidations require the distributing corporation to recognize gain or loss when distributing noncash property unless one of a series of limited exceptions applies to loss recognition. The shareholder reports a capital gain or loss equal to the difference between the FMV of the property distributed and the shareholder’s adjusted basis for the distributed property. pp. C:6-2 and C:6-3, and Chapter C:4. C:6-6 A shareholder who uses the accrual method reports the gain or loss using accrual concepts, i.e., the shareholders recognize gain or loss when all the events have occurred that fix the amount of the liquidating distribution and when the shareholders are entitled to receive the distribution upon surrender of their shares. A shareholder who uses the cash method reports the gain when he or she has actually or constructively received the liquidating distribution. p. C:6-6. C:6-7 A shareholder may prefer capital gain treatment to offset capital losses recognized in the same year or an earlier year and which carryover to the liquidation year. Recognition of capital gains on a liquidation can permit the recognition of previously unrealized capital losses and reduce the tax cost of making the liquidation. Net capital gains recognized by an individual shareholder are taxed at a preferential capital gains rate. Ordinary loss treatment is preferable to capital loss treatment due to the $3,000 loss limitation on capital losses that applies to an individual shareholder. This low limitation does not apply to an ordinary loss (e.g., one recognized under Sec. 1244 and limited to $50,000 generally or $100,000 for taxpayers filing a joint return). Ordinary losses can carry over as part of the shareholder’s NOL. p. C:6-6. C:6-8 Generally, no. In most cases, the results of the two alternatives are the same. If the corporation sells its assets, it recognizes gains and losses (Sec. 1001), pays its taxes, and distributes the remaining cash to its shareholders, who in turn recognize gain or loss on the distributions. If instead the corporation distributes its assets directly to the shareholders, the corporation still recognizes gain or losses as if it sold its assets (Sec. 336(a)). The corporation then pays its taxes and Copyright © 2024 Pearson Education, Inc.

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distributes the remaining assets to its shareholders. The FMV of the distributed assets should be the same amount as the distributed cash under the first alternative. Thus, the shareholders recognize the same gain or loss. Because the shareholders take a FMV basis in the distributed assets (Sec. 334(a)), they recognize no further gain or loss upon selling the assets. The results could differ, however, if the corporation is subject to loss limitations under Sec. 336(d) upon the distribution of property to certain shareholders. The Sec. 336 limitations do not apply to direct sales by the corporation to outside third parties. Note: A property’s basis may have been reduced under Sec. 362(e)(2) upon contribution to the corporation, which would reduce a realized loss upon a subsequent sale or distribution. pp. C:6-5 through C:6-10. C:6-9 A liquidating corporation does not recognize gain or loss under four circumstances. These are: 1. Liquidation of a subsidiary corporation - The liquidating corporation recognizes no gain or loss on liquidating distributions made to a parent corporation who owns at least 80% of the subsidiary’s stock. 2. Distributions to minority shareholders - The liquidating corporation recognizes gain but not loss on liquidating distributions made to minority shareholders when the Sec. 332 nonrecognition rules apply to the parent corporation. 3. Distributions to related persons - Loss recognition is disallowed when the liquidating corporation makes a distribution to a related person, as defined in Sec. 267(b), if (1) the distribution is not pro rata or (2) the property distributed is disqualified property. Disqualified property is property acquired by the corporation in a nontaxable Sec. 351 formation or as a capital contribution during the five-year period ending on the distribution date or property having an adjusted basis that carries over from a disqualified property. 4. Sales having a tax-avoidance purpose - Loss recognition is restricted where property is transferred to the corporation in a Sec. 351 transaction or capital contribution after a date two years before the date that the corporation adopts a plan of complete liquidation. Tax avoidance is presumed in these situations unless the corporation uses the property in its trade or business. Note: A property’s basis may have been reduced under Sec. 362(e)(2) upon contribution to the corporation, which would reduce a realized loss upon a subsequent sale or distribution. A situation encountered less often involves distributions or sales of a subsidiary corporation’s stock. A corporation can elect under Sec. 336(e) to treat the sale, exchange, or distribution of a subsidiary’s stock as a taxable disposition of all the subsidiary’s assets, resulting in no gain or loss being recognized on the sale, exchange, or distribution of the stock. pp. C:6-6 through C:6-10, C:6-12, and C:6-13. C:6-10 Under Sec. 336(b), the FMV of Kelly Corporation’s distributed property cannot be less than the amount of the liability assumed or acquired by the shareholder. Therefore, the corporation’s recognized gain or loss is determined by comparing the amount of the assumed mortgage to the basis of the land. Under a strict interpretation of Secs. 336(b) and 334(a), the shareholder of the liquidated corporation will take a basis for the distributed property equal to its actual FMV. Some tax commentators, however, believe that the shareholder should take a basis equal to the liability assumed or acquired. pp. C:6-7 and C:6-8. C:6-11 Congress enacted the Sec. 332 liquidation rules to permit a nontaxable liquidation of a subsidiary corporation into its parent corporation. These rules allow a corporation to form a subsidiary corporation tax-free under Sec. 351, operate the subsidiary corporation for a period of Copyright © 2024 Pearson Education, Inc.

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time, and then liquidate the subsidiary corporation tax-free back into its parent corporation and continue to operate it as a division within the parent corporation’s shell. The Sec. 332 rules also would apply if the parent purchased the subsidiary stock from a third party and subsequently liquidated the subsidiary. In either case, the subsidiary’s business remains in corporate form. If the general Sec. 331 liquidation rules applied to the subsidiary’s liquidation, the parent corporation might be deterred from liquidating the subsidiary corporation because of the potential taxable gains upon liquidation. pp. C:6-10 and C:6-11. C:6-12 The following three requirements must be satisfied to have the Sec. 332 rules apply to a corporate shareholder: 1. The parent corporation must own (a) at least 80% of the total combined voting power of all classes of stock entitled to vote and (b) 80% of the total value of all classes of stock (other than certain nonvoting preferred stock issues) for the period beginning on the date of adoption of the plan of liquidation and ending upon receipt of the subsidiary corporation’s assets. 2. The distribution of the property must be in complete cancellation or redemption of all the subsidiary corporation’s stock. 3. Distribution of the property must (a) occur within a single tax year or (b) be one of a series of distributions completed within three years from the close of the tax year during which the first of the series of liquidating distributions is made. p. C:6-11. C:6-13 a. The Sec. 331 general liquidation rules require the distributee corporation’s entire realized gain or loss to be recognized. Section 332, however, does not permit either a realized gain or loss to be recognized. b. The Sec. 336 general liquidation rules require the distributing corporation to recognize any gain or loss when distributing its assets pursuant to a complete liquidation. The recognized gain or loss is determined as if the distributing corporation sold the assets for their FMV immediately preceding the distribution. Section 337 does not require the recognition of gain or loss by a subsidiary corporation when a distribution of assets to its parent corporation occurs. The subsidiary, however, recognizes gain (but not loss) under Sec. 336(d)(3) when it distributes assets to minority shareholders. c. The Sec. 334(a) general liquidation rules require the basis of the assets in the distributee corporation’s hands to be stepped-up or down to their FMV. Section 334(b)(1) requires the distributee corporation in a Sec. 332 liquidation to use the same basis that the liquidating corporation had for the assets prior to the liquidation. d. The tax attributes of the distributing corporation disappear under the general liquidation rules. Section 381(a) requires a distributee corporation to assume the tax attributes of a subsidiary corporation in a Sec. 332 liquidation. pp. C:6-5 through C:6-14. C:6-14 No Sec. 332 treatment. The liquidation fails to qualify for nonrecognition treatment under Sec. 332, because Subsidiary Corporation made no liquidating distribution to Parent Corporation, its shareholder. Parent recognizes an ordinary loss for its investment in Subsidiary under the special Sec. 165(g)(3) worthless security rules. Tracy recognizes a capital loss to the extent of her investment under the Sec. 331 general liquidation rules. However, Tracy may recognize an ordinary loss under the Sec. 1244 rules if its requirements are satisfied. p. C:6-12.

C:6-4

C:6-15 Subsidiary Corporation recognizes no gain when it distributes appreciated property to satisfy an indebtedness owed to Parent on the date it adopted a plan of complete liquidation. Parent Corporation recognizes gain or loss upon receipt of property in payment of Subsidiary’s indebtedness. The gain or loss equals the difference between the amount Parent receives and Parent’s basis in the debt obligation. These results can be contrasted to a distribution in redemption of part or all of Parent’s holdings of Subsidiary stock where neither Parent nor Subsidiary recognizes gain or loss. In both cases, Parent takes a carryover basis in the transferred assets. pp. C:6-17 and C:6-18. C:6-16 Shareholders receiving liquidating distributions generally recognize gain or loss under Sec. 331 on the exchange of their stock interest. A special rule applies to the parent corporation when a controlled subsidiary corporation is liquidated. The parent corporation (80% distributee) recognizes neither gain nor loss when it receives a liquidating distribution (Sec. 332). A minority shareholder on the other hand recognizes gain or loss when receiving the distribution under the general Sec. 331 rules. Two exceptions to the general Sec. 336 gain or loss recognition rules apply to property distributions made by a controlled subsidiary corporation. First, under Sec. 337, the subsidiary corporation does not recognize gain or loss when it makes a liquidating distribution to an 80% distributee corporation. Second, under Sec. 336(d)(3), the subsidiary corporation recognizes gain (but not loss) when it makes a liquidating distribution to a minority shareholder. pp. C:6-12 and C:6-13. C:6-17 Appreciated property to Parent; cash to Sally. Distributions of appreciated noncash property to a minority shareholder cause gain recognition by the distributing corporation as contrasted to nonrecognition under Sec. 337(a) when such property is distributed to a parent corporation. Specifically, Secs. 336(a) and 336(d)(3) require the liquidating corporation to recognize gain (but not loss) when it distributes noncash property to a minority shareholder. Therefore, a distribution of appreciated property should be made to the parent corporation so the liquidating corporation does not have to recognize the appreciation as gain (Sec. 337(a)). However, by transferring the appreciated property to the parent corporation, a carryover basis (from the subsidiary corporation) is used instead of the FMV basis that would be available if the liquidating corporation distributes such property to the minority shareholder. The shareholder would recognize gain or loss on the distribution whether the corporation distributes cash or property (FMV). pp. C:6-12 through C:6-14. C:6-18 Liquidation of controlled corporation rules apply. By acquiring the additional stock, the Sec. 332 stock ownership requirement is satisfied. Parent Corporation recognizes no gain when it receives Subsidiary Corporation’s assets in exchange for its stockholdings (Sec. 332). Subsidiary recognizes no gain when it distributes its assets in redemption of its stock (Sec. 337). A disadvantage is that Parent’s basis for the assets received are not stepped-up to their FMV as would be the case under the general liquidation rules (Sec. 334(a)). Moreover, Parent’s basis in its Subsidiary stock disappears leaving Parent with assets having a lower basis than the stock basis. A possible advantage or disadvantage is that Parent must assume Subsidiary’s tax attributes (e.g., E&P and loss and tax credit carryovers). The IRS might challenge the stock acquisition and the nontaxable liquidation treatment by saying that an informal plan of liquidation was adopted prior to the acquisition date for the additional shares of stock. If the IRS challenge is successful, it will result in the transaction being taxable to all parties. pp. C:6-19 and C:6-20.

C:6-5

C:6-19 General liquidation rules apply. A series of partially liquidating distributions that result in a complete liquidation are taxed under Sec. 331 instead of the Sec. 302 stock redemption and partial liquidation rules. The Sec. 331 regulations permit the shareholder’s basis to be recovered first and require the recognition of gain once the basis of a particular share or block of stock has been fully recovered. A shareholder cannot recognize a loss with respect to a share or block of stock until he or she receives the final liquidating distribution, or until the time that no more liquidating distributions will occur. p. C:6-15. C:6-20 When the value of a property (i.e., oil lands) received in a corporate liquidation cannot be determined by the usual valuation techniques, the shareholder may attempt to rely on the open transaction doctrine. Under this doctrine, Robert’s gain or loss from the liquidation will not be determined until (1) the land is subsequently sold, (2) revenue from the oil wells is collected, or (3) the land can be accurately valued. The IRS allows this treatment only in unusual circumstances and may treat the distribution of the land as a closed transaction. Closed transaction treatment requires Able and Robert to recognize gain or loss when the land is distributed, based on the appraisals or a value determined by the IRS. Robert’s basis for the land is its FMV on the distribution date. Any subsequent sale or exchange transaction involving the land requires Robert to recognize the appropriate gain or loss. The character of the additional gain or loss depends on the asset’s use in Robert’s hands. p. C:6-16. C:6-21 The IRS position is that the open transaction method may be used only in unusual circumstances. The IRS prefers the closed transaction alternative. In a closed transaction, gain or loss is determined based on the FMV of the property distributed on the distribution date. This FMV amount becomes the property’s basis. At the time the property is sold, collected, or its value is definitely determined, the taxpayer computes gain or loss by comparing the property’s value at that time to its adjusted basis. p. C:6-16. C:6-22 Recognition of the shareholder’s gain can be deferred if the liquidating corporation (1) adopts a plan of liquidation, (2) sells its assets in an installment sale, and (3) distributes the installment obligations to its shareholders. The shareholder recognizes gain as he or she collects the installment obligations. No gain deferral occurs at the corporate level when it distributes the installment obligation to the shareholders. The corporation must recognize the appropriate amount of gain as determined under Sec. 336 when it distributes the obligations. p. C:6-16. C:6-23 Because the corporation acquired the installment obligation when it sold property, Jim and Anna can elect to use the installment method of accounting to report the gain from the redemption of their Cable stock if (1) the sale took place during the 12-month period beginning on the date a plan of complete liquidation was adopted and (2) the liquidation is completed during such 12-month period. In this situation, the installment sale permits a one-year income deferral for the shareholders’ recognized gain attributable to the second installment obligation collection. Excluded from the installment method of accounting is the portion of the sale relating to inventory items, property held for sale to customers, and depreciable property sold to a related party (Sec. 453(h)(1)(C)). p. C:6-16.

C:6-6

C:6-24 a. Reduces the amount of gain recognized by the liquidating corporation on the asset sale. b. Deducted in the final corporate tax return. c. Deducted in the final corporate tax return. d. Treated as a liquidating distribution made to the shareholder equal to the FMV of the prepaid rent on the distribution date. The distributing corporation usually recognizes gain at the time of liquidation under Sec. 336 because the liquidating corporation has expensed the rent, giving the prepaid rent a zero basis. pp. C:6-16 and C:6-17. C:6-25 The $250,000 ($600,000 - $350,000) gain Andover recognizes when the asset distribution occurs, as well as any profits earned during the final tax year, will be offset by $200,000 ($250,000 taxable income x 0.80) of the NOL carryover, with the remaining $50,000 gain taxed at 21%. The remaining $100,000 ($300,000 - $200,000) NOL carryover disappears when the liquidation is completed. Any profits and losses created in the year of liquidation could be passed through to Yancy and the other shareholders if the corporation made a valid S corporation election. The corporation probably would not make such an election because the $300,000 NOL carryover from the C corporation tax years would not pass through, and the gain on the distribution of the assets likely would be subject to the Sec. 1374 built-in-gains tax at the corporate level (see Chapter C:11). p. C:6-17. C:6-26 Nils Corporation must file federal income tax returns for both the current year and next year. Regulation Sec. 1.6012-2(a)(2) requires a corporation that is in existence for any part of a tax year to file a tax return. p. C:6-20. C:6-27 A plan of liquidation is a formal document that details the steps to be taken to carry out the complete liquidation. The plan of liquidation helps the corporation determine when it begins its liquidation process. Once liquidation status is determined, distributions to the shareholders qualify for liquidation treatment under Sec. 331 instead of being treated as dividends under Sec. 301 or as a stock redemption under Sec. 302. p. C:6-21. C:6-28 a. True. p. C:6-5. b. False. It generally is a capital loss. The shareholder, however, may recognize an ordinary loss if the corporation being liquidated is a small business corporation (Sec. 1244) or an insolvent subsidiary corporation (Sec. 165(g)(3)). pp. C:6-6 and C:6-19. c. False. It generally is the property’s FMV. A liquidation under Sec. 332, however, will result in a carryover basis to the parent. p. C:6-6. d. False. It generally starts on the day following the liquidation date. However, the parent’s holding period includes the subsidiary’s holding period when the liquidation qualifies under Sec. 332. p. C:6-6. e. False. The attributes generally disappear. The tax attributes, however, carryover to a parent corporation in connection with a liquidation under Sec. 332. p. C:6-14. f. False. Nonrecognition of gain or loss is mandatory if the Sec. 332 and 337 requirements are met. Gain or loss can be recognized if the Sec. 332 or Sec. 337 requirements are not met. p. C:6-10. g. True. pp. C:6-13 and C:6-14. h. True. p. C:6-13. Copyright © 2024 Pearson Education, Inc.

C:6-7

Issue Identification Questions C:6-29 Peter and John should consider the following tax issues: • • • • • •

What gain or loss does Cable recognize on the two distributions? Does Cable have to file a corporate tax return for the portion of the final tax year that it is in existence? If so, what income and expenses are included in the return? Can Cable deduct the liquidation expenses on its final tax return? What is the amount and character of the gain or loss that Peter and John recognize upon surrendering their Cable stock? What basis does Peter take for the noncash assets that he receives? What happens to Cable’s tax attributes?

Cable Corporation recognizes any gain realized on the distribution of the cable cars, support vehicles, repair parts inventory, tools, and equipment. Cable recognizes no loss on the disposition of these items because they are distributed to a related party (John owns 80% of Cable). Peter recognizes no gain on the distribution because he receives only cash. John and Peter must determine their realized and recognized gains on the liquidation. Cable can deduct the liquidation expenses in its final tax return. Any NOLs incurred in the final year disappear because post-2020 NOLs do not carryback to earlier years, and Cable no longer exists to take advantage of any carryovers. Thus, a substantial cost may be incurred in liquidating the corporation. Perhaps John should consider buying Peter’s stock and keep operating Cable Corporation in the new city, thereby avoiding the liquidation tax (e.g., on corporate and shareholder level gains). Retaining the corporation also will allow any NOLs to carryover for deduction in future years, subject to the 80% of taxable income limitation. pp. C:6-2 through C:6-10, C:6-16, and C:6-17. C:6-30 The managements of Parent and Subsidiary should consider the following tax issues: • • • • • • •

What gain or loss does Parent recognize on the transfer of its remaining property to the mortgage lender? Does Subsidiary have to recognize cancellation of indebtedness income from not having repaid its debts? Does Subsidiary have to file a corporate tax return for the portion of the final tax year that it is in existence? If so, what income and expenses are included in the return? Can Subsidiary deduct the liquidation expenses on its final tax return? What is the amount and character of the loss Parent recognizes upon surrendering its Subsidiary stock? Upon not being repaid for the open account indebtedness? Does Subsidiary have recognized income upon forgiveness of its debts? What happens to Subsidiary’s tax attributes?

Because Parent received nothing for its investment in Subsidiary, it can claim a worthless security loss for the $500,000 investment. This loss should be an ordinary loss under Sec. 165(g)(3). Subsidiary’s $35,000 debt to Parent should be deductible as a bad debt under Sec. 166. Subsidiary might have to recognize discharge of indebtedness income if the discharged debt makes Subsidiary solvent. However, if the discharge does not make Subsidiary solvent, it will not have to recognize such income under Sec. 108(a)(1)(B). Because Sec. 332 does not apply, Sec. 381(a) also does not Copyright © 2024 Pearson Education, Inc.

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apply, and Subsidiary’s tax attributes disappear rather than carryover to Parent. pp. C:6-10 through C:6-14 and C:6-16 through C:6-18. C:6-31 Harry and Rita should consider the following tax issues: • • • • • •

Can the personal holding company tax be avoided by changing the investment/operating decisions of Alpha Corporation (see Chapter C:5)? What gain or loss does Alpha recognize if a liquidation occurs? What gain or loss do Harry and Rita recognize if Alpha is liquidated? Can the open transaction doctrine apply to the liquidation of Alpha due to an inability to value the Mayfair stock? Can the personal holding company tax be avoided by having Alpha make an S election? What tax increase will occur if Harry and Rita personally own the property currently held by Alpha?

Alpha should determine whether the personal holding company (PHC) tax could be avoided by increasing the portion of Alpha’s income earned from rental real estate activities to permit the rental income to be excluded from the personal holding company income (PHCI). This technique may require that Alpha shift asset composition from stocks and bonds to real estate. If a liquidation occurs, an appraisal of the Mayfair stock will be needed. The IRS is unlikely to permit the open transaction doctrine to apply to the Alpha liquidation merely because market quotations for Mayfair stock are lacking. pp. C:6-5 through C:6-10 and C:6-16.

Problems C:6-32 a.

C:6-33 a. b.

$113,000 loss, determined as follows: $25,000 + $16,000 + $6,000 + $5,000 = $52,000 total distribution $52,000 - $165,000 = $113,000 recognized loss; $100,000 ordinary loss under Sec. 1244 and $13,000 long-term capital loss. The Sec. 1244 loss ceiling is $100,000 for a married couple filing a joint return, thereby causing the remaining $13,000 to be a long-term capital loss. $2,000 long-term capital gain, if the accounts receivable instead have a $140,000 FMV, determined as follows: $140,000 + $16,000 + $6,000 + $5,000 = $167,000 total distribution $167,000 - $165,000 = $2,000 long-term capital gain. Part a: accounts receivable, $25,000; car, $16,000; office furniture, $6,000; and cash, $5,000. Part b: accounts receivable, $140,000, car, $16,000; office furniture, $6,000; and cash, $5,000. pp. C:6-5 and C:6-6. Arlene: $10,000 long-term capital loss = $30,000 - $40,000. Billy: $10,000 long-term capital gain = [($70,000 - $45,000) + $5,000] - $20,000. Here, the liability reduces the amount realized. Arlene, $30,000 cash. Billy, $70,000 basis for land, and $5,000 cash. pp. C:6-5 and C:6-6. Copyright © 2024 Pearson Education, Inc.

C:6-9

C:6-34 a. $60,000 gain next year. Peter, a cash method taxpayer, recognizes a $60,000 ($260,000 - $200,000) gain in the next year, the year in which he receives the money. b. $60,000 gain in current year. Peter instead would report the gain in the current year, the year in which the gain amount is fixed and determinable and in which the shareholder is entitled to the distribution. p. C:6-6. C:6-35 a. Len Wallace realizes a $300,000 ($400,000 FMV - $100,000 adjusted basis) gain on the asset transfer to Ace Corporation, but he recognizes no gain (Sec. 351(a)). Len’s basis for the Ace stock he receives is $100,000 (Sec. 358(a)). Ace Corporation’s basis for the asset is $100,000 (Sec. 362(a)). Chapter C:2. b. Ace Corporation recognizes a $400,000 ($500,000 FMV - $100,000 adjusted basis) gain on the deemed sale of the asset when it distributes the assets to Len (Sec. 336(a)). Federal income taxes of $84,000 (0.21 x $400,000) are imposed on the corporation. The taxes reduce the cash distribution to $416,000 ($500,000 - $84,000). Len Wallace recognizes a $816,000 [($416,000 cash + $500,000 FMV of asset) - $100,000 adjusted basis] gain on the exchange of his Ace stock for the cash and appreciated asset (Sec. 331(a)). The $816,000 gain recognized by Len includes the $400,000 built-in gain that existed at the time he contributed the non-cash asset to Ace, minus the $84,000 of taxes imposed on the built-in gain, plus $500,000 in after-tax profits accumulated in the business. pp. C:6-5 through C:6-10. c. No, for Part a; Yes, for Part b. The answer to Part a would not change because Sec. 351 applies to the formation of a subsidiary as well as general corporate formations. Because of the parent-subsidiary relationship for Wallace Corporation and Ace Corporation, the corporate liquidation is governed by Secs. 332 and 337 (instead of Secs. 331 and 336). Ace Corporation recognizes no gain or loss when it distributes the assets to Wallace Corporation (Sec. 337(a)). Wallace Corporation recognizes no gain or loss when it exchanges the Ace stock for the cash and the appreciated asset (Sec. 332(a)). The appreciated asset’s basis to Wallace Corporation is the same as it was to Ace Corporation, or $100,000 (Sec. 334(b)). Wallace Corporation also has $500,000 of cash. pp. C:6-10 through C:6-14. C:6-36 a. $110,000 capital gain = $200,000 FMV - $90,000 basis = $200,000 basis in property received. b. Milling machine: $25,000 ordinary income = $75,000 FMV - $50,000 basis, due to Sec. 1245 depreciation recapture rules. $75,000 basis in property received. Automobile: $11,000 ordinary income = $26,000 FMV - ($40,000 cost - $25,000 depreciation), due to Sec. 1245 depreciation recapture rules. $26,000 basis in property received. c. $75,000 capital loss = $100,000 FMV - $175,000 basis, which is disallowed because the corporation distributes the marketable securities entirely to Brad and is a non-pro rata distribution (according to stock ownership) of loss property to a related party. Brad, $100,000 basis in property received. Ann, $50,000 cash. If the corporation has capital gains from other transactions, it should consider selling the securities, recognizing the loss, and distributing the sales proceeds to Brad. d. The loss from Part c is now fully deductible because the corporation distributes the stock and cash ratably to the two shareholders (66.67% to Brad and 33.33% to Ann). Brad has marketable securities with a $66,667 basis plus $33,333 cash. Ann has marketable securities with a $33,333 basis plus $16,667 cash. pp. C:6-5 through C:6-10. Copyright © 2024 Pearson Education, Inc.

C:6-10

C:6-37 a.

Land: $18,000 capital gain = $30,000 - $12,000. Personal property: $6,000 ordinary income = $15,000 - $9,000, due to Sec.1245 depreciation recapture rules. Installment obligations: $9,000 Sec. 1231 gain = $30,000 - $21,000. Supplies: $7,500 ordinary income = $7,500 - $0. The entire gain is ordinary income because the corporation expensed the asset in the preceding year. Marketable securities: $3,000 short-term capital loss = $15,000 - $18,000. The securities are not distributed to a related party nor are they disqualified property. b. Melon recognizes none of the gains or losses (Sec. 337(a)). c. The distribution to a minority shareholder requires Melon Corporation to recognize gain (but not loss) on the distribution. Thus, the corporation recognizes all the gains realized in Part a but does not recognize the loss on the distribution of the marketable securities (Sec. 336(d)(3)). pp. C:6-5 through C:6-10. C:6-38 a. as follows:

The corporation’s total $1.6 million recognized gain on the distribution is calculated

Building Amount realized (FMV of assets) Minus: Adjusted basis Realized gain and recognized

$3,000,000 (1,800,000) $1,200,000

Land

Total

$1,000,000 ( 600,000) $ 400,000

$4,000,000 (2,400,000) $1,600,000

Twenty percent of the $600,000 depreciation taken on the building, or $120,000, is ordinary income under Sec. 291. The remaining $1,080,000 ($1,200,000 - $120,000) of gain on the building distribution is Sec. 1231 gain. The entire $400,000 gain on the land distribution is Sec. 1231 gain. b. $200,000 capital gain = ($4,000,000 FMV - $3,000,000 liability) - $800,000 stock basis. The basis of the land is $1 million, and the basis of the building is $3 million. c. Section 336(b) prohibits the FMV of the property from being less than the $4.5 million liability the shareholder assumes. The corporation’s $2.1 million recognized gain on the distribution is calculated as follows:

Amount realized (deemed FMV)a Minus: Adjusted basis Realized and recognized gain Depreciation claimed Recognized gain Sec. 291 ordinary income Sec. 1231 gain a

Building

Land

Total

$3,375,000 (1,800,000) $1,575,000

$1,125,000 ( 600,000) $ 525,000 $ -0525,000 -0525,000

$4,500,000 ( 2,400,000) $2,100,000 $ 600,000 2,100,000 120,000 1,980,000

$ 600,000 1,575,000 120,000b 1,455,000c

C:6-11

20% x lesser of Sec. 1245 recapture amount or realized gain. 20% x lesser of $600,000 or $1,575,000 20% x $600,000 = $120,000 c $1,575,000 - $120,000 = $1,455,000 Because the liability exceeds FMV, the shareholder’s amount realized is zero. Therefore, MNO Partnership recognizes an $800,000 capital loss. MNO’s basis of the apartment building logically should be $3,375,000, although a strict interpretation of the IRC suggests that Sec. 336(b) applies only to the corporation’s determination of gain or loss, and therefore the basis amount should not exceed the building’s actual FMV, or $3 million. Likewise, the basis of the land logically should be $1,125,000, although a strict interpretation of the IRC again leads to the actual FMV, or $1 million. pp. C:6-7 and C:6-8. C:6-39 a. $65,000 basis. Kansas’ adjusted basis in the land immediately after the contribution is $65,000 ($75,000 - $10,000). The $10,000 reduction is computed as follows: Total adjusted basis at contribution ($75,000 + $70,000) Minus: Total FMV at contribution ($50,000 + $85,000) Section 362(e)(2) basis reduction of land

$145,000 ( 135,000) $ 10,000

b. $20,000 recognized loss. Contributions or acquisitions of property by a corporation after the date two years before the date of adoption of a plan of complete liquidation are treated as part of a tax avoidance plan. However, use of the property in Kansas Corporation’s trade or business before a plan of liquidation is adopted should prevent the property distribution from having a tax avoidance purpose and from having the loss disallowed under Sec. 336(d)(2). Thus, Kansas should be able to deduct the $20,000 loss ($45,000 FMV - $65,000 basis). Note that the initial basis reduction under Sec. 362(e)(2) effectively disallowed $10,000 of the original $25,000 precontribution loss. The $20,000 recognized loss is comprised of the remaining $15,000 precontribution loss plus the $5,000 postcontribution loss. c. $5,000 recognized loss. A portion of the loss will likely be disallowed under Sec. 336(d)(2). Kansas’ basis for gain purposes is $65,000, and its basis for loss purposes is $50,000 ($65,000 - $15,000 excess of property’s adjusted basis after the initial Sec. 362(e)(2) reduction over its FMV at the time of contribution). Kansas can recognize the post contribution loss of $5,000 ($45,000 FMV - $50,000 basis) but not the $15,000 remaining loss. Note that the total disallowed precontribution loss is $25,000, the $10,000 initially disallowed under Sec. 362(e)(2) via the basis reduction and the $15,000 disallowed under Sec. 336(d)(2) on the subsequent sale. d. $20,000 recognized loss. Because Mike contributed the land more than two years before the adoption of the liquidation plan, it will not have a tax avoidance purpose. Thus, the $20,000 loss should be allowed as in Part b. e. $15,000 recognized gain. Kansas Corporation still will have a $65,000 basis for gain purposes and a $50,000 basis for loss purposes. Kansas will recognize a gain of $15,000 ($80,000 FMV - $65,000 basis). pp. C:6-8 through C:6-10.

C:6-12

C:6-40 Gamma Corporation recognizes a $450,000 total gain under Sec. 336(a), determined as follows: Property Securities Inventory Machinery Building Total Times: Tax rate Tax liability

FMV $ 125,000 350,000 275,000 750,000 $1,500,000

Adjusted Basis $ 50,000 300,000 200,000 500,000 $1,050,000

Gain $ 75,000a 50,000b 75,000c 250,000d $450,000 0.21 $ 94,500

Long-term capital gain Ordinary income c $60,000 Sec. 1245 recapture (ordinary income); $15,000 Sec. 1231 gain d $18,000 ($90,000 x 0.20) Sec. 291 ordinary income; $232,000 Sec. 1231 gain b

Marsha recognizes a $1,380,500 long-term capital gain under Sec. 331(a), calculated as follows: Original Cash Minus: Cash to pay taxes and liabilities ($175,000 + $94,500) Cash distributed Other distributed assets at FMV: Securities Inventory Machinery Building Total distributed Minus: Marsha’s basis in her stock Long-term capital gain*

$ 400,000 ( 269,500) $ 130,500 $125,000 350,000 275,000 750,000

1,500,000 $1,630,500 ( 250,000) $1,380,500

*The gain probably qualifies for the 100% exclusion under Sec. 1202. Marsha takes the following FMV bases under Sec. 334(a): Cash Securities Inventory Machinery Building

$ 130,500 125,000 350,000 275,000 750,000

pp. C:6-5 through C:6-10.

C:6-13

C:6-41 Gamma Corporation recognizes a $450,000 total gain under Sec. 1001, determined as follows: Property Securities Inventory Machinery Building Total Times: Tax rate Tax liability

Amount Realized $ 125,000 350,000 275,000 750,000 $1,500,000

Adjusted Basis $ 50,000 300,000 200,000 500,000 $1,050,000

Gain $ 75,000a 50,000b 75,000c 250,000d $450,000 0.21 $ 94,500

Long-term capital gain Ordinary income c $60,000 Sec. 1245 recapture (ordinary income); $15,000 Sec. 1231 gain d $18,000 ($90,000 x 0.20) Sec. 291 ordinary income; $232,000 Sec. 1231 gain b

Marsha recognizes a $1,380,500 long-term capital gain under Sec. 331(a), calculated as follows: Original Cash Plus: Proceeds of sale Minus: Cash to pay taxes and liabilities ($175,000 + $94,500) Cash distributed Minus: Marsha’s basis in her stock Long-term capital gain*

$ 400,000 1,500,000 ( 269,500) $1,630,500 ( 250,000) $1,380,500

*The gain probably qualifies for the 100% exclusion under Sec. 1202. Acquiring Corporation takes the following cost bases under Sec. 1012: Securities Inventory Machinery Building

$125,000 350,000 275,000 750,000

Comparison to Problem C:6-40: The results to Gamma are identical under either method of disposing of its assets. In either situation, Marsha realizes and recognizes a $1,322,000 long-term capital gain. In Problem C:6-41, however, she has all cash instead of cash and other assets. Nevertheless, in the Problem C:6-40 situation, Marsha could sell the assets at no additional gain and obtain cash. In either situation, the person acquiring the property (Marsha in Problem C:6-40 and Acquiring in Problem C:6-41) has a FMV (cost) basis in the assets. pp. C:6-5 through C:6-10.

C:6-14

C:6-42 a.

Sigma Corporation’s total $410,000 gain recognized is determined as follows: Property

Cash Securities Equipment Land Total

Amount Realized

Adjusted Basis

$ 240,000 80,000 200,000 680,000 $1,200,000

$ 240,000 90,000 150,000 320,000 $ 800,000

Recognized Gain/Loss $

-0-050,000 360,000 $410,000

The gain on the distribution of the equipment is ordinary income (Sec. 1245). The gain on the distribution of the land is capital gain or Sec. 1231 gain. The $10,000 loss realized on the distribution of the marketable securities is not deductible because they were distributed to a related party and because they are considered disqualified property (i.e., property received as a capital contribution from a related party within the past five years). The $20,000 of liquidation expenses is deductible on Sigma’s final tax return. Sigma’s taxable income is $390,000 ($410,000 - $20,000). Sigma’s income tax liability is $81,900 ($390,000 x 0.21). Pamela reports a $798,100 [($1,200,000 - $20,000 - $81,900) - $300,000] long-term capital gain on surrendering her stock. Her bases for the noncash property received are: securities, $80,000; equipment, $200,000; and land, $680,000. In addition, Pamela has cash of $138,100 ($240,000 -$20,000 - $81,900). b. Because the contribution was not within the past five years, the corporation would recognize the $10,000 loss upon distributing the stock, thereby reducing its taxable income to $380,000 and its tax liability to $79,800 ($380,000 x 0.21). The tax savings on the loss would increase Pamela’s cash distribution and long-term capital gain by $2,100 ($81,900 - $79,800). This result assumes the original contribution did not have loss recognition as a principal purpose under Sec. 336(d)(2). pp. C:6-5 through C:6-10. C:6-43 a. $100,000 realized gain = $400,000 - $300,000, but no recognized gain (Sec. 337). b. $165,000 realized gain = $400,000 - $60,000 liabilities - $175,000, but no recognized gain (Sec. 332). c. $300,000 carryover basis. d. The basis for the Parent stock disappears and is replaced by the basis of each of the individual assets. Subsidiary’s E&P balance carries over to Parent. pp. C:6-10 through C:6-14. C:6-44 a. $105,000 realized gain = ($20,000 + $200,000 + $150,000) - ($20,000 + $125,000 + $120,000). Subsidiary Corporation recognizes no gain or loss (Sec. 337(a)). b. $195,000 realized gain = ($20,000 + $200,000 + $150,000) - $175,000. Parent Corporation recognizes no gain (Sec. 332). c. LIFO inventory, $125,000; and equipment $120,000 ($280,000 - $160,000). d. Subsidiary’s E&P balance and NOL carry over to Parent (Sec. 381(a)). e. Parent’s basis for the stock disappears. pp. C:6-10 through C:6-14.

C:6-15

C:6-45 a. Distribution with respect to stock: $1,600,000 realized gain = $4,000,000 FMV $2,400,000 adjusted basis. Subsidiary Corporation recognizes no gain or loss (Sec. 337(a)). Distribution with respect to debentures: $200,000 realized loss = $2,000,000 FMV - $2,200,000 adjusted basis. Subsidiary recognizes no gain or loss (Sec. 337(b)). b. Distribution with respect to stock: $2,700,000 realized gain = $4,000,000 FMV $1,300,000 adjusted basis. Parent Corporation recognizes no gain or loss (Sec. 332(a)). Distribution with respect to debentures: $100,000 realized and recognized gain = $2,000,000 - $1,900,000 (Sec. 1001(a)). c. $2,200,000 basis for property received in exchange for debentures and $2,400,000 basis for property received in exchange for stock (Sec. 334(b)(1)). pp. C:6-10 through C:6-14. C:6-46 The comparative results are as follows: Part a Individual Shareholder

Part b Parent Shareholder

Liquidating corporation: FMV of property distributed Minus: Basis of property distributed Gain realized Gain recognized Times: Corporate tax rate Corporate tax E&P

$1,000,000 (600,000) $ 400,000 $ 400,000 0.21 $ 84,000 Disappears

$1,000,000 (600,000) $ 400,000 $ -00.21 $ -0Carries over to parent shareholder

Shareholder: FMV of distributed property received Cash received ($200,000 - corporate tax) Total distribution Minus: Shareholder’s basis in stock Gain realized Gain recognized (LTCG) Basis of noncash property received

$1,000,000 116,000 $1,116,000 (700,000) $ 416,000 $ 416,000 $1,000,000

$1,000,000 200,000 $1,200,000 (700,000) $ 500,000 $ -0$ 600,000

pp. C:6-5 through C:6-14. C:6-47 $600,000 ordinary deduction. Because Subsidiary Corporation is insolvent, Secs. 332 and 337 are inapplicable, and Secs. 165(g)(3) and 166 apply instead. After Subsidiary pays off its general liabilities, Parent receives $600,000 ($750,000 - $150,000) of assets in partial payment of its note receivable. It receives nothing for its investment in Subsidiary stock. The tax consequences to Parent are as follows: Note receivable from Subsidiary Minus: Partial payment on note Bad debt deduction under Sec. 166 Plus: Worthless security loss under Sec. 165(g)(3) Total ordinary deduction Copyright © 2024 Pearson Education, Inc.

C:6-16

$1,000,000 ( 600,000) $ 400,000 200,000 $ 600,000

In addition, Parent takes a $600,000 FMV (cost) basis in the assets under Sec. 1012. Subsidiary realizes and recognizes no gain or loss on the transfer of assets because their FMV and adjusted basis are equal. Also, Subsidiary recognizes no income on the forgiveness of debt under Sec. 108(a)(1). Finally, because Sec. 332 does not apply, Sec. 381 also is inapplicable. Therefore, Subsidiary’s NOLs and other tax attributions do not carryover to Parent. p. C:6-12. C:6-48 a. Tax consequences to Subsidiary Corporation: Subsidiary recognizes no gain or loss on the distribution to Majority Corporation (Sec. 337(a)). Subsidiary recognizes a $7,000 ($11,000 $4,000) gain on the distribution of property to Mindy (Sec. 336(a)). Subsidiary’s tax on the gain is $1,470 ($7,000 x 0.21), leaving $18,530 cash to distribute, $16,677 to Majority and $1,853 to Mindy. Tax consequences to Majority Corporation: Majority recognizes no gain or loss on the liquidation of Subsidiary (Sec. 332(a)). Majority takes a $36,000 carryover basis in the assets received (Sec. 334(b)(1)). Tax attributes from Subsidiary, including E&P, carry over to Majority (Sec. 381). Majority’s basis in its Subsidiary stock disappears. Mindy’s amount realized is $12,853 ($11,000 FMV of assets + $1,853 cash). Her gain recognized is $7,853 ($12,853 - $5,000), and her tax liability is $1,178 ($7,853 x 0.15). Her aftertax proceeds are $11,675 ($12,853 - $1,178). Mindy takes an $11,000 FMV basis in the noncash assets received (Sec. 334(a)). b. Instead of distributing property to Mindy, Subsidiary could distribute only cash, thereby avoiding tax to Subsidiary on the distribution. The amount of cash distributed should be $13,000 [($110,000 FMV + $20,000 cash) x 0.10]. Mindy’s gain would be $8,000 ($13,000 $5,000), her tax liability would be $1,200 ($8,000 x 0.15), and her after-tax proceeds would be $11,800 ($13,000 - $1,200). Thus, on an after-tax basis, Mindy also would be better off with this approach compared to the distribution in Part a. pp. C:6-12 and C:6-13. C:6-49 Gabriel Corporation’s $10,000 total gain is determined as follows: Property--To:

Amount Realized

Adjusted Basis

Recognized Gain/Loss

Inventory--

$ 500,000 180,000 20,000 90,000 10,000 270,000 30,000 $1,100,000

$300,000a 108,000b 12,000c 72,000 8,000 360,000 40,000 $900,000

Bond retirement Zeier Goff Equipment-- Zeier Goff Land-Zeier Goff Total a

-0-08,000 -02,000d -0-0$ 10,000

$420,000 x ($500,000/$700,000). Gabriel recognizes no gain on the distribution to retire the bonds (Sec. 337(b)). b $420,000 x ($180,000/$700,000). Gabriel recognizes no gain on the distribution in redemption of stock held by the parent corporation. (Sec. 337(a)). c $420,000 x ($20,000/$700,000). Gabriel recognizes gain (but not loss) on a distribution to a minority shareholder (Secs. 336(a) and (d)(3)). d Gabriel recognizes gain (but not loss) on a distribution to a minority shareholder (Secs. 336(a) and (d)(3)). Copyright © 2024 Pearson Education, Inc.

C:6-17

Taxes owed by Gabriel Corporation: $10,000 x 0.21 = $2,100. Gain or loss recognized by Zeier Corporation: (1) Zeier recognizes no gain or loss on the redemption of Gabriel Corporation stock held by Zeier Corporation (Sec. 332). (2) Zeier recognizes no gain or loss on the retirement of Gabriel bonds held by Zeier Corporation because the amount received equals the basis of the bonds. Adjusted basis for property received: cash, $88,110 [($100,000 - $2,100 taxes) x 0.90]; inventory, $408,000 ($300,000 + $108,000); equipment, $72,000; and land, $360,000. Holding period: includes holding period of liquidated Gabriel. Tax attributes of liquidated Gabriel carryover to Zeier. Gain or loss recognized by Ray Goff: $49,790 [($9,790 cash + $20,000 inventory + $10,000 equipment + $30,000 land - $10,000 liabilities assumed) - $10,000 stock adjusted basis = $49,790 capital gain]. Adjusted basis for property received: cash, $9,790; inventory, $20,000; equipment, $10,000; and land, $30,000. Holding period begins on the day after the liquidation date. pp. C:6-10 through C:6-14. C:6-50 a. Tax consequences to Pueblo Corporation: Cash: No gain or loss realized or recognized. Inventory: Ordinary income of $50,000 ($150,000 - $100,000) realized and recognized. Marketable securities: Capital loss of $25,000 ($100,000 - $125,000) realized but not recognized because distributed to a related party (Art). Equipment: Ordinary income of $140,000 ($325,000 - $185,000) realized and recognized due to Sec.1245 depreciation recapture. Tax consequences to Art: Capital gain of $160,000 [($325,000 + $50,000 + $100,000 + $5,000) - $320,000] recognized. Tax consequences to Peggy: Capital gain of $40,000 [($20,000 + $100,000) - $80,000] recognized. b. Pueblo may spread the distributions over two tax years. The spreading of the distributions thus may permit a reduction in the shareholders’ marginal tax rates. The marketable securities might have been distributed to Art and Peggy ratably according to their stockholdings with some change needed in the other assets distributed. A ratable distribution would permit Pueblo to recognize the loss on the distribution. c. The following tax results occur if Art and Peggy are corporations: Tax consequences to Pueblo Corporation: Inventory: Ordinary income of $33,333 ($100,000 - $66,667) recognized. Pueblo reports the gain recognized only on the distribution to the minority shareholder, Peggy Corporation. The distribution to Art Corporation is nontaxable under Sec. 337 because it owns 80% of Pueblo Corporation. Tax consequences to Art Corporation: No gain or loss recognized under Sec. 332. Tax consequences to Peggy Corporation: Capital gain of $40,000 [($20,000 + $100,000) - $80,000] recognized. pp. C:6-5 through C:6-14. Copyright © 2024 Pearson Education, Inc.

C:6-18

C:6-51 a. $200,000 loss. Bell Corporation realizes and recognizes a $200,000 loss on the asset sale. The loss from selling the assets (as well as any other losses or expenses incurred in connection with the liquidation) can pass through to George in Bell’s final tax year if an S election is in effect for the tax year in which the sale occurs. If Bell does not make an S election, the NOLs expire when Bell liquidates. The NOL carryovers from C corporation tax years cannot pass through to George if Bell makes an S election (see Chapter C:11). b. The loss carryovers could be used to offset the profits from the new trade or business, subject to the 80% of taxable income limitation in post-2020 years. The Sec. 382 loss limitation rules do not apply because a change in the ownership of Bell’s stock has not occurred (see Chapter C:7). p. C:6-17. C:6-52 a.

Current year distribution: Ron: $ 5,000 long-term capital gain = $20,000 - $15,000 Steve: $ 7,500 unrecovered basis = $20,000 - $27,500 Next year distribution: Ron: All $20,000 of the distribution is long-term capital gain. Steve: $12,500 long-term capital gain = $20,000 - $7,500 b. $20,000 for each shareholder c. Current year distribution: Neither shareholder would recognize a gain because each would have unrecovered basis in the Union stock remaining after the distribution. Ron: $ 9,000 unrecovered basis = $ 6,000 - $15,000 Steve: $21,500 unrecovered basis = $ 6,000 - $27,500 Next year distribution: Ron: = $11,000 long-term capital gain = $20,000 - $ 9,000 Steve: $ 1,500 long-term capital loss = $20,000 - $21,500 Each shareholder has a $6,000 basis in the land received. p. C:6-15. C:6-53 The $5,000 held back and placed in escrow is excluded from the calculation of Tina’s $30,000 long-term capital gain in the prior liquidation year. Because Tina never receives or recognizes this amount, it is not deductible as a loss by Tina. Because Tina is a cash method taxpayer and because her original gain was capital in nature, she can deduct the additional $2,500 in the next year as a long-term capital loss under the Arrowsmith doctrine. pp. C:6-15 and C:6-16.

Comprehensive Problem C:6-54 a. Formation of Lifecycle Corporation: No gain or loss recognized by Able, Baker, or the corporation. Basis of Lifecycle Corporation stock to shareholders: Able $16,000 Baker $22,000 Holding period of stock includes holding period of land transferred. Copyright © 2024 Pearson Education, Inc.

C:6-19

Lifecycle Corporation’s basis of land: Land A $16,000 Land B $20,000 [limited to FMV under Sec. 362(e)(2)] Holding period of Land A includes Able’s holding period prior to transfer. Holding period of Land B begins the day after the transfer. b. Corporate taxable income and taxes: 2023 Sales $1,200,000 Minus: COGS (450,000) Gross profit $ 750,000 Plus: Dividend income -0STCG; LTCG -0Minus: Depreciation (524,000) a Interest expense (120,000) Salary expense -0Charitable contributions ded. -0Operating expenses (30,000) Dividends-received ded. -0Taxable income (NOL) $ 76,000 Tax liability (21%)b $ 15,960

2024 $990,000 (500,000) $490,000

2025 $400,000 (280,000) $120,000

2,000 1,000

-03,000

(25,000) (114,000) (12,000) (500) (40,000) (1,000) $300,500 $ 63,105

(25,000) (112,000) -0-0(60,000) -0$(74,000)c $ -0-

The corporation is exempt from the business interest limitation because of its low gross receipts. b Assume that Lifecycle pays its taxes in the same year they accrue. c The corporation may not carry back the NOL but can carry it over indefinitely, subject to the 80% limitation in the carryover year.

C:6-20

Earnings & Profits: 2023: Corporate taxable income Plus: Depreciation ($500,000 - $21,000) Minus: Taxes Balance at December 31, 2023

$ 76,000 479,000 (15,960) $539,040

2024: Corporate taxable income Plus: Dividends-received deduction Tax-exempt interest Minus: Depreciation ($0 - $42,000) Taxes Dividends to shareholders ($42,000 + $28,000) Balance at December 31, 2024

(42,000) (63,105) (70,000) $667,235

2025: Corporate NOL Minus: Depreciation ($0 - $42,000) Balance at December 31, 2025

(74,000) (42,000) $551,235

2026: E&P gain on asset sale ($1,366,000 - $1,357,000) Tax on taxable gain* Balance before liquidating distribution Note: The E&P disappears upon liquidation. *

Sales proceeds Adjusted basis of assets Gain on sale Minus: NOL carryover from 2025 Taxable income Tax (21%) Liquidation Liquidation proceeds (1) Basis of stock surrendered (2) LTCG on liquidation (3) Tax on LTCG at 23.8% (4) After-tax proceeds (1 - 4)

1,000 1,800

9,000 (69,300) $490,935 $1,366,000 962,000 $ 404,000 (74,000) $ 330,000 $ 69,300

Able (60%) $316,161 (16,000) $300,161 $ 71,438 $244,723

C:6-21

300,500

Baker (40%) $210,774 (22,000) $188,774 $ 44,928 $ 165,846

Tax Strategy and Critical Thinking Problems C:6-55 If Sarah operates the business in corporate form, her after-tax amount will be $1,421,386, calculated as follows: Corporate Taxable Income

Year Investment 1 $ 40,000 2 70,000 3 90,000 4 150,000 5 350,000 Liquidation proceeds Minus: Sarah’s stock basis Gain on liquidation Times: Tax rate on capital gains (20% + 3.8%) Tax on liquidation After-tax amount ($1,553,000 - $131,614)

Corporate Tax $ 8,400 14,700 18,900 31,500 73,500

After-Tax Amount $1,000,000 31,600 55,300 71,100 118,500 276,500 $1,553,000 (1,000,000) $ 553,000 0.238 $ 131,614 $1,421,386

Alternatively, if Sarah operates the business as a sole proprietorship, her after-tax amount will be $1,492,800, calculated as follows: Year Investment 1 2 3 4 5 After-tax amount

Net Incremental Taxable Incomea

Incremental Individual Taxb

$ 32,000 56,000 72,000 120,000 280,000

$ 11,840 20,720 26,640 44,400 103,600

After-Tax Amountc $1,000,000 28,160 49,280 63,360 105,600 246,400 $1,492,800

Taxable income stated in problem x 80%, to reflect the 20% qualified business income deduction. b At a 37% marginal tax rate. c Taxable income stated in the problem (before 20% reduction) minus tax. Thus, from a tax perspective, Sarah should operate as a sole proprietorship. As discussed in Chapters C:9 through C:11, she also could operate the business as a single member limited liability company (LLC) or an S corporation, thereby achieving the same tax advantage while establishing limited liability for her business.

C:6-22

C:6-56 a. Operate the business as a C corporation: The corporate-level after-tax rate of return is 7.9%, calculated as 10% (1 - 0.21). Thus, if the client operates the business in a C corporation for 20 years, she will obtain an after-tax accumulation of $372,445, calculated as follows: ATA = $100,000 [(1.079)20 (1 - 0.238) + 0.238] = $372,445. Operate the business as a sole proprietorship: Taking into account the 20% qualified business income deduction, your client will face a 29.6% (37% x 0.8) effective tax rate on her business income. Thus, your client will obtain an after-tax accumulation of $389,871, calculated as follows: ATA = $100,000 [1 + 0.1 (1 - 0.296)]20 = $389,871. Thus, the client should operate as a sole proprietorship. b.

If the investment period is 40 years the C corporation produces the following

results: ATA = $100,000 [(1.079)40 (1 - 0.238) + 0.238] = $1,618,899. While the proprietorship produces the following results: ATA = $100,000 [1 + 0.1 (1 - 0.296)]40 = $1,520,002. Thus, with the longer investment period, the C corporation form prevails. c. Operate the business as a C corporation: This alternative remains the same as in Part a, with an after-tax accumulation of $372,445, calculated as follows: ATA = $100,000 [(1.079)20 (1 - 0.238) + 0.238] = $372,445. Operate the business as a sole proprietorship: Without the 20% qualified business income deduction, your client will face a 37% effective tax rate on her business income. Thus, your client will obtain an after-tax accumulation of $339,364, calculated as follows: ATA = $100,000 [1 + 0.1 (1 - 0.37)]20 = $339,364. Thus, without the qualified business income deduction in the sole proprietorship case, the C corporation prevails.

C:6-23

C:6-57 For Samantha to bear the burden of the corporate tax, Perth Corporation would pay $400,000 for the assets with the following results for Samantha: Proceeds of asset sale Minus: Adjusted basis of assets Taxable gain Corporate tax ($100,000 x 0.21) Liquidation proceeds to Samantha ($400,000 - $21,000)

$400,000 (300,000) $100,000 $ 21,000 $379,000

Thus, Samantha bears the corporate tax burden because the $400,000 potential liquidation proceeds are reduced by the cash retained to pay the corporate tax. For Perth to bear the burden of the corporate tax, it will have to pay a premium for the assets. The premium, however, will increase Tango’s gain, which further increases the premium Perth has to pay. To arrive at the premium, Perth must gross up the initial $21,000 tax as follows: $21,000 / (1 - 0.21) = $26,582, thereby increasing the purchase price to $426,582. The results to Samantha are as follows: Proceeds of asset sale Minus: Adjusted basis of assets Taxable gain Corporate tax ($126,582 x 0.21) Liquidation proceeds to Samantha ($426,582 - $26,582)

$426,582 (300,000) $126,582 $ 26,582 $400,000

Thus, Samantha receives the entire $400,000 in liquidation, and the tax burden has been shifted to Perth.

Case Study Problems C:6-58 The points presented below outline the tax consequences of the sale of the assets by Paul’s corporation. This information should be placed into a well-organized, properly formatted memorandum by each student with the appropriate grammar and punctuation. The asset sale will require Paul’s corporation to recognize gain or loss with respect to each individual asset sold. Assuming the $30,000 that is paid over and above the $745,000 ($770,000 $25,000) FMV shown in the balance sheet for the noncash assets is attributable to goodwill, thereby making total goodwill equal to $130,000. The recognized gain or loss for each asset is as follows: Inventory: $15,000 ordinary income = $75,000 - $60,000 Equipment: $150,000 ordinary income = $350,000 - $200,000, because of depreciation recapture Building: $60,000 = $160,000 - $100,000; $5,000 ordinary income (Sec. 291) and $55,000 Sec. 1231 gain Land: $20,000 Sec. 1231 gain = $60,000 - $40,000 Goodwill: $130,000 capital gain = $130,000 - $0 Copyright © 2024 Pearson Education, Inc.

C:6-24

Assuming a 21% tax rate, Paul’s corporation will owe income taxes of $78,750 ($375,000 x 0.21) on the sale. The corporation will need a portion of the $775,000 sales proceeds and the $25,000 remaining cash to pay the $78,750 in federal income taxes plus the $100,000 other liabilities owed. If the corporation liquidates, Paul is subject to the applicable capital gains tax rate on the difference between the amount of cash remaining after the payment of the liabilities including taxes and his basis in the stock. If the corporation does not liquidate, Paul could retain the cash in the corporation and use it as an investment vehicle. In this case, Paul needs to be aware that the personal holding company tax might apply (see Chapter C:5). Although the transaction is proposed as a cash purchase, Paul might consider having it structured as an installment sale. The installment sale would permit him to defer the shareholder tax on the corporate liquidation (Sec. 453(h)). The tax savings achieved, and interest income earned, however, might be insufficient to cover the additional risk of an extended payout. Section 336(a), however, would require recognition of gain at the corporate level when the corporation distributed the installment obligation to the shareholder. An S election probably would not be beneficial here. If the election is effective before the sale date, the corporation will owe the Sec. 1374 built-in gains tax in addition to Paul incurring tax at the shareholder level. If the election is effective after the sale date, the Sec. 1375 excess net passive income tax will apply to the passive income earned from the cash retained from the sale unless the corporation distributes its accumulated Subchapter C E&P (see Chapter C:11). C:6-59 This situation poses a particularly difficult problem for your accounting firm because of the large amount of revenues derived each year from the Peerless family. Despite the close relationship that has been maintained between your firm and the Peerless family, the tax practitioner has a responsibility under Statements on Standards for Tax Services, No. 3 and Treasury Department Circular 230 (see Chapter C:15) to ensure that the necessary documentation, such as appraisals, is obtained to support the values assigned to the assets upon a sale or a liquidating distribution. Specifically, SSTS, No. 3 states that “a member may in good faith rely, without verification, on information furnished by the taxpayer or by third parties. However, a member should not ignore the implications of information furnished and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the member.” Statements on Standards for Tax Services are available on the AICPA's website at http://www.aicpa.org. The transaction as stated initially affects four tax returns—the final corporate return for Peerless Real Estate Corporation, the personal tax returns for Myron and Mark for the year in which the liquidation takes place, and the initial partnership tax return. A 20% substantial underpayment penalty could be imposed on your clients (Myron, Mark, and Peerless) if the values assigned to the property sale and/or liquidating distributions are substantially understated and thereby causing the income reflected in these tax returns to be substantially understated (see Chapter C:15). The existence of an appraisal for $1.7 million most likely will be ignored because the FMV it reports (acquired at the “right price”) is substantially less than other reliable appraisals. The substantial understatement penalty is in addition to the taxes and interest that the taxpayers otherwise might owe with respect to the transaction. Copyright © 2024 Pearson Education, Inc.

C:6-25

In this case, Peerless Real Estate Corporation is selling a building and land with a $4.5 million FMV to a partnership controlled by Myron and Mark for $1.7 million ($400,000 cash + $1,300,000 assumption of mortgage balance). The corporation recognizes $700,000 gain. This gain is substantially less than the $3.5 million gain the corporation would recognize if it sold the building for its $3.2 million net FMV plus the assumption of the $1.3 million mortgage. Because Myron and Mark control the MM Partnership, IRS may apply the Sec. 482 rules upon audit of the corporation’s return. Section 482 will cause the sale of the building to be reported as if it had been sold in an arm’s length transaction. Thus, a $4.5 million gross sale price likely would be attributed to the transaction. The additional $2.8 million gain that the corporation would report in an arm’s length transaction increases the corporation’s tax cost by approximately $588,000 ($2,800,000 x 0.21) plus any applicable interest and penalties. Alternatively, the IRS might apply the step transaction doctrine and treat the transaction as a liquidating distribution of the land and building (as well as any remaining corporate assets) to Myron and Mark and a subsequent contribution of the building and land to the partnership. The corporation then would recognize the gain on the distribution of the building under Sec. 336 as if the property had been sold for $3.2 million in cash (plus the assumption of the liability) immediately preceding the distribution, that is, for its $4.5 million FMV. In addition, a shareholder level tax would be imposed on the capital gain reported by Myron and Mark on the redemption of their shares. The contribution of the building, land, and mortgage to the partnership most likely would be nontaxable. Even though the transaction as currently structured reduces the amount of corporate level gain, it may not be the most desirable alternative. The partnership’s basis, and therefore its depreciation deductions, is limited to the lower purchase price. The partnership’s reported income will be higher due to the reduced depreciation deductions. The higher income level reduces the value of the tax deferral obtained at the time of the sale. The higher depreciation deductions cannot be preserved by making an installment sale of the land and building to the MM Partnership. Section 453(g) prohibits the use of the installment method here because the partnership (the purchaser) is a related party controlled by the same persons (Myron and Mark) that control the corporation (the seller). In conclusion, the client’s proposed transaction has a number of problems that could lead to substantial additional tax costs if an IRS audit occurs. Even if one ignores the audit risk, a number of ethical questions can be encountered by approving a sale transaction that takes place without the appropriate reliable appraisals at a price that is apparently substantially below the asset’s actual market value.

Tax Research Problems C:6-60 Section 165(g)(1) allows a taxpayer to claim a capital loss to be claimed with respect to worthless security losses, Sec. 165(g)(3) holds that the loss is an ordinary loss when the worthless securities involve affiliated corporations. Section 332, on the other hand, holds that a parent corporation recognizes no gain or loss on the receipt of property in complete liquidation of a subsidiary corporation. Parent Corporation owns the requisite amount of Subsidiary Corporation common and preferred stock to satisfy the 80% stock ownership requirements of Sec. 332(b)(1). Copyright © 2024 Pearson Education, Inc.

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However, Sec. 332(b)(2) holds that the nonrecognition rules apply to those cases only where the parent corporation receives a distribution in complete cancellation of all its stock. Regulation Sec. 1.332-1(b) adds that the nonrecognition rules apply only to those cases where the parent corporation receives at least partial payment for the stock it owns in the liquidating corporation. This regulation also indicates that one should refer to the worthless security rules of Sec. 165 when Sec. 332 does not apply. The question here is whether Parent received the requisite payment that will cause Sec. 332 to apply to the transaction, or does the transaction fall outside of Sec. 332? In two cases, the Spaulding Bakeries, Inc., 27 T.C. 684 (1957) N.A., 1957-2 C.B. 8, aff’d., 1 AFTR 2d 986, 58-1 USTC ¶9320 (2nd Cir., 1958) and H. K. Porter Co., Inc., 87 T.C. 689 (1986), the parent corporation was permitted to deduct a loss on its preferred stock in situations that otherwise would come under Sec. 332. In both cases, the subsidiary made a liquidating distribution to the parent corporation with respect to preferred stock that was outstanding but made no payment with respect to the common stock. (See also Continental Grain Co. et. al, 1989 PH TC Memo ¶88,577, 56 TCM 900 and 1989 PH TC Memo ¶89,155, 57 TCM 57.) The liquidating distributions here were distributed only with respect to the preferred stock. Because the transaction does not satisfy the Sec. 332 requirements, the nonrecognition rules no longer apply. Thus, Parent recognizes a $50,000 capital loss on the redemption of the preferred stock. Parent can deduct this capital loss only to the extent it has offsetting capital gains. The $500,000 loss on the common stock is an ordinary loss under Sec. 165(g)(3) due to the worthlessness of a security in an affiliated corporation. Section 165(g)(3) treats stock of an affiliated corporation as other than a capital asset, thereby converting what otherwise would be a capital loss into an ordinary loss. Because Parent Corporation owns 85% of Subsidiary’s common stock and 100% of its preferred stock, the Sec. 165(g)(3) affiliated corporation stock ownership requirement is satisfied. Section 165(g)(3) requires at least 90% of Subsidiary’s income to come from other than passive sources. Ninety percent of Subsidiary Corporation’s income comes from nonpassive sources, thereby satisfying the income requirement. Because both requirements have been satisfied, Parent Corporation is permitted ordinary loss treatment under Sec. 165(g)(3) on the worthless Subsidiary common stock. C:6-61 Section 332(b)(1) requires the parent corporation to own on the date of adoption of the plan of liquidation, and to continue to own at all times until the receipt of the property, a sufficient amount of subsidiary corporation stock to satisfy the stock ownership requirements of Sec. 1504(a)(2). Section 1504(a)(2) establishes a two-part test. The parent corporation must own stock that (1) possesses at least 80% of the total combined voting power and (2) has at least 80% of the total value of all outstanding stock. Section 1504(b)(4) excludes nonvoting preferred stock from the stock definition. This level of stock ownership must be held on the date the plan of liquidation is adopted and continue to be owned until the receipt of the property. Parent Corporation owns all the Subsidiary Corporation stock at the time Subsidiary’s formal plan of liquidation is adopted. However, it has owned only 60% of the stock for an extended period of time. A question might be raised as to whether Parent and Tyrone had adopted an informal plan of liquidation prior to Parent agreeing to purchase Tyrone’s Subsidiary Corporation stock. Copyright © 2024 Pearson Education, Inc.

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The IRS held in Rev. Rul. 70-106, 1970-1 C.B. 70, that the requisite stock was not owned prior to adopting a plan of liquidation to permit Sec. 332 to apply when a corporate shareholder owning 75% of the subsidiary corporation’s stock causes the subsidiary to redeem the minority shareholder’s 25% interest before adopting the formal plan of liquidation. The IRS held that Sec. 332 did not apply because a plan of liquidation was adopted at the time an agreement was made with the minority shareholders to redeem their stock. The IRS adopted a different position in Rev. Rul. 75-521, 1975-2 C.B. 120, with respect to a subsidiary corporation where 50% of the stock was owned by a group of individual shareholders and 50% of the stock was owned by a single corporate shareholder. In this case, the corporation purchased the shares held by the individual shareholders and immediately adopted a plan of liquidation for the subsidiary corporation. The IRS honored the formal adoption of a plan of liquidation and permitted the liquidation to come under Sec. 332. The IRS distinguished this ruling from Rev. Rul. 70-106. The liquidation of Subsidiary will qualify for nonrecognition of gain or loss under Secs. 332 and 337. The key issue for qualifying under Sec. 332 is whether the 80% stock ownership requirement for Subsidiary has been satisfied when the plan of liquidation is adopted. Parent meets this requirement because of its acquisition of Tyrone’s Subsidiary stock. Reason for concern may exist over the close dates of acquisition and liquidation, but Rev. Rul. 75-521 seems to support the taxpayer’s position. The rules of Sec. 381(c)(2) require Parent to assume Subsidiary’s tax attributes (e.g., earnings and profits). In addition, the Sec. 334 rules require Parent to take a carryover basis in the assets it receives from Subsidiary.

“What Would You Do In This Situation?” Solution Ch. C:6, p. C:6-18. Andrea’s C corporation has operated successfully for a number of years. She faces a difficult decision about whether to convert to an LLC. The LLC offers a substantial tax savings in that no corporate income tax is imposed on an LLC treated as a partnership or proprietorship under the check-the-box regulations. Also, she may qualify for the qualified business income deduction. Her good friend, Jenna, already has formed an LLC. Her decision, however, was much easier than Andrea’s because she was starting a new business. Under the check-the-box regulations, Jenna’s LLC is treated as a partnership (if it has two or more owners) or as a proprietorship (if Jenna is the only owner). No special elections were needed to obtain pass-through treatment because the default tax classification for an LLC with two or more owners is partnership status. For an LLC with one owner, sole proprietor status is the default classification, i.e., the LLC is a disregarded entity. If Andrea wishes to operate her business as an LLC, the corporation first must liquidate, distributing its property to Andrea in exchange for her stock. Andrea then could contribute the property to an LLC tax free. Because the LLC would have only one owner, it would be considered a disregarded entity such that its income would be taxed to Andrea as a sole proprietorship. Copyright © 2024 Pearson Education, Inc.

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The liquidation, however, will cause the corporation to be taxed on the $100,000 ($800,000 $700,000) gain inherent in its property. If Andrea were to plan the liquidation to occur at the beginning of a tax year before the corporation earns any other taxable income, the tax on the $100,000 would be $21,000. That would leave $779,000 ($800,000 - $21,000) of property to be distributed to Andrea, thereby causing her to realize a $654,000 ($779,000 - $125,000) gain. Depending on whether the gain qualifies for the Sec. 1202 exclusion and on Andrea’s tax bracket, this liquidation gain could be taxed anywhere from 0% to 23.8% (including the 3.8% net investment tax rate). Thus, liquidating the corporation and subsequently forming an LLC could entail a potentially high tax cost. The question then would be whether the LLC form entails less taxation on operating income than does the existing corporate form. The corporation’s $200,000 of annual taxable income results in $42,000 of corporate level taxes. With a pass-through entity, this $200,000 might be eligible for the qualified business income (QBI) deduction and would be subject to Andrea’s individual tax rate. The QBI deduction in combination with Andrea’s tax rate could make the pass-through entity the better business form. However, this differential tax savings (if any) would have to be sufficient to outweigh the tax cost of liquidating the existing corporation. Thus, liquidating the corporation and forming an LLC may not be the best alternative for Andrea. Another alternative Andrea might want to consider is having the corporation elect S corporation status (see Chapter C:11). This election would require no liquidation of the corporation and hence no corporate or individual level liquidation tax, and Andrea still would obtain passthrough treatment on the corporation’s income, that is, the corporation’s income would not be taxed at the corporate level, would pass through to Andrea as possibly qualified business income, be eligible for the QBI deduction, and be taxed at her individual level. With S corporation status, however, if the corporation sells any of its assets within the five-year period beginning on the effective date of the S election, the corporation could be subject to the 21% built-in gains tax under Sec. 1374 (see Chapter C:11).

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Chapter C:7 Corporate Acquisitions and Reorganizations Discussion Questions C:7-1 The advantages are these: If the purchaser corporation purchases the target corporation’s stock from its shareholders, each shareholder will be taxed on a capital gain (loss) equal to the difference between the amount received for the stock and his or her stock basis. If instead, the purchaser buys the target assets, the target will be taxed on the gain (loss) for each asset with the character of each gain (loss) determined by the character of the asset. Thus, some of the gain (loss) will be ordinary, and some will be capital. To distribute the sales proceeds to the target shareholders, the target must liquidate, which creates a second layer of tax. The target shareholders will be better off with the sale of stock that provides them with only a single layer of tax. pp. C:7-2 through C:7-5. C:7-2 The buyer’s primary advantage in a taxable asset acquisition is that the buyer can step-up the bases of the target corporation’s assets (inside basis) to their acquisition cost. For example, the acquiring corporation may purchase goodwill that has no basis to the target but a cost basis to the acquiring corporation. The acquiring corporation can amortize this purchased goodwill over 15 years (Sec. 197). A secondary advantage is that the buyer can use primarily debt (i.e., a leveraged buyout) to make the acquisition. The ability to use debt reduces the amount of stock (if any) the buyer must issue and, therefore, minimizes the dilution of its shareholders’ ownership interests. The interest on the debt is deductible for income tax purposes. The seller’s primary advantage in a stock exchange is that the seller avoids having to recognize a gain on the disposition of the assets at the corporate level. In a taxable stock exchange, the shareholder level gain is capital in character. This capital gain can offset any capital loss carryovers or allow unrealized capital losses to be realized and recognized. In addition, the seller can receive solely cash which he or she can invest however he or she desires. The seller’s future wealth is not dependent on increases in value for the acquiring corporation’s stock or on the ability of the acquiring corporation to pay interest and principal on its debt obligations. The receipt of installment obligations also, can permit a deferral of the income tax liability over the duration of the obligations. A nontaxable disposition of the assets by the seller (assets-for-stock exchange) would preclude the acquirer from stepping-up the basis of the assets. Similarly, the seller’s basis in the stock received in the transaction would carryover from the assets that were exchanged. Likewise, a stock-for-stock swap between seller and acquirer would make the transaction tax-free for the seller and again deny the acquirer a stepped-up basis for the stock acquired or the underlying assets. In addition, the acquirer would receive the tax attributes (NOLs, capital losses, etc.) in both an assetfor-stock exchange and a stock-for-stock exchange. pp. C:7-2 through C:7-5.

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C:7-3 Some of the advantages and disadvantages of purchasing all the target corporation’s stock for cash and subsequently liquidating the target corporation into the acquiring corporation are: • •

• •

The only tax cost incurred to accomplish the transaction is that the target corporation’s shareholders must recognize gain/loss (generally capital) on the sale of their target corporation stock. No tax cost is incurred in the transfer of the assets from the target corporation to the acquiring corporation. Sections 332 and 337 together permit the liquidation to take place tax-free to both the liquidating (target) corporation and the acquiring corporation. An asset sale followed by a liquidation of the target corporation is taxed both to the target corporation and its shareholders. The acquiring corporation assumes the tax attributes of the target corporation (e.g., net operating losses, net capital losses, tax credit carryovers, etc.). The major disadvantage of purchasing Target’s stock and subsequently liquidating Target into Acquiring under Secs. 332 and 337 is that the acquiring corporation does not obtain a stepped-up basis in the acquired assets. The outside basis in the target stock acquired equals the price paid for the stock. The inside bases for the target’s assets remain at their current values (usually historical cost, less depreciation, amortization, etc., if applicable) and, in aggregate, generally will be substantially below the stocks outside basis. A Sec. 338 election can be used to step-up the assets’ inside bases. The Sec. 338 election, however, generally involves tax on the gain from the deemed Sec. 338 sale.

A stock purchase and subsequent liquidation of the target corporation can take place tax-free with only 80% of the target corporation’s stock being purchased for cash. The 80% is a threshold that may reduce the cost of acquiring the target corporation’s assets. In such a situation, the 20% minority interest may be cashed out as part of the liquidation or at some future date. pp. C:7-4 and C:7-5. C:7-4 The acquiring parent corporation might make a Sec. 338 election if it desires to step-up the basis of the target corporation’s assets. Few corporations will want to pay additional tax now just to get a tax savings later from a stepped-up basis. Most corporations that choose a Sec. 338 election have other tax losses that will significantly reduce the tax burden of the gain they must recognize under Sec. 338. The Sec. 338 election should not be made when the basis of target corporation assets would be stepped-down, or substantial tax attributes (e.g., loss carryovers) would be lost as a result of the deemed liquidation. The availability of the loss carryovers is an advantage since the gain recognized on the deemed sale of target assets can be offset by the loss carryovers to reduce or eliminate the tax cost of stepping-up the assets’ bases. p. C:7-5. C:7-5 a. Under the residual method. This method allocates the total cost or basis of a group of assets (for example, the adjusted grossed-up basis of Theta’s stock) to individual properties in the following sequence: •

C:7-2

• • • • • •

Class II: Actively-traded personal property (as defined in Sec. 1092(d)(1)), such as stock that is part of a straddle, U.S. government securities, and publicly-traded securities. Class III: Accounts receivable, mortgages, and credit card receivables from customers that arise in the ordinary course of business. Class IV: Inventory or other property held primarily for sale to customers in the ordinary course of its trade or business. Class V: All assets other than Class I, II, III, IV, VI, and VII assets. Class VI: All amortizable Sec. 197 assets except goodwill and going concern value. Class VII: Sec. 197 intangible assets in the nature of goodwill and going concern value.

Based on the information given, $1.8 million would be allocated to the Class I through VI assets, and the remaining $700,000 would be allocated to the Class VII asset, goodwill. Under Sec. 197, the amount allocated to goodwill can be amortized for tax purposes. b. The $1.4 million adjusted grossed-up basis is first allocated to the Class I, II, III, and IV tangible assets starting with the Class I assets. The difference between the total allocation to the Class I, II, III, and IV assets and the $1.4 million total adjusted grossed-up basis is allocable to the Class V, VI, and VII assets. If the FMV of the Class V assets exceeds the unallocated basis, the remaining basis is allocated to all Class V assets based on, and not to exceed, their relative FMVs. No basis is allocated to the Class VI and VII assets. Should this be the case, all the Class V, VI, and VII assets will have a tax basis that is less than their FMV. Should the FMV of the Class V assets be less than the unallocated basis, each Class V asset will receive a basis equal to its FMV. The amount remaining after making the Class V asset allocation would be assigned first to the Class VI and second to the VII assets under rules similar to the Class V allocation rules. pp. C:7-7 through C:7-9. C:7-6 a. A taxable asset acquisition involves the use of primarily cash and debt instruments of the acquiring corporation to make the acquisition. The acquisition may involve some stock of the acquiring corporation or its parent corporation. A nontaxable reorganization involves primarily stock and securities of the acquiring corporation or its parent corporation. Generally, the stock portion must constitute more than half the total consideration used. b. The target corporation recognizes all realized gains and losses in a taxable asset acquisition. When, as part of a reorganization, the target corporation receives and retains boot property it recognizes gain equal to the lesser of the realized gain or the sum of the money plus the FMV of the nonmoney boot property retained. The target corporation recognizes no gain as a result of receiving boot property when the boot property received is distributed to its shareholders as a part of the reorganization. Gain may be recognized when boot property received by the target corporation in the reorganization, or property retained by the target corporation, is distributed to the shareholders as part of the target’s liquidation. Such gain, which is recognized as a result of the liquidating distribution, generally is small if the target corporation immediately distributes the boot property to its shareholders because the basis for such property in the target corporation’s hands is its FMV on the date of the reorganization. c. In a taxable asset acquisition, the acquiring corporation takes a cost basis in the acquired property (generally equal to FMV). In a reorganization, the acquiring corporation takes a carryover basis from the target corporation. This basis is stepped-up only for the amount of gain recognized by the target corporation (transferor). Such gain is not currently recognized except under conditions specified in Sec. 361(b)(1)(B) [when boot property is retained by the target corporation] Copyright © 2024 Pearson Education, Inc.

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and Sec. 357(c) [when liabilities are assumed or acquired that exceed the basis of the transferred property in Type D reorganizations]. d. When the target corporation is liquidated in a taxable asset acquisition, the target corporation and its shareholders recognize all realized gains and losses. An exception applies where the target corporation is an 80%-or-more-owned subsidiary. In this case, no gain or loss is recognized by either party under Secs. 332 and 337. Generally, in a reorganization, gains and losses are not recognized when the target corporation liquidates by distributing stock or obligations of the acquiring corporation or another corporation that is a party to the reorganization. Gain, but not loss, is recognized on the distribution of other (boot) property to shareholders or creditors. Gain also is recognized at the shareholder level, but not exceeding the amount of boot property received or the realized gain, whichever is smaller. e. Under Sec. 381(a), the target corporation’s tax attributes, such as net operating losses and capital losses, carry over to the acquiring corporation in a reorganization. The use of net operating losses, capital losses, and some tax credits are limited under Secs. 382 and 383 following a major change in ownership of a “loss” corporation. The target corporation’s tax attributes do not carry over to the acquiring corporation in a taxable transaction. pp. C:7-2 through C:7-4, C:7-10 through C:7-13, C:7-43 through C:7-46. C:7-7 a. No recognized gain if notes distributed. The short-term notes are considered boot. The target corporation recognizes no gain if it receives and then distributes the notes to its shareholders. b. No recognized gain. This transaction should be nontaxable. Assumption of the target corporation’s liabilities is not tantamount to the receipt of money. Alternatively, if the amount of debt obligations assumed is large relative to the stock received, the IRS may attempt to recharacterize the entire reorganization as a taxable purchase. If such an attempt is successful, the entire amount of the target corporation’s realized gain is recognized. c. No recognized gain. The excess of liabilities assumed by the acquiring corporation over the adjusted basis of the target corporation assets is not recognized by the transferor as a gain. Note: Sec. 357(c) does not apply to acquisitive Type D reorganizations. d. No recognized gain if money distributed. The money is considered boot. The target corporation recognizes no gain since the money received is distributed to the shareholders (Sec. 361(b)(1)). e. No recognized gain. The money is considered boot. The target corporation recognizes no gain because under Sec. 361(b)(3) transfers to creditors are considered to be distributions of boot property as part of the reorganization. The money is not considered to have been retained when determining the recognized gain. pp. C:7-14 and C:7-15. C:7-8 The Sec. 302(b) redemption rules. Boot property received results in the shareholders recognizing gain equal to the lesser of their realized gain or the amount of boot property received (e.g., amount of money received plus the FMV of nonmoney boot property). The character of the shareholders’ gain in an acquisitive reorganization is determined under the stock redemption rules of Sec. 302(b) (Rev. Rul. 93-61). Rev. Rul. 93-61 characterizes the gain in terms of a hypothetical transaction in which a portion of the acquiring corporation’s stock is redeemed with the boot property. Thus, the taxpayer is treated as having made an exchange of target corporation stock exclusively for acquiring corporation stock (not a combination of acquiring corporation stock and boot property) and then having a portion of the acquiring corporation’s stock redeemed for the boot Copyright © 2024 Pearson Education, Inc.

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property. Based on the tests of Sec. 302(b), the gain realized in the hypothetical stock redemption will be treated as either a dividend or a capital gain. For most taxpayers, both the dividend income and capital gains are currently taxed at the capital gains rate. pp. C:7-16 through C:7-18. C:7-9 Essentially true. For most taxpayers, both dividend income and capital gains are taxed at the capital gains rate. However, individual shareholders might prefer to report capital gains when they receive boot in a corporate reorganization because these gains can be used to offset capital loss carryovers or current year capital losses where dividend income cannot. Corporate shareholders, on the other hand, generally prefer to recognize dividend income to avail themselves of the 50%, 65%, or 100% dividends-received deduction with respect to part or all of the recognized gain. pp. C:7-16 through C:7-18. C:7-10 For nonrecognition property, adjusted substituted basis; for boot, FMV. The bases in the stocks and securities received are determined by taking the total basis in the stocks and securities surrendered and increasing it by the amount of gain recognized by the shareholder. This total basis is decreased by the amount of money received and the FMV of any other boot property received. This basis is allocated ratably (based on relative FMVs) between the stocks and non-boot securities received. The basis of any other boot property received is its FMV. p. C:7-18. C:7-11 In a Type A reorganization (merger or consolidation), under recent Treasury Regulations, at least 40% of the consideration used must be the acquiring corporation’s stock (see Reg. Sec. 1.3681(e)(2)(v), Example 1). This rule permits money, securities, and other property to constitute up to 60% of the total consideration used. By contrast, in a Type B (stock-for-stock) reorganization, solely acquiring corporation voting stock must be used; money can be used only in very limited circumstances. The acquiring corporation can use money to redeem fractional shares of the acquiring corporation stock or pay certain expenses of the liquidation. The target corporation also can use money to redeem stock of shareholders who are exercising their rights under state law to have their shares repurchased for cash. The Type C (asset-for-stock) reorganization requires that acquiring corporation voting stock be used to acquire 80% of the target corporation’s property. Money, securities, nonvoting stock, and other property can be used to acquire up to 20% of the target corporation’s property. Liabilities assumed or acquired can exceed the 20% threshold only if no money or other property is used. Voting stock of the acquiring corporation’s parent corporation can be used in triangular type A, B, or C reorganizations. pp. C:7-19 through C:7-33. C:7-12 Currently, a 40% threshold. For advance ruling purposes, the IRS previously required the former shareholders of the target corporation to receive in aggregate at least 50% of their total consideration in the form of acquiring corporation stock. The IRS and the courts have accepted lower stock consideration percentages for Type A reorganizations in certain circumstances. Treasury Regulations now accept 40% as the continuity of interest threshold (see Reg. Sec. 1.3681(e)(2)(v), Example 1). p. C:7-41. C:7-13 A Type A reorganization meets the continuity of business enterprise requirement if the acquiring corporation continues the target corporation’s line of business or uses the target assets in its (the acquiring corporation’s) business. pp. C:7-41 and C:7-42.

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C:7-14 Potential advantages: To be nontaxable, a Type C reorganization requires that “substantially all” the target corporation’s assets be acquired. Thus, only those assets the acquiring corporation agrees to acquire are obtained in a Type C reorganization, provided the “substantially all” requirement is met. A merger offers the acquiring corporation the advantage of not having to acquire “substantially all” of target assets. Generally, all target assets and liabilities other than those assets that are not wanted and which are sold, exchanged, or otherwise disposed of are acquired in a merger. The IRC sets no statutory limit on the amount of assets the target corporation can sell or exchange prior to a merger, as in the case with a Type C reorganization. Potential disadvantages: A Type C reorganization does not require the acquiring corporation to assume or acquire all the target corporation’s liabilities. Only those liabilities that the acquiring corporation agrees to assume or acquire are obtained from the target. Although this restriction may be a disadvantage to the target, it also may be an advantage to the acquiring corporation. A second disadvantage of a Type C reorganization is that only a limited amount of cash (up to 20%) can be used to effect the reorganization. If the acquiring corporation assumes a substantial amount of liabilities, then, as a practical matter, it can use no cash to effect the reorganization. Under Reg. Sec. 1.368-1(e)(2)(v), Example 1, a merger permits up to 60% of the consideration paid to be other than acquiring corporation stock (e.g., money, securities, assumption of liabilities, and other boot property). p. C:7-27. C:7-15 Based on a 70% / 90% test. For advance ruling purposes, the IRS interprets “substantially all” to mean that at least 70% of the FMV of the gross assets and 90% of the FMV of the target corporation’s net assets be acquired. The courts have employed a flexible standard, which has varied depending on the nature of the assets retained, the reason for retaining the assets, and whether such assets are to be used in a new trade or business or distributed pursuant to the liquidation of the target corporation. pp. C:7-26 and C:7-27. C:7-16 Because the assumption of liabilities could preclude the use of cash. In a Type C reorganization, the consideration used can include up to 20% cash and other boot property. However, any liabilities assumed or acquired reduce on a dollar-for-dollar basis the 20% ceiling. If the liabilities assumed or acquired exceed the 20% ceiling, any cash or other boot property used would disqualify the transaction as a nontaxable reorganization. Because target corporation liabilities exceed the 20% ceiling in many industries, as a practical matter, the acquiring corporation might be prohibited from using cash as part of the consideration. pp. C:7-26 and C:7-27. C:7-17 Type D. When an acquisition qualifies as either a Type C or a Type D reorganization, it is considered to be a Type D reorganization. pp. C:7-28 and C:7-29. C:7-18 The element of control. Both the Type C and Type D are acquisitive “asset-for-stock” reorganizations. With the Type C reorganization, the target corporation’s shareholders usually do not control the acquiring corporation after the acquisition. With the Type D reorganization, the target corporation or one of its shareholders must control the transferee (acquiring) corporation immediately after the asset transfer. In a Type D reorganization, control is defined in terms of a 50% threshold (not the 80% threshold used in a Type B reorganization). pp. C:7-28 and C:7-29.

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C:7-19 Money and other property can be used by the acquiring corporation in a Type B reorganization (1) to eliminate a shareholder’s right to receive a fractional share of the acquiring corporation’s stock or (2) to pay certain reorganization expenses. The target corporation can use money and other property to redeem the stock of dissenting shareholders under applicable state law. pp. C:7-29 and C:7-30. C:7-20 The tender offer can be accomplished as a Type B reorganization only if it is completely independent of the 5% stock purchase for cash. Generally, the IRS will look at the time intervening between the two transactions. If the transactions are more than 12 months apart, the transactions generally will be considered independent events. If the time between the two transactions is 12 months or less, the IRS generally will collapse the stock purchase and the tender offer and find that the “solelyfor-voting-stock” requirement has not been met, thereby rendering the transaction fully taxable. Alternatively, the 5% interest purchased for cash could be sold to an independent party and the necessary 80% or more interest could be acquired at a later date in a separate tender offer. pp. C:7-30 and C:7-31. C:7-21 Treated as a Type B reorganization if structured properly. This transaction would be classified as a Type B reorganization because it is a stock-for-stock transaction in which Alpha Corporation obtains an 85% controlling interest in Theta Corporation stock. To preserve the nontaxable character of the transaction, four options exist for the subsequent acquisition of the minority shareholder’s stock: (1) Theta can redeem the minority shareholder’s stock for cash either prior to or after the reorganization; (2) Alpha can purchase the shares for cash in a transaction that is not part of the reorganization (i.e., the transactions should be kept separate from the reorganization by a time period of more than 12 months); (3) a Theta shareholder could purchase for cash the 15% minority interest and then tender the shares as part of the reorganization; or (4) Alpha could make a second tender offer at a later date with Alpha stock as consideration. Any additional Theta shares obtained in the second tender offer would meet the Type B reorganization minimum ownership requirement because Alpha already would have owned a controlling interest. pp. C:7-29 through C:7-31. C:7-22 A triangular reorganization involves a parent corporation, a subsidiary of the parent corporation, and a target company. Typically, the parent corporation stock is used to carry out the reorganization because it generally is more marketable than the stock of one of the parent corporation’s subsidiaries. The parent corporation transfers some of its stock to the subsidiary as a capital contribution. The subsidiary then uses the parent stock to carry out the reorganization. For example, the subsidiary can exchange the parent stock for a target corporation’s stock in a nontaxable transaction. Following the reorganization, the parent corporation still would own its original subsidiary (except in a reverse triangular merger), and it also would have an indirect interest in the newly acquired corporation (through the acquiring subsidiary). By having the subsidiary make the acquisition, the parent may reduce its liability as well as the time and cost of obtaining shareholder approval for the acquisition. pp. C:7-24, C:7-25, and C:7-28. C:7-23 Section 368(a)(1)(D) allows three forms of nontaxable divisive Type D reorganizations. For a divisive reorganization, a plan of reorganization that generally involves two steps is required. The first step is the transfer of part or all of the assets of a transferor corporation to one or more controlled corporations in exchange for stock and possibly securities, money, and/or other boot Copyright © 2024 Pearson Education, Inc.

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property. In a spin-off, the parent distributes the stock of the controlled corporation (subsidiary) to all its shareholders without receiving anything in exchange. The stockholders end up with stock ownership in both the distributing and controlled corporations. In a split-off, the parent corporation distributes the stock of a controlled corporation (subsidiary) to some or all of its shareholders in exchange for part or all of their parent stock. Some shareholders may terminate their interest in the distributing corporation. In a split-up, the parent distributes the stock of two or more controlled corporations (subsidiaries) to some or all of its shareholders in exchange for all their parent stock. The parent corporation then goes out of existence. pp. C:7-33 through C:7-38. C:7-24 The difference relates to an asset transfer and plan of reorganization. In a nondivisive Sec. 355 distribution, stock of an existing controlled corporation (subsidiary) can be distributed tax free even if none of the distributing corporation’s assets are transferred to the controlled corporation in a related transaction. To qualify as a divisive Type D reorganization, the asset transfer and stock distribution must occur as part of an integrated transaction governed by a plan of reorganization in accordance with Sec. 368(a)(1)(D). pp. C:7-36 and C:7-37. C:7-25 A distribution of the stock and securities of a controlled corporation is nontaxable to the shareholders if the following Sec. 355 requirements are met: • • • • • •

The property distributed must consist solely of stock or securities of a corporation controlled by the distributing corporation immediately before the distribution. The distribution must not have been used principally as a device to distribute the E&P of the distributing corporation, the controlled corporation, or both. Immediately after the distribution, the distributing corporation and the controlled corporation both must be engaged in the active conduct of a trade or business that also was actively conducted for at least five years prior to the distribution. The distributing corporation must distribute either (a) all the stock and securities in the controlled corporation held by it immediately before the distribution or (b) an amount of stock in the controlled corporation constituting control (generally 80% stock ownership). The distribution must have a substantial business purpose. The persons who directly or indirectly owned the controlled corporation(s) prior to its division must maintain a continuing equity interest in one or more of the corporations following the division.

Events that will trigger the recognition of gain or loss by the shareholders include the distribution of: money, securities of the controlled corporation in a principal amount exceeding the principal amount of the securities surrendered, any stock of the controlled corporation purchased within the previous five years in a taxable transaction, and stock or securities that represent a distribution of accrued interest. The nontaxable transaction also can be contrasted with a taxable transaction in which the distributing corporation recognizes gain or loss when it distributes non-cash property. In addition, taxable transactions generally trigger the recognition of dividend income or capital gain or loss. pp. C:7-37 and C:7-38.

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C:7-26 Upon the distribution of appreciated property. A corporation generally recognizes gain or loss on a distribution of stock and securities in a controlled corporation (nonrecognition property) to its shareholders when it distributes boot in the transaction, and the boot property has appreciated in value. The distributing corporation, however, recognizes no loss on the distribution of boot property that has declined in value. The general rule is subject to one additional exception. A distribution of disqualified stock (as defined in Sec. 355(d)) to a shareholder, who directly or indirectly owns 50% or more of such stock, requires the distributing corporation to recognize gain as would be the case in the distribution of boot property. pp. C:7-36 through C:7-38. C:7-27 A nontaxable reorganization that results in a change to a single corporation’s equity or debt structure. Recapitalizations include the exchange of one class of common stock for a second class of common stock; for example, the exchange of Class B common stock for Class A common stock. The stock the shareholder receives may have different rights than the stock surrendered. Two other types of recapitalizations are (1) the exchange of preferred stock for common stock or (2) the exchange of debt for preferred or common stock. An exchange of common stock or preferred stock for corporate debt generally is a taxable event for the shareholders, much like the redemption of stock. pp. C:7-38 through C:7-40. C:7-28 Through an exchange of common stock for nonvoting preferred stock. Specifically, a recapitalization, such as in a Type E reorganization, can be used to transfer voting control in a family corporation by senior family members’ exchanging part or all of their common stock for nonvoting preferred stock. Members of the junior generation(s) may ultimately become the only remaining holders of the common stock, or they can acquire part or all of the common stock through a purchase. The junior generation already may hold common stock that it previously purchased or received through gift or inheritance. The holders of the common stock (the junior generation) will have a residual claim to the corporation’s earnings after the corporation pays dividends to the preferred stockholders. In most cases, following the recapitalization, the members of the junior generation will have voting control through common stock ownership. pp. C:7-38 through C:7-40. C:7-29 Because of a violation of judicial or regulatory doctrines. A transaction might satisfy the letter of the reorganization provisions yet be treated by the IRS and the courts as a taxable transaction if it violates one or more judicial doctrines relating to reorganizations (e.g., the business purpose doctrine). For example, in Gregory v. Helvering, as a result of the taxpayer’s failing the business purpose requirement, the Supreme Court rejected the taxpayer’s arguments for a nontaxable reorganization and insisted that the transaction was taxable to all parties even though the statutory requirements for a Type D reorganization had been satisfied. Treasury Regulations also contain various doctrines that a reorganization must satisfy, such as continuity of business enterprise and continuity of interest in acquisition transactions. See Reg. Sec. 1.368-1. pp. C:7-40 through C:7-42. C:7-30 Types A, C, acquisitive D, F, and G. The target corporation’s tax attributes carryover to the acquiring corporation in the Type A, C, acquisitive D (but not divisive D), F, and G reorganizations. In the divisive Type D reorganization, E&P is allocated between two tax entities, but the authority for this allocation is derived from Sec. 355, not Sec. 381. The target corporation’s tax attributes remain with the target corporation in a Type B reorganization. Also, they remain with the corporation in a Type E or F reorganization because only one corporation is engaged in the transaction. p. C:7-43. Copyright © 2024 Pearson Education, Inc.

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C:7-31 Section 381 restricts the carryover of tax attributes to certain types of tax-free reorganizations, and also limits the acquiring corporation’s use of the tax attributes in the year of acquisition. Section 381 also prohibits the carryback of tax attributes (for example, NOLs) to prior tax years following an acquisitive reorganization. Section 382 limits the use of loss carryovers acquired in certain taxable purchases and nontaxable reorganizations that result in a stock ownership change. Section 383 provides similar restrictions for acquisitions intended to facilitate the use of capital loss and tax credit carryovers. Section 384 prevents pre-acquisition losses of either the acquiring or target corporations (the loss corporation) from offsetting built-in gains recognized during the five-year post-acquisition period by another corporation (the gain corporation). Section 269 precludes the claiming of a loss or deduction where the principal purpose of the acquisition is the evasion or avoidance of tax by securing the benefit of a deduction, credit, etc. that otherwise would not be available. pp. C:7-43 through C:7-46. C:7-32 Because the Sec. 382 annual loss limitation is computed by multiplying the FMV of the old loss corporation’s stock, immediately before the ownership change, by the long-term tax-exempt federal rate. By implication, if the FMV of the loss corporation stock is substantial relative to the size of its NOLs, the Sec. 382 limitation probably will not be an obstacle to the use of the NOL carryovers. pp. C:7-43 through C:7-46. C:7-33 A proposal for a transaction specifically defined as a reorganization. Nonrecognition of gain or loss is limited to exchanges or distributions that (1) are a part of a reorganization and (2) undertaken for reasons germane to the continuance of the business of a corporation that is a party to a reorganization. As a practical matter, the parties should reduce a plan of reorganization to writing lest the reorganization be challenged by the IRS. p. C:7-47. C:7-34 To ensure against adverse tax consequences. Advance rulings generally are requested because of the complexity of the tax law in the realm of reorganizations and because these transactions involve substantial dollar amounts. A subsequent redetermination by the IRS or the courts that a completed reorganization is taxable might have adverse tax consequences for the parties involved in the transaction. An advance ruling offers a degree of security and generally can be relied upon by the parties to the reorganization. However, a transaction carried out in a manner different from the plan set forth in the ruling request may be challenged by the IRS. The IRS in Rev. Proc. 2023-3 has indicated an unwillingness to issue “comfort rulings” to taxpayers (for example, advance rulings in situations involving reorganizations where adequate guidance already exists in the IRC, regulations, etc.). Consequently, an increasing number of reorganizations are consummated without an advance ruling but with an opinion letter from tax counsel. p. C:7-48. C:7-35 In a sense, yes. A taxpayer generally can expect that the IRS’s position set forth in a favorable private letter ruling will be followed when the IRS audits the completed transaction. If, however, the taxpayer chooses not to follow the plan previously reviewed by the IRS, a possibility exists that the completed transaction will be subject to IRS scrutiny. Such scrutiny might lead the IRS to conclude that the transaction is materially different from what the taxpayer had previously proposed and what the IRS approved in the private letter ruling. If the deviation from the original plan is material, the IRS may reject the taxpayer’s position. p. C:7-48.

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Issue Identification Questions C:7-36 The following tax issues should be considered by Rodger Powell when evaluating Karin Godfrey’s proposal and by Karin in drafting her proposal: Rodger: • What is the amount and character of the gain or loss Fireside will recognize on the sale of the noncash assets? On distributing the installment obligation? • What are the relative tax costs (and non-tax benefits) of receiving a lump-sum cash payment? Of selling the Fireside stock to Karin? • What is the amount and character of the gain or loss Rodger will recognize on surrendering his Fireside stock? On receipt of the subsequent payments? • Does Fireside have to file a corporate tax return for the portion of the final tax year it is in existence? If so, what income and expenses are included in the return? • Can Fireside deduct the liquidation expenses on its final tax return? • Can Fireside deduct any unamortized organizational costs on the final return? Start-up costs? • How will the interest income from the installment obligations be taxed to Rodger? • What are the tax costs and benefits of Fireside’s remaining in business to collect the installment payments and then liquidating? Karin: • What entity form and capital structure should be used to conduct the business? • What will be Karin’s total basis in the noncash assets to be acquired? What portion of the total basis should be allocated to each individual asset? • Should the assets be acquired by Karin or by her business entity? • What are the tax consequences of transferring the assets to the business entity selected? • What tax year and accounting methods should Karin elect for her new business? • Are any of her pre-acquisition costs deductible? Capitalizable as start-up expenses? • Are any other capitalized costs amortizable? • What capital recovery rules apply to each tangible and intangible asset? • Is the interest paid on the installment purchase deductible by Karin or her business entity? The gain realized on the asset sale may be recognized under the installment sale rules. If so, Fireside Bar and Grill Corporation can report the total gain for tax purposes over a six-year period. The interest earned on the installment obligations will be reported as ordinary income by the corporation while it holds the debt. Subject to limitations on the deductibility of business interest, Karin or her business entity can deduct the interest expense incurred on the installment debt. If the corporation sells the assets in an installment sale and liquidates within a 12-month period, the corporation will have to recognize any realized gain (i.e., difference between FMV of the obligations and their basis on the corporation’s books) when the obligations are distributed to the shareholders. Rodger need not recognize his gain on the sale or exchange of his stock as part of Fireside’s liquidation except to the extent he receives cash on the liquidation date. His remaining gain can be recognized as the installment obligations are collected. As an alternative to deferring his total tax Copyright © 2024 Pearson Education, Inc.

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burden, Rodger might consider selling the stock. If such an alternative is adopted, Karin may find herself disadvantaged—no step-up in basis in the acquired assets. pp. C:7-2 through C:7-10 (also see Chapter C:6). C:7-37 The following tax issues should be considered in connection with the Acme Beverage Company-Lotus Technologies spin-off: •

•

Acme Beverage Issues: What gain or loss does Acme recognize when it transfers the assets of the aluminum sheet, consumer-products packaging, and ceramic units to Lotus? What basis does Acme take in the Lotus stock received? What is Acme’s holding period for the Lotus stock? What gain or loss does Acme recognize when it distributes the Lotus stock to its shareholders? Acme Shareholders’ Issues: What gain or loss do the Acme shareholders recognize when they receive Lotus stock? Is any gain recognized by the shareholders when they receive cash in lieu of fractional Lotus shares? What is the character of the recognized gain? What basis do the shareholders take in the Lotus shares they receive? Lotus Technologies Issues: What gain or loss does Lotus recognize when it issues its stock in exchange for the assets it acquires from Acme? What basis does Lotus take in the assets it acquires from Acme? What tax attributes does Lotus acquire from Acme?

The transfer of the Acme assets to Lotus is part of a divisive Type D (spin-off) reorganization. Acme recognizes no gain on the asset transfer unless it receives and retains boot. The Lotus stock belonging to Acme takes a carryover basis that references the bases of the assets transferred. The subsequent distribution of the stock to the Acme shareholders is nontaxable. No gain is recognized by either Acme or its shareholders except to the extent that fractional Lotus shares are redeemed for cash. The shareholders allocate the basis for their Acme stock between the Acme and Lotus stocks based on their relative fair market values. The holding period for their Acme stock carries over to the Lotus stock. Fractional shares redeemed for cash receive an allocation of the basis from the Acme stock, and the recognized gain is a capital for most shareholders. Acme recognizes no gain or loss on the asset transfer to Lotus, and the assets transferred take a carryover basis and holding period in Lotus’s hands. pp. C:7-33 through C:7-38. C:7-38 The following issues might have been important to the parties to the reorganization: • • •

Does either corporation recognize gain or loss? Do Zalco’s shareholders recognize gain or loss? What bases and holding periods do the parties have in their stock or assets received?

In the merger, Bioteknic would recognize no gain or loss on issuing its common stock to Zalco’s shareholders. The Zalco shareholders would recognize no gain or loss on exchanging their Zalco shares for the Bioteknic shares (except to the extent of Zalco fractional shares being purchased with cash). The Zalco shareholders would take a substituted basis and holding period in the Bioteknic stock they would receive that would reference their basis and holding period in the Zalco stock they surrendered. If an asset transfer occurred, Zalco would recognize no gain or loss on the asset transfer, and the assets’ tax Copyright © 2024 Pearson Education, Inc.

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bases would carry over to Bioteknic. Zalco’s tax attributes also would carry over to Bioteknic. pp. C:714 through C:7-24.

Problems C:7-39 a. Yes. Alpha Corporation purchased the minimum 80% of Theta Corporation’s stock within the continuous period of January 1 through October 1 of the current year. The acquisition date will be October 1 of the current year. The election must be made by Alpha on or before July 15 of the following year. b. No. A qualified purchase has not occurred. Alpha purchased only 60% of Theta’s stock within any 12-month period. Thus, the purchase is not eligible for the Sec. 338 election. c. By March 31 of the following year. In Part b, at least 80% of Theta’s stock was not acquired in a 12-month time period. If the initial purchase was made on April 1 of the current year, at least 80% of target company stock must be purchased within 12 months from that date. pp. C:746 and C:7-48. C:7-40 a. The acquisition date is April 10 of the following year (Sec. 338 (h)(2)). The Sec. 338 election must be made by January 15 following the April 10 acquisition date (Sec. 338(g)(1)). b. The aggregate deemed sales price (ADSP) is $2,612,658, determined as follows: ADSP =

G + L - (TR x B) (1 - TR)

$1,900,000 + $500,000 - (0.21 x $1,600,000) (1 - 0.21) ADSP = $2,612,658 ADSP =

c. Total basis = $2,612,658 = $1,900,000 (stock basis) + $500,000 (nontax liabilities) + $212,658 (tax liability). The $212,658 tax liability is calculated on the gain as follows: 0.21 x ($2,612,658 ADSP - $1,600,000 adjusted basis of assets). d. Likely to lower the acquisition price. The additional tax cost imposed at the time of the Sec. 338 deemed asset sale is in effect a “toll charge” incurred to accomplish the transaction. The toll charge may have the effect of reducing the price a potential purchaser would be willing to pay for the corporate stock as compared to an outright purchase of the corporate assets. The recovery time for this toll charge depends on the assets held by the acquired corporation and when their basis increase can be deducted for tax purposes. e. The tax attributes disappear if Acquiring makes a Sec. 338 election because the “old” target corporation goes out of existence. pp. C:7-5 through C:7-10. C:7-41 a. If Gator Corporation acquired the assets directly, it would obtain assets with a tax basis equal to their FMV. In so doing, it also acquires none of the known liabilities included in the balance sheet and none of the contingent liabilities that might exist. Bulldog Corporation would be taxed on the gain from the asset sale, and then Bulldog’s shareholders would be taxed on the liquidation of Bulldog. Bulldog, however, does not have to be liquidated. It can remain in existence to conduct a new trade or business. In such case, the shareholders would not incur a capital gain until the liquidation transaction takes place. Copyright © 2024 Pearson Education, Inc.

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b. The purchase of the Bulldog stock is a taxable event to the selling shareholder. Gator will take a $1 million basis in the Bulldog stock. The $1 million “outside” basis is not reflected in the “inside” basis for the Bulldog assets. Liquidation of Bulldog (a subsidiary) into Gator (the parent company) is nontaxable under Secs. 332 and 337. The stock transaction does not provide a step-up for the “inside” basis in Bulldog’s assets unless a Sec. 338 election is made on behalf of Bulldog by the management of its parent corporation (Gator). The Sec. 338 election imposes a tax cost on the deemed sale conducted by Gator and Bulldog to achieve the step-up in basis. If such an election is anticipated, the tax cost of the Sec. 338 election should be reflected in the (lower) purchase price that Gator pays for the Bulldog stock. Other issues that may arise are: • Additional legal costs may be incurred in an asset acquisition on the transfer of the title for each of the individual assets; • State income taxes may be levied on the asset sale; and • State transfer taxes and/or sales taxes may be levied on the asset transfer. c. The $250,000 NOL incurred by Bulldog in the current year can reduce the cost of making the Sec. 338 election. The gain recognized by Bulldog when carrying out the Sec. 338 election is substantially larger than the $250,000 NOL. The NOL will reduce the tax cost by $52,500 ($250,000 x 0.21). pp. C:7-2 through C:7-10. C:7-42 The pertinent amounts are as follows: Grossed-up stock basisa ADSPb Legato’s gain (loss)c Tax liabilityd AGUBe Basis of inventory Basis of landf Basis of goodwill Mr. Bachman’s gaini

Part a $666,000 850,000 400,000 84,000 850,000 250,000 600,000 -0182,800

Part b $750,000 956,329 506,329 106,329 956,329 250,000 600,000 106,329g 250,000

Part c $587,500 750,633 300,633 63,133 750,633 250,000 500,633 -0120,000

Part d $ 837,500 1,067,089 617,089 129,589 1,067,089 250,000 600,000 217,089h 320,000

G = Purchase price / 0.80 ADSP = [G + L - TR (B)] / (1 - TR), where L = $100,000, TR = 0.21, B = $450,000 c ADSP - $450,000 d (ADSP - $450,000) x 0.21 e G + L + Tax liability, where L = $100,000 f AGUB - $250,000 inventory FMV, but not to exceed $600,000 land FMV g AGUB - $850,000; Note that the residual goodwill equals the tax liability. h AGUB - $850,000; Note that the residual goodwill exceeds the tax liability by $87,500, which means that Legato had that amount of goodwill attributable to its going concern value. i Stock purchase price - $350,000 b

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Observations: In the given facts, Legato Corporation’s assets have a built-in tax liability of $84,000 [($850,000 FMV - $450,000 adjusted basis) x 0.21]. This built-in tax liability can influence the purchase price of the stock. In Part a, the purchase price is calculated as follows: ($750,000 equity FMV - $84,000 built-in tax liability) x 0.80 = $532,800. Thus, 80% of the built-in tax liability is shifted to the Mr. Bachman, the shareholder, via a reduced stock price. In Part b, the purchase price is calculated as follows: $750,000 equity FMV x 0.80 = $600,000. Thus, Staccato Corporation, the purchaser, absorbs the built-in tax liability. In Part c, Staccato purchases the Legato stock at a bargain price, and in Part d, Staccato pays a premium beyond the tax liability for additional value represented by going concern goodwill. pp. C:7-5 through C:7-10. C:7-43 a.

The aggregate deemed sales price is $431,899, determined as follows: ADSP = G + L - (TR x B) (1 - TR) $300,000 + $100,000 - (0.21 x $280,000) (1 - 0.21) ADSP = $431,899 ADSP =

Cash: No gain or loss Marketable securities: $20,000 capital gain = $38,000 - $18,000 Accounts receivable: $1,000 ordinary loss = $65,000 - $66,000 Inventory: $22,000 ordinary income = $43,000 - $21,000 Equipment: $49,000 ordinary (Sec. 1245) income = $144,000 - $95,000 Land: $6,000 Sec. 1231 gain = $12,000 - $6,000 Building: $24,000 = $48,000 - $24,000; $2,000 ordinary income (Sec. 291) and $22,000 Sec. 1231 gain. The $2,000 of ordinary income is 20% times the $10,000 depreciation recapture under Sec. 1245. Goodwill: $31,899 capital gain = $31,899 - $0 c. Adjusted grossed-up basis is $431,899, determined as follows: Theta’s tax liability: $31,899 = ($431,899 ADSP - $280,000 total basis) x 0.21 Total liabilities: $131,899 = $40,000 + $60,000 + $31,899 Adjusted grossed-up basis: $431,899 = $300,000 + $131,899 liabilities Allocation of basis: Cash, $50,000; Marketable securities, $38,000; Accounts receivable, $65,000; Inventory, $43,000; Equipment, $144,000; Land, $12,000; Building, $48,000; and Goodwill, $31,899. d. Theta Corporation’s tax attributes do not carry over from “old” Theta to “new” Theta when the purchasing corporation makes a Sec. 338 election. However, new Theta retains old Theta’s employer identification number and remains liable for old Theta’s liabilities. Also, new Theta is considered an extension of old Theta for the purpose of Social Security taxes and employee benefit plans. e. The $31,899 of goodwill created by Alpha Corporation in the Sec. 338 transaction can be amortized on a straight-line basis over a 15-year period. pp. C:7-6 through C:7-9.

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C:7-44 a. b. c. d.

Realized gain: $ 225,000 = ($600,000 + $100,000) - $475,000 Boot: $0 Recognized gain: $0 $475,000 Distribution gain or loss: $0 (a) Realized loss: ($50,000) = ($600,000 + $100,000) - $750,000 Boot: $0 Recognized loss: $0 (b) Basis: $750,000 (c) Distribution gain or loss: $0 (a) Gain realized and recognized by Thomas Corporation: $125,000 = $600,000 $475,000 (b) Basis of assets to Andrews: $600,000 (c) Distribution gain or loss: $0

pp. C:7-14 through C:7-19. C:7-45 a.

Realized gain: $100,000 = $300,000 - $200,000 Boot: $0 Recognized gain: $0 b. Stock basis: $200,000. Holding period for Alpha stock carries over and begins on August 1, 2019. c. Realized gain: $100,000 = ($240,000 + $60,000) - $200,000 Boot: $60,000 Recognized gain: $60,000 Stock basis: $200,000 = $200,000 + $60,000 gain - $60,000 boot received The $60,000 recognized gain should be capital in character based on the following analysis. If Silvia had received all Alpha stock, she would have owned 500 shares of Alpha stock valued at $600 per share ($300,000 ÷ 500). The receipt of $60,000 cash, in effect, is a substitute for 100 shares of stock, so Silvia ends up owning 400 shares of Alpha stock. The other Alpha shareholder would own 1,500 shares, so that a total of 1,900 shares would be outstanding after the hypothetical stock redemption. The 100 shares redeemed in the hypothetical redemption reduce Silvia’s interest from 25% (500 ÷ 2,000) to 21.05% (400 ÷ 1,900). Not enough stock is considered to have been redeemed to qualify the redemption as “substantially disproportionate” under Sec. 302(b)(2). Specifically, the transaction fails the 80% test because the percentage ownership after the redemption is not less than 80% of the shareholder’s prior percentage ownership, i.e., 21.05% is not less than 20% (25% x 0.80). Nevertheless, the gain still could be capital under Sec. 302(b)(1). Specifically, the redemption most likely is “not essentially equivalent to a dividend” because the reduction in Silvia’s proportionate stock ownership is significant, and Silvia is a minority shareholder. Moreover, the Clark decision and Rev. Rul. 93-61 suggest that Sec. 302(b)(1) should apply in this situation. pp. C:7-14 through C:7-19. C:7-46 a.

Realized gain: $3,150,000 = ($3,000,000 + $750,000) - $600,000 Boot: $750,000 Recognized gain: $750,000 Character of gain: dividend. Yong would have owned approximately 65.22% of the Alpha stock (75,000 shares out of 115,000 shares outstanding) if he had received only Alpha stock in the reorganization. The $750,000 of boot property received is equivalent to 15,000 shares of Alpha stock. The hypothetical redemption of 20% (15,000 ÷ 75,000) of Yong’s Alpha stock for cash would reduce his interest from 65.22% (75,000 shares out of 115,000 outstanding shares) to 60% (60,000 shares out of 100,000 outstanding shares). Because Yong retains more than 50% ownership Copyright © 2024 Pearson Education, Inc.

C:7-16

after the hypothetical redemption, the distribution does not qualify for capital gain treatment under the Sec. 302(b) provisions and therefore is characterized as a dividend. b. $600,000 basis = $600,000 + $750,000 - $750,000 c. Yong would have owned 75,000 (60,000 + 15,000) shares (out of 195,000 [180,000 + 15,000] shares outstanding) if he had received only Alpha stock in the reorganization. The hypothetical redemption of 20% of Yong’s Alpha stock for cash would reduce his interest from 38.46% to 33.33%. However, the redemption fails to meet the Sec. 302(b)(2) requirements because the percentage ownership after the redemption is not less than 80% of the shareholder’s prior percentage ownership, i.e., 33.33% is not less than 30.77% (38.46% x 0.80). Nevertheless, the gain still could be capital under Sec. 302(b)(1). Specifically, the redemption most likely is “not essentially equivalent to a dividend” because the reduction in Yong’s proportionate stock ownership is significant, and Yong is a minority shareholder. Therefore, the gain would be treated as a capital in character. No change in the basis calculation illustrated in Part b would occur. A higher percentage of cash to total consideration would be needed to qualify the redemption as substantially disproportionate. pp. C:7-14 through C:719. C:7-47 a. Yes. This transaction is a statutory merger under Florida law and thus qualifies as a Type A reorganization. The transaction meets the continuity of business enterprise requirement. However, some students might wonder whether the combination of a relatively small voting common stock interest with a large block of nonvoting preferred shares will meet the continuity of proprietary interest test. Significantly, in 1997 Congress was concerned that some preferred shares resemble debt more than equity and added Sec. 356(e), which treats “nonqualified preferred stock” as boot property. Section 351(g) defines nonqualified preferred stock to include the right to require the issuer to repurchase the shares within 20 years or a right to dividends linked to interest rates, commodity prices, or similar indices. If the preferred stock meets the definition of nonqualified preferred stock, it will be treated as boot and may violate the continuity of proprietary interest doctrine (see RIA Federal Tax Coordinator, ¶ F-3603). The following solution assumes the preferred stock is qualified and thus treated as stock. Consequently, the stock Mr. High receives meets the continuity of proprietary interest requirement and results in no boot recognition. b. No. Springs recognizes no gain or loss in either transaction. c. Realized gain: $460,000 = $700,000 - $240,000 basis Boot: $0 Recognized gain: $0 Mr. High’s basis in Newberry shares is $240,000, allocated between the preferred and common shares based on relative FMVs. Preferred: $222,857 [($240,000 x $650,000) / $700,000]. Common: $17,143 [($240,000 x $50,000) / $700,000]. The holding period includes Mr. High’s holding period in the Springs stock. pp. C:7-14 through C:7-19. C:7-48 The transaction qualifies as a Type A reorganization because it is pursuant to Indiana law and 60% ($15,000,000 ÷ $25,000,000) of the total consideration received is Ace Corporation common stock. Thus, the continuity of proprietary interest requirement is satisfied. The Turbo shareholders fall into three groups.

C:7-17

• •

•

Turbo shareholders that own only common stock recognize no gain or loss on the transaction because they receive only Ace common stock in the exchange. The Ace common stock takes a substituted basis that references the Turbo common stock. Turbo shareholders that own only preferred stock are treated as having redeemed their stock for cash. Shareholders owning only preferred stock will recognize their entire realized gain or loss as capital in character because their interest in Turbo is treated as terminated under Sec. 302(b)(3) unless a waiver of the stock attribution rules is not made or permitted. Turbo shareholders that own both common stock and preferred stock are treated as having received boot in the reorganization. The general boot rules apply, and the shareholders recognize gain equal to the lesser of their realized gain or the FMV of the boot received. The character of the gain most likely will be capital because the Sec. 302(b)(1) “not essentially equivalent to a dividend” or the Sec. 302(b)(2) “substantially disproportionate” redemption exceptions likely will apply to the hypothetical redemption of the cash for the preferred stock of a minority shareholder. Even though boot is received by those shareholders owning both common and preferred stock, a realized loss is not recognized.

pp. C:7-14 through C:7-19. C:7-49 Transactions a, b, d and e. The transaction in Part c does not qualify as a nontaxable reorganization because Anchor uses no stock to acquire the assets. The transaction in Part f does not qualify as a nontaxable reorganization even though it qualifies as a merger under state law. The transaction fails the continuity of proprietary interest test because the Tower shareholders no longer retain ownership. pp. C:7-19 through C:7-23. C:7-50 a. Zero. Trail Corporation recognizes no gain on the transfer of the assets to Armor Corporation or pursuant to the liquidation of Trail as part of the merger. This result ensues whether, under state law, Trail transfers the assets to Armor and then liquidates or Trail’s shareholders transfer their stock to Armor and Armor then liquidates Trail. b. $875,000 c. Realized gain: $160,000 = ($200,000 + $60,000) - $100,000 Boot: $60,000 Recognized gain: $60,000 According to Rev. Rul. 93-61, the Sec. 302(b) test applies to the acquiring corporation. Under this approach, the following results ensue: Description

Total Shares

Antonello’s Shares (Percent)

Stock ownership if all stock had been received Minus: Stock hypothetically redeemed for bonds Stock ownership held after hypothetical redemption

21,500c ( 1,500)b 20,000a

1,300e ( 300)d 1,000

C:7-18

(6.047%) (5.000%)

Antonello holds 1,000 shares (5%) of Armor stock after the reorganization. Thus, Armor has 20,000 (1,000 ÷ 0.05) shares outstanding after the merger. Because Antonello received 1,000 shares worth $200,000, Armor’s stock must be worth $200 per share. Thus, Trail’s shareholders will hold in total 5,000 ($1,000,000 ÷ $200/share) shares of Armor stock after the reorganization and would have held 6,500 ($1,300,000 ÷ $200/share) shares if only Armor stock had been used to accomplish the reorganization. Armor’s total shares outstanding before the reorganization was 15,000 (20,000 - 5,000). b $300,000 ÷ $200 c 20,000 + 1,500 d $60,000 ÷ $200 e 1,000 + 300 The hypothetical redemption probably would qualify for capital gain treatment under Sec. 302(b)(1) because Antonello’s proportionate stock ownership declines significantly, and Antonello holds a minority interest in Armor both before and after the hypothetical redemption. The Clark decision and Rev. Rul. 93-61 lead one to believe that not essentially equivalent to a dividend treatment under Sec. 302(b)(1) is permitted in this type of a situation. After the reorganization, Antonello owns 82.7% of his pre-transaction stock ownership. This percentage is higher than the 80% ceiling on Sec. 302(b)(2) redemptions but still is below his hypothetical “all stock” ownership level. d. Stock: $ 100,000 = $100,000 + $60,000 gain - $60,000 FMV of bonds. Bonds: $60,000. pp. C:7-14 through C:7-24. C:7-51 Parts a, b, d. The transaction in Part c is not a Type C reorganization because Arnold Corporation used only nonvoting stock to effect the transaction. The transaction in Part e is not a Type C reorganization because the cash used plus the liabilities assumed by Arnold exceed the 20% boot ceiling. pp. C:7-25 through C:7-27. C:7-52 a.

Transfer: Realized gain: $75,000 = ($250,000 + $50,000) - $225,000 Boot: $50,000; Recognized gain: $0 Distribution: Recognized gain: $0 Texas Corporation recognizes no gain on the asset transfer because Texas distributed the $50,000 of boot to its shareholders. b. Ash Corporation takes a $225,000 basis in the assets it acquired. c. Barbara: Realized gain: $100,000 = ($125,000 + $25,000) - $50,000 Boot: $25,000; Recognized gain: $25,000 capital gain George: Realized loss: ($50,000) = ($125,000 + $25,000) - $200,000 Boot: $25,000; Recognized loss: $0 According to Rev. Rul. 93-61, the Sec. 302(b) stock redemption test applies to the acquiring corporation. This approach leads to the following results: Description

Total Shares

Barbara or George’s Shares (Percent)

Stock ownership if all stock had been received Minus: Stock hypothetically redeemed for bonds Stock ownership after hypothetical redemption

64,500 ( 2,000) 62,500

6,000 (1,000) 5,000*

C:7-19

(9.302%) (8%)

* Barbara, who is unrelated to George, holds 5,000 shares of Ash Corporation stock (out of 62,500 shares) after the reorganization. This amount represents 8% of the outstanding stock. George holds an additional 5,000 shares of Ash stock. Bush Corporation’s two former shareholders each would have held 6,000 shares of stock (out of 64,500 shares) if only stock had been received in the reorganization. For each shareholder, this holding represents 9.302% of the stock that would have been outstanding. The stock-for bond hypothetical redemption would have to qualify as “not essentially equivalent to a dividend” under Sec. 302(b)(1) for capital gain treatment. This outcome is likely because Barbara’s stock ownership declines significantly, and she holds a minority stock ownership position before (9.302%) and after (8%) the redemption. To qualify for Sec. 302(b)(2) treatment, ownership must be reduced to 7.44%. Although this result was not achieved, the reduction should qualify for Sec. 302(b)(1) treatment because it approaches the level of ownership specified under Sec. 302(b)(2). (The characterization of the hypothetical redemption is a moot point for George because he has a realized loss that he cannot recognize.) d. Barbara: stock, $50,000 = $50,000 + $25,000 gain - $25,000 FMV of boot; bonds, $25,000. George: stock, $175,000 = $200,000 - $25,000 FMV of bonds; bonds, $25,000. pp. C:7-14 through C:7-19, and C:7-25 through C:7-28. C:7-53 a.

Transfer: Realized gain: $125,000 = ($250,000 + $50,000) - $175,000 Boot: $0; Recognized gain: $0 Distribution: Recognized gain: $0 b. $175,000 c. No effect. No gain or loss will be recognized on the asset transfer by Akron Corporation or the issuance of stock for property by Subsidiary Corporation. The $175,000 basis of the assets and Tulsa Corporation’s tax attributes will carryover to Subsidiary. d. Realized gain: $150,000 = $250,000 - $100,000 Boot: $0 Recognized gain: $0 e. $100,000 basis. The holding period for the Akron stock carries over from the Tulsa stock that Michelle surrendered. f. The transfer of the Akron shares to Akron-Sub is treated as a contribution to capital and thus is nontaxable. The results of a triangular Type C reorganization would be the same as for a regular Type C reorganization outlined above. pp. C:7-14 through C:7-19, and C:7-25 through C:7-28. C:7-54 Parts a, b, d, e and f. The stock-for-stock exchange in Part a is a Type B reorganization. Accordingly, the Taylor Corporation shareholders recognize no gain or loss under Sec. 354(a)(1) when they exchange their stock for Allen Corporation stock. The debt-for-debt exchange in Part b also is nontaxable under Sec. 354(a)(1). Gain is recognized under Sec. 354(a)(2)(A) only when securities with an excess principal amount are received. This is not the case here because the face amounts of the two securities are $500,000. See Rev. Rul. 98-10, 1998-1 C.B. 643. The transaction in Part c does not qualify as a Type B reorganization because Allen used nonstock consideration (bonds). The transaction in Part f qualifies as a triangular Type B reorganization in which a controlled subsidiary uses its parent’s stock to acquire the target stock. pp. C:7-29 through C:7-31.

C:7-20

C:7-55 Juan’s solution: a. Realized gain: $125,000 = $250,000 - $125,000 Recognized gain: $0 b. Basis of stock: $125,000 c. $425,000 basis. Adams Corporation recognizes no gain or loss when it issues 5,000 shares of its stock for the Trent stock owned by Juan and Miguel. Because the transaction is nontaxable, Adams takes a $425,000 basis in the Trent stock ($125,000 from Juan and $300,000 from Miguel). Miguel’s solution: a. Realized loss: ($50,000) = $250,000 - $300,000 Recognized loss: $0 b. Basis of stock: $300,000 c. See solution for Juan. d. The transaction does not qualify as a Type B reorganization in Part d because Adams used cash as part of the consideration exchanged for Juan and Miguel’s shares. Cash is acceptable in a Type B reorganization for acquiring fractional shares but not whole shares. The answers would change as follows: Juan’s revised solution: a. Realized gain: $125,000 = $250,000 - $125,000 Recognized gain: $125,000 b. Basis of stock: $200,000 (FMV of the stock) Miguel’s revised solution: a. Realized loss: ($50,000) = $250,000 - $300,000 Recognized loss: $50,000 b. Basis of stock: $200,000 (FMV of the stock) Adam’s revised solution: c. Adams recognizes no gain or loss when it issues 4,000 shares of its stock for the Trent stock owned by Juan and Miguel. Because the transaction is taxable, Adams takes a $500,000 basis in the Trent stock ($100,000 paid in cash and $400,000 paid in stock). pp. C:7-14 through C:7-19, and C:7-29 through C:7-31. C:7-56 a.

Realized gain: $1,125,000 = $1,500,000 - $375,000 Boot: $0 Recognized gain: $0 b. $375,000 basis c. $375,000 basis d. The two parts of the transaction are treated as a Type C reorganization because they are related (Rev. Rul. 67-274, 1967-2 C.B. 141 as amplified by Rev. Rul. 2001-46, 2001-2 C.B. 141). Accordingly, Austin Corporation recognizes no gain or loss on issuing its stock, takes a carryover basis in the assets it receives, and assumes all of Travis’s tax attributes. Travis recognizes no gain or loss on the asset transfer. Ingrid’s recognized gain and basis are computed as in Parts a and b. If the two parts of the transaction are unrelated, the Sec. 332 rules apply to the liquidation of Travis into Austin. The results generally will be the same, either outcome being nontaxable.

C:7-21

e. The bond-for-bond exchange does not trigger recognition of gain when Travis bonds are exchanged for Austin bonds. Under Sec. 354(a)(1), two bond issues of equal face amounts can be exchanged tax-free. Gain is recognized when the principal (face) amounts of the two issues differ. In that case, the FMV of the difference is treated as boot property under Sec. 354(a)(2) and triggers recognition of a realized gain. pp. C:7-14 through C:7-19, and C:7-25 through C:7-28. C:7-57 a.

Andrea and Bill:

Realized gain: $1,050,000 = $1,200,000 - $150,000, each. Boot: $0 Recognized gain: $0 Cathy: The sale is taxable. Her entire realized gain or loss ($250,000 - her basis) is recognized. Because more than 12 months passed between the two transactions, the second transaction likely will be treated as independent of the first, and the second will be treated as a reorganization. b. Andrea, $150,000; and Bill, $150,000. Cathy has $250,000 of cash. c. $550,000 basis = $250,000 (stock acquired from Cathy) + $150,000 (stock acquired from Andrea) + $150,000 (stock acquired from Bill). d. If the remaining stock had been acquired on May 30 of the current year, less than 12 months will have intervened between the two transactions. As a result, the two transactions likely will be collapsed into a single acquisition, which will be fully taxable. The revised answers would be as follows: Revised a. Realized and recognized gain: $1,050,000 capital gain each for Andrea and Bill. Cathy still has a gain as well. Revised b. $1,200,000 basis each to Andrea and Bill; $250,000 cash to Cathy Revised c. $2,650,000 basis = $250,000 (stock acquired from Cathy) + $1,200,000 (stock acquired from Andrea) + $1,200,000 (stock acquired from Bill) e. No effect. The acquisition would not affect the adjusted bases of the individual assets held by Todd Corporation. Similarly, the tax attributes of Todd would not be increased or decreased. f. Yes. Ashton Corporation is the parent of the Ashton-Todd affiliated group and can file a consolidated tax return because it meets the Sec. 1504 stock ownership requirements. g. No. Because the two original transactions were separated by more than one year, the transactions were not collapsed into a single taxable transaction. Because the second part of the transaction constituted a nontaxable reorganization, a Sec. 338 election to step-up the basis of target corporation assets would not be permitted even if made in a timely fashion. If the second part of the acquisition took place within 12 months of the first part, the acquisition would be taxable and a Sec. 338 election likely could be made to step-up the basis of Todd’s assets. pp. C:7-14 through C:7-19, and C:7-29 through C:7-31.

C:7-22

C:7-58 a. Transfer: Realized gain: $1,650,000 = ($2,250,000 FMV of Food stock + $500,000 liabilities) - $1,100,000 adjusted basis; Boot: $0; Recognized gain: $0 Distribution: No gain recognized, assuming the Sec. 355 requirements have been met. It appears that they have been met. The transaction is not a disqualified distribution. b. Zero. The distribution meets the requirements of Sec. 355. None of the shareholders recognizes any gain, loss, or income on the distribution. c. The bases for each shareholder’s stock interests are determined as follows: Description

Road

Food

Total

FMV of corporate stock Percent of total FMV Basis for each shareholder*

$1,500,000 40% $ 80,000

$2,250,000 60% $ 120,000

$3,750,000 100% $ 200,000

*Total stock basis ($200,000) x percentage of total FMV = Basis for block of stock. pp. C:7-33 through C:7-38. C:7-59 a. Transfer: Realized gain: $150,000 = ($400,000 FMV of Dark stock + $100,000 release from liabilities) - $350,000 basis Boot: $0 Recognized gain: $0 Distribution to Tarek: No gain is recognized. b. Realized gain: $250,000 = $400,000 - $150,000 Boot: $0 Recognized gain: $0 c. $150,000 basis d. Dark acquires none of the Sec. 381 tax attributes. Light Corporation’s E&P will be allocated ratably between the two corporations (Reg. Sec. 1.312-10). pp. C:7-33 through C:7-38. C:7-60 a. Zero. Because the distribution meets the requirements of Sec. 355, Alan recognizes no gain, loss, or income on the distribution. Application of Sec. 355 prevents Alan from having to recognize a $25,000 dividend on the distribution under Sec. 301 (but see Part e for a variation). b. Diesel stock, $10,000; Parent stock, $30,000. Alan must allocate his predistribution $40,000 Parent stock basis between the Diesel stock and Parent stock based on their relative FMVs as follows: Diesel stock: $10,000 =

$25,000 $25,000 + $75,000

x $40,000

Parent stock: $30,000 =

$75,000 $25,000 + $75,000

x $40,000

C:7-23

Alan’s holding period for the Diesel stock includes his holding period for the Parent

stock. d. Zero. Parent recognizes no gain or loss on the distribution under Sec. 361(c) even though the $25,000 FMV of the 25 shares exceeds the shares’ $16,250 total adjusted basis. e. Taxable transaction. If the controlled corporation’s stock was acquired in a taxable transaction and held for only two years, the distribution does not meet the requirements of Sec. 355. Consequently, under Sec. 301, the Diesel stock distribution is treated as a $25,000 taxable dividend to Alan, who takes a $25,000 FMV basis in the Diesel stock. His holding period in the stock begins the day after the distribution date. In addition, under Sec. 311(b), Parent recognizes an $8,750 ($25,000 FMV - $16,250 basis) gain on the distribution to Alan because Parent distributed appreciated property. Similarly, Parent also would recognize gain on distributions to other shareholders who are party to the spin-off. pp. C:7-33 through C:7-38. C:7-61 a. No gain recognized. The distribution meets the requirements of Sec. 355. Bill’s realized gain is $70,000 [($1,500 x 100) - $80,000]. Bill recognizes no gain or loss on the exchange because no boot property is involved. b. Bill’s basis in his stock is $80,000, the same as his basis in the Parent stock exchanged. c. Bill’s holding period for the Subsidiary stock includes his holding period for the Parent stock, which began in 2016. d. If instead, Parent purchased the stock in 2021, the distribution does not meet the requirements of Sec. 355. Bill must recognize a $70,000 ($150,000 FMV - $80,000 basis) long-term capital gain on the exchange. Bill’s basis in the Subsidiary stock is $150,000 (100 shares x $1,500 per share). Bill’s holding period for the Subsidiary stock begins on the day after the exchange. pp. C:7-33 through C:7-38. C:7-62 a.

$20,000 gain recognized, calculated as follows: FMV of Garnet stock Plus: FMV of Garnet security Amount realized Minus: Basis of Ruby stock Realized gain Amount of boot received Recognized gain (lesser of realized gain or boot received)

$60,000 20,000 $80,000 ( 50,000) $30,000 $20,000 $20,000

Fred likely would report a $20,000 capital gain from the exchange because he held 25% of the Ruby stock immediately before and 20% immediately after the hypothetical redemption of $20,000 of the Ruby stock for the $20,000 of Garnet securities. The logic behind this proposition is presented below. • Because 100 shares of Ruby stock are outstanding, Fred would own 25 shares before the redemption and surrender 6.25 [25 x (20/80)] shares for the Garnet securities. • This hypothetical redemption would have reduced his ownership interest to 20% [18.75/(100 - 6.25) = 0.20], which is not less than 80% x 25%. • Although such a redemption is not “substantially disproportionate,” it likely would qualify as “not essentially equivalent to a dividend” under Sec. 302(b)(1) because Fred holds a minority interest (25%) before the redemption and a substantially smaller minority interest (20%) after the hypothetical redemption. In other words, although he remains a minority shareholder, his proportionate stock interest declines significantly. Copyright © 2024 Pearson Education, Inc.

C:7-24

b. $50,000 and $20,000 basis, respectively. Fred’s basis in the Garnet stock is $50,000, determined with reference to the Ruby stock. Fred’s basis in the Garnet securities is $20,000, their FMV. c. Zero. Ruby recognizes no gain or loss on the distribution of either the stock or the securities. d. Fred’s holding period for the Garnet stock includes his holding period for the Ruby stock. His holding period for the Garnet security begins the day after the exchange date. e. Taxable transaction. If the exchange did not meet the requirements of Sec. 355 or 356, Fred would recognize a $30,000 ($80,000 - $50,000) capital gain on the stock redemption. Fred’s basis in the Garnet stock would be $60,000, and his basis in the Garnet securities would be $20,000. His holding period for the stock and the securities would begin on the day after the date of the exchange. pp. C:7-33 through C:7-38. C:7-63 a. No gain or loss. Jean Corporation is divided between the two brothers according to their ownership interests. Jean transfers the assets of the two divisions to Cookware and Home Appliance corporations in a divisive reorganization, specifically, a split-up. Jean recognizes no gain or loss on the transfer of the assets to the two corporations (Sec. 361(a)). Bill and Bob recognize no gain or loss on the exchange of their Jean stock for the new corporation’s stocks assuming all the requirements of Sec. 355 are met. Cookware and Home Appliance each take a carryover basis in the assets, $600,000 to Cookware and $300,000 to Home Appliance (Sec. 362(a)). b. Bill receives the Cookware stock. Bill’s basis in the Cookware stock is the same as his basis in the Jean stock (i.e., $700,000). The holding period for the stock received includes the holding period for the stock surrendered. Should Bill sell the Cookware stock for its $980,000 fair market value, he would recognize a $280,000 long-term capital gain. Bob receives the Home Appliance stock. Bob’s basis in the Home Appliance stock received is the same as his basis in the Jean stock surrendered ($300,000). Should Bob sell the stock for its $420,000 fair market value, he would recognize a $120,000 long-term capital gain. pp. C:7-33 through C:7-38. C:7-64 a. This transaction qualifies as a Type E reorganization. The $300,000 cash on the preferred stock is taxable as a dividend to the extent of Master Corporation’s E&P but does not impact the nontaxability of the stock exchange. b. The bond-for-stock transaction qualifies as a Type E reorganization. Neither Master nor its bondholders recognize gain or loss on the exchange. The tax basis in the preferred stock is substituted with reference to the basis in the bonds. The former bondholders will recognize interest income of $180,000. c. This transaction qualifies as a Type E reorganization. Because the principal amount of the debt surrendered equals that of the new bonds, there is no excess principal amount, and hence, no boot property and no recognized gain. The bond holders recognize $180,000 of taxable interest income. pp. C:7-38 through C:7-40. C:7-65 Alternative 1: The redemption of the preferred stock for cash is taxable. Each shareholder recognizes $120 of dividend income per share. The redemption probably will not be eligible for capital gain treatment because the shareholders own 100% of the stock before the transaction and because their relative interests in the common stock are the same before and after the redemption. The basis in the redeemed preferred stock increases the basis of the common stock. Copyright © 2024 Pearson Education, Inc.

C:7-25

Alternative 2: The exchange of the preferred stock for common stock is nontaxable under Sec. 368(a)(1)(E). Neither the corporation nor the shareholders recognize gain, and the shareholders’ basis in the common stock is a substituted basis referenced to the preferred stock they surrendered. The two alternatives have substantially different tax and economic consequences. The first alternative requires an outlay of cash today to eliminate the need to pay future preferred stock dividends the firm is generally obligated to pay at least annually. The common stock dividends do not involve the same kind of obligation. Alternative No. 2 permits the elimination of the preferred stock dividend without requiring the corporation to make a cash outlay. In either case, the necessary business purpose for the transaction should be present. pp. C:7-38 through C:7-40. C:7-66 a. Type F. The first transaction is a Type F reorganization involving a change in the state of incorporation from Florida to Georgia. b. Type E. The second transaction is a bond swap, which is a Type E (recapitalization) reorganization. c. Type A. The third transaction appears to be a Type A reorganization that consolidates two entities into a single entity. d. Type G or E. The last transaction involves a bankrupt company. The transaction appears to be a Type G (bankruptcy) or a Type E (recapitalization) reorganization. pp. C:7-21 and C:7-38 through C:7-40. C:7-67 a. The use of a relatively large amount of debt and small amount of common stock could render the transaction taxable. b. The transaction satisfies the continuity of business enterprise doctrine because Alabama Corporation has continued one of the target corporation’s two lines of business. The sale of the meat distribution division’s assets may lead the IRS to question whether Alabama has acquired substantially all of Texas Corporation’s assets because, at most, 60% of the assets have been retained. c. This transaction is similar to that in Gregory v. Helvering, which met the statutory requirements of the IRC for a reorganization but failed to satisfy the business purpose judicial doctrine. The transaction also fails the requirement that each corporation conduct a trade or business immediately after the exchange. The distribution of the stock probably will be taxed under the general liquidation rules of Sec. 331 or stock redemption rules of Sec. 302 instead of the Sec. 355 distribution rules. pp. C:7-19 through C:7-24, and C:7-40 through C:7-42. C:7-68 a. Type A (consolidation) b. Type F c. Type E d. Type B e. Type D (divisive/split-up) f. Type C g. With owners equity constituting only 10% of the capital structure, one can argue that the transaction should be considered a taxable purchase because the assumption of target corporation liabilities constitutes most of the consideration (90%). pp. C:7-19 through C:7-42.

C:7-26

C:7-69 a. 2023.

Alaska Corporation: A single return covering January 1, 2023, through December 31,

Tennessee Corporation: A final tax return covering the period January 1, 2023, through May 31, 2023. b. $205,000 NOL carryover = ($95,000 - $20,000) + $90,000 + $40,000. Because the NOLs arose after 2017, the $205,000 balance is subject to the 80% of taxable income limitation in post-2017 tax years. c. $42,800 NOL = $73,000 × 214/365 (for a non-leap year) under Sec. 381(c). Alaska then will carry over to 2024 the remaining $162,200 ($205,000 - $42,800) post-2017 NOLs (subject to the 80% limitation). Note that Alaska’s $100,000 NOL from 2020 was completely absorbed by Alaska’s 2021 and 2022 taxable income. p. C:7-43. C7-70 $160,000 NOL used in 2023; $840,000 NOL carryover to 2024; Sec. 382 limitation increased to $590,000 for 2024. Said’s purchase of all the Murray Corporation stock represents an ownership change under Sec. 382. As a result, the loss corporation’s (Murray’s) NOLs are limited by Secs. 382 and 172(a). The NOL carryovers offset Murray’s 2023 taxable income by the lesser of (1) 80% of its taxable income ($160,000 = $200,000 x 0.80) or (2) the Sec. 382 annual limitation of $375,000 ($7,500,000 x 0.05). Thus, after the NOL deduction, Murray’s 2023 taxable income is $40,000 ($200,000 - $160,000). The NOL carryover to 2024 is $840,000 ($1,000,000 - $160,000). In addition, the $215,000 ($375,000 - $160,000) unused Sec. 382 limitation for 2023 carries over to 2024 to increase the Sec. 382 limitation in that year to $590,000 ($375,000 + $215,000). pp. C:7-43 through C:7-46. C:7-71 $360,000 with a $2.14 million NOL carryover. The reorganization results in an ownership change because Albert Corporation’s shareholders owned none of the old loss corporation’s (Turner Corporation’s) stock before the reorganization. They own 85% of the new loss corporation’s (Albert’s) stock after the reorganization. The 2023 and 2024 NOL are calculated as follows: 2023 = $360,000 after Sec. 172(a) and 382 limitations; i.e., the lesser of: $360,000 = $8,000,000 x 0.045, or $800,000 = $1,000,000 x 0.80 2024 = $2,140,000 NOL carryover before limitations = $2,500,000 - $360,000 The $2.14 million NOL carryover to 2024 will be subject to the lesser of (1) the Sec. 382 annual limitation of $360,000 or (2) the Sec. 172(a) limitation based on 80% of taxable income. pp. C:7-43 through C:7-46.

C:7-27

C:7-72 The present value of tax benefits from the NOL deductions is $34,704, determined as follows: FMV of Tempo stock Times: Long-term tax exempt federal rate Sec. 382 annual loss limitation Year 1 2 3 4 Total

NOL Deduction $ 29,250 29,250 29,250 27,250 $115,000

Tax Benefit at 21% $ 6,143 6,143 6,143 5,723 $24,152

$900,000 0.0325 $ 29,250 Discount Divisor 1.05 (1.05)2 (1.05)3 (1.05)4

PV of NOL Deduction $ 5,850 5,571 5,307 4,708 $21,436

p. C:7-45.

Comprehensive Problem C:7-73 a.

Richard Smith: Realized gain = $1,360,000 = $1,560,000 - $200,000 Recognized gain = $1,360,000 LTCG SKE’s basis in the RSSB stock = $1,560,000 No effect on RSSB’s tax basis in its assets or its loss carryovers (if any). RSSB’s realized gain is $690,000, determined as follows:

Assets

Amount Realized

Adjusted Basis

Realized Gain

Inventory Equipment Building Land Goodwill Total

$ 600,000 275,000 295,000 120,000 250,000 $1,540,000

$470,000 100,000 200,000 80,000 -0$850,000

$130,000 175,000 95,000 40,000 250,000 $690,000

All the realized gain is recognized. The character of the gain is as follows: Inventory, $130,000 ordinary income; Equipment, $175,000 ordinary income (Sec. 1245); Building, $16,000 (0.20 x $80,000) ordinary income (Sec. 291) and $79,000 ($95,000 - $16,000) Sec. 1231 gain; Land, $40,000 Sec. 1231 gain; and Goodwill, $250,000 long-term capital gain. RSSB incurs a $144,900 ($690,000 x 0.21) income tax liability on the gain. Richard Smith’s gain is: ($1,740,000 - $120,000 mortgage paid - $60,000 accounts payable paid - $144,900 taxes paid) - $200,000 adjusted basis for stock = $1,215,100 long-term capital gain. [Assumption: The mortgage on the building was not assumed by the purchaser because the $1,540,000 FMV for the assets was the price paid for the assets by the purchaser.] Copyright © 2024 Pearson Education, Inc.

C:7-28

c. Richard realizes and recognizes a $1.36 million gain (see Part a above). SKE (the parent corporation) recognizes no gain or loss on the liquidation of RSSB under the Sec. 332 parentsubsidiary liquidation rules. Similarly, RSSB (the subsidiary corporation) recognizes no gain or loss on the asset transfer under the Sec. 337 parent-subsidiary liquidation rules. RSSB’s bases in the assets and RSSB’s tax attributes carryover to SKE. d.

The aggregate deemed sales price is $1,923,418, calculated as follows: ADSP = G + L - (TR x B) (1 - TR) ADSP = $1,560,000 + $180,000 - (0.21 x $1,050,000) (1 - 0.21) 0.79 ADSP = $1,519,500

ADSP = $1,923,418 The adjusted grossed-up basis of the RSSB stock is $1,923,418, calculated as follows: Grossed-up basis of stock $1,560,000 Plus: Liabilities assumed 180,000 Taxes owed on sale 183,418 Adjusted grossed-up basis of RSSB stock $1,923,418 This amount is allocated to the assets as follows: Cash, $200,000; inventory, $600,000; equipment, $275,000; building, $295,000; land, $120,000; and goodwill, $433,418. The RSSB tax attributes stay with “old” RSSB and therefore are not available to the “new” RSSB. e. The transaction qualifies as a Type C reorganization. It also can qualify as a Type A reorganization if it satisfies the merger law requirements of RSSB’s state of incorporation. RSSB’s asset transfer: Realized gain = $690,000 = $1,540,000 - $850,000 Boot = $0 Recognized gain = $0 RSSB’s stock distribution: Realized gain = $690,000 = $1,540,000 - $850,000 Boot = $0 Recognized gain = $0 RSSB neither realizes nor recognizes gain on the distribution of the $20,000 cash that remains after settling the accounts payable and mortgage. Richard Smith: Realized gain = $1,360,000 = ($1,540,000 + $20,000) - $200,000 Boot = $20,000 Recognized gain = $20,000 Copyright © 2024 Pearson Education, Inc.

C:7-29

Character of gain = dividend income or long-term capital gain (see analysis below). Basis in SKE stock = $200,000 = $200,000 + $20,000 gain - $20,000 boot The character of the gain is determined through the following analysis: Richard would have received $1.56 million in SKE stock if he had received all stock in exchange for his RSSB stock. This stock holding is slightly more than one-third of the outstanding SKE shares (34.21%) based on the fact that RSSB had $3 million in shares outstanding prior to the acquisition, and that a total of $4.56 million in SKE shares would have been outstanding if Richard had received all stock. The $20,000 in SKE stock that would have been surrendered in the hypothetical redemption set forth in the Clark opinion and Rev. Rul. 93-61 reduces Richard’s stock position from $1.56 million (34.21%) to $1.54 million (33.77%). Although Richard changes from one minority stock position to another minority stock position, it is doubtful that such an insignificant reduction would result in Sec. 302(b)(1) capital gain treatment as “not essentially equivalent to a dividend.” The 33.77% stock ownership should be compared to the 27.368% ownership (i.e., less than 80% x 34.21%) required for the redemption to be substantially disproportionate under Sec. 302(b)(2). SKE’s issuing the stock and receiving the assets: Recognized gain on issuing the stock: $0 Basis in assets received: $850,000 = $1,050,000 total basis - $200,000 cash not acquired SKE also acquires RSSB’s tax attributes. f.

The transaction qualifies as a Type B reorganization. Richard Smith’s realized gain = $1,360,000 = $1,560,000 - $200,000 Boot = $0 Recognized gain = $0 Adjusted basis of SKE stock = $200,000 No change to the bases of RSSB’s assets or RSSB’s tax attributes as a result of the acquisition.

g. Neither SKE nor SKE-Sub recognizes gain or loss when SKE transfers its stock to SKE-Sub as a capital contribution. The resulting stock acquisition is a triangular Type B reorganization. No gain is recognized by SKE-Sub or Richard Smith when exchanging the $1.56 million of SKE stock for all of the RSSB stock. SKE-Sub ultimately owns 100% of the RSSB stock and takes a $200,000 carryover basis in the RSSB stock. SKE-Sub’s holding period for the RSSB stock includes Richard’s holding period for the RSSB stock. Similarly, the basis in the SKE stock acquired by Richard is the same as his basis for the RSSB stock. Richard’s holding period for the SKE stock includes his holding period for the RSSB stock surrendered. h. Neither SKE nor SKE-Sub recognizes gain or loss when SKE transfers its stock to SKE-Sub as a capital contribution. The resulting asset-for-stock acquisition is a triangular Type C reorganization. Both RSSB and SKE-Sub avoid recognizing gain or loss when exchanging the $1.54 million of SKE stock for RSSB non-cash assets. RSSB’s tax attributes carry over to SKE-Sub under Sec. 381. Thus, SKE-Sub inherits the bases, holding periods, and Sec. 1245 recapture potential for RSSB’s assets. The results for Richard Smith are the same as in Part e. Copyright © 2024 Pearson Education, Inc.

C:7-30

Tax Strategy and Critical Thinking Problems C:7-74 If S&J Corporation purchases all of Theta Corporation’s stock in exchange for cash, all of Theta’s assets, liabilities, and tax attributes are simultaneously acquired. Because S&J acquires Theta’s stock, Theta’s bases in its individual assets remain unchanged. Because S&J and Theta have a parent-subsidiary relationship following the stock purchase, the two corporations can file a consolidated tax return if they so elect. Theta’s owner, Angel Macias, receives capital gain treatment of the entire profit on his sale of Theta stock. S&J might consider making a Sec. 338 election with respect to Theta’s assets. Generally, the Sec. 338 election steps-up the bases of Theta’s assets to their FMV. It triggers an income tax liability, which represents the cost of stepping up the assets’ bases. Goodwill may be generated in a Sec. 338 election and is amortized over a 15-year period for tax purposes. Because Theta does not have any NOLs, it will bear the full tax cost of the Sec. 338 election. S&J Corporation might consider acquiring all of Theta’s stock and then liquidating Theta into S&J. The liquidation would be nontaxable to both corporations. The bases of Theta’s assets carry over to S&J. Thus, no step-up or step-down of individual assets to their FMV will result. Theta’s tax attributes also carry over to S&J. Another option would be to take advantage of one of the reorganization provisions. S&J could use a Type A (merger or consolidation), Type B (stock-for-stock), or Type C (asset-for-stock) reorganization to acquire Theta. The advantage of this type of transaction is that it would be nontaxable to Theta’s shareholders. Moreover, S&J would not have to obtain cash or debt financing to accomplish the acquisition. However, S&J’s owners may be reluctant to use stock as the medium of exchange because it dilutes their ownership interests. A second disadvantage for S&J’s owners is that the bases of Theta’s assets cannot be stepped-up as in a taxable purchase. Under current FASB rules, the acquisition will be reported under the purchase method. Purchased goodwill remains on the book balance sheet as an asset subject to impairment. C:7-75 Pedernales might structure an acquisition as either a taxable stock purchase or a reverse triangular merger in which Dorado would acquire a wholly-owned subsidiary of Pedernales. Key considerations in this structure are the following: • • •

•

Dorado owns key licenses, which might be nontransferable. If the acquisition is structured as either a straight merger or an asset sale, these licenses could be forfeited. Dorado disposes chemical wastes, an activity that exposes it to significant legal liability. To shield itself from such liability, Pedernales might preserve Dorado as a separate legal entity. Dorado has accumulated substantial business and foreign tax credits. This factor weighs in favor of a taxable stock acquisition in which Dorado’s tax attributes would remain with the entity; alternatively, a nontaxable reorganization in which Pedernales would succeed to Dorado’s tax attributes. The Rodriguez Family wants to retain control of Pedernales. This aim eliminates the possibility of a Type B reorganization in which consideration must consist of voting stock.

The fivefold increase in the value of Dorado stock might create an obstacle to a purely cash acquisition. Pedernales could overcome this obstacle by assembling a package of cash and non-cash consideration. Copyright © 2024 Pearson Education, Inc.

C:7-31

Finally, the threefold increase in the value of Dorado assets suggests that Pedernales’ making a Sec. 338 election would result in a substantial gain. Pederales might consider either deferring this gain by avoiding a Sec. 338 election or offsetting the gain with losses, if any. C:7-76 An infusion of $2 million in capital by Karla Boroff to Beta Corporation will be nontaxable. Karla will have a $2 million basis in her 50% interest in the Beta stock that she receives. Assuming the capital contribution is cash, the holding period for Karla’s stock investment begins on the day after the contribution. One strategy for accomplishing Karla’s objective that the two companies be freestanding is to have Alpha Corporation distribute one-half of the Beta stock to Tom Smith and the remaining Beta stock to Karla as a dividend. After the distributions, Tom and Karla each would own 50% of the Beta stock. Beta has been profitable and will have positive earnings and profits, so the distribution likely will be taxable as a dividend to both shareholders. The cost of making the distribution can be reduced for the portion paid to Alpha because a 65% dividends-received deduction is available with respect to the dividend it receives. Karla is fully taxable on the distribution without the benefit of a dividendsreceived deduction even though she has been a Beta shareholder for only a short time period and most of the earnings to be distributed were earned before she became part owner of Beta. An alternative to the dividend distribution would be to have Alpha spin-off the Beta stock to the two shareholders under Sec. 355(a). Alpha and Karla each would receive one-half of the Beta stock without having to surrender any Alpha stock. Alpha would recognize no gain or loss when it distributes the Beta stock to the two shareholders. The two shareholders would not be taxed on the distribution if the requirements of Sec. 355 are satisfied. In the distribution, the following requirements must be met: 1. The property distributed must consist solely of stock or securities of a corporation controlled (80% or more) by the distributing corporation (Alpha) immediately before the distribution. 2. The distribution must not be used as a device to distribute the E&P of the distributing corporation (Alpha), the controlled corporation (Beta), or both. 3. Immediately after the distribution, both the distributing corporation (Alpha) and the controlled corporation (Beta) must be engaged in the active conduct of a trade or business that was actively conducted for at least five years before the distribution. 4. The distributing corporation must distribute either (a) all stock and securities of the controlled corporation held by it immediately before the distribution or (b) an amount constituting control. 5. The distribution must have a substantial business purpose. 6. The shareholders who directly or indirectly owned the controlled corporation before the distribution must maintain a continuing equity interest in one or more of the corporations following the distribution. These six requirements likely could be satisfied by Alpha, Beta, and the two shareholders (Tom and Karla). After the distribution, Alpha and Karla each will own 50% of the Beta stock. The distribution will be nontaxable to Tom, Karla, and Alpha. From a tax perspective, this alternative seems to be less expensive for all three parties than does the dividend distribution alternative.

C:7-32

C:7-77 If the parties attempt a Type B reorganization, the transaction will fail to meet the solely for stock (no boot) requirement of Sec. 368(a)(1)(B) and thus will not qualify as a Type B reorganization. Consequently, the transaction will be fully taxable to Terry, and he will recognize a $150,000 gain, calculated as $200,000 FMV of Pi voting stock + $50,000 cash $100,000 basis of Tau stock exchanged. On the other hand, if the parties structure the transaction as a reverse triangular merger, Pi can provide up to 20% of boot in the transaction, as Sec. 368(a)(2)(E)(ii) says that the shareholder (Terry) of the surviving corporation (Tau) merely has to receive voting stock of the controlling corporation (Pi) in an amount that constitutes a controlling interest (80%) in the surviving corporation (Tau). Thus, 20% of the consideration can be cash in exchange for the remaining Tau stock. The reverse triangular merger is structured as follows: 1. 2. 3. 4. 5.

Pi issues its voting stock plus $50,000 cash to Temp Sub in exchange for Temp Sub stock. Temp Sub merges into Tau, whereby it uses the Pi voting stock and cash in exchange for Tau stock surrendered by Terry. Terry receives the Pi voting stock and cash when he surrenders his Tau stock. Temp Sub distributes the Tau stock to Pi in exchange for the Temp Sub stock held by Pi in liquidation of Temp Sub. Pi now holds the Tau stock with Tau being its subsidiary.

The transaction is nontaxable to Pi, Temp Sub, and Tau. Terry will recognize $50,000 of boot gain on the transaction rather than the full $150,000 gain realized, calculated as follows: FMV of Pi voting stock received Plus: Cash received Amount realized Minus: Basis of Tau stock surrendered Gain realized Gain recognized (to the extent of boot)

$200,000 50,000 $250,000 (100,000) $150,000 $ 50,000

In effect, the reverse triangular merger, which is a variation of a Type A reorganization, functions very much like a Type B reorganization but with some boot allowed. In the end, the target corporation, Tau in this case, becomes a subsidiary of the acquiring corporation (Pi) and maintains its identity as Tau Corporation.

C:7-33

Case Study Problems C:7-78 The information presented below is a summary of the points students should address in their memorandum concerning the tax consequences of the three alternatives to Bailey Corporation. The information should be organized in a properly formatted memorandum with good grammar and punctuation. Asset purchase: Bailey’s basis in the assets will be $2.55 million. Assuming the market values for the properties are correct, $80,000 [$2,550,000 - ($2,720,000 - $250,000 cash)] will be allocated to goodwill. The goodwill can be amortized under Sec. 197 over a 15-year period. The remaining assets will be recorded at their FMVs. No depreciation recapture potential will carryover from Bill Smith to Bailey because a taxable acquisition has occurred. Stock purchase: The basis of the acquired stock is $2.6 million. The stock acquisition does not trigger the recognition of any gain or loss with respect to the assets, nor does it result in a stepped-up basis in the assets to their market values. Bill Smith’s corporation will continue as a subsidiary of Bailey. A consolidated tax return might be filed with Bailey and the newly acquired subsidiary. Alternatively, the newly acquired corporation could liquidate into Bailey. The liquidation could be accomplished tax-free under Secs. 332 and 337. The adjusted basis of the assets to the parent corporation ($1,185,000) will be less than the stock acquisition cost ($2.6 million). The purchasing corporation (Bailey) can make a Sec. 338 election following the stock acquisition. The resultant aggregate deemed sale price is $3,229,304, determined as follows: ADSP =

G + L - (TR x B) (1 - TR)

ADSP =

$2,600,000 + $200,000 - (0.21 x $1,185,000) (1 - 0.21)

ADSP =

$2,551,150 0.79

ADSP =

$3,229,304

The Sec. 338 election requires the subsidiary (Bill’s corporation) to recognize gain of $2,044,304 ($3,229,304 ADSP - $1,185,000 adjusted basis) and pay federal income taxes of $429,304 ($2,044,304 x 0.21). The $3,229,304 ADSP substantially exceeds the $2.72 million FMV of the assets. As a result, $509,304 ($3,229,304 - $2,720,000) of goodwill will be generated. The goodwill can be amortized over 15 years under Sec. 197. The total basis of the assets after the deemed sale will be their adjusted gross-up basis of $3,229,304 ($2,600,000 + $200,000 liabilities + $429,304 federal income taxes). Because of the substantial tax liability and goodwill, it is unlikely the purchaser will make a Sec. 338 election unless the stock purchase price can be significantly reduced. No NOL carryovers are available to reduce the tax cost of the Sec. 338 election.

C:7-34

Reorganization: Bailey recognizes no gain or loss on the exchange of its stock for the assets. The assets take a $1,185,000 carryover basis following the acquisition. Bailey inherits the tax attributes of Bill Smith’s corporation including the earnings and profits and depreciation recapture potential. Summary: The outright purchase of the assets with higher basis has a substantial advantage to Bailey. The increased asset basis also can be obtained through the stock acquisition, but Bailey incurs a substantial tax cost in making a Sec. 338 election, which may suggest a lower purchase price for the stock if a Sec. 338 election is desirable. A nontaxable reorganization offers an advantage to Bailey in that it does not require a cash outlay. On the other hand, the basis of the assets are not stepped-up to their market value as in a taxable transaction, and a substantial amount of Bailey stock may need to be transferred to Bill Smith to accomplish the acquisition. A variety of nontax factors must be considered as well. Will the additional notes that must be issued alter Bailey Corporation’s credit rating? Will the additional stock result in too large a dilution of earnings or loss of voting control (or both) for existing Bailey shareholders? Should Bailey secure a covenant not to compete from Bill Smith as part of the acquisition? Should this “asset” be capitalized? Can Bailey deduct annual payments on the covenant? As indicated above, three alternative transactions are proposed. The first two result in the payment of cash and notes to acquire the assets or stock of the target corporation in a taxable transaction. The third transaction involves the use of the acquiring corporation’s stock to acquire target assets in a nontaxable reorganization. Accounting Standards Codification (ASC) 805, Business Combinations (formerly SFAS No. 141R) requires the acquisition method of accounting for all acquisitions. The acquisition method of accounting is described in the next paragraph. Under the acquisition method, the acquiring corporation reports the purchased assets at their acquisition cost whether they are acquired directly in a bulk purchase or through the acquisition of target stock. In the stock acquisition case, however, the adjustment of the assets occurs during the financial statement consolidation process. The acquisition cost usually is the FMV of the stock surrendered, the FMV of debt obligations surrendered, the amount of cash disbursed, and the fair value of target liabilities assumed. When the assets are conveyed in bulk, the individual assets must be valued. The assignment of the acquisition cost to specific asset categories is accomplished under ASC 805 guidelines. Generally, there will be a step-up or step-down of the assets’ carrying cost on the acquiring corporation’s books from their carrying cost on the target corporation’s books. The amounts reported for financial accounting purposes generally may be different from their adjusted bases for tax purposes, particularly in a nontaxable asset acquisition or a stock acquisition (without a Sec. 338 election). Accounting Standards Codification (ASC) 350, Intangibles (formerly SFAS No. 142 – Goodwill and Other) applies to intangible assets acquired individually or in bulk. An intangible asset that has a definite life is amortized over the asset’s finite useful life. In general, such an asset will be amortized under the straight-line method. If no legal, regulatory, contractual, or other factors limit the useful life of an intangible asset, its useful life is considered to be indefinite. An intangible asset, such as goodwill, which is not subject to amortization must be reviewed and tested for Copyright © 2024 Pearson Education, Inc.

C:7-35

impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. If an asset is impaired, the corporation recognizes an impairment loss. C:7-79 The memorandum might note that the Capital Group apparently is interested in acquiring a corporation with $7 million to $10 million of annual earnings so as to use its $105 million loss. The acquisition of a target corporation’s assets or stock in exchange for Capital stock and/or cash will trigger the Sec. 382 loss limitation rules on the Capital Group’s loss if a more than 50 percentage point change in the Capital Group’s stock ownership (i.e., an ownership change) occurs within the testing period. The Sec. 382 rules apply whether the acquisition is achieved in a nontaxable reorganization or a taxable purchase. On the other hand, no problem should arise with the use of the loss carryover if the Capital Group acquires the stock or assets of a smaller, profitable corporation. By acquiring a smaller, profitable corporation, an ownership change will not occur that would trigger the Sec. 382 loss limitation rules. If the Capital Group acquires the stock of a target corporation, it can file a consolidated tax return that includes the operating results of the target corporation. The Capital Group’s loss carryover will not be subject to the SRLY (separate return limitation year) loss limitation because it will be the parent corporation of the new affiliated group (see Chapter C:8). By avoiding the Sec. 382 loss limitation rules, all the losses of the Capital Group and the acquired corporation(s) can be used to reduce its post-acquisition taxable income. If the Sec. 382 loss limitation applies, use of the loss would be limited to the Capital Group’s value on the acquisition date times the long-term tax-exempt rate. The Sec. 382 rules apply in either separate tax reporting or consolidated tax reporting.

Tax Research Problems C:7-80 The memorandum should address the following points: The transaction is structured as a stock-for-stock acquisition, which will be nontaxable under the reorganization rules if the requirements of Sec. 368(a)(1)(B) are satisfied. Section 368(a)(1)(B) requires the acquiring corporation to use solely voting stock (or voting stock of its parent corporation) to acquire a controlling interest in the target corporation. Regulation Sec. 1.368-2(c) provides that a Type B reorganization is permitted in a single transaction or a series of transactions over a relatively short period of time such as 12 months. Failure to meet the solely-for-voting stock requirement would result in a taxable transaction. However, because the two steps in the acquisition occur within eight months, the IRS probably will consider them to be a single transaction. Consequently, the cash acquisition would disqualify the entire transaction because the “solely for voting stock” requirement will not have been met. The First and Third Circuit Courts of Appeal have held that control and the solely for voting stock requirements are not met when the acquiring corporation uses cash, even though it acquires over 80% of target stock with voting stock. See Eldon S. Chapman, et al. v. CIR, 45 AFTR 2d 801290, 80-1 USTC ¶9330 (1st Cir., 1980) and Arden S. Heverly, et al. v. CIR, 45 AFTR 2d 80-1122, 80-1 USTC ¶9322 (3rd Cir., 1980).

C:7-36

To purchase the initial block of stock for cash, Austin Corporation should ensure that the two steps in the transaction are independent of one another. One alternative would be for Austin to delay the second step in the transaction beyond the 12-month period specified in the Treasury Regulations. Despite this delay, the acquisition of the first block of stock for cash would remain taxable. Only the acquisition of the second block of stock would be nontaxable. Another alternative would be for Austin to sell its initial block of Travis stock and then acquire at least 80% of the Travis stock in a subsequent transaction. The stock sale must involve an independent party. The sale in the Chapman and Heverly cases involved a related party who was protected against loss on the transaction, and the courts disregard such sale as a disposition. C:7-81 This area of taxation has been subject to litigation for years and, most recently, to complex Treasury Regulations. A key question is whether these expenses qualify as ordinary and necessary business expenses under Sec. 162 (or, perhaps under Sec. 165, as costs of an abandoned transaction) or whether they must be capitalized. The Supreme Court in INDOPCO, Inc. v. Comm., 69AFTR 2d 92-694, 92-1 USTC ¶50,113 (USSC, 1992), ruled in a friendly takeover situation that the target’s expenses associated with the takeover created long-term benefits for the business (such as the availability of the acquiring corporation’s resources and the opportunity for synergy) and accordingly had to be capitalized. The court in INDOPCO maintained that it was not necessary for the expenditures to create or enhance a separate or distinct asset to merit capitalizing the expense; all that is required is that the expenditure produce significant long-term benefits. The Federated Department Stores, Inc., 74 AFTR 2d 94-5519, 94-2 USTC ¶50,418 (Ohio, 1994) case concerned a hostile takeover situation. In that case, the target enticed a “White Knight” into a takeover, but ultimately the hostile bid was accepted. The court allowed the target to deduct the costs of the efforts to avoid the takeover and reasoned that the target incurred fees to defend the corporation from attack and not to attain future benefits. The 1995 Tax Court decision in A.E. Staley Manufacturing Co. v. Comm., 80 AFTR 2d 975060, 97-2 USTC ¶50,521 (7th Cir., 1997), required capitalization of most of the target’s expenditures in the effort to stave off a hostile takeover that ultimately was finalized. The Tax Court maintained that the relevant question was whether an identifiable loss had been sustained and whether the costs were incurred in connection with a change in ownership of the taxpayer that “portended strategic changes.” In 1997, the Seventh Circuit (80 AFTR 2d 97-5060, 97-2 USTC ¶50,521) reversed the Tax Court and allowed Staley to deduct most of the expenses of fighting the takeover, reasoning that the costs were to defend the status quo and not to attain future benefits. The Sec. 263 regulations are complex, but Examples 11 and 12 of Reg. Sec. 1.263(a)-5 are especially helpful. These examples indicate that, if the takeover does not occur, the expenditures can be deducted. If the takeover is finalized, the general rule is that only the expenditures that occur after the earlier of (1) the date on which a letter of intent is signed or (2) the date on which material terms of the acquisition are authorized must be capitalized. Generally, items incurred before this date can be deducted. However, a number of other items are considered to always be incurred to facilitate the merger, such as the cost of the investment broker’s fee to determine whether the offer is fair to the target’s shareholders. These items must be capitalized regardless of when they are incurred. Copyright © 2024 Pearson Education, Inc.

C:7-37

C:7-82 The memorandum should point out that Sec. 368(a)(1)(D) permits a corporation to transfer part or all of its assets to a controlled corporation in exchange for its stock and securities and distribute these stock and securities to its shareholders in a nontaxable divisive reorganization. The distribution of the stocks and securities must satisfy the requirements of Secs. 354, 355, or 356. Section 355(b)(1) requires the distributing corporation and the controlled corporation to be engaged in the active conduct of a trade or business immediately after the transaction. Section 355(b)(2)(B) requires this trade or business to have been conducted throughout the five-year period ending on the distribution date. The issue at hand is whether Diversified and MRE Corporations were actively engaged in the conduct of a trade or business both before and after the reorganization. Regulation Sec. 1.3553(b)(2)(ii) defines a trade or business. Regulation Sec. 1.355-3(b)(2)(iv)(B) qualifies this definition in that the ownership and operation (including leasing) of real or personal property used in a trade or business does not constitute the active conduct of a trade or business unless the owner performs significant services with respect to the operation and management of the property. Diversified has owned the new office building for only six months. It apparently is having problems finding tenants for the upper floors. Most of these floors are vacant. Examples 12 and 13 of Reg. Sec. 1.355-3(c)(4)(iii) illustrate situations where rental properties do and do not constitute the active conduct of a trade or business. Both of the properties in the examples have been owned for more than five years prior to the proposed Type D reorganization. The bank has not previously owned any real property. All of its other bank facilities are leased. The five-year requirement will not be met if the real estate activities are considered to be a trade or business separate from the banking activities. It will be met if the real estate activities are considered to be part of the banking activities that have been conducted for the requisite five years. In Rev. Rul. 56-555, 1956-2 C.B. 210, a bank occupied 35% of a building it owned and leased the remaining 65% of space to 40 tenants. The IRS held that the bank and rental activities constituted the conduct of two separate active businesses, thereby meeting the requirements of Secs. 355(b)(1) and (b)(2)(B). The IRS, however, revoked this ruling in Rev. Rul. 88-19, 1988-1 C.B. 114, because it failed to state sufficient facts to support the conclusion. An insurance and real estate corporation was held not to be engaged in the active conduct of the trade or business of leasing where it occupied 50% of the floor space constituting 70% of the rental value of a building. Consequently, the corporation could not take advantage of its five-year insurance business history for purposes of establishing the necessary time period to qualify under Sec. 355. See Appleby v. Comm., 9 AFTR 2d 372, 62-1 USTC ¶9178 (3rd Cir., 1962). In Reg. Sec. 1.355-3(c), Example (12), Corporation X, a bank, owned an 11-story building for seven years. The bank occupied the ground floor and rented the remaining ten floors to various tenants. Corporation X transferred the building to a new subsidiary and distributed the subsidiary stock to its (X’s) shareholders. The example concluded that Corporation X and the subsidiary both meet the active business requirements of Sec. 355(b). Diversified probably will not encounter the same problem establishing a separate trade or business as in Appleby because it intends to lease 83.33% of the floor space in the building. Moreover, Diversified’s situation is similar to Example (12) of the Treasury Regulations. However, Diversified has owned the building for only six months. Because of this short time period, it appears the proposed transaction will not qualify as a divisive Type D reorganization. Diversified will fail to satisfy the five-year trade or business test. So doing, however, will not preclude Copyright © 2024 Pearson Education, Inc.

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Diversified from transferring the building to MRE Corporation tax-free under Sec. 351. It will, however, preclude Diversified’s distributing the stock tax-free to its shareholders. Diversified must recognize gain on the distribution of the MRE stock under Sec. 311(b). The Diversified shareholders must recognize dividend income or capital gain on receiving the stock depending on whether any of the Diversified shares are redeemed. This transaction appears to satisfy the Rev. Proc. 2023-1 and 2023-3, requirements for obtaining a private letter ruling.

“What Would You Do In This Situation?” Solution Ch. C:7, p. C:7-32. As an employee of a CPA firm that serves as the independent auditor of Intergalactic, you should advise your supervisor that complying with the client’s request potentially violates the Public Company Accounting Reform and Investor Protection Act of 2002, also known as the SarbanesOxley Act. This Act restricts or prohibits an independent audit firm from performing certain services for its public clients. Among the prohibited services are “expert services” unrelated to the audit. Although the Act does not define the term expert services, Rule 210.2-01 under the Act states that an accountant’s independence is impaired “if the accountant renders or supports expert opinions for the audit client in legal, administrative, or regulatory filings or proceedings.” An opinion relating to whether a proposed merger transaction comports with a tax law doctrine (i.e., the continuity of interest requirement) would fall into this category. You also might advise your supervisor that complying with the client’s request could result in severe statutory penalties, including: • • • • •

Suspension or revocation of ProfessionalCPA’s registration with the Public Company Accounting Oversight Board Suspension or termination of Ms. Coward’s and/or your association with ProfessionalCPA Restriction of the activities, functions, or operations of ProfessionalCPA and/or Ms. Coward and you Civil penalty not exceeding $100,000 imposed on Ms. Coward and/or you Civil penalty not exceeding $2 million imposed on ProfessionalCPA.

See Sec. 104(c)(4), (5), and (7) of the Sarbanes-Oxley Act.

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Chapter C:8 Consolidated Tax Returns Discussion Questions C:8-1 80% minimum ownership. The IRC requires that a parent corporation own stock in at least one includible corporation having at least 80% of the includible corporation’s total voting power and at least 80% of the total value of the includible corporation’s outstanding stock. The IRC also requires that, for each affiliated group member other than the parent corporation, the parent corporation and other group members must own stock having at least 80% of the member corporation’s total voting power and at least 80% of the total value of the member corporation’s outstanding stock. Certain nonvoting preferred stock is ignored for these stock ownership requirements. pp. C:8-2 and C:8-3. C:8-2 a. Includible. b. Generally not includible. However, Sec. 1504(d) allows inclusion of certain 100%-owned Canadian and Mexican corporations that are maintained to comply with local law regarding title and operation of property. c. Generally not includible. However, Sec. 1504(c)(1) permits two or more Sec. 801 domestic life insurance companies to file a consolidated return, and Sec. 1504(c)(2) permits a parent corporation to elect to have all domestic life insurance companies for which the 80% stock ownership tests have been met for at least five years to be included in its consolidated tax return. d. The limited liability company (LLC) may or may not be includible. Under the checkthe-box regulations (Chapter C:2), an unincorporated business entity may choose whether to be taxed as a corporation or not. If the LLC chooses to be taxed as a corporation, it is treated as an includible corporation, provided it otherwise qualifies (e.g., it is a domestic LLC and has not elected to be treated as an S corporation). If the LLC has not elected to be treated as a corporation, it is not an includible corporation and generally cannot be included in a consolidated tax return. However, if such an LLC is wholly owned by one of the affiliated group members, the tax law will treat the LLC as a disregarded entity, and the group member will treat the LLC’s profits and losses as its own profits and losses. If the LLC has not elected to be treated as a corporation and it has two or more owners, it is treated as a partnership. The LLC’s profits and losses pass through to its owners under the partnership tax rules and will be included in an affiliated group’s consolidated tax return if the group elects to file a consolidated tax return and one or more affiliated group members are owners of the LLC. Unlike a single-member LLC, a multi-member LLC is not a disregarded entity, so the consolidated tax return rules (e.g., intercompany transaction rules) do not apply to it. pp. C:8-3 and C:8-4. C:8-3 a. P, S, and T comprise an affiliated group. P and S are part of the group because P owns at least 80% of S’s stock. T is included because it is at least 80%-owned by P and S (49% + 51% = 100%). R is not part of the affiliated group because it is not at least 80%-owned by the corporations in the group; Pamela owns its stock.

C:8-1

b. P, R, S, and T comprise a controlled group. Even though only P, S, and T comprise an affiliated group, all four corporations comprise a controlled group. P, S, and T comprise a parentsubsidiary controlled group for reasons similar to the reasons they comprise an affiliated group. P and R comprise a brother-sister controlled group (under the 50%-80% definition) because both are wholly owned by the same individual. Because P is the parent corporation of a parent-subsidiary controlled group and also is a member of a brother-sister controlled group, P, R, S, and T comprise a combined controlled group. c. An affiliated group would not exist. S would not be included in an affiliated group because, as a foreign corporation, it is not an includible corporation. Although T is an includible corporation, it is not an affiliated group member because it is not at least 80%-owned by corporations in an affiliated group. (Stock attribution rules are not used to determine whether a group of corporations meets the affiliated definition.) R is not an affiliated group member because, as in Part a, it is not at least 80%-owned by corporations in an affiliated group. pp. C:8-3, C:8-4, and Chapter C:3. C:8-4 P and S comprise both an affiliated group of corporations and a controlled group of corporations. As a new affiliated group, P and S can elect to file a consolidated tax return, but they are not required to do so. If P and S do not elect to file a consolidated tax return, each will file a separate tax return. As a controlled group, they are allowed to benefit only once from certain items, such as the $250,000 accumulated earnings credit (Chapter C:5) and the maximum amount of depreciable property that can be immediately expensed under Sec. 179 (Chapter I:10). In addition, they are treated as if they were a single corporation to determine whether they qualify for certain benefits that are targeted at smaller corporations, such as making estimated tax payments based on the prior year’s tax (Chapter C:3). P and S allocate each such item equally between them unless they adopt a special apportionment plan. As a controlled group, P and S also are treated as related parties (Chapter I:6). If P and S elect to file a consolidated tax return, the P-S group will compute its consolidated taxable income and tax liability under the consolidated tax return rules, which generally treat the group as if it were one corporation. The group will not have to allocate the $250,000 accumulated earnings credit, as well as the other tax provisions that a controlled group’s members must allocate among themselves, because they are filing a single tax return. However, if P and another corporation, X, comprise a brother-sister controlled group, these items must be allocated between the P-S consolidated group and X. pp. C:8-2 through C:8-4, and Chapter C:3. C:8-5 Some of the differences between an affiliated group and a controlled group are as follows: 1. Brother-sister controlled groups exist, but brother-sister affiliated groups do not exist. For example, if an individual owns all the stock of A and B Corporations, A and B comprise a brother-sister controlled group but do not comprise an affiliated group.

C:8-2

2. For both an affiliated group and a parent-subsidiary controlled group, the parent corporation must own at least 80% of the stock of at least one other corporation in the group, and the parent corporation and other group members must own at least 80% of the stock of each corporation in the group other than the parent. For an affiliated group, this 80% stock ownership must be met with respect to the member corporation’s total voting power and the total value of its stock. For a parent-subsidiary controlled group, this 80% stock ownership must be met with respect to the member corporation’s total voting power or the total value of its stock. Thus, the group must meet both 80% stock ownership tests to be an affiliated group, but meeting either of the two tests will cause the two corporations to be a parent-subsidiary controlled group. 3. For the 80% stock ownership tests, the corporations must apply stock attribution rules to determine whether a controlled group exists, but they do not apply attribution rules to determine whether an affiliated group exists. 4. The types of corporations having special status that are not includible corporations for affiliated groups differ from those that are not includible corporations for controlled groups. 5. The existence of a controlled group generally is determined only at December 31. The existence of an affiliated group is determined on each day of the year. See Chapter C:3 for further discussion of controlled group topics. pp. C:8-2 through C:8-4. C:8-6 Only an affiliated group of corporations can file a consolidated tax return. To comprise an affiliated group, the corporations all must be includible corporations and must satisfy two 80% stock ownership requirements. Only P and S1 comprise an affiliated group. S3 is not included in the group because it is not at least 80%-owned by affiliated group members. S2 is not included in the group because, as a foreign corporation, it is not an includible corporation. Financial accounting rules require a consolidated set of financial statements for a parent corporation and those subsidiaries it controls. Control generally is deemed to exist when the parent directly or indirectly owns more than 50% of the subsidiary’s stock. The consolidated subsidiary can be domestic or foreign. Thus, P, S1, S2, and S3 generally must be included in a set of consolidated financial statements. Consolidation is required and thus is not elective under financial accounting rules, unlike the rules for federal income tax purposes. pp. C:8-2 through C:8-4. C:8-7 Section 1502 specifically authorizes the Treasury Department to write consolidated return regulations so that a consolidated group’s tax liability “may be returned, determined, computed, assessed, collected, and adjusted, in such manner as clearly to reflect the income tax liability.” Thus, Congress is delegating its rule-making authority to the Treasury Department, making the consolidated return regulations legislative regulations. In contrast, interpretive regulations merely make the IRC’s statutory language easier to understand and apply. Congress chose to delegate this rule-making authority to the Treasury Department because the consolidated return area is complex. Congress gave the consolidated return regulations further authority by allowing an affiliated group to file a consolidated tax return on the condition that the group consents to the consolidated return regulations in effect before the due date (without extensions) for its first consolidated tax return. pp. C:1-10, C:8-4, and C:8-5. C:8-8 a. No. The affiliated group does not cease to exist because P continues to be affiliated with at least one other corporation, S.

C:8-3

b. T may or may not be required to file a consolidated tax return with Z. If Z is a member of an affiliated group that has been filing consolidated tax returns, T must join in its filing. If Z is not an affiliated group member (or is a member of an affiliated group that has not elected to file a consolidated tax return), T is not required to file a consolidated tax return with Z. However, Z and T (and any other corporations affiliated with them) could elect to do so. c. Generally, no. A corporation generally has to wait 60 months before it can rejoin the same consolidated group. After the 60-month period expires, T must again file a consolidated tax return with P and S, assuming that the affiliated group continues to exist and the IRS has not granted it permission to discontinue filing on a consolidated basis. The 60-month rule does not prevent T from filing a consolidated tax return with Z while they are affiliated. The IRS may grant permission to rejoin the same consolidated group before the 60-month period expires. d. In Part a, the affiliated group would cease to exist, assuming P does not become affiliated with another corporation before the end of the current year. The answer for Part b would not change. The answer for Part c would not change except P and T would not be required to file a consolidated tax return after the 60-month period expires. Because the previous P-T affiliated group ceases to exist, a new affiliated group arises when P purchases all of T’s stock from Z. This new P-T affiliated group may elect to file a consolidated tax return after the 60-month period expires, but it is not required to do so. pp. C:8-5 and C:8-6. C:8-9 If an affiliated group elects to file tax returns on a consolidated basis, it generally must continue to do so for as long as the group’s common parent remains as the common parent and is affiliated with at least one subsidiary at the beginning of the year with which it was affiliated at the end of the prior year. Thus, P, S, and T could file separate tax returns if P no longer owns at least 80% (by vote and by value) of S’s and T’s stock. This situation would occur if P were to sell more than 20% of S’s and T’s stock or if S and T were to issue stock to another person such that P’s ownership decreases to less than 80%. If this situation were to occur during the current year, the group still would have to file a consolidated tax return for the current year and include in it P’s taxable income or loss for the entire year and S’s and T’s taxable income or loss for the part of the year they were group members. S and T would file separate tax returns for the post-affiliation part of the year, and all three corporations would file separate tax returns in the next year (assuming none of the corporations becomes affiliated with another consolidated group). Alternatively, the IRS could, for “good cause,” permit the P-S-T group to discontinue filing a consolidated tax return. pp. C:8-5 through C:8-8. C:8-10 a. An intercompany transaction is a transaction occurring during a consolidated return year between corporations that are members of the same consolidated group immediately after the transaction. b. Intercompany items are the seller’s (or service provider’s) income, gain, deduction, and loss items arising from an intercompany transaction. c. Corresponding items are the buyer’s (or service user’s) income, gain, deduction, and loss items arising from an intercompany transaction or from property acquired in an intercompany transaction.

C:8-4

d. Recomputed corresponding items are the buyer’s (or service user’s) income, gain, deduction, and loss items that would arise from an intercompany transaction or from property acquired in an intercompany transaction if the buyer and seller were two divisions of a single corporation and the transaction were between those divisions. In other words, if the buyer and seller were two divisions of a single corporation, how much income, gain, deduction, and loss would that single corporation have? e. Under the matching rule, the seller’s intercompany item is not necessarily included in consolidated taxable income at the time of the intercompany transaction. Instead, the timing of its inclusion depends on the timing of the buyer’s corresponding item. The intercompany item the group includes in its consolidated taxable income in a particular tax year equals the recomputed corresponding item for that year minus the corresponding item for that year. This computation matches the seller’s intercompany item with the buyer’s corresponding items so that it produces the same outcome that would occur if the seller and buyer were two divisions of a single corporation. f. The consolidated group’s circumstances may change in a way that the seller’s intercompany item cannot be fully matched with the buyer’s corresponding items. For example, the buyer may depart the consolidated group before its corresponding items arise. Under the acceleration rule, the seller’s intercompany items that have not yet been included in consolidated taxable income are so included immediately before the time it first becomes impossible to match the seller’s intercompany item with the buyer’s corresponding items. pp. C:8-8 through C:8-12. C:8-11 a. The sale is an intercompany transaction. As a result of S1’s acquisition of S2 on June 15, S2 became a member of S1’s affiliated group. That group has filed consolidated tax returns for several years, so S2 is a member of S1’s consolidated group immediately after the sale on September 1. b. The sales are intercompany transactions. P and S1 are members of the same consolidated group throughout the current year, so all of the inventory sales are intercompany transactions. c. The services S2 performs for S1 from January 1 through June 15 are not intercompany transactions because S2 is not yet a member of S1’s consolidated group, but the services performed from June 16 through December 31 are intercompany transactions. d. The sale is not an intercompany transaction because, as an unincorporated entity, the partnership is not a member of P’s consolidated group. If the S1-S2 Partnership had elected to be treated as a corporation under the “check-the-box” regulations, it would be a member of the affiliated group filing a consolidated tax return, so P’s sale of inventory to the partnership would be an intercompany transaction. pp. C:8-2 through C:8-4 and C:8-8 through C:8-10. C:8-12 a. Intercompany item: Interest income accrued by P. Corresponding item: Interest expense accrued by S1. Recomputed corresponding item: Zero because the group has no interest income or expense.

C:8-5

b. Intercompany item: S1’s profit or loss on inventory sold to P. Corresponding item: None yet because P has not sold the inventory to a person outside the consolidated group. When this outside sale occurs, P’s profit or loss on the sale will be a corresponding item. Recomputed corresponding item: None yet, for the same reason as for the corresponding item. c. Intercompany item: P’s gain or loss on the land sold to S2. Corresponding item: None yet because S2 has not sold the land to a person outside the consolidated group. When this outside sale occurs, S2’s gain or loss on the sale will be a corresponding item. Recomputed corresponding item: None yet, for the same reason as for the corresponding item. d. Intercompany item: Profit or loss on the engineering services accrued by S1. Corresponding item: S2’s depreciation deductions on the building and S2’s gain or loss when it sells the building to a person outside the consolidated group. Recomputed corresponding item: The group’s depreciation on the building and the group’s gain or loss when S2 sells the building to a person outside the consolidated group. pp. C:8-10, C:8-11, and C:8-16 through C:8-18. C:8-13 The lending group member’s (S’s) interest income is matched with the borrowing group member’s (B’s) interest expense for consolidated tax return purposes under the matching rule. The intercompany items are S’s interest income accruals. The corresponding items are B’s interest expense accruals. The recomputed corresponding items are zero because there would be no interest income or expense if S and B were a single entity; the intercompany loan would be merely an internal loan. S’s interest income accrues at the same time as B’s interest expense accrues because they both use the accrual method of accounting, so the group will immediately include S’s interest income in consolidated taxable income under the matching rule. S’s interest income and B’s interest expense generally will offset one another in arriving at consolidated taxable income. The group will not defer the interest income’s inclusion because no lapse in time occurs between S’s accrual of its interest income and B’s accrual of its interest expense. For consolidated financial statement purposes, S’s interest income and B’s interest expense are usually eliminated. This elimination generally has the same zero net effect on consolidated net income as it has on consolidated taxable income. Eliminating the interest income and interest expense, rather than allowing them to merely offset one another, is important because it may affect ratios that a financial statement user computes. pp. C:8-10, C:8-11, C:8-15, and C:8-16. C:8-14 The problem does not provide enough information to tell whether the corporations would obtain a greater charitable contributions deduction for the current year by filing a consolidated tax return or separate tax returns. Recall that the corporate charitable contributions deduction is limited to 10% of taxable income computed without regard to the charitable contributions deduction, capital loss carrybacks, and the dividends-received deduction. Brooklyn and Bronx might obtain the same charitable contributions deduction whether they file a consolidated tax return or separate tax returns. This result might occur if each corporation’s charitable contributions are less than its separate 10% limitation and their total charitable contributions are less than the consolidated 10% limitation. Copyright © 2024 Pearson Education, Inc.

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A second possibility is that Brooklyn and Bronx would obtain a larger charitable contributions deduction by filing a consolidated tax return than by filing separate tax returns. This result might occur if Brooklyn makes charitable contributions greater than its separate 10% limitation and Bronx makes no contributions. By filing a consolidated tax return, the group may increase its deductions because Bronx’s 10% limitation in excess of its zero contributions may allow the group to deduct more of Brooklyn’s contributions than Brooklyn could deduct separately. In short, Bronx’s excess limitation can offset Brooklyn’s excess contributions. A third possibility is that Brooklyn and Bronx would obtain a smaller charitable contributions deduction by filing a consolidated tax return than by filing separate tax returns. This might occur if Brooklyn makes charitable contributions greater than its separate 10% limitation and Bronx makes no contributions and has a net operating loss for the current year. By filing a consolidated tax return, the amount of deductions may decrease because Bronx’s net operating loss makes the consolidated 10% limitation less than Brooklyn’s separate 10% limitation, so the group could deduct fewer charitable contributions on a consolidated basis than it could on a separate basis. p. C:8-19. C:8-15 Many reasons may explain why the group’s consolidated capital gain net income or net capital loss is not merely the sum of the members’ separate capital gain net incomes and net capital losses if they were to file separate tax returns. Three important reasons are the following: 1. Net Sec. 1231 gains are treated as long-term capital gains (if they are not treated as ordinary income due to nonrecaptured net Sec. 1231 losses), but net Sec. 1231 losses are treated as ordinary losses. For example, suppose that one group member has a $10,000 net Sec. 1231 gain and another group member has an $8,000 net Sec. 1231 loss. If the group’s members file separate tax returns, the $10,000 gain is treated as a long-term capital gain, and the $8,000 loss is treated as an ordinary loss. If the group files a consolidated tax return, it nets the $10,000 gain and $8,000 loss and reports a $2,000 consolidated net Sec. 1231 gain, which is treated as a long-term capital gain. 2. Corporations can use capital losses to offset capital gains but cannot use them to offset ordinary income. For example, suppose that one group member has a $7,000 capital gain net income and another group member has a $6,000 net capital loss. If the group files a consolidated tax return, the $6,000 loss offsets part of the $7,000 gain. If the group’s members file separate tax returns, the $6,000 loss cannot offset any of the $7,000 gain but must be used to offset that member’s capital gain net incomes in the three preceding and five succeeding tax years. 3. The consolidated group applies the matching and acceleration rules to report Sec. 1231 gains and losses and capital gains and losses arising from intercompany transactions. As a result, the consolidated group may report such gains and losses at a different time than the constituent corporations would report them if they were to file separate returns. pp. C:8-10 through C:8-14, C:8-19, and C:8-20. C:8-16 a. The group member includes the dividend in its gross income but may claim a 50% dividends-received deduction for it, assuming the 5%-owned corporation is not a member of the affiliated group (i.e., other group members do not own 75% or more of its stock). b. Because the 100%-owned corporation is a consolidated group member, the distributee group member excludes the intercompany dividend from its gross income and cannot claim a dividends-received deduction for it. The distributee group member also makes a corresponding negative adjustment to its basis in the distributing corporation’s stock. Copyright © 2024 Pearson Education, Inc.

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c. The group member includes the dividend in its gross income but may claim a 100% dividends-received deduction for it under Sec. 245A (see Chapter C:3). The distributing corporation is not a member of the affiliated group because, as a foreign corporation, it is not an includible corporation. d. If the life insurance company is not included in the group’s consolidated tax return, the distributee group member must include the dividend in its gross income but may claim a 100% dividends-received deduction for it. If the life insurance company is included in the group’s consolidated tax return, the distributee group member excludes the intercompany dividend from its gross income, cannot claim a dividends-received deduction for it, and makes a corresponding negative adjustment to its basis in the distributing corporation’s stock. e. Because the dividend-paying corporation is a consolidated group member, the distributee group members exclude the intercompany dividend from their gross incomes, claim no dividends-received deductions for it, and make corresponding negative adjustments to their bases in the distributing corporation’s stock. pp. C:8-2, C:8-3, C:8-20 through C:8-22, C:8-31, and C:832. C:8-17 The P-S-T group carries over indefinitely the current year consolidated net operating loss (NOL). Assuming the three corporations file consolidated tax returns during the carryover period, the group uses the NOL first to offset up to 80% of its consolidated taxable income (before the NOL deduction) in the next year. The group then uses any remaining NOL to offset, in chronological order, up to 80% of such taxable income in the second succeeding year, in the third succeeding year, etc. This consolidated NOL treatment is similar to the treatment of an unaffiliated corporation’s NOL (see Chapter C:3). If S does not file a consolidated tax return with the other group members for the year to which the NOL carries over, the group must apportion a fraction of the unused consolidated NOL to S so that S can use it on S’s separate tax return for that year. The fraction equals S’s separate NOL for the year the consolidated NOL arose divided by the sum of S’s and T’s separate NOLs for the year the consolidated NOL arose. In a similar fashion, the group must apportion a fraction of its unused NOL to T if T does not file a consolidated tax return with the other group members for the year to which the NOL carries over. pp. C:8-25 and C:8-26. C:8-18 A SRLY is a separate return limitation year. It is any separate return year except for (1) a separate return year of the consolidated group’s parent corporation or (2) a separate return year of any corporation that was a member of the affiliated group for every day of the loss year. The SRLY rules limit the amount of an NOL incurred in a SRLY that may be used in a consolidated return year. The SRLY limitation is based on the cumulative SRLY register for the group member having the SRLY NOL. This register accumulates, for the years since the member joined the group, increases for its taxable incomes, decreases for its losses, and decreases for the amounts of consolidated taxable income that were needed to support the group’s deductions of the member’s SRLY NOLs. For post-2020 tax years where the SRLY NOLs arose after 2017, the SRLY rules limit the amount of such NOLs that may be used in a consolidated return year to the lesser of: (1) 80% of the cumulative SRLY register, after increasing it for the member’s current year taxable income (or decreasing it for its current year loss) but before decreasing it for the group’s current year use of the member’s SRLY NOLs, Copyright © 2024 Pearson Education, Inc.

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(2) 80% of consolidated taxable income computed without the NOL deduction, or (3) The remaining NOL carryover. The SRLY rules are intended to restrict the group’s cumulative use of the member’s SRLY NOLs to the member’s cumulative use of the NOLs had it remained unaffiliated. Special rules apply to SRLY losses incurred by a subgroup, to SRLY losses incurred by a corporation in a transaction that is also subject to the Sec. 382 loss limitation, and to reverse acquisitions. pp. C:8-26 through C:8-30. C:8-19 The overlap rule waives the application of the SRLY rules in many circumstances where the Sec. 382 limitation also applies. The SRLY limitation applies to NOLs that carry from a separate return limitation year to a consolidated return year. The Sec. 382 limitation applies when a Sec. 382 stock ownership change occurs, which generally is the case when the percentage of stock of the new loss corporation owned by one or more 5% shareholders has increased by more than 50 percentage points over the lowest percentage of stock in the old loss corporation owned by such shareholders at any time during the preceding three-year (or shorter) testing period (See Chapter C:7). Many corporate acquisitions would be subject to both the SRLY and Sec. 382 limitations if the overlap rule did not exist. For example, if S Corporation has unused NOLs and P Corporation purchases 100% of S’s stock, the SRLY limitation would apply because S’s NOLs arose in a separate return limitation year, and the Sec. 382 limitation would apply because P’s ownership of S increases by more than 50 percentage points. The overlap rule reduces the P-S consolidated group’s tax compliance burden by eliminating the SRLY limitation and applying only the Sec. 382 limitation. pp. C:8-30 and C:8-31. C:8-20 a. S’s taxable income is taxed on the consolidated tax return. If S did not pay any dividends to P, the earnings S retains likely would increase the value of S’s stock. Thus, if P did not increase the basis in its S stock by S’s taxable income, P would realize a larger gain (or smaller loss) if it were to sell S’s stock. However, this increased gain (or reduced loss) is attributable to earnings that previously were taxed to the consolidated group. To prevent such double taxation, the tax law allows P to increase the basis of its S stock by S’s taxable income. Similarly, when S pays a dividend to P, the value of the S stock that P owns likely will decrease. If P did not decrease its basis by the dividend received from S, it would realize a smaller gain (or larger loss) if it were to sell S’s stock. However, this reduced gain (or increased loss) is attributable to the intercompany dividend, which P excludes from its gross income. To prevent a second tax benefit from the intercompany dividend, the tax law requires P to reduce the basis of its S stock by the dividend received from S. P also must increase the basis for its S stock by S’s tax-exempt income and decrease it for S’s nondeductible, noncapital expenditures. b. As in Part a, P must increase the basis in its S stock by S’s taxable income and tax-exempt income and decrease the basis by S’s nondeductible, noncapital expenditures and the dividends S pays to P. Similarly, S must increase the basis for its T stock by T’s taxable income and tax-exempt income and decrease it by T’s nondeductible, noncapital expenditures and the dividends T pays to S. The adjustments that S makes to the basis for its T stock tier up so that P also adjusts the basis in its S stock for these amounts, in addition to the adjustments P makes because of S’s income and expense items. pp. C:8-31 through C:8-33. C:8-21 One likely advantage of filing a consolidated tax return is that the P-S1-S2 group can use S2’s current year losses to offset P’s and S1’s current year profits. (The 80% of taxable income limitation for NOLs does not apply to the use of a member’s loss against other members’ incomes Copyright © 2024 Pearson Education, Inc.

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within the same consolidated return year.) The group’s ability to use S2’s losses from its first two years of operations to offset its current year profits may be limited. If S2’s loss carryovers are separate return limitation year (SRLY) losses, the group’s use of them is subject to the SRLY limitation, but an exception to the SRLY rules applies if S2 was a member of the affiliated group on each day of the loss year. The Sec. 382 loss limitation also may apply to S2’s losses if P acquired S2 after S2 incurred its losses. Neither the SRLY nor the Sec. 382 limitations apply if P has owned at least 80% of S2 since S2’s inception. Another likely advantage of filing a consolidated tax return is that the group can defer taxation of S2’s profits on its intercompany sale of cosmetics to S1 until S1 sells them to retailers. The group’s consolidation of S2’s losses with P’s and S1’s profits may affect some of its deduction and credit limitations. The effect could be to increase or decrease the limitations, so this factor cannot be classified as an advantage or disadvantage without knowing more about the group’s circumstances. The deferral of S1’s intercompany profits may also affect the group’s deduction and credit limitations (the question does not indicate whether S1 has any intercompany profits). pp. C:8-33 and C:8-34. C:8-22 Assuming your client and its largest supplier would comprise a new affiliated group after the acquisition, the two companies could continue to file separate tax returns or elect to file a consolidated tax return. If the acquisition occurs before the end of the supplier’s tax year, the supplier must file a separate tax return (or join in the consolidated tax return of its former consolidated group) for the portion of its tax year before the acquisition. The primary advantage of filing a consolidated tax return in this situation is likely to be the ability to defer taxation of the supplier’s profits on its sales to the manufacturing company. The ability to offset one company’s losses against the other company’s profits in a consolidated tax return does not appear to be an advantage of filing a consolidated tax return because both companies are currently profitable. This ability to offset, however, may become an advantage if one company becomes unprofitable while the other remains profitable, but filing separate returns initially does not preclude later making an election to file on a consolidated basis. Moreover, if the losses occur after the companies become affiliated, the group will not be subject to the SRLY or Sec. 382 limitations. Dividends received by the parent corporation from its subsidiary are effectively tax-exempt whether they file a consolidated tax return or not. The parent excludes the intercompany dividend if it files a consolidated tax return. If the corporations file separate returns, the parent’s 100% dividends-received deduction fully offsets its intercompany dividend income. A final factor is the companies’ ability to use tax deductions and credits because of limitations on them (for example, the general business credit). The limitations may be increased or decreased on a consolidated basis, so this feature may be advantageous or disadvantageous. To give the president a more-informed answer, you need additional information. What is your client’s legal form of organization? Is it a corporation or an unincorporated entity? If it is an unincorporated entity, has it elected to be treated as a corporation under the check-the-box regulations? What is the supplier company’s legal form of organization, and how is it treated for federal income tax purposes? Will your client be acquiring at least 80% of the supplier’s stock by vote and by value? What amount of intercompany profits are the two companies likely to have? pp. C:8-33 and C:8-34.

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C:8-23 The affiliated group can elect to file on a consolidated basis at any time until the consolidated tax return’s due date (including any extensions). The group makes the election by filing a consolidated federal income tax return for all members of the affiliated group. The parent’s sale of its sole subsidiary’s stock could terminate an affiliated group, and this termination could occur on any day of the tax year. An affiliated group also can request IRS permission to discontinue filing a consolidated tax return, and this change in status could be effective for any date of the tax year. The IRS may or may not approve the group’s “good cause” request. Most good cause requests are the result of changes in the Internal Revenue Code or the consolidated return Treasury Regulations. pp. C:8-4 through C:8-6 and C:8-34. C:8-24 The group’s parent corporation cannot act as the group’s agent to make the election to file a consolidated tax return. Each subsidiary corporation must consent to the election by submitting to the parent a Form 1122 (Part a). Assuming the group’s members elect to file a consolidated tax return, the parent corporation acts as the group’s agent for the other three actions (Parts b, c, and d). p. C:8-35.

Issue Identification Questions C:8-25 •

• •

•

What types of corporate groups can file a consolidated tax return? • What are the stock ownership and includible corporation requirements for an affiliated group? • Do Red and Green, as brother-sister corporations, satisfy these requirements? If Red and Green currently do not comprise an affiliated group, what changes to the corporate structure could Mark make so they do comprise an affiliated group? What tax advantages would Red and Green likely obtain if they were to become an affiliated group and elect to file a consolidated tax return? • Would taxation of Red’s profits on its intercompany inventory sales to Green be deferred? • Could Green’s $30,000 current year losses offset Red’s current year profits? Are there any restrictions or limitations on deducting Green’s current year losses? • Could Green’s pre-affiliation losses offset post-affiliation consolidated taxable income? Could they offset Red’s pre-affiliation separate taxable income? Are there any restrictions or limitations on deducting the pre-affiliation losses? What might be the disadvantages if Red and Green were to become an affiliated group and elect to file a consolidated tax return? • Would it be more favorable or less favorable to apply limitations for deductions and credits on a consolidated basis or a separate return basis? • How much additional recordkeeping is involved in filing a consolidated return instead of two separate tax returns?

Red and Green currently have a brother-sister relationship, so they do not comprise an affiliated group and cannot file a consolidated tax return. If Red owned at least 80% of Green’s stock by vote and by value (or vice versa), they would have a parent-subsidiary relationship, would comprise an affiliated group, and could elect to file a consolidated tax return. Mark could accomplish this restructuring by making a capital contribution of at least 80% of Green’s stock to Red (or at least 80% of Red’s stock to Green). Copyright © 2024 Pearson Education, Inc.

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By filing a consolidated tax return, Red and Green could defer the taxation of Red’s profits on its intercompany inventory sales to Green. These intercompany sales have increased during the last five years. Depending on the inventory method employed (e.g., LIFO or FIFO), the tax deferral could either be short-term or long-term. The companies could compare the results under each alternative. Without obtaining additional information, it cannot be determined whether applying limitations on deductions and credits on a consolidated basis would be more favorable or less favorable than on a separate return basis. Red and Green would have additional recordkeeping if they file a consolidated tax return, but this disadvantage might be outweighed by the advantages of consolidated filing. If they were to file a consolidated tax return, Green’s post-change NOLs could offset Red’s profits. (The 80% of taxable income limitation for NOLs does not apply to the use of a member’s loss against other members’ incomes within the same consolidated return year.) If Red and Green become an affiliated group because Mark contributes Green’s stock to Red, Green’s pre-change NOLs generally would be SRLY losses and could be used by the Red-Green consolidated group only to 80% of the extent to which Green subsequently earns a net profit. Red and Green might try to increase Green’s post-affiliation profits, thereby increasing the SRLY limitation, by reducing the price that Red charges Green on its intercompany inventory sales, but this strategy may indicate a tax avoidance motive and might cause the IRS to apply the Sec. 482 transfer pricing rules to the intragroup transfers. If Mark were to contribute Red’s stock to Green, Green’s pre-change NOLs generally would not be SRLY losses because Green would be the parent corporation, but the SRLY limitation would apply to the NOLs if Green’s acquisition of Red were a reverse acquisition. pp. C:8-33 and C:8-34. C:8-26• • • • •

Does the existing Alpha-Baker affiliated group include Charter in its consolidated tax return filing? What tax year(s) can Charter elect? What overall accounting method(s) can Charter elect? What inventory method can Charter elect? Can Charter elect to amortize its organizational expenditures and/or its start-up expenditures?

Charter is a new member of the existing affiliated group because at least 80% of its stock is owned by Alpha and Baker (i.e., Baker owns 100%), so Charter must file a consolidated tax return with Alpha and Baker. Charter must use the same tax year as Alpha and Baker. Charter need not use the same accounting method as Alpha and Baker, so it generally can elect to use the cash, accrual, or hybrid methods of accounting. However, it is producing parts for the automobile industry, so inventories likely will be a material income-producing factor. If so, it must use the accrual method of accounting for its sales-related activities, assuming the group is not exempted from this requirement because its gross receipts exceed $29 million (for 2023). Charter may be able to use the hybrid accounting method; if so, Charter would not have to use the accrual method of accounting for its other income and expense items. The consolidated group can make a Sec. 248 election to deduct and amortize Charter’s organizational expenditures. If it makes this election, the group can deduct $5,000 of the organizational expenditures in the current year and amortize the remaining $7,000 ($12,000 - $5,000) over the 180-month period beginning in the month Charter begins business. Similarly, the consolidated group can make a Sec. 195 election to deduct and amortize its start-up costs. If it makes this election, the group must amortize over 180 months all $60,000 of the start-up Copyright © 2024 Pearson Education, Inc.

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costs because they exceed $55,000. The group can make the Sec. 248 and Sec. 195 elections without regard to whether it made these elections for Alpha and Baker. Under Reg. Secs. 1.195-1 and 1.2481, Charter is deemed to make these elections unless it elects to forego the deduction and amortization of the costs. pp. C:8-2, C:8-3, C:8-6, and Chapter C:3. C:8-27 Hawkeye’s $260,000 of losses are SRLY losses because Hawkeye was not affiliated with the Wildcat-Baker group in the years the losses arose. Consequently, the group’s use of the NOLs is subject to the SRLY limitation, assuming the overlap rule does not apply because Wildcat’s acquisition of Hawkeye does not trigger the Sec. 382 limitation. The group’s use of the $260,000 is limited to the lesser of: (1) 80% of the cumulative SRLY register for Hawkeye, after increasing it for Hawkeye’s current year taxable income (or decreasing it for its current year loss) but before decreasing it for the group’s current year use of Hawkeye’s SRLY NOLs, (2) 80% of consolidated taxable income computed without regard to the NOL deduction, or (3) the unused NOLs of Hawkeye. If the group’s profits expectations are accurate, the group’s annual use of the NOLs in each of the next six years will be as follows: • Hawkeye’s cumulative SRLY register at the beginning of the year will be zero. • Hawkeye’s cumulative SRLY register for the SRLY limitation will be $50,000 ($0 at the beginning of the year + Hawkeye’s $50,000 current year profit) • The SRLY limitation for Hawkeye’s NOLs will be $40,000 (0.80 x $50,000). • The group deducts $40,000 of Hawkeye’s NOLs [lesser of $40,000, $240,000 (0.80 x $300,000), or the unused NOLs]. • Hawkeye’s cumulative SRLY register at the end of the year will be zero [$50,000 – (1.25 x $40,000)]. At the end of the sixth year, $20,000 [$260,000 – (6 x $40,000)] of Hawkeye’s NOLs will be unused. The group will be able to use all of this amount as an NOL deduction in the seventh year. If Wildcat’s acquisition of Hawkeye qualifies as a Sec. 382 ownership change, the overlap rule applies. Assuming this ownership change occurs simultaneously with the SRLY event, the Sec. 382 limitation will apply to Hawkeye’s losses instead of the SRLY limitation. If the Sec. 382 limitation is greater than $40,000, the group can expect to use the losses more quickly under this limitation than it would had the SRLY limitation applied. However, the Sec. 382 limitation could be less than $40,000 depending on Hawkeye’s value and the long-term tax-exempt federal interest rate at the time of the ownership change. Also, Hawkeye’s $40,000 portion of annual group profits is only an expectation. Thus, whether the Sec. 382 limitation provides faster NOL usage than would the SRLY limitation is somewhat uncertain. The corporations could manipulate the transfer prices charged for goods and services between Hawkeye and the other two corporations so as to increase Hawkeye’s profits, enabling the group to use the NOLs more quickly. However, Sec. 482 allows the IRS to reallocate income, deductions, and other tax return items for non-arm’s length transfer pricing arrangements. pp. C:826 through C:8-30.

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Problems C:8-28 a. B, C, and D comprise an affiliated group because B owns at least 80% of at least one includible corporation’s stock (i.e., C and D) and at least 80% of C’s and D’s stock is owned by other corporations in the group. b. B, C, D, and E comprise an affiliated group. B owns at least 80% of another includible corporation’s stock, and at least 80% of each corporation’s stock (except for B, the parent) is owned by other group members. F is not a group member because group members do not own at least 80% of F’s stock (and F is not the parent corporation). c. B, C, and D comprise an affiliated group. B owns at least 80% of another includible corporation’s stock (i.e., C’s stock), and at least 80% of each corporation’s stock (except for B, the parent) is owned by other group members. B and C together own 81% (40% + 41%) of D’s stock. d. An affiliated group does not exist because a parent corporation does not own at least 80% of another corporation’s stock. Although Luciano owns all of M’s and N’s stock, Luciano is not a corporation. However, M and N comprise a brother-sister controlled group under the 50%80% definition. e. W and Y comprise an affiliated group, and X and Z comprise another affiliated group. The four corporations do not comprise an affiliated group because an individual, rather than a corporation, owns all of W’s and X’s stock. However, the four corporations comprise a combined controlled group. pp. C:8-2 through C:8-4. C:8-29 a. P and S comprise an affiliated group because P owns at least 80% of S’s stock. T and U are not members of the group because, as foreign corporations, they are not includible corporations. b. P and S comprise an affiliated group because P owns at least 80% of S’s stock. T is not a member of the group because, as a foreign corporation, it is not an includible corporation. U is not a member of the group, even though it is an includible corporation, because P and S do not own at least 80% of U’s stock. P, S, and U comprise a parent-subsidiary controlled group; P is treated as owing all of U’s stock because of the Sec. 1563(e) attribution rules. Attribution rules apply to determine the corporations that comprise a controlled group but do not apply to determine the corporations that comprise an affiliated group. c. An affiliated group does not exist because P does not own at least 80% of S’s stock. P and S comprise a brother-sister controlled group because of the Sec. 1563(e) attribution rules. d. P and S comprise an affiliated group because P owns at least 80% of S’s stock. G is not a member of the group because it is a foreign corporation. P and S are includible corporations even though P’s sole shareholder, G, is not an includible corporation. e. At a minimum, P and S comprise an affiliated group; T might or might not also be a member of the group. As an unincorporated entity, T can choose whether to be taxed as a corporation under the check-the-box regulations. If T so chooses, P, S, and T will comprise an affiliated group. If T does not choose to be treated as a corporation, it will be treated as a partnership and will not be a member of the affiliated group. pp. C:8-2 through C:8-4. C:8-30 a. No. Pierre and Salem will not be eligible to file a consolidated tax return because they will not comprise an affiliated group. To comprise an affiliated group, Pierre would have to own at least 80% of Salem’s total voting power and at least 80% of the total value of Salem’s Copyright © 2024 Pearson Education, Inc.

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outstanding stock. Salem’s total voting power is 250,000 [(4 × 60,000) + (1 × 10,000)] votes, so Pierre would have to acquire Salem stock having at least 200,000 (250,000 × 80%) votes. Pierre would possess 240,000 (60,000 × 4) votes after the acquisition, so this stock ownership requirement would be met. The value of Salem’s outstanding stock is $3.15 million [(60,000 × $40) + (10,000 × $75)], so Pierre would have to acquire Salem stock that is worth at least $2.52 million ($3,150,000 × 80%). If Pierre were to acquire all of Salem’s common stock and none of Salem’s preferred stock, Pierre would own Salem stock worth $2.4 million (60,000 × $40) after the acquisition, so this stock ownership requirement would not be met. b. Many combinations of Salem common stock and preferred stock Pierre could acquire would qualify the two corporations to file a consolidated tax return. As noted above, Pierre would have to acquire Salem stock with at least 200,000 votes and worth at least $2.52 million. If Pierre acquired all of Salem’s common stock, it also would have to acquire Salem preferred stock worth at least $120,000 [$2,520,000 - $2,400,000], which would be at least 1,600 ($120,000 ÷ $75) shares. Alternatively, if Pierre acquired all of Salem’s preferred stock, the stock would possess 10,000 (1 × 10,000) votes and be worth $750,000 (10,000 × $75). Pierre would have to acquire Salem common stock possessing at least 190,000 (200,000 - 10,000) votes and worth at least $1.77 million ($2,520,000 - $750,000). Pierre would satisfy the 80%-by-vote stock ownership requirement by acquiring at least 47,500 (190,000 ÷ 4) Salem common shares, and it would satisfy the 80%-by-value stock ownership requirement by acquiring at least 44,250 ($1,770,000 ÷ $40) Salem common shares. Because Pierre’s ownership of Salem stock must satisfy both requirements, Pierre would have to acquire at least 47,500 common shares for it to file a consolidated tax return with Salem. Many other combinations of Salem common and preferred stock that Pierre could acquire would allow the two corporations to file a consolidated tax return. One way to determine these combinations is to graphically depict them using the number of common shares as the horizontal axis and the number of preferred shares as the vertical axis. All points lying on or to the northeast of the line connecting the solution’s data points are feasible combinations. c. Zero. Pierre does not have to acquire any of the nonvoting preferred stock because the stock is ignored for both 80% stock ownership requirements. The stock is ignored because it is nonvoting, limited and preferred as to dividends, does not participate in corporate growth to any significant extent, has redemption and liquidation rights limited to its issue price (plus a reasonable redemption or liquidation premium), and is not convertible into another class of stock. pp. C:8-2 through C:8-4. C:8-31 a. The affiliated group does not terminate; it merely includes T as another member. b. The affiliated group does not terminate. Even though the corporation with which P is affiliated at the beginning of the year is not affiliated with P at the end of the year, an affiliated group continues to exist if the common parent remains as the common parent and is affiliated with at least one subsidiary at the beginning of the year with which it was affiliated at the end of the prior year. In this case, P is affiliated with S at the end of the prior year and the beginning of the current year, and P is affiliated with T at the end of the current year and the beginning of the next year. c. The affiliated group does not terminate even though P was not affiliated with any corporation from April 2 through September 1. P is affiliated with S at the end of the prior year and the beginning of the current year, and P is affiliated with T at the end of the current year and the beginning of the next year. Copyright © 2024 Pearson Education, Inc.

C:8-15

d. The affiliated group terminates because P is not affiliated with any subsidiary at the end of the current year. A new affiliated group, comprised of P and T, begins its existence on January 2 of the next year. e. The affiliated group terminates because P is no longer its common parent. A new affiliated group, comprised of R, P, and S, begins its existence on June 2 of the current year. f. The P-S affiliated group terminates because P is no longer its common parent. P and S join R’s affiliated group, which continues its existence. pp. C:8-5 and C:8-6. C:8-32 a. The affiliated group must file a consolidated tax return for the current year because it has filed consolidated tax returns for the prior several years (as stated in the facts for Problem C:831). The consolidated tax return includes P’s and S’s taxable income or loss for January 1 through December 31 and T’s taxable income or loss for February 2 through December 31. T must file a separate tax return for the short period January 1 through February 1. b. The consolidated tax return includes P’s taxable income or loss for January 1 through December 31, S’s taxable income or loss for January 1 through October 1, and T’s taxable income or loss for March 2 through December 31. S must file a separate tax return for October 2 through December 31, and T must file a separate tax return for January 1 through March 1. c. The consolidated tax return includes P’s taxable income or loss for January 1 through December 31, S’s taxable income or loss for January 1 through April 1, and T’s taxable income or loss for September 2 through December 31. S must file a separate tax return for April 2 through December 31, and T must file a separate tax return for January 1 through September 1. d. The current year consolidated tax return includes P’s taxable income or loss for January 1 through December 31 and S’s taxable income or loss for January 1 through May 1. S must file a separate tax return for May 2 through December 31. T is unaffiliated with P in the current year, so T must file a separate tax return for January 1 through December 31. In the next year, P and T may elect to file a consolidated tax return but are not required to do so. e. The P-S consolidated tax return includes P’s and S’s taxable income or loss for January 1 through June 1. If the newly created R-P-S affiliated group elects to file a consolidated tax return in the current year, it will include R’s taxable income or loss for January 1 through December 31 and P’s and S’s taxable income or loss for June 2 through December 31. If the R-P-S group does not elect to file a consolidated tax return, R must file a separate tax return including its income or loss for January 1 through December 31, and P and S must each file a separate tax return including its taxable income or loss for June 2 through December 31. f. The P-S consolidated tax return includes P’s and S’s taxable income or loss for January 1 through July 1. Another consolidated tax return includes P’s and S’s taxable income or loss for July 2 through December 31 and R’s and its other wholly owned subsidiaries’ taxable income or loss for January 1 through December 31. pp. C:8-6 through C:8-8. C:8-33 The sale could have several effects on the group’s current year consolidated taxable income: 1. S1’s taxable income or loss for January 1 through September 15 must be included in current year consolidated taxable income. S1’s taxable income or loss for September 16 through December 31 must be included in its separate tax return. 2. Any deferred income, gain, deduction, or loss from intercompany transactions involving S1 may need to be included in current year consolidated taxable income under the acceleration rule. Copyright © 2024 Pearson Education, Inc.

C:8-16

3. The group must determine the amount attributable to S1 of any consolidated net operating loss carryovers, consolidated capital loss carryovers, and consolidated charitable contributions carryovers remaining after calculating current year consolidated taxable income. 4. P’s gain or loss on the sale of S1’s stock must be taken into account for current year consolidated taxable income. P’s basis in its S1 stock must be adjusted for the preceding three items. pp. C:8-6 through C:8-8, C:8-10 through C:8-12, C:8-19, C:8-20, C:8-25, C:8-26, and C:831 through C:8-33. C:8-34 a. The calendar year. S must change its tax year to the calendar year because the consolidated group files its tax return using P’s tax year. b. P and S are not required to change their accounting methods when they begin filing consolidated tax returns. P and S can continue to use the accrual method and cash method, respectively, as their overall accounting methods. However, P and S also comprise a parentsubsidiary controlled group. C corporations generally cannot use the cash method if they do not meet a $29 million gross receipts test (for 2023), and a controlled group of corporations is treated as a single entity for this purpose. c. The 2023 consolidated tax return includes P’s taxable income or loss for January 1, 2023, through December 31, 2023, and S’s taxable income or loss for August 1, 2023, through December 31, 2023. S must file a separate tax return for July 1, 2022, through June 30, 2023, and another separate return for July 1, 2023, through July 31, 2023. pp. C:8-6 through C:8-8. C:8-35 a. P and S file a consolidated tax return for the current year that includes P’s income for the entire year and S’s income for the 77 days from October 16 through December 31. Thus, consolidated taxable income for the current year is $937,600 {$876,000 + [(77 ÷ 365) × $292,000]}. S must file a separate tax return for the 288 days from January 1 through October 15 of the current year, and it will include $230,400 [(288 ÷ 365) × $292,000] of income. b. P files a separate tax return for the current year that includes all $876,000 of its income for the year. S files a separate tax return that includes all $292,000 of its income for the year. pp. C:8-6 through C:8-8. C:8-36 a. The intercompany item is S1’s $155,000 ($275,000 - $120,000) Sec. 1231 gain on the sale of the land to S2 in Year 1. The corresponding item is S2’s $125,000 ($400,000 - $275,000) Sec. 1231 gain on the sale of the land to a third party in Year 3. The recomputed corresponding item is the $280,000 ($400,000 - $120,000) Sec. 1231 gain that would be realized on the Year 3 land sale if S1 and S2 were two divisions of one corporation. b. The group includes S1’s gain in consolidated taxable income according to the matching rule, under which S1’s intercompany item is matched with S2’s corresponding item so as to reflect the group’s recomputed corresponding item in consolidated taxable income:

Recomputed corresponding item Minus: S2’s corresponding item S1’s intercompany item taken into account

Year 1

Year 3

$-0-0$-0-

$280,000 (125,000) $155,000

C:8-17

S1’s $155,000 gain is not included in consolidated taxable income until Year 3, when S2 reports its $125,000 corresponding item. Because the recomputed corresponding item is $280,000, all $155,000 of S1’s intercompany item is included in Year 3 consolidated taxable income. S2’s gain arises from a sale to a third party and not from an intercompany transaction, so it is included in Year 3 consolidated taxable income. The group can report these transactions using the following worksheet format: Consolidated Taxable Income S1’s sale to S2 in Year 1 S2’s sale to third party in Year 3 Total

Adjustments & Eliminations

S1’s Separate Reporting

-0-

$(155,000)

$155,000

280,000 $ 280,000

155,000 $ -0-

_______ $155,000

S2’s Separate Reporting

$125,000 $125,000

pp. C:8-8 through C:8-11. C:8-37 a. Intercompany item $15,000, corresponding item $5,000, recomputed corresponding item $20,000, determined as follows: Year 1: Sale price to B Minus: S’s basis Intercompany item: S’s gain

$55,000 (40,000) $15,000

Year 3: Sale price to third party Minus: B’s basis Corresponding item: B’s gain

$60,000 (55,000) $ 5,000

Sale price to third party $60,000 Minus: S’s basis (40,000) Recomputed corresponding item* $20,000 *Gain on the sale of the property in Year 3 that would be realized if S and B were two divisions of one corporation. b. S’s $15,000 gain and B’s $5,000 gain are included in Year 3 consolidated taxable income. The group includes S’s gain in consolidated taxable income according to the matching rule, under which S’s intercompany item taken into account is calculated as follows:

Recomputed corresponding item Minus: B’s corresponding item S’s intercompany item taken into account

Year 1

Year 3

$ -0-0$ -0-

$20,000 (5,000) $15,000

C:8-18

The group includes all $15,000 of S’s gain and all $5,000 of B’s gain in Year 3 consolidated taxable income. B’s gain arises from a sale to a third party and not from an intercompany transaction, so its inclusion in consolidated taxable income is not subject to the matching rule. The group can report the transactions using the following worksheet format, which includes only the transaction between S and B and the transaction between B and the third party: Consolidated Taxable Income

Adjustments & Eliminations

S’s Separate Reporting

S’s sale to B in Year 1 B’s sale to third party in Year 3

$ -020,000

$(15,000) 15,000

$15,000 -0-

Total

$20,000

$15,000

$5,000

-0-

B’s Separate Reporting -05,000

c. Intercompany item $15,000, corresponding item $(2,000), recomputed corresponding item $13,000, determined as follows: Year 1: Sale price to B Minus: S’s basis Intercompany item: S’s gain

$55,000 (40,000) $15,000

Year 3: Sale price to third party Minus: B’s basis Corresponding item: B’s loss

$53,000 (55,000) $ (2,000)

Sale price to third party Minus: S’s basis Recomputed corresponding item

$53,000 (40,000) $13,000

Under the matching rule, the group includes S’s gain in consolidated taxable income in the following manner:

Recomputed corresponding item Minus: B’s corresponding item S’s intercompany item taken into account

Year 1

Year 3

$ -0-0$ -0-

$13,000 (-2,000)* $15,000

C:8-19

As in Part b, the group includes all $15,000 of S’s gain in Year 3 consolidated taxable income, as well as B’s $2,000 loss. The group can report these transactions using the following worksheet format: Consolidated Taxable Income S’s sale to B in Year 1 $ -0B’s sale to third party in Year 3 13,000 Total $13,000

Adjustments & Eliminations $(15,000) 15,000 $ -0-

S’s Separate Reporting $15,000 -0$15,000

B’s Separate Reporting $ -0(2,000) $(2,000)

d. At the time P sells B’s stock, the consolidated group has not included any of S’s gain in its taxable income. When B sells the property to a third party in Year 3, the remaining P-S consolidated group will be unable to match S’s $15,000 gain with B’s $5,000 gain because B will no longer be a member of the group. Under the acceleration rule, the P-S-B consolidated group includes this $15,000 gain in Year 2 consolidated taxable income, immediately before B departs the group. pp. C:8-8 through C:8-12. C:8-38 a. The intercompany item is P’s $36,000 (2,400 × ($45 - $30)) capital gain on the sale of the stock to S1 in Year 1. The corresponding items are S1’s $4,200 (1,400 × ($48 - $45)) capital gain on the sale of the 1,400 shares in Year 1 and S1’s $7,000 (1,000 × ($52 - $45)) capital gain on the sale of the 1,000 shares in Year 2. The recomputed corresponding items are the $25,200 (1,400 × ($48 - $30)) capital gain on the sale of the 1,400 shares in Year 1 and the $22,000 (1,000 × ($52 - $30)) capital gain on the sale of the 1,000 shares in Year 2 that would be realized if P and S1 were two divisions of one corporation. b. The group includes P’s gain in consolidated taxable income according to the matching rule, under which P’s intercompany item is matched with S1’s corresponding item so as to reflect the group’s recomputed corresponding item in consolidated taxable income:

Recomputed corresponding item Minus: S1’s corresponding item P’s intercompany item taken into account

Year 1

Year 2

$25,200 (4,200) $21,000

$22,000 (7,000) $15,000

The group includes $21,000 of P’s $36,000 gain in Year 1 consolidated taxable income and includes the remaining $15,000 in Year 2, as S1 reports its corresponding items of $4,200 in Year 1 and $7,000 in Year 2. S1’s gains arise from sales to third parties and not from intercompany transactions, so their inclusion in consolidated taxable income is not subject to the matching rule. The group can report the transactions using the following worksheet format:

C:8-20

P’s sale to S1 and S1’s sale to third party in Year 1 S1’s sale to third party in Year 2 Total a

Consolidated Taxable Income

Adjustments & Eliminations

P’s Separate Reporting

S1’s Separate Reporting

$25,200

$( 15,000)a

$36,000

$ 4,200

22,000 $47,200

15,000a $ -0-

_______ $36,000

7,000 $11,200

P’s $36,000 intercompany item minus $21,000 of it taken into account in Year 1.

An alternative way of obtaining this answer is to recognize that the group will defer inclusion of P’s gain until the years S1 sells the stock to third parties. Thus, the group will include $21,000 (1,400 shares × ($45 - $30)) of P’s gain in Year 1 consolidated taxable income and $15,000 (1,000 × ($45 - $30)) of P’s gain in Year 2 consolidated taxable income. c. When P sells S1’s stock, the consolidated group has included in its taxable income under the matching rule only $21,000 of P’s $36,000 gain and has not included the other $15,000. When S1 sells the 1,000 shares to a third party in Year 2, the P-S2 consolidated group will be unable to match S1’s $7,000 gain with P’s $15,000 gain because S1 will not be a member of the group. Under the acceleration rule, the P-S1-S2 consolidated group must include this $15,000 gain in Year 1 consolidated taxable income, immediately before S1 departs the group. The group thus includes all $36,000 of S1’s gain in its Year 1 consolidated taxable income ($21,000 under the matching rule and $15,000 under the acceleration rule). d. S1’s Year 2 corresponding item is now a $1,000 capital loss (1,000 × ($44 - $45)), and the Year 2 recomputed corresponding item is now a $14,000 capital gain (1,000 × ($44 - $30)). P’s intercompany item is the same $36,000 capital gain as in Parts a and b, S1’s Year 1 corresponding item is the same $4,200 capital gain as in Parts a and b, and the group’s Year 1 recomputed corresponding item is the same $25,200 capital gain as in Parts a and b. Under the matching rule, the group includes P’s gain in consolidated taxable income in the following manner:

Recomputed corresponding item Minus: S1’s corresponding item P’s intercompany item taken into account

Year 1

Year 2

$25,200 (4,200) $21,000

$14,000 (-1,000)* $15,000

*Because S1’s Year 2 corresponding item is a $1,000 capital loss, a negative $1,000 is subtracted, which is equivalent to adding $1,000.

C:8-21

As in Part b, the group includes $21,000 of P’s $36,000 gain in Year 1 consolidated taxable income, and it includes the other $15,000 in Year 2 consolidated taxable income. The group can report these transactions using the following worksheet format: Consolidated Taxable Income

Adjustments & Eliminations

P’s Separate Reporting

S1’s Separate Reporting

P’s sale to S1 and S1’s sale to third party in Year 1 $ 25,200 $(15,000)* $36,000 $ 4,200 S1’s sale to third party in Year 2 14,000 15,000* _______ (1,000) Total $39,200 $ -0$36,000 $ 3,200 *P’s $36,000 intercompany item minus $21,000 of it taken into account in Year 1. pp. C:8-8 through C:8-13. C:8-39 a. The intercompany item is P’s $40,000 ($60,000 - $20,000) gain on the sale of the land to S in Year 3. When S sells the land to Z, it realizes a $120,000 ($180,000 - $60,000) gain. Assuming the installment method applies (see Chapter I:11), S’s gross profit percentage is 66.667% ($120,000 ÷ $180,000). S receives $36,000 in each of Years 7 through 11, so S reports $24,000 ($36,000 × 66.667%) of gain in each of those years. Each of these $24,000 amounts is a corresponding item. If P and S were two divisions of one corporation, the gain realized on the land sale to Z would be $160,000 ($180,000 - $20,000). Assuming the installment method applies, the gross profit percentage would be 88.889% ($160,000 ÷ $180,000), and $32,000 ($36,000 × 88.889%) of gain would be reported in each of Years 7 through 11. Each of these $32,000 amounts is a recomputed corresponding item. b. $8,000 of P’s gain and $24,000 of S’s gain in each of Years 7 through 11. P’s $40,000 gain is not included in consolidated taxable income until S reports a corresponding item related to it. In each of Years 7 through 11, S reports a $24,000 corresponding item. The recomputed corresponding item is $32,000 in each of those years, so the group includes $8,000 ($32,000 $24,000) of P’s gain in consolidated taxable income in each of Years 7 through 11 under the matching rule. c. S includes the income earned on the installment sale to Z in its separate reporting. The timing of the interest income recognition depends on the accounting method that S uses (e.g., cash or accrual). The interest income is not an intercompany item because it pertains to a transaction with a non-group member, so it is included in consolidated taxable income when S reports it. pp. C:8-8 through C:8-14. C:8-40 a. For S1’s gain, the group includes in its consolidated taxable income $28,261 in Year 3, $22,609 in Year 4, and $14,130 in Year 5. For P’s gain, the group includes in its consolidated taxable income $6,522 in Year 3, $5,217 in Year 4, and $3,261 in Year 5. S1’s intercompany item is its $65,000 ($100,000 – $35,000) gain on the sale of land to P in Year 1. When P sells the land to the third party in Year 3, it realizes a $15,000 ($115,000 $100,000) gain. Assuming the installment method applies (see Chapter I:11), P’s gross profit percentage is 13.0435% ($15,000 ÷ $115,000), and P reports the gain as follows: Copyright © 2024 Pearson Education, Inc.

C:8-22

Year 3: $50,000 × 13.0435% = $ 6,522 Year 4: $40,000 × 13.0435% = 5,217 Year 5: $25,000 × 13.0435% = 3,261 $15,000 Each of these amounts is a corresponding item, and the group includes them in consolidated taxable income as P reports them. If P and S1 were two divisions of a single corporation, the gain realized on the Year 3 land sale to the third party would be $80,000 ($115,000 - $35,000). Assuming the installment method applies, the gross profit percentage would be 69.5652% ($80,000 ÷ $115,000), so the single corporation would report the gain as follows: Year 3: $50,000 × 69.5652% = $34,783 Year 4: $40,000 × 69.5652% = 27,826 Year 5: $25,000 × 69.5652% = 17,391 $80,000 Each of these amounts is a recomputed corresponding item. To determine the portion of S1’s $65,000 gain included in consolidated taxable income each year, the consolidated group applies the matching rule, thereby subtracting the corresponding item from the recomputed corresponding item each year as follows: Year 3: $34,783 - $6,522 = $28,261 Year 4: $27,826 - $5,217 = 22,609 Year 5: $17,391 - $3,261 = 14,130 $65,000 The total amount of S1’s gain and P’s gain the group includes in consolidated taxable income is as follows: Year 3: $28,261 + $6,522 = $34,783 Year 4: $22,609 + $5,217 = 27,826 Year 5: $14,130 + $3,261 = 17,391 $80,000 b. When P sells S1’s stock, the group has included in its consolidated taxable income only $50,870 ($28,261 + $22,609) of S1’s gain from the intercompany transaction. P’s sale of the S1 stock triggers the acceleration rule because it can no longer match P’s corresponding items with S1’s remaining intercompany item, so the group includes in its Year 4 consolidated taxable income the remaining $14,130 ($65,000 - $50,870) of S1’s intercompany item. c. For S1’s gain, the group includes in its consolidated taxable income $39,783 in Year 3, $27,826 in Year 4, and $17,391 in Year 5. For P’s loss, the group includes in its consolidated taxable income all $5,000 of the loss in Year 3. S1’s intercompany item is its $85,000 ($120,000 - $35,000) gain on the land’s sale to P in Year 1. P’s corresponding item is the $5,000 ($115,000 - $120,000) loss it realizes when it sells the land to the third party in Year 3. P reports the entire loss in Year 3 because the installment method does not apply to losses. The recomputed corresponding items are the same as in Part a: $34,783 in Year 3, $27,826 in Year 4, and $17,391 in Year 5. The group applies the matching rule and includes S1’s gain in its consolidated taxable income as follows: Copyright © 2024 Pearson Education, Inc.

C:8-23

Year 3: $34,783 - (-$5,000)* Year 4: $27,826 - $0* Year 5: $17,391 - $0*

= $39,783 = 27,826 = 17,391 $85,000

The corresponding items subtracted are P’s $5,000 loss in Year 3 and $0 gain or loss in Years 4 and 5. The total amount of S1’s gains and P’s loss the group includes in consolidated taxable income is $80,000, calculated as follows: Year 3: $39,783 - $5,000 Year 4: $27,826 + $0 Year 5: $17,391 + $0

= $34,783 = 27,826 = 17,391 $80,000

pp. C:8-8 through C:8-14. C:8-41 A $5,000 reduction in consolidated taxable income. Because P and S file a consolidated tax return, the transaction is an intercompany transaction. The intercompany item is S’s $1,000 ($6,000 - $5,000) profit from providing the cleaning services to P, the corresponding item is P’s $6,000 cleaning services expense, and the recomputed corresponding item is the $5,000 of expenses the group incurs when providing the intercompany services. Under the matching rule, the group matches all $1,000 [-$5,000 - (-$6,000)] of S’s profit with P’s $6,000 expense, so the net effect on the group’s consolidated taxable income is -$5,000 ($1,000 - $6,000). S’s $6,000 revenue and P’s $6,000 expense are not eliminated in the tax consolidation process, but they offset each other when computing consolidated taxable income. pp. C:8-8 through C:8-10, and C:8-15. C:8-42 P’s intercompany items are its interest income of $12,500 ($250,000 x 0.12 x 5/12) in Year 1 and $17,500 ($250,000 × 0.12 × 7/12) in Year 2. S’s corresponding items are its interest expense of $12,500 in Year 1 and $17,500 in Year 2. The recomputed corresponding items are zero in Years 1 and 2 because no income or deduction would result from the intercompany loan if P and S were two divisions of a single corporation. Under the matching rule, the group matches P’s $12,500 ($0 recomputed corresponding item minus -$12,500 corresponding item) of interest income with S’s $12,500 of interest expense in Year 1, and it matches P’s $17,500 ($0 recomputed corresponding item minus -$17,500 corresponding item) of interest income with S’s $17,500 of interest expense in Year 2. The interest income and interest expense offset one another in determining consolidated taxable income. pp. C:8-8 through C:8-12, and C:8-15. C:8-43 The transaction is an intercompany transaction because P and S are members of the same consolidated group immediately after the transaction. S’s intercompany item is the $120,000 ($10,000 × 12) of rental income it earned from renting the warehouse to P. P’s corresponding item is the $120,000 of rental expense it incurred from renting the warehouse from S. The recomputed corresponding item is zero because the transaction is wholly within the group and not with a third party. Under the matching rule, the group matches S’s $120,000 of rental income with P’s $120,000 of rental expense. The rental income and rental expense offset one another in determining consolidated taxable income. pp. C:8-8 through C:8-12, and C:8-15. Copyright © 2024 Pearson Education, Inc.

C:8-24

C:8-44 a. The intercompany item is S’s $600 ($5,000 - $4,400) profit from drilling the well. The corresponding items are B’s $1,000 ($5,000 ÷ 5 years) deductions in each of Years 2 through 6. The recomputed corresponding items are the $880 ($4,400 ÷ 5 years) deductions in each of Years 2 through 6 that would arise if S and B were two divisions of one corporation. b. The consolidated group includes $120 of S’s profit and deducts B’s $1,000 expense for its consolidated taxable income for each of Years 2 through 6. The group includes S’s profit in consolidated taxable income according to the matching rule, under which S’s intercompany item is matched with B’s corresponding items so as to reflect the group’s recomputed corresponding items in consolidated taxable income in each year:

Recomputed corresponding item* Minus: B’s corresponding item* S’s intercompany item taken into account

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

$ -0-

$(880)

-0-

(-1,000)

$ -0-

$ 120

The recomputed corresponding items and corresponding items for Years 2 through 6 are negative because they are deduction items. In each of Years 2 through 6, the group includes in its consolidated taxable income $120 of S’s profit and B’s $1,000 expense. The net result is an $880 ($120 - $1,000) reduction in consolidated taxable income, which equals the recomputed corresponding item. The group can report the transactions using the following worksheet format for each year:

S’s profit in Year 1 B’s deduction in: Year 2 Year 3 Year 4 Year 5 Year 6 Total

Consolidated Taxable Income $ -0-

Adjustments & Eliminations $(600)

S’s Separate Reporting $600

B’s Separate Reporting $ -0-

(880) (880) (880) (880) (880) $(4,400)

120 120 120 120 120 $ -0-

-0-0-0-0-0$600

(1,000) (1,000) (1,000) (1,000) (1,000) $(5,000)

pp. C:8-8 through C:8-11, and C:8-16.

C:8-25

C:8-45 $65,000 for Year 1 and $322,000 for Year 2. The intercompany items are P’s $75,000 and $240,000 profits on its inventory sales to S in Years 1 and 2. The corresponding items are S’s profits on reselling the inventory items it purchased from P. These profits are $25,000 in Year 1 and $127,000 ($22,000 + $105,000) in Year 2. The recomputed corresponding items are the group’s total profits when S sells the inventory items to third parties. These total profits are $65,000 ($40,000 + $25,000) in Year 1 and $322,000 ($35,000 + $22,000 + $160,000 + $105,000) in Year 2. Under the matching rule, the P-S group includes $40,000 ($65,000 - $25,000) of P’s intercompany inventory profits in its Year 1 consolidated taxable income, and it includes $195,000 ($322,000 - $127,000) of P’s intercompany inventory profits in its Year 2 consolidated taxable income. The following table summarizes these results: Year 1 $65,000 (25,000) $40,000

Recomputed corresponding item Minus: S’s corresponding item P’s intercompany item taken into account

Year 2 $322,000 (127,000) $195,000

The group can report these transactions using the following worksheet format:

P’s sales to S and S’s sales to third parties in Year 1 P’s sales to S and S’s sales to third parties in Year 2 Total

Consolidated Taxable Income

Adjustments & Eliminations

P’s Separate Reporting

S’s Separate Reporting

$ 65,000

$(35,000)a

$ 75,000

$ 25,000

35,000b 322,000 (80,000)b 240,000 127,000 $387,000 $(80,000) $315,000 $152,000 a P’s $75,000 intercompany item minus $40,000 taken into account in Year 1. b Net $(45,000): P’s $240,000 intercompany item minus $195,000 taken into account in Year 2. An alternative way of obtaining this answer is to recognize that the group will defer inclusion of P’s intercompany inventory profits in consolidated taxable income from the year of the intercompany sale to the year S sells the inventory to third parties. Thus, the group will defer $35,000 from Year 1 to Year 2 and will defer $80,000 from Year 2 to Year 3, as shown in the following table:

Consolidated taxable income before adjusting for profits on intercompany inventory sales Adjustments for P’s deferred profits on sales to S: Inventory sold to S in Year 1 Inventory sold to S in Year 2 Consolidated taxable income

Year 1

Year 2

$100,000

$367,000

(35,000) ________ $ 65,000

35,000 (80,000) $322,000

C:8-26

Assuming S sells to third parties in Year 3 the items in its inventory at the end of Year 2, the P-S group makes a positive $80,000 adjustment when determining its Year 3 consolidated taxable income. pp. C:8-8 through C:8-12 and C:8-16 through C:8-18. C:8-46 $985,000 for Year 1, $1,610,000 for Year 2, and $700,000 for Year 3. The intercompany items are S’s $400,000 (50,000 x $8) and $720,000 (80,000 x $9) profits on its inventory sales to P in Years 1 and 2. The corresponding items are P’s profits on reselling the inventory items it purchased from S. These profits are $225,000 (37,500 x $6) in Year 1, $465,000 [(12,500 + 65,000) x $6] in Year 2, and $105,000 (15,000 x $7) in Year 3. The recomputed corresponding items are the group’s total profits when P sells the inventory items to third parties. These total profits are calculated as follows: Year 1: 37,500 x ($8 + $6)

$ 525,000

Year 2: 12,500 x ($8 + $6) 65,000 x ($9 + $6) Total for Year 2

$ 175,000 975,000 $ 1,150,000

Year 3: 15,000 x ($9 + $7)

$ 240,000

Under the matching rule, the P-S group includes $300,000 of S’s intercompany inventory profits in its Year 1 consolidated taxable income, it includes $685,000 of S’s intercompany inventory profits in its Year 2 consolidated taxable income, and it includes $135,000 of S’s intercompany profit in its Year 3 consolidated taxable income. The following table calculates these results:

Recomputed corresponding item Minus: P’s corresponding item S’s intercompany item taken into accounta

Year 1

Year 2

Year 3

$525,000 (225,000) $300,000

$1,150,000 (465,000) $ 685,000

$240,000 (105,000) $135,000

These amounts also can be calculated as follows: Year 1, 37,500 x $8 = $300,000; Year 2, (12,500 x $8) + (65,000 x $9) = $685,000; Year 3, 15,000 x $9 = $135,000. The group can report these transactions using the following worksheet format for each year:

C:8-27

Year 1 Profit (loss) from other bus. activities in Year 1 S’s sales to P and P’s sales to third parties in Year 1 Total for Year 1 a

Profit (loss) from other bus. activities in Year 2 S’s sales to P and P’s sales to third parties in Year 2 Total for Year 2

P’s Separate Reporting

S’s Separate Reporting

$(40,000)

$500,000

225,000 $185,000

400,000 $900,000

$460,000 $(100,000)a $(100,000)

525,000 $985,000

Consolidated Taxable Income

Adjustments & Eliminations

P’s Separate Reporting

S’s Separate Reporting

$ (40,000)

$ 500,000

465,000 $425,000

720,000 $1,220,000

$ 460,000 a

$ 100,000 (135,000)a $ (35,000)

1,150,000 $1,610,000

Net $(35,000): S’s $720,000 intercompany item minus $685,000 taken into account in Year 2.

Year 3 Profit (loss) from other bus. activities in Year 3 P’s sales to third parties in Year 3 Total for Year 3 a

Adjustments & Eliminations

S’s $400,000 intercompany item minus $300,000 taken into account in Year 1.

Year 2

Consolidated Taxable Income

Adjustments & Eliminations

P’s Separate Reporting

S’s Separate Reporting

$ (40,000)

$500,000

$105,000 $ 65,000

-0$500,000

$460,000 240,000 $700,000

$135,000a $135,000

S’s intercompany item taken into account in Year 3.

An alternative way of obtaining this answer is to recognize that the group will defer inclusion of S’s intercompany inventory profits in consolidated taxable income from the year of the intercompany sale to the year P sells the inventory to third parties. Thus, the group will defer $100,000 from Year 1 to Year 2 and will defer $135,000 from Year 2 to Year 3, as shown in the following table:

C:8-28

Year 1 Consolidated taxable income before adjusting for profits on intercompany inventory sales Adjustments for S’s deferred profits on sales to P: Inventory sold to P in Year 1 Inventory sold to P in Year 2 Consolidated taxable income

Year 2

Year 3

$ 1,085,000a

$ 1,645,000b

565,000c

(100,000)d _________ $ 985,000

100,000d (135,000)e $1,610,000

135,000e $ 700,000

$500,000 - $40,000 + $400,000 + $225,000 = $1,085,000. $500,000 - $40,000 + $720,000 + $465,000 = $1,645,000. c $500,000 - $40,000 + $105,000 = $565,000. d 12,500 units x $8 per unit = $100,000. e 15,000 units x $9 per unit = $135,000. b

pp. C:8-8 through C:8-12 and C:8-16 through C:8-18. C:8-47 a. Consolidated taxable income is $293,600, calculated as follows: Consolidated adjusted taxable income = $334,000 = ($200,000 - $30,000) + $150,000 + $10,000 + $4,000. Charitable contributions deduction before limitation = $50,000 = $45,000 + $5,000 Charitable contributions deduction limitation = $33,400 = 10% x $334,000 Charitable contributions deduction = $33,400 = lesser of $50,000 or $33,400 Dividends-received deduction before limitation = $7,000 = 50% x ($10,000 + $4,000) Dividends-received deduction limitation = $150,300 = 50% x ($334,000 - $33,400) Dividends-received deduction = $7,000 = lesser of $7,000 or $150,300 Consolidated taxable income = $293,600 = $334,000 - $33,400 - $7,000 b. Consolidated charitable contributions carryover = $16,600 = $50,000 - $33,400. The group can carry over the $16,600 for five years, subject to limitations in carryover years. Excess charitable contributions do not carry back. c. Consolidated regular tax liability = $61,656 = $293,600 x 0.21 pp. C:8-19 through C:8-22. C:8-48 a. Taxable income is $305,100 for Mobile, $195,800 for Newark, and $100,000 for Omaha, calculated as follows: Mobile:

Net Sec. 1231 gain = $6,000 = $18,000 - $12,000; treated as a long-term capital gain under the Sec. 1231 rules Capital gain net income = $5,100 = $3,500 - $2,000 + $0 - $2,400 + $6,000 Taxable income = $305,100 = $300,000 + $5,100

C:8-29

Newark:

Net Sec. 1231 loss = ($5,000) = $9,000 - $14,000; treated as an ordinary loss under the Sec. 1231 rules Capital gain net income = $800 = $0 - $0 + $8,100 - $7,300 Taxable income = $195,800 = $200,000 - $5,000 + $800

Omaha:

Net Sec. 1231 gain = $0 Net capital loss = $700 = $0 - $6,200 + $5,500 - $0; not deductible in current year but carries back three years and forward five years Taxable income = $100,000

b. $600,200 consolidated taxable income, calculated as follows: Consolidated net Sec. 1231 gain = $1,000 = $27,000 - $26,000; treated as a long-term capital gain under the Sec. 1231 rules Consolidated capital gain net income = $200 = $3,500 - $8,200 + $13,600 - $9,700 + $1,000 Consolidated taxable income = $600,200 = $600,000 + $200 Note that this $600,200 is $700 less than the $600,900 ($305,100 + $195,800 + $100,000) sum of the taxable incomes in Part a. By filing a consolidated tax return, the group deducts Omaha’s $700 net capital loss against the other members’ capital gain net incomes. Thus, the group has no capital loss carryback or carryover. pp. C:8-19 and C:8-20, and Chapter I:13. C:8-49 a. Taxable income is $88,100 for Alpha and $70,000 for Beta, calculated as follows: Alpha:

Capital gain net income = $8,100 = $20,000 - $11,900 Taxable income = $88,100 = $80,000 + $8,100

Beta:

Net capital loss = ($2,000) = $15,000 - $17,000; not deductible in current year but carries back three years and over five years Taxable income = $70,000

The intercompany transaction rules do not defer taxation of Alpha’s $4,400 gain on its transaction with Beta because the two corporations do not file a consolidated tax return. b. Consolidated taxable income is $151,700, determined as follows: Consolidated capital gain net income = $1,700 = ($35,000 - $4,400) - $28,900. Under the matching rule, the group does not take into account in the current year Alpha’s $4,400 gain from its intercompany transaction with Beta. Thus: Consolidated taxable income = $151,700 = $150,000 + $1,700. Note that this $151,700 is $6,400 less than the $158,100 ($88,100 + $70,000) sum of the taxable incomes in Part a. By filing a consolidated tax return, the group deducts Beta’s $2,000 net capital loss against Alpha’s capital gain net income. Thus, the group has no capital loss carryback or carryover. In addition, the group defers taxation on Alpha’s $4,400 gain. pp. C:8-19 and C:8-20. Copyright © 2024 Pearson Education, Inc.

C:8-30

C:8-50 a. $65,000 of dividend income. The P-S-T group excludes from its taxable income the $125,000 dividend that P receives from T because the dividend apparently will reduce P’s basis for its T stock. The group includes the other three dividends in its consolidated taxable income. Therefore, P, S, and T include $65,000 ($15,000 + $40,000 + $10,000) of dividends in consolidated taxable income. b. $51,000 dividends-received deduction. P’s dividend from the 100%-owned nonconsolidated U.S.-based life insurance company qualifies for a 100% dividends-received deduction. S’s dividend from the 25%-owned domestic corporation qualifies for a 65% dividendsreceived deduction. P’s dividend from the 51%-owned foreign corporation qualifies for a 100% dividends-received deduction under Sec. 245A (see Chapter C:3). The total dividends received deduction is $51,000 [($15,000 × 100%) + ($40,000 × 65%) + ($10,000 × 100%)]. c. Consolidated taxable income = $319,000 = $200,000 + $(70,000) + $175,000 + $65,000 - $51,000. Consolidated regular tax liability = $66,990 = $319,000 × 0.21. Note: The P-S-T group may have some global intangible low-taxed income (GILTI) from the foreign corporation because P owns at least 10% of its stock (this topic is beyond the scope of the text). The solution assumes that there is zero GILTI. pp. C:8-20 through C:8-22. C:8-51 a. Total tax is $16,800 whether filing separate returns or a consolidated return. If Miami and Tampa file separate tax returns, Miami’s tax liability is $10,500 ($50,000 × 0.21), and Tampa’s tax liability is $6,300 ($30,000 × 0.21). Their total tax liability is $16,800 ($10,500 + $6,300). If Miami and Tampa file a consolidated tax return, their consolidated taxable income is $80,000 ($50,000 + $30,000), and their consolidated tax liability is $16,800 ($80,000 × 0.21). b. Total tax is $14,700 if filing separate returns and $11,550 if filing a consolidated tax return. If Miami and Tampa file separate tax returns, Miami’s tax liability is $14,700 ($70,000 × 0.21), and Tampa’s tax liability is zero (because it has a loss). Their total tax liability is $14,700 ($14,700 + $0). Tampa, however, can carry over its NOL subject to the 80% of taxable income limitation in the carryover year. If Miami and Tampa file a consolidated tax return, their consolidated taxable income is $55,000 [$70,000 + $(15,000)], and their consolidated tax liability is $11,550 ($55,000 × 0.21). The consolidated tax liability thus is $3,150 ($14,700 – $11,550) less if they file a consolidated tax return rather than separate tax returns, which is the group’s $3,150 ($15,000 × 0.21) benefit of deducting Tampa’s loss against Miami’s profits currently on a consolidated tax return rather than Tampa carrying over its loss from a separate tax return. p. C:8-25. C:8-52 a. The group’s federal tax liability is $12,000. Its regular tax is $63,000 (0.21 × $300,000), and its general business credit limitation is calculated as follows: Regular tax Minus: Credits allowed under Secs. 21-30D Net income tax Minus: 25% of net tax exceeding $25,000 [0.25 × ($63,000 – $25,000)] General business credit limitation

$63,000 -0$63,000 (9,500) $53,500

C:8-31

The group can claim all $51,000 of the general business credit because it is less than the $53,500 limitation. Its federal tax liability is $12,000 ($63,000 – $51,000). b. The group has no unused general business credit, so it has no credit carryovers. If its general business credit limitation had been $50,000 rather than $53,500, it would have a $1,000 ($51,000 – $50,000) unused general business credit, which it would carry back one year and over 20 years. pp. C:8-22 and C:8-23. C:8-53 $4,000 in Year 3 and $6,000 in Year 4. Because the NOL arose in a post-2020 year, the group carries over indefinitely the Year 2 NOL and does not carry back any of it to Year 1. S’s Year 1 loss merely offsets part of P’s income when calculating Year 1 consolidated taxable income; S’s loss does not carry over to another year. Year 3: The group has all $10,000 of its Year 2 NOL available, but its Year 3 NOL deduction limitation is $4,000 (0.80 × $5,000). The group deducts $4,000 of the Year 2 NOL, making its Year 3 consolidated taxable income $1,000 ($5,000 – $4,000). Year 4: The group has $6,000 ($10,000 – $4,000 used in Year 3) of its Year 2 NOL available, and its Year 4 NOL deduction limitation is $21,600 (0.80 × $27,000). The group deducts the remaining $6,000 of the Year 2 NOL, making Year 4 consolidated taxable income $21,000 ($27,000 – $6,000). pp. C:8-24 and C:8-25. C:8-54 The group first carries over the $70,000 NOL to Year 2, offsetting $30,400 (0.80 × $38,000) of the group’s consolidated taxable income that year. This treatment leaves $39,600 ($70,000 - $30,400) of NOL carryover to be allocated between the P-S1 consolidated group and S2. The group allocates the NOL to S2 as follows: $28,000 S2’s Year 1 separate NOL $70,000 total Year 1 separate NOLs

x $39,600 NOL carryover = $15,840 allocated to S2

The group allocates the remaining $23,760 ($39,600 - $15,840) NOL to the P-S1 consolidated group to be used in its consolidated tax returns for Year 3 and later years. S2 uses $12,800 (0.80 × $16,000) of its allocated amount in its Year 2 separate return, and $3,040 ($15,840 - $12,800) carries over to S2’s Year 3 separate return. The consolidated group’s and S2’s allocated NOLs carry over indefinitely. pp. C:8-25 and C:8-26. C:8-55 a. If the affiliated group files a consolidated tax return in Year 2, the group combines P’s $30,000 loss and S’s $20,000 of income, resulting in a $10,000 consolidated NOL. The 80% limitation on the NOL deduction does not apply to this combining within consolidated taxable income. The group carries over indefinitely this $10,000 NOL. S’s Year 1 NOL cannot be used to offset P’s Year 1 taxable income because the corporations do not file a consolidated tax return that year. The P-S group cannot use any of S’s Year 1 NOL in Year 2 because the group has a NOL in Year 2. If P and S file separate tax returns in Year 2, P carries over indefinitely its $30,000 NOL. S can deduct $16,000 (0.80 × $20,000) of its Year 1 NOL in Year 2, making its Year 2 taxable income $4,000 ($20,000 - $16,000). The remaining $13,000 ($29,000 - $16,000) Year 1 NOL Copyright © 2024 Pearson Education, Inc.

C:8-32

carries over to Year 3. If P and S continue to be affiliated, the group can elect to file a consolidated tax return in Year 3, even if it did not so elect in Year 2. b. S’s $29,000 NOL from Year 1 is a SRLY loss. S’s cumulative SRLY register for the Year 3 SRLY limitation is $26,000: $0 at the beginning of Year 2 + S’s $20,000 Year 2 profit + S’s $6,000 Year 3 profit. (As noted in the solution for part a, the P-S group cannot use any of S’s Year 1 NOL in Year 2 because the group has a NOL in Year 2.) Under the SRLY rules, the loss can offset in Year 3 the lesser of S’s SRLY limitation, $20,800 (0.80 x $26,000); 80% of consolidated taxable income computed without regard to the NOL deduction, $21,600 (0.80 × $27,000); or the remaining NOL carryover, $29,000. Thus, the P-S group deducts for Year 3 $20,800 of S’s Year 1 NOL, and the remaining $8,200 ($29,000 - $20,800) of S’s NOL carries over to Year 4. S’s cumulative SRLY register at the end of Year 3 is zero [$26,000 – (1.25 x $20,800)]. The $10,000 Year 2 consolidated NOL is also available for the group to use in Year 3, and its use is not subject to the SRLY limitation. The group’s Year 3 NOL deduction, however, is limited to $21,600 (0.80 x $27,000), and the $20,800 deduction for S’s Year 1 NOL is taken into account before the group’s Year 2 NOL because NOLs are used on a first-in, first-out (FIFO) basis. The group thus deducts for Year 3 $800 ($21,600 - $20,800) of its Year 2 consolidated NOL and carries over to Year 4 the remaining $9,200 ($10,000 - $800) of it. Year 3 consolidated taxable income is $5,400 ($27,000 - $20,800 - $800). pp. C:8-25 through C:8-31. C:8-56 a. $40,816 NOL available for S2’s Year 3 separate tax return. S2’s intercompany item is the $15,000 ($90,000 - $75,000) gain on its Year 1 land sale to S1. S1’s sale of the land in Year 2 creates a $1,000 ($91,000 - $90,000) corresponding item and a $16,000 ($91,000 - $75,000) recomputed corresponding item that year. Thus, the group includes in its Year 2 consolidated taxable income all $15,000 ($16,000 - $1,000) of S2’s intercompany item under the matching rule. The group’s Year 2 consolidated NOL is $80,000 (-95,000 + $15,000). The group does not use any of this NOL in Year 3 because it has a net loss that year, so the fraction of the Year 2 consolidated NOL apportioned to S2 carries over to S2’s Year 3 separate tax return. The group members’ separate Year 2 NOLs sum to $245,000: zero for P, $120,000 for S1, and $125,000 (-$140,000 + $15,000) for S2. S1’s Year 2 reported taxable loss includes the $1,000 gain from selling the land to the third party. Of the $80,000 consolidated NOL, the group apportions $40,816 ($80,000 × ($125,000 ÷ $245,000)) to S2. This amount is available to S2 on its Year 3 separate tax return. b. $51,154 NOL available for S2’s Year 3 separate tax return. As in Part a, S2’s intercompany item is its $15,000 gain, S1’s corresponding item is its $1,000 gain, and the recomputed corresponding item is the $16,000 gain. However, the $1,000 and $16,000 gains now occur in Year 3. The group’s Year 2 consolidated NOL is now $95,000. The group does not use any of this NOL in Year 3 because it has a $28,000 (-$43,000 + $15,000) net loss that year, so the fraction of the Year 2 consolidated NOL apportioned to S2 carries over to S2’s Year 3 separate tax return. The group members’ separate NOLs sum to $260,000: zero for P, $120,000 for S1, and $140,000 for S2. Of the $95,000 consolidated NOL, the group apportions $51,154 ($95,000 × ($140,000 ÷ $260,000)) to S2. This amount is available to S2 on its Year 3 separate tax return. pp. C:8-8 through C:8-12, C:8-25, and C:8-26. C:8-57 Consolidated taxable income (CTI) is $110,000 for Year 2, $86,600 for Year 3, $3,800 for Year 4, and $99,600 for Year 5. Copyright © 2024 Pearson Education, Inc.

C:8-33

Each year, the amount of S’s Year 1 NOL the P-S group can deduct equals the lesser of (1) the SRLY limitation, (2) 80% of CTI before any NOL deduction, or (3) the amount of the NOL carryover that has not been previously deducted: Year 2

Year 3

Year 4

Year 5

-0-

$(15,000)

-0-

$ 16,000

(15,000) $(15,000)

18,000 $ 3,000

35,000 $ 35,000

45,000 $ 61,000

-0$(15,000)

(3,000) $ -0-

(19,000) $ 16,000

(56,750) $ 4,250

$(15,000) x 0.80 $ -0$ 88,000a $ 63,000

$ 3,000 x 0.80 $ 2,400 $ 71,200b $ 63,000

$ 35,000 x 0.80 $ 28,000 $ 15,200c $ 60,600d

$ 61,000 x 0.80 $ 48,800 $116,000e $ 45,400f

S’s NOL the group deducts [lesser of (1), (2), or (3)] Times: 125% Reduction in cumulative SRLY register

$ x $

-01.25 -0-

$ 2,400 x 1.25 $ 3,000

$ 15,200 x 1.25 $ 19,000

$ 45,400 x 1.25 $ 56,750

Consolidated taxable income: CTI before any NOL deduction Minus: NOL deduction CTI

$110,000 -0$110,000

$ 89,000 2,400 $ 86,600

$19,000 15,200 $ 3,800

$145,000 45,400 $ 99,600

S’s cumulative SRLY register: Register at the beginning of the year Plus: S’s current year taxable income (subtract if current year loss) Register for the SRLY limitation Minus: 125% of S’s Year 1 NOL the group absorbs in the current year (see below) Register at the end of the current year Group’s deduction of S’s NOL and reduction in cumulative SRLY register: S’s cumulative SRLY register for the SRLY limitation Times: 80% (1) SRLY limitation (not less than zero) (2) 80% of CTI before any NOL deduction (3) S’s Year 1 NOL not previously deducted

0.80 x $110,000 0.80 x $89,000 c 0.80 x $19,000 d $63,000 - $2,400 e 0.80 x $145,000 f $60,600 - $15,200 b

C:8-34

C:8-58 a. Year 2 consolidated taxable income (CTI) is $36,700. The group must use S2’s $10,000 loss to offset P’s and S1’s Year 2 taxable incomes. P’s Year 1 NOL is not a SRLY loss because the SRLY rules generally do not apply to a consolidated group’s parent corporation, so the $7,700 offsets a portion of Year 2 CTI. S1’s and S2’s Year 1 NOLs are SRLY losses. The Year 2 SRLY limitations for their NOLs are determined as follows: Cumulative SRLY register at the beginning of Year 2 Plus: Year 2 taxable income (subtract if Year 2 loss) Cumulative SRLY register for the SRLY limitation Year 2 SRLY limitation (not less than zero)

S1 Corp. $ -022,000 $22,000 x 0.80 $17,600

S2 Corp. $ -0(10,000) $(10,000) x 0.80 $ -0-

In Year 2, the group can use $17,600 of S1’s Year 1 NOL (lesser of S1’s $23,200 NOL carryover or S1’s $17,600 SRLY limitation). The group cannot use any of S2’s Year 1 NOL because of its $0 SRLY limitation. The group’s use of P’s $7,700 Year 1 NOL and $17,600 of S1’s Year 1 NOL also is limited to 80% of the group’s CTI before the NOL deduction, but this $49,600 (0.80 x $62,000) is greater than the $25,300 total NOL. Thus, Year 2 CTI is $36,700 ($62,000 - $25,300). The cumulative SRLY registers at the end of Year 2 are zero [$22,000 - (1.25 x $17,600)] for S1 and -$10,000 for S2. b. Year 3 CTI is $3,000. The NOL carryovers available to the group in Year 3 are $5,600 ($23,200 NOL for Year 1 - $17,600 the group used in Year 2) for S1 and $15,700 for S2. The Year 3 SRLY limitations are as follows: Cumulative SRLY register at the beginning of Year 3 Plus: Year 3 taxable income (subtract if Year 3 loss) Cumulative SRLY register for the SRLY limitation Year 3 SRLY limitation (not less than zero)

S1 Corp. $ -0(18,000) $(18,000) x 0.80 $ -0-

S2 Corp. $(10,000) $ 15,000 $ 5,000 x 0.80 $ 4,000

In Year 3, the group can use $4,000 of S2’s Year 1 NOL (lesser of S2’s $15,700 NOL carryover, S2’s $4,000 SRLY limitation for Year 3, or 80% of the group’s $7,000 CTI). The group cannot use any of S1’s remaining Year 1 NOL because of its $0 SRLY limitation. Thus, Year 3 CTI is $3,000 ($7,000 - $4,000). c. In Year 4, none of P’s NOL is available (the group used it in Year 2), $5,600 of S1’s NOL is available, and $11,700 ($15,700 - $4,000) of S2’s NOL is available. S1’s and S2’s NOLs are subject to the Year 4 SRLY limitations, for which insufficient information is available because their Year 4 taxable incomes and losses are not given. d. The SRLY rules will not apply to any of the Year 1 NOLs. As in Part a, P’s NOL is not restricted by the SRLY limitation because P is the group’s parent corporation. S1’s and S2’s NOLs are not subject to the SRLY limitation because they were members of the affiliated group for every day of the Year 1 loss year. The Year 1 NOLs total $46,600 ($7,700 + $23,200 + $15,700). This amount is less than the group’s Year 2 NOL deduction limitation of $49,600 (0.80 x $62,000). The three Year 1 NOLs carry over to Year 2 and reduce that year’s CTI to $15,400 ($62,000 - $46,600). No NOL carryover remains to be used in Year 3 and later years. pp. C:8-26 through C:8-30. Copyright © 2024 Pearson Education, Inc.

C:8-35

C:8-59 a. $50,000 NOL. A Sec. 382 ownership change has taken place because P increases its stock ownership of T by more than 50 percentage points (from 49% to 100%). Assuming the value of T’s stock equals $1 million ($510,000 ÷ 51%), the annual Sec. 382 limitation on the group’s use of T’s NOLs is $50,000 ($1,000,000 × 5%). Thus, the group can deduct $50,000 of T’s NOLs for its Year 2 consolidated taxable income, which is the lesser of: (a) $50,000 Sec. 382 limitation, (b) $592,000 = 0.80 × ($400,000 + $250,000 + $90,000), i.e., 80% of Year 2 consolidated taxable income before the NOL deduction, or (c) $160,000 of T’s NOL carryover. P and S could not include T in their consolidated tax return prior to Year 2 because they did not own at least 80% of T’s stock at that time. Thus, T’s unused NOLs are SRLY losses. However, the losses are not subject to the SRLY limitation because of the overlap rule. The SRLY event occurs on December 31 of Year 1, when the P-S group first owns at least 80% of T. The Sec. 382 event also occurs on December 31 of Year 1, when the P-S group increases its ownership of T by more than 50 percentage points. The two events occur within six months of each other, so the tax law waives the SRLY limitation’s application after the Sec. 382 event. b. $72,000 NOL. A Sec. 382 ownership change has not taken place because P has increased its stock ownership by only 45 percentage points, which is not more than 50 percentage points. However, the SRLY limitation applies because the P-S group’s December 31 of Year 1 acquisition of T’s stock increases its T ownership from less than 80% to at least 80% (from 49% to 94%). The overlap rule does not apply because no Sec. 382 event has occurred. T’s cumulative SRLY register for the SRLY limitation is $90,000 ($0 at the beginning of Year 2 + T’s $90,000 of Year 2 taxable income), and its SRLY limitation is $72,000 (0.80 x $90,000). Thus, the group can deduct $72,000 of T’s NOL carryovers for its Year 2 consolidated taxable income, which is the lesser of: (a) T’s $72,000 Year 2 SRLY limitation, (b) $592,000 = 0.80 × ($400,000 + $250,000 + $90,000), i.e., 80% of Year 2 consolidated taxable income before the NOL deduction, or (c) $160,000 of T’s NOL carryover. pp. C:8-26 through C:8-30. C:8-60 P Corporation determines the $2,206,500 basis for its S stock as follows: Initial basis (purchase price) Plus: Taxable income Tax-exempt income Minus: Federal income taxes ($350,000 x 0.21) Distribution from S to P Basis on December 31

$ 2,000,000 350,000 30,000 ( 73,500) (100,000) $ 2,206,500

pp. C:8-31 and C:8-32.

C:8-36

C:8-61 a. P’s basis for its S stock is $5,474,000, and S’s basis for its T stock is $3,197,500. S’s basis for its T stock: Basis on January 1 Plus: T’s taxable income Minus: Federal income taxes on T’s taxable income ($250,000 x 0.21) Basis on December 31 P’s basis for its S stock: Basis on January 1 Plus: S’s taxable income Minus: Federal income taxes on S’s taxable income ($350,000 x 0.21) Plus: Tiering up of adjustments S makes to the basis for its T stock ($250,000 - $52,500) Basis on December 31

$3,000,000 250,000 (52,500) $3,197,500 $5,000,000 350,000 (73,500) 197,500 $5,474,000

b. P’s basis for its S stock is $5,394,000, and S’s basis for its T stock is $3,107,500. S’s basis for its T stock: Basis on January 1 Plus: T’s taxable income Minus: Federal income taxes on T’s taxable income ($250,000 x 0.21) Distribution from T to S Basis on December 31 P’s basis for its S stock: Basis on January 1 Plus: S’s taxable income S’s tax-exempt dividend from T Minus: Federal income taxes on S’s taxable income ($350,000 x 0.21) Distribution from S to P Plus: Tiering up of adjustments S makes to the basis for its T stock ($250,000 - $52,500 - $90,000) Basis on December 31

$3,000,000 250,000 (52,500) (90,000) $3,107,500

$5,000,000 350,000 90,000 (73,500) (80,000) 107,500 $5,394,000

See Reg. Sec. 1.1502-32(b)(5)(ii) Example 5(b) for tiering up of basis adjustments when a lower-tier subsidiary distributes cash to an intermediate-tier subsidiary. pp. C:8-31 through C:8-33.

C:8-37

C:8-62 a. Because they file separately, P and S do not adjust their taxable incomes for the profits on the intercompany inventory sales. Thus, each year, P’s federal income tax is $79,800 ($380,000 × 0.21), S’s federal income tax is $63,000 ($300,000 × 0.21), and their total tax is $142,800 ($79,800 + $63,000). P and S must file consolidated financial statements because P’s 100% ownership of S gives P control of S. In preparing these statements, the group must defer inclusion of the profits on the intercompany inventory sales until P sells the inventory to third parties. Assuming no book-tax differences other than the intercompany inventory sales, consolidated net income before income tax expense is as follows:

Consolidated pre-tax net income before adjusting for profits on intercompany inventory sales S’s profits deferred: From Year 1 to Year 2 From Year 2 to Year 3 Pre-tax consolidated net income a

Year 1

Year 2

Year 3

$680,000

(70,000)a ________ $610,000

70,000a (90,000)b $660,000

90,000b $770,000

10,000 units x $7.00 per unit = $70,000. 12,000 units x $7.50 per unit = $90,000.

In Years 1 and 2, the group increases a prepaid asset account, such as prepaid taxes, by the tax S pays on the eliminated intercompany inventory profit, which is $14,700 ($70,000 × 0.21) in Year 1 and $18,900 ($90,000 × 0.21) in Year 2. In Years 2 and 3, the group decreases the prepaid taxes account by the tax S paid on the restored intercompany inventory profit, which is $14,700 in Year 2 and $18,900 in Year 3. Thus, the group records a $14,700 increase in prepaid taxes for Year 1, a net $4,200 ($18,900 - $14,700) increase in the account for Year 2, and a $18,900 decrease in the account for Year 3. Accordingly, the group makes the following book journal entries (the federal income tax expense equates (balances) the debits and credits): Year 1: Federal income tax expensea Prepaid taxes Federal income taxes payable

128,100 14,700b

Year 2: Federal income tax expensea Prepaid taxes Federal income taxes payable

138,600 4,200c

Year 3: Federal income tax expensea Prepaid taxes Federal income taxes payable

161,700

142,800

18,900d 142,800

Pre-tax consolidated net income × 21% tax rate. $70,000 deferred profit × 21% tax rate = $14,700. c ($90,000 deferred profit - $70,000 deferred profit) × 21% tax rate = $4,200. d $90,000 deferred profit × 21% tax rate = $18,900. b

C:8-38

b. Because the marketable securities are not inventory, the group recognizes current and deferred income taxes on the intercompany profit. As in Part a, federal income taxes payable are $142,800 each year. The journal entries are determined as follows: Year 1: At the end of Year 1, P’s adjusted basis for the 10,000 unsold shares it purchased from S is $70,000 (10,000 shares × $7.00 per share) higher than the shares’ financial statement carrying value, so the group increases its deferred tax assets by $14,700 ($70,000 × 0.21). This results in federal income tax expense of $128,100 ($142,800 – $14,700): Federal income tax expense Deferred tax assets Federal income taxes payable

128,100 14,700 142,800

Year 2: At the end of Year 2, P’s adjusted basis for the 12,000 unsold shares it purchased from S is $90,000 (12,000 × $7.50 per share) higher than the shares’ financial statement carrying value, so the group reports deferred tax assets of $18,900 ($90,000 × 21%). The group thus increases its deferred tax assets by $4,200 ($18,900 minus $14,700 balance at the end of Year 1), which results in federal income tax expense of $138,600 ($142,800 – $4,200): Federal income tax expense Deferred tax assets Federal income taxes payable

138,600 4,200 142,800

Year 3: At the end of Year 3, P has no unsold shares it purchased from S, so the group reports zero deferred tax assets. It thus decreases its deferred tax assets by $18,900 (balance at the end of Year 2), which results in federal income tax expense of $161,700 ($142,800 + $18,900): Federal income tax expense Deferred tax assets Federal income taxes payable

161,700 18,900 142,800

pp. C:8-36 through C:8-38. C:8-63 $189,000 deferred tax asset and $126,000 valuation allowance. S’s NOL may provide future tax savings for the consolidated group, so the group records for its consolidated financial statements a $189,000 ($900,000 × 0.21) deferred tax asset. However, management estimates that the group will not be able to use $600,000 ($900,000 - $300,000) of S’s NOL, so it records a $126,000 ($600,000 × 0.21) valuation allowance. The group’s deferred tax assets, net of valuation allowance, is $63,000 ($189,000 - $126,000, or $300,000 × 0.21). p. C:8-38.

C:8-39

Comprehensive Problems C:8-64

Description

Consolidated Taxable Income (CTI)

Adjustments And Eliminations

P’s Separate Reporting

S’s Separate Reporting

P’s basis in S stock at the beginning of the current year

$1,400,000

C:8-40

Separate return taxable income: 1. Land – S’s gain now included in CTI 2. Adjustment for dividend exclusion 3. P’s profit on inventory sales to S: a. Deferred from the previous year to the current year b. Deferred from the current year to the next year 4. NOL carryover 5. Consolidated charitable contributions 6. Dividends received deduction Consolidated taxable income (CTI)

$450,000 22,000 (12,000)

$22,000 (12,000)

5,000

( 8,000)

( 20,000) ( 28,000) ( 5,000) $404,000

(20,000) (28,000) ( 5,000) $(46,000)

Consolidated tax liability

$ 84,840*

Other basis adjustments: 8. S’s tax-exempt income 9. Federal income taxes paid by S P’s basis in S stock at the end of the current year *$404,000 × 0.21 = $84,840.

P’s Basis Adjustments for S’s Stock

$200,000

$250,000

250,000 22,000 (12,000)

(20,000) (11,000) $200,000

$250,000

1,600 (50,610) $1,579,990

(1) S’s intercompany item is its $22,000 ($70,000 - $48,000) gain when it sold the land to P two years ago. Under the matching rule, the P-S group includes the gain in CTI by matching it with P’s corresponding item so as to result in the recomputed corresponding item. The corresponding item is P’s $10,000 ($80,000 - $70,000) gain when it sells the land to the third party. The recomputed corresponding item is the $32,000 ($80,000 - $48,000) gain that would be realized on the current year land sale if P and S were two divisions of a single corporation. Under the matching rule, the group includes $22,000 ($32,000 - $10,000) of S’s gain in its current year CTI. No adjustment is needed for P’s gain because the gain already is included in P’s separate return taxable income. (2) Because P and S file a consolidated tax return, the P-S group excludes the $12,000 dividend from its gross income, so it makes a negative adjustment to remove the $12,000 because it was included in P’s separate return taxable income. The group is not allowed a dividendsreceived deduction for the $12,000 (see item 6 below). P decreases the basis for S’s stock for the dividend it receives from S. (3) Under the matching rule, the consolidated group does not include intercompany inventory profits in its CTI until the inventory is sold outside the group. The group defers inclusion of the $5,000 from the previous year to the current year, and it defers inclusion of the $8,000 from the current year to next year, thereby requiring a positive $5,000 adjustment and a negative $8,000 adjustment for current year CTI. P does not adjust its basis for S’s stock for these intercompany inventory profits because they pertain to P (not S). (4) Because S’s separate return taxable income is before the NOL deduction, the group must adjust CTI to include the NOL. The SRLY and Sec. 382 limitations do not apply to the NOL because it arose in the previous year, which was a consolidated return year. The NOL deduction is limited to 80% of CTI without regard to the NOL deduction, but the $20,000 NOL is less than this limitation of $339,200 [0.80 × ($450,000 + $22,000 – $12,000 + $5,000 – $8,000 – $28,000 – $5,000)]. (5) Because P’s and S’s separate return taxable incomes are before the charitable contributions deduction, the group must adjust CTI to include this deduction. The consolidated charitable contributions deduction is limited to 10% of consolidated adjusted taxable income: Consolidated adjusted taxable income: $437,000 = $450,000 + $22,000 - $12,000 + $5,000 - $8,000 - $20,000 Limitation: $43,700 = $437,000 x 0.10 Consolidated charitable contributions: $28,000 = $17,000 + $11,000 Consolidated charitable contributions deduction: $28,000 = lesser of $43,700 or $28,000 (6) The consolidated dividends-received deduction is limited to $214,500 [0.50 × ($450,000 + $22,000 - $12,000 + $5,000 - $8,000 - $28,000)], which is greater than the $5,000 (0.50 × $10,000) dividends-received deduction that would be allowed in the absence of the limitation. No dividendsreceived deduction is allowed for the intercompany dividend S paid to P. (7) Under the matching rule, P’s interest income and S’s interest expense offset for CTI, so the group makes no adjustment for the $6,000 of interest. S’s $250,000 of separate return taxable income (before the items specified in the problem) takes into account S’s $6,000 interest expense, so P adjusts its basis for S’s stock for this $6,000 when it adjusts the basis for the $250,000. (8) P increases the basis for S’s stock by the tax-exempt income S receives.

C:8-41

(9) S’s portion of CTI is calculated as follows: Separate return taxable income $250,000 Gain deferred from two years ago to the current year (see item 1) 22,000 NOL deducted (see item 4) (20,000) Charitable contributions deduction (see item 5) (11,000) S’s portion of CTI $241,000 The federal income tax S pays is $50,610 ($241,000 × 0.21). C:8-65 Separate tax returns for Flying Gator and T Corporations for 2022: Line 1a 1b 1c 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

Title Gross receipts or sales Returns and allowances Balance (net receipts or sales) Cost of goods sold Gross profit Dividends & inclusions Interest Gross rents Gross royalties Capital gain net income Net gain or loss/Form 4797 Other income Total income Compensation of officers Salaries and wages Repairs and maintenance Bad debts Rents Taxes and licenses Interest Charitable contributions Depreciation Depletion Advertising Pension, profit-sharing, etc. plans Employee benefit programs Reserved for future use Other deductions Total deductions

Flying Gator $2,500,000 -02,500,000 (1,500,000) 1,000,000 100,000b 15,000 -0-04,000c -0-0$1,119,000 80,000 95,000 25,000 10,000 -018,000 30,000 22,000e 85,000 -0-0-0-0-0160,000 525,000

T Corporation $1,250,000 -01,250,000 (700,000) 550,000a 50,000 -0-0-023,000d 25,000 -0$ 648,000 65,000 135,000 40,000 5,000 -024,000 20,000 5,900e 40,000 -0-0-0-0-0260,000 594,900

28 29a 29b 30

TI before NOL and special deductions NOL deduction Special deductions–DRD Taxable income

594,000 (50,000) (100,000)f $ 444,000

53,100 -0(32,500)f $ 20,600

Gross tax liability (taxable income x 0.21) Minus: Estimated tax payments Net tax liability (or refund)

93,240 (90,000) $ 3,240

Total taxes when filing separate tax returns = $93,240 + $4,326 = $97,566 Tax when filing consolidated tax return = $91,568 (see solution to Problem C:8-68) Difference = $97,566 - $91,568 = $5,998 Copyright © 2024 Pearson Education, Inc.

C:8-42

4,326 (10,000) $ ( 5,674)

T reports all the profits on its current year inventory sales to Flying Gator in the current year. They do not make any adjustments to defer inventory profits because they file separate tax returns. b

Flying Gator does not exclude from gross income the dividend received from T because they file separate tax returns, but Flying Gator is allowed a 100% dividends-received deduction for it (see item f). c

Flying Gator cannot deduct the $9,000 loss on the land sale to T because of the Sec. 267(a) related party rules. Adding back the $9,000 loss to the $5,000 net long-term capital loss results in a $4,000 net long-term capital gain. d

$(3,000) net STCL + $6,000 net LTCG + $20,000 net Sec. 1231 gain = $23,000 capital gain net income. e

Charitable contributions deduction limitation (2022):

Flying Gator Corporation: Adjusted taxable income = $1,119,000 - $80,000 - $95,000 - $25,000 - $10,000 - $18,000 $30,000 - $85,000 - $160,000 - $50,000 = $566,000 Limitation = $566,000 x 0.10 = $56,600 Deduction = lesser of $22,000 or $56,600 = $22,000 T Corporation: Adjusted taxable income = $648,000 - $65,000 - $135,000 - $40,000 - $5,000 - $24,000 $20,000 - $40,000 - $260,000 = $59,000 Limitation = $59,000 x 0.10 = $5,900 Deduction = lesser of $48,000 or $5,900 = $5,900 Note: The CARES Act increased from 10% to 25% the charitable contributions deduction limitation for a C corporation’s cash contributions made in calendar year 2020 (and the Taxpayer Certainty and Disaster Tax Relief Act of 2020 did so for such contributions made in calendar year 2021). This problem, however, is for the 2022 calendar year. f

Flying Gator can claim a 100% dividends-received deduction for dividends received from T when it files a separate return. T Corporation can claim a 65% dividends-received deduction on dividends from a corporation that is at least 20%-owned but less than 80%-owned by T. T’s dividends-received deduction, however, is limited to 65% of taxable income before this deduction: T’s taxable income before dividends-received deduction = $648,000 - $65,000 - $135,000 $40,000 - $5,000 - $24,000 - $20,000 - $5,900 - $40,000 - $260,000 = $53,100 Limitation for T’s dividends-received deduction = 0.65 x $53,100 = $34,515 T’s dividends-received deduction = lesser of $32,500 (0.65 x $50,000) or $34,515 = $32,500

C:8-43

Tax Strategy and Critical Thinking Problems C:8-66 Alpha and Beta Corporations comprise a brother-sister controlled group under the 50%80% definition. The 50% test is met because the sum of Sandra’s and John’s identical ownership in Alpha and Beta is more than 50% (50% for Sandra plus 50% for John equals 100%). The 80% test is met because Sandra and John together own at least 80% of Alpha’s and Beta’s stock. However, Alpha and Beta do not comprise an affiliated group because there is not a parent corporation. Therefore, they cannot file a consolidated tax return. If Sandra and John want to continue to maintain separate corporations, they should consider converting Alpha and Beta from a brother-sister corporate structure to a parent-subsidiary corporate structure that qualifies as an affiliated group. If they do so, Alpha and Beta could elect to file a consolidated tax return, on which Beta’s subsequent operating losses can offset Alpha’s subsequent operating profits. In addition, Sandra and John should consider making Beta the parent corporation so that its NOLs will not be subject to the SRLY limitations. A consolidated tax return also would allow the group to defer, under the matching rule, taxation of Alpha’s profits on its inventory sales to Beta. The corporations can form the parent-subsidiary group in two ways: (1) with Alpha as the parent or (2) with Beta as the parent. To make Alpha the parent, Sandra and John can transfer their Beta stock to Alpha in a nontaxable transfer under Sec. 351, or Alpha can acquire Beta stock in a nontaxable reorganization under Sec. 368 (i.e., Type B; see Chapter C:7). Similarly, Sandra and John can make Beta the parent by contributing their Alpha stock to Beta or by having Beta acquire the Alpha stock in a reorganization. If Alpha is the parent, the $100,000 of NOL carryovers from its separate return years will not be SRLY losses. Thus, the consolidated group’s use of Alpha’s NOLs will be limited only by 80% of the group’s consolidated taxable income. Beta’s NOL carryovers from its separate return years are SRLY losses, so the consolidated group can use them only to the extent of 80% of Beta’s cumulative SRLY register for the SRLY limitation. Given that Beta expects losses for the next five years, the group will not be able to use Beta’s NOL carryovers for several years. Section 382 would not limit use of the NOLs because the requisite more than 50 percentage point increase in stock ownership of the loss corporation will not have occurred. Alternatively, if Beta is the parent, its NOL carryovers generally will not be SRLY losses, so the consolidated group’s use of them will be limited only by 80% of the group’s consolidated taxable income. Alpha’s NOL carryovers will be SRLY losses, but Alpha will generate positive income in the future, allowing the group to use Alpha’s NOL carryovers to the extent of 80% of Alpha’s cumulative SRLY register for the SRLY limitation. Thus, it appears that the best alternative is to have Beta be the parent, which allows the consolidated group to use both corporations’ separate return year NOL carryovers. However, if Beta is smaller than Alpha, Beta’s acquisition of Alpha likely would qualify as a reverse acquisition. If it does, Beta’s NOL carryovers will be subject to a SRLY limitation and Alpha’s NOL carryovers will not. Similarly, if Alpha acquires Beta and it qualifies as a reverse acquisition, Alpha’s NOL carryovers will be subject to a SRLY limitation and Beta’s NOL carryovers will not. Copyright © 2024 Pearson Education, Inc.

C:8-44

If John and Sandra conclude for business reasons that Alpha must be the parent and it does not qualify as a reverse acquisition, they have three ways to use Beta’s NOLs from separate return years. First, they could increase Beta’s corporate profits (and taxable income). One way to accomplish this goal is to reduce the transfer price at which Alpha sells inventory to Beta, shifting some of the group’s overall profit from Alpha to Beta. Sandra and John should be made aware of the Sec. 482 transfer pricing rules, which may constrain their ability to increase Beta’s profits so as to increase the use of Beta’s NOLs. Second, if Alpha and Beta have common costs that they allocate among themselves, they might allocate a higher percentage of the costs to Alpha in future years. This strategy would increase Beta’s SRLY limitation, increasing the amount of Beta’s SRLY NOLs the group could use, but Sec. 482 again may constrain the flexibility to allocate these items. Third, Beta could liquidate into Alpha after the parent-subsidiary relationship is created. The liquidation might be prudent if management believes that having two separate corporations serves no substantial business purpose. The liquidation would be nontaxable under Secs. 332 and 337 (see Chapter C:6). Alpha and Beta then could operate as separate divisions of a single corporation. Alpha would assume Beta’s NOL carryover under Sec. 381. The need to file consolidated tax returns to offset Beta’s losses against Alpha’s profits and to use up Beta’s NOL carryovers would be eliminated. In addition, the use of Beta’s NOLs would not be limited by the SRLY restrictions encountered with a consolidated filing. Sandra and John should be made aware that the IRS could disallow the liquidation’s tax benefits under Sec. 269 if its principal purpose is to facilitate usage of Beta’s NOLs. Another way to combine Alpha and Beta into a single corporation would be a nontaxable merger of one into the other. C:8-67 River and Lake currently can file a consolidated tax return because they comprise an affiliated group. River owns at least 80% of Lake’s total voting power and at least 80% of the total value of Lake’s stock: Number of Shares Common stock Preferred stock

900,000 250,000

Voting power Per Share Total 2 1

Value Per Share

Total

$38 $26

$34,200,000 6,500,000 $40,700,000

1,800,000 250,000 2,050,000

River currently owns Lake stock having 87.80% (1,800,000/2,050,000) of Lake’s total voting power and 84.03% ($34,200,000/$40,700,000) of the total value of Lake’s stock. The extent to which Lake can issue additional shares yet continue to file a consolidated tax return with River can be determined algebraically. Let z equal the number of common shares Lake issues to its management. River’s post-issuance ownership percentage is a function of z. Set this function to be at least 80%, and solve for z. This calculation must be done by voting power and by value (recall that each share of common stock is worth $38 and has two votes):

C:8-45

By voting power: 1,800,000 / (2,050,000 + 2z) ≥ 0.80 1,800,000 ≥ 1,640,000 + 1.6z z ≤ 100,000 By value:

34,200,000 / (40,700,000 + 38z) ≥ 0.80 34,200,000 ≥ 32,560,000 + 30.4z z ≤ 53,947.37

Thus, to maintain River’s 80%-or-more ownership by vote, Lake cannot issue more than 100,000 shares. To maintain it by value, Lake cannot issue more than 53,947 shares. Lake thus cannot issue more than 53,947 shares to satisfy both the voting and value requirements. An alternative way of determining the 100,000 and 53,947 shares is to use an Excel worksheet. Set a cell to an arbitrary value for z (the cell is A1 for this explanation). Another cell contains the formula =1800000/(2050000+(2*A1)), and a third cell contains the formula =34200000/(40700000+(38*A1)). Excel’s Goal Seek feature can then be used, setting the second cell to 0.80 by changing cell A1, then doing so again for the third cell (the answers Goal Seek generates may differ slightly from 100,000 and 53,947 because its iterative process ends when the resulting answer is very close to the desired value rather than exactly equaling it).

Tax Form/Return Preparation Problem C:8-68 (See Instructor’s Resource Manual)

Case Study Problem C:8-69 The points listed below are the primary ones that should be included in the memorandum to the tax partner concerning Carol’s tax problem. The student should include these points in a properly formatted memorandum using good grammar and punctuation. P and J Corporations appear to be ideal candidates for filing a consolidated tax return because one corporation is profitable and the other corporation has losses. The client foresees continued expansion of the automobile service franchises, and it appears that J will continue to incur losses in the short run because of the interest expense and MACRS depreciation deductions for the six additional locations. P and J comprise a brother-sister controlled group under the 50%-80% definition. The 50% test is met because Carol’s 100% identical ownership in P and J is more than 50%. The 80% test is met because Carol owns at least 80% of P’s and J’s stock. However, P and J do not comprise an affiliated group because there is not a parent corporation. Therefore, they cannot file a consolidated tax return. Carol could restructure her stock ownership to create the necessary parentsubsidiary relationship, making them eligible to file a consolidated tax return. One possibility is for Carol to create a holding company and transfer her P and J stock to it. A second possibility is for Carol to transfer the stock of one corporation to the other corporation. Either way, the transaction would be nontaxable under Sec. 351, and J would retain its NOL carryovers.

C:8-46

Note: A taxable transfer of J’s assets (rather than its stock) to a holding company or to P should be discouraged because J’s NOL carryovers would not be acquired by the transferee. A transfer by Carol of J’s stock to a holding company or to P would preserve the existence of J’s NOLs. Affiliation of P and J will permit them to file a consolidated tax return. J’s post-affiliation losses can offset P’s post-affiliation profits. J’s pre-affiliation losses are subject to the SRLY limitation (assuming a reverse acquisition does not occur), so the consolidated group can use the losses only to the extent of 80% of J’s cumulative SRLY register for the SRLY limitation. Carol should give some consideration to adjusting the lease arrangement between P and J. If P were to pay J more rent, J’s SRLY limitation would increase, allowing the group to use J’s pre-affiliation losses more quickly. Carol should document business reasons for doing so because the IRS might view such changes as a scheme for increasing the usability of the NOLs. The transfer of the P and J stock to the holding company or the transfer of one corporation’s stock to the other corporation would not trigger the application of the Sec. 382 loss limitation because Carol would own all the holding company’s stock after the transfer. The Tax Planning Considerations section of the text contains a summary of the other advantages and disadvantages of filing a consolidated tax return. Other advantages and disadvantages of filing on a consolidated basis that are relevant in this situation also should be included in the memorandum.

Tax Research Problems C:8-70 P and S1 Corporations are members of an affiliated group at the beginning of the current year. A and B Corporations are not included in the affiliated group because they are brother-sister corporations to P and fail to satisfy the Sec. 1504(a) stock ownership requirements. A and B do not have a parent corporation because an individual, Angela, owns all the stock of A and B. The sale of the A stock has no effect on the affiliated group for consolidated tax return purposes because A is not a member of the affiliated group at any time in the current year. The acquisition of the S2 stock by S1 creates a new member of the affiliated group. S1 owns the necessary 80% of the voting power and value of the S2 stock (excluding the nonconvertible, nonvoting preferred stock that is not considered to be “stock” under Sec. 1504(a)(4)). The affiliated group includes the income and expenses of S2 starting with the day after the November 25 acquisition date through December 31 (Reg. Sec. 1.1502-76(b)).

The controlled group test applies on December 31st of the tax year in question (Sec. 1563(b)(1)). On that date B, P, S1, and S2 apparently would constitute a combined controlled group under Sec. 1563(a)(3). However, Sec. 1563(b)(3) considers a corporation to be a member of a controlled group under the “additional member” rule if the corporation (1) is a member of a controlled group of corporations at any time during a calendar year, (2) is not a member of the group on December 31st of the calendar year, and (3) is a member of such group for one-half (or more) of the number of days in such tax year which precede December 31st. A Corporation satisfies this requirement because it was a member of the controlled group from January 1 through July 10 (191 days) even though it is not a member of group on December 31st. A has been a member of the controlled group for more than half of the 365 days in the current year. Copyright © 2024 Pearson Education, Inc.

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S2 is an excluded corporation under Sec. 1563(b)(2)(A) and, therefore, is not a part of the controlled group. S2 is excluded because it was a member of the group for 35 days in the tax year that preceded December 31st (it was a member for less than half of the 365 days in the current year). See. Reg. Sec. 1.1563-1(b)(4) for examples that illustrate the counting of days for this purpose. The current year controlled group is thus comprised of P, S1, A, and B Corporations. This group is a combined controlled group. In future years, P, S1, S2, and B will be the only four members of the controlled group unless an acquisition or disposition takes place. The required tax returns for the current year are as follows:

Corporation

Period

Consolidated or Separate Return

A B P S1 S2 S2

1/1 - 12/31 1/1 - 12/31 1/1 - 12/31 1/1 - 12/31 1/1 - 11/25 11/26 - 12/31

Separate Separate Consolidated Consolidated Separate Consolidated

If S2’s books are not closed on November 25, S2 allocates its nonextraordinary items of income, gain, expense, loss, and credits to the periods before and after the acquisition date based on the relative number of days in each period, assuming it uses the same tax year as the P-S1 group (i.e., the calendar year). S2 allocates its extraordinary items to the day S2 reports them under its normal tax accounting methods. The easiest way for B to become a member of the affiliated group is for Angela to contribute her B stock to P in a nontaxable transfer under Sec. 351. C:8-71 X Corporation would not be allowed to retain its S election because Sec. 1361(b)(1)(B) prevents an S corporation from having a shareholder that is other than an individual, an estate, a trust, or certain tax-exempt organizations. Therefore, under Sec. 1362(d)(2), the S election will terminate on June 30. X will join the affiliated group, which will continue to include P, R, and T. The group’s current year consolidated tax return will include P’s, R’s, and T’s income or loss for the entire tax year, and it will include X’s income or loss for June 30 through December 31. (Normally, the group includes an entering member’s income or loss starting the day after the acquisition date, but a special rule applies for the acquisition of an S corporation. See Reg. Sec. 1.1502-76(b)(1)(ii)(A)(2) and Reg. Sec. 1.1502-76(b)(5) Example 7 for more details.) X will file a separate S corporation tax return (Form 1120-S) for January 1 through June 29. Because X has always been an S corporation, it will not be bringing any tax attributes, such as NOL carryovers or earnings and profits, to the consolidated group. A number of its tax elections will carryover, such as its overall accounting method. X will continue to use a calendar year as its tax year because it is the same tax year used by the consolidated group. Copyright © 2024 Pearson Education, Inc.

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C:8-72 The explanation below assumes that the practice management company (PMCo) is a corporation. If it is not a corporation (and is not treated as a corporation under the check-the-box regulations), the PMCo would not be an includible corporation and thus would not be able to file a consolidated tax return with Anna’s personal service corporation (PSC). At first glance, it appears that Anna’s PSC and the PMCo would not be able to file a consolidated tax return because they would not comprise an affiliated group. Anna would continue to own all the PSC’s stock, and the PMCo’s shareholders would continue to own all of the PMCo’s stock. The two corporations thus would appear to fail the requirement of Sec. 1504(a)(1) that there be a parent corporation that owns at least 80% of the stock of at least one other corporation. However, Rev. Rul. 84-79, 1984-1 C.B. 190, notes that, for this purpose, it is the beneficial ownership of stock that is important rather than nominal ownership. The ruling quotes several cases, which mention “dominion over the property” and “actual command over the property.” PLR 201451009 has facts similar to those of your firm’s client. A parent corporation owns a subsidiary corporation through two LLCs that are disregarded entities under the check-the-box regulations. The subsidiary has agreements with two professional corporations that are owned by a shareholder. The agreements effectively transfer much of the shareholder’s power over the professional corporations to the subsidiary. The IRS holds in the ruling that the two professional corporations are in the same affiliated group as the parent corporation. A private letter ruling is binding on the IRS only for the taxpayer to whom it was issued, but PLR 201451009’s holding is consistent with several courts’ decisions. If Anna engages the services of the PMCo in the manner she described, her PSC and the PMCo likely will comprise an affiliated group (you should obtain more details about this arrangement before giving a more definitive answer). If the PMCo is already a member of an affiliated group filing a consolidated tax return, Anna’s PSC likely will be required to join in that filing. If PMCo is not already a member of an affiliated group (or is a member of an affiliated group that has not been filing consolidated tax returns), Anna’s PSC and the PMCo are not required to file a consolidated tax return but likely may elect to do so.

“What Would You Do In This Situation?” Solution Ch. C:8, p. C:8-7. The failure to include a new corporation in a consolidated federal income tax return cannot be justified under a de minimis income rule. Unlike individuals, who can avoid filing a federal tax return when they earn a small amount of income, C corporations do not have a minimum income amount that can go unreported. Therefore, P Corporation must include X Corporation in the P-S-T-X affiliated group’s consolidated tax return for the current year. Regulation Sec. 1.1502-75(e) states that, if a consolidated return is required for the taxable year, the tax liability of all group members must be computed on a consolidated basis, even if (1) separate returns are filed by one or more group members or (2) there has been a failure to include in the consolidated return the income of any group member. The oversight of excluding X Copyright © 2024 Pearson Education, Inc.

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Corporation from the consolidated group does not prevent the group from filing a consolidated tax return in the current year or in a future year. Likewise, the oversight cannot be used as a means to “break” the consolidated return election so that the companies can commence filing on a separate return basis. The filing of the consolidated tax return requires the inclusion of all subsidiary corporations on the Form 851 (Affiliations Schedule) that is part of the return. The affiliations schedule provides a listing of all corporations included in the consolidated tax return. In addition, Form 1122 (Authorization and Consent of Subsidiary Corporation to be Included in a Consolidated Income Tax Return) must be completed by each group member. Failure to include a Form 1122 for X Corporation in the consolidated tax return, however, will not exclude the corporation from the consolidated tax return. Under Reg. Sec. 1.1502-75(b)(2), the IRS has the power to determine that a corporation is a group member even though the Form 1122 was not filed. The omitted corporation will be treated as if the Form 1122 had been filed. One situation where the IRS has used this power is in the case where a dormant or new subsidiary has been overlooked.

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Chapter C:9 Partnership Formation and Operation Discussion Questions C:9-1 Although the question asks for three advantages, here are five possible advantages of a partnership for Yvonne and Larry include: 1. The partnership itself is not subject to tax, thereby eliminating the problem of double taxation that exists for C corporations. 2. Partners may divide the partnership’s profit or loss among themselves without regard to their proportionate capital interests (as long as the allocation has substantial economic effect). 3. Partnerships are popular because of the relative simplicity and informality inherent in creating and operating such entities. No legal agreement is required to form a partnership but a written agreement is advisable. 4. Under the conduit principle of taxation, partnership losses and other items receiving special tax treatment pass through to the partners. 5. The partners may be eligible for the qualified business income (QBI) deduction. pp. C:2-4, C:2-5, C:9-2 through C:9-4, and C:9-17 through C:9-19. C:9-2 Lack of limited liability. A corporation provides limited liability protection for the business owners while a general partnership does not. The purchase of the inn is likely to be financed with debt and additional debt is likely to be incurred during the renovations. The construction required during the renovation and the day-to-day operation of the inn provides significant exposure for liability from lawsuits. The partnership form would not protect the owners of the business from possibly losing their individual assets. If the owners want the advantages of a partnership and still have limited liability, they may want to consider a limited liability company (LLC) or a limited liability limited partnership (LLLP) if available in the taxpayer’s state. pp. C:2-3 through C:2-6 and C:9-2 through C:9-4. C:9-3 General partnership. Because Sam will be providing business advice, this partnership should be arranged as a general partnership. Both brothers will be actively managing the business and therefore limited liability protection would not be available to Sam if the partnership is created as a limited partnership with Sam as the limited partner. The brothers, however, also may want to consider an LLC instead of a partnership. pp. C:9-2 through C:9-4. C:9-4 Whether Doug receives a profits interest or a capital and profits interest; he theoretically should report the value of the property he receives for services as ordinary income. In this case, the initial basis for his partnership interest equals the amount he reports as income. If the profits interests cannot be valued, however, Doug recognizes no income and has a zero basis in his partnership interest. Also, under Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS will not treat receipt of a profits interest as a taxable event unless one of the following events occurs: (1) the profits interest relates to a substantially certain and predicable income stream, (2) the partner disposes of the interest within two years of receipt, or (3) the interest is a publicly traded partnership. (Note: The IRS is in Copyright © 2024 Pearson Education, Inc.

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the process of revising its rules concerning service partners. See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-10 through C:9-12. C:9-5 a. Probably not. The existing partner could contribute the property tax-free to the partnership, but Sec. 704(c) requires that the tax attributes from contributed property be allocated to the partner that contributes the property. Under Sec. 704(c), the partners must specially allocate among themselves the income, gain, loss, and deductions attributable to contributed property in a manner that reflects the difference between the property’s FMV and its tax basis at the time of the contribution. In addition, the partnership will have the property with a carryover basis, which is below its FMV. For depreciable assets, the partnership will get smaller depreciation deductions and the special allocation of depreciation among the partners may not totally compensate the other partners. pp. C:9-6 through C:9-10, C:9-21, and C:9-22. b. Sell or lease the property to the partnership or sell the property to a third party who then contributes the property to the partnership. pp. C:9-31 and C:9-32. c. Ordinary income recognition is required on a partner’s sale of property to the partnership where the seller owns more than 50% of the capital or profits interests if the property is either depreciable, or is not a capital asset, in the hands of a partnership. If the partner leases property to a partnership, the partner retains the depreciation and other deductions with respect to the property. The leasing partner also avoids the depreciation recapture provisions. Rentals received from the partnership are taxed as ordinary income. A sale of the property to a third party is taxed as any other sale would be with no special tax consequences. pp. C:9-31 and C:9-32. C:9-6 a. The partner recognizes gain on the contribution of property and assumption of a liability if the amount of the liability assumed by the other partners exceeds the contributing partner’s basis in the contributed property plus her share of existing partnership liabilities. b. Net decrease. The basis in the partnership interest will be decreased by the amount of the liability assumed by the other partners. Viewed another way, her basis will increase by her share of the increase in partnership liabilities and decrease by her liability assumed by the partnership, for a net decrease. pp. C:9-6 through C:9-8. C:9-7 a, b, and d. p. C:9-12. C:9-8 No. Partnership ordinary income is the total of partnership income and deduction items that do not have to be separately stated. This partnership has $100,000 of ordinary income. Partnership taxable income, however, is the sum of all taxable items that are either separately stated or included in ordinary income. BW’s partnership taxable income is $150,000 ($100,000 ordinary income + $50,000 long-term capital gain). p. C:9-17. C:9-9 The partner’s distributive share will equal the sum of the partner’s earnings for one-half of his or her beginning-of-the-year interest for the entire year and the partner’s earnings for the other one-half of his or her beginning-of-the-year interest for nine months (calculated on a daily basis). pp. C:9-20 and C:9-21. C:9-10 Usually no because a limited partner normally has no economic risk for recourse debt. However, a limited partner’s basis is increased by recourse liabilities to the extent the limited partner is liable to incur an economic loss, for example, to the extent he or she is obligated to repay a general Copyright © 2024 Pearson Education, Inc.

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partner should the general partner have to pay the debt or to the extent the limited partner has guaranteed the debt. pp. C:9-24 through C:9-27. C:9-11 Qualified nonrecourse real estate financing is included in the at-risk basis of both general and limited partners. This financing meets the requirements for qualified nonrecourse real estate financing. p. C:9-29. C:9-12 Less restrictive. Section 704(d) limits the loss to the adjusted basis (before reduction by current year’s losses) of a partner’s interest in the partnership at the end of the partnership tax year in which the loss occurs. This basis includes recourse debt (to the extent of a partner’s economic risk of loss) and includes nonrecourse debt. The at-risk basis does not include nonrecourse debt (other than qualified nonrecourse real estate financing). Thus, the at-risk rules are more restrictive than the Sec. 704(d) rule. p. C:9-29. C:9-13 No. As a limited partner in the JRS Partnership, Jeff is almost certainly subject to the passive loss limitation rules on losses from this partnership. Accordingly, income from a general partnership in which Jeff materially participates (and thus earns active income) cannot be used to offset the passive losses. Jeff can use losses from the JRS Partnership only to offset passive income, or he can claim the losses when he sells his entire interest in the JRS Partnership or when the partnership terminates. pp. C:9-29 and C:9-30. C:9-14 Contribute the property. ABC Partnership will hold the land as inventory for resale to customers and not as a capital asset. Because Helen owns more than a 50% interest in the ABC Partnership, the sale of the land to the partnership will generate ordinary income instead of capital gain for Helen. If Helen instead contributes the land to the partnership, it will recognize no gain until it sells the lots. Then, as the partnership sells each lot, Helen will recognize the precontribution gain as well as her share of any postcontribution appreciation, and all the gain will be ordinary income taxable at a marginal rate of up to 37%. In total, the ordinary income under this alternative will be the same as if Helen had sold the land to the partnership. A contribution, however, will allow her to delay the gain recognition. Even better results occur if Helen can dispose of 5% or more of her partnership interest so that she owns, directly and indirectly, 50% or less of the ABC Partnership. If she owns 50% or less, she can recognize capital gain on the sale of the land to the partnership and use these gains to offset any capital losses she already may have recognized or that she may desire to recognize. Capital gains are taxed at rates between 0% and 23.8% (including the 3.8% rate on net investment income) depending on the taxpayer’s ordinary tax bracket. These rates are below the rate applicable to ordinary income. Alternatively, she could sell the land to a third party who would then contribute the land to the ABC Partnership, assuming the partnership desires a new partner. Her gain on the sale of the land would be capital gain, and the contributing partner would recognize no gain when he or she transferred the land to the partnership. pp. C:9-31 and C:9-32. C:9-15 Yes. Regulation Sec. 1.707-1(c) provides that a partner reports guaranteed payments as ordinary income in the partner’s tax year that includes the last day of the partnership’s tax year in which the partnership deducted the payments under its method of accounting. A partner reports his or her distributive share of partnership items (determined under Sec. 702(a)) in the tax year that includes the last day of the partnership’s tax year. Thus, from a timing perspective, the two payments schemes are the same to Tracy. Copyright © 2024 Pearson Education, Inc.

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Other points of comparison are relevant as well. First, a general partner’s self-employment income includes both his or her distributive share of partnership ordinary income and any guaranteed payment. Second, however, the guaranteed payment does not qualify as business income for the QBI deduction while partnership ordinary income does qualify. pp. C:9-32 and C:9-33. C:9-16 The Sec. 704(e) rules apply only to a capital interest in a partnership, where capital is a material income producing factor and where the family member is the true owner of the interest. If capital is a material income-producing factor for the partnership, the family partnership rules apply. pp. C:9-33 and C:9-34. C:9-17 Congress enacted the qualified business income deduction to give pass-through entity owners a tax rate somewhat comparable to the 21% corporate tax rate. Thus, Congress did not want to give a tax break to C corporations while not giving a tax break to businesses operating in a pass-through form. pp. C:9-17 through C:9-19.

Issue Identification Questions C:9-18 • • • • • • • •

Does Bob recognize any gain on the formation? When will he recognize the precontribution gain? What is Bob’s basis and holding period for his partnership interest? Does Kate recognize any loss on the contribution of property in exchange for her partnership interest? When will she recognize the precontribution loss? What will the character of the loss be? What is Kate’s basis and holding period for the partnership interest she received in exchange for property? What basis and holding period does the partnership have in the property received? What are the Sec. 1250 ramifications for the building? What type of gain will the partnership and partners recognize on the sale of the building? Did Kate receive any of her partnership interest for services? • If so, what gain, loss, or deductions must the partnership recognize? • What income must Kate recognize? • Does the guaranteed payment qualify for the QBI deduction?

Bob must determine his basis in the partnership interest ($65,000 = $95,000 - $60,000 + $30,000 share of liabilities) and his holding period for his interest in the partnership (begins with his ownership of the office building). Because Bob recognizes no gain or loss, he does not have to be concerned with any recapture potential under Sec. 1250. Also, Sec. 1250 depreciation recapture will not be a concern if the parties have depreciated the property under straight-line MACRS rules. Bob, however, will have to recognize precontribution gain on the office building at a future date. This gain will be part unrecaptured Sec. 1250 gain subject to the 25% (and possibly an additional 3.8%) capital gains tax rate under Sec. 1(h)(l)(D) (and possibly Sec. 1411) and part Sec. 1231 gain subject to the applicable capital gains tax rate. Kate must determine her basis in the partnership interest ($105,000 = $75,000 + $30,000 share of liabilities) and her holding period for her interest in the partnership (begins with her Copyright © 2024 Pearson Education, Inc.

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ownership of the land). (Also see discussion of services in the last paragraph of this solution.) Kate recognizes no loss at the time of the partnership formation. If the land was a capital asset to Kate and the partnership sells the land within five years of Kate’s contribution, the loss will be a capital loss up to $25,000, and that capital loss will be allocated to Kate as a precontribution loss. After five years, the character of the loss will be determined by the character of the land to the partnership, but Kate still will have to report any precontribution loss recognized. Guaranteed payments will be reported as ordinary income. The partnership must be concerned with the basis and holding period of the assets it receives (carryover for both basis and holding period). The partnership can deduct from ordinary income the guaranteed payments made to Kate. An additional tax issue must be addressed. Bob contributed property with a net value of $70,000 for a one-half interest in the partnership while Kate contributed property with a net value of only $50,000 for a one-half interest in the same partnership. The total partnership has a net value of $120,000 ($130,000 + $50,000 - $60,000 liability). One possibility is that Bob has made a $10,000 gift to Kate. If so, both partners’ bases must be adjusted to reflect the gift. Alternatively, the facts suggest that Kate may be receiving some of her partnership interest in exchange for her services in managing the business for the first year while receiving no guaranteed payment. If so, Kate must recognize ordinary income and increase her basis for the value of the partnership interest she received in exchange for services. If Kate is receiving some of her partnership interest for services, the partnership must recognize gain or loss on the partnership assets she is deemed to receive and must adjust the basis of the assets for her deemed recontribution. The partnership also must deduct the guaranteed payment. Regarding the guaranteed payment, Kate also needs to be aware that the guaranteed payment will not qualify as business income for the QBI deduction. (Note: The IRS is in the process of revising its rules concerning partners who contribute services. See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-5 through C:9-12, C:9-32, and C:9-33. C:9-19 • • •

What items qualify as organizational expenditures, which are start-up expenditures, and what items can be deducted currently? Does the partnership want to deduct (up to $5,000) and then amortize organizational expenditures and/or start-up expenditures? If so, over what time period does the amortization occur (if applicable)? When does the partnership business begin?

The partnership first must characterize each expenditure as an organizational expenditure, a start-up expenditure (Chapter C:3), another expenditure to be capitalized, or a current period expense. The costs of drawing up the partnership agreement and of establishing the accounting system are organizational expenditures (totaling $3,200). The cost of searching for a retail outlet is a start-up expenditure ($1,600), and the cost of having an income statement prepared is a current period expense ($500). The partnership then must decide how it wants to handle the organizational and start-up expenditures. Because each of these items is less than $5,000, the partnership can elect to deduct the expenditures currently under Sec. 195 for the start-up expenditures and under Sec. 709 for the organizational expenditures. If the expenditures had exceeded $5,000 each, the partnership would amortize the balances over 180 months. Copyright © 2024 Pearson Education, Inc.

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Another issue the partnership must face is when is the partnership is considered to begin business. Regulation Sec. 1.709-2(c) states that business begins when the partnership “starts the business operation for which it was organized.” Had the expenditures exceeded $5,000, amortization of both the excess organizational expenditures and the excess start-up expenditures would begin with the month in which business begins. p. C:9-12. C:9-20 • • •

Is the receipt of a profits interest in the ABC Partnership in exchange for Cara’s services a taxable event? If it is a taxable event, what is the amount and character of the income recognized? What is Cara’s basis and holding period for her partnership interest?

The receipt of the partnership interest is not a taxable event. Under Rev. Proc. 93-27, 1993-2 C.B. 343, the receipt of a profits interest is taxable only under circumstances where the FMV of the interest can be readily determined. This situation does not fit into one of the three exceptions contained in the revenue procedure guidelines as being a taxable event. (Note: The IRS is in the process of revising its rules concerning partners who contributed services. See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-10 through C:9-12. C:9-21 • • • •

What is George’s basis in his partnership interest? Does the repayment of the partnership liability cause an adjustment to George’s basis in his partnership interest? Is the repayment of the nonrecourse liability a taxable event for George? If so, what is the amount and character of the income reported? Can George take the QBI deduction for his share of partnership ordinary income?

Repayments of partnership liabilities are treated as distributions to the partners. A distribution made to a partner that exceeds his or her basis for the partnership interest produces a taxable gain. The gain can be calculated as follows: Basis at the beginning of the year Plus: George’s share of income (0.20 x $20,000) George’s basis before the distribution Minus: George’s deemed distribution from repayment of partnership liability (0.20 x $100,000) George’s recognized gain

$15,000 4,000 $19,000 (20,000) $ 1,000

After these adjustments, George’s basis in the partnership interest is zero. Also, the gain is a capital gain if the “distribution” is deemed proportionate (see Chapter C:10). Regarding the partnership ordinary income, George should be able to claim the QBI deduction for his share. pp. C:9-17 through C:9-19, and C:9-24 through C:9-28.

C:9-6

C:9-22 • • • • • •

What is Katie’s deductible loss from her partnership investment? What is Katie’s Sec. 704(d) basis in her partnership interest? What is Katie’s at-risk basis in her partnership interest? Is the loss from the JKL Partnership a passive loss? Does Katie have passive income from this investment or other investments? • If so, can she deduct her losses? • If not, do the losses carryover to later years? Is Katie subject to the limitation on excess business losses?

As a limited partner, Katie is presumed not to materially participate in the partnership. Therefore, because the loss is from a passive activity, she cannot deduct it unless she has passive income from other investments, or she terminates her interest in the limited partnership. If no such income exists, the losses carry over to later years. Katie would not be subject to the limitation on excess business losses this year because the passive activity loss limitation applies first. Also, her loss is low enough to stay below the threshold where the limitation clicks in. pp. C:9-29 and C:9-30. C:9-23 • • • • • •

Do the family partnership rules apply when no family relationship exists? Does reasonable compensation need to be paid to Daniel for his services? If so, what is reasonable compensation for Daniel’s services? Does David need to be recognized as a partner in the CD Partnership? If so, what is David’s allocable share of the partnership income? What is Daniel’s allocable share of the partnership income?

The family partnership rules under Sec. 704(e) are written in terms of the donor-donee relationship. Accordingly, they apply in this situation. Both Daniel and David would be allocated a reasonable compensation amount. Then, the remainder of the income originally allocated to Daniel and David would be reallocated to them based on their relative capital interests. pp. C:9-33 and C:934.

Problems C:9-24 a.

Neither partner recognizes gain or loss (Sec. 721).

b. Basis of contributed property Plus: Share of partnership liabilities Minus: Partnership assumption of individual liabilities Basis in partnership

Suzanne $59,000 40,000

Bob $95,000 40,000*

$99,000

(80,000)* $55,000

*Alternatively, Bob reduces his basis by $40,000 ($40,000 - $80,000), which is the amount of his liability assumed by the other partner. c. The partnership takes a carryover basis in each asset: inventory (securities), $14,000; land, $45,000; and building, $50,000; plus $45,000 of cash. Copyright © 2024 Pearson Education, Inc.

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d. The partnership’s initial book value is each asset’s FMV at the time of contribution: inventory, $15,000; land, $40,000; and building, $100,000; plus $45,000 of cash. e.

Amount realized Minus: Adjusted basis Realized gain

$20,000 ( 14,000) $ 6,000

Precontribution gain of $1,000 ($15,000 FMV at contribution - $14,000 basis) is allocated to Suzanne. Bob and Suzanne share the remaining $5,000 gain equally. Thus, Suzanne reports $3,500 of gain, and Bob reports $2,500 of gain. The gain is ordinary (and not capital) because the property was inventory to Suzanne and because the partnership sold the inventory within five years of its contribution. pp. C:9-5 through C:9-10, C:9-21, C:9-22, and C:9-24 through C:9-28. C:9-25 a. The partnership recognizes no gain or loss under Sec. 731(b), and neither partner recognizes gain or loss under Sec. 731(a). b. $51,000 ending partnership basis for Able; $71,000 ending partnership basis for Baker, determined under Secs. 705 and 752 as follows: Basis in partnership interest: Initial contribution Plus: Share of bank liability Share of assumed liability Partnership ordinary income Minus: Assumption of Able’s liability Ending basis

Able $30,000 14,000 5,000* 12,000 (10,000)* $51,000

Baker $40,000 14,000 5,000 12,000 -0$71,000

*Alternatively, Able reduces his basis by $5,000 ($5,000 - $10,000), which is the amount of his liability assumed by the other partner. c.

Ending balance sheets:

Cash ($40,000 + $28,000) Contributed property New property Total assets Liabilities ($10,000 + $28,000) Capital accounts: Able Baker Total liabilities and capital accounts

Tax $ 68,000 30,000 24,000 $122,000

Book $ 68,000 50,000 24,000 $142,000

$ 38,000

32,000a 52,000c $122,000

52,000b 52,000 $142,000

$30,000 adjusted basis contributed - $10,000 liability + $12,000 share of partnership ordinary income. b $50,000 FMV contributed - $10,000 liability + $12,000 share of partnership ordinary income. c $40,000 cash contributed + $12,000 share of partnership ordinary income. Copyright © 2024 Pearson Education, Inc.

C:9-8

d. The corporation recognizes no gain or loss under Sec. 1032(a), and neither shareholder recognizes gain or loss under Sec. 351(a). Able’s ending stock basis is $20,000, and Baker’s ending stock basis is $40,000, determined under Sec. 358(a)(1) as follows: Basis in corporate stock: Initial contribution Liability assumed by the corporation Ending basis

Able $30,000 (10,000) $20,000

Baker $40,000 -0$40,000

The liability assumed by the corporation is treated as boot received for the stock basis calculation, but it is not treated as boot for purposes of gain recognition if the liability assumption has a valid business purpose and no tax avoidance purpose (Secs. 357(a) and 358(d)). The corporation’s ordinary income does not affect the stock basis. pp. C:9-5 through C:9-9, C:9-24 through C:9-28, and C:2-16 through C:2-20. C:9-26 a. Fred recognizes ordinary income (compensation) of $15,000. Ed recognizes $89,000 (calculated in Part c below) of Sec. 1231 gain. The other partners recognize no gain or income. b. The partnership recognizes no gain, loss, or income on the transfers. c.

Al:

Cash contribution Mortgage allocated to partner Basis of partnership interest

$ 15,000 19,500 $ 34,500

Bob:

Accounts receivable basis to Bob Mortgage allocated to partner Basis of partnership interest

Clay:

Equipment basis to Clay Mortgage allocated to partner Basis of partnership interest

$ 13,000 19,500 $ 32,500

Dave:

Land basis to Dave Mortgage allocated to partner Basis of partnership interest

$ 50,000 19,500 $ 69,500

Ed:

Building basis to Ed Mortgage contributed to partnership Mortgage allocated to partner Tentative basis (and amount of gain recognized) Actual basis (basis cannot be less than zero)

$ 15,000 (130,000)* 26,000* $ 89,000 $ -0-

-026,000 $ 26,000

*Or minus $104,000 ($130,000 - $26,000) mortgage assumed by other partners Fred:

C:9-9

$ 15,000 19,500 $ 34,500

d. Bases: cash, $15,000; accounts receivable, $0; equipment, $13,000; land, $50,000; building, $15,000; and organizational expenditures, $15,000. e. Book values: cash, $15,000; accounts receivable, $20,000; equipment, $15,000; land, $15,000; building, $150,000; and organizational expenditures, $15,000. f. The building has no depreciation recapture potential because straight-line MACRS depreciation has been used. However, part or all of a subsequent gain will be classified as unrecaptured Sec. 1250 gain subject, at the partner level, to the 25% (and possibly an additional 3.8%) capital gains tax rate under Sec. 1(h)(l)(D) (and possibly Sec. 1411). The depreciation recapture potential for the office equipment carries over to the partnership. The partnership will recognize the recapture when it sells or exchanges the property in a taxable transaction. g. If Fred’s profits interest had an ascertainable value, the result is unchanged. If the profits interest has no ascertainable value at the time of the transaction, Fred recognizes no income, and the partnership has no organizational expenditure for which an amortization deduction can be claimed. Also, under Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS will not treat receipt of a profits interest as a taxable event unless one of the following events occurs: (1) the profits interest relates to a substantially certain and predicable income stream, (2) the partner disposes of the interest within two years of receipt, or (3) the interest is in a publicly traded partnership. (Note: The IRS is in the process of revising its rules concerning partners who contributed services. See Notice 2005-43, 2005-24 C.B. 1221.) h. Partnership: Amount realized on sale $ 9,000 Minus: Adjusted basis ( 50,000) Recognized loss ($41,000) Dave:

Other Partners:

Fair market value when contributed Minus: Adjusted basis Precontribution loss Total loss Minus: Precontribution loss Postcontribution loss Precontribution loss Plus: Share of postcontribution loss (0.15 x $6,000) Dave’s distributive share of loss Postcontribution loss allocated to other partners ($6,000 - $900)

$15,000 50,000 ($35,000) $41,000 ( 35,000) $ 6,000 $35,000 900 $35,900 $ 5,100

Each partner can claim his share of the $5,100 loss only when he has sufficient basis in his partnership interest. pp. C:9-5 through C:9-12, C:9-20, C:9-21, C:9-27, and C:9-28. C:9-27 a. Julie and Kay recognize no income on the partnership formation. Susan recognizes ordinary income equal to the value of the partnership interest received, or $20,000. (Note: The IRS is in the process of revising its rules concerning partners who contributed services. See Notice 2005-43, 2005-24 C.B. 1221.)

C:9-10

b. Julie $ -016,200

Basis of property contributed Plus: Share of liabilities Minus: Liabilities assumed by partnership Plus: Income recognized (for services) Basis in partnership

$16,200

Kay $75,000 32,400* (54,000)* _______ $53,400

Susan N/A $ 5,400 20,000 $25,400

*Or minus $21,600 ($54,000 - $32,400) liabilities assumed by other partners.

c. and d.

Basis Book Value Accounts receivable $ -0$ 60,000 Land 30,000 58,000 Building 45,000 116,000 Organizational expenditure 20,000 20,000 All of Kay’s precontribution gain is allocated to her, and no postcontribution gain remains to be allocated to other partners.

Kay’s gains are analyzed as follows: Cash received Plus: Liability assumed by buyer Amount realized Minus: Adjusted basis Gain realized and recognized Character of gains: Unrecaptured Sec. 1250 gain* Sec. 1231 gain Total

Land $40,000 18,000 $58,000 ( 30,000) $28,000

Building $ 80,000 36,000 $116,000 ( 45,000) $ 71,000

$ 15,000 56,000 $ 71,000

-028,000 $ 28,000

*The Sec. 1250 property is not subject to depreciation recapture because of straight-line depreciation, but to the extent of depreciation taken, the gain is unrecaptured Sec. 1250 gain subject to the 25% capital gains tax rate under Sec. 1(h)(l)(D) (and possibly an additional at 3.8% under Sec. 1411). pp. C:9-5 through C:9-12, C:9-21, and C:9-22.

C:9-11

C:9-28 a. Sean reports $75,000 of ordinary income and has a $75,000 basis in his partnership interest. The partnership deducts $75,000 as compensation, allocating the deduction to the old partners (none to Sean). The partnership (and the remaining partners) also recognize gains and losses as if 20% of each asset had been sold at its FMV to pay for Sean’s services. The basis in each asset having a gain (or loss) related to it will be adjusted upward (or downward) by the amount of the gain (or loss) recognized. Also, any gains allocated to the old partners will increase the basis in their partnership interests, and any deduction or losses will decrease their basis. In addition, the $100,000 of current year ordinary income is allocated as follows under the varying interest rule and also will increase the basis in their partnership interests: Old partners: (100% x 335/365 x $100,000) + (80% x 30/365 x $100,000) = $98,356 Sean: 20% x 30/365 x $100,000 = $1,644 b. Under Sol Diamond, 33 AFTR 2d 74-852, 74-1 USTC ¶9306 (7th Cir., 1974), if an ascertainable FMV exists for the interest, such value must be reported as income by Sean and is deductible by the XYZ Partnership. However, if the 20% interest has no ascertainable FMV, neither Sean nor the XYZ Partnership has any current tax consequences except that the $100,000 ordinary income is allocated as in Part a. In addition, under Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS will not treat receipt of a profits interest as a taxable event unless one of the following events occurs: (1) the profits interest relates to a substantially certain and predicable income stream, (2) the partner disposes of the interest within two years of receipt, or (3) the interest is in a publicly traded partnership. (Note: The IRS is in the process of revising its rules concerning partners who contributed services. See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-10 through C:9-12, C:9-20, and C:9-21. C:9-29 Marjorie:

Income: $15,000 ($20,000 FMV of interest - $5,000 cash) Basis in partnership interest: $15,000 income recognized + $5,000 cash contributed + Marjorie’s share of partnership liabilities (not given in problem).

Eldorado:

Capitalizes the $15,000. This amount is a syndication fee and cannot be deducted now nor amortized in the future as an organizational expenditure. The $5,000 cash contribution increases the partnership’s assets. Marjorie’s capital account includes $15,000 + $5,000, or $20,000. In addition, the partnership would recognize gain or loss on the deemed exchange of property for Marjorie’s services, and this gain or loss would be allocated to the other partners. The partnership also would adjust the basis of its assets for the recognized gain or loss.

(Note: The IRS is in the process of revising its rules concerning partners who contributed services. See Notice 2005-43, 2005-24 I.R.B. 1221.) pp. C:9-5 through C:9-12.

C:9-12

C:9-30 a. Possible Tax Year-Ends 6/30 Partner Name

Partnership Interest

Tax Year

Months Deferred

1/3 1/3 1/3

6/30 9/30 10/31

0 3 4

Beta Chi Delta

9/30

Total

Months Deferred

.00 1.00 1.33 2.33

9 0 1

10/31

Total

Months Deferred

3.00 .00 .33 3.33

8 11 0

Total 2.67 3.67 .00 6.34

The partnership must use a June 30 year-end, or with a Sec. 444 election, a tax year that ends on March 31, April 30, or May 31. b. The natural business year that ends on January 31. c. The partnership would be required to use an October 31 year-end, or the tax year of the majority partner. Alternatively, with IRS permission, the partnership could use a natural business year-end (January 31), or with a Sec. 444 election, the partnership could use a tax year that did not exceed a three-month deferral of income. pp. C:9-12 through C:9-15. C:9-31 a. December 31. The tax year-end of majority partners Boris and Damien is December 31, making this the required year-end for the partnership. b. Yes. Possible year-ends are those that allow for no more than a three-month deferral from the required December 31 year-end. These year-ends include September 30, October 31, and November 30. pp. C:9-12 through C:9-15. C:9-32 a. and b. Total Partnership ordinary income items: Sales Minus: Cost of goods sold Gross profit Plus: Sec. 1245 gain Minus: Ordinary expenses: Depreciation Guaranteed payment Business interest Business meals (50% in 2023) Partnership ordinary income

Mark

Pamela

$ 86,500

$450,000 (210,000) $240,000 33,000 $27,000 30,000 42,000 1,000

(100,000) $173,000

C:9-13

Separately stated items: Dividend income T-E interest income Sec. 1231 gain Net long-term capital gain ($12,000 - $10,000) Short-term capital loss Investment interest expense Charitable contributions Nonded. business meals Nondeductible interest on loan for T-E interest Guaranteed payment

$ 15,000 4,000 18,000 2,000 (9,000) (9,200) (5,000) (1,000) (2,800) 30,000

c. Beginning basis in partnership interest Plus: Partnership ordinary income Dividend income T-E interest income Sec. 1231 gain Net long-term capital gain Minus: Distributions Reduction in partnership liabilities Short-term capital loss Investment interest expense Charitable contributions Nondeductible business meals Nondeductible interest on loan for T-E interest Ending basis in partnership interest

7,500 2,000 9,000 1,000 (4,500) (4,600) (2,500) (500) (1,400)

Mark $150,000 86,500 7,500 2,000 9,000 1,000 (40,000) (7,000) (4,500) (4,600) (2,500) (500) __(1,400) $195,500

7,500 2,000 9,000 1,000 (4,500) (4,600) (2,500) (500) (1,400) 30,000

Pamela* $150,000 86,500 7,500 2,000 9,000 1,000 (40,000) (7,000) (4,500) (4,600) (2,500) (500) __(1,400) $195,500

*Note: Pamela’s basis calculation does not reflect the guaranteed payment because the increase for recognition and the decrease for payment net to zero. Partnership ordinary income qualifies as business income for the QBI deduction. The guaranteed payment to Pamela does not qualify, however. See Problem C:9-59 for related 2022 Form 1065, Schedule K. Note: In 2022, 100% of the meals expense for business meals is deductible because it was incurred in restaurants. In 2023, only 50% of the meals expense is deductible—so the treatment of meals on the 2022 tax form will differ from the treatment in this problem. pp. C:9-16 through C:9-28.

C:9-14

C:9-33

Transaction Income Operating profit Rental income Interest on municipal bonds Interest on corporate bonds Dividend Gain on investment land LTCG STCL Sec. 1231 gain Unrecaptured Sec. 1250 gain Expenses Depreciation Interest: Mortgage Mun. bond loan Guaranteed payment Total

(a) Financial Income

(b) Taxable Income

(d) Separately Stated Items

$ 94,000 30,000 15,000 3,000 20,000 60,000 10,000 ( 7,000) 9,000 44,000

$ 94,000 31,000a

$ 94,000

$ 31,000 15,000 3,000 20,000 66,000c 10,000 ( 7,000) 9,000 44,000

( 39,000)

( 41,000)d

( 18,000) ( 5,000) ( 30,000) $186,000

( 18,000)

3,000 20,000 66,000b 10,000 ( 7,000) 9,000 44,000

-0-e $ 211,000

(12,000) ( 29,000)

( 30,000) $35,000

( 18,000) ( 5,000) 30,000

Prepaid rental income is reported for tax purposes when it is received. For financial accounting purposes, the book value of the land was $15,000 and generated a book gain of $60,000. The tax basis was $6,000 smaller, so the tax gain is $6,000 larger. c The precontribution gain of $6,000 ($15,000 - $9,000) must be specially allocated to Jim while the postcontribution gain of $60,000 ($66,000 total gain - $6,000 precontribution gain) is allocated ratably to all three partners. d MACRS depreciation is used for tax purposes. e The guaranteed payment both reduces ordinary income and increases separately stated income items that are taxable and, hence, offset. However, the guaranteed payment does not qualify for the QBI deduction for Jim. b

Each partner will be notified of his share of low-income housing expenditures qualifying for the credit. pp. C:9-16 through C:9-24.

C:9-15

C:9-34 a. Partner Items

Total

Becky

Chuck

Dawn

Ordinary income Long-term capital gain Short-term capital loss Charitable contribution deduction

$120,000 18,000 6,000 20,000

$24,000 3,600 1,200 4,000

$36,000 5,400 1,800 6,000

$60,000 9,000 3,000 10,000

b. Partnership Total

Becky’s %

Becky’s Amount

Chuck’s %

Chuck’s Amount

1/1 through 6/30a Ordinary income LTCG STCL Charitable contribution

$59,507 8,926 2,975 9,918

20% 20% 20% 20%

$11,901 1,785 595 1,984

30% 30% 30% 30%

$17,852 2,678 893 2,975

7/1 through 12/31b Ordinary income LTCG STCL Charitable contribution

$60,493 9,074 3,025 10,082

25% 25% 25% 25%

$15,123 2,269 756 2,521

25% 25% 25% 25%

$15,123 2,269 756 2,521

1/1 through 6/30 is 181 days in a non-leap year. 7/1 through 12/31 is 184 days in a non-leap year.

Note: If instead the LTCG and STCL were extraordinary items, the STCL on March 2 would be allocated 20% to Becky, 30% to Chuck, and 50% to Dawn, and the LTCG on September 1 would be allocated 25% to Becky, 25% to Chuck, and 50% to Dawn. See Additional Comment on p. C:9-21. pp. C:9-20 and C:9-21.

C:9-16

C:9-35 Partnership ordinary income $2.5 million; taxable income $970,200, calculated as follows: Gross profit Minus: General business expenses Salaries (W-2 wages) Depreciation Interest expense* Partnership ordinary income

$ 9,000,000 (2,400,000) (1,600,000) (1,000,000) (1,200,000) $ 2,800,000

*Limited to 30% of adjusted taxable income: ($9,000,000 - $2,400,000 - $1,600,000 - $1,000,000) x 0.30. Note that the $1,000,000 of depreciation is deducted for the limitation in tax years beginning after 2021. The $800,000 of excess interest ($400,000 to each partner) is treated as an NOL carryover at the partner level, but it reduces the partner’s basis in the partnership, $400,000 to each partner, in the current year. pp. C:9-19 and C:9-20. C:9-36 Patty: Ordinary income: Long-term capital gain: Precontribution Postcontribution Total income/gain

$ 3,200 (0.40 x $8,000) 6,000 ($10,000 - $4,000) 1,600 [0.40 x ($14,000 - $10,000)] $10,800

Dave reports $4,800 ($8,000 x 0.60) of ordinary income and $2,400 ($4,000 x 0.60) of long-term capital gain. pp. C:9-21 and C:9-22. C:9-37 As stated in text Example C:9-27, the allocation meets the first test of shifting because the partners’ capital accounts increase by $10,000 whether with the special allocation or with an equal allocation. The following calculations show the tax effects of the two allocations: Special allocation: Taxable interest income Tax-exempt interest income Total allocation Taxable income Times: Tax rate Tax liability

Andy $ -010,000 $10,000

Becky $10,000 -0$10,000

$10,000 0.12 $ 1,200

-00.32 -0-

C:9-17

Total

$1,200

Equal allocation: Taxable interest income Tax-exempt interest income Total allocation

Andy $ 5,000 5,000 $10,000

Becky $ 5,000 5,000 $10,000

Taxable income Times: Tax rate Tax liability

$ 5,000 0.32 $ 1,600

$ 5,000 0.12 $ 600

Total

$2,200

Thus, shifting occurs because the special allocation does not alter the partners’ capital accounts and because the special allocation reduces the partners’ total tax liability. Therefore, the special allocation lacks substantiality. pp. C:9-21 through C:9-24. C:9-38 a. No. This special allocation does not meet the test of having substantial economic effect and will not be acceptable to the IRS. In particular, shifting occurs because the special allocation does not alter the partners’ capital accounts, and the special allocation reduces the partners’ total tax liability by shifting enough short-term capital gain to Clark to offset his entire short-term capital loss. b. The special allocation affects only the partners’ tax consequences and not the economic consequences. Each partner’s distributive share is still $100,000. Accordingly, the special allocation will not be accepted, and the income must be allocated according to the partners’ 50/50 interest in the partnership. The partners must report the following: Short-term capital gain Ordinary income

Total $ 60,000 140,000

Clark $30,000 70,000

Lois $30,000 70,000

pp. C:9-21 through C:9-24. C:9-39 a.

Carryover basis of contributed property Minus: Debt assumed by other partners (0.80 x $10,000) Partnership interest basis

$14,000 ( 8,000) $ 6,000

Carryover basis from friend Plus: Share of partnership liabilities Partnership interest basis

$34,000 20,000 $54,000

The interest’s FMV used in valuing the estate ($120,000) is Kelly’s basis.

pp. C:9-24 through C:9-28.

C:9-18

C:9-40 a.

The FMV of the partnership interest, or $25,000. (Note: The IRS is in the process of revising its rules concerning partners who contributed services. See Notice 2005-43, 2005-24 C.B. 1221.) b. Land basis $ 6,000 Car basis 15,000 Cash contributed 2,000 Share of recourse liabilities (0.40 x $100,000) 40,000 Basis in partnership interest $63,000 pp. C:9-24 through C:9-28. C:9-41 a.

Purchase price Plus: Share of liabilities (0.40 x $200,000) Distributive share of taxable items ($30,000 + $10,000 - $1,000) Distributive share of tax-exempt items ($8,000 - $2,000) Minus: Change in liabilities (0.40 x $20,000) Basis on December 31

39,000 6,000 ( 8,000) $167,000

Purchase price Plus: Share of recourse liabilities (0.30 x $200,000) Distributive share of taxable items Distributive share of tax-exempt items Increase in nonrecourse liabilities (0.40 x $80,000) Minus: Reduction in recourse liabilities (0.30 x $100,000) Basis on December 31

$ 50,000 60,000 39,000 6,000 32,000 ( 30,000) $157,000

Purchase price Plus: Distributive share of taxable items Distributive share of tax-exempt items Increase in nonrecourse liabilities (0.40 x $80,000)* Basis on December 31 *Tina has no economic risk of loss for the recourse liabilities and therefore receives no basis for these liabilities.

$ 50,000 39,000 6,000 32,000 $127,000

pp. C:9-24 through C:9-28.

C:9-19

$ 50,000 80,000

C:9-42 a. and b. Analysis of Outside Basis and At-Risk Basis: Outside basis at January 1 Plus: Short-term capital gain Partnership nonrecourse liability Outside basis before losses Minus: Reduction for losses (see below) Outside basis after losses

Kerry $200,000 150,000 50,000 $400,000 ( 400,000)a $ -0-

City Corporation $200,000 150,000 50,000 $400,000 ( 400,000) $ -0-

At-risk basis before losses Minus: Reduction for losses At-risk basis after losses

$350,000 (350,000) $ -0-

N/A

Treatment of Losses: Losses: Ordinary loss Long-term capital loss Total

Kerry $450,000 50,000 $500,000

City Corporation $450,000 50,000 $500,000

Loss allowed

$350,000a

$400,000b

Character of losses allowed: Ordinary loss (450/500 x loss allowed) Long-term capital loss (50/500 x loss allowed) Total

$315,000 35,000 $350,000

$360,000 40,000 $400,000

Kerry’s loss is limited under Sec. 465 to his at-risk basis. Nevertheless, his outside basis is reduced by $400,000. Because Kerry is married filing jointly, the business loss would not be further limited by the limitation on excess losses because of the $578,000 (in 2023) threshold. b City Corporation is not subject to the at-risk rules because it is not closely held. Thus, the corporation’s loss is limited to its outside basis. c. The qualified nonrecourse liability is considered to be at-risk. Therefore, both partners can deduct a $400,000 loss and have a zero outside basis for their partnership interest after the year’s operations. Thus, City Corporation’s results are the same as in Parts a and b, and Kerry’s results are now the same as City’s. pp. C:9-29 and C:9-30.

C:9-20

C:9-43 Gary (General Partner-60%) Mary (General Partner-40%) Tax Basis At-Risk Basis Tax Basis At-Risk Basis Beginning basis without debt Recourse debt (accts. pay.) Nonrecourse debt Basis before losses Operating loss* Ending basis

$ 42,000 18,000 60,000 $120,000 (120,000) $ -0-

$42,000 18,000 -0$60,000 (60,000) $ -0-

$28,000 12,000 40,000 $80,000 (80,000) $ -0-

$28,000 12,000 -0$40,000 (40,000) $ -0-

*Gary recognizes a $60,000 loss, and Mary recognizes a $40,000 loss, both limited by the at-risk rules. Nevertheless, Gary and Mary reduce their partnership bases by the full amount of the losses. They can deduct the disallowed losses in future years if they increase their at-risk bases. The losses in future years would not be further limited by the limitation on excess business losses as long as they remain below the threshold for the application of that limitation. pp. C:9-29 and C:9-30. C:9-44 a. Beginning basis Plus: Share of LTCG Basis before loss

Eve $46,000 8,000 $54,000

Tom $75,000 12,000 $87,000

Share of loss

$56,000

$84,000

Limitations on loss Sec. 704(d) limit At-risk limit Passive activity limit

$54,000 54,000 N/A

$87,000 87,000a 12,000b

Deductible loss

$54,000

$12,000

Because the partnership has no nonrecourse liabilities, the at-risk basis equals the partnership basis for both partners. Thus, the at-risk rules under Sec. 465 do not limit the losses the partners can deduct. b

Eve materially participates in the partnership business, so the partnership’s ordinary loss is an active loss for her. Tom is a limited partner and does not materially participate, so his deduction for losses is limited under Sec. 469 to the passive income he earns from this (and all other) passive activities during this year. Because the problem states that he has no other income except his salary, Tom can deduct the loss only to the extent of his share of income from this partnership. This result assumes that the long-term capital gain relates to the partnership’s operations and is not portfolio income. These rules determine the amount of loss Tom can deduct. The character (and the treatment of Tom’s income on the tax return) remains $12,000 ordinary loss and $12,000 long-term capital gain.

C:9-21

b. The additional $100,000 recourse debt would increase both the Sec. 704(d) basis and the at-risk basis for Eve, who has the economic risk of loss. This increase would give her enough at-risk basis to deduct her full $56,000 distributive share of partnership losses. As a limited partner, Tom would have a basis increase only if he had some agreement to assume an economic risk of loss related to the recourse borrowings. Even if he had a basis increase (which is unlikely), Tom could not deduct any additional loss because the passive activity loss rules still limit passive losses to passive income. Note: The losses in any case are too small to be affected by the limitation on excess business losses. pp. C:9-29 and C:9-30. C:9-45 a. Kate

Chad

Stan

Basis before gain and loss Plus: Capital gain Basis before loss At-risk basis before lossa

$100,000 20,000 $120,000 $ 70,000

$50,000 10,000 $60,000 $35,000

Distributive share of loss Character of loss Deductible loss

$ 80,000 Active $ 70,000

$ 80,000 Passive $ 20,000b

$40,000 Passive $10,000b

Basis before loss minus nonrecourse liability. Passive losses are deductible to the extent of passive income earned during the year, the capital gain in this case. This result assumes the partners have no passive income from other sources that can be offset by the passive loss and that the capital gain is not portfolio income. b

b. Rental activities are passive activities, so Kate and Chad are limited to a $25,000 loss deduction, $20,000 because of the capital gain plus $25,000 because their AGIs do not exceed $100,000. The $25,000 portion of the deduction, however, would have to be reduced if Kate’s and Chad’s AGIs were to exceed $100,000. Stan does not actively participate in the rental activity, so he has the same deductible loss as in Part a. pp. C:9-29 and C:9-30.

C:9-22

C:9-46 a. & b. Analysis without the at-risk and passive activity loss (PAL) rules: The following analysis shows the partnership’s gain or loss for the Years 1 through 5 and the beginning of Year 6. The $82,000 gain at the beginning of year six is all ordinary income because of Sec. 1245 depreciation recapture. The total tax savings without discounting are zero. However, with discounting, the total tax savings are $4,172. Thus, without the at-risk and PAL rules, the partners obtain a deferral advantage. Year Lease income Minus: Depreciation Interest expense

1 $ 10,000 ( 40,000) ( 7,000)

2 $ 10,000 ( 25,000) ( 6,500)

3 $ 10,000 ( 15,000) ( 6,500)

4 $ 10,000 ( 8,000) ( 6,000)

5 $ 10,000 ( 8,000) ( 6,000)

Beg. 6 $82,000 ( 4,000) -0-

Gain (loss)

($37,000)

($21,500)

($11,500)

($ 4,000)

$78,000

Tax (tax savings) (32%) Present value (7%)

($11,840) (11,065)

($ 6,880) (6,009)

($ 1,280) (977)

($ 1,280) (913)

$ 24,960 17,796

($ 3,680) (3,004)

Total -0(4,172)

c. Analysis with Sec. 465 at-risk and Sec. 469 passive activity loss rules: With the at-risk and PAL rules in effect, the deferral advantage disappears, and the partners achieve no tax savings. The following table shows this result. Year Lease income Minus: Depreciation Interest expense Gain (loss) At-risk disallowance

1 $ 10,000 ( 40,000) ( 7,000) ($37,000) 35,000

2 $10,000 ( 25,000) ( 6,500) ($21,500) 21,500

3 $ 10,000 ( 15,000) ( 6,500) ($11,500) 11,500

4 $10,000 ( 8,000) ( 6,000) ($ 4,000) 4,000

5 $10,000 ( 8,000) ( 6,000) ($ 4,000) 4,000

PAL disallowance Net gain (loss)

2,000 $ -0-

-0-0-

Beg. 6 $82,000 ( 4,000) -0$78,000 (76,000)* ( 2,000)* $ -0-

*The partners can deduct these amounts in Year 6 because, after the sale, they have at-risk basis and are allowed to deduct the deferred passive active loss.

d. The following table shows the combined basis of both partners’ interests in the partnership. Each partner will have half the amounts shown in this table. Note that the partners’ bases are always positive, so the Sec. 704(d) loss limitation does not apply.

C:9-23

Year Beginning basis Contributions Debt Gain (loss) Basis before distributions

-02,000 95,000 (37,000) $60,000

$60,000 -0( 3,500) ( 21,500) $35,000

$35,000 -0( 3,500) ( 11,500) $20,000

$20,000 -0( 4,000) ( 4,000) $12,000

$12,000 -0( 4,000) ( 4,000) $ 4,000

Final distribution Ending basis

Beg. 6 $

4,000 -0(80,000) 78,000 $ 2,000 ( 2,000) $ -0-

pp. C:9-29 and C:9-30. C:9-47 a.

Amount realized $ 40,000 Minus: Adjusted basis ( 60,000) Realized loss ($20,000) Susan cannot recognize the loss because she is deemed to own 100% of the partnership. The partnership has a $40,000 cost basis in the securities. b. Amount realized $ 40,000 Minus: Adjusted basis ( 50,000) Realized loss ($ 10,000) Susan recognizes the entire $10,000 loss because she owns only 15% of the partnership. c. Amount realized $ 40,000 Minus: Adjusted basis ( 30,000) Realized gain $ 10,000 Susan recognizes the entire $10,000 as a capital gain, even though she owns directly and indirectly 65% of the partnership, because the property is a capital asset to the partnership. d. The partnership reduces its gain realized by any previously disallowed loss (Sec. 707(b)(1) and Sec. 267(d)). The reduction, however, cannot create or increase a loss. Thus, the partnership’s results are as follows: Selling price Minus: Partnership’s basis Gain (loss) realized Reduction of gain for previously disallowed loss Gain (loss) recognized

Case 1 $70,000 ( 40,000) $30,000 ( 20,000) $10,000

pp. C:9-31 and C:9-32.

C:9-24

Case 2 $55,000 ( 40,000) $15,000 ( 15,000) $ -0-

Case 3 $35,000 ( 40,000) ($ 5,000) -0($ 5,000)

C:9-48

Other unrelated partners

37%

45% Maura 15% KLM 35%

Kara (Maura’s Mother)

KTV 45%

20% 3% Lynn Maura’s interest in KTV is counted as indirectly owned by Kara. Therefore, KLM and KTV are partnerships in which the same persons own directly or indirectly more than 50% of the capital or profits interests. a.

Amount realized Minus: Adjusted basis Realized loss The KTV Partnership does not recognize the $ 30,000 loss. b. Amount realized Minus: Adjusted basis Realized gain The KTV Partnership recognizes a $27,000 capital gain. c. Amount realized Minus: Adjusted basis Realized gain The KTV Partnership recognizes $15,000 of ordinary income.

$50,000 ( 80,000) ($30,000) $50,000 ( 23,000) $27,000 $50,000 ( 35,000) $15,000

d. The KLM Partnership reduces its gain realized by any previously disallowed loss (Sec. 707(b)(1) and Sec. 267(d)). The reduction, however, cannot create or increase a loss. Thus, KLM Partnership’s results are as follows: Case 1 Case 2 Case 3 Selling price $130,000 $70,000 $ 40,000 Minus: Partnership’s basis in stock ( 50,000) ( 50,000) ( 50,000) Gain (loss) realized $ 80,000 $20,000 ($10,000) Reduction of gain for previously disallowed loss ( 30,000) ( 20,000) ( -0-) Gain (loss) recognized $ 50,000 $ -0($10,000) pp. C:9-31 and C:9-32.

C:9-25

C:9-49 SD Partnership Ordinary income before guaranteed payments Minus: Guaranteed payments Partnership ordinary income Capital gain OI = Ordinary income

$23,000 (10,000) $13,000 $14,000

Allocation to Partner: Scott Dave $5,000 OI $6,500 OI $7,000 LTCG

$5,000 OI $6,500 OI $7,000 LTCG

LTCG = long-term capital gain

The arrangement of guaranteed payments is not a good idea because the amount of ordinary income allocated to each partner would be $11,500 with or without the guaranteed payments. However, by allocating amounts as guaranteed payments, the partners have reduced the business income qualifying for the QBI deduction. pp. C:9-32, C:9-33, C:9-35, and C:9-36. C:9-50 a. AB Partnership Ordinary income before guaranteed payment Minus: Guaranteed payment Partnership ordinary income Total to partners

$160,000 ( 90,000) 70,000 $160,000

Allocation to Partner: Allen Bob $ 90,000 35,000 $125,000

$35,000 $35,000

b. AB Partnership Ordinary income before guaranteed payments Minus: Adjustment for guaranteed payment* Income allocation *Guaranteed minimum Minus: Bob’s distributive share Guaranteed payment

Allocation to Partner: Allen

Bob

$160,000

$80,000

-0$160,000

( 10,000) $70,000

10,000 $90,000

$90,000 (80,000) $10,000

C:9-26

c. AB Partnership LTCG Guaranteed payment Minus: Ordinary loss allocated* Total to partners

$140,000 80,000 ( 80,000) $140,000

Allocation to Partner: Allen Bob $70,000 (40,000) $30,000

$ 70,000 80,000 ( 40,000) $110,000

*$0 ordinary income before guaranteed payment - $80,000 guaranteed payment = ($80,000) ordinary loss. Note that, in all three cases, Bob’s ordinary income allocation (and hence potential cash flow) is higher with the guaranteed payment than without the guaranteed payment, so he should be better off even though guaranteed payments do not qualify for the QBI deduction. pp. C:9-32, C:933, C:9-35, and C:9-36. C:9-51 a.

LTCG Guaranteed payment Minus: Ordinary loss allocated Total to partners

PS Partnership

Allocation to Partner: Pam Susan

$ 10,000 40,000 (40,000)* $ 10,000

$ 3,000 40,000 (12,000) $31,000

7,000

( 28,000) ($ 21,000)

*$0 ordinary income before guaranteed payments - $40,000 guaranteed payment = ($40,000) ordinary loss. b. PS Partnership Guaranteed payment Ordinary income allocated Sec. 1231 gain Total to partners

$ 35,000 45,000* 60,000 $140,000

Allocation to Partner: Pam Susan $35,000 9,000 12,000 $56,000

$36,000 48,000 $84,000

*$80,000 ordinary income before guaranteed payment - $35,000 guaranteed payment = $45,000

C:9-27

Ordinary income before guaranteed payment Times: Pam’s distributive share of partnership income Pam’s distributive share Plus: Pam’s guaranteed payment ($60,000 - $48,000) Pam’s total payment (guaranteed minimum) PS Partnership

Guaranteed payment Ordinary income allocated Total received

$ 12,000 108,000a $120,000

$120,000 0.40 $ 48,000 12,000 $ 60,000

Allocation to Partner: Pam Susan $12,000 48,000 $60,000

$60,000b $60,000

$120,000 ordinary income before guaranteed payment - $12,000 guaranteed payment = $108,000 b The $60,000 allocation to Susan can be viewed two ways: $108,000 partnership allocation minus $48,000 allocation to Pam, or $72,000 ($120,000 × 0.60) Susan’s share minus $12,000 guaranteed payment to Pam. pp. C:9-32, C:9-33, C:9-35, and C:9-36. C:9-52 Assuming Son passes the tests for ownership of the partnership interest, Son is a partner since capital is a material income producing factor. Allocation of the income would occur as follows: Dad (0.70 x $100,000) Fred (0.10 x $100,000) Son (0.20 x $100,000) Total distributive shares

$ 70,000 10,000 20,000 $100,000

pp. C:9-33 and C:9-34. C:9-53 Partnership income before guaranteed payment Minus: Reasonable compensation for Steve Partnership ordinary income Distributive shares:

Steve (60%) Tracy (20%) Vicki (20%) Total

$160,000 ( 70,000) $ 90,000 $ 54,000 18,000 18,000 $ 90,000

In addition to his distributive share, Steve receives $70,000 of ordinary income from the guaranteed payment, for a total of $124,000. However, the guaranteed payment does not qualify as business income for the QBI deduction. pp. C:9-33 and C:9-34. Copyright © 2024 Pearson Education, Inc.

C:9-28

Comprehensive Problems C:9-54 a. Rick’s distributive share of income is his 40% loss share because the partnership has an overall loss. Specifically, Rick’s distributive share is: Ordinary loss Long-term capital gain Sec. 1231 gain

($176,000) 40,000 60,000

b. What Rick can report on his tax return is restricted by loss limitation rules. In all cases, he must report the $40,000 long-term capital gain and the $60,000 Sec. 1231 gain. Beginning basis Income (LTCG + Sec. 1231 gain) Loss limitation Allowed loss Ending basis

Sec. 704(d) Limit $ 50,000 100,000 $150,000 (150,000) $ -0-

At-Risk Limit $ 20,000 100,000 $ 120,000 ( 120,000) $ - 0-

Although the Sec. 704(d) limit would allow Rick to deduct $150,000, the at-risk rules under Sec. 465 limit his loss to $120,000. (The $20,000 beginning at-risk amount is Rick’s beginning $50,000 basis in the partnership less the $30,000 portion of the basis attributable to his share of the nonrecourse debt, for which he is not at risk.) Further, the passive activity loss rules under Sec. 469 apply because Rick does no work in this partnership. The passive activity loss rules limit his loss deduction to passive activity income. He has $100,000 income from this activity (and no other investments). As long as the $100,000 is passive (and not portfolio income), he can deduct $100,000 on this tax return. c. Rick’s basis is zero as calculated above. Even though he can deduct only $100,000, his partnership basis is reduced by the full $150,000.

C:9-29

C:9-55 a.

Partnership ordinary income: Total

Sales—Inventory A Minus: COGS—Inventory A Gross profit—Inventory A Minus: Precontribution profit Postcontribution profit

$60,000 ( 35,000) $25,000 ( 15,000)

Sales—Inventory B Minus: COGS—Inventory B Gross profit—Inventory B

$58,000 ( 40,000) 18,000 (20,000) ( 500) ( 7,000) $ 500

Total $ 1,000 15,000

Charles (40%) $ 400 15,000

Mary (60%) $ 600

Charles (40%) $ 70,000 200 400 15,000 1,600 ( 2,000) $ 85,200

Mary (60%) $150,000 300 600

Charles (40%) $100,000 200 400 ( 2,000) $ 98,600

Mary (60%) $150,000 300 600 ( 3,000) $147,900

Separately stated items:

Short-term capital gain Precontribution profit c.

Partners’ basis in partnership:

Beginning basis (adjusted basis of original contributions) Plus: Partnership ordinary income Short-term capital gain Precontribution profit Share of ending liabilities ($5,000 - $1,000) Minus: Distributions Ending basis d.

Mary (60%)

$10,000

Minus: Operating expenses Interest expense Depreciation Partnership ordinary income b.

Charles (40%)

Partners’ book capital accounts:

Beginning balance (FMV of original contributions) Plus: Partnership ordinary income Short-term capital gain Minus: Distributions Ending balance

C:9-30

200

300

2,400 ( 3,000) $150,300

Analysis of cash:

Increases: Mary’s contribution Original loan amount Cash from sales ($60,000 + $58,000) Sale of ST Corporation stock (proceeds) Total increase Decreases: Purchase of equipment Purchase of Inventory B Purchase of ST stock Loan principal repayment Operating expenses Interest expense Distributions Total decrease Ending cash balance f.

$150,000 5,000 118,000 6,000 $279,000 $ 50,000 80,000 5,000 1,000 20,000 500 5,000 ( 161,500) $117,500

Tax balance sheet:

Assets: Cash Stock Inventory Equipment (ending: $50,000 - $7,000) Total

Beginning $150,000 70,000 _______ $220,000

Liabilities and Capital Accounts: Liabilities Charles’ tax capital account Mary’s tax capital account Total a

-070,000 150,000 $220,000

5,000 70,000 150,000 $225,000

Ending $117,500a 75,000b 43,000 $235,500 $

4,000 83,600c 147,900c $235,500

See Part e.

Post-Purchase $ 20,000 5,000 150,000 50,000 $225,000

Analysis of inventory: Contribution of Inventory A (carryover basis) Purchase of Inventory B Sale of inventory ($35,000 + $40,000) Ending balance

$ 70,000 80,000 ( 75,000) $ 75,000

See Part c. Same as ending basis minus each partner’s share of partnership liabilities.

C:9-31

Book balance sheet:

Assets: Cash Stock Inventory Equipment (ending: $50,000 - $7,000) Total

Beginning $150,000 100,000 _______ $250,000

Liabilities and Capital Accounts: Liability Charles’ book capital account Mary’s book capital account Total a

$ -0100,000 150,000 $250,000

Post-Purchase $ 20,000 5,000 180,000 50,000 $225,000 $

5,000 100,000 150,000 $255,000

Ending $117,500a 90,000b 43,000 $250,500 $

4,000 98,600c 147,900c $250,500

See Part e.

Analysis of Inventory: Contribution of Inventory A (FMV) Purchase of Inventory B Sale of inventory ($50,000 + $40,000) Ending balance c

$100,000 80,000 ( 90,000) $ 90,000

See Part d.

C:9-32

Tax Strategy and Critical Thinking Problem C:9-56 a. (1) Corporation’s taxable income and tax liability: Sales Beginning inventory Plus: Purchases Minus: Ending inventory Cost of goods sold Gross profit Plus: Long-term capital gain Dividends received Total other income Minus: Operating expenses Deductible interest expense Dividends-received deduction ($4,000 x 0.50) Total deductions Taxable income

$3,000,000 $1,770,000 2,100,000 (1,650,000) (2,220,000) $ 780,000 $

20,000 4,000 24,000

$ 500,000 30,000 2,000 ( 532,000) $ 272,000

Income tax liability (at 21%)

57,120

(2) Sarah’s and Rex’s AGI, taxable income, and tax liability (both are the same, so only one computation follows based on 2023 schedules): Dividend income (AGI) Minus: Standard deduction QBI deduction (not applicable) Taxable income (all dividend income subject to reduced tax rates)

$ 60,000 ( 13,850) ( -0-) $ 46,150

Income tax liability [(0.00 x $44,625) + (0.15 x $1,525)] Times: Number of taxpayers Total income tax liability for Sarah and Rex (3) Total tax liability for the corporation and its owners

229 2 458 $ 57,578

b. (1) Partnership ordinary income: Gross profit (same as Part a(1)) Minus: Operating expenses Deductible business interest expense Partnership ordinary income

Total $780,000 ( 500,000) ( 30,000) $250,000

C:9-33

Sarah

Rex

$125,000

(2) Separately stated items: Total $20,000 4,000 2,200

Long-term capital gain Dividend income Tax-exempt interest income

Sarah $10,000 2,000 1,100

Rex $10,000 2,000 1,100

(3) Sarah’s and Rex’s AGI, taxable income, and tax liability (Both are the same, so only one computation follows): Partnership ordinary income Plus: Long-term capital gain Dividend income Minus: One-half self-employment tax Adjusted gross income (AGI) Minus: Standard deduction QBI deduction* Taxable income Minus: Long-term capital gain and dividend income Ordinary taxable income

$125,000 10,000 2,000 ( 8,830) $128,170 ( 13,850) ( 20,464) $ 93,856 ( 12,000) $ 81,856

*Lesser of combined QBI of $23,234 [($125,000 - $8,830) x 0.20] or excess taxable income of $20,464 [($128,170 - $13,850 - $12,000) x 0.20]. Income tax liability on ordinary taxable income {$5,147 + [0.22 x ($81,856 - $44,725)]} Plus: Tax on LTCG and dividend income ($12,000 x 0.15) Total income tax Plus: Self-employment tax Total tax liability Times: Number of taxpayers Total tax liability for Sarah and Rex

$ 13,316 1,800 $ 15,116 17,660 $ 32,776 2 $ 65,552

(4) Partners’ basis in their partnership interest (both are the same, so only one computation follows): Initial contribution to partnership $ 800,000 Plus: Share of partnership liabilities 200,000 Partnership ordinary income 125,000 Long-term capital gain 10,000 Dividend income 2,000 Tax-exempt interest income 1,100 Minus: Distribution ( 60,000) Ending basis for each partner $1,078,100 c. Based on the analyses in Parts a and b, the corporation gives the better result in terms of total tax liabilities, primarily because of the low corporate tax rate and the 0% tax rate on a large portion of the dividend distributions. A one-year analysis has two main shortcomings, however. Copyright © 2024 Pearson Education, Inc.

C:9-34

First, it does not take into account future operations, distributions, and tax rates. Second, it does not factor in the shareholders’ taxes upon a final disposition or liquidation of the corporation. d. The corporation will not reduce the overall tax liability by paying out the $60,000 amounts to each shareholder as salary rather than dividends. Assuming the $60,000 amounts are reasonable, the salaries would be deductible. However, they would trigger payroll taxes and tax at ordinary rates. The following calculation shows the total additional tax cost assuming the corporation pays and deducts a 7.65% payroll tax on the salaries and that the shareholder-employees also pay a 7.65% payroll tax via a reduction of their paychecks. The revised total tax is $59,273 ($57,578 from Part a + $1,696 net additional tax cost as calculated below). Deductible salary expense ($60,000 x 2) Deductible payroll tax ($120,000 x 0.0765) Total corporate deduction Times: Corporate marginal tax rate Corporate tax savings Minus: Corporate payroll tax paid Employees’ payroll taxes ($60,000 x 0.0765 x 2) Additional individual tax* Net tax additional tax cost

$120,000 9,180 $129,180 0.21 $ 27,128 ( 9,180) ( 9,180) ( 10,464) $ (1,696)

*Tax on $46,150 of ordinary taxable income Times: Number of taxpayers Total Minus: Tax on $46,150 of dividend income for two taxpayers Additional individual tax

Tax Form/Return Preparation Problems C:9-57 (See Instructor’s Resource Manual) C:9-58 (See Instructor’s Resource Manual) C:9-59 (See Instructor’s Resource Manual)

C:9-35

5,461 2 $ 10,921 ( 458) $ 10,464

Case Study Problems C:9-60 The points listed below are the major ones that should be covered in the presentation to be made. Students should incorporate these points into a properly structured presentation and should be encouraged to create the audio-visual aids needed to make an effective presentation. The bases for Abe and Brenda’s partnership interests on December 31 are as follows:

12/31 basis before income and liabilities Plus: Current income items Basis before losses

Abe

Brenda

$81,000 12,000 $93,000

$104,000 12,000 $116,000

The tax year is a loss year (because losses exceed income), so the 50% - 50% loss interest ratios are used to allocate both income and loss items. Income items of $24,000 ($10,000 Sec. 1231 gain and $14,000 municipal bond income) are evenly allocated to the two partners and reflected in the above bases numbers. Each partner is allocated one-half of each item of loss or deduction for a total of $125,000 each. The partners cannot reduce their basis below zero, so a pro rata portion of each loss item is used to reduce basis.

Ordinary loss LTCL STCL Total

Abe

Brenda

$37,200* 5,208* 50,592* $93,000

$ 46,400** 6,496** 63,104** $116,000

*93/250 x Loss item amount **116/250 x Loss item amount Abe, who is an active partner, reports the following amounts: $5,000 Sec. 1231 gain, $37,200 ordinary loss, $5,208 LTCL, and $50,592 STCL. His losses are not limited further by the Sec. 469 passive activity rules or the limitation on excess business losses. His $7,000 share of municipal bond income increases his basis in his partnership interest but is not recognized as income. His basis at year-end is zero. He has losses of $32,000 ($125,000 - $93,000), which he can deduct in future years when he again has basis in his partnership interest. Brenda is a passive partner, so she can deduct losses from this passive activity (her only passive activity) up to the amount of income from this activity, the $5,000 Sec. 1231 gain. All other losses will be suspended until she has passive income (from this or some other passive investment) or until she disposes of her entire interest in the partnership. Her allocated share of losses reduces her basis to zero even though she can deduct only $5,000. Copyright © 2024 Pearson Education, Inc.

C:9-36

The need to borrow money next year gives Abe (but not Brenda) the opportunity to deduct some of the suspended loss from this year’s operations. If the borrowings are recourse or qualified real estate nonrecourse financing, they will increase both partners’ partnership and at-risk bases. Note that recourse loans will be allocated between the partners based on their economic risk of loss while the nonrecourse debt would be divided on their 40% - 60% profit ratios. Abe will be able to deduct his losses from the current year along with any losses from next year’s operations up to the extent of his basis at the end of next year. Brenda’s partnership and at-risk bases also will be increased by the borrowings, but her passive losses will remain suspended until she has passive income. If the partnership earns money next year, she will have passive income and can recognize some of her suspended passive losses. If this partnership does not soon earn passive income, Brenda should consider adding investments to her portfolio that will generate passive income. C:9-61 Relevant facts: Mr. Jones made an error last year in allowing the partnership return to be filed. Mr. Jones is no longer with the firm, and the client already is unhappy about adjusting to a new accountant. Filing as a partnership reduces the client’s tax bill. The client is very important to the firm. Some ethical issues: 1. 2. 3. 4. 5.

Should Wise and Johnson prepare the Andres Partnership’s tax return? Should Wise and Johnson prepare an amended return for Dr. Andres for the prior year including all the Andres Partnership’s income in his personal return? How should John respond to Ms. Watson’s question about whether he is positive that the arrangement does not qualify as a partnership? If the firm decides to prepare the return and Ms. Watson tells John to prepare it, should he prepare it? How should the firm (and Ms. Watson and John) balance loyalty to the retired partner against misgivings about compromising integrity? Some possible alternatives: For John:

1. 2. 3. 4. 5.

Tell Ms. Watson he is not sure about his conclusion, and prepare the return if she wants to give the client a partnership return. Tell Ms. Watson he is sure about his conclusion, but prepare the return if she still wants to give the client a partnership return. Tell Ms. Watson he is sure about his conclusion, and ask to be taken off the assignment if she still wants to give the client a partnership return. Tell Ms. Watson he is sure about his conclusion, and talk to another partner in the firm if she still wants to give the client a partnership return. Resign, and let the firm work out its problem. Copyright © 2024 Pearson Education, Inc.

C:9-37

For Wise and Johnson: 1. 2. 3.

Prepare the current partnership return, and say nothing to the client. Refuse to prepare the current partnership return, but do nothing about correcting last year’s error. Refuse to prepare the current partnership return, and tell the client that an amended return must be filed for last year. Examples of questions to be asked in discussing the ethics of the alternatives:

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

How much value should be placed on (a) maintaining the firm’s reputation for quality work, (b) keeping the client, (c) John’s professional integrity, (d) Ms. Watson’s professional integrity, and (e) Mr. Jones’s professional reputation? What are the likely consequences of each alternative? Which alternative would provide the greatest benefit to the greatest number of the people involved? Does John have the right to refuse to prepare the partnership return? Does Ms. Watson have the right to insist that John prepare the partnership return? Which alternative distributes the benefits and burdens of this situation most fairly? What impact (if any) does the AICPA’s Statements on Standards for Tax Services have on the issues at hand? Does the firm or an individual tax return preparer have any liability for penalties under the tax return preparer rules (see Chapter C:15)? Does the firm face any sanctions under Treasury Department Circular 230? Does the firm have a responsibility for notifying the IRS about the error? Do Dr. Andres and his sons have any penalty exposure under the substantial underpayment provisions?

Tax Research Problems C:9-62 Basis at Time of Contribution Wally’s basis in the property at the time of contribution: Office furniture: Cost Minus: MACRS 7-year property ($60,000 x .1429 x 8/12) Basis at contribution (September 1, 2023)

$60,000 ( 5,716) $54,284

Sources: Sec. 168(e)(1), Sec. 168(k), and Rev. Proc. 87-57, 1987-2 C.B. 687, Table 1. (Also see Table 1 in Appendix C of the text.)

C:9-38

Building: Cost Prior years’ depreciation (MACRS 39year straight-line depreciation): 2019 (0.01391 x $100,000) 2020 (0.02564 x $100,000) 2021 (0.02564 x $100,000) 2022 (0.02564 x $100,000) 2023 (0.02564 x $100,000 x 8/12) Basis at contribution (September 1, 2023)

$100,000 $1,391 2,564 2,564 2,564 1,709 ( 10,792) $ 89,208

Sources: Sec. 168(c)(1) and IRS Publication 946, Table A-7a. (also see Table 9 in Appendix C of the text.) Land: Cost basis

$ 8,000

Partnership Depreciation The partnership continues the depreciation method used by the related party prior to the contribution (Sec. 168(i)(7)). The partnership is assumed to have held the property for the entire month in which the property is transferred (Prop. Reg. Secs. 1.168-5(b)(4)(i) and 1.168-5(b)(2)(i)(B)). Accordingly, the current year depreciation is: Office furniture ($60,000 x 0.1429 x 4/12)

$ 2,858

Building (0.02564 x $100,000 x 4/12)

855

Allocation of Depreciation to the Partners Section 704(c)(1) requires that depreciation on contributed property be allocated to take into account the difference between the basis and FMV amounts at the time of contribution. Treasury Regulations describe three alternatives for allocating depreciation between the partners. Regulation Sec. 1.704-3(b), and especially Reg. Sec. 1.704-3(b)(2) Example 1, illustrates the traditional method of allocation between the partners. For book purposes, the partnership records contributed property at its FMV at the time of contribution (Reg. Sec. 1.704-1(b)(2)(iv)(d)). Caitlin is treated as though she purchased a one-half interest in this book value. Consequently, she has an allocable right to tax depreciation in an amount that equals one-half the book depreciation. According to Reg. Sec. 1.704-1(b)(2)(iv)(g)(3), book depreciation is based on the following ratio: Book depreciation = Tax depreciation x (Book value / Adjusted basis) Thus, for the year of transfer, book depreciation is calculated as follows: Office furniture: $2,858 x ($66,000 / $54,284) = $3,475 Building: $855 x ($120,000 / $89,208) = $1,150 Copyright © 2024 Pearson Education, Inc.

C:9-39

The $66,000 and $120,000 book values in the above calculations are the FMVs at the time of contribution. Caitlin, then, is allocated tax depreciation equal to one-half these book amounts, and Wally receives any remaining tax depreciation. The following table summarizes the allocation of tax depreciation.

Partnership Office Furniture: ($3,475 x 0.5) ($2,858 - $1,738)

$2,858

Building: ($1,150 x 0.5) ($855 - $575)

Caitlin

Wally

$1,738 $1,120 855 $

575 $ 280

Treasury Regulations provide two other methods of allocating depreciation on contributed property among the partners: the traditional method with curative allocations and the remedial method. These elective methods are used only if the traditional method cannot give the noncontributing partner (in our case, Caitlin) tax depreciation equal to her share of book depreciation because the partnership’s tax depreciation on the contributed asset is less than the book value depreciation to be allocated to the noncontributing partner. One of these two methods would be used if partnership tax depreciation on the office furniture was less than $1,738 or if the partnership depreciation on the building was less than $575. Neither of these methods applies to our situation because the traditional method already gives Caitlin tax depreciation equal to her share of book depreciation. Depreciation Recapture and Unrecaptured Sec. 1250 Gain Both the office furniture and the building are Sec. 1231 property at the time of the contribution. The building is technically subject to Sec. 1250 recapture but only to the extent that accelerated depreciation claimed exceeds straight-line depreciation (Sec. 1250(a)). Because MACRS mandates straight-line depreciation, no Sec. 1250 depreciation recapture potential exists for the building. However, the building is subject to the unrecaptured Sec. 1250 gain rules of Secs. 1(h)(1)(D) and 1(h)(7), which tax such gain at a 25% rate (and possibly an additional 3.8%). At the time of the contribution, the office furniture is subject to Sec. 1245 recapture for the full $5,716 depreciation that Wally has claimed (Sec. 1245(a)). However, the contribution of the office furniture to the partnership triggers recapture only if gain must be recognized (Sec. 1245(b)(3)), and Wally recognizes no gain on this contribution. The recapture potential carries over to the partnership (Reg. Sec. 1.1245-2(c)(2)). At the time of contribution, the building has potential unrecaptured Sec. 1250 gain of $10,792, the amount of depreciation that Wally has claimed. But because the contribution triggers no gain recognition, the unrecaptured Sec. 1250 gain potential carries over to the partnership. Copyright © 2024 Pearson Education, Inc.

C:9-40

Note: The problem did not request the allocation of recapture upon sale of the furniture by the partnership. However, students may ask, and the answer is not the expected one. The allocation of Sec. 1245 recapture at the time of the sale of the office furniture by the partnership will not necessarily allocate all the precontribution recapture amounts to Wally. Regulation Sec. 1.1245-1(e)(2) specifies that the recapture is to be “allocated to the partners in the same proportion as the total gain is allocated” if the partnership agreement does not specifically allocate the Sec. 1245 recapture. This pro rata allocation may or may not allocate the full precontribution recapture to the contributing partner depending on the amount and allocation of postcontribution gain. Similar treatment probably also applies to unrecaptured Sec. 1250 gain. C:9-63 Under prior law, partnerships with large losses could admit a new partner near the end of the partnership’s tax year and allocate a substantial portion of the entire year’s losses to that new partner. Congress then enacted Sec. 706(d)(1), which requires that a partnership allocate losses and income based on the partner’s varying interest during the year, seemed to close this loophole. Soon, however, creative taxpayers decided to use a cash method partnership, which could incur expenses during the tax year while deferring their payment as late in the year as feasible. A new partner was admitted near the end of the tax year, and the unpaid items were then paid and expensed. The Tax Court’s decision in Cecil R. Richardson, 76 T.C. 12, aff’d. 51 AFTR 2d 83-418, 83-1 USTC ¶9109 (5th Cir., 1982), established the precedent that allowed this technique to be used and essentially permitted a retroactive allocation of losses. Subsequently, however, Congress closed off much of this technique by adding Sec. 706(d)(2), which requires that a partnership using the cash method of accounting accrue four types of expenses (interest, taxes, payments for services or for the use of property, and any other appropriate item specified by Treasury Regulations) for purposes of determining distributive shares. (The Treasury Department has not yet issued related regulations.) Thus, the current Sec. 706 rules prevent the retroactive allocation of certain partnership losses. Using the Sec. 706 rules, Raj can gain no benefit from the use of the cash method of accounting for the interest or the utilities. It is not clear whether the partnership would be allowed to use the cash method of accounting for the maintenance that has been pushed into December, but current law contains no prohibition against it. Under these rules, Raj would be allocated 25% of the December loss from the partnership of: ($12,000) = 0.25 x [$33,000 revenue - ($20,000 interest + $1,000 utilities + $60,000 maintenance)] In the Tax Court decision in Mary K.S. Odgen, 84 T.C. 871 (1985), rev’d. 57 AFTR 2d 861333, 86-1 USTC ¶9368 (5th Cir., 1986), a partner who was admitted late in the tax year received a one-time special allocation of the partnership’s loss that accrued during the period of time after her admission to the partnership. The Tax Court accepted the special allocation as meeting the tests for substantial economic effect and, in effect, allowed this method of achieving a disproportionate allocation of loss to a new partner. On appeal, the Fifth Circuit Court of Appeals ruled that the allocation lacked substantial economic effect because, by agreement, partners with deficit accounts did not have to restore the deficit nor receive smaller distributions on termination of the partnership. Even though the Ogden allocation was not valid, the technique still may be valid if (1) partnership agreements are drawn so that the requirements for special allocations are met and (2) the loss that is being specially allocated accrued after the new partner joined the partnership. Copyright © 2024 Pearson Education, Inc.

C:9-41

With a carefully drawn partnership agreement, Raj might be allocated the entire $48,000 loss that the partnership sustains in December. The technique, however, remains controversial. C:9-64 Upon forming the partnership, neither the partners nor the partnership recognized any gain or loss under Sec. 721(a). Under Sec. 722, Alice and Beth each took a $100,000 basis in their partnership interests, and Carl took a $160,000 basis in his partnership interest. Under Sec. 723, the partnership took a $160,000 adjusted basis in the land. However, see discussion below concerning Sec. 704(c)(1)(C). Under Sec. 704(c)(1)(A) and Reg. Sec. 1.704-3(a)(1), the partnership must take into account the difference between the land’s FMV and adjusted basis at the time of contribution. Thus, if Carl had remained a partner when the partnership sold the land, the partnership would have allocated the $60,000 precontribution loss to him. Regulation Sec. 1.704-3(a)(7) states that, if a contributing partner sells his or her partnership interest, any precontribution gains and losses must be allocated to the incoming partner as they would have been allocated to the selling partners. This rule, however, opens the possibility of transferring losses from one partner to another and possibly doubling losses. For example, if this regulation applies as stated, Carl recognizes a $60,000 capital loss on the sale of his partnership interest, and Dan recognizes a $60,000 capital loss when the partnership sells the land. (Note, however, that Dan’s partnership basis decreases to $40,000 so that he would recognize a $60,000 capital gain should the partnership subsequently liquidate and distribute $100,000 to him. Thus, the loss recognition by Dan is a timing issue.) Nevertheless, to prevent transferring a loss to the new partner, Congress enacted Sec. 704(c)(1)(C). This section states that any built-in loss on contributed property can be allocated only to the contributing partner. Furthermore, for purposes of allocating items to other partners, the partnership must treat the built-in loss property as if its adjusted basis equals the property’s FMV at the time of contribution. Accordingly, no built-in precontribution loss from the property contributed by Carl can be allocated to Dan. Therefore, Dan recognizes no loss when the partnership sells the property, and his basis in the partnership remains at $100,000.

“What Would You Do In This Situation?” Solution Ch. C:9, p. C:9-14. The IRS almost certainly will consider this transaction a part-sale, part-contribution. The IRS is likely to say that Bob sold land with a FMV of $150,000 (basis of $15,000) to the partnership and contributed land with a FMV of $150,000 (basis of $15,000) to the partnership. Their position is buttressed by the fact that Tom contributed $150,000 cash for his 50% interest while Bob is trying to claim a contribution of land worth $300,000 for an identical 50% interest. The payment to Bob was not made out of partnership profits, so it would be difficult to argue that Bob’s receipt of the payment was contingent on partnership performance. Accordingly, you should advise Bob to report this as a part-sale, part-contribution.

C:9-42

Chapter C:10 Special Partnership Issues Discussion Questions C:10-1 A liquidating distribution. A current distribution is a distribution that does not terminate the partner’s interest in the partnership, nor is the payment one of a series of payments intended to terminate the partner’s interest in the partnership. A liquidating distribution is made with the intention of terminating the partner’s entire interest in the partnership either with this payment or with a planned series of payments including this one. The January distribution to Javier is the first in a series of distributions that will terminate his interest in the partnership and, therefore, is a liquidating distribution. p. C:10-2. C:10-2 The basis of a single asset received in a liquidating distribution is determined by two factors: the basis of the distributed property in the partnership’s hands and the distributee partner’s basis in his or her partnership interest prior to the distribution. However, the total basis to the distributee partner of the assets received generally will equal the partner’s basis in the partnership interest immediately prior to the distribution. Because Mariel received a single asset that was not money, accounts receivable, or inventory, her basis will be $60,000 in the land regardless of what the partnership’s basis in the land was prior to its distribution. pp. C:10-12 through C:10-14. C:10-3 Cindy’s basis for the property she receives will be reduced to $4,000 from its $4,500 basis to the CDE Partnership because it is limited to Cindy’s basis in her partnership interest before the distribution. Even though Cindy will hold the property as an investment, the sale of the inventory would generate ordinary income for five years from the date of the distribution. The sale of the capital asset would generate long-term capital gain that is taxed at the applicable capital gains rate. pp. C:10-4 through C:10-7. C:10-4 Sec. 1245 depreciation recapture potential. The partnership’s accounts receivable probably are not unrealized receivables because the partnership uses the accrual method of accounting. However, depreciation recapture potential under Secs. 1245 is treated as an unrealized receivable. The partnership has Sec. 1245 recapture potential on the machines used to produce the inventory (and presumably also from other machinery, furniture, and equipment the partnership owns). The building has no Sec. 1250 recapture potential, and therefore does not produce an additional unrealized receivable because it was depreciated under MACRS, which requires straight-line depreciation. The building, however, does have unrecaptured Sec. 1250 gain potential, but unrecaptured Sec. 1250 gain is not an unrealized receivable. p. C:10-8. C:10-5 a, b, c, e. In essence, any property that is not a capital asset or Sec. 1231 property (to the extent exceeding Sec. 1245 and Sec. 1250 elements). p. C:10-8. C:10-6 For Sec. 751 to come into play in a current distribution, the distributing partnership must have both Sec. 751 assets (unrealized receivables and/or substantially appreciated inventory) and non-Sec. 751 assets. In addition, the distributee partner must have given up some of his or her Copyright © 2024 Pearson Education, Inc.

C:10-1

interest in one of the two classes of assets in exchange for an increased interest in the other class of assets. In other words, the distribution must be disproportionate. p. C:10-9. C:10-7 Under Sec. 731, a partner can recognize a loss on a distribution only if the distribution is a liquidating distribution that consists only of money, unrealized receivables, and/or inventory. The partner recognizes a loss if the amount of money and the carryover basis of the receivables and inventory are less than the partner’s predistribution basis in his or her partnership interest. p. C:1012. C:10-8 Yes. In determining the character of gain and/or loss on the sale of a partnership interest, the partnership is deemed to sell all its assets in a hypothetical sale for their FMV. The selling partner is then allocated his or her share of the ordinary income or loss from the sale of Sec. 751 assets. The partner’s residual gain or loss on the sale is capital gain or loss. If the partnership owns loss assets in addition to Sec. 751 assets, the allocable ordinary income could exceed the partner’s total gain, in which case the residual amount would be a capital loss. This result occurs in Example C:10-20 in the text. pp. C:10-16 through C:10-19. C:10-9 a. When Tyra’s interest in the partnership terminates, she will be deemed to have received a money distribution in the amount of her interest in partnership liabilities. Because she has a zero basis, she must report gain equal to the money distribution. Any other property she receives in the distribution will have a zero basis. b. The amount realized will equal the sum of the money received and any liabilities assumed by the purchaser. Because her basis is zero she will report a large gain. pp. C:10-12 and C:10-16 through C:10-18. C:10-10 If the entire partnership terminates, the Sec. 736 provisions do not apply at all. Rather each partner is taxed under the liquidating distribution rules. Section 736 applies if one or more partners (but fewer than all the partners) dies or retires. Accordingly, Sec. 736 applies to the payments to Tom. pp. C:10-19 and C:10-20. C:10-11 Section 736 divides payments into two categories. Section 736(b) payments are for a partner’s interest in partnership property, and these payments are taxed under the rules for liquidating distributions. The partner recognizes capital gain if she receives money exceeding basis in her partnership interest, so Lucia will report a capital gain of $3,000 ($23,000 - $20,000) on the payment she receives for partnership assets. Section 736(a) payments will be taxed as a guaranteed payment (ordinary income) if the distribution is not based on partnership income. If the payment is based on partnership income, the partner will be taxed on a distributive share of partnership income with the character of the income determined at the partnership level. Accordingly, Lucia will report her share of partnership income as a distributive share. pp. C:10-19 and C:10-20. C:10-12 No. The Tax Cuts and Jobs Act of 2017 repealed the technical termination rule of Sec. 708(b)(1)(B) for partnership tax years beginning after 2017. Therefore, the partnership will not terminate if Jason sells his 55% interest in the partnership. pp. C:10-22 and C:10-23.

C:10-2

C:10-13 A publicly traded partnership (PTP) is defined as a partnership whose interests are either traded on an established securities exchange or are traded in a secondary market or the equivalent thereof. Two groups of PTPs are not taxed as corporations. A PTP that existed on December 17, 1987, and which has not added a substantial new line of business, was not taxed as a corporation until tax years beginning after December 31, 1997. These partnerships, which were grandfathered under the 1987 law for ten years, were granted a new election in the Taxpayer Relief Act of 1997 (TRA of 1997). The TRA of 1997 allows these PTPs to continue to be taxed as partnerships if they elect to do so and agree to pay an annual tax of 3.5% of gross income from the partnership’s trade or business. Partnerships that have 90% or more of their gross income being “qualifying income” (interest, dividends, real property rents, etc.) continue to be taxed as partnerships. pp. C:10-28 and C:10-29. C:10-14 From a legal standpoint, all the owners of a limited liability company (LLC) have limited liability for the firm’s debts. In a limited partnership, all general partners have significant liability for firm debts. Under the check-the-box regulations, an LLC can choose whether to be treated as a partnership or taxed as a corporation. If the LLC chooses partnership treatment, the LLC and the limited partnership are treated similarly except the limited partnership must have at least one general partner. pp. C:10-29 and C:10-30. C:10-15 Yes. Even though the partnership’s total basis in assets does not exceed their FMV by more than $250,000, the new partner would be allocated a loss of $600,000 ($2,400,000 x 0.25) if the partnership were to sell its assets. This allocated loss exceeds $250,000, so a substantial built-in loss exists, which in turn makes a mandatory downward basis adjustment of $600,000 necessary. pp. C:10-26 and C:10-27.

Issue Identification Questions C:10-16 • • • • •

Does Kayla recognize a gain or loss on the current distribution? What is Kayla’s basis in the office equipment? When does Kayla’s holding period begin for the property? Does any depreciation recapture carryover to Kayla from the partnership? What is Kayla’s basis in her partnership interest following the distribution?

Kayla recognizes no gain or loss on the distribution. Her basis for the equipment would be a carryover basis from the partnership ($35,000) if that were possible, but it is limited to her basis in her partnership interest prior to the distribution ($30,000). Kayla’s holding period for the office equipment includes the holding period the partnership had for the property. Her basis in the partnership interest is zero following the distribution. The depreciation recapture potential is an unrealized receivable that will generate ordinary income under Sec. 735 (a)(1) when Kayla sells the property. pp. C:10-2 through C:10-7.

C:10-3

C:10-17 • • • • •

How much is Joel’s distribution? Does the partnership have Sec. 751 assets? If the partnership has Sec. 751 assets, did Joel exchange any interest in Sec. 751 assets for cash? How much ordinary income must Joel recognize if he exchanges Sec. 751 assets for cash? How must Joel treat any cash distribution received that exceeds the amount deemed to be part of the Sec. 751 exchange?

The amount of the distribution includes both the cash and the relief from liabilities that he received when his interest in the partnership changed from one-third to one-fourth. The partnership probably has Sec. 751 assets because the partnership inventory is substantially appreciated. Furthermore, the cash basis partnership probably has unrealized accounts receivable, and the partnership may have recapture potential if it has any depreciable personality. Again, an exchange of Sec. 751 assets for cash probably occurred because Joel received only cash and probably gave up a portion of his interest (from one-third to one-fourth) in each Sec. 751 asset. The amount of ordinary income is the difference between the amount of cash Joel is deemed to have received for the Sec. 751 assets and the adjusted basis that Joel would have had in the Sec. 751 assets had the Sec. 751 assets been distributed to Joel immediately before the deemed Sec. 751 sale (usually a carryover from the partnership’s basis in these Sec. 751 assets). Any cash or deemed cash exceeding the amount deemed to be part of the Sec. 751 exchange is treated as a current distribution. The current distribution will reduce his basis in his partnership interest. If the current distribution is greater than his basis in the partnership interest, Joel will recognize gain because he receives cash exceeding his basis. Note: The discussion in this chapter pertaining to disproportionate distributions conforms to existing Treasury Regulations under Sec. 751(b). The Treasury Department has issued proposed regulations that would alter the method for calculating disproportionate distributions and their tax consequences. When this textbook went to press, those regulations were still only proposed. Therefore, this textbook continues to apply the methods contained in existing Treasury Regulations. pp. C:10-7 through C:10-11. C:10-18 • • •

Does the partnership have Sec. 751 assets? What is the amount and character of the gain on the sale of Scott’s partnership interest? Should the partnership make a Sec. 754 election so Sally can obtain an optional basis adjustment?

The partnership has no unrealized receivables, but the partnership does have inventory. The results of the sale are determined as follows: Application of step 1 yields the following gain on Scott’s sale of his partnership interest: Amount realized on sale $43,000 Minus: Adjusted basis of partnership interest ( 33,000) Total gain realized $10,000 Copyright © 2024 Pearson Education, Inc.

C:10-4

Application of step 2 yields the following allocation to Sec. 751 property: Deemed Sale of Assets Inventory Building Land a

Partnership Gain $9,000 15,000a 6,000

Scott’s Share (1/3) $3,000 5,000b 2,000

$5,400 of which is unrecaptured Sec. 1250 gain. $1,800 of which is unrecaptured Sec. 1250 gain.

Thus, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income and $1,800 of unrecaptured Sec. 1250 gain. Application of step 3 yields the following residual allocation to capital gain: Total gain realized $10,000 Minus: Allocation to ordinary income and unrecaptured Sec. 1250 gain ( 4,800) Capital gain recognized $ 5,200 In summary, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income, $1,800 of unrecaptured Sec. 1250 gain, and a $5,200 capital gain. If the partnership made a Sec. 754 election, Sally’s optional basis adjustment would be calculated as follows: Cash purchase price $43,000 Minus: Sally’s share of partnership’s basis in assets (1/3 x $99,000) ( 33,000) Optional basis adjustment $ 10,000 The optional basis adjustment would be allocated $3,000 to the inventory, $5,000 to the building, and $2,000 to the land. pp. C:10-16 through C:10-19 and C:10-25 through C:10-27. C:10-19 •

Is this gift going to make Haley a partner in the HotWheels LLC for tax purposes?

•

If Alex restructures the gift so that Haley has true control over the interest, how will the LLC’s income be allocated between Alex and Haley?

Haley probably will not be a partner. For Haley to be considered a partner, she must have control of the interest. For a minor, control includes the situation where the interest is placed in trust for the benefit of the minor but only if the trustee is someone who will act in the best interest of the trust beneficiary. It is not clear that Alex is giving up any control over this interest since he will continue to control the 15% share he placed into Haley’s trust. Thus, Haley is unlikely to be considered a partner. A two-step allocation process will be used to allocate partnership income. First, Alex must be allocated a FMV salary. His current salary is described as small, and it may be too small to be considered equal to the Copyright © 2024 Pearson Education, Inc.

C:10-5

FMV of his services. Once Alex is allocated a FMV salary, all other income allocated to Alex and Haley must be divided on a pro rata basis. Alex must receive three-fourths and Haley must receive one-fourth. In effect, the family partnership income allocation rules override the special allocation to Alex. pp. C:9-33 and C:9-34. C:10-20 • • •

•

Should Krypton choose to be taxed as a partnership or as a corporation? How much will be kept in the business for growth, and how much will be distributed to the owners each year? The larger the percentage of earnings that will be distributed, the more advantageous a flow-through entity such as a partnership can be. What is the marginal tax rate for Jeff, Susan, and Richard? If Jeff, Susan, and Richard have lower marginal tax rates than does Krypton, partnership status has advantages. When considering the individual tax rates, the 20% effective reduction in the rates resulting from the qualified business income deduction must be factored into the analysis. How should Jeff’s pay for operating the business be structured? If the business is taxed as a corporation, a generous but reasonable salary will decrease the amount of income subject to double taxation. However, the lower capital gains tax rate on dividend income mitigates the double taxation of dividends. Also, the low 21% C corporation tax rate takes some of the bite out of double taxation. If the business is structured as a partnership, the partners need to decide whether to structure the payment as distributive share, as an outright guaranteed payment, or whether to establish a guaranteed minimum that may be some combination of the two. The guaranteed payment has a major disadvantage, however. Any amounts diverted to guaranteed payments will not qualify for the 20% qualified business income deduction. pp. C:2-3 through C:2-8, C:9-32, and C:9-33.

C:10-21 What method should XYZ Limited Partnership choose to use to operate under the publicly traded partnership rules? • • • •

Pay the annual 3.5% of gross income tax and continue to be taxed as a publicly traded partnership? Buy back enough interests (or restrict opportunities for trading) so the partnership is no longer publicly traded? Incorporate the entity and be taxed as a regular C corporation? If the XYZ Limited Partnership chooses to continue as a partnership, should it elect to come under the electing large partnership rules?

The best alternative will be a function of the amount of gross income, amount of taxable income, tax rates of the partners, amount of profits the firm wants to retain, and costs of buying back partnership interests, and/or restricting trading, or incorporating. The election reduces the partnership’s annual cost of providing information to partners but will require some start-up cost to make the change. The election also has the advantage of making it more difficult to accidentally terminate the partnership because of trades. However, the election significantly reduces the partners’ reporting and audit options. pp. C:10-28 and C:10-29.

C:10-6

Problems C:10-22a.

Ending partnership interest basis is $7,000, determined as follows: Beginning basis Minus: Cash received Land basis Ending basis

$ 25,000 ( 4,000) ( 14,000) $ 7,000

Lisa recognizes no gain. Her basis in the land is $14,000. b.

Ending partnership interest basis is zero, determined as follows: Beginning basis Minus: Cash received Basis before distribution of land Minus: Basis of land to Lisa Ending basis

$ 25,000 ( 4,000) $ 21,000 ( 21,000) $ -0-

Lisa recognizes no gain. Her basis in the land is limited to $21,000, which is the basis of her partnership interest reduced by the cash distributed. c.

Ending partnership interest basis is zero, determined as follows: Beginning basis Minus: Cash received Basis before distribution of land (but not less than zero) Minus: Basis of land to Lisa Ending basis

$ 25,000 ( 28,000) $ -0-0$ -0-

Lisa recognizes a $3,000 gain, the amount by which cash distributed exceeds her partnership basis before the cash distribution. Her basis in the land is limited to zero, which is the basis of her partnership interest reduced by the cash distributed. d.

Ending partnership interest basis is zero, determined as follows: Beginning basis Minus: Cash received Basis before distribution of property Minus: Basis of receivables and inventory Basis before distribution of land Minus: Basis of land to Lisa Ending basis

$ 25,000 ( 4,000) $ 21,000 ( 10,000) $ 11,000 ( 11,000) $ -0-

Lisa recognizes no gain. Her basis in the receivables is zero, and her basis in the inventory is $10,000. Her basis in the land is limited to $11,000, which is the basis of her partnership interest reduced by the cash distributed and by the basis of receivables and inventory distributed.

C:10-7

FMV of land distributed Minus: Basis of land distributed Gain recognized by the corporation (Sec. 311(b))

$ 30,000 ( 14,000) $ 16,000

In addition, the corporation increases its E&P by the E&P gain (which also is $16,000), decreases E&P by taxes on the tax gain, and decreases E&P by the $34,000 ($4,000 cash + $30,000 FMV of land) dividend distribution to Lisa (Sec. 312). Lisa recognizes a $34,000 ($4,000 cash + $30,000 FMV of land) dividend (Sec. 301(c) and Sec. 316). Her basis in the land is its $30,000 FMV (Sec. 301(d)), and her basis in her corporate stock remains at $25,000. f.

FMV of land distributed Minus: Basis of land distributed Gain recognized by the corporation (Sec. 311(b))

$ 30,000 ( 14,000) $ 16,000

One-half the $16,000 gain passes through to Lisa. Lisa’s basis in S corporation stock: Beginning basis Plus: Gain pass-through Basis before distributions Minus: Distributions excluded from Lisa gross income Ending basis

$ 25,000 8,000 $ 33,000 ( 33,000) $ -0-

Lisa received a $34,000 ($4,000 cash + $30,000 FMV of land) distribution, which exceeded her stock basis before the distribution. Thus, in addition to the $8,000 pass-through gain, Lisa recognizes a $1,000 capital gain on the excess distribution (Sec. 1368(b)(2)). Her basis in the land is its $30,000 FMV (Sec. 301(d)). pp. C:10-2 through C:10-7, C:4-2 through C:4-11, and C:11-25 through C:11-29. C:10-23

Partner’s Postdistribution Gain/Loss Basis -0$7,000

-0-

$4,000

$9,000

-0-

$14,000

Property Land Machinery Land Inventory Land - Parcel 1 Land - Parcel 2 Land - Parcel 1 Land - Parcel 2 Land - Parcel 3

pp. C:10-2 through C:10-7.

C:10-8

Basis to Partner $4,000 3,000 6,000 7,000 -0-04,000 6,000 4,000

C:10-24a. $3,000 gain recognized. Because Mario does not receive cash exceeding his partnership basis, he recognizes no gain under the current distribution rules of Sec. 731. However, Sec. 737 requires an additional step when some precontribution gain remains unrecognized. Mario must recognize gain equal to the lesser of: 1. 2.

Remaining precontribution gain ($8,000 = $18,000 - $10,000) or The excess of the FMV of the property distributed over the adjusted basis of the partnership interest immediately preceding the distribution ($3,000 = $23,000 $20,000 partnership basis). Under Sec. 737, Mario recognizes a $3,000 gain, which takes its character from the land Mario contributed to the partnership having the precontribution gain. b. $8,000 basis, determined as follows: Mario’s basis in partnership interest before the distribution $20,000 Plus: Sec. 737 gain recognized on the distribution 3,000 Minus: Carryover basis of property distributed (15,000) Basis in partnership interest after the distribution $ 8,000 Because Mario recognized gain under Sec. 737, he must increase the basis of his partnership interest by the $3,000 amount of the Sec. 737 gain. His basis is increased before reducing the basis for the distribution. c. $13,000 basis. Because Mario recognizes $3,000 of gain under Sec. 737, the partnership must increase its basis in the property related to the precontribution gain that Mario recognized. The partnership’s basis in the land is increased to $13,000 ($10,000 carryover basis from Mario at the time of the contribution + $3,000 Sec. 737 gain recognized on this distribution). Students may note that $5,000 of precontribution gain related to this land remains, which could be recognized under Sec. 737 if Mario receives other distributions that trigger the recognition of this gain within seven years of the original contribution of the land to the partnership. pp. C:10-2 through C:10-7. C:10-25a. $3,000 gain by Andrew. Andrew must recognize the gain that would have been allocated to him had the partnership sold the land for its FMV instead of distributing it to Bob. Amount deemed realized $21,000 Minus: Adjusted basis ( 18,000) Capital gain on deemed sale $ 3,000 b. and c. Basis in partnership interest: $24,000 for Andrew; $9,000 for Bob. Basis in land to Bob is $21,000. All $3,000 of the gain would have been allocated to Andrew because his pre-contribution gain was $4,000, so Andrew must recognize a $3,000 gain. He increases his basis in the partnership interest by the $3,000 gain he recognizes to $24,000. Bob’s basis in his partnership interest is not affected by the gain recognition. The partnership’s basis in the land is deemed increased by the $3,000 gain to $21,000 immediately before the land is distributed. Accordingly, the basis of the land to Bob is $21,000, and Bob’s basis in his partnership interest is reduced to $9,000 ($30,000 - $21,000) by the distribution. Andrew’s basis in his partnership interest is not affected by the distribution. pp. C:10-2 through C:10-7. Copyright © 2024 Pearson Education, Inc.

C:10-9

C:10-26 Basis in property after distribution: Land, $8,000; Inventory, $4,000; Cash, $10,000. Basis in partnership interest after distribution: Alonzo, $11,000; Beth, $15,000; Cathy, $11,000. First, Alonzo is not subject to Sec. 737 because he originally contributed only cash to the partnership. Second, under Sec. 704(c)(1)(B), Beth must recognize precontribution gains on the land distributed to Alonzo. Her potential gain is calculated as follows: Land: Amount deemed realized Minus: Adjusted basis Gain on deemed sale

$10,000 ( 4,000) $ 6,000

The precontribution gain allocated to Beth on the deemed sale is $4,000 ($8,000 FMV - $4,000 basis at contribution). Beth’s basis in her partnership interest after the deemed sale is $19,000 ($15,000 + $4,000 gain recognized). The land’s basis to the partnership immediately before the distribution to Alonzo is $8,000 ($4,000 basis + $4,000 gain recognized by Beth). Beth also has potential gain recognition under Sec. 737 because she contributed land to the partnership and then received a contribution of inventory contributed by Cathy. However, she recognizes no additional gain because she already has recognized all of her precontribution gain under Sec. 704(c)(1)(B). See Reg. Sec. 1.737-1(c)(2)(iv). Third, under Sec. 704(c)(1)(B), Cathy must recognize precontribution gain on the land distributed to Beth. Her potential gain is calculated as follows: Inventory: Amount deemed realized Minus: Adjusted basis Gain on deemed sale

$10,000 ( 1,000) $ 9,000

The precontribution gain allocated to Cathy on the deemed sale is $3,000 ($4,000 FMV - $1,000 basis at contribution). Cathy’s basis in the partnership interest after the deemed sale is $21,000 ($18,000 + $3,000 gain recognized). The inventory’s basis to the partnership immediately before the distribution to Beth is $4,000 ($1,000 + $3,000 gain recognized). Then, the current distributions must be analyzed using the normal rules. Alonzo’s distribution: Basis in partnership interest before distribution Minus: Carryover basis in land (see Beth’s analysis above) Basis in partnership interest after distribution

$19,000 ( 8,000) $11,000

Beth’s distribution: Basis in partnership interest before distribution (see Beth’s analysis above) Minus: Carryover basis in inventory (see Cathy’s analysis above) Basis in partnership interest after distribution

$19,000 ( 4,000) $15,000

C:10-10

Cathy’s distribution: Basis in partnership interest before distribution (see Cathy’s analysis above) Minus: Cash received in distribution Basis in partnership interest after distribution

$21,000 ( 10,000) $11,000

pp. C:10-2 through C:10-7. C:10-27a. Accounts receivable and depreciation recapture on the equipment. b. Yes. The inventory’s $76,000 FMV ($16,000 + $52,000 + $1,500 equipment depreciation recapture + $6,500) exceeds 120% of its adjusted basis [1.20 x ($0 + $50,000 + $0 + $6,000) = $67,200]. The $1,500 depreciation recapture arises from the $1,500 built-in gain on the equipment, all of which would be Sec.1245 because of the $4,000 depreciation taken on the equipment. Supplies are part of inventory because Sec. 751(d) defines inventory essentially as anything other than cash, capital assets, and Sec. 1231 property. c. (2) Kay’s Interest After Distribution (1/4)

(3) Hypothetical Proportionate Distribution (3)=(1)-(2)

(4)

(5)

Beginning Partnership Amount

(1) Kay’s Interest Before Distribution (1/3)

Actual Distribution

Difference (5)=(4)-(3)

Sec. 751 Assets: Receivables Inventory Supplies Recapture Total

$16,000 52,000 6,500 1,500 $76,000

$ 5,333 17,333 2,167 500 $25,333

$ 4,000 13,000 1,625 375 $19,000

$ 1,333 4,333 542 125 $ 6,333

$-0-0-0-0$-0-

$(1,333) ( 4,333) ( 542) ( 125) $(6,333)

Other Assets: Cash Equipment Land Total

$ 30,000 9,000 65,000 $104,000

$10,000 3,000 21,667 $34,667

$ 2,500 2,250 16,250 $21,000

$ 7,500 750 5,417 $13,667

$20,000 -0-0$20,000

$12,500 ( 750) ( 5,417) $ 6,333

Kay’s sale: Amount realized Minus: Adjusted basis Recognized gain (ordinary income) Kay’s basis in partnership interest: Beginning basis Minus: Sec. 751 transaction: Inventory ($50,000/$52,000 x $4,333) Supplies ($6,000/$6,500 x $542) Basis after Sec. 751 transaction Minus: Non-Sec. 751 distribution Ending partnership interest basis a

$ 6,333 ( 4,666)a $ 1,667 $33,750 ( 4,166) ( 500) $29,084 (13,667)b $15,417

$0 receivables + $4,166 inventory + $500 supplies + $0 depreciation recapture. $20,000 total - $6,333 Sec. 751 exchange.

C:10-11

Note: The discussion in this chapter pertaining to disproportionate distributions conforms to existing Treasury Regulations under Sec. 751(b). The Treasury Department has issued proposed regulations that would alter the method for calculating disproportionate distributions and their tax consequences. When this textbook went to press, those regulations were still only proposed. Therefore, this textbook continues to apply the methods contained in existing Treasury Regulations. pp. C:10-7 through C:10-11. C:10-28a. Sec. 1245 recapture on machinery. The receivables are not included because they have been realized. b. Yes. The inventory’s $86,000 FMV ($12,000 + $24,000 + $50,000 machinery depreciation recapture) exceeds 120% of its adjusted basis [1.20 x ($12,000 + $21,000 + $0) = $39,600]. Realized as well as unrealized receivables are included in the Sec. 751(d) definition of inventory. c.

Beginning Partnership Amount

(1) Jack’s Interest Before Distribution (1/4)

(2) Jack’s Interest After Distribution (1/5)

(3) Hypothetical Proportionate Distribution (3)=(1)-(2)

(4)

(5)

Actual Distribution

Difference (5)=(4)-(3)

Sec. 751 Assets: Receivables Inventory Recapture Total

$12,000 24,000 50,000 $86,000

$ 3,000 6,000 12,500 $21,500

$ 2,400 4,800 10,000 $17,200

$ 600 1,200 2,500 $4,300

$-0-0-0$-0-

$( 600) ( 1,200) ( 2,500) $(4,300)

Other Assets: Cash Machinery Land Total

$ 48,000 190,000 76,000 $314,000

$12,000 47,500 19,000 $78,500

$ 4,600 38,000 15,200 $57,800

$ 7,400 9,500 3,800 $20,700

$25,000 -0-0$25,000

$17,600 ( 9,500) ( 3,800) $ 4,300

Jack’s sale: Amount realized Minus: Adjusted basis Recognized gain (ordinary income) Jack’s basis in partnership interest: Beginning basis Minus: Sec. 751 transaction Accounts receivable Inventory ($21,000/$24,000 x $1,200) Basis after Sec. 751 transaction Minus: Non-Sec. 751 distribution Ending basis a

$ 4,300 ( 1,650)a $ 2,650 $76,875 ( 600) ( 1,050) $75,225 (20,700)b $54,525

$600 receivables + $1,050 inventory + $0 recapture. $25,000 total - $4,300 Sec. 751 exchange.

C:10-12

that would alter the method for calculating disproportionate distributions and their tax consequences. When this textbook went to press, those regulations were still only proposed. Therefore, this textbook continues to apply the methods contained in existing Treasury Regulations. pp. C:10-7 through C:10-11. C:10-29

Beginning Partnership Amount

(1) Paula’s Interest Before Distribution (1/4)

(2) Paula’s Interest After Distribution (1/5)

(3) Hypothetical Proportionate Distribution (3)=(1)-(2)

(4)

(5)

Actual Distribution

Difference (5)=(4)-(3)

Sec. 751 Assets: Receivables Inventory Total

$ 40,000 100,000 $140,000

$10,000 25,000 $35,000 $86,000

$ 8,000 18,000 $26,000

$2,000 7,000 $9,000

-010,000 $10,000

$ (2,000) 3,000 $ 1,000

Other Assets: Cash

$ 20,000

$ 5,000

$ 4,000

$1,000

$(1,000)

Deemed cash distribution Partnership’s sale of inventory for cash: Amount realized Minus: Adjusted basis of inventory (0.80 x $1,000) Partnership’s recognized gain

-0-

$1,000 $1,000 ( 800)a $ 200b

Because the total basis for the inventory is $80,000 and the total FMV is $100,000, the basis of this portion of the inventory is assumed to be 80% of its FMV. b The $200 gain is allocated one-third to each of the other three partners (Reg. Sec. 1.7511(b)(2)(ii)). Thus, each other partner recognizes $67 of ordinary income. Basis in partnership interest: Paula Partner Q Partner R Partner S Beginning basis $25,000 $25,000 $25,000 $25,000 Plus: Share of partnership income 67 67 67 Minus: Deemed distribution of cash (1,000) Distribution of remaining inventory (adjusted basis = 0.80 x $9,000) ( 7,200) _______ _______ _______ Ending basis $16,800 $25,067 $25,067 $25,067 Paula’s basis in inventory: Portion deemed purchased from partnership (cost) Remaining distribution (adjusted basis) Total

$1,000 7,200 $8,200

C:10-13

($1,000)

When this textbook went to press, those regulations were still only proposed. Therefore, this textbook continues to apply the methods contained in existing Treasury Regulations. pp. C:10-7 through C:10-11. C:10-30 The results of the two types of distributions are compared as follows: Part a Gain (loss) recognized Basis in partnership interest Part b Gain (loss) recognized

Cleo $2,000 -0-

Leo -02,000

2,000

(2,000)

A partner recognizes gain on either type of distribution to the extent cash distributed exceeds the partner’s basis in his or her partnership interest before the distribution. A partner recognizes a loss only with liquidating distributions and then only where the partnership distributes no assets other than cash, inventory, and/or unrealized receivables. The loss equals the excess of the partner’s basis in the partnership interest over the amount of these assets distributed (in this case, cash). pp. C:10-2, C:10-4, and C:10-12. C:10-31

Partner’s Postdistribution Basis None

Gain/Loss -0-

-0-

None

$9,000

None

-0-

None

Predistribution basis Less: Cash distribution Basis to allocate

Property Land Machinery Land Inventory Land - 1 Land - 2 Land - 1 Land - 2 Land - 3

Basis to Partner $11,000a 3,000 10,000b 7,000 -0-c -06,462d 10,769 10,769

$20,000 ( 6,000) $14,000

Basis of property to partners: First allocate to property basis Then allocate to property appreciation Total

Land $ 4,000 7,000 $11,000

$20,000 ( 3,000) $17,000 ( 7,000) $10,000

Predistribution basis Less: Cash distribution Basis to allocate Less: Allocation to inventory Allocation to land

C:10-14

Machinery $ 3,000 -0$ 3,000

Predistribution basis Less: Cash distribution Basis to allocate (but not less than zero) d Basis of property to partners: Predistribution basis First allocate to property basis Balance Then allocate to property appreciation Finally allocate on relative FMV Total

$26,000 ( 35,000) $ -0Land 1

Land 2

Land 3

$4,000

$ 6,000

$ 4,000

2,000 462 $6,462

4,000 769 $10,769

6,000 769 $10,769

Basis to Allocate $28,000 ( 14,000) $14,000 ( 12,000) (2,000) $ -0-

pp. C:10-12 through C:10-16. C:10-32 Marinda: $30,000 capital gain; Partnership: No gain recognized. Even though Marinda does not receive her proportionate share of each partnership asset in the liquidating distribution, the transaction has no Sec. 751 implications because the partnership has no Sec. 751 assets. Marinda is deemed to have received $110,000 in cash or deemed cash ($100,000 cash + $10,000 release from liability). Accordingly, she must recognize capital gain of $30,000 ($110,000 received - $80,000 basis). The partnership recognizes no gain. pp. C:10-12 through C:10-16. C:10-33 Basis before liability reduction Minus: Liability reduction (deemed distribution) Basis before distributions Minus: Cash distributions Basis to be allocated Minus: Basis allocable to inventory Basis allocable to receivables Amount allocable to other property Minus: Basis allocable to land Basis allocable to building Ending basis in partnership interest a

Alison $ 110,000 ( 50,000) $ 60,000 ( 20,000) $ 40,000 ( 32,195)a ( 7,805)a $ -0( -0-) ( -0-) $ -0-

Bob $ 180,000 ( 50,000) $ 130,000 ( 20,000) $110,000 ( 33,000) ( 10,000) $ 67,000 ( 15,000)b ( 52,000)b $ -0-

Alison’s allocation: FMV of asset Minus: Partnership’s basis for the asset Difference Step 1: Give each asset the partnership’s basis for the asset Minus: Alison’s basis to be allocated Decrease to allocate

Inventory $ 35,000 ( 33,000) $ 2,000

Receivables $ 8,000 ( 10,000) ( $2,000)

Total $43,000 (43,000) $ -0-

$ 33,000

$10,000

$ 43,000 ( 40,000) $ 3,000

C:10-15

Step 2: Asset basis after Step 1 Allocate the decrease first to assets that have declined in value Adjusted basis at this point in the calculation Step 3: Allocate $1,000 remaining decrease based on relative adjusted basis at this point in the calculation Alison’s basis in the assets

$10,000

$43,000

-0-

( 2,000)

$ 33,000

$ 8,000

$41,000

( 805)* $ 32,195

( 195) $ 7,805

( 1,000) $40,000

*$33,000/($33,000 + $8,000) x $1,000 remaining decrease to be allocated. b

Bob’s allocation:

FMV of asset Minus: Partnership’s basis for the asset Difference Step 1: Give each asset the partnership’s basis for the asset Minus: Bob’s basis to be allocated Increase to allocate Step 2: Allocate the $12,000 increase first to assets that have appreciated in value Bob’s basis in the asset

Land

Building

Total

$10,000 ( 15,000) ($ 5,000)

$60,000 ( 40,000) $20,000

$70,000 ( 55,000) $15,000

$15,000

$40,000

$55,000 ( 67,000) $12,000

-0$15,000

12,000 $52,000

12,000 $67,000

The basis in each asset received is the number used to reduce the partner’s basis in the partnership interest. Note that Alison’s basis in the inventory and receivables is smaller than a carryover basis from the partnership while Bob’s basis in the building is larger than a carryover basis. Neither the partners nor the partnership recognize any gain or loss. pp. C:10-12 through C:10-14. C:10-34 a, b, c, and d. Larry’s basis in his partnership interest: Part a Part b Basis before distribution $ 40,000 $46,500 Minus: Cash distribution ( 2,500) ( 2,500) Basis to be allocated $.37,500 $44,000 a Minus: Basis allocable to inventory ( 8,000) ( 8,000) Basis to be allocated to capital assetsb $ 29,500 $36,000 a

Part c $46,500 ( 2,500) $44,000 ( 8,000) $36,000

Part d $34,500 ( 2,500) $32,000 ( 8,000) $24,000

Inventory is not substantially appreciated. Therefore, Sec. 751 does not apply. See Parts a – d below for remaining allocations. Also see summary of bases after Part d.

a. FMV of asset Minus: Partnership’s basis for the asset Difference

Capital Asset 1 Capital Asset 2 Total $ 15,000 $ 17,500 $ 32,500 ( 10,000) ( 15,000) ( 25,000) $ 5,000 $ 2,500 $ 7,500

C:10-16

Step 1: Give each asset the partnership’s basis for the asset $ 10,000 $15,000 $ 25,000 Minus: Larry’s basis to be allocated ( 29,500) Increase to allocate $ 4,500 Step 2: Basis after Step 1 $ 10,000 $15,000 $ 25,000 Allocate the $4,500 increase to assets that have increased in value* 3,000 1,500 4,500 Larry’s basis in the capital assets $13,000 $16,500 $ 29,500 *Based on relative unrealized appreciation: Capital Asset 1, $5,000/$7,500 x $4,500; Capital Asset 2, $2,500/$7,500 x $4,500 b. Capital Asset 1 FMV of asset $ 15,000 Minus: Partnership’s basis for the asset ( 10,000) Difference $ 5,000 Step 1: Give each asset the partnership’s basis for the asset $10,000 Minus: Larry’s basis to be allocated Increase to allocate Step 2: Basis after Step 1 $10,000 Allocate the increase to assets that have increased in valuea 5,000 Basis after Step 2 $15,000 Step 3: Allocate the remaining $3,500 increaseb 1,615 Larry’s basis in the capital assets $16,615 a

Capital Asset 2 $ 17,500 ( 15,000) $ 2,500

Total $32,500 ( 25,000) $ 7,500

$15,000 $15,000

$25,000 ( 36,000) $11,000 $25,000

2,500 $17,500

7,500 $32,500

1,885 $19,385

3,500 $36,000

But not more than the unrealized appreciation. Based on relative FMV: Capital Asset 1, $15,000/$32,500 x $3,500; Capital Asset 2, $17,500/$32,500 x $3,500

c. FMV of asset Minus: Partnership’s basis for the asset Difference Step 1: Give each asset the partnership’s basis for the asset Minus: Larry’s basis to be allocated Increase to allocate Step 2: Basis after Step 1 Allocate the increase to assets that have increased in valuea Basis after Step 2 Step 3: Allocate the remaining $1,000 increaseb Larry’s basis in the capital assets

Capital Asset 1 $15,000 ( 10,000) $ 5,000 $10,000

$20,000

$10,000

$20,000

$30,000 ( 36,000) $ 6,000 $30,000

5,000 $15,000

-0$20,000

5,000 $35,000

462 $15,462

538 $20,538

1,000 $36,000

C:10-17

Capital Asset 2 Total $17,500 $32,500 ( 20,000) (30,000) ($ 2,500) $ 2,500

But not more than the unrealized appreciation. Based on relative FMV: Capital Asset 1, $15,000/$32,500 x $1,000; Capital Asset 2, $17,500/$32,500 x $1,000

d. Capital Asset 1 Capital Asset 2 FMV of asset $15,000 $17,500 Minus: Partnership’s basis for the asset ( 10,000) ( 20,000) Difference $ 5,000 ($ 2,500) Step 1: Give each asset the partnership’s basis for the asset $10,000 $20,000 Minus: Larry’s basis to be allocated Decrease to allocate Step 2: Basis after Step 1 $10,000 $ 20,000 Allocate the decrease to assets that have decreased in valuea -0( 2,500) Basis after Step 2 $10,000 $ 17,500 Step 3: Allocate the remaining $3,500 decreaseb ( 1,273) ( 2,227) Larry’s basis in the capital assets $ 8,727 $ 15,273 a

Total $32,500 ( 30,000) $ 2,500 $30,000 ( 24,000) ($ 6,000) $30,000 ( 2,500) $27,500 ( 3,500) $24,000

But not more than the unrealized depreciation. Based on relative adjusted bases after the Step 2 adjustments: Capital Asset 1, $10,000/$27,500 x ($3,500) Capital Asset 2, $17,500/$27,500 x ($3,500)

Summary of asset bases: Cash Inventory Capital Asset 1 Capital Asset 2 Total

Part a $ 2,500 8,000 13,000 16,500 $40,000

Part b $ 2,500 8,000 16,615 19,385 $46,500

Part c $ 2,500 8,000 15,462 20,538 $46,500

Part d $ 2,500 8,000 8,727 15,273 $34,500

pp. C:10-12 through C:10-14. C:10-35a.

Kelly’s January 1 basis Plus: Share of January income [($15,000 + $6,000) x ⅓] Kelly’s February 1 basis

$35,000 7,000 $42,000

b. Kelly recognizes $20,000 of ordinary income, $1,333 of unrecaptured Sec. 1250 gain, and a $1,667 capital gain. The partnership has inventory and Sec. 1250 property. Accordingly, the sales transaction must be analyzed as follows:

C:10-18

Application of step 1 yields the following gain on Kelly’s sale of her partnership interest: Amount realized on sale ($45,000 cash + $20,000 liabilities) Minus: Adjusted basis of partnership interest Total gain realized

$65,000 ( 42,000) $23,000

Application of step 2 yields the following allocation to Sec. 751 property: Deemed Sale of Assets Inventory Building Land

Partnership Gain $60,000 4,000 (all unrecaptured Sec. 1250 gain) 5,000

Kelly’s Share (1/3) $20,000 1,333 1,667

Thus, on the sale of her partnership interest, Kelly recognizes ordinary income of $20,000 and an unrecaptured Sec. 1250 gain of $1,333. Application of step 3 yields the following residual allocation to capital gain: Total gain realized $23,000 Minus: Allocation to ordinary income and unrecaptured Sec. 1250 gain ( 21,333) Capital gain recognized $ 1,667 c.

$65,000 = $45,000 cash paid + $20,000 share of partnership liabilities.

Unchanged from the basic facts. However, Margaret may have a special basis adjustment in the assets if a Sec. 754 election is in effect.

pp. C:10-16 through C:10-19, C:10-26, and C:10-27. C:10-36a. Clay recognizes $9,000 of ordinary income and a $3,000 capital loss. The results of the sale are determined as follows: Application of step 1 yields the following gain on Clay’s sale of his partnership interest: Amount realized on sale ($75,000 cash + $15,000 liabilities) Minus: Adjusted basis of partnership interest ($168,000 x 0.50) Total gain realized

C:10-19

$ 90,000 ( 84,000) $ 6,000

Application of step 2 yields the following allocation to Sec. 751 property: Partnership Gain (Loss) $ 30,000 ( 10,000)

Deemed Sale of Assets Inventory Land

Clay’s Share (60% x 0.50) $ 9,000 ( 3,000)

Thus, on the sale of his partnership interest, Clay recognizes ordinary income of $9,000. Application of step 3 yields the following residual allocation to capital loss: Total gain realized Minus: Allocation to ordinary income Capital loss recognized

$ 6,000 ( 9,000) $( 3,000)

Also, Clay’s ending basis in his remaining partnership interest is $84,000 ($168,000 × 0.50). b. Steve’s basis is $90,000, his purchase price of $75,000 cash paid plus $15,000 in liabilities assumed. c. The partnership’s basis will not be affected. However, Steve may have a special basis adjustment in the assets if a Sec. 754 election is in effect. d. If Clay sold his entire interest to Steve, the partnership would not terminate on the date of the sale because of the repeal of the technical termination rule. Thus, Clay’s gain is twice the amounts shown in Part a ($18,000 ordinary income and $6,000 capital loss). Steve’s basis in the partnership interest is $180,000 ($150,000 cash paid + $30,000 in liabilities assumed). pp. C:10-16 through C:10-19, C:10-22, and C:10-23. C:10-37a. Alice recognizes $24,000 of ordinary income, $10,000 of unrecaptured Sec. 1250 gain, and a $16,000 capital gain. The result of the sale is determined as follows: Application of step 1 yields the following gain on Alice’s sale of her partnership interest: Amount realized on sale ($125,000 cash + $35,000 liabilities) Minus: Adjusted basis of partnership interest Total gain realized

C:10-20

$160,000 ( 110,000) $ 50,000

Application of step 2 yields the following allocation of Sec. 751 property: Deemed Sale of Assets Receivable Inventory Machinery Building Land Investments a

Partnership Gain (Loss) $21,000 15,000 42,000a 45,000b ( 6,000) 33,000

Alice’s Share (⅓) $ 7,000 5,000 14,000a 15,000b ( 2,000) 11,000

Partnership depreciation is $36,000, and Alice’s share is $12,000. Partnership unrecaptured Sec. 1250 gain is $30,000, and Alice’s share is $10,000.

Thus, on the sale of her partnership interest, Alice recognizes ordinary income of $24,000 ($7,000 + $5,000 + $12,000 recapture). In addition, Alice’s unrecaptured Sec. 1250 gain is $10,000. Application of step 3 yields the following residual allocation to capital gain: Total gain realized Minus: Allocation to ordinary income and unrecaptured Sec. 1250 gain Capital gain recognized

$50,000 (34,000) $16,000

b. Darla’s basis in her partnership interest is $160,000 ($125,000 cash paid + $35,000 share of liabilities assumed). Also, Darla may have a special basis adjustment in the partnership assets if a Sec. 754 election is in effect. pp. C:10-16 through C:10-19 and C:10-25 through C:10-27. C:10-38a. $30,000 capital gain and $15,000 ordinary income. Suzanne’s share of partnership assets is $135,000 (1/3 x $405,000). Therefore, $135,000 of the $150,000 she receives ($130,000 cash + $20,000 release from liabilities) is a Sec. 736(b) payment. The Sec. 736(b) payment is treated as a distribution, so Suzanne must recognize a $30,000 gain (cash distribution of $135,000 exceeding $105,000 basis). The gain is capital gain if Suzanne held the partnership interest as a capital asset. The remaining $15,000 payment does not represent a payment for property. Because the payment is not determined based on partnership income, it is a guaranteed payment. Thus, the $15,000 payment is ordinary income to Suzanne. Note: Because of Suzanne’s recognized gain, the partnership could adjust the basis of the land upward by $30,000 if a Sec. 754. election is in effect. b. Suzanne’s capital account will be removed because she is no longer a partner. The partnership gets no deduction for the payments taxed as Sec. 736(b) payments, but the partnership can deduct the guaranteed payment of $15,000. The remaining partners’ bases in the partnership must be increased to reflect the additional amount of liability each is allocated when Suzanne is no longer a partner. pp. C:10-19, C:10-20, C:10-27, and C:10-28.

C:10-21

C:10-39a.

$9,600 capital gain, determined as follows: Amount realized ($41,600 cash + $8,000 liability) Minus: Sec. 736(b) payment = ($124,000 x 0.40) Sec. 736(a) payment

$49,600 (49,600) $ -0-

Sec. 736(b) payment Minus: Basis in partnership Capital gain

$49,600 ( 40,000) $ 9,600

$8,400 ordinary income and $9,600 capital gain, determined as follows: Amount realized ($50,000 cash + $8,000 liability) $58,000 Minus: Sec. 736(b) payment ($124,000 x 0.40) ( 49,600) Sec. 736(a) payment (ordinary income) $ 8,400 Sec. 736(b) payment Minus: Basis in partnership Capital gain

$49,600 ( 40,000) $ 9,600

Brian is taxed on the Sec. 736(a) payment as a guaranteed payment, and the partnership deducts the payment. The guaranteed payment, however, will not be eligible for the qualified business income deduction. (Note: The capital gains recognized in Parts a and b could create a basis adjustment to the land if a Sec. 754 election is in effect.) pp. C:10-19, C:10-20, C:10-27, and C:10-28. C:10-40a.

$15,000 capital gain, determined as follows: Amount realized ($65,000 cash + $25,000 liabilities) Minus: Sec. 736(b) payment (FMV of property interest) Sec. 736(a) payment (ordinary income)

$90,000 ( 90,000) $ -0-

Sec. 736(b) payments Minus: Basis in partnership Recognized gain

$90,000 ( 75,000) $15,000

The character of the gain is capital because the partnership has no unrealized receivables or substantially appreciated inventory. b.

$10,000 ordinary income and $15,000 capital gain, determined as follows: Amount realized ($75,000 cash + $25,000 liabilities) $100,000 Minus: Sec. 736(b) payment (FMV of property interest) ( 90,000) Sec. 736(a) payment (ordinary income) $ 10,000 Sec. 736(b) payments Minus: Basis in partnership Recognized gain

$ 90,000 ( 75,000) $ 15,000

C:10-22

The character of the gain is capital gain because the partnership has no Sec. 751 assets. The Sec. 736(a) payment is treated as a guaranteed payment because it is determined without reference to partnership income. It is ordinary income to Kim (but not eligible for the qualified business income deduction) and deductible by the partnership. (Note: The recognized gains in Parts a and b could create basis adjustment to the land if a Sec. 754 election is in effect.) pp. C:10-19, C:10-20, C:1027, and C:10-28. C:10-41 a. $90,000 of ordinary income. The FMV of Jerry’s partnership interest at the date of his death plus his share of partnership liabilities is $160,000 ($130,000 + $30,000). His estate will receive payments totaling $250,000 ($220,000 cash + $30,000 release from liabilities) during the two-year period following death. The payments are Sec. 736(b) payments up to the FMV of his partnership interest plus his share of liabilities for a total of $160,000. See Reg. Sec. 1.736-1(b) (1). The basis of his partnership interest to his successor-in-interest is $160,000 ($130,000 FMV on the date of Jerry’s death + $30,000 share of liabilities). Accordingly, the first $160,000 of payments is treated as liquidating distributions and will generate no gain. The remaining payments ($90,000) are Sec. 736(a) payments, which are not tied to partnership income and therefore are taxed as guaranteed payments to the successor-in-interest. These payments will be taxed as ordinary income to the successor-in-interest and are not eligible for the qualified business income deduction. b. The partnership gets no deduction for the Sec. 736(b) payments, but it can deduct the Sec. 736(a) payments. Because this was a two-person partnership, the partnership will continue only until the partnership makes the last payment to Jerry’s successor-in-interest. At the time the partnership makes the last payment, the partnership will terminate unless a new partner(s) is admitted. pp. C:10-19 and C:10-20. C:10-42a.

Amount realized ($130,000 cash + $20,000 liabilities) Minus: Adjusted basis ($130,000 FMV at date of death + $20,000 liabilities) Realized gain

$150,000 (150,000) $ -0-

b. 10% of partnership income is treated as Bruce’s successor-in-interest’s distributive share in each of the next three years. It is not deductible by the partnership. c. When the partnership makes the final payment. pp. C:10-19 and C:10-20. C:10-43a. Because the accounts receivable have a basis equal to their FMV and because the building has no depreciation recapture potential, the partnership holds no unrealized receivables. However, the building does have $60,000 of unrecaptured Sec. 1250 gain potential, of which $36,000 ($60,000 x 0.60) is John’s share. John’s sales: Each of the two sales (one to Stephen and one to Andrew) is as follows: Amount realized Minus: Adjusted basis Recognized gain a

Total $222,000a ( 166,800)b $ 55,200

$186,000 + $36,000 release from liabilities ($261,600 x 0.50) + $36,000 share of liabilities

C:10-23

John’s total gain from the two sales is $110,400, of which $36,000 is an unrecaptured Sec. 1250 gain subject to the 25% capital gains tax rate, and $74,400 is a capital gain. The sale of a 60% interest does not terminate the JAS Partnership, and the partnership remains intact if Andrew and Stephen continue to operate as a partnership. b. John’s distributions are Sec. 736(b) distributions. For distribution purposes, the partnership holds no Sec. 751 assets. Thus, no Sec. 751 exchange occurs, and John will recognize no gain or loss on the distribution. His basis in each asset is determined as follows: Beginning basis in partnership interest ($261,600 + $72,000 share of liabilities) Minus: Actual cash Deemed cash (liability relief) Receivables Basis allocable to land and building Minus: Building Land Ending basis in partnership interest

$333,600 ( 24,000) ( 72,000) ( 60,000) $177,600 (120,000) ( 57,600) $ -0-

John holds the following assets after the distribution: Cash Receivables Building Land Total

Adjusted Basis $ 24,000 60,000 120,000 57,600 $261,600

FMV $ 24,000 60,000 180,000 108,000 $372,000

Notice that the built-in gain on these assets is $110,400 ($372,000 - $261,600). Thus, John’s total gain is the same as in Part a, except here the gain is deferred rather than recognized immediately. The partnership does not terminate and has the following postdistribution balance sheet: Assets: Cash Receivables Building Land Total Liabilities and Capital: Liabilities Capital - Andrew - Stephen Total

Partnership’s Basis $136,000 40,000 80,000 38,400 $294,400

FMV $136,000 40,000 120,000 72,400 $368,000

$120,000 87,200 87,200 $294,400

$120,000 124,000 124,000 $368,000

C:10-24

C:10-44a.

$60,000 capital gain, determined as follows: Sec. 736(b) property: Cash Receivables Land Total

$ 60,000 20,000 100,000 $180,000

The amount realized equals $160,000 cash + $20,000 release from liabilities, which is allocated all to the Sec. 736(b) property. Amount realized ($160,000 cash + $20,000 liabilities) Minus: Adjusted basis of partnership interest Recognized gain or loss

$180,000 ( 120,000) $ 60,000

The character of the gain is capital gain because the partnership has no Sec. 751 assets or Sec. 1250 property. b. $60,000 capital gain, determined as follows: Amount realized ($160,000 cash and $20,000 liabilities) Minus: Adjusted basis of partnership interest Recognized gain or loss

$180,000 ( 120,000) $ 60,000

The character of the gain is capital because the partnership has no Sec. 751 assets or Sec. 1250 property. Thus, in total, the results are the same as in Part a. pp. C:10-12 through C:10-19. C:10-45a. A taxable transaction occurs. determined as follows:

The recognized gains for Josh and Diana are

Josh: Amount realized Minus: Adjusted basis Recognized gain

$60,000 (40,000) $20,000

Diana: Amount realized Minus: Adjusted basis Recognized gain

$60,000 (20,000) $40,000

All or part of the gains might be unrecaptured Sec. 1250 gain if the underlying real property was subject to depreciation. b. An exchange of a partner’s general partnership interest for a limited partnership interest in the same partnership is treated much like a corporate recapitalization and is likely to be nontaxable. See Rev. Rul. 84-52, 1984-1 C.B. 157. Similarly with conversion from a partnership to an LLC. See Rev. Rul. 95-37, 1995-1 C.B. 130. pp. C:10-20 through C:10-22.

C:10-25

C:10-46a. No. Sale of the partnership interest does not terminate the partnership. b. No. Liquidating distributions do not terminate a partnership. c. Yes. Only one member of the partnership continues as owner. d. No. The technical termination rule of Sec. 708(b)(1)(B) has been repealed. e. The ABC Partnership terminates on December 30 of the current year. The WXY Partnership is treated as having continued. f. The WXY Partnership terminates on January 1 of the current year. pp. C:10-22 through C:10-24. C:10-47a. The KL Partnership continues while the MN Partnership terminates. b. The ABC Partnership continues while the CD Partnership terminates. c. The YZ and WX Partnerships both terminate. d. The DE Partnership is a continuation of the DEFG Partnership. The FG Partnership is a new partnership. e. The HIJK Partnership terminates. pp. C:10-23 and C:10-24. C:10-48Amount realized Minus: Adjusted basis Recognized gain a $5 cash + release from $100,000 liability.

$100,005a ( -0-) $100,005

pp. C:10-16 through C:10-19 and C:10-22 through C:10-24. C:10-49a.

The total optional basis adjustment is $20,000, calculated as follows: Cash purchase price Minus: Patty’s share of partnership’s basis in asset’s (1/3 x $240,000) Optional basis adjustment

$100,000 ( 80,000) $ 20,000

The partnership recognizes a $60,000 ($220,000 - $160,000) gain.

c. Patty’s share of the gain is $20,000. However, she recognizes none of this gain because of her $20,000 basis adjustment. pp. C:10-24 through C:10-27. C:10-50a. $110,000 loss to Latisha, made up of $90,000 of ordinary income and a $200,000 capital loss. $110,000 downward mandatory basis adjustment to Larry. These results are determined as follows: Partnership Latisha’s Assets Basis FMV Gain (Loss) Share Inventory $ 800,000 $1,070,000 $ 270,000 $ 90,000 Land 1,600,000 1,000,000 (600,000) (200,000) Total $2,400,000 $2,070,000 $(330,000) $(110,000) Copyright © 2024 Pearson Education, Inc.

C:10-26

Latisha’s loss recognized: Cash received Minus: Basis of partnership interest Loss on sale of partnership interest

$ 690,000 (800,000) $(110,000)

Analysis of Latisha’s loss: Total loss recognized Minus: Allocation to ordinary income Capital loss recognized

$(110,000) (90,000) $(200,000)

Summary of loss: Ordinary income Capital loss Total loss

$ 90,000 (200,000) $(110,000)

Computation of mandatory basis adjustment to Larry: Larry’s cost basis in his partnership interest Minus: Larry’s share of basis in partnership assets ($2,400,000 x 1/3) Mandatory downward basis adjustment

$ 690,000 (800,000) $(110,000)

Although beyond the scope of the textbook, the allocation of the basis adjustment is as follows: Partnership Allocation to Gain (Loss) Larry (1/3) Allocation to inventory $270,000 $ 90,000 Allocation to land (600,000) (200,000) pp. C:10-26 and C:10-27. C:10-51a. The ABC Company (an LLC) will be treated as a partnership. Alex will report his one-third share of each income item reported by the LLC. Ordinary income Short-term capital gain Long-term capital loss

$10,000 4,000 ( 2,000)

The distribution is not taxable because it does not exceed Alex’s basis in his ABC Company interest. b.

Beginning basis Plus: Share of ordinary income Minus: Capital loss Distribution Ending basis

C:10-27

$40,000 14,000 ( 2,000) (12,000) $40,000

Comprehensive Problems C:10-52a.

Formation of Lifecycle Partnership:

Able, Baker, and Lifecycle Partnership recognize no gain or loss on the transfer of land to the partnership. Lifecycle Partnership takes the following tax basis and book values in the land: Tax Basis Book Value Land A $16,000 $30,000 Land B 22,000 20,000 The partnership’s tax holding period for the land includes Able’s and Baker’s holding periods prior to the transfers. Able’s beginning basis in his partnership interest is $16,000, and Baker’s beginning basis is $22,000. b.

(1) Partnership ordinary and separately stated items:

Sales Minus: Cost of goods sold Gross profit Minus: Depreciation Interest expense Salary expense (guaranteed payment) Operating expenses Partnership ordinary income (loss) Separately stated items: Dividend income STCG; LTCG Tax-exempt interest Charitable contribution

2023 $1,200,000 (450,000) $ 750,000

2024 $990,000 (500,000) $490,000

2025 $400,000 (280,000) $120,000

(524,000) (120,000) -0(30,000) $ 76,000

(25,000) (114,000) (12,000) (40,000) $299,000

(25,000) (112,000) -0(60,000) $ (77,000)

-0-0-0-0-

(2) Book capital accounts:

2,000 1,000 1,800 (500)

Able $ 30,000 45,600 $ 75,600 179,400 600 1,200 1,080

Contribution of land (FMV) Plus: Partnership ordinary income Balance 12/31/2023 Plus: Partnership ordinary income Short-term capital gain Dividend income Tax-exempt interest

C:10-28

-03,000 -0-0-

Baker $ 20,000 30,400 $ 50,400 119,600 400 800 720

Minus: Charitable contribution Distributions to partners Balance 12/31/2024 Plus: Long-term capital gain Minus: Partnership ordinary loss Balance 12/31/2025 (3) Tax basis capital accounts: Contribution of land (FMV) Plus: Partnership ordinary income Balance 12/31/2023 Plus: Partnership ordinary income Short-term capital gain Dividend income Tax-exempt interest Minus: Charitable contribution Distributions to partners Balance 12/31/2024 Plus: Long-term capital gain Minus: Partnership ordinary loss Balance 12/31/2025

(300) (42,000) $215,580 1,800 (46,200) $171,180

(200) (28,000) $143,720 1,200 (30,800) $114,120

Able $ 16,000 45,600 $ 61,600 179,400 600 1,200 1,080 (300) (42,000) $201,580 1,800 (46,200) $157,180

Baker $ 22,000 30,400 $ 52,400 119,600 400 800 720 (200) (28,000) $145,720 1,200 (30,800) $116,120

Able $ 16,000 1,200,000 45,600 $1,261,600 179,400 600 1,200 1,080 (300) (42,000) (60,000) $1,341,580 1,800 (46,200) (18,000) $1,279,180

Baker $ 22,000 800,000 30,400 $852,400 119,600 400 800 720 (200) (28,000) (40,000) $905,720 1,200 (30,800) (12,000) $864,120

(4) Basis in partnership interests: Contribution of land (tax basis) Plus: Increase in partnership liabilities Partnership ordinary income Balance 12/31/2023 Plus: Partnership ordinary income Short-term capital gain Dividend income Tax-exempt interest Minus: Charitable contribution Distributions to partners Decrease in partnership liabilities Balance 12/31/2024 Plus: Long-term capital gain Minus: Partnership loss Decrease in partnership liabilities Balance 12/31/2025

C:10-29

(1) Results of asset sales:

Sale of assets for books: Total $1,366,000 (976,000) $ 390,000

Selling price Minus: Total book value Book gain

Able

Baker

$ 234,000

$156,000

Able

Baker

14,000 234,000 $ 248,000

$ (2,000) 156,000 $154,000

Sale of assets for tax: Total $1,366,000 (964,000) $ 402,000

Selling price Minus: Total adjusted basis Tax gain Precontribution gain (loss) Postcontribution gain Total

12,000 390,000 $ 402,000

(2) Book capital accounts: Balance 12/31/2025 Plus: Book gain on asset sales Balance before liquidating distributions

Able $ 171,180 234,000 $ 405,180

Baker $114,120 156,000 $270,120

Able $ 157,180 248,000 $ 405,180

Baker $116,120 154,000 $270,120

Able $1,279,180

Baker $864,120

14,000 234,000 (1,122,000) $ 405,180

(2,000) 156,000 (748,000) $270,120

(3) Tax basis capital accounts: Balance 12/31/2025 Plus: Tax gain on asset sales Balance before liquidating distributions (4) Basis in partnership interests: Basis 12/31/2025 Plus: Tax gain (loss) on asset sales: Precontribution Postcontribution Minus: Decrease in partnership liabilities Basis before liquidating distributions

(5) Upon liquidation, Able receives $405,180, and Baker receives $270,120, which are the amounts of their book capital accounts. Able and Baker recognize no gain or loss on the liquidating distributions because their bases in their partnership interests before the liquidation are the same amounts as the distributions. After the liquidation, the partners have no basis in the partnership because it has terminated.

C:10-30

C:10-53 a.

Anne must recognize a guaranteed payment of $28,640, other ordinary income of $33,280, and capital gain of $69,280, determined as follows: Cash payment Liability relief Total payment

$220,000 31,200 $251,200

Sec. 736(b) payment (52% of asset FMV) Sec. 736(a) payment [Total - 736(b)]

$222,560 $ 28,640

This Sec. 736(a) payment of $28,640 is a guaranteed payment (ordinary income) to Anne, but it does not qualify for the business income deduction. Analysis of Sec. 736(b) payment ($222,560): First separate out the Sec. 751 portion of the Sec. 736(b) payment. Assume the partnership first distributed her share of these assets to Anne and then purchased her share of these assets for their FMV. Deemed distribution of Sec. 751 assets to Anne: Anne’s basis before the Sec. 751 transaction $120,000 Basis of Sec. 751 assets deemed distributed 12,480 Anne’s basis after the Sec. 751 transaction $107,520 Deemed sale to the partnership at FMV: FMV of 52% of Sec. 751 assets [0.52 x ($64,000 + $24,000)] $ 45,760 Adjusted basis of 52% of Sec. 751 assets 12,480 Ordinary income Anne must recognize $ 33,280 Analysis of remaining Sec. 736(b) payment ($222,560 - $45,760): Anne’s basis after Sec. 751 transaction $107,520 Cash distribution ($222,560 - $45,760) 176,800 Cash distribution in excess of basis (capital gain) $ 69,280 Partnership tax results: Deduct the guaranteed payment of $28,640 paid to Anne. (In addition, the partnership would increase its basis in its accounts receivable to reflect the fact that some receivables were deemed purchased from Anne for $33,280.) b.

On the sale of her partnership interest, Anne recognizes $33,280 of ordinary income and a $97,200 capital gain, determined as follows:

C:10-31

Application of step 1 yields the following gain on Anne’s sale of her partnership interest: Amount realized on sale ($220,000 cash + $31,200 liabilities) Minus: Adjusted basis of partnership interest Total gain realized

$251,200 ( 120,000) $131,200

Application of step 2 yields the following allocation to Sec. 751 property: Partnership gain on receivable = $64,000; Anne’s share = $64,000 x 0.52 = $33,280. Thus, on the sale of her partnership interest, Anne recognizes ordinary income of $33,280. Application of step 3 yields the following residual allocation to capital gain: Total gain realized Minus: Allocation to ordinary income Capital gain recognized

$131,200 ( 33,280) $ 97,920

Partnership tax results: The ABC Partnership does not terminate because of the repeal of the technical termination rule. Thus, the partnership remains intact.

C:10-32

Tax Strategy and Critical Thinking Problem C:10-54 a.

The three options are analyzed below.

Option 1 (disproportionate distribution of cash)

Beginning Partnership Amount

(1) Daniel’s Interest Before Distribution (1/3)

(2) Daniel’s Interest After Distribution (-0-)

(3)

(4)

(5)

Hypothetical Proportionate Distribution (3)=(1)-(2)

Actual Distribution

Difference (5)=(4)-(3)

Sec. 751 Assets: Receivables

$ 60,000

$20,000

-0-

$20,000

-0-

($20,000)

Other Assets: Cash Land Total

$ 60,000 60,000 $120,000

$20,000 20,000 $40,000

-0-0-0-

$20,000 20,000 $40,000

$60,000 -0$60,000

$40,000 (20,000) $20,000

Deemed distribution of receivables (adjusted basis) Daniel’s deemed sale of receivables for cash: Amount realized Minus: Adjusted basis of receivables Daniel’s recognized gain (ordinary income) Daniel’s basis in partnership interest: Beginning basis Minus: Deemed distribution of receivables Distribution of remaining cash ($60,000 - $20,000) Ending basis (but not less than zero)

-0-

$20,000 ( -0-) $20,000 $30,000 ( -0-) (40,000) $ -0-

Because the $40,000 remaining cash distribution exceeds Daniel’s partnership basis ($30,000), he recognizes a $10,000 capital gain. Summary of results: Current ordinary income Current capital gain

$20,000 10,000

C:10-33

Option 2 (proportionate distribution of assets) Daniel receives the following assets: Basis $20,000 -010,000 $30,000

Cash Receivables Land A Total

FMV $20,000 20,000 20,000 $60,000

Because Daniel’s partnership basis exceeds the amount of cash distributed, he recognizes no gain on the distribution. His partnership basis is $10,000 after reduction for the cash distribution. He takes a zero basis in the receivables and a $10,000 basis in Land A. Daniel recognizes gain or income when he sells the assets. Summary of results: Deferred ordinary income Deferred capital gain

$20,000 10,000

Option 3 (sale of partnership interest) The results of the sale are determined as follows: Application of step 1 yields the following gain on Daniel’s sale of his partnership interest: Amount realized on sale Minus: Adjusted basis of partnership interest Total gain realized

$60,000 ( 30,000) $30,000

Application of step 2 yields the following allocation of Sec. 751 property: Partnership Gain (Loss) $60,000 10,000 10,000 10,000

Deemed Sale of Assets Receivables Land A Land B Land C

Daniel’s Share (1/3) $20,000* 3,333 3,333 3,333

*Thus, on the sale of his partnership interest, Daniel recognizes ordinary income of $20,000. Application of step 3 yields the following residual allocation to capital gain: Total gain realized Minus: Allocation to ordinary income Capital gain recognized

C:10-34

$30,000 ( 20,000) $10,000

Summary of results: Current ordinary of income Current capital gain

$20,000 10,000

b. Options 1 and 3 yield the same results: current gain recognition, a disadvantage, and current receipt of cash, an advantage. Conversely, Option 2 defers gain recognition and cash collection until Daniel collects on the receivables and sells the land. Thus, if Daniel has immediate need for cash, he should select Option 1 or Option 3. If he does not have immediate cash needs, he should consider Option 2.

Case Study Problem C:10-55 The points presented below are the major ones that should be covered in the memorandum to the two brothers. This information should be incorporated by the student into a properly structured memorandum using good form with proper grammar and punctuation. The analyses do not take into account present values of the results. Option 1: Michael’s purchase of interest. Amount realized = ($120,000 cash + $330,000 installment note + $200,000 liabilities) Minus: Adjusted Realized gain (LTCG)

$650,000 ( 300,000) $350,000

Because the sale is an installment sale, Mark would recognize his gain on an installment basis. In the first year, he would recognize gain of $93,333, calculated as follows: Gain realized Contract price

x Installment =

$350,000 $450,000

x $120,000 = $93,333

Assuming an 18.8% capital gains tax rate (including the 3.8% net investment tax), the gain would result in taxes of $17,547, leaving Mark $102,453 ($120,000 - $17,547) of after-tax proceeds for the first year. In each of the following three years, he would recognize gain of $85,556, calculated as follows: Gain realized Contract price

x Installment

= $350,000 $450,000

x $110,000 = $85,556

Assuming an 18.8% tax rate on the capital gains each year, the gain would result in taxes of $16,085, leaving Mark $93,915 ($110,000 - $16,085) of after-tax proceeds each year. Total proceeds for Mark for the four years are $450,000, and total taxes are $65,800 ($350,000 x 0.188). Thus, Mark’s total undiscounted after-tax proceeds are $384,200 ($450,000 - $65,800). Note that Michael is using after-tax dollars to pay Mark each year. Because this transaction is an installment sale between related parties, Mark would have to recognize any unrecognized gain if Michael later resold this partnership interest to another partner. Copyright © 2024 Pearson Education, Inc.

C:10-35

If no other partner is admitted to the partnership, the partnership will terminate when Michael buys Mark’s interest. Michael would receive all the partnership assets in a liquidating distribution. The basis of the partnership assets would be changed as follows: Michael’s partnership interest basis Basis of partnership interest purchased from Mark ($450,000 installment sale + $200,000 share of liabilities) Deemed cash contributed by Michael because he assumes the partnership’s liability Balance before distributions Minus: Cash and deemed cash distributed Accounts receivable Remaining basis allocable to land

$ 300,000 650,000 400,000 $1,350,000 ( 600,000) ( 90,000) $ 660,000

Notice that this basis adjustment has greatly decreased the potential capital gain that Michael will recognize on the subsequent sale of the land investment. Option 2A: Retirement from the partnership for $150,000 plus 50% of partnership profits for the next three years. Assuming the brothers correctly project income to be approximately $200,000 for each of the next three years, Mark will receive a total of $450,000 over the four years. His gain will be $350,000, calculated as follows: Amount realized Minus: Adjusted basis Realized gain

$650,000 (300,000) $350,000

In the initial year, Mark will receive $150,000 cash that he will treat as a normal partnership distribution that reduces his basis. In future years, he will be allocated a 50% share of the partnership earnings (with the character they have at the partnership level), which will increase his basis. He also will receive a distribution from the partnership equal to the amount of income he recognizes, and this distribution will reduce his basis by the same amount the income recognition increases it. Accordingly, he will not be taxed on the distribution. After the final payment, Mark no longer will be a partner, so his final payment will include the deemed cash from the release of his liability share. Mark will report approximately $300,000 of income under this method, and the character of the income is determined at the partnership level. Because the main source of partnership income is the sale of investment land, most of the gain Mark will recognize also will be capital gain. Assuming all partnership income is capital gain for the three years, each year Mark will be allocated $100,000 in capital gains and will pay taxes of $18,800 so that he has after-tax income of $81,200. The first year’s payment is nontaxable so he has after-tax receipts of $150,000 for the first year. Cash received over the four years is $450,000, and he will pay taxes of $56,400 ($18,800 x 3), leaving undiscounted after-tax receipts of $393,600 ($450,000 - $56,400). Copyright © 2024 Pearson Education, Inc.

C:10-36

Michael’s share of income for the three years is reduced by the income allocated to Mark. The partnership will continue in operation under this option until Mark receives his final payment from the partnership. Option 2B: Retirement from the partnership for $150,000 cash plus $100,000 guaranteed payment for three years. In this option, as in the preceding one, Mark’s first year payment is simply a distribution from the partnership, which reduces his basis in the partnership interest. Likewise, in the final year Mark will be deemed to receive cash equal to the share of liabilities that he no longer will be liable for. Assuming the liabilities do not change, these two distributions will have the following results: Beginning basis Minus: Year one cash Basis after cash distribution Minus: Year four liability release Basis (but not less than zero)

$300,000 (150,000) 150,000 (200,000) $ -0-

Mark will recognize a $50,000 long-term capital gain in year four. At an 18.8% capital gains tax rate, he will owe taxes of $9,400. Because this gain is caused by the deemed cash distribution from the liability release, Mark is not receiving any cash to pay these taxes. The $100,000 guaranteed payment will be taxed as ordinary income in each of the next three years, but it will not qualify for the business income deduction. Assuming Mark’s ordinary tax rate is 35% each year, he will pay $35,000 in taxes for an after-tax amount of $65,000. Over the four years, Mark will receive cash of $450,000 and will pay taxes of $114,400 [($35,000 x 3) + $9,400] for undiscounted after-tax receipts of $335,600 ($450,000 - $114,400). Option 3: Outside purchase of interest. Under this option, Mark will report a $350,000 long-term capital gain determined as follows: Amount realized ($450,000 cash + $200,000 liabilities) Minus: Adjusted basis Realized gain (LTCG)

$650,000 (300,000) $350,000

Assuming an 18.8% tax rate on capital gains, the gain would result in taxes of $65,800, leaving Mark $384,200 ($450,000 cash - $65,800 taxes) of after-tax proceeds. (Mark receives the same after-tax benefit that he receives if Michael is the purchaser, ignoring discounting.) With this option, the partnership continues to remain in existence. This result contrasts with Option 1, where the partnership goes out of existence. If Michael wants to continue the partnership form of conducting the investment, he should consider this option. Also, unless the partnership has made a Sec. 754 election, no increased basis for the investment land occurs under this option. Summary: Mark’s after-tax receipts are highest for Option 2A -- the retirement from the partnership for $150,000 cash plus a 50% distributive share for the next three years. The memorandum should emphasize to Mark that this option is the only sales arrangement under which Copyright © 2024 Pearson Education, Inc.

C:10-37

uncertainty exists about what he will receive. If land sales are unusually slow for the three-year payout period, Mark may receive little more than the $150,000 first year payment. Accordingly, students may want to recommend the sale to John or the sale to Michael depending on whether or not Michael wants to continue as a sole proprietor or as John Watson’s partner.

Tax Research Problems C:10-56 Tax Results: Revenue Ruling 84-111, 1984-2 C.B. 88, requires that the tax results for incorporating a partnership must follow the results generated by the form of the transaction. Accordingly, the formation of the corporation is nontaxable to the transferor partnership under Sec. 351 and is nontaxable to the transferee corporation under Sec. 1032. The liquidation of the partnership is subject to the rules of Sec. 731, and the ex-partner’s basis in the new corporation’s stock is governed by Sec. 732. Asset and Liability Transfer: Each asset will take a carryover basis from the partnership transferor under Sec. 362, so the total basis of corporate assets will be $360,000. Under Sec. 358, the partnership, as the sole shareholder, has a basis in its corporate stock equal to the carryover basis of its assets ($360,000) reduced by the partnership’s liability assumed by the corporation ($100,000), or $260,000. Partnership Liquidation: Upon liquidation of the partnership, neither the partners nor the partnership recognize gain or loss under Secs. 731(a) and (b). The partnership terminates under Sec. 708(b)(1). Under Sec. 732(b), the partners’ bases in the corporate stock distributed equals their basis in the partnership as shown in the following table, and, under Sec. 1223(1), the holding period for the stock includes the holding period of the partners’ interest in the partnership. Partner Basis in pshp. int. before transfer Minus: Liab. reduction Basis in pshp. int. before distribution Basis in stock distributed

Arnie

Becky

Clay

Total

$120,000 (25,000) $ 95,000 $ 95,000

$360,000 (75,000) $285,000

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Financial Accounting Results: Generally, when a business combination occurs, the acquiring entity records the assets received at fair value. If the fair value differs from the tax basis, deferred tax assets and liabilities may have to be recorded. However, Accounting Standard Codification (ASC) 805-50 provides special rules for transactions between entities under common control. These rules lead to a different recording measure than fair value. ASC 805-50-15-6 provides several examples of common control transactions, one of which includes an entity that “charters a newly formed entity and then transfers some or all of its net assets to that newly chartered entity.” The incorporation of the ABC General Partnership falls into this classification. ASC 805-50-30-5 provides the following: When accounting for a transfer of assets … between entities under common control, the entity that receives the net assets … shall initially measure the recognized assets and liabilities transferred at their carrying amounts in the accounts of the transferring entity at the date of transfer. In the current situation, the assets transferred to ABC Corporation have carrying amounts (book value) that are the same as their tax bases. Therefore, the corporation records the assets for financial accounting purposes in the same amount as the tax bases, thereby negating the need for deferred assets or liabilities. If the assets had carrying amounts that differed from their tax basis, presumably, the entity would record deferred tax assets and/or liabilities for the difference between the carrying amounts and the tax bases. However, because of the common control transaction rule, the new entity still would not record assets at their fair value. C:10-57 Della’s share of property: Sec. 736(b) property - Cash Receivables Equipment Building Land Goodwill Total

$16,667 10,000 16,667 33,333 13,333 7,000 $97,000

All payments based on partnership income also will be Sec. 736(a) payments taxed as distributive shares. Total fixed payments = $20,000 x 5 = $100,000 Sec. 736(b) payments as portion of fixed payments: $97,000/$100,000 = 97%

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Allocation of payments for years 1-5:

5% of partnership income: Sec. 736(a) Total

$19,400a 600 guaranteed payment that is taxed as ordinary income 5,000 distributive share $25,000

Sec. 736(b) payment Minus: One-fifth basis in partnership interest Capital gain

$19,400 (14,000) $ 5,400

$20,000 payment: Sec. 736(b) (97%) Sec. 736(a) (3%)

Taxation of the partnership is not affected by the payments made for Della’s interest in property. It takes no deduction and does not reduce the continuing partners’ distributive share of the payments made for the interest in property. The small guaranteed payment each year is deductible by the partnership, but it does not qualify for the business income deduction for Della. The $5,000 distributive share results in a smaller distributive share for each of the remaining partners. C:10-58 Transfer of an interest in a partnership by gift does not terminate the partnership tax year for the donor. However, the donor must recognize income from the partnership up to the date of the gift. Because the partnership tax year does not close on the date of the gift, the income is included in the partner’s tax year that includes the normal partnership year-end (Reg. Sec. 1.706-1(c)(5)). On his tax return for the tax year ending June 30 of the current year, Pedro will report partnership income from the tax year that ended on December 31 of last year. He will report partnership income earned between January 1 of the current year and his June 15 gift on his tax return for the tax year that ends on the next June 30. Juan and the American Red Cross must report all partnership income earned after June 14 of the current year. Transfer of a majority interest by gift does not constitute a sale or exchange that can terminate a partnership (Reg. Sec. 1.708-1(b)(1)(ii)). Although part-sale, part-gift transactions like this one are not clearly covered by the Treasury Regulation, the sale portion of the transaction does not appear to be a majority interest. This issue is probably moot now that the technical termination rule has been repealed. The transfer to Juan is a part-sale and part-gift. See Victor P. Diedrich v. CIR, 47 AFTR 2d 81-977, 81-1 USTC ¶9249 (8th Cir., 1981). The 30% interest transferred to Juan is considered sold to him because the liability is one-half of the FMV ($50,000 liability / $100,000 FMV of partnership interest transferred). Pedro must recognize gain on the sale of a 15% interest of $30,000 ($50,000 liabilities transferred - $20,000 basis). The remaining 15% interest is a gift to Juan. Pedro must report the gift portion for gift tax purposes at its FMV of $50,000. The transfer to the American Red Cross also is a part-sale and part-gift but the allocation of basis to the sale and gift differ from the allocation above (Rev. Rul. 75-194, 1975-1 C.B. 80). Only a pro rata portion of the basis is allocated to the sale transaction, so basis of $10,000 ([$50,000 liability / $100,000 FMV] x $20,000 basis) is allocated to the sale, and the remaining $10,000 of basis is allocated to the gift portion of the transaction. On the sale transaction, Pedro must recognize gain of $40,000 ($50,000 liability transferred - $10,000 basis allocated to sale transaction). Pedro makes a Copyright © 2024 Pearson Education, Inc.

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charitable contribution of the remaining partnership interest, which has a basis of $10,000 and FMV of $50,000. The contribution is eligible for a charitable contribution deduction. C:10-59 Helen’s Gain (Loss): On the sale of her partnership interest, Helen recognizes $32,540 of ordinary income and an $8,400 capital loss, determined as follows: Application of step 1 yields the following gain on Helen’s sale of her partnership interest: Amount realized on the sale Minus: Adjusted basis of partnership interest Total gain realized

$190,000 ( 165,860) $ 24,140

Application of step 2 yields the following allocation to Sec. 751 property under Reg. Sec. 1.751-1(a)(2): Deemed Sale of Assets Asset 1 (all Sec. 1245 recap.) Asset 2

Gain (Loss) $97,620 ( 25,200)

Helen’s Share (1/3) $32,540 ( 8,400)

All the gain on Asset 1 is ordinary income under the Sec. 1245 recapture rules and is therefore an unrealized receivable as defined in Sec. 751(c). Thus, Helen recognizes $32,540 of ordinary income. Application of step 3 yields the following residual allocation to capital loss: Total gain realized Minus: Allocation to ordinary income Capital loss recognized

$24,140 ( 32,540) $( 8,400)

Hank’s Optional Basis Adjustment and Allocation: Hank’s optional basis adjustment under Sec. 743(b)(1) is $24,140, calculated as follows: Initial basis in partnership (purchase price) $190,000 Minus: Share (1/3) of partnership’s basis in assets ( 165,860) Optional basis (Sec. 743(b)) adjustment $ 24,140 Under Reg. Sec. 1.751-1(a), the Sec. 1245 recapture attributable to Asset 1 is ordinary income property, and Asset 2 is capital gain property because it meets the definition of Sec. 1231 property. For purposes of allocating the Sec. 743(b) adjustment, Reg. Sec. 1.751-1(b)(1)(ii) requires a hypothetical asset sale computation similar to the one shown in step 2 of Helen’s calculations above. Regulation Sec. 1.751-1(b)(2) then requires that the Sec. 743(b) adjustment first be allocated to ordinary income property to the extent of any hypothetical gain inherent in that property, in this case, a positive $32,540. The total Sec. 743(b) adjustment minus the amount allocated to ordinary Copyright © 2024 Pearson Education, Inc.

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income property then gets allocated to capital gain property. This calculation results in an $8,400 negative adjustment to Asset 2, specifically, $24,140 - $32,540. Hank’s Allocable Depreciation Deductions in 2023: Under Reg. Sec. 1.743-1(j)(2), a partnership first determines its items of income, deduction, gain, or loss and allocates them among the partners in accordance with Sec. 704. The partnership then adjusts a partner’s distributive share to reflect any Sec. 743(b) adjustments. Under Reg. Sec. 1.743-1(j)(4)(i), the increased basis to depreciable property is treated as newly purchased property while the unadjusted basis, or the partnership’s common basis, continues to be depreciated as before the sale of the partnership interest. Accordingly, Hank’s share of 2023 depreciation on Asset 1 is as follows: Partnership depreciation ($600,000 x 0.1249)* Times: Hank’s percentage Hank’s distributive share of common depreciation Plus: Hank’s depreciation on Sec. 743(b) adjustment (Year 1, $32,540 x 0.1429) Hank’s total depreciation on Asset 1 in 2023 *Appendix C, Table 1, Recovery Year 4

$74,940 1/3 $24,980 4,650 $29,630

Under Reg. Sec. 1.743-1(j)(4)(ii), the negative Sec. 743(b) adjustment to depreciable property decreases the partner’s allocable partnership depreciation according to the following formula: Partnership depreciation for the year Adjusted basis at time of transfer

x Negative Sec. 743(b) adjustment

In Hank’s case, this formula results in a $3,360 reduction as follows: $46,080 ($240,000 x 0.192)* x $(8,400) $115,200 Thus, Hank’s share of 2023 depreciation on Asset 2 is as follows: Partnership depreciation ($240,000 x 0.192)* Times: Hank’s percentage Hank’s distributive share of common depreciation Minus: Sec. 743(b) adjustment Hank’s total depreciation on Asset 2 in 2023 *Appendix C, Table 1, Recovery Year 3

$46,080 1/3 $15,360 ( 3,360) $12,000

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“What Would You Do In This Situation?” Solution Ch. C:10, p. C:10-4. You probably should tell Betty and Thelma that the transaction will not be tax-free. First, Sec. 704 requires that the contributing partner recognize any remaining precontribution gain (up to the amount of precontribution gain that would be recognized if the property were sold on the distribution date) when contributed property is distributed to another partner within seven years of the contribution. Therefore, both Betty and Thelma would recognize gain when the properties were distributed unless the partnership held the property for more than seven years. Second, Treasury Regulations might prevent tax-free treatment even if the partnership held the property for more than seven years. Several years ago, the Treasury Department issued regulations to stop the abusive use of the partnership form to get tax treatment that is not available otherwise. These regulations require that all transactions be entered into for a substantial business purpose, and Thelma and Betty have no apparent business purpose for contributing these properties to the partnership or for distributing the properties from the partnership. Further, the regulations provide that if the partnership is used to frustrate any IRC provision, the IRS can treat the partnership as an aggregate of the partners. Because the exchange contemplated by Thelma and Betty clearly does not qualify as a nontaxable like-kind exchange if the exchange were made directly between the two women, it is unlikely that they can make it nontaxable by routing the exchange through their partnership. [See Reg. Secs. 1.702-2(e) and 1.704-4, and Prop. Reg. Sec. 1.704-4.]

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Chapter C:11 S Corporations Discussion Questions C:11-1 Nine advantages of S corporation treatment are illustrated on text page C:11-3. Nine disadvantages of S corporation treatment are illustrated on text pages C:11-3 and C:11-4. C:11-2 Many items must be considered when converting a C corporation to an S corporation. Julio must compare his and the corporation’s potential tax liabilities under both the C and S corporation scenarios. His marginal tax rate is only slightly higher than the C corporation’s 21% tax rate, but his dividend income also is taxed, albeit, at the applicable capital gains rate. If Julio elects S corporation status, the entire amount of corporate income would be taxable to him regardless of whether the corporation distributes it. Accordingly, much of the income would be taxed at the 32% to 35% marginal rates, possibly necessitating increased cash distributions from the corporation to pay the increased taxes. If Julio claims the 20% qualified business income deduction, these marginal tax rates can be effectively reduced to 25.6% [32% x (1 - 0.20)] or 28% [35% x (1 - 0.20)]. However, none of the $25,000 in dividends currently being paid would be subject to the double taxation under the current C corporation status if the corporation made an S election. In addition, the income passed through to Julio will step-up the basis of Julio’s S corporation stock. Such a basis step-up does not occur with a C corporation. He also must consider the possible effect of the built-in gains tax that could arise during the first five years after a C corporation converts to an S corporation. Thus, Julio should make a thorough analysis of the short- and long-term benefits of S corporation status including a comparison of the treatment of pensions and fringe benefits for each class of corporation, and the potential estate planning considerations. Some of the advantages and disadvantages of making an S election are outlined on pages C:11-3 and C:11-4. C:11-3 Taxpayers must consider many items in making the decision regarding the initial tax form of a business. The corporate (either C or S corporation) form offers the advantage of limited liability, which is important for a new business. S corporations often are an attractive form for a new business because the losses in the initial years pass through to the shareholder and offset any income that Celia would earn from other sources. Then, in profitable years, the shareholder may be eligible for the qualified business income deduction. The S corporation status can be terminated fairly easily, if in the future C corporation status becomes more desirable. The noncorporate entity form known as a limited liability company (LLC) also should be investigated. This business form provides the limited liability benefits usually associated with a corporation, and it provides the tax benefits associated with a partnership. Under the check-the-box regulations, an LLC also can elect to be taxed as either a C corporation or an S corporation even if not organized as a corporation under federal or state law. It may prove advantageous for an LLC to elect to be taxed as a C corporation. An LLC probably would not want to elect to be treated as an S corporation because, in most instances, it already is treated as a partnership under the check-the-box regulations without such an election. A thorough analysis of the short- and long-term tax advantages of the possible tax forms for the business should be conducted before Celia makes a decision. Some of the advantages and disadvantages of creating a corporation and making an S election are outlined on text pages C:11-3 and C:11-4. Copyright © 2024 Pearson Education, Inc.

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C:11-4 An LLC is treated as a partnership and therefore offers a number of advantages not available with an S corporation. Some of the important advantages include: • • • •

No restrictions are imposed on the type or number of owners that an LLC can have. An S corporation is limited to 100 shareholders, none of which may be a corporation or a partnership. Income and deduction allocations are based on the LLC agreement and not based on the number of shares of stock owned. Thus, special income, gain, loss, and deduction allocations are permitted for an LLC. The basis of the LLC interest includes a ratable share of the LLC’s liabilities. This amount can be greater than the basis provided for the S corporation’s stock and permits a greater loss or deduction pass-through. LLCs are not subject to the corporate level taxes (i.e., built-in gains tax, excess net passive income tax, and LIFO recapture tax).

pp. C:11-3 and C:11-4 (also see Chapters C:2 and C:10). C:11-5 b, c, and f. A domestic S corporation can be a shareholder in a Qualified Subchapter S Subsidiary (QSub). pp. C:11-4 through C:11-7. C:11-6 a. No. The passive income will not terminate the S election because the corporation has no Subchapter C earnings and profits and has not generated excess passive income for three years. b. Yes. The nonvoting stock would terminate the election because it has different distribution rights and therefore constitutes a second class of stock. Different voting rights alone, however, will not constitute a second class of stock if the stock possesses identical distribution and liquidation rights as other voting stock. c. No. Owning 100% stock of a subsidiary does not terminate the S election. Moreover, the parent corporation can elect to treat the subsidiary as a Qualified Subchapter S Subsidiary (QSub), in which case all assets, liabilities, income, deductions, etc. of the QSub are treated as belonging to the parent S corporation. d. No. Transfer of stock to the charity will not terminate the S election because charities as described in the text chapter are permissible shareholders. e. No. Earning tax-exempt income will not terminate the S election. pp. C:11-9 through C:11-13. C:11-7 An inadvertent termination is one where the IRS, corporation, and shareholders all agree was unintentional (e.g., failing the passive investment income test for three consecutive years as a result of improperly computing the corporation’s Subchapter C E&P). Once such a determination is made, the S corporation or its shareholders must take the necessary steps, within a reasonable time period after discovering the event causing the termination, to restore its small business corporation status (e.g., distributing the money or property needed to eliminate the E&P balance in the preceding situation). By having the termination classified as inadvertent, the income passes through to the S corporation’s shareholders and is not taxed to the corporation under the C corporation rules. The IRS also can grant relief for inadvertent terminations of a QSub election. pp. C:11-11 through C:11-13. Copyright © 2024 Pearson Education, Inc.

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C:11-8 Five years. An S corporation that revokes or terminates its S election must wait five tax years before making a new election. This delay applies unless the IRS consents to an earlier reelection. Regulation Sec. 1.1362-5(a) indicates that permission for an early reelection can occur when (1) more than 50% of the corporation’s stock is owned by persons who did not own stock on the date of the termination or (2) the termination was caused by events not reasonably within the control of the corporation or the shareholders owning a substantial interest in the corporation and was not part of a plan to terminate the election involving the corporation or its shareholders. p. C:11-12. C:11-9 An S corporation generally must adopt a permitted tax year (which normally is a calendar year or a 52–53 week year) as its tax year. Alternatively, it can adopt a fiscal year for which it has established the necessary business purpose (e.g., natural business year). If the corporation uses the business purpose exception as authority to adopt a fiscal year, IRS approval of the tax year is required. As another alternative, the S corporation can elect under Sec. 444 to adopt or change to a tax year with a limited deferral period (e.g., three months or shorter period), if the adoption or change does not result in a greater deferral period than does the year presently being used. The adoption of a fiscal year with a limited deferral period is permitted in the corporation’s initial tax year or after the S corporation has been in business for one or more years. Other acceptable tax years include an ownership year, a “grandfathered” fiscal year, or a tax year based on a business purpose other than a natural business year (e.g., facts and circumstances year). pp. C:11-13 and C:11-14. C:11-10 To maintain a fiscal year under a Sec. 444 election, Cable must choose a year-end of September 30, October 31, or November 30 so the deferral period is three months or less. The corporation also must make the required payments mandated under Sec. 7519 and file a Form 8752 annually. pp. C:11-13 and C:11-14. C:11-11 Subchapter C earnings and profits (E&P) are profits earned in a tax year for which an S election was not in effect (e.g., a tax year preceding an S election during which the corporation was a C corporation) or E&P that the S corporation inherited from a C corporation under the tax attribute carryover rules of Sec. 381 (see Chapter C:7). The existence of Subchapter C E&P at the close of a tax year prevents the corporation from earning an unlimited amount of passive investment income and being exempt from the excess net passive income tax for the year in question. An S corporation having Subchapter C E&P at the end of its tax year is subject to the excess net passive income tax if its passive investment income for the tax year exceeds 25% of its gross receipts. Failing the 25% test for three consecutive tax years while having Subchapter C E&P at the end of each tax year results in termination of the S election at the beginning of the fourth year in addition to imposition of the tax for each of the three years. pp. C:11-10, C:11-15, and C:11-16.

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C:11-12 The S corporation’s ordinary income or loss and each separately stated item are allocated to each shareholder as follows: a. Allocate an equal portion of the item to each day in the tax year (by dividing the amount of the item by the number of days in the S corporation’s tax year). b. Allocate an equal portion of the daily amount for the item to each share of stock outstanding on each day (by dividing the daily amount for the time period by the number of shares of stock outstanding on a particular day). c. Total the daily allocations for each outstanding share of stock. d. Total the amounts allocated to each share of stock held by the shareholder. The S corporation rules do not permit special allocations of income, gain, loss, or deduction items (like those available to a partnership). Special rules apply if the S election terminates in the tax year or if a shareholder sells or otherwise disposes of his or her entire S corporation stock interest. pp. C:11-19 through C:11-21. C:11-13 Stock and debt basis limitations on losses. Each shareholder’s deduction for his or her share of the ordinary loss and the separately stated loss and deduction items is limited to the sum of the adjusted basis for his or her S corporation stock plus the adjusted basis of any indebtedness owed directly by the S corporation to the shareholder. Excess loss and deduction items carry over to subsequent years in which the shareholder again has a positive basis amount. In determining stock basis for the loss limitation, the shareholder first makes positive basis adjustments for any separately stated income or gain items and makes a negative basis adjustment for any distribution. Debt basis for the loss limitation is the balance before any adjustments. Unused losses lapse if the shareholder transfers his or her stock to anyone other than a spouse or former spouse incident to a divorce. In addition to basis loss limitation, the shareholder’s loss or deduction allocation may be subject to the at-risk rules, the passive activity limitation rules, the limitation on excess business losses, the investment interest deduction rules, the hobby loss rules, or the regular shareholder deduction limitations (e.g., the shareholder’s charitable contribution deduction limitation). These other limitations may prove more restrictive than the general basis limitation. pp. C:11-21 through C:1123. C:11-14 Increase stock or debt basis. The shareholder can make additional capital contributions or make additional loans to the corporation by year-end. This basis increasing strategy permits the loss deduction to be larger in the current year provided the special loss limitations such as the at-risk rules, passive activity limitation rules, or the limitation on excess business losses do not restrict the deduction available under the shareholder’s basis limitation. Depending on the shareholder’s marginal tax rates for the current year and next year, the shareholder should consider deferring the additional capital contributions or loans until after year-end when he or she expects the marginal tax rate to be higher in the next tax year to obtain a larger tax savings. pp. C:11-36 and C:11-37. C:11-15 A post-termination transition period generally is a one-year period immediately following the last day of the final S corporation tax year in which loss and deduction carryovers can be used by the S corporation’s shareholders even though the S election has been revoked or terminated. In some cases, the post-termination transition period may run to the due date for the S corporation tax return (including extensions). A post-termination transition period also includes the 120-day period beginning on a determination date (e.g., date on which a court decision becomes final) or a closing agreement is finalized. The loss and deduction carryovers can be deducted only up to the adjusted Copyright © 2024 Pearson Education, Inc.

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basis of the shareholder’s stock at the end of the post-termination transition period. Loss and deduction carryovers cannot be deducted against the basis for amounts owed by the corporation to a shareholder. To prevent losses from not being deductible, the shareholder should consider making capital contributions before the end of the post-termination transition period. pp. C:11-23 and C:11-24. C:11-16 Shareholders make positive adjustments to the basis of their S corporation stock annually for additional capital contributions made during the tax year and their allocable share of ordinary income and separately stated income and gain items. They make negative adjustments to the basis of their S corporation stock annually for (1) distributions excluded from the shareholder’s gross income, (2) expense items not deductible in determining ordinary income (loss) and that cannot be charged to the capital account, and (3) the shareholder’s allocable share of ordinary loss and separately stated loss and deduction items. Special stock basis adjustment rules apply to S corporations that claim a deduction for percentage depletion with respect to oil and gas wells. The same positive and negative income and loss basis adjustments apply to the basis of any S corporation debt owed to the shareholder except that distributions do not reduce debt basis. However, the downward loss and deduction adjustments reduce the shareholder’s debt basis only after the shareholder’s basis for the S corporation stock has been reduced to zero. Any net positive basis adjustments restore the basis of S corporation debt owed to the shareholder before any positive basis adjustments increase the shareholder’s basis for the S corporation stock. pp. C:11-25 through C:11-28. C:11-17 An S corporation recognizes gain (but not loss) under Sec. 311(b) when it makes a nonliquidating property distribution to its shareholders. A partnership recognizes no gain or loss when it makes a nonliquidating property distribution except to the extent that (1) the Sec. 751 rules may apply to certain disproportionate distributions or (2) the precontribution gain rules of Sec. 737 apply to the distribution. S corporations having no E&P will make nontaxable distributions if the total amount of the distribution does not exceed the shareholder’s basis for his or her stock. This procedure generally follows the rules for partnership distributions except to the extent the S corporation recognizes gain when distributing appreciated property, in which case the shareholder increases stock basis by his or her share of the gain and reduces his or her stock basis by the property’s FMV. Some S corporations must maintain records of their accumulated adjustments account (AAA) and Subchapter C E&P. Similar concepts are not found in partnership taxation. For S corporations having an E&P balance, distributions follow a complex set of rules and are sourced in part or in full from the AAA or Subchapter C E&P. pp. C:11-28 through C:11-33 (also see Chapter C:10). C:11-18 Nonliquidating distributions paid by an S corporation that has no accumulated E&P are treated as a return of the shareholder’s basis for his or her stock investment. As such, all distributions paid to the shareholder up to the amount of his or her stock basis are nontaxable. Distributions exceeding the shareholder’s stock basis are taxable as capital gains. Different rules apply to S corporations that have accumulated E&P. Distributions out of the accumulated adjustments account (AAA) are nontaxable and reduce (but not below zero) the shareholder’s stock basis. Distributions out of the S corporation’s accumulated E&P are taxable as dividend income. Distributions exceeding the S corporation’s accumulated E&P also are nontaxable and reduce the shareholder’s stock basis. Distributions exceeding the shareholder’s stock basis are taxable as capital gains. pp. C:11-28 through C:11-33. Copyright © 2024 Pearson Education, Inc.

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C:11-19 The accumulated adjustments account (AAA) is the cumulative total of ordinary income or loss and separately stated items for the S period. The AAA is required only of S corporations that have an accumulated E&P balance. The S period is the most recent continuous period during which the corporation has been an S corporation. Tax years beginning before January 1, 1983 are not included in this period. Tax-exempt income and nondeductible expenses related to the production of the tax-exempt income do not increase or decrease the AAA but instead are included in the other adjustments account (OAA), which is not a separate earnings balance but is included in the basis of the S corporation stock. All other income, gain, loss, and deduction items increase and decrease AAA and the shareholder’s stock basis. Even if the corporation has no accumulated E&P at year-end, the IRS recommends reporting a AAA according to the instructions for Form 1120-S. pp. C:11-29 through C:11-33. C:11-20 a. S corporation shareholders report ordinary income or loss (as well as separately stated items) on their individual returns and may be eligible for the qualified business income deduction. A C corporation reports ordinary income or loss in its taxable income. b. Dividends pass through the S corporation as a separately stated item, and the S corporation shareholders report the dividends in their individual returns, subject to the applicable capital gains tax rate. A C corporation includes dividends received in its gross income and then takes a 50%, 65%, or 100% dividends-received deduction. c. Capital gains and losses pass through the S corporation as separately stated items, and the S corporation shareholders report them on their individual returns along with their other capital gains and losses. Capital gains and losses recognized by a C corporation are reported in the corporation’s taxable income. d. Tax-exempt interest income passes through to the S corporation’s shareholders as a separately stated item. It is not taxed either to the S corporation’s shareholders or to the S corporation. C corporations are not taxed on their tax-exempt income; however, such amounts are included in the C Corporation’s E&P and are taxable to its shareholders when distributed. e. Charitable contributions pass through the S corporation as a separately stated item, and the S corporation shareholders report them on their tax returns along with their other charitable contributions. The charitable contribution deduction limitation applies at the shareholder level. A C corporation deducts charitable contributions, which are limited to 10% of its adjusted taxable income. f. Nonliquidating property distributions made by an S corporation without accumulated E&P are treated as a nontaxable return of capital and reduce the shareholder’s basis for his or her S corporation stock. Distributions that exceed the stock basis are taxed as capital gains. Different rules apply to S corporations that have accumulated E&P. Any such distributions these corporations make out of accumulated E&P are taxable as a dividend. Distributions made out of the accumulated adjustments account (AAA) are nontaxable until the shareholder’s stock basis has been reduced to zero. Nonliquidating distributions made by a C corporation are taxable as a dividend if paid out of current or accumulated E&P. Distributions exceeding E&P reduce the shareholder’s basis for his or her stock. Distributions exceeding the shareholder’s basis are taxed as capital gains. Both C and S corporations recognize gain on the distribution of appreciated property. C corporations pay tax on that gain while S corporations pass the gain to its shareholders. g. Fringe benefits paid to or on behalf of an owner-employee owning more than 2% of the S corporation’s stock are treated as if the corporation were a partnership. As such, the owner-employee is not an employee, and the fringe benefit is treated as compensation taxable to the Copyright © 2024 Pearson Education, Inc.

C:11-6

shareholder-employee unless the benefit is excludible from the gross income of a partner. The corporation deducts compensation. Fringe benefits paid to or on behalf of an owner-employee of a C corporation, or to an S corporation shareholder-employee owning less than 2% of the stock, are excluded by the individual and deductible by the corporation. pp. C:11-14, C:11-15, C:11-28 through C:11-35. C:11-21 The S corporation’s tax return is due on the fifteenth day of the third month following the close of the tax year. The corporation can request, via Form 7004, an automatic six-month extension of time to file the return. p. C:11-39. C:11-22 S corporations must make estimated tax payments for the two special corporate level taxes--the excess net passive income tax and the built-in gains tax. The estimated tax minimums for an S corporation differ from those of a C corporation. Both require 100% of the tax shown on the return for the current year. The prior year tax rule for S corporations is 100% of the built-in gains tax for the current year and 100% of the excess net passive income tax for the preceding year (instead of the 100% of prior year tax liability rule applicable to C corporations). Any tax payments made by the S corporation do not reduce the shareholder’s required estimated tax payments, but the estimated payments reduce the ordinary income and separately stated items passed through to the shareholders. pp. C11-39 and C:11-40. C:11-23 Some of the similarities and differences are listed below; however, this list should not be considered all inclusive: Similarities among all three returns: 1. Cost of goods sold is calculated the same. 2. A balance sheet is presented for all business forms. 3. Schedule M-1 or Schedule M-3 on Forms 1120, 1120-S, and 1065 reconciles book income with income reported on the return. For the S corporation return, this reconciliation is to the ordinary income (loss) amount plus separately stated income and deduction items. Schedule M-2 on the Form 1120 reconciles accumulated book income (retained earnings), and Form 1120-S reconciles three accumulated earnings account balances while the Form 1065 reconciles the capital account balance. Differences: 1. Form 1120 taxable income includes all income earned by the corporation during the tax year, but Forms 1065 and 1120-S ordinary income excludes separately stated items. 2. Forms 1065 and 1120-S have Schedules K and K-1 to report pass-through items in total and to each of the owners while Form 1120 does not. 3. Forms 1065 and 1120-S require specific information on rental real estate activities while Form 1120 does not. 4. Controlling ownership information is given on all three forms; however, Forms 1065 and 1120-S list all ownership interests on the Schedule K-1s for the owners. 5. Form 1065 does not include any tax calculations or estimated tax payments. Forms 1120 and 1120-S require tax calculations and possibly estimated tax payments. 6. All three forms request different additional information. Copyright © 2024 Pearson Education, Inc.

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Form 1120 includes the dividends-received deduction while Forms 1065 and 1120-S

do not. 8. Form 1120 requests information on officer’s compensation while Forms 1065 and 1120-S do not.

Issue Identification Questions C:11-24• • • • • • • • • •

Does the incorporation transaction qualify as nontaxable under Sec. 351? Are advantages to be gained by transferring the partnership’s assets to the corporation in exchange for its stock and then liquidating the partnership? Alternatively, are advantages to be gained by first liquidating the partnership and then transferring the assets to the corporation in exchange for its stock? What is the amount and character of the gain or loss recognized on the incorporation by the partnership? The corporation? The partners? What is the corporation’s basis in the assets? What is each shareholder’s basis in the corporation stock? When does the holding period start for the assets? The corporation’s stock? What tax year should the corporation elect? Does this tax year have to be the same tax year used by the partnership? What accounting methods should the corporation elect? Do these accounting methods have to be the same accounting methods used by the partnership? What procedures must the corporation and shareholders follow to make an S election? • By what date must the corporation make the election? • What format does the election take? • What consents are required of the shareholders?

One underlying question that might be brought up is: Should the tax practitioner and the transferor consider converting the partnership to an LLC instead of an S corporation? The entity making the S election does not have to be a corporation. A noncorporate entity can make an S election and is deemed to automatically make the election to be treated as a corporation under Reg. Sec. 301.7701-3(h)(3). If the partnership formally incorporates, however, the method of incorporation does matter. The tax consequences (gain recognized, basis amounts, etc.) can differ depending on which of the three basic methods are used to terminate the partnership and transfer the assets to the corporation. The three methods, described in Rev. Rul. 84-111, 1984-2 C.B. 885, are: (1) the partnership transfers assets to the corporation in exchange for stock, and the partnership transfers the stock to its partners in liquidation; (2) the partnership transfers assets to its partners in liquidation, and the former partners transfer the assets to the corporation in exchange for stock; and (3) the partners transfer their partnership interests to the corporation in exchange for stock, and the partnership transfers the assets to the corporation in liquidation. Without further information, the gain and basis amounts cannot be determined, nor can we say which of the three ways is better. The S corporation can use a tax year different than the partnership, but it does have to be a required year. Likewise, the S corporation can elect any accounting method that it chooses without regard to the method employed by the partnership. The corporation must file an S election (Form 2553) in a timely manner, and the shareholders must provide the appropriate consents. Copyright © 2024 Pearson Education, Inc.

C:11-8

A conversion from a partnership to an LLC is covered by rules different than for a corporate formation (see Chapter C:10). pp. C:11-2 through C:11-9, and C:11-13 through C:11-15 (also see Chapter C:2). C:11-25 The questions listed below are based on the presumption that an S election will be advantageous and that the S corporation is the best entity choice for the corporation. •

• • • • • • • •

What procedures must the corporation and shareholders follow to make an S election? • By what date must the corporation make the election? • What format does the election take? • What consents are required of the shareholders? What tax year should the S corporation elect? Does this tax year have to be the same tax year used by the C corporation? What accounting methods should the S corporation elect? Do these accounting methods have to be the same accounting methods used by the C corporation? What possible built-in gains tax liability will the S corporation incur? Should the corporation obtain an appraisal of the assets as of the first day of the S election? What tax attributes (e.g., NOLs and capital losses) will be suspended as a result of making the S election? What possible excess net passive income tax liability will the S corporation incur? Should the corporation consider distributing its Subchapter C E&P to eliminate this tax liability? What possible LIFO recapture tax liability will the corporation incur in its final C corporation tax year?

The corporation must file an S election (Form 2553) in a timely manner, and the shareholders must provide the appropriate consents. The S corporation cannot automatically use a tax year different than that used by the C corporation, but it may have to change to a required tax year, usually a calendar year. The S corporation must continue to use the accounting methods the C corporation used. Section 1374 imposes built-in gains tax liability on asset dispositions occurring within ten years of the first day of the S election period (unless the shortened seven-year or five-year recognition period applies). The parties should consider obtaining an appraisal to establish the amount of the builtin gains and losses to minimize the built-in gains tax liability. C corporation NOLs and net capital losses can reduce the built-in gains tax liability but cannot pass through to the shareholders. In addition, if the S corporation has Subchapter C E&P, it may incur the excess net passive income tax liability if it earns a substantial amount of passive income. Also, the S corporation may incur the LIFO recapture tax if it used the LIFO inventory method in its final C corporation tax year. pp. C:11-7 through C:11-9, C:11-13 through C:11-18, and C:11-38.

C:11-9

C:11-26• • •

What is Peter’s allocable share of the Air South ordinary loss? What portion of the loss is limited by the S corporation stock basis and debt basis? The at-risk rules? The passive activity loss rules? The limitation on excess business losses? If his use of the loss is limited only by the S corporation stock basis and debt basis, should Peter invest additional amounts before year-end to increase the basis of the stock and/or debt? When should such an investment be made? Before year-end? After year-end? Should he not make an additional investment and use the loss against future profits?

Peter should anticipate a $187,500 ordinary loss pass-through, which exceeds his $100,000 basis for the Air South stock. He should make the additional investment only if it is economically wise. Even if Peter makes the additional investment, he still might not be able to deduct the loss. The passive activity loss rules may deny the loss until Peter has passive income from this or another activity or until he completely disposes of his investment. His share of losses will be too small to be subject to the limitation on excess business losses. The tax year to make the additional investment, and deduct the loss, will be the year in which Peter anticipates the highest marginal tax rate (discounted for the time value of money.) pp. C:11-19 through C:11-23, C:11-36, and C:11-37. C:11-27• • • • •

What gain or loss does Glacier Smokeries recognize on making the distribution? Will the shareholders have to recognize this gain or loss? Does the gain or loss trigger any built-in gains tax liability? What is each shareholder’s basis for the Glacier Smokeries’ stock immediately preceding the distribution? What basis reduction does the distribution cause for each shareholder? Does the basis reduction trigger the recognition of any income by the shareholder (e.g., if the distribution reduces the shareholder’s basis to zero). What is each shareholder’s basis for the Glacier Smokeries stock immediately following the distribution? What is each shareholder’s basis and holding period for the land received?

Glacier Smokeries will recognize a $225,000 ($300,000 - $75,000) gain on the distribution. This gain is not subject to the Sec. 1374 built-in gain tax because Glacier was never a C corporation. This gain and Glacier Smokeries’ ordinary income from operations will pass through to the shareholders and increase their stock bases. Adam and Rodney take $350,000 ($175,000 + $112,500 + $62,500) and $400,000 ($225,000 + $112,500 + $62,500) bases, respectively. Each shareholder reduces his stock basis by $150,000 ($300,000 x 0.50) for the distribution. pp. C:11-16 through C:11-18, and C:11-28 through C:11-33.

C:11-10

Problems C:11-28a.

$31,500 total tax if no distribution or salary payment made, calculated as follows:

Delta: Income tax ($150,000 x 0.21) Social Security tax Carl: Income tax Social Security tax Total tax b.

$31,500 -0-0-0$31,500

$34,729 total tax if dividend of $80,000 paid, calculated as follows:

Delta: Income tax ($150,000 x 0.21) Social Security tax Carl: Income tax [($44,625 x 0.0) + $21,525 x 0.15)]* Social Security tax Total tax

$31,500 -03,229 -0$34,729

*Carl’s taxable income is $66,150 ($80,000 dividend - $13,850 standard deduction), which is subject to the 0% and 15% tax rates on qualified dividends. c.

$35,516 total tax if salary of $80,000 paid, calculated as follows:

Delta: Income tax ($63,880 x 0.21)a Social Security tax Carl: Income tax [$5,147 + 0.22 x ($66,150 - $44,725)]b Social Security tax Total tax

$13,415 6,120 9,861 6,120 $35,516

Delta’s taxable income is $63,880 ($150,000 - $80,000 salary deduction - $6,120 Social Security tax deduction). b Carl’s taxable income is $66,150 ($80,000 salary - $13,850 standard deduction), which is subject to ordinary tax rates. Conclusion: To get $80,000 from the C corporation to Carl, the dividend alternative entails the lowest total tax liability because of the low corporate tax rate and the large portion of the dividend that is taxed at a 0% tax rate. The difference between the dividend and salary alternatives, however, is not large because the salary alternative avoids double taxation on the $80,000 amount deducted as salary, although this alternative does introduce the Social Security tax.

C:11-11

d. a.

Parts a – c variation with Delta being an S corporation. $19,541 total tax if no distribution or salary payment made, calculated as follows:

Delta: Income tax Social Security tax Carl: Income tax [$16,290 + 0.24 x ($108,920 - $95,375)]* Social Security tax Total tax

-0-0-

19,541 -0$19,541

*Carl’s taxable income is $108,920 ($150,000 pass-through income - $13,850 standard deduction - $27,230 QBI deduction), which is subject to ordinary tax rates. Combined QBI = $30,000 ($150,000 x 0.20). 20% of excess taxable income = $27,230 [($150,000 - $13,850) x 0.20]. Thus, QBI deduction = $27,230. b.

$19,541 total tax if distribution of $80,000 made:

Same as Part a (of Part d variation). Carl’s pass-through income from Delta is $150,000 whether or not Delta distributes any of it. Also, the QBI deduction remains the same. c.

$33,781 total tax if salary of $80,000 paid, calculated as follows:

Delta: Income taxa Social Security tax Carl: Income tax [$16,290 + 0.24 x ($117,254 - $95,375)]b Social Security tax Total tax

-06,120

21,541 6,120 $33,781

Delta’s ordinary income is $63,880 ($150,000 - $80,000 salary deduction - $6,120 Social Security tax deduction), which passes through to Carl. b Carl’s taxable income is $117,254 ($80,000 salary + $63,880 pass-through income $13,850 standard deduction - $12,776 QBI deduction), which is subject to ordinary tax rates. Combined QBI = $12,776 ($63,880 x 0.20). 20% of excess taxable income = $26,006 [($80,000 + $63,880 - $13,850) x 0.20]. Thus, QBI deduction = $12,776. Conclusion: To get $80,000 from the S corporation to Carl, the distribution alternative entails the lowest total tax liability because it avoids the Social Security taxes on a salary payment, and it increases the QBI deduction. Because of this tax savings opportunity, the IRS might challenge the level of salary ($0) as unreasonably low. pp. C:9-17 through C:9-19, C:11-20, and C:11-21. C:11-29a. Voyles Corporation makes the S election by filing Form 2553 in a timely manner with all its shareholders consenting to the election. b. The corporation can make the S election (1) any time during the tax year preceding the year for which the election is to be effective (2023) or (2) on or before the fifteenth day of the Copyright © 2024 Pearson Education, Inc.

C:11-12

third month of the year for which the election is effective (March 15, 2024). Corporations making an S election in their initial tax year must make the election not later than the fifteenth day of the third month of the initial tax year. c. The election will take effect on the first day of the next tax year (2025) unless the corporation obtains relief from the IRS for its late election. pp. C:11-8 and C:11-9. C:11-30a. The sale of the second class of stock terminates the S election on September 11, 2023, the day on which an event occurs that causes Orlando to fail to meet the definition of a small business corporation. b. Two tax returns are required covering the following time periods: (1) an S corporation return for January 1, 2023, through September 10, 2023 (the day before the termination event); and (2) a C corporation return for September 11, 2023, through December 31, 2023. The day of the termination event is the first day of the C corporation short year [Reg. Sec. 1.1362-3(a)]. According to Sec. 1362(e)(6)(B), the S return is due on March 15, 2024; the C return is due on April 15, 2024. c. The IRS does not treat the Class B common stock as a second class of stock, and the S corporation election does not terminate if the only difference between the original common stock and the Class B common stock is the voting rights. pp. C:11-5 through C:11-7, C:11-9, and C:11-10. C:11-31a. Tango Corporation must file a revocation statement to which the sole shareholder consents. If Tango files the revocation before the end of 2024, it can designate a prospective revocation date for some date in the remaining part of 2024 or for a later year. If Tango does not make a prospective revocation but files a revocation on or before March 15, 2024, the revocation takes effect at the beginning of 2024. If Tango makes the election in 2024 after March 15, the revocation takes effect at the beginning of 2025. Thus, to have a revocation take effect in 2024, Tango must either make a non-prospective revocation on or before March 15, 2024 or make a prospective revocation for a desired date in the remainder of 2024. b. The corporation files an S corporation return for the period January 1, 2024, through March 31, 2024. The corporation files C corporation returns for the period April 1, 2024, through December 31, 2024, and January 1, 2025, through December 31, 2025. The 2024 S return is due on March 17, 2025 (the first business day after a weekend), and the 2024 C return is due on April 15, 2025. The 2025 C return is due on April 15, 2026. c. The S corporation must wait five tax years before making a new election unless the IRS consents to an earlier reelection. The new election takes effect on January 1 of the fifth year beginning after the revocation year. pp. C:11-9 through C:11-12. C:11-32 The sale will terminate the S corporation election because the partnership is an ineligible shareholder. Under the general S corporation rules, the termination will be effective on December 31 of the current year. Galleon Corporation files an S corporation return for the period January 1 through December 31 of the current year. For next year and later tax years, Peter and Alice must include the Galleon distributions in their gross income as dividend income, provided Galleon has E&P. No other income or loss pass-throughs will occur while Galleon operates as a C corporation. To avoid the termination, Galleon could claim relief under the inadvertent termination rules if the shareholders take immediate steps to eliminate the cause of the termination. To correct the inadvertent termination, Rob and Susan should liquidate their partnership and distribute the Galleon stock to themselves, again holding it as individuals. Therefore, the ineligible shareholder would be Copyright © 2024 Pearson Education, Inc.

C:11-13

eliminated. Alternatively, the partnership could sell the stock back to Peter and Alice. Also, the parties must obtain the IRS’s approval to waive the inadvertent termination. pp. C:11-9 through C:11-13. C:11-33a. No. The maximum deferral the corporation can elect is three months unless a business purpose exists for the fiscal year ending January 31. Classic Corporation can adopt a September 30 year-end if it makes a timely Sec. 444 election and makes the required payments under Sec. 7519. The September 30 year-end will permit a three-month income deferral. b. Yes. The June 30 year-end conforms to its natural business year; therefore, it satisfies the business purpose requirement. IRS approval of the natural business year is required, as is conformity to the income requirement for the last two months of the natural business year. pp. C:1113 and C:11-14. C:11-34a. Yes; $18,342 tax. North Corporation is subject to the excess net passive income tax because (1) it has passive investment income ($160,000) that exceeds 25% of its gross receipts (0.25 x $210,000 = $52,500) and (2) it has Subchapter C E&P at the close of the current year. The services income is not passive investment income because it is derived from the active conduct of a trade or business. North’s tax liability is determined as follows: Excess net passive income ($87,344) a

Net passive income ($130,000)a

$160,000 - (0.25 x $210,000) $160,000

($100,000 + $60,000) - $30,000 direct expenses = $130,000

Tax = 0.21 x $87,344 = $18,342 The S corporation pays the Sec. 1375 tax in the form of estimated tax payments made during the tax year. b. The excess net passive income tax reduces, on a pro rata basis, the amount of ordinary income and separately stated items (dividends and rents in this case) that were subject to tax and passed through to the shareholders. The reduction is as follows: Dividends:

$18,342 x

$60,000 $60,000 + $100,000

= $6,878

Rents:

$18,342 x

$100,000 $60,000 + $100,000

= $11,464

The dividend pass-through is $53,122 ($60,000 - $6,878). The rental income pass-through is $58,536 ($100,000 - $30,000 - $11,464). c. Tax planning alternatives available to North include: (1) earning more active income (e.g., services income); (2) earning less passive income (e.g., dividend or rental income); (3) distributing the $60,000 of Subchapter C E&P to its shareholders; or (4) distributing the stocks Copyright © 2024 Pearson Education, Inc.

C:11-14

and/or rental property to the shareholders. If the passive income situation persists for three years, the S election will terminate. pp. C:11-15, C:11-16, C:11-37, and C:11-38. C:11-35 $20,160 built-in gains tax, determined as follows: Receivables Automobile (Sec. 1245 gain) Land (Sec. 1231 gain) Accounts payables Recognized built-in gains Limited to smaller of: Current year taxable income Net unrealized built-in gain Recognized built-in gains

$200,000 1,000a 20,000b (125,000)c $ 96,000 $400,000 295,000d 96,000

$2,300 [$3,500 - ($2,000 - $800)] recognized gain. Limited to $1,000 built-in gain on first day of first S corporation tax year (last year). b $35,000 ($60,000 - $25,000) recognized gain. Limited to $20,000 built-in gain on first day of first S corporation tax year (last year). c Deductible accounts payable only. d $420,000 ($600,000 - $180,000) unrealized built-in gains - $125,000 unrealized built-in losses = $295,000 net unrealized built-in gain. Neither special limitation (taxable income nor net unrealized built-in gain) applies because the total recognized built-in gains are less than either limitation. The built-in gains tax liability equals $20,160 ($96,000 x 0.21). The built-in gains tax liability reduces the income pass-through for the receivables, the automobile gain (ordinary income), and the land gain (Sec. 1231 gain) on a ratable basis. pp. C:11-16 through C:11-18. C:11-36a.

S corporation ordinary income: Sales Minus: Cost of goods sold Gross profit Plus: Sec. 1245 gain Minus: Depreciation Salary to Nancy Business interest Business meals (50% in 2023) S corporation ordinary income

C:11-15

$300,000 ( 140,000) $160,000 22,000 $18,000 20,000 32,000 1,100

( 71,100) $110,900

Separately stated items: Dividend income Sec. 1231 gain Net long-term capital gain ($8,000 - $7,000) Tax-exempt interest income Short-term capital loss Investment interest expense Charitable contributions Nondeductible business meals Nondeductible interest on tax-exempt interest income

$ 10,000 12,000 1,000 3,000 (6,000) (6,400) (2,000) (1,100) (1,800)

See Problem C:11-63 for related 2022 Form 1120-S, Schedule K. Note: In 2022, 100% of the meals expense for business meals is deductible because it was incurred in restaurants. In 2023, only 50% of the meals expense is deductible—so the treatment of meals on the 2022 tax form will differ from the treatment in this problem. b. Mike and Nancy each would report one-half of S corporation ordinary income and one-half of each separately stated item. c.

Stock basis adjustments: Beginning basis Plus: S corporation ordinary income Dividend income Sec. 1231 gain NLTCG ($8,000 - $7,000) Tax-exempt interest income Minus: Distributions Nondeductible business meals Nondeductible interest NSTCL Investment interest expense Charitable contributions Ending basis

Mike $100,000 55,450 5,000 6,000 500 1,500 (15,000) (550) (900) (3,000) (3,200) (1,000) $144,800

pp. C:11-14, C:11-15, C:11-25, and C:11-26.

C:11-16

Nancy $100,000 55,450 5,000 6,000 500 1,500 (15,000) (550) (900) (3,000) (3,200) (1,000) $ 144,800

C:11-37

John:

$125,000 x 100% x

162* 365

$ 55,479

$125,000 x 90% x

203 365

62,569 $118,048

*The donor is assigned the income for the gift date. See Reg. Sec. 1.1377 – 1(a)(2)(ii). Michael: $125,000 x 10% x

203 365

6,952

pp. C:11-19 through C:11-21, C:11-35, and C:11-36. C:11-38On a daily basis, the pass-through income would be allocated as follows: Al:

Ruth:

Patty:

OI:

$180,000 x 50% =

$ 90,000

Sec. 1231: $ 75,000 x 50% =

37,500 $127,500 95 365

= $ 23,425a

Sec. 1231: $ 75,000 x 50% x

95 365

OI:

$180,000 x 50% x

270 365

= $ 66,575

Sec. 1231: $ 75,000 x 50% x

270 365

OI:

$180,000 x 50% x

9,760 $ 33,185

27,740 $ 94,315

The seller is allocated the income for the sale date. See Reg. Sec. 1.1377-1(a)(2)(ii).

However, because Ruth terminated her interest on April 5, Chemical Corporation can elect to allocate income according to the accounting method used by the corporation. This closing of books election produces the following income allocation:

C:11-17

Al:

OI:

$180,000 x 50% =

$ 90,000

Sec. 1231: $ 75,000 x 50% =

37,500 $127,500

Ruth:

OI:

$ 47,500a x 50% =

$ 23,750

Patty:

OI:

$132,500b x 50% =

$ 66,250

Sec. 1231: $ 75,000 x 50% =

37,500 $103,750

($15,000 x 3) + (5/30 x $15,000) = $47,500. Five days of income are allocated to Ruth in the fourth month because the seller is allocated the income for the sale date. No Sec. 1231 gain is allocated to Ruth because the corporation sold the asset after Ruth sold her stock investment. Only Al and Patty receive an allocation of the Sec. 1231 gain. b $180,000 - $47,500 = $132,500 All affected shareholders in Chemical must agree to the election. Affected shareholders include shareholders whose interests are terminated and all shareholders to whom the terminating shareholders transferred their interest. In this case, the affected shareholders are Ruth and Patty. The difference in the income reported by Ruth and Patty under the two alternatives should be a point for negotiation when entering into the sales agreement. pp. C:11-20, C:11-21, C:11-35, and C:1136. C:11-39a. The changes in stock ownership during the year require an allocation based on the number of days the shareholders held the stock. The results of this allocation and the formulas used are presented below. Note: the shareholder who disposes of his or her stock is treated as the shareholder on the day of disposition. See Reg. Sec. 1.1377-1(a)(2)(ii).

Allocation to Shareholder

Boba

Aliceb

Carterc

Miked

Total

Ordinary income Long-term capital loss Charitable contributions

$72,000 6,000 3,600

$26,926 2,244 1,346

$10,981 915 549

$10,093 841 505

$120,000 10,000 6,000

60 100

365 365

x Total Amount

30 100

181 365

x Total Amount +

x 334

x Total Amount

15 100

184 365

Total Amount

C:11-18

100 d

15 100

365 x b.

184 365

x Total Amount +

10 100

31 365

Total Amount

Adjusted basis = $26,000 + $10,981 - $915 - $549 = $35,517 Recognized gain = $45,000 - $35,517 = $9,483

pp. C:11-19 through C:11-21, C:11-35, and C:11-36.

C:11-19

C:11-40The sale of the additional stock terminates the S corporation election at the close of business on June 30. The income for the first half year is allocated equally to Rod and Kurt. The income for the last half year is taxed to Redfern Corporation under the C corporation rules. Daily allocation:

Pre-7/1a

Shareholder

Ordinary Income

Capital Loss

Rod Kurt Blackfoot Corporation Redfern Corporation Total

$30,993 30,993 -0______ $61,986

($3,719) ( 3,719) -0______ ($7,438)

181 x Amount = 365

Amount allocated to pre-July 1 period

Post-6/30b Ordinary Income

-063,014 $63,014

Capital Loss

$ -0( 7,562) ($7,562)

184 x Amount = Amount allocated to post-June 30 period 365 Accounting method allocation: Pre-July 1: Ordinary income: $125,000 x 0.20 = $25,000 allocated to S corporation short-year; $12,500 to each Rod and Kurt. Capital loss: $0, because the corporation sold asset in the C short year. b

Post-June 30:

Ordinary income: $125,000 - $25,000 (allocated to C short year) = $100,000 taxed to Redfern Corporation in C short year. Capital loss: $15,000 (carried over to next year by Redfern).

Some tax savings might accrue by creating a second tax paying entity (the C corporation after the loss of its S election), having the income taxed at the lower 21% corporate tax rates, and retaining the income within the corporation. Thus, the accounting method election might maximize the income taxed at the corporate level in the last half of the tax year. pp. C:11-19 through C:11-23. C:11-41a. The answers below assume the three sons are considered to be bona fide owners of the S corporation stock. Betty: John: Andrew: Stephen:

$60,000 salary and $132,000 ordinary income (0.55 x $240,000) $36,000 ordinary income (0.15 x $240,000) $36,000 ordinary income (0.15 x $240,000) $36,000 ordinary income (0.15 x $240,000)

Because Andrew and Stephen are younger than 18 years old, their income will be taxed at a special rate based on the estate and trust income tax rates. John is 24; therefore, he will be taxed under the regular progressive rate structure. The distributions do not trigger any additional tax liability.

C:11-20

Betty: John: Andrew: Stephen:

$120,000 salary and $99,000 ordinary income (0.55 x $180,000) $27,000 ordinary income (0.15 x $180,000) $27,000 ordinary income (0.15 x $180,000) $27,000 ordinary income (0.15 x $180,000)

Betty: $60,000 salary and $240,000 ordinary income. p. C:11-25.

C:11-42a. Monte

Allie

Allocation to shareholders: Ordinary loss Tax-exempt interest income Long-term capital loss

$87,500 10,000 16,000

$ 87,500 10,000 16,000

Loss limitation: Beginning stock basis Plus: Tax-exempt interest Stock basis before losses Plus: Debt basis Loss limitation

$80,000 10,000 $90,000 -0$90,000

$ 90,000 10,000 $100,000 10,000 $110,000

Loss deduction: Ordinary loss Capital loss

$76,087a $13,913b

$ 87,500c $ 16,000c

[$87,500/($87,500 + $16,000)] x $90,000 = $76,087 [$16,000/($87,500 + $16,000)] x $90,000 = $13,913 c No limitation applies because the total loss of $103,500 ($87,500 + $16,000) is less than the Allie’s $110,000 limitation. b. Monte’s stock: $90,000 - $90,000 = $0 c. Allie’s stock: $100,000 - $100,000 = $0 Allie’s note: $10,000 - $3,500 = $6,500 d. Monte has an $11,413 ($87,500 - $76,087) ordinary loss carryover and a $2,087 ($16,000 - $13,913) capital loss carryover to the next year. Allie has no loss carryovers. b

C:11-21

e. Monte

Allie

Allocation to partners: Ordinary loss Tax-exempt interest income Long-term capital loss

$ 87,500 10,000 16,000

Loss limitation: Beginning basis in partnership interest Tax-exempt interest Note payable to Allie Accounts payable Mortgage payable Total

$ 80,000 10,000 -045,000 15,000 $150,000

$ 90,000 10,000 10,000* 45,000 15,000 $170,000 $ 87,500 $ 16,000

Deduction: Ordinary loss Capital loss

$ 87,500 $ 16,000

*Under Reg. Sec. 1.752-2(c)(1), a partner who lends money to the partnership bears the economic risk of loss assuming no other partner bears an economic risk for the loan. Accordingly, Allie is allocated the $10,000 liability. The larger bases under the partnership rules allow the individuals to deduct the ordinary and capital losses in full. pp. C:11-19 through C:11-23.

C:11-22

C:11-43a. Monte

Allie

Allocation to shareholders: Ordinary income Tax-exempt interest income Long-term capital loss

$37,500 10,000 12,500

Carryover from prior years: Ordinary loss Long-term capital loss

$11,413 2,087

-037,500 10,000 12,500 $60,000 -0$60,000

$26,087a 10,413b

$37,500 12,500

Loss limitation for next year: Stock basis on 1/1 Plus: Ordinary income Tax-exempt income Long-term capital gain Stock basis before losses Plus: Note basis on 1/1 Loss limitation Income/loss reported next year: Ordinary income Net long-term capital gain a

-0-0-

-037,500 10,000 12,500 $60,000 6,500 $66,500

$37,500 - $11,413 carryover = $26,087. $12,500 - $2,087 carryover = $10,413.

1/1 Basis Plus: Ordinary income (OI) Tax-exempt interest Long-term capital gain Minus: OI carryover LTCG carryover 12/31 Basis

$ -037,500 10,000 12,500 (11,413) ( 2,087) $46,500

Stock: $0 + ($37,500 - $3,500 restoration of note basis) + $10,000 + $12,500 = $56,500. Note: $6,500 + $3,500 restoration = $10,000.

d. Monte has fully deducted his ordinary and capital loss carryovers from the prior year. Therefore, no further carryovers exist. pp. C:11-19 through C:11-23.

C:11-23

C:11-44a. $150,000 ($100,000 basis for stock + $50,000 basis for note). b. Stock: $0 Note: $0 c. Next year’s activities: ordinary income, $60,000; loss carryover from prior year, $25,000 ordinary loss; long-term capital gain on note repayment, $15,000 ($50,000 - $35,000 debt basis after restoration). Even though the corporation repaid the note before year-end, debt basis was increased for the restoration at the time of the repayment. The restoration equals the net increase of $35,000 ($60,000 ordinary income - $25,000 loss carryover). The stock basis at year-end is zero ($25,000 increase - $25,000 loss allowed). pp. C:11-19 through C:11-23, and C:11-25 through C:11-28. C:11-45 a. $50,000 loss and $0 ending basis to each shareholder. The allowed loss in the current year is limited to each shareholder’s basis in his or her stock, which does not include corporate level liabilities. Basis in stock before loss (from contribution) Share of S corporation loss allowed Basis in stock at year end

Harold $ 50,000 (50,000) $ -0-

Faye $ 50,000 (50,000) $ -0-

Harold and Faye each carry over $5,000 of disallowed loss to the next year. b. $55,000 loss and $15,000 ending basis to each partner. The allowed loss in the current year is limited to each partner’s basis in his or her partnership interest, which includes each partner’s share of partnership liabilities. Harold $ 50,000 20,000 $ 70,000 (55,000) $ 15,000

Contribution Share of partnership liabilities Basis in partnership interest before loss Share of partnership loss allowed Basis in partnership interest at year end

Faye $ 50,000 20,000 $ 70,000 (55,000) $ 15,000

In this case, the loss is not limited because each partner has sufficient basis in his or her partnership interest. pp. C:11-20 through C:11-23, C:11-25, C:11-26, and C:9-24 through C:9-28. C:11-46a.

Stock and debt basis:

Beginning basis Minus: Ordinary loss allowed Basis at end of current year Plus: Ordinary income Loss allowed Basis at the end of next year a

Harry Stock $10,000 ( 10,000)a $ -08,000 ( 3,000) $ 5,000

Rita Stock $10,000 ( 10,000) $ -05,000 -0$ 5,000

C:11-24

Debt $7,000 ( 3,000) $4,000 3,000b -0$7,000

Rita restores her debt basis by $3,000 before increasing her stock basis by the remaining $5,000 of ordinary income. (Rita’s net increase is $8,000, but she cannot restore debt basis beyond its original amount.) Pass-through items: Current year: Ordinary loss allowed ($3,000 carries over for Harry)

Harry ($10,000)

Rita ($13,000)

$ 8,000 ( 3,000)

$ 8,000

Harry Stock $10,000 ( 10,000)a $ -08,000 ( 6,000) ( 2,000) $ -0-

Rita

Next year: Ordinary income Loss carryover allowed b.

Stock and debt basis:

Beginning basis Minus: Ordinary loss allowed Basis at end of current year Plus: Ordinary income Minus: Distribution Loss allowed Basis at the end of next year

Stock $10,000 ( 10,000) $ -06,000 ( 6,000) -0$ -0-

Debt $7,000 ( 3,000) $4,000 2,000b -0$6,000

Harry’s allowed loss is limited to $10,000, his basis in stock. The net increase is $2,000 ($8,000 ordinary income - $6,000 distribution). Thus, Rita restores her debt basis by $2,000 before increasing her stock basis by the remaining $6,000 of ordinary income. b

Pass-through items: Current year: Ordinary loss allowed ($3,000 carries over for Harry)

Harry ($10,000)

Next year: Ordinary income $ 8,000 Loss carryover allowed ( 2,000) (Remaining $1,000 carries over for Harry)

C:11-25

Rita ($13,000)

$ 8,000

Basis in partnership interest:

Beginning basis Plus: Liability to bank Liability to Rita Minus: Ordinary loss allowed Basis at end of current year Plus: Ordinary income Minus: Distribution Basis at the end of next year

Harry $10,000 4,000* ( 13,000) $ 1,000 8,000 ( 6,000) $ 3,000

Rita $10,000 4,000 7,000** ( 13,000) $ 8,000 8,000 ( 6,000) $10,000

*Harry’s share of partnership liabilities, added to his beginning basis, gives him sufficient basis to deduct the entire $13,000 loss in the current year. **Under Reg. Sec. 1.752-2(c)(1), a partner who loans money to the partnership bears the economic risk of loss assuming no other partner bears an economic risk for the loan. Accordingly, Rita is allocated the $7,000 liability. Pass-through items: Current year: Ordinary loss allowed

Harry ($13,000)

Rita ($13,000)

Next year: Ordinary income

$ 8,000

pp. C:11-19 through C:11-23, C:11-25 through C:11-28 (also see Chapter C:9). C:11-47a. $60,000 each, limited to their stock basis. b. $45,000 each [($210,000/2) - $60,000]. c. The losses exceeding $5,000 create an NOL on Chuck’s individual tax return. d. None, unless Chuck and Linda have basis in their Stein Corporation stock at the end of the post-termination transition period (December 31 of Year 2 because the revocation is retroactive to the beginning of Year 2). Chuck and Linda could attain the necessary basis through additional capital contributions. e. The corporation could revoke the S election with a prospective revocation date late enough in Year 2 so that each shareholder would be allocated $45,000 of ordinary income. Revoking the S election on March 1 of Year 2 with no prospective date specified causes the revocation to take effect at the beginning of the tax year and forces Chuck and Linda to make additional capital contributions to be able to deduct the losses under the post-termination transition period rules. However, an early prospective revocation effective on April 1 of Year 2 should permit enough ordinary income ($15,000 per month per shareholder x 3 months = $45,000 income) to pass through to each shareholder to fully use the $45,000 of loss carryover. pp. C:11-19 through C:11-24.

C:11-26

C:11-48 Rocket Corporation expects to report a $120,000 ordinary loss in Year 1. Additional capital contributions of $40,000 ($120,000 loss - $80,000 basis) made in Year 1 would permit Tina to deduct the entire loss in Year 1 at 32% and 35% marginal tax rates. (The incremental $40,000 loss and her standard deduction cause part of the tax benefit to occur in the 32% tax bracket.) An additional capital contribution of $20,000 is needed in Year 2 to enable the loss incurred in that year to be deductible at a 24% marginal tax rate. If Tina does not make the additional capital contributions, $60,000 of the losses ($40,000 from Year 1 and $20,000 from Year 2) carry over to Year 3 (and Year 4). Because Tina obtains $35,000 of stock basis in Year 3 and after, she can use $35,000 of the carryover in Year 3, and the remaining $25,000 in Year 4 to offset her pass-through income from the corporation in those years. These losses can be deducted at a 24% marginal tax rate (assuming post-Year 1 tax rates are such that she is not in a higher tax bracket). Because Tina’s marginal tax rate in Year 1 is higher than in future years, Tina should consider making the additional capital contributions in Year 1 to take advantage of the high marginal tax rates and the time value of money. If, under the alternative set of facts, Tina makes the additional $40,000 capital contribution in Year 1, she will generate a $45,000 ($120,000 loss - $75,000 income) NOL in her Year 1 individual tax return. This NOL carries over indefinitely. Thus, part of the Year 1 loss offsets income at a low tax rates, and the balance carries over to a high tax rate year. By delaying the contribution, she can deduct the entire loss against the larger income she expects to earn in Year 2, thereby obtaining the full tax benefit at her higher marginal tax rate in that year. pp. C:11-19 through C:11-23, C:11-36, and C:11-37. C:11-49 Ordinary Income/Loss a. b. c. d. e. f. g. h. i. j. k. l. m. n.

Operating profit Dividend income from stocks Interest income from bonds Life insurance proceeds Long-term capital gain Sec. 1231 loss Sec. 1245 gain (recapture) Charitable contributions Fines paid for overweight trucks Depreciation Employee pension plan contributions Salary paid to owner Life insurance premiums on policy in d Money distribution

+ -

AAA

Stock Basis

+ + +

+ + + + + + -

+ + -

Items b, c, d, e, f, h, i, and m are separately stated items. Items d and m, the tax-exempt life insurance proceeds and the premiums paid on the policy are taken into account when determining the other adjustments account (OAA) balance. Copyright © 2024 Pearson Education, Inc.

C:11-27

The salary payment (item l) reduces ordinary income (or increases loss) and is separately reported to the shareholder-employee on Form W-2. Salary payments made to a shareholderemployee are subject to Social Security tax and income tax withholding. Such treatment is different from the treatment of guaranteed payments made to a partner, which are reported on Schedules K and K-1 of Form 1065 and which are treated as self-employment income. Also, salary paid to an S corporation owner, like guaranteed payments to a partner, is not considered to be qualified business income for the QBI deduction. pp. C:11-14, C:11-15, and C:11-25 through C:11-33. C:11-50a. None. The corporation recognizes no gain because it is an S corporation and does not distribute appreciated property. The shareholder recognizes no gain because the distribution does not exceed stock basis. b. $61,000 basis = $40,000 + $36,000 - $5,000 - $10,000 c. $76,000 nontaxable; $4,000 capital gain. The basis for the stock is $76,000 immediately after positive basis adjustments. Thus, $76,000 is a nontaxable return of capital. However, Tammy recognizes a $4,000 capital gain on the excess distribution. The nontaxable distribution reduces Tammy’s stock basis to zero. Thus, Tammy cannot deduct the short-term capital loss in the current year because allowable losses are limited to Tammy’s stock basis. She can deduct the loss in a future year when she obtains sufficient stock basis or obtains debt basis. pp. C:11-28 and C:11-29. C:11-51a.

Stock basis:

Beginning basis Plus: Ordinary income Gain on distribution of appreciated property ($26,000 - $16,000) Basis before distributions Minus: Property distributions (FMV) Ending basis

George $45,000 20,000

Martha $45,000 20,000

5,000 $70,000 ( 26,000) $44,000

George $20,000 5,000 26,000

Martha $20,000 5,000 26,000

Pass-through items: Ordinary income Gain on distributed property Basis in distributed property (FMV)

b. The property distributions have two disadvantages. First, the S corporation recognizes gain on the distribution of appreciated property to Martha, and George has to recognize half of this pass-through gain even though the corporation distributes it to Martha. This disadvantage is not too serious, however, because George receives $26,000 of FMV on his distribution, which is the same result that would occur if the corporation sold both properties first and then distributed cash to George and Martha. Second, and more serious, under Sec. 311(a), the corporation does not recognize loss on the distribution to George. Nevertheless, under Sec. 301(d), George takes a FMV basis in the property distributed to him. Consequently, George never recognizes the loss on the property. The shareholders would have been better off had the corporation sold the loss property and then distributed the proceeds to George. In this case, each shareholder would have recognized a pass-through loss of $7,000 [($26,000 - $40,000) x 0.50]. Copyright © 2024 Pearson Education, Inc.

C:11-28

Basis in partnership interest:

Beginning basis Plus: Ordinary income Basis before distributions Minus: Property distributions (basis) Ending basis

George $45,000 20,000 $65,000 ( 40,000) $25,000

Martha $45,000 20,000 $65,000 ( 16,000) $49,000

George $20,000 40,000

Martha $20,000 16,000

Pass-through items: Ordinary income Basis in distributed property (carryover) pp. C:11-28, C:11-29, and C:10-4. C:11-52a. This distribution is a nontaxable return of capital. Therefore, it does not result in reportable income to Curt. However, in addition to ordinary income, Sec. 1231 gain, and the charitable contribution, Vogel Corporation recognizes an $8,000 gain ($18,000 FMV - $10,000 basis) under Sec. 311(b) as a result of distributing appreciated property. This gain passes through to Curt. Curt excludes the tax-exempt interest income from his gross income. Under Sec. 301(d), Curt’s basis in the land is $18,000, its FMV. b. and c. Original capital contribution Ordinary income Sec. 1231 gain Tax-exempt interest income Gain recognized on distribution of land Charitable contribution Predistribution balance Distribution ($5,000 cash + $18,000 FMV land) Charitable contribution Ending balance

Stock Basis $ 70,000 60,000 40,000 5,000 8,000 -0$183,000 ( 23,000) ( 3,000) $157,000

AAA -060,000 40,000 -08,000 ( 3,000) $105,000 (23,000) -0$ 82,000 $

Form 1120-S instructions recommend maintenance of the AAA balance in case the S corporation acquires E&P in an acquisition transaction (e.g., a nontaxable reorganization). pp. C:11-28 through C:11-33.

C:11-29

C:11-53a. Neither the corporation nor Hal recognize income, gain, or loss because the corporation distributed cash instead of appreciated property and because the cash distribution did not exceed Hal’s stock basis. b. Stock basis: $80,000 = $120,000 + $30,000 + $15,000 - $65,000 - $20,000 c. AAA: $30,000 = $85,000 + $30,000 - $20,000 - $65,000 Accumulated E&P: $22,000 Other adjustments account (OAA): $15,000 = $0 + $15,000 d. Part a. The first $95,000 of the distribution is nontaxable because it comes from AAA and does not exceed Hal’s stock basis. The next $22,000 is from accumulated E&P and taxable to Hal. The remaining $3,000 is from the OAA and is nontaxable because it does not exceed Hal’s stock basis. Part b. Stock basis: $47,000 = $120,000 + $30,000 + $15,000 - $98,000 - $20,000. The $98,000 reduction is the $95,000 out of the AAA and the $3,000 out of the OAA. Part c. AAA: $0 = $85,000 + $30,000 - $20,000 - $95,000 Accumulated E&P: $0 = $22,000 - $22,000 OAA: $12,000 = $0 + $15,000 - $3,000 pp. C:11-28 through C:11-33. C:11-54a.

Items reported by the shareholder: Year 1: Ordinary income Tax-exempt income

$30,000 5,000

Year 2: Ordinary loss allowed

($40,000)

b. Beginning Year 1 Plus: Ordinary income Tax-exempt income Ending Year 1 Minus: Distribution Ordinary loss Ending Year 2

Stock Basis $10,000 30,000 5,000 $45,000 (15,000) (30,000) $ -0-

Debt Basis $12,000 -0-0$12,000 -0(10,000) $ 2,000

Corp. AAA $ -030,000 -0$ 30,000 ( 15,000) ( 40,000) ($25,000)

Accum. E&P $ 6,000 -0-0$ 6,000 -0-0$ 6,000

Corp. OAA $ -0-05,000 $5,000 -0-0$5,000

The net negative adjustment is $40,000. Thus, the $15,000 distribution reduces the AAA before the net negative adjustment does.

C:11-30

Items reported by the shareholder: Year 1: Same as Part a Year 2: Dividend income Ordinary loss allowed Remaining loss carries over

Year 1 same as Part b Ending Year 1 Minus: Distribution Ordinary loss Ending Year 2

$ 5,000 ( 27,000) ( 13,000)

Stock Basis

Debt Basis

Corp. AAA

Accum. E&P

Corp. OAA

$ 45,000 ( 30,000) ( 15,000) $ -0-

$ 12,000 -0( 12,000) $ -0-

$ 30,000 ( 30,000) ( 40,000) ($ 40,000)

$ 6,000 ( 5,000) -0$ 1,000

$5,000 -0-0$5,000

The net negative adjustment is $40,000. Thus, $30,000 of the distribution reduces the AAA before the net negative adjustment does. The remaining $5,000 distribution comes out of accumulated E&P as a taxable dividend. The loss allowed is limited to $27,000 ($15,000 stock basis + $12,000 debt basis). d.

Items reported by the shareholder: Year 1: Same as Parts a and c Year 2: Long-term capital gain Dividend income Ordinary loss allowed Stock Basis

Year 1 same as Parts b and c Ending Year 1 $45,000 Plus: Long-term capital gain 18,000 Minus: Partial ordinary loss -0Predistribution balance $63,000 Minus: Distribution ( 30,000) Ordinary loss ( 33,000) Net neg. adjustment -0Ending Year 2 $ -0-

$18,000 5,000 (40,000) Debt Basis

Corp. AAA

Accum. E&P

Corp. OAA

$12,000 -0-0$12,000 -0( 7,000) -0$ 5,000

$ 30,000 18,000 ( 18,000)* $ 30,000 ( 30,000) -0( 22,000) ($ 22,000)

$ 6,000 -0-0$ 6,000 ( 5,000) -0-0$ 1,000

$5,000 -0-0$5,000 -0-0-0$5,000

C:11-31

*The net negative adjustment is $22,000 ($18,000 LTCG - $40,000 ordinary loss). Thus, $18,000 of the ordinary loss offsets the LTGG before the distribution reduces the AAA. Then, $30,000 of the distribution comes out of the AAA tax free, and the remaining $5,000 distribution comes out of accumulated E&P as a taxable dividend. pp. C:11-28 through C:11-33. C:11-55a.

Items Reported by Shareholder: Year 1: Ordinary loss allowed Remaining loss carries over

($36,000) ( 4,000)

Year 2: Ordinary income Loss carryover allowed

$27,000 ( 4,000)

Year 3: Ordinary income

$22,000

Beginning Year 1 Minus: Ordinary loss Ending Year 1 Plus: Ordinary income Minus: Cash distribution Loss carryover allowed Ending Year 2 Plus: Ordinary income Minus: Cash distribution Ending Year 3

Stock Basis $ 20,000 ( 20,000) $ -014,000 ( 10,000) ( 4,000) -019,000 ( 17,000) $ 2,000

Debt Basis $16,000 ( 16,000) $ -013,000a -0-013,000 3,000b -0$16,000

Net increase is $13,000 ($27,000 ordinary income - $10,000 distribution - $4,000 loss carryover allowed). b Net increase is $5,000 ($22,000 ordinary income - $17,000 distribution) but can restore debt basis only to its original amount.

C:11-32

Items Reported by Shareholder: Year 1: Same as Part a Year 2: Ordinary income Capital gain on excess distribution

$ 8,000 2,000

Year 3: Ordinary income Loss carryover allowed

$22,000 ( 4,000)

Ending Year 1 Plus: Ordinary income Minus: Cash distribution excluded from gross income Ending Year 2 Plus: Ordinary income Minus: Cash distribution Loss carryover allowed Ending Year 3

Stock Basis $ -08,000 ( 8,000) $ -021,000 ( 17,000) ( 4,000) $ -0-

Debt Basis $ -0-0-a -0-01,000b -0-0$ 1,000 $

Net increase is $0 ($8,000 ordinary income - $8,000 of distribution). The remaining distribution does not reduce this amount because it is included in gross income. b Net increase is $1,000 ($22,000 ordinary income - $17,000 distribution - $4,000 loss carryover allowed). c.

Items Reported by Shareholder: Year 1: Ordinary loss allowed Remaining loss carries over

($36,000) ( 4,000)

Year 2: Ordinary income Dividend income Loss carryover allowed

$27,000 10,000 ( 4,000)

Year 3: Ordinary income Dividend income

$22,000 2,000

C:11-33

Beginning Year 1 Plus: Ordinary loss Ending Year 1 Plus: Ordinary income Predistribution balance Minus: Cash distribution Loss carryover allowed Ending Year 2 Plus: Ordinary income Predistribution balance Minus: Cash distributiond Ending Year 3

Stock Basis $20,000 ( 20,000) $ -011,000 $11,000 -0( 4,000) $ 7,000 22,000 $29,000 (15,000) $14,000

Debt Basis $ 16,000 ( 16,000) $ -016,000a $ 16,000 -0-0$ 16,000 -0$ 16,000 -0$ 16,000

Corp. AAA $ -0( 40,000) ( $40,000) 27,000 ($ 13,000) -0-0-c ($ 13,000) 22,000 $ 9,000 ( 9,000) $ -0-

Accum. E&P $12,000 -0$12,000 -0$12,000 ( 10,000)b -0$ 2,000 -0$ 2,000 ( 2,000) $ -0-

Net increase is $23,000 ($27,000 ordinary income - $4,000 loss carryover allowed) but can restore debt basis only to its original amount. The distribution does not reduce the net increase because it is included in gross income. b The entire distribution comes out of accumulated E&P as a taxable dividend because the AAA balance is negative. c The loss carryover does not reduce the AAA in Year 2 because it reduced the AAA in Year 1 as part of the $40,000 reduction in that year. d Of the $17,000 distribution, $9,000 is excluded from gross income and reduces the AAA and stock basis. Then, $2,000 comes out of accumulated E&P as a taxable dividend. Finally, the remaining $6,000 also is excluded from gross income and reduces stock basis, for a total reduction in stock basis of $15,000 ($9,000 + $6,000). pp. C:11-28 through C:11-33.

Comprehensive Problems C:11-56 C and S corporation formation--The Sec. 351 rules do not apply to the transfer because the transaction fails the 80% control test due to Steve’s contribution of services. Consideration: $100,000 = $40,000 by Cara + $39,000 by Bob + $21,000 by Steve Services: $600/$20,400 = 2.94% [Note: The cash contributed by Steve is less than the 10% minimum required for a private letter ruling. Therefore, the stock received by Steve cannot be counted towards the 80% control test.] The property contributors do not achieve control because Cara and Bob together own only 79% (40% + 39%). Therefore, Sec. 351 does not apply, and the contributors recognize their realized gains and losses. (Sec. 1001).

C:11-34

Cara’s transfer: Stock receivedb Debt assumptionb Amount realized Minus: Adjusted basis Gain (loss) realized and recognized a

FMV of land FMV of building Total Minus: Debt assumed FMV of stock

Land

Building

Total

$30,769 19,231 $50,000 ( 36,000) $14,000

$ 9,231 5,769 $ 15,000 ( 27,000) ($12,000)

$40,000a 25,000 $65,000 ( 65,000) $ -0-

$50,000 15,000 $65,000 (25,000) $40,000

Allocation of consideration received by Cara: Stock: Land--50/65 x $40,000 = $30,769 Building--15/65 x $40,000 = $9,231 Debt: Land--50/65 x $25,000 = $19,231 Building--15/65 x $25,000 = $5,769 Cara’s basis in the stock is $40,000, its FMV. The stock’s holding period begins on the day after the exchange date. The corporation takes a $50,000 FMV basis for the land and a $15,000 FMV basis for the building. The corporation’s holding period for each asset begins on the day after the exchange date. Bob’s transfer: Acquired cost for machinery and equipment Minus: Depreciation (5 years)* Adjusted basis

$100,000 ( 77,690) $ 22,310

*2018: $100,000 x 0.1429 = $14,290 2019: $100,000 x 0.2449 = 24,490 2020: $100,000 x 0.1749 = 17,490 2021: $100,000 x 0.1249 = 12,490 2022: $100,000 x 0.0893 = 8,930 Total $77,690 FMV of machinery Minus: Adjusted basis Gain realized and recognized

$ 39,000 ( 22,310) $ 16,690

Bob’s basis in the stock is $39,000, its FMV. His holding period begins on the day after the exchange date. The corporation takes a $39,000 FMV basis for machinery and equipment.

C:11-35

The corporation’s holding period for the asset begins on the day after the exchange date. The corporation makes a new depreciation election under the MACRS rules. Steve’s transfer: Steve recognizes no gain on the $600 of stock received for the cash transferred. The $20,400 in stock he receives for services contributed is taxed as ordinary income. Steve’s basis in the stock is $21,000 ($20,400 + $600). The holding period for all his stock begins on the day after the exchange. The cash has a $600 basis to the corporation. The services have a $20,400 basis to the corporation. Part or all of the services are likely to be deductible (up to $5,000) and amortizable under either Secs. 248 or 195. Some of the services, if a current operating expense, are deductible under Sec. 162. The $50,000 recourse borrowing does not become part of the shareholder’s stock basis whether the corporation makes an S election or not. Partnership formation: The partnership formation transaction does not depend on receiving a particular percentage of the interests in exchange for property. None of the three partners will recognize gain on his or her property transfers. Steve will recognize $20,400 of ordinary income because he receives a portion of his partnership interest in exchange for services. (Note: The IRS is in the process of revising its rules concerning partners who contribute services. See Notice 2005-43, C.B. 1221.) The basis of the three partnership interests are as follows:

Property and services contributed Minus: Liabilities transferred Plus: Liabilities Share of recourse debt Basis of interest

Cara

Bob

Steve

Total

$63,000 (15,000)

$22,310

$21,000

9,750 19,500 $51,560

5,250 10,500 $36,750

$106,310 ( 15,000) 15,000 50,000 $156,310

20,000 $68,000

Allocation of Cara’s liabilities to Bob and Steve are based on Bob’s and Steve’s relative interests in the partnership. For simplicity, this solution assumes the partnership interests are proportionate to the FMVs of the three partners contributions to the partnership (Cara = 40%, Bob = 39%, and Steve = 21%). All partners are general partners and share profits and losses in the same proportions. A similar allocation allocates the recourse debt to the three partners. The $15,000 negative adjustment to Cara’s basis is the net of the $25,000 liability assumed by the partnership and her $10,000 share of that liability. The holding period for the partnership interest includes the holding period for the property transferred. The partnership takes a carryover basis for the assets transferred to the partnership. The basis for the assets are: land, $36,000; building, $27,000; machinery and equipment, $22,310; cash, $600; and services, $20,400. Part or all of the services are deductible (up to Copyright © 2024 Pearson Education, Inc.

C:11-36

$5,000) and amortizable as organizational expenditures under Sec. 709. Some of the remaining services may be deductible as an operating expense under Sec. 162. Alternate Facts: C and S corporation formation--The Sec. 351 rules apply to the transfer because Steve’s property contribution (cash) is at least 10% of the FMV of stock received for services. Thus, all of Steve’s stock counts toward the 80% control test. Consideration: $100,000 = $40,000 by Cara + $39,000 by Bob + $21,000 by Steve Services: $2,600/$18,400 = 14.13%. Because the three transferors achieve control (100% ownership), Sec. 351 applies.

Cara’s transfer: Stock receivedb Debt assumptionb Amount realized Minus: Adjusted basis Gain (loss) realized Boot received Gain (loss) recognized a

FMV of land FMV of building Total Minus: Debt assumed FMV of stock

Land

Building

Total

$30,769 19,231 $50,000 (36,000) $14,000 $ -0$ -0-

$40,000a 25,000 $65,000 (65,000) $ -0$ -0$ -0-

9,231 5,769 $ 15,000 ( 27,000) ($ 12,000) $ -0$ -0-

$50,000 15,000 $65,000 (25,000) $40,000

Allocation of consideration received by Cara: Stock: Land--50/65 x $40,000 = $30,769 Building--15/65 x $40,000 = $9,231 Debt: Land--50/65 x $25,000 = $19,231 Building--15/65 x $25,000 = $5,769

The zero gain recognized is based on Sec. 357(b) not applying to the transaction (i.e., a business purpose exists for the transfer of the liability to the corporation). Alternatively, if Sec. 357(b) applies to treat the entire amount of the debt as boot, Cara recognizes a $14,000 gain on the land transfer (i.e., the smaller of the $14,000 realized gain or the $19,231 of liabilities assumed that are treated as boot under Sec. 357(b)). Cara recognizes no gain or loss on the building transfer because she realized a loss. Cara’s basis in the stock is $38,000 ($36,000 basis of land + $27,000 basis of building - $25,000 debt assumed). Its holding period is divided into two parts and includes the time the transferor held the two transferred properties. The corporation takes a $36,000 carryover basis for the land and a Copyright © 2024 Pearson Education, Inc.

C:11-37

$27,000 carryover basis for the building. The corporation does not have to reduce its basis under Sec. 362(e)(2) because the total FMV transferred by Cara ($50,000 + $15,000) exceeds the total adjusted basis of the property ($36,000 + $27,000). The corporation’s holding period for both assets includes the transferor’s holding period. Bob’s transfer: Acquired cost for machinery and equipment Minus: Depreciation (5 years) Adjusted basis FMV of machinery Minus: Adjusted basis Gain realized Boot received Gain recognized

$100,000 ( 77,690) $ 22,310 $ 39,000 ( 22,310) $ 16,690 $ -0$ -0-

Bob’s basis in the stock is $22,310. The stock’s holding period includes his holding period for the machinery and equipment. The corporation takes a $22,310 basis for machinery and equipment. The corporation’s holding period for the assets includes Bob’s holding period. The corporation continues to depreciate the property using the MACRS election that Bob used. Steve recognizes no gain on the $2,600 of stock received for the cash transferred. The $18,400 of stock he receives for the services contributed is taxed as ordinary income. Steve’s basis in the stock is $21,000 ($2,600 cash + $18,400 services). The holding period for all his stock begins on the day after the exchange. The cash has a $2,600 basis to the corporation. The services have a $18,400 basis to the corporation. Part or all of the services are likely to be deductible (up to $5,000) and amortizable under either Secs. 248 or 195. Some of the services, if a current operating expense, are deductible under Sec. 162. Note that Steve still is taxed on the stock received for services even though the transaction qualifies under Sec. 351. His qualifying as a property contributor helped Cara and Bob receive tax-free treatment. The $50,000 recourse borrowing does not become part of the shareholder’s stock basis whether the corporation makes an S election or not. Partnership formation: The partnership formation transaction does not depend on receiving a particular percentage of the interests in exchange for property. None of the three partners will recognize gain on his or her property transfers. Steve will recognize $18,400 of ordinary income because he receives a portion of his $21,000 partnership interest in exchange for services. (Note: The IRS is in the process of revising its rules concerning partners who contribute services. See Notice 2005-43, C.B. 1221.)

C:11-38

The basis of the three partnership interests are as follows:

Property and services contributed Minus: Liabilities transferred Plus: Liabilities acquired Share of recourse debt Basis of interest

Cara

Bob

Steve

Total

$63,000 (15,000)

$22,310

$21,000

9,750 19,500 $51,560

5,250 10,500 $36,750

$106,310 ( 15,000) 15,000 50,000 $156,310

20,000 $68,000

Allocation of Cara’s liabilities to Bob and Steve are based on Bob’s and Steve’s relative interests in the partnership. For simplicity, this solution assumes the partnership interests are proportionate to the FMVs of the three partners contributions to the partnership (Cara = 40%, Bob = 39%, and Steve = 21%). All partners are general partners and share profits and losses in the same proportions. A similar allocation allocates the recourse debt to the three partners. The $15,000 negative adjustment to Cara’s basis is the net of the $25,000 liability assumed by the partnership and her $10,000 share of that liability. The holding period for the partnership interest includes the holding period for the property transferred. The partnership takes a carryover basis for the assets transferred to the partnership. The basis for the assets is: land, $36,000; building, $27,000; machinery and equipment, $22,310; cash, $2,600; and services, $18,400. Part or all of the services are deductible (up to $5,000) and amortizable as organizational expenditures under Sec. 709. Some of the remaining services may be deductible as an operating expense under Sec. 162. The partnership continues to depreciate the property using the MACRS election that Bob used. C:11-57 a. C Corporation

Operating profit Dividends Municipal bond interest Corporate bond interest Capital gain on land Sec. 1245 gain (depr. recap.) Sec. 1231 loss LTCL STCL MACRS depreciation Charitable contribution* Inv. interest expense Salary Div. rec. ded. Total *Limited to $87,000 x 0.10) C corporation tax ($65,950 x 0.21)

b. S Corporation

Amount

Taxable Income

Ord. Inc.

$120,000 19,000 18,000 29,000 40,000 5,000 (28,000) (4,000) (5,000) (36,000) (23,000) (16,000) (37,000) _______ $ 82,000

$120,000 19,000 0 29,000 40,000 5,000 (28,000) (4,000) (5,000) (36,000) (8,700) (16,000) (37,000) (12,350) $ 65,950

$120,000

Sep. Stat.

Ord. Inc.

Sep. Stat.

$120,000 $19,000 18,000 29,000 40,000

5,000

$19,000 18,000 29,000 40,000 5,000

(28,000) (4,000) (5,000) (36,000)

(23,000) (16,000) (37,000) _______ $52,000

$ 13,850

C:11-39

c. Partnership

(23,000) (16,000) (37,000) _______ $ 52,000

C:11-58a.

E&P, January 1 Current year taxable income before distribution Capital gain on distribution of land* Minus: Federal income taxes ($70,000 x 0.21) E&P before distribution Minus: Cash distribution Property distribution (FMV) E&P, December 31 *E&P and tax gains are the same.

$155,000 $40,000 30,000 (14,700)

55,300 $210,300 (100,000) (100,000) $ 10,300

Both distributions are fully taxable as dividends to Jeff and John in the amount of $100,000 each. John takes a $100,000 FMV basis in the land he receives. b.

AAA, January 1 Current year ordinary income Capital gain on distribution of land AAA before distribution Minus: Cash distribution Noncash distribution AAA, December 31

$125,000 $40,000 30,000

AE&P, January 1 Minus: Remainder of cash and property distributions AE&P, December 31

70,000 $195,000 ( 97,500) ( 97,500) $ -0$ 30,000 ( 5,000) $ 25,000

Of each distribution, $97,500 is nontaxable assuming the shareholder has sufficient basis in his stock. The remaining $2,500 of each distribution is a dividend included in the shareholder’s gross income. John takes a $100,000 FMV basis in the land he receives. Jeff’s stock basis: Basis, January 1 Plus: Allocable share of current year ordinary income and gain Predistribution basis Minus: Cash distribution from AAA Basis, December 31

$100,000 35,000 $135,000 ( 97,500) $ 37,500

John’s stock basis: Basis, January 1 Plus: Allocable share of current year ordinary income and gain Predistribution basis Minus: Property distribution from AAA (FMV) Basis, December 31

$ 80,000 35,000 $115,000 ( 97,500) $ 17,500

C:11-40

Jeff’s basis in partnership: Basis, January 1 Plus: Allocable share of current year ordinary income Predistribution basis Minus: Cash distribution Basis, December 31

$100,000 20,000 $120,000 ( 100,000) $ 20,000

John’s basis in partnership: Basis, January 1 Plus: Allocable share of current year ordinary income Predistribution basis Minus: Property distribution (adjusted basis) Basis, December 31

$ 80,000 20,000 $100,000 ( 70,000) $ 30,000

Neither distribution is taxable to the partners. John takes a $70,000 carryover basis in the land he receives. d.

No change occurs to the C corporation answer or the S corporation answer. However, the partnership answer in Part c will change as follows: Jeff’s basis in partnership: Basis, January 1 Plus: Allocable share of current year ordinary income Precontribution gain on land distributed [Sec. 704(c)(l)(B)] Predistribution basis Minus: Cash distribution Basis, December 31

$100,000 20,000 25,000 $145,000 ( 100,000) $ 45,000

John’s basis in partnership: Basis, January 1 Plus: Allocable share of current year income Predistribution basis Minus: Property distribution Basis, December 31

$ 80,000 20,000 $100,000 ( 95,000) $ 5,000

Neither distribution is taxable to the partners except for Jeff’s recognition of gain upon the distribution to John. John takes a $95,000 ($70,000 carryover basis + $25,000 precontribution gain recognized by Jeff) basis in the land he receives (see Chapter C:10).

C:11-41

Tax Strategy and Critical Thinking Problems C:11-59The solution to this problem uses the 2023 tax rate schedule and assumes a standard deduction of $27,700. In addition, the solution ignores payroll taxes on Alice’s salary. A complete solution would have the corporation deduct payroll taxes at 7.65% on Alice’s salary and have Alice pay a 7.65% payroll tax via a deduction from her paycheck (and possibly an additional 0.9%). Inclusion of payroll taxes in the analysis would not change the rankings of the alternatives. Alternative 1 S Corp. Current Year

S Corp. Next Year

Ordinary income (loss) before salary Minus: Salary to Alice Ordinary income (loss)

($80,000) -0($80,000)

$220,000 ( 90,000) $130,000

Corporate tax

Corporate level:

-0-

Individual level: Income from other sources Plus: Salary income from corporation Ordinary income pass-through Minus: Ordinary loss pass-through Adjusted gross income Minus: Standard deduction QBI deduction (NY: $130,000 x 0.20) Taxable income

$ 115,000 -0-0( 80,000) $ 35,000 ( 27,700) -0$ 7,300

$115,000 90,000 130,000 -0$335,000 ( 27,700) ( 26,000) $281,300

Individual tax

730

$ 54,312

Total corporate and individual tax Divided by: Discount factor Present value of total tax

730 1 730

$ 54,312 1.05 $ 51,726

Sum of present values for two years

$ 52,456

C:11-42

Alternative 2 S Corp. Current Year

C Corp. Next Year

Ordinary income (loss) before salary Minus: Salary to Alice Ordinary loss; taxable income

($80,000) -0($80,000)*

$220,000 ( 90,000) $130,000

Corporate tax

-0-

$ 27,300

Income from other sources Plus: Salary income from corporation Minus: Ordinary loss pass-through Adjusted gross income Minus: Standard deduction Taxable income

$115,000 -0( 80,000) $ 35,000 ( 27,700) $ 7,300

$115,000 90,000 -0$205,000 ( 27,700) $177,300

Individual tax

730

$ 29,621

Total corporate and individual tax Divided by: Discount factor Present value of total tax

730 1 730

$ 56,921 1.05 $ 54,210

Sum of present values for two years

$ 54,940

Corporate level:

Individual level:

*The S corporation ordinary loss passes through to the shareholder and cannot carry over to a C corporation year at the corporate level (Sec. 1371(b)(2)). Alternative 3 C Corp. Current Year

C Corp. Next Year

Ordinary income (loss) before salary Minus: Salary to Alice NOL carryover Taxable income (NOL)

($80,000) -0-0($80,000)

$220,000 ( 90,000) ( 80,000) $ 50,000

Corporate tax

$ 10,500

Corporate level:

-0-

C:11-43

Individual level: Income from other sources Plus: Salary income from corporation Adjusted gross income Minus: Standard deduction Taxable income

$115,000 -0$115,000 ( 27,700) $ 87,300

$115,000 90,000 $205,000 ( 27,700) $177,300

Individual tax

$ 10,036

$ 29,621

Total corporate and individual tax Divided by: Discount factor Present value of total tax

$ 10,036 1 $ 10,036

$ 40,121 1.05 $ 38,210

Sum of present values for two years

$ 48,246

Alternative 4 C Corp. Current Year

S Corp. Next Year

Ordinary income (loss) before salary Minus: Salary to Alice NOL; ordinary income

($80,000) -0($80,000)*

$220,000 ( 90,000) $130,000

Corporate tax

Corporate level:

-0-

Individual level: Income from other sources Plus: Salary income from corporation Ordinary income pass-through Adjusted gross income Minus: Standard deduction QBI deduction (NY: $130,000 x 0.20) Taxable income

$115,000 -0-0$115,000 ( 27,700) -0$ 87,300

$115,000 90,000 130,000 $335,000 ( 27,700) ( 26,000) $281,300

Individual tax

$ 10,036

$ 54,312

Total corporate and individual tax Divided by: Discount factor Present value of total tax

$ 10,036 1 $ 10,036

$ 54,312 1.05 $ 51,726

Sum of present values for two years

$ 61,762

*The C corporation NOL does not carry over to an S corporation year (Sec. 1371(b)(1)). Therefore, it cannot be used until the corporation again becomes a C corporation. Copyright © 2024 Pearson Education, Inc.

C:11-44

Summary of results ranked from best to worst Alternative 3 1 2 4

Corporate Form C Corp./C Corp. S Corp./S Corp. S Corp./C Corp. C Corp./S Corp.

PV of Total Tax $48,246 52,456 54,940 61,762

Thus, based on a two-year analysis, Alice should operate the corporation for both years as a C corporation (Alternative 3). This alternative beats the next best alternative (1) primarily because the tax benefit of the NOL deduction at the corporate level provides more of an incremental tax benefit than does shifting $130,000 of ordinary income to the shareholder’s tax rate net of the QBI deduction benefit. However, this analysis has two main shortcomings. First, it does not account for future operations, tax rates, personal tax circumstances, etc. Second, it does not account for the shareholder tax when the corporation liquidates or when the shareholder sells her stock. C:11-60The after-tax accumulations for the three alternative models are summarized in the following table: Years (n) 6 18 40 S corporation: ATA = [1 + 0.18 (1 - 0.296)]n 2.0460 8.5642 118.2062 C corporation (without Sec. 1202 exclusion): ATA = [1 + 0.18 (1 - 0.21)]n (1 - 0.238) + 0.238

1.9300

8.5808

155.7061

C corporation (with 100% Sec. 1202 exclusion): ATA = [1 + 0.18 (1 - 0.21)]n

2.2205

10.9486

204.0263

The S corporation model entails only one level of tax at the shareholder level because the shareholder’s basis increases as the S corporation accumulates its earnings. The S corporation grows at an after-tax rate of return, however, because the model assumes the S corporation distributes enough cash each year to allow the shareholder to pay individual taxes on the S corporation’s earnings. Thus, the S corporation can reinvest only after-tax earnings. However, the shareholder can claim the QBI deduction, thereby reducing his or her effective tax rate on S corporation earnings. In the C corporation model, the corporation pays taxes currently, and the shareholder incurs a capital gain when the corporation liquidates or when the shareholder sells his or her stock. During the life of the C corporation, the corporation makes no distributions, and the shareholder’s stock basis remains constant. If the 100% Sec. 1202 exclusion applies, however, the shareholder pays no tax upon the sale of the C corporation stock. Compared to the C corporation with no Sec. 1202 exclusion, the S corporation outperforms the C corporation for the six-year investment horizon. Although the shareholder tax rate is 29.6% on S corporation income as compared to a 21% corporate tax rate on C corporation income, the Copyright © 2024 Pearson Education, Inc.

C:11-45

shareholder bears an additional capital gains tax upon the sale of the C corporation stock. This double taxation makes the C corporation less favorable for short investment horizons (e.g., six years). However, for long investment horizons, the C corporation does better than the S corporation, and edges out the S corporation in 18 years because the lengthy deferral of the shareholder-level capital gains tax ultimately lessens the impact of this second level tax. The advantage of the C corporation increases as the investment horizon increases, as evidenced by the large difference at the 40 year mark. With the 100% Sec. 1202 exclusion, the C corporation beats the S corporation for all years because the C corporation tax rate is less than the shareholder’s tax rate even with the QBI deduction factored in, and the shareholder pays no second level tax upon the sale of the stock. The key variables in the S corporation vs. C corporation decision are the before-tax rates of return, the corporate and shareholder tax rates (including the preferential treatment of capital gains and the QBI deduction), and the investment horizon. Changes in these variables can alter the outcome of the above example. For additional information on the models developed here, see Chapter I:18 of the Individuals volume. For additional issues to consider in the C corporation versus S corporation decision, see Problems C:11-28 and C:11-64.

Tax Form/Return Preparation Problems C:11-61 (See Instructor’s Resource Manual) C:11-62 (See Instructor’s Resource Manual) C:11-63 (See Instructor’s Resource Manual)

Case Study Problem C:11-64 The solution below presents the major points the students should bring up during the lunch discussion. Students should present in good format a memorandum containing some or all of the points that follow. Nontax advantages 1.

Limited legal liability. As a family counselor, Debra might want to form a professional association or professional corporation. The professional corporation would not insulate her against possibility liability for her professional actions but would provide limited liability for her other debts. Alternately, Debra might consider whether the limited liability company (LLC) form of doing business would provide an advantage over the S corporation form. The LLC form might allow Debra to avoid some of the S corporation shareholder and corporate restrictions. For tax purposes, however, the check-the-box regulations would treat a onemember LLC as a sole proprietorship.

Free transferability of interest. The corporate form might permit her to expand her family counseling business by taking in new “partners” who would be shareholders in her professional corporation, or enable her to form a partnership of the professional corporations of one or more family counselors. Copyright © 2024 Pearson Education, Inc.

C:11-46

Automobile expenses. The standard mileage rate can be used with the personal automobile even after incorporation. The automobile need not be transferred to the corporation at the time of incorporation. If planning incorporation, Debra should consider leasing the automobile to the corporation instead of continuing to use the standard mileage rate. Because her personal miles probably are substantially larger than her business miles, the current reimbursement method might prove simpler to operate.

Condominium ownership. The condominium need not be transferred to the corporation at the time of incorporation. If planning incorporation, Debra should consider leasing the condominium to the corporation instead of transferring it as a capital contribution. She may be able to deduct some or all of any tax losses experienced on the condominium ownership.

Tax advantages 1.

Lower marginal tax rate. Double taxation associated with a C corporation would be avoided if the corporation made an S election or if Debra retained the sole proprietorship. The C corporation, however, could provide an advantage by having the 21% tax rate apply to amounts retained in the business. If the corporation is a personal service corporation, it also will be subject to flat 21% tax rate. A disadvantage of not operating as a C corporation is that the top individual tax rates are higher than the corporate tax rate.

Avoidance of double taxation by paying salaries and fringe benefits. Debra should consider paying herself a reasonable salary. This salary would be subject to the Social Security tax requirements for the employer and employee and would not be eligible for the qualified business income (QBI) deduction). On the other hand, salary would eliminate part or all of the double taxation associated with a C corporation that otherwise pays dividends to its owners. However, dividends are taxed at the applicable capital gains rate. The total employment tax liability should be relatively close to what her self-employment tax liability was with the sole proprietorship. Although she would be a more-than-2% shareholder, she could claim fringe benefits, which would be treated as a salary payment (deductible by the corporation and taxable to the shareholder).

Section 1202 exclusion. C corporation status permits 100% of the gain recognized on the sale or exchange of small business corporation stock to be excluded from taxation under Sec. 1202 if the stock is held for more than five years. The exclusion, however, is not available for S corporations. The benefit of the Sec. 1202 exclusion essentially is a 0% tax rate on the gain from the disposition of qualified Sec. 1202 stock.

Retirement plan. Debra should consider establishing a qualified plan, such as a Sec. 401(k) plan, if she uses an S corporation or make periodic contributions to an IRA plan up to the contribution limit. Whether Debra has a part-time or full-time employee to handle her clerical requirements may impact her decision about the appropriateness of the various available “qualified” retirement plans.

C:11-47

Incorporation. Incorporation can occur with Debra and her new corporation recognizing no gain or loss. The corporation will recognize any uncollected accounts receivable from the proprietorship and can deduct any unpaid liabilities for expense items when it pays them. A carryover basis will apply for the assets transferred to the new corporation. The corporation would claim depreciation under the same methods and conventions used by the proprietorship. The basis in Debra’s stock would be a substituted basis referencing the basis of the assets transferred.

Tax year. A calendar year probably would be the simplest for either a C or an S corporation.

Accounting method. The cash method of accounting probably would be the simplest for either a C or an S corporation. If the C corporation qualifies as a personal service corporation or meets the $29 million (in 2023) gross receipts test, it can retain the cash method.

State and local taxes should be considered. Corporate entities may be subject to a state income tax liability even though they operate as S corporations.

In summary, incorporation should not be a forgone conclusion. It has some advantages and disadvantages. If Debra seriously considers incorporation, she should evaluate both the C and S corporation options. As part of the evaluation, alternative treatments for the automobile and condominium should be considered as well as different retirement and fringe benefits packages. The check-the-box regulations permit partnerships, LLCs, and LLPs to be taxed as C corporations even though they are not an incorporated entity. Some discussion of the influence these Treasury Regulations will have on the decision should be included. Note: The instructor could expand this case by providing additional facts regarding incorporation or by providing annual income for a period of years in the future so the students have to make projections of future tax liabilities. Also, Tax Strategy Problems C:11-59 and C:11-60 adopt a quantitative approach to alternative entity business forms.

Tax Research Problems C:11-65 Section 1361(c)(2) permits seven types of trusts to own stock of an S corporation. These include a beneficiary-controlled trust treated as owned by an individual who is a U.S. citizen or resident alien under Sec. 678, a trust treated as owned by a U.S. citizen or resident alien immediately before the death of the deemed owner, a testamentary trust, a grantor trust, or a voting trust. Section 1361(d) also permits an electing Qualified Subchapter S Trust (QSST) to own an S corporation’s stock, and Sec. 1361(e) allows a small business trust to own S corporation stock. These trusts can be complex trusts and primarily are estate planning devices. No interest in a small business trust can be acquired in a purchase transaction. Interests in these trusts usually are acquired by gift or bequest. All current beneficiaries must be individuals or estates. Each beneficiary is counted for purposes of the 100-shareholder limit (Sec. 1361(e)). Section 1362(d)(2) provides that an S election terminates when a corporation ceases to be a small business corporation. Section 1361(b)(1) provides that a corporation ceases to be a small business corporation when someone other than a qualified shareholder owns an S corporation’s stock. Copyright © 2024 Pearson Education, Inc.

C:11-48

The trust created by Tim and Elesa appears to be one of the several types of trusts permitted to own an S corporation’s stock. The trust appears to be a qualified small business trust (as defined by Sec. 1361(e)). The one area open to question is the method used to transfer the stock to the Reid and Susan Trust. If Tim and Elesa sold the stock to the trust, the trust would not be a qualified small business trust because the trust’s basis for the stock is the acquisition cost under Sec. 1012. If they gifted the stock to the children via the trust, the trust apparently would meet the requirement that an interest in the trust must be acquired by a gift, bequest, or other “non-purchase” acquisition. The Sec. 1361(e) rules apply to tax years beginning after December 31, 1996. Because Tim and Elesa transferred the stock after the effective date of the small business trust provisions, the S election can be continued without any problems, provided the stock transfer was a gratuitous transfer and not a stock sale. If Tim and Elesa sold the stock to the trust, the transfer would cause a termination of the S election. The S election terminates on the date of transfer (March 10 of last year) unless the transfer can be considered to be an inadvertent termination under Sec. 1362(f). The S election can be maintained if the IRS determines the termination to be inadvertent. See Rev. Rul. 86-110, 1986-2 C.B. 150, which holds that a transfer of stock to an irrevocable trust is an inadvertent termination. The corporation will be considered to be a small business corporation for the period of time the trust owned the stock, provided it takes the steps described below. These steps require the filing of a request to treat the termination as inadvertent and the reporting of the income allocable to the Cato Corporation shares held by the trust in the trust’s gross income for the period of time it held them. See Reg. Sec. 1.1362-4(c) for the procedures required to be followed for a corporation to request a determination for an inadvertent termination, -4(d) for the adjustments required, and -4(e) for the corporate and shareholder consent requirements for the IRS’s determination. Because the trust is not a QSST, the automatic relief for an inadvertent termination provided under Rev. Proc. 2003-43, 2003-23 C.B. 998, Rev. Proc. 2007-62, 2007-41 C.B. 786, and Rev. Proc. 2013-30, 2013-36 I.R.B. 173 is not available. Tim and Elesa apparently can transfer the stock to the trust as long as the Sec. 1361(e) requirements are met. C:11-66 Section 1366(d)(1) limits the deduction for losses passed through to an S corporation shareholder to the sum of the shareholder’s adjusted basis for the S corporation stock at the end of the tax year plus the shareholder’s adjusted basis for any indebtedness of the S corporation to the shareholder (determined without any positive or negative adjustment to the debt basis for the tax year). Cecil will take a $100,000 basis for the stock by investing $100,000 in the corporation. Whether Cecil’s loss limitation is increased above $100,000 depends on the method used to affect the borrowing. The first alternative--having the corporation borrow the funds with the shareholder acting as guarantor--usually does not increase the shareholder’s basis for the debt. In general, a shareholder’s guarantee of a loan does not increase his or her loss limitation [Milton T. Raynor, 50 T.C. 762 (1968)]. The basis increase occurs only when the shareholder is called on to honor the guarantee (Rev. Ruls. 70-50, 1970-1 C.B. 178 and 75-144, 1975-1 C.B. 277). Generally, a loan guarantee is permitted to increase the shareholder’s loss limitation only when he or she is the primary obligor on the debt obligation. See Edward M. Selfe v. U.S., 57 AFTR 2d 86-464, 86-1 USTC ¶9115 (11th Copyright © 2024 Pearson Education, Inc.

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Cir., 1985). See also the Fourth Circuit Court of Appeals decision that denied a basis increase in Estate of Daniel Leavitt v. CIR, 63 AFTR 2d 89-1437, 89-1 USTC ¶9332 (4th Cir., 1989). The Leavitt decision has been followed in a number of subsequent judicial decisions dealing with guarantees of debt by an S corporation shareholder. The second alternative—having the corporation borrow the funds from the estate of the shareholder’s late husband—does not increase the shareholder’s basis for the debt because the corporation is obligated to the estate instead of the shareholder who is the beneficiary of the estate [Ruth M. Prashker, 59 T.C. 172 (1972)]. The third alternative--have the shareholder lend the funds from her personal funds--will increase Cecil’s loss limitation. Cecil can accomplish the same effect by borrowing the funds from a bank, lending the funds to the corporation in exchange for a note, and pledging the note to the bank as security for the loan. This sequence avoids the problem with the guarantee not providing a basis increase that was outlined above. Even if the losses are deductible under the general Sec. 1366(d)(1) limitation, the losses may be subject to the at-risk or the passive activity limitation rules. Such limitations, when calculated at the shareholder level, may suspend the losses until a later year when the shareholder again has an amount at-risk, has earned passive income, or disposes of his or her investment. C:11-67 Under Sec. 1366(d)(1), Joe’s Year 1 loss is limited to his $50,000 stock basis. Under Sec. 1366(d)(2)(A), the remaining $10,000 loss carries over and is treated as incurred in Year 2. Under Sec. 1367(a)(2)(B), the $50,000 allowed loss reduces Joe’s stock basis to zero at the end of Year 1. In Year 2, Joe cannot deduct any of that year’s $12,000 loss because his stock basis is zero. Under Reg. Sec. 1.1366-2(a)(5)(i), carryover losses are not transferrable. However, Sec. 1366(d)(2)(B) and Reg. Sec. 1.1366-2(a)(5)(ii) make an exception in the situation where, under Sec. 1041(a), an S corporation shareholder transfers stock to a former spouse incident to a divorce. In this case, a carryover loss is treated as incurred by the corporation in the year after the transfer to the former spouse. Examples under Reg. Sec. 1.1366-2(a)(5)(iii) demonstrate these rules, with Example (1) being particularly relevant. In Joe’s situation, the $10,000 carryover loss from Year 1 is deemed to be incurred in Year 3. Moreover, under Reg. Sec. 1.1366-2(a)(5)(ii), this Year 1 loss is prorated between Joe and Marsha based on their proportionate ownership at the beginning of Year 3, which is 50% each. Accordingly, Joe and Marsha each are allocated $5,000 of this carryover loss. In Year 2, Joe is a 100% shareholder for the first quarter of the year and a 50% shareholder for the remaining three quarters. Thus, Joe’s ownership proportion for Year 2 is 62.5% [(100% x 1/4) + (50% x 3/4)], and Marsha’s ownership proportion for Year 2 is 37.5% (50% x 3/4). Accordingly, Joe’s share of the Year 2 loss is $7,500 ($12,000 x 0.625), and Marsha’s share is $4,500 ($12,000 x 0.375). These losses carry over to Year 3 because each shareholder has a zero stock basis in Year 2. The following table summarizes the effect of these transactions:

C:11-50

Beginning stock basis Income Year 1 loss allowed Year 2 loss allowed Ending stock basis

Year 1 Joe $50,000 -0(50,000) $

-0-

--------- Year 2 ----------Joe Marsha $ -0$ -0-0-0-0-0$

-0-

------- Year 3 ------Joe Marsha $ -0- $ -020,000 20,000 ( 5,000) ( 5,000) (7,500) (4,500) $ 7,500 $10,500

“What Would You Do In This Situation?” Solution Ch. C:11, p. C:11-12. When Harry sold 25% of his Xeno Corporation shares to Pedro, he caused the S corporation election to terminate under Sec. 1362(d)(2). Section 1362(f) and Reg. Sec. 1.1362-4, however, provide relief for an inadvertent termination under the following conditions: 1. 2. 3. 4.

The election terminates because the corporation ceased to be a small business corporation; The IRS determines that the termination was inadvertent; The corporation takes steps to reestablish small business corporation status within a reasonable period of time; and The corporation and its shareholders agree to any adjustments the IRA might require.

Although the corporation meets the first and third condition, it did not comply with the second and fourth conditions. Thus, you should advise Harry to seek IRS approval to retain S corporation status. Regulation Sec. 1.1362-4(c) sets out the procedure for obtaining this approval. Essentially, the corporation must file a ruling request with the IRS that describes the facts pertaining to the terminating event. The ruling request must include the date the corporation elected S corporation status, a detailed explanation of the event causing the termination, when and how the corporation and its shareholders discovered the event, and the steps taken to return to small business corporation status. In helping the client make this request, you must keep in mind that the taxpayer bears the burden of establishing to the IRS’s satisfaction that the termination was inadvertent. If the IRS accepts that the termination was inadvertent, it may require, under Reg. 1.13624(d), adjustments consistent with treating the corporation as an S corporation during the period in question. Moreover, it may require that the eligible shareholder be treated as an S corporation shareholder during the time he held the stock, and it may require adjustments to prevent revenue losses to the government. See Ltr. Rul. 8620027 (February 13, 1986) for such a request involving a transfer to an ineligible nonresident alien. In summary, the actions Xeno Corporation and Harry already have taken are not sufficient to waive the termination. The corporation and its shareholders also must obtain IRS approval.

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Chapter C:12 The Gift Tax Discussion Questions C:12-1 The same tax rates apply for both gift and estate tax purposes, and the unified credit is the same in each context, $5,113,800 for 2023. Taxable gifts made subsequent to 1976 affect the estate tax base and, consequently, the rates at which the estate is taxed. pp. C:12-3 and C:12-4. C:12-2 Congress enacted gift splitting to allow for equitable treatment of donors living in common law states in comparison with donors living in community property states. pp. C:12-4 and C:12-5. C:12-3 False. Due to the unified credit, relatively large taxable gifts can be made before a gift tax liability is triggered. p. C:12-6. C:12-4 The unified credit is reduced by 20% of the amount of the specific exemption (now repealed) claimed with respect to gifts made between September 9, 1976 and December 31, 1976. The maximum specific exemption that could have been claimed is $30,000, so the maximum credit reduction is $6,000. p. C:12-7. C:12-5 Yes. Under Sec. 2503(e), the direct payment of tuition expenses is exempt from gift treatment regardless of for whom paid. p. C:12-8. C:12-6 Transactions a and e. Transaction a (the transfer of the insurance policy) and the imputed interest on the loan in transaction e constitute gifts. The IRC exempts transaction d from classification as a gift. No gift arises in transaction c because each joint tenant contributes equally to the purchase price. For transaction b, a gift will arise when the other party spends or withdraws funds. pp. C:12-7, C:12-8, C:12-13 through C:12-15, C:12-28, and C:12-29. C:12-7 a. $161,586 gift. Dick’s gift to his distant cousin Earl is the present value of an eightyear income interest, a term certain interest. From Table B of the actuarial tables of Reg. Sec. 20.7520-1(a)(2) contained in Appendix G, the factor for an eight-year income interest at a 4% interest rate is 0.269310 (1.0 - 0.730690, the factor for the remainder interest). The amount of the gift is $161,586 (0.269310 x $600,000). The actual yield of 6% is not relevant to the calculations. b. Yes. The tables used for valuing the gift contain a variety of earnings rates. The assumed rate of 4% was applicable for our calculation. Thus, if Dick transfers an income interest in property earning a 6% rate, the tables we used have “undervalued” the wealth that Dick has shifted to Earl. This transaction would be a favorable, legal transaction for Dick to pursue. pp. C:12-11 through C:12-13. C:12-8 To make a gift of a life insurance policy, Antonio must irrevocably transfer all incidents of ownership in the policy to another party. pp. C:12-14 and C:12-15.

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C:12-9 A potential donor who wants to freeze a property’s value but who lacks sufficient liquid assets to pay the gift tax might be interested in making a net gift (a transfer in which the donee agrees to pay the gift tax as a condition of receiving the gift). The donor of a net gift must recognize a gain if the gift tax the donee pays (which is treated as debt relief) exceeds the donor’s adjusted basis in the property transferred. pp. C:12-15 and C:12-16. C:12-10 Congress enacted the annual exclusion for administrative simplicity to keep “routine” gifts (e.g., birthday, wedding, and Christmas gifts) from needing to be reported for gift tax purposes. p. C:12-16. C:12-11 Gifts of future interests are not eligible for the annual exclusion. Only gifts of present interests are eligible for the exclusion. Treasury Regulations explain that present interests entitle the donee to current income and/or enjoyment. Incidentally, transfers to Sec. 2503(c) trusts and Crummey trusts are eligible for the exclusion. pp. C:12-16 through C:12-18. C:12-12 Both trusts are eligible for the annual exclusion. A Sec. 2503(c) trust can be created only for the benefit of a minor and, in general, must terminate when the beneficiary reaches age 21. Crummey trusts can be created for beneficiaries of any age, and the donor has complete flexibility in specifying the termination date of the trust. Both trusts are discretionary trusts. A beneficiary of a Crummey trust has the power to demand each year that the trustee distribute the lesser of (1) an amount specified by the donor in the trust instrument or (2) the amount transferred to the trust that year. pp. C:12-17 and C:12-18. C:12-13 Crummey trust. A parent likely would prefer to use a Crummey trust because the grantor has the freedom to specify the termination date and still receive an annual exclusion. A Sec. 2503(c) trust generally must end when the beneficiary attains age 21. Neither trust mandates annual distribution of the income. pp. C:12-17 and C:12-18. C:12-14 The requirements for a qualified terminable interest property (QTIP) transfer are that the donee spouse be entitled to receive all the income for life and that the income be paid out at least annually. In addition, no one can have a power to appoint any part of the property to anyone other than the donee-spouse unless such power is not exercisable while the donee-spouse is alive. Finally, the donor must elect to claim a marital deduction. p. C:12-20. C:12-15 Some donors find a QTIP arrangement especially attractive because it enables them to receive a marital deduction (which results in their transfer being nontaxable) and also permits them to designate who will receive the property upon the donee spouse’s death. p. C:12-20. C:12-16 The client is misinformed. You should advise the client that a donor can sometimes incur a gift tax liability as a result of making a gift to a U.S. charitable organization because some gifts to charitable organizations do not qualify for a charitable contribution deduction. In the case of split interest transfers of remainder interests, for example, the remainder interest must be in a charitable remainder annuity trust or unitrust, a pooled income fund, a personal residence, or a farm or ranch for the charitable interest to be deductible. pp. C:12-21 and C:12-22.

C:12-2

C:12-17 The advantages of using gift splitting include (1) doubling the amount eligible for the annual exclusion, (2) allowing each spouse to make use of the unified credit, and (3) reducing the amount taxed to each taxpayer, thereby potentially reducing the marginal tax rate at which the transfers are taxed. At present, however, if tax is owed, the rate is a flat 40%. pp. C:12-22 and C:12-23. C:12-18 No. Their gift tax calculated will not necessarily be identical, but no tax has to be paid until they have used all of their unified credit. Their marginal tax rates may differ and their unused unified credit amount may differ because in previous periods they did not necessarily make the same amount of taxable gifts. However, because of the huge unified credit increase that began in 2018, neither spouse will owe gift tax. pp. C:12-23 through C:12-25. C:12-19 The current period. The rate schedule for the current period is used to determine the tax on taxable gifts of previous periods. Requiring calculation of the gift tax on prior gifts at the current rates makes sure that the current gifts are taxed at the appropriate place in the rate schedule. pp. C:12-23 through C:12-25. C:12-20 The bonds. By making an inter vivos transfer of the apartment building, the transfer tax value of the building would be frozen at $600,000. On the other hand, the donee’s basis would be the donor’s lower tax basis; consequently, the donee likely would have to report a large gain upon disposition. The apartment is producing a net loss, and it is not a good strategy to shift losses to persons in lower tax brackets. Also, the daughter might have trouble deducting the loss because of the passive activity loss limitation. Making a gift of the bonds also would freeze their value for transfer tax purposes at $600,000. The donee would not receive a step-up in basis, but this fact is not as much of a drawback as for the apartment building because the adjusted basis and FMV of the bonds are closer together and, unlike for the building, cost recovery deductions are not available on the bonds. The interest income would be shifted to a taxpayer in a lower tax bracket. However, with her increased income from the bond portfolio, the daughter might experience an increase in her marginal income tax bracket. Either person will possibly owe the additional 3.8% tax on investment income (the bond interest). Nevertheless, it probably would be preferable to gift the bonds instead of the apartment even though the bonds may have less potential for appreciation in value. pp. C:12-26 through C:12-28. C:12-21 Marcy should give Phil approximately $12.92 million of assets in 2023. She would not make a taxable gift because of the annual exclusion and marital deduction. If Phil dies in 2023 and wills his assets to someone other than Marcy, he will have taken full advantage of his $5,113,800 unified credit ($12.92 million basic exclusion amount), the majority of which otherwise would have been wasted. (He will owe a small amount of estate tax if the estate exceeds $12.92 million.) Thus, $12.92 million of property will have been shifted off the transfer tax rolls. In addition, the basis of the assets will be stepped-up to their value as of Phil’s date of death, assuming he does not will them back to Marcy. Of course, if he wills the property to Marcy, he will have wasted his credit. The previous sentence ignores the portability to the other spouse of the unused unified credit, a rule that became effective in 2011. Chapter C:13 discusses this topic. pp. C:12-26 through C:12-28.

C:12-3

C:12-22 a. Marcy’s taxable gift is zero because of her $17,000 exclusion and $11,483,000 marital deduction. Phil’s taxable estate is $11.7 million ($11,500,000 from Marcy + $200,000 of his own property), but because of the unified credit his estate tax liability will be zero [($11,700,000 $11,700,000) x 0.40)]. b. She should give him the stock. If he does not will the gifted property to her, the property’s basis will be stepped-up to its date of death value at Phil’s death. Because of the larger appreciation inherent in the stock (compared with the land), more appreciation can be removed from the income tax rolls by Marcy’s giving Phil the stock (instead of the land) and letting it pass through Phil’s estate to the children. Incidentally, gain on the sale of each asset will be long-term capital gain. pp. C:12-26 through C:12-28. C:12-23 A lifetime gift of property “freezes” the property’s value for transfer tax purposes because the amount subject to taxation is the property’s value on the date of the gift, a very beneficial result if the property’s value increases substantially. If the property had been retained and transferred at death, the date of death value (or alternate valuation date value) would have been the amount subject to taxation. This value likely would be a higher amount. Inter vivos transfers keep post-gift appreciation from being subject to transfer taxes. p. C:12-29. C:12-24 Five advantages of disposing of property by gift include: 1. Donors can take advantage of the annual exclusion, for which there is no counterpart under the estate tax system. 2. Post-gift appreciation is not subject to transfer taxes. 3. In general, the size of the gross estate is reduced by any gift taxes paid. 4. Income can be shifted to a taxpayer in a lower income tax bracket, but, with the current compressed income tax rate schedules, it is less likely that the donee receiving large gifts will be in a substantially lower tax bracket. The tax rate on dividends may be the same regardless of who owns the stock, with the result that the former income tax savings from making gifts of stock will decline. In some situations, the donor (but not the donee) would owe the 3.8% tax on net investment income. 5. State transfer taxes can be lower if the state levies a gift tax but not a form of death tax. (Connecticut is the only state that imposes a gift tax.) Two disadvantages of making gifts include: 1. The donee does not receive the step-up in basis that would apply had the transfer taken place at death, but this drawback is less severe because of the relatively low tax rate on long-term capital gains. 2. If the gift is large enough to trigger the payment of any gift tax, the gift tax paid is, in a sense, a prepayment of the estate tax. The prepayment, however, earns no interest. pp. C:12-29 and C:12-30. C:12-25 Generally, April 15 of the next year. Gifts always are reportable on a calendar-year basis. The due date for a gift tax return generally is April 15th of the year following the year in which the donor made the gifts even if the donor reports on a fiscal year for income tax purposes. If the donor dies during the year, the gift tax return must be filed no later than the due date for the estate tax return (nine months after the date of death). If an extension is requested for filing the donor’s Copyright © 2024 Pearson Education, Inc.

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individual income tax return, an extension until October 15 also is granted for filing the gift tax return. pp. C:12-30 and C:12-31. C:12-26 a. Yes. Frank did not file a gift tax return for 2008; therefore, the IRS may collect the gift tax in 2023. In the absence of the filing of a return, the statute of limitations does not begin to run. b. Yes, 40% of the tax on a $1.5 million gift plus penalties for failure to file and failure to pay. Section 6662 imposes a penalty on a sliding-scale basis for certain under valuations of property for estate and gift tax purposes. The penalty rate (either 20% or 40%) is a function of the relationship between the value claimed on the return and the correct value. Even though no return was filed and, therefore, no value was literally reported on the return, the penalty likely would be assessed. The penalty would be 40% of the transfer tax attributable to the $1.5 million unreported gift. For 2008, the exemption equivalent for gift taxes was only $1 million. The donor also would owe the failure-to-file and failure-to-pay penalties discussed in Chapter C:15. pp. C:12-31 and C:12-32.

Issue Identification Questions C:12-27 •

Will the gift to Maya be eligible for the marital deduction under Sec. 2523? If not, should Kwambe consider postponing the gift until after the wedding? • Will gift splitting under Sec. 2513 be available on the planned gifts to the three children? • If gift splitting is available, will the gift splitting election produce favorable tax results? The gift to Maya will not be eligible for the marital deduction unless Kwambe postpones the gift until after their marriage. Because the anticipated gift to Maya is substantial, and his only tax break if he makes the gift before marriage is the $17,000 annual exclusion, he should consider postponing the gift and having it be nontaxable under the unlimited marital deduction rules. Gift splitting will be available on the planned gifts to the children only if he makes them after marrying Maya. Gift splitting would produce favorable tax results because with gift splitting the $34,000 planned gift to each child would be fully shielded by two $17,000 per donee annual exclusions. Each spouse would be deemed to make a gift to each donee. pp. C:12-4, C:12-5, and C:12-19. C:12-28 • • •

Will any or all of Janet’s transfers be classified as gifts of a present interest? Will the transfer in trust qualify for an annual exclusion under the Sec. 2503(c) trust provisions? Does gift splitting seem to be advisable?

The trust is a discretionary trust, so Gordon is not guaranteed to receive any distribution for the 20 years of the trust. Also, Joanna will not receive anything until 20 years from now. Thus, Janet will make no present interest gifts. The trust is not a Sec. 2503(c) trust because it does not terminate when Gordon becomes age 21 (nor does it give Gordon a “window” soon after attaining age 21 to ask for the trust assets). In addition, when the trust terminates, some of the assets will go to Gordon’s sister instead of all of them passing to Gordon. As a result, no annual exclusions will be available.

C:12-5

We do not have sufficient facts about the spouses’ prior gift history to give a definitive answer about whether gift splitting would be advisable. Because no annual exclusions will be allowed if Janet carries out the transactions as described, the usual benefit of doubling the annual exclusion will not be available. However, given the very large unified credit, gift splitting likely will be beneficial by reducing the tax rate on the gifts because they can have the gifts taxed beginning at the bottom tax rate for each spouse and will get to use two unified credits. With gift splitting, no tax is payable. Otherwise, Janet will owe some gift tax. Janet should consider having Crummey clauses for Gordon and Joanna added to the trust agreement so the annual exclusion would become available. pp. C:12-4, C:12-5, and C:12-16 through C:12-18. C:12-29 • Do the estate freeze rules apply to this transaction? • If they do, what is the amount of the deemed gift from Melvin to Pamela? • What is the significance of the 2.5% actual income yield? The estate freeze rules of Sec. 2702 do apply to this transaction. Melvin makes a transfer in trust for the benefit of a family member (a daughter in this situation) and retains an interest in such trust. His retained interest, however, is not an annuity interest or a unitrust interest (a specified percentage of the fair market value of the trust assets, as redetermined annually). Because Melvin did not keep a so-called qualified interest, described as an annuity interest or a unitrust interest, Sec. 2702 treats the value of his retained interest as being zero. Thus, he is deemed to have made a gift to Pamela of the total value, or $1 million. The gift would have been smaller if Melvin had kept an annuity interest (used a Grantor Retained Annuity Trust [GRAT]) or a unitrust interest; the Sec. 7520 4% interest rate would have been used to value his interest. The actual income yield of 2.5% would not be relevant in arriving at the valuation of the gift. It is not an advantageous tax strategy to fund a GRAT if the Sec. 7520 rate exceeds the actual yield of the assets transferred to the trust because the assets’ hypothetical yield under the actuarial assumptions would exceed their actual yield. Thus, the actuarial tables would overvalue the amount calculated for the remainder interest gift compared with the actual wealth expected to be shifted. p. C:12-13.

Problems C:12-30 The tax payable is zero, determined as follows: a. Tax on $500,000 $ 155,800 Minus: Tax on $200,000 (current rate schedule) ( 54,800) Tax on $300,000 $ 101,000 Minus: Remaining unified credit ($5,113,800 - $54,800 used) ( 5,059,000) Tax payable $ -0b. No tax is owed. The current rate schedule is used to determine the tax on the $200,000 gift. The computation would be the same except that the remaining unified credit would be $5,113,800. Because the $200,000 gift was made prior to the advent of the unified credit, none of the credit has been used. The tax payable would be zero ($101,000 – $101,000). pp. C:12-23 through C:12-25.

C:12-6

C:12-31

The tax payable is zero, calculated as follows: Tax on $2.6 million (40% top rate) Minus: Tax on $2 million (current rate schedule; 40% top rate) Tax on $600,000 Minus: Remaining unified credit (for 2023, $5,113,800 $211,300 used in 1999)*** Tax payable

$985,800* ( 745,800)** $ 240,000 (4,902,500) $ -0-

* $345,800 + 40% ($1,600,000) **$345,800 + 40% ($1,000,000) ***Because Amir made the $800,000 gift in 1975, before the advent of the unified credit, it absorbs none of the unified credit. For 1999, the exemption equivalent (now called basic exclusion amount) was $650,000. A tax rate of 37% was applicable in 1999 to the interval between $500,000 and $750,000. Because this rate does not exceed the top rate of 40%, in calculating the remaining credit for 2023, there is no need to revise the 1999 credit claimed. pp. C:12-23 through C:12-25. C:12-32 a. $17,000. Beth made gifts of $34,000 [($40,000 - $18,000) + $12,000] to Linda. Beth receives an annual exclusion of $17,000. Thus, Beth’s taxable gifts are $17,000. b. $5,000. Beth’s taxable gift to Linda is $5,000 [($40,000 - $18,000) - $17,000] and to Patrick is $0 ($12,000 - $12,000). Thus, total taxable gifts for Beth are $5,000. pp. C:12-7 and C:12-16. C:12-33 a. $200,000 = 8 x ($42,000 - $17,000) taxable gifts. b. $32,000 for Kent, and $64,000 total taxable gifts. Each spouse is deemed to have given each grandchild $21,000. Taxable gifts are $32,000 [8 x ($21,000 - $17,000)] for each spouse, or $64,000 total. pp. C:12-4, C:12-5, C:12-22, and C:12-23. C:12-34 a.

Each spouse reports $178,000 of taxable gifts, calculated as follows: David’s gifts: To David, Jr. Minus: One-half of David’s gift, deemed made by spouse Plus: One-half of wife’s gifts, deemed made by David (0.50 x $244,000) Total before exclusions Minus: Exclusions (2 x $17,000) Taxable gifts David’s wife’s gifts: To George To David, Jr. Total Minus: One-half of gifts deemed made by David Plus: One-half of David’s gift Total before exclusions Minus: Exclusions (2 x $17,000) Taxable gifts Copyright © 2024 Pearson Education, Inc.

C:12-7

$180,000 ( 90,000) 122,000 212,000 ( 34,000) $178,000 $200,000 44,000 $244,000 ( 122,000) 90,000 212,000 ( 34,000) $178,000

b. $161,000 taxable gifts by each spouse. There would be three donees now and, thus, $51,000 of exclusions for each donor. Thus, taxable gifts for each spouse would be lower by $17,000, or $161,000 taxable gifts each. pp. C:12-4, C:12-5, C:12-22, and C:12-23. C:12-35 $18,000 taxable gifts each for Yolanda and Xavier, calculated as follows: Yolanda’s actual gifts: Andy, cash Betty, stock Total gifts made by Yolanda Minus: One-half of above gifts, gifts deemed made by Xavier Plus: One-half of Xavier’s gifts, gifts deemed made by Yolanda Total gifts deemed made by Yolanda Minus: Exclusions Charitable contribution deduction Yolanda’s taxable gifts

$ 40,000 60,000 $100,000 (50,000) 58,000 $108,000 (72,000)* (18,000)** $ 18,000

Xavier’s actual gifts: Cathy, stock Danny, cash withdrawn from joint tenancy account State Technological Institute, stock Total gifts made by Xavier Minus: One-half of above gifts, gifts deemed made by Yolanda Plus: One-half of Yolanda’s gifts, gifts deemed made by Xavier Total gifts deemed made by Xavier Minus: Exclusions Charitable contribution deduction Xavier’s taxable gifts

$ 38,000 8,000 70,000 $116,000 (58,000) 50,000 $108,000 (72,000)* (18,000)** $ 18,000

*$17,000 for Andy, Betty, Cathy, and the State Technological Institute; $4,000 (0.50 x $8,000) for Danny. **(0.50 x $70,000) - $17,000. pp. C:12-4, C:12-5, C:12-22, and C:12-23. C:12-36 a. No gift arises because a completed transfer has not occurred. The beneficiary designation is not irrevocable. pp. C:12-14 and C:12-15. b. Emily makes a $17,000 gift to Matt when Matt withdraws $17,000 more than he deposited. p. C:12-14. c. No gift occurs because the transaction is a direct payment of medical expenses. p. C:12-8. d. Emily makes a $60,000 gift to Olive when she transfers title to the property. p. C:12-7.

C:12-8

C:12-37 After the credit, no tax is owed. Emily’s current gifts from Problem C:12-36 total $77,000 ($17,000 + $60,000). Her taxable gifts are $43,000 ($77,000 - $34,000 of exclusions). Emily’s gift tax liability is determined as follows: Tax on $1,543,000 (40% top rate) $ 563,000* Minus: Tax at current rates on $1,500,000 of prior gifts ( 545,800) Tax on $43,000 $ 17,200 Minus: Remaining unified credit ($5,113,800 for 2023 - $202,050 used in 1998**) (4,911,750) Tax payable $ -0* $345,800 + 40% ($543,000) ** $202,050 is the tax on $625,000, the exemption equivalent (now called basic exclusion amount) for 1998, with a 37% rate applicable to the interval between $500,000 and $750,000. Because the tax rates on this interval have not changed since 1998, there is no need to recalculate the credit used. pp. C:12-23 through C:12-25. C:12-38 a. $70,961 gift. Marge makes a gift of the remainder interest, which is valued at $70,961 [$100,000 - ($8,000 x 3.6299)]. The factor for the annuity (3.6299) is determined by subtracting the factor for the remainder interest (0.854804, Table B, 4 years, 4.0% interest rate, Appendix G) from 1.0 and dividing the difference by the 4% interest rate [(1.0 - 0.854804)/0.04 = 3.6299 factor]. pp. C:12-11 through C:12-13. b. The statute exempts direct payments of tuition from classification as a gift. p. C:12-8. c. Marge makes a gift of $72,000. p. C:12-7. d. The $150,000 transfer is not a gift because it is an incomplete transfer. The trust is revocable. The payment of the $18,000 of trust income is a completed transfer because Marge cannot get back the cash that was distributed and, thus, it is a gift. p. C:12-10. C:12-39 a. The parent makes a gift of the bargain element of $800,000 ($1,800,000 $1,000,000). p. C:12-7. b. No gift arises because the transaction occurs in the ordinary course of the business. p. C:12-7. c. No gift occurs because he makes the expenditures for support of his minor child. p. C:12-8. d. The statute exempts transfers to political organizations from classification as a gift. p. C:12-8. e. The forgone interest is a gift. The interest amount is determined by multiplying the $600,000 principal amount times the 6% assumed applicable federal interest rate times the portion of the year (5 months) for which the loan was outstanding. The forgone interest is $15,000 ($600,000 x 0.06 x 5/12). pp. C:12-28 and C:12-29. C:12-40 a. $5,113,800, the amount for 2023; here, the credit is not reduced because Sue used the specific exemption against a gift made in March 1976 instead of a gift made between September 9 and December 31, 1976. b. $5,107,800 [$5,113,800 - (0.20 x $30,000)]. The credit is reduced by 20% of the $30,000 exemption claimed for gifts made late in 1976. pp. C:12-6, C:12-24, and C:12-25. Copyright © 2024 Pearson Education, Inc.

C:12-9

C:12-41 $31,350 gift. $30,000 interpolated terminal reserve + unexpired premium of $1,350 (9/12 x $1,800) = $31,350 gifts. pp. C:12-14 and C:12-15. C:12-42 $683,000 marital and $83,000 charitable deductions. For gift tax purposes, Tina’s marital deduction is $683,000, and her charitable contribution deduction is $83,000. The deductions cannot exceed the amount of the “included gifts.” These deductions are available in addition to the $17,000 annual exclusion for each gift. The income tax charitable contribution deduction for the year of the gift is $100,000, provided this amount does not exceed applicable AGI limitations. pp. C:12-18 through C:12-22. C:12-43 a. A $17,000 exclusion is available; this is a Sec. 2503(c) trust. b. No exclusion is available; May does not have a present interest because the trust is discretionary, and it is not a Sec. 2503(c) trust or a Crummey trust. c. A $17,000 exclusion is available; May receives a present interest of $17,000, the amount she can withdraw, which is equal to the annual exclusion amount. This is a Crummey trust. pp. C:12-16 through C:12-18. C:12-44 Will and Helen each will receive $21,000 of annual gift tax exclusions as follows: Will, Jr. Suzy (future interest because it is a remainder interest) Joyce (0.50 x $8,000) Total

$17,000 -04,000 $21,000

The exclusion for the gift to Joyce is limited to $4,000 per spouse, the amount of the deemed gift after gift splitting. Together, the total gift tax exclusions Will and Helen receive are $42,000 ($21,000 x 2). pp. C:12-16 through C:12-18. C:12-45 Bonnie receives one exclusion; only Carol receives a present interest. (The trust beneficiaries, not the trust, are the donees, and Carol’s children receive future interests.) p. C:12-16.

C:12-10

C:12-46 The gift tax liability is zero for 2022 and $21,000 each (before reduction by the unified credit) for Hugo and Wanda in 2023, calculated as follows: 2022 Gift to each donee after gift splitting (0.50 x $16,000) Minus: Exclusion per donee Taxable gift per donee

$ 8,000 ( 8,000) $ -0-

Gift tax liability

2023 Gift to each donee after gift splitting (0.50 x $40,000) Minus: Exclusion per donee Taxable gift per donee Times: Number of donees Taxable gifts for each spouse

$20,000 ( 17,000) $ 3,000 30 $90,000

Each spouse’s minimum gift tax (no previous taxable gifts) before reduction for unified credit

$21,000

-0-

pp. C:12-22 through C:12-24. C:12-47 a. $483,000. If Hugh makes an election, Hugh receives a $483,000 marital deduction on this QTIP transfer. The marital deduction is limited to the amount of the gift that exceeds the $17,000 annual exclusion. Note that the entire transfer, not just the income interest, is deemed to be a gift to Winnie. b. None. No marital deduction is available; this trust does not meet the QTIP requirements because the spouse is not entitled to all the income for life. Her interest will cease if she remarries, and the trustee can exercise discretion in paying out income. Incidentally, this transfer is ineligible for an annual exclusion because the income distribution is discretionary. Also, Hugh used the annual exclusion against the earlier gift in Part a. pp. C:12-19 and C:12-20. C:12-48 a. $28,000. The marital deduction is $28,000 ($45,000 - $17,000 exclusion). b. None. No marital deduction is available because the transfer is of a nondeductible terminable interest. The transfer is not eligible for QTIP treatment because the property passes to the daughter at the end of 12 years, not at Lance’s death. Incidentally, the annual exclusion was used against the gift of land made earlier in the year. pp. C:12-19 and C:12-20. C:12-49 a. $59,764 [0.59764 (Table S, Appendix G, 4.0%, Age 70) x $100,000]. No annual exclusion is available for a gift of a remainder interest. The vacation cabin is a personal residence. b. No charitable contribution deduction is available because this is a split interest transfer, and the remainder is not in a personal residence, farm, or ranch. pp. C:12-21 and C:12-22.

C:12-11

C:12-50 a.

The total tax payable with gift splitting is zero ($0 + $0), calculated as follows: Wilma’s tax liability: Gift to Art Plus: Gift to Bart Total gifts Minus: One-half of Wilma’s gifts, deemed made by Homer (0.50 x $406,000) Plus: One-half of Homer’s gifts to third parties, deemed made by Wilma (0.50 x $900,000) (See note) Taxable gifts before exclusions and charitable contribution Minus: Exclusions Charitable contribution deduction ($50,000 - $17,000) Taxable gifts Tax on $566,000 (37% marginal rate) Minus: Remaining unified credit for 2023 Tax payable Homer’s tax liability: Gift to Linda Plus: Gift to charitable organization Gift to Norma (future interest) Total gifts (See note) Minus: One-half of Homer’s gifts to third parties deemed made by Wilma Plus: One-half of Wilma’s gifts Taxable gifts before exclusions and charitable contribution Minus: Exclusions Charitable contribution deduction ($50,000 - $17,000) Taxable gifts Tax on $2,066,000 ($1,500,000 prior gifts + $566,000 current taxable gifts), 40% top rate Minus: Tax at current rates on $1,500,000 Tax on $566,000 Minus: Remaining credit ($5,113,800 - $192,800 used in 1996)b Tax payable

$ 400,000 6,000 $ 406,000 ( 203,000) 450,000 $ 653,000 ( 54,000)a ( 33,000) $ 566,000 $ 180,220 (5,113,800) $ -0$ 600,000 100,000 200,000 $ 900,000 ( 450,000) 203,000 $ 653,000 ( 54,000)a ( 33,000) $ 566,000 $ 772,200 ( 545,800) $ 226,400 (4,921,000) $ -0-

Exclusions are available for the gifts to Art, Bart, Linda, and the charitable organization. The exclusion for the $6,000 gift to Bart is only $3,000 (0.50 x $6,000) instead of $17,000 per donee. No exclusion is allowed for the gift of a future interest to Norma. b Because Homer made the $100,000 gift in 1975, before the advent of the unified credit, it absorbs none of the unified credit. The unified credit based on the $600,000 exemption equivalent (now called basic exclusion amount) for 1996 with a 37% rate on the interval between $500,000 and $600,000 is $192,800. Because the tax on $600,000 did not exceed the tax at rates for the current year, no recalculation of the credit is necessary. Copyright © 2024 Pearson Education, Inc.

C:12-12

Note: Homer’s charitable gift needs to be reported on the gift tax return even though the charity receives the entire interest in the property because he has to file a gift tax return to report other gifts. The taxable charitable gift is zero because of the exclusion and deduction. b.

The total tax payable without gift splitting is zero ($0 + $0), the same amount as with gift splitting. The lack of a difference here results from the large unified credit. Wilma’s tax liability: Gift to Art Plus: Gift to Bart Total gifts Minus: Exclusions ($17,000 + $6,000) Taxable gifts

$ 400,000 6,000 $ 406,000 ( 23,000) $ 383,000

Tax on $383,000 Minus: Unified credit for 2023 Tax payable

$ 116,020 (5,113,800) $ -0-

Homer’s tax liability: Gift to Linda $ 600,000 Plus: Gift to charitable organization 100,000 Gift to Norma (future interest) 200,000 Total gifts $ 900,000 Minus: Exclusions ( 34,000) Charitable contribution deduction ($100,000 - $17,000) ( 83,000) Taxable gifts $ 783,000 Tax on $2,283,000 ($1,500,000 prior taxable gifts + $783,000 current taxable gifts) Minus: Tax at current rates on $1,500,000 Tax on $783,000 Minus: Remaining credit ($5,113,800 for 2023 - $192,800 used in 1996)* Tax payable *See footnote b in Part a. pp. C:12-23 through C:12-26.

C:12-13

$ 859,000 ( 545,800) $ 313,200 (4,921,000) $ -0-

C:12-51 The gift tax is zero, calculated as follows: Gift to Janet Plus: Gift to Cindy Plus: Gift to Henry (spouse) Total gifts Minus: One-half of Wendy’s gifts to third parties, deemed made by Henry (0.50 x $150,000) Plus: One-half of Henry’s gifts to Janet Total before exclusions and marital deduction Minus: Exclusions (three donees) Marital deduction ($50,000 - $17,000) Taxable gifts Tax on $1,056,000 (40% top rate) Minus: Tax at current rates on $1,000,000 Tax on $56,000 Minus: Remaining credit ($5,113,800 for 2023 - $192,800 used in 1995*) Tax payable

80,000 70,000 50,000 $ 200,000 ( 75,000) 15,000 140,000 ( 51,000) ( 33,000) $ 56,000 $368,200 ( 345,800) $ 22,400 (4,921,000) $ -0-

* $192,800 is the tax on the $600,000 exemption equivalent (now called basic exclusion amount) for 1995 with a 37% rate on the interval between $500,000 and $600,000. Because this amount does not differ from the tax on $600,000 at current rates, no recalculation of the amount used is necessary. pp. C:12-23 through C:12-26. C:12-52 a. Zero because of the annual exclusion and marital deduction. b. $75,000 ($95,000 - $20,000 Karen’s former basis). Hal’s basis for the gifted property was Karen’s former basis because the property was appreciated and Karen paid no gift tax. c. $85,000 basis under the step-up in basis rules. d. $20,000 basis because Hal (the donee) dies within a year of receiving the appreciated property, and he wills the property to the donor, his spouse (Sec. 1014(e)). e. $85,000 basis to Karen because Hal survives the date of the gift from Karen to him by more than one year. pp. C:12-26 through C:12-28. C:12-53 Siu should give away the Gold stock. Giving the Gold stock would be the better approach from an income tax standpoint because Siu’s basis in Gold is higher, and the donee would receive a higher basis ($450,000 instead of $100,000). The transfer tax implications are neutral because each stock has the same FMV and the same anticipated appreciation rate. Siu should retain the Ace stock because it has the larger basis step-up potential. pp. C:12-26 through C:12-28. C:12-54 $125,000 gift. Sam makes a gift to Tom of the forgone interest equal to $125,000 ($10,000,000 x 0.05 x 1/4 year). Sam gets a $17,000 annual exclusion on the deemed gift. Sam reports $125,000 interest income (the amount of the forgone interest). Tom is deemed to receive a gift of $125,000, excludible for income tax purposes, and has $125,000 of imputed interest expense. Copyright © 2024 Pearson Education, Inc.

C:12-14

Depending on the classification of the interest, all or a portion of this amount may be personal interest and, thus, nondeductible, or investment interest and deductible only to the extent of Tom’s net investment income. pp. C:12-28 and C:12-29.

Comprehensive Problem C:12-55 Ginger’s taxable gifts are $38,000, and she owes zero tax. Note that Ginger made a qualified disclaimer of the $250,000 bequest, meaning that she made no gift when she disclaimed. She need not report this transaction on her gift tax return. Thus, it is omitted from the calculations below. She does need to report her $100,000 gift to her alma mater on her gift tax return (even though it receives her entire interest in the property) because she must file a return to report other gifts. Ginger’s actual gifts: State University, cash Denise, life insurance premiums Stevie, withdrawal from joint bank account Red Cross, remainder interest in cottage (0.30360 x $70,000) QTIP trust for husband Greg with remainder to Drucilla Ginger’s total actual gifts Minus: One-half of gifts to third parties (0.50 x $173,252) Plus: One-half of Greg’s gifts to Stevie (0.50 x $80,000) Minus: Annual exclusions of $17,000 each for State University, Stevie, and Greg and $11,000 (0.50 × $22,000) for Denise Charitable contribution deduction (0.50 x $21,252) + [(0.50 x $100,000) - $17,000] Marital deduction ($300,000 - $17,000) Taxable gifts Tax on cumulative taxable gifts of $213,000 ($175,000 + $38,000) Minus: Tax on $175,000 at current rates Tax on $38,000 Minus: Unified credit ($5,113,800 for 2023 - $46,800 used already) Tax payable No annual exclusion is allowed for the future interest gift to the Red Cross.

C:12-15

$ 100,000 22,000 30,000 21,252 300,000 $ 473,252 ( 86,626) 40,000 ( 62,000) ( 43,626) ( 283,000) $ 38,000 $ 58,960 ( 46,800) $ 12,160 (5,067,000) $ -0-

Tax Strategy and Critical Thinking Problems C:12-56 George and Martha can gift split and save $532,000 in current gift taxes, determined as follows: With gift-splitting election: George Tax on current taxable gifts of $8 million (no earlier taxable gifts) Minus: Unified credit Tax payable

$3,145,800 (5,113,800) $ -0-

Martha Tax on cumulative taxable gifts of $8,250,000 Minus: Tax on $250,000 earlier taxable gifts Tax on $8 million Less unified credit ($5,113,800 - $70,800) Tax payable

$3,245,800 (70,800) $3,175,000 (5,043,000) $ -0-

Combined tax liability for the couple

-0-

Without gift-splitting election: George Tax on current taxable gifts of $2 million (no earlier taxable gifts) Minus: Unified credit Tax payable

$ 745,800 (5,113,800) $ -0-

Martha Tax on cumulative taxable gifts of $14,250,000 Minus: Tax on $250,000 earlier taxable gifts Tax on $14 million Less unified credit ($5,113,800 - $70,800) Tax payable

$5,645,800 (70,800) $5,575,000 (5,043,000) $ 532,000

Combined tax liability for the couple

$ 532,000

From a present value standpoint, it is better to elect gift splitting and avoid payment of $532,000, the tax owed by Martha in the absence of gift splitting. On the other hand, by gift splitting, George uses $2.4 million ($3,145,800 - $745,800) more of his unified credit, meaning he will have a smaller credit available when he makes the $20 million of taxable gifts.

C:12-16

C:12-57 Samantha’s alternatives are as follows: Alternative 1: Disclaim the bequest. If Samantha disclaims the bequest in writing within nine months of her father’s death, she will be treated as not having received the $1.5 million from her father’s estate. Instead, she will be treated as predeceasing her father, and the money will pass under the disclaimer provisions to Joseph. Consequently, no taxable gift from Samantha will arise as a result of Joseph receiving the money. However, she indicated she does not like Joseph or his family, so she likely would not want to disclaim the bequest. Alternative 2: Do not disclaim the bequest. If Samantha does not disclaim the bequest and receives the $1.5 million from her father’s estate, it will not constitute gross income to her. She then can use the funds to make a cash contribution to her alma mater to fund most of the scholarship endowment in which she has expressed an interest. Moreover, she will be able to deduct the contribution on her income tax return, subject to the limitation rules for charitable contribution deductions. Conclusion. Samantha would best meet her objectives by accepting the bequest and making the contribution to her alma mater, particularly given that the inheritance does not constitute gross income and the contribution provides a deduction. Thus, her alma mater will benefit and so will she since the deduction reduces her taxable income from other sources. Joseph’s situation, however, will not be enhanced, which apparently is fine with Samantha. If Joseph and his family were in Samantha’s good graces, she probably would prefer to disclaim the bequest to help him out. Having Joseph in the picture highlights the fact that nontax factors are important in resolving gift and estate tax issues.

Tax Form/Return Preparation Problems C:12-58 (See Instructor’s Resource Manual) C:12-59 (See Instructor’s Resource Manual)

Case Study Problems C:12-60 The points listed below are the major ones that should be covered in the memorandum to the tax partner. The student should incorporate these points into a properly structured memorandum using good form with proper grammar and punctuation. If Karen Kross gives $36,000 to each of the five college-age grandchildren, and they use the funds to pay their college expenses, she will have made gifts to each of $36,000. Even with gift splitting, taxable gifts to each of $1,000 ($18,000 - $17,000) will occur. If she pays the tuition directly to the college, such amount will not be considered a gift. If the portion she pays directly to the college for tuition is $19,000 or higher, the amount deemed to be a gift to each (the room and board) will not exceed $17,000, the amount shielded by the annual exclusion. By the same token, if Karen gives cash to her younger grandchildren, she will have made a gift to them. Karen can avoid gift treatment by paying the orthodontist directly. Because of the small amounts, no taxable gift to Copyright © 2024 Pearson Education, Inc.

C:12-17

the younger grandchildren will arise even if she does not pay the orthodontist directly. Because Karen plans to give cash, the basis of the transferred property will not be a consideration. If Karen gives her daughter stock, her daughter’s basis will be the same as Karen’s basis. Any post-gift appreciation in the stock will escape transfer taxation. The gift will qualify for the annual exclusion. If Karen’s transfer to her son is via a discretionary trust, it will not be eligible for the annual exclusion unless she sets up a Crummey trust. If Karen and Larry do not elect gift splitting and she creates a Crummey trust, her taxable gifts to her daughter and son will total $766,000 ($383,000 + $383,000), but she will not incur a gift tax liability because she made no taxable gifts in prior years and the current basic exclusion amount is $12.92 million. If Karen and Larry elect gift splitting, she likewise will owe no tax because her taxable gifts will not exceed $12.92 million (the basic exclusion amount in 2023). Larry will not owe any gift taxes because his cumulative taxable gifts do not exceed $12.92 million, the basic exclusion amount in 2023. If Karen and Larry elect gift splitting, they will double the excludible portion of their gifts. This election will be especially important if she gives cash to the five college-age grandchildren instead of directly paying their tuition. With gift splitting, taxable gifts of $1,000 ($18,000 - $17,000) per grandchild will occur on the transfers to the five older grandchildren. Minimizing taxable gifts is especially important because doing so also minimizes the estate tax base, as Chapter C:13 discusses in the context of adjusted taxable gifts (post-1976 taxable gifts). The contemplated transfer of the remainder interest in the farm to the museum will be an arrangement eligible for the charitable contribution deduction for gift tax purposes. A remainder in a farm is a tax-favored charitable transfer. She also will receive an income tax deduction for the value of the remainder interest. C:12-61 You should not prepare a gift tax return in accordance with Mr. Jory’s desires and claim gift tax annual exclusions on the transfers to the employees. The transfers to the employees are not really gifts to the employees because the workers were instructed to endorse the stock certificates back over to Mr. Jory’s children. The facts in this scenario are very similar to those of Mary Ann Heyen, Exec. v. U.S., 91-2 USTC ¶60,085, 68 AFTR 2d 91-6044 (10th Cir., 1991), in which the court denied annual exclusions for transfers to “donees” who endorsed stock certificates received by “gift” to members of the donor’s family. The court also sustained a civil fraud penalty. The court pointed out that Reg. Sec. 25.2511-1(g)(1) does not preclude consideration of the donor’s subjective motives in determining whether a gift arose. Estate of Marie A. Bies, TC Memo 2000-338, involved a situation where daughter-in-law “donees” had entered into agreements to transfer to their spouses shares that were nominally given to them. The court ruled that the “gifts” to the in-laws were indirect gifts to their spouses. With respect to ethical considerations, Statements on Standards for Tax Services (SSTSs), apply to tax returns and claims for refund filed with any taxing authority. SSTS No. 1 (reproduced in Appendix E of the text) indicates that a CPA should “determine and comply with the standards, if any, that are imposed by the applicable taxing authority.” This authority is Sec. 6694 (discussed below). Claiming gift tax exclusions for the transfers to the employees would not meet the standard of SSTS No. 1. Copyright © 2024 Pearson Education, Inc.

C:12-18

The tax return preparer rules of Sec. 6694 have been expanded to apply to estate and gift tax returns. Under the IRC, a penalty would apply if the transaction were not disclosed unless there is substantial authority for the position. Alternatively, you are permitted to take a position if there is a “reasonable basis” for the tax return position and the position is disclosed. On the other hand, if the transaction is viewed as a tax shelter, it must be more likely than not that the position will be upheld; otherwise, a penalty will apply. There is not sufficient support, however, to adopt the position Mr. Jory wants.

Tax Research Problems C:12-62 She is not viewed as making a gift. The requirements for a qualified disclaimer under Sec. 2518, which would result in Winona not making a gift of her half interest in the property to the children, are as follows: 1. 2. 3. 4.

It must be an irrevocable, unqualified, written refusal to accept the property. It must be made no later than nine months after Mike’s death. The disclaimant may not have accepted the property interest or any of its benefits. The property must pass without direction on the part of the disclaimant to the spouse or a person other than the disclaimant.

One potential problem for Winona is the second requirement because she has been a joint tenant since 2002 and, thus, the disclaimer potentially could be too late. Under Maine law, the joint tenancy could have been severed unilaterally by either Mike or Winona. The courts have held that in such circumstances, the transfer creating the survivorship interest occurs on the date of death of the first joint tenant to die. Thus, the clock began running at Mike’s date of death, and Winona disclaimed about two months later. Consequently, there is no problem with the timing. According to Reg. Sec. 25.2518-2(d)(1), “a joint tenant will not be considered to have accepted the joint interest in a personal residence merely because the tenant resided on the property prior to disclaiming his interest.” Consequently, Winona will not be treated as having received the property or enjoyed its benefits. The other requirements for a qualified disclaimer are clearly met. As a result, Winona is not viewed as making a gift of a one-half interest to the children. The authority is Ltr. Rul. 9733008. One search request that shows this authority is “Maine disclaimer joint tenancy.” C:12-63 The annual exclusion is available. Ltr. Rul. 200633015 addresses a very similar situation although in its scenario several trusts are involved, and the trust instruments include Crummey withdrawal powers that would apply should the trusts not terminate at age 21. In addition, the letter ruling addresses generation-skipping transfer tax implications. It points to the fact that the beneficiary can ask for the property upon attaining age 21 and concludes that gifts to the trust until the beneficiary reaches age 21 are eligible for the annual exclusion under Sec. 2503(c). As support, the letter ruling cites Reg. Sec. 25.2503-4(b), providing that a transfer does not fail the test of Sec. 2503(c) simply because the donee, upon attaining age 21, has the right to extend the term of the trust. In addition, it cites Rev. Rul. 74-43, 1974-1 C.B. 285, which concludes that a trust satisfies the requirements of Sec. 2503(c) if the trust instrument allows the beneficiary upon becoming age 21 “a right during a limited period to compel immediate distribution of the trust corpus…, which if not exercised will permit the trust to continue by its own terms.” Thus, the transfers to the trust until Heather reaches age 21 will be eligible for the annual exclusion. Incidentally, any transfers to the Copyright © 2024 Pearson Education, Inc.

C:12-19

trust after she attains age 21 will not be eligible as the trust is no longer a trust for a minor nor is it a Crummey trust. Thus, the requirements for a Sec. 2503(c) trust are not actually as stringent as the IRC suggests because the Treasury Regulations and IRS rulings do not mandate a termination and distribution of assets at age 21 provided certain conditions are met. This private letter ruling can be found when searching in CHECKPOINT, using these search terms: “trust minor exclusion 21 2006.” Ltr. Rul. 200634007 has similar facts and allows an exclusion. C:12-64 The gift cannot be revalued. Okerlund vs. U.S., 93 AFTR 2d 2004-1715, 2004-1 USTC ¶60,481 (Fed. Cir., 2004), affirming 90 AFTR 2d 2002-6124, 2002-2 USTC ¶60,447 (Fed. Cl., 2002), addresses a similar scenario. In that case, several individuals made gifts of closely held stock. Subsequently, the firm founder died and a salmonella outbreak occurred. The donors argued for reducing the value shown on their gift tax returns and a restoration of some of the unified credit claimed because the two events caused the earnings of the firm to decline. They argued that the value shown on the gift tax returns was too high in light of these circumstances. The court did not agree. It emphasized that the death of the founder and the salmonella outbreak, though identifiable risks, “were unexpected occurrences” that led to declines in the value of the stock. It concluded, “Valuation must always be made as of the donative date relying primarily on ex ante information; ex post data should be used sparingly.” The memo should state that the gift cannot be revalued and, thus, Janet cannot receive a refund or restoration of some of her unified credit. C:12-65 a. The IRS alleged Redstone made the gift in 1972, but it did not issue a notice of deficiency until 2013. b. Redstone did not file a gift tax return for 1972 to report a gift, or even to disclose the transaction in question. Thus, the statute of limitations never began. c. Redstone received no monetary compensation from his children. d. The Tax Court concluded that Redstone did not make a gift and, thus, owed no gift tax. Its rationale was that the transfer of stock to his children “constituted a bona fide, arm’s-length transaction that was free from donative intent and was thus ‘made in the ordinary course of business.’” In a family dispute, Edward Redstone had reached a compromise whereby he obtained ownership rights over 2/3 of the assets in question provided he transferred the remaining 1/3 in trust for the children. The Tax Court viewed the transaction as falling under the realm of a transfer in the ordinary course of business and, thus, not a gift. C:12-66 Section 529(c)(2)(A) provides that transfers to Sec. 529 plans are treated as completed gifts that are not future interest gifts, with the result that the transfers qualify for the gift tax annual exclusion. Ginger’s transfer to each grandchild, however, exceeds the annual exclusion amount. Thus, in the absence of some additional tax favorable provision, a taxable gift to each grandchild would arise. Section 529(c)(2)(B) provides that, if the transfers per donee exceed the excludible amount and the donor so elects, the donor can treat the transfers as being made ratably over a fiveyear period beginning with the year of the transfer. With this election, Ginger would have been treated as giving each grandchild $11,000 per year, an amount fully shielded by the gift tax annual exclusion. Unfortunately, Ginger did not make the election because she did not file a gift tax return for 2018. The instructions for Schedule A, Part B, for Form 709, state that a taxpayer makes the election to treat transfers to Sec. 529 plans as being made ratably over a five-year period by checking the box on Line B at the top of Schedule A. The election must be made for the calendar year in which the Copyright © 2024 Pearson Education, Inc.

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taxpayer makes the contribution. In addition, the taxpayer must attach an explanation that includes the following information: • • •

The total amount contributed per individual beneficiary The amount for which the election is being made The name of the individual for whom the contribution was made

Ginger’s facts are similar to those in Estate of Edward G. Beyer, T.C. Memo 2016-183, because Mr. Beyer did not file a gift tax return to report one set of transfers to Sec. 529 plans (those made in 2002). For another year (2005), he did file a gift tax return but did not report his 2005 transfers to Sec. 529 plans. Thus, he did not make elections to treat transfers as having been made ratably. In Beyer, the Tax Court emphasized the necessity of making the election on Form 709 to treat the transfers as made ratably and to thereby take advantage of five years’ worth of gift tax annual exclusions. For the year 2002, for which Mr. Beyer did not file a gift tax return, the court levied a failure to file penalty and a failure to pay penalty under Secs. 6651(a)(1) and (a)(2), respectively. However, Ginger may be able to avoid penalties if she can convince the IRS that she relied on professional advice from her tax preparer. C:12-67 Benefits of a Crummey trust include the following: • • • • •

The beneficiary has no right to receive the property at age 18 or 21, and the trust can continue for as long as specified in the trust agreement. The trust can be established for beneficiaries of any age, including beneficiaries who have already reached age 21. Although the beneficiary has the right to withdraw any contribution, he or she may be reluctant to do so because of fearing the donor will discontinue adding property to the trust. The maximum amount the beneficiary can withdraw in a year is the amount contributed in that year, not the entire property in the trust. When the beneficiary does not withdraw a particular contribution, control over that contribution rests with the trustee.

Disadvantages of a Crummey trust include the following: • • •

•

There are costs involved because of incurring attorney fees for drafting the trust document. The trust is treated as an asset of the child in the context of determining the financial aid formula of the child. If the donor serves as a trustee and dies before the trust terminates, the trust is part of the donor’s gross estate provided the donor retained certain powers (discussed in Chapter C:13 of the text) over the trust property. There is a possibility that the beneficiary will exercise a withdrawal power and, thus, not cooperate.

The source of this information is www.finaid.org/savings/crummey.phtml

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C:12-68 The IRS will not levy taxes retroactively on gifts made earlier that, because of the large unified credit available then, did not trigger a tax payable. The Treasury finalized regulations in November 2019. Find the article, “Final regs. eliminate estate and gift tax clawback,” by Sally P. Schreiber, J.D., in the November 2019 issue of Journal of Accountancy (and The Tax Adviser). Consequently, you may advise Mr. Martino that, if Congress does not extend the large unified credit after 2025, he will not have to pay additional gift taxes in the future as a result of the credit returning to its pre-2018 amount.

“What Would You Do In This Situation?” Solution Ch. C:12, p. C:12-9. Ms. Trong makes a taxable gift of $8.3 million, which generates a $3,265,800 tax (see below) and thus uses $3,265,800 of her $5,113,800 unified credit but owes no gift tax. As a CPA, you wish all your clients would check with you before entering any transaction with great tax implications. The form of a transaction can take precedence over its substance if it is not properly structured. Ms. Trong engaged in a very kind and magnanimous act of generosity by giving each of the 100 graduating high school seniors $100,000 for a college education. The gifts reflect the sort of private charitable giving that has long been a hallmark of the U.S. culture. However, even though all 100 students used the funds as Ms. Trong intended, the U.S. tax laws may not be as kind to her as she has been to the donees. The basic issue centers around the interpretation of Secs. 2503(b) and 2503(e). Under Sec. 2503(b), a donor may exclude up to $17,000 per donee per year from the computation of his or her taxable gifts for the year. This exclusion may be claimed for transfers of present interests to an unlimited number of donees. In addition to this annual exclusion, Sec. 2503(e) exempts certain additional “qualified transfers” from being treated as gifts for purposes of gift taxation. These qualified transfers include direct payments for tuition to an educational organization qualified under Sec. 170(b)(1)(A)(ii) and direct payments for medical care, as defined by Sec. 213(d). These payments can be made tax-free on behalf of individuals in addition to the $17,000 exclusion allowed under Sec. 2503(b). Unfortunately for Ms. Trong, even though the spirit of the two IRC sections was complied with, the letter of the law was not. It is your unhappy duty as her CPA to report to her that she made a substantial taxable gift in this transaction and thereby used a large portion of her unified credit. It would not be ethical to argue that the college really received the money and that the spirit of Sec. 2503(e) was complied with. Thus, the CPA’s position must be that Mrs. Trong’s tax liability is as follows: Total FMV of gift transfer (100 donees x $100,000 each) Minus: Sec. 2503(a) exclusions (100 donees x $17,000 each) Minus: Reduction under Sec. 2503(e) (payments were not directly paid to the college as required by Sec. 2503(e)) Taxable gift

C:12-22

$10,000,000 ( 1,700,000) ( -0-) $ 8,300,000

Assuming Ms. Trong made no prior taxable transfers, the gift tax for 2023 on the $8.3 million taxable gift would be computed as follows: Tax on first $1,000,000 Tax on excess over $1,000,000 ($7,300,000 x 0.40) Total tax Minus: Unified credit Gift tax Remaining unified credit ($5,113,800 - $3,265,800)

345,800 2,920,000 $3,265,800 ( 5,113,800) $ -0$ 1,848,000

This situation graphically illustrates how important it is for your client to check and doublecheck with you before engaging in important transactions. Trong will be unnecessarily using $3,265,800 of her unified credit because of a technical slip in the method of payment. Like it or not, the IRC is a minefield littered with tax trap mines such as this. The spirit of the law is important, but in taxation, technical compliance is even more important. It is your ethical duty to make your clients aware of this distinction. Note that legislation enacted in 2007 extended the tax return preparer rules to encompass estate and gift tax returns (and not just income tax returns). Statements on Standards for Tax Services No. 1 provides that a CPA “should determine and comply with the standards, if any, that are imposed by the applicable taxing authority.” Section 6694 states that, for a tax return preparer to take a pro-taxpayer position, there must be substantial authority for the position. Alternatively, a position with a reasonable basis may be taken if disclosed. Here, the lower threshold of support, reasonable basis, does not exist for treating these transactions as being eligible for the direct payment of tuition rule.

C:12-23

Chapter C:13 The Estate Tax Discussion Questions C:13-1 In general, items included in the gross estate are valued at their fair market values (FMVs) on the date of death or alternate valuation date; that is, the amount upon which a willing buyer and a willing seller would agree. Section 2032A allows a departure from the general FMV rule for farm land meeting certain requirements. Such land is valued under a formula approach at less than its FMV. Congress enacted this exception to reduce the probability that the heirs would have to sell the land to pay estate taxes. pp. C:13-2, C:13-3, C:13-6 through C:13-8, and C:13-29. C:13-2 For gift tax purposes, properties are valued at their FMVs as of the date of the gift. For estate tax purposes, properties are valued at their FMVs at either the date of death under Sec. 2031 or, if certain requirements are met, the alternate valuation date under Sec. 2032, which generally is six months after date of death. pp. C:13-6 through C:13-8. C:13-3 Interpolated terminal reserve versus face value. For gift tax purposes, a life insurance policy is valued at its interpolated terminal reserve plus the amount of any unexpired premiums. A term insurance policy’s interpolated terminal reserve value is zero because it builds up no cash surrender value. For estate tax purposes, the policy is valued at its $150,000 face value. p. C:13-6. C:13-4 Shares traded on a stock exchange are valued at the average of their high and low selling prices as of the applicable valuation date. The blockage rule allows a reduction from the average value where the decedent owned a large block of shares that would be difficult to dispose of at one time without using an underwriter and/or accepting a lower price. pp. C:13-6 and C:13-7. C:13-5 No. The executor may not use the alternate valuation date if the total value has risen. The executor cannot elect it unless it will result in (1) a lower gross estate amount and (2) a smaller amount of estate tax payable. pp. C:13-7 and C:13-8. C:13-6 An advantage of electing the alternate valuation date is that the estate tax liability is lower; a disadvantage is that the heirs receive the property at a lower total basis. pp. C:13-7 and C:13-8. C:13-7 No. The land is not included in the gross estate because the only properties included in the gross estate under the transfers-within-three-years-of-death rule are those interests that would have been included under Secs. 2036 through 2038 (the transferor provisions) or Sec. 2042 (life insurance) if the decedent had not made the transfer. Land that was gifted with no strings attached does not fall under any of these exceptions, so it is not included in the gross estate. The taxable gift will be included in the estate tax base as part of the adjusted taxable gifts (and valued at date of gift value) if a taxable gift resulted from the transfer. pp. C:13-10 and C:13-11.

C:13-1

C:13-8 It would be more favorable for the estate if the other person purchased the policy. Under this approach, even though the other person purchased the policy with funds received from the insured/client, the client will not potentially be affected by the transfers-within-three-years-of-death rule because the client did not make a gift of the insurance policy. The three-year rule potentially would apply if the client bought the policy and then gave it to someone. pp. C:13-10 and C:13-11. C:13-9 The “gross-up” rule requires that gift taxes imposed on gifts made by the decedent within three years of death be included in the gross estate. The rule forecloses some of the opportunities that formerly existed for reducing the gross estate and the estate taxes by making “deathbed” gifts and paying gift tax. Gift taxes on gifts made more than three years prior to death are excluded from the gross estate. In both situations, the gift taxes paid are subtracted to arrive at the estate tax payable. pp. C:13-10 and C:13-11. C:13-10 The gross-up rule will apply only to the gift taxes the client pays from her own funds and to half the gift taxes paid from a joint bank account of her and her spouse. The gross-up rule applies only to gift taxes on gifts made during the three-year period ending with the donor’s date of death. pp. C:13-10 and C:13-11. C:13-11 a. Because of the retention period for life, the residence is included in her gross estate, but her estate receives a charitable contribution deduction for the residence’s entire value. b. The eighteenth century residence is not included in her gross estate because she retained no enjoyment. Thus, in both situations the taxable estate is not increased. pp. C:13-11 and C:13-12. C:13-12 If the joint tenants are not spouses, the consideration furnished test of Sec. 2040(a) applies. Under this test, the gross estate includes the percentage of the value of the property that equals the proportion of the consideration that the decedent furnished. Incidentally, if the joint tenants are spouses, under Sec. 2040(b) one-half of the property’s value is included in the decedent’s gross estate regardless of how much consideration he or she provided. pp. C:13-14 and C:3-15. C:13-13 Life insurance is included in the decedent’s gross estate under Sec. 2042 if (1) the decedent possessed incidents of ownership in the policy at the time of his or her death or (2) the policy proceeds are payable to the executor or for the benefit of the estate. Even if the insurance policy escapes being taxed under Sec. 2042, it can be included under Sec. 2035 if the decedent/insured transferred it by gift within three years of death. pp. C:13-16 and C:13-17. C:13-14 This solution describes three situations, but other possibilities exist. The entire value of the property, in which the decedent previously gave away a remainder interest but retained a life estate, will be included in the gross estate (Sec. 2036). There will be an inclusion of reversionary interests, provided their value exceeds 5% of the property’s value, if the decedent previously gave away property but kept a reversionary interest therein (Sec. 2037). If the decedent earlier provided all of the consideration for an asset and had it titled in the joint names of himself and a child, 100% of the property’s value will be included in the decedent’s gross estate due to the consideration furnished test (Sec. 2040). pp. C:13-11 through C:13-13. Copyright © 2024 Pearson Education, Inc.

C:13-2

C:13-15 The property will be included in Tess’s gross estate because Tess has a general power of appointment exercisable at death. The testamentary power to appoint to whomever she desires is a power to appoint to her estate, a general power. Her lifetime powers are not general because she cannot appoint the property to herself except under an ascertainable standard. The power to appoint to herself for health or support needs is governed by the ascertainable standard. pp. C:13-15 and C:1316. C:13-16 The statement is correct only for pre-October 22, 1942 general powers of appointment. A post-October 21, 1942 general power of appointment is included regardless of whether it is exercised. pp. C:13-15 and C:13-16. C:13-17 It depends on the marital deduction claimed. The trust assets are fully included in Maria’s gross estate at their $1.7 million value if the executor made an election to claim a marital deduction in Carlos’s estate for the entire QTIP trust. If the executor made a partial QTIP election, the pro rata portion of the trust for which the election was made is included in Maria’s gross estate. Otherwise, the trust assets are not included in her gross estate. pp. C:13-17 and C:13-18. C:13-18 Allowed estate tax deductions are as follows: marital, charitable contribution, funeral and administration expenses, debts, casualty and theft losses, and state death taxes. Incidentally, before 2005, state death taxes generated a credit instead of a deduction. Gift tax deductions consist of only the marital deduction and the charitable contribution deduction. pp. C:13-18 through C:13-22. C:13-19 Administration expenses may be deducted on either the estate tax return or the estate’s income tax return or some in each place. The executor should deduct them on the return where they will produce the greatest tax savings. In 2023 the top rate for estate tax purposes is 40%, and the top rate for income tax purposes is 37%, plus the extra 3.8% tax on undistributed net investment income, if applicable. In some circumstances the tax savings will be approximately the same regardless of where deducted. The decedent’s debts are deductible only on the estate tax return unless they constitute deductions in respect of a decedent (a topic of Chapter C:14). pp. C:13-18 and C:13-19. C:13-20 a. Yes. The marital deduction is allowed for the life insurance. Her spouse is the beneficiary, and the policy is included in Judy’s gross estate because Judy had incidents of ownership. b. Yes. The estate is allowed a marital deduction for $350,000, the inclusion in Judy’s gross estate. Under the spousal joint tenancy rules, 50% of the property is automatically included in Judy’s gross estate. pp. C:13-20 through C:13-22. C:13-21 The four credits available for estate tax purposes and illustrations of each are as follows: • Gift tax credit—prior to 1977 the decedent made a gift of a remainder interest in property in which he kept a life estate and paid gift tax. The gifted property is in the donor’s gross estate. • Previously taxed property credit—the decedent received property that was taxed in the estate of a person who predeceased the decedent by not more than ten years. • Foreign death tax credit—the decedent owned real property in a foreign country and paid death taxes to that country. • Unified credit of $5,113,800 for 2023.

C:13-3

Incidentally, through 2004, estates were allowed a state death tax credit if the estate paid estate or inheritance taxes to the state. The only credit available for gift tax purposes is the unified credit, which is $5,113,800 for 2023. pp. C:13-23 through C:13-25. C:13-22 The tax policy reason for allowing installment payments of estate taxes attributable to interests in closely held businesses is to reduce the likelihood that some or all of the business would have to be sold to pay the estate taxes. pp. C:13-28 and C:13-29. C:13-23 Because of the unlimited marital deduction, the timing does not matter for transfer tax purposes, but it does for income tax purposes. The unlimited marital deduction for gift and estate tax purposes causes the transfer tax results to be neutral. From an income tax perspective, however, a transfer at death is preferable to an inter vivos transfer because a step-up in basis for appreciated property occurs only for transfers at death. On the other hand, if the asset is not depreciable and/or if it probably will not be sold, basis is a moot point. p. C:13-32. C:13-24 The advantage of freezing values by removing post-gift appreciation from the transfer tax rolls will be most dramatic if Bala makes a gift of the life insurance policy (provided he survives the transfer by more than three years). The next best items to transfer are the stock in the firm with a “bright” future and the land in a “boom town” because these assets have a high potential for appreciation. The cash will not appreciate. With interest rates rising, the value of the bonds can be expected to decline. p. C:13-34. C:13-25 If Bala dies within three years of giving away the insurance policy, the policy will be included in his gross estate. This result, however, is no worse than if he had not made the transfer. The chance for a step-up in basis for the stock and land will be lost if Bala makes gifts of these assets. If Bala incurs a gift tax liability for a transfer of any of these properties and dies within three years of the transfer, his gross estate will be “grossed up” by the gift taxes, but, of course, his cash balance will be lower because of the taxes he paid. Thus, the gross-up balances out the lower cash account. p. C:1334. C:13-26 Disposing of an amount equal to the basic exclusion amount to persons other than one’s spouse allows the decedent’s estate to make full use of the unified credit and prevents such property from being taxed in the surviving spouse’s estate. Note that the new portability rule allows the executor for a decedent who did not use all of his or her basic exclusion amount ($12.92 million in 2023) to elect to have the unused amount transferred to the surviving spouse. Therefore, even if the decedent transferred his or her entire estate to the surviving spouse, because of portability, he or she would not have wasted his or her unified credit. p. C:13-32. C:13-27 In general, the estate tax is due by the due date for the estate tax return, which is nine months after the date of death. An extension of up to one year is available to pay the estate taxes. See Sec. 6161(a)(1). For reasonable cause, the Secretary may grant an extension of up to ten years. See Sec. 6161(a)(2). The estate qualifies for installment payments automatically if a large enough portion of the estate consists of an interest in a closely held business. See Sec. 6166. pp. C:13-27, C:13-28, and C:13-35.

C:13-4

Issue Identification Questions C:13-27 • • • •

Will Henry make a gift if he purchases the land and titles it in joint tenancy form? What portion of the land will be in Henry’s gross estate? (Stated differently, will using this form of ownership reduce his estate taxes?) Are there any other estate tax implications? What are the generation-skipping transfer tax implications?

At the time of purchase, Henry will make a gift to his grandson of $7 million, half the land’s cost. Because Henry provided all the consideration, under the consideration-furnished test of Sec. 2040, Henry’s gross estate will include 100% of the land’s date of death value. This strategy will not reduce his estate tax liability. The gift will be so large that gift taxes will be owed. Thus, if Henry dies within three years of acquiring the land, there will be a gross-up under Sec. 2035 for the gift taxes he paid. Fortunately, such gift taxes will be subtracted to determine his estate tax payable regardless of how long he survives. The grandchild is two generations younger than Henry and, thus, is a skip person. Generation-skipping transfer tax will be owed in addition to the gift and estate taxes. The amount of the transfer exceeds the GSTT exemption amount of $12.92 million (in 2023). pp. C:13-10, C:1311, C:13-14, C:13-15, C:13-30, and C:13-31. C:13-28 •

Should Dave consider making a disclaimer? If so, of how much?

At first blush, it appears that, unless Dave makes a disclaimer, Annie’s estate will waste its basic exclusion amount of $12.92 million. Thus, it seems Dave should disclaim at least $12.92 million to allow Annie’s estate to make use of her entire unified credit. Because Dave is in poor health (and likely has a short life expectancy), already has property of about $5 million, and any additional inclusion in his estate will be taxed at 40%, general advice is that he should consider disclaiming some amount exceeding $12.92 million to allow some of the property in Annie’s taxable estate to have tax (before the unified credit) calculated at rates below 40%. However, the top rate of 40% will apply to tax bases exceeding $1 million. Note that Dave cannot be forced to make a disclaimer. If Dave does not disclaim, Annie’s executor can elect to let Annie’s unused basic exclusion amount be used by Dave under the portability rule. Thus, because portability will allow $12.92 million basic exclusion to shift to Dave, increase his basic exclusion amount, and reduce his estate tax liability, Dave should consider disclaiming only a small portion of the $13.3 million he otherwise would receive. The property included in Dave’s estate will get a basis step up (or step down) at his death. The basis step-up will be especially important if the property’s value appreciates substantially between Annie’s death and Dave’s death. p. C:13-34. C:13-29 In this alternative scenario, the issue is what marital deduction (if any) should be claimed on the trust? The executor can elect to forego the marital deduction on all or a portion of the QTIP trust. The QTIP trust is a more flexible arrangement because the executor can affect the size of the marital deduction through a partial QTIP election or foregoing the election, whereas with the outright bequest the amount of the marital deduction will be altered only if Dave is willing to make a disclaimer. Even if a partial QTIP (or no) election is made, Dave will receive 100% of the trust income. If the executor does not forego the marital deduction, the portability rule, discussed in Copyright © 2024 Pearson Education, Inc.

C:13-5

Problem C:13-29, can benefit the couple by allowing Annie’s unused basic exclusion to shift to Dave. pp. C:13-17, C:13-20 through C:13-22, and C:13-33. C:13-30 • • • •

What deductions will Jeung’s estate receive? Where should the administrative expenses be deducted? What is the amount of his taxable estate and estate tax base? Has Jeung made any prior taxable gifts? If so, did he make any within three years of death?

Jeung’s estate will receive a $60,000 deduction for the debts, a $200,000 deduction for the charitable bequest, and up to a $75,000 deduction for the administration expenses. After deducting the debts and the charitable contribution, Jeung’s taxable estate is $14.24 million ($14,500,000 $260,000). Thus, potentially all of the $75,000 of administrative expenses should be deducted on the estate tax return because the marginal estate tax rate is 40%, which is slightly greater than the estate’s 37% top income tax rate, ignoring the 3.8% tax on net investment income. If Jeung made no taxable gifts, Jeung’s taxable estate and estate tax base will be $14,165,000 ($14,240,000 - $75,000) if the administrative expenses are deducted on the estate tax return. pp. C:13-18 through C:13-20.

Problems C:13-31 a. b. c. d.

$110,000 = 4,000 shares x [0.50 x ($30 + $25)] $600,000 $14,920 = $14,000 + $920 $175,000

pp. C:13-6 and C:13-7. C:13-32 Gross estate and taxable estate (using alternate valuation date) Tentative estate tax Minus: Unified credit Estate tax due

$15,800,000 $ 6,265,800 ( 5,113,800) $ 1,152,000

Mary’s estate can use the alternate valuation date because electing this valuation date results in a lower gross estate and lower estate tax payable. pp. C:13-7 and C:13-8. C:13-33 a.

A donor’s gross estate is increased by any gift tax that she or her estate pays on any gift the decedent or her spouse makes during the three-year period ending with the decedent’s death. If Sue’s date of death was within three years of the gift—the threeyear period beginning October 1, 2019, and ending September 30, 2022—then the gross-up rule would apply. In this case, however, it has been more than three years, so none of the gift tax is included in Sue’s estate.

C:13-6

If the date of death was within three years of this gift, the following calculation would be appropriate: The annual exclusion for 2019 was $15,000, making the taxable gift $17 million. Tax on this amount was $345,800 + 40% x ($17,000,000 - $1,000,000) = $6,745,800. Inclusion in gross estate under gross-up rule was ($6,745,800 tax on the 2019 $17 million taxable gift - $4,505,800 unified credit) = $2,240,000. b.

Adjusted taxable gifts ($17,015,000 - $15,000 annual exclusion amount in 2019) = $17,000,000.

p. C:13-11. C:13-34 a. $400,000 (date of death value of the policy) because the gift of a life insurance policy was made within three years of death. b. No amount is included in the gross estate because the property given away within three years of dying was land instead of life insurance and because Val retained no interest in or powers over the land. c. No amount is included in the gross estate because the transfer of the insurance policy arose more than three years before Val’s death. pp. C:13-10 and C:13-11. C:13-35 $1,808,000 is included in the gross estate and $16.1 million is the amount of the adjusted taxable gift. The amount included in Jody’s gross estate is just the gross-up amount of the gift tax paid because the gift property would not have been included under Secs. 2036-2038 or Sec. 2042 had the property not been transferred. The adjusted taxable gift amount is $16.1 million, the amount of the post-1976 taxable gifts (after considering the $15,000 2020 annual exclusion) valued at date of gift values. pp. C:13-10 and C:13-11. C:13-36 $1,808,000 is included in the gross estate and $16.1 million adjusted taxable gift. The amount included in Kate’s gross estate is the gross-up amount of $1,808,000 gift taxes she paid. In no event would the transferred property be included in her gross estate because she is not the actual transferor. Kate’s adjusted taxable gift amount is $16.1 million, the amount of her post-1976 taxable gifts (after considering gift splitting and the $15,000 2020 annual exclusion), valued at date of gift values. pp. C:13-10 and C:13-11. C:13-37 a. $480,000 (Sec. 2038 – the trust is revocable) b. $230,000 (Sec. 2036 – retention period did not in fact end before his date of death) c. None (Sec. 2036 – does not apply because he did not keep control or economic benefits, and 2038 does not apply because he kept no control.) d. None because he kept no control or benefits and the trust is irrevocable (Secs. 2036 and 2038 do not apply). pp. C:13-11 through C:13-13. C:13-38 a. $68,884 [0.34442 (Life Table, Age 50, Appendix G) x $200,000] because Latoya’s power to alter or amend the trust extends to only the remainder interest, following the life of a person (Al) age 50. b. None, because she retained no income or powers. pp. C:13-11 and C:13-12. Copyright © 2024 Pearson Education, Inc.

C:13-7

C:13-39 a. None for the first annuity and $110,000 for the second annuity. Annuity purchased by Maria’s father--No inclusion because Maria did not furnish any consideration. Annuity purchased by Maria’s employer--$110,000 is included because the employer’s contributions are treated as Maria’s. b. $45,000 greater inclusion. The nonemployer annuity also would be included here because Maria purchased it. The amount includible for it is $45,000. c. No change. $110,000 still would be included. The employer’s contributions are treated the same as Maria’s. pp. C:13-13 and C:13-14. C:13-40 a. $300,000 (100% x $300,000); Art provided all the consideration. b. $0 (0.0 x $300,000); Bart furnished no consideration. c. $320,000 under Sec. 2033 because Bart owned the property outright after Art’s death and Sec. 2040 no longer applies. pp. C:13-14 and C:13-15. C:13-41 $150,000 [($50,000/$150,000) x $450,000] because Andy provided one-third of the consideration. However, Andy’s executor needs proof that Andy’s contribution was less than 100%. pp. C:13-14 and C:13-15. C:13-42 a. $100,000 (0.50 x $200,000) because of the automatic 50% inclusion (spousal rule). b. $100,000 (the amount included) because the property passes to Mr. Cobb, the survivor. c. $240,000 under Sec. 2033 because he became the owner in fee simple after Mrs. Cobb’s death. pp. C:13-14 and C:13-15. C:13-43 a. No, because Tai has only a special power of appointment. He can designate only his descendants to receive the property. b. Yes, because Tai has a testamentary general power of appointment. He does not need to have a lifetime power also. c. No, because Tai did not have a general power. His lifetime powers are governed by the ascertainable standard, and he has no testamentary powers. d. No, because Tai did not exercise this pre-1942 general power of appointment. e. Yes, because this is a post-1942 general power of appointment, and it does not matter whether Tai exercised it or not. pp. C:13-15 and C:13-16. C:13-44 Policy Number 123 757 848 414

Amount included (ignoring any marital deduction) $400,000 because Joy is the owner $225,000 because Joy’s estate is the beneficiary $0 because the estate was not the owner or beneficiary and because Joy gave away the policy more than three years before death $175,000 because Joy gave the policy to her daughter within three years of her death

pp. C:13-16 and C:13-17.

C:13-8

C:13-45 $225,000 net addition. The net addition to the taxable estate is $225,000 because of policy No. 757, where the estate is the insurance beneficiary and her son is the policy owner. Policy No. 123 generates a $400,000 marital deduction and, thus, does not increase the taxable estate. Policy No. 414 generates a $175,000 marital deduction, so it does not increase the taxable estate either. Policy No. 848 generates a zero net addition because it is not in the gross estate, as stated in the solution to Problem C:13-45. pp. C:13-16, C:13-17, and C:13-20 through C:13-22. C:13-46 $12,668,000 taxable estate, calculated as follows: Gross estate Minus: Debts Funeral expenses Administration expenses Charitable contribution deduction Marital deduction Taxable estate

$16,000,000 ( 300,000) ( 12,000) ( 120,000) ( 800,000) (1,100,000) $13,668,000

pp. C:13-18 through C:13-22. C:13-47 a.

Taxable estate before marital deduction (from C:13-47) Minus: Marital deduction Taxable estate

QTIP with 100% Marital Deduction Election $14,768,000 (1,500,000) $13,268,000

QTIP without 100% Marital Deduction Election $14,768,000 (1,100,000) $13,668,000

Note: Other possibilities include claiming a marital deduction for some fraction of the QTIP trust, whereupon in Part b such fraction would be in the surviving spouse’s gross estate. Note that the portability rule would not apply because, even with the QTIP election, Yuji’s taxable estate exceeded the $12.92 million basic exclusion amount. b. With QTIP election: the $1.1 million of property willed to Yuji’s wife outright, valued as of her date of death, and the QTIP trust, also valued as of her date of death. Without QTIP election: the $1.1 million of property, valued as of her date of death. pp. C:13-20 through C:13-22.

C:13-9

C:13-48

Yuji’s taxable estate (from the previous problem)

QTIP with 100% Marital Deduction Election $ 13,268,000

$13,668,000

Yuji’s tentative estate tax (2023) Minus: Unified credit (2023) Estate tax due

$ 5,253,000 ( 5,113,800) $ 139,200

$ 5,413,000 ( 5,113,800) $ 299,200

324,000 432,000 1,188,000 $ 1,944,000

$ 723,400 ( 5,113,800) $ -0-

$ 550,600 ( 5,113,800) $ -0-

Wife’s gross estate:a Her own property ($300,000 x 1.08) QTIP trust ($400,000 x 1.08) Property received outright from Yuji ($1,100,000 x 1.08) Gross and taxable estate Wife’s tentative estate tax (2023) Minus: Unified credit (2023) Estate tax due

Yuji’s estate tax $ Plus: Wife’s estate tax Total tax for the couple $ a The value of each asset increased by 8% from the basic facts.

139,200 -0139,200

QTIP without 100% Marital Deduction Election

324,000 -01,188,000 $ 1,512,000

$ $

299,200 -0299,200

Claiming a 100% marital deduction on the $400,000 QTIP results in a lower overall tax by $160,000 ($299,200 - $139,200). In addition, it minimizes the taxes due upon Yuji’s death. The surviving spouse’s estate does not owe any estate tax regardless of whether Yuji’s estate forgoes the marital deduction on the QTIP trust because of the large unified credit in 2023. Note that, if the order of the two deaths had been reversed, the portability rule would have allowed Yuji’s estate to benefit from his spouse’s large unused unified credit. pp. C:13-20 through C:13-22, C:13-32 through C:13-34. C:13-50 Sam’s basic exclusion amount was $11.58 million as he died in 2020. For portability purposes, the amount, once elected, is not indexed. a. $8.28 million. Sam’s tax base is $3.3 million ($7,000,000 - $3,700,000). His unused basic exclusion amount, the amount portable to Janet, is $8.28 million ($11,580,000 - $3,300,000). The amount portable to Janet, once calculated, is not adjusted for inflation in later years. b. $5.68 million. Sam’s tax base is $5.9 million ($7,000,000 - $1,100,000). His unused basic exclusion amount, the amount portable to Janet, is $5.68 million ($11,580,000 - $5,900,000). c. None. Sam’s tax base is $1.5 million ($7,000,000 - $5,500,000). His unused basic exclusion amount, the amount tentatively portable to Janet, is $10.08 million ($11,580,000 $1,500,000). However, portability applies for a surviving spouse only with respect to her last deceased spouse, in this case, her new spouse. Her new spouse has no unused amount because his taxable estate is $13 million, in comparison with a $12.92 million tax-free amount for 2023. Janet cannot use Sam’s unused basic exclusion amount because he is not her last deceased spouse. p. C:13-24. Copyright © 2024 Pearson Education, Inc.

C:13-10

C:13-51 a.

Gross estate and taxable estate Plus: Adjusted taxable gifts Estate tax base

$15,000,000 360,000 $15,360,000

b. $15.09 million tax base. The adjusted taxable gifts would be only $90,000 because Will made the first gift before January 1, 1977. Thus, the estate tax base would be $15.09 million. p. C:13-23. C:13-52 a.

$13.16 million estate tax base, calculated as follows: Gross estate Minus: Deductions Taxable estate Plus: Adjusted taxable gifts (from 2017) Estate tax base

$12,500,000 ( 80,000) $12,420,000 740,000 $13,160,000

The gift of the life insurance policy is not an adjusted taxable gift because the gift is included in the gross estate (under the three-year rule). The facts indicate the size of the gross estate is $12.5 million, which should be interpreted to include the gross up, if any, and the $100,000 life insurance policy. However, no gross up is included here because the unified credit reduced the gift tax on the gift of the insurance policy to zero. b. $5,113,800. Her estate will subtract a unified credit of $5,113,800, the 2023 amount. The amount to subtract for the credit is not reduced by any credit claimed for gift tax purposes. pp. C:13-23 through C:13-25. C:13-53 $13.96 million estate tax base, calculated as follows: Gross estate Minus: Section 2053 deductions Charitable contribution deduction Marital deduction Taxable estate Plus: Adjusted taxable gifts (from 1999) Estate tax base

$17,200,000 $ 100,000 200,000 3,440,000

C:13-11

(3,740,000) $13,460,000 500,000 $13,960,000

C:13-54 $728,050 estate tax payable, calculated as follows: Taxable estate Plus: Adjusted taxable gifts (from 2000) Estate tax base

$14,100,000 650,000 $14,750,000a

Estate tax before subtraction of the unified credit Minus: Unified credit Post-1976 gift taxes Estate tax payable

$5,845,800 (5,113,800) (3,950)b $ 728,050

The basic exclusion amount portable to his spouse is zero because his estate tax base exceeded the basic exclusion amount of $12.92 million. b

The tax payable on the $650,000 gift in 2000 was $224,500 ($248,300 - $23,800 tax on $100,000), less the $220,550 unified credit available that year, or $3,950. C:13-55 a. 49.27%. The adjusted gross estate (gross estate minus Sec. 2053 and Sec. 2054 deductions) is $12.99 million ($40,000 + $4,200,000 + $2,550,000 + $6,400,000 - $200,000). The estate tax payable in installments is 49.27% ($6,400,000/$12,990,000) of the tax liability. The first installment is due not later than February 1, 2029, five years after the due date for the estate tax return. b. No. The adjusted gross estate is $18.99 million ($40,000 + $10,200,000 + $2,550,000 + $6,400,000 - $200,000). In this case, the closely held business interest makes up only 33.7% ($6,400,000/$18,990,000) of the adjusted gross estate. Therefore, the estate is not eligible for the Sec. 6166 deferral. pp. C:13-28, C:13-29, and C:13-34. C:13-56 $13,859,800 estate tax base, calculated as follows: Gross estate Minus: Debts State death taxes Taxable estate Plus: Adjusted taxable gifts Estate tax base

$13,900,000 ( 30,000) ( 110,200) $13,759,800 100,000 $13,859,800

Note that, since 2005, state death taxes generate a deduction instead of a credit. p. C:13-23.

C:13-12

Comprehensive Problems C:13-57 a.

c. d. e. f.

Checking account Savings account Stock--joint tenancy (nonspousal, consideration-furnished test) Land--joint tenancy (spousal, automatic 50% inclusion) Residence Life insurance Trust under mother’s will- general power of appointment Gross-up on 2020 gift Gross estate Gross estate Minus: Debts Funeral and administration expenses Charitable contribution deduction Marital deduction: Residence QTIP trust Joint tenancy land State death taxes Taxable estate Adjusted taxable gifts (from 2020) Taxable estate Plus: Adjusted taxable gifts Tax base (no basic exclusion is portable) Tentative tax on estate tax base Tentative tax on estate tax base Minus: Unified credit Post-1976 gift tax Federal estate tax payable

199,750 430,000 25,000 180,000 450,000 5,000,000 9,000,000 668,000a $ 15,952,750 $ 15,952,750 ( 60,000) ( 80,000) ( 47,000) ( 450,000) ( 250,000) ( 180,000) ( 65,000)b $ 14,820,750 $ 13,250,000 $14,820,750 13,250,000 $ 28,070,750 $ 11,174,100 $ 11,174,100 (5,113,800) ( 668,000)a $ 5,392,300

$668,000 ($5,245,800 taxes on the 2020 $13.25 million taxable gift - $4,577,800 gift tax unified credit for 2020) was the actual gift tax paid. The Tax Relief Act limits the amount to be subtracted to what the gift tax would have been at date of death rates minus what the credit would have been at the date of death rate. Here, the rates are the same, so you can subtract the tax actually paid ($668,000). b Beginning in 2005 the state death credit was replaced with a deduction. pp. C:13-23 through C:13-27.

C:13-13

C:13-58 a. $15,970,750 gross estate. The only difference in the gross estate is that the inclusion for the joint tenancy land is $198,000 (0.55 x $360,000) instead of $180,000. Thus, the gross estate is valued at $15,970,750 [$15,952,750 + ($198,000 - $180,000)]. b. There is no marital deduction for the land because the son is the other joint tenant. The executor does not elect the marital deduction for the trust. Thus, the marital deduction does not include the $180,000 and $250,000 amounts shown in Problem C:13-57. Gross estate Minus: Debts Funeral and administration expenses Charitable contribution deduction Marital deduction--residence State death taxes Taxable estate c. Adjusted taxable gifts d. Taxable estate Plus: Adjusted taxable gifts Tax base (no basic exclusion amount is portable) e. Tentative tax on estate tax base f. Tentative tax on estate tax base Minus: Unified credit Post-1976 gift tax Estate tax payable pp. C:13-23 through C:13-27.

C:13-14

$15,970,750 ( 60,000) ( 80,000) ( 47,000) ( 450,000) ( 65,000) $15,268,750 $ 13,250,000 $15,268,750 13,250,000 $28,518,750 $ 11,353,300 $ 11,353,300 (5,113,800) ( 668,000) $ 5,571,500

Tax Strategy and Critical Thinking Problems C:13-59

Cash Land Stock Gross estate, taxable estate, estate tax base

Using Date of Death Fair Market Value $10 ,900,000 1,000,000 2,000,000 $13,900,000

Using Alternate Valuation Date Value $10,900,000 1,100,000 1,600,000 $13,600,000

Tax before unified credit Minus: Unified credit Estate tax payable

$ 5,505,800 ( 5,113,800) $ 392,000

$ 5,385,800 ( 5,113,800) $ 272,000

Gain on sale of stock: Sales price ($1,600,000 x 1.677) Minus: Adjusted basis Gain

$ 2,683,200 ( 2,000,000) $ 683,200

$ 2,683,200 ( 1,600,000) $ 1,083,200

Tax on gain at 23.8% (20% + 3.8%) (the assumed rate in 2028) After-tax wealth: Cash Minus: Amount paid for estate taxes Plus: Land (no appreciation after 7/11) Sales proceeds from sale of stock Minus: Tax on gain After-tax wealth

162,602

$10,900,000 ( 392,000) 1,100,000 2,683,200 ( 162,602) $14,128,598

257,802

$10,900,000 ( 272,000) 1,100,000 2,683,200 ( 257,802) $14,153,398

Because of the lower estate taxes, after-tax wealth is $24,800 ($14,128,598 - $14,153,398) higher six years hence if the executor elects alternate valuation date even though the election results in higher income taxes being owed. The difference in after-tax wealth would be even greater with the alternate valuation date election if we assumed that the estate invested the cash left after paying estate taxes. Thus, the executor should elect the alternate valuation date. Note that, because Gilda does not plan to sell the land, the basis of the land is not relevant in this scenario.

C:13-15

C:13-60 Pass on at death Gross estate: Cash Hyteche stock Total Deductions Taxable estate and estate tax base Tax Less: Unified credit Estate tax Total transfer tax Give now Taxable gift ($8,000,000 - $16,000) Tax Less: Unified credit Gift tax

$ 9,000,000 10,000,000 $19,000,000 -0$19,000,000 $ 7,545,800 ( 5,113,800) $ 2,432,000 $ 2,432,000 $ 7,984,000 $ 3,139,400 ( 5,113,800) $ -0-

Gross estate: Cash ($9,000,000 - $0 gift tax paid) Gross up Total Deductions Taxable estate Adjusted taxable gifts Estate tax base

$ 9,000,000 -0$ 9,000,000 -0$ 9,000,000 7,984,000 $16,984,000

Estate tax: Less: Unified credit Post-1976 gift tax Estate tax

$ 6,739,400 ( 5,113,800) ( -0-) $ 1,625,600

Total transfer tax

$ 1,625.600

Thus, the total transfer tax is $806,400 ($2,432,000 - $1,625,600) lower with giving the stock now and thus freezing its value. This savings happens by freezing the value of the stock and keeping $2 million of appreciation off the tax rolls, plus saving taxes on the $16,000 excluded gift. [Proof: ($2,000,000 + $16,000) x 0.40 = $806,400] Of course, giving the stock results in the loss of the basis step up, mentioned as not important here.

C:13-16

C:13-61 Matt’s estate will owe $1,432,000 and Nancy’s zero if Nancy disclaims. If she does not disclaim, Matt’s estate will owe zero and Nancy’s will owe $264,000. Not disclaiming will involve a lower outflow for estate taxes and an even lower outflow after considering present values as Matt has already died, and Nancy is still living.

Matt’s gross estate Marital deduction Taxable estate and tax base

Nancy Disclaims $16,500,000 -0$16,500,000

Matt’s estate tax after $5,113,800 unified credit

$ 1,432,000a

-0-

Basic exclusion amount portable to Nancy

-0-b

$12,920,000

Nancy’s gross estate Deductions, minimal (so ignore) Nancy’s taxable estate and tax base

$10,000,000 -0$10,000,000

$26,500,000c -0$26,500,000

Nancy’s estate tax after unified credit, giving consideration to basic exclusion amount, if any, portable to Nancy

-0-d

Nancy Does Not Disclaim $16,500,000 (16,500,000) $ -0-

264,000e

($345,800 + 0.4 x $15,500,000) – $5,113,800. Zero because his estate tax base exceeds $12.92 million. c $16,500,000 + $10,000,000. d Her tax base in 2023 does not exceed her $12.92 million basic exclusion amount, so her estate owes no tax even without the benefit of any amount portable to her, which is zero here. e Her tax base in 2023 exceeds her $12.92 million basic exclusion amount plus the $12.92 million amount portable to her. Her estate tax on $26.5 million is $10,545,800 before the unified credit. She receives the equivalent of two basic exclusion amounts of $12.92 million each because of the $12.92 million portable from Matt. This total of $25.84 million is referred to on the Form 706, line 9.d. as the applicable exclusion amount. From the $10,545,800 estate tax before unified credit, deduct the tentative tax on the $25,840,000 applicable exclusion amount. This amount is $10,281,800 [$345,800 + (0.40 x $24,840,000)]. Thus, Nancy’s estate tax payable is $264,000 ($10,545,800 - $10,281,800). b

If she does disclaim, the property will go to the children in equal shares, which is consistent with the results under her current will. If she decides to disclaim, she needs to be sure to do so in writing within nine months of Matt’s date of death so that she will avoid making a gift.

C:13-17

Case Study Problems C:13-64 Hal’s gross estate is quite large, exceeding the basic exclusion amount by a significant amount. Thus, the estate will owe estate taxes potentially (and actually under the current facts). Hal’s spouse Winona is not a U.S. citizen (and apparently does not want to become one). Therefore, in general, Hal’s estate will not receive a marital deduction for property his spouse will receive upon his death unless he revises his will and disposes of the property he would like for her to receive to a qualified domestic trust (QDT). Because Hal does not spend any time at the Vail cabin, he should consider giving it to Halbert soon if he thinks its value will substantially increase. If a nonresident alien becomes a stockholder in an S corporation, the corporation will lose its qualification for S status. Given that Winona (an Australian citizen) has expressed an interest in returning to Australia, Hal should consider disposing of the Dolrah stock to a person (or persons) other than Winona and perhaps leaving most of his stock portfolio to Winona instead of Halbert, Jr. Hal’s will treats the children equally, but they are not being treated equally in terms of the aggregate amount received by gift and to be received at Hal’s death. Julianna will receive more than Gina because of her joint tenancy interest in the mutual fund that will pass down to her by survivorship. If Hal gives the cabin to Halbert, Halbert will receive assets with a total value exceeding the value of what Julianna and Gina will receive. Hal does not have any life insurance, but perhaps his cash and the publicly traded stocks will provide sufficient liquidity. If Hal decides he needs some life insurance, he should consider having a trust or one of his children buy the policy so that it will not be in his gross estate under either Sec. 2042 or Sec. 2035. To avoid a Sec. 2042 inclusion, his estate should not be the beneficiary of the policy. The estate tax attributable to the stock in Harold’s Hammocks will not qualify for installment payments because it does not represent a large enough portion of his adjusted gross estate. This situation probably cannot be changed because of the relatively low value of the stock. Generation-skipping transfer taxes will not be owed despite the large transfer to the grandchild Halbert, Jr. because the amount does not exceed the tax-free amount. Other grandchildren (if there are any) are not receiving any property. Your supervising partner should ask Hal whether this is a result he deliberately wants to accomplish. C:13-65 The Statements on Standards for Tax Services (SSTSs), updated April 30, 2018, are enforceable as part of the AICPA’s Code of Professional Conduct. Statement No. 3, Para. 2 states “a member may in good faith rely, without verification, on information furnished by the taxpayer or by third parties. However, a member should not ignore the implications of information furnished and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the member. Further, a member should refer to the taxpayer’s returns for one or more prior years whenever feasible.” SSTSs are not limited to federal income tax practice; thus, they would apply in this scenario. Copyright © 2024 Pearson Education, Inc.

C:13-18

Section 6694 (concerning tax return preparers) applies not only to income tax returns but also to estate and gift tax returns. Section 10.34(d) of Treasury Department Circular 230, which addresses the practice of CPAs (and others) before the Internal Revenue Service, has a provision about reliance on information that clients furnish. It states that, in general, the preparer may rely on information that the client furnished. It adds, however, that the practitioner may not ignore the implications of information received or what the practitioner already knows from other sources. In addition, the practitioner must make “reasonable inquiries” if the information received appears to be incorrect, inconsistent, or incomplete. Because of your familiarity with real estate values and “gut” feeling that the appraisals may have understated the values, you should speak with the executor and suggest obtaining appraisals from another appraiser. Section 10.37(b) of Treasury Circular 230 states, “A practitioner may only rely on the advice of another person if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when … [t]he practitioner knows or reasonably should know that the opinion of the other person should not be relied on …” Section 6662(g), in connection with Secs. 6662(a) and 6662(b), provides for the imposition of an undervaluation penalty at the rate of 20% if the value shown on the return is 65% or less of the “correct” value (as determined in an audit or a court proceeding). Under Sec. 6662(h), the penalty rises to 40% if the value shown on the return is not at least 40% of the correct value. The IRS will not levy the penalty, however, if the taxpayer demonstrates good faith and reasonable cause for the valuation shown on the return.

Tax Research Problems C:13-66 No. The IRS is correct in disallowing the deduction. Unfortunately, under the IRC, Arthur’s good deeds should be “rewarded” with a zero charitable contribution deduction on his estate tax return because the trustee failed to abide by the terms of the trust and actually make the annuity payments to Arthur. These facts are about the same as those in Estate of Atkinson, 90 AFTR 2d 2002-6845, 2002-2 USTC ¶60,449 (11th Cir. 2002), cert. denied, affirming 115 T.C. 26 (2000), where annuity payments were not made until after the death of the annuitant. Because the trust did not make the annuity payments, it did not comply with the requirement for classification as a CRAT to distribute at least 5% of the original value of the trust. The court stated, “To preserve the estate’s ability to claim a charitable deduction for a remainder interest in property, the trust must not only be set up as a CRAT, but it must also comply with the CRAT statutory requirements from its formation to the final disposition of the trust’s assets.” C:13-67You have good news for your manager and Amber’s estate. Revenue Procedure 2001-38, 2001-1 C.B. 1335, addresses scenarios where the marital deduction was claimed for a trust eligible for QTIP treatment in the estate of the first spouse but the election did not result in estate tax savings for that estate. In other words, in the absence of the election, the first estate would have owed no estate taxes. The wording of the procedure indicates that it “provides relief for surviving spouses and their estates.” In the absence of claiming a marital deduction for the trust, Jasper’s taxable estate would have been $1.43 million ($3,000,000 gross estate - $120,000 Sec. 2053 deductions - $450,000 marital deduction for residence - $1,000,000 marital deduction for life insurance). For 2008, the year Jasper died, the exemption equivalent (now called basic exclusion amount) was $2 million. Without electing the marital deduction for the trust, the taxable estate would not have exceeded the Copyright © 2024 Pearson Education, Inc.

C:13-19

exemption equivalent. Thus, Amber’s estate qualifies for the relief under this revenue procedure, which nullifies a QTIP election where the election was not necessary to reduce the estate tax liability to zero. Revenue Procedure 2016-49, 2016-42 I.R.B. 462, modifies and supersedes Rev. Proc. 200138. The IRS took this action to address situations where making the QTIP election was not necessary to reduce the estate tax liability but electing QTIP treatment would increase the unused basic exclusion amount under the portability rules. (Amber died before 2011, the date the portability rules arose.) The 2016 revenue procedure treats QTIP elections as void if: 1. 2. 3.

The Federal estate tax liability was zero, regardless of the QTIP election; The executor did not make and was not considered to have made the portability election; and The procedural requirements of the Rev. Proc. 2016-49 (including filing a supplemental Form 706) are satisfied.

The usual inclusion rules of Sec. 2044 will not apply here, and the trust will not have to be included in Amber’s gross estate. The search term “unnecessary QTIP election,” for example, will find the 2001 revenue procedure. C:13-68 As decided in Estate of Sower,149 T.C. 279 (2017), despite the receipt by August Couch’s estate of the Estate Tax Closing Document (which is not the same as a Closing Agreement), information reported on his estate tax return is not “cast in stone” in his situation. The estate improperly did not take into consideration $1 million of taxable gifts that August made in the calculation of his unused basic exclusion amount. The closing agreement for August’s estate can be reopened because there was a “misrepresentation of a material fact” (failure to take $1 million of taxable gifts into consideration in calculating the DSUE). Thus, the amount elected as portable to his widow June is overstated by $1 million, the amount of August’s 2014 taxable gifts. The correct portable amount is $1.33 million. If June’s estate tax base exceeds $14.25 million ($12,920,000 + $1,330,000), June’s estate will owe some estate taxes. Regulation Sec. 20.2010-2(d) provides “[T]he IRS may examine returns of a decedent in determining the decedent's DSUE amount, regardless of whether the period of limitations on assessment has expired for that return. See Reg. Sec. 20.2010-3(d) for additional rules relating to the IRS's authority to examine returns.” Regulation Sec. 2010-3(d) provides “[F]or the purpose of determining the DSUE amount to be included in the applicable exclusion amount of a surviving spouse, the Internal Revenue Service (IRS) may examine returns of each of the surviving spouse's deceased spouses whose DSUE amount is claimed to be included in the surviving spouse's applicable exclusion amount, regardless of whether the period of limitations on assessment has expired for any such return. The IRS's authority to examine returns of a deceased spouse applies with respect to each transfer by the surviving spouse to which a DSUE amount is or has been applied. Upon examination, the IRS may adjust or eliminate the DSUE amount reported on such a return of a deceased spouse. However, the IRS may Copyright © 2024 Pearson Education, Inc.

C:13-20

assess an additional tax on that return only if that tax is assessed within the period of limitations on assessment under Sec. 6501 applicable to the tax shown on that return.” The statute of limitations for August’s estate tax return has expired. Consequently, the IRS cannot assess an additional estate tax, if any, attributable to the fact that August’s estate tax return incorrectly omitted $1 million of adjusted taxable gifts. You should address these points in the memo to your manager. C:13-69 This scenario is similar to the facts of Estate of Franklin Z. Adell, et al., T.C. Memo 2014155. In that case, an adult son of the decedent, Mr. Adell, was very important to the corporation whose stock is owned by a trust funded by Mr. Adell. The Tax Court decided that the valuation of the stock should take into account the personal goodwill of the son because the son “was free to leave” the firm and “use his relationships to directly compete against his previous employer.” The son was not bound by an employment agreement or a covenant not to compete. The value of the son’s personal goodwill reduced the value that the stock would otherwise have. Your memo should address these facts and conclude that the appraisal should reflect the negative effect on the stock’s value of the absence of an employment agreement and a covenant not to compete. C:13-70 a. Philip executed his will in October 2004, at which time he had only one child, Cooper. b. His will names Marianne O’Donnell to receive all of his property. She is referred to as his longtime companion, and they were not spouses at the time of Philip’s death. c. His estate will not receive a marital deduction because he did not leave property to a spouse. If New York recognizes common law marriages, an argument could be made that they had a common law marriage, whereupon the property passing to Marianne would qualify for a marital deduction. d. The will does provide for a disclaimer. Any disclaimed property would pass to a trust with son Cooper as the only beneficiary. Under the trust, Cooper would receive half the property outright at age 25 and the other half at age 30. e. The beneficiary of the insurance policy would receive the insurance proceeds. Unless the policy listed “my estate” as the policy beneficiary, the proceeds would pass outside the will to the named beneficiary. Thus, one does not learn the full details about the recipients of his property because Hoffman may have had non-probate property. C:13-71 Section 2-102 of the Uniform Probate Code addresses intestate succession. It provides that, if the decedent has no surviving parent or descendants, and a spouse survives the decedent, the surviving spouse’s share is the entire intestate estate. C:13-72 The instructions to Form 8971, Page 4, first column, address this type of situation. According to the instructions, “If the executor hasn’t determined which beneficiary is to receive an item of property as of the due date of the Form 8971 . . ., the executor must list all items of property that could be used, in whole or in part, to fund the beneficiary’s distribution on that beneficiary’s Schedule A. (This means that the same property may be reflected on more than one Schedule A.)” Incidentally, each beneficiary receives a separate Schedule A that reports only those assets he or she received or potentially may receive. A cash bequest does not have to be reported on Schedule A because basis is a moot issue for cash. Copyright © 2024 Pearson Education, Inc.

C:13-21

“What Would You Do In This Situation?” Solution Ch. C:13, p. C:13-31. As a CPA specializing in wealth transfer taxation, you are interested in minimizing your clients’ estate taxes. Your client has rented at a below market rate portions of his store building to tenants. Upon the client’s death, his son will continue his rental practices. If the decedent’s rental practices are continued and the Sec. 2032A special use valuation rules employed, the value of the estate will be slightly below the $12.92 million basic exclusion amount. Should you propose to your client to use the special Sec. 2032A rules? Is it ethical to value the property using its historical income stream? The history of Sec. 2032A is rooted in a Congressional attempt to preserve the family farm because a number of cases occurred where family farms had to be liquidated by heirs to satisfy estate tax liabilities. This “land rich, cash poor” problem led Congress to add Sec. 2032A. Section 2032A allows estates to elect to use a valuation method based on existing use (such as for farming) rather than the so-called “highest and best” use (such as for subdivision lots). Although this IRC section was aimed primarily at providing relief for farmers, it also can be used in real estate-based trade or business valuations. It acts to preserve small family businesses where the heirs agree to materially participate in the business during a required statutory period. In this case, from an ethical standpoint, it probably is not advisable to propose the use of Sec. 2032A, and the CPA should fully explain the difficulties with the position if the client presses for going forward with that valuation. According to Treasury Department Circular 230, the practitioner must inform the client of the penalties reasonably likely to apply to the client with respect to a position taken. The SSST No. 1 requires the same of AICPA members. Under revised Sec. 6694, the tax return preparer penalties now apply to estate tax returns. Revised Sec. 6694 also provides that, to avoid a penalty if sufficient support to meet the “substantial authority” test does not exist, the CPA must disclose the position taken on the tax return, and there must be a “reasonable basis” for the position. In this situation, it is unlikely that either the substantial authority or the less strenuous reasonable basis tests can be satisfied. The IRS most likely would contend that, if Sec. 2032A were to be applied in this case, the full FMV of the rental use of this real estate should be used rather than the historical (below market) rent charged by the owner. Using the $1,000 or more per week rental value, the Sec. 2032A valuation will be much the same as the value based on comparable sales of $780,000. In addition, Sec. 2032A involves an ongoing contractual arrangement between the IRS and the heirs that the heirs will continue to materially participate in the business for ten years after the decedent’s death. Otherwise, a “recapture tax” will apply when their participation ceases. Continued material participation does not appear likely from the fact pattern as presented, and so imposition of the recapture tax appears likely. The CPA should not allow his client to use the Sec. 2032A valuation in this case. To do so would certainly be sliding down a very slippery ethical slope.

C:13-22

Chapter C:14 Income Taxation of Trusts and Estates Discussion Questions C:14-1 The estate or trust pays tax only on amounts retained, less the personal exemption. The taxable income of an estate or trust is reduced by the distribution deduction for amounts distributed, and the beneficiary reports these amounts as gross income. p. C:14-4. C:14-2 The opportunity for income tax savings by using trusts is limited because of the compressed fiduciary rate schedules and because of the reduced tax rate on dividends, a common type of income for trusts. For trusts, the additional 3.8% tax on net investment income begins at a much lower threshold than for individuals, which further limits the ability to save taxes. Non-tax reasons for creating trusts still exist, however, including providing for expert management, assuring that assets are preserved, and reducing probate costs. p. C:14-3. C:14-3 Section 641(b) provides that taxable income of estates and trusts is computed in the same manner as for individuals unless Part I of Subchapter J provides a rule to the contrary. Among the major differences are a small personal exemption deduction for fiduciaries (but suspended for individuals) and a much more compressed rate schedule for fiduciaries, with the top rate beginning at taxable incomes exceeding $14,450 (in 2023). Also, fiduciaries receive a distribution deduction and have no ceiling on deductible charitable contributions. p. C:14-4. C:14-4 Often the trustee cannot distribute principal, or can do so only in limited circumstances. Many trust instruments mandate that all of the income and/or nothing but income (meaning income in the accounting, not tax, context) be distributed annually. Thus, the categorization of a receipt, gain, expenditure, or loss item as principal or income often affects the dollar amount that the beneficiary can receive. pp. C:14-4 and C:14-5. C:14-5 Under the 2000 Uniform Act, common examples of principal include the gain (plus return of capital) upon the disposition of an asset owned by the fiduciary. Common examples of income include dividends, interest, and rents. pp. C:14-5 and C:14-6 and Topic Review C:14-1 (p. C:14-7). C:14-6 In general, state law (which often is a version of the Uniform Act) controls; however, if provisions in a trust instrument provide for a different allocation, the provisions in the trust instrument prevail over state law. p. C:14-5. C:14-7 No. Under the 2000 Uniform Act, the gain is not classified as income for fiduciary accounting purposes. Note that Irene is entitled to receive only income. pp. C:14-5 and C:14-6. C:14-8 The trust pays the tax on the gain, which is allocated to principal and retained by the trust for ultimate distribution to Beth. The tax is imposed in the year of the sale. pp. C:14-5 and C:14-6. Copyright © 2024 Pearson Education, Inc.

C:14-1

C:14-9 The 2000 Uniform Act, allows (but does not require) a trustee to “transfer to principal a reasonable amount” for depreciation. If the trustee makes this “transfer,” accounting income is not reduced by depreciation; however, for tax purposes, all the depreciation is allocated to the beneficiary if all the income is distributed. Depreciation charged to corpus (principal) does not reduce the amount distributable to the income beneficiary. If the trust instrument required a reserve equal to the depreciation expense claimed for tax purposes, accounting income and the cash distribution would decline by the amount of the depreciation, and the trust would deduct the depreciation in full. p. C:14-6. C:14-10 The personal exemption deduction for estates is $600. Trusts that must distribute all their income currently receive a $300 exemption, and all other trusts receive a $100 exemption. The amount is not indexed. The TCJA of 2017 did not suspend deductions for these exemptions. pp. C:14-9 and C:14-10. C:14-11 DNI sets the ceiling on (1) the fiduciary’s distribution deduction and (2) the amount of income taxed to the beneficiaries. pp. C:14-10 and C:14-11. C:14-12 a. No. Net accounting income and DNI can differ in amount. b. One common reason why net accounting income and DNI differ is because some of the fiduciary’s fee is charged to principal. This portion of the fee reduces DNI but not net accounting income. If some of the fiduciary’s state and local taxes are not deductible because they exceed $10,000, DNI will not be reduced by the nondeductible portion, but net accounting income nevertheless will be reduced. This result is a rather subtle aspect of the changes made by the TCJA of 2017 that limits the deduction for state and local taxes. c. No. Because capital gains are generally classified as principal, they usually are not included in DNI. pp. C:14-10 through C:14-13. C:14-13 No. None of the rental expenses needs to be allocated to tax-exempt income because such expenses were directly incurred in producing the rental income. Thus, all of the rental expenses are deductible. Indirect expenses, on the other hand, have to be allocated between taxable and tax-exempt income. pp. C:14-14 and C:14-15. C:14-14 a. Under the short-cut approach, the taxable income is the excess of capital gains over the personal exemption deduction. Refer to the comment for C:14-12, Part b, for a complexity added by the TCJA of 2017. b. No. The short-cut verification process cannot be used unless the trust distributes all of its accounting income. If the trust retains income, the most important step in determining its taxable income is the computation of the distribution deduction; no check figure can be generated for the distribution deduction. p. C:14-16. C:14-15 An NOL of a fiduciary passes through and produces a tax deduction for the beneficiaries only in the year the fiduciary terminates. At the beneficiary level, the pass-through NOL is subject to the 100% of taxable income limitation in 2020. For post-2020 tax years, a pass-through NOL is subject to the 100% of taxable income limitation if it arose in the estate or trust prior to 2018 and the 80% of taxable income limitation if it arose in the estate after 2017. p. C:14-16. Copyright © 2024 Pearson Education, Inc.

C:14-2

C:14-16 a. If a simple trust recognizes a net capital loss, generally no tax benefit will arise from the capital loss until the trust recognizes a capital gain or until the year the trust terminates. Capital losses do not pass through to beneficiaries except in the year of termination. Capital losses can be used by a fiduciary only to the extent of the lesser of $3,000 or the amount of the fiduciary’s taxable income. Except in unusual situations, accounting income equals or exceeds the taxable DNI, and in the case of a simple trust only net capital gains are taxable at the trust level because the distribution deduction equals the trust’s DNI. A capital loss provides no tax benefit in the year of sale unless there is a capital gain it can offset. p. C:14-24. b. No. Complex trusts do not necessarily distribute all their income currently. Thus, it is possible for a complex trust to receive a current tax benefit from a net capital loss. A complex trust can offset its capital losses against its capital gains and, in addition, deduct up to $3,000 of capital losses against current income that it retains. p. C:14-24. C:14-17 The tier system distinguishes between mandatory (tier-one) distributions and discretionary (tier-two) distributions. Tier-one beneficiaries are taxed on the smaller of DNI or the amount of the mandatory distributions. Tier-two beneficiaries are taxed on the lesser of (1) DNI remaining after the mandatory distributions or (2) the amount of the discretionary distributions. pp. C:14-21 and C:14-22. C:14-18 The statement is accurate. Beneficiaries receiving mandatory distributions are taxed on the amount they receive as long as the amount does not exceed their share of DNI. Beneficiaries who receive discretionary distributions are taxed on the lesser of (1) their distributions or (2) their share of the DNI that remains after mandatory distributions have been subtracted from DNI. pp. C:14-21 and C:14-22. C:14-19 a. Income in respect of a decedent (IRD) is composed of items of gross income that the decedent had earned prior to death, but which were not properly reportable on the decedent’s final individual income tax return because they had not been collected before death, and the decedent’s accounting method was the cash or installment method. pp. C:14-27 and C:14-28. b. A disadvantage of IRD items is that they do not receive a step-up in basis. On the other hand, IRD items have the advantage of triggering a Sec. 691(c) deduction for the Federal estate taxes attributable to the inclusion of the IRD items in the gross estate. The Sec. 691(c) deduction has become less common because of the increased amount exempt from the estate tax. pp. C:14-27 through C:14-29. C:14-20 The grantor trust rules can apply if (1) the grantor has “too large” a reversionary interest in the trust assets because the property reverts “too soon,” (2) the trust is revocable, or (3) the trust income is used to pay premiums on a life insurance policy on the grantor’s life. The grantor trust rules also can apply in other situations described in the text. pp. C:14-30 through C:14-33. C:14-21 No, because the value of the spouse’s remainder interest is too large. The grantor trust rules will not apply only if the value of the remainder interest at the time of creation (funding) is 5% or less of the value of the trust even though the grantor’s spouse is the remainderman. The value of a remainder interest would be this small only if the trust property passes to the spouse quite a number of years further in the future than 20 years. p. C:14-31.

C:14-3

C:14-22 This is a revocable trust, and all the income (no matter to whom distributed) will be taxed to the grantor, Amelia. Although the trust will be included in her gross estate, it will have the effect of reducing the size of Amelia’s gross estate. Income will be diverted to Jason, so there will be a smaller buildup of unspent income in Amelia’s gross estate. Amelia’s gross estate will be depleted further because of income taxes she will pay on the trust income. Some estate planners encourage clients to deliberately trigger a grantor trust rule so that the grantor will continue to pay income taxes on the trust income. p. C:14-31. C:14-23 The benefit of the 65-day rule is that it allows estates or complex trusts to shift income from being taxed on the fiduciary’s tax return to a beneficiary’s (or beneficiaries’) tax return(s). Sometimes at year end the exact amount of the fiduciary’s income will not be known nor will the tax situation of the beneficiaries necessarily be known. The 65-day rule lets fiduciaries postpone making distributions until early in the next year so that the tax situations of the fiduciary and the beneficiaries can be assessed and an intelligent decision made concerning whether to have income taxed at the fiduciary or the beneficiary level or some in each place. With the advent of the 3.8% tax on net investment income, this rule has perhaps become even more beneficial. pp. C:14-33 and C:14-34. C:14-24 a. Fiduciary returns are due by the fifteenth day of the fourth month after the end of the fiduciary’s tax year. For trusts, this date is April 15 because trusts must use a calendar year. A fiveand-a-half month extension became available for tax years beginning after 2015. pp. C:14-35 and C:14-36. b. Yes. Trusts must pay estimated taxes. Estates also must pay estimated taxes, but only after their first two tax years. p. C:14-35.

Issue Identification Questions C:14-25 • • •

When and where will the gain on the sale of the building be reported? Will there be any income in respect of a decedent (IRD)? If there will be IRD, will there be a 691(c) deduction?

Unless Art’s executor elects on Art’s final individual return (for 2023) not to use installment reporting for the gain, only the portion of the gain attributable to the down payment will be reported on Art’s 2023 individual return, and the remaining gain will be reported on the estate’s income tax returns when the principal is collected. The estate need not use a calendar year. If the estate terminates prior to collecting all of the principal, Amelia will report the remaining gain when she collects the principal. If the executor elects out of installment reporting, all the gain will be reported on Art’s 2023 return. This election would be a favorable option if the gain can offset losses Art incurred that would otherwise “die” with Art if they were not fully deductible on his 2023 return. The gain inherent in the principal payments on the note will be IRD unless the executor elects out of installment reporting. No step-up in basis is allowed for IRD items. Art’s estate will owe estate taxes, and a Sec. 691(c) deduction will be allowed for the Federal estate taxes attributable to the IRD, the gain inherent in the note included in Art’s gross estate. pp. C:14-28 and C:14-29.

C:14-4

C:14-26 • • •

May the estate elect to use a tax year-end other than December 31? What year-end should the estate elect if a December 31 year-end is not mandatory? What distributions (if any) should the estate make to Joe prior to the termination of the estate?

The estate may elect a year-end other than December 31. To do so it must file an income tax return on a timely basis, meaning by the fifteenth day of the fourth month after the desired year-end. However, the estate should consider a December 31 year-end for the reasons discussed below. The estate should distribute $34,400 to Joe by December 31, 2022, and elect a December 31 year-end. The estate will have $35,000 ($7,000 per month) of DNI by December 31, and if it distributes $34,400 to Joe by this date, the estate will receive a $34,400 distribution deduction, and Joe will have $34,000 of income to offset against his $34,000 NOL, most of which would otherwise expire. Because the NOL arose before 2018, it is not subject to the 80% of taxable income limitation, and $34,000 will wind up being untaxed for all practical purposes. Joe can offset his standard deduction of $12,9 50 against the remaining $400 distribution and his $10,000 of earnings to zero out his taxable income. The rest of the estate’s income, $600 minus the $600 exemption, will result in zero tax to the estate. If the estate chooses a year-end later than December 31 and makes distributions to Joe (even in 2022), such distributions will be income on Joe’s 2023 return, and his NOL will have expired and been wasted. Likewise, if the estate makes no distribution, the income will be taxed to the estate, and Joe’s NOL will be wasted because his standard deduction exceeds his $10,000 gross income. pp. C:14-10 through C:14-13, C:14-33, and C:14-34. C:14-27 Raj transferred depreciated property to the trust, something he should not have done because of the basis rules for property received by gift. If the trustee sells the Webbco stock at a loss, the trust’s basis for determining loss will be $35,000, the stock’s value on the date of the gift. (If the trustee sells the property at a gain, the basis will be Raj’s basis of $39,000.) Thus, if the trust sells the stock for its current value of $27,000, it can recognize only $8,000 of loss (less than the economic loss). Because the trust (a simple trust) must distribute all of its income currently, there will be no non-capital gain income against which to offset the capital loss. The only year(s) the trust will get a tax benefit from the capital loss will be when it has capital gains. Any unused capital loss will pass through to the beneficiaries when the trust terminates in the distant future. Deferring the stock sale is not necessarily the best strategy because there may be little expectation that the value of the stock will “recover,” and it could decline further. If the trust owns some appreciated assets, the trustee should consider selling some of them and offsetting the loss from Webbco against the gain on their sale. pp. C:14-16 and C:14-17.

C:14-5

Problems C:14-28 The trust’s tax is $9,795, calculated as follows: $9,208a 587b $9,795

Tax on $29,900 of taxable income Tax on net investment income Total tax a

$3,491 + [0.37 x ($29,900 - $14,450)] In this example, MAGI and undistributed net investment income are both $29,900 ($30,000 - $100). Thus, the incremental tax equals ($29,900 - $14,450) x 0.038, or $587. b

The single individual’s tax would be $1,718, calculated as follows: Adjusted gross income Minus: Standard deduction Taxable income

$30,000 (13,850) $16,150

Tax on $16,150 of taxable income

$ 1,718*

*$1,100 + [0.12 x ($16,150 - $11,000)] Thus, the less compressed tax rate schedule and higher standard deduction make the individual’s tax situation much more favorable than that of the trust. Moreover, the individual in this case is not subject to the 3.8% tax on net investment income. Accordingly, the trustee, if permitted by the trust instrument, may want to consider distributing income to its beneficiary if he or she is in a similar tax situation to the individual in this problem. pp. C:14-7 through C:14-10.

C:14-6

C:14-29 Total tax is $16,511 with the distribution and $17,774 without the distribution, determined as follows: Tax with the $37,250 distribution: Interest income Minus: Personal exemption Distribution deduction Taxable income of the estate

$50,000 $

600 37,250

Tax on the estate [$2,126 + 0.35 x ($12,150 - $10,550)]* Incremental tax on Thomas from the distribution** Total tax

(37,850) $12,150 $ 2,686 13,825 $16,511

Estates may owe 3.8% incremental tax on net investment income in excess of $14,450, while individual taxpayers are subject to the tax if their modified adjusted gross income exceeds $200,000. *An estate is subject to this tax on the lesser of its undistributed net investment income or its modified adjusted gross income in excess of $14,450. All of the estate’s income here is net investment income, as it is entirely interest income. The lesser of these two amounts is the estate’s undistributed net investment income of $12,150. **Thomas’ other taxable income is $210,000, so the first $21,250 is taxed at 32% with the remaining $37,250 - $21,250 = $16,000 taxed at 35%. In addition, Thomas’ income is subject to the 3.8% NII tax on the entire distribution. $21,250 x 32% + $16,000 x 35% + $37,500 x 3.8% = $13,825. Tax with no distribution: Interest income Minus: Personal exemption Taxable income of the estate

$50,000 (600) $49,400

Tax on estate taxable income [$3,491 + 0.37 x ($49,400 - $14,450)] Tax on net investment income [($50,000 - $14,450) x 0.038)] Total tax on the estate (No additional tax on Thomas because of no distribution.)

$16,423 1,351 $17,774

The taxes are higher in the second scenario (no distribution) because some of the estate’s taxable income is taxed at 37%, the top rate, and the undistributed income in the 37% bracket is subject to the 3.8% tax on net investment income. Thus, the first scenario produces the lower tax because some income is shifted from the high bracket on the estate (37%) to the lower bracket of the beneficiary (35%). pp. C:14-7 through C:14-10. Copyright © 2024 Pearson Education, Inc.

C:14-7

C:14-30 a.

Taxable income is $14,700, calculated as follows: Dividends Long-term capital gain Minus: Trustee’s fees Distribution deduction Personal exemption Taxable income

$20,000 15,000 ( 1,500) (18,500)a ( 300) $14,700

Limited to: $20,000 - $1,500 trustee’s fees = $18,500.

Capital gain Minus: Personal exemption Taxable income

$15,000 ( 300) $14,700

pp. C:14-7 through C:14-10, and C:14-16. C:14-31 Taxable income would not change. DNI is $8,000 greater because of the tax-exempt income, but the taxable income still would be $14,700 because the $8,000 of tax-exempt interest is not included in gross income, and no distribution deduction is available for the tax-exempt interest (net of the trustee’s fee allocable thereto). A portion of the trustee’s fee, $429 [$1,500 x ($8,000/$28,000)], is nondeductible because it must be allocated to the tax-exempt income. The distribution deduction is increased by $429 from $18,500 to $18,929 ($20,000 dividends - $1,071 deductible trustee’s fee). The net change to taxable income therefore is zero. The effect of the tax-exempt income on taxable income can be verified with the short-cut method, which would show $14,700 ($15,000 - $300) being taxed at the trust level. The beneficiary receives a larger cash distribution than in C:14-31 because he or she also receives the tax-exempt income, net of expenses. pp. C:14-7 through C:14-10, and C:14-16. C:14-32 a.

Taxable income is $4,700, calculated as follows: Corporate bond interest Long-term capital gain Minus: Trustee’s fee Distribution deduction Personal exemption Taxable income

$ 40,000 5,000 ( 1,633)a ( 38,367)b ( 300) $ 4,700

$2,000 - [$2,000 x ($9,000/$49,000)] = $1,633 $40,000 - $1,633 = $38,367

Tax on taxable income is $255, calculated as follows: Tax on $4,700, all long-term capital gain: First $3,000 at 0% Remaining $1,700 at 15% Total tax on taxable income

$ -0255 $255

The trust does not owe the 3.8% tax on net investment income because its modified AGI does not exceed $14,450, the point at which the 37% rate begins. pp. C:14-7 through C:14-10. Copyright © 2024 Pearson Education, Inc.

C:14-8

C:14-33 a.

Distribution is $58,500, calculated as follows: Corporate bond interest Minus: Trustee’s fees charged to income (50% per Uniform Act) Amount to be distributed

$60,000 ( 1,500) $58,500

Taxable income is $19,700, calculated as follows: Long-term capital gain Minus: Personal exemption Taxable income

$20,000 ( 300) $19,700

The distribution deduction is limited to $57,000, the amount of DNI ($60,000 - $1,500 trustee’s fee charged to income - $1,500 trustee’s fee charged to corpus). pp. C:14-7 through C:14-10. C:14-34 a. DNI is $23,000 ($24,000 net accounting income - $1,000 fee charged to principal). Its distribution deduction is $23,000, the DNI amount. b. Its distribution deduction is $21,000 ($23,000 DNI - $2,000 net tax-exempt income included therein). c. Its distribution deduction is $10,000, the amount distributed (which is lower than DNI, all from taxable sources). pp. C:14-15, C:14-19, and C:14-20. C:14-35 Roy: $48,000; Sandy: $32,000. Because all distributions are discretionary and the distributions exceed the $80,000 of DNI, each beneficiary reports a pro rata amount of the DNI based on the distributions he or she receives in relation to the total distributions. Roy reports $48,000 [$80,000 x ($60,000/$100,000)]. Sandy reports $32,000 [$80,000 x ($40,000/$100,000)]. p. C:14-21. C:14-36 Sandy reports $33,333: Mandatory distribution (tier-one)--amount distributed Discretionary distribution (tier-two)--pro rata, remaining DNI ($80,000 - $10,000) x ($30,000/$90,000) Total Roy reports $46,667: Discretionary distribution (tier-two)--pro rata, remaining DNI ($80,000 - $10,000) x ($60,000/$90,000) pp. C:14-21 through C:14-23.

C:14-9

$10,000 23,333 $33,333

$46,667

C:14-37 The income to the beneficiaries is determined as follows: Year 1 Mandatory distribution (less than DNI) Discretionary distribution* Total income for Year 1

Bart $20,000 -0$20,000

Thelma $30,000 12,000 $42,000

*Smaller of discretionary distribution ($67,000 - $50,000 = $17,000) or remaining DNI ($62,000 - $50,000 = $12,000). Year 2 Mandatory distribution (less than DNI) Discretionary distribution* Total income for Year 2

Bart $20,000 5,000 $25,000

Thelma $30,000 6,000 $36,000

*Smaller of discretionary distribution ($61,000 - $50,000 = $11,000) or remaining DNI ($66,000 - $50,000 = $16,000). pp. C:14-21 through C:14-23. C:14-38 Net accounting income is $26,100, calculated follows: Dividends Tax-exempt interest Rental income Minus: Property taxes Trustee’s fee charged to income Net accounting income

$15,000 7,000 6,000 ( 1,000) ( 900) $26,100

The maximum amount distributable is $26,100, the net accounting income. pp. C:14-4 through C:14-6.

C:14-10

C:14-39 a.

$450 nondeductible fee = $1,800 x ($7,000/$28,000). The deductible fee is $1,350 ($1,800 - $450).

Taxable income before distribution deduction is $18,350, calculated as follows: Dividends $15,000 Rental income 6,000 Minus: Property taxes ( 1,000) Trustee’s fee ( 1,350)a Personal exemption ( 300) Taxable income exclusive of distribution deduction $18,350

DNI is $25,200, calculated as follows: Taxable income exclusive of distribution deduction Plus: Personal exemption Net tax-exempt income DNI

$18,350 300 6,550b $25,200

Taxable income is negative: Dividends Rental income Minus: Property taxes Trustee’s fee Distribution deduction Personal exemption Taxable income

$15,000 6,000 ( 1,000) ( 1,350) (18,650)c ( 300) $ (300)d

See Part a. $7,000 - $450 = $6,550 c $25,200 DNI - $6,550 net tax-exempt income = $18,650. d Verification: The trust retains no income and has no net capital gain; thus, taxable income is a negative $300, the amount of the exemption. b

Note: Unless the deductible portion of the trustee’s fee relates solely to a particular type of income, the trust has discretion in allocating it against the various categories of income. Treasury Regulations impose no constraints other than requiring that some of the fee be allocated to tax-exempt income. Because, the top tax rate on dividend income is lower than the top rate on interest and rent income, a trust should allocate the deductible portion of the fee against income other than dividends. The dividends retain their character when distributed. pp. C:14-13 through C:14-17.

C:14-11

C:14-40 The answer to Part a (deductible trustee’s fee) will not change if the trust makes a discretionary distribution of only $12,000. The answer to Part b (taxable income exclusive of the distribution deduction) will be $200 higher because the personal exemption will be $100 (instead of $300). The details in Part c (DNI) will be different, but DNI will not change. Taxable income exclusive of the distribution deduction will be $18,550, and the personal exemption will be $100. The answer to Part d (taxable income) will change to $6,669 as follows: The trust distributes 47.61904% ($12,000/$25,200) of its DNI and thereby 47.61904% of its net tax-exempt income. Its distribution deduction would be as follows: Amount distributed Minus: Net tax-exempt income deemed distributed (0.4761904 x $6,550 net tax-exempt income) Distribution deduction

$12,000 ( 3,119) $ 8,881

Part d changes to $6,669 taxable income, calculated as follows: Dividends Capital loss Rental income Minus: Property taxes Trustee’s fee Distribution deduction Personal exemption Taxable income

$15,000 ( 3,000) 6,000 ( 1,000) ( 1,350) ( 8,881) ( 100) $ 6,669

Note: Here the trust can offset $3,000 of its capital loss against income taxable at the trust level. Unless the deductible portion of the trustee’s fee relates solely to a particular type of income, the trust has discretion in allocating it against the various categories of income. Treasury Regulations impose no constraints other than requiring that some of the fee be allocated to tax-exempt income. Because of the lower top tax rate on dividend income, a trust should allocate the deductible portion of the fee against income other than dividends because the top tax rate on such other income is higher than the rate on dividends, even after considering the potential 3.8% tax on net investment income. pp. C:14-19 through C:14-22. C:14-41 Total deductible expenses are $4,415, calculated as follows: Property taxes CPA’s fee Trustee’s fee Total a

$ 2,000 800 1,615a $ 4,415

$1,900 - [$1,900 x ($6,000/$40,000)] = $1,615 deductible portion. The trust’s expenses other than the trustee’s fee do not have to be allocated in part to tax-exempt income. pp. C:14-14 and C:14-15. Copyright © 2024 Pearson Education, Inc.

C:14-12

C:14-42 A $3,000 capital loss is potentially deductible on the 2022 return. Because the trust is a simple trust, has no capital gain in 2021, and must distribute all of its income, the capital loss produces no tax benefit in 2022. Thus, the $10,000 capital loss carries over to the 2023 return. The $10,000 loss is offset against the $15,000 capital gain on the 2023 fiduciary return. No loss remains to carry to the next year. pp. C:14-16 and C:14-17. C:14-43 $3,000 of the capital loss offsets part of the $8,000 corporate interest income on the 2022 return. The remaining $7,000 capital loss carries over to the 2023 return and offsets part of the $15,000 capital gain recognized in 2023. p. C:14-24. C:14-44 All is taxed to Amir, the grantor. Because the trust is revocable, the rent income is taxed to the grantor, Amir. In addition, Amir reports the capital loss on his tax return. None of the income is taxed to the trust or its beneficiary, Ali. Amir makes a present interest gift to Ali of $22,000 when the trust distributes the income to Ali. The income distributed is reportable by Amir until Amir makes the trust irrevocable. p. C:14-31. C:14-45 All is taxed to Holly, the grantor. The post-March 1, 1986 rules apply, and the assets eventually pass to the grantor’s spouse. The value of his remainder interest (determined under the term certain tables in Appendix H) exceeds 5%. The $20,000 of dividends is taxed to the grantor, Holly, under the reversionary interest rules. The $18,000 capital gain is taxed in the current year to Holly, the grantor, under the reversionary interest rules because her husband will receive the property upon the trust’s termination. p. C:14-31. C:14-46 a. Dividends are taxed to son Jack, and gains to the trust. There is no reversion to Holly or remainder to her spouse; thus, the dividends are taxed to Jack, the income beneficiary. Because the gains are held for ultimate distribution to the nephew Nathan, they are taxed at the trust level. The grantor trust rules do not apply to this trust. b. All is taxed to Holly. This trust is governed by the post-1986 tax rules, under which Holly, the grantor, is taxed on both the dividends and the gain because the value of her reversionary interest at the end of 25 years (determined under the term certain tables in Appendix H) exceeds 5%. The results are the same as in Problem C:14-45. p. C:14-31. C:14-47 Total IRD is $39,500, calculated as follows: Dividends (record date prior to death) Interest accrued (9/12 x $18,000) Gain on sale of land [$24,000 x ($40,000 gain/$48,000 sales price)] Total IRD

$ 6,000 13,500 20,000 $39,500

pp. C:14-27 through C:14-29. C:14-48 Gross income is $6,400, calculated as shown below. There is $4,000 of IRD. May salary (IRD collected after death) $ 4,000 June, September, and December dividends (collected after death) ($800 x 3) 2,400 Estate’s gross income $ 6,400 Copyright © 2024 Pearson Education, Inc.

C:14-13

The record date for the June dividend is subsequent to her date of death, May 27; thus, only the salary ($4,000) constitutes IRD and generates a Sec. 691(c) deduction if her estate owes any estate taxes. The salary was the only income earned, but not received, prior to Julie’s death. pp. C:14-27 through C:14-29. C:14-49 a. $75,000 deduction. The trust’s distribution deduction is for the property’s FMV ($75,000) because the trustee elected to recognize gain on the distribution. The DNI exceeds $75,000. b. $75,000 gross income. Marilyn should report $75,000 gross income, the same amount as the distribution deduction, which is lower than the DNI. c. $75,000 basis. Because the trustee elected to recognize gain, Marilyn’s basis in the asset is $75,000, its FMV when distributed. p. C:14-34. C:14-50 The income is taxed to Kathy on the return for Kathy’s tax year in which the estate’s tax year ends. Nothing is taxed on Kathy’s 2022 return. On her 2023 return, Kathy is taxed on the $27,000 ($5,000 + $10,000 + $12,000) distributed through the estate’s March 31 year-end. Kathy reports the $14,000 August 2023 distribution on her 2024 tax return, provided the estate has at least $14,000 DNI in its 2023–2024 tax year. p. C:14-34.

Comprehensive Problem C:14-51 a. The deductible fee is $3,333 ($4,000 - $667). The nondeductible fee is $667 {[$9,000/ ($27,000 + $18,000 + $9,000)] x $4,000}. b.

Total IRD is $33,000, and IRD for the period ended June 30, 2022, is $23,000. The total IRD is $33,000, calculated as follows: Dividend, record date October 25, 2021 Corporate interest for September and October 2021 (2/6 of $18,000) Gain on sale of land (2 remaining installments x $10,000 gain each) Total

$ 7,000 6,000 20,000 $33,000

IRD reported on the return for the period ended June 30, 2022, is all of the estate’s IRD except for the $10,000 gain attributable to principal to be collected in March 2023. Thus, the IRD reported on the return for the period ended June 30, 2022, is $23,000 and for the period ended June 30, 2023, is $10,000. Note: The tax-exempt interest income accrued as of the date of death is not IRD because it is not included in gross income when collected.

C:14-14

Total Sec. 691(c) deduction is $13,200, calculated as follows: Federal estate tax liability (on $16.7 million at 2021 rates) Minus: Unified credit for 2021 Federal estate tax liability if gross estate did not include net IRD of $33,000 (tax on $16,667,000 at 2021 rates) Minus: Unified credit for 2021 Total Sec. 691(c) deduction

d. e.

$6,625,800 (4,625,800) $6,612,600 (4,625,800)

Section 691(c) deduction deductible on return for period ended June 30, 2022 ($23,000/$33,000 x $13,200)

$2,000,000

1,986,800 $ 13,200 $

9,200

Taxable income is $41,867, calculated as follows: Dividends Corporate interest Gain on sale of land Executor’s fee ($45,000/$54,000 x $4,000) Sec. 691(c) deduction Personal exemption Taxable income

$ 27,000 18,000 10,000 ( 3,333) ( 9,200) ( 600) $ 41,867

Note: Unless the deductible portion of the executor’s fee relates solely to a particular type of income, the estate has discretion in allocating the fee against the various categories of income. Treasury Regulations impose no constraints other than requiring that some of the fee be allocated to tax-exempt income. An estate should allocate the deductible portion of the fee against income other than dividends because the tax rate on such other income is higher than the rate on dividends. f. For taxable years beginning in 2021, the marginal tax rate is 37% on the ordinary income over $13,050. In addition, this estate incurs a 3.8% tax on the estate’s undistributed net investment income that exceeds $13,050.

Tax Strategy and Critical Thinking Problems C:14-52 The overall taxes for the trust plus Gordon will decline by $10,970 ($13,555 - $2,585) if the trustee uses the 65-day rule and elects to treat distributions made during the first 65 days of 2024 as if made in 2023. Thus, the trustee could elect to treat the $40,000 distributed in 2024 (assuming it is distributed during the first 65 days) as being distributed in 2023. This strategy would keep the $40,000 of income from being taxed to the trust, where almost all of it would be taxed at the top tax rate and also be subjected to the 3.8% tax on net investment income. (Note that the remaining $10,000 less the $100 exemption still will be taxed to the trust.) With this election, Gordon will have an additional $40,000 of gross income on his 2023 tax return. This amount plus his $52,000 of other income can be offset in large part by the $72,000 loss from the partnership. In the absence of the election, Gordon’s Copyright © 2024 Pearson Education, Inc.

C:14-15

share of the partnership loss would exceed his income, and for 2023 he would waste his standard deduction. Gordon will not incur the 3.8% tax. The below analysis compares the tax results: Without Election

With Election

$50,000 -0( 100) $49,900

$50,000 ( 40,000) ( 100) $ 9,900

$16,608

$ 1,970

1,347 $17,955

-0$ 1,970

Individual level: Other income Trust income Minus: Partnership loss Adjusted gross income Minus: Standard deduction Taxable income Tax on taxable income

$52,000 -0( 52,000) -0( 13,850) $( 13,850) $ -0-

$52,000 40,000 ( 72,000) $20,000 ( 13,850) $ 6,150 $ 615

Tax savings from carryover of remaining partnership loss ($20,000 x 0.22)*

$ ( 4,400)

Overall taxes (trust + individual – tax savings)

$ 13,555

$ 2,585

Trust level: Interest income Minus: Distribution deduction Personal exemption Taxable income Tax under rate schedule on trust income 3.8% tax on $35,450 ($50,000 - $100 - $14,450); none with election Total tax on trust income

-0-

*22% is Gordon’s estimated marginal tax rate for the next few years. C:14-53 The two-trust alternative results is $9,990 more in total distributions to the twins at the termination point than does the one-trust alternative. This amount results from the net savings (lower taxes net of higher trustee’s fees) from having two trusts. The planning strategy employed here is spreading trust income between two trusts, thereby pushing taxable income into lower tax brackets and eliminating the net investment income tax on the bond interest. Results with one trust Annual trust income Minus: Trustee’s fee Exemption Annual taxable income

$20,000 (1,000) (100) $18,900

Tax on taxable income [$3,491 + 0.37 x ($18,900 - $14,450)] Tax on net investment income [0.038 x ($18,900 - $14,450] Annual tax Total tax for ten years

$ 5,138 169 $ 5,307 $53,070

C:14-16

Results with two trusts Annual trust income per trust Minus: Trustee’s fee Exemption Annual taxable income

$10,000 (900) (100) $ 9,000

Tax on taxable income [$290 + (0.24 x ($9,000 - $2,900)] Tax on net investment income Annual tax per trust Total tax for two trusts for ten years (2 x 10 x $1,754)

$ 1,754 -0$ 1,754 $35,080

Net savings using two trusts Taxes for ten years with one trust Minus: Taxes for ten years with two trusts Net tax savings with two trusts Minus: Increment trustee’s fees with two trusts [10 years x ($1,800 - $1,000] Net savings with two trusts

$53,070 (35,080) $17,990 (8,000) $ 9,990

C:14-54 Alternative A – Payment of all of the expenses in 2022: Interest income for 2022 Deduction for administration expenses Exemption Taxable income (loss) for 2022

$ 18,000 (25,000) (600) $ (7,600)

The loss does not pass through to the beneficiaries because 2022 is not the year of termination nor does the loss produce a net operating loss deduction. Thus, this alternative provides no net benefit. Alternative B – Payment of $4,350 of the expenses in 2022 and the rest in 2023: Interest income for 2022 Deduction for administration expenses Exemption Taxable income for 2022

$18,000 (4,350) (600) $13,050

All of the estate’s income is taxed at a rate below 37%, the marginal tax bracket of the beneficiaries. Specifically, the estate’s income tax on $13,050 for 2022 is $3,099. Moreover, it does not incur the 3.8% tax on net investment income. Interest income for 2023 Deduction for administration expenses ($25,000 - $4,350) Exemption—none in year of termination Taxable income (loss) for 2023 Copyright © 2024 Pearson Education, Inc.

C:14-17

$ 1,500 (20,650) -0$(19,150)

The $19,150 loss passes through to the beneficiaries ($9,575 each) in 2023, the year of termination, and provides them aggregate tax savings of $7,086 ($19,150 x 0.37). This result reflects the holdings in Notice 2018-61, 2018-31 I.R.B 278, and Reg. Sec. 1.67-4 effective October 19, 2020. This alternative has the disadvantage from a present value standpoint of requiring payment of some income taxes by the estate for the year 2022 and the potential advantage of generating a larger loss for the beneficiaries to deduct in 2023. The potential net tax savings, however, are $3,987 ($7,086 $3,099), without discounting. Alternative C – Payment of $17,400 of the expenses in 2022 and the rest in 2023: Interest income for 2022 Deduction for administration expenses Exemption Taxable income for 2022

$ 18,000 (17,400) (600) $ -0-

The estate reports exactly zero taxable income for 2022, and thus it pays no taxes. Interest income for 2023 Deduction for administration expenses ($25,000 - $17,400) Exemption—none in year of termination Taxable income (loss) for 2023

$ 1,500 (7,600) -0$( 6,100)

The $6,100 loss passes through to the beneficiaries ($3,050 each) in 2023, the year of termination, and potentially provides them aggregate tax savings of $2,257 ($6,100 x 0.37). This alternative has the advantage from a present value standpoint of no income taxes being payable by the estate for the year 2022 and the disadvantage of generating a smaller loss for the beneficiaries to deduct in 2023 and thereby lower tax savings. Overall assessment of alternatives: Alternative A B C

Net Tax Savings $ -03,987 2,257

Note: The problem asked the students to devise a strategy. Some students’ strategies may differ from the above.

C:14-18

Tax Form/Return Preparation Problems C:14-55 (See Instructor’s Resource Manual) C:14-56 (See Instructor’s Resource Manual) C:14-57 (See Instructor’s Resource Manual)

Case Study Problems C:14-58 The points that should be covered in the memorandum to the tax partner are outlined below and keyed to the seven questions (parts) within the problem. The student should incorporate these points into a properly structured memorandum using good form with proper grammar and punctuation. a. b. c. d. e.

f. g.

If he creates three trusts, he will have created three new taxpayers instead of one. Each trust will have $2,900 (in 2023) taxed at the 10% rate, the lowest rate. The friend suggested a January 31 year-end because the friend probably thought such a year-end would achieve a deferral of the beneficiary’s tax. The beneficiary is taxed on the trust income in his or her tax year in which the trust’s tax year ends. Unfortunately, trusts must be on a calendar year. A discretionary trust is taxed on the income it retains, and the beneficiary is taxed on the income distributed. The trust would not be a grantor trust. Because of the extreme compression of the rate schedule for fiduciaries, trusts that retain income provide little or no tax benefit as income shifting devices. In addition, the 3.8% tax on net investment income begins at a much lower level for trusts than for individuals. Arthur should not be apprehensive about a complex trust. “Complex” trust is terminology used in the Treasury Regulations for a trust that does not currently distribute all of its income, make charitable contributions, or distribute corpus. Any trust income spent on meeting Arthur’s legal obligation of supporting his minor children will be taxed to Arthur under the grantor trust rules (Sec. 677). Also, keep in mind that, under the kiddie tax rules, the income distributed to the minor children (even if not spent on their support) will be taxed at the fiduciary tax rate.

C:14-59 a. According to Statements on Standards for Tax Services (SSTS) No. 6 (reproduced in Appendix E of the text), you should inform Robert about the error and its potential consequences and suggest that he revise the trust return for Year 1 and report the distributable net income (DNI) as being taxable to himself. If a trust is required to distribute income, such required distribution is taxable to the beneficiary currently whether distributed or not (Sec. 652(a)). Because the trust is in a lower tax bracket than is Robert, the tax owed would be higher if the income were reported on Robert’s return (because he is at the top marginal tax rate). According to SSTS No. 6, you may not inform the IRS about the error unless Robert grants permission. If Robert does not take steps to correct the error, you should consider withdrawing from preparing the current return.

C:14-19

b. In the second scenario, you are representing Robert in an audit of his individual return. SSTS No. 6, states that you should recommend to Robert the measures to be taken--that the error be reported to the IRS. You should request Robert’s permission to disclose the error to the IRS, but you may not disclose the error without obtaining Robert’s permission. If Robert does not agree to disclose the error, you should consider withdrawing from the engagement. Note that, in each scenario, the term “error” does not include “an item that has an insignificant effect on the taxpayer’s tax liability.” Depending on the amount of Robert’s tax liability reported for Year 1, it is possible that there is an “out” under the “insignificant” language.

Tax Research Problems C:14-60 The memo should address the fact that, at the time Francois funded the trust, Claudette had only one child. Later, three others were born. The issue is whether the trust must be treated as one trust or can be treated as four, which would mean four taxpayers, each starting at the bottom of the rate schedule. The facts are very similar to those of Judy Trust for David Quinn, 61 AFTR2d 88-315, 833 F.2d 563 (CA-5, 1987). The court concluded in Judy that the trust must be treated as a single trust. Its rationale was that, at the time of funding, there was only one trust beneficiary because the other children were not “in being and ascertainable.” Thus, the creation of separate trusts failed for lack of additional beneficiaries. Based on Judy, all the income should be reported on one trust return. C:14-61 The facts here are very similar to those of The Mattie K. Carter Trust, 91 AFTR2d 2003-1946, 2003-1 USTC ¶ 50,418 (DC ND TX, 2003). In Carter, the court ruled that, because the trust is the taxpayer, material participation is to be assessed based on the activities of the trust through its trustee, employees, and agents. However, unlike the situation for Ritter Trust, in Carter the court concluded that the trustee met the material participation test in his own right. Thus, the taxpayer would have won even if only the trustee’s activities could have been considered. Nevertheless, based on the Carter case, there is authority for considering the activities of the ranch manager and the other employees. Thus, according to Carter, the trust should meet the material participation test with the result that the PAL rules would not limit the deductibility of the loss. The IRS does not agree with Carter. In PLR 201029014, it concluded that one must look to the activities of the trustee, who must be involved on a “regular, continuous and substantial basis.” It indicated that this interpretation is consistent with the treatment of other business owners. In technical advice memo (TAM) 200733023, the IRS ruled that, regardless of Carter, in the absence of regulations the trustee must participate substantially on a regular and continuous basis. The Tax Court in Stangeland, T.C. Memo 2010-185, distinguished the facts from Carter and stated it “need not address whether or how a trust may materially participate . . . . ” In a 2014 case involving rental real estate, Frank Aragona Trust et al. v. Comm., 142 T.C. 165, the Tax Court concluded that, if trustees are individuals, their hours worked can be considered as work done by individuals in a trade or business and considered as services performed by the trust. C:14-62 Section 678(a) provides that a person other than the grantor will be taxed on any part of the trust with respect to which that person has the power exercisable by only himself or herself to vest the income or corpus in himself or herself. In the trust’s first year, the trust’s sole income was from Copyright © 2024 Pearson Education, Inc.

C:14-20

dividends, which Eileen could vest in herself, and she was the only person with this power. Thus, she is taxed on 100% of the dividends, and not just the amount she distributed to herself. Thus, no income is taxed to the trust. Students should cover this point in their memos. C:14-63 If Sue does not sell any capital assets before the end of the current year, the maximum capital loss that the couple can use on their tax return for the current year is $3,000, and the rest of the $40,000 long-term capital loss (all attributable to Sam) will expire with the current year, his year of death. Given that Sue owns some appreciated stocks, she can sell stocks and recognize up to $40,000 of capital gain without increasing the adjusted gross income reportable on the couple’s tax return for the current year. She might consider generating additional capital gain because, for the current year, the beneficial joint income tax rates will apply. If she sells all three of the stocks, she should wait until she has held ABC for more than 12 months. Otherwise, she will have to report the ABC gain as shortterm capital gain. JKL and TUV (if sold this year) will generate long-term capital gain, which will be offset to the extent of $40,000 by Sam’s long-term capital loss. If she sells just the ABC and TUV stocks, the gain (using current values) will be offset exactly by Sam’s capital loss, and consequently, AGI will not increase. The article from The Tax Adviser is “Till Death Do Us Part: Dealing With Carryovers When a Spouse Dies” by Jan F. Lewis (Editor: Valrie Chambers) from the January 2017 issue.

“What Would You Do In This Situation?” Solution Ch. C:14, p. C:14-32. You should not adhere to Mr. Cain’s request. Under Sec. 677, Mr. Cain, the grantor, is taxed on the $4,000 of trust income used to provide support for a child whom he is legally obligated to support. He was obligated to support his child, Candy, until she became 18 in August, and he used trust income to discharge part of his support obligation. Treating the income as taxable to Candy would definitely be a position lacking in support. If you adhered to Mr. Cain’s request, you would be departing from Statements on Standards for Tax Services No. 1, which in Para. 4 states that a member “should determine and comply with the standards, if any, that are imposed by the applicable taxing authority.” Section 6694(a)(2) requires that a tax return preparer have (a) substantial authority for a position or (b) have a reasonable basis for the position and disclose the position. Incidentally, the kiddie tax rules do not apply to Candy for last year because she was age 18 by the end of the year and provided over one-half of her own support for the year. In addition, her earned income exceeded half of her support. If these rules did apply, the distribution clearly would be taxed under the kiddie tax rules at a modified version of the fiduciary rates, and Mr. Cain likely would not be putting as much pressure on you.

C:14-21

Chapter C:15 Administrative Procedures Discussion Questions C:15-1 IRS Service Centers verify the tax calculation. They check to see whether amounts are properly carried from one line to another on the return and whether items such as signatures or social security numbers are missing. p. C:15-3. C:15-2 The IRS issues revenue rulings, revenue procedures, letter rulings, determination letters, announcements, notices, and information releases. p. C:15-2. C:15-3 a. The IRS has gathered data to develop its DIF statistical models through two programs: (1) the Taxpayer Compliance Measurement Program (TCMP) and (2) the National Research Program (NRP). b. The TCMP was based on special audits of all line-by-line items; the NRP is based on pre-existing audit data as well as data compiled in ordinary audits of portions of tax returns. c. The IRS has used these models to identify tax returns with items that significantly depart from a statistical norm, and thus flag the returns for examination. p. C:15-4. C:15-4 Ben’s, because it includes a number of items that probably depart from the DIF statistical norm. Al’s, however, has a large number of exemptions plus a loss that the IRS might think is a nondeductible hobby loss. pp. C:15-4 and C:15-5. C:15-5 No. Even though the IRS audited his return for two years earlier, that audit dealt with a different issue. Therefore, the IRS can challenge the interest expense deduction on the current year return. pp. C:15-5 and C:15-6. C:15-6 Brad has the following alternatives: • Brad may agree that he owes the additional taxes; if so, he may sign Form 870 (Waiver of Statutory Notice) if requested. • He may ask to meet with the examining agent’s supervisor. • If the matter is complex and highly technical, Brad may urge the IRS employee to seek technical advice from the IRS’s national office. • He may meet with an appeals officer. • He may file a petition with the Tax Court without paying the deficiency. • After being notified of the deficiency, he may pay the taxes and file for a refund in a U.S. district court or the U.S. Court of Federal Claims. pp. C:15-6 through C:15-8.

C:15-1

C:15-7 a. Taxpayer has 30 days from the date of the letter to request a conference with an IRS appeals officer, or to file a protest letter. b. Taxpayer has 90 days from the date of the letter to file a petition with the Tax Court. c. Taxpayer has two years to sue the IRS for a refund in a U. S. district court or the U.S. Court of Federal Claims. pp. C:15-6 through C:15-8. C:15-8 A taxpayer can initiate litigation in the Tax Court, the U.S. Court of Federal Claims, or a U.S. district court. pp. C:15-7 and C:15-8. C:15-9 Taxpayers frequently litigate in the Tax Court because, to access it, they do not have to pay the amount in question and in certain circumstances can use the small cases procedure. However, taxpayers cannot appeal decisions of the small claims division. Also, the Tax Court has greater tax expertise than the other courts have. pp. C:15-7 and C:15-8. C:15-10 Protest letters are necessary if the amount of additional tax plus penalties and interest in question exceeds $25,000. p. C:15-6. C:15-11 A statement of all relevant facts including: • Names, addresses, telephone numbers, and taxpayer identification numbers of all interested parties • The taxpayer’s annual accounting period and method • A description of the taxpayer’s business operations • A complete statement of the business reasons for the transaction. • A detailed explanation of the transaction • All other facts relating to the transaction or to the taxpayer’s requested tax treatment. See Rev. Proc. 2023-1, I.R.B. 2023-1, Sec. 7.01. Copies of all pertinent contracts, agreements, and other documents that affect the transaction also should be included. p. C:15-9. C:15-12 Four conditions must be met, as follows: • Taxpayer must introduce credible evidence regarding the issue. • Taxpayer must comply with the recordkeeping and substantiation requirements of the IRC. • Taxpayer must cooperate with reasonable IRS requests for witnesses, information, documents, meetings, and interviews. • Taxpayer must be either a legal person with net worth not exceeding $7 million or a natural person. pp. C:15-8 and C:15-9. C15-13 The IRS will rule on estate tax matters for a decedent if the estate tax return has not been filed. It also will rule on the estate tax consequences of transactions of a living person. No requests will be considered, however, with respect to prospective estate tax rulings involving computations of tax, actuarial factors, and factual matters (Rev. Proc. 2023-1, I.R.B. 2023-1, 1, Sec. 5.06). p. C:15-10. Copyright © 2024 Pearson Education, Inc.

C:15-2

C:15-14 The chances of an IRS private letter ruling are as follows: a. Unlikely. The capital gain reflects a completed transaction for which the taxpayer already has filed a return. b. Likely. The exchange involves a proposed transaction. The IRC is unsettled or unclear on the tax treatment. c. Unlikely. No transaction is involved. The result is hypothetical. d. Likely. The issue pertains to a transaction for which the taxpayer has not yet filed a return, and the IRC is unsettled or unclear on the tax treatment. p. C:15-10. C:15-15 No. You should not advise Tracy to request a ruling. The IRS cannot respond by the time Tracy must finalize the transaction. Should a ruling be requested and the IRS rule against the taxpayer, it will be too late to restructure the transaction to obtain a more favorable tax result. p. C:15-10. C:15-16 a. b.

Individuals 15th day of 4th month after end of tax year 6 months after original due date for returns

a. b.

Corporations 15th day of 4th month after end of tax year 6 months after original due date

pp. C:15-10 and C:15-11. C:15-17 Your client must file a form requesting an “automatic” extension. For individuals, the requisite document is Form 4868, which allows a six-month extension. For corporations and other entities, the requisite document is Form 7004, which allows a six- or seven-month extension depending on the type of entity and the entity’s year end. p. C:15-11. C:15-18 No. The client is incorrect. An automatic extension does not extend the due date for the payment of the tax. The taxpayer will owe interest and penalties on any tax not paid by the original due date for the return. However, a corporation will not be assessed a penalty if it pays in at least 90% of its tax due by the original due date for the return and pays the balance by the extended due date. p. C:15-11. C:15-19 Generally, the interest rate charged on deficiencies is three percentage points higher than the federal short-term rate (Sec. 6621). For large corporate underpayments, the rate is five percentage points above the federal short-term rate. Rates are rounded to the nearest full percent. The rate for overpayments generally is three percentage points above the federal short-term rate (two percentage points in the case of a corporation). For corporate tax overpayments exceeding $10,000, the interest rate is reduced to the federal short-term rate plus one-half percentage point. The rate potentially changes once a quarter, in January, April, July, and October. The new rate usually is made public in the month preceding the month in which the next quarter begins. p. C:15-12. C:15-20 Stan should request an extension for filing to avoid the failure-to-file penalty. If Stan is delinquent in paying his taxes on time, he will still owe the smaller failure-to-pay penalty. pp. C:15-15 and C:15-16. Copyright © 2024 Pearson Education, Inc.

C:15-3

C:15-21 The rate for calculating the penalty for underpaying estimated taxes is the same as the interest rate for taxes that are not timely paid. The separate penalty for each quarter is based on the amount of the underpayment of the estimated taxes due at a payment date times the annual rate times the fraction of the year (in days) between the due date for the payment and the date the payment is made. pp. C:15-17 and C:15-18. C:15-22 No. The negligence penalty is levied on just the portion of the underpayment attributable to negligence. p. C:15-20. C:15-23 The IRS might not impose a substantial understatement penalty because (1) it might conclude that the taxpayer has substantial authority for the position adopted on the return or (2) the taxpayer made adequate disclosure on the return or in a statement attached to the return, and a reasonable basis exists for the position. p. C:15-21. C:15-24 Not necessarily. Because of the amount of the deficiency, the penalty may be imposed [i.e., it exceeds the greater of 10% of the tax required to be shown on the return (0.10 x $40,000 = $4,000), or $5,000]. However, the penalty will not be imposed if Maria shows reasonable cause and good faith for her position. In addition, assuming the underpayment is not attributable to a tax shelter item, Maria will not owe the penalty if (l) she has substantial authority for her position or (2) she made adequate disclosure on the return or in a statement attached to her return, and a reasonable basis exists for her position. p. C:15-21. C:15-25 The negligence penalty is imposed where the tax underpayments result from negligence or disregard of the rules and regulations, but without the intent to commit fraud. The civil fraud penalty is levied where the taxpayer has deliberately deceived (e.g., systematic omissions of gross income, fictitious deductions, or falsification of records). pp. C:15-20, C:15-22, and C:15-23. C:15-26 The government must prove civil fraud by “preponderance of the evidence.” It must prove criminal fraud “beyond a reasonable doubt.” p. C:15-23. C:15-27 Sec. 7206 is broader than Sec. 7201. Accordingly, the government is more likely to prevail in an action based on the former provision than on the latter. Sec. 7201 applies only to one specific misdeed: the willful attempt to evade or defeat the tax. Sec. 7206 applies to several misdeeds, including willfully subscribing to a document that one does not believe to be true and correct, and willfully aiding or assisting in the preparation of a document, which is fraudulent or false. The maximum penalties are as follows: • Sec. 7201--$100,000 ($500,000 for corporations), a prison sentence of up to five years, or both • Sec. 7203--$25,000 ($100,000 for corporations), a prison sentence of up to one year, or both • Sec. 7206--$100,000 ($500,000 for corporations), a prison sentence of up to three years, or both p. C:15-24.

C:15-4

C:15-28 Three years after the later of the due date for the return or the date on which the return was filed. Four exceptions are as follows: • Omissions from gross income exceeding 25% of the gross income shown on the return--six years. (A similar exception applies for estate and gift tax purposes.) • No return--no limitations period • Civil fraud--no limitations period • Criminal fraud--six years after the commission of the offense pp. C:15-24 through C:15-27. C:15-29 To protect the spouse from liability. Specifically, the principal purpose of the innocent spouse provisions is to relieve a spouse from joint and several liability for taxes attributable to omissions of income or deductions improperly claimed by the other spouse if it would be unfair to hold the innocent spouse liable. Relief is available in limited circumstances. pp. C:15-27 and C:15-28. C:15-30 No. A nonsigning preparer who gives advice to a taxpayer or another preparer, with that advice leading to a substantial position on a tax return, will be considered the preparer with respect to that item. p. C:15-29. C:15-31 Penalties assessable against tax return preparers include the following: • Understating a taxpayer’s tax liability because of an undisclosed position that does not have substantial authority, or taking a frivolous position; greater of $1,000 or 50% of the income derived from the return • Understating a taxpayer’s tax liability because of a willful attempt to understate taxes or reckless or intentional disregard of rules or regulations; $5,000 or 75% of the income derived from the return • Failure to furnish the taxpayer with a copy of the return or claim for refund; $60 per failure* • Failure to sign a return; $60 per failure* • Failure to furnish one’s identification number; $60 per failure* • Failure to keep a copy of a return or claim or to maintain a list of taxpayers for whom returns or claims were prepared; $60 per failure* • Failure to file correct information returns; $60 per failure* • Endorsement or negotiation of an income tax refund check payable to anyone other than the preparer; $600 per check • Failure to be diligent in determining eligibility for filing head of household status and for claiming the Child Tax Credit, Hope and Lifetime Learning Credit, and the Earned Income Tax Credit; $600 per failure *Up to a $30,000 maximum. The IRC does not require a CPA to verify the information that a client provides except where the CPA has reason to believe the information is incorrect. pp. C:15-33 and C:15-34. C:15-32 Substantial authority or reasonable basis. Under Circular 230, for a CPA to take a position on a tax return, he or she should believe that the position has substantial authority, or that the position has a reasonable basis if the position is properly disclosed. p. C:15-32. Copyright © 2024 Pearson Education, Inc.

C:15-5

C:15-33 a. Under Statement on Standards for Tax Services (SSTS) No. 6, the tax practitioner should promptly inform the client of the deduction error and recommend that the client file an amended return to correct the error. b. Under SSTS No. 6, the tax practitioner should consider whether to withdraw from preparing the client’s return and whether to continue the professional relationship. c. Under SSTS No. 3, the tax practitioner is under no duty to verify the expense amount unless it appears incorrect, incomplete, or inconsistent on its face, or on the basis of other facts known to the practitioner. d. Under SSTS No. 3, the tax practitioner should inquire into whether the client has satisfied the record-keeping requirements of Sec. 274 (pertaining to business-related entertainment expenses.) e. Under SSTS No. 7, unless bound by agreement or unless assisting the client in implementing exemption-related plans, the tax practitioner is under no duty to notify the client of the exemption increase. pp. C:15-32 through C:15-35.

Issue Identification Questions C:15-34 • • • •

Will you as the tax return preparer have sufficient support, under Sec. 6694 (substantial authority) and the AICPA’s SSTSs (realistic possibility of success), to advise the client to deduct the expenditure? Will the client have substantial authority for a deduction? If not, will the client have a reasonable basis for a deduction? If the client decides to deduct the expenditure, should you attach a disclosure statement to the tax return?

Background comments: the information presented is not complete enough for the students to conclude definitively whether the reasonable basis and substantial authority standards are met. The problem is designed, however, as an issue recognition problem, not a question for which there is a definitive answer. According to the AICPA’s SSTSs, you (the preparer) should believe that sufficient authority exists to meet the realistic possibility test. AICPA’s SSTS Interpretation of Statement No. 1 provides that a tax return position has a realistic possibility of success if it has a one-in-three or greater likelihood that the position will be upheld on its merits if it is challenged. If you do not believe that sufficient authority exists for meeting this test, you may adopt a pro-taxpayer position so long as you make a disclosure, and the position is not frivolous. The substantial authority standard is less stringent than the “more likely than not” (>50%) test, which implies that the authorities supporting a position are more substantial than authorities going the other way. Substantial authority may exist for more than one position. Treasury Regulations explain that reasonable basis refers to a position that is arguable but unlikely to be upheld in court. Provided a disclosure is made and sufficient support exists to meet the reasonable basis standard, the client will not owe the substantial understatement penalty (of Sec. 6662) in the event the IRS audits the taxpayer’s return and the taxpayer agrees to forego the $1 million deduction. Without such a disclosure, the IRS might levy the 20% substantial underpayment penalty. Furthermore, the IRS might levy a preparer penalty against you if you do not include a disclosure Copyright © 2024 Pearson Education, Inc.

C:15-6

with the return. The preparer penalty is $1,000 or 50% of the income derived from the return. pp. C:15-21, C:15-22, C:15-29, and C:15-30. C:15-35 •

Will Mr. Goedert be liable for a penalty if the $47,000 is excluded from his gross income? • What limitations period applies? If you are correct in believing that substantial authority exists for excluding the $47,000, Mr. Goedert should not be subjected to any penalties even if his return is audited and he agrees to include the $47,000 in his income. Unless a disclosure concerning the $47,000 is attached to Mr. Goedert’s return, the limitations period will be six years (from the date he files his return or from the due date for the return, if later) instead of the regular three years. The reason is that he will have omitted from his gross income more than 25% of the $140,000 of gross income reported on his return (25% x $140,000 = $35,000). To invoke a shorter limitations period, Mr. Goedert might make a disclosure. pp. C:15-20 through C:15-25. C:15-36 Pertinent tax compliance issues include the following: • Did Darryl understate his gross income by misreporting his earnings from baseball card shows? • Are the tax years in question still open under the applicable limitations period? • What amount of additional taxes (if any) does Darryl owe on the underreported income? • What amount of interest and penalties does Darryl owe on the understated tax liability? • What amount of civil and criminal penalties might be imposed on Darryl? • What tax-return-preparer, civil, and criminal penalties might be imposed on Darryl’s agent and/or CPA for underreporting Darryl’s tax liability? • What sanctions might the AICPA and/or the appropriate state board of public accountancy impose on the tax return preparer? The facts and circumstances of the situation will determine the penalties levied on Darryl and his CPA. At a minimum, a penalty will be imposed for failure-to-pay taxes. Because Darryl filed his tax return, no failure-to-file penalty will be imposed. In addition, interest may apply to the failure to make the appropriate estimated tax payments. A 20% negligence penalty also may be imposed on Darryl if the IRS can show that the underpayment was due to negligence or disregard of the IRC and Treasury Regulations. Also, a 20% substantial understatement penalty may be imposed under Sec. 6662(d). As an alternative, depending on the taxpayer’s intent, the IRS may impose a civil and criminal fraud penalty. The limitations period may be extended from three to six years if Darryl failed to report more than 25% of gross income on his tax return. (Whether this penalty applies cannot be discerned from public information.) No limitations period would apply if fraud could be proven. Criminal penalties under Secs. 7201, 7203, or 7206 could be supplemented by up to five years in prison. Various provisions apply to the tax return preparer. We do not have enough information to know which civil or criminal penalties, if any, might have been imposed. If the CPA actively participated in the fraudulent activity, he or she may lose his or her license to practice as a CPA or may lose the authority to practice before the IRS. If the CPA had no knowledge of the card show activities, etc., the CPA probably would not lose his or her license or authority to practice. pp. C:1512 through C:15-27, C:15-21 through C:15-26, and C:15-29 through C:15-32. Copyright © 2024 Pearson Education, Inc.

C:15-7

Problems C:15-37 a.

Failure-to-pay penalty– .005 x ($24,000 - $15,000) x 4 months $ 180 Failure-to-file penalty– .05 x ($24,000 - $15,000) x 4 months $1,800 Minus: Failure-to-pay penalty ( 180) 1,620 Total penalties $1,800 b. $9,000. Amy owes interest on $9,000 from April 16 through August 13 or for 120 days. pp. C:15-12 through C:15-17. C:15-38 a.

Failure-to-pay penalty– .005 x ($24,000 - $19,000) x 5 months $125 Failure-to-file penalty*– .05 x ($24,000 - $19,000) x 3 months $750 Minus: Failure-to-pay penalty for 3 months ( 75) 675 Total penalties $800 Amy owes interest on $5,000 from April 16 through September 8 or for 146 days. b. No penalties or interest are imposed because the taxes withheld exceeds the tax owed. * The minimum failure to file penalty equals the lesser of $485 or the tax owed. c. Failure-to-pay penalty only, plus interest. If Amy requests an extension, the failureto-file penalty will not apply because she files the return before the October 15 extended due date. The failure-to-pay penalty will be imposed because the additional tax due with the filing of the return ($5,000) exceeds $2,400, or 10% of the $24,000 tax owed for the year (Reg. Sec. 301.66511(c)(3)). Amy owes interest on $5,000 for 146 days from April 16 through September 8. pp. C:15-12 through C:15-17. C:15-39 $210 penalty. Hu’s Year 1 AGI did not exceed $150,000. Therefore, she does not owe the penalty for underpaying estimated tax for Year 2 because she paid through withholding an amount equal to her Year 1 tax liability. She does not owe the failure-to-file penalty because she filed a timely return. She owes the failure-to-pay penalty for 15 months. The penalty is $210 (.005 x $2,800 x 15). pp. C:15-13 through C:15-20. C:15-40 None. Ted owes no penalty for failure-to-file or failure-to-pay because the amount withheld exceeds the tax liability owed. pp. C:15-15 through C:15-19. C:15-41 Failure-to-pay penalty– .005 x $5,100 x 7 months Failure-to-file penalty– .05 x $5,100 x 4 months Minus: Failure-to-pay penalty for same time period– .005 x $5,100 x 4 months Total penalties

$ 179 $1,020 (102)

918 $1,097

C:15-8

C:15-42 Carl owes the penalty for underpaying estimated taxes unless he has paid in amounts equal to 90% of his current year’s tax or 100% of his prior year’s tax. •

In the first situation, $20,000 is less than $20,700 (0.90 x $23,000). However, the $20,000 withheld equals or exceeds 100% of last year’s tax liability, or $19,000, so he owes no penalty for underpaying the estimated taxes.

•

In the second situation, $20,000 is not less than $18,720 (0.90 x $20,800), so he owes no penalty for underpaying the estimated taxes. The $20,000 also equals or exceeds 100% of last year’s tax liability.

In addition, Carl owes the failure-to-pay penalty unless the additional tax owed does not exceed 10% of the tax for the current year. •

In the first situation, the $3,000 unpaid amount ($23,000 - $20,000) exceeds the 10% limit ($2,300 = 0.10 x $23,000). Carl owes a penalty of $45 (.005 x $3,000 x 3) for his failure to pay.

•

In the second situation, the $800 unpaid amount ($20,800 - $20,000) does not exceed the 10% limit ($2,080 = 0.10 x $20,800); therefore, Carl owes no failure-to-pay penalty.

pp. C:15-12 through C:15-20. C:15-43 a. Carl will owe interest on $3,000 ($23,000 - $20,000) in the first situation [or on $800 ($20,800 - $20,000) in the second situation] from April 16 through June 18 of the following year, or for 63 days. b. $31.07 (0.06 x (63/365) x $3,000). In Rev. Proc. 95-17, the factor for 6% compounded for 63 days is 0.010409115. Applying this method yields $31.22 of interest. pp. C:15-12 and C:15-13. C:15-44 Because Ed’s AGI for last year does not exceed $150,000, he should remit $24,000 (100% of the prior year liability), at a minimum, to avoid the penalty. pp. C:15-17 through C:15-20. C:15-45 Ed’s AGI for last year does not exceed $150,000. Therefore, he should remit $13,500 (0.90 x $15,000) because this amount is less than his last year’s tax liability. A problem arises, however, because the large gain causes his actual tax for this year to exceed $15,000. If he remits only $13,500, he will owe a penalty for underpayment of estimated taxes. pp. C:15-17 through C:15-20. C:15-46 a. Pam will owe a penalty for not paying estimated taxes because she did not pay at least the lesser of $29,340 (0.90 x $32,600) or $23,000 (100% of her last year’s tax).

C:15-9

Amount that should have been paid in each quarter ($23,000 x 0.25) Minus: Amount paid in each quarter ($20,000 x 0.25) Amount per quarter subject to penalty

$5,750 ( 5,000) $ 750

The penalty is imposed for the following time periods: Quarter 1st 2nd 3rd 4th

Time periods April 16, Year 2 - April 2, Year 3 June 16, Year 2 - April 2, Year 3 September 16, Year 2 - April 2, Year 3 January 16, Year 3 - April 2, Year 3

c. Pam will meet the relief requirement – at least 90% of the current year tax liability – so she will not owe an underpayment penalty. pp. C:15-17 through C:15-20. C:15-47 $6,400 withholding. The amount paid to date is $14,300 (11 x $1,300). Amir should remit the lesser of $21,000 (100% of last year’s tax liability) or $20,700 (90% of this year’s tax liability). His withholding for December should be $6,400 ($20,700 - $14,300). This amount, because it is from withholding taxes, is treated as having been paid equally throughout the year. The total amount withheld thus equals 90% of the tax for the current year. Therefore, Amir will incur no penalty for underpaying estimated taxes. The $2,300 ($23,000 - $20,700) balance due must be paid when he files the return. pp. C:15-17 through C:15-20. C:15-48 $560 plus interest. The negligence penalty is $560 (0.20 x $2,800), the portion of the deficiency attributable to negligence. The penalty bears interest at the rate applicable to underpayments. pp. C:15-20 and C:15-21. C:15-49 The negligence penalty is $448 (0.20 x $2,240). pp. C:15-20 and C:15-21. C:15-50 a. None. Carmen incurs no substantial understatement penalty because the underpayment ($1,860) does not exceed the greater of (1) $2,186 (0.10 x $21,860 correct tax) or (2) $5,000. b. No. Carmen incurs no penalty, but had she, the penalty would be subject to interest. c. $1,240 penalty plus interest. The understatement ($6,200) would exceed the greater of (l) $2,620 (0.10 x $26,200 correct tax) or (2) $5,000. The penalty would be $1,240 (0.20 x $6,200). Interest also would be owed. p. C:15-21. C:15-51 No penalty. Because Carmen discloses her position, which is not frivolous; the underpayment is not treated as an understatement. Thus, she incurs no penalty. p. C:15-21. C:15-52 a. The civil fraud penalty is $42,000 (0.75 x $56,000). b. Under Sec. 7201 the fine could be as high as $100,000. In addition, Luis could receive a maximum prison sentence of five years. pp. C:15-22 through C:15-24. Copyright © 2024 Pearson Education, Inc.

C:15-10

C:15-53 a. The penalty incurred because of fraud is $13,125 (0.75 x 0.35 tax rate x $50,000). This answer assumes that the couple establishes that the overstatement of deductions is not because of fraud; otherwise, the penalty applies to the total underpayment. The fraud penalty cannot be collected from Hal because he did not commit a fraudulent act. b. She can be fined up to $100,000 and/or receive a prison sentence of up to five years. Hal cannot be imprisoned. pp. C:15-23 and C:15-24. C:15-54 a. After April 15 of Year 8. His understatement of gross income is $52,000. This amount exceeds 25% of the gross income he reported ($25,000 = 0.25 x $100,000). The limitations period expires after April 15 of Year 8. b. There is no limitations period. pp. C:15-21, and C:15-24 through C:15-26. C:15-55 After October 8 of Year 9. The limitations period for a criminal indictment expires six years after the date of the last fraudulent act. A fraudulent act can occur subsequent to the filing of the return. Here the limitations period expires after October 8 of Year 9. Taxes still can be collected after the criminal statute expires. pp. C:15-24 through C:15-27. C:15-56 April 15 of Year 5. By three years from the due date of the return, that is, by April 15 of Year 5. p. C:15-24. C:15-57 Partially. (1) Wilma and Hank filed a joint return; (2) the return contained an understatement of tax attributable to Hank’s erroneous item; and (3a) Wilma can establish that she did not know of the understatement. However, (3b) Wilma also must establish that she had no reason to know of the understatement; (4) based on all the facts and circumstances, holding Wilma liable for the deficiency must be inequitable; and (5) Wilma must elect innocent spouse relief no later than two years after the IRS begins its collection efforts. pp. C:15-27 and C:15-28. C:15-58 Probably not. Although (1) Joe and Joan filed a joint return, and (2) the return contained an understatement of tax attributable to Joan’s erroneous item, and (3) Joe can establish that he did not actually know of the understatement he nevertheless had reason to know. He had reason to know because he benefited directly from Joan’s prize. The receipt of this benefit should have alerted him to the requirement to report it as taxable income. pp. C:15-27 and C:15-28. C:15-59 Activities (c) and (d) constitute the unauthorized practice of law because they involve the drafting and filing of legal documents. Activities (a) and (b) fall within the traditional domain of accountants. Activity (e) may properly be conducted by either accountants or lawyers. pp. C:15-35 and C:15-36. C:15-60 Activities (a), (b), and (c) constitute the unauthorized practice of law because they potentially involve a determination or modification of the rights of the company’s stockholders or creditors. Activity (d) falls within the traditional domain of accountants. Activity (e) may properly be conducted by either accountants or lawyers. pp. C:15-35 and C:15-36. C:15-61 Only communication (b) is privileged because it is made for the purpose of obtaining professional tax advice. Communication (a) is not privileged because it is made for tax preparation purposes only. Communication (c) is not privileged because it does not involve a tax matter. p. C:15-36. Copyright © 2024 Pearson Education, Inc.

C:15-11

C:15-62 Communications (b) and (c) are not privileged, the former because it involves a written communication relating to a tax shelter (i.e., any plan or arrangement, a significant purpose of which is tax avoidance), the latter because it is discoverable in a criminal proceeding. Although communication (a) relates to a tax shelter, it was not made in writing. p. C:15-36.

Comprehensive Problem C:15-63 Yes. Paragraph 12 of AICPA Statement No. 1 provides that a member may “consider a well-reasoned construction of the applicable statute, well-reasoned articles or treatises, or pronouncements issued by the applicable taxing authority, regardless of whether such sources would be treated as authority under” IRC 6662. Here, Edith relied on an authority in addition to those evaluated when determining whether substantial authority exists. This authority was an article in a recognized professional tax publication. This standard is predicated on both primary and secondary tax authorities.

Tax Strategy and Critical Thinking Problem C:15-64 You should choose Alternative 2: Waive the statute of limitations for the deduction only (and for a reasonable period of time). Waiving the statute of limitations for the entire return (Alternative 1) would give the IRS time to audit other items on the return. While you have a duty to report these items correctly and to pay your fair share of the tax burden; the IRS also has a duty to bring finality to taxpayer affairs within the timeframe set by Congress. Your refusing to waive the statute of limitations in any way, shape, or form (Alternative 3) not only might prompt the audit agent to assess a higher penalty at the last minute, but also preclude the possibility of your appealing the assessment to the IRS Appeals Office or the courts. Because you have substantial authority for the deduction, Alternative 2 relieves you of the possibility of an accuracy-related penalty. It also gives you time to appeal any adverse audit decision and opens the door for a possible offer in compromise.

Case Study Problem C:15-65 If you prepare Horace’s return in accordance with his wishes, you will not have met the requirements of Treasury Department Circular 230. Because the Treasury Regulation is the only authority, it does not appear that a position contrary to the regulation will have substantial authority. A position contrary to a Treasury Regulation may have reasonable basis, but Horace is not willing to disclose such a position. In addition, you, the preparer, will not be in compliance with Sec. 6694 if the position (going against the regulation) is not disclosed. Thus, you might incur a maximum penalty of the greater of $1,000 or 50% of your income derived from Horace’s return. Moreover, if you defer to Horace’s wishes, you probably will not have abided by the Statements on Standards for Tax Services (SSTS) No. 1, which, at a minimum, require that a CPA have a good faith belief that the position, if challenged, would be sustained on its merits.

C:15-12

Tax Research Problems C:15-66 The estate will owe the failure-to-file penalty. Reliance on the attorney’s advice does not constitute reasonable cause for filing late. Section 6075(a) states that estate tax returns must be filed within nine months after the date of the decedent’s death. Section 6151(a) provides that the person required to file the return shall pay the tax at the time and place fixed for filing the return. Section 6651 provides that the penalty can be waived if the taxpayer demonstrates that the failure is “due to reasonable cause and not due to willful neglect.” U.S. v. Robert W. Boyle, 55 AFTR 2d 85-1535, 85-1 USTC ¶13,602 (USSC, 1985), is a U.S. Supreme Court case dealing with the imposition of the failure-to-file penalty. In Boyle, the executor engaged an attorney to prepare an estate tax return. Whenever he inquired of the attorney, he was assured that the return would be timely filed, but the return was filed late. The Supreme Court would not waive the penalty because, in its opinion, reliance on an agent’s advice is not reasonable cause. It emphasized that Congress placed the burden of prompt filing on the executor and that a person does not need special training to ascertain a deadline and ensure that it is met. The Court contrasted the present case with one where a taxpayer “relied on the erroneous advice of counsel concerning a question of law.” C:15-67 Students should argue that, because the taxpayers had a reasonable basis for claiming the deductions, the penalty should not be imposed. The taxpayers were naive in their knowledge of the tax law and attempted to comply by having a CPA prepare their return. They read legal information about the investment and had their advisor explain what they could not understand. Because of their education level, their lack of investment knowledge, and their attempt to prepare a correct tax return, the IRS should not impose the penalty. Harold and Betty’s facts are very similar to those of David E. Heasley v. CIR, 66 AFTR 2d 90-5068, 90-1 USTC ¶50,314 (5th Cir., 1990), reversing PH Memo T.C. ¶88,408, 55 TCM 1748). In Heasley, the Fifth Circuit waived the penalty because the unsophisticated investors’ reliance on the advice of their accountant and investment advisor was deemed to constitute reasonable cause for their tax understatement. However, in Action on Decision (AOD) 1991-013 (7/15/1991) the IRS announced that it still contends that reliance on professional advice does not show good faith in the absence of a showing that the reliance was reasonable. Harold and Betty’s facts also resemble those of George S. Mauerman, 73 AFTR 2d 94-2002, 94-1 USTC ¶50,222 (10th Cir., 1994), reversing RIA Memo TC ¶93,023, 65 TCM 1772, where the penalty was waived on the ground that the taxpayer (a physician not trained in tax law) consulted with and relied on disinterested tax advisors. Regulation Sec. 1.6664-4(c) states that reliance on professional advice constitutes reasonable cause and good faith if, considering all the circumstances, the reliance was reasonable and the taxpayer acted in good faith. The taxpayer’s education, sophistication, and business experience are relevant in this determination.

C:15-13

C:15-68 In arguing that the trusts should qualify for the annual exclusion, the ruling request should emphasize the following points: 1. Until each beneficiary reaches age 21, the trustee is empowered to distribute income and/or principal at its discretion. This trust provision is consistent with Sec. 2503(c), which treats the transfer as a present interest. 2. Upon attaining age 21, each beneficiary has 60 days in which to demand that the trustee distribute the assets to him or her. In Rev. Rul. 74-43, 1974-1 C.B. 285, the IRS stated that an annual exclusion is available if the beneficiary, upon attaining age 21, had a right to compel immediate distribution of the assets, provided such right is continuing or exists for a limited time period. Gene’s factual situation is governed by this revenue ruling. The ruling request should incorporate a statement that each beneficiary will be advised in writing in a timely fashion of his power to demand distribution of the assets. Thus, the demand right, contrary to that at issue in Rev. Rul. 81-7, 1981-1 C.B. 474, should not be classified as illusory. C:15-69 The issues raised by this problem are as follows: 1. 2. 3. 4.

Is there a substantial understatement of the Tylers’ Year 1 taxes? a. Does substantial authority exist for the deduction? b. If the position was not frivolous, was this position disclosed on the return? Is Renee liable for any potential understatement? Is she jointly liable for the partnership’s potential fraud, failure to file, and failure to keep adequate records? Is “innocent spouse” relief available for Renee? a. Given her level of education, relationship to the partners, and work as a receptionist, did she have actual or constructive knowledge of a substantial understatement? b. Based on all the facts and circumstances, would it be inequitable to hold her liable for the deficiency?

Issue 1: The understatement exceeds the greater of 10% of the tax required to be shown on the return ($305 or $5,000): a. Although substantial authority exists for the loss deduction (Sec. 165), and b. Although the position is not frivolous and a reasonable basis in law exists for the deduction, a reasonable basis in fact, which was disclosed on the Tylers’ return (perhaps via a Schedule K-1), may not exist. Thus, the Tylers might be assessed a substantial understatement penalty equal to 20% of $5,308, or $1,061.60. Issue 2: Because Renee presumably signed the joint return; she would be jointly and severally liable for the substantial understatement penalty. However, three possibilities exist. First, if Renee neither knew nor had reason to know of the understatement (and otherwise qualifies for innocent spouse relief), she will not be liable for taxes, interest, and penalties attributable to the full amount of the understatement. Second, if Renee knew or had reason Copyright © 2024 Pearson Education, Inc.

C:15-14

to know of the understatement but not the extent of the understatement (and otherwise qualifies for innocent spouse relief), she will not be liable for taxes, interest, and penalties attributable to that portion of the understatement of which she was unaware. Third, if Renee (1) neither knew or had reason to know of the understatement, (2) is separated or divorced, (3) did not reside in the same household as Adam during the preceding 12 months (and otherwise qualifies for innocent spouse relief), she will be liable only for taxes, interest, and penalties attributable to her separate taxable items. See Rev. Proc. 2013-14, 2013-43 I.R.B 397, for the IRS’s procedures for gaining relief under the innocent spouse provisions. Issue 3: Because Renee did not sign a partnership return (and indeed, because she is not a partner in the partnership), she would not be liable for the partnership’s potential fraud, failure to file, and failure to keep adequate records. Issue 4: One test for innocent spouse relief has been met; a joint return was filed. The questions thus become: • • •

Did the return contain an understatement of tax attributable to the erroneous items of Adam? Did Renee know, or have reason to know, of the substantial understatement? Based on all the facts and circumstances, would it be inequitable to hold Renee liable for the deficiency?

The Tyler’s return appears to have understated the tax by $5,308. This potential understatement is attributable to Adam’s partnership loss. Circumstances suggest that deducting the loss was erroneous. b. Although Renee may not have actually known of the substantial understatement, she may have constructively known (i.e., had reason to know). She appears to have been fairly educated (a marketing consultant). She had family ties to the partners. She occasionally worked in the partnership. Her husband gave her a car purchased with cash withdrawn from the partnership. On the other hand, Renee was not active in the partnership business and simply may have assumed that the loss was bona fide. c. Depending on the Tylers’ financial condition, Adam’s health, and Renee’s personal circumstances, it may be inequitable to hold Renee liable for the deficiency. More information is needed. To qualify for innocent spouse relief, Renee must elect such relief no later than two years after the IRS begins its collection efforts. If she establishes that she either knew or had reason to know of the understatement, but not the extent of the understatement, she will be relieved of liability for taxes, interest, and penalties attributable to that portion of the understatement of which she was unaware. Adam and Renee’s facts are most similar to those of the taxpayers in Rebecca Jo Reser v. CIR, 79 AFTR 2d 97-2743, 97-1 USTC ¶50416 (5th Cir., 1997). In Reser, which was based on pre1998 law, the Fifth Circuit granted innocent spouse relief to Mrs. Reser, based on many of the factors mentioned above. In addition, the court found Mrs. Reser not liable for the substantial understatement penalty. Copyright © 2024 Pearson Education, Inc.

C:15-15

C:15-70 The memorandum should point out that the investment proposal is a “listed transaction” within the meaning of Sec. 6707A(c)(2). Therefore, it would be subject to the taxpayer disclosure requirements of Reg. Sec. 1.6011-4 and Sec. 6111. The proposal also is a “reportable transaction” within the meaning of Reg. Sec. 301.6112-1. Therefore, it would be subject to listing requirements of that regulation. The proposal is a “listed transaction” because it is substantially similar to a transaction identified by the Treasury Department in Notice 2000-44, 2000-2 C.B. 255, as a tax avoidance scheme. The identified transaction involves a taxpayer’s borrowing at a premium and a partnership’s subsequent assumption of taxpayer indebtedness to generate a tax loss without economic substance. The proposal is a “tax shelter” because it is an investment with respect to which any person might reasonably infer from the representations made in connection with its offering for sale that the tax shelter ratio may be greater than 2 to 1. The tax shelter ratio is the ratio of deductions (in this case, the $5000 capital loss) to the investment base (in this case, $0 taxpayer equity). The proposal is a “potentially abuse tax shelter” because it is a “listed transaction” subject to the disclosure requirements of Reg. Sec. 1.6011-4. Regulation Sec. 1.6011-4(d) requires every taxpayer who has participated in a listed transaction to attach to his or her return Form 8886 (Reportable Transaction Disclosure Statement). Section 6111(a) and Reg. Sec. 1.6011-3 requires every tax shelter organizer to register the tax shelter with the Treasury Department and to furnish to any person who acquires an interest in the tax shelter an identification number assigned to it by the Treasury Department. Regulation Sec. 301.6112-1 requires every organizer and seller of a potentially abusive tax shelter to maintain a list of tax shelter investors and to furnish this list to the IRS upon request. The memorandum also might mention that, under Sec. 6707A(b)(2)(A), the taxpayer’s failure to disclose the tax shelter would subject him or her to a penalty ranging from $100,000, if a natural person, to $200,000 for all other taxpayers. Under Reg. Sec. 301.6701-1, the organizer’s failure to file a return with proper disclosures would subject him or her to a penalty equal to the greater of $200,000 or (2) 50 percent of the advisor’s fees (75 percent if the failure was intentional). Under Reg. Sec. 301.6708-1, the organizer’s failure to maintain a list of tax shelter investors and to provide that list to IRS within 20 days of the request would subject him or her to a penalty of $10,000 per day that the list was not provided. The advisor can show good cause why he or she cannot comply with the request within 20 days and request an extension of time. C:15-71 The IRS is correct in its allegation because the series of transactions lack economic substance. In addition, their principal purpose is tax avoidance. The IRS is not precluded by the normal three-year limitations period because (1) Spyros omitted from his earlier return an income amount that was properly includible, (2) this amount exceeded 25% of gross income reported on Spyros’ return, and (3) Spyros did not adequately disclose this amount. Thus, under Sec. 6501(a), the six-year limitations period applies.

C:15-16

The facts of the problem are analogous to those of Brandon Ridge Partners v. U.S., 100 AFTR 2d 2007-5347, 2007-2 USTC ¶50,573 (DC FL, July 30, 2007). In Brandon Ridge, Nelson Jefferson, a majority shareholder in Florida Electronic Supply, Inc. (FES), transferred his low basis FES stock to newly formed Brandon Ridge Partners (BRP). Simultaneously, his wife transferred property of nominal value to BRP. Subsequent to the transfer, Nelson owned 99% of BRP, while his wife owned the remaining 1%. Later, Nelson transferred his 99% BRP interest to newly formed Brandon Ridge, Inc. (BRI), in exchange for 100% of its shares. As a result of this exchange, Nelson controlled BRI, which in turn controlled BRP as well as the FES stock. Under Sec. 708, the transfer of the partnership interest caused a technical termination of BRP. However, the Jeffersons agreed to continue the partnership business as a reconstituted BRP. The reconstituted partnership then elected under Sec. 754 to increase its basis in the FES stock to its fair market value. Following the election, it sold the FES stock to an unrelated third party at a nominal low gain. Nearly six years later, the IRS audited the Jeffersons’ joint return and alleged that the couple had substantially understated their gross income. The Jeffersons countered that no such understatement occurred because they had properly reported all income on their earlier return. They further argued that, even if an understatement did occur, the normal three-year limitations period barred any IRS action to recover the additional tax due. The U.S. Court for the Middle District of Florida reviewed the case and agreed with the IRS. The Court reasoned: (1) the series of transactions conducted by the Jeffersons lacked economic substance causing the initial built-in gain to be recognized; (2) as a result of this gain recognition, the Jeffersons’ gross income for the year in question had been substantially understated; and (3) as a result of this substantial understatement, the six-year rather than three-year limitations period applied.

“What Would You Do In This Situation?” Solution Ch. C:15, p. C:15-25. Section 7206(2) provides that any person who “willfully aids or assists in, or procures, counsels, or advises the preparation or presentation under, or in connection with any matter arising under the internal revenue laws, of a return, affidavit, claim, or other document, which is fraudulent or is false as to any material matter, whether or not such falsity or fraud is with the knowledge or consent of the person authorized or required to present such return, affidavit, claim, or document...” shall be guilty of a felony. Upon conviction thereof, he or she shall be fined not more than $100,000 ($500,000 in the case of a corporation) or imprisoned not more than three years, or both, and will be liable for the costs of prosecution. Section 7206 provides for substantial penalties when the amount in question is material. The penalties are imposed not on the taxpayer but on the tax preparer. Civil penalties of up to $100,000, criminal penalties, and/or a maximum prison sentence of three years may be imposed.

C:15-17

Among the other penalties that might apply if a lesser offense were committed are: a. c. d.

20% negligence penalty b. 20% substantial underpayment of income tax penalty Civil fraud penalty–75% of underpayment attributable to fraud Tax return preparer penalties

Sec. 6662(c) Sec. 6662(d) Sec. 6663 Secs. 6694 and 6695

If the errors involve significant dollar amounts, individual clients may sue their tax advisors under the malpractice rules of the state in which the advisor practices. The cost of defending against these charges and paying damages may outweigh the benefits accruing to the advisors from overaggressive or unfounded tax positions and an expanded practice. In addition, repeat offenses could lead to a suspension of the tax advisor’s authority to practice before the IRS (Treasury Department Circular 230). If the violations are serious enough, the IRS can suspend the tax advisor’s license for a period of time, including life. The IRS reviews each return that results in an additional assessment to see whether a tax return preparer penalty might apply. The IRS accumulates these data for each tax return preparer. Repeated violations of a similar nature might be gleaned from these data and may result in additional sanctions under Circular 230. Depending on the nature of the violations, the tax advisor’s CPA license might be suspended by the board of public accountancy for his or her state.

C:15-18

2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

C:1-1 C:1-2 C:1-3 C:1-4 C:1-5 C:1-6 C:1-7 C:1-8 C:1-9 C:1-10 C:1-11 C:1-12 C:1-13 C:1-14 C:1-15 C:1-16 C:1-17 C:1-18 C:1-19 C:1-20 C:1-21 C:1-22 C:1-23 C:1-24 C:1-25 C:1-26 C:1-27 C:1-28 C:1-29 C:1-30 C:1-31 C:1-32

Chapter C:1 Discussion Questions:

Problems: C:1-33 C:1-34 C:1-35 C:1-36

C:SQR-1

2023 Edition Modification "M"

2024 Edition Questions and Problems C:1-37 C:1-38 C:1-39 C:1-40 C:1-41 C:1-42 C:1-43 C:1-44 C:1-45 C:1-46 C:1-47 C:1-48 C:1-49 C:1-50 C:1-51 C:1-52 C:1-53 C:1-54 C:1-55 C:1-56 C:1-57 C:1-58 C:1-59

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:1-37 C:1-38 C:1-39 C:1-40 C:1-41 C:1-42 C:1-43 C:1-44 C:1-45 C:1-46 C:1-47 C:1-48 C:1-49 C:1-50 C:1-51 C:1-52 C:1-53 C:1-54 C:1-55 C:1-56 C:1-57 C:1-58 C:1-59

Comprehensive Problem: C:1-60

C:1-60

Tax Strategy and Critical Thinking Problem: C:1-61

C:1-61

Case Study Problem: C:1-62

C:1-62

Tax Research Problems: C:1-63 C:1-64 C:1-65 C:1-66 C:1-67

C:1-63 C:1-64 C:1-65 C:1-66 C:1-67

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2023 Edition Modification "M" M

2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

Chapter C:2 Discussion Questions: C:2-1 C:2-2 C:2-3 C:2-4 C:2-5 C:2-6 C:2-7 C:2-8 C:2-9 C:2-10 C:2-11 C:2-12 C:2-13 C:2-14 C:2-15 C:2-16 C:2-17 C:2-18 C:2-19 C:2-20 C:2-21 C:2-22 C:2-23 C:2-24

C:2-1 C:2-2 C:2-3 C:2-4 C:2-5 C:2-6 C:2-7 C:2-8 C:2-9 C:2-10 C:2-11 C:2-12 C:2-13 C:2-14 C:2-15 C:2-16 C:2-17 C:2-18 C:2-19 C:2-20 C:2-21 C:2-22 C:2-23 C:2-24

Issue Identification Questions: C:2-25 C:2-26 C:2-27

C:2-25 C:2-26 C:2-27

Problems: C:2-28 C:2-29 C:2-30 C:2-31 C:2-32 C:2-33 C:2-34 C:2-35

C:SQR-3

2023 Edition Modification "M"

2024 Edition Questions and Problems C:2-36 C:2-37 C:2-38 C:2-39 C:2-40 C:2-41 C:2-42 C:2-43 C:2-44 C:2-45 C:2-46 C:2-47 C:2-48 C:2-49 C:2-50 C:2-51 C:2-52 C:2-53

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:2-36 C:2-37 C:2-38 C:2-39 C:2-40 C:2-41 C:2-42 C:2-43 C:2-44 C:2-45 C:2-46 C:2-47 C:2-48 C:2-49 C:2-50 C:2-51 C:2-52 C:2-53

Comprehensive Problems: C:2-54 C:2-55

C:2-54 C:2-55

Tax Strategy and Critical Thinking Problems: C:2-56 C:2-57 C:2-58

C:2-56 C:2-57 C:2-58

Case Study Problems: C:2-59 C:2-60

C:2-59 C:2-60

Tax Research Problems: C:2-61 C:2-62 C:2-63 C:2-64 C:2-65

C:2-61 C:2-62 C:2-63 C:2-64 C:2-65

Chapter C:3 Discussion Questions: C:3-1 C:3-2 C:3-3

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2023 Edition Modification "M"

2024 Edition Questions and Problems C:3-4 C:3-5 C:3-6 C:3-7 C:3-8 C:3-9 C:3-10 C:3-11 C:3-12 C:3-13 C:3-14 C:3-15 C:3-16 C:3-17 C:3-18 C:3-19 C:3-20 C:3-21 C:3-22 C:3-23 C:3-24 C:3-25 C:3-26 C:3-27

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:3-4 C:3-5 C:3-6 C:3-7 C:3-8 C:3-9 C:3-10 C:3-11 C:3-12 C:3-13 C:3-14 C:3-15 C:3-16 C:3-17 C:3-18 C:3-19 C:3-20 C:3-21 C:3-22 C:3-23 C:3-24 C:3-25 C:3-26 C:3-27

Issue Identification Questions: C:3-28 C:3-29 C:3-30 C:3-31

C:3-28 C:3-29 C:3-30 C:3-31

Problems: C:3-32 C:3-33 C:3-34 C:3-35 C:3-36 C:3-37 C:3-38 C:3-39 C:3-40 C:3-41

C:SQR-5

2023 Edition Modification "M"

2024 Edition Questions and Problems C:3-42 C:3-43 C:3-44 C:3-45 C:3-46 C:3-47 C:3-48 C:3-49 C:3-50 C:3-51 C:3-52 C:3-53 C:3-54 C:3-55 C:3-56 C:3-57 C:3-58 C:3-59 C:3-60 C:3-61 C:3-62

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:3-42 C:3-43 C:3-44 C:3-45 C:3-46 C:3-47 C:3-48 C:3-49 C:3-50 C:3-51 C:3-52 C:3-53 C:3-54 C:3-55 C:3-56 C:3-57 C:3-58 C:3-59 C:3-60 C:3-61 C:3-62

2023 Edition Modification "M"

Comprehensive Problem: C:3-63

C:3-63

Tax Strategy and Critical Thinking Problems: C:3-64 C:3-65

C:3-64 C:3-65

Tax Form/Return Preparation Problems: C:3-66 C:3-67 C:3-68 C:3-69

C:3-66 C:3-67 C:3-68 C:3-69

Case Study Problems: C:3-70 C:3-71

C:3-70 C:3-71

Tax Research Problems: C:3-72 C:3-73

C:3-72 C:3-73

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2024 Edition Questions and Problems

Chapter C:4

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

2023 Edition Modification "M"

Discussion Questions: C:4-1 C:4-2 C:4-3 C:4-4 C:4-5 C:4-6 C:4-7 C:4-8 C:4-9 C:4-10 C:4-11 C:4-12 C:4-13 C:4-14 C:4-15 C:4-16 C:4-17 C:4-18 C:4-19 C:4-20 C:4-21

C:4-1 C:4-2 C:4-3 C:4-4 C:4-5 C:4-6 C:4-7 C:4-8 C:4-9 C:4-10 C:4-11 C:4-12 C:4-13 C:4-14 C:4-15 C:4-16 C:4-17 C:4-18 C:4-19 C:4-20 C:4-21

Issue Identification Questions: C:4-22 C:4-23 C:4-24 C:4-25

C:4-22 C:4-23 C:4-24 C:4-25

Problems: C:4-26 C:4-27 C:4-28 C:4-29 C:4-30 C:4-31 C:4-32 C:4-33 C:4-34 C:4-35

C:SQR-7

2024 Edition Questions and Problems C:4-36 C:4-37 C:4-38 C:4-39 C:4-40 C:4-41 C:4-42 C:4-43 C:4-44 C:4-45 C:4-46 C:4-47 C:4-48 C:4-49 C:4-50 C:4-51 C:4-52 C:4-53 C:4-54 C:4-55 C:4-56 C:4-57

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:4-36 C:4-37 C:4-38 C:4-39 C:4-40 C:4-41 C:4-42 C:4-43 C:4-44 C:4-45 C:4-46 C:4-47 C:4-48 C:4-49 C:4-50 C:4-51 C:4-52 C:4-53 C:4-54 C:4-55 C:4-56 C:4-57

2023 Edition Modification "M"

Comprehensive Problem: C:4-58

C:4-58

Tax Strategy and Critical Thinking Problem: C:4-59

C:4-59

Case Study Problems: C:4-60 C:4-61

C:4-60 C:4-61

Tax Research Problems: C:4-62 C:4-63 C:4-64 C:4-65 C:4-66

C:4-62 C:4-63 C:4-64 C:4-65 C:4-66

C:SQR-8

2024 Edition Questions and Problems

Chapter C:5

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

2023 Edition Modification "M"

Discussion Questions: C:5-1 C:5-2 C:5-3 C:5-4 C:5-5 C:5-6 C:5-7 C:5-8 C:5-9 C:5-10 C:5-11 C:5-12 C:5-13 C:5-14 C:5-15 C:5-16 C:5-17 C:5-18 C:5-19 C:5-20

N N

C:5-1 C:5-2 C:5-3 C:5-4 C:5-5 C:5-6 C:5-7 C:5-8 C:5-9 C:5-10 C:5-11 C:5-12 C:5-13 C:5-14 C:5-15 C:5-16 C:5-17 C:5-18 ---

M M

Issue Identification Questions: C:5-21 C:5-22

C:5-19 C:5-20

Problems: C:5-23 C:5-24 C:5-25 -C:5-26 C:5-27 C:5-28 C:5-29 C:5-30 C:5-31 C:5-32 C:5-33 C:5-34

N N N N

C:5-21 C:5-22 C:5-23 C:5-24 ----C:5-25 C:5-26 C:5-27 C:5-28 C:5-29

C:SQR-9

2024 Edition Questions and Problems C:5-35 C:5-36 C:5-37 C:5-38 C:5-39 C:5-40 C:5-41 C:5-42

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:5-30 C:5-31 C:5-32 N -N -N -N -N --

Comprehensive Problem: C:5-43

C:5-33

Tax Strategy and Critical Thinking Problems: C:5-44 C:5-45

C:5-34 C:5-35

Case Study Problems: C:5-46 C:5-47

C:5-36 C:5-37

Tax Research Problems: C:5-48 C:5-49

C:5-38 C:5-39

Chapter C:6 Discussion Questions: C:6-1 C:6-2 C:6-3 C:6-4 C:6-5 C:6-6 C:6-7 C:6-8 C:6-9 C:6-10 C:6-11 C:6-12 C:6-13 C:6-14 C:6-15 C:6-16

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2024 Edition Questions and Problems C:6-17 C:6-18 C:6-19 C:6-20 C:6-21 C:6-22 C:6-23 C:6-24 C:6-25 C:6-26 C:6-27 C:6-28

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:6-17 C:6-18 C:6-19 C:6-20 C:6-21 C:6-22 C:6-23 C:6-24 C:6-25 C:6-26 C:6-27 C:6-28

Issue Identification Questions: C:6-29 C:6-30 C:6-31

C:6-29 C:6-30 C:6-31

Problems: C:6-32 C:6-33 C:6-34 C:6-35 C:6-36 C:6-37 C:6-38 C:6-39 C:6-40 C:6-41 C:6-42 C:6-43 C:6-44 C:6-45 C:6-46 C:6-47 C:6-48 C:6-49 C:6-50 C:6-51 C:6-52 C:6-53

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2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

Comprehensive Problem: C:6-54

C:6-54

Tax Strategy and Critical Thinking Problems: C:6-55 C:6-56 C:6-57

C:6-55 C:6-56 C:6-57

Case Study Problems: C:6-58 C:6-59

C:6-58 C:6-59

Tax Research Problems: C:6-60 C:6-61

C:6-60 C:6-61

Chapter C:7 Discussion Questions: C:7-1 C:7-2 C:7-3 C:7-4 C:7-5 C:7-6 C:7-7 C:7-8 C:7-9 C:7-10 C:7-11 C:7-12 C:7-13 C:7-14 C:7-15 C:7-16 C:7-17 C:7-18 C:7-19 C:7-20 C:7-21 C:7-22 C:7-23 C:7-24

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2024 Edition Questions and Problems C:7-25 C:7-26 C:7-27 C:7-28 C:7-29 C:7-30 C:7-31 C:7-32 C:7-33 C:7-34 C:7-35

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:7-25 C:7-26 C:7-27 C:7-28 C:7-29 C:7-30 C:7-31 C:7-32 C:7-33 C:7-34 C:7-35

Issue Identification Questions: C:7-36 C:7-37 C:7-38

C:7-36 C:7-37 C:7-38

Problems: C:7-39 C:7-40 C:7-41 C:7-42 C:7-43 C:7-44 C:7-45 C:7-46 C:7-47 C:7-48 C:7-49 C:7-50 C:7-51 C:7-52 C:7-53 C:7-54 C:7-55 C:7-56 C:7-57 C:7-58 C:7-59 C:7-60 C:7-61

C:7-39 C:7-40 C:7-41 C:7-42 C:7-43 C:7-44 C:7-45 C:7-46 C:7-47 C:7-48 C:7-49 C:7-50 C:7-51 C:7-52 C:7-53 C:7-54 C:7-55 C:7-56 C:7-57 C:7-58 C:7-59 C:7-60 C:7-61 Copyright © 2024 Pearson Education, Inc.

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2024 Edition Questions and Problems C:7-62 C:7-63 C:7-64 C:7-65 C:7-66 C:7-67 C:7-68 C:7-69 C:7-70 C:7-71 C:7-72

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:7-62 C:7-63 C:7-64 C:7-65 C:7-66 C:7-67 C:7-68 C:7-69 C:7-70 C:7-71 C:7-72

Comprehensive Problem: C:7-73

C:7-73

Tax Strategy and Critical Thinking Problems: C:7-74 C:7-75 C:7-76 C:7-77

C:7-74 C:7-75 C:7-76 C:7-77

Case Study Problems: C:7-78 C:7-79

C:7-78 C:7-79

Tax Research Problems: C:7-80 C:7-81 C:7-82

C:7-80 C:7-81 C:7-82

Chapter C:8 Discussion Questions: C:8-1 C:8-2 C:8-3 C:8-4 C:8-5 C:8-6 C:8-7 C:8-8 C:8-9 C:8-10 C:8-11

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2024 Edition Questions and Problems C:8-12 C:8-13 C:8-14 C:8-15 C:8-16 C:8-17 C:8-18 C:8-19 C:8-20 C:8-21 C:8-22 C:8-23 C:8-24

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:8-12 C:8-13 C:8-14 C:8-15 C:8-16 C:8-17 C:8-18 C:8-19 C:8-20 C:8-21 C:8-22 C:8-23 C:8-24

2023 Edition Modification "M"

Issue Identification Questions: C:8-25 C:8-26 C:8-27

C:8-25 C:8-26 C:8-27

Problems: C:8-28 C:8-29 C:8-30 C:8-31 C:8-32 C:8-33 C:8-34 C:8-35 C:8-36 C:8-37 C:8-38 C:8-39 C:8-40 C:8-41 C:8-42 C:8-43 C:8-44 C:8-45 C:8-46 C:8-47 C:8-48

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2024 Edition Questions and Problems C:8-49 C:8-50 C:8-51 C:8-52 C:8-53 C:8-54 C:8-55 C:8-56 C:8-57 C:8-58 C:8-59 C:8-60 C:8-61 C:8-62 C:8-63

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:8-49 C:8-50 C:8-51 C:8-52 C:8-53 C:8-54 C:8-55 C:8-56 C:8-57 C:8-58 C:8-59 C:8-60 C:8-61 C:8-62 C:8-63

Comprehensive Problems: C:8-64 C:8-65

C:8-64 C:8-65

Tax Strategy and Critical Thinking Problems: C:8-66 C:8-67

C:8-66 C:8-67

Tax Form/Return Preparation Problem: C:8-68

C:8-68

Case Study Problem: C:8-69

C:8-69

Tax Research Problems: C:8-70 C:8-71 C:8-72

C:8-70 C:8-71 C:8-72

Chapter C:9 Discussion Questions: C:9-1 C:9-2 C:9-3 C:9-4 C:9-5 C:9-6

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2024 Edition Questions and Problems C:9-7 C:9-8 C:9-9 C:9-10 C:9-11 C:9-12 C:9-13 C:9-14 C:9-15 C:9-16 C:9-17

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:9-7 C:9-8 C:9-9 C:9-10 C:9-11 C:9-12 C:9-13 C:9-14 C:9-15 C:9-16 C:9-17

Issue Identification Questions: C:9-18 C:9-19 C:9-20 C:9-21 C:9-22 C:9-23

C:9-18 C:9-19 C:9-20 C:9-21 C:9-22 C:9-23

Problems: C:9-24 C:9-25 C:9-26 C:9-27 C:9-28 C:9-29 C:9-30 C:9-31 C:9-32 C:9-33 C:9-34 C:9-35 C:9-36 C:9-37 C:9-38 C:9-39 C:9-40 C:9-41 C:9-42 C:9-43

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2023 Edition Modification "M"

2024 Edition Questions and Problems C:9-44 C:9-45 C:9-46 C:9-47 C:9-48 C:9-49 C:9-50 C:9-51 C:9-52 C:9-53

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:9-44 C:9-45 C:9-46 C:9-47 C:9-48 C:9-49 C:9-50 C:9-51 C:9-52 C:9-53

Comprehensive Problems: C:9-54 C:9-55

C:9-54 C:9-55

Tax Strategy and Critical Thinking Problem: C:9-56

C:9-56

Tax Form/Return Preparation Problems: C:9-57 C:9-58 C:9-59

C:9-57 C:9-58 C:9-59

Case Study Problems: C:9-60 C:9-61

C:9-60 C:9-61

Tax Research Problems: C:9-62 C:9-63 C:9-64

C:9-62 C:9-63 C:9-64

Chapter C:10 Discussion Questions: C:10-1 C:10-2 C:10-3 C:10-4 C:10-5 C:10-6 C:10-7 C:10-8 C:10-9 C:10-10

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2024 Edition Questions and Problems C:10-11 C:10-12 C:10-13 C:10-14 C:10-15

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:10-11 C:10-12 C:10-13 C:10-14 C:10-15

Issue Identification Questions: C:10-16 C:10-17 C:10-18 C:10-19 C:10-20 C:10-21

C:10-16 C:10-17 C:10-18 C:10-19 C:10-20 C:10-21

Problems: C:10-22 C:10-23 C:10-24 C:10-25 C:10-26 C:10-27 C:10-28 C:10-29 C:10-30 C:10-31 C:10-32 C:10-33 C:10-34 C:10-35 C:10-36 C:10-37 C:10-38 C:10-39 C:10-40 C:10-41 C:10-42 C:10-43 C:10-44 C:10-45 C:10-46 C:10-47

C:10-22 C:10-23 C:10-24 C:10-25 C:10-26 C:10-27 C:10-28 C:10-29 C:10-30 C:10-31 C:10-32 C:10-33 C:10-34 C:10-35 C:10-36 C:10-37 C:10-38 C:10-39 C:10-40 C:10-41 C:10-42 C:10-43 C:10-44 C:10-45 C:10-46 C:10-47 Copyright © 2024 Pearson Education, Inc.

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2024 Edition Questions and Problems C:10-48 C:10-49 C:10-50 C:10-51

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:10-48 C:10-49 C:10-50 C:10-51

Comprehensive Problems: C:10-52 C:10-53

C:10-52 C:10-53

Tax Strategy and Critical Thinking Problem: C:10-54

C:10-54

Case Study Problem: C:10-55

C:10-55

Tax Research Problems: C:10-56 C:10-57 C:10-58 C:10-59

C:10-56 C:10-57 C:10-58 C:10-59

Chapter C:11 Discussion Questions: C:11-1 C:11-2 C:11-3 C:11-4 C:11-5 C:11-6 C:11-7 C:11-8 C:11-9 C:11-10 C:11-11 C:11-12 C:11-13 C:11-14 C:11-15 C:11-16 C:11-17 C:11-18 C:11-19 C:11-20

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2024 Edition Questions and Problems C:11-21 C:11-22 C:11-23

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:11-21 C:11-22 C:11-23

Issue Identification Questions: C:11-24 C:11-25 C:11-26 C:11-27

C:11-24 C:11-25 C:11-26 C:11-27

Problems: C:11-28 C:11-29 C:11-30 C:11-31 C:11-32 C:11-33 C:11-34 C:11-35 C:11-36 C:11-37 C:11-38 C:11-39 C:11-40 C:11-41 C:11-42 C:11-43 C:11-44 C:11-45 C:11-46 C:11-47 C:11-48 C:11-49 C:11-50 C:11-51 C:11-52 C:11-53 C:11-54 C:11-55

C:11-28 C:11-29 C:11-30 C:11-31 C:11-32 C:11-33 C:11-34 C:11-35 C:11-36 C:11-37 C:11-38 C:11-39 C:11-40 C:11-41 C:11-42 C:11-43 C:11-44 C:11-45 C:11-46 C:11-47 C:11-48 C:11-49 C:11-50 C:11-51 C:11-52 C:11-53 C:11-54 C:11-55

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2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

Comprehensive Problems: C:11-56 C:11-57 C:11-58

C:11-56 C:11-57 C:11-58

Tax Strategy and Critical Thinking Problems: C:11-59 C:11-60

C:11-59 C:11-60

Tax Form/Return Preparation Problems: C:11-61 C:11-62 C:11-63

C:11-61 C:11-62 C:11-63

Case Study Problem: C:11-64

C:11-64

Tax Research Problems: C:11-65 C:11-66 C:11-67

C:11-65 C:11-66 C:11-67

Chapter C:12 Discussion Questions: C:12-1 C:12-2 C:12-3 C:12-4 C:12-5 C:12-6 C:12-7 C:12-8 C:12-9 C:12-10 C:12-11 C:12-12 C:12-13 C:12-14 C:12-15 C:12-16 C:12-17 C:12-18

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2024 Edition Questions and Problems C:12-19 C:12-20 C:12-21 C:12-22 C:12-23 C:12-24 C:12-25 C:12-26

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:12-19 C:12-20 C:12-21 C:12-22 C:12-23 C:12-24 C:12-25 C:12-26

Issue Identification Questions: C:12-27 C:12-28 C:12-29

C:12-27 C:12-28 C:12-29

Problems: C:12-30 C:12-31 C:12-32 C:12-33 C:12-34 C:12-35 C:12-36 C:12-37 C:12-38 C:12-39 C:12-40 C:12-41 C:12-42 C:12-43 C:12-44 C:12-45 C:12-46 C:12-47 C:12-48 C:12-49 C:12-50 C:12-51 C:12-52 C:12-53 C:12-54

C:12-30 C:12-31 C:12-32 C:12-33 C:12-34 C:12-35 C:12-36 C:12-37 C:12-38 C:12-39 C:12-40 C:12-41 C:12-42 C:12-43 C:12-44 C:12-45 C:12-46 C:12-47 C:12-48 C:12-49 C:12-50 C:12-51 C:12-52 C:12-53 C:12-54

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2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

Comprehensive Problem: C:12-55

C:12-55

Tax Strategy and Critical Thinking Problems: C:12-56 C:12-57

C:12-56 C:12-57

Tax Form/Return Preparation Problems: C:12-58 C:12-59

C:12-58 C:12-59

Case Study Problems: C:12-60 C:12-61

C:12-60 C:12-61

Tax Research Problems: C:12-62 C:12-63 C:12-64 C:12-65 C:12-66 C:12-67 C:12-68

C:12-62 C:12-63 C:12-64 C:12-65 C:12-66 C:12-67 C:12-68

Chapter C:13 Discussion Questions: C:13-1 C:13-2 C:13-3 C:13-4 C:13-5 C:13-6 C:13-7 C:13-8 C:13-9 C:13-10 C:13-11 C:13-12 C:13-13 C:13-14 C:13-15 C:13-16 C:13-17

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2024 Edition Questions and Problems C:13-18 C:13-19 C:13-20 C:13-21 C:13-22 C:13-23 C:13-24 C:13-25 C:13-26 C:13-27

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:13-18 C:13-19 C:13-20 C:13-21 C:13-22 C:13-23 C:13-24 C:13-25 C:13-26 C:13-27

Issue Identification Questions: C:13-28 C:13-29 C:13-30 C:13-31

C:13-28 C:13-29 C:13-30 C:13-31

Problems: C:13-32 C:13-33 C:13-34 C:13-35 C:13-36 C:13-37 C:13-38 C:13-39 C:13-40 C:13-41 C:13-42 C:13-43 C:13-44 C:13-45 C:13-46 C:13-47 C:13-48 C:13-49 C:13-50 C:13-51 C:13-52 C:13-53 C:13-54 C:13-55 C:13-56

C:13-32 C:13-33 C:13-34 C:13-35 C:13-36 C:13-37 C:13-38 C:13-39 C:13-40 C:13-41 C:13-42 C:13-43 C:13-44 C:13-45 C:13-46 C:13-47 C:13-48 C:13-49 C:13-50 C:13-51 C:13-52 C:13-53 C:13-54 C:13-55 C:13-56 Copyright © 2024 Pearson Education, Inc.

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2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

Comprehensive Problems: C:13-57 C:13-58

C:13-57 C:13-58

Tax Strategy and Critical Thinking Problems: C:13-59 C:13-60 C:13-61

C:13-59 C:13-60 C:13-61

Tax Form/Return Preparation Problems: C:13-62 C:13-63

C:13-62 C:13-63

Case Study Problems: C:13-64 C:13-65

C:13-64 C:13-65

Tax Research Problems: C:13-66 C:13-67 C:13-68 C:13-69 C:13-70 C:13-71 C:13-72

C:13-66 C:13-67 C:13-68 C:13-69 C:13-70 C:13-71 C:13-72

Chapter C:14 Discussion Questions: C:14-1 C:14-2 C:14-3 C:14-4 C:14-5 C:14-6 C:14-7 C:14-8 C:14-9 C:14-10 C:14-11 C:14-12 C:14-13 C:14-14

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2024 Edition Questions and Problems C:14-15 C:14-16 C:14-17 C:14-18 C:14-19 C:14-20 C:14-21 C:14-22 C:14-23 C:14-24

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:14-15 C:14-16 C:14-17 C:14-18 C:14-19 C:14-20 C:14-21 C:14-22 C:14-23 C:14-24

Issue Identification Questions: C:14-25 C:14-26 C:14-27

C:14-25 C:14-26 C:14-27

Problems: C:14-28 C:14-29 C:14-30 C:14-31 C:14-32 C:14-33 C:14-34 C:14-35 C:14-36 C:14-37 C:14-38 C:14-39 C:14-40 C:14-41 C:14-42 C:14-43 C:14-44 C:14-45 C:14-46 C:14-47 C:14-48 C:14-49 C:14-50

C:14-28 C:14-29 C:14-30 C:14-31 C:14-32 C:14-33 C:14-34 C:14-35 C:14-36 C:14-37 C:14-38 C:14-39 C:14-40 C:14-41 C:14-42 C:14-43 C:14-44 C:14-45 C:14-46 C:14-47 C:14-48 C:14-49 C:14-50

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2024 Edition Questions and Problems

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D"

Comprehensive Problem: C:14-51

C:14-51

Tax Strategy and Critical Thinking Problems: C:14-52 C:14-53 C:14-54

C:14-52 C:14-53 C:14-54

Tax Form/Return Preparation Problems: C:14-55 C:14-56 C:14-57

C:14-55 C:14-56 C:14-57

Case Study Problems: C:14-58 C:14-59

C:14-58 C:14-59

Tax Research Problems: C:14-60 C:14-61 C:14-62 C:14-63

C:14-60 C:14-61 C:14-62 C:14-63

Chapter C:15 Discussion Questions: C:15-1 C:15-2 C:15-3 C:15-4 C:15-5 C:15-6 C:15-7 C:15-8 C:15-9 C:15-10 C:15-11 C:15-12 C:15-13 C:15-14 C:15-15 C:15-16 C:15-17

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2024 Edition Questions and Problems C:15-18 C:15-19 C:15-20 C:15-21 C:15-22 C:15-23 C:15-24 C:15-25 C:15-26 C:15-27 C:15-28 C:15-29 C:15-30 C:15-31 C:15-32 C:15-33

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:15-18 C:15-19 C:15-20 C:15-21 C:15-22 C:15-23 C:15-24 C:15-25 C:15-26 C:15-27 C:15-28 C:15-29 C:15-30 C:15-31 C:15-32 C:15-33

Issue Identification Questions: C:15-34 C:15-35 C:15-36

C:15-34 C:15-35 C:15-36

Problems: C:15-37 C:15-38 C:15-39 C:15-40 C:15-41 C:15-42 C:15-43 C:15-44 C:15-45 C:15-46 C:15-47 C:15-48 C:15-49 C:15-50 C:15-51 C:15-52 C:15-53 C:15-54

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2024 Edition Questions and Problems C:15-55 C:15-56 C:15-57 C:15-58 C:15-59 C:15-60 C:15-61 C:15-62

Summary of Question and Problem Revisions 2024 Edition 2023 Edition 2023 Edition New Problems Questions and Deletions "N" Problems "D" C:15-55 C:15-56 C:15-57 C:15-58 C:15-59 C:15-60 C:15-61 C:15-62

Comprehensive Problem: C:15-63

C:15-63

Tax Strategy and Critical Thinking Problem: C:15-64

C:15-64

Case Study Problem: C:15-65

C:15-65

Tax Research Problems: C:15-66 C:15-67 C:15-68 C:15-69 C:15-70 C:15-71

C:15-66 C:15-67 C:15-68 C:15-69 C:15-70 C:15-71

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Instructor's Resource Manual Mitchell Franklin

Pearson’s Federal Taxation 2024 Corporations, Partnerships, Estates & Trusts Luke E. Richardson Mitchell Franklin

Chapter C:1 Tax Research Learning Objectives After studying this chapter, the student should be able to: 1.

Distinguish between closed fact and open fact tax situations.

Describe the steps in the tax research process.

Explain how the facts influence tax consequences.

Identify the sources of tax law and assess the authoritative value of each.

Consult tax services to research an issue.

Apply the basics of Internet-based tax research.

Use a citator to assess tax authorities.

Describe professional guidelines that CPAs in tax practice should follow.

Prepare work papers and communicate to clients.

Areas of Greater Significance Since this will usually be a student’s first exposure to tax research, the importance of the facts to the tax results, federal tax services and the citator should be discussed. The widespread use of Internet-based databases for tax research makes this means of tax research much more important. An effort should be made to introduce Internet-based searches to the students if at all possible. The text discusses two types of professional guidelines for CPAs in tax practice.

Areas of Lesser Significance In the interest of time, the following areas may be omitted: Sample work papers and client letter (Appendix A).

Problem Areas for Students The following areas may prove especially difficult to students: 1.

Understanding how to use the tax services and citators.

Learning the authoritative value of each source of tax law.

Highlights of Recent Tax Law Changes 1.

For revenue rulings (and other IRS pronouncements) issued after 1999, the full four digits of the year of issuance are provided in the title. For revenue rulings and other pronouncements issued before 2000, only the last two digits of the year of issuance are provided in the title.

Students should become familiar with the use of Internet-based databases which have replaced the paper services.

For changes to the IRC enacted after July 29, 1996, the Treasury is generally precluded from issuing regulations with retroactive effect. In the case of final regulations, however, a regulation can be effective on the date proposed or the date on which temporary regulations are filed with the Federal Register. Regulations issued within 18 months of the date of a change to the statute can be issued with retroactive effect.

Both CCH and RIA provide tax-related information via the Internet. The United States Tax Reporter is also available on LexisNexis and Westlaw.

Teaching Tips 1.

Example C:1-2: Use the example to emphasize to the students the importance of considering nontax objectives as well as tax objectives. p. C:1-2.

Steps in the Tax Research Process, Paragraph 1: Walk through the steps in the tax research process. As you do this, emphasize to the students that the steps of the tax research process provide an excellent format for a written communication to a client or for a client file. You might consider going over the client communication contained in Appendix A.

If proper citations are being stressed in the course, Table C:1-3 is a good reference.

Lecture Outline I.

Overview of Tax Research.

Tax research can be conducted in a number of different settings. Tax research involves solving a specific tax-related question using a number of tax law sources as they apply to a particular situation. Sample work papers demonstrating how to document the results of a research effort are included in Appendix A. In addition, the text discusses two types of professional guidelines for CPAs in tax practice: the AICPA’s guidelines for CPAs in tax practice, the Statements on Standards for Tax Services and Treasury Department Circular 230 (reproduced in Appendix E). A.

Client-oriented research is conducted by accounting and law firms for the benefit of their clients. It involves determining the tax consequences of a certain transaction for a given client. It is performed in: 1. 2.

Closed-fact or tax compliance situations. (See Example C:1-1.) p. C:1-2. Open-fact or tax-planning situations. (See Example C:1-2.) p. C:1-2.

Academic settings. Tax policy research may be conducted by individuals in an academic setting (e.g., accounting programs, law schools, economics departments, etc.).

The tax advisor should always bear in mind the financial accounting implications of proposed transactions. Though interrelated, the two fields of accounting have different orientations and different objectives. Tax accounting is oriented primarily to the Internal Revenue Service. Its objectives include calculating, reporting, and predicting one’s tax liability according to legal principles. Financial accounting is oriented primarily to shareholders, creditors, managers, and employees. Its objectives include determining, reporting, and predicting a business’s financial position and operating results according to Generally Accepted Accounting Principles. II.

Steps in the Tax Research Process.

When doing tax research in the context of tax planning or just in engaging in tax planning, the emphasis should be placed on the circular nature of the tax research process. It often requires the determination of different facts, restatement of the research question, or reliance on additional authorities. (Refer here to Figure C:1-1) p. C:1-4. There are, however, six basic steps to the tax research process: 1.

Determine the facts.

Identify the issues (questions).

Evaluate the authorities and choose those to follow where the authorities conflict.

Analyze the facts in terms of the applicable authorities.

Communicate conclusions and recommendations to the client.

A professional needs to keep a number of points in mind. A.

The objective is not to minimize taxes per se but rather to maximize the after-tax return.

One does not engage in unilateral transactions; thus, the tax ramifications to all parties to the contract are relevant.

Taxes are but one cost of doing business.

The time for tax planning is not restricted to when one enters into an investment, contract, or other arrangement, but rather the time extends throughout the life of the activity.

Appendix A walks students through the research process. Tax research often involves a “gray area;” that is, one that does not have a clear-cut, unequivocally correct solution. The issue should be pursued through the use of a specifically tailored set of detailed questions. Tax research may also involve determining which issues need to be researched. It requires a fairly extensive knowledge of tax law to be able to determine which issues need to be researched. A tax advisor should always bear in mind the financial accounting implications of proposed transactions. An answer that may be desirable from a tax perspective may not always be desirable from a financial accounting perspective. Success in any tax practice, especially at the managerial level, requires consideration of both sets of objectives and orientations. III.

Importance of the Facts to the Tax Consequences.

The importance of a particular set of facts to the tax results should be emphasized. Three illustrations are presented for class discussion. These illustrations should naturally lead into a discussion of how a factual situation can be designed to meet the statutory requirements. IV.

The Sources of Tax Law.

The term “tax law” generally encompasses much more than just the tax statutes as enacted by Congress. The law contains very general language that requires interpretation, both administrative and judicial. Administrative interpretations include Treasury Regulations, revenue C:IO1-4 Copyright © 2024 Pearson Education, Inc.

rulings, and revenue procedures. Judicial interpretations consist of court decisions. Tax law also consists of committee reports issued by Congress during the legislative process. A.

Legislative Process. All tax legislation must originate in the House of Representatives. Tax bills are referred to the House Ways and Means Committee. After a bill is approved by the House Ways and Means Committee, it moves to the floor of the House for consideration. If approved by a majority of the House, it moves to the Senate. After consideration by the Senate Finance Committee, it moves to the Senate floor for approval. Usually the House and Senate bills will not be in complete agreement. The bill will then go to a conference committee consisting of members of both houses. A compromise will then be made between the two versions of the tax bill. The compromise is then voted on by both houses of Congress and goes on to the President for his signature or veto. Both houses of Congress generally hold extensive hearings at which time interested parties are free to testify. The U.S. Government Printing Office publishes the statements made at hearings. Committee reports explaining Congress’s purpose in drafting legislation are published by the U.S. Government Printing Office in the Cumulative Bulletin. Committee reports are particularly useful in interpreting the law prior to issuance of Treasury regulations. (See Example C:1-4.) p. C:1-8.

Internal Revenue Code. The Internal Revenue Code is the foundation of all tax law. It was first codified in 1939. Recodified in 1954, it has now been named the Internal Revenue Code of 1986. Whenever the law is changed, old language is deleted and new language is added.

Treasury Regulations. The Treasury Department issues Treasury Regulations as interpretations of the statute. They provide examples complete with computations to assist in understanding how IRC provisions are applied. Because statutory changes occur frequently, regulations are not always updated in a timely manner. When referring to a regulation, the tax advisor should consult the introductory note in order to determine when the regulation was adopted. Treasury Regulations are first provided in proposed form and the public has an opportunity to comment and suggest changes. Proposed regulations have no more authoritative weight than the position the IRS argues for in a brief, but provide guidance on the Treasury Department’s interpretation of a statute. Temporary regulations (which generally are effective upon publication) are often issued soon after a major statutory change to provide guidance on procedural and computational matters. Temporary regulations have the same authoritative value as final regulations; however, they cannot remain temporary for more than a three-year period. Temporary regulations must be issued concurrently with proposed regulations. Final regulations are drafted after the public has had time to comment on the proposed regulations. Final regulations have the same authoritative weight as the statute and generally take effect retroactive to the effective date of the statutory language they interpret. For changes to the IRC enacted after July 29, 1996, the Treasury is generally precluded from issuing regulations with retroactive effect. In the case of final C:IO1-5 Copyright © 2024 Pearson Education, Inc.

regulations, however, a regulation can be effective on the date proposed or the date on which temporary regulations are filed with the Federal Register. Regulations issued within 18 months of the date of a change to the statute can be issued with retroactive effect. Regulations may also be classified as either interpretative or legislative. Interpretative regulations are issued under the general authority of Sec. 7805 and make the statutory language easier to understand and apply. They provide illustrations about how to perform certain computations. Legislative regulations provide rules on highly technical matters where Congress has delegated the rulemaking to the Treasury Department (e.g., consolidated tax return issues). Both types of regulations have the same authoritative weight and will be overturned only in very limited cases such as when, in the Court’s opinion, the regulations exceed the scope of power delegated to the Treasury Department, are contrary to the IRC, or are unreasonable. Section 7805 provides that the Secretary of the Treasury has the right to prescribe regulations and to provide what extent they are to be applied retroactively. Occasionally, taxpayers can successfully argue that a regulation is invalid and, consequently, should not be followed. This will occur only if the courts find that the regulation is “unreasonable and plainly inconsistent with the revenue statutes.” Some courts apply the legislative reenactment doctrine, which holds that regulations finalized many years earlier and not amended by Congress through changes to the statutory language have Congressional approval. Regulations are cited as follows. Numbers before the decimal point indicate the general subject matter of the regulation. Numbers to the right of the decimal place refer to the IRC section being interpreted. Numbers to the right of that number indicate the number of the regulation. Temporary or proposed regulations are cited as Temp. Reg. Sec. or Prop. Reg. Sec. When providing a citation, the researcher should be as precise as possible. An example of this would be Reg. Sec. 1.165-5(I), Ex. 2(I), which refers to the first portion of Example 2 that is contained in the first portion of the fifth regulation interpreting Sec. 165. You may wish at this point to use the Stop and Think material, which illustrates the force of law certain regulations have. pp. C:1-10-C:1-11. D.

Administrative Pronouncements. There are a number of different means that the IRS uses for interpreting the statute. After referring to the IRC and Treasury Regulations, tax advisors are likely to refer next to IRS interpretations for further authority for answering a tax question. 1.

Revenue Rulings. Revenue rulings are used to indicate the tax status of a specific transaction, which has wide taxpayer interest. They represent the viewpoint of the IRS and do not have as much authority as federal court cases or regulations. Approximately one hundred rulings are issued each year. A taxpayer does not have to follow a ruling if there is sufficient authority for different treatment. An IRS agent is, however, bound by the C:IO1-6 Copyright © 2024 Pearson Education, Inc.

rulings. Rulings are published weekly in the Internal Revenue Bulletin (I.R.B.) and semiannually in the Cumulative Bulletin (C.B.) prior to 2009. Refer now to p. C:1-12 to see how revenue rulings are cited. 2.

Revenue Procedures. Revenue procedures usually deal with procedural aspects of tax practice. They are first published in the Internal Revenue Bulletin and later in the Cumulative Bulletin until 2009. Refer now to p. C:1-12 to illustrate how revenue procedures are cited. In addition to revenue rulings and revenue procedures, the Cumulative Bulletin contains IRS notices, as well as the texts of proposed regulations, tax treaties, committee reports, and U.S. Supreme Court decisions. For revenue rulings issued after 2008, the Internal Revenue Bulletin is the final reference.

Letter Rulings. Letter rulings are initiated by taxpayers who ask the IRS to explain the tax consequences of a particular transaction. The IRS responds in a letter ruling that can be relied on only by the person requesting it. They provide insight into the current thinking of the IRS. CCH publishes rulings with any confidential information deleted in a separate letter ruling service. Refer to pp. C:1-12-C:1-13 to illustrate how letter rulings are cited.

Technical Advice Memoranda. When a taxpayer’s return is being audited with respect to a complicated, technical matter, the taxpayer may request that the matter be referred to the IRS National Office in Washington, D.C. concerning the appropriate tax treatment. The answer is issued in the form of a Technical Advice Memoranda, which is made available in the form of a letter ruling. Refer to p. C:1-13 to illustrate how technical advice memoranda are cited.

Tax Information Releases. Tax Information releases contain information about interpretations of general interest and are released to the news media throughout the United States. Refer now to p. C:1-13 to illustrate how information releases are cited.

Announcements and Notices. Information releases that are more technical and aimed at tax practitioners are issued in the form of Announcements. Announcements are often issued before temporary or proposed regulations can be issued. The IRS is bound by announcements and notices in the same way as if contained in a revenue ruling. Notices and announcements issued prior to 2009 appear in both the Internal Revenue Bulletin and the Cumulative Bulletin. As of 2009, they appear only in the Internal Revenue Bulletin. Refer now to p. C:1-13 to illustrate how announcements are cited.

Judicial Decisions. Judicial decisions comprise an important source of tax law. Judicial decisions in different jurisdictions are sometimes in conflict. See Figure C:1-1, p. C:1-15 for a summary of the court system. Overview of the Court System. There are three trial courts - the U.S. Tax Court, the U.S. Court of Federal Claims, and the U.S. District Courts. Litigation may begin in any court, but precedent is an important factor in determining where it should begin. Cash flow also may be an important factor. Taxes must be paid before litigation begins in the U.S. Court of Federal Claims or the U.S. District Courts. After the taxes are paid, a claim for refund is filed, which will be denied by the IRS. A suit for refund is then brought and, if won, a refund with interest is obtained. A suit may be brought in the Tax Court. If lost, the deficiency plus any interest and penalties must be paid. The District Courts are the only place that a jury trial is possible. Decisions can be appealed from the Tax Court and the U.S. District Courts to the Court of Appeals in the taxpayer’s circuit. Appeals from the U.S. Court of Federal Claims are taken to the Court of Appeals for the Federal Circuit. A party who loses at the appellate level can ask the Supreme Court for a writ of certiorari. The Supreme Court hears only about six to ten tax cases a year. (See Table C:1-1 Federal Judicial Circuits for a listing of states in the various Courts of Appeals on p. C:1-15.) (See Table C:1-2 for an overview of the court system on p. C:1-16.) U.S. Tax Court. The U.S. Tax Court originated in 1942 as the successor to the Board of Tax Appeals. It is a court of national jurisdiction that hears only taxrelated cases. All taxpayers, regardless of their state of residence, may litigate in the Tax Court. It has 19 judges, including one chief judge. The President, with the consent of the Senate, appoints the judges for a 15-year term and may reappoint them for an additional term. The judges, specialists in tax-related matters, periodically travel to roughly one hundred cities throughout the country to hear cases. In most instances, only one judge hears a case. The Tax Court has a special policy in dealing with cases where the amount in question does not exceed $50,000 a year (i.e., small cases). Taxpayers can represent themselves without an attorney. The cases are heard by special commissioners instead of one of the Tax Court judges. Decisions under this procedure cannot be appealed. The IRS has an acquiescence policy with regard to federal court decisions that have been decided in the taxpayer’s favor. If it wishes to go on record that it agrees with a federal court decision, it acquiesces. If it wishes to disagree with a decision, it issues a nonacquiescence. This policy is not followed in all federal court decisions. An acquiescence or nonacquiescence is binding on an IRS agent. If a taxpayer is audited and has taken a position, in which the IRS has issued a nonacquiescence, litigation will likely be the only recourse for the taxpayer. IRS acquiescences and nonacquiescences are published in the Internal Revenue Bulletins and Cumulative Bulletins. C:IO1-8 Copyright © 2024 Pearson Education, Inc.

Regular decisions of the Tax Court are published by the U.S. Government Printing Office in a bound volume known as the Tax Court of the United States Reports. Soon after a decision is made public, it is also published by RIA and CCH in their loose-leaf reporters of Tax Court decisions. Refer now to Table C:13, p. C:1-22 to illustrate regular and memo Tax Court citations. U.S. District Courts. Each state has a U.S. district court and more populous states have several district courts. Many different types of cases are heard by this court and a taxpayer may request a jury trial. District court decisions are officially reported in the Federal Supplement (F. Supp.) published by West. Tax decisions are also published by RIA in the American Federal Tax Reports (AFTR) and by CCH in the U.S. Tax Cases (USTC). Refer now to Table C:1-3, p. C:1-22 to illustrate a district court citation. U.S. Court of Federal Claims. The U.S. Court of Federal Claims, as reorganized in 1982 and renamed in 1992, is a national court with decisions appealable to the Circuit Court of Appeals for the Federal Circuit. U.S. Court of Federal Claims decisions were published in the Claims Court Reporter by West Publishing Co. from 1982 to 1992. These cases are now reported in the Federal Claims Reporter (Fed. Cl.). In addition, the AFTR and USTC services report these tax decisions. Refer now to Table C:1-3, p. C:1-22 to illustrate this citation. Circuit Courts of Appeal. Trial court decisions are appealable to a particular circuit court of appeals depending upon where the litigation originated. In the case of an individual, it depends upon the taxpayer’s residence on the date of appeal. In the case of a corporation, it is the principal place of business that controls. There are 11 geographical circuits, the circuit for the District of Columbia and the Federal Circuit. (See Figure C:1-3, p. C:1-22.) New circuit court of appeals decisions are reported officially in the Federal Reporter, Third Series (F.3d) published by West. In addition, AFTR and USTC services report these decisions. Refer now to Table C:1-3, p. C:1-22 to illustrate this citation. Supreme Court. A decision of an appellate court can be appealed to the U.S. Supreme Court. Unless the circuits are divided on the proper treatment of an issue or the issue is deemed of great significance, the Supreme Court will not grant certiorari. Decisions of the Supreme Court are the law of the land. If Congress does not agree with a Supreme Court decision, statutory language can be amended to reach the desired result. Supreme Court decisions are published in the United States Supreme Court Reports (U.S.) by the U.S. Government Printing Office, the Supreme Court Reporter (S.Ct.) by West, and the United States Reports, Lawyers’ Edition (L.Ed.) by Lawyer’s Co-Operative Publishing Co. In addition, the AFTR and USTC services report these tax decisions. Refer now to Table C:13, p. C:1-22 to illustrate this citation.

Precedential Value of Various Decisions. 1.

The Tax Court will generally rule uniformly for taxpayers. It is bound by Supreme Court decisions. In 1970, the Golsen rule was adopted which mandates that the Tax Court will follow decisions of the court for the circuit to which a case in question is appealable.

U.S. district court decisions have precedential value only for subsequent cases heard in the same district. District courts must follow decisions of the Supreme Court and the court of appeals to which the case is appealable.

The U.S. Court of Federal Claims must rule consistently with the Supreme Court, Circuit Court of Appeals for the Federal Circuit, and its own earlier decisions.

A circuit court of appeals is bound by the Supreme Court and earlier decisions made by that circuit. Green v. US 185 F. 3d 67, 84 AFTR 2d 995415, 99-2 USTC ¶50,701 (3rd Cir, 1999). The Green Case appears on page 67, volume 185 of the Federal Reporter, Third Series. It is also published in volume 84, page 99-5415 on AFTR, Second Series, and in Volume 2, Paragraph 50,701 of the 199 USTC. The parenthetical information indicates that the Third Circuit decided the case in 1999 (The Federal Reporter, Second Series reference is found in footnote 33 of this chapter).

Because the courts are not always in agreement, a taxpayer can sometimes forum shop to select a court that is likely to be most favorable to the taxpayer’s position. You may wish to use the Stop and Think materials at this point, which illustrate the importance of forum shopping. p. C:1-24. F.

Tax Treaties. The United States has treaties with a number of foreign countries. The treaties may pertain to tax and other matters. The provisions contained in a treaty in most cases override the rules contained in the IRC. p. C:1-24.

Tax Periodicals. Writings of tax experts in tax periodicals can provide useful insight into provisions contained in the IRC, Regulations, cases, or rulings. A list of periodicals is found on p. C:1-24. Published articles and tax service commentaries are secondary sources of authority. Primary sources of authority are the IRC and administrative and judicial interpretations. Only primary authorities should be cited.

Tax Services. Organizationally, there are two types of tax services: first, “annotated,” and second, “topical.” An annotated tax service is organized by IRC section. The IRC-arranged subdivisions of this service are likely to encompass several topics. A topical tax service is organized by broad topic. The topically arranged subdivisions of this service are likely to encompass several IRC sections. The principal annotated tax services are United States Tax Reporter and Standard Federal Tax Reporter. The main topical services are Federal Tax Coordinator 2d and Tax Management Portfolios.

VI.

The Internet as a Research Tool. Internet databases are rapidly replacing books as the principal source of tax-related information. These databases encompass not only the IRC, Treasury Regulations, court cases, state laws, and other primary authorities, but also citators and secondary sources such as tax service reporters, treatises, journals, and newsletters. The principal advantages of using Internet-based tax services are ease and speed of access. The databases can be accessed using annotations or a “key word” approach. The annotated versions are arranged by IRC section. The annotations accompany editorial commentaries and include digests and summaries of IRS pronouncements and court opinions that interpret a particular IRC section. A topical tax service is organized by broad topic, including income taxes, estate and gift taxes, and excise taxes. The topically arranged sub-divisions of this service are likely to encompass several IRC sections. Each database is updated on a timely basis. See Table C:1-4 on p. C:1-25 for a summary of the key features of tax services. The most widely used Internet-based research services are RIA’s Federal Tax Coordinator and Analysis, often referred to as CHECKPOINT. accessible at http://checkpoint.riag.com, and the CCH Tax Research NetWork™ (hereafter CCH NETWORK), accessible at http://tax.cchgroup.com/network. Both services are updated continuously and store information in databases (called libraries). This chapter and the textbook discuss Internet-based tax services in general and focus on CHECKPOINT for illustrative purposes, but they all work in a similar manner.

VII.

Citators. Citators serve two functions: (1) they provide a history of the case; and (2) they list other authorities that have cited the case. The citator allows the user to input the names of specific case citations, and see all related pronouncements and status changes.

VIII. Professional Guidelines for Tax Services. Professional guidelines for tax services are contained in both government-imposed and professional-imposed tax standards. Circular 230 sets forth rules to practice before the Internal Revenue Service and pertains to certified public accountants, attorneys, enrolled agents, and other persons representing taxpayers before the IRS. It presents duties and C:IO1-11 Copyright © 2024 Pearson Education, Inc.

restrictions relating to such practice and prescribes sanctions and disciplinary proceedings for violating these regulations. Circular 230 also provides guidelines for written advice to taxpayers. In June 2014, these guidelines were significantly revised and eliminated the distinction between covered opinions and written advice. All rules are now governed under what is referred to as a “reasonable practitioner standard.” In the case of written advice, the practitioner is now supposed to base advice under reasonable assumptions and consider the facts that are important and not base an opinion on the probability of audit. Statements on Standards for Tax Services (SSTS), issued by the American Institute of Certified Public Accountants and reproduced in Appendix E, set forth guidelines governing ethical issues in tax practice. Although the SSTSs are not legally enforceable, they carry significant moral weight, and may be cited in a negligence lawsuit as the proper “standard of care” for tax practitioners. They also provide grounds for the termination or suspension of one’s professional license. The Standards provide an ethical framework to govern the normative relationship between a tax advisor and his or her client, where, unlike an auditor, a tax advisor acts as the client’s advocate. Instructors also may wish to reference how Cornell University offers free access to many resources. This should be emphasized to students, specifically if they do not have college library access to the professional databases referenced within the chapter. IX.

Sample Work Papers. Appendix A presents a set of sample work papers, including a draft of a client letter and a memo to the file. The work papers indicate the issues to be researched, the authorities addressing the issues, and the researcher’s conclusions concerning the appropriate tax treatment, with rationale for its use. Formats differ from firm to firm. The sample offers general guidance concerning the content of work papers.

Court Case Briefs The following court cases illustrate how the courts, through judicially enunciated doctrines, impact the interpretation of tax law. Hirotoshi Yamamoto v. CIR, 73 T.C. 946 (1980), aff’d. in unpublished opinion 672 F.2d 924 (9th Cir., 1982). Yamamoto (Y) owned 100% of the stock of P Corporation. P Corporation owned 100% of the stock of subsidiary S. S was heavily indebted to P. During 1970 and 1971, S made loans to Y. Y transferred real property to S, those transactions being recorded as sales, in exchange for cash, release of Y’s indebtedness to S and assumption of Y’s liabilities by S. Subsequently, S transferred this property to P at a price equal to S’s book value in the property. Additionally, Y purchased stock of P in exchange for cash. Y argued that the step-transaction theory should apply to these transactions so they should be collapsed into one transaction and qualify for tax-free treatment under IRC Sec. 351. The court rejected this argument, stating that the rules for transfers to a controlled corporation did not apply because the property transfers and stock transfer had separate legal significance. The facts were consistent with this decision. This case involves a detailed analysis of the substance over form issue. Evelyn F. Gregory v. Helvering, 293 U.S. 465 (1935). Mrs. Gregory owned all of the stock of a corporation, which owned 1,000 shares of stock of another corporation. To get these shares and to obtain more favorable tax treatment, a new corporation was organized and the 1,000 shares of stock were transferred to it by the old corporation in what was claimed to be a nontaxable reorganization. The new corporation then dissolved and distributed its only asset, the shares of stock, to its sole shareholder, Mrs. Gregory. Mrs. Gregory then sold the stock and reported capital gains tax treatment on the sale. The Supreme Court held that a nontaxable reorganization had not occurred since the new corporation had no relation to the business of the old corporation and was formed solely as part of a preconceived plan with no business purpose. Tax avoidance was held not to be a sufficient business purpose to permit a tax-free reorganization to occur.

Chapter C:2 Corporate Formations and Capital Structure Learning Objectives After studying this chapter, the student should be able to: 1.

Discuss the tax advantages and disadvantages of alternative business forms.

Apply the check-the-box regulations to partnerships, corporations, and trusts.

Recognize the legal requirements and tax considerations related to forming a corporation.

Discuss the requirements for deferring gain or loss upon incorporation.

Explain the tax implications of alternative capital structures.

Determine the tax consequences of worthless stock or debt obligations.

Identify tax planning opportunities in corporate formations.

Comply with procedural rules for corporate formations.

Areas of Greater Significance It is important for the student to understand the tax consequences of forming a corporation, including the impact on both corporation and shareholder. The tax advantages and disadvantages of alternative forms of doing business should also be stressed.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than by class discussion: 1.

Capital contributions.

Compliance and procedural considerations (Reporting requirements under Sec. 351).

Choice of capital structure.

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Allocating basis in a partially tax-free incorporation.

Characterization of an instrument as debt or equity.

Understanding that the tax basis for property contributed to a corporation is different from the basis that is used for financial accounting purposes.

Highlights of Recent Tax Law Changes The Tax Cuts and Jobs Act of 2017 has significantly changed tax rates. These changed rates alter many traditional decisions often made by individuals when selecting a business entity. Changes can make the C Corporation more useful compared to the S Corporation and increases the complexity of the decision-making process. The deduction for qualified business income, known as the Section 199A deduction, is a significant change that needs to be addressed as part of the decision-making process.

Teaching Tips 1.

Limited liability companies (LLCs) and limited liability partnerships (LLPs) have become more prevalent forms of doing business. Some discussion of LLCs and LLPs should take place here with particular emphasis on (1) the treatment of LLCs in the state where your school is located; and (2) the use of LLPs by the Big 4 accounting firms. More discussion on LLCs and LLPs takes place in Chapters C:9 and C:10.

Use Examples C:2-11 and C:2-12 to illustrate the rationale behind treating a Sec. 351 transaction as a nontaxable exchange. pp. C:2-12 and C:2-13. Some discussion might be incorporated about the fact that a corporate liquidation is not a tax-free transaction. As a result, it is inexpensive to create a corporation, but may be expensive to liquidate a corporation.

Table C:2-1 may be used as a format for presenting the tax consequences of a Sec. 351 transaction. p. C:2-11.

Use Example C:2-23 as an illustration of a prearranged disposition of stock that disqualifies a Sec. 351 transaction. p. C:2-16.

Tables C:2-2 and C:2-3 can be used as a format for presenting the advantages and disadvantages of issuing equity vs. debt. Point out that cash flow consideration may make equity more attractive than debt. pp. C:2-29 and C:2-30.

Lecture Outline I. Organization Forms Available. Businesses can be conducted in one of several forms. A brief summary of these forms will provide the students with an overview of some of the factors that enter into the business form decision. A.

Sole Proprietorships. A sole proprietorship is a business owned by one individual and often is selected by individuals who are beginning a new business. The income and expenses are reported on a Schedule C of Form 1040 since a sole proprietorship is not a separate tax entity. All of the business assets are owned by the proprietor. Examples C:2-1 and C:2-2 illustrate the effect this will have on the amount of tax that will be paid on business income. A completed Schedule C and the related facts are included in Appendix B. These facts are used (with minor modifications) to illustrate the similarities and differences in the tax reporting process for a sole proprietorship, C corporation, partnership, and S corporation. 1. Tax Advantages. The tax advantages of doing business as a sole proprietorship are listed beginning on p. C:2-3. Profits may qualify for the 20% qualified business income deduction (Section 199A Deduction), which is the most significant change under the TCJA of 2017 to be emphasized. 2. Tax Disadvantages. The tax disadvantages of operating as a sole proprietorship are listed beginning on p. C:2-3.

Partnerships. A partnership is an unincorporated business carried on by two or more individuals or other entities. A partnership is a tax reporting, non-taxpaying entity, which acts as a conduit. All items of income, expense, gain, loss, and credit flow through to the partners’ tax returns. A partnership must file a Form 1065 annually. Each partner receives a Schedule K-1 (Form 1065), which provides the information that must be reported on the partner’s tax return. Examples C:2-3 and C:2-4, p. C:2-4, illustrate the effect of partnership income and loss on an individual partner’s tax liability. Only those partnerships maintaining a fiscal year under the Sec. 444 reporting period rules must make tax payments based on the amount of income deferral. A completed Form 1065 and the related facts are included in Appendix B. A partnership can be either a general partnership or a limited partnership. In a general partnership, each partner has unlimited liability for partnership debts. In a limited partnership, at least one partner must be a general partner, and at least one partner must be a limited partner. Limited partners are liable only to the extent of their investment plus any amount that they commit to contribute to the partnership if called upon. C:IO2-3 Copyright © 2024 Pearson Education, Inc.

Tax Advantages. A partnership is exempt from taxation. Marginal tax rates of the individual partners may be lower than the marginal corporate tax rate on the same income historically, but this may not be the case as of the TCJA of 2017. p. C:2-4. Pass through income may qualify for 20% of qualified business income deductions. No double taxation is inherent in the use of the partnership form. Profits are taxed only when earned. Generally, additional taxes are not imposed on withdrawals. Losses generally can be used to offset income from other sources. A positive basis adjustment is made when income is earned by the partnership and taxed to the partners. This reduces the gain recognized when a sale or exchange of the partnership interest occurs. No such basis adjustment occurs with a C corporation.

Tax Disadvantages. All profits are taxed when earned even though reinvested in the business. Marginal tax rates of the partners may be greater than the applicable marginal tax rate if the income is taxed to a corporation. Additional disadvantages can be found on p. C:2-4. A partner is not an employee. Employment taxes must be paid on a partner’s self-employment income from the partnership. Some tax-exempt fringe benefits are not available to partners. The partnership’s taxable year generally must conform to that of its partners or be a calendar year unless a special election is made to use a fiscal year. pp. C:2-4 and C:2-5.

C Corporations. A C corporation is a separate entity that for tax years beginning after December 31, 2017 is taxed at 21% on taxable income. A C corporation must report all its income and expenses and compute its tax liability on Form 1120 (U.S. Corporation Income tax Return). A completed Form 1120 appears in Appendix B. Shareholders are not taxed on the corporation’s earnings unless these earnings are distributed as dividends, and qualified dividends are taxed at the shareholder’s tax rate for long-term capital gains can be 0%, 15%, or 20%, depending on the individual’s tax status and level of taxable income. In addition, an incremental 3.8% tax rate applies to net investment income for taxpayers whose modified AGI exceeds $200,000 ($250,000 for married filing jointly). Net investment income includes, among other things, interest, dividends, annuities, royalties, rents, and net gains from the disposition of property not used in trade or business, all reduced by deductions allocable to such income or gains. In contrast,

a C Corporation’s capital gains are taxed at the same 21% tax rate as its other income. 1.

Tax Advantages. Shareholders employed by the corporation are treated as employees for fringe benefit purposes. As employees they are eligible to receive deductible salary payments. This allows them to adjust their compensation (within limits) to cause the income to be taxed partly on the corporate return and partly on the shareholders’ returns, to minimize their overall tax liability. A C corporation is allowed to use a fiscal year. There are restrictions on using a fiscal year that apply to personal service corporations unless a special election is made under Sec. 444 by the corporation. p. C:2-6.

Tax Disadvantages. Double taxation occurs when dividends are paid or the corporation’s stock is sold or exchanged. Shareholders can generally not withdraw money from the corporation without tax consequences. Distributions are taxable as dividends to the extent of earnings and profits. Net operating losses have limited benefit to shareholders. They can be carried back (only if incurred before 2021) or carried over to offset income in future years. This can be a significant disadvantage for start-up companies that may have to wait several years before they can recognize benefit from a loss, and make other business entities much more attractive. Capital losses provide no benefit in the year that they are incurred. They can only be used to offset capital gains. p. C:2-6.

S Corporations. S corporations are corporations that elect to be taxed as a partnership. Generally no tax is paid by the corporation. Instead, all items of income, deduction, gain, loss, and credit flow through to the individual shareholders. Corporate rules apply unless overridden by the Subchapter S provisions. A completed Form 1120S (U.S. Income Tax Return for an S Corporation) is included in Appendix B. 1. Tax Advantages. S corporations are generally exempt from taxation. The shareholders pay tax at their marginal tax rates, which are generally lower than the C corporation’s marginal tax rate. See the Tax Strategy Tip on p. C:2-7. Pass through income may qualify for the 20% qualified business income deduction. It is important to note that there are many limitations to this deduction.

Losses pass through to shareholders and generally can be used to offset income earned from other sources. Passive loss rules may limit loss deductions to shareholders. (See Chapter C:11.) Capital gains are taxed to individual shareholders as though they were earned by the individual. An individual may be able to offset these gains with capital losses from other sources or have them taxed at their own capital gains rates. Capital losses flow through separately to the shareholders and can be used to offset other capital gains and to a limited extent ordinary income. Shareholders can contribute or withdraw money from the S corporation without adverse tax consequence. Profits are taxed as earned. The earnings are generally not taxed a second time when distributed as dividends. A positive basis adjustment is made when income is earned by the S corporation and taxed to the shareholders. This reduces the gain recognized when a sale or exchange of the S corporation stock occurs. No such basis adjustment occurs with a C corporation. 2.

Tax Disadvantages. All the corporation’s profits are taxed when earned, whether distributed or not. Distributions generally are made to at least cover the taxes paid by the shareholders on their share of the corporation’s earnings. If the shareholders’ marginal tax rates exceed those for a C corporation, the capital that remains for reinvestment may be reduced. Tax-free fringe benefits are generally not available to shareholders. When provided, they are deductible by the corporation and taxable to the shareholder as compensation. Shareholders are treated as employees for purposes of social security taxes. An S corporation generally must select a calendar year as its tax year unless a special election is made under Sec. 444 to use a fiscal year.

Limited Liability Company. A limited liability company (LLC) combines the best features of a partnership and corporation even though it is neither. It is taxed like a partnership while providing the limited liability of a corporation.

Limited Liability Partnership. Many states also have statutes that allow a business to operate as a limited liability partnership (LLP). This partnership form is particularly attractive to professional service partnerships, such as public accounting firms. Under state LLP laws, partners are liable for their own acts and the acts of individuals under their direction. LLP partners are not liable for the negligence or misconduct of other partners. p. C:2-8. C:IO2-6 Copyright © 2024 Pearson Education, Inc.

II.

A side-by-side comparison of the tax and nontax attributes of C corporations, partnerships, and S corporations is presented in Appendix F. It might be helpful to periodically refer to this comparison throughout Chapters C:2 through C:11.

Check-the-Box Regulations. Unincorporated businesses are able to choose whether to be taxed as a partnership or corporation. The rules are commonly referred to as “check-the-box” regulations. Treasury Regulations provide that an unincorporated business with two or more owners is taxed as a partnership unless it elects to be taxed as a corporation. An unincorporated business with one owner may elect to be taxed as a corporation or be disregarded as a separate entity and be taxed directly to the owner on a Schedule C. This election is not available to corporations, trusts, or certain special entities such as Real Estate Investment Trusts, Real Estate Mortgage Investment Conduits, or Publicly Traded Partnerships. An eligible entity may affirmatively elect its classification on Form 8832 [Entity Classification Election]. Examples C:2-8 and C:2-9, p. C:2-8, illustrate the default rules. If an entity makes an election to change its classification, it cannot again change its classification by election during the 60 months following the effective date of the election. There are tax consequences to the changing of classifications. When applying check-the-box regulations, taxpayers must also check whether or not their state will treat an entity in a consistent manner for state tax purposes. p. C:2-8.

III.

Legal Requirements and Tax Considerations Related to Forming a Corporation. The legal requirements for forming a corporation depend on the laws of the state in which the corporation is incorporated. These laws provide for legal capital minimums, incorporation fee, franchise tax, and corporate tax rules. Most corporations are incorporated in the state in which they commence business. Articles of incorporation must be filed. A fee is charged for incorporation and an annual franchise tax is collected. It is important to note that these fees and taxes can be substantial, and should be a consideration prior to formation.

IV.

Tax Considerations in Forming a Corporation. Property, money, or services are transferred to the corporation in exchange for a debt or equity interest. Tax consequences may occur for both the shareholder, debtholder, and the corporation. Example C:2-10 on p. C:2-10 illustrates these tax consequences for the corporation and its shareholders. At this point you may wish to use Table C:2-1, Overview of Corporate Formation Rules. This summary is found on p. C:2-11 of the text and is a good tool to be used to explain each of the parts of the incorporation transaction. Book-tax accounting issues are discussed later in this chapter.

Section 351: Deferring Gain or Loss upon Incorporation. No gain or loss is recognized when property is transferred to a corporation solely in exchange for stock provided that immediately after the exchange, the transferors are in control. Recognition of gain or loss is deferred through adjustment of the shareholder’s basis in the stock. (See Example C:2-11 on p. C:2-12.) The requirements for nonrecognition treatment are discussed below. A.

The Property Requirement. Property must be transferred to the corporation in an exchange transaction. Property includes money, and almost any other kind of property including installment obligations, accounts receivable, inventory, equipment, patents, and other intangibles representing “know-how,” trademarks, trade names, and computer software. Excluded from the property definition are services received in exchange for stock in a corporation, indebtedness of the transferee corporation that is not evidenced by a security, and interest on an indebtedness of the transferee corporation that accrued on or after the beginning of the transferor’s holding period for the debt.

The Control Requirement. The transferors as a group must be in control immediately after the exchange. Control is ownership of at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock. Only stock received for property is counted when determining if control has been received. Stock received for services does not count for purposes of determining control unless property is also contributed. A transfer of property to an existing corporation will be tax-free only if an 80% interest in the corporation is acquired, or existing shareholders also transfer enough additional property to the corporation to permit the 80% requirement to be satisfied by the transferors as a group. Transferors must be in control of the corporation immediately after the exchange. The exchanges do not need to be simultaneous, but must be agreed to beforehand and executed in an expeditious and orderly manner.

The Stock Requirement. No gain or loss is recognized by transferors who exchange property solely for transferee corporation qualifying stock. Voting or nonvoting stock may be received by the transferors. Nonqualified preferred stock is preferred stock that has one of the following characteristics: 1. The shareholder can require the corporation to redeem the stock. 2. The corporation is required to redeem the stock. 3. The corporation has the right to redeem the stock, and is more likely than not to do so, or 4. The dividend rate on the stock varies in relation to interest rates or other such indices. However, nonqualified preferred stock is treated as boot. Stock rights or stock warrants are not considered stock for purposes of Sec. 351. p. C:2-16. C:IO2-8 Copyright © 2024 Pearson Education, Inc.

At this point, you may wish to review with the students by referencing Topic Review C:2-1, which provides a concise overview of the requirements of Sec. 351. This review is found on p. C:2-17 in the text. D.

Effect of Sec. 351 on the Transferors. If all the requirements of Sec. 351 are met, the transferors do not recognize any gain or loss on contribution of their property to the corporation. The receipt of property other than stock does not completely disqualify the transaction from coming under Sec. 351. However the receipt of property other than stock may cause the exchange to be partly taxable. Property other than stock that is received is considered boot. Gain is recognized to the extent of the lesser of (1) the transferor’s realized gain or (2) the amount of money plus FMV of the nonmoney boot property received. A loss is never recognized. The character of the gain depends upon the type of the property transferred. (See Example C:2-24.) Where several properties are transferred, a “separate properties approach” is used. (See Example C:2-25.)

Basis of Stock Received. The basis of the stock received in a Sec. 351 exchange is the adjusted basis of the property transferred plus any gain recognized by the transferor minus (1) any money received (including liabilities transferred to the corporation that are treated like money) and (2) the FMV of any nonmoney boot property that is received. (See Example C:2-26.)

Tax Consequences to Transferee Corporation. The transferee corporation needs to determine the amount of gain or loss (if any) it must recognize and the basis of property or services acquired. No gain or loss is recognized by a transferee corporation exchanging stock or debt instruments for property. A transferee corporation must recognize gain (but not loss) if it transfers appreciated property to a transferor as part of a Sec. 351 exchange. (See Examples C:2-29 and C:2-30.) If the transaction is taxable to the transferor, the basis of the property acquired is its acquisition cost.

Topic Review C:2-2 presents a summary of the tax consequences of a tax-free asset transfer to the transferor and the transferee corporation and may be referred to at this point to summarize the more important material relating to partially tax-free in corporations. This review is presented on p. C:2-20. G.

Assumption of the Transferor’s Liabilities. The assumption of liabilities does not cause the transferor to recognize part or all of his realized gain unless (1) the transfer is made for a tax avoidance purpose or there is no bona fide business purpose for the acquisition and/or assumption of the debt, or (2) the liabilities assumed are in excess of the basis of the properties transferred.

The most important factor in determining whether a tax avoidance purpose is present is the length of time between the incurrence of the liability and the transfer of the liability to the corporation. Liabilities are considered to have a business purpose if the liabilities are incurred in the normal course of business or in the course of acquiring business property. If no business purpose is found, all of the liabilities assumed or acquired are considered boot. If the total amount of liabilities transferred to a controlled corporation by a transferor exceeds the total adjusted basis of all properties transferred by the transferor, the excess liability is a gain that is taxable to the transferor. (See Example C:2-37.) The term liabilities for a cash or hybrid method of accounting transferor does not include (1) any amount that would give rise to a deduction when paid or (2) any amount that is payable to a retired partner or to liquidate a deceased partner’s interest. (See Example C:2-38.) Topic Review C:2-3 presents a summary of the liability assumption and acquisition rules of Sec. 357 and may now be used to review this material with the students. This review is presented on p. C:2-25. H.

Other Considerations in a Sec. 351 Exchange. 1.

Recapture of Depreciation. If a Sec. 351 exchange is nontaxable, no depreciation recapture is required. The transferor’s recapture potential is transferred to the transferee corporation. (See Example C:2-39.)

Computing Depreciation. When a shareholder transfers depreciable property to a corporation in a Sec. 351 transaction, the corporation must continue to use the same depreciation method and recovery period with respect to the shareholder’s basis in the property. An allocation of the depreciation for the year that includes the transfer date must be made between the transferor and transferee. If a basis adjustment occurs because the transferor recognizes a gain, a second depreciable asset is created which is generally depreciated as a new asset under the MACRS rules. (See Example C:2-40.)

Assignment of Income Doctrine. This doctrine is a judicial requirement that income be taxed to the person who earns it. This doctrine does not apply to a Sec. 351 exchange if the transferor transfers substantially all the business assets and liabilities to the corporation and a business purpose exists for the transfer. Accounts receivable take a zero basis in the corporation’s hands and are included in income when collected. (See Example C:2-42.)

VI.

Choice of Capital Structure. A.

Characterization of Obligations as Debt or Equity Capital. The tax laws provide an incentive for closely held corporations to maximize the amount of allowable interest deductions. Where debt financing resembles equity obligations, the form of the transaction will be ignored and debt will be reclassified as common or preferred stock. No single factor is controlling in determining when reclassification will occur.

Debt Capital. 1.

Issuance of Debt. C Corporations with average gross receipts for the previous three years exceeding $29 million (in 2023) are limited in the interest deduction to the sum of (1) businesses interest income; (2) 30% of adjusted taxable income; and (3) floor plan financing interest for corporate tax payers who sell motor vehicles. Interest expense greater than the sum of these three items carries over to the next tax year, subject to the limitation in that year. The carry over period is indefinite. To arrive at adjustable taxable income, a C Corporation calculates taxable income without regard to (1) any item of income, gain, deduction, or loss not properly allocable to a trade or business; (2) any business interest or business interest income; (3) any net operating loss deduction; and (4) any deduction allowable for depreciation, amortization, or depletion taken in years before 2023. C Corporations with average gross receipts of $29 million or less are not limited in their business interest deduction. In contrast to business interest expenses, the corporation cannot deduct dividends paid on equity security.

When Interest Is Paid. Interest paid on debt is deductible by the payor. Dividends paid on stock are not deductible by the corporation. Noncorporate investors who borrow funds in order to make an investment in a C corporation will find that the interest expense incurred to carry such an investment is generally subject to the investment interest limitation; unless the investment is a passive activity and the interest expense comes under the passive activity limitation rules.

When an Indebtedness Is Satisfied. Repayment of an indebtedness is not considered an exchange transaction. An obligation that is repaid by a corporation does not result in a gain or loss being recognized by the creditor. The satisfaction of a debt instrument (e.g., note, bond, or a debenture) is an exchange for the holder of a debt instrument and gain or loss will be recognized if the amount received is different from the asset’s basis. Table C:2-2 presents the tax advantages and disadvantages of using debt in the capital structure. This table may be found on p. C:2-29. You may C:IO2-11 Copyright © 2024 Pearson Education, Inc.

want to discuss the case presented in the box on p. C:2-31 concerning extremely long-term debt issued to raise capital by a corporation. C.

Equity Capital. The reasons for use of multiple classes of stock are found on p. C:2-29. Because of the many different types of equity issues that are possible, all tax and nontax advantages of each type cannot be listed. Table C:2-3, Tax Advantages and Disadvantages of Using Stock in the Capital Structure, is found on p. C:2-30.

Capital Contributions by Shareholders. A corporation does not recognize any income when it receives money or property as a capital contribution from a shareholder. If additional contributions are made without additional stock being issued, the payments are regarded as an additional price paid for the existing stock. (See Example C:2-44.)

Capital Contributions by Nonshareholders. Nonshareholders sometimes contribute capital to a corporation in the form of cash or other property. For example, a city government might make a “contribution to capital” to a corporation in the form of undeveloped land to induce a corporation to locate within the city and provide jobs for citizens of the municipality. For transfers before December 23, 2017, such “contributions to capital” were excluded from the corporation’s gross income if the money or property contributed was neither a payment for goods or services nor a subsidy to induce the corporation to limit production. However, for transfers after December 22, 2017, the term “contribution of capital” no longer includes contributions to the corporation by nonshareholders who are customers, potential customers, governmental entities, or civic groups. In these cases, the transfers will continue to be nontaxable. In this case, the corporation will continue to take a zero basis in the property received, which precludes the corporation from claiming depreciation deductions or other capital recovery offsets with respect to the contributed property. If a nonshareholder, who is not a customer, potential customer, governmental entity or civic group, contributes cash, the basis of any property acquired with the cash during a 12-month period beginning on the day the corporation received the contribution is reduced by the cash amount used to acquire the property. This basis reduction applies to the corporation’s other property in the following order: 1. Depreciable Property 2. Amortizable Property 3. Depletable Property 4. All other property

In the sequence of these downward adjustments, however, a property’s basis may not be reduced below zero.

VII.

Worthlessness of Stock or Debt Obligations. A.

Securities. A debt or equity investment that is evidenced by a security and that becomes worthless results in a capital loss for the investor on the last day of the tax year in which the worthlessness occurs. Ordinary loss can be reported in some situations. An example of this would be securities that are held by dealers as inventory. A domestic corporation is also permitted to claim an ordinary loss in connection with the worthlessness of a security of an affiliated corporation. The Sec. 1244 rules permit an ordinary loss to be claimed for qualifying stock issued by a small business corporation that is sold, exchanged, or becomes worthless. Ordinary loss treatment is only allowed an individual who was originally issued the stock, or by a partner in a partnership that was originally issued the stock, and whose distributive share includes the losses for the corporate stock. If a shareholder contributes additional money or property to a corporation after acquiring Sec. 1244 stock, the amount of ordinary loss recognized upon the sale, exchange, or worthlessness of the Sec. 1244 stock is limited to the shareholder’s capital contribution at the time the shares were issued. The ordinary loss is limited to $50,000 (or $100,000 if the taxpayer is married and files jointly). Losses in excess of the dollar ceiling are capital losses.

Post-2020 NOLs do not carry back but carry over indefinitely, subject to an 80% of taxable income limitation in the carryover year. This is further discussed in Chapter C:3. B.

Unsecured Debt Obligations. Shareholders may make loans to corporations. The type of loss that can be claimed on these advances depends on the nature of the loan. If the advance is treated as paid-in capital, the amount of the loan increases the worthless securities loss on the stock. A loan made to a corporation that is not evidenced by a security can be deducted under either the business or nonbusiness bad debt rules. Most unsecured advances are considered to be made outside the shareholder’s trade or business. If a noncorporate shareholder makes the loan, it will generally be considered a nonbusiness bad debt that is a short-term capital loss, and is limited to a $3,000 deduction per year.

VIII. Tax Planning Considerations. Sec. 351 treatment is mandatory, not elective, if the provisions are met. In some cases shareholders may wish to recognize gains or losses. In order to accomplish this, one of the provisions necessary for the application of Sec. 351 must be violated. (See Example C:2-50.)

IX.

Compliance and Procedural Requirements. Every person who receives stock, securities, or other property in an exchange qualifying under Sec. 351 must attach a statement to his tax return for the period that includes the date of the exchange. A list of the required information for the transferor is found on p. C:2-36. The transferee corporation must attach a statement to its tax return for the year in which the exchange takes place. A list of the transferee corporation’s required information is found on p. C:2-36.

Court Case Briefs Charles E. Wolfe v. U.S., 612 F. Supp 605 (DC Mont, 1985) aff’d. 798 F.2d 1241 (9th Cir., 1986). The taxpayer, Charles E. Wolfe, was the sole shareholder and president of Wolfe & Company, a corporation which leased tractor-trailers. Mr. Wolfe also operated an “over-the-road” trucking business as a sole proprietorship. The corporation incurred a large federal tax bill which was paid by Mr. Wolfe personally when the corporation was unable to pay. Mr. Wolfe contended that he should not be held personally liable for the tax liability of the corporation. The main issue was whether the corporation was the alter ego of Mr. Wolfe. If so, then the Internal Revenue Service could “pierce the corporate veil” and look to Mr. Wolfe’s personal assets for satisfaction of the corporate tax liability. The court considered eleven factors, including level of ownership and control of the corporation, commingling of personal and corporate funds, common books and records, distribution of earnings and profits, and representation of corporate-personal relationship. In this case, the facts represented a classic case of a shareholder so dominating corporate affairs such that the corporation and the shareholder did not appear to have separate identities. Therefore, the Service could pierce the corporate veil and look to the personal assets of the sole shareholder for payment of the taxes. Further, neither economic difficulties nor employee’s illness constituted reasonable cause for failure to file or pay tax. American Bantam Car Company v. CIR, 11 T.C. 397 (1948), aff’d. per curiam 177 F.2d 513 (3rd Cir., 1949). This is a leading case in the determination of whether a transfer to a corporation is a tax-free transfer to a controlled corporation under the Code Sec. 351. This case is based on Section 112(b)(5) of the Revenue Act of 1936, the precursor of Code Sec. 351. In this case, property was transferred to the newly formed American Bantam Car Company in exchange for stock of the corporation by three individuals, who immediately after the transfer owned greater than an 80% interest in the corporation. Subsequent to this transfer, the corporation entered into agreements with underwriters for the public offering of stock of the corporation, which if such offering had resulted in sufficient sales, would have reduced the C:IO2-14 Copyright © 2024 Pearson Education, Inc.

interests of these three initial shareholders, based on the voting rights endowed upon the stock in the articles of incorporation. The issue before the court was whether these transactions were all part of an integrated plan, thereby eliminating tax-free exchange treatment under Section 112(b)(5) or whether they were actually separate transactions. The court looked at four factors in making their decision: 1) intent of the parties, 2) mutual interdependence of steps, 3) time element, and 4) ultimate result. There is a detailed analysis of each factor and a summary of prior court cases in this case. The court held that the transactions were indeed separate and that the transfer of assets to the corporation should be treated as a tax-free exchange. Therefore, the basis of the assets for the corporation was their basis in the hands of the transferors on the date of the exchange.

Chapter C:3 The Corporate Income Tax Learning Objectives After studying this chapter, the student should be able to: 1.

Select tax years and accounting methods for C corporations.

Calculate deductions particular to corporations and arrive at corporate taxable income and tax liability.

Recognize what a controlled group is and determine the tax consequences of being a controlled group.

Identify planning strategies to reduce taxes for corporations and their shareholders.

Comply with corporate tax filing requirements.

Determine the financial statement implications of corporate federal income taxes.

Areas of Greater Significance This is a basic chapter in understanding the impact of taxation on corporations. Emphasis should be placed on calculating taxable income and the resulting tax liability, as well as transactions between a corporation and its shareholders. The definition of controlled groups and the rules applying to these groups should be covered. Compliance and procedural considerations are particularly important in this chapter and should not be omitted.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Tax planning considerations (Compensation planning for shareholder employees, special allocation to allocate reduced tax rate benefits, and using NOL carrybacks and carryovers). ASC 740 may be covered in a financial accounting class instead.

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Application of the controlled group test.

Using NOL carryovers and carrybacks and ASC 740.

Highlights of Recent Tax Law Changes 1.

The TCJA of 2017 has changed the way that corporate tax liability is calculated. Focus should be on the new rate, and perhaps provide discussion on how the recent changes differ from how corporate tax liability has historically been computed. The impact of proposed tax rate increases under the current presidential administration and context also provides solid discussion on the importance of tax policy and decision making.

The primary document that dictates financial statement treatment is Accounting Standards Codification (ASC) 740, formerly found in SFAS No. 109 and FASB Interpretation No. 48 (Fin 48). In January, 2010, the IRS issued Announcement 2010-9 that would require certain taxpayers to provide information about their uncertain tax positions. The required information could provide the IRS a road map for auditing the tax return. Since 2010, only corporations with assets of $100 million will be required to file Form 1120 UTP. This requirement presently applies to corporations with assets of $10 million.

Teaching Tips 1.

Use Examples C:3-36 and C:3-37 to illustrate a case when the 50% test is satisfied and one when it is not satisfied. Also point out that both the 80% and the 50% tests must be satisfied for a brother-sister controlled group to exist. p. C:326.

You may wish to use Example C:3-42 here to illustrate how the reduced 15% rate on dividends makes the difference between salary and dividends much less.

Example C:3-46 may be expanded to illustrate a situation in which the taxpayer may wish to forgo an NOL carryback to avoid losing expiring tax credits. p. C:335.

Draw the students’ attention to Figure C:3-5. Discussion of the Schedule M-1 entries is an excellent way to tie together their financial accounting and tax backgrounds. p. C:3-42. It might be helpful to illustrate to the students the book income-to-taxable income reconciliation worksheet on p. B-12 of Appendix B. Additional annotations have been added to the chapter making book-to-tax C:IO3-2 Copyright © 2024 Pearson Education, Inc.

accounting comparisons. 5.

Refer the students to the completed Form 1120 that can be found in Appendix B, pp. B-7 through B-10. The facts for this return are also available in Appendix B. At some point in the course coverage, the C corporation, partnership, and S corporation tax returns contained in Appendix C should be tied together for the students. The similar facts used in all three returns will make for easy comparisons between the three returns.

Lecture Outline A corporation is a separate taxpaying entity. This chapter discusses the rules for determining a corporation’s taxable income and tax liability. It discusses how to file a corporate tax return. The chapter also discusses the financial implications of corporate income taxes. Some of these implications appear briefly in the Book-to-Tax Accounting Comparisons, and a more detailed discussion appears at the end of this chapter. The corporations discussed in this chapter are regular corporations or C corporations. Corporations that are not classified as domestic are foreign corporations. Foreign corporations are taxed like domestic corporations if they conduct a trade or business in the United States. I.

Corporate Elections. When a corporation is formed, there are certain elections that must be made. A.

Choosing a Calendar or Fiscal Year. A new corporation may select either a calendar or fiscal year by filing its first tax return for the selected period. The corporation’s tax year must be the same as its annual accounting period that is used for financial accounting purposes. A corporation’s first tax year may not cover a full 12-month period. In that case, a short-period tax return must be filed. A corporation’s final year may also cover a short period. Some corporations may be restricted in their ability to select a tax year. A corporation that is a member of an affiliated group of corporations that files a consolidated return must use the same tax year as the group’s parent corporation. A personal service corporation may elect to use certain fiscal years even when there is no business purpose. A new PSC may elect to use a September 30, October 31, or November 30 year-end provided that it meets minimum distribution requirements to employee-owners during the deferral period. A personal service corporation (PSC) is defined for this purpose as a corporation whose principal activity is the performance of personal services. A corporation is not a PSC unless its employee-owners own more than 10% of the stock (by value) on any day of the year and the personal services are substantially performed by C:IO3-3 Copyright © 2024 Pearson Education, Inc.

the employee-owners. A corporation wishing to change its accounting period must secure the prior approval of the IRS unless a change is specifically authorized under the Regulations. A request for change is filed on Form 1128 by the due date of the short period tax return, including extensions. The change will be granted if there is a substantial business purpose. A corporation may change its tax year without the prior approval of the IRS if: 1. 2. 3. 4. 5. 6. 7. B.

The corporation files a short-period tax return for the year of change and annualizes its income when computing its tax for the short period. The corporation files full 12-month returns for subsequent years ending on the new year-end. The corporation closes its books as of the last day of the short period and subsequently computes its income and keeps its books using the new tax year. If the corporation generates an NOL or capital loss in the short period, it may not carry back the losses but must carry them over to future years. The corporation must not have an interest in a pass-through entity as of the end of the short period (with some exceptions). The corporation must not have an interest in a pass-through entity as of the end of the short period (with some exceptions). The corporation is not an S corporation, personal service corporation, taxexempt organization, or other specialized corporation.

Accounting Methods. A new corporation must select the method of accounting it will use to keep its books and records. The same method must be used to compute financial accounting income and taxable income. 1.

Accrual Method. Income is reported when earned and expenses are reported when incurred. C corporations must use this method unless they come under one of the following exceptions. If the corporation meets any of the below exceptions, they have the option to select the accrual method or either of the other two methods presented. a.

A farming business.

A qualified personal service corporation where substantially all of its activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and where substantially all of the stock is held by current (or retired) employees performing the services, their estates, or (for 2 years only) persons who inherited their stock from such employees.

II.

Corporations with gross receipts of $29 million or less. See special rule for determining if the $29 million ceiling has been violated.

S corporations.

Cash Method. Income is reported when received and expenses are reported when paid. This method may not be used if the taxpayer does not meet the $29 million (in 2023) gross receipts test and inventories are a material income-producing factor.

Hybrid Method. The corporation uses the accrual method of accounting for sales, cost of goods sold, inventories, accounts receivable, and accounts payable. The cash method of accounting is used for all other income and expense items.

General Formula for Determining the Corporate Tax Liability. Each year a corporation is responsible for computing its regular tax liability. In addition, the corporation may owe the alternative minimum tax and possibly either the accumulated earnings tax or personal holding company tax. The total tax liability equals the sum of the two primary corporate tax liabilities plus the amount of any special levies that are owed. Table C:3-1 should be used at this point. p. C:3-3.

III.

Determining a Corporation’s Taxable Income and Tax Liability. Computing a corporation’s taxable income is very similar to computing an individual’s taxable income. A.

Differences between Individual and Corporate Taxable Income. Table C:3-1 on p. C:3-3 outlines the computation of corporate taxable income and the corporate income tax liability. Gross income is computed in much the same way as for an individual. Review with the students the various types of income on which a corporation is taxed. Some specific differences between individual and corporate taxable income are discussed below.

Sales and Exchanges of Property. Sales and exchanges of property are treated the same for corporations as they are for individuals except for capital losses and an additional 20% depreciation recapture that is required under Sec. 291. Corporations are not subject to the 25% tax rate on recaptured Section 1250 gains. A corporation nets all of its capital gains and losses together. Net long-term capital gains and net short-term capital gains are included in gross income. (See Example C:3-2.) Net capital losses cannot be deducted in the current year. They can only be used to offset capital gains. Any excess losses must be carried back as short-term capital losses to the third previous year and then carried forward for five years. Any losses that remain after the carryforward period are lost. (See C:IO3-5 Copyright © 2024 Pearson Education, Inc.

Example C:3-3.) Note that the carryback can be accomplished through the filing of a Form 1139 or 1120X. If Sec. 1250 property is sold at a gain, a corporation must recapture as ordinary income an additional amount equal to 20% of the additional ordinary income that would have been recognized on a sale, exchange, or other disposition of the property if it had been Sec. 1245 property rather than Sec. 1250 property. (See Example C:3-4.) C.

Business Expenses. Deductions are allowed for ordinary and necessary business expenses. No deductions are allowed for interest on amounts borrowed to purchase tax-exempt securities, illegal bribes or kickbacks, fines or penalties imposed by a government, or insurance premiums incurred to insure the lives of officers and employees when the corporation is the beneficiary. When covering the nondeductible payments, consider covering the What Would You Do In This Situation? materials presented on p. C:3-8. This material looks at illegal kickback payments. Some special deductions that relate to corporations are discussed below: 1.

Organizational Expenditures. A corporation is deemed to have made the Sec. 248 election for the tax year the corporation begins business. If the corporation chooses to forgo the deemed election, it can elect to capitalize the expenditures (without amortization) on a timely filed tax return for the tax year the corporation begins business. If the corporation chooses to amortize expenses, it can deduct the first $5,000 of organizational expenditures. However, the corporation must reduce the $5,000 by the amount by which cumulative organizational expenditures exceed $50,000, although the $5,000 cannot be reduced below zero. The remaining organizational expenditures can be amortized over a 180-month period beginning in the month it begins business. See the list of organizational expenses beginning on p. C:3-9. Organizational expenses do not include expenditures connected with issuing or selling a corporation’s stock or securities. (See Examples C:3-5 and C:3-6.)

Start-Up Expenditures. Start-up expenditures are ordinary and necessary business expenses that are paid or incurred to investigate the creation or acquisition of an active trade or business, to create an active trade or business, or to conduct an activity engaged in for profit or the production of income before the time the activity becomes an active trade or business. The expenditures must be such that they would be deductible if they were incurred in the conduct of a trade or business. Similar to the rules for organizational expenses, a corporation may elect to deduct the first $5,000 of start-up expenditures on a timely filed return for the year the corporation begins business. However, this amount is reduced (but not below zero) by the amount by which the cumulative start-up costs exceed C:IO3-6 Copyright © 2024 Pearson Education, Inc.

$50,000. The remainder of the start-up costs can be amortized over a 180month period beginning in the month it begins business. You may want to point out the Stop and Think example on p. C:3-10 that points out the difference between an organization expenditure and a start-up expenditure. 3.

Limitation on Deductions for Accrued Compensation. If a corporation accrues an obligation to pay compensation, the payment must be made within 2 1/2 months after the close of the corporation’s tax year. Otherwise, the deduction cannot be taken until the year of payment. (See Example C:3-7.)

Entertainment Expenses. For 2021 and 2022, the 50% limitation on the deduction for business meals served at restaurants was suspended so that 100% of such meal expenses were deductible. This deduction was originally disallowed after 2017. In 2023, no deduction is allowed for any activities that involve entertainment, amusement, or recreation, including expenses related to a facility connected with these activities.

Executive Compensation. Section 162(m) limits the deduction for compensation paid to a “covered” employee to $1 million.

Charitable Contributions. Charitable contributions for corporations differ from the treatment afforded individuals in three ways. Normally a charitable contribution is deductible in the year paid. Corporations, that use the accrual method of accounting, may elect to take a charitable contribution deduction in the year accrued if the board of directors authorizes the contribution in the year accrued, and the contribution is paid on or before the 15th day of the fourth month following the end of the tax year. (See Example C:3-9.) The amount deductible includes the amount of money or the fair market value of property contributed in most instances. In the case of ordinary income property, the amount deductible is limited to the property’s fair market value minus the amount of ordinary income or short-term capital gain that would have been recognized if the property were instead sold. In the case of certain inventory (medical items or scientific research equipment) property, “apparently wholesome food,” the amount deductible is the property’s adjusted basis plus one-half of the difference between the property’s adjusted basis and fair market value. The amount of the deduction cannot exceed twice the adjusted basis. For tax years beginning after December 31, 2007 contributions of computer software, computer or peripheral equipment, and fiber optics related to computers that are used within the United States for educational purposes will be limited to the adjusted basis of such property. (See Example C:3-10.) C:IO3-7 Copyright © 2024 Pearson Education, Inc.

If property is contributed by a corporation to a charity, corporations must comply with a new substantiation requirement. If the contribution exceeds $500, the corporation must include with its tax return a description of the property and any other information required by regulation. If the contribution exceeds $5,000, a qualified appraisal must be obtained. If the contribution exceeds $500,000 a qualified appraisal must be attached to the return. Failure to comply will cause the deduction to be forfeited (See Example C:3-11). A corporation’s contribution deduction is limited to 10% of adjusted taxable income in 2023. Adjusted taxable income is taxable income computed without regard to the charitable contributions, an NOL carryback, a capital loss carryback, or any dividends-received or dividends-paid deduction. Contributions in excess of that limit can be carried forward for five years. (See Example C:3-12.) Topic Review C:3-1 on p. C:3-13 summarizes the basic corporate charitable contribution deduction rules and may be reviewed by the class at this point. D.

Special Deductions. Three types of special deductions are commonly encountered by C corporations. They are the dividends-received deductions, NOL deductions, and the U.S. production activities deduction. 1.

Dividends-Received Deduction. The deduction is generally 50% or 65% of the amount of the dividend received. The deduction percentage depends on the amount of the distributing corporation stock that is owned. (See Example C:3-13.) The 50% deduction applies if less than 20% of the distributing corporation’s stock (as measured by voting power and value) is owned. An 80% deduction is permitted if at least 20% of the voting power or value is owned. Separate limitations are calculated for the 70% and 80% dividends-received deductions. The dividends-received deduction is further limited to the lesser of 50% or 65% of taxable income computed without regard to the dividends-received deduction, NOL deduction, or capital loss carryback. (See Example C:3-14.) A corporation that receives both dividends eligible for the 80% dividendsreceived deduction and the 50% dividends-received deduction must reduce taxable income by the aggregate amount of dividends eligible for the 80% deduction before computing the 50% deduction. (See Examples C:3-15 and C:3-16.) Members of an affiliated group of corporations can take a 100% dividends-received deduction. No limit exists on the amount of the 100% dividends-received deduction. If an affiliated group files a consolidated tax return, the recipient of the dividend does not claim the 100% dividend C:IO3-8 Copyright © 2024 Pearson Education, Inc.

received deduction because the intercompany dividend gets eliminated in the consolidation. (See Chapter C:8.) No dividends-received deduction is generally allowed for dividends paid by foreign corporations. A limited deduction may be allowed if the foreign corporation earns income by conducting a trade or business in the United States. The dividends-received deduction is not allowed for dividends received on any share of stock which the corporate shareholder held for 46 days or less during the 90-day period that begins 45 days before the stock becomes ex-dividend with respect to the dividend. The dividends-received deduction is not allowed to the extent that the stock on which a dividend is paid is debt financed. (See Example C:3-19.) Affiliated corporations and consolidated tax returns are discussed in more depth in Chapter C:8.

Net Operating Losses (NOLs). An NOL is the amount by which a corporation’s deductions exceed its gross income. In computing an NOL, no deduction is allowed for a carryover or carryback of an NOL from a preceding or succeeding year. NOLs arising in years beginning after 2020 carry over to succeeding tax years indefinitely (i.e., they do not expire). Also, NOLs arising in tax years beginning after 2020 will be limited in the carryover to 80% of taxable income before the NOL deduction. Thus, the NOL deduction is the lesser of the aggregate carryovers or 80% of taxable income computed without regard to the NOL deduction. Any amount of NOL carryover deduction disallowed because of the 80% limit carries over indefinitely. NOLs incurred before 2018 carry over 20 years and are not subject to the 80% of taxable income limitation.

Sequencing the Deduction Calculations. The computation of the charitable contribution deduction, dividends-received deduction, and NOL deduction require the proper sequencing. The correct order for taking the deductions is: (1) all deductions other than the charitable contributions deduction, the dividends-received deduction, and the NOL deduction; (2) the charitable contributions deduction; (3) the dividends-received deduction; (4) the NOL deduction; and (5) the U.S. production activities deduction. Example C:3-23 provides an example showing that an NOL carryback does not change the charitable deduction previously taken in the carryback year.

Exceptions for Closely-Held Corporations. Congress has placed certain limits on the rules explained above to prevent abuse in situations where a corporation is closely held.

IV.

Transactions between a Corporation and Its Shareholders. A controlling shareholder is one who owns more than 50% (in value) of the corporation’s stock. Certain constructive ownership rules apply. Special rules apply to transactions between a corporation and its controlling shareholders. a.

Gains on Sale or Exchange Transactions. Capital gain on the sale of property that is depreciable by the purchaser is converted into ordinary income. (See Example C:3-24.)

Losses on Sale or Exchange Transactions. A deduction is denied for losses realized on a sale of property by the corporation to a controlling shareholder or on a sale of property by the controlling shareholder to the corporation. If the property is later sold to another party, gain will be recognized only to the extent it exceeds the disallowed loss. (See Example C:3-25.)

Corporation and Controlling Shareholder Using Different Accounting Methods. A deduction is denied for accrued expenses or interest owed by a corporation to a controlling shareholder or by a controlling shareholder to a corporation when (1) the two parties use different accounting methods and (2) the payee will include the accrued expense as part of gross income at a date that is later than when it is accrued by the payer. The deduction may not be claimed until the day the payee includes the payment in gross income. (See Example C:3-26.)

Loss Limitation Rules. a.

At-Risk Rules. If five or fewer individuals own more than 50% of the value of the outstanding stock of a C corporation at any time during the last half of the corporation’s tax year, it is subject to the at-risk rules. Further discussion of these rules is found in Chapter C:9.

Passive Activity Limitation Rules. Personal service corporations and closely-held C corporations may be subject to the passive activity limitations. Further discussion of these rules is found in Chapter C:9.

Controlled Groups of Corporations. Special tax rules apply to corporations that are under common control to prevent them from being used to avoid taxes. These rules apply in cases that would otherwise be due falling below specified limitations by spreading certain transactions across a number of C:IO3-10 Copyright © 2024 Pearson Education, Inc.

corporations. Three key limitations to which the controlled group rules apply are those pertaining to the Sec. 179 expense, the minimum accumulated earnings credit, and the general business credit. A.

What Is a Controlled Group? A controlled group is a group of two or more corporations that are owned directly or indirectly by the same shareholder or group of shareholders. 1.

Parent-Subsidiary Controlled Groups. A parent-subsidiary controlled group is a group of two or more corporations where one corporation (the parent) owns directly at least 80% of the voting power of all classes of voting stock, or 80% of the total value of all classes of stock of a second corporation. There can be more than one subsidiary in the group. If the parent and/or a subsidiary own in total 80% of the voting power of all classes of voting stock, or 80% of the total value of all classes of stock of another corporation, that corporation is included in the controlled group.

Brother-Sister Controlled Groups. A group of two or more corporations is a brother-sister controlled group if five or fewer individuals, trusts, or estates own (1) At least 80% of the voting power of all classes of voting stock (or at least 80% of the total value of the outstanding stock) of each corporation, and (2) more than 50% of the voting power of all classes of stock (or more than 50% of the total value of the outstanding stock) of each corporation, taking into account only the stock ownership that each person has that is common with respect to each corporation. A shareholder’s common ownership is the percentage of stock the shareholder owns that is common or identical in each of the corporations. Examples C:3-31 and C:3-32 provide illustrations of these rules. A second definition of a brother-sister group is a broader definition. Under the 50% definition five or fewer shareholders must satisfy only the 50% common ownership test described above. Consequently, in situations where the 50%-only definition applies, more corporations may be pulled into the controlled group than under the 50%-80% definition.

Combined Controlled Groups. A controlled group is a group of three or more corporations that are members of the above groups where one is a parent corporation of a parent-subsidiary controlled group and a member of a brother-sister controlled group. (See Example C:3-33.) See Figure C:3-3 on p. C:3-25.

Application of the Controlled Group Test. The controlled group test is applied on December 31. A corporation is included in the group if it is a member on December 31 and has been a member of that group for at least one-half of the days in its tax year, which precedes December 31. A corporation is not included C:IO3-11 Copyright © 2024 Pearson Education, Inc.

in the controlled group even if it is a member on December 31, when it has been a member of the group for less than one-half of the days in its tax year, which precedes December 31. Other excluded members include tax-exempt organizations, certain foreign corporations, and certain life insurance companies. C.

Special Rules Applying to Controlled Groups. Table 3-2 discusses how certain items must be re-apportioned. Section 267 (a)(2) disallows certain deductions between related corporations.

Consolidated Tax Returns. Most parent-subsidiary controlled groups are eligible to file a consolidated return. An election is made to file a consolidated tax return by combining all of the income and expenses of each member on a Form 1120. Each corporate member of the affiliated group must consent to the election. For brother-sister corporations, the broader 50% only definition applies for limiting the reduced tax rates. (See Chapter C:8.) The main advantages of filing a consolidated return are listed on p. C:3-26. The use of NOLs is generally enhanced by filing a consolidated tax return. Example C:3-35 illustrates one of the advantages of filing a consolidated return. The main disadvantages of filing a consolidated return are listed beginning on p. C:3-27.

Tax Planning Considerations. A.

Compensation Planning For Shareholder-Employees. Salary and fringe benefit payments are desirable because they eliminate the problem of double taxation. There are four constraints that restrict or modify the tax planning that can be undertaken in the salary and fringe benefit area. 1.

Advantage of Fringe Benefits. The advantage of noncash compensation is that there will be either an exclusion or deferral from taxes. Qualified pension, profit sharing, and stock bonus plans generally provide a tax deferral. Fringe benefits generally provide an exclusion. Examples of fringe benefits that may be provided by a closely held corporation are group term life insurance premiums, accident and health insurance premiums, among others.

Limitation on Deductible Compensation Payments for ShareholderEmployees. The amount of compensation that is reasonable for an employee-shareholder depends on the facts and circumstances of the situation. Any portion of the compensation considered unreasonable is generally treated as a constructive dividend to a shareholder-employee. The corporation bears the burden of proof to show that the amount of cash and deferred compensation plus fringe benefits paid to a shareholderemployee is reasonable.

VI.

The TCJA of 2017. However, with dividends being taxed at preferential capital gains rates and the corporation being taxed at a low 21% tax rate, the double taxation of corporate income is not as onerous as it has been under past higher tax rate regimes. Moreover, the 21% corporate tax rate provides less of a tax benefit for a salary deduction than in the past.

Compliance and Procedural Considerations. A.

Estimated Taxes. Every corporation must pay four installments of estimated taxes equal to 25% of its required annual payment. For corporations other than large corporations, the required annual payment for tax years beginning after December 31, 1993, is the lesser of 100% of the tax shown on the return for the current year or 100% of the tax shown on the return for the preceding year. The estimated tax amount is defined as the corporation’s income tax liability in excess of its tax credits. A large corporation (one whose taxable income was $1 million or more in any one of its three immediately preceding tax years) is not allowed to use the prior year’s tax liability to determine its estimated tax payments although it can base its first estimated tax payment on the prior year’s tax liability. The shortfall arising from using the prior year tax liability for the first installment must be made up with the second estimated payment. (See Example C:3-38.)

Requirements for Filing and Paying Taxes. Every corporation must file a return even if there is no taxable income for the year. If it is in existence for part of a year, it must file a short-period return for the partial year. Corporations must use Form 1120 (U.S. Corporation Income Tax Return). A completed return illustrating Form 1120 is found in Appendix B. (See note concerning the completed tax returns in the Teaching Tips section of this outline.) Form 1120-A (U.S. Short Form Income Tax Return) became obsolete beginning in 2007.

When the Return Must Be Filed. Corporate returns must be filed by the fifteenth day of the fourth month following the close of the corporation’s tax year. If a corporation has a June 30 year end, the filing deadline remains as the fifteenth day of the third month after the end of its taxable year (i.e. September 15) until tax years beginning after 2025. For corporations with taxable years ending on June 30, the extension for filing the tax return is seven months until 2026. An automatic 6-month extension of time to file may be obtained by filing Form 7004 by the original due date of the return. Special rules apply for corporations with a June 30 or December 31 year-end.

Tax Return Schedules. Form 1120 requires a balance sheet showing the financial accounting results for the beginning and end of the tax year. They must be provided on Schedule L of Form 1120. Schedule M-1 requires a reconciliation of book income and taxable income. Form 1120 also requires an analysis of the unappropriated retained earnings account on Schedule M-2. Corporations with total assets of $10 million or more on the last day of the tax year must complete Schedule M-3 instead of Schedule M-1. This schedule provides the IRS with more detailed information than does Schedule M-1 on differences between book income and taxable income. This additional transparency of corporate transactions will increase the IRS’s ability to audit corporate tax returns. Appendix B provides a sample completed Form 1120. Facts are provided for the completed Form 1120. Schedule M-1 is used to reconcile the differences between book and taxable income. Lists of these differences are provided beginning on p. C:3-35. See the completed corporate tax return found on page B-7 of Appendix B for an illustration of the worksheet used by many tax practitioners to reconcile book income and taxable income. The worksheet should be tied into the completed Form 1120.

VII.

Financial Statement Implications. Book-tax differences have implications not only for preparing the reconciliation schedules M-1 and M-3 but also affect how a firm’s financial statements present income taxes. Income tax expense usually breaks down into a current component and a deferred component. The current component ties into the taxes payable for the current year, and the deferred component arises from book-tax temporary differences. The income tax expense also can contain a state tax component. A.

Scope, Objectives, and Principles of ASC 740. ASC 740 establishes principles of accounting for current income taxes and for deferred taxes arising from temporary differences. Specifically consequences of the following events are covered: 1. 2. 3.

Revenues, expenses, gains, or losses recognized for tax purposes in an earlier or later year than recognized for financial statement purposes. Other events that create differences between book and tax bases of assets and liabilities. Operating loss and tax credit carrybacks or carryforwards.

ASC 740 set out two objectives: (1) to recognize current year taxes payable or refundable and (2) to recognize deferred tax liabilities and assets for the future tax consequences of events recognized in a firm’s financial statement or tax return. This standard used to be referred to as FIN 48, a pre-codification designation, but many professionals still utilize this terminology.

Temporary Differences. A list of deferred tax liabilities and deferred tax assets can be found on p. C:3-39.

Deferred Tax Assets and the Valuation Allowance. A deferred tax asset indicates that a firm will realize the tax benefit of an event some tine in the future. If the firm likely will not realize the entire tax benefit, it must record a valuation allowance to reflect the unrealizable portion. A deferred tax asset must be reduced by a valuation allowance if, based on the weight of evidence available, the firm more likely than not will fail to realize the benefit of the deferred asset. More likely than not means a greater than 50% likelihood. A firm must consider both negative and positive evidence, where negative evidence leads toward establishing a valuation allowance while positive evidence helps avoid a valuation allowance.

Uncertain Tax Positions. ASC 740 specifically prescribes acceptable accounting for uncertain tax positions. For tax purposes, a firm may take a position in claiming a tax benefit that might not be sustained under IRS scrutiny. The FASB, however, believes that, for financial reporting such uncertain tax positions either should not be recognized or should be recognized only partially. Accordingly, the FASB issued FIN 48 (now incorporated into ASC 740) to address this particular type of contingent liability. Beginning on p. C:3-42 there is a detailed example of how uncertain tax positions are to be reflected in the financial statements.

Balance Sheet Classification. Deferred tax liabilities and assets must be classified as either current or noncurrent. Prior to 2016, if related to another asset or liability, the classification is the same as the related asset. If a deferred tax liability or asset does not relate to a particular asset or liability, it is classified as current or noncurrent depending on its expected reversal date. Once classified as current and noncurrent, all current deferred tax liabilities and assets must be netted and presented as one amount. All noncurrent deferred tax liabilities and assets must be netted and presented as one amount. For periods beginning after December 15, 2016 for public entities, and December 15, 2017 for other entities all deferred tax assets and liabilities are presented as noncurrent. Based on this classification, they can also be netted in disclosure.

Court Case Briefs Elliotts, Inc. v. CIR, 1980 T.C. Memo 80-282, rev’d. and rem’d. 716 F.2d 1241 (9th Cir., 1983), 1984 T.C. Memo 84-516. The issue in this case concerns the deductibility by a corporation of payments made, as compensation for services, to a sole shareholder who is also an employee of the corporation. A determination of reasonable compensation for services must be made. In this case, Edward Elliott was the sole shareholder and chief executive officer of Elliotts, Inc. He had total managerial responsibility and performed the functions of a sales and credit manager, working about 80 hours per week. Elliott was paid a fixed salary plus a bonus at year’s end fixed at 50% of net profits (before taxes and bonuses). The IRS partially recast these payments for 1975 and 1976 as dividends to the extent that the IRS felt the payments were in excess of reasonable compensation. There is a two-prong test for deductibility of reasonable compensation under Code Sec. 162(a)(1): 1.

the amount of the compensation must be reasonable, and

the payments must in fact be purely for services.

A relevant inquiry is whether an independent investor would be willing to compensate the employee as he was compensated considering the nature and quality of services rendered as well as the effect of the amount of the rate of return on equity. The court considered the following factors in its decision: role in company, external comparison, character and condition of company, conflict of interest, and internal consistency. Based on its analysis the court held that the payments were part of a long-standing bonus compensation plan and should not be considered unreasonable compensation. Gary A. Sargent, et al, v. CIR, 93 T.C. 572, rev’d. 929 F.2d 1252 (8th Cir., 1991). The petitioners were professional hockey players who formed personal service corporations (PSC) to obtain certain benefits such as the establishment of a pension plan. They contracted to furnish their services to those corporations. The corporations, in turn, contracted with the Northstar Hockey Partnership, the owner of the Minnesota North Stars hockey team, to furnish the services of the players. The question was one of determining if there was an employer-employee relationship, i.e., the extent to which the PSCs had control over the activities of the players, “not only as to result but as to the means and methods for accomplishing the results.” The control of the partnership over the services performed by the players was sufficient to render the players employees of the partnership rather than of the PSCs. This was a classic case for the application of the assignment of income doctrine (Sec. 61). Therefore, the amounts received by the PSCs for the players’ services constituted taxable income allocable to the players, under Code Secs. 61 or 482. C:IO3-16 Copyright © 2024 Pearson Education, Inc.

Chapter C:4 Corporate Nonliquidating Distributions Learning Objectives After studying this chapter, the student should be able to: 1.

Ask the key questions pertaining to corporate liquidations.

Calculate a corporation’s earnings and profits (E&P).

Determine the tax consequences of nonliquidating distributions.

Determine the tax consequences of stock dividends and the issuance of stock rights.

Decide whether a stock redemption should be treated as a sale or a dividend.

Explain the tax treatment of preferred stock bailouts.

Assess the applicability and tax consequences of Sec. 304 to stock sales.

Identify tax planning opportunities in nonliquidating distributions.

Comply with procedural rules for nonliquidating distributions.

Areas of Greater Significance Due to the reliance on E&P when calculating the adjusted current earnings portion of the corporate alternative minimum tax, greater emphasis should be placed on the calculation of E&P than just in the determination of when a distribution is a dividend. The tax consequences of property distributions and stock dividends and stock rights should also be emphasized.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading rather than class discussion: 1.

Tax planning considerations (Avoiding unreasonable compensation, bootstrap acquisitions, and timing of distributions).

Compliance and procedural considerations (Corporate reporting of nondividend distributions, and agreement to terminate interest under Sec. 302(b)(3)).

Additionally, preferred stock bailouts and stock redemptions by related corporations should not receive a great deal of emphasis.

Problem Areas for Students The following areas may prove especially difficult for students: 1.

The attribution rules for stock redemptions.

Stock redemptions by related corporations.

Calculation of E&P.

Highlights of Recent Tax Law Changes Section 311(b)(2) provides that when property is distributed subject to a liability, or the shareholder assumes a liability of the distributing corporation, the FMV of the property is at least equal to the amount of the liability. The basis of the property is equal to the amount of the liability. The TCJA has changed traditional strategies for compensation planning. This should be considered as part of class discussion.

Teaching Tips 1.

When explaining the effects of a particular transaction on earnings and profits (e.g., a distribution of appreciated property or the making of a stock redemption), it can be helpful to use “T” accounts to show the increases and decreases that occur to E&P.

Example C:4-16 provides an example illustrating the point made in the previous section relating to the distribution of property subject to a liability. p. C:4-10.

A schematic is provided to illustrate Example C:4-45, a brother-sister redemption, and Example C:4-47, a parent-subsidiary redemption. I like to teach this subject by having the students think of E&P as something very close to financial accounting’s retained earnings.

Lecture Outline I.

Nonliquidating Distributions in General. A shareholder must include in gross income as a dividend any nonliquidating distribution by a corporation to the extent that it is out of earnings and profits (E&P). Qualified dividends received by a noncorporate shareholder are subject to a maximum 20% tax rate. The distribution can be in money, securities, or any other property except stock or stock rights of the distributing corporation. To the extent the distribution exceeds E&P, it is a return of capital and reduces the shareholder’s basis in his stock. To the extent that the distribution exceeds the basis in the stock, the distribution is treated as a sale or exchange. If the stock is a capital asset in the shareholder’s hands, the gain is capital in character. (See Example C:41.)

II.

Earnings and Profits. The term E&P is not specifically defined in the Code. Its meaning must be determined with reference to judicial decisions, Treasury regulations, and some rules provided in the Code. The purpose is to measure a corporation’s economic ability to pay dividends. A.

Current E&P. E&P consists of two parts - current and accumulated E&P. Current E&P is calculated annually. E&P is calculated annually for corporations making annual distributions at or near financial statement net income. Most corporations never actually calculate E&P because it isn’t a part of the tax return, nor is it needed for a corporation with small distributions relative to retained earnings. Accumulated E&P is the sum of undistributed current E&P for all tax years less distributions made out of accumulated E&P and prior year current E&P deficits. Distributions come first from current E&P and then from accumulated E&P if current E&P is insufficient. (See Example C:4-2.) Table C:4-1 can be used at this point to illustrate the computation of current E&P. 1.

Computing Current E&P. The starting point for computing current E&P is the corporation’s taxable income or NOL for the year. This must be adjusted to arrive at economic income or loss (current E&P) for the year. Table C:4-1 on p. C:4-4 lists some of the adjustments that must be made to taxable income to derive current E&P.

Income Excluded from Taxable Income but Included in E&P. Income that is specifically excluded from gross income must be included in current E&P if it increases the corporation’s ability to pay a dividend and is not a contribution of capital. (See Example C:4-3.)

Income Deferred to a Later Period. Gains and losses on property transactions are generally included in E&P when they are recognized for tax purposes. An exception is installment sales. Gain is recognized in the year of sale for E&P purposes in the case of an installment sale. (See Example C:4-5.)

III.

Income and Deduction Items That Must be Recomputed For E&P. Tangible personal property must be depreciated using the alternative depreciation system for E&P purposes. Realty is depreciated over 40 years using the straight-line method and mid-month convention. (See Example C:4-6.) Other adjustments must be made for percentage depletion, intangible drilling costs, and the completed contract method of accounting.

Deductions Allowed For Taxable Income Purposes But Denied For E&P Purposes. Some deductions claimed in computing taxable income are not allowed when computing E&P. These include the dividends-received deduction, NOL carryovers, charitable contribution carryovers, business interest expense, capital loss carryovers from other tax years, the U.S. production activities deduction, and amortization of organization expenses.

Expenses and Losses Denied For Taxable Income Purposes But Allowed For E&P Purposes. When computing E&P, federal income taxes are deductible in the year accrued or paid. Charitable contributions are deductible without regard to the 10% limitation. Other deductible items for E&P purposes are life insurance premiums on key employees, capital losses in excess of capital gains, business interest expenses in excess of limitations, nondeductible expenses incurred in the production of tax-exempt income, losses on sales to related parties, and nondeductible fines, penalties, and political contributions.

Distinction Between Current and Accumulated E&P. Nonliquidating distributions are treated as coming first out of current E&P. When distributions exceed current E&P, current E&P is allocated to those distributions on a pro rata basis regardless of when in the year the distributions were made. Distributions in excess of current E&P are deemed to come from accumulated E&P in chronological order. Distributions in excess of accumulated E&P are treated as a return of capital and reduce the shareholder’s basis in their stock on a dollar-for-dollar basis (but not below zero). These distributions do not create an E&P deficit. Deficits arise only because of losses. (See Example C:4-11.) You may wish at this point to use the Stop and Think material on p. C:4-8 which illustrates why it is necessary to maintain separate balances for current and accumulated E&P.

Nonliquidating Property Distributions. A.

Consequences of Nonliquidating Property Distributions to the Shareholders. Property is defined as money, securities, and any other property except stock or stock rights of the corporation making the distribution. When property is distributed to shareholders, the amount of the distribution is generally the amount of money plus the FMV of any nonmoney property received. Any liability assumed reduces the amount of the distribution, but not below zero. The distribution is considered a dividend to the extent that it is out of E&P. The shareholder’s basis in the property is C:IO4-4 Copyright © 2024 Pearson Education, Inc.

its FMV unreduced by liabilities assumed. The holding period begins on the day after the distribution date. (See Example C:4-14.) You may wish to use the Stop and Think material on p. C:4-9 at this point, which illustrates why liabilities reduce the amount of income reported when a distribution is made to a shareholder, but do not reduce the shareholder’s adjusted basis for the property. You may wish to use Topic Review C:4-1 on p. C:4-10 at this point to review the consequences of a nonliquidating distribution on shareholders. B.

Effect of Property Distributions on the Distributing Corporation. A corporation must recognize gain when it distributes property that has appreciated in value. A loss will not be recognized on a nonliquidating distribution of property that has declined in value. (See Example C:4-15.) If distributed property is subject to a liability or the shareholder assumes a liability in connection with the distribution, the FMV of the property is deemed to be at least equal to the amount of the liability. (See Example C:4-16.) The gain recognized is taxable to the corporation and results in an increase in E&P equal to the E&P gain which is the excess of the property’s FMV over its adjusted basis for E&P purposes. E&P gain may differ from the corporation’s recognized gain upon distribution. If the adjusted basis of the noncash asset that is distributed equals or exceeds its FMV, E&P is reduced by the asset’s adjusted basis. If the FMV of the asset that is distributed exceeds its adjusted basis, E&P is reduced by the asset’s FMV. In either case the E&P reduction is net of (1) any liability that the asset is subject to or which is assumed by the shareholder in connection with the distribution, and (2) the income taxes incurred on the gain recognized. (See Example C:4-17.) Topic Review C:4-2 on p. C:4-11 presents a summary of the tax consequences of a nonliquidating distribution on the distributing corporation. This material may be reviewed with the students at this point. You may wish to call the students’ attention to the difference between book and tax accounting for distributions of appreciated property.

Constructive Dividends. A constructive dividend is an indirect payment to a shareholder without the benefit of a formal dividend declaration. They usually arise in the context of a closely held corporation. 1.

Intentional Efforts to Avoid Dividend Treatment. Excessive salaries or loans to shareholders are often devices used to avoid dividend treatment while benefiting the shareholder. They may be reclassified as a dividend, fully taxable to the shareholder and not deductible by the corporation in computing its taxable income. The dividend will not be subject to incremental payroll taxes.

Unintentional Constructive Dividend. Shareholders are not always aware that the benefits that they are receiving are really constructive dividends. When they are discovered by the IRS or a tax advisor, the books and records of both the corporation and the shareholder will have to be adjusted. A CPA should always be an advocate for his client if the question of whether a constructive dividend has been paid or not is in doubt.

Loans to Shareholders. Loans to shareholders will be considered disguised dividends unless it can be shown that the loan is bona fide and the shareholder intends to repay it. If inadequate interest is charged, interest is imputed on the loan. The corporation will report interest income from the loan and the shareholder may have a deduction for interest deemed paid. The imputed interest is treated as a dividend paid to the shareholder, thereby resulting in no offsetting deduction for the corporation.

Insufficient Salary Amount. With the corporate tax rate at 21% beginning in 2018 and the top individual tax rate at 37%, shareholder-employees of closely-held corporations may have an incentive to minimize the salaries paid to themselves to avoid the higher tax rate on salary income. This possibility could lead the IRS to question whether the salaries are too low rather than excessive.

Excessive Compensation Paid to Shareholder-Employees. Excessive compensation received by a shareholder-employee is generally treated as a dividend.

Excessive Compensation Paid to Shareholders for the Use of Shareholder Property. Rents, interest, and royalties that are paid to shareholders which are excessive in amount are generally recast as constructive dividends.

Corporate Payments for the Shareholder’s Benefit. If a corporation pays a shareholder’s personal obligation, the payment may be treated as a constructive dividend. Disallowed corporate deductions may also be treated as constructive dividends.

Bargain Purchase of Corporate Property. If a shareholder purchases property from a corporation for less than its FMV, the discount amount may be treated as a constructive dividend.

Shareholder Use of Corporate Property. If a shareholder is allowed to use corporate property (e.g., an automobile, airplane, or yacht) without paying adequate compensation to the corporation, the FMV of such use (minus any amounts paid) may be a constructive dividend to the shareholder.

IV.

Stock Dividends and Stock Rights. In 1919, the Supreme Court ruled in Eisner v. Macomber that a stock dividend was not income to the shareholder because it took nothing from the property of the corporation and added nothing to the property of the shareholder. This position is the general rule today with some exceptions to circumvent certain tax-avoidance schemes. The dividend is taxable when a stock dividend has the potential to change the shareholder’s proportionate interest in the distributing corporation. A.

Nontaxable Stock Dividends. If a stock dividend is nontaxable, the basis of the stock with respect to which the distribution is made must be allocated between the old and new stock in proportion to their relative FMVs on the distribution date. The holding period of the new shares includes the holding period of the old shares.

Nontaxable Stock Rights. A distribution of stock rights is tax-free unless it has the potential to change the shareholders’ proportionate interests in the distributing corporation. If the value of the stock rights is less than 15% of the value of the stock with respect to which the rights were distributed, the basis of the rights is zero unless the shareholders elect to allocate basis to those rights. If the value of the rights is 15% or more of the value of the underlying stock, the shareholder must allocate the basis of the stock between the stock and the stock rights based on the relative FMVs of the stock and stock rights. (See Examples C:4-21 and C:4-22.) If the stock rights are sold, gain or loss is measured by subtracting the allocated basis of the rights (if any) from the sale price. If the rights are exercised, the basis allocated to the rights is added to the basis of the stock purchased with those rights. If basis is allocated to the rights and the rights are allowed to lapse, the allocated basis is returned to the underlying shares. No loss can be claimed. (See Example C:4-23.)

Effect of Nontaxable Stock Dividends on the Distributing Corporation. Nontaxable distributions of stock or stock rights have no effect on the distributing corporation. The corporation does not recognize any gain or loss on the distribution and its E&P is unaffected. You might note that, for financial accounting purposes, stock dividends do reduce retained earnings.

Taxable Stock Dividends and Stock Rights. If the distribution is taxable, the amount of the distribution equals the FMV of the stock or stock rights that are distributed on the distribution date. It is a dividend to the extent it is made out of E&P. At this point you may wish to use Topic Review C:4-3 Tax Consequences of a Stock Dividend to review the material about stock dividends.

Stock Redemptions. A stock redemption is defined as the acquisition by a corporation of its own stock in exchange for property (Sec. 317(b)). The property exchanged can be money, securities, or any other property that the corporation wants to use to acquire the stock. The acquired stock may be canceled, retired, or held as treasury stock. Reasons for a stock redemption are listed on p. C:4-16. A.

Effect of the Redemption on the Shareholder. When a shareholder’s stock is redeemed by a corporation, the transaction will either be treated as a sale or exchange, or as a dividend. The reason is that some redemptions closely resemble a sale or exchange to a third party, while others are essentially equivalent to a dividend. (See Examples C:4-24 and C:4-25.) A redemption qualifies for sale or exchange treatment if it satisfies any one of the five conditions listed on p. C:4-18. Corporate shareholders on the other hand may prefer dividend treatment in order to claim a dividends-received deduction.

Substantially Disproportionate Redemptions. If a stock redemption qualifies as substantially disproportionate under Sec. 302(b)(2), it qualifies as a sale (Sec. 302(b)(2)). A redemption is substantially disproportionate if: 1.

After the redemption, the shareholder owns less than 50% of the total combined voting power of all classes of voting stock;

After the redemption, the shareholder owns less than 80% of his percentage ownership of voting stock before the redemption; and

After the redemption, the shareholder owns less than 80% of his percentage ownership of common stock (voting or nonvoting) before the redemption.

The constructive ownership rules of Sec. 318 are applied individually to each shareholder in determining if a redemption is substantially disproportionate. (See Example C:4-31.) C.

Complete Termination of the Shareholder’s Interest. A redemption qualifies as a sale if it satisfies the requirements for a complete termination under Sec. 302(b)(3). If a shareholder’s interest in a corporation is completely terminated, the family attribution rules of Sec. 318(a)(1) may be waived and other family members may continue to own the stock. In order to waive the family attribution rules, the following requirements must be met: 1.

The shareholder must not retain any interest in the corporation after the redemption except as a creditor.

The shareholder must not acquire any such interest (other than by bequest or inheritance) for at least ten years from the date of the redemption.

The shareholder must file a written agreement that the IRS will be notified if any prohibited interest is acquired. The written agreement allows the IRS to assess additional taxes for the year of the distribution if the prohibited interest is acquired, even if the basic three-year statute of limitations has run out.

Waiver of the family attribution rules is not permitted if: 1.

Part or all of the stock redeemed was acquired, directly or indirectly, within the 10-year period ending on the date of the distribution by the distributee from a person whose stock ownership would be attributable (at the time of the distribution) to the distributee under Sec. 318.

Any person who owns (at the time of the distribution) stock of the redeeming corporation, the ownership of which is attributable to the distributee under Sec. 318 and such person acquired any stock in the redeeming corporation, directly or indirectly, from the distributee within the 10-year period ending on the distribution date.

These prohibitions do not apply if the distributee can show that the acquisition or disposition of the stock did not have a tax avoidance purpose. D.

Redemptions Not Essentially Equivalent to a Dividend. Section 302(b)(1) provides that a stock redemption will be treated as a sale if it is not essentially equivalent to a dividend. The Supreme Court’s decision in Maclin P. Davis provides us with some criteria to follow. The Supreme Court held that (1) business purpose is irrelevant in determining whether a redemption is essentially equivalent to a dividend, (2) the Sec. 318 attribution rules must be used to determine dividend equivalency, and (3) a redemption of part of a sole shareholder’s stock is always essentially equivalent to a dividend. There must be a “meaningful reduction” in the shareholder’s proportionate interest in the corporation after taking into account the constructive ownership rules of Sec. 318(a) to qualify under Sec. 302(b)(1). (See Example C:4-35.) The rules are still unclear as to what constitutes a meaningful reduction.

Partial Liquidations. A partial liquidation occurs when a corporation discontinues one line of business, distributes the assets related to that business to the shareholders, and continues in at least one other line of business. Under Sec. 302(b)(4), a redemption also qualifies as a partial liquidation if the distribution is not essentially equivalent to a dividend. In either case, the distribution must be made within the tax year in which the plan of partial liquidation is adopted or within the succeeding year.

Determination Made at the Corporate Level. The determination that a distribution is not essentially equivalent to a dividend is made at the corporate level. The distribution must result in a bona fide contraction of the corporation’s business.

Safe Harbor Rule. A distribution qualifies as a partial liquidation if:

The distribution is attributable to the distributing corporation’s ceasing to conduct a qualifying trade or business, or consists of the assets of a qualifying trade or business.

Immediately after the distribution, the distributing corporation is engaged in the active conduct of at least one qualifying trade or business. (See Example C:4-36.)

Effect of Partial Liquidation on the Shareholders. A distribution qualifying as a partial liquidation is treated as a sale of stock for a noncorporate shareholder. In the case of a corporate shareholder, the same transaction is treated as a dividend unless the transaction qualifies for sale treatment under one of the other Sec. 302(b) provisions. Dividend treatment may be preferred by a corporate shareholder in order to take advantage of the 50%, 65%, or 100% dividends-received deduction. (See Example C:4-37.)

Redemptions to Pay Death Taxes. If corporate stock represents a substantial portion of a decedent’s gross estate, a redemption of the stock by the estate or its beneficiary may qualify for sale treatment. Section 303 provides that a redemption of stock that was included in the decedent’s gross estate is treated as a sale of stock by the shareholder if the following conditions are met: 1.

The value of the redeeming corporation’s stock included in the decedent’s gross estate is more than 35% of the value of the adjusted gross estate.

The maximum amount of the redemption distribution that can qualify for sale treatment is the sum of all federal and state estate and inheritance taxes, plus any interest due on those taxes, and all funeral and administrative expenses that are allowable as deductions on the federal estate tax return.

Section 303 applies to the redemption distribution only to the extent that the recipient shareholder’s interest in the estate is reduced by the payment of death taxes and funeral and administrative expenses.

The redemption must take place on or before 90 days after the expiration of the statute of limitations for the assessment of the federal estate tax.

the 35% requirement, provided 20% or more of the value of each corporation’s outstanding stock is included in the gross estate. G.

Effect of Redemptions on the Distributing Corporation. 1.

VI.

Corporate Gain or Loss on Property Distributions. The rules for the recognition of gain or loss by a corporation that distributes property in redemption of its stock are: a.

The corporation recognizes gain when it distributes appreciated property in redemption of its stock as if it had sold the property immediately before the redemption. The character of the gain depends on the character of the distributed property.

The corporation does not recognize any loss realized when it distributes property that has declined in value.

Effect of Redemptions on E&P. If appreciated property is distributed, the gain (net of taxes) is included in the E&P account. If the redemption is treated as a dividend by the shareholder, the corporation must reduce E&P by the amount of money, the principal amount of any obligation, and the FMV of any other property distributed. If the redemption qualifies as a sale, current and accumulated E&P balances are reduced by the portion of E&P attributable to the redeemed stock, but not by more than the actual redemption distribution amount. The remainder of the distribution reduces the corporation’s paid-in capital account. (See Example C:4-42.)

Preferred Stock Bailouts. The rules with respect to stock redemptions were added to the IRC to permit sale treatment for stock redemptions under certain specific circumstances and to require dividend treatment in all other situations. In most cases, taxpayers prefer sale treatment. Consequently taxpayers have devised methods to circumvent Congress’s intent. One such method, devised prior to enactment of the IRC of 1954, is known as the preferred stock bailout. A.

Sec. 306 Stock Defined. Sec. 306 stock is: 1.

Stock (other than common issued with respect to common stock), which is received as a nontaxable stock dividend.

Stock (other than common) received in a tax-free corporate reorganization or corporate division if the effect of the transaction was substantially the same as the receipt of a stock dividend, or if the stock was received in exchange for Sec. 306 stock.

Stock which has a basis determined by reference to the basis of Sec. 306 stock. One example of this category of Sec. 306 stock is stock received as a gift.

Stock (other than common) acquired in an exchange to which Sec. 351 applies if the receipt of money (in lieu of the stock) would have been treated as a dividend.

Preferred stock issued by a corporation with no current or accumulated E&P is not Sec. 306 stock.

VII.

Dispositions of Sec. 306 Stock. If a shareholder sells or otherwise disposes of Sec. 306 stock, the amount realized is treated as ordinary income to the extent it would have been treated as a dividend at the time of the distribution if money had been distributed rather than stock. (See Example C:4-43.)

Redemptions of Sec. 306 Stock. If Sec. 306 stock is redeemed by the issuing corporation, the amount realized is a dividend to the extent of E&P in the year of redemption. Any amount received in excess of E&P is first a recovery of basis and then gain from sale or exchange of the stock. (See Example C:4-44.)

Exceptions to Sec. 306 Treatment. Sec. 306 does not apply in the following situations: 1.

A shareholder sells all of his or her common and preferred stock in a corporation, thus completely terminating his or her interest in the corporation.

The corporation redeems all of the shareholder’s common and preferred stock, completely terminating the shareholder’s interest in the corporation.

Stock Redemptions by Related Corporations. A.

Brother-Sister Corporations. Brother-sister corporations occur where one or more shareholders are in control of each of two corporations and a parent-subsidiary relationship is not present. Control means ownership of at least 50% of the voting power, or 50% of the total value of all stock of the corporation. If a controlling shareholder sells stock of one corporation to the other corporation in exchange for property, the exchange is recast as a redemption. If the redemption does not qualify as a sale, it is treated as a dividend made first by the acquiring corporation to the extent of its E&P, and then by the issuing corporation to the extent of its E&P. The shareholder’s basis in the issuing corporation’s stock that was sold is added to his or her basis for the acquiring corporation’s stock. The acquiring corporation takes the same basis in the issuing corporation’s shares that the shareholder had. (See Example C:4-45. There is a schematic on p. C:4-31 illustrating this problem.) Example C:4-46 illustrates the situation when a sale exists. C:IO4-12 Copyright © 2024 Pearson Education, Inc.

If the redemption qualifies as a sale, the shareholder’s recognized gain or loss is the difference between the amount received from the acquiring corporation and the shareholder’s basis in the surrendered shares. B.

Parent-Subsidiary Corporations. If a shareholder sells stock in a parent corporation to a subsidiary of the parent corporation, the exchange is treated as a distribution in redemption of part or all of the shareholder’s stock in the parent corporation. For this purpose, a parent-subsidiary relationship exists if one corporation owns at least 50% of the voting power or 50% of the total value of all stock in the subsidiary. If the redemption does not qualify as a sale, the distribution is treated as a dividend from the subsidiary corporation to the extent of its E&P and then from the parent corporation to the extent of its E&P. As in the case of Sec. 306, dividend treatment results in the gain being taxed at a maximum rate of 15%. The shareholder’s basis in his or her remaining parent corporation stock is increased by his or her basis in the stock transferred to the subsidiary. (See Examples C:4-47 and C:4-48. There is a schematic illustrating this example on p. C:4-32.)

Topic Review C:4-5 presents a summary of the methods by which a redemption transaction can be characterized as a sale or exchange as well as the special stock redemption rules. These provisions should be reviewed with the students at this point. VIII. Tax Planning Considerations. A.

Avoiding Unreasonable Compensation. Corporations can avoid the double taxation problem associated with a constructive dividend by entering into a hedge agreement with a shareholder-employee, which obligates the shareholder to repay any portion of the salary that is disallowed by the IRS as a deduction. The shareholder-employee deducts the amount of the repayment under Sec. 162 in the year the repayment is made, provided that a legal obligation exists under state law to make the payment. (See Example C:4-49.)

Bootstrap Acquisition. A prospective purchaser who wants to acquire the stock of a corporation may not have sufficient cash to make the purchase. Instead, corporate funds may be used to make part of the purchase. This can be accomplished by having the seller sell part of his stock to the purchaser and having the corporation redeem the remainder of the seller’s stock. Such an arrangement is called a bootstrap acquisition. Care must be taken to structure the transaction so that a constructive dividend does not occur when the corporation redeems some of the stock. (See Example C:4-50.)

Timing of Distribution. If distributions can be timed to be made when the corporation has little or no E&P, the distributions are treated as a return of capital. (See Example C:4-52.) C:IO4-13 Copyright © 2024 Pearson Education, Inc.

IX.

Compliance and Procedural Considerations. A.

Corporate Reporting of Nondividend Distributions. A corporation that makes a nondividend distribution to its shareholders must file Form 5452 (Corporate Report of Nondividend Distributions).

Agreement to Terminate Interest Under Sec. 302(b)(3). In order to waive the family attribution rules, a statement must be attached to the first return filed by the shareholder in the year of redemption stating that he will notify the IRS if any prohibited interest is acquired within the ten-year period following redemption.

Court Case Briefs Est. of Vincent DeNiro v. CIR, 795 F.2d 582 (6th Cir., 1986) aff’g. 1982 T.C. Memo 1982-497. The Estate of Vincent DeNiro received a distribution from National Cigarette Sales (NCS), a corporation formerly controlled by DeNiro, with which to pay estate taxes. The payment was deducted as a business expense by NCS and treated as a nontaxable return of capital by the estate. The IRS assessed taxes, saying the distribution was a dividend paid out of accumulated earnings and profits (E&P). In seeking to establish that there was a deficit in accumulated E&P, the corporation’s accountant presented a calculation using the retained earnings figure in a recent tax return rather than a complete separate calculation of E&P. The Tax Court felt this was inadequate, as E&P is not equivalent to retained earnings, but the Appeals Court overruled this finding, stating that the taxpayer had presented acceptable evidence to meet its burden of proof. Beatrice Levin v. CIR, 385 F.2d 521 (2nd Cir., 1967) aff’g. 47 T.C. 258 (1966). Taxpayer received annual payments from a family corporation for redemption of her stock. Redemption was affected to transfer ownership from taxpayer and her brother to taxpayer’s son. Taxpayer remained as a director, officer, and employee of the corporation after the redemption. Taxpayer’s son owned 100% of the corporation’s stock after the redemption. The family attribution rules of Sec. 302(b)(1) were applied to attribute the son’s ownership to the taxpayer. Capital gain treatment of the distribution payments was disallowed. While in form, taxpayer had redeemed her stock, in substance, she still enjoyed all the benefits and control of the corporation as she had before the redemption. Therefore, she had not parted with anything justifying capital gain treatment

Chapter C:5 Other Corporate Tax Levies Learning Objectives After studying this chapter, the student should be able to: 1.

Identify ways a C Corporation might be used to reduced income taxes, despite its double taxation.

Determine whether a corporation is a personal holding company (PHC) and, if so, calculate the PHC tax.

Establish whether a corporation is subject to the accumulated earnings tax and, if so, calculate the tax.

Determine whether a corporation is subject to the book minimum tax and, if so, calculate the tax.

Identify tax planning opportunities to avoid the PHC and accumulated earnings taxes.

Comply with PHC and accumulated earnings tax procedures.

Areas of Greater Significance Students need to know how to avoid the imposition of penalty taxes like the PHC and AET. This should be covered when discussing what the TCJA did on the Corporate Alternative Minimum Tax, and how it changed the corporate tax structure. Students also should be made aware of how to book any minimum taxes as a result of the book minimum tax.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading rather than class discussion: 1.

Details relating to the calculation of the personal holding company tax and accumulated earnings tax.

Tax compliance considerations for the accumulated earnings tax and the personal holding company tax.

Problem Areas for Students There are no problem areas in this chapter.

Highlights of Recent Tax Law Changes 1.

The PHC and AET tax rate are now tied to the highest rate for a dividend, which is 20%.

The new book minimum tax has been added as a result of the Inflation Reduction Act.

Teaching Tips 1.

You may wish to incorporate into the discussion the election to depreciate Sec. 1245 property using the straight-line method.

Lecture Outline I.

Identify Ways a C Corporation Might be Used to Reduce Income Taxes, Despite its Double Taxation. Individuals in high tax brackets possibly can use C corporations to reduce income taxes. This possibility may seem counterintuitive because a C corporation’s income is taxed twice: once when earned by the corporation, and again when the corporation distributes a dividend out of that income to its shareholders. Nevertheless, it sometimes might be beneficial to incur two smaller taxes instead of one larger tax. A high tax bracket individual can enhance the avoidance of income taxes through a C corporation by having the corporation retain its after-tax earnings rather than paying them out as a dividend. This strategy allows after-tax corporate income to compound and grow at a higher after-tax rate of return if the corporation’s marginal tax rate is less than the individual’s marginal tax rate. It also defers taxation at the shareholder level on any future dividend distributions. An individual’s use of a C corporation to avoid income taxes can be further enhanced by not having the corporation pay dividends at all by retaining all after-tax income. Upon the individual’s death, his or her heirs can liquidate the corporation and realize little or no gain because they obtain a stepped-up basis for the corporation’s stock. Similar to the way an individual can use a C corporation to mitigate income taxes on interest income, he or she can use a C corporation to mitigate income taxes on compensation for personal services. For example, consider a professional athlete earning millions of dollars per year. The sports team could employ the athlete directly. C:IO5-2 Copyright © 2024 Pearson Education, Inc.

Alternatively, the athlete could form a corporation that employs him or her, and that corporation could contract with the sports team to provide the athletes services. The latter arrangement substitutes a 21% corporate income tax rate for the athletes’ 47% individual income tax rate. Although it also incurs a 20% (or 23.8%) dividend tax, the latter arrangement still can be beneficial to the athlete for the reasons highlighted in the examples. II.

Personal Holding Company Tax. A closely-held corporation that satisfies both the stock ownership test and the passive income test is classified as a personal holding company for the tax year. A PHC must pay the greater of the regular income tax or the corporate alternative minimum tax and possibly the PHC penalty tax of 20%. Congress set this tax rate to equal an individual’s top 20% tax rate for qualified dividends (not counting the 3.8% tax on the next investment income). A.

Personal Holding Company Defined. A personal holding company is any corporation that has five or fewer individual shareholders who own more than 50% of the corporation’s outstanding stock at any time during the last half of its tax year, and has personal holding company income (PHCI) that is at least 60% of its adjusted ordinary gross income (AOGI) for the tax year. Corporations that retain special tax status generally are excluded from the PHC definition. Among those excluded are S corporations and tax-exempt organizations.

Stock Ownership Requirement. A corporation satisfies the PHC stock ownership requirement if more than 50% of the value of its outstanding stock is directly or indirectly owned by five or fewer individuals at any time during the last half of its tax year.

Passive Income Requirement. A closely held corporation must also satisfy the passive income test to be classified a PHC. The passive income test is met if at least 60% of the closely held corporation’s adjusted ordinary gross income (AOGI) for the tax year is personal holding company income (PHCI). 1.

Adjusted Ordinary Gross Income Defined. Figure C:5-1 illustrates the calculation of AOGI. For most corporations AOGI equals the corporation’s gross income minus its Sec. 1231 and capital gains, and interest, property taxes, and depreciation connected with its rental income.

Personal Holding Company Income Defined. PHCI includes 12 categories of income, which are listed and defined on p. C:5-9. Special exclusions apply to these types of income. These exclusions are summarized in Table C:5-1, which may be used at this point as you summarize the exclusions permitted in computing personal holding company income. The two exclusions, which should be emphasized, are C:IO5-3 Copyright © 2024 Pearson Education, Inc.

the following: Adjusted income from rents (AIR) is included in PHCI unless the special exception applies for a corporation whose earnings are predominantly rental income. PHCI does not include rents if (1) AIR is at least 50% of AOGI and (2) the dividends-paid deduction equals or exceeds the amount by which nonrental PHCI exceeds 10% of OGI. Income earned from contracts under which the corporation is to perform personal services and income earned from the sale of such contracts are included in PHCI if the two special conditions listed on p. C:5-19 are met. (See Example C:5-16.) D.

Calculate the PHC Tax. Determination of the PHC penalty tax is illustrated in Example C:5-8. This figure may be used as you discuss the calculation of this tax. 1.

Calculating the Undistributed Personal Holding Company Income (UPHCI) Amount. A series of adjustments must be made to taxable income to arrive at UPHCI. The positive and negative adjustments are listed beginning on p. C:5-9. These adjustments attempt to convert taxable income into a better measure of income retained by the business. In addition, a dividends-paid deduction can be claimed for cash and noncash dividends paid during the year plus consent dividends.

Calculating the Tax. The PHC tax is 20% times the UPCHI amount. Figure C:5-2 illustrates the PHC tax calculation.

Avoiding the PHC Designation and Tax Liability Through the Use of Dividend Distributions. Consent dividends are hypothetical dividends deemed paid to shareholders on the last day of the corporation’s tax year. Consent dividends permit a corporation to reduce its PHC tax liability when it is prevented from making an actual distribution due to a lack of money. In addition to consent dividends, five different types of actual cash or property dividends qualify for the dividends-paid deduction. 1.

Current Year Dividends. A dividends-paid deduction, however, is not available for preferential dividends. Dividends are preferential when the amount distributed to a shareholder exceeds his ratable share of the distribution or the amount received by a class of stock is more or less than its rightful amount.

Throwback Dividends. Throwback dividends are distributions paid in the first 3 ½ months after the close of the tax year. Subject to a dollar limitation (i.e., 20% of dividends other than cash dividends paid during the year), an election may be made to treat these dividends as a dividend distribution made in the prior year for PHC tax purposes. For companies C:IO5-4 Copyright © 2024 Pearson Education, Inc.

whose tax year ends on June 30, the 2 ½-month rule continues until 2025. 3.

Liquidating Dividends. A dividends-paid deduction is available for liquidating distributions that are made by a PHC within 24 months of the adoption of a plan of liquidation.

Deficiency Dividends. A corporation that determines that it owes the PHC penalty tax can avoid paying the tax by electing to pay a deficiency dividend under Sec. 547. Under this procedure, an income tax is levied on the dividend payment at the shareholder level instead of the payment of the PHC tax at the corporate level. The shareholders include the deficiency dividend in their gross income for the tax year in which it is received, not the tax year in which the PHC claims a dividends-paid deduction.

Dividends Carryover. In addition, dividends that are paid in the preceding two tax years can be used as a dividend carryover to reduce the amount of the current year’s PHC tax liability. The amount by which dividends eligible for the dividends-paid deduction exceeds UPHCI income for the two preceding years can be carried forward and claimed as a dividends-paid deduction in the current year.

Topic Review C:5-1 on p. C:5-13 may be used at this point to summarize the provisions of the Personal Holding Company tax. Example C:5-8 illustrates the PHC Tax Calculation. III.

Accumulated Earnings Tax. The accumulated earnings tax is a penalty tax assessed on corporations that accumulate income beyond the reasonable needs of their business. An exemption of $250,000 of accumulated earnings is permitted during the corporation’s lifetime. The exemption is limited to $150,000 in the case of certain service corporations. A.

Corporations Subject to the Penalty Tax. The accumulated earnings tax applies to every corporation used to avoid the income tax on shareholders by permitting earnings and profits to accumulate instead of being divided or distributed. Corporations exempt from this tax are listed on p. C:5-12. The two primary exceptions are personal holding companies and S corporations. In theory, the penalty tax applies to all corporations. In practice, the tax applies to closely-held corporations where management can utilize the corporate dividend policy to reduce the tax liability of the shareholder group.

Proving a Tax-Avoidance Purpose. The accumulation of earnings and profits beyond the reasonable needs of the business indicates a tax avoidance motive unless the corporation can prove that earnings are not being accumulated to avoid taxes. Tax avoidance is indicated, for example, where there are loans made C:IO5-5 Copyright © 2024 Pearson Education, Inc.

between the shareholders and the corporation, investments are made that have no clear connection with the business, or where there is a low dividend and wage payout accompanied by an accumulation of earnings. Holding and investment companies are held to a stricter standard than are operating companies. C.

Evidence Concerning the Reasonableness of an Earnings Accumulation. No single factor has been held to be indicative of an unreasonable accumulation of earnings and profits. A discussion of some of these factors follows: 1.

Evidence of a Tax-Avoidance Motive. A list of factors to be avoided in order to minimize exposure to the accumulated earnings tax is found on p. C:5-14.

Evidence of Reasonable Business Needs. Reasonable business needs include reasonably anticipated needs of the business, Sec. 303 redemption needs, and excess business holdings redemption needs. In order to show reasonable business needs, there must be a specific, definite, and feasible plan for the use of accumulations. Reasonable needs are covered on p. C:5-15. The Bardahl formula is used for determining working capital requirements. This formula is found on p. C:5-16. See Example C:5-9 for an application of the Bardahl formula.

Determining the Accumulated Earnings Tax Liability. Determination of the accumulated earnings tax liability is illustrated in Figure C:5-3, which should be used at this point to illustrate the computation of the accumulated earnings tax liability. The tax is levied at a 20% rate. The tax base can be reduced by making dividend distributions. Once the IRS or the courts have determined that the accumulated earnings tax is owed, its payment cannot be avoided by deficiency dividends. 1.

Accumulated Taxable Income. The starting point for the accumulated taxable income calculation is the corporation’s taxable income. A series of positive and negative adjustments is then made in an attempt to convert taxable income into a better measure of income retained by the business. These adjustments are found beginning on p. C:5-18.

Dividends-Paid Deduction. The dividends-paid deduction is available for four types of distributions. These include dividends paid during the tax year, throwback dividends, consent dividends, and liquidating distributions. The throwback dividend rules are mandatory unlike the PHC tax where it is elective. No dividend carryover is available.

serves to reduce the accumulated taxable income amount. Different rules apply for operating companies, service companies, and holding or investment companies. These rules are explained on p. C:5-20. The accumulated E&P balance used in computing the credit is reduced by the amount of any throwback distributions paid during the current year that are considered to have been paid out of the preceding year’s E&P. (See Example C:5-10.) E.

Comprehensive Example. Example C:5-11 illustrates the calculation of accumulated taxable income and the determination of the accumulated tax liability.

Topic Review C:5-4 may be used at this point to summarize the provisions, which determine the imposition of the accumulated earnings tax. IV.

Book Minimum Tax. Congress enacted a book minimum tax as part of the Inflation Reduction Act of 2022, effective for taxable years beginning after December 31, 2022. This tax applies only to large C corporations and is 15% of adjusted financial statement income exceeding the regular tax. It is payable in addition to the regular tax, so their total is the greater of the regular tax or 15% of adjusted financial statement income. A.

Adjusted Financial Statement Income. 1. AFSI is based on the corporation’s net income or loss in its financial statements. See Example C:5-12 on p. C:5-23. 2. AFSI is also adjusted to reflect depreciation deducted for taxable income rather than depreciation subtracted for net income or loss.

Applicable Corporations. 1. For a particular year, the book minimum tax generally applies to a corporation if its average annual AFSI for any prior three-taxable-year period exceeds $1 billion, but only the three-taxable-year periods ending after December 31, 2021, are considered for this purpose. 2. Special rules apply for certain types of corporations. S corporations, regulated investment companies, and real estate investment trusts are exempt from the book minimum tax.

Tax Credits. 1. General business credit for a C corporation generally is limited to the corporation’s net income tax over 25% of its net income tax exceeding C:IO5-7 Copyright © 2024 Pearson Education, Inc.

$25,000, where the net income tax includes the corporation’s regular tax and its book minimum tax. 2. Any general business credit exceeding the limitation carries back one year and forward ten years. 3. The book minimum tax also creates a minimum tax credit, which the corporation may use to offset future regular taxes. The amount of unused minimum tax credits from prior years a corporation can use in a tax year is limited to the extent its regular tax exceeds 15% of its AFSI. A corporation’s unused minimum tax credits carry forward indefinitely. See Topic Review C:5-3 on p. C:5-25. V.

Tax Planning Considerations. A.

Avoiding the Personal Holding Company Tax. Five types of tax planning can be used to avoid the PHC tax. 1.

Making Changes in the Corporation’s Stock Ownership. Additional stock can be sold to unrelated parties in order to avoid having five or fewer shareholders owning more than 50% (in value) of the outstanding stock at any time during the last half of the tax year.

Changing the Amount and Type of Income Earned by the Corporation. Several tax-planning options are available including adding additional operating activities, changing the type of investment income earned, or adding additional passive income. These are discussed on pp. C:5-25 and C:5-26.

Making Dividend Distributions. Dividends reduce the tax base used to levy the PHC tax. The inclusion in PHCI of certain income forms (e.g., adjusted income from rents) can be avoided by paying enough dividends to reduce the amount of other PHCI to below the maximum acceptable level. Some of these dividends can be paid after year-end (e.g., throwback or consent dividends) in order to engage in last-minute tax planning.

Making an S Election. S corporations are statutorily exempt from the tax. An S election is less attractive because the individual tax rates are now generally above the corporate tax rates, but may avoid double taxation of corporate earnings that are distributed as dividends.

Liquidating the Corporation. A PHC can be liquidated and the assets held by the shareholders. The liquidating distributions are eligible for the dividends-paid deduction and can reduce the UPHCI amount. This election is less attractive because the individual tax rates are now generally above the corporate tax rates, but may avoid the penalty tax and C:IO5-8 Copyright © 2024 Pearson Education, Inc.

avoid double taxation of the corporate earnings that are distributed as dividends. B.

VI.

Avoiding the Accumulated Earnings Tax. The primary defense against this line of attack by the IRS is to document that the earnings accumulations are necessary to meet the future capital needs of the business. The existence of these plans must be documented each year. The plans should be as specific as possible and be revised periodically. Completed projects must be documented and abandoned projects deleted from the plan. A current timetable is also desirable. Transactions that are indicative of unreasonable accumulations of earnings should be avoided. Corporations with a potential for accumulated earnings problems may consider making an S election to eliminate accumulated earnings tax problems on a prospective basis.

Compliance and Procedural Considerations. A.

Personal Holding Company Tax. A PHC must file a corporate income tax return Form 1120 including a Schedule PH. The statute of limitations is extended from three to six years if a PHC fails to file the Schedule PH, even though no additional tax may be due. The payment of deficiency dividends eliminates the additional tax that is owed, but does not prevent the corporation from having to pay interest and penalties if the PHC penalty tax is paid after the due date for filing the return.

Accumulated Earnings Tax. No formal schedule is required for the accumulated earnings tax. Interest is charged on any tax owed from the date the return is originally due to the receipt of payment. The penalty for negligent underpayment of taxes may be assessed in accumulated earnings tax situations.

Court Case Briefs Simons-Eastern Company (Formerly Eastern Engineering Company) v. U.S., 354 F.Supp. 1003 (DC GA, 1972). The court held that for a service corporation, the accumulation of reserves for one full operating cycle under the Bardahl formula plus 60 days of professional payroll was a reasonable operation reserve. Additional building reserve accumulations for the purchase of land and equity were also held reasonable. Montgomery Coca-Cola Bottling Company, Inc. v. U.S., 35 AFTR 2d 75-1081 (Ct. Cls., 1975). A contract between a bottler and sub-bottler involved the rent for the use of property, equipment, and a franchise. The rent consisted of 20 cents per gallon. The court held that the bottler was a personal holding company and the rent payments were personal holding company income. The payments were not rent, but royalties for use of the franchise. The parties’ intent not to assign value to the franchise were not controlling because they were not dealing at arm’s length.

Chapter C:6 Corporate Liquidating Distributions Learning Objectives After studying this chapter, the student should be able to: 1.

Discuss the issues involved in corporate liquidations.

Determine the tax consequences to the shareholders and liquidating corporation when the general liquidation rules apply.

Determine the tax consequences when a parent corporation liquidates a controlled subsidiary.

Recognize special reporting issues pertaining to shareholders and the liquidating corporation.

Assess when a liquidating corporation recognizes gains and losses on the retirement of debt.

Identify tax planning opportunities in corporate liquidations.

Comply with procedural rules for corporate liquidations.

Areas of Greater Significance Emphasis should be placed on the effect of liquidating a corporation on the shareholders and the corporation.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Compliance and procedural considerations (general liquidation procedures Sec. 332 liquidations, and plans of liquidation).

Problem Areas for Students The following areas may prove especially difficult for students: 1.

The loss disallowance rules for distributions made by the liquidating corporation.

Tax attribute carryovers.

Highlights of Recent Tax Law Changes Due to the TCJA, many of the rates for capital gains have changed. Ensure the proper rates are discussed.

Teaching Tips Remind the students that under Sec. 351, usually no tax cost is involved in forming a corporation. However, as this chapter will illustrate, the tax costs of liquidating a corporation may be substantial. p. C:6-2. The discussion should re-introduce Section 351 and demonstrate this.

Lecture Outline I.

Overview of a Corporate Liquidation. This chapter initially presents an overview of the tax and nontax consequences of a corporate liquidation to both the shareholders and the distributing corporation. Before introducing the tax consequences of a corporate liquidation, it might be helpful to review Figure C:6-1 on p. C:6-4, which provides a graphical illustration of the basic liquidation transaction illustrated in Example C:6-1. A.

The Shareholder. When a corporation is liquidated, the liquidating distribution is treated as an amount received in exchange for the shareholder’s stock. Gain or loss is recognized to the extent that money and the FMV of property received exceed the adjusted basis of the stock surrendered. The tax rate on capital gains could now be significant for some taxpayers. The basis of property received is its FMV on the liquidation date. Table C:6-1, p. C:6-5 should be used at this point to discuss the Tax Consequences of Liquidation to the Shareholders.

The Corporation. Section 336 requires the liquidating corporation to recognize gain or loss on the distribution of property to its shareholders. The gain or loss is the amount of gain or loss that would have been recognized if the property were sold to the distributee. Table C:6-2 provides a summary of the tax consequences of liquidation to the corporation. Table C:6-2, p. C:6-7, should be used at this point as you summarize these provisions. The tax attributes of the corporation disappear on C:IO6-2 Copyright © 2024 Pearson Education, Inc.

liquidation. The tax attributes of a controlled subsidiary generally carry over to its parent corporation. C.

Definition of a Complete Liquidation. The term “complete liquidation” as defined in Reg. Sec. 1.332-2(c) indicates that distributions made by a liquidating corporation must either completely cancel or redeem all of its stock in accordance with a plan of liquidation or be one of a series of distributions that completely cancels or redeems all of its stock in accordance with a plan of liquidation. A distribution that is made before a plan of liquidation is adopted will generally be taxed under the dividend distribution or stock redemption rules. A liquidation status exists when the corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining properties to its shareholders. The retention of a nominal amount of assets does not prevent liquidation from occurring under the tax rules. The liquidation of a corporation does not mean that the corporation has undergone dissolution. Dissolution is a legal term that implies that the corporation has surrendered the charter it received from the state. A corporation may complete its liquidation before surrendering its charter to the state and undergoing dissolution. Dissolution may never occur if the corporation retains its charter in order to protect the corporate name from being acquired by another party. Thus, a corporation may liquidate for tax purposes even though it does not dissolve. See the “Stop and Think” on p. C:6-4 for details on consideration of the tax on the overall business entity selection decision.

II.

General Liquidation Rules. The liquidation rules are presented in two parts—the general liquidation rules, and the special rules applying to liquidations of 80%-or-more-owned subsidiary corporations. The general liquidation rules are divided into two parts—the effects of liquidating on the shareholders, and the effects of liquidating on the corporation. A.

Effects of Liquidating on the Shareholders. 1.

Amount of Recognized Gain or Loss. The amount received as a distribution in complete liquidation is treated as full payment for the stock or debt that is surrendered. Gain or loss is measured as the difference between the amount realized and the basis of the stock surrendered. Any liabilities assumed or acquired reduce the amount realized. (See Examples C:6-3 and C:6-4.) Table C:6-1 provides an overview of the liquidation rules applying to shareholders. p. C:6-5. a.

occurred that fix the amount of the liquidating distribution and the shareholder is entitled to receive it upon surrender of his/her shares. A cash method of accounting shareholder recognizes gain or loss when they are in actual or constructive receipt of the distribution. b.

When Stock Is Acquired. A shareholder must compute gain or loss separately for each share or block of stock owned.

Character of the Recognized Gain or Loss. Gain or loss is generally a capital gain or loss. For some individual shareholders, the loss may be ordinary if the stock qualifies as small business corporation stock under Sec. 1244. Two exceptions to capital gain or loss treatment are listed on p. C:6-6.

Basis of Property Received in the Liquidation. The basis of property received is its FMV on the date of distribution. The holding period starts on the day after the distribution date.

If incurred in tax years after 2017, NOL deductions will be limited to 80% of taxable income without regard to the NOL deduction.

Effects of Liquidating on the Liquidating Corporation. 1.

Recognition of Gain or Loss When Corporation Distributes Property in Redemption of Stock. Section 336(a) provides that gain or loss must be recognized by the liquidating corporation when property is distributed in a complete liquidation. The amount and character of the gain or loss are determined as if the property is sold to the distributee immediately before the distribution at its FMV. (See Example C:6-5.) An overview of the tax consequences applying to the liquidating corporation is presented in Table C:6-2 on p. C:6-7.

Liabilities Assumed or Acquired by the Shareholder. When liabilities assumed or acquired by the shareholder exceed the property’s adjusted basis, gain will be recognized at the time of the distribution in an amount equal to the greater of (1) the liability assumed or acquired, or (2) the FMV of the property distributed, minus the property’s basis. (See Example C:6-7 on p. C:6-8.)

Exceptions to the General Gain or Loss Recognition Rule. There are four exceptions to these rules, which are listed below. a.

No gain or loss is recognized by the liquidating corporation on the distribution of property to an 80% distributee in a complete liquidation of a subsidiary corporation to which Sec. 332 applies.

No loss is recognized when a distribution of property is made to minority shareholders in a complete liquidation of a subsidiary corporation to which Sec. 332 applies.

No loss is recognized in connection with distributions of property to a related person if the distribution is other than pro rata, or the property being distributed is a disqualified property.

Losses are limited on the sale, exchange, or distribution of properties acquired by the liquidating corporation in a Sec. 351 transaction, or as a contribution to capital, where the acquisition of the property by the liquidating corporation is part of a plan that has as its principal purpose the recognition of a loss by the liquidating corporation.

Topic Review C:6-1 can be used here to review the general corporate liquidation rules. p. C:6-10. III.

Liquidation of a Controlled Subsidiary. The discussion of the controlled subsidiary exception is divided into three parts—the requirements for using the exception, the effects of liquidating on the parent corporation, and the effects of liquidating on the subsidiary corporation. Section 332(a) applies to the parent corporation and provides that no gain or loss is recognized when a controlled subsidiary corporation is liquidated into its parent corporation. Sec. 337 permits the liquidating corporation to recognize no gains or losses on the assets distributed to the parent corporation. Gains (but not losses) are recognized on distributions made to shareholders holding minority interests. (See Example C:6-13.) A.

Requirements. The following requirements must all be met for a liquidation transaction to come under the Sec. 332 nonrecognition rules: (1) The parent corporation must own at least 80% of the total combined voting power of all classes of stock entitled to vote and 80% of the total value of all classes of stock (other than certain nonvoting preferred stock issues) from the date on which the plan of liquidation is adopted until receipt of the property of the subsidiary corporation; (2) the property distribution must be in complete cancellation or redemption of all of the subsidiary corporation’s stock; (3) property distribution must occur within a single tax year or be one of a series of distributions that are completed within three years of the close of the tax year during which the first of the series of liquidating distributions is made. 1.

Stock Ownership. The parent corporation must own 80% of the total combined voting power of all classes of stock entitled to vote and 80% of the total value of all classes of stock (other than certain nonvoting preferred stock issues) from the date on which the plan of liquidation is adopted until receipt

of the property of the subsidiary. The Sec. 318 attribution rules do not apply when determining if the 80% minimum has been met.

Cancellation of the Stock. The subsidiary corporation must distribute its properties in complete cancellation or redemption of all of its stock in accordance with a plan of liquidation. All property must be distributed under the plan of liquidation. Retention of a nominal amount of properties to permit retention or sale of the corporate name is permitted.

Timing of Distributions. The distribution of all the subsidiary corporation’s assets within one tax year of the liquidating corporation, in complete cancellation or redemption of all its stock, is considered a complete liquidation. The subsidiary corporation can carry out the plan of liquidation by making a series of distributions that extend over a period of more than one tax year to cancel or redeem its stock. A formal plan of liquidation must be adopted when the liquidating distributions extend beyond a single tax year. A series of distributions must be completed within three years.

Effects of Liquidating on the Shareholders. 1.

Recognition of Gain or Loss. The Sec. 332(a) nonrecognition rules apply only to a parent corporation that receives a liquidating distribution from a solvent subsidiary. They do not apply to a parent corporation that receives a liquidating distribution from an insolvent subsidiary, to minority shareholders who receive liquidating distributions, or to a parent corporation that receives a payment to satisfy the subsidiary’s indebtedness to the parent. a.

Insolvent Subsidiary. The nonrecognition provisions do not apply to a parent corporation that receives a liquidating distribution from an insolvent subsidiary. In such a situation, generally an ordinary loss is recognized under Sec. 165(g)(3) in the amount of the adjusted basis of the parent corporation’s stock investment. (See Example C:6-14.) You may wish at this point to use the Stop and Think material illustrating the liquidation of an insolvent subsidiary. p. C:6-12.

Treatment of Minority Shareholders. Liquidating distributions made to minority shareholders are taxed under the Sec. 331 general liquidation rules. These rules require the minority shareholders to recognize gain or loss - which is generally capital - upon the redemption of their stock in the subsidiary corporation. (See Example C:6-15.)

Basis of Property Received. Basis of property received by the parent corporation is its basis in the hands of the subsidiary corporation. Property received by minority shareholders has a basis equal to its FMV because gain C:IO6-6 Copyright © 2024 Pearson Education, Inc.

or loss is recognized by the minority shareholders upon receipt of the liquidating distribution. (See Example C:6-16.) Upon the liquidation of a foreign subsidiary, a special rule prevents the importation of built-in losses. Specifically, the parent takes an FMV basis in each transferred property if the following three conditions are met: (1) the parent is a U.S. corporation, (2) the liquidating subsidiary is a foreign corporation, and (3) the aggregate adjusted basis of the transferred property exceeds the aggregate FMV. C.

Effects of Liquidating on the Subsidiary Corporation. 1.

Recognition of Gain or Loss. No gain or loss is recognized by the liquidating corporation on the distribution of property to the 80% distributee in a complete liquidation. The depreciation recapture provisions do not override the nonrecognition rule. Liquidating distributions that are made to minority shareholders are not eligible for the protection of Sec. 337(a). The liquidating corporation must recognize gain (but not loss) when property is distributed to the minority shareholders.

Tax Attribute Carryovers. Tax attributes disappear when a liquidation is complete. They carry over, however, in the case of a controlled subsidiary corporation that is liquidated into its parent corporation under Sec. 332. The common tax attributes include NOLs and capital losses. A list of attributes is provided on p. C:6-14.

Topic Review C:6-2 may be used at this point to summarize the special rules applicable to the liquidation of a controlled subsidiary. p. C:6-14. IV.

Special Shareholder Reporting Issues. A.

Partially Liquidating Distributions. When a series of partially liquidating distributions are made in complete liquidation, the complete liquidation rules apply. The shareholder’s basis is first recovered and then gain is recognized once the basis of a particular share or block of stock has been fully recovered. Losses are generally not recognized until the final liquidating distribution is actually or constructively received. (See Examples C:6-19 and C:6-20.)

Subsequent Assessments Against the Shareholder. A shareholder may be required to pay a contingent liability of the corporation or a liability that is not anticipated at the time of the liquidating distribution. If the liquidation resulted in a capital gain being reported in the year of liquidation, then a capital loss is reported in the year the liability is paid by a cash basis shareholder, or at the time the liability is incurred by an accrual basis shareholder. (See Example C:6-21.)

Open Versus Closed Transactions. Not all properties are susceptible to valuation. Gain, but not loss, is recognized when liquidation occurs taking into account only C:IO6-7 Copyright © 2024 Pearson Education, Inc.

those properties that can be valued. As properties that could not be valued are sold, collected, or able to be valued, the additional amounts received are treated as a return of capital or as gain that is reported in the same way as was any gain originally reported when the property that was able to be valued was received. The position of the IRS is that the FMV of almost any asset should be able to be determined. Thus, the IRS assumes that the open transaction method should be used only in extraordinary circumstances. D.

VI.

Installment Obligations. Normally installment obligations received by a shareholder in a distribution are reported at their FMV to determine the shareholder’s recognized gain or loss on the liquidation. Shareholders who receive an installment obligation that was acquired by the liquidating corporation in connection with the sale or exchange of its property are eligible for special treatment in reporting their gain on the liquidating transaction if the sale or exchange takes place during the 12month period beginning on the date a plan of complete liquidation is adopted and ending on the date the liquidation is completed. These shareholders may report their gain as the installment obligations are collected.

Pertaining to the Liquidating Corporation. A.

Expenses of Liquidation. The corporation is permitted to deduct on its final return the costs of liquidation. These include attorneys’ fees, accountants’ fees, costs incurred in drafting the plan of liquidation and obtaining shareholder approval, etc. The cost of selling assets reduces the sales proceeds from the assets sale. This reduces the amount of gain or loss recognized by the liquidating corporation. (See Example C:6-22.)

Treatment of Net Operating Losses. An NOL created in the final year of a corporation’s existence may be carried back to offset taxes paid in prior years. If the loss is not used prior to the corporation’s liquidation, it is lost. See, however, the tax attribute carryover rules below that permit subsidiary corporation NOLs to be acquired by its parent corporation, if these losses occurred after 2020.

Recognition of Gain or Loss When Property Is Distributed In Retirement of Debt. A.

General Rule. No gain or loss is recognized when an unsecured debt obligation owed by the liquidating corporation to a shareholder is paid. An exception to this rule is made when a security is retired and the amount received by the shareholder is different from the shareholder’s adjusted basis for the obligation. The shareholder will recognize gain or loss in this case. These same rules apply whether the debt is paid or retired as part of a debtor corporation’s operations or as part of its liquidation. The debtor corporation recognizes gain or loss when it uses cash to satisfy its debt obligations. Gain is recognized when appreciated noncash property is used by a debtor corporation to satisfy its debt obligations. Similarly, a loss is recognized when noncash property that has declined in value is used by a debtor corporation to satisfy its debt obligations. p. C:6-17. C:IO6-8 Copyright © 2024 Pearson Education, Inc.

VII.

Satisfaction of the Subsidiary’s Debt Obligations. The Sec. 332(a) nonrecognition rules apply only to amounts received by the parent corporation in its role as a shareholder. The parent corporation, however, does recognize gain or loss upon receipt of property in payment of a subsidiary corporation’s indebtedness. (See Example C:6-23.)

Tax Planning Considerations. A.

Timing of Liquidations. Liquidating distributions often are made over two tax years. Selling or distributing loss property while the corporation still has business income will allow these losses to be recognized and offset profits that may be taxed at higher rates. Delaying recognition of gain on appreciated property sales and distributions will defer the payment of taxes one year and possibly result in this income being taxed at lower tax rates if the corporation has discontinued operations. The tax position of individual shareholders should also be considered when making liquidating distributions.

Recognition of Ordinary Losses When a Liquidation Occurs. Section 1244 is available when a complete liquidation occurs. This provision provides that $50,000 of ordinary loss can be claimed when stock is surrendered, or $100,000 if the taxpayer is married and files a joint return. Ordinary loss treatment is also available for a domestic corporation that owns stock or debt securities in a subsidiary corporation. Since Sec. 332 does not apply when a subsidiary corporation is insolvent, the parent corporation recognizes a loss on the worthless stock and debt securities. This loss is ordinary (rather than a capital loss) if at least 80% of the voting stock and 80% of each class of nonvoting stock are owned by the domestic corporation and more than 90% of the liquidating corporation’s gross income for all tax years has been from sources other than passive income.

Obtaining 80% Ownership to Achieve Sec. 332 Benefits. A parent corporation wishing to use the nonrecognition provisions of Sec. 332 may acquire additional shares of a subsidiary’s stock in order to meet the 80% stock ownership minimum prior to the adoption of the plan of liquidation. (See Example C:6-24.) The parent corporation might also have the subsidiary redeem the shares of the minority shareholders in order for the parent to meet the 80% stock ownership minimum. Property distributions in liquidation of the subsidiary would be nontaxable to both corporations under Sec. 332(a). Property distributions to minority shareholders would be taxable. (See Example C:6-25.)

Avoiding Sec. 332 to Recognize Losses. A parent corporation may wish to avoid the nonrecognition rules of Sec. 332 and recognize a loss when a solvent subsidiary liquidates. This can be accomplished by selling some of the subsidiary’s shares to reduce the parent’s stock ownership below the 80% stock ownership minimum prior

to adopting the plan of liquidation. The subsidiary would also be able to recognize a loss since the nonrecognition provisions of Sec. 337 would also not be applicable. VIII. Compliance and Procedural Considerations. A.

General Liquidation Procedures. A corporation must file a Form 966 [Corporate Dissolution or Liquidation] within 30 days after the adoption of any resolution or plan calling for the dissolution or liquidation of the corporation. An additional Form 966 must be filed within 30 days if there is an amendment or supplement. The form is filed with the District Director. Every corporation that makes a distribution of $600 or more during a calendar year must file a Form 1099-DIV [U.S. Information Return for Recipients of Dividends and Distributions]. A separate form is filed for each shareholder.

Sec. 332 Liquidations. Every corporation receiving distributions in a complete liquidation under the Sec. 332 nonrecognition rules is required to maintain permanent records. These include a certified copy of the plan of liquidation, a list of all the properties received in distribution, a statement of any indebtedness of the liquidating corporation to the recipient corporation, and a statement of stock ownership that must be included in the corporate distributee’s return for the tax year in which a liquidating distribution is received.

Plan of Liquidation. A plan of liquidation is a written document detailing the steps to be undertaken while carrying out liquidation. The date of adoption of a plan is the date the shareholders adopt a resolution authorizing the distribution of all of the corporation’s assets in redemption of their stock. Informal agreements and resolutions have been accepted by the IRS and the Courts that may accelerate the date on which a plan of liquidation has been adopted.

Court Case Briefs George L. Riggs, Inc. v. CIR., 64 TC 474 (1975), acq. 1976-2 C.B. 2. The taxpayer owned less than 80% interest in a subsidiary that was to be liquidated. Pursuant to this plan a tender offer was made to minority shareholders to purchase their shares. At the point in time when 90% of the outstanding shares of the subsidiary had been obtained, a formal plan of liquidation was adopted to liquidate the subsidiary under Sec. 332. The issue was whether the discussions of a possible liquidation prior to obtaining 80% of the outstanding stock caused the liquidation to be taxable. The court held that the possibility of liquidation was not sufficient to be considered the adoption of an actual plan of liquidation. There was no evidence of an agreement between the majority and minority shareholders prior to the tender offer. Burnet v. Edith A. Logan, 9 AFTR 1453, 283 U.S. 404 (USSC, 1931). The value of a contract to sell stock contained a provision for payment of 60 cents a ton for all iron ore mined. The courts ruled that gain could not be computed on the sale until basis (fair market value on the date of death of the original shareholder) was recovered. This case illustrates how an open transaction is to be treated.

Chapter C:7 Corporate Acquisitions and Reorganizations Learning Objectives After studying this chapter, the student should be able to: 1.

Identify types of taxable acquisitions and determine the consequences of a Sec. 338 deemed sale election.

Distinguish between taxable and nontaxable acquisitions.

Recognize the types of nontaxable reorganizations and determine their tax consequences.

Describe the structure and requirements of each type of acquisitive reorganization.

Describe the structure and requirements of divisive reorganizations.

Define other types of reorganizations.

Explain judicial doctrines pertaining to corporate reorganizations.

Determine the tax treatment of NOL carryovers and other tax attributes in a reorganization.

Identify tax planning opportunities in reorganizations and taxable acquisitions.

10.

Comply with procedural rules for reorganizations and taxable acquisitions.

11.

Determine the financial statement implications of corporate acquisitions.

Areas of Greater Significance The areas of greater significance include understanding the effects of a taxable acquisition versus the effects of a tax-free reorganization. More emphasis should be placed on Type A, B, and C acquisitive reorganizations and Type D divisive reorganizations.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Other reorganization transactions (Acquisitive Type D and Type E, F, and G reorganizations).

Judicial restrictions on the use of corporate reorganizations.

Tax attributes.

Tax planning considerations: (why use a reorganization instead of a taxable transaction avoiding the reorganization provisions?)

Compliance and procedural considerations (Sec. 338 deemed liquidation reporting requirements, plan of organization, party to a reorganization, ruling requests, and reporting requirements).

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Basis adjustments under Sec. 338.

The dividend equivalency test.

Triangular reorganizations.

Highlights of Recent Tax Law Changes There have been no recent tax law changes to impact the issues within this chapter.

Teaching Tips 1.

Example C:7-16: Most students will find the characterization of the gain recognized when boot property is received a very difficult issue to understand. Should an instructor plan to cover this in class, he or she needs to spend a considerable amount of time. Probably, the best way to deal with this in class is simply to make the students aware that this issue exists and explain that capital gain treatment generally applies when the shareholder holds a minority position in the acquiring corporation and receives boot property. p. C:7-16.

Lecture Outline I.

Taxable Acquisition Transactions. Acquiring corporations have two primary ways to acquire the assets of a target corporation. The acquiring corporation can acquire the needed assets directly from the target corporation. Alternatively, the acquiring corporation can acquire an indirect interest in the assets by purchasing a controlling (more than 50%) interest in the target corporation’s stock. A listing of the options available after a stock interest is acquired is listed on p. C:7-2. A summary of the tax consequences of these alternatives is presented in Table C:7-1. A.

Asset Acquisitions. The asset acquisition transaction is reported by the seller determining the gain or loss recognized on the sale of each individual asset. Sale of depreciable assets may give rise to depreciation recapture. The purchaser’s bases for the assets are their acquisition cost. The purchaser can claim depreciation based upon the property’s total acquisition cost. There are several advantages to an asset acquisition. First, a significant portion of the acquisition can be debt-financed. Second, only those assets and liabilities that are designated in the purchase-sale agreement are acquired. The target corporation may be liquidated after the asset sale takes place. The target corporation recognizes gain or loss with respect to the assets that are sold as well as any properties that are retained by the target corporation and sold to third parties or distributed to the shareholders as part of the liquidation. Both the liquidating corporation and the target corporation’s shareholders report gain or loss on the liquidation. (See Example C:7-1.)

Stock Acquisitions. 1.

Stock Acquisition with No Liquidation. A stock acquisition is the simplest of the acquisition transactions. If part of the consideration is deferred until a later year, the seller’s gain can be reported using the installment method. If part of the consideration received by the seller represents an agreement with the purchaser not to compete, the consideration received is ordinary income. The purchaser’s basis for the stock is its acquisition cost. (See Example C:7-2.)

Stock Acquisition Followed By a Liquidation. If the parent corporation owns at least 80% of the subsidiary stock, then the liquidation of the acquired subsidiary into the acquiring parent is nontaxable under Sec. 332 and 337. The subsidiary basis for the assets on its books carries over to the parent corporation. If the parent paid a premium for the assets, then this premium is lost when the liquidation occurs because the parent basis for the stock disappears when the tax-free liquidation occurs. This disappearing basis provides no tax benefit. (See Example C:7-3.) C:IO7-3 Copyright © 2024 Pearson Education, Inc.

Sec. 338 Deemed Liquidation Election. The Sec. 338 deemed liquidation election permits the acquiring and target corporations to elect an indirect (two-step) acquisition of the target corporation’s assets. First the target corporation’s shareholders sell their stock to the acquiring corporation. The acquiring corporation makes a deemed liquidation election with respect to the acquisition of the target corporation’s stock. The transaction requires that the “old” target corporation recognize gain and loss on the hypothetical sale of the assets from the “old” target corporation to the “new” target corporation. The “new” target corporation is treated as a new entity for tax purposes. 1.

Eligible Stock Acquisitions. In order to elect under Sec. 338, the acquiring corporation must purchase 80% or more of the target corporation’s voting stock and 80% of the total value of all classes of stock (except certain nonvoting preferred stock) during a 12-month acquisition period beginning on the day the first purchase is made. (See Example C:7-4.)

The Election. A Sec. 338 election must be made not later than the fifteenth day of the ninth month, beginning after the month in which the acquisition date occurs. The acquisition date is the first day of the 12-month acquisition period on which the 80% stock ownership requirement is met. (See Example C:7-6.)

Deemed Sale Transaction. When a Sec. 338 election is made, the target corporation is treated as having sold all of its assets at their FMV in a single transaction at the close of the acquisition date. The asset sale is taxable with gain or loss being recognized by the target corporation. (See Example C: 77.)

Basis of the Assets after the Deemed Sale. The basis of the acquiring corporation’s assets are stepped-up to the amount paid by the acquiring corporation for the target corporation’s stock plus an adjustment for the target corporation’s liabilities on the day following the acquisition date and other relevant items. This amount is called the adjusted grossed-up basis.

Allocation of Basis to Individual Assets. The adjusted grossed-up basis is allocated among four classes of assets using the residual method. The residual method assumes that the adjusted and grossed up basis should be allocated to the corporation’s tangible property and intangible property using a hierarchical basis. Any amount not allocated to tangible or intangible assets of the target corporation is allocated to goodwill and going concern value. The Omnibus Reconciliation Act of 1993 provides that intangible property acquired after August 6, 1993 is amortizable over a 15-year period if used in the active conduct of a trade or business. Among the assets included in the

definition of Sec. 197 intangibles are goodwill, going concern value, covenants not to compete, etc. (See Example C:7-10.) 6.

Tax Accounting Elections for the New Corporation. The “new” target corporation continues to file a tax return and is treated as a new tax entity. Elections can be made with respect to the corporation’s tax year and accounting methods. New MACRS depreciation deductions can be taken without regard to the ACRS or MACRS elections made by the old corporation. The holding period for assets begins on the day after the acquisition date. The new corporation is not considered a continuation of the old corporation for purposes of the tax attribute carryover rules, thus any loss carryovers of the “old” target corporation are lost. Gain recognized on the deemed sale transaction can reduce the amount of any target corporation loss and credit carryovers that might otherwise be lost.

At this point Topic Review C:7-1 may be used to summarize the Section 338 Deemed Liquidation Election. 7.

II.

Section 336(a) Deemed Sale Election. Under certain circumstances, the taxpayer may elect to have the transaction treated as if the target corporation disposed of the assets in a taxable transaction. As a result, no gain or loss is recognized on the sale or distribution of the target corporation stock. Additionally, the target corporation also recognizes no gain or loss other than when there are certain distributions to shareholders. To qualify for this election, the shareholder must dispose of at least 80% of the target stock by vote and value over a 12-month period. As a result, several events are deemed to have occurred.

Comparison of Taxable and Nontaxable Asset Acquisition Transactions. A.

Taxable and Tax-Free Asset Acquisitions. Topic Review C:7-2, p. C:7-12, provides a comparison of taxable and nontaxable asset acquisition transactions. A walk-through of the table with the students contrasting the results to the target corporation, the acquiring corporation, and the target corporation’s shareholders should be used to focus class attention on the material being covered.

Tax Consequences for Acquiring Corporation. Acquiring Corporation does not recognize gain or loss when its stock is issued in exchange for property in either a taxable or tax-free transaction. Assets that are received in a taxable transaction have their tax basis adjusted upward or downward to their acquisition cost. The holding period for the acquired assets commences on the day after the transaction date. If the assets are acquired in a tax-free reorganization, their bases are generally the same as they were on the target corporation’s books because a basis step-up is permitted only when the target corporation receives boot property that it retains, and thereby recognizes a gain. The retention of boot by the target corporation generally does not C:IO7-5 Copyright © 2024 Pearson Education, Inc.

occur since most acquisitive reorganizations result in the target corporation being liquidated. Acquiring’s holding period tacks on to the target corporation’s holding period. Because a taxable acquisition is treated as a purchase transaction, all of the target corporation’s tax attributes disappear when it is liquidated. On the other hand, tax attributes are acquired in a tax-free reorganization. C.

Tax Consequences for Target Corporation. All gains and losses realized by the target corporation on selling its assets are recognized. A tax-free reorganization is one exception to the general rule. Gains realized by the target corporation in a taxfree disposition of its assets are generally not recognized because it is liquidated and gain is recognized only if boot property received in the reorganization is retained by the target corporation. Losses realized on asset dispositions are not recognized. When the target corporation is liquidated, it recognizes no gain or loss when making a distribution of stock or debt received in the reorganization to its shareholders or creditors. It must recognize gain (but not loss) when other property (e.g., nonmoney boot property) is distributed to a shareholder or creditor.

Tax Consequences for Target Corporation’s Shareholders. When the target corporation is liquidated as part of a taxable acquisition, its shareholders recognize gain or loss from the surrender of their stock. The assets received take a basis equal to their FMV. A tax-free reorganization requires the shareholder to recognize gain only to the extent that boot is received. The gain is generally taxed as a capital gain, although dividend income may be reported in certain situations. The stocks and securities received take a substituted basis that references the basis of the target stock and securities surrendered. The basis of any boot property is its FMV.

Accounting for the Acquisition. Only the purchase method is available for acquisition accounting. As such, record at FMV, and annually test the goodwill for impairment.

Topic Review C:7-2 on p. C:7-12 presents a comparison of taxable and tax-free asset acquisition transactions. F.

Comparison of Taxable and Tax-Free Stock Acquisitions. Assume that Acquiring Corporation acquires all of the target corporation’s stock and the target becomes a controlled subsidiary. If Acquiring Corporation uses cash, debt obligations and its stock to make the purchase, the acquisition is taxable. If Acquiring Corporation acquires all of the target’s stock using solely its voting stock or voting stock of its parent corporation to effect the transaction, the acquisition qualifies as a tax-free reorganization.

Tax Consequences for Target Corporation. The target corporation’s basis for its assets does not change as a result of either a taxable or tax-free transaction.

Tax Consequences for Acquiring Corporation. Acquiring Corporation does not recognize gain or loss when its stock is issued in exchange for property in either a taxable or tax-free transaction. Acquiring Corporation’s basis for the stock in a taxable acquisition is its acquisition cost. In a tax-free transaction, basis for the stock is the same as it was in the hands of the target corporation’s shareholders.

Tax Consequences for Target Corporation’s Shareholders. The shareholder’s gain is recognized in a taxable acquisition. In a tax-free transaction, it is only recognized to the extent that boot is received. Gain recognized on a taxable stock transaction is capital gain if the stock is a capital asset in the seller’s hands. In a tax-free reorganization the gain can be either dividend income or capital gain, although the latter result usually occurs. The seller’s gain can be reported using the installment method of accounting if part or all of the consideration is deferred into a later year.

At this point you may wish to use Topic Review C:7-3 on p. C:7-13 to review the comparison between taxable and tax-free stock acquisitions. III.

Types of Reorganizations and their Tax Consequences. Types of Reorganizations. Section 368 authorizes seven types of reorganizations to accommodate the major forms of business acquisitions, divestitures, and restructurings. The different types of reorganizations are generally referred to by the subparagraph letter of Sec. 368 that defines them. An acquisitive reorganization is a transaction where the acquiring corporation obtains part or all of the assets of the target corporation. Types A, B, C, D, and G reorganizations can be classified as acquisitive transactions. A divisive reorganization is a transaction in which part of a transferor corporation’s assets are transferred to a second, newly-created corporation that is controlled by either the transferor or its shareholders. Type D or G reorganizations can be either acquisitive or divisive. A Type E reorganization is a recapitalization of an existing corporation. A Type F reorganization changes the identity, legal form, or state of incorporation. A.

Target or Transferor Corporation. 1.

Recognition of Gain or Loss on Asset Transfer. Section 361(a) prevents a target corporation from recognizing gain or loss on any exchange of property that occurs as part of a tax-free reorganization in order to prevent the transferee corporation from increasing its basis for the assets it acquires. The receipt of money or other property does not disqualify the transaction or trigger the recognition of gain if the money or boot is distributed to C:IO7-7 Copyright © 2024 Pearson Education, Inc.

shareholders or creditors. The retention of boot by the target corporation generally does not occur since most acquisitive reorganizations result in the target corporation being liquidated. (See Example C:7-11.) 2.

Depreciation Recapture. The depreciation recapture rules do not override the nonrecognition of gain provisions of Sec. 361. Depreciation recapture potential carries over to the acquiring corporation.

Assumption of Liabilities. The acquisition or assumption of liabilities of the target corporation by the acquiring corporation will not trigger the recognition of gain. The target corporation recognizes gain if the sum of the liabilities assumed or acquired exceeds the total adjusted bases of the properties transferred and the tax-free reorganization is either an acquisitive or divisive Type D reorganization.

Recognition of Gain or Loss on Distribution of Stock and Securities. No gain or loss is recognized by the target corporation when it distributes the stock and securities received in a tax-free reorganization to its shareholders or creditors as part of the reorganization plan. Distributions of boot property made pursuant to the reorganization plan require the recognition of gain, but not loss. If property is distributed to a shareholder or creditor subject to a liability, the FMV of the property is considered to be not less than the amount of the liability. (See Example C:7-12.)

Acquiring or Transferee Corporation. 1.

Amount of Gain or Loss Recognized. No gain or loss is recognized by the acquiring corporation when it receives money or other property in exchange for its stock or securities as part of a tax-free reorganization.

Basis of Acquired Property. The basis of property received in a tax-free reorganization is its basis in the target corporation’s hands increased by any gain recognized by the target corporation. There will generally be no step-up in basis because gain or loss is usually not recognized by the target corporation. (See Example C:7-13.)

Holding Period of Acquired Property. The holding period includes the target corporation’s holding period for the acquired property.

Shareholders and Security Holders. 1.

securities, either in the acquiring corporation or in another corporation that is also a party to the reorganization. Section 356(a) requires that gain be recognized to the extent of the lesser of the realized gain or the amount of money plus the FMV of other boot property received. Nontraditional preferred stock (for example, preferred stock that must be redeemed or purchased by the issuer) may also be considered boot property. (See Example C:7-14.) Gain is also recognized if the value of the securities received exceeds the value of the securities surrendered and treated as boot. The boot amount is the FMV of the excess. (See Example C:7-15.) 2.

Character of the Recognized Gain. Section 356(a)(2) requires that gain recognized be characterized as a dividend if the receipt of property has the same effect as the receipt of a dividend. The Sec. 302(b) stock redemption rules are employed to test whether the exchange has the effect of a dividend distribution. Tax-free reorganizations do not generally involve actual redemptions of the stock of the target corporation’s shareholders. Instead, the shareholder is treated as having exchanged his target corporation stock in a tax-free reorganization solely for stock in the acquiring corporation. After having received the acquiring corporation’s stock, a hypothetical redemption of a portion of the acquiring corporation’s stock occurs in exchange for the boot property. Capital gain treatment results only if the boot that is received causes the hypothetical redemption to qualify for exchange treatment under Sec. 302(b). (See Example C:7-16.)

Basis of Stock and Securities Received. If no gain or loss is recognized by the shareholders or security holders, the stock and securities received take a substituted basis from the stock and securities exchanged. If gain is recognized, the substituted basis is increased by the amount of the gain recognized and reduced by the amount of money plus the FMV of any other boot property received. (See Example C:7-17.)

Holding Period. The holding period for stocks and securities that are nonrecognition property includes the holding period for the stocks and securities that are surrendered. The holding period for stocks and securities that are boot property and any other boot property begins on the day following the transaction date.

At this point Topic Review C:7-4 may be used to summarize the tax consequences of a taxfree reorganization to the target corporation, the acquiring corporation, and the target corporation’s shareholders.

IV.

Acquisitive Reorganizations. The various types of acquisitive reorganizations are discussed below. Topic Review C:7-5 provides a summary of their requirements. A.

Type A Reorganization. There are three types of A reorganizations: mergers or consolidations, triangular mergers, and reverse triangular mergers. 1.

Merger or Consolidation. A Type A reorganization is a merger or a consolidation that satisfies the corporation laws of the United States, a state, or the District of Columbia. Figure C:7-1 illustrates a merger. A consolidation is illustrated in Figure C:7-2. The tax consequences of a merger transaction are illustrated in Example C:7-18. A tax-free reorganization also allows the transfer of the assets and liabilities acquired from the acquiring corporation to a controlled subsidiary corporation. No gain is recognized by the parent or the controlled subsidiary on the transfer. The basis of the individual assets carries over from the parent to the subsidiary.

Advantages and Disadvantages of a Merger Transaction. A merger allows greater flexibility than other types of reorganizations because there is no restriction that the consideration be solely voting stock as in the case of some other reorganization forms. There is no requirement that “substantially all” of the assets of the target corporation be acquired. Disadvantages include the need to comply with state corporation laws, which usually include approval of the plan by shareholders of both corporations. All liabilities of the target corporation must be assumed, including unknown and contingent liabilities.

Triangular Mergers. Triangular mergers are similar to the conventional Type A merger forms except the parent uses a controlled subsidiary corporation to act as the acquiring corporation. The target corporation is merged into the subsidiary corporation. Triangular mergers must satisfy state law. In addition, the stock used to acquire the target corporation is limited to the parent corporation’s stock. The subsidiary must acquire substantially all of the target corporation’s assets as part of the plan of reorganization. A list of additional advantages provided by a triangular merger is found on p. C:7-24. Figure C:7-3 may be used to illustrate a triangular merger.

Reverse Triangular Merger. Reverse triangular mergers are similar to triangular mergers except that the subsidiary is merged into the target corporation, and the target stays alive as a subsidiary of the parent.

Type C Reorganization. A Type C reorganization is an asset for stock transaction and is illustrated in Figure C:7-4. The acquiring corporation obtains substantially all of the target corporation’s assets in exchange for its voting stock and a limited amount of other consideration. C:IO7-10 Copyright © 2024 Pearson Education, Inc.

The acquired corporation must distribute the stock, securities, and other property received in the reorganization, plus any other property that it retained, to its shareholders as part of the plan of reorganization. The acquired corporation may retain its corporate charter and other assets, if any, needed to satisfy the minimum capital requirements under state law to maintain its corporate existence. 1.

Consideration Used to Effect the Reorganization. Consideration used to effect the reorganization must be solely voting stock. The acquisition of the target corporation’s liabilities or property subject to liabilities is disregarded for this purpose. Other consideration may be used provided at least 80% of the target corporation’s property is acquired for voting stock. (See Example C:7-20.)

Advantages and Disadvantages of a Type C Reorganization. A list of advantages and disadvantages is found on p. C:7-27.

Tax Consequences of a Type C Reorganization. The tax consequences of a Type C reorganization are found in Example C:7-21. A triangular Type C reorganization allows the voting stock of the parent corporation to be used by a controlled subsidiary corporation to acquire substantially all of the target corporation’s assets. The stock used must be solely the voting stock of the parent corporation. The subsidiary can provide additional consideration in the form of securities, money, or other property.

Type D Reorganization. Type D reorganizations can be either acquisitive or divisive. An acquisitive Type D reorganization involves the transfer by a corporation of substantially all of its assets to a controlled corporation in exchange for such corporation’s stock and securities pursuant to a plan of reorganization. The stock, securities, and other property received, plus any property retained must be distributed pursuant to a complete liquidation of the transferor corporation. (See Figure C:7-5.) 1.

Control Requirement. The transferor corporation and/or one or more of its shareholders must control the transferee corporation immediately after the asset transfer. Control is defined as either 50% or more of the total combined voting power of all classes of voting stock, or 50% or more of the total value of all classes of stock. The transferor’s shareholders must maintain a continuing equity interest in the transferee corporation.

Tax Consequences of a Type D Reorganization. The tax consequences of an acquisitive Type D reorganization are the same as for a Type C reorganization. If the reorganization satisfies both the requirements of a Type C and a Type D reorganization, the transaction will be treated as a Type D. C:IO7-11 Copyright © 2024 Pearson Education, Inc.

Type B Reorganization. A Type B reorganization is one in which the target corporation’s stock is exchanged for voting stock of the acquiring corporation and the target corporation remains in existence as a subsidiary of the acquiring corporation. Figure C:7-6 may be used at this point to illustrate a Type B reorganization. The basis of the target corporation’s assets and the amount of its tax attributes remain unchanged. After the reorganization, the parent and target corporation can elect to file a consolidated tax return. 1.

Solely for Voting Stock Requirement. The requirement that only voting stock be used in the acquisition precludes the use of other property except to redeem fractional shares or to pay certain reorganization expenses. The voting stock can be either common or preferred. For purposes of the control requirement, control is defined as 80% of the total combined voting power of all classes of voting stock and 80% of each class of nonvoting stock. Minority shareholders can be bought out with cash used by the target corporation to redeem its stock without destroying the tax-free nature of the transaction.

Triangular Type B Reorganizations. This reorganization form is similar to the other triangular reorganizations. The stock of the acquiring corporation’s parent is exchanged for a controlling stock interest in the target corporation.

Tax Consequences of a Type B Reorganization. A list of tax consequences is provided on p. C:7-31. Example C:7-24 illustrates these consequences. The “Stop and Think” on p. C:7-31 illustrates problems that can arise in the basis of stock as a result of a Type B transaction.

Advantages of a Type B Reorganization. A Type B reorganization usually can be accomplished simply without formal shareholder approval. A tender offer can be made directly to the target corporation’s shareholders even if management does not approve the transaction. The target corporation’s tax attributes are not lost or reduced as in some reorganizations. The corporate name, goodwill, licenses, and rights of the target company can continue on after the acquisition. The acquiring corporation does not directly acquire the target corporation’s liabilities as is the case with some of the other acquisitive reorganizations.

Disadvantages of a Type B Reorganization. The consideration used to effect the transaction is limited to voting stock. At least 80% of the target’s stock must be acquired to effect control. The acquisition of less than 100% of the stock may lead to a vocal minority group. The basis of the target

corporation’s assets is not stepped-up to their FMV when the ownership change occurs. E.

Type G Acquisitive Reorganization. A Type G reorganization takes place according to a court-approved plan in bankruptcy, receivership, or other similar situation. In an acquisitive Type G reorganization, the financially troubled company might transfer substantially all of its assets to an acquiring corporation according to a court-approved plan and then distribute all the stock, securities, and other property received in the exchange, plus any property retained, to its shareholders, security holders, and other creditors in exchange for their stock and debt interests.

Divisive Reorganizations. A divisive reorganization involves the transfer of part of a transferor corporation’s assets to a controlled corporation in exchange for its stock and securities (and possibly some boot). The stock and securities are then distributed to the transferor’s shareholder(s). Divisive reorganizations are usually Type D reorganizations, but may be Type G reorganizations if accomplished in connection with a bankruptcy or other restructuring. A.

Type D Divisive Reorganization. A Type D reorganization must take place as part of a plan of reorganization and satisfy the requirements of Secs. 368(a)(1)(D) and 355. There are three forms of Type D reorganization: spin-offs, split-offs, and split-ups. Figure C:7-7, p. C:7-35, may be used to illustrate a divisive Type D reorganization. 1.

Asset Transfer. The transferor corporation recognizes no gain or loss on the asset transfer, except when boot is received and retained. Gain or loss may be recognized under Sec. 357(c) by the transferor when liabilities in excess of the basis of the property transferred are assumed by the transferee. No gain or loss is recognized by the controlled corporation when it exchanges its stock for the transferor corporation’s property. The transferor corporation’s basis and holding period for the property carry over to the controlled corporation.

Distribution of Stock and Securities. No gain or loss is recognized by the transferor corporation when it distributes the controlled corporation’s stock or securities to its shareholders. Gain may be recognized if boot property is distributed to the shareholder. The shareholders recognize no gain or loss on receipt of the stock or securities, except to the extent they receive boot. The basis of the stock or securities received equals the basis of the stock or securities surrendered, increased by any gain recognized and reduced by money and the FMV of any other boot property received. The holding period includes the holding period of the stock or securities surrendered. Example C:7-25 illustrates the tax effects of this type of reorganization.

VI.

The Sec. 355 Requirements. The Sec. 355 requirements must be met in order for the distribution of a subsidiary’s stock as part of a Type D reorganization or as an independent event to be tax-free. The six requirements of Sec. 355 are listed beginning on pp. C:7-37 and C:738.

Type G Divisive Reorganization. The divisive Type G reorganization involves the transfer of part of the assets of a corporation to a second corporation according to a court-approved plan. The transferee’s securities are distributed by the transferor corporation to its shareholders, security holders, and creditors. The transferor corporation may continue in business or be liquidated by the bankruptcy court.

Other Reorganization Transfers. A.

Type E Reorganization. A Type E reorganization is a recapitalization, which is the restructuring of the corporate financial structure within an existing corporate entity. There needs to be a bona fide business purpose. Three types of adjustments qualify for tax-free treatment. They are: 1.

Stock-for-Stock Exchange. An exchange of common stock for common stock or preferred stock for preferred stock can qualify as a recapitalization. (See Example C:7-27.) Substantial income tax and estate and gift tax planning opportunities exist when recapitalizing a closely-held corporation. In order to prevent abuses in this area, Code Secs. 2701-2704 were added to the Internal Revenue Code by the Revenue Reconciliation Act of 1990. These rules provide procedures for more accurately valuing the stock for transfer tax purposes.

Bond-for-Stock Exchange. A bond-for-stock exchange is tax-free, except to the extent that a portion of the stock is received in satisfaction of the corporation’s liability for accrued interest on the bonds.

Bond-for-Bond Exchange. These exchanges are tax-free only to the extent the principal amount of the debt received does not exceed the principal amount of the debt surrendered. The FMV of any excess amount that is received is taxed as boot.

Type F Reorganization. A Type F reorganization is a mere change in identity, form, or place of organization of one corporation. This reorganization is traditionally used to change the state of incorporation. Example C:7-29 illustrates this type of reorganization.

VII.

Judicial Restrictions on the Use of Corporate Reorganizations. To be nontaxable, the transaction must comply with four judicial doctrines in addition to the IRC provisions. Some of these doctrines have been incorporated into treasury regulations. The four additional primary restrictions are discussed below. A.

Continuity of Interest. In order for a transaction to be tax-free, it must be a change in an investment from one form to another rather than a liquidation of an investment. The business enterprise must continue under a modified corporate form and the owners must continue to have an interest in the entity. This interest must be a common or preferred stock interest. (See Example C:7-30.)

Continuity of Business Enterprise. The acquiring corporation must continue to operate the historic business of the acquired corporation, or to use a significant portion of the acquired corporation’s historic assets in a new business. The test is based on facts and circumstances of the particular situation. The continuity of interest doctrine, however, does not require that the target corporation’s historic business be continued. (See Examples C:7-31 and C:7-32.)

Business Purpose Requirement. A transaction must serve a bona fide business purpose to qualify as a reorganization. (See Example C:7-33.)

Step Transaction Doctrine. The step transaction doctrine may be used by the IRS to collapse a multi-step reorganization into a single taxable transaction. Alternatively, a series of independent taxable events may be collapsed into a tax-free reorganization. (See Example C:7-34.)

VIII. Tax Attributes. A.

Assumption of Tax Attributes. In Type A, C, acquisitive D, F, and acquisitive G reorganizations, the acquiring corporation obtains both the tax attributes and the assets. The tax attributes do not change hands in Type B and E reorganizations. The only attribute to change hands in a divisive Type D or G reorganization is an allocation of E&P between the corporations (Reg. Sec. 1.312-10). An acquired corporation’s NOL carryover is determined as of the transaction’s acquisition date and carried over to tax years ending after that date. NOLs arising in tax years beginning after 2017 and before 2020 can carry back five years unless the corporation elects out of the carryback. Post-2020 NOLs can be carried over to future tax years, indefinitely.

Limitation on Use of Tax Attributes. Sections 382 and 269 prevent the purchasing of the assets or stock of a corporation having loss carryovers primarily to acquire the tax attributes.

IX.

Section 382. Section 382 restricts the use of NOLs in purchase transactions and tax-free reorganizations when a substantial change in the stock ownership of the loss corporation occurs.

Section 383. Section 383 restricts the use of tax credit and capital loss carryovers when a stock ownership change occurs that comes under the purview of Sec. 382. The same restrictions that apply to NOLs are applied to the general business credit, the minimum tax credit, and the foreign tax credit.

Section 269. Section 269 applies to transactions where control of a corporation is secured and the principal purpose of the acquisition is “the evasion or avoidance of federal income tax by securing the benefit of a deduction...” This provision can be used to disallow a loss or credit carryover when Sec. 382 does not apply.

Tax Planning Considerations. A.

Why Use a Reorganization Instead of a Taxable Transaction. The choice between a taxable and tax-free transaction can be a difficult one. Depending upon their relative importance, they will impact on the negotiations leading up to the reorganization. 1.

Acquiring Corporation’s Shareholders. A tax-free reorganization generally allows more capital to be retained after any taxes owed due to the receipt of boot are paid. A taxable transaction allows the shareholders of the target corporation to receive liquid assets that can be invested in other investments. Losses can not be recognized in a tax-free reorganization, while they can be recognized in a taxable one. Gains recognized in a tax-free reorganization may be taxable as a dividend (an advantage to a corporation but a disadvantage to an individual shareholder).

Transferor Corporation. In a tax-free reorganization, assets are exchanged with no gain being recognized. The recapture burden is shifted to the acquiring corporation.

Purchaser. A tax-free reorganization permits an acquisition to take place without substantial cash or securities being used. Tax-free reorganizations allow the use of the target corporation’s tax attributes by the acquiring corporation.

Avoiding the Reorganization Provisions. The reorganization provisions can be avoided by using a type of consideration that is disallowed (e.g., cash as part of a stock-for-stock transaction). (See Example C:7-40.)

XI.

Compliance and Procedural Considerations. A.

Section 338 Deemed Liquidations. The statement of election under Sec. 338 is made by the acquiring corporation on Form 8023 (Election under Sec. 338(g)). This election is made by the fifteenth day of the ninth month beginning after the month in which the acquisition date occurs.

Plan of Reorganization. A plan of reorganization is necessary in order to qualify for nonrecognition of gain. The plan or reorganization is a plan for restructuring an enterprise that complies with the reorganization provisions of the Internal Revenue Code and associated Treasury Regulations. A written plan is not necessary, but it is safest to reduce any agreement to writing either as a communication to shareholders, as part of the corporate records, or as part of a written agreement between the parties.

Ruling Requests. Ruling before undertaking any transaction. Advance rulings are only issued to transactions that meet the requirements of various revenue rulings. To obtain a ruling, the taxpayer makes a written request covering all of the facts in the transaction. If the taxpayer does not like the result of the ruling request, he can abort the transaction, restructure it, or go ahead with it. If a negative ruling is received, the taxpayer should be prepared to have the transaction challenged if the plan is carried out.

Financial Statement Implications. A.

Financial Statement Implications. Under ASC 805, an acquiring corporation must use the purchase method for financial statement purposes whether the business combination is a taxable purchase or a nontaxable reorganization. Differences may occur in the recording of deferred tax accounts and the treatment of goodwill.Also,a stock acquisition has its own particularities because recording the transaction occurs in the process of consolidating the financial statements of the acquiring parent and the acquired subsidiary. An example is provided at this point that is used throughout the discussion.

Taxable Asset Acquisition. In a taxable purchase, the acquiring corporation’s tax basis in the purchased assets likely will be the same as the recorded book basis. If so, deferred tax liabilities and assets will not arise as a result of the business combination. Also, if tax goodwill and book goodwill are equal, future amortization of tax goodwill under Sec. 197 will create temporary differences because book goodwill can be expensed under ASC 350 only if impaired. An example of a taxable asset acquisition is provided.

Nontaxable Asset Acquisition. In a nontaxable business combination, such as a Type A or Type C reorganization, the bases recorded for financial statement purposes differ from the carryover tax bases of acquired assets. The acquiring corporation must recognize a deferred tax asset or liability for differences between C:IO7-17 Copyright © 2024 Pearson Education, Inc.

the assigned financial statement values and the tax bases of the transferred assets and liabilities. Goodwill, which can not be amortized for financial reporting purposes, does not give rise to a temporary difference. An example is provided at this point to illustrate the accounting treatment. D.

Stock Acquisition. In a stock acquisition, the target corporation remains intact as a subsidiary of the acquiring corporation. The adjustments necessary to implement ASC 805 purchase accounting rules and ASC 740 income tax rules occur when the corporations prepare their consolidated financial statements. An example is provided.

Pricing the Acquisition. A discussion is provided illustrating why an acquisition might be priced at an amount different than the FMV value of the underlying assets to take into account the built-in tax liability.

Net Operating Losses. If the target corporation has net operation loss carryovers (NOLs), the acquiring corporation must establish a deferred tax asset along with a valuation allowance if necessary.

Court Case Briefs J. Robert Fisher, 62 T.C. 73 (1974). Taxpayer was the sole shareholder of Fisher Chemical Co., Inc. A plan of reorganization was executed between this corporation and Ashland Oil, Inc., whereby Fisher was to receive 168,800 shares of Ashland voting cumulative preferred stock in exchange for all of the outstanding stock of Fisher Chemical. This was to result in a tax-free Type B reorganization. To protect the tax-free status of the reorganization, an additional agreement was executed whereby the first quarterly dividend payable on the stock would be waived by taxpayer in exchange for 1,614 additional shares of Ashland. This was done because the sale date was delayed so that the shares and the dividend would be payable concurrently to the taxpayer. Taxpayer then treated the 1,614 shares as part of the reorganization proceeds rather than as a separate dividend. The IRS contested this treatment and the Court upheld that the reorganization and the agreement to forego the cash dividend were separate transactions. The Type B reorganization was valid, but the additional 1,614 shares were to be treated as a taxable dividend. American Potash & Chemical Corp. v. U.S., 399 F.2d 194 (Ct. Cl., 1968) recon. on another issue 402 F.2d 1000 (Cl. Ct., 1968). Taxpayer Corporation obtained all of the stock of Western Electrochemical Company (Wecco) as the result of two separate offers to purchase that were 14 months apart. Wecco was then liquidated and the assets transferred to American Potash. American Potash depreciated the Wecco assets using a cost basis. The IRS contended that since the ultimate goal was to obtain the Wecco assets, the stock acquisitions were part of a Type C reorganization. The IRS reasoning was based on the presumption that the acquisition did not qualify as a Type B reorganization because the “12-month rule” had been violated. It therefore concluded that the subsequent liquidation transformed the acquisition into a Type C reorganization. A Type C reorganization requires that the acquiring corporation use a carryover basis to depreciate the acquired assets. The court ruled that the liquidation could not be attached to the non-qualifying Type B reorganization so as to transform it into a valid Type C reorganization. Therefore, the higher depreciation deductions, using the cost basis of the acquired assets, were allowable.

Chapter C:8 Consolidated Tax Returns Learning Objectives After studying this chapter, the student should be able to: 1.

Determine whether a group of corporations is an affiliated group.

Describe how an affiliated group makes a consolidated return election and how it discontinues the election.

Calculate consolidated taxable income for a consolidated group.

Apply the rules for reporting intercompany transactions.

Compute on a consolidated basis deductions and credits subject to limitations.

Determine a consolidated group’s NOL, calculate the carryback or carryover of a consolidated NOL, and apply the SRLY restrictions on NOL usage.

Adjust the parent’s basis in stock of a consolidated subsidiary.

Compare the advantages and disadvantages of filing a consolidated tax return.

Comply with the procedures for making a consolidated return election.

10.

Explain the financial statement implications of various consolidated transactions.

Areas of Greater Significance The instructor should emphasize the definition of an affiliated group, the reporting of intercompany transactions and dividends by the group members, and the calculation of taxable income on a consolidated basis.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Special loss limitations (SRLY and Sec. 382 loss limitations).

Tax planning considerations (advantages and disadvantages of filing a consolidated tax return).

Compliance and procedural considerations (the basic election, parent corporation as agent for the affiliated group, and liability for taxes).

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Inclusion in consolidated taxable income of income, gains, deductions, and losses related to intercompany transactions.

Special loss limitations (SRLY and Sec. 382 loss limitations).

Carryback and carryforward of consolidated NOLs.

Highlights of Recent Tax Law Changes Qualifying for the dividends-received deduction are dividends from a corporation that would be a member of the distributee’s consolidated group but is excluded because it is a life insurance company. The Tax Cuts and Jobs Act also has changed many of the carryback and carryforward rules.

Teaching Tips 1. The sample consolidated tax return contained in Appendix B can be a helpful teaching device. The Form 1120 corporate tax return includes a completed worksheet that can be used to illustrate the conversion of separate taxable income into consolidated taxable income. The worksheet illustrates two different intercompany transactions, the exclusion of dividends, and the netting of gains and losses.

Lecture Outline I.

Definition of an Affiliated Group. A.

Requirements. 1.

Stock Ownership Requirement. Only an affiliated group of corporations can elect to file a consolidated return. The stock ownership requirements that must be satisfied are: (1) a parent corporation must directly own stock having at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the total value of all outstanding stock in at least one includible corporation; (2) for each other corporation C:IO8-2 Copyright © 2024 Pearson Education, Inc.

eligible to be included in the affiliated group, stock having at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the total value of all outstanding stock must be owned directly by the parent corporation and the other group members. (See Examples C:81, C:8-2, C:8-3, and C:8-4.) The definition of stock excludes most nonvoting preferred stock. Special rules are provided regarding the treatment of warrants, convertible obligations, and options as stock, inadvertent failure of the 80% of value test, and transfers of stock within the affiliated group to bring about deconsolidation. 2.

Comparison with Controlled Group Definition. There are three types of controlled groups: brother-sister groups, parent-subsidiary groups, and combined groups. (See Chapter C:3.) Brother-sister groups cannot file a consolidated tax return. Parent-subsidiary groups and the parent-subsidiary portion of combined controlled group can elect to file a consolidated tax return. For example, when computing the accumulated earnings tax, a controlled group’s members generally are limited to one $250,000 accumulated earnings credit. 1.

II.

Includible Corporation Requirement. As few as two corporations may satisfy the definition of an affiliated group. In the United States, some affiliated groups are composed of hundreds of corporations. Not all subsidiaries are able to participate in the consolidated tax return because they are not includible corporations. A list of corporations that are not includible is found on p. C:8-3. If both the stock ownership and includible corporation requirements are satisfied, the subsidiary corporation must be included in the consolidated return election made by the parent. (See Example C:8-5.)

Difference Between Definitions. Only affiliated groups can elect to file consolidated tax returns. Four differences between the definitions of Sec. 1504 and Sec. 1563 (parent-subsidiary controlled group) do exist. These differences cause some members of a controlled group to be excluded from the affiliated group. The differences are listed on p. C:8-4.

Consolidated Tax Return Election. A.

Consolidated Return Regulations. Code Secs. 1501 through 1504 are the primary statutory provisions governing the filing of consolidated tax returns. The statute is very general and primarily defines the composition of affiliated groups that are eligible to file a consolidated tax return. Regulations provide much of the guidance needed to file consolidated tax returns.

Termination of the Affiliated Group. An affiliated group “remains in existence for a tax year if the common parent remains as the common parent and at least C:IO8-3 Copyright © 2024 Pearson Education, Inc.

one subsidiary that was affiliated with it at the end of the prior year remains affiliated with it at the beginning of the year.” The parent corporation need not own the same subsidiary throughout the entire tax year nor own any subsidiary throughout the tax year. (See Examples C:8-6 and C:8-7.)

III.

Good Cause Request to Discontinue Status. The IRS sometimes grants permission to discontinue filing a consolidated tax return. For example, this permission may be granted in response to a taxpayer’s “good cause” request. In new intercompany transaction regulations issued in the mid1990s, the IRS gave blanket permission to all affiliated groups to discontinue their consolidated tax return election.

Effects on Former Members. The termination of an affiliated group affects its former members in several ways. Some of these ways are listed on p. C:8-6. In addition, disaffiliation of a corporation from an affiliated group prevents the corporation from being included in a consolidated return with the same affiliated group, or any other affiliated group having the same common parent, until five years after the end of the tax year in which it ceased to be a member of the group.

Consolidated Taxable Income. The five steps to use in calculating consolidated taxable income are found on p. C:8-9. An overview of these steps is found in Table C:8-1. Table C:8-1 may be used at this point as you cover the steps necessary to calculate consolidated taxable income. The tax due is calculated using the tax rates found in Sec. 11. The corporate alternative minimum tax, or one of the other special tax levies, may increase this amount. A sample consolidated tax return worksheet is included in Appendix B that illustrates the consolidated taxable income calculation. A.

Affiliated Group Elections. 1.

Tax Years. An affiliated group must file its consolidated tax return using the parent corporation’s tax year. Beginning with the initial consolidated return year, each subsidiary must adopt the parent corporation’s tax year.

Methods of Accounting. Each consolidated group member uses the same accounting method that it would have used if it were filing a separate tax return. The possibility of finding a mixture of cash and accrual method corporations in a consolidated group is restricted because of the Sec. 448 restrictions on the use of the cash method of accounting by a C corporation. C:IO8-4 Copyright © 2024 Pearson Education, Inc.

Income Included in the Consolidated Tax Return. A consolidated tax return includes the parent corporation’s income for its entire tax year, except for any portion of the year that it was a member of another affiliated group that filed a consolidated tax return. A subsidiary corporation’s income is included in the consolidated tax return only for the portion of the affiliated group’s tax year for which it was a group member. When a member of the affiliated group is a member for only part of the year, the member’s income for the remainder of the year is included in a separate tax return or the consolidated tax return of another affiliated group. The short period return is a full tax year for purposes of NOL and other carryovers. (See Example C:8-8.) A corporation that becomes or ceases to be a group member during a consolidated return year changes its status at the end of the day on which such change occurs (i.e., the change date). Its tax year ends for federal income tax purposes at the end of the change date. Transactions that occur on the change date that are allocable to the portion of the day after the event resulting in the change (e.g., a stock sale or merger) are accounted for by the group member (and all related parties) as having occurred on the next day. Tax returns for the years that end and begin with a corporation becoming, or ceasing to be, a member of a consolidated group are separate return years. The returns are, in general, short period returns (i.e., for applying the MACRS rules), but do not require annualization of the tax liability or estimated tax calculations when a corporation joins a consolidated group. Allocation of income between the consolidated tax return and a member’s separate return year takes place according to the accounting methods employed by the individual corporation. If this allocation cannot be readily determined, the allocation of items included in each tax return (other than ones considered to be extraordinary) can be based upon the relative number of days of the original tax year included in each tax year.

IV.

Intercompany Transactions. An intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction. The Regulations specify two general rules for including the income, gains, deductions, or losses related to intercompany transactions: the matching rule and the acceleration rule. The intent of these rules is to determine consolidated taxable income on a single entity basis. The Regulations denote the two corporations involved in the intercompany transaction as S (the corporation selling goods or services) and B (the corporation buying goods or services). A.

Terminology. There are three important terms related to the matching and acceleration rules.

Intercompany item. S’s income, gain, deduction, and loss from an intercompany transaction.

Corresponding item. B’s income, gain, deduction, and loss from an intercompany transaction or from property acquired in an intercompany transaction. Recomputed corresponding item. The corresponding item B would have if S and B were divisions of a single corporation and the transaction were between those divisions.

Matching rule. S’s intercompany item is included in consolidated taxable income such that, when it is combined (i.e., matched) with B’s corresponding item, the result is the same as the recomputed corresponding item (i.e., the same result as if the consolidated group were a single corporation). The amount of S’s intercompany item that is included in consolidated taxable income can be calculated as follows: Amount of recomputed corresponding item - Amount of B’s corresponding item = Amount of S’s intercompany item taken into account for consolidated taxable income.

Acceleration rule. If it becomes impossible to match B’s corresponding item to S’s intercompany item (e.g., S or B departs the consolidated group before B’s corresponding item occurs), the acceleration rule requires that S’s intercompany item be included in consolidated taxable income immediately before the time it first becomes impossible to apply the matching rule.

The matching and acceleration rules are more conceptual, rather than mechanical, in nature. They require someone applying them to think about the reporting of the transaction by the two corporations involved on a separate entity basis (i.e., how S and B would each report the transaction if their affiliation with each other were ignored) and about the reporting of the transaction on a single entity basis (i.e., how a single corporation with S and B as two divisions would report the transaction). Students may find it easier to understand the matching and acceleration rules by applying them to specific sets of facts and circumstances. The application of the two rules to several situations is illustrated on pp. C:8-12 through C:8-17. Intercompany sale of stock. Application of the matching rule often results in S’s gain or loss on the sale of stock to B to be included in consolidated taxable income when B sells the stock to a third party. However, if B’s sale to a third party is an installment sale, the inclusion of S’s gain or loss in consolidated taxable income could be spread over several years.

Performance of services. If B expenses the services obtained from S, S’s income will be included in consolidated taxable income under the matching rule at the same time as B’s expenses are included. The two items offset in consolidated taxable income. If B capitalizes the amounts paid to obtain services from S, S’s income will be included in consolidated taxable income under the matching rule as B reports deductions for the capitalized costs (e.g., depreciation, amortization) or reports a gain or loss on its disposition. Intercompany sale of inventory. Many consolidated groups have sales of inventory within the group. The matching rule applies in this situation and allows the consolidated group to defer taxation of profit from the intercompany transaction until B sells the inventory to a third party. (See Examples C:8-25 and C:8-26.) V.

Items Computed on a Consolidated Basis. A consolidated group calculates deductions and credits that are subject to limitations on a consolidated basis rather than separately for each corporation in the group. The calculations are very similar to those for unaffiliated corporations except that consolidated tax return amounts are used. Calculating a deduction or credit on a consolidated basis rather than a separate basis could lead to a larger or smaller amount of deduction or credit. A.

Charitable contributions. In 2020 and 2021 this was allowed at 25%-ofadjusted-taxable-income limitation based on consolidated adjusted taxable income as a result of COVID legislation. In 2022 the limit has reverted back to 10% of consolidated adjusted taxable income.

Net Section 1231 gain or loss. All of the group members’ Section 1231 gains and losses are netted rather than netting the gains and losses for each member separately.

Capital gains and losses. All of the group members’ capital gains and losses are netted rather than netting the gains and losses for each member separately.

Dividend-received deduction. The limitation on the dividends-received deduction is calculated on a consolidated basis for dividends received from corporations outside of the consolidated group. Dividends received by one consolidated group member from another group member are eliminated in calculating consolidated taxable income, so no dividends-received deduction is allowed for them.

Regular tax liability. The consolidated group applies the Sec. 11 corporate tax rates to determine its consolidated tax liability. The credit the group can claim in the current year is limited to the excess of (1) the group’s consolidated net tax over (2) 25% of its consolidated net tax exceeding $25,000, and must be C:IO8-7 Copyright © 2024 Pearson Education, Inc.

apportioned if the company is in a parent-subsidiary controlled group. The net tax is the regular tax reduced by certain credits, e.g., foreign tax credit.

VI.

Tax credits. The limitations on the general business credit and foreign tax credit are determined on a consolidated basis.

Estimated tax payments. A consolidated group generally determines its estimated tax payments on a consolidated basis. However, in the first two years of its consolidated status, it may elect to make estimated tax payments on a consolidated basis or a separate basis.

Net Operating Losses (NOL). If a net operating loss (NOL) arose in 2017 or an earlier year (pre-2018 year), the corporation carried it back two years and over twenty years. NOLs arising in 2018, 2019, and 2020 carried back five years and over indefinitely. A taxpayer, however, could elect out of the carryback period for NOLs that arose before 2021. NOLs arising in 2021 or a later year (post-2020 year) carry over indefinitely but do not carry back. The limitation on the NOL deduction in carryback and carryover years depends on the year the NOL arose and the year to which it is carried. For taxable years beginning before January 1, 2021, the NOL deduction is limited to taxable income before the NOL deduction. For taxable years beginning after December 31, 2020, the NOL deduction is determined as follows: 1.

Deduct pre-2018 NOL carryovers (but not more than taxable income before the NOL deduction).

Deduct NOL carryovers that arose in 2018 or a later year (post-2017 year) limited to the lesser of (1) the post-2017 NOL carryovers or (2) 80% of the excess of taxable income before the NOL deduction over the NOL deduction attributable to pre-2018 NOL carryovers.

One advantage of filing a consolidated tax return is the ability of the consolidated group to offset one member’s NOLs against the taxable income of other group members. The NOL rules that apply for consolidated tax returns are based on the NOL rules that apply for unaffiliated corporations, but the consolidated NOL rules are more complex because a consolidated group is comprised of multiple corporations. A.

Current Year NOLs. Each member’s separate taxable income is combined to determine combined taxable income before any adjustment is made for NOL carryovers. (See Table C:8-1.) Only the consolidated NOL (if any) carries over.

Carrybacks and Carryforwards of Consolidated NOLs. When members of the consolidated group are not the same in the carryback or carryforward period, an apportionment must be made. The consolidated NOL is apportioned to each C:IO8-8 Copyright © 2024 Pearson Education, Inc.

corporation that was both a member of the consolidated group and incurred a separate NOL during the loss year. C.

Carryback of Consolidated NOL to Separate Return Year. A consolidated NOL may be carried back and absorbed against a member’s taxable income from a preceding separate return year. To effect this, part or all of the consolidated NOL must be apportioned to the member. A special carryback rule applies to new members that are “offspring” of other corporations that were members of the affiliated group in a carryback year. (See Examples C:8-40 and C:8-41.)

Carryforward of Consolidated NOL to Separate Return Year. If a corporation ceases to be a member of the consolidated group during the current year, the portion of the consolidated NOL that is allocable to the departing member becomes the member’s separate carryforward. This calculation is made after the available carryover is absorbed to the extent permitted in the current consolidated return year. (See Example C:8-41.) If the NOL occurs after 2017, it carries over indefinitely.

Special Loss Limitations. Two loss limitations, the separate return limitation year (SRLY), and the Sec. 382 loss limitation rules are imposed on affiliated groups. 1.

Separate Return Limitation Year Rules. A member incurring an NOL in a separate return year, that is available to be used in a consolidated return year, is subject to a limit on the use of the NOL when the loss year is designated a separate return limitation year (SRLY). Page C:8-27 in the textbook provides the calculation for a SRLY limitation.

Section 382 Loss Limitations. Section 382 prevents the purchasing of the assets or stock of a corporation having loss carryovers (known as the loss corporation) primarily to acquire the corporation’s tax attributes. The consolidated Sec. 382 rules generally provide that the ownership change and Sec. 382 limitation are determined with respect to the entire consolidated group, or a subgroup that is acquired and that has an NOL carryover, and not for the separate corporations. Following an ownership change for a loss group, the consolidated taxable income for a post-change taxable year that may be offset by a pre-change NOL cannot exceed the consolidated Sec. 382 limitation.

VII.

Stock Basis Adjustments. A.

General Basis Rules. The basis for an investment in a subsidiary corporation is adjusted annually for the subsidiary’s profits and losses as well as for its distributions to higher-tier subsidiaries, or to its parent corporation. These rules parallel those used in the equity method of accounting, but use tax numbers instead of book income numbers. The making of the stock basis adjustment reduces the gain (increases the loss) recognized when the stock investment in the subsidiary corporation is sold.

Basis Adjustments. 1.

The starting point for the basis calculation is the original basis for the stock investment (e.g., cost basis, carryover basis for Sec. 351 transaction, etc.).

The initial basis amount is then increased or decreased for the basis adjustments. Some common basis adjustments are listed on p. C:8-31.

VIII. Tax Planning Considerations.

IX.

Advantages of Filing a Consolidated Return. Filing a consolidated return offers a number of advantages and disadvantages. Some of the more important advantages are found on p. C:8-32.

Disadvantages of Filing a Consolidated Return. Some of the more important disadvantages of filing a consolidated corporate return are found on p. C:8-33.

Compliance and Procedural Considerations. A.

The Basic Election. An affiliated group makes an election to file tax returns on a consolidated basis by filing a tax return that includes the income, expenses, etc., of all of its members. See Appendix B. The election must be made no later than the due date of the parent’s return including extensions. See p. C:8-34 for due date and filing deadlines. Each corporation that is a member of the affiliated group must consent to the election. The parent consents by filing the consolidated return. Other members of the group consent by filing a Form 1122 (Authorization and Consent of Subsidiary to Be Included in a Consolidated Income Tax Return). Each consolidated tax return must include an Affiliations Schedule (Form 851). This form includes the name, address, and identification number of the corporations included in the affiliated group, the corporation’s tax prepayments, the stock holdings at the beginning of the tax year, and all stock ownership changes occurring during the tax year.

The due date for the consolidated tax return is the 15th day of the third month after the end of the affiliated group’s tax year. A six-month extension is permitted if the parent corporation files Form 7004 (Application for Automatic Extension of Time to File Corporation Income Tax Return) and pays the estimated tax liability for the group.

Parent Corporation as Agent for the Affiliated Group. The parent corporation acts as agent for each subsidiary corporation and for the affiliated group. No subsidiary corporation can act in its own behalf, except in cases where the parent corporation is prohibited from acting.

Liability for Taxes Due. The parent corporation and every other member of the affiliated group are severally liable for the consolidated taxes.

Financial Statement Implications. A.

Intercompany Transactions. Intercompany transactions can raise deferred tax issues depending on the type of transaction and whether the affiliated group files consolidated tax returns or separate tax returns. The discussion assumes a 100%owned subsidiary and addresses just two types of intercompany transactions: (1) distributed and undistributed subsidiary profits and (2) intercompany sales of property. For a parent with a 100%-owned subsidiary, intercompany dividends and undistributed subsidiary earnings cause no temporary differences. If the group files a consolidated tax return, the intercompany dividend is eliminated for both tax and consolidated financial statement purposes. If the group files separate returns, the parent takes a 100% dividends-received deduction because it owns at least 80% of the subsidiary’s stock. Undistributed subsidiary earnings are included in consolidated financial statements, but a parent filing separate tax returns would not include these earnings in its income until the subsidiary distributed them as dividends. If a consolidated return is filed for the group, the group defers income on intercompany sales for both tax and consolidated financial statement purposes. If separate returns are filed, the selling member recognizes income for tax purposes but not for consolidated financial statement purposes, thereby creating a temporary difference. Instead, the group recognizes a deferred tax asset on the difference between the seller’s profit deferred in the consolidated financial statements and the taxes paid on the seller’s separate tax return. ASC 810, Consolidated Financial Statements, requires the group to defer recognizing income taxes on intercompany profits on assets remaining within the group, but ASC 740 Income Taxes prohibits recognition of a deferred tax asset for the difference between the tax basis of the assets in the buyer’s jurisdiction and their cost as reported in the consolidated financial statements. Thus, even though the C:IO8-11 Copyright © 2024 Pearson Education, Inc.

buyer’s tax basis may exceed the financial statement basis, the group does not recognize a deferred tax asset. Instead, the group recognizes a prepaid asset. The text provides an example illustrating these rules. It is important to note that Example C:8-51 and prior discussion only applies to the sale of inventory. Recent GAAP changes (ASU 2016-66) do not permit this treatment for intercompany sales of other property. For property transactions, the group recognizes current and deferred income taxes on the sale intercompany profit or loss, even though the group defers recognition of the loss for consolidated financial statement purposes. See Example C:8-52 for an explanation. B.

SRLY Losses. A net operating loss (NOL) from a separate return limitation year (SRLY) will create a deferred tax asset possibly subject to a valuation allowance. An example is provided in the text illustrating this rule. See Example C:8-52.

Court Case Briefs U.S. v. Manor Care, Inc., 490 F.Supp 355 (DC MD, 1980). Manor Care, Inc. owned various subsidiary corporations, including corporations involved in the nursing home business. Certain pre-opening expenses of these subsidiaries were paid for by the parent corporation and were deducted by the subsidiaries in the consolidated income tax return filed for the affiliated group. The activities of the separate corporate entities were operated together as if they were a single business unit. The court ruled that the deductibility of these expenses must be determined on the basis of the facts of each case. This depends on whether the particular subsidiary may deduct the expenses and not on the basis of whether items could be deducted by an affiliated group. Therefore, each company must be treated as a separate tax entity for claiming deductions on a consolidated return. Georgia-Pacific Corp. v. U.S., 648 F.2d 653 (9th Cir., 1981) aff’g. 43 AFTR 2d 79-337 (DC OR, 1978). Georgia Pacific Corp. (GP) was the parent corporation of an affiliated group which included two wholly owned subsidiaries, Rex Timber Corp. and Timber, Inc. The group filed consolidated income tax returns. GP owned timber lands and timber cutting rights. GP entered into a timber contract with Timber whereby Timber could buy and cut timber on GP land. GP also transferred timber and timber cutting rights to Rex as a contribution to capital and then entered into a timber cutting contract to buy and cut timber on the land transferred to Rex. Capital gains treatment for the sales by GP and Rex were claimed on the consolidated return. The IRS contended and the court upheld that because the sales were deferred intercompany transactions the gain must be treated as ordinary income. The buyers had acquired economic interests in the standing timber and were therefore entitled to depletion deductions. Therefore the gain on the sales of the timber was to be treated as ordinary income in accordance with the consolidated return regulations related to such transactions.

Chapter C:9 Partnership Formation and Operation Learning Objectives After studying this chapter, the student should be able to: 1.

Compare and contrast the various partnership forms.

Describe the basic concepts of partnership taxation.

Explain the tax results of a contribution of property or services in exchange for a partnership interest.

Establish the permitted tax year for a partnership.

Distinguish between items included in partnership ordinary income or loss and those that must be separately stated.

Determine a partner’s distributive share of partnership income, gain, loss, deduction, or credit items.

Calculate a partner’s basis in a partnership interest and its effect on losses allowed.

Discuss the at-risk and passive activity loss limitations.

Determine the tax consequences of property sales between a partner and the partnership and of guaranteed payments to a partner.

10.

Recognize the special tax issues associated with family partnerships.

11.

Identify planning techniques to get the best tax advantages from partnership losses.

12.

Comply with the requirements for filing a partnership tax return.

Areas of Greater Significance Emphasis should be placed on the formation of a partnership and the reporting of partnership income.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Tax planning considerations (timing of loss recognition).

Loss limitations.

Family partnerships.

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Special allocations of partnership income.

Effect of liabilities on a partner’s basis.

At-risk rules and passive activity limitations.

Highlights of Recent Tax Law Changes The tax return filing dates have changed. Partnership returns are due on March 15, where CCorporation returns are now due on April 15. Section 199a of the TCJA has also significantly altered how many partners are taxed on income. It is suggested to discuss how the change in corporate tax rates have impacted tax planning for partnerships.

Teaching Tips 1.

Go over Examples C:9-6 and C:9-7 with students to illustrate the effects of liabilities in determining a partner’s basis. p. C:9-7.

Students find it helpful to use T-accounts when working with the determination of a partner’s basis for his/her partnership interest.

Students sometimes find it difficult to comprehend the difference between a partner’s capital account balance and his/her basis in the partnership interest. Particularly troublesome is the handling of partnership liabilities. Side-by-side T-accounts for determining tax basis and the capital account balance for a partner can be helpful in explaining the difference between these two concepts.

Example C:9-15: Present this example in class to illustrate the steps necessary in determining the effects of the contribution of services to the partnership. p. C:9-11.

Have the students review the partnership tax return Form 1065 in Appendix B in their books to illustrate the complexity of Form 1065 preparation. The facts for the completed Form 1065 are presented in Appendix B. These same facts are used with the C and S corporation tax returns that are also included in Appendix B.

Lecture Outline I.

Definition of a Partnership. For tax purposes, the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization, which carries on a business or financial operation or venture. If two people (or business entities) work together to carry on any business or financial operation with the intention of making a profit and sharing that profit as co-owners, a partnership exists for federal income tax purposes. A partner is any individual, trust, estate, or corporation that is a member of a partnership. A.

General and Limited Partnerships. Each state has laws as well as statutes governing the rights and restrictions of partnerships. Many of these statutes are patterned after the Uniform Partnership Act or the Uniform Limited Partnership Act. 1.

General Partnership. A general partnership exists any time two or more partners join together and do not specifically provide that one or more of the partners are a limited partner.

Limited Partnership. In a limited partnership, there are two classes of partners. There must be one general partner who has the same rights and liabilities as a general partner in a general partnership. A limited partner is limited in liability only to the amount invested in the limited partnership plus any additional amount he has committed to contribute. He has no rights to actively manage the partnership.

Limited Liability Limited Partnership (LLLP). The LLLP is a partnership formed under a state’s limited partnership laws but that can elect under the state’s laws to provide the general partners with limited liability. Only about half of the states provide for this type of partnership. It becomes potentially useful in states that do not extend LLC status to personal service firms but allow such firms to operate as an LLLP.

Limited Liability Companies (LLCs). With the advent of LLCs, businesses have the chance to be taxed as a partnership while having limited liability protection for every owner. State law provides the limited liability. Checkthe-box regulations permit each LLC to choose whether to be taxed as a partnership or as a corporation.

a general partnership and an LLP is that a partner is not liable for damages resulting from failures in the work of other partners or of people supervised by other partners. LLPs can be taxed under the check-the-box regulations as a partnership or as a corporation. II.

Overview of Taxation of Partnership Income. A.

Partnership Profits and Losses. A partnership is not a taxpaying entity and income earned by a partnership is not subject to two layers of federal income taxes. Each partner reports his share of the partnership’s income, gain, loss, deduction, and credit items as part of his regular tax return. The partnership files a Form 1065 [U.S. Partnership Return of Income], an information return, which provides the IRS with information about the partnership’s income and its allocation to the partners. It might be helpful to walk the students through the basics of the completed partnership tax return (Form 1065) that is included in Appendix B. The facts for this tax return are included in Appendix B. These are the same facts that were introduced with the Form 1120 in Chapter C:3 and will be covered later with the Form 1120S in Chapter C:11. As you are going through the Form 1065, it might be helpful to make comparisons to the Form 1120 that was reviewed in Chapter C:3. As a result of the TCJA, the partnership may also be a more attractive option due to the qualified income deduction. It is also important to discuss and illustrate how the reduced corporate tax rate can impact entity planning, specifically the role of the Section 199A deduction.

The Partner’s Basis. A partner’s basis in his partnership interest begins with his or her contribution to the partnership. The partner’s basis is increased by the partner’s share of the partnership liabilities. In addition, basis is increased by the partner’s share of income and decreased by the partner’s share of loss. Basis serves to limit the amount of losses deductible by the partner and can never be less than zero. (See Examples C:9-1 through C:9-3.)

Partnership Distributions. Distributions are generally tax-free to partners because they already have paid taxes on the earnings of the partnership. Distributions reduce the partner’s basis in his partnership interest. If the distribution exceeds basis, it generally will be taxed as capital gain. A loss is recognized when the partner receives only cash, inventory, and unrealized receivables in complete liquidation of their partnership interest. (Chapter C:10 presents detailed coverage of current and liquidating distributions.)

III.

Tax Implications of Formation of a Partnership. A.

Contribution of Property. 1.

Nonrecognition of Gain or Loss. Formation of a partnership is governed by Sec. 721. When property is exchanged for a partnership interest, no gain or loss will be recognized by the partner or the partnership. The partnership’s basis in the property is the partner’s basis increased by any gain recognized by the partner.

Recognition of Gain or Loss. Exceptions to the general nonrecognition rule occur when liabilities are contributed in excess of the property’s basis such that the partner would have a negative basis for his partnership interest (including his allocation of general partnership liabilities) immediately after the contribution, or where the partnership would be considered an investment company if incorporated. Gain will also be recognized where there is a contribution of property followed by a distribution in an arrangement that may be considered a sale rather than a contribution. (See Examples C:9-4 and C:9-5.)

Effects of Liabilities. Each partner’s basis is increased by his share of the partnership’s liabilities as if he had contributed cash to the partnership in the amount of his share of the partnership liabilities. A partner whose personal liabilities are assumed by the partnership is treated as though cash had been distributed to him in the amount of the assumed liability. (See Example C:9-6.) You may wish to discuss the Stop and Think material, which illustrates why loss property should not be contributed to a partnership. The rules for nonrecourse liabilities are different from the rules explained here and are discussed later in the chapter.

Partner’s Basis in Partnership Interest. A partner’s beginning basis in his partnership interest equals the sum of money contributed plus a substituted basis from the contributed property. Beginning basis also includes the partner’s share of partnership liabilities at the time of contribution. Gain recognized because of the assumption of a partner’s liability (that is treated as a deemed cash distribution) is not used to increase basis. This is commonly called the outside basis.

Holding Period for Partnership Interest. The holding period for the partnership interest includes the transferor’s holding period for the contributed property if that property is a capital asset or a Sec. 1231 asset in the transferor’s hands. (See Examples C:9-8 and C:9-9.)

Partnership’s Basis in Property. The partnership’s basis in contributed assets is the same as its basis in the hands of the contributing partner increased by any gain recognized under the investment company rules (but C:IO9-5 Copyright © 2024 Pearson Education, Inc.

not the liability assumption rules). Properties that are unrealized receivables, inventory, or capital loss property in the hands of the contributing partner and were contributed to a partnership after March 31, 1984, generally retain their character for subsequent partnership dispositions. This is commonly called inside basis. See Book to Tax Accounting Comparison on p. C:9-8. Unrealized Receivables. An unrealized receivable is any right to payment for goods or services that has not been included in income because of the method of accounting being used. If an unrealized receivable is contributed to a partnership, ordinary income or loss is recognized when a subsequent disposition or collection occurs. Inventory. If property is inventory in the hands of a contributing partner, it remains inventory to the partnership for a five-year period. After five years, the character of the property may be changed if the property is a capital asset or Sec. 1231 asset in the partnership’s hands. (See Example C:9-10.) Capital Loss Property. A loss recognized by a partnership on disposition of contributed capital loss property within five years of its contribution is a capital loss. The amount of loss so characterized is limited to the amount of loss that would have been recognized had the asset been sold on the date of contribution. (See Example C:9-11.)

Partnership’s Holding Period. The partnership’s holding period for its contributed assets includes the holding period of the contributing partner.

Section 1245 and 1250 Recapture Rules. Depreciation is not recaptured on contribution of Sec. 1245 or Sec. 1250 property to a partnership unless gain is recognized. The adjusted basis and recapture potential carry over to the partnership.

Contribution of Property After Formation. Anytime property is contributed in exchange for a partnership interest, the rules outlined above apply. They apply whether the contribution occurs during the formation of the partnership or at a later point in time. Most contributions of property in exchange for a partnership interest are nontaxable even if they occur years after the partnership was formed.

Contribution of Services. A partner who receives a partnership interest in exchange for services has been compensated and recognizes ordinary income. Generally no income is realized on the receipt of a restricted interest in a partnership, until the restriction lapses or the interest can be freely transferred. (See Example C:9-12.) Much of the uncertainty in this area of tax law was resolved when Rev. Proc 93-27 was issued which provides that the IRS generally will not tax a profits interest received for services. Such a profits interest will be taxed upon receipt only in three specified instances in which a FMV is readily ascertainable at the time it is granted. C:IO9-6 Copyright © 2024 Pearson Education, Inc.

The Treasury Department has issued proposed regulations, and the IRS will issue a new revenue procedure that will alter the landscape of taxing partnership interests transferred for services.

Consequences to the Partnership. Payments made by the partnership in the form of a partnership interest are either deductible as an expense or capitalized. The timing of the partnership’s deduction for the expense matches the timing for the partner to include the value of the partnership interest in income. The expense deduction is allocated among the partners other than the service partner. (See Example C:9-13.) If the service performed is of a nature where it should be capitalized, the partnership would amortize it appropriately. (See Example C:9-14.)

Partnership Gain or Loss. When an interest in a partnership is transferred for services rendered, gain or loss will be recognized by the partnership on the difference between the FMV of the property deemed transferred by the partnership and its adjusted basis. (See Example C:9-15.)

Organizational and Syndication Expenditures. The costs of organizing a partnership are treated as capital expenditures. The partnership can deduct the first $5,000 of these expenditures in the tax year it begins business. The first $5,000 of these expenditures must be reduced by the amount by which total organizational expenditures exceed $50,000 although the $5,000 cannot be reduced below zero. Any remaining organizational expenditures are amortized over a period of 180 months beginning the month the partnership commences business. For organizational expenditures paid or incurred after September 8, 2008, a partnership is deemed to have made this election unless they capitalize these expenses on a timely filed return. Once the election is made, it is irrevocable.

At this point you may wish to use Topic Review C:9-1, which summarizes the tax consequences of the formation of a partnership. You also may wish to use the What Would You Do in this Situation? example, which provides an accountant with an ethical problem. IV.

Partnership Elections. A.

Partnership Taxable Year. The selection of a partnership tax year determines the timing of when each partner takes his share of income, expense, gain, loss, deduction, and credit items into his or her return. The partnership must use the same tax year as one or more majority partners (i.e., those partners who have an aggregate interest in partnership profits and capital in excess of 50%). If such a rule does not apply, then the tax year of all of its principal partners (i.e., a partner who owns a 5% or more interest in capital or profits) must be used or the tax year which provides the “least aggregate deferral” is used. An alternative tax year based on an acceptable business purpose (e.g., natural business year) may be used. (See Examples C:9-16 through C:9-18.)

The Revenue Act of 1987 provided an election under Sec. 444 which permits a partnership, that does not either (1) establish a business purpose for its tax year, (2) adopt or change to a tax year that conforms to the taxable year of its principal partners, or (3) did not obtain IRS approval for its tax year, to elect under Sec. 444 to retain either the tax year used in 1986 or a tax year-end which results in a deferral period of the lesser of the current deferral period or three months. At this point you may wish to use Topic Review C:9-2 to review the rules covering the allowable tax year for a partnership. B.

Other Partnership Elections. In general, all elections that can affect the computation of taxable income from the partnership must be made by the partnership. Three elections are specifically reserved for the partners. These are treatment of discharge of indebtedness, deduction, and recapture of certain mining exploration expenditures, and the choice between deducting and crediting foreign income taxes.

Partnership Reporting of Income. A.

Partnership Taxable Income. Partnership taxable income is calculated much the same way as the taxable income of individuals with a few differences. Taxable income is divided into separately stated items and ordinary income or loss. Certain deductions are not allowed to partnerships. These include income taxes paid or accrued to a foreign country or U.S. possession, charitable contributions, oil and gas depletion, and net operating loss (NOL) carrybacks or carryovers.

Separately Stated Items. A list of the items that must be separately stated is found on p. C:9-16. As a general rule, an item must be separately stated if the income tax liability of any partner that would result from treating the item separately is different from the liability that would result if that item is included with partnership ordinary income.

Partnership Ordinary Income. All items that are not separately stated are combined into a single amount called partnership ordinary income or loss. Each individual partner’s share of ordinary income or loss is reported on Schedule E of Form 1040. (See Example C:9-19.)

Special Deductions and Limitations. The Qualified Business Income Deduction (QBI), beginning after 2017, allows for a deduction for a percentage of qualified business income. This deduction has limitations and is based on income earned in a US trade or business. Service-related businesses have income phase-out thresholds to limit this deduction. (See Examples C:9-20 and C:9-21 for the calculation.) It should be noted that QBI income only includes income from a U.S. trade or business and also has service-related professions that are excluded from the deduction subject to threshold amounts.

VI.

Partner Reporting of Income. A.

Partner’s Distributive Share. A partner pays taxes on his distributive share of partnership ordinary income or ordinary loss and the separately stated income, gain, loss, deduction, or credit items. The distributive share is normally determined by the terms of the partnership agreement, or, if the partnership agreement is silent, by the partner’s overall interest in the partnership as determined by taking into account all facts and circumstances. 1.

Partnership Agreement. A partnership agreement may describe a partner’s distributive share by indicating the partner’s profits and loss interest, or it may indicate separate profits and loss interests. If only one interest percentage is stated, it is used to allocate both profit and loss. (See Example C:9-22.)

Varying Interest Rule. If a partner’s ownership interest changes during the partnership tax year, the income or loss allocation takes into account the varying interest. There are two methods for application of this rule: A) the interim closing method and B) an elective proration method. Special rules apply to extraordinary items and cash basis items (See Example C:9-23.)

Special Allocations. 1.

Allocations Related to Contributed Property. When property is contributed to a partnership, it takes a substituted basis that references the contributing partner’s basis. Pre-contribution gains or losses are allocated to the contributing partner for any property contributed to a partnership after March 31, 1984. Income and deductions reported in connection with the contributed property (e.g., depreciation) must be allocated to reflect the difference between FMV and adjusted basis on the date of contribution. (See Examples C:9-24 and C:9-25.)

Substantial Economic Effect. Special allocations relating to other than contributed property must meet certain criteria that are designed to ensure that the allocations affect the partner’s economic consequences and not just the tax consequences. (See Example C:9-26.) An allocation has economic effect if it meets the conditions listed on p. C:9-22. The second requirement for a special allocation to be accepted under Treasury Regulations is that the economic effect be substantial, which requires that there is a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the partners independent of tax consequences. For example, the allocation in Example C:9-26 does not have a substantial effect.

You may at this point want to stop and discuss the Stop and Think example on p. C:9-24, which discusses why a special allocation may be desirable. VII.

Basis for Partnership Interest. A.

Beginning Basis. A partner’s beginning basis for a partnership interest acquired through contributing property or services was discussed above. If a partner purchases his partnership interest from another partner, the basis is the purchase price. If the interest is inherited, the basis of the interest is its FMV on the date of death, or alternate valuation date if elected by the executor. If the partnership interest is received as a gift, the basis is generally the donor’s basis increased by the portion of any gift tax paid by the donor that relates to appreciation in the partnership interest.

Effects of Liabilities. 1.

Increases and Decreases in Liabilities. Two changes in partnership liabilities are treated as contributions of cash by the partners. The first is an increase in the share of partnership liabilities. The second is for a partner to assume partnership liabilities in an individual capacity. Two liability changes are treated as distributions of cash to the partners. The first is a decrease in the share of partnership liabilities. The second is a decrease in the partner’s individual liabilities caused by the partnership’s assumption of a liability of the partner. (See Example C:9-28.)

A Partner’s Share of Liabilities. A recourse loan is the usual kind of loan for which the borrower remains liable until the loan is paid. A nonrecourse loan is one in which the lender may sell the security if the loan is not paid, but the borrower is not liable for any additional amounts. Recourse liabilities are added to a partner’s basis only to the extent that the partner has a risk of economic loss. Most, if not all, recourse liabilities are allocated to the general partners. Nonrecourse debts are allocated to general and limited partners based on their profit ratio. (See Example C:9-29.) If the partnership has more than one general partner, the economic risk of loss computation entails computing a hypothetical loss and allocating that loss to the general partners. The hypothetical loss computation assumes the partnership sells all its assets (including cash) for the amount of nonrecourse liabilities. If the partnership does not have nonrecourse liabilities, the assets are deemed sold for zero dollars. The hypothetical loss then is subtracted from the partners’ capital accounts to determine the economic risk of loss. (See Example C:9-30.)

Effects of Operations. A partner’s basis is a summary of contributions and the partnership’s liabilities, earnings, losses, and distributions. Basis is increased for additional contributions made to the partnership plus the distributive share of a C:IO9-10 Copyright © 2024 Pearson Education, Inc.

partner’s current and prior years’ taxable income (both separately stated items and partnership ordinary income) and tax-exempt income of the partnership. Basis is decreased (but not below zero) by distributions from the partnership and the partner’s distributive share of losses of the partnership (both separately stated items and partnership ordinary loss) and expenditures that are not deductible for tax purposes and that are not capital expenditures. (See Examples C:9-31 and C:9-32). Any distributive share of loss that cannot be deducted because of the basis limit is simply noted in the partner’s financial records. It is not reported on the partner’s tax return, nor does it reduce the partner’s basis. The losses can be carried forward until the partner has positive basis again from capital contributions, additional partnership borrowings, or partnership earnings. (See Examples C:9-33 and C:9-34.) Topic Review C:9-3 summarizes the rules for determining the initial basis for a partnership interest and the annual basis adjustments required to determine the interest’s adjusted basis. VIII. Special Loss Limitations. A.

At-Risk Loss Limitations. Partnership losses that can be taken as deductions are limited to the at-risk basis. The at-risk basis is essentially the same amount as the regular partnership basis with the exception that liabilities increase the at-risk basis only if the partner is at-risk with respect to the amount. Under the at-risk rules, the amount that a partner can deduct may be considerably less than the amount under the regular (Sec. 704(d)) basis limitation rules. (See Example C:9-34.) The at-risk rules do not apply to qualified nonrecourse real estate financing. The partner is at risk for his share of nonrecourse real estate financing if all of the requirements found on p. C:9-29 are met.

Passive Activity Limitations. A further limitation on the amount of loss that can be deducted is the passive activity loss and credit limitations. Under Sec. 469, all income is divided into (1) amounts derived from passive activities; (2) active income such as salary, bonuses, and income from businesses in which the taxpayer materially participates; and (3) portfolio income (e.g., dividends and interest). Generally, losses of a noncorporate partner from a passive activity cannot be used to offset either active income or portfolio income. (See Example C:9-35.) Special rules apply to passive losses of C corporations. Both of the special loss limitations generally act to severely curtail the use of partnership losses at the partner level, much more than do the general partnership basis rules of Sec. 704(d).

Limitation on Excess Business Losses. For tax years beginning after 2020 and before January 2029, the tax law imposes a limitation on excess business losses, applicable to noncorporate taxpayers. The IRC defines an excess business loss as the excess of: C:IO9-11 Copyright © 2024 Pearson Education, Inc.

• •

The aggregate deductions for the year attributable to trades and businesses, over The sum of aggregate gross income or gain attributable to such trades or businesses, plus $289,000 ($578,000 for married taxpayers filing jointly).

The $289,000 ($578,000) will be adjusted for inflation. Any disallowed excess loss carries over as a net operating loss subject to the 80% of taxable income limitation on NOLs in the carryover year. For partnerships and S corporations, the limitation applies at the partner or shareholder level with each partner or shareholder taking into account his or her share of entity level items of income, gain, deduction, or loss. However, the new limitation applies after the application of the Sec. 469 passive activity loss limitation. IX.

Transactions Between a Partner and the Partnership. A.

Sales of Property. No loss can be deducted on the sale or exchange of property between a partnership and a person who directly or indirectly owns more than 50% of the partnership’s capital or profits interests. Losses are also disallowed on sales or exchanges of property between two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital and profits interests. Gain will be ordinary in a sale of property between a partnership and a person who owns a controlling interest. This rule only applies when the property that is sold or exchanged at a profit is not a capital asset in the transferee’s hands. (See Examples C:9-37 through C:9-39.)

Guaranteed Payments. A partner is not an employee of his partnership and most fringe benefits are taxable to the partner. Partners, who perform services for their partnership, are compensated for these services through the use of guaranteed payments. The term guaranteed payments includes more than just salary type of payments. Guaranteed payments can also be made for the use of invested capital that are similar to interest. 1.

Determining the Guaranteed Payment. Sometimes the guaranteed payment is expressed as a specific dollar amount. Other times it is expressed as a guaranteed minimum (that may or may not be in excess of the partner’s distributive share). (See Examples C:9-41 and C:9-42.)

Tax Impact of Guaranteed Payments. Like salary and interest income, guaranteed payments are always ordinary income to the recipient. The guaranteed payment is included in the recipient’s tax year during which the partnership tax year ends and the partnership deducts or capitalizes the payments. (See Example C:9-43.)

For the partnership, the payment is treated as though it were made to an outsider. If the service is of a nature that it must be capitalized, the guaranteed payment must be capitalized. Otherwise the guaranteed payment is deductible from ordinary income. X.

XI.

Family Partnerships. A.

Capital Ownership. Family partnerships allow income from an investment to be spread among family members having low marginal tax rates. The question of whether a family member is a partner is an issue that is frequently litigated. Three tests must be met if a family member is to be considered the owner of a capital interest in a family partnership: (1) the partnership interest must be a capital interest; (2) capital must be a material income-producing factor in the partnership’s business activity; and (3) the family member must be the true owner of the interest.

Donor-Donee Allocations of Income. Partnership income must be properly allocated between a donor and a donee in order to be accepted by the IRS. The donor must be allocated reasonable compensation for services rendered to the partnership. Any remaining income must be allocated based on relative capital interests. (See Example C:9-45.)

Tax Planning Considerations. A.

Timing of Loss Recognition. Loss limitation rules provide a unique opportunity for tax planning. Income can be projected for the current and future tax years to determine when losses can be used to the greatest advantage. The partner can use a loss in the current year if there is sufficient basis in the partnership interest. If basis is not sufficient, an additional contribution of capital can be made by the end of the year, or the partner can convince the partnership to incur additional partnership liabilities in order to obtain the needed basis. If it is desirable to defer the loss until a later year, basis can be kept low so that the distributive share of losses exceeds basis and the loss utilization is deferred to a later tax year. (See Example C:9-43.)

XII.

Compliance and Procedural Considerations. A.

Reporting to the IRS and the Partners. 1.

Forms. By the 15th day after the third month after the end of the partnership tax year, the partnership must file a Form 1065 with the IRS. The IRS allows an automatic six-month extension of time to file the 1065. Appendix B contains a completed Form 1065. A partnership return is an information return and the partnership pays no taxes. Included on Form 1065 are all the items of income, gain, loss, and deduction that are not separately stated by the partners. Schedule K of Form 1065 reports both the summary of ordinary C:IO9-13 Copyright © 2024 Pearson Education, Inc.

income and loss and the separately stated items. Schedule K-1 is prepared for each partner and reflects that partner’s share of ordinary income or loss and separately stated items. At this point, if not previously done, the students should review the completed partnership tax return in Appendix B. 2.

For tax years ending on or after December 31, 2006, a partnership must file Schedule M-3 in lieu of Schedule M-1 if any one of the conditions listed on p. C:9-36 is met.

Sec. 444 Election and Required Payments. The election to use a tax year other than a required year is made by filing an election under Sec. 444 on Form 8716 by the earlier of (1) the 15th day of the fifth month following the month that includes the first day of the tax year for which the election is effective, or (2) the due date of the income tax return resulting from the Sec. 444 election. A partnership making a Sec. 444 election needs to annually make a required payment under Sec. 7519. The required payment has the effect of collecting a deposit from the partnership equal to the tax (at the highest individual tax rate plus one percentage point) on the partnership’s deferred income. The required payment is made when Form 8752 is filed along with a computational worksheet, which is illustrated in the instructions to the Form 1065. Refunds of excess required payments are also obtained by filing the Form 8752.

Estimated Taxes. A partnership pays no income taxes so the partnership makes no estimated tax payments. Partners must make estimated tax payments based on their separate tax positions including their distributive share of partnership income or loss for the current year.

Partner’s self-employment income is reported on Form 1065. A general partner’s self-employment income includes both guaranteed payments of salary, partnership ordinary income and loss, and separately stated items, but generally excludes capital gains and losses, Sec. 1231 gains and losses, interest, dividends, and rentals. This self-employment income is included by the partners with their other self-employment income in determining their self-employment tax liability. The distributive share of partnership income allocable to a limited partner is not self-employment income. (See Examples C:9-48 and C:9-49.) B.

IRS Audit Procedures. For partnership years beginning after 2017, a partner must treat an item in his or her tax return in a manner with the way the item is treated at the partnership level. Any adjustment to items of gain, loss, deduction, or credit of a partnership will be determined, assessed, and collected at the partnership level. Each partnership must designate a partner or other person as the partner representative. This person will have the sole authority to act on behalf of the partnership, and the partnership and partners will be bound by the actions of the designated representative. Partnerships with 100 or fewer partners may elect out of these

procedures if the partnership follows certain procedures and notifies the partners that it made such an election.

Court Case Briefs U.S. v. D. N. Stafford, 727 F.2d 1043 (11th Cir., 1984) rev’g. 552 F.Supp 311 (DC GA, 1982). The taxpayer received a partnership interest in exchange for a letter of intent for the purchase of property. This letter of intent was held to qualify as a contribution of property in exchange for an interest in the partnership. Therefore, the nonrecognition treatment of Sec. 721 was applicable to the receipt of the partnership interest. It was held that the property and exchange requirements of Sec. 721 were satisfied. This decision was based on a finding that the letter of intent encompassed a sufficient bundle of rights and obligations to be deemed property. The exchange requirements were met because the letter was owned by the taxpayer as an individual and because individual members of the transferee partnership did not have to agree to the transfer for an exchange to occur. U.S. v. James A. Basye, 410 U.S. 441 (USSC, 1973). A medical partnership, Permanente, agreed to supply medical services to members of a health foundation, Kaiser. Part of the compensation for these services was paid by Kaiser in the form of contributions to a retirement trust for the benefit of the Permanente physicians. These physicians could not collect benefits from the trust unless certain age and length of service requirements were met or unless there was a substantial reorganization of the partnership. These payments were not included in partnership income in the years paid by Kaiser. The court held that the partnership and therefore the individual partners must include in taxable income the amounts contributed by Kaiser in the years paid and earned in accordance with their proportionate shares of current partnership income. This ruling was based on two principles. First, income is taxable to the party who earns it. Liability for taxes cannot be avoided by an anticipatory assignment of income. Second, partners are taxable on their distributable or proportionate shares of current partnership income whether or not such income is actually distributed to them.

Chapter C:10 Special Partnership Issues Learning Objectives After studying this chapter, the student should be able to: 1.

Determine the gain, loss, and basis consequences of a nonliquidating partnership distribution.

Identify the partnership’s Sec. 751 assets and assess the tax consequences of a nonliquidating distribution when these assets are involved.

Determine the gain, loss, and basis consequences of liquidating or selling a partnership interest.

Recognize other means of terminating a partnership interest and related issues.

Analyze the effect of optional and mandatory basis adjustments.

Compare and contrast the various special forms a partnership might take.

Identify tax planning opportunities in liquidating or selling a partnership interest.

Areas of Greater Significance 1.

The effect of nonliquidating distributions should be emphasized. The student should also be familiar with the provisions governing the termination of a partnership interest.

Students should understand the reason for the rather complex Sec. 751 rules.

Students should be able to use the step-by-step analysis approach to analyze the results of disproportionate nonliquidating and liquidating distributions involving Sec. 751 property.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading and use of online textbook materials, rather than by class discussion: 1.

Publicly traded partnerships, limited liability companies, and limited liability partnerships.

Compliance and procedural considerations (Sec. 754 election).

Electing Large Partnerships.

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Sec. 751 calculations.

Retirement and death of a partner calculations.

Highlights of Recent Tax Law Changes There have been no recent tax law changes to impact the issues within this chapter.

Teaching Tips 1.

Go over Example C:10-9 in class to illustrate the three types of property that can be included in a partnership distribution. p. C:10-6. Consider using “T” accounts to illustrate the effects that the nonliquidating and liquidating property distributions have on the partner’s basis for his/her partnership interest.

Walk through the steps of the Sec. 751 transaction and nonliquidating distributions using Examples C:10-12 through C:10-14 and Table C:10-1. p. C:10-10.

Lecture Outline I.

Nonliquidating Distributions. There are two categories of distributions from a partnership: liquidating distributions and nonliquidating distributions. A liquidating distribution is one distribution or series of distributions that terminates a partner’s entire interest in the partnership. All other distributions, including those which substantially reduce a partner’s interest, are governed by the nonliquidating distribution rules. A.

Recognition of Gain. A current distribution that does not involve Sec. 751 assets results in no recognition of loss. Partners recognize gain only if they receive money in excess of basis. For distribution purposes, money includes cash, deemed cash from reductions in a partner’s share of liabilities and the fair market value of marketable securities. (See Example C:10-1.) Precontribution Gain Recognition While a current distribution causes gain or loss to be recognized only in the conditions listed above, the distribution event may also trigger recognition of previously unrecognized precontribution gain or loss. This recognition of the C:IO10-2 Copyright © 2024 Pearson Education, Inc.

remaining precontribution gain or loss can occur if contributed property is distributed to any partner (other than the contributing partner) within seven years of the contribution date. It also may occur if the contributing partner receives a distribution with a fair market value in excess of his adjusted basis in his partnership interest. In this case, the remaining precontribution gain on any property he contributed to the partnership in the preceding seven years may have to be recognized. The contributing partner must recognize the precontribution gain or loss when a property is contributed after October 3, 1989, and is distributed to any other partner within seven years of the contribution. The gain that is recognized is the amount that would have been allocable to the contributing partner if the property had been sold for its FMV on the distribution date. The partner’s basis in the partnership interest and the partnership’s basis in the property immediately before the distribution are adjusted for any recognized gain or loss. (See Example C:10-2.) Property distributions made to a partner may force the partner to recognize his remaining precontribution gain if the fair market value of distributed property exceeds the partner’s basis in the partnership interest immediately prior to the property distribution. The gain to be recognized under Sec. 737 is the lesser of (1) remaining precontribution net gain or (2) the excess of the fair market value of distributed property over the adjusted basis of the partnership interest immediately before the property distribution (but after reduction for any money distributed at the same time). (See Examples C:10-3 and C:10-4.) If gain is recognized under Sec. 737, the partner’s basis in his partnership interest is increased by the recognized gain. Further, the partnership’s basis in the property which was the source of the precontribution gain is increased by the recognized gain. (See Example C:10-5.) You may wish to have the class discuss the What Would You Do in This Situation? example, which deals with the use of a partnership to exchange property. B.

Basis Effects of Distribution. A partner’s basis in property distributed by the partnership carries over from the partnership. The partner’s basis is reduced by the amount of money received plus the basis claimed for the distributed property. (See Example C:10-6.) The total bases of all distributed property in the partner’s hands are limited to the partner’s predistribution basis in his partnership interest plus gain recognized on the distribution under Sec. 737. The order of allocating partnership basis to the individual properties is important. First, cash and deemed cash distributions reduce the partner’s basis. Next the remaining basis is allocated first to unrealized receivables and inventory, and then any remaining basis to all other property. Where there are several assets distributed in each category, the basis allocated to that category is allocated to the individual assets in proportion to their relative bases in the hands of the partnership and their FMV. First, each asset is given its basis to the partnership, and then the difference between the carryover basis from the partnership and the partner’s basis in C:IO10-3 Copyright © 2024 Pearson Education, Inc.

the partnership interest is calculated. There is a decrease to allocate if the partner’s basis in the partnership interest (after any money distribution) is smaller than the carryover basis from the partnership. (See Examples C:10-7 through C:10-9.) C.

II.

Holding Period and Character of Distributed Property. The partner’s holding period for property distributed in a current distribution includes the partnership’s holding period for the property. Special rules determine the character of gain or loss recognized when a partner subsequently sells or exchanges unrealized receivables or inventory distributed to the partner. If the partnership distributes property that is an unrealized receivable in its hands, the distributee partner recognizes ordinary income or loss on a subsequent sale of that property. If inventory is distributed, a subsequent sale of the inventory by the distributee partner results in ordinary income or loss if the sale occurs within five years of the distribution date. If the sale occurs more than five years after the distribution date, the character of any gain or loss is determined by the character of the property in the partner’s hands.

Nonliquidating Distributions with Sec. 751. A.

Section 751 Assets Defined. Sec. 751 assets include unrealized receivables and inventory. These two categories include all property that is likely to generate ordinary income when sold or collected. 1.

Unrealized Receivables. Unrealized receivables are certain rights to payments to be received by a partnership that have not already been recognized as income. The term also includes most potential ordinary income recapture items (e.g., Sec. 1245 gains).

Inventory. Inventory includes items held for sale in the normal course of business, other property which if sold by the partnership would not be considered a capital asset or Sec. 1231 asset, and any other property which if held by the distributee partner would be one of the two previous types of property. For purposes of calculating the impact of Sec. 751 on distributions (but not sales), inventory is only considered a Sec. 751 asset if the inventory is substantially appreciated. The test to determine whether inventory is substantially appreciated is purely mechanical. Inventory is substantially appreciated if its FMV exceeds 120% of its adjusted basis to the partnership. For purposes of testing whether inventory is substantially appreciated, inventory also includes unrealized receivables.

III.

Exchange of Sec. 751 Assets and Other Property. A current distribution receives treatment under Sec. 751 only if (1) the partnership has Sec. 751 assets and (2) there is an exchange of Sec. 751 property for non-Sec. 751 property. Analyzing a transaction to determine what property is involved in the Sec. 751 distribution is best done in an orderly step-by-step analysis. These steps are listed and described beginning on p. C:10-9. At this point you can use Table C:10-1 to illustrate this stepby-step approach. Examples C:10-12 through C:10-14 illustrate the steps involved in analyzing a Sec. 751 distribution.

Liquidating or Selling a Partnership Interest. A.

Liquidating Distributions. A liquidating distribution is defined as a distribution or series of distributions that terminates a partner’s interest in a partnership. 1.

Gain or Loss Recognition by the Partner. Gain is recognized only if the money distributed (including money deemed distributed to the partner from a liability reduction or the FMV of marketable securities that are treated like money) exceeds the partner’s predistribution basis in his partnership interest. A loss is recognized only if (1) the distribution consists of money (including money deemed distributed), unrealized receivables, and inventory, but no other property, and (2) the partner’s basis in the partnership interest exceeds the total basis of these distributed properties including cash. The amount of the loss that is recognized is the difference between the partner’s basis and the money plus the partnership’s basis in the receivables and inventory received. (See Example C:10-15.)

Basis in Assets Received. The basis in unrealized receivables and inventory is generally the same as the basis in the partnership’s hands. In some instances these bases may be reduced because the partner’s basis in the partnership interest is smaller than the basis of the distributed property in the hands of the partnership. In this case, the remaining basis in the partnership interest must be allocated between the assets received based first on their decline in value and then on their relative bases as adjusted to reflect the decline in value. (See Examples C:10-16 and C:10-17.)

Holding Period in Distributed Assets. If a contributing partner held the property, the holding period will also include the holding period of the contributing partner. (See Example C:10-18.)

Effects of Sec. 751. Sec. 751 has the same impact for both liquidating and nonliquidating distributions. A step-by-step analysis of Sec. 751 on liquidating distributions is provided on p. C:10-15. Table C:10-2 should be used to illustrate the application of the Sec. 751 table to a nonliquidating distribution in Example C:10-19.

Effects of Distribution on the Partnership. A partnership recognizes no gain or loss on a liquidating distribution to its partners. If a Sec. 751 deemed sale occurs, the partnership may be required to recognize gain or loss on assets deemed sold to its partners. Finally, the partnership may be subject to optional or mandatory basis adjustments.

Topic Review C:10-1 presents a summary of the tax consequences of current and liquidating distributions. B.

Sale of a Partnership Interest. When a partner sells a partnership interest, capital gain or loss is recognized as if corporate stock was sold. To the extent Sec. 751 applies, the partner recognizes ordinary income or loss from the sale of his share of unrealized receivables and inventory. 1.

Section 751 Properties. First, the definition of Sec. 751 property is slightly different for sales or exchanges because inventory does not have to be substantially appreciated to be included. All inventory and all unrealized receivables are Sec. 751 assets in a sales or exchange situation. As with distributions, the effect of Sec. 751 must first be calculated. First, determine the amount realized for the Sec. 751 property and calculate the adjusted basis of such property to the partner. (See Example C:10-20.) It should be noted that Section 751 modifies rules as governed under Section 741 for typical asset sales. After the Sec. 751 portion of the sale is analyzed, the remainder of the sale is analyzed. Any gain or loss on the sale of the remaining partnership interest is considered to be gain or loss derived from the sale of a capital asset. See Example C:10-20, which illustrates that the sale of a partnership interest may result in both ordinary income and a capital loss being recognized. The Stop and Think discussion at this point illustrates why the sale of a partnership interest is not treated in the same way as the sale of stock.

Liabilities. When the partnership interest is sold, a partner is relieved of his share of the partnership liabilities. The amount realized includes the seller’s distributive share of the partnership liabilities that are assumed or acquired by the purchaser. (See Example C:10-21.)

Impact on the Partnership. When a partner sells his interest in a partnership, there is usually no effect on the partnership. The partnership is affected if the interest sold is sufficiently large so that under Sec. 708 the partnership is terminated for tax purposes. Also, the partnership may have to make optional or mandatory basis adjustments to its assets.

IV.

Other Partnership Termination Issues. A.

Retirement or Death of a Partner. If a partner dies or retires from a partnership, that partner’s interest can be sold either to an outsider or to one or more existing partners. Frequently, however, a partner or a deceased partner’s assignee departs from the partnership in return for payments made by the partnership itself. These payments are made in exchange for the former partner’s interest in partnership property and other payments. 1.

Payments for Partnership Property. The valuation placed on the retiring partner’s interest in the partnership properties by the partners in an arm’slength transaction is generally accepted by the IRS. The payments are taxed under the liquidating distribution rules with two exceptions. These two exceptions, for unrealized receivables and goodwill not provided for in the partnership agreement made to general partners in a service partnership, are taxed as ordinary income. The remaining payments are likely to generate no gain or capital gain, except to the extent they are for substantially appreciated inventory. These property payments are not deductible by the partnership. If the retiring or deceased partner was a general partner and the partnership is a service partnership, payments made for unrealized receivables and goodwill are not considered payments for property absent a provision for goodwill. These payments will be considered “other payments.”

Other Payments. Payments made to a retiring partner or to a deceased partner’s successor in interest which exceed the value of that partner’s share of partnership property have a very different tax result for both the retiring partner and for the partnership. Very few payments which do represent payments for property (e.g., payments to a general partner retiring from a service partnership for his interest in unrealized receivables and for his interest in partnership goodwill) are also taxed under these rules. Payments are taxed either as a distributive share or a guaranteed payment. If the payment is a function of partnership income, it is considered a distributive share of partnership income. If the payment for other property is determined without regard to partnership income, the payment is treated as a guaranteed payment. The payment is taxable to the retiring partner as ordinary income, and is deductible by the partnership. (See Examples C:10-22 and C:10-23.)

Exchange of a Partnership Interest. 1.

Exchange for Another Partnership Interest. An exchange of a partnership interest in one partnership for a partnership interest in a different partnership will trigger the recognition of gain or loss from the sale or exchange of a partnership interest. C:IO10-7 Copyright © 2024 Pearson Education, Inc.

Exchange for Corporate Stock. A partnership interest may be exchanged for corporate stock in an exchange that qualifies under Sec. 351. The basis of the corporate stock is determined by the basis in the partnership interest. The holding period for the stock includes the holding period for the partnership interest. As a result of the exchange, one of the corporation’s assets is an interest in a partnership, and the corporation reports its distributive share of the partnership income in the corporate tax return along with all of its other earnings.

Incorporation. When a partnership becomes extremely profitable or when limited liability is important, the entire partnership may choose to incorporate. Normally the transaction can be structured under Sec. 351 and be partially or totally tax-exempt. There are three ways a partnership can choose to incorporate, which are listed on p. C:10-21. These methods may have different tax consequences.

Formation of an LLC, LLP, or LLLP. A second option for obtaining limited liability for all owners is for the partnership to become an LLC, LLP, or LLLP. Under the check-the-box regulations, an LLC with more than one member is treated as a partnership unless it elects to be taxed as a corporation. Change from a general partnership to one of these forms will not cause the recognition of income on the transfer of property. Further, the transfer of property does not cause the tax year of the partnership or any partner to change. Basis of the partners’ interest in the partnership will be changed only if the liability shares for the partners change. In some states partners can achieve limited liability through a limited liability limited partnership (LLLP).

Income Recognition and Transfers of a Partnership Interest. The partnership year closes with respect to any partner who sells or exchanges his entire interest in a partnership or any partner whose interest in the partnership is liquidated. The year closes with the date of the sale or exchange, or the final payment in the case of a liquidation. As a result, that partner’s share of all items earned by the partnership must be reported in the partner’s tax year that includes the transaction date. A partner’s tax year now closes on the date of death. The partner’s final return will include all partnership income up to the date of death.

Termination of a Partnership. 1.

Events Causing a Termination to Occur. Only two conditions terminate a partnership. These are discussed below: No Business Operated as Partnership. If no partner continues to operate any business, financial operation, or venture of a partnership through the same or

another partnership, the original partnership terminates. To avoid termination, a partnership must maintain both partners and business activity. Sale or Exchange of at Least a 50% Interest. A partnership terminates if there is a sale or exchange of at least 50% of the total interests in both partnership capital and profits within a 12-month period.

Effects of Termination. When a partnership terminates, its tax year is closed, requiring the partners to include their share of partnership earnings for the short-period partnership tax year in their tax returns. This may cause a bunching of income, particularly if the partnership is on a fiscal year. (See Example C:10-25.)

Liquidating Distributions and Contributions. When a termination occurs for tax purposes, a pro rata liquidating distribution is deemed to have been made to all partners. Gain or loss must be recognized by the partners under the liquidating distribution rules. The basis of assets deemed distributed must be adjusted as they would be in an actual liquidating distribution.

Mergers and Consolidations. When two or more partnerships merge, an old partnership, whose partners own more than 50% of the profits and capital interests of the new partnership, is considered to be continued as the new partnership. The new partnership continues with the tax year and accounting methods and elections of the old partnership. All the other old partnerships are considered terminated. (See Example C:10-26.) When two or more partnerships meet the more than 50% of profits and capital interests requirement, the partnership that is considered contributing the greater dollar value of assets to the new partnership is considered the continuing partnership. If no partnership contributed the requisite amount, all of the partnerships terminate and the new entity can make its own tax year and accounting method elections. (See Example C:10-27.)

Division of a Partnership. When a partnership is divided into two or more partnerships, any of the new partnerships whose partners own collectively more than 50% of the profits and capital interest in the old partnership are considered a continuation of the old partnership. The new partnership(s) are bound by the accounting method and tax year elections of the continuing partnership. (See Example C:10-28.)

Optional and Mandatory Basis Adjustments. In general, a partnership makes no adjustment to the basis of its property when a partner sells or exchanges his or her interest in the partnership, when a partner’s interest transfers upon the partner’s death, or when the partnership makes a property distribution to a partner. A.

Adjustments on Transfers. If an incoming partner purchases his or her partnership interest from an existing partner, the new partner’s basis in the partnership interest C:IO10-9 Copyright © 2024 Pearson Education, Inc.

equals the purchase price plus the new partner’s share of partnership liabilities. The new partner’s basis in the partnership is likely to be different from his or her share of basis of the underlying assets in the partnership. If an incoming partner makes an election under Sec. 754, or an election is already in place for the partnership, Sec 743 mandates a special basis adjustment equal to the difference between the transferee partner’s basis in the partnership interest and the transferee partner’s share of basis of partnership assets. This basis adjustment belongs only to the transferee partner and eliminates the inequities of different inside and outside basis. (See Example C:1029.) The rules impose a mandatory basis adjustment if the partnership has a substantial built-in loss and has no Sec. 754 optional basis adjustment election in effect. A substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds the FMV of the property by more than $250,000. B.

VI.

Adjustments on Distributions. If a Sec. 754 election is in place, a partnership makes the adjustments listed on pp. C10-27 and C:10-28. For sales and exchanges after October 22, 2004, a mandatory basis adjustment is required if the partnership has a substantial built-in loss and has no Sec. 754 optional basis adjustment election in effect. The built-in loss is considered substantial if the difference between basis and FMV exceeds $250,000.

Special Forms of Partnerships. Limited partnerships are discussed in the beginning sections of Chapter C:9 and in this chapter. Here, we examine a series of special partnership forms, including tax shelters that are organized as limited partnerships, publicly traded partnerships, limited liability companies, and limited liability partnerships. A.

Tax Shelters and Limited Partners. Prior to the 1986 Tax Act, limited partnerships were the primary vehicle for tax shelter investments; subsequently laws changed this by invoking passive activity loss limitations for activity conducted in limited partnership forms. The passive loss rules have changed this. Limited partnerships that generate passive income are now becoming popular investment vehicles.

Publicly Traded Partnerships. The Revenue Act of 1987 changed the tax treatment of certain publicly traded partnerships. Any partnership that meets the requirements of Sec. 7704 is taxed as a corporation instead of being taxed as a partnership under Subchapter K unless they are grandfathered by being in existence on December 17, 1987, and have not added a substantial new line of business since the date they are grandfathered, or earn primarily qualifying income. A publicly traded partnership is a partnership whose interests are either traded on an established securities exchange or are traded on a secondary market or the equivalent thereof. Many publicly traded partnerships are traded on major stock exchanges such as the New York Stock Exchange. The Taxpayer Relief Act of 1997 added an election which will allow the grandfathered partnerships to continue to be taxed as partnerships after the original 10-year window and until the election is revoked. In order to elect to continue to be C:IO10-10 Copyright © 2024 Pearson Education, Inc.

taxed as a partnership, the publicly traded partnership must agree to pay a 3.5% annual tax on gross income from the active conduct of any trade or business. The election may be revoked by the partnership, but once revoked, cannot be reinstated. C.

Limited Liability Companies (LLCs). The limited liability company (LLC) combines the legal and tax benefits of the partnership and S corporation forms of doing business. All 50 states have adopted limited liability company rules or are considering them. The LLC business form combines the advantage of limited liability for all its owners with the possibility of achieving the conduit treatment and the flexibility of being taxed as a partnership.

Limited Liability Partnerships (LLPs). Many states have added limited liability partnerships (LLP) to the list of business forms, which can be formed. Most LLPs are service partnerships. Under current state laws, the primary difference between a general partnership and a limited liability partnership is that in a limited liability partnership, a partner is not liable for damages resulting from failures in the work of other partners or of people supervised by other partners. This feature is one reason why the Big 4 (and other large accounting firms) have converted to status. Like a general or limited partnership, this business form is a partnership for tax purposes except under very unusual circumstances. You may wish to have the students discuss the impact that they think the new “check the box” regulations will have on new business formations, as well as existing corporations using the Stop and Think material. As a result of the Tax Cut and Jobs Act of 2017, several other factors need to be considered in the entity choice decision. C corporations now face a much lower tax rate (21%) than they did prior to this act, which takes some of the sting out of double taxation. Owners of S corporations, partnerships, and LLCs, if eligible, can claim the 20% business income deduction, which effectively lowers their tax rate on business income. However, owners of these entities also may be subject to the limitation on excess business losses. See Chapter C:9 for further discussion of these provisions.

Limited Liability Limited Partnership (LLLPs). Another recent innovation in some states (but not all) is the limited liability limited partnership (LLLP). The LLLP is a partnership formed under a state’s limited partnership laws but that can elect under the state’s laws to provide the general partners with limited liability. Thus, the LLLP is similar to an LLC. It becomes potentially useful in states that do not extend LLC status to personal service firms but allow such firms to operate as an LLLP.

VII.

Tax Planning Considerations. A.

Liquidating Distribution or Sale to Partners. When a partner withdraws from a partnership, the transaction can be structured as either a liquidating distribution or a sale of the partnership interest to the remaining partners. The difference in form can create a number of different tax consequences even though the transactions achieve C:IO10-11 Copyright © 2024 Pearson Education, Inc.

substantially the same result. These differences are listed on p. C:10-35. Because of these tax implications, partners should make their choice only after careful consideration.

Court Case Briefs Leon A. Harris, Jr., 61 T.C. 770 (1974). Harris owned a 40% interest in a partnership, which owned and operated a shopping center. Harris decided that he wanted to liquidate his interest in the partnership as he was pessimistic about the future of the project. The other partners did not want to liquidate. In 1967 the partnership sold a 10% interest in the shopping center to certain trusts whose beneficial interest related to the partners. The proceeds of the sale and the resulting loss were allocated to Harris and his capital account and partnership interests were reduced accordingly. In 1968, the partnership distributed a 30% interest in the shopping center to Harris in complete liquidation of his interest. In the same year, Harris sold this interest to certain trusts related to the remaining partners. The IRS held that the step transaction doctrine should be applied to collapse the transactions and that a sale of a partnership interest had actually occurred in each case. The court upheld Harris’s and the partnership’s treatment of the losses as losses on the sale of real property used in a trade or business since no partnership interest was ever held by the trusts to which the shopping center interests were sold. Edward F. Neubecker, 65 T.C. 577 (1975). Neubecker and another partner withdrew from a three-man legal partnership and formed their own partnership. They took a minimal amount of physical assets from the offices of the prior partnership and set up business in new offices. They also took some of the clients they had served under the old partnership. Neubecker claimed a loss on liquidation of his partnership interest in the amount of his capital account at the time of his withdrawal. The court disallowed this loss, holding that the partnership had not actually terminated. The two withdrawing partners were considered to have continued the operation of the old partnership. The remaining third partner did not continue operations as a partner and so could not be considered to be continuing the old partnership’s operations. Further, even if the partnership were considered to have liquidated, the continuing partners did not receive property of the type required to allow recognition of any realized loss.

Chapter C:11 S Corporations Learning Objectives After studying this chapter, the student should be able to: 1.

Discuss the advantages and disadvantages of making the S election.

List the requirements for being eligible to elect S corporation status.

Explain how a corporation elects, revokes, or terminates S corporation status.

Classify an S corporation’s ordinary and separately stated items, and calculate special S corporation taxes.

Allocate an S corporation’s ordinary and separately stated items to its shareholders and apply loss limitation rules.

Calculate a shareholder’s basis in his or her S corporation stock and debt.

Determine the taxability of an S corporation’s distributions to its shareholders.

Explain other rules that pertain to S corporations.

Identify tax planning opportunities for an S corporation and its shareholders.

10.

Comply with S corporation procedural and filing requirements.

Areas of Greater Significance After studying this chapter the student should be able to identify the requirements that must be met in order to make an S election. The student should be able to identify how an S corporation is taxed. Students should also be able to describe how a distribution from an S corporation is taxed. It is a good tax planning discussion to focus on the loophole of self-employment tax in an S Corporation versus other passthrough entities.

Areas of Lesser Significance Less attention may be paid to procedural matters such as how to make an S election and the requirements for and steps in filing a Form 1120S.

Problem Areas for Students Students may find it difficult to understand how the Accumulated Adjustment Account works. A study of this may be combined with a discussion of the equity section of the balance sheet of an S corporation and the reporting of the Accumulated Adjustments Account on Form 1120S.

Highlights of Recent Tax Law Changes 1.

In the case of an S corporation, the U.S. production activities deduction applies at the shareholder level. The S corporation will report each shareholder’s share of qualified production activities income on the K-1.

If the shareholder transfers the S corporation stock to a spouse or former spouse incident to a divorce, the suspended losses transfer to the spouse or former spouse. Thus the spouse or former spouse can deduct the losses when he or she obtains sufficient basis.

The TCJA of 2017 has created many different considerations for applicability of the S Corporation. There are several considerations that make the S Corporation less attractive than before the act.

Teaching Tips 1.

Many students find it easier to understand the S corporation basis rules for stock and debt by using “T” accounts for the stock and debt investments of the shareholder and making the appropriate debit and credit entries to reflect basis increases and decreases.

Example C:11-27: Use this example to illustrate the difference in the tax treatment of distributions for S and C corporations. p. C:11-30.

Many students find it easier to understand the various earnings accounts (e.g., AAA, E&P) by using separate “T” accounts for each of the types of earnings and making the appropriate debits and credits to the individual accounts to reflect the earnings and distributions for the tax year. A separate “T” account also needs to be used as part of the illustration to keep track of the stock’s basis. Students need to be made aware of the fact that the Other Adjustments Account is not an earnings pool in the distribution sequence even though it is reported along with the Accumulated Adjustments Account amount on the last page of the Form 1120S.

Lecture Outline I.

Should An S Election Be Made? A.

Advantages of S Corporation Treatment. Some advantages available to a corporation that elects to be treated as an S corporation are listed on p. C:11-3. There is no general rule that can be applied to determine whether an S election should be made. The management and shareholders should examine the long- and short-run advantages and disadvantages of filing as a C corporation and as an S corporation before making a decision. The election can be revoked or terminated at any time with minimal effort. Shareholders may be eligible for the qualified 20% business income (QBI) deduction.

B. II.

Disadvantages of S Corporation Treatment. Some disadvantages also exist when a corporation makes an S election. They are listed on pp. C:11-3 and C:11-4.

S Corporation Requirements. The S corporation requirements are divided into two categories – shareholder-related requirements and corporation-related requirements. A corporation that satisfies both sets of requirements is known as a small business corporation. A.

Shareholder-Related Requirements. There can be no more than 100 shareholders. A husband and wife are automatically counted as one person. If stock is owned jointly by more than one person, each is counted as a single shareholder. After 2004, this single shareholder rule expands to include all members of a family if any family member so elects. Members of a family for this purpose include the common ancestor, lineal descendants of the common ancestor, the spouses (or former spouses) of the common ancestor or lineal descendants and their estates. The election remains in effect until terminated as provided by regulation. Corporations and partnerships in general cannot own S corporation stock. Seven types of trusts can own S corporation stock – grantor trusts, voting trusts, testamentary trusts, qualified Subchapter S trusts (QSSTs), trusts that distribute all of their income to a single beneficiary, who is treated as the owner of the trust, qualified retirement plan trusts, and small business trusts. (See Example C:11-1.) An election must be made in order for a trust to be classified as a QSST or a small business trust. Organizations that are exempt from the federal income tax under Sec. 501(a) (e.g., a tax-exempt public charity or private foundation) can hold S corporation stock. These organizations count as one shareholder when calculating the 100 shareholder rule.

Individuals who are not U.S. citizens can only own S corporation stock if they are U.S. residents or are married to a U.S. citizen or resident alien and make an election to be taxed as a resident alien. Small business trusts can own S corporation stock starting in 1997. These trusts can be complex trusts, and are primarily used as estate planning devices. Interests in small business trusts cannot be purchased, but are generally acquired as a result of a gift or bequest. All current beneficiaries of a small business trust must be individuals or estates. An affirmative election is required to obtain small business trust status. Charitable remainder unitrusts and charitable remainder annuity trusts do not qualify as small business trusts. While both trusts may provide income interests to individual shareholders, a remainder interest must be provided to a charitable organization, which is not an eligible shareholder. An unincorporated eligible entity that makes a valid S election is automatically treated as making an election to be treated as a corporation under the check-the-box regulations. Thus the entity does not have to make two separate elections. B.

Corporation-Related Requirements. Foreign corporations and unincorporated entities not taxed as an association cannot be an S corporation. However, an unincorporated entity that elects to be treated as a corporation under the check-thebox regulations may be an S corporation. Corporations that maintain a special federal income tax status are not eligible to make an S election. For example, financial institutions that use the reserve method for bad debts and insurance companies are not eligible. Corporations that have elected the special Puerto Rico and U.S. possessions tax credit or the special Domestic International Sales Corporation tax exemption are ineligible to make the S election. S corporations can own the stock of a C corporation or another S corporation without any limitation on the percentage of voting power or value that is held. The prohibition against a C corporation owning the stock of an S corporation remains. An S corporation that owns the stock of a C corporation cannot participate in the filing of a consolidated tax return. An S corporation can own the stock of a Qualified Subchapter S Subsidiary (QSSS). A QSSS is a domestic corporation that qualifies as an S corporation, is 100% owned by an S corporation, and for which an affirmative election to be treated as a QSSS is made. The assets, liabilities, income, deductions, losses, etc. of the QSSS are treated as those of its S corporation parent and reported on the parent’s tax return. An S corporation can have only one class of stock. A second class of stock is not created if the only difference in the two classes of stock is voting rights. (See Example C:11-2.)

The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds. Debt instruments, corporate obligations, or deferred compensation arrangements are in general not treated as a second class of stock. A series of safe harbors exist for characterizing S corporation obligations as debt. III.

Election of S Corporation Status. S corporations are exempt from all taxes except the built-in gains tax, excess net passive income tax, LIFO recapture tax, and recapture of any investment tax credits. S corporations are exempt from the personal holding company tax, the accumulated earnings tax, and the corporate alternative minimum tax in the year in which the election is first effective and in all subsequent years until the election is terminated. Shareholders pay tax on their pro rata share of the corporate income. Most distributions to the shareholders will be tax-free. The basis in the shareholder’s stock is adjusted for their ratable share of ordinary income and separately stated items. A.

Making the Election. The S election can only be made by qualified small business corporations. It must be made in a timely manner by filing the election on a Form 2553. The election can be made any time during the preceding tax year, or on or before the fifteenth day of the third month of the tax year in which the election is to be effective. (See Example C:11-3.) A new corporation can make an S election at any time during the first two and a half months of its existence. An S corporation’s initial year commences on the earliest date that it has shareholders, acquires assets, or begins business. A corporation must remain a small business corporation on each day of the tax year preceding the election, on the election day, and on all days after that in order for a retroactive election to be valid. The tax law provides some relief for improper elections. If the corporation misses the deadline for making the S corporation election, the IRS can treat the election as timely made if the IRS determines that the corporation had reasonable cause for making the late election. If the election was ineffective because the corporation inadvertently failed to qualify as a small business corporation or because it inadvertently failed to obtain shareholder consents, the IRS can honor the election if the corporation and shareholders take steps to correct the deficiency within a reasonable period of time. 1.

shareholders for the tax year, if the election is retroactive. (See Example C:11-4.) Each tenant (whether husband and wife or not) must consent to the S election. If the stock is owned as community property, the consent must be made by husband and wife. A minor or his legal representative must consent to the S election. At this point you may wish to use Topic Review C:11-1 to review the S corporation requirements and election procedures. B.

Termination of the Election. The S election is terminated either when the corporation revokes the election, or the election is terminated because the corporation ceases to be a small business corporation. The termination generally occurs on the day of the terminating event. If the corporation revokes the S election, shareholders owning more than one-half the stock on the day of revocation must consent to the revocation. A revocation made by the fifteenth day of the third month is retroactive to the beginning of the tax year unless another subsequent date is requested. All other revocations are effective on the date of the revocation or some subsequent date, at the election of the corporation. (See Example C:11-5.) 1.

Termination of the Election. The S election is terminated if the corporation fails one or more of the small business corporation requirements. See Topic Review C:11-1 for these requirements. The passive income requirement is applied annually. A termination will result if more than 25% of the corporation’s gross receipts are passive income for each of three consecutive tax years and the corporation has Subchapter C earnings and profits at the end of each tax year. If the test is failed for three consecutive years, the election terminates on the first day of the fourth year. Passive investment income includes royalties, rents, dividends, interest, annuities, and gains from the sale or exchange of stocks and securities. Passive investment income excludes income derived from the active conduct of a trade or business. (See Example C:11-6.)

Allocation of Income. If a termination occurs at a time other than the first day of a tax year, an S termination year occurs. The S termination year is divided into an S short year and a C short year. The S short year commences on the first day of the tax year and ends on the last day preceding the day the termination is effective. The C short year commences on the day of the terminating event. (See Example C:11-7.) The S short year’s income is allocated to the shareholders. The C short year taxable income is annualized to determine the corporate tax liability. Income is allocated between the two short years on a daily basis unless an election is C:IO11-6 Copyright © 2024 Pearson Education, Inc.

made to allocate the income using the corporation’s tax accounting elections. All shareholders during the S short year and on the first day of the C short year must consent to this election. A pro rata allocation cannot be used when an S termination year occurs and during such year sales or exchanges of 50 percent or more of the corporation’s outstanding stock occur. In such case, the corporation’s tax accounting elections must be used to make the allocation.

IV.

Inadvertent Termination. If an inadvertent termination occurs, the S corporation and its shareholders must take the necessary steps within a reasonable time after discovering the disqualifying event to restore the corporation’s small business corporation status. The IRS may require adjustments to be made if the S election is to remain in effect continuously. After 2004, the IRS can grant relief for inadvertent terminations of the election to treat a subsidiary as a QSSS and the election to treat family members as one shareholder. (See Example C:11-8.)

Other IRS Waivers. The IRS cannot only waive a termination that it deems to be inadvertent, it can validate certain invalid elections. Validation of an invalid election can occur when the election failed to meet the basic S corporation requirements of IRC Sec. 1361 or failed to provide the necessary shareholder consents. The IRS also can exercise this authority in situations where a corporation never filed an election. Relief can also be obtained for filing a late election. The authority to validate certain invalid elections applies to tax years beginning after December 31, 1982.

New Election Following a Termination. A corporation that terminates its S election must wait five tax years before making a new election. The IRS may waive this rule if the termination was inadvertent, or if more than 50% of the stock is owned by persons who did not own the stock when the termination occurred. Congress enacted a special one-time waiver of the 5-year reelection-waiting period for S corporations’ terminations occurring in tax years beginning before January 1, 1997. These corporations can re-elect S corporation status immediately without IRS consent. (See Example C:119.)

Avoiding Termination of an S Election. A number of negative tax consequences can occur if an S election is inadvertently terminated. Some of the steps that can be taken to avoid an inadvertent termination are listed on p. C:11-12.

S Corporation Operations. S corporations make the same accounting period and accounting method elections as C corporations.

Taxable Year. Section 1378(a) requires that the S corporation’s taxable year be a permitted year, defined as: 1. 2.

A tax year ending on December 31 (including a 52–53 week year) Any fiscal year for which the corporation establishes a business purpose (See Example C:11-10.)

At this point you may wish to use Topic Review C:11-2 to review the alternative S corporation tax years. B.

Accounting Method Elections. Most accounting method elections are made by the S corporation. These elections are independent of the elections made by the shareholders. The three elections that are made by the S corporation’s shareholders relate to income from the discharge of indebtedness, deducting and recapturing of mining exploration expenditures, and deducting or crediting foreign income taxes.

Ordinary Income or Loss and Separately Stated Items. S corporations are treated as individuals for income tax purposes. They report ordinary income or loss and separately stated items in the same manner as partnerships. The character of the income or deduction is not changed because it passes through to the shareholder. A list of some items that must be separately stated can be found on pp. C:11-14 and C:11-15. A list of deductions that cannot be claimed also can be found on p. C:11-15.

Similarity to C Corporation Treatment. S corporations are treated as corporations for certain tax matters. For example, an S corporation can elect to amortize its organizational expenditures under Sec. 248. Also, the 20% reduction in certain tax benefits under Sec. 291 applies to an S corporation if the corporation (or a predecessor corporation) was a C corporation in any of its three preceding tax years.

Carryovers When Status Changes. Carryovers that originate in a C corporation tax year cannot be used in an S corporation tax year (other than to reduce the built-in gains tax). Likewise, carryovers originating in an S corporation tax year cannot be used in a C corporation tax year.

Special S Corporation Taxes. S corporations are subject to four special tax levies. 1.

Excess Net Passive Income Tax. The excess net passive income tax is levied when an S corporation has passive investment income for the tax year that exceeds 25% of its gross receipts, and it has Subchapter C E&P at the close of the tax year. Tax on the excess net passive income is assessed at the highest marginal corporate rate (21% for 2022). (See Example C:11-11.)

conversion from C corporation to S corporation status if the corporation had used the accrual method of accounting and which is reported during a 5-year period commencing on the day the S election takes effect. Built-in losses reduce the amount of recognized built-in gains when determining the built-in gains tax liability. A four-step calculation for determining the built-in gains tax is provided on p. C:11-17. The built-in gains tax applies to former C corporations when the S corporation election was made after December 31, 1986. (See Examples C:11-12 and C:11-13.) At this point you may wish to use the material in the Ethical Point to discuss valuation of appreciated property when an S election is made. This is found on p. C:11-18. 3.

LIFO Recapture Tax. If a C corporation using the LIFO inventory method makes an S election, Sec. 1363(d)(3) requires the corporation to include its LIFO recapture amount in gross income for its last C corporation tax year. The tax increase is paid in four annual installments commencing with the final C corporation tax year. (See Example C:11-14.)

At this point you may wish to use the Stop and Think material as a discussion tool with your students to point out why certain taxes are levied at the corporate level when a C corporation is converted to an S corporation. V.

Taxation of the Shareholder. A.

Income Allocation Procedures. Shareholders report their allocable share of ordinary income and loss and separately stated items in the tax year in which the S corporation’s tax year ends. The steps in determining each shareholder’s allocable share are listed on p. C:11-19. These allocation rules are known as the “per day/per share” method. Special allocations are not allowed. If stock is transferred during the year, income must be allocated between the owners. (See Examples C:11-15 and C:11-16.) A special election is available for allocating the ordinary income or loss and separately stated items when the shareholder’s interest in the S corporation is terminated during the tax year or when the interest is substantially reduced, even if not completely terminated. If the election is made, the income is allocated according to the accounting methods used by the S corporation (instead of on a daily basis). The election divides the S corporation’s tax year into two parts ending on (1) the day the shareholder’s interest in the corporation is terminated, and (2) the last day of the S corporation’s tax year. This election can only be made if all affected shareholders agree to the election.

Loss and Deduction Pass-Through to Shareholders. A corporation’s ordinary loss and separately stated loss and deduction items pass through to the shareholder(s) in the tax year in which the S corporation’s tax year ends. C:IO11-9 Copyright © 2024 Pearson Education, Inc.

Allocation of Loss. Allocation of loss occurs on a daily basis. Losses and deductions allocated in excess of the shareholder’s income create an NOL for the shareholder and results in a carryover to the shareholder’s other tax years. (See Example C:11-19.)

Shareholder Loss Limitations. The deduction allowed each shareholder for his share of the loss and separately stated loss and deduction items is limited to his basis in his stock plus the adjusted basis of any indebtedness owed directly by the S corporation to the shareholder. Any amounts of income or gain for the year are added to basis before determining the loss limitation. Once the loss limitation is determined, the basis decreases occur in the following sequence: decreases attributable to nondeductible, noncapital expenditures, decreases attributable to ordinary losses, separately stated loss and deduction items and distributions that are not includible in the shareholder’s income. Sequencing the basis reduction for distributions ahead of the absorption of the losses means that distributions reduce the deductibility of S corporation loss and deduction pass-throughs, but losses do not change the taxability of S corporation distributions. (See Example C:11-20.) If stock in an S corporation is sold while there are unused losses due to lack of basis, the losses lapse and cannot be used by the purchaser. However, if the shareholder transfers the S corporation stock to a spouse or former spouse incident to a divorce, the suspended losses transfer to the spouse or former spouse. Thus, the spouse or former spouse can deduct the losses when he or she obtains sufficient basis. If a limited loss is made up of more than one type of income, the loss limitation is prorated between the different types of losses.

Special Shareholder Loss and Deduction Limitations. S corporation shareholders are subject to three additional loss limitations: the at-risk rules; the passive activity loss and credit limitation rules; and the hobby loss rules. In addition, various separately stated loss and deduction items are subject to shareholder limitations (e.g., charitable contributions, long-term capital losses and investment interest expense) though they are not subject to corporate limitations. Some separately stated items are subject to corporate limitations but not shareholder limitations (e.g., the 50% nondeductible portion of travel and entertainment expenses).

Post-Termination Loss Carryovers. Loss and deduction carryovers can be carried over after an S election is terminated and deducted by the shareholder in the post-termination transition period.

VI.

Family S Corporations. The IRS can reallocate income attributable to stock that is transferred to a family member when the transferor retains the economic benefits and control over the stock. The IRS can also allocate the items of income, deduction, gain, loss, and credit to reflect the value of services rendered or capital contributed by a family member. (See Example C:11-23.)

Basis Adjustments. A.

Basis Adjustments to S Corporation Stock. The formula for determining the basis for S corporation stock is found on pp. C:11-24 and C:11-25. The basis adjustments parallel those made to determine a partnership interest’s basis. Adjustments include taxable and tax-exempt income, and separately stated items. (See Example C:11-24.) Basis adjustments are made on the last day of the tax year.

Basis Adjustments to Shareholder Debt. After a shareholder’s basis in the S corporation stock is reduced to zero, basis in debt owed the shareholder by the corporation is reduced to zero. When income or gain items are allocated to shareholders, they first restore their basis in shareholder debt, and then are allowed to increase the basis in the stock. If debt is repaid before the basis is fully restored, the shareholder will recognize a gain. The gain will be ordinary gain if the debt is unsecured and capital gain if the debt is secured by a note or other evidence of indebtedness. (See Example C:11-26.)

VII.

S Corporation Distributions. A.

Corporations Having No Earnings and Profits. For S corporations with no accumulated E&P, a two-tier rule applies. Distributions from an S corporation having no E&P first reduce the basis in the stock. Distributions in excess of basis will generate capital gain. Distributions do not reduce a shareholder’s basis in shareholder debt. (See Example C:11-27.) As was the case with partnership distributions, it may be helpful to explain the S corporation distribution rules by using a T account, which reflects the basis increases and decreases. Like C corporations, S corporations must recognize gain on the distribution of appreciated property. Gain is measured by the difference between FMV and the adjusted basis for the property. The gain recognized by the corporation is allocated to the shareholders and may be subject to tax at the corporate level. No losses are recognized when property that has declined in value is distributed.

Corporations Having Accumulated Earnings and Profits. Prior to 1983, a corporation’s undistributed taxable income was taxed to its shareholders as a deemed C:IO11-11 Copyright © 2024 Pearson Education, Inc.

distribution at year-end. This income was accumulated in a previously taxed income (PTI) account. E&P earned in excess of PTI became part of a corporation’s accumulated E&P account. Starting in 1997, pre-1983 accumulated E&P earned while an S corporation is no longer a source of S corporation distributions. Under current (post-1982) rules, some S corporations still have PTI and post-1982 E&P balances earned while a C corporation from which part or all of a distribution may be treated as having been made. Corporations with PTI or E&P must maintain an Accumulated Adjustments Account (AAA) and an Other Adjustments Account in order to determine the taxability of their distributions. Distributions first come from AAA. 1.

Money Distributions. For corporations having an accumulated E&P account, cash distributions come from the four tiers of earnings illustrated in Table C:11-1. Table C:11-1 may be used at this point to illustrate the source of distributions made by S corporations having accumulated E&P. Distributions are made from each tier until the tier is exhausted. The AAA is the cumulative total of the ordinary income or loss and separately stated items for the S period but not tax-exempt income and the expenses related to its production. The calculation of the AAA account is illustrated on p. C:11-29. The four differences between basis adjustments and adjustments required for the AAA are listed on p. C:11-30. (See Example C:11-29.) The Other Adjustments Account (OAA) is maintained only when there are accumulated E&P at year-end. The account is primarily increased for taxexempt income and decreased for expenses related to tax-exempt income. OAA is not an earnings account in the distribution sequence. Earnings in the OAA are considered to be part of the stock basis when determining the source of a distribution. Allocation of the AAA balance to individual distributions occurs at year-end after taking into account current year income and loss items. In general, the AAA amount is allocated ratably to individual distributions (other than those distributions coming from E&P or PTI) based on the amount of money or FMV of nonmoney property distributed.

Property Distributions. Distributions of nonmoney property cannot reduce PTI. PTI can only be distributed in money. Property distributions may also force the recognition of income or gain by the distributing corporation under Sec. 311 as discussed above. The FMV of nonmoney property distributed will reduce AAA.

Distribution Ordering Elections. Two elections are available to change the distribution order. Separate elections are available to the S corporation to skip C:IO11-12 Copyright © 2024 Pearson Education, Inc.

over the AAA and PTI accounts in determining the source of a cash or property distribution. If either election is made, the distributions will normally come from accumulated E&P. This election can be used to eliminate the possibility of the excess net passive income tax applying or the passive income test being failed and causing a loss of S corporation status. 4.

Post-Termination Transition Period. Nontaxable distributions of money made during the S corporation’s post-termination transition period can be made to those shareholders who owned S corporation stock at the time of the termination. These distributions are considered as coming first from AAA and then from current and accumulated E&P. The amounts coming from AAA are tax-free and reduce the shareholder’s basis in the stock. Distributions from current and accumulated E&P are taxable. AAA remaining after the post-termination transition period ends can only be distributed as a basis reduction after current and accumulated E&P has been exhausted. Corporations who do not have E&P do not need to maintain an AAA for reporting purposes (i.e., the Form 1120S balance sheet). The IRS suggests, however, that an AAA be maintained in case E&P is acquired from a C corporation. Such is not the usual practice of most CPAs.

Topic Review C:11-4 provides a summary of the taxation of S corporation income and distributions. The Stop and Think material at this point illustrates why the special tracking rules are necessary. VIII. Other Rules. A.

Tax Preference Items and Other AMT Adjustments. An S corporation is not subject to the alternative minimum tax, but the AMT does apply to individuals. Items of adjustment or tax preference flow through to the shareholders. Allocation of adjustment or tax preference items is made on a daily basis unless one of the special allocation elections is in place. S corporations do not have to make the adjustment for the difference between adjusted current earnings and pre-adjustment alternative minimum taxable income that is required of other corporations.

Transactions Involving Shareholders and Other Related Parties. The Sec. 267 related party rules deny a payer a deduction when a mismatching of income and expense items occurs as a result of two different accounting methods being used. S corporations are denied a deduction when payments involve persons who directly, indirectly, or constructively own S corporation stock and different accounting methods are used. Losses are also disallowed on sales and exchanges between S corporations and related parties as defined in Sec. 267.

more than 2% of the S corporation stock are treated as partners for purposes of determining the treatment for fringe benefits. Shareholder-employees owning 2% or less of the S corporation stock are treated as an ordinary employee. A more-than-2% shareholder-employee is taxed on the amount of the fringe benefit, but may deduct the item if it otherwise qualifies as an itemized deduction (e.g., health insurance benefits incurred by an S corporation shareholder-employee that are deductible under Sec. 162(l)). They are included as wages on the Form W-2 provided to the morethan-2% shareholder-employee. Fringe benefits paid to the more-than-2% shareholder as compensation are deductible by the corporation. The special fringe benefit rules only apply to “statutory fringe benefits.” They do not apply to stock options, qualified retirement plans, and nonqualified deferred compensation. Fringe benefits which are limited by the more-than-2%-shareholder rule include: group term life insurance premiums; accident and health benefit plan insurance premiums and payments; meals and lodging furnished by the employer; and cafeteria plan benefits. Fringe benefits that may be excluded by a more-than-2%-shareholder include: compensation for injuries and sickness; educational assistance program benefits; dependent care assistance program benefits; and certain other fringe benefits. For purposes of the Sec. 162(l) above-the-line deduction for self-employed taxpayer’s health insurance premiums, a more-than-2%-shareholder is deemed to be self-employed. IX.

Tax Planning Considerations. A.

Election to Allocate Income Based on the S Corporation’s Accounting Methods. As a general rule, an S corporation’s income, gain, loss, deductions, and credits are allocated on a per-share, per-day basis. An election is available to allocate these amounts using the corporation’s tax accounting methods when an S election is terminated or an S corporation shareholder terminates his entire interest. The use of the S corporation’s accounting methods can serve to shift income from one shareholder to another. (See Example C:11-33.) By electing to use the S corporation’s tax accounting method to allocate profits or losses between the C short year and S short year in the year in which the S election terminates, it is possible to (1) shift losses into an S short year where an immediate benefit is obtained by the shareholders at a marginal tax rate of up to 35%; or (2) shift profits into a C short year to take advantage of the 15 and 25% marginal corporate tax rates. (See Example C:11-34.)

Increasing the Benefits from S Corporation Losses. A shareholder is limited in the amount of loss that can be deducted to his basis in his stock. If income is expected to be taxed at a higher marginal rate in future years, basis should not be restored until the later year in order to increase the amount of tax savings from the unused loss. (See Example C:11-35.) C:IO11-14 Copyright © 2024 Pearson Education, Inc.

The S corporation loss carryover is only available to the shareholder who held the stock when the loss was incurred. A shareholder should consider increasing the basis of the stock in order to take advantage of the loss carryover before the stock is sold or exchanged. The purchasing shareholder does not acquire the loss carryover. C.

Passive Income Requirements. An S corporation with Subchapter C E&P is limited as to the amount of passive income that can be earned if the excess net passive income tax is to be avoided. In addition, excessive net passive income may terminate the S election. An election is available to distribute Subchapter C E&P and avoid the corporate level tax. This may be desirable if the E&P amount is small, or the shareholder has a NOL. While the distribution will be taxable, it may be desirable because unlimited amounts of passive income can be earned in the future. Corporations with rental income can avoid the passive loss rules if significant services are rendered or if significant costs are incurred in the rental business. Net leases will not qualify. All the facts and circumstances must be considered including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred other than depreciation.

Salary Levels. An S corporation shareholder that also is an employee can pay himself or herself a salary. The salary is subject to employment taxes and is not qualified business income for the QBI deduction. Thus, the shareholder/employee can reduce employment taxes and increase the QBI deduction by reducing the salary level and taking distributions instead. Compensation, however, must be reasonable under the tax law. In a C corporation, unreasonable salary issues usually arise for excessively high salaries intended to avoid the double taxation inherent in dividend distributions. Conversely, in an S corporation situation, salaries tend to be unreasonable if too low. Prior to the enactment of the QBI deduction, the low salary strategy mainly focused on reducing employment taxes. With the advent of the QBI deduction, the low salary strategy also increases the QBI deduction by increasing S corporation ordinary income. This double benefit of low salaries may have the effect of drawing increased IRS scrutiny. Therefore, S corporation shareholders/employees will need to be increasingly diligent in having substantiation to support the reasonableness of their salaries.

Compliance and Procedural Considerations. A.

Making the Election. The S election is made by filing Form 2553 (Election by Small Business Corporation to Tax Corporate Income Directly to Shareholders). The election can be signed by any person who is authorized to sign the corporation’s tax return under Sec. 6037. No extensions of time to file the S election are granted. Shareholder consents can be made either on the Form 2553 or on a separate consent statement signed by the shareholder and attached to the corporation’s election form. Extensions of time to file shareholder consents can be granted by the IRS. C:IO11-15 Copyright © 2024 Pearson Education, Inc.

Filing the Corporate Tax Return. An S corporation, whether or not there is any income, must file a return for part or all of the tax year that they are in existence. The return is filed not later than the fifteenth day of the third month following the close of the tax year. All S corporations that file a return are required to furnish any shareholder owning stock during the year a copy of the return. The basic three-year statute of limitations applies to S corporations.

Estimated Tax Payments. S corporations are subject to estimated tax payments for the following taxes that they may owe: built-in gains tax, excess net passive income tax, and recapture of investment tax credits claimed in tax years when the S corporation was a C corporation. No estimated taxes are owed unless the total of these taxes is reasonably expected to exceed $500. The S corporation is subject to penalties and interest for its failure to make timely payments of any estimated tax liabilities. The S corporation’s shareholders are also subject to estimated tax payments on their share of the S corporation’s income. The amounts are treated as received concurrently by the shareholders throughout the year.

Consistency Rules. Shareholders are required to treat all items of income, gain, loss, deduction or credit (i.e., a Subchapter S item) in a manner consistent with their treatment on the Form 1120S (Sec. 6037(c)). If an item is reported in an inconsistent manner, the shareholder is required to notify the IRS of the difference. Failure to notify the IRS may result in the imposition penalty under Sec. 6662.

Sample S Corporation Tax Return. A sample S corporation Form 1120S and supporting Schedule K-1s are found in Appendix B. The facts for the sample return are also presented. These facts are the same as were used for the sample sole proprietorship, C corporation, and partnership tax returns. The S corporation tax return provides for the determination of the corporate tax liability and the payment of the special taxes that can be levied against an S corporation. Form 1120S requires the reconciliation of the corporation’s book income to Line 18 of Schedule K (ordinary income and loss plus or minus certain separately stated items) and the reporting of the changes to the Previously Taxed Income, Accumulated Adjustments Account, and Other Adjustments Account during the tax year. The AAA reconciliation is only required of S corporations that have an accumulated E&P balance, although it is recommended that the AAA be maintained by all S corporations. Alternatively, an S corporation must file Schedule M-3 in lieu of Schedule M-1 if the amount of total assets reported in Schedule L of Form 1120S (Balance Sheet per Books) equals or exceeds $10 million. The S corporation also may file Schedule M-3 voluntarily even if not required to do so. If the corporation files Schedule M-3, in C:IO11-16 Copyright © 2024 Pearson Education, Inc.

either case, it checks the appropriate box on page 1 of Form 1120S and does not file Schedule M-1. The sample tax return in Appendix B does not include Schedule M-3.

Court Case Briefs William B. Howell, 57 T.C. 546 (1972). A corporation was formed by three individuals for the purpose of acquiring property for investment. The corporation was to sell such property for a profit. The corporation’s only asset was a piece of land. No income was received from this property. The corporation made a proper election to be taxed as a Subchapter S corporation. The gains from sale of the land were treated as long-term capital gains on the individual tax returns of the shareholders in proportion to their ownership interest. The court held that this capital gains treatment was valid. Even though the corporation’s only activity was the sale of the land, the proceeds from such sale need not be treated as ordinary income because the land was not held primarily for sale in the ordinary course of a trade or business. The land had been acquired as an investment. The Tax Court also held that the corporation had made a valid Subchapter S election. The corporation’s only income had been from the sale of real estate. It had no passive investment income and therefore was not prohibited from making a Subchapter S election. Opine Timber Co., 64 T.C. 700 (1975) aff’d. without opinion 552 F2d 368 (5th Cir., 1977). Opine Timber had elected to be taxed as a Subchapter S corporation. During certain tax years over 20% of its gross receipts came from “delay rentals,” i.e., payments under a standard oil, gas, or mineral lease for years in which the lessee does not perform any drilling or mining. If these delay rentals are not paid, the lessee loses the right to hold the lease in succeeding years. In years when drilling occurs, royalties are paid to the lessor. The issue to be decided by the court was whether these “delay rentals” were “rents” within the meaning of Sec. 1372(e)(5). If so, then the corporation’s Subchapter S election would be terminated in the first year in which over 20% of gross receipts were obtained from such rents. The Tax Court held that the “delay rentals” were rent and therefore the election was terminated. The Tax Court also held that a retroactive Subchapter S election was not valid.

Chapter C:12 The Gift Tax Learning Objectives After studying this chapter, the student should be able to: 1.

Explain the basic concepts of the unified transfer tax system.

Apply the gift tax formula.

Recognize a number of transactions subject to the gift tax.

Determine whether an annual gift tax exclusion is available.

Identify the deductions available for gift tax purposes.

Apply the gift-splitting rules.

Calculate the gift tax liability.

Recognize how basis affects the overall tax consequences.

Determine the tax consequences of below-market loans.

10.

Identify tax planning opportunities in gift situations.

11.

Comply with the filing requirements for gift tax returns.

Areas of Greater Significance Students should understand the impact of making lifetime gifts under the unified transfer tax system. Property transfers subject to the gift tax, gift tax exclusions and deductions and basis considerations are important to further understanding the transfer tax system.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Below market loans.

Tax planning considerations (tax savings features of inter vivos gifts and negative aspects of gifts).

Compliance and procedural considerations (filing requirements, due date, gift splitting election, short-form gift tax return, liability for tax, determination of value, and statute of limitations).

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Present interest requirement to qualify for the annual exclusion.

Calculation of transfers for inadequate consideration.

Highlights of Recent Tax Law Changes 1.

Various tax acts over past years have modified the unified transfer tax system in terms of (1) the threshold (called the exemption equivalent or basic exclusion amount) above which the tax becomes effective, (2) the tax rates applicable to estates and gifts, and (3) a number of other aspects of the unified transfer tax system. Rates and exclusions are available in the Quick Reference guide in the textbook.

The amount of the annual gift tax exclusion is $17,000 for 2023 ($34,000 for a married couple).

Teaching Tips 1.

Many students get a better feeling for the detail of the gift tax law if they are given a visual picture of the entire gift tax computation very early. Thus, it may be worthwhile to take time in class to briefly review the comprehensive problem on p. C:12-25. Table C:12-1 illustrates the solution to this problem. p. C:12-26.

An extension of using the comprehensive illustration in (1) is to review with the students the completed gift tax return (Form 709) contained in Appendix B that uses the facts from the comprehensive illustration. C:IO12-2 Copyright © 2024 Pearson Education, Inc.

Example C:12-28: Point out that the net gift calculation becomes even more complicated when more than one marginal gift tax rate applies. p. C:12-15.

Lecture Outline I.

Concept of Transfer Taxes. Gifts and inheritances are specifically excluded from the income of a recipient. The donor must pay a gift tax on the value of property transferred by gift. The estate pays an estate tax on the value of property in the taxable estate. A.

II.

History and Purpose of Transfer Taxes. The United States has had an estate tax since 1916 and a gift tax since 1932. The structure of these taxes has remained fairly constant. One of the most important purposes of the gift tax is to raise revenue. Because of the generous exclusion, the gift tax raises a very small amount of the total revenue. Another purpose of the gift tax is to provide a backstop for the estate tax. The gift tax prevents wealthy donors from transferring large portions of their assets during life to escape the estate tax. The continuity of the estate tax is broken for 2010 for estates whose executors elect to have the estate tax not apply for that year, with a modified carryover basis rule to apply instead. The system also includes the generation-skipping transfer tax.

The Unified Transfer Tax System. A.

Unified Rate Schedule. Before the 1976 Act, there was a separate rate schedule for gift tax purposes that was only 75% of the estate tax rates. Since that time there has been a unified rate schedule with graduated rates. See the Quick Reference guide in the textbook for details on the most current rates.

Impact of Taxable Gifts on Death Tax Base. Taxable gifts are added into the estate tax base. They are valued at their FMV on the date of the gift. The addition of post-1976 adjusted taxable gifts to the estate tax base results in a higher probability of transfers made at death becoming taxable. Gift taxes paid on lifetime gifts are subtracted from the estate tax liability. (See Example C:12-1.)

Unified Credit. The unified credit reduces dollar-for-dollar a certain amount of the tax computed on the taxable gifts or the taxable estate. The amount of the credit varies depending on the year of transfer. In the gift and estate tax formulas, the full credit is available for lifetime transfers and again in determining the tax payable at death. The benefit of the credit is reduced at death by the amount of the credit used in making lifetime gifts.

III.

Gift Tax Formula. A.

Determination of Gifts. A determination must first be made as to whether any transfers made by a taxpayer constitute a gift. The transfer is valued at the FMV of the property on the date of the gift. The aggregate amount of gifts for the period is then determined. Aggregate gifts are reduced by any exclusions or deductions to determine taxable gifts. The formula to compute the tax is provided in Figure C:12-1, p. C:12-5. Figure C:12-1 may be used at this point to illustrate the computation of the gift tax.

Exclusions and Deductions. For 2023, the amount of the annual exclusion is $17,000 per donee per year ($34,000 if married). Exclusions may be claimed for an unlimited number of donees. Unlimited deductions are allowed for marital transfers and gifts to charities.

Gift-Splitting Election. Congress authorized gift-splitting provisions to provide for comparable tax results for residents of community property and common law states. Under this provision, gifts made to third parties by one spouse will be treated as made one-half by each for purposes of the annual exclusion and unified credit. (See Example C:12-2.) As a result of the Supreme Court’s 2013 decision in U.S. v. Windsor, same-sex spouses are eligible for the gift-splitting election. The IRS announced that it will honor the Windsor decision for same-sex spouses whose domicile is in states that do not recognize such marriages if they were married in jurisdictions permitting such marriages. The ruling does not apply to civil unions or domestic partnerships. However, Obergefell v. Hodges et al. requires all states to allow and honor same-sex marriages.

IV.

Cumulative Nature of Gift Tax. Computation of gift tax liabilities is cumulative in nature. The marginal tax rate depends on both the taxable gifts of the current and prior periods. (See Example C:12-3.)

Unified Credit. Prior to 1977, the Code allowed a $30,000 specific exemption. The exemption was repealed and replaced by the unified credit. The unified credit amount has changed over the years. A table showing the amount of the unified credit and applicable exclusion amount is provided in the Quick Reference guide in the textbook. In 2023, the credit amount is $5,113,800, the tax on $12.92 million. (See Example C:12-4.)

Transfers Subject to the Gift Tax. A.

Transfers for Inadequate Consideration. Property transferred for less than adequate consideration in money or money’s worth is deemed a gift. A transfer is subject to the gift tax even though not entirely gratuitous if the value of the property transferred exceeds the value of money or other consideration given. C:IO12-4 Copyright © 2024 Pearson Education, Inc.

Bargain Sales. A prospective buyer may wish to transfer property at less than adequate and full consideration. A part-sale, part-gift will then occur. The amount of the gift is the difference between the sales price and the property’s FMV on the date of the transfer. (See Example C:12-6.)

Transfers in Normal Course of Business. A transfer arising in the ordinary course of business, which is bona fide, arm’s length, and free from any donative intent is considered made for adequate consideration. (See Example C:12-7.)

Statutory Exemptions from the Gift Tax. There are certain statutory exemptions from the gift tax. 1.

Payment of Medical and Tuition Expenses. A qualified transfer is not treated as a gift. A qualified transfer is defined as an amount paid on behalf of an individual to an educational organization for tuition or to any person who provides medical care as payment for such medical care. The payment must be made directly to the educational institution or the person or entity providing the medical care. It includes tuition, but not room, board, and books. The identity of the person benefiting is not important and does not need to be a relative. If payments made are for the support of an individual under state law, the payments do not constitute a gift. State law determines the definition of support. (See Examples C:12-8 and C:12-9.) At this point you may wish to discuss the material in the ethics box relating to gifts to cover tuition costs.

Transfers to Political Organizations. Transfers to a political organization are not considered gifts. (See Example C:12-10.)

Property Settlements in Conjunction with Divorce. Section 2516 sets out circumstances in which property settlements in connection with a divorce are exempted from being treated as a gift. To come under these provisions, the spouses must adopt a written agreement concerning their marital property rights and the divorce must occur during a three-year period beginning one year before the agreement is made. (See Example C:12-11.)

Qualified Disclaimers. People may sometimes wish to disclaim a gift if they are old, ill, or very wealthy. States provide disclaimer statutes, which allow an individual to disclaim a gift. People making a qualified disclaimer will be treated as though they never received the property. State law or a provision in the will addresses how to determine who will receive the property after the original beneficiary declines to accept it. A qualified disclaimer must meet the four tests listed on p. C:12-9. (See Example C:12-12.) C:IO12-5 Copyright © 2024 Pearson Education, Inc.

Cessation of Donor’s Dominion and Control. A gift does not occur until a transfer becomes complete. A gift is complete and thus is deemed made and valued when the donor has parted with dominion and control so as to leave him without power to change its disposition, whether for his own benefit or the benefit of another. 1.

Revocable Trusts. A transfer of property to a revocable trust has not made a completed transfer. If the trustee makes a distribution from a revocable trust to a beneficiary, a completed gift is made. (See Examples C:12-14 and C:12-15.)

Other Retained Powers. Transfers to an irrevocable trust may not be deemed complete with respect to the portion of the trust that the creator keeps control over. If a donor reserves any power over the property’s disposition, the gift may be wholly or partially incomplete depending upon the facts in the case. A gift is incomplete to the extent the donor can name new beneficiaries or change the interests of beneficiaries.

At this point you may wish to use Topic Review C:12-1 on p. C:12-11, which illustrates types of complete and incomplete transfers. D.

Valuation of Gifts. 1.

General Rules. All gifts are valued at their FMV on the date of the gift. FMV is defined as the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.

Life Estates and Remainder Interests. The value of a transfer of a life estate or a remainder interest is determined based upon actuarial tables found in Appendix H. Table S is used for valuing life estates and remainders and Table B for term certain interests. The interest rate is to be revised every month to the rate that is 120% of the Federal midterm rate applicable for the month of the transfer. (See Examples C:12-19 through C:12-22.) You may at this point wish to use the Stop and Think example, which illustrates the effect the age of the income beneficiary has on the value of the remainder interest.

Special Valuation Rules: Estate Freezes. In recent years Congress became concerned that individuals were able to shift wealth to other individuals, usually in a younger generation, without paying their fair share of the transfer taxes. An approach commonly used was the estate freeze, where a corporation was recapitalized. In 1990 Congress addressed C:IO12-6 Copyright © 2024 Pearson Education, Inc.

this perceived problem by enacting new Chapter 14 (Secs. 2701 through 2704). These rules are too complex for discussion here. E.

Gift Tax Consequences of Certain Transfers. Some transactions that cause the transferor to be considered as having made a gift are not straightforward. 1.

Creation of Joint Bank Accounts. Funding a joint bank account is an incomplete transfer. A gift occurs when one party withdraws an amount in excess of the amount they deposited. (See Example C:12-23.)

Creation of Other Joint Tenancies. A completed gift occurs when a transferor titles real estate or other properties in the names of him and another as joint tenants. Each joint tenant is deemed to have an equal interest in the property. The person furnishing consideration for the property is deemed to have made a gift to the other joint tenant in an amount equal to the value of the donee’s pro rata interest in the property. (See Example C:12-24.)

Transfer of Life Insurance Policies. The mere naming of another as the beneficiary on a life insurance policy is an incomplete transfer. If the owner of a policy irrevocably assigns all ownership rights in the policy to another, a completed gift has been made. Ownership rights include the ability to change the beneficiary, borrow against the policy, and cash the policy in for its cash surrender value. The payment of premiums on a policy is considered a gift to the policy’s owner in the amount of the premium paid. (See Examples C:12-25 and C:12-26.)

Exercise of a General Power of Appointment. A power of appointment exists when a person transfers property and grants someone else the power to specify who will eventually receive the property. Powers can be general or special. A person possesses a general power of appointment if he has the power to appoint the property to himself, his creditors, his estate, or the creditors of his estate. A gift occurs when a person exercises a general power of appointment and names some other person to receive the property. The gift is made to the person receiving the property. The exercise of a power of appointment in favor of the holder of the power is not a gift. (See Example C:12-27.)

Net Gifts. A net gift occurs when an individual makes a gift to a donee who agrees to pay the gift tax as a condition to receiving the gift. The amount of the gift is the excess of the value of the transferred property over the amount of the gift tax paid by the donee. (See Example C:12-28.) A net gift has one potential disadvantage: the Supreme Court has ruled that the donor must recognize as a gain the excess of the gift tax payable over his or her adjusted basis in the property. C:IO12-7 Copyright © 2024 Pearson Education, Inc.

VI.

Exclusions. A.

Amount of the Exclusion. For 2023, the amount of the gift tax exclusion is currently $17,000. It is available annually for an unlimited number of donees. The exclusion is indexed for inflation with adjustments rounded to the next lowest multiple of $1,000. (See Example C:12-29.)

Present Interest Requirement. A donor receives an exclusion for a gift only if it is a gift of a present interest. 1.

Definition of Present Interest. A present interest is an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.

Definition of Future Interest. A future interest is the opposite of a present interest. Gifts of a future interest are not eligible for the annual exclusion. A future interest is a legal term and includes reversions, remainders, and other interests which are limited to commence in use, possession, or enjoyment at some future date or time. (See Examples C:12-30 and C:12-31.)

Special Rule for Trusts for Minors. Parents creating trusts for children under the age of 21 can provide that income be accumulated in the trust and the trust will qualify for the annual exclusion provided the trust meets the two Sec. 2503 trust requirements on p. C:12-17.

Crummey Trusts. A Crummey trust is a technique that allows a donor to set up a trust and obtain an annual exclusion. The trust can terminate at whatever age the donor specifies and can be created for an individual of any age. A “Crummey power” entitles each beneficiary to demand a distribution of the lesser of a specific amount or the amount transferred to the trust that year. If the power is not exercised by a certain date, it expires. The demand power is held to be a present interest. (See Example C:12-32.) At this point you may wish to use the Stop and Think example, which highlights the meaning of a present interest.

Gift Tax Deductions. A.

Marital Deduction. Generally, because of the marital deduction, interspousal transfers are tax-free, including those in same-sex marriages. There is an exception for terminable interests. 1.

Unlimited Amount. Over the years the amount of the marital deduction has varied. Currently, there is an unlimited marital deduction. Transfers of community property are now eligible for the deduction. (See Example C:12-33.) C:IO12-8 Copyright © 2024 Pearson Education, Inc.

Gifts of Terminable Interests - General Rule. A terminable interest is an interest that ends or is terminated when some event occurs (or fails to occur) or a specified amount of time passes. A marital deduction is denied only when the transfer is a nondeductible terminable interest. Examples C:12-34 through C:12-36 illustrate some of the subtleties of the definition of a nondeductible terminable interest.

QTIP Provisions. Under the QTIP provisions, transfers of qualified terminable interest property are eligible for the marital deduction. The QTIP rules are listed on p. C:12-20. Under these provisions, donors can now receive the marital deduction without having to grant their spouse full control over the property. The deduction is elective. If the donor claims the marital deduction, the donee-spouse must include the QTIP property in their estate. (See Example C:12-37.)

At this point you may wish to use Topic Review C:12-2, which illustrates the tax consequences of marital transfers. B.

VII.

Charitable Contribution Deduction. A donor who makes no noncharitable gifts in excess of the excludible amount does not have to report charitable gifts on a gift tax return provided a charitable contribution deduction is available and the charitable organization receives the donor’s entire interest in the property. There is no percentage limitation for a charitable contribution for gift tax purposes. An income tax deduction can also be claimed subject to the percentage of AGI limitations. (See Example C:12-38.) 1.

Transfers Eligible for the Deduction. To be eligible for the deduction, a gift must be made to a charitable organization. A deduction is available for gifts to the categories of organizations listed beginning on p. C:12-21.

Split-Interest Transfers. Special rules apply when a transfer is made for both private and public purposes. An example would be a gift of a residence made to a sister for life, and with the remainder to a college or university. (See Example C:12-39.)

The Gift-Splitting Election. The gift-splitting provisions allow spouses to treat a gift that is made to a third party as if each spouse had actually made one-half of the gift. In order to take advantage of this provision, spouses must meet the two conditions listed on p. C:12-22. Each year’s election stands alone and is not binding on future years. (See Example C:12-40.) Upon the death of the actual donor or the spouse who consented to gift splitting, the amount of such decedent’s adjusted taxable gifts must be included in the estate tax base. Adjusted taxable gifts include only the portion of the gift that is taxable on the gift tax C:IO12-9 Copyright © 2024 Pearson Education, Inc.

returns filed by the donor-decedent. The Stop and Think example at this point illustrates a situation where gift splitting may not be desirable. VIII. Computation of the Gift Tax Liability. The gift tax computation is a cumulative process. All previous gifts made in 1932 or later years plus the taxable gifts for the current year affect the marginal tax rate at which the current gifts will be taxed. (See Example C:12-41.) Congress enacted a unified credit for transfers made in 1977 and later years. The amount of the credit has been increased over the years. In 2023, the credit is $5,113,800, which is the tax at a maximum tax rate on the $12.92 million applicable exclusion amount. Any credit used in post-1976 gift transfers reduces the amount of the credit currently available. (See Example C:12-42.) The Stop and Think example emphasizes the cumulative nature of the unified credit. IX.

Comprehensive Illustration. A comprehensive illustration is provided beginning on p. C:12-25. Table C:12-1 illustrates the solution to the comprehensive problem. Figure C:12-1 contains the gift tax formula and may be used to review the comprehensive gift tax illustration. Appendix B contains a completed Form 709 for use with this comprehensive illustration.

Basis Considerations for a Lifetime Giving Plan. Prospective donors should consider a lifetime giving program. In addition to the estate tax savings, there is an income tax savings as well through the removal of income to a return with lower marginal tax rates. These two advantages must be weighed against the unattractive basis rules applicable for such transfers. A.

Property Received by Gift. Carryover basis rules apply to property received by gift. All of the gift taxes paid are added to the donor’s basis for pre-1977 gifts. For post-1976 gifts, only the gift tax on appreciation in the property’s value is added to the donor’s basis. In no event can this adjustment plus the donor’s basis exceed the FMV of the property on the date of the gift. If the FMV is less than the donor’s basis on the date of the gift, the FMV is the donee’s basis for purposes of determining loss. No gain or loss is recognized if the donee sells the property for an amount between the FMV and the adjusted basis. Prospective donors should sell property that has declined in value instead of gifting it.

Property Received At Death. Property received from a decedent has a basis equal to its FMV on the date of death or alternate valuation date. Under this rule, a person receiving property from a decedent will have a basis equal to the lesser of (1) the decedent’s adjusted basis in the property, or (2) the property’s fair market value at the date of the decedent’s death. A special rule will allow a $1.3 C:IO12-10 Copyright © 2024 Pearson Education, Inc.

million basis increase (and an additional $3 million basis increase for property transferred to a surviving spouse) not to exceed the property’s fair market value. XI.

Below Market Loans: Gift and Income Tax Consequences. One of the most interesting issues in recent years has been whether interest-free loans constitute a gift. Historically the government has held that a gift of the foregone interest occurs in each period the loan is outstanding. The lower courts had held that interest-free demand loans did not constitute a gift. The Supreme Court held in the Dickman case (1984) that the gratuitous transfer of the right to use money is a transfer of property for purposes of determining whether a gift is made. The Court did not address how to value the gift.

XII.

General Rules. Section 7872 provides definitive rules concerning both the income and gift tax consequences of below-market loans. The lender is treated as making a gift to the borrower and receiving interest income. The borrower is treated as paying interest expense. In the case of a demand loan, the lender is treated as making a gift in each year the loan is outstanding. The foregone interest is treated as being retransferred from the borrower to the lender on the last day of each calendar year the loan is outstanding. The lender reports the foregone interest as income for the year. The borrower gets an interest expense deduction unless one of the rules limiting the interest deduction applies. (See Example C:12-44.)

De Minimis Rules. Neither the income nor the gift tax rules apply to any gift loan made directly between individuals for any day on which the aggregate loans outstanding between the borrower and the lender are $10,000 or less. All loans are counted irrespective of their interest rate. For loans of $100,000 or less, the amount of interest income and expense that is imputed for income tax purposes is limited to the amount of net investment income of the borrower. If the borrower’s net investment income for the year is $1,000 or less, the amount of net investment income is treated as zero. (See Example C:12-45.)

Tax Planning Considerations. A.

Tax-Saving Features of Inter Vivos Gifts. 1.

Use of the Annual Exclusions. If gifts are made to several individuals early in a person’s lifetime, substantial amounts of property can be transferred free of tax.

Removal of Post-Gift Appreciation from Tax Base. Post-gift appreciation is removed from an estate through gifting property. Appreciation in property for unified transfer purposes is frozen on the date of the gift. C:IO12-11 Copyright © 2024 Pearson Education, Inc.

Removal of Gift Tax Amount from Transfer Tax Base. With one exception, gift taxes paid by the donor are removed from the transfer tax base. Gift taxes paid on gifts made within three years of death are included in the tax base for estate tax purposes.

Income Shifting. The compression of income tax rates beginning in 1987 has lessened the benefits of income shifting. Income tax benefits that do accrue will do so over a period of years and may become quite sizable.

Gift in Contemplation of Donee-Spouse’s Death. At times, a terminally ill spouse may have few assets. If they die, the unified credit to which they are entitled would be wasted. If the healthier spouse is wealthy, gifts can be made to the terminally ill spouse to take advantage of that spouse’s unified credit.

Lessening State Transfer Costs. Currently about 18 states levy an estate and/or inheritance tax, but only two states impose a gift tax. Therefore, in some states the tax cost of lifetime transfers is lower than that for transfers at death. State death taxes are deductible in calculating the taxable estate, but they still add to death-associated costs.

Income Tax Savings from Charitable Gifts. When charitable transfers are considered, the income tax implications should be considered as well. Transfers during one’s lifetime are eligible for both the gift tax charitable contribution deduction and the income tax charitable contribution deduction.

Negative Aspects of Gifts. 1.

Loss of Step-up in Basis. The donee receives no step-up in basis for property acquired by gift.

Prepayment of Estate Tax. A donor making gifts in excess of the exemption equivalent must pay a gift tax. The tax paid during the donor’s lifetime reduces the amount of estate taxes to be paid. The payment of gift taxes results in the prepayment of estate taxes.

XIII. Compliance and Procedural Considerations. A.

Filing Requirements. A donor files a Form 709 (United States Gift Tax Return) or a simpler Form 709A (United States Short-Form Gift Tax Return) whenever annual gifts to an individual exceed $17,000. A return is not filed for gifts to charitable organizations if the gift is deductible and the organization receives the donor’s entire interest in the property. A return is not filed for gifts to a spouse, unless the gift to the spouse is a qualified terminable interest. C:IO12-12 Copyright © 2024 Pearson Education, Inc.

Due Date. All gift tax returns must be filed on a calendar year basis. The returns are due no later than April 15 following the close of the gift year. An extension for the filing of the income tax return is deemed an automatic extension for the filing of the gift tax return. An extension of time to file the gift tax return does not extend the time for paying the gift taxes. Estimated payments are not required for gift tax liabilities.

Gift-Splitting Election. In order for gifts to be computed under the gift-splitting provisions, both spouses must consent to gift splitting by one of the ways listed on p. C:12-31.

Short-Form Tax Return. A gift tax return is necessary for gift splitting even if no gift tax return is otherwise due. In this case a Form 709A can be filed.

Liability for Tax. The gift tax is paid by the donor and, if the spouses consent to gift splitting, the entire gift tax is a joint and several liability of the spouses.

Determination of Value. The determination of value for a gift is one of the most difficult problems faced by donors and their tax advisors. This is especially true for stock in a closely held business, an oil and gas property, or land in an area where few sales occur. If property is difficult to value, it should be appraised before filing the gift tax return. 1.

Penalty for Undervaluation. Section 6662 imposes a penalty at varying rates on underpayments of gift and estate taxes resulting from a valuation understatement.

Statute of Limitations. The statute of limitations is three years for gift tax purposes. This is extended from three to six years if the donor omits from the gift tax return gifts whose value in total is more than 25% of the gifts reported on the return. If no return is filed, the tax may be assessed at any time. Once the statute of limitations has expired, the IRS cannot argue that taxable gifts of prior periods were undervalued (and thus that the current period’s gifts should be taxed at a higher rate than that used by the donor) as long as a gift tax was paid on the earlier gifts. For gifts after August 5, 1997, this rule applies even if the donor paid no gift tax.

Court Case Briefs Arthur W. Clark, 65 T.C. 126 (1975). Arthur Clark made gifts of principal interests in Central Wisconsin Motor Transport Co. stock, which was the principal of two Clifford trusts that had been set up for the benefit of Clark’s two sons. In the years of these gifts, Clark claimed the then-applicable annual gift tax exclusion of $3,000 per donee in his annual gift tax returns. The IRS contended that the stock represented future interests and the gift tax exclusion was not allowable. The court upheld the common law doctrine of merger under Wisconsin law, which meant that the income beneficiaries had all the rights and full possession of the stock immediately following execution of the principal interests in the stock. The gift tax exclusion was therefore allowable. U.S. v. Ray Dodge, 443 F. Supp. 535 (DC OR, 1977). Ezra and Bonnie Royce were brothers who engaged in several joint business enterprises, which were very successful. Bonnie had no children and made an oral agreement with Ezra in 1938 that one-half of Bonnie’s estate would go to Ezra’s only child, Eunice, if Ezra took care of Bonnie’s business affairs from then on and served as executor for Bonnie’s estate with no compensation. Ezra fulfilled his obligations under the agreement. The brothers were later estranged and Bonnie had a new will drawn up which did not include Eunice. Upon Bonnie’s death Eunice sued to have the 1938 oral agreement recognized and to collect one-half of Bonnie’s estate. Such recovery was granted, two years after Ezra’s death. The IRS tried to include the right to this property in Ezra’s estate as a taxable gift by Ezra to Eunice because Eunice was only entitled to the property because Eunice fulfilled his obligation to Bonnie. The court held that the right to this property was uncertain enough at the time of Ezra’s death that Ezra could not have passed this right on to Eunice. Therefore, Ezra’s estate was not liable for tax thereon or to include the “gift” in the estate.

Chapter C:13 The Estate Tax Learning Objectives After studying this chapter, the student should be able to: 1.

Explain the formula for the estate tax.

Describe the methods for valuing interests in the gross estate.

Recognize which interests are includible in the gross estate.

Identify the deductions available for estate tax purposes.

Calculate the estate tax liability.

Explain tax provisions that alleviate liquidity problems.

Summarize the basic concepts of the generation-skipping transfer tax.

Recognize tax planning opportunities for estates.

Comply with the filing requirements for estate tax returns.

Areas of Greater Significance Greatest emphasis should be placed on the property included in the gross estate and the estate tax deductions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Liquidity concerns

Generation-skipping transfer tax.

Tax planning considerations (use of inter vivos gifts, use of exemption equivalent, what size marital deduction is best, use of disclaimers, qualifying the estate for installment payments, and where to deduct administration expenses).

Problem Areas for Students The following areas may prove especially difficult for students: 1.

General powers of appointment.

Generation-skipping transfer tax.

Highlights of Recent Tax Law Changes An estate or trust could incur an incremental 3.8% on net investment income. The TCJA has increased the minimum estate size subject to the estate tax, and this tax will not apply to a significantly reduced number of estates. It is suggested that there be a discussion with the class to place this tax into context as to what percentage of total estates are subject to the tax, and the percentage of total tax revenues for which this tax is responsible.

Teaching Tips 1.

Figure C:13-1: Many students get a better feeling for the detail of the estate tax law if they are given a visual picture of the entire estate tax computation very early. Thus, it may be worthwhile to take time in class to briefly review the comprehensive illustration on pp. C:13-25 through C:13-27 when explaining Figure C:13-1. p. C:13-3.

An extension of using the comprehensive illustration in (1) is to have students review the completed estate tax return (Form 706) contained in Appendix B that uses the facts from the comprehensive illustration.

Lecture Outline I.

Estate Tax Formula. The federal estate tax is a wealth transfer tax, not a property tax or an income tax. The tax base for the federal estate tax is the total of the decedent’s taxable estate and adjusted taxable gifts. The estate tax formula appears in Figure C:13-1. Figure C:13-1 should be used at this point to illustrate the estate tax formula. A.

Gross Estate. The process of arriving at the decedent’s estate tax liability begins with determining the items to be included in the gross estate. Such assets are valued at the date of death or the alternate valuation date. The estate tax is levied on dispositions that are testamentary in nature. A transfer is considered testamentary if the transferor’s control or enjoyment of the property ceases at death, not before death. The gross estate may include gifted property if either the right to receive the income generated by the property or control over the property is retained for the donor’s lifetime. (See Example C:13-1.) C:IO13-2 Copyright © 2024 Pearson Education, Inc.

II.

Deductions. The five categories of deductions are listed on pp. C:13-3 and C:13-4.

Adjusted Taxable Gifts and Tax Base. Adjusted taxable gifts are added to the taxable estate to determine the amount of the estate tax base. Adjusted taxable gifts are taxable gifts made after 1976 other than gifts that are included in the gross estate. (See Example C:13-2.)

Tentative Tax on Estate Tax Base. After the tax base is determined, the next step is to calculate the tax on this base. The unified tax rates are found in the Quick Reference guide in the textbook. The tax determined by the rate schedule is reduced by the decedent’s post-1976 gift taxes calculated using date of death rates. The unified tax rates for the current year are located within the textbook’s Quick Reference guide.

Reduction for Post-1976 Gift Taxes. Gifts are not taxed twice because post-1976 gift taxes that are paid reduce the amount of the estate tax payable at death. This credit against the estate tax is calculated using the unified rate schedule in effect in the year of death and the unified credit for the year of the gift. (See Examples C:13-4 and C:13-5.)

Unified Credit. The unified credit allows a tax base of a certain size, referred to as an exemption equivalent or applicable exclusion amount, to be completely free of the transfer tax. The amount of the credit varies depending on the year of death. Congress increased the tax-free amount to $12.92 million beginning in 2023. The rate in 2022 was $12.06 million. This increased amount, indexed annually, will continue through 2025.

The Gross Estate - Valuation. A.

Date-of-Death Valuation. All property included in the gross estate is valued at its FMV at the date of death or alternate valuation date. Fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Life insurance is valued at its face value at the date of death rather than at its interpolated terminal reserve value as in the case of a gift. 1.

Listed Stocks. Stocks traded on a stock exchange are valued at the average of their highest and lowest selling price on the date of death. If no sales occur on the date of death, the FMV is a weighted average of the high and low sales prices on the nearest trade dates before and after the date of death. (See Examples C:13-6 and C:13-7.)

Interests in Firms Where Their Stock Is Not Publicly Traded. Detailed guidelines are found in Rev. Rul. 59-60 that provide guidance in valuing stock that is not publicly traded. Relevant factors, including book value and earning capacity, are included in that revenue ruling. If the stock represents a minority interest in a closely held firm, the courts often grant a discount for the minority interest.

Real Estate. Specific guidance is not provided for the valuation of real estate. Appraisal literature discusses three techniques for valuing real estate: comparable sales, reproduction cost, and capitalization of earnings. The method used depends on the real estate being valued. At times, all three methods are used.

Annuities, Interests for Life or a Term of Years, Reversions, Remainders. Annuities, interests for life or a term of years, reversions, and remainders are valued using current interest rates and actuarial tables. These tables are contained in Appendix H. (See Example C:13-8.)

Alternate Valuation Date. The executor can elect under Sec. 2032 to value all property included in the gross estate at its FMV on the date of death or the alternate valuation date (six months after the date of death). In situations where the property is distributed, sold, exchanged, or otherwise disposed of within the six-month period, the alternate valuation date is the date of disposition. (See Example C:13-9.) If the executor elects the alternate valuation date, generally any changes in value that occur due to the mere lapse of time are to be ignored in determining the property’s value. An example of this is the valuing of a patent. The basis of property received because of another’s death is its value on either the date of death or alternate valuation date. The alternate valuation date value can only be elected if the election decreases the value of the gross estate and the estate tax liability (after the reduction for credits). The Stop and Think example at this point provides an illustration of when the alternate valuation date can prove effective for both estate tax and income tax purposes.

III.

The Gross Estate - Inclusions. A.

Comparison of Gross Estate with Probate Estate. The probate estate can be defined as encompassing those properties that pass subject to the will and are subject to court administration. The probate estate is defined by state law. The gross estate is a federal tax law concept and includes property not included in the probate estate. Table C:13-1 on p. C:13-9 provides an overview of the inclusions in the gross estate. The Stop and Think example at this point illustrates the difference between the property included in a decedent’s gross estate and probate estate.

Property in Which the Decedent Had an Interest. The gross estate includes the value of all property the decedent beneficially owned at the time of death. Its scope extends beyond property in which the decedent held title. (See Examples C:13-10 and C:13-11.)

Dower or Curtesy Rights. State law in some states defines dower and curtesy rights. Under these rules, state law entitles the surviving spouse to a certain portion of the decedent spouse’s estate, even though the decedent may have willed a smaller portion to the surviving spouse. (See Example C:13-12.)

Transferor Provisions. Sections 2035 through 2038 serve to pull property back into the gross estate that the decedent transferred earlier prior to death and when the decedent has not received full and adequate consideration for the property. 1.

Gifts Made Within Three Years of Death (Sec. 2035(a)). Certain gifts made within three years of death, i.e., life insurance proceeds and transfers made under Secs. 2036 through 2038 are pulled back into the gross estate and valued as of the date of death. (See Examples C:13-13 and C:13-14.)

Gross-Up Rule (Sec. 2035(b)). The donor-decedent’s gross estate is increased by any gift tax that he or his estate pays on any gift that he or his spouse makes during the three-year period ending with the date of death. (See Examples C:13-15 and C:13-16.)

Transfers with Retained Life Estate (Sec. 2036). Property is included in the gross estate when the transferor keeps the income or enjoyment of the property or the right to control other individuals’ income or enjoyment. The retention of voting rights in stock of a controlled corporation that has been transferred will also cause the stock to be included in the decedent’s gross estate under these provisions. (See Examples C:13-17 through C:1319.)

Reversionary Interests (Sec. 2037). The gross estate includes earlier transferred property if the decedent stipulates that another person must survive him in order to own the property, and the value of the decedent’s reversionary interest exceeds 5% of the value of the transferred property. Actuarial techniques are used to value the reversionary interest. (See Example C:13-20.)

Revocable Transfers (Sec. 2038). Section 2038 covers the rules for revocable transfers. This provision also taxes transfers over which the decedent has, as of the time of his death, the power to change the enjoyment by altering, amending, revoking, or terminating an interest. Revocable trusts, sometimes called living trusts, are popular arrangements from a non-tax C:IO13-5 Copyright © 2024 Pearson Education, Inc.

standpoint because assets held by a revocable trust pass outside of probate. Unlike a will, a revocable trust is not a matter of public record. (See Examples C:13-21 and C:13-22.) E.

Annuities and Other Retirement Benefits. Under Sec. 2039, an annuity is includible in the gross estate if payments have been made under a contract or agreement, and the decedent is receiving these payments at death and has the right to receive them alone or with another person. If the annuity simply ceases with the death of the decedent in question, nothing is to be received by another party and nothing is included in the gross estate. 1.

Annuities Not Related to Employment. The amount included in the gross estate with respect to annuities or other retirement benefits is a fraction of the value of the annuity or lump-sum payment to be received by the surviving beneficiary. (See Example C:13-23.)

Employment-Related Retirement Benefits. Contributions made by a decedent’s employer (or former employer) are treated as contributions made by the decedent, provided such payments are made as a result of the employment relationship. 100% of the benefits from an employment-related annuity are included in the gross estate. (See Example C:13-24.)

Jointly Owned Property. Jointly owned property passes at the death of one joint owner to the other automatically where property is held in a joint tenancy with right of survivorship or tenancy by the entirety. 1.

Ownership Involving Persons Other Than Spouses. When persons other than spouses own property jointly, the portion of the property included in the gross estate is determined based upon the amount of consideration provided. (See Examples C:13-25 and C:13-26.)

Ownership Involving Only Spouses. If only spouses are joint owners, the property is classified as a qualified joint interest. The decedent’s gross estate includes one-half the value of the qualified joint interest. This rule is automatic regardless of the amount of consideration provided. (See Example C:13-27.)

General Powers of Appointment. Section 2041 provides that the holder of a general power of appointment must include the property over which he holds the power in his gross estate. A general power of appointment exists if the holder can exercise the power in favor of himself, his estate, his creditors, or the creditors of his estate. If the power of appointment is limited by an ascertainable standard, it is not a general power of appointment. (See Example C:13-28.)

Life Insurance. Under Sec. 2042, life insurance policies owned by the decedent are included in the gross estate to the extent that they are payable to his estate, or he held any incidents of ownership in the policy at the time of his death. Section 2033 includes life insurance policies owned by the decedent on the lives of others. A life insurance policy is includible in a decedent’s gross estate if the policy is transferred within three years of death. (See Examples C:13-30 through C:13-32.)

IV.

Consideration Offset. The gross estate is reduced by an offset for partial consideration received in certain transactions. If consideration is received in an earlier transaction for property that is transferred, the value of the property included in the gross estate is reduced by the amount of consideration received, not a pro rata portion of the cost paid by the decedent. (See Example C:13-33.)

Recipient Spouse’s Interest in QTIP Trust. If a marital deduction is claimed for QTIP property, the property is generally included in the recipient spouse’s gross estate. The property is valued at the date of death or alternate valuation date FMV. (See Example C:13-34.)

Deductions. At this point you may wish to introduce Table C:13-2, p. C:13-18, which summarizes the estate tax deductions. A.

Debts and Funeral and Administrative Expenses. Under Sec. 2053, deductions are allowed for mortgages and other debts of the decedent, the decedent’s funeral expenses, and administrative expenses of the estate. Mortgages and other debts are deductible if they represent bona fide contracts for an adequate and full consideration in money or money’s worth. Interest, state, and local taxes and trade or business expenses that are accrued at the date of death are deductible on both the estate’s income tax return and the estate tax return. (See Example C:13-35.)

Losses. Section 2054 authorizes a deduction for losses from theft or casualty incurred while the estate is being settled. The amount of the loss takes into account the amount of the insurance received. If the alternate valuation date is selected, the loss may be used to reduce the alternate value and then used again as a loss deduction. The loss can be taken either on the estate tax return or the estate’s income tax return. (See Examples C:13-36 and C:13-37.)

Charitable Contribution Deduction. Section 2055 authorizes a deduction for transfers to a charitable organization. The rules for determining eligible donees are the same as for the gift tax. Because there is no ceiling on the charitable contribution deduction, it could eliminate completely any amounts in the gross estate in excess of the basic exclusion amount.

Computing the Deduction. The charitable contribution deduction computation can be complicated when the residue of an estate is to go to charity, and any estate taxes are to be paid out of the residue. (See Example C:13-38.)

Split-Interest Transfers. Where a decedent’s will provides for a splitinterest transfer, the rules governing whether or not the charitable contribution deduction is available are very technical. (See Example C:13-39.)

Marital Deduction. For estates of decedents dying after 1981, the marital deduction is unlimited. To be eligible for the marital deduction, transfers to a surviving spouse must either be includible in their estate or subject to the gift tax if transferred. Three tests must be met for property to qualify for the marital deduction. 1.

Test 1: Inclusion in the Gross Estate. No property passing to the surviving spouse is eligible for the marital deduction unless the property is included in the gross estate. (See Example C:13-40.)

Test 2: The Passing Requirement. Property must pass to the surviving spouse in a qualifying manner. It must be received in one of the ways listed on p. C:13-21. Retirement benefits are also considered to pass if they are included in the gross estate.

Test 3: The Terminable Interest Rule. The spouse’s interest in property cannot be classified as a nondeductible terminable interest. (See Example C:13-41.)

QTIP Transfers. The QTIP provisions allow a marital deduction in cases where the surviving spouse does not control the eventual ownership of the property. Qualified terminable interests are defined as property, which passes from a decedent in which the surviving spouse has a qualifying income interest for life, and to which an election applies. If the marital deduction is elected in the first spouse’s estate, the property is taxed in the surviving spouse’s estate or is subject to the gift tax if disposed of during the spouse’s lifetime. (See Example C:13-42.)

State Death Taxes. For estates of decedents dying after 2004, Sec. 2058 allows a deduction for state death taxes. Eligible taxes include estate, inheritance, legacy, and succession taxes paid to a state or the District of Columbia. The taxes must be paid no later than four years after the filing of the estate tax return. The deduction is for the amount paid and is not restricted to a maximum amount, as was the situation for the state death tax credit available prior to 2004.

The Supreme Court’s 2013 decision in U.S. v. Windsor allowed same-sex spouses to qualify for the marital deduction. The Court ruled that the provision in the Defense of Marriage Act (DOMA) that recognized only marriages between a man and a woman was unconstitutional. The IRS announced that it will honor the Windsor decision for same-sex spouses domiciled in states that do not recognize such marriages if they were married in jurisdictions permitting such marriages. In Obergefell v. Hodges et al, the Supreme Court ordered that all states must recognize same-sex marriages, and these marriages are valid in all states regardless of where conducted. This further allows a greater number of same-sex couples to qualify for the marital deduction.

The aggregate amount of deductions is subtracted from the gross estate in arriving at the taxable estate. V.

Computation of Tax Liability. A.

Taxable Estate and Tax Base. The value of the gross estate is reduced by allowable deductions in arriving at the taxable estate. The estate tax base consists of the taxable estate plus adjusted taxable gifts. Adjusted taxable gifts are defined as all taxable gifts made after 1976 other than gifts included in the gross estate. Adjusted taxable gifts are valued at their date of gift value.

Tentative Tax and Reduction for Post-1976 Gift Tax. The tentative tax is computed on the estate tax base. The unified transfer tax rates are reproduced in the Quick Reference guide in the textbook. The tentative tax is reduced by the decedent’s post-1976 gift taxes. The amount of the gift tax paid takes into account the giftsplitting provisions. The amount of the tax deemed paid is the amount that would have been paid using the estate tax rates for the date of death.

Portability Between Spouses of Exemption Amount. This benefit applies only if the executor elects portability by filing an estate tax return for the first decedent whether a return would otherwise be required or not. The unused exclusion amount is not indexed for inflation. If a surviving spouse was predeceased by more than one spouse, the surviving spouse can use only the unused exemption amount of the last deceased spouse. The portable amount is called the “deceased spousal unused exclusion amount.” As a result of the Windsor case, this also applies to same-sex couples. (See Examples C:13-44 and C:13-45.)

Other Credits. In addition to the unified credit, there are three other credits allowed. 1.

Credit for Pre-1977 Gift Taxes. A credit is authorized for gift taxes paid by the decedent on pre-1977 gifts that are included in the gross estate. In calculating the amount of the credit, estate tax rates in effect at death are used.

prior transfers reduces the tax impact of property being taxed in more than one estate in quick succession. The potential credit is the smaller of the federal estate tax of the transferor-decedent that is attributable to the transferred interest, or the federal estate tax of the transferee-decedent that is attributable to the transferred interest. The potential credit is then multiplied by a percentage that varies inversely with the time between the two transfers. See the schedule provided on p. C:13-25 for the credit percentage. (See Examples C:13-47 and C:13-48.) 3.

VI.

Foreign Death Tax Credit. A credit is provided for some or all of the death taxes paid to a foreign country for property located in that foreign country and included in the gross estate.

Comprehensive Illustration. A comprehensive illustration is provided beginning on p. C:13-25. The solution is illustrated in Table C:13-3. Table C:13-1 provides an overview of the estate tax calculation and may be of assistance as you review this solution with the students. Appendix B contains a completed Form 706 for use with this illustration.

VII.

Liquidity Concerns. Liquidity is one of the major problems facing individuals planning their estates. Life insurance is one source often used to address this problem. In general, the entire amount of the estate tax liability is due nine months after the date of death. Certain provisions allow the executor to defer the payment of estate taxes. A.

Deferral of Payment of Estate Taxes. 1.

Reasonable Cause. The Secretary of the Treasury is allowed to extend the payment date for estate taxes for up to 12 months. The payment can be further extended for a maximum period of ten years if the executor shows reasonable cause for not being able to pay some or all of the estate tax on the due date. The estate will owe interest on the portion of the tax that is deferred.

Remainder or Reversionary Interests. The executor can elect to postpone payment of tax attributable to remainder or reversionary interests until six months after the other interests terminate. The Secretary of the Treasury can grant an additional extension of up to three years.

Interests in Closely Held Businesses. The executor can pay the estate tax in as many as ten annual installments if the requirements listed on p. C:13-28 are met. Once the election is made the restrictions regarding its use that are listed on p. C:13-29 must be met. Interest accruing on the unpaid estate tax balance is no longer deductible on the estate income tax return or the estate tax return. C:IO13-10 Copyright © 2024 Pearson Education, Inc.

Stock Redemptions to Pay Death Taxes. Section 303 allows a corporation to redeem a decedent’s stock for payment of death taxes and funeral and administrative expenses and treat the redemption as a sale or exchange of property. The stock in the corporation that is redeeming the shares must make up more than 35% of the value of the decedent’s gross estate less the allowable Sec. 2053 and 2054 deductions.

Special Use Valuation of Farm Realty. Section 2032A allows property used in farming or a trade or business other than farming to be valued using a formula approach that attempts to value the property at what it is worth for farming purposes. (See p. C:13-29.) The limitation is indexed for inflation with adjustments rounded to the next lowest $10,000. For 2023, the indexed amount is $1.31 million. (You may at this point wish to discuss with your class the “What Would You Do In This Situation?” box on p. C:13-31.)

VIII. Generation-Skipping Transfer Tax. The GSTT levies the highest marginal estate tax rate (currently 35%) on taxable terminations and taxable distributions that skip generations. Generation assignments are made according to the family tree. A generation-skipping transfer is a disposition that provides interests for more than one generation of beneficiaries who are in a younger generation than the transferor, or provides an interest solely for a person two or more generations younger than the transferor. A direct skip skips more than one generation. (See Examples C:13-49 through C:13-52.) Effective for 2022, the exempt amount is $12.06 million and is indexed annually. The grantor elects when, and against what transfers, to take the exemption. IX.

Tax Planning Considerations. A.

Use of Inter Vivos Gifts. One of the most significant planning techniques is a well-designed, long-term gift-giving program.

Use of Basic Exclusion Amount. As mentioned earlier, the so-called basic exclusion amount of $12.92 million in 2023 is portable between spouses. Thus, any basic exclusion amount that remains unused at the first spouse’s death can be used by the second spouse. However, this benefit applies only if the executor elects portability. Property up to the amount of the unified credit should be left to children or grandchildren in order to fully take advantage of this basic exclusion amount. Taking advantage of the portability provision is another opportunity for making use of the decedent’s basic exclusion amount. The Stop and Think example at this point illustrates the cumulative nature of the exemption equivalent during life and at death.

What Size Marital Deduction Is Best? It may be beneficial for the first spouse’s estate to pay some death taxes if the surviving spouse already has substantial property and has a relatively short life expectancy. This planning device is especially helpful if the decedent’s assets are expected to rapidly appreciate in value. The Stop C:IO13-11 Copyright © 2024 Pearson Education, Inc.

and Think example at this point allows the students to examine both advantages and disadvantages to making a QTIP election. Making use of the basic exclusion amount has become less important because the portability election allows the surviving spouse to use the decedent’s basic exclusion amount.

Use of Disclaimers. If all property is willed to a surviving spouse, a disclaimer should be used so that at least the amount of the exemption equivalent can be used in the estate. One disadvantage is that the person making a qualified disclaimer has no control over where the disclaimed property is to go.

Role of Life Insurance. The reasons for purchasing life insurance are listed on p. C:13-33. Some discussion of the role of life insurance in estate planning might be helpful for the students who may have had little exposure to the topic before this chapter.

Qualifying the Estate for Installment Payments. Judicious selection of properties to be disposed of by lifetime gifts can help qualify an estate for installment estate tax payments at the attractive 2% interest rate.

Where to Deduct Administration Expense. The decision as to where to deduct administrative expenses, on the estate tax return or the estate income tax return, is made based upon where the greatest tax savings will result.

Compliance and Procedural Issues. A.

Filing Requirements. An estate tax return is not necessary unless the gross estate exceeds the amount of the basic exclusion amount. A completed Form 706 appears in Appendix B that uses the facts of the comprehensive illustration contained in the chapter.

Due Date. Estate tax returns are generally filed nine months after the date of death. A reasonable extension of time may be granted for filing the return. The maximum extension period is six months. To avoid interest, the estate tax must be paid on or before the due date.

Valuation. A penalty is assessed for under valuation of an asset if the value reported on the return is 65% or less of the amount determined to be the proper value. The penalty can be waived when there is proof a reasonable cause exists for the valuation claimed and the claim is made in good faith.

Election of Alternate Valuation Date. The executor makes an election to use the alternate valuation date on the estate tax return. The election is irrevocable. No election is possible if the return is filed more than one year after the due date including extensions.

Court Case Briefs CIR v. Est. of Herman J. Bosch, 387 U.S. 456 (1967), aff’g., rev’g., & rem’g. 363 F.2d 1009 (2nd Cir., 1966). The issue here was whether a Federal court or agency in a Federal estate tax case is bound by the decision of a state trial court adjudication of property rights or characterization of property interests when the U.S. is not a party to such proceedings. The Supreme Court ruled that the state court’s ruling was not binding. The State’s highest court is considered to be the best authority on its own laws. Where there has been no decision by that court, the estate tax laws provide that “proper regard” be given to relevant rulings of state courts other than the state’s highest court. However, “proper regard” does not mean that the Federal court or agency is bound by such decision. If that were the intent, the laws would so state. Therefore, the Federal court was not bound by the state trial court’s decision on property rights for purposes of determining the marital deduction for the estate. Est. of Helen M. Johnson v. CIR, 718 F.2d 1303 (5th Cir., 1983) rev’g. & rem’g. 77 T.C. 120 (1981). The value of the surviving spouse’s homestead interest was deducted from the value of the decedent’s gross estate. This was done under the assumption that property subject to a restriction has a lesser value than if there are no restrictions on the property. However, Sec. 2034 provides for the inclusion of the value of dower or curtesy in the gross estate. The taxpayer argued that homestead rights were different from dower or curtesy. The court ruled that homestead rights were established to obtain the same protection for widows/widowers and their children by preserving use of the homestead as is the objective in dower or curtesy. Therefore, the value of homestead rights must be included in the gross estate.

Chapter C:14 Income Taxation of Trusts and Estates Learning Objectives After studying this chapter, the student should be able to: 1.

Describe the basic concepts concerning trusts and estates.

Distinguish between the accounting concepts of principal and income.

Calculate the income tax liability of a trust or an estate.

Explain the significance of distributable net income.

Calculate the taxable income of a simple trust.

Calculate the taxable income of a complex trust and an estate.

Recognize the significance of income in respect of a decedent.

Explain the effect of the grantor trust provisions.

Identify tax planning opportunities in trust and estate income taxation.

10.

Comply with procedural rules for trust and estate income taxation.

Areas of Greater Significance Emphasis should be placed on making sure the student understands how a trust operates, the importance of determining accounting income, and the role of DNI. The student should be able to calculate taxable income for simple and complex trusts.

Areas of Lesser Significance In the interests of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Compliance and procedural considerations (filing requirements, due date for return and tax, documents to be furnished to IRS, and sample simple and complex trust returns).

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Computing DNI.

The tier system for complex trusts.

Income in respect of a decedent.

Highlights of Recent Tax Law Changes On November 19, 2021, the House passed the Build Back Better Act. In this act, when enacted, there will be a new 3% federal income tax (after applying the 5% additional tax) on MAGI over $500,000 for estates and non-grantor trusts.

Teaching Tips 1.

A side-by-side comparison of the individual tax rate schedule and the trust and estate tax rate schedule can be used to illustrate the compression that exists for the trust and estate rates. Emphasis should be placed on the nontax reasons for using trusts.

Comprehensive illustrations of the tax calculation for simple and complex trusts are contained in the chapter. The facts and tax calculations are contained on pp. C:14-17 through C:14-19 (simple trust) and C:14-24 through C:14-27 (complex trust). It might be useful to explain these illustrations by using the two completed Form 1041s for simple and complex trusts contained in Appendix B.

Lecture Outline I.

Basic Concepts. A.

Inception of Trusts. Trusts may be created at any time by transferring property to one for tax or asset conservation reasons. The property in the trust is administered by the trustee (named by the transferor) for the benefit of the beneficiaries. If the trust is created during the grantor’s lifetime, it is an inter vivos trust and the transferor is called a grantor. A trust created by will is called a testamentary trust. A trust may continue as long as provided by the trust agreement subject to the Rule Against Perpetuities.

Inception of Estates. Estates come into being due to the death of the individual (decedent) whose assets are being administered. An estate continues until the duties of the executor or administrator (where the decedent died without a will) to manage and distribute the property have been completed. The estate is a separate tax entity and will be terminated for federal income tax purposes after a reasonable length of time for performance of administrative duties.

Reasons for Creating Trusts. 1.

Tax Saving Aspects of Trusts. Irrevocable trusts are able to achieve income splitting. After TRA86, trusts do not offer the same advantages for income splitting that they previously did due to the compressed tax rate schedules. Sprinkling trusts allow the trustee some discretion in making distributions. The trustee has the option of distributing income to the beneficiary(ies) having the lowest rates. By making distributions when the rate is low, the trustee can minimize the amount of income that will be taxed at the highest tax brackets. Trusts also may save estate taxes provided the transferor does not retain the right to receive the trust income or the power to control which other persons receive the income, or have, at the time of death, the power to alter the identity of any persons named earlier to receive such assets.

Nontax Aspects of Trusts. Trusts are often used so that a trustee can manage the assets. This reason will be true where minors or incapacitated adults are involved. Trusts also are used where the beneficiary is deemed to not have sufficient management skill, or is likely to consume the assets. In addition, trusts are sometimes needed to protect assets from creditors. Revocable trusts are used for a number of reasons other than tax reasons. They allow the grantor to determine how well the trustee is capable of managing the trust assets. They also provide a reduction in the cost of administering an estate as well as an increased degree of privacy as to the disposition of assets.

Basic Principles of Fiduciary Taxation. 1.

Trusts and Estates as Separate Taxpayers. An estate or trust is a separate taxpaying entity. The tax is calculated on Form 1041. The rates are annually indexed for inflation. The rates are very compressed compared to those for individuals. As is true for individuals, an estate or trust’s long-term capital gains are taxed at a top tax rate of 15% or 20%, depending on the tax bracket, if the asset was held for more than 12 months. The top tax rate for qualified dividends is also 20%. (See Example C:14-1.) Depending on entity tax brackets, the rate can be 15% or 20%. C:IO14-3 Copyright © 2024 Pearson Education, Inc.

II.

No Double Taxation. There is no double taxation with income earned by a trust or estate. A deduction for income distributed to beneficiaries is provided. The beneficiaries report the distributed trust income on their individual returns. If all income is not distributed, some of it will be taxed to the fiduciary. (See Example C:14-2.)

Conduit Approach. Distributed income has the same character in the hands of the beneficiary as it has in the trust. (See Example C:14-3.)

Similarity to Rules for Individuals. In general, the income tax consequences for a trust or estate are determined in the same manner as for individuals. The top tax rate for individuals is the top tax rate for trusts.

Principles of Fiduciary Accounting. A.

The Importance of Identifying Income and Principal. One of the most important features of Subchapter J is determining the difference between principal (corpus) and income. Income, as referred to in Subchapter J, means the amount of income in the estate or trust for the taxable year determined under the terms of the governing instrument and local law.

Effects of State Law or Terms of the Trust Instrument. The trust instrument can specify the accounting rules to follow in determining principal and income. Absent a provision in the trust instrument, state law will control. In recent years a number of states have adopted the Uniform Principal and Income Act (2000). This Act provides that if certain conditions are met, the trustee may shift distribution amounts between principal and income as deemed necessary.

Principal and Income - The Uniform Act. 1.

Income Receipts. Income is defined as the return in money or property derived from the use of principal.

Principal Receipts. Principal is defined as the property which has been set aside by the owner or the person legally empowered so that it is held in trust eventually to be delivered to the remainderman while the return or use of the principal is in the meantime taken or received by or held for accumulation for an income beneficiary.

Expenditures. Important charges for which income is to be reduced are listed on p. C:14-6. Charges that reduce principal are also listed on p. C:14-6. Generally the trust agreement allocates the trustee’s fee between income and principal. (See Example C:14-5.)

Categorization of Depreciation. The Uniform Act does not provide specific mandates regarding depreciation. Rather, it states that a “trustee may transfer to principal a reasonable amount of the net cash receipts from a principal asset that is subject to depreciation. A statement in the trust instrument concerning the accounting treatment of depreciation overrides the discretion granted to the trustee by the Uniform Act.

At this point you may wish to introduce Topic Review C:14-1, which summarizes the treatment under the Uniform Act of 2000 of the major receipts and expenditures of fiduciaries. III.

Formula for Taxable Income and Tax Liability. A.

Gross Income. The items included in a trust’s or estate’s gross income are the same as those included in an individual’s gross income. This income must be allocated between principal (corpus) and income. (See Example C:14-7.) Figure C:14-1 illustrates the formula for computing taxable income and net tax liability for an estate or trust and should be used at this point.

Deductions for Expenses. Fiduciaries incur deductible expenses in the same manner as individuals. In addition, the fiduciary’s administration fee is deductible. There is no limit on the trust’s charitable contribution deduction. Depreciation or depletion deductions are available to the trust or estate only to the extent they are not allowable to the beneficiaries. Depreciation is allocable between the beneficiaries and the trust pursuant to the terms of the trust agreement. If the trust instrument is silent, depreciation is allocated based on the amount of income allocated to each. (See Example C:14-8.) Costs incurred for trustees’ and executors’ fees are incremental costs attributable to the holding of the property by a trust or estate as are the costs of having income tax returns prepared for trusts and estates. Thus, trustees’ and executors’ fees and tax return preparation fees are not categorized as miscellaneous itemized deductions and are not subject to the 2% floor. The IRS has recently ruled that unbundled trustees’ fees are not subject to the 2% floor. Effective October 19, 2020, final Treasury Regulations clarify that estates and non-grantor trusts may continue to deduct Sec. 67(e)(1) expenses.

Distribution Deduction. 1.

Simple Trusts. Trusts that must distribute all of their income currently and are not empowered to make charitable contributions are called simple trusts. If the accounting income that must be distributed exceeds the trust’s DNI, the distribution deduction is limited to DNI. The amount deductible by the trust is taxed to the beneficiaries irrespective of the amount they actually receive.

IV.

Complex Trusts. Trusts not required to distribute all of their income currently are called complex trusts. The distribution deduction for complex trusts and estates is the sum of the income required to be distributed currently and any other amounts properly paid, credited, or required to be distributed for the year. The distribution deduction may not exceed the trust’s or estate’s DNI reduced by tax-exempt income (net of deductions). Beneficiaries report income equal to the amount of the distribution deduction. (See Example C:14-9.)

Personal Exemption. Estates are entitled to a $600 exemption. If the trust instrument requires that all income be distributed annually, the trust receives a $300 exemption. Otherwise the exemption is $100. Trusts may qualify for a $300 exemption in one year, and a $100 exemption in the next, depending upon the income distribution requirements. (See Example C:14-10.) No exemption is allowed in the year of termination.

Credits. The rules governing credits for trusts and estates are the same as those governing individuals. Some of the personal credits such as household and dependent care credits are not available. The foreign tax credit must be allocated between the beneficiaries and the trust or estate.

Distributable Net Income. A.

Significance of DNI. DNI sets the ceiling on the amount of the distributions that are taxed to the beneficiaries. DNI also determines the maximum amount that can be deducted by the fiduciary. The distribution deduction is reduced further by the amount of tax-exempt income (net of expenses). DNI determines the character of the beneficiary’s income. The character of each type of income is allocated in the same proportion that the total of each class of income bears to DNI. A special allocation among beneficiaries is possible provided the provision in the trust instrument has economic effect independent of the tax results. (See Example C:14-12.)

Definition of DNI. DNI is the fiduciary’s taxable income adjusted as described. If capital gains and extraordinary dividends are allocated to corpus, they are excluded from DNI. DNI includes tax-exempt income reduced by nondeductible expenses allocated to the income. The distribution deduction is DNI reduced by tax-exempt income (net of expenses). DNI and accounting income are different in that expenses charged to principal reduce DNI, but not accounting income. This adjustment reduces the amount taxable to the income beneficiary without reducing the amount of income that can be distributed to the income beneficiary. (See Topic Review C:14-2.) The TCJA limits the deduction for state and local taxes to $10,000. As these taxes are charged to accounting income, the excess does not reduce DNI due to the limit it sets on the deduction.

Manner of Computing DNI. DNI can be calculated by starting with taxable income (exclusive of the distribution deduction) and making the adjustments to taxable income that the Code specifies. (See Examples C:14-13 and C:14-14.) The Stop and Think example illustrates how DNI limits the taxability of income.

Determining a Simple Trust’s Taxable Income. A simple trust is one that requires that all income be distributed currently and does not authorize charitable contributions. The trustee also must not invade principal during the year. Trusts can be simple trusts in one year and complex trusts in the next year depending on the terms of the trust instrument and the actions of the trustee. Table C:14-1 highlights the trust classification and the $300 or $100 exemption dichotomy. A.

Allocation of Expenses to Tax-Exempt Income. A portion of the expenses relating to producing income must be allocated to tax-exempt income. This allocation includes all expenses directly related to the production of the tax-exempt income plus a proportion of the expenses not directly related to any item of income such as the trustee’s fee. (See Example C:14-15.)

Determination of DNI and the Distribution Deduction. A simple trust must distribute all of its income currently. A simple trust generally receives a distribution deduction equal to the amount of its net accounting income. There are two exceptions to this rule.

Tax Treatment for Beneficiary. The aggregate of gross income reported by the beneficiaries is net accounting income not to exceed DNI. DNI is apportioned ratably among the beneficiaries. Income received by the beneficiaries retains the character it had in the trust. Income is allocated proportionately to DNI unless the trust instrument provides for a specific allocation. (See Example C:14-16.) Beneficiaries of a simple trust are taxed currently on their pro rata share of DNI whether or not the amount is actually distributed during the period.

Short-Cut Approach to Proving Correctness of Taxable Income. Taxable income under the short-cut approach should equal taxable income determined under the formula approach illustrated in Figure C:14-1. The steps to the short-cut approach are found on p. C:14-16. (See Example C:14-17.)

Effect of Net Operating Loss. An NOL which arises in a trust does not pass through to the beneficiaries unless the trust terminates. Trusts can carry the NOL forward. Also, NOL deductions for NOLs arising after 2017 and carried over to tax years beginning after 2020 are limited to 80% of taxable income computed without regard to the NOL carryover. Any remaining NOL is allocated to beneficiaries receiving trust property in the year that the trust terminates. (See Example C:14-18.). Pre-2018 NOLs carried back two years. C:IO14-7 Copyright © 2024 Pearson Education, Inc.

Effect of Net Capital Losses. Capital losses can only be used by a trust to offset capital gains. Excess losses can offset ordinary income up to $3,000 each year. Because simple trusts must distribute all of their income annually, such an offset does not occur often. Any remaining capital losses are passed through to the beneficiaries succeeding to the trust property in the year that the trust terminates. (See Example C:14-19.)

Comprehensive Illustration - Determining a Simple Trust’s Taxable Income. A comprehensive illustration of the taxable income calculation for a simple trust is provided. A sample Form 1041 for a simple trust is included in Appendix B using the facts included in this illustration. At this point you may wish to introduce Topic Review C:14-3, which summarizes the calculation of trust taxable income. VI.

Determining Taxable Income for Complex Trusts and Estates. A.

Determination of DNI and the Distribution Deduction. The distribution deduction for complex trusts and estates is the sum of the total current income required to be paid out currently plus any other amounts properly paid, credited, or required to be distributed to the beneficiary during the year. The trust’s DNI acts as a ceiling on the amount of the distribution deduction. (See Example C:14-20.) No distribution deduction is allowed with respect to tax-exempt income (net of allocable expenses). (See Example C:14-21.) DNI is not reduced by the charitable contribution deduction when determining the ceiling on the distribution deduction for mandatory distributions of income. DNI is reduced by the charitable contribution deduction when calculating the deductible discretionary distributions. (See Example C:14-22.)

Tax Treatment for Beneficiary. 1.

General Rules. The amount of distributions from complex trusts or estates that are required to be included in the beneficiary’s income is the sum of the amount of current income required to be distributed to the beneficiary currently, plus any other amounts properly paid, credited, or required to be distributed to be beneficiary during the year. Tax-exempt income flows through to the beneficiaries in the same proportion that it contributes to total DNI. When the total income required to be distributed currently exceeds DNI, each beneficiary reports as gross income the ratio of DNI attributable to taxable sources. (See Example C:14-23.) C:IO14-8 Copyright © 2024 Pearson Education, Inc.

Exception – The Tier System. In years in which the amount required to be distributed currently, and all other amounts properly paid, credited, or required to be distributed currently exceeds DNI, the amount taxable to each beneficiary is calculated under the tier system. Beneficiaries to whom income distributions must be made are referred to as tier-1 beneficiaries. All other beneficiaries are tier-2 beneficiaries. Under the tier system, tier-1 beneficiaries absorb the income first. (See Example C:14-24.)

Exception – Separate Share Rule. The separate share rule applies to trusts and estates with governing instruments that require that distributions be made in substantially the same manner as though separate trusts had been created. In calculating the trust’s taxable income, these trusts are treated as a single taxpaying entity. (See Example C:14-25.)

Exception – Specific Bequests. Distributions of principal from a trust or estate may carry out with them DNI. (See Example C:14-26.) Distributions of a specific sum of money or of a specific property required under a decedent’s will do not carry out DNI. The Stop and Think example at this point illustrates that specific bequests do not carry out DNI.

Effect of a Net Operating Loss. An NOL of an estate or complex trust can be carried forward but not back. In the year the trust terminates, any remaining NOL is passed through to the beneficiaries who succeed to the assets. In addition, in its termination year, an estate passes through to its beneficiaries any excess of current fees and non-operating expenses over current income.

Effect of a Net Capital Loss. The tax effect of having capital losses in excess of capital gains is generally the same for estates and complex trusts as for simple trusts. The maximum capital loss deduction is the lesser of $3,000 or the excess of its capital losses over capital gains. Complex trusts and estates often do not distribute all of their income and have taxable income against which a capital loss may be offset. (See Example C:14-28.)

Comprehensive Illustration—Determining a Complex Trust’s Taxable Income. A comprehensive illustration of a complex trust is found beginning on p. C:14-24. A sample Form 1041 for a complex trust is included in Appendix B using the facts in this illustration. It might be helpful at this point to compare the complex trust return to the simple trust return that was covered earlier. Table C:14-3 provides a comprehensive illustration of the determination of taxable income and tax liability in the case of a complex trust.

VII.

Income in Respect of a Decedent. A.

Definition and Common Examples. Income in respect of a decedent (IRD) is defined as gross income that the decedent earned prior to his death but was not includible in computing his taxable income for the tax year ending on the date of his death or for an earlier tax year under the accounting method employed by the decedent. Examples of IRD are listed on p. C:14-28.

Significance of IRD. IRD is includible in the decedent’s estate and the income tax returns of the estate, a trust, or beneficiary as they are collected. 1.

Deductions in Respect of a Decedent. Deductions in respect of a decedent (DRD) include trade or business expenses for the production of income, taxes, interest, depletion, etc. that have accrued prior to death but are not deductible on the decedent’s final return because of the method of accounting used. These expenses are deductible as debts on the estate tax return. They are also deductible on the estate income tax return when paid. (See Example C:14-30.) The Stop and Think example at this point illustrates when an item of income or expense is IRD.

Section 691(c) Deduction. For estates that owe estate taxes, a deduction is allowed for estate taxes attributable to an item of IRD. The amount of the deduction is the excess of the decedent’s actual federal estate tax over the federal estate tax that would be payable if the item of IRD was excluded from the decedent’s gross estate. The deduction must be apportioned among the items of IRD and is deductible by the tax entity that includes the item of IRD in income. (See Example C:14-31.)

No Step-Up in Basis. Most property received as the result of a decedent’s death acquires a basis equal to its FMV on the date of death or the alternate valuation date. Property classified as IRD, however, retains the basis it had in the decedent’s hands. (See Example C:14-32.)

VIII. Grantor Trust Provisions. A.

Purpose and Effect. The grantor trust rules are intended to make grantors who do not give up enough control or economic benefits when they create a trust to be taxed on all or part of the trust’s income. For transfers after March 1, 1986, the grantor is generally taxed on the trust’s income if the trust property will return to the grantor or the grantor’s spouse.

Revocable Trusts. The grantor of assets transferred to a revocable trust is taxed on the income generated by the trust. (See Example C:14-33.)

Post-1986 Reversionary Interest Trusts. For transfers after March 1, 1986, the accounting income of a trust will be taxed to the grantor if the property reverts back to the grantor or his spouse provided the spouses live together. (See Examples C:1434 and C:14-35.)

Retention of Administrative Powers. The grantor is taxed on the accounting income and gains if he or his spouse holds certain administrative powers. Some of these powers are listed on p. C:14-31.

Retention of Economic Benefits. A grantor is taxed on the accounting income of any portion of a trust that provides economic benefits such as those listed on p. C:14-31. Use of trust income to provide support for a child when the grantor is legally obligated to support the child causes that income to be taxed to the grantor. (See Examples C:14-36 and C:14-37.)

Control of Others’ Enjoyment. The grantor of a trust is taxed on trust income if, he, his spouse, or someone not having an interest in the trust has the power to control others’ beneficial enjoyment such as deciding how much income to distribute. (See Example C:14-38.)

Topic Review C:14-4 may be introduced at this point to summarize the grantor trust rules. IX.

Tax Planning Considerations. A.

Ability to Shift Income. One of the primary advantages of using trusts under preTRA86 law was the ability to shift income from the donor to the trust or to beneficiaries in low marginal tax rate brackets. The compression of tax rates today makes this opportunity less beneficial.

Timing of Distributions. Persons managing estates and discretionary trusts can reduce the overall tax liability by carefully timing distributions to beneficiaries. Sprinkling trusts allow the trustee to make distributions to the lowest tax bracket beneficiaries. The special 65-day rule for complex trusts and estates allows trustees of complex trusts and executors or administrators of estates to treat distributions made during the first 65 days of the trust’s tax year as if they had been made on the last day of the preceding year.

Property Distributions. A trustee can elect to recognize gain on the distribution of appreciated property to the beneficiary. If gain is recognized, the basis of the property is its FMV. If the property is to be sold soon after distribution, this election allows the trustee to determine whether the gain will be recognized by the trust or the beneficiary. (See Example C:14-39.)

Choice of Year-End for Estates. Trusts are now required to use a calendar year as their tax year. Estates are allowed to elect any tax year they wish as long as the first tax year is not longer than 12 months. (See Example C:14-40.)

Deduction of Administration Expenses. Administration expenses can be deducted on either the estate tax return or the estate’s income tax return. They should be deducted on the return that will provide the greatest tax savings. This point was covered earlier in Chapter C:13.

Compliance and Procedural Considerations. A.

Filing Requirements. General Rule. Every estate that has gross income of $600 for the tax year must file an income tax return [Form 1041 (U.S. Fiduciary Income Tax Return)]. A trust is required to file a Form 1041 if it has taxable income, or gross income of $600 or more. Every estate or trust with a nonresident alien beneficiary must file an income tax return.

Due Date for Return and Tax. The due date for fiduciary returns is the fifteenth day of the fourth month following the close of the tax year. If an extension is desired, a Form 7004 must be filed. The automatic extension period is five and one half months for tax years beginning after 2015. Both trusts and estates make estimated tax payments, but an estate is exempt from the estimated tax payment requirement for its first two years. The rules for the timing of the estimated tax payments (and need to pay any underpayment penalties) are the same as those for individuals.

Documents to Be Furnished to IRS. If the IRS requests a copy of the will or the trust instrument, the executor or trustee should also transmit the additional required statements.

Sample Simple and Complex Trust Returns. Appendix B contains samples of simple and complex trust returns. (Form 1041s). They also illustrate the completion of Form K-1 for reporting income to the beneficiary. These two returns use the facts contained in the comprehensive illustrations presented earlier in the chapter.

Court Case Briefs Helvering v. George B. Clifford, Jr., 309 U.S. 331 (USSC, 1940). The income of a trust which was to endure for five years, except that the trust would end on the earlier of the death of the grantor or the beneficiary (his wife) was taxable to the grantor. The grantor was trustee with sole discretion as to amounts which should be distributed to his wife and had wide powers of control over the corpus. The short duration of the trust, the fact that the wife was the beneficiary, and the fact of the retention of control over the corpus led to the conclusion that the grantor continued to be the owner for income tax purposes. Katherine Channing v. Hassett, 200 F.2d 514 (1st Cir., 1952). Trusts were created under the terms of a will for the benefit of each of the testator’s two children. The trustees were directed to pay to the beneficiaries the current income on a quarterly or more frequent basis. There were also instructions for the set-aside from current income, for future allocation or to add to the trust’s principal, amounts of current income determined at the trustee’s discretion as not needed for the comfortable support and maintenance of the beneficiaries. In such years as current income was set aside, the question arose as to whether the taxpayer-beneficiary was liable for income tax on the total current distributable net income or only on those amounts actually paid or credited to the taxpayer during the taxable year. The court ruled that the taxpayer was not required to pay tax on the whole amount available for distribution when the trustee exercised the authorized discretion to set aside income amounts, but was only taxable on amounts actually received or credited for the taxable year.

Chapter C:15 Administrative Procedures Learning Objectives After studying this chapter, the student should be able to: 1.

Describe the role of the IRS in our tax system.

Discuss how returns are selected for audit and the alternatives available to tax payers whose returns are audited.

Explain the IRS’s ruling process.

Identify the due dates for filing tax returns and paying taxes.

Distinguish the various types of penalties imposed by the IRS.

Calculate the penalty for not paying estimated taxes.

Describe the more severe penalties, including the fraud penalty.

Recognize when the statute of limitations applies.

Explain from whom the government may collect unpaid taxes.

10.

Apply the professional and governmental standards for tax practitioners.

Areas of Greater Significance 1.

Students should acquire a clear understanding of the role of the IRS and the audit process. Penalties are assuming a more important role in the revenue raising process and should be introduced to the student at this point.

The Statement on Standards for Tax Services is now discussed more fully in this chapter. While the standards are not legally enforceable, they may be cited in a negligence lawsuit and failure to follow them may be grounds for the termination or suspension of one’s professional license.

The unauthorized practice of law is a significant issue that is being raised more often. Students should understand the areas of tax practice that an accountant is qualified to practice in and when an attorney should be called in to lend their expertise.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1.

Tax practice issues (statutory provisions concerning tax return preparers, rules of Treasury Department Circular 230).

Liability for tax.

Problem Areas for Students The following areas may prove especially difficult for students: 1.

Payment requirements for estimated taxes.

Differences between civil and criminal fraud.

Highlights of Recent Tax Law Changes Beginning in 2010, the IRS began phasing in a new requirement on Form 1120, Schedule UTP (Uncertain Tax Position Statement). An uncertain tax position is a tax position taken in a tax return that would result in an adjustment to a line on the tax return if the position is not sustained. The schedule will help the IRS identify and prioritize issues for audit. Schedule UTP requires a description of each uncertain tax position for which the taxpayer recorded a reserve in its audited financial statements or for which no reserve has been recorded because of expected litigation. Taxpayers also must rank the uncertain positions and disclose if any tax position exceeds 10% of the aggregate amount of reserves for all tax positions. For 2023, the threshold for filing Schedule UTP is $10 million in assets.

Teaching Tips 1.

Letter rulings: Refer students back to page C:1-12 for guidance on how to locate copies of letter rulings. p. C:15-9.

Without the existence of a failure-to-pay penalty, taxpayers could be more aggressive with the positions they take on their tax returns. For example, if a taxpayer took an aggressive position and was later audited, he would only have to pay additional taxes plus interest – essentially paying back a loan from the government. The failure-topay penalty has increased the risk to those taxpayers who take aggressive positions on their tax returns. p. C:15-16.

Lecture Outline I.

Role of the Internal Revenue Service. The Internal Revenue Service is a part of the Treasury Department. It is headed by the Commissioner of Internal Revenue and supervised by an oversight board consisting of nine members. These members are appointed by the President. The Commissioner of Internal Revenue is appointed by the President. The responsibilities of the IRS include enforcing and interpreting the tax laws.

II.

Enforcement and Collection. The United States employs a system of voluntary compliance. Audits are performed on selected taxpayers and certain nonfilers. The IRS attempts to uncover positions taken on returns in certain gray areas with which they do not always agree with taxpayers. They also act to enforce collection.

Interpretation of the Statute. Statutory language is so general that administrative and judicial interpretation is necessary. The IRS issues revenue rulings, revenue procedures, announcements, notices, and information releases. These are available to the public. Private letter rulings are issued to individual taxpayers upon request.

Audits of Tax Returns. One of the IRS’s most significant enforcement activities is the auditing of tax returns. Besides mathematical verification of the return, a computer-matching program compares individual tax returns with information returns filed with the IRS. If the service center detects an error, a notice is sent to the taxpayer detailing the additional tax or refund due. A.

Percentage of Returns Audited. Only a small fraction of returns are audited. Over one-half of the returns are subjected to a computerized “instant” audit.

Selection of Returns for Audit. Returns are selected for audit in a variety of ways, with many returns being selected for audit under the discriminant function (DIF) process. The DIF selection process has decreased the number of no-change individual returns selected for audit. Recently the IRS began an audit approach known as the Market Segment Specialization Program (MSSP). Under this program, IRS personnel develop industry expertise and audit guides by industry. 1.

The IRS conducts what are called “financial status” or “lifestyle” audits. The purpose of these audits is to identify inconsistencies between a taxpayer’s reported income and his or her lifestyle. Although the courts have generally sanctioned the use of financial status audits, Congress has limited their use to situations in which the IRS has a reasonable indication of unreported income.

Other Methods. Occasionally, the IRS intensively investigates particular types of transactions or entities to ascertain overall taxpayer compliance with the tax law. The results of these investigations may inform future audit C:IO15-3 Copyright © 2024 Pearson Education, Inc.

priorities. For example, in 2004, through a combination of audits, summons and targeted litigation, the IRS launched an initiative to identify and deter promoters of abusive tax shelters.1 In November 2009, the IRS announced its first ever employment tax research study in 25 years. In 2017, the IRS announced a major campaign targeting 13 issues impacting large businesses. Issues targeted for future audits include the domestic production activities deduction, Sec. 48C energy credits, related party transactions, and S corporation losses in excess of basis. The IRS trains teams as experts on these transactions, develops strategies to identify affected companies, and perform efficient audits. C.

Alternatives for a Taxpayer Whose Return Is Audited. When a taxpayer is notified of an audit, he or she is told whether the audit will be a correspondence audit, office audit, or field audit. The notice informing the taxpayer about the audit indicates which items will be examined and what information should be brought to the audit. Field examinations are common for business returns and more complex individual returns. The IRS employee conducts these audits at either the taxpayer’s place of business or residence or at his/her tax advisor’s office. 1.

Special Relief Rule. A taxpayer who receives an audit notice can request that the examination be suspended while a review is conducted to determine whether the audit should proceed if his return was audited for the same item in at least one of the two previous years and the earlier audit did not result in a change in his tax liability. (See Examples C:15-1 and C:15-2.)

Meeting with a Revenue Agent. The taxpayer and/or his representative can meet with a revenue agent. If additional tax is due, the taxpayer may disagree with the agent. A meeting with the agent’s supervisor may lead to agreement on the issue. If the taxpayer agrees with the result of the audit, a Form 870 (Waiver of Statutory Notice) is signed. This form indicates the taxpayer agrees to waive any restrictions on the IRS’s ability to assess the tax and consents to the IRS’s collecting the tax. If Form 870 is signed, interest ceases to accrue, and the taxpayer has 10 days from the date the additional tax is billed to make the payment.

Technical Advice Memoranda. Sometimes highly complex, technical issues will be involved in an audit. An IRS employee may request advice from the IRS’s National Office. The taxpayer may also urge that the employee seek advice on the issue. The advice is given in the form of a Technical Advice Memorandum, which is made public in the form of a letter ruling.

Appeal to Appeals Division. If the taxpayer does not sign Form 870, the IRS will send the taxpayer a report, known as a 30-day letter, detailing the proposed changes and notifying the taxpayer of his right to pursue the matter

1 I.R. 2003-51, April 15, 2003.

in the Appeals Office. The taxpayer has 30 days from the date on the letter to request an appeal. If the audit was a field audit and the amount in question exceeds $10,000, a formal protest letter must be filed within the 30-day period. If the taxpayer does not respond to the 30-day letter, the IRS follows up with a 90-day letter. Historically, appeals conferences were conducted in person. Beginning in October 2016, conferences are conducted over the phone unless a taxpayer requests an in-person meeting. D.

Ninety-Day Letter. A 90-day letter is a statutory notice of deficiency. It details information concerning the deficiency and informs the taxpayer that the IRS will assess the deficiency unless a petition is filed in the Tax Court within 90 days of the date the letter is mailed. Taxpayers who pay the assessment can sue for refund in a U.S. district court or the U.S. Court of Federal Claims.

Litigation. Taxpayers must consider the time and expense involved in litigating an issue. Even though they may disagree with the IRS position, they may decide to pay the additional assessment. If the decision is made to litigate, it is important to select the proper court. 1.

Tax Court. Taxpayers desiring to litigate in the Tax Court must file their petition with the Tax Court within 90 days of the date of the Statutory Notice of Deficiency (90-day letter). There are some advantages of going the Tax Court route, including not having to pay the deficiency as a prelude to filing suit. If the deficiency does not exceed $50,000, an informal small case procedure may be used. Small case decisions cannot be appealed.

A U.S. District Court or U.S. Court of Federal Claims. As a condition of going to a U.S. district court or the U.S. Court of Federal Claims, the taxpayer must pay his deficiency and file a claim of refund. The claim will be denied by the IRS, and the taxpayer can file a suit for refund.

Appeal of a Lower Court’s Decision. Whichever party loses, the government or the taxpayer, an appeal of the lower court decision may be made to an appellate court. An appeal from the Tax Court or a district court goes to the appellate court in the circuit in which the taxpayer resides, or the corporation has its principal place of business. Cases originating in the U.S. Court of Federal Claims are appealable to the U.S. Court of Appeals for the Federal Circuit. Either the taxpayer or the government can request a writ of certiorari for the Supreme Court to review the appellate court’s decision. If the Supreme Court decides to hear a case, it will grant certiorari.

You may wish at this point to discuss with the class the Stop and Think material that illustrates the importance of selecting the proper court to litigate in.

III.

Requests for Rulings. A.

Information to Be Included in Taxpayer’s Request. Early in each year, the IRS issues a revenue procedure that details how to request a ruling and the information to be contained in the ruling request.

Will the IRS Rule? With respect to income tax and gift tax matters, the IRS will only rule on prospective transactions and on completed transactions for which a return has not yet been filed. For estate tax matters, a ruling generally will not be issued if the estate tax return has been filed or involves the estate tax consequences of a living person. If temporary or final regulations have not been issued. There are certain topics on which the IRS will not rule. A list of these areas is issued in a revenue procedure early each year. The IRS has announced that except in extraordinary circumstances it will discontinue granting letter rulings addressing “issues that are clearly and adequately addressed by published authorities.”

IV.

When Rulings Are Desirable. In some circumstances it is useful to get the IRS’s position on a particular transaction. Where favorable rulings using the same fact pattern were issued in the past, the taxpayer may still wish to receive assurance that his transaction will be viewed in the same way. The IRS has restricted a taxpayer’s ability to obtain a “comfort” ruling in situations where the outcome of the ruling is well established. Where the outcome of a ruling is uncertain, it may be better for the taxpayer not to request a ruling.

Due Dates and Penalties. A.

Due Dates for Returns. Returns for individuals and fiduciaries are due on the fifteenth day of the fourth month following the close of the tax year. Corporate returns (S corporations) as well as partnerships are due on the fifteenth day of the third month following the close of their tax year. C Corporations are due on the 15th day of the fourth month, or April 15 for calendar year taxpayers. Until tax years beginning after 2025, C Corporations with a June 30 year end must complete filings by the 15th day of the third month, or September 15. All corporations subject to tax and partnerships must file a return annually.

Extensions. Extensions are granted for a reasonable period of time, not to exceed six months unless the taxpayer is abroad. Individuals are eligible for an automatic 6-month extension. 1.

Individuals. Individuals can receive an automatic extension by filing Form 4868 (Application for Automatic Extension of Time to File U.S. Individual Income Tax Return). (See Example C:15-3.)

by the original due date of the return. The automatic extension is for six months, and no additional extension is available. (See Example C:15-4.) For tax years beginning after 2015, but before 2026, C Corporations with a December 31 year end can only request one five-month extension until September 15. C Corporations with a June 30 year end can request an automatic seven-month extension until April 15. C.

Due Dates for Payment of Tax. Obtaining an extension extends the time for filing a return, not for paying the taxes. The first individual estimated tax installment is due on the due date for the preceding year’s return, and the additional payments are due two, five, and nine months later. Slightly different time periods apply to corporations. If the IRS computes the tax due, taxpayers have 30 days from the date the IRS mails the notice stating the amount of tax payable to pay the amount that is owed. Interest is assessed on all taxes not paid by the return due date. Additional taxes that are projected to be owed must be paid with the request for extension. If the gift tax return is also being extended, any gift tax due must be included with the request for extension.

Interest on Tax Not Timely Paid. Any tax not paid on the original due date is subject to interest. Instances where interest is assessed are listed on p. C:15-12. 1.

Determination of Rate. The interest charged on unpaid taxes varies with the short-term federal rates as determined at the beginning of each calendar quarter. The rate for overpayments is two percentage points higher than the short-term federal rate. For corporate tax overpayments in excess of $10,000, the interest rate is reduced to the federal short-term rate plus one-half percentage point starting in 1995. Recent applicable interest rates are found on p. C:15-12. (See Example C:15-5.)

Daily Compounding. Interest is accrued using daily compounding. Rev. Proc. 95-17 contains tables to use for calculating the compounded interest. In addition, software packages are available for the interest calculation.

Accrual Period. Interest is usually imposed from the due date of the return until the date of payment. If a Form 870 is signed, no interest is assessed from 30 days after the execution of Form 870 until the date the IRS issues its notice and demand. No additional interest is charged if the taxpayer pays the tax due within 10 days of the billing date. Taxpayers litigating in the Tax Court may make a deposit to reduce the interest potentially owed. If the court decides that the taxpayer owes a deficiency, interest will not accrue on the amount of the deposit. (See Examples C:15-6 and C:15-7.)

Abatement. The IRS does not abate interest except for unreasonable errors or delays resulting from its managerial or ministerial acts. (See Example C:15-9.)

Penalties. In addition to the interest charged, penalties are assessed for failure to pay by the due date and failure to file on time. 1.

Failure to File. Taxpayers who fail to file a return are assessed a failure-tofile penalty of 5% a month (or a fraction thereof), not to exceed 25%. The penalty is waived for the showing of reasonable cause. Taxpayers owing any tax at all are subject to a $485 minimum penalty if they fail to file a return within 60 days of the due date.

Failure to Pay. The failure-to-pay penalty is imposed at 0.5% per month to a maximum of 25%. The failure-to-pay penalty may be waived with the showing of reasonable cause. If both the failure-to-pay and failure-to-file penalty are assessed, the combined penalty cannot exceed 5% per month. (See Examples C:15-12 and C:15-13.)

Estimated Taxes. Individuals receiving income from sources other than wages are usually required to pay estimated taxes. Corporations are required to pay estimated taxes as are trusts. Estates are exempt from estimated tax payments for a period of two years from the date of death. S corporations pay estimated taxes only on their corporate tax levies. A.

Payment Requirements. Individuals should make estimated tax payments if they have more than relatively small amounts of income from sources other than wages. The payments are usually made evenly throughout the year. The steps in calculating the estimated tax due are listed on p. C:15-17. (See Example C:15-16.) To avoid a penalty, individual taxpayers should pay the lesser of 90% of current year’s taxes or 110% of prior year’s taxes. (See Example C:15-17.)

Penalty for Underpaying Estimated Taxes. If estimated taxes are not paid by the due date, interest is assessed on the underpayment in the same manner as for late payment of taxes. Withholding is deemed to have been paid evenly each quarter unless the taxpayer shows otherwise. Example C:15-18 illustrates these computations.

Exceptions to the Penalty. No penalty is imposed if the taxpayer’s tax exceeds the taxes withheld from wages for the year in question by less than $1,000. No penalty is imposed if the amount paid is at least as much as the tax imposed in the preceding year, regardless of the amount of the underpayment. (See Example C:15-19.)

VI.

Other More Severe Penalties. A.

Negligence. The 20% negligence penalty applies whenever the IRS determines that taxpayers have underpaid any part of their taxes as a result of negligence or disregard of the rules and regulations and when the taxpayer does not prove to the contrary. The negligence penalty applies only to the portion of the underpayment that is attributable to negligence. Negligence is defined as any failure to make a reasonable attempt to comply with the provisions of the IRC and any careless, reckless, or intentional disregard of the rules and regulations. The Treasury regulations state that there is a strong indication of negligence if the taxpayer does not include in gross income an amount of income shown on an information return or does not reasonably attempt to ascertain the correctness of a deduction, credit, or exclusion that a reasonable and prudent person would think was “too good to be true.”

Substantial Understatement. A substantial understatement is an underpayment of tax exceeding the greater of 10% of the tax required to be shown on the return or $5,000 ($10,000 in the case of C corporations). For tax payers claiming the qualified business income deduction under Sec. 199A, the applicable percentage is 5% instead of 10%. The penalty is equal to 20% of the amount of the understatement of the tax that is attributable to the substantial understatement. 1.

Understatement Versus Underpayment. The amount of tax classified as attributable to the substantial understatement may be less than the amount of the underpayment. An underpayment for a transaction other than a tax shelter item is not treated as an understatement if either of the following is true: • There is or was substantial authority for the tax treatment the taxpayer adopted. • The taxpayer discloses, either on the return or in a statement attached to the return, the relevant facts affecting the tax treatment for the transaction and there is a reasonable basis for such treatment. Reg. Sec. 1.6662-3(b)(3) explains that reasonable basis is “significantly higher” than not frivolous and that the standard will generally be satisfied if the position is based on one or more of the authorities applicable for assessing whether substantial authority exists.

Concept of “Substantial Authority.” The substantial understatement penalty is not imposed for transactions where the taxpayer has substantial authority for the tax treatment adopted. Treasury Regulations provide guidance as to what constitutes substantial authority. A summary of the Treasury Regulation guidelines for this concept is found on p. C:15-24. (See Example C:15-24.)

Civil Fraud Penalty. Civil fraud penalties may be assessed in addition to penalties and interest if errors on a taxpayer’s return are attributable to fraudulent acts. The burden of proof is on the IRS. Proof consists of clear and convincing evidence. Fraud involves a deliberate attempt to deceive. The fraud penalty is 75% of the portion of the underpayment attributable to fraud. You may wish to discuss with the class the Stop and Think example dealing with a major omission of income which illustrates that the fraud penalty is not stacked. p. C:15-25.

Criminal Fraud Penalties. The Justice Department must agree with the IRS’s contention that criminal fraud charges should be filed. Conviction rates are high, and prison terms result more than half the time. 1.

Burden of Proof. The government must prove beyond a reasonable doubt that the taxpayer actually committed the crime of which he is accused.

Criminal Fraud Investigations. Criminal fraud investigations are carried out by the Criminal Investigation Division of the IRS. The special agent must identify himself to the taxpayer at the first meeting.

Penalty Provisions. The maximum penalty is $100,000, a prison sentence of up to three years, or both for persons who willfully attempt to evade or defeat any tax (Sec. 7201). The maximum penalty is $25,000 ($100,000 for a corporation), a prison sentence of no more than 1 year, or both, if there is a willful failure to pay tax or file a return. Persons other than the taxpayer are subject to a maximum penalty of $100,000 ($500,000 for corporations), a prison sentence of up to three years, or both.

You may also wish to discuss with the class the ethics problem presented in the What Would You Do In This Situation? material. VII.

Statute of Limitations. A.

General 3-Year Rule. The statute of limitations is three years after the return is filed, regardless of whether the return is timely filed. A return filed before its due date is treated as being filed on its due date. (See Example C:15-26.)

Six-Year Rule for Substantial Omissions. 1.

Income Tax Returns. In the case of substantial omissions, the statute of limitations is six years after the later of the date the return is filed or the return’s due date. A substantial omission is an amount exceeding 25% of the gross income shown on the return. (See Examples C:15-27 and C:15-29.)

Gift and Estate Tax Returns. A similar six-year rule applies to gift and estate tax returns. (See Example C:15-30.)

When No Return Is Filed. There is no statute of limitations if a taxpayer does not file a return.

Other Exceptions to the 3-Year Rule. The taxpayer and the IRS can mutually agree to extend the statute of limitations. This agreement is usually done when the return is being audited near the end of the limitation period.

Carrybacks. In the case of a year to which net operating losses are carried back, the statute of limitations is open until the statute expires with respect to the year in which the net operating loss arises.

When Fraud is Proven. If the government is able to prove that a taxpayer’s return was false or fraudulent, the statute of limitations is unlimited.

Refund Claims. Taxpayers are generally not entitled to a refund of overpayments of tax unless they file a claim for refund by the later of three years from the date the return is filed, or two years from the date the tax is paid. (See Examples C:15-34 and C:15-35.)

VIII. Liability for Tax. A.

Joint Returns. If two spouses file a joint return, the liability is joint and several. If two spouses file jointly, they cannot amend their return and file separately after the due date of the return. A joint return must include the signatures of both spouses in order to be recognized as valid. Congress enacted the innocent spouse provision in order to provide relief from liability for additional taxes in certain circumstances. The five conditions indicated on p. C:15-27 must be met in order to invoke the innocent spouse provisions. (See Examples C:15-36 through C:15-38.)

Transferee Liability. Taxes may be collected from fiduciaries and transferees. The statute of limitations expires one year after the statute of limitations would have run out with respect to the taxpayer in the case of income taxes, the executor for estate taxes, and the donor for gift taxes. (See Example C:15-39.)

IX.

Tax Practice Issues. A.

Statutory Provisions Concerning Tax Return Preparers. Sections 6694 through 6696 regulate tax return preparers by imposing penalties on them in certain circumstances. Tax return preparers are divided into two categories: signing preparers and non-signing preparers. A signing preparer has primary responsibility for the overall substantive accuracy of the preparation of the return or refund claim. A non-signing preparer gives advice to a taxpayer or another preparer, and the advice leads to a position or entry that is a substantial portion of the return or refund claim. As a result, more than one preparer can be subject to the preparer penalties. The 2007 Small Business Act expanded the definition of a preparer from “one preparer per firm” to “one preparer per position per firm.” The preparer responsible for the position giving rise to the understatement is subject to preparer penalties related to that position. The Act also broadened the definition of tax return preparer to include a person preparing non-income tax returns, such as estate, gift, excise, or employment tax returns. The tax return preparer penalties are listed on p. C:15-29.

Reportable Transaction Disclosures. The IRS has continued its focus on tax shelters, including reportable and listed transactions, and has issued extensive and detailed reporting requirements on individuals who advise clients on certain aggressive tax schemes. A reportable transaction is any transaction required to be disclosed because the IRS has determined it to have the potential for tax evasion or avoidance. A material advisor is any person who provides material aid, assistance, or advice with respect to any reportable transaction, and who receives gross income from the activity in excess of $10,000 if the tax benefits flow primarily to individuals or $25,000 for corporations and other entities, and transactions of interest. A material advisor must file Form 8918 to avoid severe penalties.

Rules of Circular 230. Treasury Department Circular 230 regulates the practice of attorneys, CPAs, enrolled agents, and enrolled actuaries before the IRS. Practice before the IRS includes representing clients in meetings with IRS agents and appeals officers. Persons not complying with the rules and regulations can be barred from practice before the IRS. Like Sec. 6694, Treasury Department Circular 230 provides that a tax practitioner should not give advice or prepare a return taking a position unless there is substantial authority for a tax return position. Standards for tax advisors are listed on p. C:15-33. The AICPA Statements on Standards for Tax Practice state that a member should not recommend that a tax return position be taken with respect to any item unless the member has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. The IRS will treat a position as having met the realistic possibility of being sustained on “its merits” if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater likelihood of being sustained on its merits. Additional discussion of this and other standards can be found beginning on p. C:15-34. C:IO15-12 Copyright © 2024 Pearson Education, Inc.

Tax Accounting and Tax Law. Accountants and lawyers frequently deal with the same business issues. In the area of federal taxation, achieving a clear line of demarcation between the role of the accountant and the role of the attorney has been difficult. Toward clarifying the responsibilities of each, the AICPA and American Bar Association have issued the Statement on Practice in the Field of Federal Income Taxation. The areas covered by this statement are found on p. C:15-35.

Accountant-Client Privilege. The accountant-client privilege encompasses communications between an accountant and a client for the purpose of obtaining or giving professional advice. It is limited to tax advice, may be asserted only in a noncriminal tax proceeding before a federal court or the IRS, and excludes written communications between an accountant and a corporation, relating to a “tax shelter.”

Court Case Briefs CIR v. Fred N. Acker, 361 U.S. 87 (USSC, 1959) aff’g. 258 F.2d 568 (6th Cir., 1958) mod. 1957 PH T.C. Memo ¶ 57,017. The taxpayer did not pay estimated taxes for the years 1947 through 1950, as required by law. He claimed that these laws were unconstitutional because “the enumerated powers of the Congress do not include any power to compel a citizen to prophesy.” The IRS sought to impose both the failureto-file and the substantial underestimation of tax penalties. The court ruled that both penalties could not be imposed. The taxpayer also argued that the income tax provisions were unconstitutional because the rates were so high as to be confiscatory and arbitrary, in violation of the Fifth Amendment to the Constitution. The court held that there was no reasonable basis in fact or in law to hold that the income tax provisions were unconstitutional. S. L. Elfmon v. U.S., 209 F.2d 642 (4th Cir., 1954) rev’g. 112 F.2d Supp (DC NC, 1953). The taxpayer was a physician who served in the military from 1942 to 1945. He filed his 1942 return in 1946 and understated the income earned in that year from his medical partnership. However, this return was not actually necessary due to the Current Tax Payment Act of 1943, which exempted him from income tax for the year 1942, as long as there were no additions to the 1942 tax due to fraud. The IRS sought to disallow his exemption because he had filed a fraudulent return for 1942. The court ruled that Elfmon could not be assessed penalties for fraud with intent to invade tax because he did not actually owe any tax for 1942 at the time he filed the return. Therefore, the relief provisions of the Current Tax Payment Act of 1943 were available and no penalties were due.

SUGGESTED SYLLABUS STANDARD SECOND COURSE IN TAXATION - SEMESTER BASIS (12-Chapter Course) Instructor: Office: Office Phone: Office Hours: Texts: 1. 2.

Class Time: Class Location: Class Section: Richardson/Franklin, Pearson’s Federal Taxation 2024: Corporations, Partnerships, Estates & Trusts (Required) Internal Revenue Code (Optional)

Course Description: This course is directed at undergraduate and graduate accounting students who desire to obtain additional tax knowledge beyond the Federal Income Tax Accounting 1 course. It is designed to present a survey approach to the following topics: Tax Research, Corporate Taxation, Partnership Taxation, and International Taxation. Course Objectives: 1. 2. 3.

To enable the students to learn the fundamental concepts of the federal income tax system as applied to entities other than individuals. To enable the students to learn the fundamental concepts of tax research. To apply the fundamentals learned in these two areas to problem situations likely to be encountered in tax practice.

Prerequisite: Problems: A number of problems will be assigned during this term. Each problem involves an analysis and/or computation of a situation you might expect to encounter in public or industrial accounting when you leave school. The problems will not be collected but will form the basis for class discussion. Solutions to the problems will be placed in the library after the chapter is completed.

Research Memo: A tax research question will be assigned. The problem involves researching a client-related problem. The memorandum will not exceed five pages in length. Tax Returns: A C corporation tax return (Form 1120) will be assigned. The return will be done in groups of two. Using the same tax return information, you also will be required to complete a partnership tax return (Form 1065), an S Corporation tax return (Form 1120-S), and Schedule K-1s for the owners after the appropriate topics have been covered. Case Analysis Problems: Two case analysis problems will be assigned. These will be broader analyses of business situations likely to be encountered in public accounting practice. The write-ups will involve use of tax research techniques as well as tax concepts learned during the discussions of the various topical areas (i.e., corporate and partnership taxation). Additional instructions will be provided at the time the cases are assigned. Grades: Assignments Class Participation Tax Returns: C corporation Partnership S corporation Tax Research Memo Case Analysis (20% each) Total

Author’s Note:

Points 100 150 100 50

300 200 400 1000

No classes are scheduled on days that major assignments are due. These days are used to give the students immediate feedback about the assignments that are being turned in. Adopters might choose to hold classes on those days and cover, in addition, Chapter C:15 [Administrative Procedures].

Date Week 1

Session Number 1 (50 mins. each)

Topic Introduction & Tax Research

Chapter* None

Code Section & Related Regulations None

Tax Research (continued)

C:1(pp. 1-14)

None

C:1-3,C:1-8,C:1-9, C:1-10,C:1-33,C:1-36

Tax Research (continued)

C:1(pp. 14-24)

None

C:1-14,C:1-20,C:1-39

Tax Research (continued) **Research Memo Assigned**

C:1(pp. 25-34) Appendix A

None

C:1-43,C:1-47,C:1-49, C:1-51,C:1-56

Formation of the Corporation

C:2(pp. 1-20)

351,358

C:2-25,C:2-30,C:2-34

Formation of the Corporation (continued)

C:2(pp. 20-34)

362,357,1032,165(g), 1244

C:2-44,C:2-45,C:2-50, C:2-51,C:2-55,C:2-56, C:2-57

Taxation of the Corporation

C:3(pp. 1-19)

1,63,163(j),170(a)(2),170 (b)(2),172(d), 243(a),248

C:3-33,C:3-34,C:3-37, C:3-39,C:3-42,C3:43, C:3-44

Taxation of the Corporation (continued)

C:3(pp. 19-29)

1,267,1561(a),1563(a)

C:3-45,C:3-47,C:3-51 C:3-52,C:3-53,C:3-63

Procedural Matters

C:3(pp. 29-37)

6655

C:3-56,C:3-57,C:3-58 C:3-63

Financial Statement Implications

C:3(pp. 37-49)

ASC740

C:3-60,C:3-61,C:3-62

**Tax Research Memo Due**

None

Problems None

Week 2

Week 3

Week 4

C:S-3

Date

Week 5

Week 6

Week 7

Week 8

Session Number 12

Topic Nonliquidating Distributions

Chapter C:4(pp. 1-13)

Code Section & Related Regulations 301,311,312(a)-(b)

Stock Dividends and General Stock Redemption Rules

C:4(pp. 13-23)

302,305,307

C:4-23,C:4-39,C:4-42, C:4-44

Special Rules **C Corporation Tax Return Assigned**

C:4(pp. 23-27)

302(e),303(a)-(b)

C:4-45,C:4-47,C:4-48, C:4-51,C:4-58, C:4-59

Other Corporate Tax Levies PHCs, A/E Tax, and Book Minimum Tax

C:5(pp. 1-22)

531-533,541-543

C:5-28,C:5-31, C:5-33

Liquidating Distributions General Liquidation

C:6(pp. 1-10, 15-17)

331,336

C:6-36,C:6-40,C:6-41

Liquidating Distributions Controlled Subsidiary Corporation

C:6(pp. 10-14)

332,337

C:6-43,C:6-47,C:6-48, C:6-54,C:6-55,C:6-56

Taxable and Nontaxable Acquisition Transactions

C:7(pp. 1-13)

338

C:7-39,C:7-43,C:7-44

Acquisitive Reorganizations: Type A

C:7(pp. 14-25)

368,354-356,361,362(b)

C:7-46,C:7-48,C:7-50

Acquisitive Reorganizations: Types C and B

C:7(pp. 25-33)

None

C:7-51,C:7-53,C:7-55, C:7-57

Divisive Reorganizations: Type D **C Corporation Tax Return Due**

C:7(pp. 33-38)

None

C:7-60,C:7-62

Nontaxable Reorganizations: Judicial and Other Concepts

C:7(pp. 40-42)

381(a)-(b)

C:7-67,C:7-68

C:S-4

Problems C:4-28,C:4-30,C:4-33

Date

Week 9

Week 10

Week 11

Week 12

Session Number 23

Topic Consolidated Tax Returns

Chapter C:8(pp. 1-8)

Code Section & Related Regulations 1501-1504

Consolidated Tax Returns (continued)

C:8(pp.8-18)

None

C:8-36,C:8-45,C:8-46

Consolidated Tax Returns (continued) **Case No. 1 Assigned**

C:8(pp. 18-33)

None

C:8-47,C:8-50,C:8-51, C:8-65,C:8-68

Partnership Formation

C:9(pp. 1-12)

709,721-724

C:9-26,C:9-28

Partnership Operations

C:9(pp. 12-20)

702-704,706 163(j),199A

C:9-30,C:9-32,C:9-33, C:9-34,C:9-35

Partnership Operations (continued)

C:9(pp. 20-30)

752

C:9-36,C:9-37,C:9-41,C:942,C:9-46,C:9-55,C:9-56

Guaranteed Payments and Family Partnerships

C:9(pp. 31-36)

707,704(e)

C:9-48,C:9-50,C:9-52

Partnership Nonliquidating Distributions

C:10(pp. 1-11)

731-734,754

C:10-22,C:10-23,C:10-27, C:10-28,C:10-29

**Case No. 1 Due**

None

Partnership Liquidating Distributions

C:10(pp. 11-16, 27-28)

731-734,754

C:10-31,C:10-32,C:10-33, C:10-34

Sale of Partnership Interest **Partnership Return Assigned**

C:10(pp. 16-19, 24-27)

735,741,743,751,754

C:10-35,C:10-36,C:10-37, C:10-49,C:10-54

Other Dispositions of an Interest

C:10(pp. 19-24)

736

C:10-40,C:10-42

C:S-5

Problems C:8-28,C:8-29,C:8-33 C:8-34

Date

Week 13

Week 14

Final Exam

Session Number 35

Code Section & Related Regulations 1361,1362

Problems C:11-29,C:11-30,C:11-31

C:11(pp. 13-18)

1363,1374,1375,1377, 1378

C:11-34,C:11-35,C:11-36, C:11-37,C:11-56

**Partnership Return Due** *Case No. 2 Assigned*

None

S Corporations - Basis and Loss Pass-throughs

C:11(pp. 19-27)

1366,1367

C:11-44,C:11-46,C:11-57, C:11-59

S Corporations - Distributions and Other Rules **S Corporation Return Assigned**

C:11(pp. 27-34)

1368,1371(a),1372

C:11-50,C:11-51, C-11:54,C:11-55

Administrative Procedures

C:15(pp. 2-15)

None

C:15-37,C:15-38,C:15-43

Administrative Procedures

C:15(pp. 15-36)

None

C:15-54,C:15-57

Administrative Procedures **S Corporation Return Due**

C:15(pp. 15-36 cont.)

None

C:15-62,C:15-64

Topic S Corporations - Requirements and Election

Chapter C:11(pp. 1-13)

S Corporations - Operations

**Case No. 2 Due**

*The text reading includes the appropriate portion of the tax planning considerations and compliance and procedural considerations sections of the chapter.

C:S-6

SUGGESTED SYLLABUS STANDARD SECOND COURSE IN TAXATION - SEMESTER BASIS (14-Chapter Course) Instructor: Office: Office Phone: Office Hours: Texts: 1. 2.

Class Time: Class Location: Class Section: Richardson/Franklin, Pearson’s Federal Taxation 2024: Corporations, Partnerships, Estates & Trusts (Required) Internal Revenue Code (Optional)

Course Description: This course is directed at undergraduate and graduate accounting students who desire to obtain additional tax knowledge beyond the Federal Income Tax Accounting I course. It is designed to present a survey approach to the following topics: Tax Research, Corporate Taxation, Partnership Taxation, Transfer Taxation, and Income Taxation of Estates and Trusts. Course Objectives: 1. 2. 3.

Research Memo: A tax research question will be assigned. The problem involves researching a client-related problem. The memorandum will not exceed five pages in length. Tax Returns: A C corporation tax return (Form 1120) will be assigned. The return will be done in groups of two. Using the same tax return information, you also will be required to complete a partnership tax return (Form 1065), and an S Corporation tax return (Form 1120-S), and Schedule K-1s for the owners after the appropriate topics have been covered. Case Analysis Problems: Two case analysis problems will be assigned. These will be broader analyses of business situations, likely to be encountered in public accounting practice. The write-ups will involve use of tax research techniques as well as tax concepts learned during the discussions of the various topical areas (i.e., corporate and partnership taxation). Additional instructions will be provided at the time the cases are assigned. Grades: Assignments Class Participation Tax Returns: C corporation Partnership S corporation Tax Research Memo Case Analysis (20% each) Total

Points 100 150 100 50

300 200 400 1000

Date Week 1

Session Number 1 (50 mins. each)

Topic Introduction & Tax Research

Chapter* None

Code Section & Related Regulations None

Tax Research (continued)

C:1(pp. 1-14)

None

C:1-3,C:1-8,C:1-9, C:1-10,C:1-33,C:1-36

Tax Research (continued)

C:1(pp. 14-24)

None

C:1-14,C:1-20,C:1-39

Tax Research (continued) **Tax Research Memo Assigned**

C:1(pp. 25-34) Appendix A

None

C:1-43,C:1-47,C:1-49, C:1-51,C:1-56

Formation of the Corporation

C:2(pp. 1-20)

351,358

C:2-25,C:2-30,C:2-34

Formation of the Corporation (continued)

C:2(pp. 20-34)

362,357,1032,165(g),1244

C:2-44,C:2-45,C:2-50, C:2-51,C:2-55,C:2-56, C:2-57

Taxation of the Corporation

C:3(pp. 1-19)

1,63,163(j),170(a)(2),170 (b)(2),172(d),243(a),248

C:3-33,C:3-34,C:3-37, C:3-39,C:3-42,C3:43, C:3-44

Taxation of the Corporation (continued)

C:3(pp. 19-29)

1,267,1561(a),1563(a)

C:3-45,C:3-47,C:3-51 C:3-52,C:3-53,C:3-63

Procedural Matters

C:3(pp. 29-37)

6655

C:3-56,C:3-57,C:3-58 C:3-63

Financial Statement Implications

C:3(pp. 37-49)

ASC740

C:3-60,C:3-61,C:3-62

**Tax Research Memo Due**

None

Problems None

Week 2

Week 3

Week 4

C:S-9

Date

Week 5

Week 6

Week 7

Week 8

Session Number 12

Code Section & Related Regulations 301,311,312(a)-(b)

Topic Nonliquidating Distributions

Chapter C:4(pp. 1-13)

Stock Dividends and General Stock Redemptions Rules

C:4(pp. 13-23)

302,305,307

C:4-23,C:4-39,C:4-42, C:4-44

Special Rules **C Corporation Tax Return Assigned**

C:4(pp. 23-27)

302(e),303(a)-(b)

C:4-45,C:4-47,C:4-48, C:4-51,C:4-58,C:4-59

Other Corporate Tax Levies PHCs, A/E Tax, and Book Minimum Tax

C:5(pp. 1-22)

531-533,541-543

C:5-28,C:5-31,C:5-33

Liquidating Distributions General Liquidation

C:6(pp. 1-10, 1517)

331,336

C:6-36,C:6-40,C:6-41

Liquidating Distributions Controlled Subsidiary Corporations

C:6(pp. 10-14)

332,337

C:6-43,C:6-47,C:6-48, C:6-54,C:6-55,C:6-56

Taxable and Nontaxable Acquisition Transactions

C:7(pp. 1-13)

338

C:7-39,C:7-43,C:7-44

Acquisitive Reorganizations: Type A

C:7(pp. 14-25)

368,354-56,361,362(b)

C:7-46,C:7-48,C:7-50

Acquisitive Reorganizations: Types C and B

C:7(pp. 25-33)

None

C:7-51,C:7-53,C:7-55, C:7-57

Divisive Reorganizations: Type D

C:7(pp. 33-38)

None

C:7-60,C:7-62

**C Corporation Tax Return Due**

Nontaxable Reorganizations: Judicial and Other Concepts

C:7(pp. 40-42)

381(a)-(b)

C:7-67,C:7-68

C:S-10

Problems C:4-28,C:4-30,C:4-33

Date

Week 9

Week 10

Week 11

Session Number 24

Topic Consolidated Tax Returns

Chapter C:8(pp. 1-8)

Code Section & Related Regulations 1501-1504

Consolidated Tax Returns (continued)

C:8(pp.8-18)

None

C:8-36,C:8-45,C:8-46

Consolidated Tax Returns (continued) **Case No. 1 Assigned**

C:8(pp. 18-33)

None

C:8-47,C:8-50,C:8-51, C:8-65,C:8-68

Partnership Formation

C:9(pp. 1-12)

709,721-724

C:9-26,C:9-28

Partnership Operations

C:9(pp. 12-20)

702-704,706 163(j),199A

C:9-30,C:9-32,C:9-33, C:9-34,C:9-35

Partnership Operations (continued)

C:9(pp. 20-30)

752

C:9-36,C:9-37,C:9-41, C:9-42,C:9-46,C:9-55,C:9-56

Guaranteed Payments and Family Partnerships

C:9(pp. 31-36)

707,704(e)

C:9-48,C:9-50,C:9-52

Partnership Nonliquidating Distributions

C:10(pp. 1-11)

731-734,754

C:10-22,C:10-23,C:10-27, C:10-28,C:10-29

**Case No. 1 Due**

None

Partnership Liquidating Distributions

C:10(pp. 11-16, 27-28)

731-734,754

C:10-31,C:10-32,C:10-33, C:10-34

Sale of Partnership Interest **Partnership Return Assigned**

C:10(pp. 16-19, 24-27)

735,741,743,751,754

C:10-35,C:10-36, C:10-37,C:10-49,C:10-54

Other Dispositions of an Interest

C:10(pp. 19-24)

Problems C:8-28,C:8-29,C:8-33 C:8-34

Week 12

C:S-11

736

C:10-40,C:10-42

Date

Week 13

Week 14

Week 15

Final Exam

Session Number 36

Code Section & Related Regulations 1361,1362

Problems C:11-29,C:11-30,C:11-31

C:11(pp. 13-18)

1363,1374,1375,1377, 1378

C:11-34,C:11-35,C:11-36, C:11-37,C:11-56

S Corporations - Basis and Loss Passthroughs **Partnership Return Due**

C:11(pp. 19-27)

1366,1367

C:11-44,C:11-46,C:11-57, C:11-59

S Corporations - Distribution and Other Concepts **S Corporation Return Assigned**

C:11(pp. 27-34)

1368,1371(a),1372

C:11-50,C:11-51, C:11-54,C:11-55

Gift Taxes - Calculation of Transfer Tax Base

C:12(pp. 1-23)

2501-2505

C:12-33,C:12-34,C:12-35

Gift Taxes - Calculation of Tax Liability **Case No. 2 Assigned**

C:12(pp. 23-28)

None

C:12-50,C:12-55,C:12-56

Estate Taxes - Calculation of Transfer Tax Base

C:13(pp. 1-22)

2031,2032

C:13-47,C:13-49

Estate Taxes - Calculation of Tax Liability

C:13(pp. 23-27)

2001,2010,2011

C:13-51,C:13-57,C:13-59

Income Taxation of Trusts & Estates **S Corporation Return Due**

C:14(pp. 1-19)

641-645

C:14-30,C:14-32,C:14-34

Income Taxes of Trusts & Estates (continued)

C:14(pp. 19-33)

None

C:14-38,C:14-39,C:14-44, C:14-51,C:14-52

Topic S Corporations - Requirements and Election

Chapter C:11(pp. 1-13)

S Corporations - Operations

**Case No. 2 Due**

*The text reading includes the appropriate portion of the tax planning/considerations and compliance and procedural considerations sections of the chapter.

C:S-12

C:3-66 Melodic Musical Sales, Inc. XX-2024022

2022 Form 1120

Notes to Instructor: Instructors may want to simplify the tax return project by giving students some or all of the following information rather than having them calculate the items: Current year depreciation on property placed in service before 2022: Building ($2,000,000 × 0.02564) Equipment 1 ($250,000 × 0.1249 × 0.5) Equipment 2 ($500,000 × 0.1249) Trucks ($100,000 × 0.192) Total

$ 51,280 15,613 62,450 19,200 $148,543

Current year depreciation on equipment placed in service in 2022: Sec. 179 expensing

$600,000

Total current-year depreciation

$748,543

Capital gains and losses for 2022: Short-term capital gain on sale of PDQ stock Long-term capital loss on sale of JSB stock

$ 55,000 (10,000)

Sale of Equipment 1: Selling price Cost Minus: Accumulated depreciation Adjusted basis Gain recognized Sec. 1245 recapture Sec. 1231 gain

$250,000 (156,288)

$280,000

(93,712) $186,288 $156,288 $ 30,000

Underpayment penalty: Omit Form 2220 and just insert $4,286 penalty on Form 1120, Page 1, Line 33. Schedule M-3: Omit this schedule.

C:3-66

1120

U.S. Corporation Income Tax Return

Form Department of the Treasury Internal Revenue Service A Check if: 1a Consolidated return (attach Form 851)

b Life/nonlife consoli-

dated return . . . 2 Personal holding co. (attach Sch. PH) . .

3 Personal service corp. (see instructions) .

Tax, Refundable Credits, and Payments

Deductions (See instructions for limitations on deductions.)

Income

4 Schedule M-3 attached

For calendar year 2022 or tax year beginning

OMB No. 1545-0123

, 2022, ending

2022

, 20

Go to www.irs.gov/Form1120 for instructions and the latest information. Name

TYPE OR PRINT

B Employer identification number

Melodic Musical Sales, Inc.

XX-2024022

Number, street, and room or suite no. If a P.O. box, see instructions.

C Date incorporated

City or town, state or province, country, and ZIP or foreign postal code

D Total assets (see instructions)

5500 Fourth Avenue

✓ E Check if: (1)

12/31/2018

City, ST 98765

(2)

Initial return

(3)

Final return

Name change

Gross receipts or sales .

b c 2

Returns and allowances . . . . . . Balance. Subtract line 1b from line 1a . Cost of goods sold (attach Form 1125-A) .

. . .

. .

1b . . . .

3 4 5

Gross profit. Subtract line 2 from line 1c . . Dividends and inclusions (Schedule C, line 23) Interest . . . . . . . . . . .

. . .

6 7 8

Gross rents . . . . . . . . . . . . . . Gross royalties . . . . . . . . . . . . . Capital gain net income (attach Schedule D (Form 1120)) .

. . .

9 10 11 12

Net gain or (loss) from Form 4797, Part II, line 17 (attach Form 4797) Other income (see instructions—attach statement) . . . . . . Total income. Add lines 3 through 10 . . . . . . . . . Compensation of officers (see instructions—attach Form 1125-E) .

. . . .

13 14

Salaries and wages (less employment credits)

Repairs and maintenance

15 16 17

Bad debts . . . Rents . . . . Taxes and licenses

. . .

7,955,494

(4)

Address change

10,000,000 250,000 . .

. .

1c 2

. . .

3 4 5

. . .

6 7 8

. . . .

9 10 11

12 13 14

. . .

15 16 17

18 19 20

Interest (see instructions) . . . . . . . . . . . . . . . . . . . . . . . Charitable contributions . . . . . . . . . . . . . . . . . . . . . . . . Depreciation from Form 4562 not claimed on Form 1125-A or elsewhere on return (attach Form 4562) .

. . .

18 19 20

21 22 23

Depletion . . . . . . . . Advertising . . . . . . . Pension, profit-sharing, etc., plans

. . .

21 22 23

24 25 26

Employee benefit programs . . Reserved for future use . . . . Other deductions (attach statement)

. . .

24 25 26

27 28 29a

Total deductions. Add lines 12 through 26 . . . . . . . . . . . . . . . . . . . Taxable income before net operating loss deduction and special deductions. Subtract line 27 from line 11. Net operating loss deduction (see instructions) . . . . . . . . . . . 29a

27 28

b c 30

Special deductions (Schedule C, line 24) . . . . . . . . Add lines 29a and 29b . . . . . . . . . . . . . Taxable income. Subtract line 29c from line 28. See instructions

. . .

. .

29b . . . .

. .

31 32 33

Total tax (Schedule J, Part I, line 11) . . . . . . Reserved for future use . . . . . . . . . . Total payments and credits (Schedule J, Part III, line 23)

. . .

34 35 36

Estimated tax penalty. See instructions. Check if Form 2220 is attached . . . . . Amount owed. If line 33 is smaller than the total of lines 31 and 34, enter amount owed Overpayment. If line 33 is larger than the total of lines 31 and 34, enter amount overpaid

. . .

Sign Here

. . .

Enter amount from line 36 you want: Credited to 2023 estimated tax

6,000 . .

. .

29c 30

. . .

31 32 33

. . .

✓

Refunded

9,750,000 4,500,000 5,250,000 12,000 60,000 156,288 5,478,288 650,000 400,000 20,500 40,000 137,000 210,000 30,000 748,543 48,000 177,000 2,461,043 3,017,245 6,000 3,011,245 632,361 555,000 4,286 81,647

34 35 36 37

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Mary Travis

Signature of officer

Print/Type preparer’s name

Paid Preparer Use Only Firm’s name

4-14-23

Date

Preparer’s signature

May the IRS discuss this return with the preparer shown below? See instructions. Yes No

President

Title

Date

Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11450Q

Form 1120 (2022)

C:3-66 Page 2

Form 1120 (2022)

Schedule C

Dividends, Inclusions, and Special Deductions (see instructions)

Dividends from less-than-20%-owned domestic corporations (other than debt-financed stock) . . . . . . . . . . . . . . . . . . . . . . . .

Dividends from 20%-or-more-owned domestic corporations (other than debt-financed stock) . . . . . . . . . . . . . . . . . . . . . . . .

Dividends on certain debt-financed stock of domestic and foreign corporations

Dividends on certain preferred stock of less-than-20%-owned public utilities

(a) Dividends and inclusions

(b) %

12,000

See instructions

23.3

Dividends on certain preferred stock of 20%-or-more-owned public utilities .

26.7

Dividends from less-than-20%-owned foreign corporations and certain FSCs

Dividends from 20%-or-more-owned foreign corporations and certain FSCs

Dividends from wholly owned foreign subsidiaries

100

Subtotal. Add lines 1 through 8. See instructions for limitations .

Dividends from domestic corporations received by a small business investment company operating under the Small Business Investment Act of 1958 . . . . .

100

Dividends from affiliated group members .

100

Dividends from certain FSCs

100

Foreign-source portion of dividends received from a specified 10%-owned foreign corporation (excluding hybrid dividends) (see instructions) . . . . . . . . .

Dividends from foreign corporations not included on line 3, 6, 7, 8, 11, 12, or 13 (including any hybrid dividends) . . . . . . . . . . . . . . . . .

Reserved for future use .

16a

Subpart F inclusions derived from the sale by a controlled foreign corporation (CFC) of the stock of a lower-tier foreign corporation treated as a dividend (attach Form(s) 5471) (see instructions) . . . . . . . . . . . . . . . . . . . . .

Subpart F inclusions derived from hybrid dividends of tiered corporations (attach Form(s) 5471) (see instructions) . . . . . . . . . . . . . . . . . . .

Other inclusions from CFCs under subpart F not included on line 16a, 16b, or 17 (attach Form(s) 5471) (see instructions) . . . . . . . . . . . . . . . . .

100

Global Intangible Low-Taxed Income (GILTI) (attach Form(s) 5471 and Form 8992) .

Gross-up for foreign taxes deemed paid

IC-DISC and former DISC dividends not included on line 1, 2, or 3

Other dividends

Deduction for dividends paid on certain preferred stock of public utilities

Section 250 deduction (attach Form 8993)

Total dividends and inclusions. Add column (a), lines 9 through 20. Enter here and on page 1, line 4 . . . . . . . . . . . . . . . . . . . . . .

Total special deductions. Add column (c), lines 9 through 22. Enter here and on page 1, line 29b .

6,000

100

See instructions

12,000

6,000

12,000 .

6,000

Form 1120 (2022)

C:3-66 Page 3

Form 1120 (2022)

Schedule J

Tax Computation and Payment (see instructions)

Part I—Tax Computation 1 2

Check if the corporation is a member of a controlled group (attach Schedule O (Form 1120)). See instructions Income tax. See instructions . . . . . . . . . . . . . . . . . . . . . . .

3 4 5a

Base erosion minimum tax amount (attach Form 8991) . Add lines 2 and 3 . . . . . . . . . . . . Foreign tax credit (attach Form 1118) . . . . . .

. . .

b c d

Credit from Form 8834 (see instructions) . . . . General business credit (attach Form 3800) . . . Credit for prior year minimum tax (attach Form 8827)

. . .

e 6 7

Bond credits from Form 8912 . . . Total credits. Add lines 5a through 5e Subtract line 6 from line 4 . . . .

. . .

8 9a b

Personal holding company tax (attach Schedule PH (Form 1120)) . Recapture of investment credit (attach Form 4255) . . . . . Recapture of low-income housing credit (attach Form 8611) . .

. . .

c d

Interest due under the look-back method—completed long-term contracts (attach Form 8697) . . . . . . . . . . . . . . . . . . . . . . . Interest due under the look-back method—income forecast method (attach Form 8866)

9c 9d

e f

Alternative tax on qualifying shipping activities (attach Form 8902) Interest/tax due under section 453A(c) and/or section 453(l) . .

9e 9f

. . .

Other (see instructions—attach statement)

. . .

. .

. . . . 5a

. .

. . . .

. .

6 7

. . .

2 3 4

. . .

. .

5e . . . . . . 9a 9b

Total tax. Add lines 7, 8, and 10. Enter here and on page 1, line 31 .

Part II—Reserved For Future Use 12

Reserved for future use .

632,361

Total. Add lines 9a through 9g .

632,361

5b 5c 5d

632,361

Part III—Payments and Refundable Credits 13

2021 overpayment credited to 2022

14 15 16

2022 estimated tax payments . . . 2022 refund applied for on Form 4466 . Combine lines 13, 14, and 15 . . .

. . .

14 15 ( 16

17 18 19

Tax deposited with Form 7004 . . . . Withholding (see instructions) . . . . Total payments. Add lines 16, 17, and 18

. . .

17 18 19

Refundable credits from: Form 2439 . . . . . Form 4136 . . . . .

. .

20a 20b

Reserved for future use . . . . . . Other (attach statement—see instructions) Total credits. Add lines 20a through 20d .

. . .

20c 20d . . .

22 23

Reserved for future use . . . . . . . . . . . . . . . . . . . Total payments and credits. Add lines 19 and 21. Enter here and on page 1, line 33 .

. .

22 23

a b c d

. .

555,000 555,000

)

555,000

Form 1120 (2022)

C:3-66 Page 4

Form 1120 (2022)

Schedule K

Other Information (see instructions)

1 2 a

Check accounting method: a Cash See the instructions and enter the: Business activity code no.

Business activity Product or service

c 3

✓ Accrual

Yes

Other (specify)

451140 Retail sales Musical instruments

Is the corporation a subsidiary in an affiliated group or a parent–subsidiary controlled group? If “Yes,” enter name and EIN of the parent corporation

At the end of the tax year:

Did any foreign or domestic corporation, partnership (including any entity treated as a partnership), trust, or tax-exempt organization own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of the corporation’s stock entitled to vote? If “Yes,” complete Part I of Schedule G (Form 1120) (attach Schedule G) . . . . . .

Did any individual or estate own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of the corporation’s stock entitled to vote? If “Yes,” complete Part II of Schedule G (Form 1120) (attach Schedule G) .

At the end of the tax year, did the corporation:

Own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of stock entitled to vote of any foreign or domestic corporation not included on Form 851, Affiliations Schedule? For rules of constructive ownership, see instructions. If “Yes,” complete (i) through (iv) below. (i) Name of Corporation

(ii) Employer Identification Number (if any)

✓

✓ ✓

(ii) Employer Identification Number (if any)

(iii) Country of Organization

✓

(iv) Percentage Owned in Voting Stock

(iii) Country of Incorporation

b Own directly an interest of 20% or more, or own, directly or indirectly, an interest of 50% or more in any foreign or domestic partnership (including an entity treated as a partnership) or in the beneficial interest of a trust? For rules of constructive ownership, see instructions. If “Yes,” complete (i) through (iv) below. (i) Name of Entity

✓

(iv) Maximum Percentage Owned in Profit, Loss, or Capital

During this tax year, did the corporation pay dividends (other than stock dividends and distributions in exchange for stock) in excess of the corporation’s current and accumulated earnings and profits? See sections 301 and 316 . . . . . . . . If “Yes,” file Form 5452, Corporate Report of Nondividend Distributions. See the instructions for Form 5452. If this is a consolidated return, answer here for the parent corporation and on Form 851 for each subsidiary.

At any time during the tax year, did one foreign person own, directly or indirectly, at least 25% of the total voting power of all classes of the corporation’s stock entitled to vote or at least 25% of the total value of all classes of the corporation’s stock? .

✓

For rules of attribution, see section 318. If “Yes,” enter: (a) Percentage owned and (b) Owner’s country (c) The corporation may have to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Enter the number of Forms 5472 attached 8

Check this box if the corporation issued publicly offered debt instruments with original issue discount . . . . . . . If checked, the corporation may have to file Form 8281, Information Return for Publicly Offered Original Issue Discount Instruments. Enter the amount of tax-exempt interest received or accrued during the tax year $ Enter the number of shareholders at the end of the tax year (if 100 or fewer)

If the corporation has an NOL for the tax year and is electing to forego the carryback period, check here (see instructions)

5,000 3

If the corporation is filing a consolidated return, the statement required by Regulations section 1.1502-21(b)(3) must be attached or the election will not be valid. 12

Enter the available NOL carryover from prior tax years (do not reduce it by any deduction reported on page 1, line 29a.) . . . . . . . . . . . . . . . . . . . . . . . . . $

N/A Form 1120 (2022)

C:3-66 Page 5

Form 1120 (2022)

Schedule K 13

Other Information (continued from page 4)

Are the corporation’s total receipts (page 1, line 1a, plus lines 4 through 10) for the tax year and its total assets at the end of the tax year less than $250,000? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . If “Yes,” the corporation is not required to complete Schedules L, M-1, and M-2. Instead, enter the total amount of cash distributions and the book value of property distributions (other than cash) made during the tax year $

Yes

✓ ✓

Is the corporation required to file Schedule UTP (Form 1120), Uncertain Tax Position Statement? See instructions If “Yes,” complete and attach Schedule UTP.

15a b

Did the corporation make any payments in 2022 that would require it to file Form(s) 1099? If “Yes,” did or will the corporation file required Form(s) 1099? . . . . . . . . .

. .

During this tax year, did the corporation have an 80%-or-more change in ownership, including a change due to redemption of its own stock? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

✓

During or subsequent to this tax year, but before the filing of this return, did the corporation dispose of more than 65% (by value) of its assets in a taxable, non-taxable, or tax deferred transaction? . . . . . . . . . . . . . . . . . .

✓

Did the corporation receive assets in a section 351 transfer in which any of the transferred assets had a fair market basis or fair market value of more than $1 million? . . . . . . . . . . . . . . . . . . . . . . . . . . .

✓

During the corporation’s tax year, did the corporation make any payments that would require it to file Forms 1042 and 1042-S under chapter 3 (sections 1441 through 1464) or chapter 4 (sections 1471 through 1474) of the Code? . . . . . . . .

Is the corporation operating on a cooperative basis?.

✓ ✓

During the tax year, did the corporation pay or accrue any interest or royalty for which the deduction is not allowed under section 267A? See instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . If “Yes,” enter the total amount of the disallowed deductions $

✓

Does the corporation have gross receipts of at least $500 million in any of the 3 preceding tax years? (See sections 59A(e)(2) and (3)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

✓

Did the corporation have an election under section 163(j) for any real property trade or business or any farming business in effect during the tax year? See instructions . . . . . . . . . . . . . . . . . . . . . . . . . . .

. .

✓

If “Yes,” complete and attach Form 8991.

24 a b c 25 26

Does the corporation satisfy one or more of the following? See instructions . . . . . . . . . . . . . The corporation owns a pass-through entity with current, or prior year carryover, excess business interest expense.

The corporation’s aggregate average annual gross receipts (determined under section 448(c)) for the 3 tax years preceding the current tax year are more than $27 million and the corporation has business interest expense. The corporation is a tax shelter and the corporation has business interest expense. If “Yes,” complete and attach Form 8990. Is the corporation attaching Form 8996 to certify as a Qualified Opportunity Fund? . . . . . . . . . . . . . . If “Yes,” enter amount from Form 8996, line 15 . . . . . $ Since December 22, 2017, did a foreign corporation directly or indirectly acquire substantially all of the properties held directly or indirectly by the corporation, and was the ownership percentage (by vote or value) for purposes of section 7874 greater than 50% (for example, the shareholders held more than 50% of the stock of the foreign corporation)? If “Yes,” list the ownership percentage by vote and by value. See instructions . . . . . . . . . . . . . . . . . . . . . . . Percentage: By Vote By Value

✓ ✓

✓

Form 1120 (2022)

C:3-66 Page 6

Form 1120 (2022)

Schedule L

Balance Sheets per Books

Beginning of tax year (a) (b)

Assets 1

Cash

2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

Trade notes and accounts receivable . Less allowance for bad debts . . . Inventories . . . . . . . . . U.S. government obligations . . . Tax-exempt securities (see instructions) Other current assets (attach statement) Loans to shareholders . . . . . Mortgage and real estate loans . . . Other investments (attach statement) . Buildings and other depreciable assets Less accumulated depreciation . . . Depletable assets . . . . . . . Less accumulated depletion . . . . Land (net of any amortization) . . . Intangible assets (amortizable only) . Less accumulated amortization . . . Other assets (attach statement) . . . Total assets . . . . . . . .

. . . . . . . . . . . . . . . . . .

16 17 18 19 20 21 22

(

400,000 20,000

a Preferred stock . . . . b Common stock . . . . Additional paid-in capital . . . . . . . Retained earnings—Appropriated (attach statement) Retained earnings—Unappropriated . . . Adjustments to shareholders’ equity (attach statement) Less cost of treasury stock . . . . . . Total liabilities and shareholders’ equity . .

23 24 25 26 27 28

Schedule M-1

(c)

516,774

380,000 2,500,000

)

(

(d)

500,000 25,000

815,494 475,000 3,500,000

)

30,000

30,000 260,000

2,850,000 ( 317,500

)

(

)

(

)

2,532,500 200,000 60,000 6,479,274

Liabilities and Shareholders’ Equity

Capital stock:

End of tax year

1,500,000

50,000

3,200,000 ( 395,000

)

(

)

(

)

2,805,000 200,000 80,000 7,955,494

300,000 800,000 21,880

270,000 640,000 103,461

1,800,000 57,394

600,000 167,593 1,500,000

1,500,000

1,500,000 2,000,000 (

6,479,274

4,674,440 )

(

Reconciliation of Income (Loss) per Books With Income per Return

7,955,494

)

Note: The corporation may be required to file Schedule M-3. See instructions. 1

Net income (loss) per books .

Federal income tax per books

Excess of capital losses over capital gains

Income subject to tax not recorded on books this year (itemize):

a b c 6

Expenses recorded on books this year not deducted on this return (itemize): Depreciation . . . . $ Charitable contributions . $ Travel and entertainment . $

See schedule on p. C:TRP-21

Add lines 1 through 5 .

Schedule M-2 1 2 3

81,288

5,000 Deductions on this return not charged against book income this year (itemize): a Depreciation . . $ b Charitable contributions $

596,043*

Cap.loss C/O

35,000 3,633,288

9 10

15,000

Add lines 7 and 8 . . . . . . Income (page 1, line 28)—line 6 less line 9

Analysis of Unappropriated Retained Earnings per Books (Schedule L, Line 25)

Balance at beginning of year Net income (loss) per books . Other increases (itemize):

. .

2,000,000 2,774,440

6 7 8

4,774,440 *See schedule on p. C:TRP-21 for additional information.

Income recorded on books this year not included on this return (itemize): Tax-exempt interest $

5,000

Gain on equip. (186,288 – 105,000)*

2,774,440 742,560

Add lines 1, 2, and 3 .

Distributions: a Cash . b Stock . c Property . Other decreases (itemize):

. . .

Add lines 5 and 6 . . . . . . Balance at end of year (line 4 less line 7)

611,043 616,043 3,017,245 100,000 100,000 4,674,440

Form 1120 (2022)

C:3-66 SCHEDULE D (Form 1120) Department of the Treasury Internal Revenue Service

Capital Gains and Losses

OMB No. 1545-0123

Attach to Form 1120, 1120-C, 1120-F, 1120-FSC, 1120-H, 1120-IC-DISC, 1120-L, 1120-ND, 1120-PC, 1120-POL, 1120-REIT, 1120-RIC, 1120-SF, or certain Forms 990-T.

2022

Go to www.irs.gov/Form1120 for instructions and the latest information.

Employer identification number

Name

Melodic Musical Sales, Inc.

XX-2024022

Yes

. . . . If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

Part I

X No

Short-Term Capital Gains and Losses—Assets Held One Year or Less

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

145,000

90,000

(g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

55,000

4 Short-term capital gain from installment sales from Form 6252, line 26 or 37 .

5 Short-term capital gain or (loss) from like-kind exchanges from Form 8824

6 Unused capital loss carryover (attach computation)

7 Net short-term capital gain or (loss). Combine lines 1a through 6 in column h

Part II

Long-Term Capital Gains and Losses—Assets Held More Than One Year

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

110,000

120,000

(g) Adjustments to gain or loss from Form(s) 8949, Part II, line 2, column (g)

(

15,000 ) 40,000

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

(10,000) 30,000

12 Long-term capital gain from installment sales from Form 6252, line 26 or 37 .

13 Long-term capital gain or (loss) from like-kind exchanges from Form 8824

14 Capital gain distributions (see instructions)

15 Net long-term capital gain or (loss). Combine lines 8a through 14 in column h

20,000

16 Enter excess of net short-term capital gain (line 7) over net long-term capital loss (line 15) . . . . . 17 Net capital gain. Enter excess of net long-term capital gain (line 15) over net short-term capital loss (line 7) 18 Add lines 16 and 17. Enter here and on Form 1120, page 1, line 8, or the applicable line on other returns

16 17 18

40,000 20,000 60,000

Part III

Summary of Parts I and II

Note: If losses exceed gains, see Capital Losses in the instructions. For Paperwork Reduction Act Notice, see the Instructions for Form 1120.

Cat. No. 11460M

Schedule D (Form 1120) 2022

C:3-66 Form

8949

Department of the Treasury Internal Revenue Service Name(s) shown on return

Sales and Other Dispositions of Capital Assets Go to www.irs.gov/Form8949 for instructions and the latest information. File with your Schedule D to list your transactions for lines 1b, 2, 3, 8b, 9, and 10 of Schedule D.

Melodic Musical Sales, Inc.

OMB No. 1545-0074

2022

Attachment Sequence No. 12A

Social security number or taxpayer identification number

XX-2024022

Before you check Box A, B, or C below, see whether you received any Form(s) 1099-B or substitute statement(s) from your broker. A substitute statement will have the same information as Form 1099-B. Either will show whether your basis (usually your cost) was reported to the IRS by your broker and may even tell you which box to check.

Part I

Short-Term. Transactions involving capital assets you held 1 year or less are generally short-term (see instructions). For long-term transactions, see page 2. Note: You may aggregate all short-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS and for which no adjustments or codes are required. Enter the totals directly on Schedule D, line 1a; you aren’t required to report these transactions on Form 8949 (see instructions).

You must check Box A, B, or C below. Check only one box. If more than one box applies for your short-term transactions, complete a separate Form 8949, page 1, for each applicable box. If you have more short-term transactions than will fit on this page for one or more of the boxes, complete as many forms with the same box checked as you need. (A) Short-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS (see Note above) (B) Short-term transactions reported on Form(s) 1099-B showing basis wasn’t reported to the IRS (C) Short-term transactions not reported to you on Form 1099-B 1 (a) Description of property (Example: 100 sh. XYZ Co.)

(b) Date acquired (Mo., day, yr.)

Adjustment, if any, to gain or loss. If you enter an amount in column (g), (e) (h) enter a code in column (f). (d) Cost or other basis. Gain or (loss). See the separate instructions. Proceeds See the Note below Subtract column (e) (sales price) and see Column (e) from column (d) and (f) (g) (see instructions) in the separate combine the result Code(s) from instructions with column (g) Amount of instructions adjustment

100 shares PDQ Corp. 12/10/21 10/07/22 145,000

90,000

55,000

90,000

55,000

2 Totals. Add the amounts in columns (d), (e), (g), and (h) (subtract negative amounts). Enter each total here and include on your Schedule D, line 1b (if Box A above is checked), line 2 (if Box B above is checked), or line 3 (if Box C above is checked)

145,000

Note: If you checked Box A above but the basis reported to the IRS was incorrect, enter in column (e) the basis as reported to the IRS, and enter an adjustment in column (g) to correct the basis. See Column (g) in the separate instructions for how to figure the amount of the adjustment. For Paperwork Reduction Act Notice, see your tax return instructions.

Cat. No. 37768Z

Form 8949 (2022)

C:3-66 Attachment Sequence No. 12A

Form 8949 (2022) Name(s) shown on return. Name and SSN or taxpayer identification no. not required if shown on other side

Melodic Musical Sales, Inc.

Page 2

Social security number or taxpayer identification number

XX-2024022

Before you check Box D, E, or F below, see whether you received any Form(s) 1099-B or substitute statement(s) from your broker. A substitute statement will have the same information as Form 1099-B. Either will show whether your basis (usually your cost) was reported to the IRS by your broker and may even tell you which box to check.

Part II

Long-Term. Transactions involving capital assets you held more than 1 year are generally long-term (see instructions). For short-term transactions, see page 1. Note: You may aggregate all long-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS and for which no adjustments or codes are required. Enter the totals directly on Schedule D, line 8a; you aren’t required to report these transactions on Form 8949 (see instructions).

You must check Box D, E, or F below. Check only one box. If more than one box applies for your long-term transactions, complete a separate Form 8949, page 2, for each applicable box. If you have more long-term transactions than will fit on this page for one or more of the boxes, complete as many forms with the same box checked as you need. (D) Long-term transactions reported on Form(s) 1099-B showing basis was reported to the IRS (see Note above) (E) Long-term transactions reported on Form(s) 1099-B showing basis wasn’t reported to the IRS (F) Long-term transactions not reported to you on Form 1099-B 1 (a) Description of property (Example: 100 sh. XYZ Co.)

75 shares JSB Corp.

(b) Date acquired (Mo., day, yr.)

(d) Proceeds (sales price) (see instructions)

09/17/20 06/17/22 110,000

Adjustment, if any, to gain or loss. If you enter an amount in column (g), (e) (h) enter a code in column (f). Cost or other basis. Gain or (loss). See the separate instructions. See the Note below Subtract column (e) and see Column (e) from column (d) and (f) (g) in the separate combine the result Code(s) from instructions with column (g) Amount of instructions adjustment

120,000

(10,000)

120,000

(10,000)

2 Totals. Add the amounts in columns (d), (e), (g), and (h) (subtract negative amounts). Enter each total here and include on your Schedule D, line 8b (if Box D above is checked), line 9 (if Box E above is checked), or line 10 (if Box F above is checked) . .

110,000

Note: If you checked Box D above but the basis reported to the IRS was incorrect, enter in column (e) the basis as reported to the IRS, and enter an adjustment in column (g) to correct the basis. See Column (g) in the separate instructions for how to figure the amount of the adjustment. Form 8949 (2022)

C:3-66 SCHEDULE M-3 (Form 1120)

Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More

OMB No. 1545-0123 (Rev. December 2019) Attach to Form 1120 or 1120-C. Department of the Treasury Internal Revenue Service Go to www.irs.gov/Form1120 for instructions and the latest information. Name of corporation (common parent, if consolidated return) Employer identification number

Melodic Musical Sales, Inc.

Check applicable box(es):

(2)

Consolidated return (Form 1120 only)

Mixed 1120/L/PC group

(4)

Dormant subsidiaries schedule attached

(3)

Part I

XX-2024022

(1) ✓ Non-consolidated return

Financial Information and Net Income (Loss) Reconciliation (see instructions)

Did the corporation file SEC Form 10-K for its income statement period ending with or within this tax year? Yes. Skip lines 1b and 1c and complete lines 2a through 11 with respect to that SEC Form 10-K. ✓ No. Go to line 1b. See instructions if multiple non-tax-basis income statements are prepared. b Did the corporation prepare a certified audited non-tax-basis income statement for that period? Yes. Skip line 1c and complete lines 2a through 11 with respect to that income statement. ✓ No. Go to line 1c. c Did the corporation prepare a non-tax-basis income statement for that period? ✓ Yes. Complete lines 2a through 11 with respect to that income statement. No. Skip lines 2a through 3c and enter the corporation’s net income (loss) per its books and records on line 4a. Ending 2a Enter the income statement period: Beginning 01/01/2022 12/31/2022 b Has the corporation’s income statement been restated for the income statement period on line 2a? Yes. (If “Yes,” attach an explanation and the amount of each item restated.)

✓ No.

Has the corporation’s income statement been restated for any of the five income statement periods immediately preceding the period on line 2a? Yes. (If “Yes,” attach an explanation and the amount of each item restated.)

Is any of the corporation’s voting common stock publicly traded?

✓ No.

Yes.

✓ No.

If “No,” go to line 4a. b Enter the symbol of the corporation’s primary U.S. publicly traded voting common stock . . . . . . . . . . . . . . . . . . . . . . . . . . c Enter the nine-digit CUSIP number of the corporation’s primary publicly traded voting common stock . . . . . . . . . . . . . . . . . . . . . . . 4a Worldwide consolidated net income (loss) from income statement source identified in Part I, line 1 . b Indicate accounting standard used for line 4a (see instructions): (1) ✓ GAAP (2) IFRS (3) Statutory (4) Tax-basis (5) Other (specify) 5a Net income from nonincludible foreign entities (attach statement) . . . . . . . . . . . . b Net loss from nonincludible foreign entities (attach statement and enter as a positive amount) . . . 6a Net income from nonincludible U.S. entities (attach statement) . . . . . . . . . . . . . b Net loss from nonincludible U.S. entities (attach statement and enter as a positive amount) . . . . 7a Net income (loss) of other includible foreign disregarded entities (attach statement) . . . . . . b Net income (loss) of other includible U.S. disregarded entities (attach statement) . . . . . . . c Net income (loss) of other includible entities (attach statement) . . . . . . . . . . . . . Adjustment to eliminations of transactions between includible entities and nonincludible entities (attach 8 statement) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 10a b c 11 12 a b c d

5a ( 5b 6a ( 6b 7a 7b 7c

2,774,440 ) )

8 Adjustment to reconcile income statement period to tax year (attach statement) . . . . . . . 9 Intercompany dividend adjustments to reconcile to line 11 (attach statement) . . . . . . . . 10a Other statutory accounting adjustments to reconcile to line 11 (attach statement) . . . . . . . 10b Other adjustments to reconcile to amount on line 11 (attach statement) . . . . . . . . . . 10c Net income (loss) per income statement of includible corporations. Combine lines 4 through 10 . 11 2,774,440 Note: Part I, line 11, must equal Part II, line 30, column (a) or Schedule M-1, line 1 (see instructions). Enter the total amount (not just the corporation’s share) of the assets and liabilities of all entities included or removed on the following lines. Total Assets Total Liabilities

Included on Part I, line 4 . Removed on Part I, line 5 . Removed on Part I, line 6 . Included on Part I, line 7 .

. . . .

7,995,494

For Paperwork Reduction Act Notice, see the Instructions for Form 1120.

1,781,054

Cat. No. 37961C

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-66 Page 2

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Melodic Musical Sales, Inc.

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(7)

(2)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Part II

XX-2024022

Subsidiary corp

Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations With Taxable Income per Return (see instructions) (a) (b) (c) (d) Income (Loss) Items Income (Loss) per Temporary Permanent Income (Loss)

(Attach statements for lines 1 through 12) 1 Income (loss) from equity method foreign corporations 2 Gross foreign dividends not previously taxed . . . 3 Subpart F, QEF, and similar income inclusions . . 4 Gross-up for foreign taxes deemed paid . . . . 5 Gross foreign distributions previously taxed . . . 6 Income (loss) from equity method U.S. corporations 7 U.S. dividends not eliminated in tax consolidation 8 Minority interest for includible corporations . . . 9 Income (loss) from U.S. partnerships . . . . . 10 Income (loss) from foreign partnerships . . . . 11 Income (loss) from other pass-through entities . . 12 Items relating to reportable transactions . . . . 13 Interest income (see instructions) . . . . . . 14 Total accrual to cash adjustment . . . . . . . 15 Hedging transactions . . . . . . . . . . 16 Mark-to-market income (loss) . . . . . . . . 17 Cost of goods sold (see instructions) . . . . . . 18 Sale versus lease (for sellers and/or lessors) . . . 19 Section 481(a) adjustments . . . . . . . . 20 Unearned/deferred revenue . . . . . . . . 21 Income recognition from long-term contracts . . 22 Original issue discount and other imputed interest . 23a Income statement gain/loss on sale, exchange, abandonment, worthlessness, or other disposition of assets other than inventory and pass-through entities b Gross capital gains from Schedule D, excluding amounts from pass-through entities . . . . .

Income Statement

per Tax Return

12,000

5,000a (4,500,000)

150,000b

-0(4,500,000)

(150,000) 85,000

85,000

(10,000)

156,288

(15,000)

(4,333,000) (1,285,060) 8,392,500

66,288 (591,043)

(5,000) (4,271,712) 772,560 (1,103,543) 8,392,500

2,774,440

(524,755)

767,560

3,017,245

2,774,440

(524,755)

767,560

3,017,245

c Gross capital losses from Schedule D, excluding amounts from pass-through entities, abandonment losses, and worthless stock losses . . . . . d Net gain/loss reported on Form 4797, line 17, excluding amounts from pass-through entities, abandonment losses, and worthless stock losses e Abandonment losses . . . . . . . . . . f Worthless stock losses (attach statement) . . . . g Other gain/loss on disposition of assets other than inventory 24 Capital loss limitation and carryforward used . . . 25 26 Total income (loss) items. Combine lines 1 through 25 27 Total expense/deduction items (from Part III, line 39) 28 . . . . . . . 29a Mixed groups, see instructions. All others, combine lines 26 through 28 . . . . . . . . . .

(5,000)

b PC insurance subgroup reconciliation totals . . . c Life insurance subgroup reconciliation totals . . . 30 Reconciliation totals. Combine lines 29a through 29c Note: Line 30, column (a), must equal Part I, line 11, and column (d) must equal Form 1120, page 1, line 28.

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-66 Page 3

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Melodic Musical Sales, Inc.

Check applicable box(es): (1)

Consolidated group 1120 group

Check if a sub-consolidated: (6)

Employer identification number Parent corp

(2)

(3)

Consolidated eliminations

(4)

XX-2024022

Subsidiary corp

(5)

Mixed 1120/L/PC group

1120 eliminations

(7)

Employer identification number

Name of subsidiary (if consolidated return)

Part III Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations With Taxable Income per Return—Expense/Deduction Items (see instructions) (a) Expense per Income Statement

Expense/Deduction Items 1 2 3 4 5

U.S. current income tax expense . . . . . . . U.S. deferred income tax expense . . . . . . State and local current income tax expense . . . State and local deferred income tax expense . . . Foreign current income tax expense (other than foreign withholding taxes) . . . . . . . .

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Foreign deferred income tax expense . . . . . Foreign withholding taxes . . . . . . . . . Interest expense (see instructions) . . . . . . . Stock option expense . . . . . . . . . . Other equity-based compensation . . . . . . Meals and entertainment . . . . . . . . . Fines and penalties . . . . . . . . . . . Judgments, damages, awards, and similar costs . Parachute payments . . . . . . . . . . . Compensation with section 162(m) limitation . . . Pension and profit-sharing . . . . . . . . . Other post-retirement benefits . . . . . . . Deferred compensation . . . . . . . . . . Charitable contribution of cash and tangible property Charitable contribution of intangible property . . Charitable contribution limitation/carryforward . . Domestic production activities deduction (see instructions) . . . . . . . . . . . . . . 23 Current year acquisition or reorganization investment banking fees . . . . . . . . 24 Current year acquisition or reorganization legal and accounting fees . . . . . . . . . . .

(b) Temporary

632,361 110,199 75,000

(632,361) (110,199)

(d) Deduction per Tax Return

75,000

210,000

30,000

25 Current year acquisition/reorganization other costs . 26 Amortization/impairment of goodwill . . . . . 27 Amortization of acquisition, reorganization, and start-up costs . . . . . . . . . . . . 28 29 30 31 32 33 34 35 36

. . . Reserved . . . . . . . . . . . . . . Depletion . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . Bad debt expense . . . . . . . . . . . Corporate owned life insurance premiums . . . Purchase versus lease (for purchasers and/or lessees) Research and development costs . . . . . . Section 118 exclusion (attach statement) . . . .

37 Section 162(r)—FDIC premiums paid by certain large financial institutions (see instructions) . .

152,500 45,000 30,000

596,043 (5,000)

1,285,060

591,043

(30,000)

748,543 40,000 -0-

38 (attach statement)

39 Total expense/deduction items. Combine lines 1 through 38. Enter here and on Part II, line 27, reporting positive amounts as negative and negative amounts as positive . . . . . . .

(772,560) 1,103,543 Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-66 Form

1125-A

Cost of Goods Sold

(Rev. November 2018)

OMB No. 1545-0123

Attach to Form 1120, 1120-C, 1120-F, 1120S, or 1065. Go to www.irs.gov/Form1125A for the latest information.

Department of the Treasury Internal Revenue Service Name

Employer identification number

XX-2024022 2,500,000 5,500,000

Melodic Musical Sales, Inc.

1 2

Inventory at beginning of year Purchases . . . . . .

. .

1 2

3 4 5

Cost of labor . . . . . . . . . . . Additional section 263A costs (attach schedule) . Other costs (attach schedule) . . . . . .

. . .

3 4 5

6 7

Total. Add lines 1 through 5 . Inventory at end of year . .

. .

6 7

8,000,000 3,500,000

Cost of goods sold. Subtract line 7 from line 6. Enter here and on Form 1120, page 1, line 2 or the appropriate line of your tax return. See instructions . . . . . . . . . . . . . . .

Check all methods used for valuing closing inventory:

4,500,000

(ii) ✓ Lower of cost or market (iii) ✓ Other (Specify method used and attach explanation.) Check if there was a writedown of subnormal goods . .

Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970)

If the LIFO inventory method was used for this tax year, enter amount of closing inventory computed under LIFO . . . . . . . . . . . . . . . . . . . . . . . . . . . 9d If property is produced or acquired for resale, do the rules of section 263A apply to the entity? See instructions .

(i)

e f

. .

Cost

FIFO .

Was there any change in determining quantities, cost, or valuations between opening and closing inventory? If “Yes,” attach explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section references are to the Internal Revenue Code unless otherwise noted.

What’s New

Small business taxpayers. For tax years beginning after December 31, 2017, the following apply. • A small business taxpayer (defined below), may use a method of accounting for inventories that either: (1) treats inventories as nonincidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories. • A small business taxpayer is not required to capitalize costs under section 263A.

General Instructions Purpose of Form Use Form 1125-A to calculate and deduct cost of goods sold for certain entities.

Who Must File Filers of Form 1120, 1120-C, 1120-F, 1120S, or 1065, must complete and attach Form 1125-A if the applicable entity reports a deduction for cost of goods sold.

merchandise is an income-producing factor. See Regulations section 1.471-1. If inventories are required, you generally must use an accrual method of accounting for sales and purchases of inventory items. Exception for certain taxpayers. A small business taxpayer (defined below) can adopt or change its accounting method to account for inventories in the same manner as material and supplies that are nonincidental, or conform to its treatment of inventories in an applicable financial statement (as defined in section 451(b)(3)), or if it does not have an applicable financial statement, the method of accounting used in its books and records prepared in accordance with its accounting procedures. See section 471(c)(3). A small business taxpayer claiming exemption from the requirement to keep inventories is changing its method of accounting for purposes of section 481. For additional guidance on this method of accounting, see Pub. 538, Accounting Periods and Methods. For guidance on changing to this method of accounting, see Form 3115 and the Instructions for Form 3115.

Inventories Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of

For Paperwork Reduction Act Notice, see instructions.

. .

Yes

✓ No

Yes

✓ No

Small business taxpayer. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of $25 million or less (indexed for inflation) for the 3 prior tax years, and (b) is not a tax shelter (as defined in section 448(d)(3)). See Pub. 538. Uniform capitalization rules. The uniform capitalization rules of section 263A generally require you to capitalize, or include in inventory, certain costs incurred in connection with the following. • The production of real property and tangible personal property held in inventory or held for sale in the ordinary course of business. • Real property or personal property (tangible and intangible) acquired for resale. • The production of real property and tangible personal property for use in its trade or business or in an activity engaged in for profit. A small business taxpayer (defined above) is not required to capitalize costs under section 263A. See section 263A(i). See the discussion on section 263A uniform capitalization rules in the instructions for your tax return before completing Form 1125-A. Also see Regulations sections 1.263A-1 through 1.263A-3. See Regulations section 1.263A-4 for rules for property produced in a farming business.

Cat. No. 55988R

Form 1125-A (Rev. 11-2018)

C:3-66 Form

1125-E

(Rev. October 2016)

Department of the Treasury Internal Revenue Service Name

Compensation of Officers Attach to Form 1120, 1120-C, 1120-F, 1120-REIT, 1120-RIC, or 1120S. Information about Form 1125-E and its separate instructions is at www.irs.gov/form1125e.

OMB No. 1545-0123

Employer identification number

Melodic Musical Sales, Inc.

XX-2024022

Note: Complete Form 1125-E only if total receipts are $500,000 or more. See instructions for definition of total receipts.

Mary Travis John Willis Chris Parker

(d) Common

(e) Preferred

(f) Amount of compensation

XXX-XX-XXXX XXX-XX-XXXX

100 %

50 %

290,000

100 %

25 %

180,000

XXX-XX-XXXX

100 %

25 %

180,000

(b) Social security number (see instructions)

(a)

Subtract line 3 from line 2. Enter the result here and on Form 1120, page 1, line 12 or the appropriate line of your tax return . . . . . . . . . . . . . . . . . . . . . .

3 4

For Paperwork Reduction Act Notice, see separate instructions.

Percent of stock owned

Cat. No. 55989C

650,000

Form 1125-E (Rev. 10-2016)

C:3-66

2220

Underpayment of Estimated Tax by Corporations

Department of the Treasury Internal Revenue Service

Attach to the corporation’s tax return. Go to www.irs.gov/Form2220 for instructions and the latest information.

Form

Name

OMB No. 1545-0123

2022

Employer identification number

Melodic Musical Sales, Inc.

XX-2024022

Note: Generally, the corporation is not required to file Form 2220 (see Part II below for exceptions) because the IRS will figure any penalty owed and bill the corporation. However, the corporation may still use Form 2220 to figure the penalty. If so, enter the amount from page 2, line 38, on the estimated tax penalty line of the corporation’s income tax return, but do not attach Form 2220.

Part I

Required Annual Payment

1 2a

Total tax (see instructions) . . . . . . . . . . . . . . . . . . Personal holding company tax (Schedule PH (Form 1120), line 26) included on line 1

Look-back interest included on line 1 under section 460(b)(2) for completed long-term contracts or section 167(g) for depreciation under the income forecast method . . Credit for federal tax paid on fuels (see instructions) . . . . . . . . . . Total. Add lines 2a through 2c . . . . . . . . . . . . . . . . .

c d

. 2a

2b 2c . .

632,361

Subtract line 2d from line 1. If the result is less than $500, do not complete or file this form. The corporation does not owe the penalty . . . . . . . . . . . . . . . . . . . . . . . . .

632,361

Enter the tax shown on the corporation’s 2021 income tax return. See instructions. Caution: If the tax is zero or the tax year was for less than 12 months, skip this line and enter the amount from line 3 on line 5 . . . .

252,000

Required annual payment. Enter the smaller of line 3 or line 4. If the corporation is required to skip line 4, enter the amount from line 3 . . . . . . . . . . . . . . . . . . . . . . . . . .

252,000

(c)

(d)

Part II

The corporation is using the adjusted seasonal installment method.

6 7 8

Reasons for Filing—Check the boxes below that apply. If any boxes are checked, the corporation must file Form 2220 even if it does not owe a penalty. See instructions.

The corporation is using the annualized income installment method.

✓The corporation is a “large corporation” figuring its first required installment based on the prior year’s tax.

Part III

Figuring the Underpayment (a)

Installment due dates. Enter in columns (a) through (d) the 15th day of the 4th (Form 990-PF filers: Use 5th month), 6th, 9th, and 12th months of the corporation’s tax year . . . . . . . . . .

Required installments. If the box on line 6 and/or line 7 above is checked, enter the amounts from Schedule A, line 38. If the box on line 8 (but not 6 or 7) is checked, see instructions for the amounts to enter. If none of these boxes are checked, enter 25% (0.25) of line 5 above in each column . . . . . . . . . . . . . .

Estimated tax paid or credited for each period. For column (a) only, enter the amount from line 11 on line 15. See instructions . . . .

(b)

04/15/22 06/15/22 09/15/22

12/15/22

63,000

253,181 158,090

158,090

35,000

190,000 165,000

165,000

35,000

190,000 165,000 28,000 91,181 162,000 73,819 -0-0-

165,000 84,271 80,729

Complete lines 12 through 18 of one column before going to the next column. 12 13 14 15

Enter amount, if any, from line 18 of the preceding column . Add lines 11 and 12 . . . . . . . . . . . . Add amounts on lines 16 and 17 of the preceding column . Subtract line 14 from line 13. If zero or less, enter -0- . .

. . . .

12 13 14 15

If the amount on line 15 is zero, subtract line 13 from line 14. Otherwise, enter -0- . . . . . . . . . . . . . . .

Underpayment. If line 15 is less than or equal to line 10, subtract line 15 from line 10. Then go to line 12 of the next column. Otherwise, go to line 18 . . . . . . . . . . . . . . . . . .

. . . .

28,000

91,181

84,271

77,361

Overpayment. If line 10 is less than line 15, subtract line 10 from line 15. Then go to line 12 of the next column . . . . . . . . . 18 Go to Part IV on page 2 to figure the penalty. Do not go to Part IV if there are no entries on line 17—no penalty is owed. For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11746L

Form 2220 (2022)

*In some years, some of the dates on this form might fall on a weekend. If so, the form nevertheless uses the fifteenth based on the following language in the instructions to Form 2220. If an installment is due on a Saturday, Sunday, or legal holiday, payments made on the next day that is not a Saturday, Sunday, or legal holiday are considered made on the due date to the extent the payment is applied against that required installment.

C:3-66 Page 2

Form 2220 (2022)

Part IV

Figuring the Penalty

Enter the date of payment or the 15th day of the 4th month after the close of the tax year, whichever is earlier. (C corporations with tax years ending June 30 and S corporations: Use 3rd month instead of 4th month. Form 990-PF and Form 990-T filers: Use 5th month instead of 4th month.) See instructions . . . . . .

Number of days from due date of installment on line 9 to the date shown on line 19 . . . . . . . . . . . . . . . Number of days on line 20 after 4/15/2022 and before 7/1/2022

Number of days on line 21 365 × 4% (0.04)

Underpayment on line 17 ×

Number of days on line 20 after 6/30/2022 and before 10/1/2022 Underpayment on line 17 ×

Number of days on line 20 after 9/30/2022 and before 1/1/2023 Underpayment on line 17 ×

Number of days on line 20 after 12/31/2022 and before 4/1/2023 Underpayment on line 17 ×

Number of days on line 20 after 3/31/2023 and before 7/1/2023

Underpayment on line 17 ×

Number of days on line 20 after 6/30/2023 and before 10/1/2023

(d)

6/15/22

9/15/22

12/15/22

4/15/23

121

187

150

77 $

962

15 $

173

1,053

Underpayment on line 17 ×

Number of days on line 20 after 9/30/2023 and before 1/1/2024

Underpayment on line 17 ×

90 $

Number of days on line 20 after 12/31/2023 and before 3/16/2024

Number of days on line 35 366 × *%

Underpayment on line 17 ×

Add lines 22, 24, 26, 28, 30, 32, 34, and 36

Penalty. Add columns (a) through (d) of line 37. Enter the total here and on Form 1120, line 34; or the comparable line for other income tax returns . . . . . . . . . . . . . . . . . . . . . . . . .

223

1,335 15

Number of days on line 33 365 × *%

203

Number of days on line 31 365 × *%

Number of days on line 29 365 × *%

Number of days on line 27 × 7% (0.07) 365

(c)

Number of days on line 25 365 × 6% (0.06)

(b)

Number of days on line 23 365 × 5% (0.05)

(a)

187

1,112

1,226

1,761 4,286

38 $ *Use the penalty interest rate for each calendar quarter, which the IRS will determine during the first month in the preceding quarter. These rates are published quarterly in an IRS News Release and in a revenue ruling in the Internal Revenue Bulletin. To obtain this information on the Internet, access the IRS website at www.irs.gov. You can also call 1-800-829-4933 to get interest rate information.

*Assumes rate on Line 30 remains at 7%.

Form 2220 (2022)

C:3-66 Form

4562

Depreciation and Amortization

Name(s) shown on return

1 2 3 4 5

Melodic Musical Sales, Inc.

Retail Sales

Election To Expense Certain Property Under Section 179 Note: If you have any listed property, complete Part V before you complete Part I.

(a) Description of property

(b) Cost (business use only)

600,000

Equipment

Attachment Sequence No. 179 Identifying number

Business or activity to which this form relates

Maximum amount (see instructions) . . . . . . . . . . . . . . . . . . . . . . . Total cost of section 179 property placed in service (see instructions) . . . . . . . . . . . Threshold cost of section 179 property before reduction in limitation (see instructions) . . . . . . Reduction in limitation. Subtract line 3 from line 2. If zero or less, enter -0- . . . . . . . . . . Dollar limitation for tax year. Subtract line 4 from line 1. If zero or less, enter -0-. If married filing separately, see instructions . . . . . . . . . . . . . . . . . . . . . . . . .

2022

Attach to your tax return. Go to www.irs.gov/Form4562 for instructions and the latest information.

Department of the Treasury Internal Revenue Service

Part I

OMB No. 1545-0172

(Including Information on Listed Property)

XX-2024022 1 2 3 4

600,000* 600,000 2,700,000 -0-

600,000

7 Listed property. Enter the amount from line 29 . . . . . . . . . 7 8 Total elected cost of section 179 property. Add amounts in column (c), lines 6 and 7 . . . . . . 8 600,000 9 Tentative deduction. Enter the smaller of line 5 or line 8 . . . . . . . . . . . . . . . . 9 600,000 10 Carryover of disallowed deduction from line 13 of your 2021 Form 4562 . . . . . . . . . . . 10 11 Business income limitation. Enter the smaller of business income (not less than zero) or line 5. See instructions 11 600,000 12 Section 179 expense deduction. Add lines 9 and 10, but don’t enter more than line 11 . . . . . . 12 600,000 . . 13 13 Carryover of disallowed deduction to 2023. Add lines 9 and 10, less line 12 Note: Don’t use Part II or Part III below for listed property. Instead, use Part V. Part II Special Depreciation Allowance and Other Depreciation (Don’t include listed property. See instructions.) 14 Special depreciation allowance for qualified property (other than listed property) placed in service during the tax year. See instructions . . . . . . . . . . . . . . . . . . . . . . . 14 15 Property subject to section 168(f)(1) election . . . . . . . . . . . . . . . . . . . . 15 16 Other depreciation (including ACRS) . . . . . . . . . . . . . . . . . . . . . . 16 Part III MACRS Depreciation (Don’t include listed property. See instructions.) Section A 17 17 MACRS deductions for assets placed in service in tax years beginning before 2022 . . . . . . . 148,543 18 If you are electing to group any assets placed in service during the tax year into one or more general asset accounts, check here . . . . . . . . . . . . . . . . . . . . . . . . Section B—Assets Placed in Service During 2022 Tax Year Using the General Depreciation System (a) Classification of property

(b) Month and year placed in service

(d) Recovery period

(e) Convention

(f) Method

(g) Depreciation deduction

19a 3-year property b 5-year property c 7-year property d 10-year property e 15-year property f 20-year property 25 yrs. S/L g 25-year property 27.5 yrs. MM S/L h Residential rental 27.5 yrs. MM S/L property 39 yrs. MM S/L i Nonresidential real MM S/L property Section C—Assets Placed in Service During 2022 Tax Year Using the Alternative Depreciation System S/L 20a Class life 12 yrs. S/L b 12-year 30 yrs. MM S/L c 30-year 40 yrs. MM S/L d 40-year

Part IV

Summary (See instructions.)

21 Listed property. Enter amount from line 28 . . . . . . . . . . . . . . . . . . . . 22 Total. Add amounts from line 12, lines 14 through 17, lines 19 and 20 in column (g), and line 21. Enter here and on the appropriate lines of your return. Partnerships and S corporations—see instructions . 23 For assets shown above and placed in service during the current year, enter the portion of the basis attributable to section 263A costs . . . . . . . . . 23 For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 12906N

21 22

748,543 Form 4562 (2022)

*Per the worksheet in the instructions for Form 4562, Line 1 should be the lesser of the maximum Sec. 179 deduction ($1,080,000 in 2022) or the total cost of Sec. 179 property. C:TRP-18 Copyright © 2024 Pearson Education, Inc.

C:3-66

4797

Form

Department of the Treasury Internal Revenue Service

Sales of Business Property

OMB No. 1545-0184

(Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2))

2022

Attach to your tax return. Go to www.irs.gov/Form4797 for instructions and the latest information.

Attachment Sequence No. 27

Identifying number

Name(s) shown on return

Melodic Musical Sales, Inc.

XX-2024022

Enter the gross proceeds from sales or exchanges reported to you for 2022 on Form(s) 1099-B or 1099-S (or substitute statement) that you are including on line 2, 10, or 20. See instructions . . . . . . . . . .

Enter the total amount of gain that you are including on lines 2, 10, and 24 due to the partial dispositions of MACRS assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Enter the total amount of loss that you are including on lines 2 and 10 due to the partial dispositions of MACRS assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part I

Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other Than Casualty or Theft—Most Property Held More Than 1 Year (see instructions) (a) Description of property

(b) Date acquired (mo., day, yr.)

(e) Depreciation allowed or allowable since acquisition

(d) Gross sales price

(f) Cost or other basis, plus improvements and expense of sale

Gain, if any, from Form 4684, line 39

4 5 6

Section 1231 gain from installment sales from Form 6252, line 26 or 37 . Section 1231 gain or (loss) from like-kind exchanges from Form 8824. . Gain, if any, from line 32, from other than casualty or theft . . . . .

. . .

4 5 6

Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows

(g) Gain or (loss) Subtract (f) from the sum of (d) and (e)

30,000 30,000

Partnerships and S corporations. Report the gain or (loss) following the instructions for Form 1065, Schedule K, line 10, or Form 1120-S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below.

8 9

Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount from line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you didn’t have any prior year section 1231 losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gain on the Schedule D filed with your return and skip lines 8, 9, 11, and 12 below. Nonrecaptured net section 1231 losses from prior years. See instructions . . . . . . . . . . . .

Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below. If line 9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as a long-term capital gain on the Schedule D filed with your return. See instructions. . . . . . . . . . . . . .

Part II

Ordinary Gains and Losses (see instructions)

Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):

Loss, if any, from line 7

11 (

12 13 14

Gain, if any, from line 7 or amount from line 8, if applicable . Gain, if any, from line 31 . . . . . . . . . . . Net gain or (loss) from Form 4684, lines 31 and 38a . . .

. . .

12 13 14

15 16 17

Ordinary gain from installment sales from Form 6252, line 25 or 36 Ordinary gain or (loss) from like-kind exchanges from Form 8824 . Combine lines 10 through 16. . . . . . . . . . . .

. . .

15 16 17

For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines a and b below. For individual returns, complete lines a and b below.

a If the loss on line 11 includes a loss from Form 4684, line 35, column (b)(ii), enter that part of the loss here. Enter the loss from income-producing property on Schedule A (Form 1040), line 16. (Do not include any loss on property used as an employee.) Identify as from “Form 4797, line 18a.” See instructions . . . . . . . . . . . . . . .

18a

b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Schedule 1 (Form 1040), Part I, line 4 . . . . . . . . . . . . . . . . . . . . . . . . . .

18b

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 13086I

)

156,288

Form 4797 (2022)

C:3-66 Page 2

Form 4797 (2022)

Part III 19

Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255 (see instructions)

(a) Description of section 1245, 1250, 1252, 1254, or 1255 property:

Property A

These columns relate to the properties on lines 19A through 19D.

24 25

Gross sales price (Note: See line 1a before completing.) . Cost or other basis plus expense of sale . . . . . Depreciation (or depletion) allowed or allowable . . . Adjusted basis. Subtract line 22 from line 21. . . .

20 21 22 23

280,000 250,000 156,288 93,712

186,288

. .

25a 25b

156,288 156,288

If section 1250 property: If straight line depreciation was used, enter -0- on line 26g, except for a corporation subject to section 291. a Additional depreciation after 1975. See instructions .

26a

b Applicable percentage multiplied by the smaller of line 24 or line 26a. See instructions. . . . . . . .

26b

c Subtract line 26a from line 24. If residential rental property or line 24 isn’t more than line 26a, skip lines 26d and 26e d Additional depreciation after 1969 and before 1976. . e Enter the smaller of line 26c or 26d . . . . . . f Section 291 amount (corporations only) . . . . . g Add lines 26b, 26e, and 26f . . . . . . . .

26c 26d 26e 26f 26g

Total gain. Subtract line 23 from line 20 . . . If section 1245 property: a Depreciation allowed or allowable from line 22 . b Enter the smaller of line 24 or 25a . . . .

01/02/19

10/16/22

Property B

Property C

Property D

If section 1252 property: Skip this section if you didn’t dispose of farmland or if this form is being completed for a partnership.

a Soil, water, and land clearing expenses . . . . . b Line 27a multiplied by applicable percentage. See instructions c Enter the smaller of line 24 or 27b . . . . . . 28 If section 1254 property: a Intangible drilling and development costs, expenditures for development of mines and other natural deposits, mining exploration costs, and depletion. See instructions b Enter the smaller of line 24 or 28a . . . . . . 29

Equipment 1

A B C D

20 21 22 23

(b) Date acquired (mo., day, yr.)

27a 27b 27c

28a 28b

If section 1255 property: a Applicable percentage of payments excluded from income under section 126. See instructions . . . b Enter the smaller of line 24 or 29a. See instructions

. .

29a 29b

Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30. 30 31

Total gains for all properties. Add property columns A through D, line 24 . . . . . . . . Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13 .

. .

30 31

186,288 156,288

Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 33. Enter the portion from other than casualty or theft on Form 4797, line 6 . . . . . . . . . . . . . . . . . . . .

30,000

Part IV

. .

Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less (see instructions) (a) Section 179

Section 179 expense deduction or depreciation allowable in prior years.

34 35

Recomputed depreciation. See instructions . . . . . . . . . . . . . . Recapture amount. Subtract line 34 from line 33. See the instructions for where to report

. .

33 34 35

(b) Section 280F(b)(2)

Form 4797 (2022)

C:3-66 Melodic Musical Sales, Inc. XX-2024022 2022 Form 1120 Page 1, Line 17 - Taxes and licenses: Payroll taxes State income tax Total

$ 62,000 75,000 $137,000

Page 1, Line 26 - Other deductions: General insurance Utilities Legal and accounting fees Total

$ 55,000 72,000 50,000 $177,000 Beginning

Ending

$60,000

$ 80,000

Beginning

Ending

Accrued payroll taxes Accrued state income taxes Accrued federal income taxes Total

$ 14,880 4,500 2,500 $ 21,880

$ 18,600 7,500 77,361 $103,461

Schedule L, Line 21 - Other liabilities:

Beginning

Ending

$57,394

$167,593

Schedule L, Line 14 - Other assets: Cash surrender value Schedule L, Line 18 - Other current liabilities:

Net deferred tax liability

Schedule M-1, Line 4 - Income subject to tax not recorded on books this year: The gain difference reported here results from the difference between the accumulated tax depreciation ($156,288) and book depreciation ($75,000) on the equipment sold and the resultant difference in book basis and tax basis. Schedule M-1, Line 5 - Expenses recorded on books, not deducted: Premiums - Officers’ life insurance $30,000 Bad debt expense ($45,000 – $40,000) 5,000 Total $35,000 Schedule M-1, Line 8a - Depreciation: $600,000 Sec. 179 expense + $148,543 MACRS – $152,500 book depreciation Form 4562, Part III, Line 17 - MACRS deductions for property placed in service before 2022: Building ($2,000,000 ×0.02564) $ 51,280 Equipment 1 ($250,000 × 0.1249 x 0.5) 15,613 Equipment 2 ($500,000 × 0.1249) 62,450 Trucks ($100,000 × 0.192) 19,200 Total $148,543 C:TRP-21 Copyright © 2024 Pearson Education, Inc.

C:3-67

1120

U.S. Corporation Income Tax Return

Form Department of the Treasury Internal Revenue Service A Check if: 1a Consolidated return

For calendar year 2021 or tax year beginning

TYPE OR PRINT

3 Personal service corp. (see instructions) .

Income Deductions (See instructions for limitations on deductions.) Tax, Refundable Credits, and Payments

, 20

Go to www.irs.gov/Form1120 for instructions and the latest information.

(attach Form 851) . b Life/nonlife consolidated return . . . 2 Personal holding co. (attach Sch. PH) . .

4 Schedule M-3 attached

OMB No. 1545-0123

, 2021, ending

Name

B Employer identification number

Number, street, and room or suite no. If a P.O. box, see instructions.

C Date incorporated

City or town, state or province, country, and ZIP or foreign postal code

D Total assets (see instructions)

Final return

(2)

Name change

(3)

(4)

Address change

Gross receipts or sales .

b c 2

Returns and allowances . . . . . . Balance. Subtract line 1b from line 1a . . Cost of goods sold (attach Form 1125-A) .

. . .

1b . . . . . .

. .

1c 2

3 4

Gross profit. Subtract line 2 from line 1c . . Dividends and inclusions (Schedule C, line 23) Interest

. . .

3 4

. . .

6 7

Gross rents . Gross royalties

. .

6 7

Capital gain net income (attach Schedule D (Form 1120)) .

9 10

Net gain or (loss) from Form 4797, Part II, line 17 (attach Form 4797) Other income (see instructions—attach statement) . . . . . .

. .

9 10

Total income. Add lines 3 through 10 .

12 13

16,631,250

✓ E Check if: (1) ✓ Initial return .

2021

12 13

Salaries and wages (less employment credits)

Repairs and maintenance

15 16

Bad debts . Rents . .

. .

15 16

Taxes and licenses

18 19

Interest (see instructions) Charitable contributions .

. .

18 19

20 21

Depreciation from Form 4562 not claimed on Form 1125-A or elsewhere on return (attach Form 4562) . Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. .

20 21

Advertising

23 24 25

Pension, profit-sharing, etc., plans Employee benefit programs . . Reserved for future use . . . .

. . .

23 24 25

. .

26 27 28

Other deductions (attach statement) $20,000 . . . . . . . Total deductions. Add lines 12 through 26 . . . . . . . . . . . . . . . . . . . Taxable income before net operating loss deduction and special deductions. Subtract line 27 from line 11.

29a b

Net operating loss deduction (see instructions) . Special deductions (Schedule C, line 24) . . . Add lines 29a and 29b . . . . . . . .

26 27 28

. .

29c

Taxable income. Subtract line 29c from line 28. See instructions

31 32 33 34 35 36

Total tax (Schedule J, Part I, line 11) . . . . . . . . . . . . . . . . Reserved for future use . . . . . . . . . . . . . . . . . . . . Total payments and credits (Schedule J, Part III, line 23) . . . . . . . . . . Estimated tax penalty. See instructions. Check if Form 2220 is attached . . . . . Amount owed. If line 33 is smaller than the total of lines 31 and 34, enter amount owed

. . . .

. . . . .

. . .

31 32

35 36

Sign Here

3,875,000 5,900,000 (850,000)

29a 29b

Overpayment. If line 33 is larger than the total of lines 31 and 34, enter amount overpaid Enter amount from line 36 you want: Credited to 2022 estimated tax

. . . . Refunded

(875,000)

33 34

Date Print/Type preparer’s name

Paid Preparer Use Only Firm’s name

Preparer's signature

May the IRS discuss this return with the preparer shown below? See instructions. Yes No

Title Date

Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11450Q

Form 1120 (2021)

C:3-67 Page 6

Form 1120 (2021)

Schedule L

Beginning of tax year

Balance Sheets per Books (a)

Assets 1

Cash

2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

Trade notes and accounts receivable . . . ( Less allowance for bad debts . . . . . Inventories . . . . . . . . . . . U.S. government obligations . . . . . Tax-exempt securities (see instructions) . . Other current assets (attach statement) Net. DTA* . Loans to shareholders . . . . . . . Mortgage and real estate loans . . . . . Other investments (attach statement) . . . Buildings and other depreciable assets . . ( Less accumulated depreciation . . . . . Depletable assets . . . . . . . . . ( Less accumulated depletion . . . . . . Land (net of any amortization) . . . . . Intangible assets (amortizable only) . . . ( Less accumulated amortization . . . . . Other assets (attach statement) . . . . . Total assets . . . . . . . . . .

End of tax year

(b)

(c)

. )

(d)

500,000

2,000,000 250,000 )

(

1,750,000 4,000,000 50,000 131,250 1,000,000

10,000,000 800,000 )

)

(

)

(

)

(

)

9,200,000

16,631,250

Liabilities and Shareholders’ Equity 16 17 18 19 20 21 22 23 24 25 26 27 28

2,610,000

Accounts payable . . . . . . . . . Mortgages, notes, bonds payable in less than 1 year Other current liabilities (attach statement) . . Loans from shareholders . . . . . . . Mortgages, notes, bonds payable in 1 year or more Other liabilities (attach statement) . . . . Capital stock: a Preferred stock . . . . b Common stock . . . . Additional paid-in capital . . . . . . . Retained earnings—Appropriated (attach statement) Retained earnings—Unappropriated . . . Adjustments to shareholders’ equity (attach statement) Less cost of treasury stock . . . . . . Total liabilities and shareholders’ equity . .

Schedule M-1

8,500,000 6,000,000

6,000,000 (478,750)

(

)

(

Reconciliation of Income (Loss) per Books With Income per Return

16,631,250

)

Note: The corporation may be required to file Schedule M-3. See instructions. 1 2 3

Net income (loss) per books . See . Schedule . . . M-3 . Federal income tax per books . . . . . Excess of capital losses over capital gains .

Income subject to tax not recorded on books this year (itemize):

Expenses recorded on books this year not deducted on this return (itemize):

a b c

Depreciation . . . . $ Charitable contributions . $ Travel and entertainment . $

Add lines 1 through 5 .

Schedule M-2 1 2 3

Income recorded on books this year not included on this return (itemize): Tax-exempt interest $

Deductions on this return not charged against book income this year (itemize): a Depreciation . . $ b Charitable contributions $

9 10

Add lines 7 and 8 . . . . . . Income (page 1, line 28)—line 6 less line 9

Analysis of Unappropriated Retained Earnings per Books (Schedule L, Line 25)

Balance at beginning of year Net income (loss) per books . Other increases (itemize):

Add lines 1, 2, and 3 .

. .

-0(478,750)

(478,750)

6 7 8

Distributions: a Cash b Stock

. .

c Property Other decreases (itemize):

Add lines 5 and 6 . . . . . . Balance at end of year (line 4 less line 7)

-0(478,750)

Form 1120 (2021)

C:3-67 SCHEDULE M-3 (Form 1120)

Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More

Permtemp Corporation

Check applicable box(es):

(2)

Consolidated return (Form 1120 only)

Mixed 1120/L/PC group

(4)

Dormant subsidiaries schedule attached

(3)

Part I

XX-1234567

(1) ✓ Non-consolidated return

Financial Information and Net Income (Loss) Reconciliation (see instructions)

Did the corporation file SEC Form 10-K for its income statement period ending with or within this tax year? Yes. Skip lines 1b and 1c and complete lines 2a through 11 with respect to that SEC Form 10-K. ✓ No. Go to line 1b. See instructions if multiple non-tax-basis income statements are prepared. b Did the corporation prepare a certified audited non-tax-basis income statement for that period? Yes. Skip line 1c and complete lines 2a through 11 with respect to that income statement. ✓ No. Go to line 1c. c Did the corporation prepare a non-tax-basis income statement for that period? ✓ Yes. Complete lines 2a through 11 with respect to that income statement. No. Skip lines 2a through 3c and enter the corporation’s net income (loss) per its books and records on line 4a. Ending 2a Enter the income statement period: Beginning b Has the corporation’s income statement been restated for the income statement period on line 2a? Yes. (If “Yes,” attach an explanation and the amount of each item restated.)

12/31/2021

01/01/2021

✓ No.

Is any of the corporation’s voting common stock publicly traded?

✓ No. Yes.

✓ No.

(478,750)

5a ( 5b 6a ( 6b 7a 7b 7c

) )

8 Adjustment to reconcile income statement period to tax year (attach statement) . . . . . . . 9 Intercompany dividend adjustments to reconcile to line 11 (attach statement) . . . . . . . . 10a Other statutory accounting adjustments to reconcile to line 11 (attach statement) . . . . . . . 10b Other adjustments to reconcile to amount on line 11 (attach statement) . . . . . . . . . . 10c Net income (loss) per income statement of includible corporations. Combine lines 4 through 10 . 11 Note: Part I, line 11, must equal Part II, line 30, column (a) or Schedule M-1, line 1 (see instructions). Enter the total amount (not just the corporation’s share) of the assets and liabilities of all entities included or removed on the following lines. Total Assets Total Liabilities

(478,750)

Included on Part I, line 4 . Removed on Part I, line 5 . Removed on Part I, line 6 . Included on Part I, line 7 .

. . . .

16,231,250

For Paperwork Reduction Act Notice, see the Instructions for Form 1120.

11,110,000

Cat. No. 37961C

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-67 Page 2

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Permtemp Corporation

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(7)

(2)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Part II

XX-1234567

Subsidiary corp

Reconciliation of Net Income (Loss) per Income Statement of Includible Corporations With Taxable Income per Return (see instructions) Income (Loss) Items

(Attach statements for lines 1 through 12) 1 Income (loss) from equity method foreign corporations 2 Gross foreign dividends not previously taxed . . . 3 Subpart F, QEF, and similar income inclusions . . 4 Gross-up for foreign taxes deemed paid . . . . 5 Gross foreign distributions previously taxed . . . 6 Income (loss) from equity method U.S. corporations 7 U.S. dividends not eliminated in tax consolidation 8 Minority interest for includible corporations . . . 9 Income (loss) from U.S. partnerships . . . . . 10 Income (loss) from foreign partnerships . . . . 11 Income (loss) from other pass-through entities . . 12 Items relating to reportable transactions . . . . 13 Interest income (see instructions) . T-E . interest . . . . 14 Total accrual to cash adjustment . . . . . . . 15 Hedging transactions . . . . . . . . . . 16 Mark-to-market income (loss) . . . . . . . . 17 Cost of goods sold (see instructions) . . . . . . ( 18 Sale versus lease (for sellers and/or lessors) . . . 19 Section 481(a) adjustments . . . . . . . . 20 Unearned/deferred revenue . . . . . . . . 21 Income recognition from long-term contracts . . 22 Original issue discount and other imputed interest . 23a Income statement gain/loss on sale, exchange, abandonment, worthlessness, or other disposition of assets other than inventory and pass-through entities b Gross capital gains from Schedule D, excluding amounts from pass-through entities . . . . .

(a) Income (Loss) per Income Statement

(b) Temporary

(d) Income (Loss) per Tax Return

50,000

15,000

(15,000)

15,000,000)

-015,000,000)

(

(14,935,000) (1,688,750) 16,145,000

(250,000)

(15,000) (14,950,000) (106,250) (2,045,000) 16,145,000

(478,750)

(250,000)

(121,250)

(250,000)

(121,250)

(478,750)

(850,000) (850,000)

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-67 Page 3

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Permtemp Corporation

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(7)

(2)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

XX-1234567

Subsidiary corp

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Expense/Deduction Items 1 2 3 4 5

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Foreign deferred income tax expense . . . . . Foreign withholding taxes . . . . . . . . . Interest expense (see instructions) . . . . . . Stock option expense . . . . . . . . . . Other equity-based compensation . . . . . . Meals and entertainment . . . . . . . . . Fines and penalties . . . . . . . . . . . Judgments, damages, awards, and similar costs . Parachute payments . . . . . . . . . . . Compensation with section 162(m) limitation . . . Pension and profit-sharing . . . . . . . . . Other post-retirement benefits . . . . . . . Deferred compensation . . . . . . . . . . Charitable contribution of cash and tangible property Charitable contribution of intangible property . . Charitable contribution limitation/carryforward . . Domestic production activities deduction (see instructions) . . . . . . . . . . . . . . 23 Current year acquisition or reorganization investment banking fees . . . . . . . . . 24 Current year acquisition or reorganization legal and accounting fees . . . . . . . . . . . .

(b) Temporary Difference

(131,250)

(d) Deduction per Tax Return

131,250

475,000

475,000 45,000

(25,000)

20,000

100,000 (100,000)

-0-

800,000 600,000 400,000 (250,000)

1,400,000 150,000

Other amortization or impairment write-offs . . . Reserved . . . . . . . . . . . . . . Depletion . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . Bad debt expense . . . . . . . . . . . Corporate owned life insurance premiums . . . Purchase versus lease (for purchasers and/or lessees) Research and development costs . . . . . . Section 118 exclusion (attach statement) . . . .

37 Section 162(r)—FDIC premiums paid by certain large financial institutions (see instructions) . .

38 Other expense/deduction items with differences (attach statement) . . . . . . . . . .

39 Total expense/deduction items. Combine lines 1 through 38. Enter here and on Part II, line 27, reporting positive amounts as negative and negative amounts as positive . . . . . . . .

1,688,750

250,000

106,250

2,045,000

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-67 Permtemp Corporation Deferred Tax Accounting 2021

Deferred Tax Assets Net operating loss Charitable contributions carryover* Net accounts receivable** Total deductible temporary difference Times: Tax rate Deferred tax asset *Charitable contributions not deductible this year because of limitation **$2,000,000 tax basis – $1,750,000 book basis

End of 2021 $ 875,000 100,000 250,000 $1,225,000 0.21 $ 257,250

Deferred Tax Liability: Net fixed assets* Times: Tax rate Deferred tax liability *$9,200,000 book basis – $8,600,000 tax basis Journal Entry: Deferred tax asset Deferred tax liability Federal income tax benefit

257,250

Adjusted Income Statement (Partial): Net loss before federal income benefit Plus: Federal income tax benefit Net loss per books Effective tax rate [$(131,250)/$(610,000)] Tax Rate Reconciliation: Statutory tax rate Nondeductible M&E expense [$25,000/($(610,000) × 21%)] Tax-exempt income [$(15,000)/$(610,000) × 21%] Dividends-received deduction [$(25,000)/$(610,000) × 21%] Effective tax rate

$600,000 0.21 $126,000

126,000 131,250 $(610,000) 131,250 $(478,750) 21.516% 21.000% (0.861)% 0.516% 0.861% 21.516%

C:3-67 Permtemp Corporation Deferred Tax Accounting 2021 Provision Reconciliation: Net loss before federal income taxes Permanent differences: Nondeductible M&E expense Tax-exempt income Dividends-received deduction Net loss after permanent differences Temporary differences: Bad debt expense Charitable contribution deduction Depreciation Net operating loss

$ (610,000) 25,000 (15,000) (25,000) $ (625,000) 250,000 100,000 (600,000) $ (875,000)

Adjusted Book Balance Sheet: Cash Accounts receivable Minus: Allowance for doubtful accounts Inventory Net deferred tax asset ($257,250 – $126,000) Fixed assets Minus: Accumulated depreciation Investment in corporate stock Investment in tax-exempt bonds Total assets

$ 2,000,000 (250,000) $10,000,000 (800,000)

Accounts payable Long-term debt Common stock Retained earnings Total liabilities and equity

500,000 1,750,000 4,000,000 131,250

9,200,000 1,000,000 50,000 $16,631,250 $ 2,610,000 8,500,000 6,000,000 (478,750) $16,631,250

C:3-67

1120

U.S. Corporation Income Tax Return

Form Department of the Treasury Internal Revenue Service A Check if: 1a Consolidated return (attach Form 851)

b Life/nonlife consoli-

dated return . . . 2 Personal holding co. (attach Sch. PH) . .

3 Personal service corp. (see instructions) .

Tax, Refundable Credits, and Payments

Deductions (See instructions for limitations on deductions.)

Income

4 Schedule M-3 attached

For calendar year 2022 or tax year beginning

OMB No. 1545-0123

, 2022, ending

2022

, 20

Go to www.irs.gov/Form1120 for instructions and the latest information. Name

TYPE OR PRINT

B Employer identification number

Permtemp Corporation

XX-1234567

Number, street, and room or suite no. If a P.O. box, see instructions.

C Date incorporated

City or town, state or province, country, and ZIP or foreign postal code

D Total assets (see instructions)

✓ E Check if: (1)

(2)

Initial return

2021

(3)

Final return

Name change

Gross receipts or sales .

b c 2

Returns and allowances . . . . . . Balance. Subtract line 1b from line 1a . Cost of goods sold (attach Form 1125-A) .

. . .

. .

1b . . . .

3 4 5

Gross profit. Subtract line 2 from line 1c . . Dividends and inclusions (Schedule C, line 23) Interest . . . . . . . . . . .

. . .

6 7 8

Gross rents . . . . . . . . . . . . . . Gross royalties . . . . . . . . . . . . . Capital gain net income (attach Schedule D (Form 1120)) .

. . .

9 10 11 12

. . . .

13 14

Salaries and wages (less employment credits)

Repairs and maintenance

15 16 17

Bad debts . . . Rents . . . . Taxes and licenses

. . .

20,425,000

(4)

Address change

33,000,000 . .

. .

1c 2

. . .

3 4 5

. . .

6 7 8

. . . .

9 10 11

12 13 14

. . .

15 16 17

18 19 20

. . .

18 19 20

21 22 23

Depletion . . . . . . . . Advertising . . . . . . . Pension, profit-sharing, etc., plans

. . .

21 22 23

24 25 26

Employee benefit programs . . Reserved for future use . . . . Other deductions (attach statement)

. .

. . .

24 25 26

27 28 29a

27 28

b c 30

Special deductions (Schedule C, line 24) . . . . . . . . Add lines 29a and 29b . . . . . . . . . . . . . Taxable income. Subtract line 29c from line 28. See instructions

. . .

29b . . . . . .

. .

31 32 33

Total tax (Schedule J, Part I, line 11) . . . . . . Reserved for future use . . . . . . . . . . Total payments and credits (Schedule J, Part III, line 23)

. . .

34 35 36

. . .

Sign Here

. . .

Other $4,675,000 + meals $20,000

. . .

875,000 27,500 . .

. .

29c 30

. . .

31 32 33

. . .

34 35 36

Refunded

Enter amount from line 36 you want: Credited to 2023 estimated tax

33,000,000 22,000,000 11,000,000 55,000

11,055,000 425,000 455,000 140,000 2,450,000

4,695,000 8,165,000 2,890,000 902,500 1,987,500 417,375

Signature of officer Print/Type preparer’s name

Paid Preparer Use Only Firm’s name

Date Preparer’s signature

May the IRS discuss this return with the preparer shown below? See instructions. Yes No

Title Date

Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11450Q

Form 1120 (2022)

C:3-67 Page 6

Form 1120 (2022)

Schedule L

Balance Sheets per Books

Beginning of tax year (a) (b)

Assets 1

Cash

2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

Trade notes and accounts receivable . . . ( Less allowance for bad debts . . . . . Inventories . . . . . . . . . . . U.S. government obligations . . . . . Tax-exempt securities (see instructions) . . a Other current assets (attach statement) Net DTA Loans to shareholders . . . . . . . Mortgage and real estate loans . . . . . Other investments (attach statement) . . . Buildings and other depreciable assets . . ( Less accumulated depreciation . . . . . Depletable assets . . . . . . . . . ( Less accumulated depletion . . . . . .

Land (net of any amortization) . . Intangible assets (amortizable only) Less accumulated amortization . . Other assets (attach statement) . . Total assets . . . . . . .

. . . . .

2,000,000 250,000 )

1,750,000 4,000,000

23 24 25 26 27 28

Schedule M-1

(

(d)

2,125,000

3,300,000 450,000 )

2,850,000 6,000,000

50,000 131,250

(

50,000

1,000,000

1,000,000 10,000,000 9,200,000 ( 1,600,000 ) 8,400,000

10,000,000 800,000 ) )

(

)

(

)

Accounts payable . . . . . . . . . Mortgages, notes, bonds payable in less than 1 year Other current liabilities (attach statement) Taxes payable Loans from shareholders . . . . . . . Mortgages, notes, bonds payable in 1 year or more Other liabilities (attach statement) Net DTLb Capital stock:

(c)

500,000

Liabilities and Shareholders’ Equity 16 17 18 19 20 21 22

End of tax year

16,631,250

20,425,000

2,610,000

2,120,000 417,375 8,500,000 378,000 6,000,000

8,500,000 6,000,000

6,000,000

600,000

(478,750) (

16,631,250

3,009,625 )

(

Reconciliation of Income (Loss) per Books With Income per Return

20,425,000

)

Note: The corporation may be required to file Schedule M-3. See instructions. 1

Net income (loss) per books See Schedule M-3

Federal income tax per books

Excess of capital losses over capital gains

Income subject to tax not recorded on books this year (itemize):

Expenses recorded on books this year not deducted on this return (itemize): Depreciation . . . . $ Charitable contributions . $ Travel and entertainment . $

a b c 6

Add lines 1 through 5 .

Schedule M-2 1 2 3

a b

Income recorded on books this year not included on this return (itemize): Tax-exempt interest $

Deductions on this return not charged against book income this year (itemize): a Depreciation . . $ b Charitable contributions $

9 10

Add lines 7 and 8 . . . . . . Income (page 1, line 28)—line 6 less line 9

. .

Analysis of Unappropriated Retained Earnings per Books (Schedule L, Line 25)

Balance at beginning of year Net income (loss) per books . Other increases (itemize):

Add lines 1, 2, and 3 .

. .

(478,750) 3,488,375

3,009,625

6 7 8

Distributions: a Cash . b Stock . c Property . Other decreases (itemize):

. . .

Add lines 5 and 6 . . . . . . Balance at end of year (line 4 less line 7)

257,250 DTA - $126,000 DTL. $472,500 DTL - $94,500 DTA.

-03,009,625

Form 1120 (2022)

C:3-67 SCHEDULE M-3 (Form 1120)

Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More

Permtemp Corporation

Check applicable box(es):

(2)

Consolidated return (Form 1120 only)

Mixed 1120/L/PC group

(4)

Dormant subsidiaries schedule attached

(3)

Part I

XX-1234567

(1) ✓Non-consolidated return

Financial Information and Net Income (Loss) Reconciliation (see instructions)

Did the corporation file SEC Form 10-K for its income statement period ending with or within this tax year? Yes. Skip lines 1b and 1c and complete lines 2a through 11 with respect to that SEC Form 10-K. ✓ No. Go to line 1b. See instructions if multiple non-tax-basis income statements are prepared. b Did the corporation prepare a certified audited non-tax-basis income statement for that period? Yes. Skip line 1c and complete lines 2a through 11 with respect to that income statement. ✓ No. Go to line 1c. c Did the corporation prepare a non-tax-basis income statement for that period? ✓ Yes. Complete lines 2a through 11 with respect to that income statement. No. Skip lines 2a through 3c and enter the corporation’s net income (loss) per its books and records on line 4a. Ending 2a Enter the income statement period: Beginning b Has the corporation’s income statement been restated for the income statement period on line 2a? Yes. (If “Yes,” attach an explanation and the amount of each item restated.)

01/01/2022

12/31/2022

✓ No.

Is any of the corporation’s voting common stock publicly traded?

✓ No.

Yes.

✓ No.

3,488,375

5a ( 5b 6a ( 6b 7a 7b 7c

) )

8 Adjustment to reconcile income statement period to tax year (attach statement) . . . . . . . 9 Intercompany dividend adjustments to reconcile to line 11 (attach statement) . . . . . . . . 10a Other statutory accounting adjustments to reconcile to line 11 (attach statement) . . . . . . . 10b Other adjustments to reconcile to amount on line 11 (attach statement) . . . . . . . . . . 10c Net income (loss) per income statement of includible corporations. Combine lines 4 through 10 . 11 Note: Part I, line 11, must equal Part II, line 30, column (a) or Schedule M-1, line 1 (see instructions). Enter the total amount (not just the corporation’s share) of the assets and liabilities of all entities included or removed on the following lines. Total Assets Total Liabilities

3,488,375

Included on Part I, line 4 . Removed on Part I, line 5 . Removed on Part I, line 6 . Included on Part I, line 7 .

. . . .

20,425,000

For Paperwork Reduction Act Notice, see the Instructions for Form 1120.

11,415,375

Cat. No. 37961C

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-67 Page 2

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Permtemp Corporation

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(7)

(2)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Part II

XX-1234567

Subsidiary corp

Income Statement (Attach statements for lines 1 through 12) 1 Income (loss) from equity method foreign corporations 2 Gross foreign dividends not previously taxed . . . 3 Subpart F, QEF, and similar income inclusions . . 4 Gross-up for foreign taxes deemed paid . . . . 5 Gross foreign distributions previously taxed . . . 6 Income (loss) from equity method U.S. corporations 7 U.S. dividends not eliminated in tax consolidation 8 Minority interest for includible corporations . . . 9 Income (loss) from U.S. partnerships . . . . . 10 Income (loss) from foreign partnerships . . . . 11 Income (loss) from other pass-through entities . . 12 Items relating to reportable transactions . . . . 13 Interest income (see instructions) . . . . . . 14 Total accrual to cash adjustment . . . . . . . 15 Hedging transactions . . . . . . . . . . 16 Mark-to-market income (loss) . . . . . . . . ) 17 Cost of goods sold (see instructions) . . . . . . ( 18 Sale versus lease (for sellers and/or lessors) . . . 19 Section 481(a) adjustments . . . . . . . . 20 Unearned/deferred revenue . . . . . . . . 21 Income recognition from long-term contracts . . 22 Original issue discount and other imputed interest . 23a Income statement gain/loss on sale, exchange, abandonment, worthlessness, or other disposition of assets other than inventory and pass-through entities b Gross capital gains from Schedule D, excluding amounts from pass-through entities . . . . .

Difference

per Tax Return

55,000

T-E interest

15,000

55,000

15,000

22,000,000

-0(

22,000,000 )

c Gross capital losses from Schedule D, excluding amounts from pass-through entities, abandonment losses, and worthless stock losses . . . . . d Net gain/loss reported on Form 4797, line 17, excluding amounts from pass-through entities, abandonment losses, and worthless stock losses e Abandonment losses . . . . . . . . . . f Worthless stock losses (attach statement) . . . . g Other gain/loss on disposition of assets other than inventory 24 Capital loss limitation and carryforward used . . . 25 Other income (loss) items with differences (attach statement) 26 Total income (loss) items. Combine lines 1 through 25 27 Total expense/deduction items (from Part III, line 39) 28 Other items with no differences . . . . . . . 29a Mixed groups, see instructions. All others, combine lines 26 through 28 . . . . . . . . . .

-0(21,930,000) (2,906,625) (1,550,000) 28,325,000 3,488,375 (1,550,000)

(15,000) 966,625 951,625

(21,945,000) (3,490,000) 28,325,000 2,890,000

3,488,375 (1,550,000)

951,625

2,890,000

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-67 Page 3

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Permtemp Corporation

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(7)

(2)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

XX-1234567

Subsidiary corp

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Expense/Deduction Items 1 2 3 4 5

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

(b) Temporary Difference

417,375 509,250

(d) Deduction per Tax Return

(417,375) (509,250)

455,000

455,000 (40,000)

60,000

40,000

20,000

40,000 100,000

100,000

800,000 625,000

1,650,000 (200,000)

2,450,000 425,000

2,906,625

1,550,000 (966,625) 3,490,000

37 Section 162(r)—FDIC premiums paid by certain large financial institutions (see instructions) . .

38 Other expense/deduction items with differences (attach statement) . . . . . . . . . . 39 Total expense/deduction items. Combine lines 1 through 38. Enter here and on Part II, line 27, reporting positive amounts as negative and negative amounts as positive . . . . . . .

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-67 Permtemp Corporation Deferred Tax Accounting 2022 Deferred Tax Assets: Beg. of 2022 Net operating loss Charitable contributions carryover Net accounts receivable Total deductible temp. diff. Times: Tax rate Deferred tax asset

End of 2022

$ 875,000 100,000 250,000 $1,225,000 0.21 $ 257,250

Change

-0-0450,000* $450,000 0.21 $ 94,500

$(875,000) (100,000) 200,000 $(775,000)

Beg. of 2022

End of 2022

Change

$600,000 0.21 $126,000

$2,250,000* 0.21 $ 472,500

$1,650,000

$(162,750)

*$3,300,000 tax basis – $2,850,000 book basis Deferred Tax Liability:

Net fixed assets Times: Tax rate Deferred tax liability

$ 346,500

*$8,400,000 book basis – $6,150,000 tax basis Journal Entry: Current federal income tax expense Deferred federal income tax expense Deferred tax asset Deferred tax liability Federal income tax payable

417,375 509,250

162,750 346,500 417,375

Adjusted Income Statement (Partial): Net income before federal income taxes Minus: Federal income tax expense ($417,375 + $509,250) Net income per books Effective tax rate [$926,625/$4,415,000]

$4,415,000 (926,625) $3,488,375 20.988%

Tax Rate Reconciliation: Statutory tax rate Nondeductible M&E expense [$40,000/$4,415,000 × 21%] Tax-exempt income [$(15,000)/$4,415,000 × 21%] Dividends-received ded. [$(27,500)/$4,415,000 × 21%] Effective tax rate

21.000% 0.190% (0.071)% (0.131)% 20.988%

C:3-67 Permtemp Corporation Deferred Tax Accounting 2022 Provision Reconciliation: Net income before federal income taxes Permanent differences: Nondeductible M&E expense Tax-exempt income Dividends-received deduction Net income after permanent differences Temporary differences: Bad debt expense Charitable contribution deduction Depreciation Net operating loss deduction Taxable income

$ 4,415,000 40,000 (15,000) (27,500) $ 4,412,500 200,000 (100,000) (1,650,000) (875,000) $ 1,987,500

Adjusted Balance Sheet: Cash Accounts receivable Minus: Allowance for doubtful accounts Inventory Fixed assets Minus: Accumulated depreciation Investment in corporate stock Investment in tax-exempt bonds Total assets

$ 3,300,000 (450,000) $10,000,000 (1,600,000)

Accounts payable Federal income tax payable Long-term debt Net deferred tax liability ($472,500 – $94,500) Common stock Retained earnings [$(478,750) + $3,488,375] Total liabilities and equity

$ 2,125,000 2,850,000 6,000,000 8,400,000 1,000,000 50,000 $20,425,000 $ 2,120,000 417,375 8,500,000 378,000 6,000,000 3,009,625 $20,425,000

C:3-68 Page 6

Form 1120 (2022)

Schedule L

Balance Sheets per Books

Beginning of tax year (a) (b)

Assets 1

Cash

2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

. . . . . . . . . . . . . . . . . .

16 17 18 19 20 21 22

End of tax year (c)

(d)

(

)

(

)

(

)

(

)

(

)

(

)

(

)

(

)

Liabilities and Shareholders’ Equity

23 24 25 26 27 28

Schedule M-1

(

)

Reconciliation of Income (Loss) per Books With Income per Return Note: The corporation may be required to file Schedule M-3. See instructions.

Net income (loss) per books .

Federal income tax per books

Excess of capital losses over capital gains

Income subject to tax not recorded on books this year (itemize):

581,760 156,240 8,000

10,000

10,000 8

5 a b c 6

Expenses recorded on books this year not deducted on this return (itemize): Depreciation . . . . $ Charitable contributions . $ Travel and entertainment . $ Add lines 1 through 5 .

Schedule M-2 1 2 3

Deductions on this return not charged against book income this year (itemize): a Depreciation . . $ b Charitable contributions $

40,000

4,000

*16,000

Income recorded on books this year not included on this return (itemize): Tax-exempt interest $

20,000 766,000

9 10

Add lines 7 and 8 . . . . . . Income (page 1, line 28)—line 6 less line 9

Analysis of Unappropriated Retained Earnings per Books (Schedule L, Line 25)

Balance at beginning of year Net income (loss) per books . Other increases (itemize):

Add lines 1, 2, and 3 .

. .

6 7 8

Distributions: a Cash . b Stock . c Property . Other decreases (itemize):

. . .

40,000 50,000 716,000

. . .

Add lines 5 and 6 . . . . . . Balance at end of year (line 4 less line 7)

Form 1120 (2022)

C:3-69 SCHEDULE M-3 (Form 1120)

Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More

Omega Corporation

Check applicable box(es):

(2)

Consolidated return (Form 1120 only)

Mixed 1120/L/PC group

(4)

Dormant subsidiaries schedule attached

(3)

Part I

XX-1234321

(1) ✓ Non-consolidated return

Financial Information and Net Income (Loss) Reconciliation (see instructions)

Did the corporation file SEC Form 10-K for its income statement period ending with or within this tax year? Yes. Skip lines 1b and 1c and complete lines 2a through 11 with respect to that SEC Form 10-K. ✓ No. Go to line 1b. See instructions if multiple non-tax-basis income statements are prepared. b Did the corporation prepare a certified audited non-tax-basis income statement for that period? Yes. Skip line 1c and complete lines 2a through 11 with respect to that income statement. ✓ No. Go to line 1c. c Did the corporation prepare a non-tax-basis income statement for that period? ✓ Yes. Complete lines 2a through 11 with respect to that income statement. No. Skip lines 2a through 3c and enter the corporation’s net income (loss) per its books and records on line 4a. Ending 2a Enter the income statement period: Beginning b Has the corporation’s income statement been restated for the income statement period on line 2a? Yes. (If “Yes,” attach an explanation and the amount of each item restated.)

01/01/2022

12/31/2022

✓ No.

Is any of the corporation’s voting common stock publicly traded?

✓ No.

Yes.

✓ No.

331,860

5a ( 5b 6a ( 6b 7a 7b 7c

) )

8 Adjustment to reconcile income statement period to tax year (attach statement) . . . . . . . 9 Intercompany dividend adjustments to reconcile to line 11 (attach statement) . . . . . . . . 10a Other statutory accounting adjustments to reconcile to line 11 (attach statement) . . . . . . . 10b Other adjustments to reconcile to amount on line 11 (attach statement) . . . . . . . . . . 10c Net income (loss) per income statement of includible corporations. Combine lines 4 through 10 . 11 Note: Part I, line 11, must equal Part II, line 30, column (a) or Schedule M-1, line 1 (see instructions). Enter the total amount (not just the corporation’s share) of the assets and liabilities of all entities included or removed on the following lines. Total Assets Total Liabilities

331,860

Included on Part I, line 4 . Removed on Part I, line 5 . Removed on Part I, line 6 . Included on Part I, line 7 .

. . . .

For Paperwork Reduction Act Notice, see the Instructions for Form 1120.

*Information not provided.

* Cat. No. 37961C

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-69 Page 2

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Omega Corporation

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(7)

(2)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Part II

XX-1234321

Subsidiary corp

Income Statement (Attach statements for lines 1 through 12) 1 Income (loss) from equity method foreign corporations 2 Gross foreign dividends not previously taxed . . . 3 Subpart F, QEF, and similar income inclusions . . 4 Gross-up for foreign taxes deemed paid . . . . 5 Gross foreign distributions previously taxed . . . 6 Income (loss) from equity method U.S. corporations 7 U.S. dividends not eliminated in tax consolidation 8 Minority interest for includible corporations . . . 9 Income (loss) from U.S. partnerships . . . . . 10 Income (loss) from foreign partnerships . . . . 11 Income (loss) from other pass-through entities . . 12 Items relating to reportable transactions . . . . 13 Interest income (see instructions) . . . . . . 14 Total accrual to cash adjustment . . . . . . . 15 Hedging transactions . . . . . . . . . . 16 Mark-to-market income (loss) . . . . . . . . ) 17 Cost of goods sold (see instructions) . . . . . . ( 18 Sale versus lease (for sellers and/or lessors) . . . 19 Section 481(a) adjustments . . . . . . . . 20 Unearned/deferred revenue . . . . . . . . 21 Income recognition from long-term contracts . . 22 Original issue discount and other imputed interest . 23a Income statement gain/loss on sale, exchange, abandonment, worthlessness, or other disposition of a assets other than inventory and pass-through entities b Gross capital gains from Schedule D, excluding amounts from pass-through entities . . . . .

Difference

1,000

Difference

per Tax Return

(1,000)

-0-

1,100,000

(11,000)

1,100,000 )

11,000 18,000

18,000

(38,000)

(1,110,000) (238,140) 1,680,000c 331,860

20,000 (15,000)b (4,000) (36,000)

(1,000) 103,140

(40,000)

102,140

20,000 (15,000) (1,115,000) (171,000) 1,680,000 394,000

331,860

(40,000)

102,140

394,000

c Gross capital losses from Schedule D, excluding amounts from pass-through entities, abandonment losses, and worthless stock losses . . . . . d Net gain/loss reported on Form 4797, line 17, excluding amounts from pass-through entities, abandonment losses, and worthless stock losses e Abandonment losses . . . . . . . . . . f Worthless stock losses (attach statement) . . . . g Other gain/loss on disposition of assets other than inventory 24 Capital loss limitation and carryforward used . . . 25 Other income (loss) items with differences (attach statement) 26 Total income (loss) items. Combine lines 1 through 25 27 Total expense/deduction items (from Part III, line 39) 28 Other items with no differences . . . . . . . 29a Mixed groups, see instructions. All others, combine lines 26 through 28 . . . . . . . . . .

(

a$9,000 installment income – $20,000 loss on stock sales. bNOL carryover. c$1,900,000 sales – $220,000 other business expenses.

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:3-69 Page 3

Schedule M-3 (Form 1120) (Rev. 12-2019) Name of corporation (common parent, if consolidated return)

Omega Corporation

Check applicable box(es): (1)

Check if a sub-consolidated: (6)

Consolidated group 1120 group

(2)

(7)

Employer identification number Parent corp

(3)

Consolidated eliminations

(4)

XX-1234321

Subsidiary corp

(5)

Mixed 1120/L/PC group

1120 eliminations Employer identification number

Name of subsidiary (if consolidated return)

Expense/Deduction Items 1 2 3 4 5

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

(b) Temporary Difference

(d) Deduction per Tax Return

82,740 8,400 27,000

(82,740) (8,400)

18,000

(2,000)

16,000

10,000

(10,000)

-0-

27,000

37 Section 162(r)—FDIC premiums paid by certain large financial institutions (see instructions) . . 38 Other expense/deduction items with differences (attach statement) . . . . . . . . . .

Warr. exp.

39 Total expense/deduction items. Combine lines 1 through 38. Enter here and on Part II, line 27, reporting positive amounts as negative and negative amounts as positive . . . . . . .

80,000

48,000

128,000

12,000

(12,000)

-0-

238,140

36,000

103,140

171,000

Schedule M-3 (Form 1120) (Rev. 12-2019)

C:8-68

1120

U.S. Corporation Income Tax Return

Form Department of the Treasury Internal Revenue Service A Check if: 1a Consolidated return (attach Form 851)

b Life/nonlife consoli-

dated return . . . 2 Personal holding co. (attach Sch. PH) . .

3 Personal service corp. (see instructions) .

For calendar year 2022 or tax year beginning

Income Deductions (See instructions for limitations on deductions.)

2022

, 20

Go to www.irs.gov/Form1120 for instructions and the latest information. Name

✓ TYPE OR PRINT

B Employer identification number

Flying Gator Corporation and Subsidiary

38-2345678

Number, street, and room or suite no. If a P.O. box, see instructions.

C Date incorporated

City or town, state or province, country, and ZIP or foreign postal code

D Total assets (see instructions)

2101 W. University Avenue

6/11/2010

Gainesburg, FL 32611

4 Schedule M-3 attached

Tax, Refundable Credits, and Payments

OMB No. 1545-0123

, 2022, ending

E Check if: (1)

(2)

Initial return

$ (3)

Final return

Gross receipts or sales .

b c 2

Returns and allowances . . . . . . Balance. Subtract line 1b from line 1a . Cost of goods sold (attach Form 1125-A) .

. . .

. .

1b . . . .

3 4 5

Gross profit. Subtract line 2 from line 1c . . Dividends and inclusions (Schedule C, line 23) Interest . . . . . . . . . . .

. . .

6 7 8

Gross rents . . . . . . . . . . . . . . Gross royalties . . . . . . . . . . . . . Capital gain net income (attach Schedule D (Form 1120)) .

. . .

9 10 11 12

. . . .

13 14

Salaries and wages (less employment credits) Repairs and maintenance . . . . . .

15 16 17

Bad debts . . . Rents . . . . Taxes and licenses

. . .

(4)

Name change

3,740,000

430,000

Address change

. .

1c 2

. . .

3 4 5

. . .

6 7 8

. . . .

9 10 11

12 13 14

. . .

15 16 17

18 19 20

. . .

18 19 20

21 22 23

Depletion . . . . . . . . Advertising . . . . . . . Pension, profit-sharing, etc., plans

. . .

21 22 23

24 25 26

Employee benefit programs . . Reserved for future use . . . . Other deductions (attach statement)

. . .

24 25 26

27 28 29a

27 28

b c 30

Special deductions (Schedule C, line 24) . . . . . . . . Add lines 29a and 29b . . . . . . . . . . . . . Taxable income. Subtract line 29c from line 28. See instructions

. . .

29b . . . . . .

. .

29c 30

31 32 33

Total tax (Schedule J, Part I, line 11) . . . . . . Reserved for future use . . . . . . . . . . Total payments and credits (Schedule J, Part III, line 23)

. . .

31 32 33

34 35 36

. . .

34 35 36

Enter amount from line 36 you want: Credited to 2023 estimated tax

Refunded

Sign Here

. . .

50,000 32,500

3,740,000 2,194,400 1,545,600 50,000 15,000 27,000 25,000 1,662,600 145,000 230,000 65,000 15,000 42,000 50,000 52,060 125,000

420,000 1,144,060 518,540 82,500 436,040 91,568 100,000 8,432 8,432

Signature of officer Print/Type preparer’s name

Paid Preparer Use Only Firm’s name

Date Preparer’s signature

May the IRS discuss this return with the preparer shown below? See instructions. Yes No

Title Date

Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11450Q

Form 1120 (2022)

C:8-68

Line

Title

Flying Gator Corporation and Subsidiary 38-2345678 2022 Form 1120 Taxable Income Computations Consolidated Adjustments Flying and Gator Eliminations $3,740,000 $ (10,000)a $2,500,000

1a Gross receipts or sales 1b Returns & allowances 1c Balance (1a minus 1b) 2 Cost of goods sold 3 Gross profit 4 Dividends & inclusions 5 Interest 6 Gross rents 7 Gross royalties 8 Capital gain net income 9 Net gain or loss/Form 4797 10 Other income 11 Total income 12 Compensation of officers 13 Salaries and wages 14 Repairs and maintenance 15 Bad debts 16 Rents 17 Taxes and licenses 18 Interest 19 Charitable contributions 20 Depreciation 21 Depletion 22 Advertising 23 Pension, profit-sharing, etc. 24 Employee benefit programs 25 Reserved for future use 26 Other deductions 27 Total deductions 28 Taxable income before NOL deduction & special ded. 29a NOL deduction 29b Special ded. (e.g., DRD) 30 Taxable income 31 Total tax

T Corp. $1,250,000

$3,740,000 (2,194,400) $1,545,600 50,000 15,000c

$ (10,000) 5,600a $ (4,400) (100,000)b

$2,500,000 (1,500,000) $1,000,000 100,000 15,000

$1,250,000 (700,000) $ 550,000 50,000

27,000 25,000

9,000e

(5,000)

23,000d 25,000

$1,662,600 145,000 230,000 65,000 15,000

$ (95,400)

$1,110,000 80,000 95,000 25,000 10,000

$ 648,000 65,000 135,000 40,000 5,000

18,000 30,000 22,000 85,000

24,000 20,000 48,000 40,000

160,000 $ 525,000 $ 585,000

260,000 $ 637,000 $ 11,000

42,000 50,000c 52,060 125,000

420,000 $1,144,060 $ 518,540

(17,940)f

$ (17,940) $ (77,460)

(50,000) (32,500)g $ 436,040 $ 91,568h

C:8-68 a

The group defers $40,700 ($92,500 − $51,800) of gross profit from the preceding year to the current year, and it defers $45,100 ($102,500 − $57,400) of gross profit from the current year to the next year. The current year net adjustments are: Gross receipts or sales: $ 92,500 − $102,500 = $(10,000) Cost of goods sold:* $(51,800) − $ (57,400) = $ 5,600 Gross profit: $ 40,700 − $ 45,100 = $ (4,400) *The $51,800 and $57,400 are negative because cost of goods sold reduces gross profit. b Exclusion of dividend T pays to Flying Gator. Adjustment is needed because the dividends are included in Flying Gator’s separate taxable income calculation. c Under the matching rule, Flying Gator’s $15,000 of interest income is matched with $15,000 of T’s interest expense. The group includes T’s interest expense on Line 18, and it includes Flying Gator’s interest income on Line 5. d ($3,000) NSTCL + $6,000 NLTCG + $20,000 net Sec. 1231 gain = $23,000 T’s capital gain net income. e The $9,000 loss on Flying Gator’s land sale to T is deferred under the intercompany transaction rules. f Charitable contributions ($22,000 + $48,000) $ 70,000 Deduction limitation: Total income (Line 11) $1,662,600 Compensation of officers (Line 12) (145,000) Salaries and wages (Line 13) (230,000) Repairs and maintenance (Line 14) (65,000) Bad debts (Line 15) (15,000) Taxes and licenses (Line 17) (42,000) Interest (Line 18) (50,000) Depreciation (Line 20) (125,000) Other deductions (Line 26) (420,000) NOL deduction (Line 29a) (50,000) Base for deduction limitation $ 520,600 Times: Contributions limitation percentage 0.10 Deduction limitation $ 52,060 Deduction (lesser of $70,000 or $52,060) $ 52,060 Carryover to next year ($70,000 − $52,060) $ 17,940 g

Dividends-received deduction = $50,000 × 0.65 = $32,500. A dividends-received deduction is not allowed for the $100,000 dividend T pays to Flying Gator because it is excluded from consolidated income (see Item b above). h $436,040 × 0.21.

C:9-57 Form

1065

U.S. Return of Partnership Income For calendar year 2022, or tax year beginning

Department of the Treasury Internal Revenue Service

Tailor

Men’s Clothes

C Business code number

, 2022, ending

, 20

2022

Go to www.irs.gov/Form1065 for instructions and the latest information.

A Principal business activity B Principal product or service

OMB No. 1545-0123

Name of partnership

D Employer identification number

Number, street, and room or suite no. If a P.O. box, see instructions.

E Date business started

City or town, state or province, country, and ZIP or foreign postal code

F Total assets (see instructions)

Dapper-Dons Partnership

Type or Print

XX-XXXXXXX 2012

123 Flamingo Drive City, ST 54321

458110 (1) (1)

1,128,000

(2) (3) Initial return Final return Name change (4) Address change (5) Amended return (2) (3) Cash Accrual Other (specify): H Check accounting method: I Number of Schedules K-1. Attach one for each person who was a partner at any time during the tax year: J Check if Schedules C and M-3 are attached . . . . . . . . . . . . . . . . . . . . . . . . . . . . . K Check if partnership: (1) Aggregated activities for section 465 at-risk purposes (2) Grouped activities for section 469 passive activity purposes

G Check applicable boxes:

Caution: Include only trade or business income and expenses on lines 1a through 22 below. See instructions for more information. 1a Gross receipts or sales . . . . . . . . . . . . . . . . . 1a b Returns and allowances . . . . . . . . . . . . . . . . 1b c Balance. Subtract line 1b from line 1a . . . . . . . . . . . . . . . . . . . . 1c 2 Cost of goods sold (attach Form 1125-A) . . . . . . . . . . . . . . . . . . 2 3 Gross profit. Subtract line 2 from line 1c . . . . . . . . . . . . . . . . . . . 3 4 Ordinary income (loss) from other partnerships, estates, and trusts (attach statement) . . . . 4 5 Net farm profit (loss) (attach Schedule F (Form 1040)) . . . . . . . . . . . . . . 5 6 Net gain (loss) from Form 4797, Part II, line 17 (attach Form 4797) . . . . . . . . . . 6 7 Other income (loss) (attach statement) . . . . . . . . . . . . . . . . . . . 7 8 Total income (loss). Combine lines 3 through 7 . . . . . . . . . . . . . . . . 8 9 Salaries and wages (other than to partners) (less employment credits) . . . . . . . . . 9 10 Guaranteed payments to partners . . . . . . . . . . . . . . . . . . . . . 10 11 Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . 11 12 Bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 13 Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 14 Taxes and licenses . . . . . . . . . . . . . . . . . . . . . . . . . . 14 15 Interest (see instructions) . . . . . . . . . . . . . . . . . . . . . . . . 15 16a Depreciation (if required, attach Form 4562) . . . . . . . . . . 16a b Less depreciation reported on Form 1125-A and elsewhere on return . 16b 16c 17 Depletion (Do not deduct oil and gas depletion.) . . . . . . . . . . . . . . . 17 18 Retirement plans, etc. . . . . . . . . . . . . . . . . . . . . . . . . . 18 19 Employee benefit programs . . . . . . . . . . . . . . . . . . . . . . . 19 20 Other deductions (attach statement) . . . . . . . . . . . . . . . . . . . . 20 21 Total deductions. Add the amounts shown in the far right column for lines 9 through 20 . . . 21 22 Ordinary business income (loss). Subtract line 21 from line 8 . . . . . . . . . . . 22 23 Interest due under the look-back method—completed long-term contracts (attach Form 8697) . 23 24 Interest due under the look-back method—income forecast method (attach Form 8866) . . . 24 25 BBA AAR imputed underpayment (see instructions) . . . . . . . . . . . . . . . 25 26 Other taxes (see instructions) . . . . . . . . . . . . . . . . . . . . . . 26 27 Total balance due. Add lines 23 through 26 . . . . . . . . . . . . . . . . . 27 28 Payment (see instructions) . . . . . . . . . . . . . . . . . . . . . . . 28 29 Amount owed. If line 28 is smaller than line 27, enter amount owed . . . . . . . . . . 29 30 Overpayment. If line 28 is larger than line 27, enter overpayment . . . . . . . . . . 30

Deductions (see instructions for limitations)

Income

2,357,000 20,000

(5,180 + 1,400)

49,782

2,337,000 1,332,050 1,004,950

1,004,950 51,000 85,000 68,300 2,100 7,400 6,580 45,000 49,782

Tax and Payment

162,553 477,715 527,235

Sign Here

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than partner or limited liability company member) is based on all information of which preparer has any knowledge.

Jeremy Dons

Signature of partner or limited liability company member

Paid Preparer Use Only

Print/Type preparer’s name

Preparer’s signature

Date

3-12-23 Date

Firm’s name

May the IRS discuss this return with the preparer shown below? See instructions. Yes No Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11390Z

Form 1065 (2022)

C:9-57 Page 2

Form 1065 (2022)

Schedule B 1 a c e 2 a

Other Information

What type of entity is filing this return? Check the applicable box: ✓ Domestic general partnership b Domestic limited partnership Domestic limited liability company d Domestic limited liability partnership Foreign partnership f Other: At the end of the tax year: Did any foreign or domestic corporation, partnership (including any entity treated as a partnership), trust, or taxexempt organization, or any foreign government own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership? For rules of constructive ownership, see instructions. If “Yes,” attach Schedule B-1, Information on Partners Owning 50% or More of the Partnership . . . . . . . . . . . . . . .

b Did any individual or estate own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership? For rules of constructive ownership, see instructions. If “Yes,” attach Schedule B-1, Information on Partners Owning 50% or More of the Partnership* . . . . . . . . . . . . . . . . . . . . 3 a

Yes

✓ ✓

At the end of the tax year, did the partnership: Own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of stock entitled to vote of any foreign or domestic corporation? For rules of constructive ownership, see instructions. If “Yes,” complete (i) through (iv) below . . . . . . . . . . . . . . . . . . . . . . . . . (i) Name of Corporation

(ii) Employer Identification Number (if any)

(iii) Country of Incorporation

✓

(iv) Percentage Owned in Voting Stock

b Own directly an interest of 20% or more, or own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital in any foreign or domestic partnership (including an entity treated as a partnership) or in the beneficial interest of a trust? For rules of constructive ownership, see instructions. If “Yes,” complete (i) through (v) below . . (i) Name of Entity

(ii) Employer Identification Number (if any)

(iii) Type of Entity

(iv) Country of Organization

✓

(v) Maximum Percentage Owned in Profit, Loss, or Capital

Yes

Does the partnership satisfy all four of the following conditions? a The partnership’s total receipts for the tax year were less than $250,000. b The partnership’s total assets at the end of the tax year were less than $1 million. c Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return.

d The partnership is not filing and is not required to file Schedule M-3 . . . . . . . . . . . . . . . If “Yes,” the partnership is not required to complete Schedules L, M-1, and M-2; item F on page 1 of Form 1065; or item L on Schedule K-1.

✓

5 6

✓

Is this partnership a publicly traded partnership as defined in section 469(k)(2)? . . . . . . . . . . . . During the tax year, did the partnership have any debt that was cancelled, was forgiven, or had the terms modified so as to reduce the principal amount of the debt? . . . . . . . . . . . . . . . . . . . . . Has this partnership filed, or is it required to file, Form 8918, Material Advisor Disclosure Statement, to provide information on any reportable transaction? . . . . . . . . . . . . . . . . . . . . . . . .

7 8

At any time during calendar year 2022, did the partnership have an interest in or a signature or other authority over a financial account in a foreign country (such as a bank account, securities account, or other financial account)? See instructions for exceptions and filing requirements for FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). If “Yes,” enter the name of the foreign country

At any time during the tax year, did the partnership receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If “Yes,” the partnership may have to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. See instructions . . . . . . . . .

10a

Is the partnership making, or had it previously made (and not revoked), a section 754 election? . . . . . . See instructions for details regarding a section 754 election. b Did the partnership make for this tax year an optional basis adjustment under section 743(b) or 734(b)? If “Yes,” attach a statement showing the computation and allocation of the basis adjustment. See instructions . . . . c Is the partnership required to adjust the basis of partnership assets under section 743(b) or 734(b) because of a substantial built-in loss (as defined under section 743(d)) or substantial basis reduction (as defined under section 734(d))? If “Yes,” attach a statement showing the computation and allocation of the basis adjustment. See instructions

*Schedule B-1 is not attached. If attached, with these facts, it would list Jeremy Dons, who owns a 60% interest in the partnership.

✓ ✓

✓ ✓ ✓ ✓ ✓

Form 1065 (2022)

C:9-57 Page 3

Form 1065 (2022)

Schedule B

Other Information (continued)

Check this box if, during the current or prior tax year, the partnership distributed any property received in a likekind exchange or contributed such property to another entity (other than disregarded entities wholly owned by the partnership throughout the tax year) . . . . . . . . . . . . . . . . . . . . . . . . .

At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property? . . . . . . . . . . . . . . . . . . . . . . . .

Yes

If the partnership is required to file Form 8858, Information Return of U.S. Persons With Respect To Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs), enter the number of Forms 8858 attached. See instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Does the partnership have any foreign partners? If “Yes,” enter the number of Forms 8805, Foreign Partner’s 14 Information Statement of Section 1446 Withholding Tax, filed for this partnership . . . . . . . . . . . Enter the number of Forms 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, attached 15 to this return . . . . . . . . . . . . . . . . . . . . . . . . . . 16a Did you make any payments in 2022 that would require you to file Form(s) 1099? See instructions . . . . . b If “Yes,” did you or will you file required Form(s) 1099? . . . . . . . . . . . . . . . . . . . . Enter the number of Forms 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, 17 attached to this return . . . . . . . . . . . . . . . . . . . . . . . 18 Enter the number of partners that are foreign governments under section 892 . . . . 19 During the partnership’s tax year, did the partnership make any payments that would require it to file Forms 1042 and 1042-S under chapter 3 (sections 1441 through 1464) or chapter 4 (sections 1471 through 1474)? . . . . 20 Was the partnership a specified domestic entity required to file Form 8938 for the tax year? See the Instructions for Form 8938 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

✓

✓ ✓

0 0

21 22

Is the partnership a section 721(c) partnership, as defined in Regulations section 1.721(c)-1(b)(14)? .

During the tax year, did the partnership pay or accrue any interest or royalty for which one or more partners are not allowed a deduction under section 267A? See instructions . . . . . . . . . . . . . . . . . If “Yes,” enter the total amount of the disallowed deductions . . . . . . . . . . $ 23 Did the partnership have an election under section 163(j) for any real property trade or business or any farming business in effect during the tax year? See instructions . . . . . . . . . . . . . . . . . . . . 24 Does the partnership satisfy one or more of the following? See instructions . . . . . . . . . . . . . a The partnership owns a pass-through entity with current, or prior year carryover, excess business interest expense. b The partnership’s aggregate average annual gross receipts (determined under section 448(c)) for the 3 tax years preceding the current tax year are more than $27 million and the partnership has business interest expense. c The partnership is a tax shelter (see instructions) and the partnership has business interest expense. If “Yes” to any, complete and attach Form 8990. 25 Is the partnership attaching Form 8996 to certify as a Qualified Opportunity Fund? . . . . . . . . . . If “Yes,” enter the amount from Form 8996, line 15 . . . . . . . . . . . . . $ Enter the number of foreign partners subject to section 864(c)(8) as a result of transferring all or a portion of an 26 interest in the partnership or of receiving a distribution from the partnership . . . . . Complete Schedule K-3 (Form 1065), Part XIII, for each foreign partner subject to section 864(c)(8) on a transfer or distribution. 27 At any time during the tax year, were there any transfers between the partnership and its partners subject to the disclosure requirements of Regulations section 1.707-8? . . . . . . . . . . . . . . . . . . .

✓ ✓ ✓ ✓ ✓ ✓

✓

Since December 22, 2017, did a foreign corporation directly or indirectly acquire substantially all of the properties constituting a trade or business of your partnership, and was the ownership percentage (by vote or value) for purposes of section 7874 greater than 50% (for example, the partners held more than 50% of the stock of the foreign corporation)? If “Yes,” list the ownership percentage by vote and by value. See instructions. Percentage: By vote: By value:

Reserved for future use

Is the partnership electing out of the centralized partnership audit regime under section 6221(b)? See instructions. If “Yes,” the partnership must complete Schedule B-2 (Form 1065). Enter the total from Schedule B-2, Part III, line 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . If “No,” complete Designation of Partnership Representative below.

✓

Designation of Partnership Representative (see instructions) Enter below the information for the partnership representative (PR) for the tax year covered by this return. Name of PR U.S. address of PR

Bob Dapper 709 Brumby Way City, ST 54321

U.S. phone number of PR

(XXX) XXX-XXXX

If the PR is an entity, name of the designated individual for the PR U.S. address of designated individual

U.S. phone number of designated individual Form 1065 (2022)

C:9-57 Page 4

Form 1065 (2022)

Schedule K

Income (Loss)

1 2 3a b c 4 5 6

Other Information

Alternative Minimum Tax (AMT) Items

International

Credits

SelfEmploy- Deductions ment

7 8 9a b c 10 11 12 13a b c d 14a b c 15a b c d e f

Partners’ Distributive Share Items

Total amount

Ordinary business income (loss) (page 1, line 22) . . . . . . . . . . . . . . . Net rental real estate income (loss) (attach Form 8825) . . . . . . . . . . . . . Other gross rental income (loss) . . . . . . . . . . . . . 3a Expenses from other rental activities (attach statement) . . . . . 3b Other net rental income (loss). Subtract line 3b from line 3a . . . . . . . . . . . . Guaranteed payments: a Services 4a b Capital 4b c Total. Add lines 4a and 4b . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends and dividend equivalents: a Ordinary dividends . . . . . . . . . . . . b Qualified dividends 6b c Dividend equivalents 6c Royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net short-term capital gain (loss) (attach Schedule D (Form 1065)) . . . . . . . . . . Net long-term capital gain (loss) (attach Schedule D (Form 1065)) . . . . . . . . . . Collectibles (28%) gain (loss) . . . . . . . . . . . . . . 9b Unrecaptured section 1250 gain (attach statement) . . . . . . 9c Net section 1231 gain (loss) (attach Form 4797) . . . . . . . . . . . . . . . . Other income (loss) (see instructions) Type: Section 179 deduction (attach Form 4562) . . . . . . . . . . . . . . . . . Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment interest expense . . . . . . . . . . . . . . . . . . . . . . Section 59(e)(2) expenditures: (2) Amount: (1) Type: Other deductions (see instructions) Type: Net earnings (loss) from self-employment . . . . . . . . . Gross farming or fishing income . . . . . . . . . . . . . . . . . . . . . Gross nonfarm income . . . . . . . . . . . . . . . Low-income housing credit (section 42(j)(5)) Low-income housing credit (other) . . . . . . . . . . . . . . . . . . . . Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) . . Other rental real estate credits (see instructions) Type: Other rental credits (see instructions) Type: Other credits (see instructions) Type:

85,000

11,000

(527,235 + 85,000) (From Page 1, Line 3)

Attach Schedule K-2 (Form 1065), Partners’ Distributive Share Items—International, and check this box to indicate that you are reporting items of international tax relevance . . . . .

17a b c d e f 18a b c 19a b 20a b c 21

Post-1986 depreciation adjustment . . . . . . Adjusted gain or loss . . . . . . . . . . Depletion (other than oil and gas) . . . . . . Oil, gas, and geothermal properties—gross income Oil, gas, and geothermal properties—deductions . Other AMT items (attach statement) . . . . . . Tax-exempt interest income . . . . . . . . Other tax-exempt income . . . . . . . . . Nondeductible expenses . . . . . . . . . Distributions of cash and marketable securities . . Distributions of other property . . . . . . . Investment income . . . . . . . . . . . Investment expenses . . . . . . . . . . Other items and amounts (attach statement) Total foreign taxes paid or accrued . . . . . .

1 2

3c 4c 5 6a 7 8 9a

10 11 12 13a 13b

85,000 11,000 (26,075) 18,000 5,050 16,400

13c(2)

13d 14a 14b 14c 15a 15b 15c 15d 15e 15f

. . . . . . . . . . . . .

17a 17b 17c 17d 17e 17f 18a 18b 18c 19a 19b 20a 20b

*$11,000 dividend is investment income if partners elect to tax dividends at ordinary rates under Sec. 163(d)(4)(B).

527,235

612,235 1,004,950

2,000 387,626 *11,000 Form 1065 (2022)

C:9-57 Page 5

Form 1065 (2022)

Analysis of Net Income (Loss) per Return 1

Net income (loss). Combine Schedule K, lines 1 through 11. From the result, subtract the sum of 1 Schedule K, lines 12 through 13d, and 21 . . . . . . . . . . . . . . . . . . . . (i) Corporate (ii) Individual (iii) Individual (iv) Partnership (v) Exempt 2 Analysis by (active) (passive) Organization partner type: a General partners b Limited partners

292,524

Schedule L 1 2a b 3 4 5 6 7a b 8 9a b 10a b 11 12a b 13 14 15 16 17 18 19a b 20 21 22

Schedule M-1

(vi) Nominee/Other

311,286

Balance Sheets per Books

Assets Cash . . . . . . . . . . . . . . . . Trade notes and accounts receivable . . . . . . Less allowance for bad debts . . . . . . . . Inventories . . . . . . . . . . . . . . U.S. Government obligations . . . . . . . . Tax-exempt securities . . . . . . . . . . Other current assets (attach statement) . . . . . Loans to partners (or persons related to partners) . Mortgage and real estate loans . . . . . . . Other investments (attach statement) . . . . . . Buildings and other depreciable assets . . . . . Less accumulated depreciation . . . . . . . Depletable assets . . . . . . . . . . . . Less accumulated depletion . . . . . . . . Land (net of any amortization) . . . . . . . . Intangible assets (amortizable only) . . . . . . Less accumulated amortization . . . . . . . Other assets (attach statement) . . . . . . . Total assets . . . . . . . . . . . . . . Liabilities and Capital Accounts payable . . . . . . . . . . . . Mortgages, notes, bonds payable in less than 1 year Other current liabilities (attach statement) . . . . All nonrecourse loans . . . . . . . . . . . Loans from partners (or persons related to partners) . Mortgages, notes, bonds payable in 1 year or more . Other liabilities (attach statement) . . . . . . . Partners’ capital accounts . . . . . . . . . Total liabilities and capital . . . . . . . . .

603,810

Beginning of tax year (a) (b)

72,600

End of tax year (c)

10,000

(d)

150,100

72,600 200,050

150,100 146,000 80,000 180,000

220,000 337,434 123,318

40,000

465,000 173,100

214,116

291,900

185,000

240,000

901,766

1,128,000

35,000 44,000 22,616

46,000 52,000 31,666

210,000

275,000

590,150 901,766

723,334 1,128,000

Reconciliation of Income (Loss) per Books With Analysis of Net Income (Loss) per Return

Note: The partnership may be required to file Schedule M-3. See instructions. Net income (loss) per books . . . . 6 Income recorded on books this year not included on Schedule K, lines 1 through 11 (itemize): 2 Income included on Schedule K, lines 1, 2, 3c, a Tax-exempt interest $ 5, 6a, 7, 8, 9a, 10, and 11, not recorded on books this year (itemize): 3 Guaranteed payments (other than health 7 Deductions included on Schedule K, insurance) . . . . . . . . . . lines 1 through 13d, and 21, not charged against book income this year (itemize): 4 Expenses recorded on books this year a Depreciation $ not included on Schedule K, lines 1 through 13d, and 21 (itemize): a Depreciation $ 8 Add lines 6 and 7 . . . . . . . . b Travel and entertainment $ 9 Income (loss) (Analysis of Net Income 5 Add lines 1 through 4 . . . . . . (Loss), line 1). Subtract line 8 from line 5

520,810

2,000

85,000

Schedule M-2 1 2 3 4 5

605,810

Analysis of Partners’ Capital Accounts

Balance at beginning of year . . Capital contributed: a Cash . . b Property . Net income (loss) (see instructions)

. . . .

Tax-exempt Other increases (itemize): interest Add lines 1 through 4 .

590,150

603,810 2,000 1,195,960

. .

Distributions: a Cash . . b Property . Other decreases (itemize):

Add lines 6 and 7 .

Balance at end of year. Subtract line 8 from line 5

Guaranteed payments .

. .

2,000 603,810 387,626 85,000 472,626 723,334

Form 1065 (2022)

C:9-57 Dapper - Dons Partnership XX-XXXXXXX 2022 Form 1065 Page 1, Line 20 - Other deductions Utilities expense Automobile expense Office supplies expense Advertising expense Travel expense ($11,020 − $4,050) Meals expense (100% deductible in 2022) Accounting and legal expense Total Page 4, Schedule K, Line Item Analysis Line No. Total 1 4 6a 8 9a 10 13a

$527,235 85,000 11,000 (26,075) 18,000 5,050 (16,400) $603,810

Dapper (40%) $210,894 85,000 4,400 (10,430) 7,200 2,020 (6,560) $292,524

$ 46,428 12,085 4,420 85,000 6,970 4,050 3,600 $162,553 Dons (60%) $316,341 -06,600 (15,645) 10,800 3,030 (9,840) $311,286

Page 5, Schedule L - Balance Sheet Line 6 - Other current assets

Marketable securities

Beginning of Tax Year $220,000

End of Tax Year $180,000

Beginning of Tax Year $14,000 3,416 5,200 $22,616

End of Tax Year $18,000 7,106 6,560 $31,666

Line 17 - Other current liabilities

Accrued salaries payable Payroll taxes payable Sales taxes payable

C:9-57 SCHEDULE D (Form 1065) Department of the Treasury Internal Revenue Service

Capital Gains and Losses

OMB No. 1545-0123

Attach to Form 1065 or Form 8865. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9, and 10. Go to www.irs.gov/Form1065 for instructions and the latest information.

2022

Employer identification number

Name of partnership

XX-XXXXXXX

Dapper-Dons Partnership

. . . . If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

Part I

Yes

X No

Short-Term Capital Gains and Losses—Generally Assets Held One Year or Less (see instructions)

lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

73,925

100,000

(g) (h) Gain or (loss) Adjustments Subtract column (e) to gain or loss from from column (d) and Form(s) 8949, Part I, combine the result with line 2, column (g) column (g)

4 Short-term capital gain from installment sales from Form 6252, line 26 or 37 .

(26,075)

5 Short-term capital gain or (loss) from like-kind exchanges from Form 8824 . . . . . . . 6 Partnership’s share of net short-term capital gain (loss), including specially allocated short-term capital gains (losses), from other partnerships, estates, and trusts . . . . . . . . . . 7 Net short-term capital gain or (loss). Combine lines 1a through 6 in column (h). Enter here and on Form 1065, Schedule K, line 8 or 11; or Form 8865, Schedule K, line 8 or 11 . . . . . .

Part II

4 5 6 7

(26,075)

Long-Term Capital Gains and Losses—Generally Assets Held More Than One Year (see instructions)

lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

(g) (h) Gain or (loss) Adjustments Subtract column (e) to gain or loss from from column (d) and Form(s) 8949, Part II, combine the result with line 2, column (g) column (g)

8a Totals for all long-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 8b . 8b Totals for all transactions reported on Form(s) 8949 with Box D checked . . . . . . . . . . . 9 Totals for all transactions reported on Form(s) 8949 with Box E checked . . . . . . . . . . . . 10 Totals for all transactions reported on Form(s) 8949 with Box F checked . . . . . . . . . . . . 11 Long-term capital gain from installment sales from Form 6252, line 26 or 37 . . . . . . . 12 Long-term capital gain or (loss) from like-kind exchanges from Form 8824 . . . . . . . 13 Partnership’s share of net long-term capital gain (loss), including specially allocated long-term capital gains (losses), from other partnerships, estates, and trusts . . . . . . . . . . 14 Capital gain distributions (see instructions) . . . . . . . . . . . . . . . . . . 15 Net long-term capital gain or (loss). Combine lines 8a through 14 in column (h). Enter here and on Form 1065, Schedule K, line 9a or 11; or Form 8865, Schedule K, line 9a or 11 . . . . .

58,000

For Paperwork Reduction Act Notice, see the Instructions for Form 1065.

Note: Form 8949 not attached. *CD stock: acquired 2/12/22; sold 8/03/22. **AB stock: acquired 12/03/20; sold 6/16/22.

40,000

Cat. No. 11393G

18,000

11 12 13 14 15

18,000 Schedule D (Form 1065) 2022

C:9-57 Form

1125-A

Cost of Goods Sold

(Rev. November 2018)

OMB No. 1545-0123

Attach to Form 1120, 1120-C, 1120-F, 1120S, or 1065. Go to www.irs.gov/Form1125A for the latest information.

Department of the Treasury Internal Revenue Service Name

Employer identification number

Dapper-Dons Partnership

Inventory at beginning of year Purchases . . . . . .

. .

1 2

3 4 5

Cost of labor . . . . . . . . . . . Additional section 263A costs (attach schedule) . Other costs (attach schedule) . . . . . .

. . .

3 4 5

6 7

Total. Add lines 1 through 5 . Inventory at end of year . .

. .

6 7

Cost of goods sold. Subtract line 7 from line 6. Enter here and on Form 1120, page 1, line 2 or the appropriate line of your tax return. See instructions . . . . . . . . . . . . . . .

Check all methods used for valuing closing inventory:

Lower of cost or market (ii) Other (Specify method used and attach explanation.) (iii) Check if there was a writedown of subnormal goods . .

Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970)

e f

. .

XX-XXXXXXX 200,050 624,000 600,000

1 2

. .

54,000 1,478,050 146,000 1,332,050

(i) ✓ Cost

Was there any change in determining quantities, cost, or valuations between opening and closing inventory? If “Yes,” attach explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section references are to the Internal Revenue Code unless otherwise noted.

What’s New

General Instructions Purpose of Form Use Form 1125-A to calculate and deduct cost of goods sold for certain entities.

Who Must File Filers of Form 1120, 1120-C, 1120-F, 1120S, or 1065, must complete and attach Form 1125-A if the applicable entity reports a deduction for cost of goods sold.

Inventories Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of

For Paperwork Reduction Act Notice, see instructions.

Yes

✓ No

Yes

✓ No

Cat. No. 55988R

Form 1125-A (Rev. 11-2018)

C:9-57

4797

Form

Department of the Treasury Internal Revenue Service

Sales of Business Property

OMB No. 1545-0184

(Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2))

2022

Attach to your tax return. Go to www.irs.gov/Form4797 for instructions and the latest information.

Attachment Sequence No. 27

Identifying number

Name(s) shown on return

Dapper-Dons Partnership

XX-XXXXXXX

Enter the total amount of gain that you are including on lines 2, 10, and 24 due to the partial dispositions of MACRS assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Enter the total amount of loss that you are including on lines 2 and 10 due to the partial dispositions of MACRS assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part I

Land

(b) Date acquired (mo., day, yr.)

(d) Gross sales price

03/17/18

08/15/22

35,050

(e) Depreciation allowed or allowable since acquisition

(f) Cost or other basis, plus improvements and expense of sale

(g) Gain or (loss) Subtract (f) from the sum of (d) and (e)

30,000

5,050

Gain, if any, from Form 4684, line 39

4 5 6

. . .

4 5 6

Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows

5,050

Partnerships and S corporations. Report the gain or (loss) following the instructions for Form 1065, Schedule K, line 10, or Form 1120-S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below.

8 9

Part II

Ordinary Gains and Losses (see instructions)

Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):

Loss, if any, from line 7

11 (

12 13 14

Gain, if any, from line 7 or amount from line 8, if applicable . Gain, if any, from line 31 . . . . . . . . . . . Net gain or (loss) from Form 4684, lines 31 and 38a . . .

. . .

12 13 14

15 16 17

Ordinary gain from installment sales from Form 6252, line 25 or 36 Ordinary gain or (loss) from like-kind exchanges from Form 8824 . Combine lines 10 through 16. . . . . . . . . . . .

. . .

15 16 17

For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines a and b below. For individual returns, complete lines a and b below.

18a

b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Schedule 1 (Form 1040), Part I, line 4 . . . . . . . . . . . . . . . . . . . . . . . . . .

18b

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 13086I

)

Form 4797 (2022)

C:9-57 651121 Final K-1

2022

Schedule K-1 (Form 1065) Department of the Treasury Internal Revenue Service /

2022

ending

Partner’s Share of Income, Deductions, See separate instructions. Credits, etc. Part I

Information About the Partnership

Partnership’s employer identification number

Partnership’s name, address, city, state, and ZIP code

xx-xxxxxxx

Dapper-Dons Partnership 123 Flamingo Drive City, ST 54321

Center City, ST

IRS center where partnership filed return:

D E F

Information About the Partner

H1 H2

Self-employment earnings (loss)

Ordinary business income (loss)

Net rental real estate income (loss)

A C

Other net rental income (loss)

Credits

Guaranteed payments for services

Guaranteed payments for capital

Schedule K-3 is attached if checked . . . . .

Total guaranteed payments

Alternative minimum tax (AMT) items

Interest income

Ordinary dividends

Qualified dividends

Tax-exempt income and nondeductible expenses

Dividend equivalents

Royalties

Net short-term capital gain (loss)

316,341

6,600 6,600

Partner’s SSN or TIN (Do not use TIN of a disregarded entity. See instructions.)

xxx-xx-xxxx

x x

(15,645)

General partner or LLC member-manager

Limited partner or other LLC member

Net long-term capital gain (loss)

Domestic partner

Foreign partner

Collectibles (28%) gain (loss)

Unrecaptured section 1250 gain

10,800

If the partner is a disregarded entity (DE), enter the partner’s: TIN

Name

Individual

What type of entity is this partner?

If this partner is a retirement plan (IRA/SEP/Keogh/etc.), check here

Net section 1231 gain (loss)

Partner’s share of profit, loss, and capital (see instructions): Beginning Ending

Other income (loss)

Section 179 deduction

Other deductions

60 % 60 % 60 %

Profit Loss Capital

60 % 60 % 60 %

Check if decrease is due to sale or exchange of partnership interest K

*316,341 *551,970

1,200

Name, address, city, state, and ZIP code for partner entered in E. See instructions.

Jeremy Dons 807 Ninth Avenue City, ST 54321 G

Check if this is a publicly traded partnership (PTP)

Part II

OMB No. 1545-0123

Part III Partner’s Share of Current Year Income, Deductions, Credits, and Other Items

For calendar year 2022, or tax year

beginning

Amended K-1

. .

Distributions

Other information

232,576

*See schedule on next page.

3,030

Foreign taxes paid or accrued

Partner’s share of liabilities: Beginning Nonrecourse

Qualified nonrecourse financing . . .

Recourse

Ending

186,970

9,840

242,800

Check this box if Item K includes liability amounts from lower tier partnerships Partner’s Capital Account Analysis Beginning capital account

Capital contributed during the year .

Current year net income (loss) .

Other increase (decrease) (attach explanation) $

Withdrawals and distributions .

Ending capital account

362,286 (49,800) 232,576 434,000

)

If “Yes,” attach statement. See instructions.

Partner’s Share of Net Unrecognized Section 704(c) Gain or (Loss) Beginning

Ending .

For Paperwork Reduction Act Notice, see the Instructions for Form 1065.

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

*See attached statement for additional information.

Did the partner contribute property with a built-in gain (loss)? Yes

354,090

0 0

For IRS Use Only

www.irs.gov/Form1065

Cat. No. 11394R

Schedule K-1 (Form 1065) 2021

C:9-57 Dapper-Dons Partnership XX-XXXXXXX 2022 Form 1065 Schedule K-1 Jeremy Dons – Part II, Item L, Partner᾽s Capital Account Analysis: This analysis is done using tax basis capital account numbers, which are the same as the Sec. 704(b) book numbers for this partnership. The “Other increase (decrease)” relates to tax-exempt interest and guaranteed payments (see Form 1065 Schedule M-2). Schedule K-1 Jeremy Dons – Part III, 14, Self-employment earnings: $316,341 ordinary income from Line 1 [($1,004,950 gross profit – $85,000 guar. pmt. to Bob) × 0.60]

A $316,341 C $551,970

Schedule K-1 Jeremy Dons – Part III, 20, Other information: Investment income [dividends are inv. inc. only to the extent a partner elects to tax them at ordinary rates under Sec. 163(d)(4)(B)] Sec. 199A QBI (Ordinary income from Line 1) Sec. 199A W-2 wages (including wages from Form 1125-A, Line 3; $651,000 × 0.60) Sec. 199A unadjusted basis of property ($465,000 × 0.60)

A Z

6,600 316,341

Z Z

390,600 279,000

C:9-57 651121 Final K-1

2022

Schedule K-1 (Form 1065) Department of the Treasury Internal Revenue Service /

2022

ending

Partner’s Share of Income, Deductions, See separate instructions. Credits, etc. Part I A

Self-employment earnings (loss)

Ordinary business income (loss)

Net rental real estate income (loss)

A C

Other net rental income (loss)

Credits

Guaranteed payments for services

Guaranteed payments for capital

Schedule K-3 is attached if checked . . . . .

Total guaranteed payments

Alternative minimum tax (AMT) items

Interest income

Ordinary dividends

Qualified dividends

Tax-exempt income and nondeductible expenses

Dividend equivalents

Royalties

Net short-term capital gain (loss)

210,894

Information About the Partnership

85,000

Partnership’s employer identification number

xx-xxxxxxx

OMB No. 1545-0123

Part III Partner’s Share of Current Year Income, Deductions, Credits, and Other Items

For calendar year 2022, or tax year

beginning

Amended K-1

Partnership’s name, address, city, state, and ZIP code

Dapper-Dons Partnership 123 Flamingo Drive City, ST 54321

Center City, ST

IRS center where partnership filed return:

85,000 4,400

Check if this is a publicly traded partnership (PTP)

Part II E F

Information About the Partner

xxx-xx-xxxx

H1 H2

x x

(10,430)

General partner or LLC member-manager

Limited partner or other LLC member

Net long-term capital gain (loss)

Domestic partner

Foreign partner

Collectibles (28%) gain (loss)

Unrecaptured section 1250 gain

7,200

If the partner is a disregarded entity (DE), enter the partner’s: TIN

Name

Individual

What type of entity is this partner?

If this partner is a retirement plan (IRA/SEP/Keogh/etc.), check here

Net section 1231 gain (loss)

Partner’s share of profit, loss, and capital (see instructions): Beginning Ending

Other income (loss)

Section 179 deduction

Other deductions

40 % 40 % 40 %

Profit Loss Capital

40 % 40 % 40 %

Check if decrease is due to sale or exchange of partnership interest K

800

Name, address, city, state, and ZIP code for partner entered in E. See instructions.

Bob Dapper 709 Brumby Way City, ST 54321 G

4,400

Partner’s SSN or TIN (Do not use TIN of a disregarded entity. See instructions.)

*295,894 *452,980

. .

Distributions

Other information

155,050

*See schedule on next page.

2,020

Foreign taxes paid or accrued

Partner’s share of liabilities: Beginning Nonrecourse

Qualified nonrecourse financing . . .

Recourse

Ending

124,646

$ $

6,560

161,866

Check this box if Item K includes liability amounts from lower tier partnerships Partner’s Capital Account Analysis Beginning capital account

Capital contributed during the year .

Current year net income (loss) .

Other increase (decrease) (attach explanation) $

Withdrawals and distributions .

Ending capital account

241,524 (33,200) 155,050 289,334

)

If “Yes,” attach statement. See instructions.

Partner’s Share of Net Unrecognized Section 704(c) Gain or (Loss) Beginning

Ending .

For Paperwork Reduction Act Notice, see the Instructions for Form 1065.

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

*See attached statement for additional information.

Did the partner contribute property with a built-in gain (loss)? Yes

236,060

0 0

For IRS Use Only

www.irs.gov/Form1065

Cat. No. 11394R

Schedule K-1 (Form 1065) 2021

C:9-57 Dapper-Dons Partnership XX-XXXXXXX 2022 Form 1065 Schedule K-1 Bob Dapper – Part II, Item L, Partner’s Capital Account Analysis: This analysis is done using tax basis capital account numbers, which are the same as the Sec. 704(b) book numbers for this partnership. The “Other increase (decrease)” relates to tax-exempt interest and guaranteed payments (see Form 1065 Schedule M-2). Schedule K-1 Bob Dapper – Part III, 14, Self-employment earnings: $210,894 ordinary income + $85,000 guaranteed payment [($1,004,950 gross profit – $85,000 guar. pmt.) × 0.40] + $85,000

A $295,894 C $452,980

Schedule K-1 Bob Dapper – Part III, 20, Other information: Investment income [dividends are inv. inc. only to the extent a partner elects to tax them at ordinary rates under Sec. 163(d)(4)(B)] Sec. 199A QBI (Ordinary income from Line 1) Sec. 199A W-2 wages (including wages from Form 1125-A, Line 3; $651,000 × 0.40) Sec. 199A unadjusted basis of property ($465,000 × 0.40)

A Z

4,400 210,894

Z Z

260,400 186,000

C:9-58 Form

1065

U.S. Return of Partnership Income For calendar year 2022, or tax year beginning

Department of the Treasury Internal Revenue Service

Manufacturing Med. Equip.

C Business code number

, 2022, ending

, 20

2022

Go to www.irs.gov/Form1065 for instructions and the latest information.

A Principal business activity B Principal product or service

OMB No. 1545-0123

Name of partnership

D Employer identification number

Number, street, and room or suite no. If a P.O. box, see instructions.

E Date business started

City or town, state or province, country, and ZIP or foreign postal code

F Total assets (see instructions)

Healthwise Medical Supplies Company

Type or Print

XX-2024022 1/1/21

2400 Second Street City, ST 12345

339110

(1) (1)

4,612,280

(2) (3) Initial return Final return Name change (4) Address change (5) Amended return (2) ✓ Accrual (3) Cash Other (specify): H Check accounting method: I Number of Schedules K-1. Attach one for each person who was a partner at any time during the tax year: J Check if Schedules C and M-3 are attached . . . . . . . . . . . . . . . . . . . . . . . . . . . . . K Check if partnership: (1) Aggregated activities for section 465 at-risk purposes (2) Grouped activities for section 469 passive activity purposes

G Check applicable boxes:

Income

7,000,000 350,000

6,650,000 2,520,000 4,130,000

Deductions (see instructions for limitations)

4,130,000 980,000 200,000 45,500

391,840*

210,000 98,000 33,600 391,840

Tax and Payment

280,000 2,238,940 1,891,060

Sign Here

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than partner or limited liability company member) is based on all information of which preparer has any knowledge.

Leisa H. Bailey Signature of partner or limited liability company member

Paid Preparer Use Only

Print/Type preparer’s name

Preparer’s signature

Date

3-11-23 Date

Firm’s name

May the IRS discuss this return with the preparer shown below? See instructions. Yes No Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11390Z

Form 1065 (2022)

C:9-58 Page 2

Form 1065 (2022)

Schedule B 1 a c e 2 a

Other Information

Yes

✓ ✓

(ii) Employer Identification Number (if any)

(iii) Country of Incorporation

✓

(iv) Percentage Owned in Voting Stock

(ii) Employer Identification Number (if any)

(iii) Type of Entity

(iv) Country of Organization

✓

(v) Maximum Percentage Owned in Profit, Loss, or Capital

Yes

✓

5 6

✓

7 8

10a

*Schedule B-1 is not attached. If attached, with these facts, it would list Thomas J. Firth, who owns a 70% interest.

✓ ✓

✓ ✓ ✓ ✓

Form 1065 (2022)

C:9-58 Page 3

Form 1065 (2022)

Schedule B

Other Information (continued)

At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property? . . . . . . . . . . . . . . . . . . . . . . . .

Yes

✓

✓ ✓

0 0

21 22

Is the partnership a section 721(c) partnership, as defined in Regulations section 1.721(c)-1(b)(14)? .

✓ ✓ ✓ ✓ ✓ ✓

✓

Reserved for future use

✓

Designation of Partnership Representative (see instructions) Enter below the information for the partnership representative (PR) for the tax year covered by this return. Name of PR U.S. address of PR

Leisa H. Bailey

U.S. phone number of PR

(XXX) XXX-XXXX

If the PR is an entity, name of the designated individual for the PR U.S. address of designated individual

1200 First Pike City, ST 12345

U.S. phone number of designated individual

Form 1065 (2022)

C:9-58 Page 4

Form 1065 (2022)

Other Information

Alternative Minimum Tax (AMT) Items

International

Credits

SelfEmploy- Deductions ment

Income (Loss)

Schedule K 1 2 3a b c 4 5 6 7 8 9a b c 10 11 12 13a b c d 14a b c 15a b c d e f

Partners’ Distributive Share Items

Total amount

Ordinary business income (loss) (page 1, line 22) . . . . . . . . . . . . . . . Net rental real estate income (loss) (attach Form 8825) . . . . . . . . . . . . . Other gross rental income (loss) . . . . . . . . . . . . . 3a Expenses from other rental activities (attach statement) . . . . . 3b Other net rental income (loss). Subtract line 3b from line 3a . . . . . . . . . . . . Guaranteed payments: a Services 4a b Capital 4b c Total. Add lines 4a and 4b . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends and dividend equivalents: a Ordinary dividends . . . . . . . . . . . . b Qualified dividends 6b c Dividend equivalents 6c Royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net short-term capital gain (loss) (attach Schedule D (Form 1065)) . . . . . . . . . . Net long-term capital gain (loss) (attach Schedule D (Form 1065)) . . . . . . . . . . Collectibles (28%) gain (loss) . . . . . . . . . . . . . . 9b Unrecaptured section 1250 gain (attach statement) . . . . . . 9c Net section 1231 gain (loss) (attach Form 4797) . . . . . . . . . . . . . . . . Other income (loss) (see instructions) Type: Section 179 deduction (attach Form 4562) . . . . . . . . . . . . . . . . . Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment interest expense . . . . . . . . . . . . . . . . . . . . . . Section 59(e)(2) expenditures: (2) Amount: (1) Type: Other deductions (see instructions) Type: Net earnings (loss) from self-employment . . . . . . Gross farming or fishing income . . . . . . . . . . . . . . . . . . . . . Gross nonfarm income . . . . . . . . . . . . . Low-income housing credit (section 42(j)(5)) Low-income housing credit (other) . . . . . . . . . . . . . . . . . . . . Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) . . Other rental real estate credits (see instructions) Type: Other rental credits (see instructions) Type: Other credits (see instructions) Type:

200,000

26,400

Investment expenses (1,891,060 + 200,000)

(From Page 1, Line 3)

Attach Schedule K-2 (Form 1065), Partners’ Distributive Share Items—International, and check this box to indicate that you are reporting items of international tax relevance . . . . .

17a b c d e f 18a b c 19a b 20a b c 21

1 2

1,891,060

3c 4c 5 6a

200,000 26,400

7 8 9a

1,344,000

10 11 12 13a 13b

700,000 56,000 4,200

13c(2)

13d 14a 14b 14c 15a 15b 15c 15d 15e 15f

. . . . . . . . . . . . .

17a 17b 17c 17d 17e 17f 18a 18b 18c 19a 19b 20a 20b

7,200 2,091,060 4,130,000

2,000 2,000,000 26,400* 7,200 Form 1065 (2022)

*Investment income if partners elect to tax dividends at ordinary rates under Sec. 163(d)(4)(B).

C:9-58 Page 5

Form 1065 (2022)

Analysis of Net Income (Loss) per Return 1

2,694,060 (vi) Nominee/Other

2,694,060

Schedule L 1 2a b 3 4 5 6 7a b 8 9a b 10a b 11 12a b 13 14 15 16 17 18 19a b 20 21 22

Balance Sheets per Books

Schedule M-1

Beginning of tax year (a) (b)

756,000 -0-

1,600,000 228,640

End of tax year (c)

958,900

(d)

840,000 -0-

756,000 1,400,000

1,062,760 840,000 1,680,000

50,000

480,000

-0-

2,300,000 1,371,360 1,320,480

979,520

5,016,260

4,612,280

140,000 700,000 4,900

182,000 140,000 6,860

4,171,360 5,016,260

4,283,420 4,612,280

Reconciliation of Income (Loss) per Books With Analysis of Net Income (Loss) per Return

2,112,060

Precontrib. gain

2,000

384,000

2,000

200,000

Schedule M-2 1 2 3 4 5

2,696,060

Analysis of Partners’ Capital Accounts

Balance at beginning of year . . Capital contributed: a Cash . . b Property . Net income (loss) (see instructions)

. . . .

3,787,360* 6

2,694,060 Tax-exempt 2,000 Other increases (itemize): interest Add lines 1 through 4 . . . . . . 6,483,420

. .

Distributions: a Cash . . b Property . Other decreases (itemize):

Add lines 6 and 7 .

Balance at end of year. Subtract line 8 from line 5

. .

Guaranteed payments .

. .

2,000 2,694,060 2,000,000 200,000 2,200,000 4,283,420

Form 1065 (2022)

*The Schedule L balance sheet reports Sec. 704(b) book amounts, including Line 21, partners’ capital accounts. Schedule M-2 reports partners’ capital accounts using tax basis amounts consistent with Item L in Schedules K-1. If the Schedule M-2 analysis were done using Sec. 704(b) book numbers, the amounts for Lines 1, 3, and 5 would be $4,171,360 + $2,112,060 = $6,283,420, which, after subtracting $2,000,000, tie to Schedule L, Line 21 above.

C:9-58 Healthwise Medical Supplies Company XX-2024022 2022 Form 1065 Page 1, Line 20 - Other deductions General insurance Travel Utilities Advertising expense Professional fees Business meals Total

$ 49,000 28,000 84,000 42,000 70,000 7,000 $280,000

C:9-58 SCHEDULE D (Form 1065) Department of the Treasury Internal Revenue Service

Capital Gains and Losses

OMB No. 1545-0123

Attach to Form 1065 or Form 8865. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9, and 10. Go to www.irs.gov/Form1065 for instructions and the latest information.

2022

Employer identification number

Name of partnership

XX-2024022

Healthwise Medical Supplies Company

qualified . . . . . If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

Part I

Yes

X No

Short-Term Capital Gains and Losses—Generally Assets Held One Year or Less (see instructions)

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(g) (h) Gain or (loss) Adjustments Subtract column (e) to gain or loss from from column (d) and Form(s) 8949, Part I, combine the result with column (g) line 2, column (g)

(e) Cost (or other basis)

Part II

4 5 6 7

Long-Term Capital Gains and Losses—Generally Assets Held More Than One Year (see instructions)

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

(g) (h) Gain or (loss) Adjustments Subtract column (e) to gain or loss from from column (d) and Form(s) 8949, Part II, combine the result with column (g) line 2, column (g)

8a Totals for all long-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 8b . 8b Totals for all transactions reported on Form(s) 8949 with Box D checked . . . . . . . . . . . . 9 Totals for all transactions reported on Form(s) 8949 with Box E checked . . . . . . . . . . . . 10 Totals for all transactions reported on Form(s) 8949 with Box F checked . . . . . . . . . . . . 11 Long-term capital gain from installment sales from Form 6252, line 26 or 37 . . . . . . . 12 Long-term capital gain or (loss) from like-kind exchanges from Form 8824 . . . . . . . 13 Partnership’s share of net long-term capital gain (loss), including specially allocated long-term capital gains (losses), from other partnerships, estates, and trusts . . . . . . . . . . 14 Capital gain distributions (see instructions) . . . . . . . . . . . . . . . . . . 15 Net long-term capital gain or (loss). Combine lines 8a through 14 in column (h). Enter here and on Form 1065, Schedule K, line 9a or 11; or Form 8865, Schedule K, line 9a or 11 . . . . .

1,440,000

For Paperwork Reduction Act Notice, see the Instructions for Form 1065.

96,000

Cat. No. 11393G

11 12

1,344,000

13 14 15

1,344,000 Schedule D (Form 1065) 2022

C:9-58 Form

8949

Department of the Treasury Internal Revenue Service Name(s) shown on return

Healthwise Medical Supplies Company

OMB No. 1545-0074

2022

Attachment Sequence No. 12A

Social security number or taxpayer identification number

XX-2024022

Part I

(b) Date acquired (Mo., day, yr.)

(d) Proceeds (sales price) (see instructions)

Cat. No. 37768Z

Form 8949 (2022)

C:9-58 Attachment Sequence No. 12A

Form 8949 (2022) Name(s) shown on return. Name and SSN or taxpayer identification no. not required if shown on other side

Healthwise Medical Supplies Company

Page 2

Social security number or taxpayer identification number

XX-2024022

Part II

(b) Date acquired (Mo., day, yr.)

(d) Proceeds (sales price) (see instructions)

1,000 sh. Fastgrowth, Inc. 01/02/19 07/06/22 1,440,000

96,000

1,344,000

96,000

1,344,000

1,440,000

C:9-58 Form

1125-A

Cost of Goods Sold

(Rev. November 2018)

OMB No. 1545-0123

Attach to Form 1120, 1120-C, 1120-F, 1120S, or 1065. Go to www.irs.gov/Form1125A for the latest information.

Department of the Treasury Internal Revenue Service Name

Employer identification number

Healthwise Medical Supplies Company

XX-2024022 1,400,000 2,800,000

1 2

Inventory at beginning of year Purchases . . . . . .

. .

1 2

Cost of labor

4 5

Additional section 263A costs (attach schedule) . Other costs (attach schedule) . . . . . .

. .

4 5

6 7

Total. Add lines 1 through 5 . Inventory at end of year . .

. .

6 7

4,200,000 1,680,000

Cost of goods sold. Subtract line 7 from line 6. Enter here and on Form 1120, page 1, line 2 or the appropriate line of your tax return. See instructions . . . . . . . . . . . . . . . Check all methods used for valuing closing inventory: (i) Cost

2,520,000

. .

Lower of cost or market (ii) Other (Specify method used and attach explanation.) (iii) Check if there was a writedown of subnormal goods . .

Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970)

e f

Was there any change in determining quantities, cost, or valuations between opening and closing inventory? If “Yes,” attach explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section references are to the Internal Revenue Code unless otherwise noted.

What’s New

General Instructions Purpose of Form Use Form 1125-A to calculate and deduct cost of goods sold for certain entities.

Who Must File Filers of Form 1120, 1120-C, 1120-F, 1120S, or 1065, must complete and attach Form 1125-A if the applicable entity reports a deduction for cost of goods sold.

Inventories Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of

For Paperwork Reduction Act Notice, see instructions.

Yes

Cat. No. 55988R

Form 1125-A (Rev. 11-2018)

C:9-58 Form

4562

Depreciation and Amortization

Name(s) shown on return

Healthwise Medical Supplies Company

1 2 3 4 5

Medical Equipment Manufacturing

Election To Expense Certain Property Under Section 179 Note: If you have any listed property, complete Part V before you complete Part I.

(a) Description of property

(b) Cost (business use only)

700,000

Equipment

Attachment Sequence No. 179 Identifying number

Business or activity to which this form relates

2022

Attach to your tax return. Go to www.irs.gov/Form4562 for instructions and the latest information.

Department of the Treasury Internal Revenue Service

Part I

OMB No. 1545-0172

(Including Information on Listed Property)

XX-2024022 1 2 3 4

700,000a 700,000 2,700,000 -0-

700,000

7 Listed property. Enter the amount from line 29 . . . . . . . . . 7 8 Total elected cost of section 179 property. Add amounts in column (c), lines 6 and 7 . . . . . . 8 700,000 9 Tentative deduction. Enter the smaller of line 5 or line 8 . . . . . . . . . . . . . . . . 9 700,000 10 Carryover of disallowed deduction from line 13 of your 2021 Form 4562 . . . . . . . . . . . 10 11 Business income limitation. Enter the smaller of business income (not less than zero) or line 5. See instructions 11 700,000 12 Section 179 expense deduction. Add lines 9 and 10, but don’t enter more than line 11 . . . . . . 12 700,000 . . 13 13 Carryover of disallowed deduction to 2023. Add lines 9 and 10, less line 12 Note: Don’t use Part II or Part III below for listed property. Instead, use Part V. Part II Special Depreciation Allowance and Other Depreciation (Don’t include listed property. See instructions.) 14 Special depreciation allowance for qualified property (other than listed property) placed in service during the tax year. See instructions . . . . . . . . . . . . . . . . . . . . . . . 14 15 Property subject to section 168(f)(1) election . . . . . . . . . . . . . . . . . . . . 15 16 Other depreciation (including ACRS) . . . . . . . . . . . . . . . . . . . . . . 16 Part III MACRS Depreciation (Don’t include listed property. See instructions.) Section A 17 17 MACRS deductions for assets placed in service in tax years beginning before 2022 . . . . . . . 391,840 18 If you are electing to group any assets placed in service during the tax year into one or more general asset accounts, check here . . . . . . . . . . . . . . . . . . . . . . . . Section B—Assets Placed in Service During 2022 Tax Year Using the General Depreciation System (a) Classification of property

(b) Month and year placed in service

(d) Recovery period

(e) Convention

(f) Method

(g) Depreciation deduction

Part IV

Summary (See instructions.)

Cat. No. 12906N

21 22

391,840b Form 4562 (2022)

aPer the worksheet in the instructions for Form 4562, Line 1 should be the lesser of the maximum Sec. 179 deduction ($1,080,000 in 2022) or the total cost of Sec. 179 property. bForm 4562 instructions say to omit Sec. 179 deduction from this line for partnerships.

C:9-58 651121 Final K-1

2022

Schedule K-1 (Form 1065) Department of the Treasury Internal Revenue Service /

2022

ending

Partner’s Share of Income, Deductions, See separate instructions. Credits, etc. Part I A

Information About the Partnership

XX-2024022

Self-employment earnings (loss)

Ordinary business income (loss)

Net rental real estate income (loss)

A C

Other net rental income (loss)

Credits

Guaranteed payments for services

Guaranteed payments for capital

Schedule K-3 is attached if checked . . . . .

Total guaranteed payments

Alternative minimum tax (AMT) items

Interest income

Ordinary dividends

Qualified dividends

Tax-exempt income and nondeductible expenses

Dividend equivalents

Royalties

Net short-term capital gain (loss)

567,318

200,000

Partnership’s name, address, city, state, and ZIP code

Healthwise Medical Supplies Company 2400 Second Street City, ST 12345

Center City, ST

IRS center where partnership filed return:

200,000

Check if this is a publicly traded partnership (PTP)

Part II E F

Information About the Partner

Partner’s SSN or TIN (Do not use TIN of a disregarded entity. See instructions.)

XXX-XX-XXXX

G H1 H2

7,920 7,920

*767,318 *1,379,000

600

Name, address, city, state, and ZIP code for partner entered in E. See instructions.

Leisa H. Bailey 1200 First Pike City, ST 12345

x x

General partner or LLC member-manager

Limited partner or other LLC member

Net long-term capital gain (loss)

Domestic partner

Foreign partner

Collectibles (28%) gain (loss)

Unrecaptured section 1250 gain

Net section 1231 gain (loss)

Other income (loss)

Section 179 deduction

Other deductions

*288,000

If the partner is a disregarded entity (DE), enter the partner’s: TIN

Name

Individual

What type of entity is this partner?

If this partner is a retirement plan (IRA/SEP/Keogh/etc.), check here

Partner’s share of profit, loss, and capital (see instructions): Beginning Ending

30 30 % 30 %

Profit

Loss Capital

. .

210,000

Partner’s share of liabilities: Beginning Nonrecourse

Qualified nonrecourse financing . . .

Recourse

Ending $

253,470

Distributions

Other information

600,000

*See schedule on next page

Check if decrease is due to sale or exchange of partnership interest K

Partnership’s employer identification number

OMB No. 1545-0123

Part III Partner’s Share of Current Year Income, Deductions, Credits, and Other Items

For calendar year 2022, or tax year

beginning

Amended K-1

Foreign taxes paid or accrued

*See schedule on next page

98,658

Check this box if Item K includes liability amounts from lower tier partnerships Beginning capital account

Capital contributed during the year .

Current year net income (loss) .

Other increase (decrease) (attach explanation) $

Withdrawals and distributions .

Ending capital account

*693,018 *(59,400) 600,000 ) 1,285,026

Did the partner contribute property with a built-in gain (loss)?

Yes N

1,251,408

If “Yes,” attach statement. See instructions.

Partner’s Share of Net Unrecognized Section 704(c) Gain or (Loss) Beginning

Ending .

0 0

For Paperwork Reduction Act Notice, see the Instructions for Form 1065.

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

*See attached statement for additional information.

For IRS Use Only

Partner’s Capital Account Analysis

www.irs.gov/Form1065

Cat. No. 11394R

Schedule K-1 (Form 1065) 2021

C:9-58 Healthwise Medical Supplies Company XX-2024022 2022 Form 1065 Schedule K-1 Bailey – Part II, L, Current year increase: This analysis is done using tax basis capital account numbers, which in Bailey’s case are the same as Sec. 704(b) book amounts. ($2,694,060 net income (loss) – $384,000 precontribution gain) × 0.30 $2,000 tax-exempt interest – $200,000 guaranteed payments) × 0.30

$693,018 ($59,400)

Schedule K-1 Bailey – Part III, 9a, Net LTCG: ($1,440,000 selling price – $480,000 book value) × 0.30

$288,000

Schedule K-1 Bailey – Part III, 13, Other deductions: Cash contribution Investment interest expense Investment expense

A H L

$16,800 1,260 2,160

$567,318 ordinary income + $200,000 guaranteed payment

$767,318

[($4,130,000 gross profit – $200,000 guar. pmt.) × 0.30] + $200,000

$1,379,000

Schedule K-1 Bailey – Part III, 14, Self-employment earnings:

Schedule K-1 Bailey – Part III, 20, Other information: Investment income [dividends are inv. inc. only to the extent a partner elects to tax them at ordinary rates under Sec. 163(d)(4)(B).] Investment expenses Sec. 199A QBI ($567,318 ord. inc. – $210,000 Sec. 179 exp.) Sec. 199A W-2 wages ($980,000 × 0.30) Sec. 199A unadjusted basis of property ($2,300,000 × 0.30)

A B Z Z Z

$7,920 2,160 357,318 294,000 690,000

Bailey’s basis in partnership interest (outside basis): Outside basis at 1/1/22

$1,504,878

Plus: Partnership ordinary income Dividend income Net long-term capital gain Tax-exempt income Minus: Distributions Decrease in share of partnership liabilities Sec. 179 expense Cash contribution Investment interest expense Investment expense Outside basis at 12/31/22

$567,318 7,920 288,000 600 $600,000 154,812 210,000 16,800 1,260 2,160

863,838

(985,032) $1,383,684

C:9-58 651121 Final K-1

2022

Schedule K-1 (Form 1065) Department of the Treasury Internal Revenue Service /

2022

ending

Partner’s Share of Income, Deductions, See separate instructions. Credits, etc. Part I

Information About the Partnership

Partnership’s employer identification number

Partnership’s name, address, city, state, and ZIP code

XX-2024022

Healthwise Medical Supplies Company 2400 Second Street City, ST 12345

Center City, ST

IRS center where partnership filed return:

D E F

Information About the Partner

H1 H2

XXX-XX-XXXX

Net rental real estate income (loss)

A C

Other net rental income (loss)

Credits

Guaranteed payments for services

Guaranteed payments for capital

Schedule K-3 is attached if checked . . . . .

Total guaranteed payments

Alternative minimum tax (AMT) items

Interest income

Ordinary dividends

Qualified dividends

Tax-exempt income and nondeductible expenses

Dividend equivalents

Royalties

Net short-term capital gain (loss)

1,323,742

18,480 18,480

1,323,742 *2,751,000

1,400

Name, address, city, state, and ZIP code for partner entered in E. See instructions.

x x

General partner or LLC member-manager

Limited partner or other LLC member

Net long-term capital gain (loss)

Domestic partner

Foreign partner

Collectibles (28%) gain (loss)

Unrecaptured section 1250 gain

Net section 1231 gain (loss)

Other income (loss)

Section 179 deduction

*1,056,000

If the partner is a disregarded entity (DE), enter the partner’s: TIN

Name

Individual

What type of entity is this partner?

If this partner is a retirement plan (IRA/SEP/Keogh/etc.), check here

Partner’s share of profit, loss, and capital (see instructions): Beginning Ending

70 70 % 70 %

Profit

Loss Capital

70 70 % 70 % . .

Partner’s share of liabilities: Beginning Nonrecourse

Qualified nonrecourse financing . . .

Recourse

Ending

591,430

Distributions

Other information

1,400,000

*See schedule on next page

Check if decrease is due to sale or exchange of partnership interest K

Self-employment earnings (loss)

Ordinary business income (loss)

Partner’s SSN or TIN (Do not use TIN of a disregarded entity. See instructions.)

Thomas J. Firth 3600 Third Blvd. City, ST 12345 G

Check if this is a publicly traded partnership (PTP)

Part II

OMB No. 1545-0123

Part III Partner’s Share of Current Year Income, Deductions, Credits, and Other Items

For calendar year 2022, or tax year

beginning

Amended K-1

Foreign taxes paid or accrued

Other deductions

*See schedule on next page

230,202

490,000

Check this box if Item K includes liability amounts from lower tier partnerships Beginning capital account

Capital contributed during the year .

Current year net income (loss) .

Other increase (decrease) (attach explanation) $

Withdrawals and distributions .

Ending capital account

*2,001,042 *(138,600) 1,400,000 ) 2,998,394

Did the partner contribute property with a built-in gain (loss)?

Yes N

*2,535,952

If “Yes,” attach statement. See instructions.

Partner’s Share of Net Unrecognized Section 704(c) Gain or (Loss) Beginning

Ending .

384,000 0

For Paperwork Reduction Act Notice, see the Instructions for Form 1065.

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

*See attached statement for additional information.

For IRS Use Only

Partner’s Capital Account Analysis

www.irs.gov/Form1065

Cat. No. 11394R

Schedule K-1 (Form 1065) 2021

C:9-58 Healthwise Medical Supplies Company XX-2024022 2022 Form 1065 Schedule K-1 Firth – Part II, L, Current year increase: This analysis is done using tax basis capital account numbers. $2,919,952 Firth’s beginning capital account balance per Sec. 704(b) book amount – $384,000 precontribution gain $2,535,952 (($2,694,060 net income (loss) – $384,000 precontribution gain) × 0.70) + $384,000 precontribution margin + (($2,000 tax-exempt interest – $200,000 guaranteed payments) × 0.70) $1,862,442 Check: Net tax based income ($2,399,622 – $537,180 from outside basis schedule below) $1,862,442 Schedule K-1 Firth – Part III, 9a, Net LTCG: ($1,440,000 selling price – $480,000 book value) × 0.70 $1,056,000 + $384,000 precontribution gain Schedule K-1 Firth – Part III, 13, Other deductions: Cash contribution Investment interest expense Investment expense Schedule K-1 Firth – Part III, 14, Self-employment earnings:

A H L

$39,200 2,940 5,040

Ordinary income from Line 1 [($4,130,000 gross profit – $200,000 guar. pmt.) × 0.70]

A C

$1,323,742 $2,751,000

A B Z Z Z

$18,480 5,040 833,192 686,000 1,610,000

Schedule K-1 Firth – Part III, 20, Other information: Investment income [dividends are inv. inc. only to the extent partner elects to tax them at ordinary rates under Sec. 163(d)(4)(B).] Investment expenses Sec. 199A QBI ($1,323,742 ord. inc. – $490,000 Sec. 179 exp.) Sec. 199A W-2 wages ($980,000 × 0.70) Sec. 199A unadjusted basis of property ($2,300,000 × 0.70) Firth’s basis in partnership interest (outside basis): Outside basis at 1/1/22 Plus: Partnership ordinary income $1,323,742 Dividend income 18,480 Net long-term capital gain 1,056,000 Tax-exempt income 1,400 Minus: Distributions $1,400,000 Decrease in share of partnership liabilities 361,228 Sec. 179 expense 490,000* Cash contribution 39,200* Investment interest expense 2,940* Investment expense 5,040* Outside basis at 12/31/22 Minus: Share of liabilities at 12/31/22 Tax basis capital account at 12/31/22 *Total expenses = $537,180 C:TRP-70 Copyright © 2024 Pearson Education, Inc.

$3,127,382

2,399,622

(2,298,408) $3,228,596 (230,202) $2,998,394

C:9-59 Page 4

Form 1065 (2022)

Other Information

Alternative Minimum Tax (AMT) Items

International

Credits

SelfEmploy- Deductions ment

Income (Loss)

Schedule K 1 2 3a b c 4 5 6 7 8 9a b c 10 11 12 13a b c d 14a b c 15a b c d e f

Partners’ Distributive Share Items

Total amount

See schedule on next page

. . . Ordinary business income (loss) (page 1, line 22) Net rental real estate income (loss) (attach Form 8825) . . . . . . . . . . . . . Other gross rental income (loss) . . . . . . . . . . . . . 3a Expenses from other rental activities (attach statement) . . . . . 3b Other net rental income (loss). Subtract line 3b from line 3a . . . . . . . . . . . . Guaranteed payments: a Services 4a b Capital 4b c Total. Add lines 4a and 4b . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends and dividend equivalents: a Ordinary dividends . . . . . . . . . . . . b Qualified dividends 6b c Dividend equivalents 6c Royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net short-term capital gain (loss) (attach Schedule D (Form 1065)) . . . . . . . . . . Net long-term capital gain (loss) (attach Schedule D (Form 1065)) . . . . . . . . . . Collectibles (28%) gain (loss) . . . . . . . . . . . . . . 9b Unrecaptured section 1250 gain (attach statement) . . . . . . 9c Net section 1231 gain (loss) (attach Form 4797) . . . . . . . . . . . . . . . . Other income (loss) (see instructions) Type: Section 179 deduction (attach Form 4562) . . . . . . . . . . . . . . . . . Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment interest expense . . . . . . . . . . . . . . . . . . . . . . Section 59(e)(2) expenditures: (2) Amount: (1) Type: Other deductions (see instructions) Type: Net earnings (loss) from self-employment . . . . . . . . . . . . . . . . . . Gross farming or fishing income . . . . . . . . . . . . . . . . . . . . . Gross nonfarm income . . . . . . . . . . . . . . . . . . . . . . . . Low-income housing credit (section 42(j)(5)) Low-income housing credit (other) . . . . . . . . . . . . . . . . . . . . Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) . . Other rental real estate credits (see instructions) Type: Other rental credits (see instructions) Type: Other credits (see instructions) Type:

30,000

15,000

Attach Schedule K-2 (Form 1065), Partners’ Distributive Share Items—International, and check this box to indicate that you are reporting items of international tax relevance . . . . .

17a b c d e f 18a b c 19a b 20a b c 21

1 2

172,000

3c 4c 5 6a 7 8 9a

10 11 12 13a 13b

30,000 15,000 (9,000) 2,000 18,000 5,000 9,200

13c(2)

13d 14a 14b 14c 15a 15b 15c 15d 15e 15f

. . . . . . . . . . . . .

17a 17b 17c 17d 17e 17f 18a 18b 18c 19a 19b 20a 20b

169,000a 240,000

4,000 2,800 80,000 15,000b Form 1065 (2022)

a$172,000 partnership ordinary income – $33,000 Sec. 1245 gain + $30,000 guaranteed payment. bInvestment income if partners elect to tax dividends at ordinary rates under Sec. 163(d)(4)(B).

C:9-59 MP Partnership 2022 Form 1065 Partnership ordinary income Schedule K, Line 1: Sales

$450,000

Minus: Cost of goods sold Gross profit Plus: Sec. 1245 gain Minus: Ordinary expenses: Depreciation Guaranteed payment Business interest Business meals (100%) Partnership ordinary income

(210,000) $240,000 33,000 $27,000 30,000 42,000 2,000

(101,000) $172,000

C:11-61 Form

1120-S

U.S. Income Tax Return for an S Corporation

OMB No. 1545-0123

Do not file this form unless the corporation has filed or is attaching Form 2553 to elect to be an S corporation. Go to www.irs.gov/Form1120S for instructions and the latest information.

2022

Department of the Treasury Internal Revenue Service

For calendar year 2022 or tax year beginning A S election effective date

01/24/2013

B Business activity code number (see instructions)

327210

TYPE OR PRINT

C Check if Sch. M-3 attached

G H I J

, 2022, ending

, 20

Name

D Employer identification number

Number, street, and room or suite no. If a P.O. box, see instructions.

E Date incorporated

City or town, state or province, country, and ZIP or foreign postal code

F Total assets (see instructions)

Bottle-Up, Inc.

XX-XXXXXXX

1234 Hill Street

1/08/2013

City, ST 33333

750,028

✓

Is the corporation electing to be an S corporation beginning with this tax year? See instructions. Yes No Check if: (1) Final return (2) Name change (3) Address change (4) Amended return (5) S election termination Enter the number of shareholders who were shareholders during any part of the tax year . . . . . . . . . Check if corporation: (1) Aggregated activities for section 465 at-risk purposes (2) Grouped activities for section 469 passive activity purposes

Caution: Include only trade or business income and expenses on lines 1a through 21. See the instructions for more information.

Tax and Payments

Deductions (see instructions for limitations)

Income

c 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22a b c 23a b c d 24 25 26 27

Sign Here

2,500,000 15,000

Gross receipts or sales . . . . . . . . . . . . . . . . 1a Returns and allowances . . . . . . . . . . . . . . . . 1b Balance. Subtract line 1b from line 1a . . . . . . . . . . . . . . . . . . . . Cost of goods sold (attach Form 1125-A) . . . . . . . . . . . . . . . . . . . Gross profit. Subtract line 2 from line 1c . . . . . . . . . . . . . . . . . . . Net gain (loss) from Form 4797, line 17 (attach Form 4797) . . . . . . . . . . . . . Other income (loss) (see instructions—attach statement) . . . . . . . . . . . . . . Total income (loss). Add lines 3 through 5 . . . . . . . . . . . . . . . . . . Compensation of officers (see instructions—attach Form 1125-E) . . . . . . . . . . . Salaries and wages (less employment credits) . . . . . . . . . . . . . . . . . Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . . Bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taxes and licenses . . . . . . . . . . . . . . . . . . . . . . . . . . Interest (see instructions) . . . . . . . . . . . . . . . . . . . . . . . . Depreciation from Form 4562 not claimed on Form 1125-A or elsewhere on return (attach Form 4562) Depletion (Do not deduct oil and gas depletion.) . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pension, profit-sharing, etc., plans . . . . . . . . . . . . . . . . . . . . . Employee benefit programs . . . . . . . . . . . . . . . . . . . . . . . Other deductions (attach statement) . . . . . . . . . . . . . . . . . . . . Total deductions. Add lines 7 through 19 . . . . . . . . . . . . . . . . . . Ordinary business income (loss). Subtract line 20 from line 6 . . . . . . . . . . . . Excess net passive income or LIFO recapture tax (see instructions) . . . 22a Tax from Schedule D (Form 1120-S) . . . . . . . . . . . . 22b Add lines 22a and 22b (see instructions for additional taxes) . . . . . . . . . . . . . 2022 estimated tax payments and 2021 overpayment credited to 2022 . 23a Tax deposited with Form 7004 . . . . . . . . . . . . . . 23b Credit for federal tax paid on fuels (attach Form 4136) . . . . . . . 23c Add lines 23a through 23c . . . . . . . . . . . . . . . . . . . . . . . Estimated tax penalty (see instructions). Check if Form 2220 is attached . . . . . . . . Amount owed. If line 23d is smaller than the total of lines 22c and 24, enter amount owed . . . Overpayment. If line 23d is larger than the total of lines 22c and 24, enter amount overpaid . . . Enter amount from line 26: Credited to 2023 estimated tax Refunded

1c 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

2,485,000 1,474,000 1,011,000 1,011,000 120,000 331,020 38,000 620 30,000 39,480 1,000 36,311 105,000 11,000 228,102 940,533 70,467

22c

23d 24 25 26 27

Paid Preparer Use Only

Henman Hiebert

Signature of officer

Print/Type preparer’s name

3/12/23

Date

Preparer’s signature

May the IRS discuss this return with the preparer shown below? Yes No See instructions.

Title Date

Firm’s name

Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11510H

Form 1120-S (2022)

C:11-61 Page 2

Form 1120-S (2022)

Schedule B 1 2 3 4

Other Information (see instructions)

Check accounting method:

a c See the instructions and enter the: a Business activity

Cash b Other (specify)

Manufacturing

x Accrual b Product or service

Yes No

Glass bottles

At any time during the tax year, was any shareholder of the corporation a disregarded entity, a trust, an estate, or a nominee or similar person? If “Yes,” attach Schedule B-1, Information on Certain Shareholders of an S Corporation . . At the end of the tax year, did the corporation: a Own directly 20% or more, or own, directly or indirectly, 50% or more of the total stock issued and outstanding of any foreign or domestic corporation? For rules of constructive ownership, see instructions. If “Yes,” complete (i) through (v) below . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (i) Name of Corporation

(ii) Employer Identification Number (if any)

(iii) Country of Incorporation

(i) Name of Entity

(iii) Type of Entity

(iv) Country of Organization

If “Yes,” complete lines (i) and (ii) below. (i) Total shares of stock outstanding at the end of the tax year . (ii) Total shares of stock outstanding if all instruments were executed

(v) Maximum Percentage Owned in Profit, Loss, or Capital

5 a At the end of the tax year, did the corporation have any outstanding shares of restricted stock? . . . . . . . If “Yes,” complete lines (i) and (ii) below. (i) Total shares of restricted stock . . . . . . . . . (ii) Total shares of non-restricted stock . . . . . . . . b At the end of the tax year, did the corporation have any outstanding stock options, warrants, or similar instruments?

(v) If Percentage in (iv) Is 100%, Enter the Date (if applicable) a Qualified Subchapter S Subsidiary Election Was Made

(iv) Percentage of Stock Owned

Has this corporation filed, or is it required to file, Form 8918, Material Advisor Disclosure Statement, to provide information on any reportable transaction? . . . . . . . . . . . . . . . . . . . . . . . . Check this box if the corporation issued publicly offered debt instruments with original issue discount . . . . .

If checked, the corporation may have to file Form 8281, Information Return for Publicly Offered Original Issue Discount Instruments. 8

If the corporation (a) was a C corporation before it elected to be an S corporation or the corporation acquired an asset with a basis determined by reference to the basis of the asset (or the basis of any other property) in the hands of a C corporation, and (b) has net unrealized built-in gain in excess of the net recognized built-in gain from prior years, enter the net unrealized built-in $ gain reduced by net recognized built-in gain from prior years. See instructions . . . . . . .

10 Does the corporation satisfy one or more of the following? See instructions . . . . . . . . . . . . . a The corporation owns a pass-through entity with current, or prior year carryover, excess business interest expense. b The corporation’s aggregate average annual gross receipts (determined under section 448(c)) for the 3 tax years preceding the current tax year are more than $27 million and the corporation has business interest expense. c The corporation is a tax shelter and the corporation has business interest expense. If “Yes,” complete and attach Form 8990, Limitation on Business Interest Expense Under Section 163(j).

x x

Does the corporation satisfy both of the following conditions? . . . . . . . . . a The corporation’s total receipts (see instructions) for the tax year were less than $250,000. b The corporation’s total assets at the end of the tax year were less than $250,000. If “Yes,” the corporation is not required to complete Schedules L and M-1.

Form 1120-S (2022)

C:11-61 Page 3

Form 1120-S (2022)

Schedule B 12

13 14a b 15

Yes

During the tax year, did the corporation have any non-shareholder debt that was canceled, was forgiven, or had the terms modified so as to reduce the principal amount of the debt? . . . . . . . . . . . . . . . . . If “Yes,” enter the amount of principal reduction . . . . . . . . . . . . . . . $ During the tax year, was a qualified subchapter S subsidiary election terminated or revoked? If “Yes,” see instructions . Did the corporation make any payments in 2022 that would require it to file Form(s) 1099? . . . . . . . . . . If “Yes,” did or will the corporation file required Form(s) 1099? . . . . . . . . . . . . . . . . . . . Is the corporation attaching Form 8996 to certify as a Qualified Opportunity Fund? . . . . . . . . . . . . If “Yes,” enter the amount from Form 8996, line 15 . . . . . . . . . . . . . . $

Alternative Minimum Tax (AMT) Items

International

Credits

Deductions

Income (Loss)

Schedule K

Items Affecting Shareholder Basis

Other Information (see instructions) (continued)

1 2 3a b c 4 5 6 7 8a b c 9 10 11 12a b c d 13a b c d e f g

Shareholders’ Pro Rata Share Items

x x x x

Total amount

Ordinary business income (loss) (page 1, line 21) . . . . . . . . . . . . . Net rental real estate income (loss) (attach Form 8825) . . . . . . . . . . . Other gross rental income (loss) . . . . . . . . . . . . 3a Expenses from other rental activities (attach statement) . . . . 3b Other net rental income (loss). Subtract line 3b from line 3a . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . Dividends: a Ordinary dividends . . . . . . . . . . . . . . . . . . b Qualified dividends . . . . . . . . . . . . 5b Royalties . . . . . . . . . . . . . . . . . . . . . . . . . Net short-term capital gain (loss) (attach Schedule D (Form 1120-S)) . . . . . . Net long-term capital gain (loss) (attach Schedule D (Form 1120-S)) . . . . . . . Collectibles (28%) gain (loss) . . . . . . . . . . . . . 8b Unrecaptured section 1250 gain (attach statement) . . . . . . 8c Net section 1231 gain (loss) (attach Form 4797) . . . . . . . . . . . . . Other income (loss) (see instructions) . . . Type: Section 179 deduction (attach Form 4562) . . . . . . . . . . . . . . . Charitable contributions . . . . . . . . . . . . . . . . . . . . Investment interest expense . . . . . . . . . . . . . . . . . . . Section 59(e)(2) expenditures . . . . . . Type: Other deductions (see instructions) . . . . Type: Low-income housing credit (section 42(j)(5)) . . . . . . . . . . . . . . Low-income housing credit (other) . . . . . . . . . . . . . . . . . Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) Other rental real estate credits (see instructions) Type: Other rental credits (see instructions) . . . Type: Biofuel producer credit (attach Form 6478) . . . . . . . . . . . . . . Other credits (see instructions) . . . . . Type:

. .

1 2

. . .

3c 4 5a

1,200 11,600

. . .

6 7 8a

48,666

. . .

9 10 11 12a 12b 12c 12d 13a 13b 13c 13d 13e 13f 13g

11,600

Investment expenses

Attach Schedule K-2 (Form 1120-S), Shareholders’ Pro Rata Share Items—International, and check this box to indicate you are reporting items of international tax relevance . . . .

15a b c d e f 16a b c d e f

Post-1986 depreciation adjustment . . . . . . . . Adjusted gain or loss . . . . . . . . . . . . Depletion (other than oil and gas) . . . . . . . . Oil, gas, and geothermal properties—gross income . . . Oil, gas, and geothermal properties—deductions . . . . Other AMT items (attach statement) . . . . . . . . Tax-exempt interest income . . . . . . . . . . Other tax-exempt income . . . . . . . . . . . Nondeductible expenses . . . . . . . . . . . Distributions (attach statement if required) (see instructions) Repayment of loans from shareholders . . . . . . . Foreign taxes paid or accrued . . . . . . . . .

. . . . . . . . . . . .

70,467

. .

. . . . . . . . . . . .

15a 15b 15c 15d 15e 15f 16a 16b 16c 16d 16e 16f

(1,100) 9,000 500 600

9,000

600 *12,500 70,000 Form 1120-S (2022)

C:11-61 Page 4

Form 1120-S (2022)

ReconOther ciliation Information

Schedule K

16 17 18 19 20 21 22 23 24 25 26 27

Total amount

17a b c d

Investment income . . . . . . . . . . . . . . . Investment expenses . . . . . . . . . . . . . . Dividend distributions paid from accumulated earnings and profits Other items and amounts (attach statement)

Income (loss) reconciliation. Combine the amounts on lines 1 through 10 in the far right column. From the result, subtract the sum of the amounts on lines 11 through 12d and 16f .

Schedule L 1 2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

Shareholders’ Pro Rata Share Items (continued)

Balance Sheets per Books

Assets Cash . . . . . . . . . . . . . Trade notes and accounts receivable . . . Less allowance for bad debts . . . . . . Inventories . . . . . . . . . . . U.S. government obligations . . . . . . Tax-exempt securities (see instructions) . . Other current assets (attach statement) . . . Loans to shareholders . . . . . . . . Mortgage and real estate loans . . . . . Other investments (attach statement) . . . Buildings and other depreciable assets . . . Less accumulated depreciation . . . . . Depletable assets . . . . . . . . . Less accumulated depletion . . . . . . Land (net of any amortization) . . . . . . Intangible assets (amortizable only) . . . . Less accumulated amortization . . . . . Other assets (attach statement) . . . . . Total assets . . . . . . . . . . . Liabilities and Shareholders’ Equity Accounts payable . . . . . . . . . Mortgages, notes, bonds payable in less than 1 year Other current liabilities (attach statement) . . Loans from shareholders . . . . . . . Mortgages, notes, bonds payable in 1 year or more Other liabilities (attach statement) . . . . Capital stock . . . . . . . . . . . Additional paid-in capital . . . . . . . Retained earnings . . . . . . . . . Adjustments to shareholders’ equity (attach statement) Less cost of treasury stock . . . . . . Total liabilities and shareholders’ equity . .

. . .

Beginning of tax year (a)

(

41,500

375,434 161,318

41,500 102,000 15,000 10,000

(

103,000

(

)

(

)

214,116

(

160,000

(

120,733

(c)

15,000

)

*12,800 600

End of tax year

(b)

)

17a 17b 17c

45,180

375,000 173,100

(d)

116,948 45,180 96,000 16,000 10,000

)

74,000 201,900

)

(

)

(

)

190,000

660,616

750,028

36,000 44,000 20,616 10,000 210,000

10,000 52,000 19,666 5,000 260,000

10,000

330,000

393,362

660,616

)

*$1,200 interest + $11,600 dividends if shareholders elect to tax dividends at ordinary rates under Sec. 163(d)(4)(B)

(

750,028

)

Form 1120-S (2022)

C:11-61 Page 5

Form 1120-S (2022)

Schedule M-1

Reconciliation of Income (Loss) per Books With Income (Loss) per Return Note: The corporation may be required to file Schedule M-3. See instructions.

Net income (loss) per books

Income included on Schedule K, lines 1, 2, 3c, 4, 5a, 6, 7, 8a, 9, and 10, not recorded on books this year (itemize)

133,362

Depreciation $

Travel and entertainment $

Schedule M-2

24,529

8,500

12,500 145,862

24,529 25,129

7 Add lines 5 and 6 . . . . . . . 8 Income (loss) (Schedule K, line 18). Subtract line 7 from line 4 . . . .

120,733

Analysis of Accumulated Adjustments Account, Shareholders’ Undistributed Taxable Income Previously Taxed, Accumulated Earnings and Profits, and Other Adjustments Account (see instructions) (a) Accumulated adjustments account

1 2 3 4 5 6 7 8

600

6 Deductions included on Schedule K, lines 1 through 12 and 16f, not charged against book income this year (itemize): a Depreciation $

Penalties 1,000 / Key person life 3,000 Add lines 1 through 3

600

a Tax-exempt interest $

Expenses recorded on books this year not included on Schedule K, lines 1 through 12 and 16f (itemize): a

5 Income recorded on books this year not included on Schedule K, lines 1 through 10 (itemize):

Balance at beginning of tax year . . . . Ordinary income from page 1, line 21 . . Other additions . . . . . . . . . Loss from page 1, line 21 . . . . . . Other reductions . . . . . . . . . Combine lines 1 through 5 . . . . . . Distributions . . . . . . . . . . Balance at end of tax year. Subtract line 7 from line 6 . . . . . . . . . . . .

. . . . ( . ( . . .

274,300 0 70,467 61,466* 23,700* 382,533 70,000 312,533

(b) Shareholders’ undistributed taxable income previously taxed

(d) Other adjustments account

-0) )

*See schedules on next pages.

600 (

600 600

)

Form 1120-S (2022)

C:11-61 Bottle-Up, Inc. XX-XXXXXXX 2022 Form 1120-S Page 1, Line 12 - Taxes and licenses: Payroll taxes Other taxes Total

$36,980 2,500 $39,480

Page 1, Line 19 - Other deductions: Utilities expense Automobile and truck expense Office supplies expense Meals and entertainment expense (deductible portion) Selling expenses Accounting and legal expense Insurance expense Total

$ 54,000 26,000 9,602 4,000 108,500 4,500 21,500 $228,102

Page 3, Schedule K, Line 16c - Nondeductible expenses: Keyperson life insurance premium Penalties Travel and entertainment expenses Total

$ 3,000 1,000 8,500 $12,500

Form 1125-A, Line 5 - Other costs: Supplies Utilities Other manufacturing costs Total

$ 80,000 100,000 188,000 $368,000

C:11-61 XX-XXXXXXX

Bottle-Up, Inc. 2022 Form 1120-S

Page 4, Schedule L, Line 18 - Other current liabilities: Accrued salaries payable Payroll taxes payable Sales taxes payable Total

Beginning of Tax Year

End of Tax Year

$12,000 3,416 5,200 $20,616

$ 6,000 7,106 6,560 $19,666

Page 4, Schedule L, Line 24 - Retained earnings reconciliation: Retained earnings, beginning of tax year

$330,000

Net income per books Distributions, other than dividends Retained earnings, end of tax year

133,362 (70,000) $393,362

Page 5, Schedule M-2, Line 3 - Other additions: Interest income Dividend income LTCG Total

$ 1,200 11,600 48,666 $61,466

Page 5, Schedule M-2, Line 5 - Other reductions: Sec. 1231 loss Charitable contributions Investment expenses Investment interest Nondeductible expenses (See Sch. M-1, Line 3b) Total

$ 1,100 9,000 500 600 12,500 $23,700

C:11-61 SCHEDULE D (Form 1120-S) Department of the Treasury Internal Revenue Service

Capital Gains and Losses and Built-in Gains

OMB No. 1545-0123

Attach to Form 1120-S. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9, and 10. Go to www.irs.gov/Form1120S for instructions and the latest information.

2022 Employer identification number

Name

Bottle-Up, Inc.

XX-XXXXXXX

. . . . If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

Part I

Yes

X No

Short-Term Capital Gains and Losses—Generally Assets Held One Year or Less (see instructions) (d) Proceeds (sales price)

to enter on the lines below. This form may be easier to complete if you round off the cents to whole dollars.

(e) Cost (or other basis)

(g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

1a Totals for all short-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 1b . . . . . . . . . . 1b Totals for all transactions reported on Form(s) 8949 with Box A checked . . Totals for all transactions reported on 2 Form(s) 8949 with Box B checked . . Totals for all transactions reported on 3 Form(s) 8949 with Box C checked . . 4 Short-term capital gain from installment sales from Form 6252, line 26 or 37 . . . . . . . . 5 Short-term capital gain or (loss) from like-kind exchanges from Form 8824 . . . . . . . . 6 Tax on short-term capital gain included on line 23 below . . . . . . . . . . . . . . 7 Net short-term capital gain or (loss). Combine lines 1a through 6 in column (h). Enter here and on Form 1120-S, Schedule K, line 7 or 10 . . . . . . . . . . . . . . . . . . .

Part II

4 5 6

(

)

Long-Term Capital Gains and Losses—Generally Assets Held More Than One Year (see instructions) (d) Proceeds (sales price)

to enter on the lines below. This form may be easier to complete if you round off the cents to whole dollars.

(e) Cost (or other basis)

(g) Adjustments to gain or loss from Form(s) 8949, Part II, line 2, column (g)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

8a Totals for all long-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 8b . . . . . . . . . . 8b Totals for all transactions reported on Form(s) 8949 with Box D checked . . 9 Totals for all transactions reported on Form(s) 8949 with Box E checked . . 10 Totals for all transactions reported on Form(s) 8949 with Box F checked . . 11 Long-term capital gain from installment sales from Form 6252, line 26 or 37 . . . . . . . . 12 Long-term capital gain or (loss) from like-kind exchanges from Form 8824 . . . . . . . . 13 Capital gain distributions (see instructions) . . . . . . . . . . . . . . . . . . . 14 Tax on long-term capital gain included on line 23 below . . . . . . . . . . . . . . 15 Net long-term capital gain or (loss). Combine lines 8a through 14 in column (h). Enter here and on Form 1120-S, Schedule K, line 8a or 10 . . . . . . . . . . . . . . . . . . .

148,666

For Paperwork Reduction Act Notice, see the Instructions for Form 1120-S.

100,000

Cat. No. 11516V

11 12 13 14 ( 15

48,666 )

48,666

Schedule D (Form 1120-S) 2022

C:11-61 Form

1125-A

Cost of Goods Sold

(Rev. November 2018)

OMB No. 1545-0123

Attach to Form 1120, 1120-C, 1120-F, 1120S, or 1065. Go to www.irs.gov/Form1125A for the latest information.

Department of the Treasury Internal Revenue Service Name

Employer identification number

Bottle-Up, Inc.

Inventory at beginning of year Purchases . . . . . .

. .

1 2

3 4 5

Cost of labor . . . . . . . . . . . Additional section 263A costs (attach schedule) . Other costs (attach schedule) . . . . . .

. . .

3 4 5

6 7

Total. Add lines 1 through 5 . Inventory at end of year . .

. .

6 7

8 9a

Lower of cost or market (ii) Other (Specify method used and attach explanation.) (iii) Check if there was a writedown of subnormal goods . .

Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970)

(i)

e f

. .

XX-XXXXXXX 102,000 900,000 200,000

1 2

. .

368,000 1,570,000 96,000 1,474,000

Cost

FIFO .

Was there any change in determining quantities, cost, or valuations between opening and closing inventory? If “Yes,” attach explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section references are to the Internal Revenue Code unless otherwise noted.

What’s New

General Instructions Purpose of Form Use Form 1125-A to calculate and deduct cost of goods sold for certain entities.

Who Must File Filers of Form 1120, 1120-C, 1120-F, 1120S, or 1065, must complete and attach Form 1125-A if the applicable entity reports a deduction for cost of goods sold.

Inventories Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of

For Paperwork Reduction Act Notice, see instructions.

Yes

Cat. No. 55988R

Form 1125-A (Rev. 11-2018)

C:11-61

4797

Form

Department of the Treasury Internal Revenue Service

Sales of Business Property

OMB No. 1545-0184

(Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2))

2022

Attach to your tax return. Go to www.irs.gov/Form4797 for instructions and the latest information.

Attachment Sequence No. 27

Identifying number

Name(s) shown on return

Bottle-Up, Inc. 1a

XX-XXXXXXX

Enter the total amount of gain that you are including on lines 2, 10, and 24 due to the partial dispositions of MACRS assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Enter the total amount of loss that you are including on lines 2 and 10 due to the partial dispositions of MACRS assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part I 2

(b) Date acquired (mo., day, yr.)

(d) Gross sales price

1231 Property

6/5/21

12/21/22

8,900

(e) Depreciation allowed or allowable since acquisition

(f) Cost or other basis, plus improvements and expense of sale

(g) Gain or (loss) Subtract (f) from the sum of (d) and (e)

10,000

(1,100)

Gain, if any, from Form 4684, line 39

4 5 6

. . .

4 5 6

Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows

(1,100)

Partnerships and S corporations. Report the gain or (loss) following the instructions for Form 1065, Schedule K, line 10, or Form 1120-S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below.

8 9

Part II

Ordinary Gains and Losses (see instructions)

Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):

Loss, if any, from line 7

11 (

12 13 14

Gain, if any, from line 7 or amount from line 8, if applicable . Gain, if any, from line 31 . . . . . . . . . . . Net gain or (loss) from Form 4684, lines 31 and 38a . . .

. . .

12 13 14

15 16 17

Ordinary gain from installment sales from Form 6252, line 25 or 36 Ordinary gain or (loss) from like-kind exchanges from Form 8824 . Combine lines 10 through 16. . . . . . . . . . . .

. . .

15 16 17

For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines a and b below. For individual returns, complete lines a and b below.

18a

b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Schedule 1 (Form 1040), Part I, line 4 . . . . . . . . . . . . . . . . . . . . . . . . . .

18b

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 13086I

)

Form 4797 (2022)

C:11-61 671121

2022

Schedule K-1 (Form 1120-S) Department of the Treasury Internal Revenue Service /

beginning

Part III Shareholder’s Share of Current Year Income, Deductions, Credits, and Other Items

Ordinary business income (loss)

Net rental real estate income (loss)

Other net rental income (loss)

Interest income

2022

ending

Information About the Corporation

35,234

Corporation’s employer identification number

5a Ordinary dividends

Corporation’s name, address, city, state, and ZIP code

5b Qualified dividends

5,800

Bottle-Up, Inc. 1234 Hill Street City, ST 33333

6 7

Royalties

5,800

Net short-term capital gain (loss)

IRS Center where corporation filed return

8a Net long-term capital gain (loss)

Corporation’s total number of shares

8b Collectibles (28%) gain (loss)

End of tax year

Part II

1,000 1,000

Shareholder’s identifying number

Shareholder’s name, address, city, state, and ZIP code

xxx-xx-xxxx

Net section 1231 gain (loss)

Other income (loss)

(550)

Herman Hiebert

Current year allocation percentage .

50% %

Shareholder’s number of shares Beginning of tax year End of tax year

500 500

Loans from shareholder Beginning of tax year .

10,000 5,000

For IRS Use Only

End of tax year

Schedule K-3 is attached if checked . . . . .

Alternative minimum tax (AMT) items

4,500

8c Unrecaptured section 1250 gain

Information About the Shareholder

Credits

24,333

Center City, ST

Beginning of tax year

600

xx-xxxxxxx

OMB No. 1545-0123

Amended K-1

For calendar year 2022, or tax year

Shareholder’s Share of Income, Deductions, Credits, etc. See separate instructions. Part I

Final K-1

Section 179 deduction

Other deductions

4,500

L H

300

Items affecting shareholder basis

300

6,250

35,000

5,000

Other information

*See schedule on next page

250

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

* See attached statement for additional information. For Paperwork Reduction Act Notice, see the Instructions for Form 1120-S.

www.irs.gov/Form1120S

Cat. No. 11520D

Schedule K-1 (Form 1120-S) 2022

C:11-61 XX-XXXXXXX

Bottle-Up, Inc.

2022 Form 1120-S

Schedule K-1 Herman Hiebert – Part III, 17, Other information: Investment income (interest) Investment income [dividends are inv. inc. only to the extent a shareholder elects to tax them at ordinary rates under Sec. 163(d)(4)(B).] Investment expenses Sec. 199A QBI (Ordinary income, Line 1) Sec. 199A W-2 wages [($200,000 + $120,000 + $331,020) × 0.50] Sec. 199A unadjusted basis of property ($375,000 × 0.50)

$600

A B V V V

5,800 300 35,234 325,510 187,500

C:11-61 671121

2022

Schedule K-1 (Form 1120-S) Department of the Treasury Internal Revenue Service /

beginning

Part III Shareholder’s Share of Current Year Income, Deductions, Credits, and Other Items

Ordinary business income (loss)

Net rental real estate income (loss)

Other net rental income (loss)

Interest income

2022

ending

Information About the Corporation

35,233

Corporation’s employer identification number

5a Ordinary dividends

Corporation’s name, address, city, state, and ZIP code

5b Qualified dividends

5,800

Bottle-Up, Inc. 1234 Hill Street City, ST 33333

6 7

Royalties

5,800

Net short-term capital gain (loss)

IRS Center where corporation filed return

8a Net long-term capital gain (loss)

Corporation’s total number of shares

8b Collectibles (28%) gain (loss)

End of tax year

Part II

1,000 1,000

Shareholder’s identifying number

Shareholder’s name, address, city, state, and ZIP code

xxx-xx-xxxx

Net section 1231 gain (loss)

Other income (loss)

(550)

Melvin Jones

Current year allocation percentage .

50% %

Shareholder’s number of shares Beginning of tax year End of tax year

500 500

Loans from shareholder Beginning of tax year .

For IRS Use Only

End of tax year

Schedule K-3 is attached if checked . . . . .

Alternative minimum tax (AMT) items

4,500

8c Unrecaptured section 1250 gain

Information About the Shareholder

Credits

24,333

Center City, ST

Beginning of tax year

600

xx-xxxxxxx

OMB No. 1545-0123

Amended K-1

For calendar year 2022, or tax year

Shareholder’s Share of Income, Deductions, Credits, etc. See separate instructions. Part I

Final K-1

Section 179 deduction

Other deductions

4,500

L H

300

Items affecting shareholder basis

300

6,250

35,000

Other information

*See schedule on next page

250

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

* See attached statement for additional information. For Paperwork Reduction Act Notice, see the Instructions for Form 1120-S.

www.irs.gov/Form1120S

Cat. No. 11520D

Schedule K-1 (Form 1120-S) 2022

C:11-61 XX-XXXXXXX

Bottle-Up, Inc.

2022 Form 1120-S

Schedule K-1 Melvin Jones – Part III, 17, Other information: Investment income (interest) Investment income [dividends are inv. inc. only to the extent a shareholder elects to tax them at ordinary rates under Sec. 163(d)(4)(B).] Investment expenses Sec. 199A QBI (Ordinary income, Line 1) Sec. 199A W-2 wages [($200,000 + $120,000 + $331,020) × 0.50] Sec. 199A unadjusted basis of property ($375,000 × 0.50)

$600

A 5,800 B 300 V 35,233 V 325,510 V 187,500

C:11-62 Form

1120-S

U.S. Income Tax Return for an S Corporation

OMB No. 1545-0123

Do not file this form unless the corporation has filed or is attaching Form 2553 to elect to be an S corporation. Go to www.irs.gov/Form1120S for instructions and the latest information.

2022

Department of the Treasury Internal Revenue Service

For calendar year 2022 or tax year beginning A S election effective date

1/1/21

B Business activity code number (see instructions)

339110

TYPE OR PRINT

C Check if Sch. M-3 attached

G H I J

, 2022, ending

, 20

Name

D Employer identification number

Number, street, and room or suite no. If a P.O. box, see instructions.

E Date incorporated

City or town, state or province, country, and ZIP or foreign postal code

F Total assets (see instructions)

Healthwise Medical Supplies Company

XX-2024022

2400 Second Street

1/1/21

City, ST 12345

4,612,280

Caution: Include only trade or business income and expenses on lines 1a through 21. See the instructions for more information.

Tax and Payments

Deductions (see instructions for limitations)

Income

c 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22a b c 23a b c d 24 25 26 27

Sign Here

7,000,000 350,000

1c 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

6,650,000 2,520,000 4,130,000 4,130,000 200,000 980,000 45,500 210,000 98,000 33,600 391,840 42,000 238,000 2,238,940 1,891,060

22c

23d 24 25 26 27

Paid Preparer Use Only

Leisa H. Bailey

Signature of officer

Print/Type preparer’s name

3/11/23

Date

Preparer’s signature

Title

President Date

Firm’s name

May the IRS discuss this return with the preparer shown below? Yes No See instructions. Check if self-employed

PTIN

Firm’s EIN

Firm’s address

Phone no.

For Paperwork Reduction Act Notice, see separate instructions.

Cat. No. 11510H

Form 1120-S (2022)

C:11-62 Page 2

Form 1120-S (2022)

Schedule B 1 2 3 4

Other Information (see instructions)

Check accounting method:

a c See the instructions and enter the: a Business activity

Cash b Other (specify)

x Accrual

Manufacturing and sales

b Product or service

Yes No

Medical equipment

(ii) Employer Identification Number (if any)

(iii) Country of Incorporation

(i) Name of Entity

(iii) Type of Entity

(iv) Country of Organization

If “Yes,” complete lines (i) and (ii) below. (i) Total shares of stock outstanding at the end of the tax year . (ii) Total shares of stock outstanding if all instruments were executed

(v) Maximum Percentage Owned in Profit, Loss, or Capital

(v) If Percentage in (iv) Is 100%, Enter the Date (if applicable) a Qualified Subchapter S Subsidiary Election Was Made

(iv) Percentage of Stock Owned

If checked, the corporation may have to file Form 8281, Information Return for Publicly Offered Original Issue Discount Instruments. 8

x x

Form 1120-S (2022)

C:11-62 Page 3

Form 1120-S (2022)

Schedule B 12

13 14a b 15

Yes

Alternative Minimum Tax (AMT) Items

International

Credits

Deductions

Income (Loss)

Schedule K

Items Affecting Shareholder Basis

Other Information (see instructions) (continued)

1 2 3a b c 4 5 6 7 8a b c 9 10 11 12a b c d 13a b c d e f g

Shareholders’ Pro Rata Share Items

x x x x

Total amount

. .

1 2

. . .

3c 4 5a

26,400

. . .

6 7 8a

1,344,000

. . .

9 10 11 12a 12b 12c 12d 13a 13b 13c 13d 13e 13f 13g

26,400

Investment expenses

Attach Schedule K-2 (Form 1120-S), Shareholders’ Pro Rata Share Items—International, and check this box to indicate you are reporting items of international tax relevance . . . .

15a b c d e f 16a b c d e f

. . . . . . . . . . . .

1,891,060

. .

. . . . . . . . . . . .

15a 15b 15c 15d 15e 15f 16a 16b 16c 16d 16e 16f

700,000 56,000 4,200 7,200

2,000 2,000,000 Form 1120-S (2022)

C:11-62 Page 4

Form 1120-S (2022)

ReconOther ciliation Information

Schedule K

16 17 18 19 20 21 22 23 24 25 26 27

Total amount

17a b c d

Income (loss) reconciliation. Combine the amounts on lines 1 through 10 in the far right column. From the result, subtract the sum of the amounts on lines 11 through 12d and 16f .

Schedule L 1 2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

Shareholders’ Pro Rata Share Items (continued)

Balance Sheets per Books

. . .

Beginning of tax year (a)

(

2,494,060

End of tax year

(b)

(c)

958,900

756,000 ) -0-

26,400* 7,200

17a 17b 17c

756,000 1,400,000

(

840,000 -0-

(d)

1,062,760 840,000 1,680,000

)

50,000

480,000

1,600,000 ( 228,640 )

1,371,360

-0-

2,300,000 ( 1,320,480

)

(

)

(

)

(

)

(

)

(

979,520

5,016,260

4,612,280

140,000 700,000 4,900

182,000 140,000 6,860

4,000,000

171,360

283,420

5,016,260

)

*Investment income if shareholders elect to tax dividends at ordinary rates under Sec. 163(d)(4)(B).

(

4,612,280

)

Form 1120-S (2022)

C:11-62 Page 5

Form 1120-S (2022)

Schedule M-1

Reconciliation of Income (Loss) per Books With Income (Loss) per Return Note: The corporation may be required to file Schedule M-3. See instructions.

Net income (loss) per books

Income included on Schedule K, lines 1, 2, 3c, 4, 5a, 6, 7, 8a, 9, and 10, not recorded on books this year (itemize)

2,112,060

384,000

Book-tax difference on stock sale gain

Depreciation $

Travel and entertainment $

Add lines 1 through 3

Schedule M-2

a Tax-exempt interest $

2,496,060

7 Add lines 5 and 6 . . . . . . . 8 Income (loss) (Schedule K, line 18). Subtract line 7 from line 4 . . . .

2,000

2,000 2,494,060

1 2 3 4 5 6 7 8

2,000

6 Deductions included on Schedule K, lines 1 through 12 and 16f, not charged against book income this year (itemize): a Depreciation $

Expenses recorded on books this year not included on Schedule K, lines 1 through 12 and 16f (itemize): a

5 Income recorded on books this year not included on Schedule K, lines 1 through 10 (itemize):

. . . . ( . ( . . .

171,360 1,891,060 1,370,400* 767,400* 2,665,420 2,000,000 665,420

(b) Shareholders’ undistributed taxable income previously taxed

(d) Other adjustments account

-0) )

*See schedules on next page.

2,000 (

2,000 2,000

)

Form 1120-S (2022)

C:11-62 Healthwise Medical Supplies Company XX-2024022

2022 Form 1120-S

Page 1, Line 19 - Other deductions: General insurance Travel Utilities Professional fees Business meals Total

$ 49,000 28,000 84,000 70,000 7,000 $238,000

Page 4, Schedule M-2, Line 3 - Other additions: Dividend income Long-term capital gain Total

26,400 1,344,000 $1,370,400

Page 4, Schedule M-2, Line 5 - Other reductions: Sec. 179 expense Cash contributions Investment expenses Investment interest expense Total

$700,000 56,000 7,200 4,200 $767,400

C:11-62 SCHEDULE D (Form 1120-S) Department of the Treasury Internal Revenue Service

Capital Gains and Losses and Built-in Gains

OMB No. 1545-0123

Attach to Form 1120-S. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9, and 10. Go to www.irs.gov/Form1120S for instructions and the latest information.

2022 Employer identification number

Name

Healthwise Medical Supplies Company

XX-2024022

Yes

. . . . If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

Part I

X No

Short-Term Capital Gains and Losses—Generally Assets Held One Year or Less (see instructions)

to enter on the lines below. This form may be easier to complete if you round off the cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

(g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

Part II

4 5 6

(

)

Long-Term Capital Gains and Losses—Generally Assets Held More Than One Year (see instructions)

to enter on the lines below. This form may be easier to complete if you round off the cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

(g) Adjustments to gain or loss from Form(s) 8949, Part II, line 2, column (g)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

8a Totals for all long-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 8b . . . . . . . . . . 8b Totals for all transactions reported on Form(s) 8949 with Box D checked . . 9 Totals for all transactions reported on Form(s) 8949 with Box E checked . . 10 Totals for all transactions reported on Form(s) 8949 with Box F checked . .* 1,440,000 96,000 11 Long-term capital gain from installment sales from Form 6252, line 26 or 37 . . . . . . . . 12 Long-term capital gain or (loss) from like-kind exchanges from Form 8824 . . . . . . . . 13 Capital gain distributions (see instructions) . . . . . . . . . . . . . . . . . . . 14 Tax on long-term capital gain included on line 23 below . . . . . . . . . . . . . . 15 Net long-term capital gain or (loss). Combine lines 8a through 14 in column (h). Enter here and on Form 1120-S, Schedule K, line 8a or 10 . . . . . . . . . . . . . . . . . . . For Paperwork Reduction Act Notice, see the Instructions for Form 1120-S.

Cat. No. 11516V

11 12 13 14 ( 15

1,344,000

)

1,344,000

Schedule D (Form 1120-S) 2022

*1,000 shares of Fastgrowth, Inc.: acquired 1/2/19; sold 7/2/22. Basis is $96,000 carryover basis upon Firth's contribution to the entity. Form 8949 not attached. See Problem C:9-58 for a sample of this form.

C:11-62 Form

1125-A

Cost of Goods Sold

(Rev. November 2018)

1 2

Healthwise Medical Supplies Company . .

. .

1 2

3 4 5

Cost of labor . . . . . . . . . . . Additional section 263A costs (attach schedule) . Other costs (attach schedule) . . . . . .

. . .

3 4 5

6 7

Total. Add lines 1 through 5 . Inventory at end of year . .

. .

6 7

4,200,000 1,680,000

2,520,000

. .

XX-2024022 1,400,000 2,800,000

. .

Employer identification number

. .

Inventory at beginning of year Purchases . . . . . .

OMB No. 1545-0123

Attach to Form 1120, 1120-C, 1120-F, 1120S, or 1065. Go to www.irs.gov/Form1125A for the latest information.

Department of the Treasury Internal Revenue Service Name

. .

Lower of cost or market (ii) Other (Specify method used and attach explanation.) (iii) Check if there was a writedown of subnormal goods . .

Check if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970)

e f

Was there any change in determining quantities, cost, or valuations between opening and closing inventory? If “Yes,” attach explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Section references are to the Internal Revenue Code unless otherwise noted.

What’s New

General Instructions Purpose of Form Use Form 1125-A to calculate and deduct cost of goods sold for certain entities.

Who Must File Filers of Form 1120, 1120-C, 1120-F, 1120S, or 1065, must complete and attach Form 1125-A if the applicable entity reports a deduction for cost of goods sold.

Inventories Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of

For Paperwork Reduction Act Notice, see instructions.

Yes

Cat. No. 55988R

Form 1125-A (Rev. 11-2018)

C:11-62 Form

1125-E

(Rev. October 2016)

Department of the Treasury Internal Revenue Service Name

Compensation of Officers Attach to Form 1120, 1120-C, 1120-F, 1120-REIT, 1120-RIC, or 1120S. Information about Form 1125-E and its separate instructions is at www.irs.gov/form1125e.

OMB No. 1545-0123

Employer identification number

XX-2024022

Healthwise Medical Supplies Company

Note: Complete Form 1125-E only if total receipts are $500,000 or more. See instructions for definition of total receipts.

(a)

(b) Social security number (see instructions)

(d) Common

(e) Preferred

Leisa H. Bailey

XXX-XX-XXXX

100 %

30 %

Subtract line 3 from line 2. Enter the result here and on Form 1120, page 1, line 12 or the appropriate line of your tax return . . . . . . . . . . . . . . . . . . . . . .

3 4

For Paperwork Reduction Act Notice, see separate instructions.

Percent of stock owned

Cat. No. 55989C

(f) Amount of compensation

200,000

Form 1125-E (Rev. 10-2016)

C:11-62 Form

4562

Depreciation and Amortization

Name(s) shown on return

Healthwise Medical Supplies Company

1 2 3 4 5

Business or activity to which this form relates

Medical Equipment Manufacturing

Election To Expense Certain Property Under Section 179 Note: If you have any listed property, complete Part V before you complete Part I.

2022

Attach to your tax return. Go to www.irs.gov/Form4562 for instructions and the latest information.

Department of the Treasury Internal Revenue Service

Part I

OMB No. 1545-0172

(Including Information on Listed Property)

(a) Description of property

(b) Cost (business use only)

700,000

Equipment

Attachment Sequence No. 179 Identifying number

XX-2024022 1 2 3 4

700,000a 700,000 2,700,000 -0-

700,000

(b) Month and year placed in service

(d) Recovery period

(e) Convention

(f) Method

(g) Depreciation deduction

Part IV

Summary (See instructions.)

Cat. No. 12906N

21 22

391,840b Form 4562 (2022)

C:11-62 671121

2022

Schedule K-1 (Form 1120-S) Department of the Treasury Internal Revenue Service /

beginning

Part III Shareholder’s Share of Current Year Income, Deductions, Credits, and Other Items

Ordinary business income (loss)

Net rental real estate income (loss)

Other net rental income (loss)

Interest income

2022

ending

Information About the Corporation

567,318

Corporation’s employer identification number

5a Ordinary dividends

Corporation’s name, address, city, state, and ZIP code

5b Qualified dividends

XX-2024022

7,920

Healthwise Medical Supplies Company 2400 Second Street City, ST 12345

6 7

Royalties

7,920

Net short-term capital gain (loss)

IRS Center where corporation filed return

8a Net long-term capital gain (loss)

Corporation’s total number of shares

8b Collectibles (28%) gain (loss)

End of tax year

Part II

Credits

Schedule K-3 is attached if checked . . . . .

Alternative minimum tax (AMT) items

403,200

Center City, ST

Beginning of tax year

OMB No. 1545-0123

Amended K-1

For calendar year 2022, or tax year

Shareholder’s Share of Income, Deductions, Credits, etc. See separate instructions. Part I

Final K-1

8c Unrecaptured section 1250 gain

Information About the Shareholder

Shareholder’s identifying number

Shareholder’s name, address, city, state, and ZIP code

Net section 1231 gain (loss)

Other income (loss)

Items affecting shareholder basis

600

XXX-XX-XXXX

600,000

Leisa H. Bailey 1200 First Pike City, ST 12345 G

Current year allocation percentage .

Shareholder’s number of shares Beginning of tax year End of tax year

30% %

Loans from shareholder Beginning of tax year .

For IRS Use Only

End of tax year

17 11

Section 179 deduction

Other deductions

210,000

A H

16,800 1,260

2,160

Other information

*See schedule on next page

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

* See attached statement for additional information. For Paperwork Reduction Act Notice, see the Instructions for Form 1120-S.

www.irs.gov/Form1120S

Cat. No. 11520D

Schedule K-1 (Form 1120-S) 2022

C:11-62 Healthwise Medical Supplies Company XX-2024022

2022 Form 1120-S

Schedule K-1 Leisa H. Bailey – Part III, 17, Other information: Investment income [dividends are inv. inc. only to the extent a shareholder elects to tax them at ordinary rates under Sec. 163(d)(4)(B).] A Investment expenses B Sec. 199A QBI ($567,318 ord. inc. – $210,000 Sec. 179 exp.) V Sec. 199A W-2 wages [($200,000 + $980,000) × 0.30] V Sec. 199A unadjusted basis of property ($2,300,000 × 0.30) V

$7,920 2,160 357,318 354,000 690,000

C:11-62 671121

2022

Schedule K-1 (Form 1120-S) Department of the Treasury Internal Revenue Service /

beginning

Part III Shareholder’s Share of Current Year Income, Deductions, Credits, and Other Items

Ordinary business income (loss)

Net rental real estate income (loss)

Other net rental income (loss)

Interest income

2022

ending

Information About the Corporation

1,323,742

Corporation’s employer identification number

5a Ordinary dividends

Corporation’s name, address, city, state, and ZIP code

5b Qualified dividends

XX-2024022

18,480

Healthwise Medical Supplies Company 2400 Second Street City, ST 12345

6 7

18,480

Royalties

Net short-term capital gain (loss)

IRS Center where corporation filed return

8a Net long-term capital gain (loss)

Corporation’s total number of shares

8b Collectibles (28%) gain (loss)

End of tax year

Part II

Credits

Schedule K-3 is attached if checked . . . . .

Alternative minimum tax (AMT) items

940,800

Center City, ST

Beginning of tax year

OMB No. 1545-0123

Amended K-1

For calendar year 2022, or tax year

Shareholder’s Share of Income, Deductions, Credits, etc. See separate instructions. Part I

Final K-1

8c Unrecaptured section 1250 gain

Information About the Shareholder

Shareholder’s identifying number

Shareholder’s name, address, city, state, and ZIP code

Net section 1231 gain (loss)

Other income (loss)

Items affecting shareholder basis

1,400

XXX-XX-XXXX

1,400,000

Thomas J. Firth 3600 Third Blvd. City, ST 12345 G

Current year allocation percentage .

70% %

17 11

Section 179 deduction

Other deductions

Shareholder’s number of shares Beginning of tax year End of tax year

Loans from shareholder Beginning of tax year .

For IRS Use Only

End of tax year

490,000

A H

39,200 2,940

5,040

Other information

*See schedule on next page

More than one activity for at-risk purposes*

More than one activity for passive activity purposes*

* See attached statement for additional information. For Paperwork Reduction Act Notice, see the Instructions for Form 1120-S.

www.irs.gov/Form1120S

Cat. No. 11520D

Schedule K-1 (Form 1120-S) 2022

C:11-62 Healthwise Medical Supplies Company XX-2024022

2022 Form 1120-S

Schedule K-1 Thomas J. Firth – Part III, 17, Other information: Investment income [dividends are inv. inc. only to the extent a shareholder elects to tax them at ordinary rates under Sec. 163(d)(4)(B).] Investment expenses Sec. 199A QBI ($1,323,742 ord. inc. – $490,000 Sec. 179 exp.) Sec. 199A W-2 wages [($200,000 + $980,000) × 0.70) Sec. 199A unadjusted basis of property ($2,300,000 × 0.70)

A B V V V

$18,480 5,040 833,742 826,000 1,610,000

C:11-62 Healthwise Medical Supplies Company XX-2024022 2022 Form 1120-S Basis in S corporation stock: Item Basis at 1/1/22 S corporation ordinary income Dividend income Long-term capital gain Tax-exempt interest Distributions Sec. 179 expense Charitable contributions (cash) Investment interest expense Investment expenses Basis at 12/31/22

Bailey

Firth

$ 1,251,408

$ 2,535,952

567,318 7,920 403,200 600 (600,000) (210,000) (16,800) (1,260) (2,160) $1,400,226

1,323,742 18,480 940,800 1,400 (1,400,000) (490,000) (39,200) (2,940) (5,040) $2,883,194

C:11-63

MN Corporation 2022 Form 1120-S

Page 3

Form 1120-S (2022)

Schedule B 12

13 14a b 15

Yes

Alternative Minimum Tax (AMT) Items

International

Credits

Deductions

Income (Loss)

Schedule K

Items Affecting Shareholder Basis

Other Information (see instructions) (continued)

1 2 3a b c 4 5 6 7 8a b c 9 10 11 12a b c d 13a b c d e f g

Shareholders’ Pro Rata Share Items

Total amount

See schedule

Ordinary business income (loss) (page 1, line 21) . . . . . Net rental real estate income (loss) (attach Form 8825) . . . . . . . . . . . Other gross rental income (loss) . . . . . . . . . . . . 3a Expenses from other rental activities (attach statement) . . . . 3b Other net rental income (loss). Subtract line 3b from line 3a . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . Dividends: a Ordinary dividends . . . . . . . . . . . . . . . . . . b Qualified dividends . . . . . . . . . . . . 5b Royalties . . . . . . . . . . . . . . . . . . . . . . . . . Net short-term capital gain (loss) (attach Schedule D (Form 1120-S)) . . . . . . Net long-term capital gain (loss) (attach Schedule D (Form 1120-S)) . . . . . . . Collectibles (28%) gain (loss) . . . . . . . . . . . . . 8b Unrecaptured section 1250 gain (attach statement) . . . . . . 8c Net section 1231 gain (loss) (attach Form 4797) . . . . . . . . . . . . . Other income (loss) (see instructions) . . . Type: Section 179 deduction (attach Form 4562) . . . . . . . . . . . . . . . Charitable contributions . . . . . . . . . . . . . . . . . . . . Investment interest expense . . . . . . . . . . . . . . . . . . . Section 59(e)(2) expenditures . . . . . . Type: Other deductions (see instructions) . . . . Type: Low-income housing credit (section 42(j)(5)) . . . . . . . . . . . . . . Low-income housing credit (other) . . . . . . . . . . . . . . . . . Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) Other rental real estate credits (see instructions) Type: Other rental credits (see instructions) . . . Type: Biofuel producer credit (attach Form 6478) . . . . . . . . . . . . . . Other credits (see instructions) . . . . . Type:

. .

1 2

. . .

3c 4 5a

10,000

. . .

6 7 8a

(6,000) 1,000

. . .

9 10 11 12a 12b 12c 12d 13a 13b 13c 13d 13e 13f 13g

10,000

Attach Schedule K-2 (Form 1120-S), Shareholders’ Pro Rata Share Items—International, and check this box to indicate you are reporting items of international tax relevance . . . .

15a b c d e f 16a b c d e f

. . . . . . . . . . . .

109,800

. .

. . . . . . . . . . . .

15a 15b 15c 15d 15e 15f 16a 16b 16c 16d 16e 16f

12,000 2,000 6,400

3,000 1,800 30,000 Form 1120-S (2022)

C:11-63

MN Corporation 2022 Form 1120-S Page 4

Form 1120-S (2022)

ReconOther ciliation Information

Schedule K

16 17 18 19 20 21 22 23 24 25 26 27

Total amount

17a b c d

Income (loss) reconciliation. Combine the amounts on lines 1 through 10 in the far right column. From the result, subtract the sum of the amounts on lines 11 through 12d and 16f .

Schedule L 1 2a b 3 4 5 6 7 8 9 10a b 11a b 12 13a b 14 15

Shareholders’ Pro Rata Share Items (continued)

Balance Sheets per Books

. . .

Beginning of tax year (a)

17a 17b 17c

10,000*

118,400

End of tax year

(b)

(c)

(d)

(

)

(

)

(

)

(

)

(

)

(

)

(

)

(

)

(

)

(

) Form 1120-S (2022)

* Investment income if shareholders elect to tax dividends at ordinary rates under Sec. 163(d)(4)(B).

C:11-63 MN Corporation 2022 Form 1120-S S corporation ordinary income, Schedule K, Line 1: Sales

$300,000

Minus: Cost of goods sold Gross profit Plus: Sec. 1245 gain Minus: Depreciation Salary to Nancy Business interest Business meals S corporation ordinary income

(140,000) $160,000 22,000 $18,000 20,000 32,000 2,200

(72,200) $109,800

C:12-58

709

United States Gift (and Generation-Skipping Transfer) Tax Return

Department of the Treasury Internal Revenue Service

(For gifts made during calendar year 2022)

Form

2 Donor’s last name

Joel

3 Donor’s social security number

Bruton

XXX-XX-XXXX

4 Address (number, street, and apartment number)

5 Legal residence (domicile)

6 City or town, state or province, country, and ZIP or foreign postal code

7 Citizenship (see instructions)

117 Panther Place

South City, NC 28000

Part 1—General Information

See instructions.

1 Donor’s first name and middle initial

North Carolina U.S.A.

and enter date of death

Yes

8 9 10

If the donor died during the year, check here

11a b

Have you (the donor) previously filed a Form 709 (or 709-A) for any other year? If "No," skip line 11b Has your address changed since you last filed Form 709 (or 709-A)? . . . . . . . . .

Gifts by husband or wife to third parties. Do you consent to have the gifts (including generation-skipping transfers) made by you and by your spouse to third parties during the calendar year considered as made one-half by each of you? (See instructions.) (If the answer is “Yes,” the following information must be furnished and your spouse must sign the consent shown below. If the answer is “No,” skip lines 13–18.) . . . . . . . . . . . . . . . . . . . .

If you extended the time to file this Form 709, check here Enter the total number of donees listed on Schedule A. Count each person only once:

Janis Bruton

4 . .

. .

XXX-XX-XXXX

Name of consenting spouse

15 16 17 18

Were you married to one another during the entire calendar year? See instructions . . . . . . . . . If line 15 is “No,” check whether married divorced or widowed/deceased, and give date. See instructions: Will a gift tax return for this year be filed by your spouse? If “Yes,” mail both returns in the same envelope . .

. .

Janis Bruton

Date:

4/14/23

Have you applied a DSUE amount received from a predeceased spouse to a gift or gifts reported on this or a previous Form 709? If “Yes,” complete Schedule C . . . . . . . . . . . . . . . . . . . . . . . . . .

Part 2—Tax Computation

14 SSN

. .

Consent of Spouse. I consent to have the gifts (and generation-skipping transfers) made by me and by my spouse to third parties during the calendar year considered as made one-half by each of us. We are both aware of the joint and several liability for tax created by the execution of this consent.

Consenting spouse’s signature:

Attach check or money order here.

OMB No. 1545-0020

Go to www.irs.gov/Form709 for instructions and the latest information.

Enter the amount from Schedule A, Part 4, line 11 .

2 3 4

Enter the amount from Schedule B, line 3 . . . . . . . . . . . . . Total taxable gifts. Add lines 1 and 2 . . . . . . . . . . . . . . . Tax computed on amount on line 3 (see Table for Computing Gift Tax in instructions)

. . .

2 3 4

5 6

Tax computed on amount on line 2 (see Table for Computing Gift Tax in instructions) Balance. Subtract line 5 from line 4 . . . . . . . . . . . . . . .

. .

5 6

Applicable credit amount. If donor has DSUE amount from predeceased spouse(s) or Restored Exclusion Amount, enter amount from Schedule C, line 5; otherwise, see instructions . . . . . . . . .

8 9

Enter the applicable credit against tax allowable for all prior periods (from Sch. B, line 1, col. C) Balance. Subtract line 8 from line 7. Do not enter less than zero . . . . . . . . . .

8 9

Enter 20% (0.20) of the amount allowed as a specific exemption for gifts made after September 8, 1976, and before January 1, 1977. See instructions . . . . . . . . . . . . . . . . . .

Balance. Subtract line 10 from line 9. Do not enter less than zero

Applicable credit. Enter the smaller of line 6 or line 11 .

13 14

Credit for foreign gift taxes (see instructions) Total credits. Add lines 12 and 13 . . . .

. .

15 16 17

Balance. Subtract line 14 from line 6. Do not enter less than zero . . . Generation-skipping transfer taxes (from Schedule D, Part 3, col. G, total) . Total tax. Add lines 15 and 16 . . . . . . . . . . . . . .

. . .

18 19 20

Gift and generation-skipping transfer taxes prepaid with extension of time to file . If line 18 is less than line 17, enter balance due. See instructions . . . . . If line 18 is greater than line 17, enter amount to be refunded . . . . . .

. . .

Sign Here

. .

. . . .

. . . . . .

1,365,000 1,000,000 2,365,000 891,800a 345,800b 546,000

10 11 12 13 14 15 16 17 18 19 20

4,769,800 220,550 4,549,250 4,549,250 546,000 0 546,000 0 0 0 0

Under penalties of perjury, I declare that I have examined this return, including any accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than donor) is based on all information of which preparer has any knowledge. May the IRS discuss this return with the preparer shown below? See instructions. Yes No

Joel Bruton

Date

Signature of donor Print/Type preparer’s name Paid Preparer Firm’s name Use Only

Preparer’s signature

4/14/23 Date

Firm’s address

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see the instructions for this form.

aTax on line 3 = $345,800 + [($2,365,000 - $1,000,000) x 0.40] bTax on line 2 = $345,800 (where first $1 million is subject to $345,800 tax)

Check if self-employed

PTIN

Firm's EIN Phone no. Cat. No. 16783M

Form 709 (2022)

C:12-58 Page 2

Form 709 (2022)

SCHEDULE A A B

Computation of Taxable Gifts (Including transfers in trust) (see instructions)

Does the value of any item listed on Schedule A reflect any valuation discount? If “Yes,” attach explanation . . . . . . Yes No Check here if you elect under section 529(c)(2)(B) to treat any contributions made this year to a qualified tuition program as made ratably over a 5-year period beginning this year. See instructions. Attach explanation.

Part 1—Gifts Subject Only to Gift Tax. Gifts less political organization, medical, and educational exclusions. See instructions. A Item number

B • Donee’s name and address • Relationship to donor (if any) • Description of gift • If the gift was of securities, give CUSIP no. • If closely held entity, give EIN

D Donor’s adjusted basis of gift

1 2 3 4

Belinda, daughter, stock Belinda, daughter, apt. bldg. & land Atlanta Art Museum, pottery Jains, wife, QTIP trust

5 6

Belinda, daughter, cash Jeanette Johnson, sister, stock

E Date of gift

F Value at date of gift

G For split gifts, enter 1/2 of column F

H Net transfer (subtract col. G from col. F)

60,000 2022 78,000 39,000 39,000 1,900,000 2022 2,476,000 1,238,000 1,238,000 100,000 2022 120,000 60,000 60,000 2,430,000 2022 3,000,000 -0- 3,000,000

Gifts made by spouse—complete only if you are splitting gifts with your spouse and he/she also made gifts.

Total of Part 1. Add amounts from Part 1, column H .

40,000 20,000 20,000 200,000 100,000 100,000

40,000 2022 120,000 2022

*4,457,000

Part 2—Direct Skips. Gifts that are direct skips and are subject to both gift tax and generation-skipping transfer tax. You must list the gifts in chronological order. A Item number

B • Donee’s name and address • Relationship to donor (if any) • Description of gift • If the gift was of securities, give CUSIP no. • If closely held entity, give EIN

C 2632(b) election out

D Donor’s adjusted basis of gift

E Date of gift

F Value at date of gift

G For split gifts, enter 1/2 of column F

H Net transfer (subtract col. G from col. F)

Gifts made by spouse—complete only if you are splitting gifts with your spouse and he/she also made gifts.

Total of Part 2. Add amounts from Part 2, column H . . . . . . . . . . . . . . . . . . . . . . . Part 3—Indirect Skips and Other Transfers in Trust. Gifts to trusts that are indirect skips as defined under section 2632(c) or to trusts that are currently subject to gift tax and may later be subject to generation-skipping transfer tax. You must list these gifts in chronological order. A Item number

B • Donee’s name and address • Relationship to donor (if any) • Description of gift • If the gift was of securities, give CUSIP no. • If closely held entity, give EIN

C 2632(c) election

D Donor’s adjusted basis of gift

E Date of gift

F Value at date of gift

G For split gifts, enter 1/2 of column F

H Net transfer (subtract col. G from col. F)

Gifts made by spouse—complete only if you are splitting gifts with your spouse and he/she also made gifts.

Total of Part 3. Add amounts from Part 3, column H . . (If more space is needed, attach additional statements.)

. Form 709 (2022)

*Four transfer types are not subject to gift tax, including tuition payments made directly to the educational institution. Per Form 709 instructions, these transfers are not "gifts" for Form 709 or its instructions. Thus, tuition paid for grandson Jacob should not be listed on Form 709, Schedule A. C:TRP-106 Copyright © 2024 Pearson Education, Inc.

C:12-58 Page 3

Form 709 (2022)

Part 4—Taxable Gift Reconciliation 1 2 3

Total value of gifts of donor. Add totals from column H of Parts 1, 2, and 3 . Total annual exclusions for gifts listed on line 1 (see instructions) . . . . Total included amount of gifts. Subtract line 2 from line 1 . . . . . .

. . .

Deductions (see instructions) 4 Gifts of interests to spouse for which a marital deduction will be claimed, based on item numbers of Schedule A . . . . . . 4 5 Exclusions attributable to gifts on line 4 . . . . . . . . . . . . . 5

1, 2, 3, 4

. . . . . less exclusions

6 7

. . .

3,000,000 16,000 2,984,000 44,000b

6 7

Marital deduction. Subtract line 5 from line 4 . Charitable deduction, based on item numbers

8 9 10 11

Total deductions. Add lines 6 and 7 . . . . . . . . . . . . . . . . . . . Subtract line 8 from line 3 . . . . . . . . . . . . . . . . . . . . . . Generation-skipping transfer taxes payable with this Form 709 (from Schedule D, Part 3, col. G, total) Taxable gifts. Add lines 9 and 10. Enter here and on page 1, Part 2—Tax Computation, line 1 . .

. . .

. . . .

4,457,000 64,000a 4,393,000

1 2 3

3,028,000 1,365,000

8 9 10

1,365,000

Terminable Interest (QTIP) Marital Deduction. (See instructions for Schedule A, Part 4, line 4.) If a trust (or other property) meets the requirements of qualified terminable interest property under section 2523(f), and: a. The trust (or other property) is listed on Schedule A; and b. The value of the trust (or other property) is entered in whole or in part as a deduction on Schedule A, Part 4, line 4, then the donor shall be deemed to have made an election to have such trust (or other property) treated as qualified terminable interest property under section 2523(f). If less than the entire value of the trust (or other property) that the donor has included in Parts 1 and 3 of Schedule A is entered as a deduction on line 4, the donor shall be considered to have made an election only as to a fraction of the trust (or other property). The numerator of this fraction is equal to the amount of the trust (or other property) deducted on Schedule A, Part 4, line 6. The denominator is equal to the total value of the trust (or other property) listed in Parts 1 and 3 of Schedule A. If you make the QTIP election, the terminable interest property involved will be included in your spouse’s gross estate upon his or her death (section 2044). See instructions for line 4 of Schedule A. If your spouse disposes (by gift or otherwise) of all or part of the qualifying life income interest, he or she will be considered to have made a transfer of the entire property that is subject to the gift tax. See Transfer of Certain Life Estates Received From Spouse in the instructions. 12

Election Out of QTIP Treatment of Annuities Check here if you elect under section 2523(f)(6) not to treat as qualified terminable interest property any joint and survivor annuities that are reported on Schedule A and would otherwise be treated as qualified terminable interest property under section 2523(f). See instructions. Enter the item numbers from Schedule A for the annuities for which you are making this election:

SCHEDULE B

Gifts From Prior Periods

If you answered “Yes,” on line 11a of page 1, Part 1, see the instructions for completing Schedule B. If you answered “No,” skip to the Tax Computation on page 1 (or Schedule C or D, if applicable). Complete Schedule A before beginning Schedule B. See instructions for recalculation of the column C amounts. Attach calculations. A Calendar year or calendar quarter (see instructions)

C Amount of applicable credit (unified credit) against gift tax for periods after December 31, 1976

B Internal Revenue office where prior return was filed

2000

D Amount of specific exemption for prior periods ending before January 1, 1977

E Amount of taxable gifts

220,550c

1,000,000

220,550

1,000,000

Totals for prior periods

2 3

Amount, if any, by which total specific exemption, line 1, column D, is more than $30,000 . . . . . . . . . Total amount of taxable gifts for prior periods. Add amount on line 1, column E, and amount, if any, on line 2. Enter here and on page 1, Part 2—Tax Computation, line 2 . . . . . . . . . . . . . . . . . . .

(If more space is needed, attach additional statements.)

a$16,000 each for Belinda, museum, Janis, and Jeanette.

b$60,000 to Atlanta Art Museum (after gift splitting) – $16,000 annual exclusion. cCredit limitation for 2000 gifts. Note: Pages 4 and 5 of form omitted. C:TRP-107 Copyright © 2024 Pearson Education, Inc.

2 3

1,000,000

Form 709 (2022)

C:12-59

709

United States Gift (and Generation-Skipping Transfer) Tax Return

Department of the Treasury Internal Revenue Service

(For gifts made during calendar year 2022)

Form

2 Donor’s last name

Ned

3 Donor’s social security number

Norris

XXX-XX-XXXX

4 Address (number, street, and apartment number)

5 Legal residence (domicile)

6 City or town, state or province, country, and ZIP or foreign postal code

7 Citizenship (see instructions)

11616 Starstruck Blvd.

Southern City, CA 90068

Part 1—General Information

See instructions.

1 Donor’s first name and middle initial

California U.S.A.

and enter date of death

Yes

If the donor died during the year, check here

9 10

If you extended the time to file this Form 709, check here Enter the total number of donees listed on Schedule A. Count each person only once:

11a b

Have you (the donor) previously filed a Form 709 (or 709-A) for any other year? If "No," skip line 11b Has your address changed since you last filed Form 709 (or 709-A)? . . . . . . . . .

Name of consenting spouse

15 16 17 18

. .

14 SSN .

Part 2—Tax Computation

Consenting spouse’s signature:

Attach check or money order here.

OMB No. 1545-0020

Go to www.irs.gov/Form709 for instructions and the latest information.

. . . . . .

Enter the amount from Schedule A, Part 4, line 11 .

2 3 4

. . .

5 6

Tax computed on amount on line 2 (see Table for Computing Gift Tax in instructions) Balance. Subtract line 5 from line 4 . . . . . . . . . . . . . . .

. .

Applicable credit amount. If donor has DSUE amount from predeceased spouse(s) or Restored Exclusion Amount, enter amount from Schedule C, line 5; otherwise, see instructions . . . . . . . . .

8 9

Enter the applicable credit against tax allowable for all prior periods (from Sch. B, line 1, col. C) Balance. Subtract line 8 from line 7. Do not enter less than zero . . . . . . . . . .

Enter 20% (0.20) of the amount allowed as a specific exemption for gifts made after September 8, 1976, and before January 1, 1977. See instructions . . . . . . . . . . . . . . . . . .

Balance. Subtract line 10 from line 9. Do not enter less than zero

12 13 14

Applicable credit. Enter the smaller of line 6 or line 11 . Credit for foreign gift taxes (see instructions) . . . Total credits. Add lines 12 and 13 . . . . . . .

. . .

15 16 17

. . .

18 19 20

. . .

Sign Here

. . .

. .

. . . . . .

. .

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

2,003,000 1,200,000 3,203,000 1,227,000a 425,800b 801,200

4,769,800 425,800 4,344,000 4,344,000 801,200 0 801,200 0 0 0 0

Ned Norris

Date

Signature of donor

Print/Type preparer’s name Paid Preparer Firm’s name Use Only

4/7/23

Preparer’s signature

Date

Firm’s address

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see the instructions for this form.

aTax on line 3 = $345,800 + [($3,203,000 - $1,000,000) x 0.40] bTax on line 2 = $345,800 + [($1,200,000 - $1,000,000) x 0.40]

Check if self-employed

PTIN

Firm's EIN Phone no. Cat. No. 16783M

Form 709 (2022)

C:12-59 Page 2

Form 709 (2022)

SCHEDULE A A B

Computation of Taxable Gifts (Including transfers in trust) (see instructions)

Part 1—Gifts Subject Only to Gift Tax. Gifts less political organization, medical, and educational exclusions. See instructions. A Item number

1 2 3 4

B • Donee’s name and address • Relationship to donor (if any) • Description of gift • If the gift was of securities, give CUSIP no. • If closely held entity, give EIN

D Donor’s adjusted basis of gift

E Date of gift

F Value at date of gift

G For split gifts, enter 1/2 of column F

300,000 2022 2,000,000 2022 18,000 320,000 2022 525,000 2022 17,000

Nathan Norris, son, land Natalie Norris, daughter, rent paid County Hospital, beach house Nathan Norris, son, ins. prem.

2,000,000 18,000 525,000 17,000

Gifts made by spouse—complete only if you are splitting gifts with your spouse and he/she also made gifts.

Total of Part 1. Add amounts from Part 1, column H .

H Net transfer (subtract col. G from col. F)

*2,560,000

Part 2—Direct Skips. Gifts that are direct skips and are subject to both gift tax and generation-skipping transfer tax. You must list the gifts in chronological order. A Item number

B • Donee’s name and address • Relationship to donor (if any) • Description of gift • If the gift was of securities, give CUSIP no. • If closely held entity, give EIN

C 2632(b) election out

D Donor’s adjusted basis of gift

E Date of gift

F Value at date of gift

G For split gifts, enter 1/2 of column F

H Net transfer (subtract col. G from col. F)

Gifts made by spouse—complete only if you are splitting gifts with your spouse and he/she also made gifts.

B • Donee’s name and address • Relationship to donor (if any) • Description of gift • If the gift was of securities, give CUSIP no. • If closely held entity, give EIN

C 2632(c) election

D Donor’s adjusted basis of gift

E Date of gift

F Value at date of gift

G For split gifts, enter 1/2 of column F

H Net transfer (subtract col. G from col. F)

Gifts made by spouse—complete only if you are splitting gifts with your spouse and he/she also made gifts.

Total of Part 3. Add amounts from Part 3, column H . . (If more space is needed, attach additional statements.)

*Four transfer types are not subject to gift tax, including tuition payments made directly to the educational institution. Per Form 709 instructions, these transfers are not "gifts" for Form 709 or its instructions. Thus, tuition paid for daughter Natalie should not be listed on Form 709, Schedule A.

Form 709 (2022)

C:12-59 Page 3

Form 709 (2022)

Part 4—Taxable Gift Reconciliation 1 2 3

. . .

2,560,000 48,000a 2,512,000

1 2 3

Deductions (see instructions) 4

Gifts of interests to spouse for which a marital deduction will be claimed, based on item numbers of Schedule A . . . . . . 4

5 6 7

Exclusions attributable to gifts on line 4 . . Marital deduction. Subtract line 5 from line 4 . Charitable deduction, based on item numbers

8 9 10 11

. .

. . . . . . . . . . less exclusions

. .

5 6 7

509,000b . . . .

. . . .

509,000 2,003,000

8 9 10

2,003,000

SCHEDULE B

Gifts From Prior Periods

B Internal Revenue office where prior return was filed

2014

Cincinnati, OH

C Amount of applicable credit (unified credit) against gift tax for periods after December 31, 1976

D Amount of specific exemption for prior periods ending before January 1, 1977

E Amount of taxable gifts

425,800c

-0-

1,200,000

425,800

-0-

1,200,000

Totals for prior periods

2 3

(If more space is needed, attach additional statements.)

-0-

1,200,000 Form 709 (2022)

a$16,000 each for gifts to Nathan, Natalie, and County Hospital. b$525,000 to County Hospital - $16,000 annual exclusion. cTax on $1.2 million gift [$345,800 + ($200,000 x 0.40)], which is less than credit limitation.

C:13-62 Form

706

United States Estate (and Generation-Skipping Transfer) Tax Return

(Rev. August 2019) Department of the Treasury Internal Revenue Service

Part 2—Tax Computation

Part 1—Decedent and Executor

1a 3a

OMB No. 1545-0015

Estate of a citizen or resident of the United States (see instructions). To be filed for decedents dying after December 31, 2018. Go to www.irs.gov/Form706 for instructions and the latest information.

Decedent’s first name and middle initial (and maiden name, if any)

1b Decedent’s last name

City, town, or post office; county; state or province; country; and ZIP or foreign postal code

3b Year domicile established

4 Date of birth

Eastern City, PA 19000

6b Executor’s address (number and street including apartment or suite no.; city, town, or post office; state or province; country; and ZIP or foreign postal code) and phone no.

1930

Marcia

2 Decedent’s social security no.

Miller

XXX XX XXXX

5 Date of death

7-23-2023

Name of executor (see instructions)

Executor’s social security number (see instructions)

6d 7a

If there are multiple executors, check here and attach a list showing the names, addresses, telephone numbers, and SSNs of the additional executors. Name and location of court where will was probated or estate administered 7b Case number

8 10

If decedent died testate, check here and attach a certified copy of the will. 9 If you extended the time to file this Form 706, check here If Schedule R-1 is attached, check here 11 If you are estimating the value of assets included in the gross estate on line 1 pursuant to the special rule of Reg. section 20.2010-2(a) (7)(ii), check here

1 2 3a b

Total gross estate less exclusion (from Part 5—Recapitulation, item 13) . . Tentative total allowable deductions (from Part 5—Recapitulation, item 24) . Tentative taxable estate (subtract line 2 from line 1) . . . . . . . . State death tax deduction . . . . . . . . . . . . . . .

Hy Phee

Phone no.

. . . .

1 2 3a 3b

Taxable estate (subtract line 3b from line 3a) .

4 5 6

Adjusted taxable gifts (see instructions) . . . . . . . . . Add lines 3c and 4 . . . . . . . . . . . . . . . Tentative tax on the amount on line 5 from Table A in the instructions

. .

3c 4 5 6

Total gift tax paid or payable (see instructions)

8 9a

Gross estate tax (subtract line 7 from line 6) . Basic exclusion amount . . . . . . .

. .

. 9a

Deceased spousal unused exclusion (DSUE) amount from predeceased spouse(s), if any (from Section D, Part 6—Portability of Deceased Spousal Unused Exclusion). Restored exclusion amount (see instructions) . . . . . . . . . Applicable exclusion amount (add lines 9a, 9b, and 9c) . . . . . .

c d

. . . .

15,611,500 x 40% + 345,800

Applicable credit amount (tentative tax on the amount in 9d from Table A in the instructions) . . . . . . . . . . . . . . Adjustment to applicable credit amount (May not exceed $6,000. See instructions.) . . . . . . . . . . . . . . . . . . Allowable applicable credit amount (subtract line 10 from line 9e) . .

12 13 14

Subtract line 11 from line 8 (but do not enter less than zero) . . . . Credit for foreign death taxes (from Schedule P). (Attach Form(s) 706-CE.) Credit for tax on prior transfers (from Schedule Q) . . . . . . .

e 10

9b 9c

9e 10 .

-0-

15 16 17

Total credits (add lines 13 and 14) . . . . . . . . . . . . . . . Net estate tax (subtract line 15 from line 12) . . . . . . . . . . . . Generation-skipping transfer (GST) taxes payable (from Schedule R, Part 2, line 10)

. . .

15 16 17

18 19 20

Total transfer taxes (add lines 16 and 17) . . . . . . . Prior payments (explain in an attached statement) . . . . Balance due (or overpayment) (subtract line 19 from line 18) .

. . .

18 19 20

. . .

. 13 14

. . .

16,611,500 -016,611,500 6,590,400 -06,590,400

12,920,000 5,113,800

12,920,000 -0-

17,962,300 1,350,800 16,611,500

. . .

5,113,800 1,476,600 1,476,600 1,476,600 1,476,600

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than the executor) is based on all information of which preparer has any knowledge.

Sign Here

Date

Signature of executor

Date

Signature of executor

Paid Preparer Use Only

Print/Type preparer’s name

Preparer’s signature

Date

Firm’s name

Check if self-employed

PTIN

Firm's EIN

Firm’s address

Phone no.

For Privacy Act and Paperwork Reduction Act Notice, see instructions.

Cat. No. 20548R

Note: Pages that are not relevant are not included.

Form 706 (Rev. 8-2019)

C:13-62 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of: Marcia Miller Part 3—Elections by the Executor

XXX

XXXX

Note: For information on electing portability of the decedent's DSUE amount, including how to opt out of the election, see Part 6— Portability of Deceased Spousal Unused Exclusion. Note: Some of the following elections may require the posting of bonds or liens. Please check “Yes” or “No” for each question. See instructions. 1 Do you elect alternate valuation? . . . . . . . .

Yes No

Do you elect special-use valuation? If “Yes,” you must complete and attach Schedule A-1

1 2

Do you elect to pay the taxes in installments as described in section 6166? . . . . . . . . . . . . . . . If “Yes,” you must attach the additional information described in the instructions. Note: By electing section 6166 installment payments, you may be required to provide security for estate tax deferred under section 6166 and interest in the form of a surety bond or a section 6324A lien. Do you elect to postpone the part of the taxes due to a reversionary or remainder interest as described in section 6163? .

3 4

Part 4—General Information

X X X X

Note: Please attach the necessary supplemental documents. You must attach the death certificate. See instructions. Authorization to receive confidential tax information under Reg. section 601.504(b)(2)(i); to act as the estate’s representative before the IRS; and to make written or oral presentations on behalf of the estate: Name of representative (print or type)

State

Address (number, street, and room or suite no., city, state, and ZIP code)

certified public accountant/ I declare that I am the attorney/ enrolled agent (check the applicable box) for the executor. I am not under suspension or disbarment from practice before the Internal Revenue Service and am qualified to practice in the state shown above.

CAF number

Signature

Date

Telephone number

Death certificate number and issuing authority (attach a copy of the death certificate to this return).

Decedent’s business or occupation. If retired, check here

Marital status of the decedent at time of death:

For all prior marriages, list the name and SSN of the former spouse, the date the marriage ended, and whether the marriage ended by annulment, divorce, or death. Attach additional statements of the same size if necessary.

x Married

and state decedent’s former business or occupation.

Single

Widow/widower

Legally separated

Divorced

Arthur Adams, ended in 1995 with his death

Surviving spouse’s name

Individuals (other than the surviving spouse), trusts, or other estates who receive benefits from the estate (do not include charitable beneficiaries shown in Schedule O) (see instructions).

4b Social security number

Matt Miller

Name of individual, trust, or estate receiving $5,000 or more

Andy Adams Annie Adams Archie Adams

4c Amount received (see instructions)

1,165,000a

Identifying number

All unascertainable beneficiaries and those who receive less than $5,000 . Total . . . . . . . . . . . . . . . . . . . . .

. .

Relationship to decedent

Amount (see instructions)

14,414,900 b,c 360,000b,d 360,000b

Son Daughter Son

. .

15,134,900e Yes No

If you answer “Yes” to any of the following questions, you must attach additional information as described. 6

Is the estate filing a protective claim for refund? . . . . . . . . If “Yes,” complete and attach two copies of Schedule PC for each claim.

Does the gross estate contain any section 2044 property (qualified terminable interest property (QTIP) from a prior gift or estate)? See instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Have federal gift tax returns ever been filed? . . . . . . . . . . . . . If “Yes,” attach copies of the returns, if available, and furnish the following information.

Period(s) covered

X X

c Internal Revenue office(s) where filed

Was there any insurance on the decedent’s life that is not included on the return as part of the gross estate? .

Did the decedent own any insurance on the life of another that is not included in the gross estate? .

X X

Page 2 aSee Schedule M for details. bAmount includes one-third of amount from included portion of QTIP trust (1/3 x $1,080,000 = $360,000). See Schedule F for QTIP calculation. c$16,611,500 – $1,476,600 – (2 x $360,000) dAmount does not include $500,000 from trust in which decedent held a special power of appointment; the trust is not included in the gross estate. e$16,611,500 taxable estate – $1,476,600 estate taxes = $15,134,900

C:13-62 Form 706 (Rev. 8-2019)

Decedent’s social security number

XXX

Estate of: Marcia Miller Part 4—General Information (continued)

XX XXXX

Yes No

If you answer “Yes” to any of the following questions, you must attach additional information as described. 10

Did the decedent at the time of death own any property as a joint tenant with right of survivorship in which (a) one or more of the other joint tenants was someone other than the decedent’s spouse, and (b) less than the full value of the property is included on the return as part of the gross estate? If “Yes,” you must complete and attach Schedule E . . . . . . . . . . .

11a

Did the decedent, at the time of death, own any interest in a partnership (for example, a family limited partnership), an unincorporated business, or a limited liability company; or own any stock in an inactive or closely held corporation? . . . .

If “Yes,” was the value of any interest owned (from above) discounted on this estate tax return? If “Yes,” see the instructions on reporting the total accumulated or effective discounts taken on Schedule F or G . . . . . . . . . . . . . .

Did the decedent make any transfer described in sections 2035, 2036, 2037, or 2038? See instructions. If “Yes,” you must complete and attach Schedule G . . . . . . . . . . . . . . . . . . . . . . . . . . . . Were there in existence at the time of the decedent’s death any trusts created by the decedent during his or her lifetime? . .

X X

12 13a b c

Were there in existence at the time of the decedent’s death any trusts not created by the decedent under which the decedent possessed any power, beneficial interest, or trusteeship? . . . . . . . . . . . . . . . . . . . . . Was the decedent receiving income from a trust created after October 22, 1986, by a parent or grandparent? . . . . . . If “Yes,” was there a GST taxable termination (under section 2612) on the death of the decedent?

If there was a GST taxable termination (under section 2612), attach a statement to explain. Provide a copy of the trust or will creating the trust, and give the name, address, and phone number of the current trustee(s).

Did the decedent at any time during his or her lifetime transfer or sell an interest in a partnership, limited liability company, or closely held corporation to a trust described in lines 13a or 13b? . . . . . . . . . . . . . . . . . . . If “Yes,” provide the EIN for this transferred/sold item.

Did the decedent ever possess, exercise, or release any general power of appointment? If “Yes,” you must complete and attach Schedule H

Did the decedent have an interest in or a signature or other authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account? . . . . . . . . . . . . . . . . . . . . .

Was the decedent, immediately before death, receiving an annuity described in the “General” paragraph of the instructions for Schedule I or a private annuity? If “Yes,” you must complete and attach Schedule I . . . . . . . . . . . . .

Was the decedent ever the beneficiary of a trust for which a deduction was claimed by the estate of a predeceased spouse under section 2056(b)(7) and which is not reported on this return? If “Yes,” attach an explanation . . . . . . . . .

X X X X X

Part 5—Recapitulation. Note: If estimating the value of one or more assets pursuant to the special rule of Reg. section 20.2010-2(a)(7)(ii), enter on both lines 10 and 23 the amount noted in the instructions for the corresponding range of values. See instructions for details. Item no.

Gross estate

Schedule A—Real Estate

2 3 4 5 6 7 8

Schedule B—Stocks and Bonds . . . . . . . . . . . . . . Schedule C—Mortgages, Notes, and Cash . . . . . . . . . . . Schedule D—Insurance on the Decedent’s Life (attach Form(s) 712) . . . . Schedule E—Jointly Owned Property (attach Form(s) 712 for life insurance) . Schedule F—Other Miscellaneous Property (attach Form(s) 712 for life insurance) Schedule G—Transfers During Decedent’s Life (att. Form(s) 712 for life insurance) Schedule H—Powers of Appointment . . . . . . . . . . . .

9 10 11

Estimated value of assets subject to the special rule of Reg. section 20.2010-2(a)(7)(ii)

Schedule U—Qualified Conservation Easement Exclusion

Total gross estate less exclusion (subtract item 12 from item 11). Enter here and on line 1 of Part 2—Tax Computation . . . . . . . . . . . . .

Schedule I—Annuities

Alternate value

Total gross estate (add items 1 through 10) .

. .

14,300,000 1,017,300 1,000,000 425,000 1,220,000 -0-0-0-017,962,300 -0-

17,962,300

Item no.

Deductions

Schedule J—Funeral Expenses and Expenses Incurred in Administering Property Subject to Claims . . . . . Schedule K—Debts of the Decedent . . . . . . . . . . . . . . . . . . . . . Schedule K—Mortgages and Liens . . . . . . . . . . . . . . . . . . . . . Total of items 14 through 16 . . . . . . . . . . . . . . . . . . . . . . . Allowable amount of deductions from item 17 (see the instructions for item 18 of the Recapitulation) . . . . . Schedule L—Net Losses During Administration . . . . . . . . . . . . . . . . . . Schedule L—Expenses Incurred in Administering Property Not Subject to Claims . . . . . . . . Schedule M—Bequests, etc., to Surviving Spouse . . . . . . . . . . . . . . . . . Schedule O—Charitable, Public, and Similar Gifts and Bequests . . . . . . . . . . . . . Estimated value of deductible assets subject to the special rule of Reg. section 20.2010-2(a)(7)(ii) . . . Tentative total allowable deductions (add items 18 through 23). Enter here and on line 2 of the Tax Computation

15 16 17 18 19 20 21 22 23 24

Value at date of death

1 2 3 4 5 6 7 8 9 10 11 12

Amount

14 15 16 17 18 19 20 21 22 23 24

135,000 800 135,800 135,800

1,165,000 50,000 1,350,800

Page 3

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Marcia Miller

XXX

XXXX

SCHEDULE B—Stocks and Bonds (For jointly owned property that must be disclosed on Schedule E, see instructions.) Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last four columns. Item number

Description, including face amount of bonds or number of shares and par value for identification. Give CUSIP number. If trust, partnership, or closely held entity, give EIN.

Unit value

Alternate valuation date

Alternate value

Value at date of death

CUSIP number or EIN, where applicable

Stock portfolio

14,300,000

Total from continuation schedules (or additional statements) attached to this schedule TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 2.) . . . . . . .

. .

14,300,000

(If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule B—Page 10

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

XXX XX XXXX

Marcia Miller SCHEDULE C—Mortgages, Notes, and Cash

(For jointly owned property that must be disclosed on Schedule E, see instructions.) Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Description

Alternate valuation date

Alternate value

Value at date of death

Cash in money market account

1,000,000

Accrued interest on money market account

2,200

Checking account, held with spouse as tenants in common, 50% of account balance is included

15,100

Total from continuation schedules (or additional statements) attached to this schedule . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 3.) . . . . . . . . . (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

1,017,300

Schedule C—Page 11

C:13-62 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of:

XXX XX XXXX

Marcia Miller SCHEDULE D—Insurance on the Decedent’s Life

You must list all policies on the life of the decedent and attach a Form 712 for each policy. Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Description

Alternate valuation date

Life insurance policy; estate is beneﬁciary

Alternate value

Value at date of death

1,000,000

Total from continuation schedules (or additional statements) attached to this schedule . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 4.) . . . . . . . . . (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

1,000,000

Schedule D—Page 12

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Marcia Miller

XXX XX XXXX

SCHEDULE E—Jointly Owned Property

(If you elect section 2032A valuation, you must complete Schedule E and Schedule A-1.)

PART 1. Qualified Joint Interests—Interests Held by the Decedent and His or Her Spouse as the Only Joint Tenants (Section 2040(b)(2)) Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Alternate valuation date

Description. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN.

Value at date of death

Alternate value

CUSIP number or EIN, where applicable

1 Principal residence 117 Brandywine Way Eastern City, PA 19000

1a 1b

850,000

Total from continuation schedules (or additional statements) attached to this schedule .

Totals . . . . . . . . . . . . . . . Amounts included in gross estate (one-half of line 1a) .

. .

850,000 425,000

1a 1b

PART 2. All Other Joint Interests 2a

State the name and address of each surviving co-tenant. If there are more than three surviving co-tenants, list the additional co-tenants on an attached statement. Name

Address (number and street, city, state, and ZIP code)

A. B. C. Item number

Enter letter for co-tenant

Description (including alternate valuation date if any). For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

Percentage includible

Includible alternate value

Includible value at date of death

CUSIP number or EIN, where applicable

Total from continuation schedules (or additional statements) attached to this schedule .

Total other joint interests

Total includible joint interests (add lines 1b and 2b). Also enter on Part 5—Recapitulation, page 3, at item 5 . . . . . . . . . . . . . . . . . . . . . . . . .

. 2b 3

425,000

(If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule E—Page 13

C:13-62 Form 706 (Rev. 8-2019)

Decedent’s social security number

XXX XX XXXX

Estate of: Marcia Miller

SCHEDULE F—Other Miscellaneous Property Not Reportable Under Any Other Schedule (For jointly owned property that must be disclosed on Schedule E, see instructions.) (If you elect section 2032A valuation, you must complete Schedule F and Schedule A-1.) Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the 706 is being value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns.

1 Did the decedent own any works of art, items, or any collections whose artistic or collectible value at date of death exceeded $3,000? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . If “Yes,” submit full details on this schedule and attach appraisals. 2 Has the decedent’s estate, spouse, or any other person received (or will receive) any bonus or award as a result of the decedent’s employment or death? . . . . . . . . . . . . . . . . . . . . . . . . . . If “Yes,” submit full details on this schedule. 3 Did the decedent at the time of death have, or have access to, a safe deposit box? . . . . . . . . . . . If ‘‘Yes,’’ state location, and if held jointly by decedent and another, state name and relationship of joint depositor.

Yes No

X X X

If any of the contents of the safe deposit box are omitted from the schedules in this return, explain fully why omitted.

Item number

Description. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

Alternate valuation date

Alternate value

Value at date of death

CUSIP number or EIN, where applicable

1 2

Household furnishings QTIP Trust at Franklin State Bank for which executor elected a 60% marital deduction; 60% of 1,800,000 is includible

140,000

1,080,000

Total from continuation schedules (or additional statements) attached to this schedule . 1,220,000 TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 6.) . . . . . . . . . . (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule F—Page 14

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

XXX XX XXXX

Marcia Miller

SCHEDULE G—Transfers During Decedent’s Life (If you elect section 2032A valuation, you must complete Schedule G and Schedule A-1.) Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Description. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

Gift tax paid or payable by the decedent or the estate for all gifts made by the decedent or his or her spouse within 3 years before the decedent’s death (section 2035(b)) . . . . . . . . . . . . Transfers includible under sections 2035(a), 2036, 2037, or 2038:

Alternate valuation date

Alternate value

Value at date of death

X X X X X

Total from continuation schedules (or additional statements) attached to this schedule . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 7.) . . . . . . . .

. .

SCHEDULE H—Powers of Appointment

(Include “5 and 5 lapsing” powers (section 2041(b)(2)) held by the decedent.) (If you elect section 2032A valuation, you must complete Schedule H and Schedule A-1.)

Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Description

Alternate valuation date

Alternate value

Value at date of death

-0-*

Total from continuation schedules (or additional statements) attached to this schedule . . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 8.) . . . . . . . . . . -0(If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

*Note: Decedent held a special, but not general, power of appointment in a $500,000 trust at Quaker State Bank. Schedules G and H—Page 15

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Marcia Miller

XXX XX XXXX

SCHEDULE J—Funeral Expenses and Expenses Incurred in Administering Property Subject to Claims Use Schedule PC to make a protective claim for refund due to an expense not currently deductible. For such a claim, report the expense on Schedule J but without a value in the last column.

Note: Do not list expenses of administering property not subject to claims on this schedule. To report those expenses, see instructions. If executors’ commissions, attorney fees, etc., are claimed and allowed as a deduction for estate tax purposes, they are not allowable as a deduction in computing the taxable income of the estate for federal income tax purposes. They are allowable as an income tax deduction on Form 1041, U.S. Income Tax Return for Estates and Trusts, if a waiver is filed to forgo the deduction on Form 706. See the Instructions for Form 1041. Are you aware of any actual or potential reimbursement to the estate for any expense claimed as a deduction on this schedule? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . If “Yes,” attach a statement describing the expense(s) subject to potential reimbursement. See instructions. Item number

Description

Expense amount

A. Funeral expenses:

Funeral and tombstone

Total funeral expenses .

Yes No

Total amount

15,000

B. Administration expenses: 1 Executors’ commissions—amount estimated/agreed upon/paid. (Strike out the words that do not apply.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Attorney fees—amount estimated/agreed upon/paid. (Strike out the words that do not apply.) . . 3 Accountant fees—amount estimated/agreed upon/paid. (Strike out the words that do not apply.) .

15,000

120,000

Expense amount

4 Miscellaneous expenses:

Total miscellaneous expenses from continuation schedules (or additional statements) attached to this schedule . . . . . . . . . . . . . . . . . . . . . Total miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 14.) . . . . . . . . . . . . . . (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

135,000

Schedule J—Page 17

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Marcia Miller

XXX XX XXXX

SCHEDULE K—Debts of the Decedent, and Mortgages and Liens

Use Schedule PC to make a protective claim for refund due to a claim not currently deductible. For such a claim, report the expense on Schedule K but without a value in the last column.

Yes No Are you aware of any actual or potential reimbursement to the estate for any debt of the decedent, mortgage, or lien claimed as a deduction on this schedule? . . . . . . . . . . . . . . . . . . . . . . . . . If “Yes,” attach a statement describing the items subject to potential reimbursement. See instructions. Are any of the items on this schedule deductible under Reg. section 20.2053-4(b) and Reg. section 20.2053-4(c)? . . If “Yes,” attach a statement indicating the applicable provision and documenting the value of the claim. Item number

Debts of the Decedent—Creditor and nature of debt, and allowable death taxes

Item number

Amount

Amount owed to country club

Total from continuation schedules (or additional statements) attached to this schedule . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 15.) . . . . . . .

800

. .

Mortgages and Liens—Description

. .

800 Amount

Total from continuation schedules (or additional statements) attached to this schedule . . . . . . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 16.) . . . . . . . . . . . . . (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule K—Page 18

C:13-62 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Marcia Miller

XXX XX XXXX

SCHEDULE M—Bequests, etc., to Surviving Spouse Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entry in the last column. Yes

1 2a b c d

Did any property pass to the surviving spouse as a result of a qualified disclaimer? . . . . . . . If ‘‘Yes,’’ attach a copy of the written disclaimer required by section 2518(b). In what country was the surviving spouse born? What is the surviving spouse’s date of birth? Is the surviving spouse a U.S. citizen? . . . . . . . . . . . . . . . . . . . . . . If the surviving spouse is a naturalized citizen, when and where did the surviving spouse acquire citizenship?

If the surviving spouse is not a U.S. citizen, of what country is the surviving spouse a citizen?

Election Out of QTIP Treatment of Annuities. Do you elect under section 2056(b)(7)(C)(ii) not to treat as qualified terminable interest property any joint and survivor annuities that are included in the gross estate and would otherwise be treated as qualified terminable interest property under section 2056(b)(7)(C)? See instructions

Item number

Description of property interests passing to surviving spouse. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

U.S.A.

N/A N/A

3 Amount

QTIP property:

Property to QTIP trust at PHL Bank

500,000

All other property:

2 3 4

Tangible personal property (household furnishings) $100,000 passing as a result of a qualiﬁed disclaimer by Annette Principal residence (JTWROS)

140,000 100,000 425,000

Total from continuation schedules (or additional statements) attached to this schedule . . . . . . . . Total amount of property interests listed on Schedule M . . . . . . . . . . . . . . . 4 Federal estate taxes payable out of property interests listed on Schedule M . . . 5a Other death taxes payable out of property interests listed on Schedule M . . . . 5b Federal and state GST taxes payable out of property interests listed on Schedule M 5c Add items 5a, 5b, and 5c . . . . . . . . . . . . . . . . . . . . . . . . . 5d Net amount of property interests listed on Schedule M (subtract item 5d from item 4). Also enter on Part 5—Recapitulation, page 3, at item 21 . . . . . . . . . . . . . . . . . . . . 6 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

1,165,000

4 5a b c d 6

1,165,000

Schedule M—Page 20

C:13-62 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of: Marcia Miller

XXX XX XXXX

SCHEDULE O—Charitable, Public, and Similar Gifts and Bequests Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entry in the last column. Yes

If the transfer was made by will, has any action been instituted to contest or have interpreted any of its provisions affecting the charitable deductions claimed in this schedule? . . . . . . . . . . . . . . . . . . If ‘‘Yes,’’ full details must be submitted with this schedule.

b According to the information and belief of the person or persons filing this return, is any such action planned? If ‘‘Yes,’’ full details must be submitted with this schedule.

Did any property pass to charity as the result of a qualified disclaimer? . . If ‘‘Yes,’’ attach a copy of the written disclaimer required by section 2518(b).

Item number

Name and address of beneficiary

Character of institution

Amount

Religious

50,000

First Lutheran Church

Total from continuation schedules (or additional statements) attached to this schedule

Total

Federal estate tax payable out of property interests listed above .

b Other death taxes payable out of property interests listed above .

Federal and state GST taxes payable out of property interests listed above .

4c .

d Add items 4a, 4b, and 4c

50,000

Net value of property interests listed above (subtract item 4d from item 3). Also enter on Part 5— Recapitulation, page 3, at item 22 . . . . . . . . . . . . . . . . . . . . . . 5 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.) 5

50,000

Schedule O—Page 21

C:13-63 Form

706

United States Estate (and Generation-Skipping Transfer) Tax Return

(Rev. August 2019) Department of the Treasury Internal Revenue Service

Part 2—Tax Computation

Part 1—Decedent and Executor

1a 3a

OMB No. 1545-0015

Decedent’s first name and middle initial (and maiden name, if any)

1b Decedent’s last name

2 Decedent’s social security no.

XXX XX XXXX

Adam

Zugg

City, town, or post office; county; state or province; country; and ZIP or foreign postal code

3b Year domicile established

4 Date of birth

5 Date of death

10-31-2023

6b Executor’s address (number and street including apartment or suite no.; city, town, or post office; state or province; country; and ZIP or foreign postal code) and phone no.

Midwest City, IL 60000 Name of executor (see instructions)

Executor’s social security number (see instructions)

6d 7a

8 10

1 2 3a b

. . . .

1 2 3a 3b

Phone no.

Taxable estate (subtract line 3b from line 3a) .

4 5 6

Adjusted taxable gifts (see instructions) . . . . . . . . . Add lines 3c and 4 . . . . . . . . . . . . . . . Tentative tax on the amount on line 5 from Table A in the instructions

. .

3c 4 5 6

Total gift tax paid or payable (see instructions)

8 9a

Gross estate tax (subtract line 7 from line 6) . Basic exclusion amount . . . . . . .

. .

. 9a

c d

13,623,800 x 40% + 345,800

12 13

Subtract line 11 from line 8 (but do not enter less than zero) . . . . Credit for foreign death taxes (from Schedule P). (Attach Form(s) 706-CE.)

14 15 16

Credit for tax on prior transfers (from Schedule Q) . Total credits (add lines 13 and 14) . . . . . . Net estate tax (subtract line 15 from line 12) . . .

e 10

12,920,000

17,527,100 2,858,300 14,668,800 45,000 14,623,800 14,623,800 5,795,320 5,795,320

9b 9c

12,920,000 5,113,800

9d 9e 10 .

5,113,800 681,520

. .

15 16

Generation-skipping transfer (GST) taxes payable (from Schedule R, Part 2, line 10)

681,520

18 19

Total transfer taxes (add lines 16 and 17) . . . . Prior payments (explain in an attached statement) .

. .

18 19

Balance due (or overpayment) (subtract line 19 from line 18) .

. . . . .

. . .

. .

. 13 14 . .

681,520 681,520

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than the executor) is based on all information of which preparer has any knowledge.

Sign Here

Date

Signature of executor

Date

Signature of executor

Paid Preparer Use Only

Print/Type preparer’s name

Preparer’s signature

Date

Firm’s name

Check if self-employed

PTIN

Firm's EIN

Firm’s address

Phone no.

For Privacy Act and Paperwork Reduction Act Notice, see instructions.

Cat. No. 20548R

Form 706 (Rev. 8-2019)

C:13-63 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of: Adam Zugg Part 3—Elections by the Executor

XXX

XXXX

Yes No

Do you elect special-use valuation? If “Yes,” you must complete and attach Schedule A-1

1 2

3 4

Part 4—General Information

X X X X

State

Address (number, street, and room or suite no., city, state, and ZIP code)

CAF number

Signature

Date

Telephone number

Death certificate number and issuing authority (attach a copy of the death certificate to this return).

Decedent’s business or occupation. If retired, check here

Marital status of the decedent at time of death:

Surviving spouse’s name

Individuals (other than the surviving spouse), trusts, or other estates who receive benefits from the estate (do not include charitable beneficiaries shown in Schedule O) (see instructions).

Office Manager

Married

Widow/widower

and state decedent’s former business or occupation.

Single

Legally separated

4b Social security number

Callie Zugg

Name of individual, trust, or estate receiving $5,000 or more

Zebulon Zugg

4c Amount received (see instructions)

2,805,100

Identifying number

All unascertainable beneficiaries and those who receive less than $5,000 . Total . . . . . . . . . . . . . . . . . . . . .

. .

Divorced

Relationship to decedent

Amount (see instructions)

13,942,280*

Son

. .

Yes No

If you answer “Yes” to any of the following questions, you must attach additional information as described. 6

Is the estate filing a protective claim for refund? . . . . . . . . If “Yes,” complete and attach two copies of Schedule PC for each claim.

Have federal gift tax returns ever been filed? . . . . . . . . . . . . . If “Yes,” attach copies of the returns, if available, and furnish the following information.

Period(s) covered

9a b

Was there any insurance on the decedent’s life that is not included on the return as part of the gross estate? .

Did the decedent own any insurance on the life of another that is not included in the gross estate? .

2017

X X

c Internal Revenue office(s) where filed

*$14,623,800 taxable estate – $681,520 estate tax owed

X X

Page 2

C:13-63 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of: Adam Zugg Part 4—General Information (continued)

XXX

XX XXXX

Yes No

If you answer “Yes” to any of the following questions, you must attach additional information as described. 10

11a

12 13a b c

Did the decedent ever possess, exercise, or release any general power of appointment? If “Yes,” you must complete and attach Schedule H

X X X X X X

X X

Gross estate

Alternate value

1 2 3 4

Schedule A—Real Estate . . . . . . . . . . . . . Schedule B—Stocks and Bonds . . . . . . . . . . . Schedule C—Mortgages, Notes, and Cash . . . . . . . . Schedule D—Insurance on the Decedent’s Life (attach Form(s) 712) .

5 6 7 8

Schedule E—Jointly Owned Property (attach Form(s) 712 for life insurance) . Schedule F—Other Miscellaneous Property (attach Form(s) 712 for life insurance) Schedule G—Transfers During Decedent’s Life (att. Form(s) 712 for life insurance) Schedule H—Powers of Appointment . . . . . . . . . . . .

9 10 11

Estimated value of assets subject to the special rule of Reg. section 20.2010-2(a)(7)(ii)

Schedule U—Qualified Conservation Easement Exclusion

Total gross estate less exclusion (subtract item 12 from item 11). Enter here and on line 1 of Part 2—Tax Computation . . . . . . . . . . . . .

Item no.

Schedule I—Annuities

Total gross estate (add items 1 through 10) .

. .

. . . .

Value at date of death

4,400,000 10,300,000 -02,000,000 5,100 22,000 -0-0800,000 -017,527,100 -017,527,100

1 2 3 4 5 6 7 8 9 10 11 12 13

Deductions

Amount

15 16 17 18 19

Schedule J—Funeral Expenses and Expenses Incurred in Administering Property Subject to Claims Schedule K—Debts of the Decedent . . . . . . . . . . . . . . . . Schedule K—Mortgages and Liens . . . . . . . . . . . . . . . . Total of items 14 through 16 . . . . . . . . . . . . . . . . . . Allowable amount of deductions from item 17 (see the instructions for item 18 of the Recapitulation) Schedule L—Net Losses During Administration . . . . . . . . . . . . .

. . . . . .

20 21 22 23 24

Schedule L—Expenses Incurred in Administering Property Not Subject to Claims . . . . . . . . Schedule M—Bequests, etc., to Surviving Spouse . . . . . . . . . . . . . . . . . Schedule O—Charitable, Public, and Similar Gifts and Bequests . . . . . . . . . . . . . Estimated value of deductible assets subject to the special rule of Reg. section 20.2010-2(a)(7)(ii) . . . Tentative total allowable deductions (add items 18 through 23). Enter here and on line 2 of the Tax Computation

. . . . . .

14 15 16 17 18 19 20 21 22 23 24

40,000 13,200 53,200 53,200

2,805,100 2,858,300

Page 3

C:13-63 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

XXX XX XXXX

Adam Zugg SCHEDULE A—Real Estate

• For jointly owned property that must be disclosed on Schedule E, see instructions. • Real estate that is part of a sole proprietorship should be shown on Schedule F. • Real estate that is included in the gross estate under sections 2035, 2036, 2037, or 2038 should be shown on Schedule G. • Real estate that is included in the gross estate under section 2041 should be shown on Schedule H. • If you elect section 2032A valuation, you must complete Schedule A and Schedule A-1. Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being ﬁled solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Description

Alternate valuation date

Undeveloped land

Alternate value

Value at date of death

4,400,000

Total from continuation schedules or additional statements attached to this schedule . . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 1.) . . . . . . . . . 4,400,000 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule A—Page 5

C:13-63 Form 706 (Rev. 8-2019)

Decedent’s social security number

XXX XX XXXX

Estate of: Adam Zugg

Description, including face amount of bonds or number of shares and par value for identification. Give CUSIP number. If trust, partnership, or closely held entity, give EIN.

Unit value

Alternate valuation date

Alternate value

Value at date of death

CUSIP number or EIN, where applicable

Stocks in public companies

Total from continuation schedules (or additional statements) attached to this schedule TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 2.) . . . . . . .

10,300,000

. .

10,300,000

(If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule B—Page 10

C:13-63 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of:

XXX

Adam Zugg

XXXX

SCHEDULE D—Insurance on the Decedent’s Life You must list all policies on the life of the decedent and attach a Form 712 for each policy. Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being filed solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns. Item number

Description

Alternate valuation date

Term life insurance on life of Adam Zugg; beneﬁciary is the Estate of Adam Zugg

Alternate value

Value at date of death

2,000,000

Total from continuation schedules (or additional statements) attached to this schedule . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 4.) . . . . . . . . . 2,000,000 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule D—Page 12

C:13-63 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Adam Zugg

XXX

SCHEDULE E—Jointly Owned Property

XXXX

(If you elect section 2032A valuation, you must complete Schedule E and Schedule A-1.)

Alternate valuation date

Description. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN.

Value at date of death

Alternate value

CUSIP number or EIN, where applicable

1a 1b

Checking account

10,200

Total from continuation schedules (or additional statements) attached to this schedule .

Totals . . . . . . . . . . . . . . . Amounts included in gross estate (one-half of line 1a) .

. .

10,200 5,100

1a 1b

PART 2. All Other Joint Interests 2a

State the name and address of each surviving co-tenant. If there are more than three surviving co-tenants, list the additional co-tenants on an attached statement. Name

Address (number and street, city, state, and ZIP code)

A. B. C. Item number

Enter letter for co-tenant

Description (including alternate valuation date if any). For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

Percentage includible

Includible alternate value

Includible value at date of death

CUSIP number or EIN, where applicable

Total from continuation schedules (or additional statements) attached to this schedule .

Total other joint interests

Total includible joint interests (add lines 1b and 2b). Also enter on Part 5—Recapitulation, page 3, at item 5 . . . . . . . . . . . . . . . . . . . . . . . . .

. 2b 3

5,100

(If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule E—Page 13

C:13-63 Form 706 (Rev. 8-2019)

Decedent’s social security number

XXX XX XXXX

Estate of: Adam Zugg

SCHEDULE F—Other Miscellaneous Property Not Reportable Under Any Other Schedule (For jointly owned property that must be disclosed on Schedule E, see instructions.) (If you elect section 2032A valuation, you must complete Schedule F and Schedule A-1.) Note: If the value of the gross estate, together with the amount of adjusted taxable gifts, is less than the basic exclusion amount and Form 706 is being solely to elect portability of the DSUE amount, consideration should be given as to whether you are required to report the value of assets eligible for the marital or charitable deduction on this schedule. See the instructions for more information. If you are not required to report the value of an asset, identify the property but make no entries in the last three columns.

Yes No

X X X

If any of the contents of the safe deposit box are omitted from the schedules in this return, explain fully why omitted.

Item number

Description. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

Alternate valuation date

Alternate value

Value at date of death

CUSIP number or EIN, where applicable

22,000

Automobile

Total from continuation schedules (or additional statements) attached to this schedule . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 6.) . . . . . . . . . . 22,000 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule F—Page 14

C:13-63 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

XXX XX XXXX

Adam Zugg

Description. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

Alternate valuation date

Alternate value

Value at date of death

X X X X X

Total from continuation schedules (or additional statements) attached to this schedule . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 7.) . . . . . . . .

. .

SCHEDULE H—Powers of Appointment

(Include “5 and 5 lapsing” powers (section 2041(b)(2)) held by the decedent.) (If you elect section 2032A valuation, you must complete Schedule H and Schedule A-1.)

Description

Alternate valuation date

Alternate value

Value at date of death

Total from continuation schedules (or additional statements) attached to this schedule . . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 8.) . . . . . . . . . . (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedules G and H—Page 15

C:13-63 Form 706 (Rev. 8-2019)

Decedent’s social security number

Estate of:

Adam Zugg

XXX

XXXX

SCHEDULE I—Annuities Note: Generally, no exclusion is allowed for the estates of decedents dying after December 31, 1984. See instructions.

Are you excluding from the decedent’s gross estate the value of a lump-sum distribution described in section 2039(f)(2) Yes No (as in effect before its repeal by the Deficit Reduction Act of 1984)? . . . . . . . . . . . . . . . . . X If “Yes,” you must attach the information required by the instructions.

Item number

Description. Show the entire value of the annuity before any exclusions

Alternate valuation date

Qualified retirement plan; beneficiary is spouse Callie

Includible alternate value

Includible value at date of death

800,000

Total from continuation schedules (or additional statements) attached to this schedule . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 9.) . . . . . . . . . . 800,000 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule I—Page 16

C:13-63 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Adam Zugg

XXX

XXXX

Description

Expense amount

Yes No

Total amount

A. Funeral expenses:

Funeral and tombstone

Total funeral expenses .

8,000

32,000

Expense amount

Total miscellaneous expenses from continuation schedules (or additional statements) attached to this schedule . . . . . . . . . . . . . . . . . . . . . Total miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 14.) . . . . . . . . . . . . . . 40,000 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.)

Schedule J—Page 17

C:13-63 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Adam Zugg

XXX

SCHEDULE K—Debts of the Decedent, and Mortgages and Liens

XXXX

Use Schedule PC to make a protective claim for refund due to a claim not currently deductible. For such a claim, report the expense on Schedule K but without a value in the last column.

Debts of the Decedent—Creditor and nature of debt, and allowable death taxes

Amount

Automobile loan

13,200

Total from continuation schedules (or additional statements) attached to this schedule . TOTAL (Also enter on Part 5—Recapitulation, page 3, at item 15.) . . . . . . . Item number

. .

Mortgages and Liens—Description

. .

13,200 Amount

Schedule K—Page 18

C:13-63 Form 706 (Rev. 8-2019)

Estate of:

Decedent’s social security number

Adam Zugg

XXX

XXXX

1 2a b c d

Did any property pass to the surviving spouse as a result of a qualified disclaimer? . . . . . . . If ‘‘Yes,’’ attach a copy of the written disclaimer required by section 2518(b). In what country was the surviving spouse born? U.S.A. What is the surviving spouse’s date of birth? Is the surviving spouse a U.S. citizen? . . . . . . . . . . . . . . . . . . . . . . If the surviving spouse is a naturalized citizen, when and where did the surviving spouse acquire citizenship?

If the surviving spouse is not a U.S. citizen, of what country is the surviving spouse a citizen?

N/A N/A

Item number

Description of property interests passing to surviving spouse. For securities, give CUSIP number. If trust, partnership, or closely held entity, give EIN

3 Amount

QTIP property:

All other property:

1 2 3

Stocks in public companies Qualiﬁed retirement plan Joint tenancy checking account

2,000,000 800,000 5,100

Total from continuation schedules (or additional statements) attached to this schedule . . . . . . . . 2,805,100 Total amount of property interests listed on Schedule M . . . . . . . . . . . . . . . 4 Federal estate taxes payable out of property interests listed on Schedule M . . . 5a Other death taxes payable out of property interests listed on Schedule M . . . . 5b Federal and state GST taxes payable out of property interests listed on Schedule M 5c Add items 5a, 5b, and 5c . . . . . . . . . . . . . . . . . . . . . . . . . 5d Net amount of property interests listed on Schedule M (subtract item 5d from item 4). Also enter on Part 5—Recapitulation, page 3, at item 21 . . . . . . . . . . . . . . . . . . . . 6 2,805,100 (If more space is needed, attach the continuation schedule from the end of this package or additional statements of the same size.) 4 5a b c d 6

Schedule M—Page 20

Form

C:14-55

1041 U.S. Income Tax Return for Estates and Trusts

2022

Department of the Treasury—Internal Revenue Service

Go to www.irs.gov/Form1041 for instructions and the latest information.

A Check all that apply: Decedent’s estate

✓Simple trust Complex trust Qualified disability trust ESBT (S portion only) Grantor type trust Bankruptcy estate—Ch. 7 Bankruptcy estate—Ch. 11 Pooled income fund B Number of Schedules K-1 attached (see instructions)

For calendar year 2022 or fiscal year beginning

Income Deductions Tax and Payments

, 20

Name of estate or trust (If a grantor type trust, see the instructions.)

C Employer identification number

Name and title of fiduciary

D Date entity created

Jenny Justice Trust

74-1234567

First Bank, Trustee

2005

E Nonexempt charitable and split-interest trusts, check applicable box(es). See instructions.

Number, street, and room or suite no. (If a P.O. box, see the instructions.)

P.O. Box 100 Southwest City, TX 75000

Described in sec. 4947(a)(1). Check here if not a private foundation . .

City or town, state or province, country, and ZIP or foreign postal code F Check

applicable boxes:

Described in sec. 4947(a)(2)

Initial return

Final return

Amended return

Net operating loss carryback

Change in trust’s name

Change in fiduciary

Change in fiduciary’s name

Change in fiduciary’s address

G Check here if the estate or filing trust made a section 645 election .

Trust TIN

1 2a b 3 4 5 6 7 8 9 10 11 12 13 14

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total ordinary dividends . . . . . . . . . . . . . . . . . . . . . . . . . Qualified dividends allocable to: (1) Beneficiaries (2) Estate or trust Business income or (loss). Attach Schedule C (Form 1040) . . . . . . . . . . . . . Capital gain or (loss). Attach Schedule D (Form 1041) . . . . . . . . . . . . . . . Rents, royalties, partnerships, other estates and trusts, etc. Attach Schedule E (Form 1040) . . Farm income or (loss). Attach Schedule F (Form 1040) . . . . . . . . . . . . . . . Ordinary gain or (loss). Attach Form 4797 . . . . . . . . . . . . . . . . . . . Other income. List type and amount Total income. Combine lines 1, 2a, and 3 through 8 . . . . . . . . . . . . . . . Interest. Check if Form 4952 is attached . . . . . . . . . . . . . . . . . Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fiduciary fees. If only a portion is deductible under section 67(e), see instructions .($2,000 . . – . $320 . . b) Charitable deduction (from Schedule A, line 7) . . . . . . . . . . . . . . . . . Attorney, accountant, and return preparer fees. If only a portion is deductible under section 67(e), see instructions . . . . . . . . . . . . . . . . . . . . . . . . . . .

15a b 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Other deductions (attach schedule). See instructions for deductions allowable under section 67(e) Net operating loss deduction. See instructions . . . . . . . . . . . . . . . . . Add lines 10 through 15b . . . . . . . . . . . . . . . . . . . . . . . . Adjusted total income or (loss). Subtract line 16 from line 9 . . . . . 17 Income distribution deduction (from Schedule B, line 15). Attach Schedules K-1 (Form 1041) . . Estate tax deduction including certain generation-skipping taxes (attach computation) . . . . Qualified business income deduction. Attach Form 8995 or 8995-A . . . . . . . . . . Exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add lines 18 through 21 . . . . . . . . . . . . . . . . . . . . . . . . . Taxable income. Subtract line 22 from line 17. If a loss, see instructions . . . . . . . . . Total tax (from Schedule G, Part I, line 9) . . . . . . . . . . . . . . . . . . . Current year net 965 tax liability paid from Form 965-A, Part II, column (k) (see instructions) . . Total payments (from Schedule G, Part II, line 19) . . . . . . . . . . . . . . . . Estimated tax penalty. See instructions . . . . . . . . . . . . . . . . . . . . Tax due. If line 26 is smaller than the total of lines 24, 25, and 27, enter amount owed . . . . Overpayment. If line 26 is larger than the total of lines 24, 25, and 27, enter amount overpaid . . Amount of line 29 to be: a Credited to 2023 ; b Refunded . . . . . .

Sign Here

OMB No. 1545-0092

, 2022, and ending

48,620

815c

27,000

1 2a 3 4 5 6 7 8 9 10 11 12 13

11,000 12,800a 50,800 1,680 500

14 15a 15b 16

2,180 37,620

18 19 20 21 22 23 24 25 26 27 28 29 30

300 37,920 10,700 1,185 2,000 815

Signature of fiduciary or officer representing fiduciary Print/Type preparer’s name

Paid Preparer Firm’s name Use Only Firm’s address

Date

Preparer’s signature

For Paperwork Reduction Act Notice, see the separate instructions.

EIN of fiduciary if a financial institution Date

May the IRS discuss this return with the preparer shown below? See instructions. Yes No

Check if PTIN self-employed Firm’s EIN Phone no.

Cat. No. 11370H

Form 1041 (2022)

Note: Problem C:14-55 instructs students to prepare a Form 1041 for 2023. Because the 2023 forms were not yet available as of the time of publication, 2023 figures were used where possible in preparing this 2022 tax return. a$15,000 (rents) – $1,500 (maintenance) – $700 (property taxes) = $12,800. Note: Per trust instrument, depreciation is charged to principal. bTrustee's fee allocable to tax-exempt interest. See calculation on next page. cThis is one example of how the overpayment could be allocated between a refund and application to estimated taxes. Note: Pages related to the AMT are omitted. C:TRP-137 Copyright © 2024 Pearson Education, Inc.

C:14-55 Page 2

Form 1041 (2022)

Schedule A

Charitable Deduction. Don’t complete for a simple trust or a pooled income fund.

1 2 3 4

Amounts paid or permanently set aside for charitable purposes from gross income. See instructions Tax-exempt income allocable to charitable contributions. See instructions . . . . . . . . . Subtract line 2 from line 1 . . . . . . . . . . . . . . . . . . . . . . . . . Capital gains for the tax year allocated to corpus and paid or permanently set aside for charitable purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5 6

Add lines 3 and 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Section 1202 exclusion allocable to capital gains paid or permanently set aside for charitable purposes. See instructions . . . . . . . . . . . . . . . . . . . . . . . . .

Charitable deduction. Subtract line 6 from line 5. Enter here and on page 1, line 13 .

Schedule B

4 5 6 7

Income Distribution Deduction

1 2 3 4 5 6

Adjusted total income. See instructions . . . . . . . . . . . . . . . . . . . . . Adjusted tax-exempt interest . ($8,000 – $320)b . . . . . . . . . . . . . . . Total net gain from Schedule D (Form 1041), line 19, column (1). See instructions . . . . . . . Enter amount from Schedule A, line 4 (minus any allocable section 1202 exclusion) . . . . . . Capital gains for the tax year included on Schedule A, line 1. See instructions . . . . . . . . Enter any gain from page 1, line 4, as a negative number. If page 1, line 4, is a loss, enter the loss as a positive number . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 8

Distributable net income. Combine lines 1 through 6. If zero or less, enter -0- . If a complex trust, enter accounting income for the tax year as determined under the governing instrument and applicable local law . . . . . . .

9 10 11 12 13 14 15

1 2 3

1 2 3 4 5

a b c d 2a b c d e 3 4 5 6 7 8 9

6 7

8 Income required to be distributed currently . . . . . . . . . . . . . . . . . . . Other amounts paid, credited, or otherwise required to be distributed . . . . . . . . . . Total distributions. Add lines 9 and 10. If greater than line 8, see instructions . . . . . . . Enter the amount of tax-exempt income included on line 11 . . . . . . . . . . . . . Tentative income distribution deduction. Subtract line 12 from line 11 . . . . . . . . . . Tentative income distribution deduction. Subtract line 2 from line 7. If zero or less, enter -0- . . Income distribution deduction. Enter the smaller of line 13 or line 14 here and on page 1, line 18

. . . . . . .

9 10 11 12 13 14 15

47,300 7,680 39,620 37,620 37,620

1,185

Tax: 1a Tax on taxable income. See instructions . . . . . . . . . . . . Tax on lump-sum distributions. Attach Form 4972 . . . . . . . . . 1b Alternative minimum tax (from Schedule I (Form 1041), line 54) . . . . . 1c Total. Add lines 1a through 1c . . . . . . . . . . . . . . . . . . . . Foreign tax credit. Attach Form 1116 . . . . . . . . . . . . . . 2a General business credit. Attach Form 3800 . . . . . . . . . . . . 2b Credit for prior year minimum tax. Attach Form 8801 . . . . . . . . 2c Bond credits. Attach Form 8912 . . . . . . . . . . . . . . . 2d Total credits. Add lines 2a through 2d . . . . . . . . . . . . . . . . . Subtract line 2e from line 1d. If zero or less, enter -0- . . . . . . . . . . . . Tax on the ESBT portion of the trust (from ESBT Tax Worksheet, line 17). See instructions Net investment income tax from Form 8960, line 21 . . . . . . . . . . . . . Recapture taxes. Check if from: Form 4255 Form 8611 . . . . . . . . Household employment taxes. Attach Schedule H (Form 1040) . . . . . . . . . Other taxes and amounts due . . . . . . . . . . . . . . . . . . . . Total tax. Add lines 3 through 8. Enter here and on page 1, line 24 . . . . . . . .

. . . . . . . .

2e 3 4 5 6 7 8 9

2022 estimated tax payments and amount applied from 2021 return . . . . . . . . . . Estimated tax payments allocated to beneficiaries (from Form 1041-T) . . . . . . . . . . Subtract line 11 from line 10 . . . . . . . . . . . . . . . . . . . . . . . . Tax paid with Form 7004. See instructions . . . . . . . . . . . . . . . . . . . Federal income tax withheld. If any is from Form(s) 1099, check here . . . . . . . . . Current year net 965 tax liability from Form 965-A, Part I, column (f) (see instructions) . . . . Other payments: a Form 2439 ; b Form 4136 ; Total . . Credit for qualified sick and family leave wages for leave taken before April 1, 2021 . . . . . Credit for qualified sick and family leave wages for leave taken after March 31, 2021, and before October 1, 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total payments. Add lines 12 through 15 and 16c through 18. Enter here and on page 1, line 26 .

. . . . . . . .

10 11 12 13 14 15 16c 17 18

aSee Line 17 on Page 1. b$8,000/($27,000 + $15,000 + $8,000) x $2,000 = $320

47,300c

1,185

Part II — Payments 10 11 12 13 14 15 16 17 18

(11,000) 45,300

Schedule G Tax Computation and Payments (see instructions) Part I — Tax Computation 1

48,620a 7,680

. .

1,185 -01,185 2,000 2,000

2,000

Form 1041 (2022)

cNet accounting income = $27,000 + $15,000 + $8,000 – $2,700 allocable expense ($2,000 trustee fee + $700 property taxes) = $47,300

C:14-55 Page 3 Yes No

Form 1041 (2022)

Other Information 1

Did the estate or trust receive tax-exempt income? If “Yes,” attach a computation of the allocation of expenses. Enter the amount of tax-exempt interest income and exempt-interest dividends . . . . $ 2 Did the estate or trust receive all or any part of the earnings (salary, wages, and other compensation) of any individual by reason of a contract assignment or similar arrangement? . . . . . . . . . . . . . . . 3 At any time during calendar year 2022, did the estate or trust have an interest in or a signature or other authority over a bank, securities, or other financial account in a foreign country? . . . . . . . . . . . . . . See the instructions for exceptions and filing requirements for FinCEN Form 114. If “Yes,” enter the name of the foreign country 4 During the tax year, did the estate or trust receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If “Yes,” the estate or trust may have to file Form 3520. See instructions . . . . . . . . . 5 Did the estate or trust receive, or pay, any qualified residence interest on seller-provided financing? If “Yes,” see the instructions for the required attachment . . . . . . . . . . . . . . . . . . . . . . . 6 If this is an estate or a complex trust making the section 663(b) election, check here. See instructions . . . 7 To make a section 643(e)(3) election, attach Schedule D (Form 1041), and check here. See instructions . . . If the decedent’s estate has been open for more than 2 years, attach an explanation for the delay in closing the 8 estate, and check here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Are any present or future trust beneficiaries skip persons? See instructions . . . . . . . . . . . . . 10 Was the trust a specified domestic entity required to file Form 8938 for the tax year? See the Instructions for Form 8938 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11a Did the estate or trust distribute S corporation stock for which it made a section 965(i) election? . . . . . . b If “Yes,” did each beneficiary enter into an agreement to be liable for the net tax liability? See instructions . . . 12 Did the estate or trust either make a section 965(i) election or enter into a transfer agreement as an eligible 965(i) transferee for S corporation stock held on the last day of the tax year? See instructions . . . . . . . . . 13 ESBTs only. Does the ESBT have a nonresident alien grantor? If “Yes,” see instructions . . . . . . . . 14 ESBTs only. Did the S portion of the trust claim a qualified business income deduction? If “Yes,” see instructions

8,000

✓ ✓ ✓

✓ ✓

✓ ✓ ✓ ✓

Form 1041 (2022)

C:14-55 SCHEDULE D (Form 1041) Department of the Treasury Internal Revenue Service

Capital Gains and Losses

OMB No. 1545-0092

Attach to Form 1041, Form 5227, or Form 990-T. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9 and 10. Go to www.irs.gov/F1041 for instructions and the latest information.

2022

Employer identification number

Name of estate or trust

74-1234567

Jenny Justice Trust

Did you dispose of any investment(s) in a qualified opportunity fund during the tax year? If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

Yes

✓

Note: Form 5227 filers need to complete only Parts I and II.

Part I

Short-Term Capital Gains and Losses—Generally Assets Held 1 Year or Less (see instructions)

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

(g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g)

(e) Cost (or other basis)

Short-term capital gain or (loss) from Forms 4684, 6252, 6781, and 8824 .

5 6

Net short-term gain or (loss) from partnerships, S corporations, and other estates or trusts . . . Short-term capital loss carryover. Enter the amount, if any, from line 9 of the 2021 Capital Loss Carryover Worksheet . . . . . . . . . . . . . . . . . . . . . . . . . . Net short-term capital gain or (loss). Combine lines 1a through 6 in column (h). Enter here and on Part III, line 17, column (3) . . . . . . . . . . . . . . . . . . . . . . . .

Part II

5 6

(

)

Long-Term Capital Gains and Losses—Generally Assets Held More Than 1 Year (see instructions)

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

11 12 13 14 15

(d) Proceeds (sales price)

(e) Cost (or other basis)

91,000

80,000

(g) (h) Gain or (loss) Adjustments Subtract column (e) from column (d) and to gain or loss from Form(s) 8949, Part II, combine the result with column (g) line 2, column (g)

11,000

Long-term capital gain or (loss) from Forms 2439, 4684, 6252, 6781, and 8824 . . . . . . . . Net long-term gain or (loss) from partnerships, S corporations, and other estates or trusts . . . . Capital gain distributions . . . . . . . . . . . . . . . . . . . . . . . . . . Gain from Form 4797, Part I . . . . . . . . . . . . . . . . . . . . . . . . . Long-term capital loss carryover. Enter the amount, if any, from line 14 of the 2021 Capital Loss Carryover Worksheet . . . . . . . . . . . . . . . . . . . . . . . . . . . Net long-term capital gain or (loss). Combine lines 8a through 15 in column (h). Enter here and on Part III, line 18a, column (3) . . . . . . . . . . . . . . . . . . . . . . . . .

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

Cat. No. 11376V

11 12 13 14 15 ( 16

)

11,000

Schedule D (Form 1041) 2022

C:14-55 Page 2

Schedule D (Form 1041) 2022

Part III 17 18 a b c 19

Summary of Parts I and II

(1) Beneficiaries’ (see instr.)

Caution: Read the instructions before completing this part. Net short-term gain or (loss) . . . . . . . . . . . . Net long-term gain or (loss): Total for year . . . . . . . . . . . . . . . . . Unrecaptured section 1250 gain (see line 18 of the worksheet) . . 28% rate gain . . . . . . . . . . . . . . . . . Total net gain or (loss). Combine lines 17 and 18a . . . . .

(2) Estate’s or trust’s

(3) Total

11,000

17 18a 18b 18c 19

Note: If line 19, column (3), is a net gain, enter the gain on Form 1041, line 4 (or Schedule A (Form 990-T), Part I, line 4a). If lines 18a and 19, column (2), are net gains, go to Part V, and don't complete Part IV. If line 19, column (3), is a net loss, complete Part IV and the Capital Loss Carryover Worksheet, as necessary.

Part IV 20

Capital Loss Limitation

Enter here and enter as a (loss) on Form 1041, line 4 (or Schedule A (Form 990-T), Part I, line 4c, if a trust), the smaller of: a

The loss on line 19, column (3) or b $3,000

20 (

)

Note: If the loss on line 19, column (3), is more than $3,000, or if Form 1041, page 1, line 23 (or Form 990-T, Part I, line 11), is a loss, complete the Capital Loss Carryover Worksheet in the instructions to figure your capital loss carryover.

Part V

Tax Computation Using Maximum Capital Gains Rates

Form 1041 filers. Complete this part only if both lines 18a and 19 in column (2) are gains, or an amount is entered in Part I or Part II and there is an entry on Form 1041, line 2b(2), and Form 1041, line 23, is more than zero. Caution: Skip this part and complete the Schedule D Tax Worksheet in the instructions if: • Either line 18b, col. (2), or line 18c, col. (2), is more than zero, or • Both Form 1041, line 2b(1), and Form 4952, line 4g, are more than zero, or • There are amounts on lines 4e and 4g of Form 4952. Form 990-T trusts. Complete this part only if both lines 18a and 19 are gains, or qualified dividends are included in income in Part I of Form 990-T, and Form 990-T, Part I, line 11, is more than zero. Skip this part and complete the Schedule D Tax Worksheet in the instructions if either line 18b, col. (2), or line 18c, col. (2), is more than zero.

21 22 23

24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

10,700

Enter taxable income from Form 1041, line 23 (or Form 990-T, Part I, line 11) 21 Enter the smaller of line 18a or 19 in column (2) but not less than zero . . . . . . . . . . . . . 22 Enter the estate’s or trust’s qualified dividends from Form 1041, line 2b(2) (or enter the qualified dividends included in income in Part I of Form 990-T) . . . . 23 24 Add lines 22 and 23 . . . . . . . . . . . If the estate or trust is filing Form 4952, enter the amount from line 4g; otherwise, enter -0- . . . . 25 Subtract line 25 from line 24. If zero or less, enter -0- . . . . . . . . 26 Subtract line 26 from line 21. If zero or less, enter -0- . . . . . . . . 27 Enter the smaller of the amount on line 21 or $2,800 . . . . . . . . 28 Enter the smaller of the amount on line 27 or line 28 . . . . . . . . 29 Subtract line 29 from line 28. If zero or less, enter -0-. This amount is taxed at 0% . . . . . . Enter the smaller of line 21 or line 26 . . . . . . . . . . . . . 31 Subtract line 30 from line 26 . . . . . . . . . . . . . . . . 32 Enter the smaller of line 21 or $13,700 . . . . . . . . . . . . . 33 Add lines 27 and 30 . . . . . . . . . . . . . . . . . . . 34 Subtract line 34 from line 33. If zero or less, enter -0- . . . . . . . . 35 Enter the smaller of line 32 or line 35 . . . . . . . . . . . . . 36 Multiply line 36 by 15% (0.15) . . . . . . . . . . . . . . . . . . . . . . . Enter the amount from line 31 . . . . . . . . . . . . . . . . 38 Add lines 30 and 36 . . . . . . . . . . . . . . . . . . . 39 Subtract line 39 from line 38. If zero or less, enter -0- . . . . . . . . 40 Multiply line 40 by 20% (0.20) . . . . . . . . . . . . . . . . . . . . . . . Figure the tax on the amount on line 27. Use the 2022 Tax Rate Schedule for Estates and Trusts (see the Schedule G instructions in the Instructions for Form 1041) . . 42 Add lines 37, 41, and 42 . . . . . . . . . . . . . . . . . . 43 Figure the tax on the amount on line 21. Use the 2022 Tax Rate Schedule for Estates and Trusts (see the Schedule G instructions in the Instructions for Form 1041) . . 44 Tax on all taxable income. Enter the smaller of line 43 or line 44 here and on Form 1041, Schedule G, Part I, line 1a (or Form 990-T, Part II, line 2) . . . . . . . . . . . . . . . . . . .

11,000

11,000 -02,800 -0-

10,700 8,200 10,700 2,800 7,900 7,900 10,700 10,700 -0-

2,800

1,185

-0-

1,185

-01,185

2,179

Schedule D (Form 1041) 2022

C:14-55 Form

8960

Department of the Treasury Internal Revenue Service

Net Investment Income Tax— Individuals, Estates, and Trusts

OMB No. 1545-2227

Attachment Sequence No. 72 Your social security number or EIN

Name(s) shown on your tax return

Jenny Justice Trust

Part I

2022

Attach to your tax return. Go to www.irs.gov/Form8960 for instructions and the latest information.

74-1234567

Investment Income

Section 6013(g) election (see instructions) Section 6013(h) election (see instructions) Regulations section 1.1411-10(g) election (see instructions) 1 Taxable interest (see instructions) . . . . . . . . . . . . . . . . . . . . . . . 2 Ordinary dividends (see instructions) . . . . . . . . . . . . . . . . . . . . . . 3 Annuities (see instructions) . . . . . . . . . . . . . . . . . . . . . . . . . 4a Rental real estate, royalties, partnerships, S corporations, trusts, etc. (see 4a instructions) . . . . . . . . . . . . . . . . . . . . . . 12,800a b Adjustment for net income or loss derived in the ordinary course of a non4b section 1411 trade or business (see instructions) . . . . . . . . . . c Combine lines 4a and 4b . . . . . . . . . . . . . . . . . . . . . . . . . . 5a Net gain or loss from disposition of property (see instructions) . . . . . 5a 11,000 b Net gain or loss from disposition of property that is not subject to net investment income tax (see instructions) . . . . . . . . . . . . 5b c Adjustment from disposition of partnership interest or S corporation stock (see instructions) . . . . . . . . . . . . . . . . . . . . . . 5c d Combine lines 5a through 5c . . . . . . . . . . . . . . . . . . . . . . . . 6 Adjustments to investment income for certain CFCs and PFICs (see instructions) . . . . . . . 7 Other modifications to investment income (see instructions) . . . . . . . . . . . . . . 8 Total investment income. Combine lines 1, 2, 3, 4c, 5d, 6, and 7 . . . . . . . . . . . . .

Part II

1 2 3

27,000

12,800

5d 6 7 8

11,000

Investment Expenses Allocable to Investment Income and Modifications

9a b c d 10 11

Investment interest expenses (see instructions) . . . State, local, and foreign income tax (see instructions) . Miscellaneous investment expenses (see instructions) . Add lines 9a, 9b, and 9c . . . . . . . . . . . Additional modifications (see instructions) . . . . . Total deductions and modifications. Add lines 9d and 10

. . .

9d 10 11

2,180

Net investment income. Subtract Part II, line 11, from Part I, line 8. Individuals, complete lines 13–17. Estates and trusts, complete lines 18a–21. If zero or less, enter -0- . . . . . . . . . . . .

48,620

Part III

. . . . . .

9a 9b 9c . . . . . . . . .

50,800

. . .

2,180b . . .

. . .

Tax Computation

Individuals: 13 14 15 16 17

Modified adjusted gross income (see instructions) . . . . . . . . . 13 Threshold based on filing status (see instructions) . . . . . . . . . 14 Subtract line 14 from line 13. If zero or less, enter -0- . . . . . . . . 15 Enter the smaller of line 12 or line 15 . . . . . . . . . . . . . . . . . . . . . . Net investment income tax for individuals. Multiply line 16 by 3.8% (0.038). Enter here and include on your tax return (see instructions) . . . . . . . . . . . . . . . . . . . . . .

Estates and Trusts:

48,620 18a Net investment income (line 12 above) . . . . . . . . . . . . . 18a b Deductions for distributions of net investment income and deductions under 37,620c 18b section 642(c) (see instructions) . . . . . . . . . . . . . . . c Undistributed net investment income. Subtract line 18b from 18a (see 11,000 instructions). If zero or less,. enter . .-0-. . . . . . . . . . . . . . . 18c 19a Adjusted gross income (see instructions) . . . . . . . . . . . . 19a 10,700d b Highest tax bracket for estates and trusts for the year (see instructions) . . 19b 14,450e c Subtract line 19b from line 19a. If zero or less, enter -0- . . . . . . . 19c -020 Enter the smaller of line 18c or line 19c . . . . . . . . . . . . . . . . . . . . . 21 Net investment income tax for estates and trusts. Multiply line 20 by 3.8% (0.038). Enter here and include on your tax return (see instructions) . . . . . . . . . . . . . . . . . . . For Paperwork Reduction Act Notice, see your tax return instructions.

16 17

20 21

Cat. No. 59474M

a$15,000 - $1,500 - $700 = $12,800 bSee Form 1041, Line 16. cSee Form 1041, Schedule B, Line 15. d$50,800 - $2,180 - $37,620 - $300 = $10,700

e$14,450 is the highest tax bracket for estates and trusts for tax years beginning in 2023.

2,180

-0-0-

Form 8960 (2022)

C:14-55

Schedule K-1 (Form 1041)

For calendar year 2022, or tax year

Department of the Treasury Internal Revenue Service

Final K-1

Amended K-1

Interest income

Ordinary dividends

Beneficiary’s Share of Income, Deductions, 2b See back of form and instructions. Credits, etc.

Qualified dividends

beginning

Part I A

/ 2022

ending

Information About the Estate or Trust

OMB No. 1545-0092

Beneficiary’s Share of Current Year Income, Deductions, Credits, and Other Items

Part III

24,820a

Net short-term capital gain

Net long-term capital gain

28% rate gain

Unrecaptured section 1250 gain

Other portfolio and nonbusiness income

Ordinary business income

Net rental real estate income

Other rental income

Directly apportioned deductions

Final year deductions

Alternative minimum tax adjustment

Credits and credit recapture

Other information

Estate’s or trust’s employer identification number

74-1234567

Estate’s or trust’s name

Jenny Justice Trust C

Fiduciary's name, address, city, state, and ZIP code

First Bank P.O. Box 100 Southwest City, TX 75000

Check if Form 1041-T was filed and enter the date it was filed

Check if this is the final Form 1041 for the estate or trust

Part II

Information About the Beneficiary

Beneficiary's identifying number

Beneficiary's name, address, city, state, and ZIP code

12,800b 2,400c

A 10

Estate tax deduction

7,680d 37,620e

XXX-XX-XXXX

Jenny Justice 2 Mountain View South City, AL 35000

X Domestic beneficiary

Foreign beneficiary

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

For IRS Use Only

*See attached statement for additional information. Note: A statement must be attached showing the beneficiary’s share of income and directly apportioned deductions from each business, rental real estate, and other rental activity.

www.irs.gov/Form1041

Cat. No. 11380D

a$27,000 taxable interest - $2,180 allocable interest expense (Form 8960, Line 11) = $24,820 b$15,000 - $1,500 - $700 = $12,800 c$2,400 from one rental activity (depreciation) d$8,000 - $320 non-deductible trustee fee e$24,820 Line 1 + $12,800 Line 7. Also see Form 8960, Line 18b.

Schedule K-1 (Form 1041) 2022

C:14-55 Page 2

Schedule K-1 (Form 1041) 2022

This list identifies the codes used on Schedule K-1 for beneficiaries and provides summarized reporting information for beneficiaries who file Form 1040 or 1040-SR. For detailed reporting and filing information, see the Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR and the instructions for your income tax return. Report on 13. Credits and credit recapture

1. Interest income

Form 1040 or 1040-SR, line 2b

2a. Ordinary dividends

Form 1040 or 1040-SR, line 3b

Code

2b. Qualified dividends

Form 1040 or 1040-SR, line 3a

A Credit for estimated taxes

3. Net short-term capital gain

Schedule D, line 5

B Credit for backup withholding

4a. Net long-term capital gain

Schedule D, line 12

C Low-income housing credit

4b. 28% rate gain

28% Rate Gain Worksheet, line 4 (Schedule D Instructions)

D Rehabilitation credit and energy credit

4c. Unrecaptured section 1250 gain

Unrecaptured Section 1250 Gain Worksheet, line 11 (Schedule D Instructions)

F Work opportunity credit

5. Other portfolio and nonbusiness income

Schedule E, line 33, column (f)

E Other qualifying investment credit G Credit for small employer health insurance premiums H Biofuel producer credit I Credit for increasing research activities J Renewable electricity, refined coal, and Indian coal production credit

6. Ordinary business income

Schedule E, line 33, column (d) or (f)

7. Net rental real estate income

Schedule E, line 33, column (d) or (f)

M Orphan drug credit

8. Other rental income

Schedule E, line 33, column (d) or (f)

N Credit for employer-provided child care and facilities

L Indian employment credit

O Biodiesel and renewable diesel fuels credit

9. Directly apportioned deductions Code

P Credit to holders of tax credit bonds

A Depreciation

Form 8582 or Schedule E, line 33, column (c) or (e)

Q Credit for employer differential wage payments

B Depletion

Form 8582 or Schedule E, line 33, column (c) or (e)

R Recapture of credits

C Amortization

Form 8582 or Schedule E, line 33, column (c) or (e)

10. Estate tax deduction

Schedule A, line 16

11. Final year deductions A Excess deductions — Section 67(e) expenses

}

K Empowerment zone employment credit

Z Other credits 14. Other information

Report on Form 1040 or 1040-SR, line 26 Form 1040 or 1040-SR, line 25c

See the beneficiary’s instructions

A Tax-exempt interest

Form 1040 or 1040-SR, line 2a

B Foreign taxes

Schedule 3 (Form 1040), line 1 or Sch. A, line 6

Schedule 1 (Form 1040), line 24k (also see the beneficiary’s instructions)

C Reserved for future use

B Excess deductions — Non–miscellaneous See the beneficiary’s instructions itemized deductions

D Reserved for future use

C Short-term capital loss carryover

Schedule D, line 5

E Net investment income

Form 4952, line 4a

D Long-term capital loss carryover

Schedule D, line 12; line 5 of the wksht. for Sch. D, line 18; and line 16 of the wksht. for Sch. D, line 19

F Gross farm and fishing income

Schedule E, line 42

G Foreign trading gross receipts (IRC 942(a))

See the Instructions for Form 8873

H Adjustment for section 1411 net investment income or deductions

Form 8960, line 7 (also see the beneficiary’s instructions)

I Section 199A information

See the beneficiary’s instructions

Z Other information

See the beneficiary’s instructions

E Net operating loss carryover — regular tax

Schedule 1 (Form 1040), line 8a

F Net operating loss carryover — minimum tax

Form 6251, line 2f

}

12. Alternative minimum tax (AMT) items A Adjustment for minimum tax purposes B AMT adjustment attributable to qualified dividends C AMT adjustment attributable to net short-term capital gain D AMT adjustment attributable to net long-term capital gain E AMT adjustment attributable to unrecaptured section 1250 gain F AMT adjustment attributable to 28% rate gain G Accelerated depreciation H Depletion I Amortization J Exclusion items

Form 6251, line 2j

Note: If you are a beneficiary who does not file a Form 1040 or 1040-SR, see instructions for the type of income tax return you are filing.

See the beneficiary’s instructions and the Instructions for Form 6251

2023 Form 8801

Form

C:14-56

1041 U.S. Income Tax Return for Estates and Trusts

2022

Department of the Treasury—Internal Revenue Service

Go to www.irs.gov/Form1041 for instructions and the latest information.

A Check all that apply: Decedent’s estate Simple trust

✓Complex trust Qualified disability trust ESBT (S portion only) Grantor type trust Bankruptcy estate—Ch. 7 Bankruptcy estate—Ch. 11 Pooled income fund B Number of Schedules K-1 attached (see instructions)

For calendar year 2022 or fiscal year beginning

Income Deductions

, 2022, and ending

, 20

Name of estate or trust (If a grantor type trust, see the instructions.)

C Employer identification number

Name and title of fiduciary

D Date entity created

74-1243565

Lopez Trust #3

First Bank, Trustee

2014

E Nonexempt charitable and split-interest trusts, check applicable box(es). See instructions.

Number, street, and room or suite no. (If a P.O. box, see the instructions.)

125 Seaview Northwest City, WA 98112

Described in sec. 4947(a)(1). Check here if not a private foundation . .

City or town, state or province, country, and ZIP or foreign postal code F Check

applicable boxes:

Described in sec. 4947(a)(2)

Initial return

Final return

Amended return

Net operating loss carryback

Change in trust’s name

Change in fiduciary

Change in fiduciary’s name

Change in fiduciary’s address

G Check here if the estate or filing trust made a section 645 election .

Tax and Payments

OMB No. 1545-0092

Trust TIN

1 2a b 3 4 5 6 7 8 9 10 11 12 13 14

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total ordinary dividends . . . . . . . . . . . . . . . . . . . . . . . . . Qualified dividends allocable to: (1) Beneficiaries (2) Estate or trust Business income or (loss). Attach Schedule C (Form 1040) . . . . . . . . . . . . . Capital gain or (loss). Attach Schedule D (Form 1041) . . . . . . . . . . . . . . . Rents, royalties, partnerships, other estates and trusts, etc. Attach Schedule E (Form 1040) . . Farm income or (loss). Attach Schedule F (Form 1040) . . . . . . . . . . . . . . . Ordinary gain or (loss). Attach Form 4797 . . . . . . . . . . . . . . . . . . . Other income. List type and amount Total income. Combine lines 1, 2a, and 3 through 8 . . . . . . . . . . . . . . . Interest. Check if Form 4952 is attached . . . . . . . . . . . . . . . . . . Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fiduciary fees. If only a portion is deductible under section 67(e), see instructions ($800 . . . – $340 . . a). Charitable deduction (from Schedule A, line 7) . . . . . . . . . . . . . . . . . Attorney, accountant, and return preparer fees. If only a portion is deductible under section 67(e), see instructions . . . . . . . . . . . . . . . . . . . . . . . . . . .

15a b 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

8,515

500b

9,200

1 2a 3 4 5 6 7 8 9 10 11 12 13

300

9,500 460 525

14 15a 15b 16

985 4,814

18 19 20 21 22 23 24 25 26 27 28 29 30

100 4,914 3,601 458 2,400 1,942 1,442

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and

Sign belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge. May the IRS discuss this return with the preparer shown below? Here Signature of fiduciary or officer representing fiduciary Print/Type preparer’s name

Paid Preparer Firm’s name Use Only Firm’s address

Date

Preparer’s signature

For Paperwork Reduction Act Notice, see the separate instructions.

EIN of fiduciary if a financial institution Date

See instructions.

Check if self-employed

Yes

PTIN

Firm’s EIN Phone no. Cat. No. 11370H

Form 1041 (2022)

Note: Problem C:14-56 instructs students to prepare a Form 1041 for 2023. Because the 2023 forms were not yet available as of the time of publication, 2023 figures were used where possible in preparing this 2022 tax return. aTrustee's fee allocable to municipal bond interest. See calculation on next page. bThis is one example of how the overpayment could be allocated between a refund and application to estimated taxes. Note: Pages related to the AMT are omitted. C:TRP-145 Copyright © 2024 Pearson Education, Inc.

C:14-56 Page 2

Form 1041 (2022)

Schedule A

Charitable Deduction. Don’t complete for a simple trust or a pooled income fund.

1 2 3 4

5 6

Charitable deduction. Subtract line 6 from line 5. Enter here and on page 1, line 13 .

Schedule B

4 5 6 7

Income Distribution Deduction

1 2 3 4 5 6

Adjusted total income. See instructions . . . . . . . . . . . . . . . . . . . . . Adjusted tax-exempt interest . . . . . . . . . . . . . . . Total net gain from Schedule D (Form 1041), line 19, column (1). See instructions . . . . . . . Enter amount from Schedule A, line 4 (minus any allocable section 1202 exclusion) . . . . . . Capital gains for the tax year included on Schedule A, line 1. See instructions . . . . . . . . Enter any gain from page 1, line 4, as a negative number. If page 1, line 4, is a loss, enter the loss as a positive number . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 8

9 10 11 12 13 14 15

1 2 3

($6,800 – $340)b

(300) 14,675

. . . . . . .

9 10 11 12 13 14 15

8,600 8,600 3,786d 4,814 8,215 4,814

458

Schedule G Tax Computation and Payments (see instructions) Part I — Tax Computation 1 a b c d 2a b c d e 3 4 5 6 7 8 9

458 .

. . . . . . . .

2e 3 4 5 6 7 8 9

2022 estimated tax payments and amount applied from 2021 return . . . . . . . . . . . Estimated tax payments allocated to beneficiaries (from Form 1041-T) . . . . . . . . . . . Subtract line 11 from line 10 . . . . . . . . . . . . . . . . . . . . . . . . . Tax paid with Form 7004. See instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal income tax withheld. If any is from Form(s) 1099, check here Current year net 965 tax liability from Form 965-A, Part I, column (f) (see instructions) . . . . . Other payments: a Form 2439 ; b Form 4136 ; Total . . . Credit for qualified sick and family leave wages for leave taken before April 1, 2021 . . . . . . Credit for qualified sick and family leave wages for leave taken after March 31, 2021, and before October 1, 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total payments. Add lines 12 through 15 and 16c through 18. Enter here and on page 1, line 26 . .

10 11 12 13 14 15 16c 17 18

Part II — Payments 10 11 12 13 14 15 16 17 18 19

8,515a 6,460

6 7

15,075c

1 2 3 4 5

aSee Line 17 on Page 1 bTrustee's fees allocable to tax-exempt income: $6,800/$16,000 x $800 = $340 c$9,200 + $6,800 – $525 – (0.50 x $800) = $15,075 d($6,460 adjusted tax-exempt interest/$14,675 DNI) x $8,600 distribution amount

458 -0458 2,400 2,400

2,400

Form 1041 (2022)

C:14-56 Page 3 Yes No

Form 1041 (2022)

Other Information 1

Did the estate or trust receive tax-exempt income? If “Yes,” attach a computation of the allocation of expenses. $ Enter the amount of tax-exempt interest income and exempt-interest dividends 2 Did the estate or trust receive all or any part of the earnings (salary, wages, and other compensation) of any individual by reason of a contract assignment or similar arrangement? . . . . . . . . . . . . . . . 3 At any time during calendar year 2022, did the estate or trust have an interest in or a signature or other authority over a bank, securities, or other financial account in a foreign country? . . . . . . . . . . . . . . See the instructions for exceptions and filing requirements for FinCEN Form 114. If “Yes,” enter the name of the foreign country 4 During the tax year, did the estate or trust receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If “Yes,” the estate or trust may have to file Form 3520. See instructions . . . . . . . . . 5 Did the estate or trust receive, or pay, any qualified residence interest on seller-provided financing? If “Yes,” see the instructions for the required attachment . . . . . . . . . . . . . . . . . . . . . . . 6 If this is an estate or a complex trust making the section 663(b) election, check here. See instructions . . . 7 To make a section 643(e)(3) election, attach Schedule D (Form 1041), and check here. See instructions . . . If the decedent’s estate has been open for more than 2 years, attach an explanation for the delay in closing the 8 estate, and check here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Are any present or future trust beneficiaries skip persons? See instructions . . . . . . . . . . . . . 10 Was the trust a specified domestic entity required to file Form 8938 for the tax year? See the Instructions for Form 8938 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11a Did the estate or trust distribute S corporation stock for which it made a section 965(i) election? . . . . . . b If “Yes,” did each beneficiary enter into an agreement to be liable for the net tax liability? See instructions . . . 12 Did the estate or trust either make a section 965(i) election or enter into a transfer agreement as an eligible 965(i) transferee for S corporation stock held on the last day of the tax year? See instructions . . . . . . . . . . . 13 ESBTs only. Does the ESBT have a nonresident alien grantor? If “Yes,” see instructions . . . . . . . . 14 ESBTs only. Did the S portion of the trust claim a qualified business income deduction? If “Yes,” see instructions

6,800

✓

✓ ✓

✓ ✓ ✓ ✓ ✓

Form 1041 (2022)

C:14-56 SCHEDULE D (Form 1041) Department of the Treasury Internal Revenue Service

Capital Gains and Losses

OMB No. 1545-0092

Attach to Form 1041, Form 5227, or Form 990-T. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9 and 10. Go to www.irs.gov/F1041 for instructions and the latest information.

2022

Employer identification number

Name of estate or trust

Lopez Trust #3

74-1243565

Yes

If “Yes,” attach Form 8949 and see its instructions for additional requirements for reporting your gain or loss.

✓

Note: Form 5227 filers need to complete only Parts I and II.

Part I

Short-Term Capital Gains and Losses—Generally Assets Held 1 Year or Less (see instructions)

lines below. This form may be easier to complete if you round off cents to whole dollars. 1a Totals for all short-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 1b . 1b Totals for all transactions reported on Form(s) 8949 with Box A checked . . . . . . . . . . . . . 2 Totals for all transactions reported on Form(s) 8949 with Box B checked . . . . . . . . . . . . . 3 Totals for all transactions reported on Form(s) 8949 with Box C checked . . . . . . . . . . . . .

(d) Proceeds (sales price)

(e) Cost (or other basis)

9,500

9,200

(g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g)

300

Short-term capital gain or (loss) from Forms 4684, 6252, 6781, and 8824 .

5 6

Part II

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

5 6

(

)

300

Long-Term Capital Gains and Losses—Generally Assets Held More Than 1 Year (see instructions)

lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(e) Cost (or other basis)

(g) (h) Gain or (loss) Adjustments Subtract column (e) from column (d) and to gain or loss from Form(s) 8949, Part II, combine the result with column (g) line 2, column (g)

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

Cat. No. 11376V

11 12 13 14 15 (

)

Schedule D (Form 1041) 2022

C:14-56 Page 2

Schedule D (Form 1041) 2022

Part III 17 18 a b c 19

Summary of Parts I and II

(1) Beneficiaries’ (see instr.)

(2) Estate’s or trust’s

(3) Total

300

18a 18b 18c 19

300

Part IV 20

Capital Loss Limitation

Enter here and enter as a (loss) on Form 1041, line 4 (or Schedule A (Form 990-T), Part I, line 4c, if a trust), the smaller of: a

The loss on line 19, column (3) or b $3,000

20 (

)

Part V

Tax Computation Using Maximum Capital Gains Rates

21 22 23

24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

Enter taxable income from Form 1041, line 23 (or Form 990-T, Part I, line 11) 21 Enter the smaller of line 18a or 19 in column (2) but not less than zero . . . . . . . . . . . . . 22 Enter the estate’s or trust’s qualified dividends from Form 1041, line 2b(2) (or enter the qualified dividends included in income in Part I of Form 990-T) . . . . 23 24 Add lines 22 and 23 . . . . . . . . . . . If the estate or trust is filing Form 4952, enter the amount from line 4g; otherwise, enter -0- . . . . 25 Subtract line 25 from line 24. If zero or less, enter -0- . . . . . . . . 26 Subtract line 26 from line 21. If zero or less, enter -0- . . . . . . . . 27 Enter the smaller of the amount on line 21 or $2,800 . . . . . . . . 28 Enter the smaller of the amount on line 27 or line 28 . . . . . . . . 29 Subtract line 29 from line 28. If zero or less, enter -0-. This amount is taxed at 0% . . . . . . . Enter the smaller of line 21 or line 26 . . . . . . . . . . . . . 31 Subtract line 30 from line 26 . . . . . . . . . . . . . . . . 32 Enter the smaller of line 21 or $13,700 . . . . . . . . . . . . . 33 Add lines 27 and 30 . . . . . . . . . . . . . . . . . . . 34 Subtract line 34 from line 33. If zero or less, enter -0- . . . . . . . . 35 Enter the smaller of line 32 or line 35 . . . . . . . . . . . . . 36 Multiply line 36 by 15% (0.15) . . . . . . . . . . . . . . . . . . . . . . . . Enter the amount from line 31 . . . . . . . . . . . . . . . . 38 Add lines 30 and 36 . . . . . . . . . . . . . . . . . . . 39 Subtract line 39 from line 38. If zero or less, enter -0- . . . . . . . . 40 Multiply line 40 by 20% (0.20) . . . . . . . . . . . . . . . . . . . . . . . . Figure the tax on the amount on line 27. Use the 2022 Tax Rate Schedule for Estates and Trusts (see the Schedule G instructions in the Instructions for Form 1041) . . 42 Add lines 37, 41, and 42 . . . . . . . . . . . . . . . . . . 43 Figure the tax on the amount on line 21. Use the 2022 Tax Rate Schedule for Estates and Trusts (see the Schedule G instructions in the Instructions for Form 1041) . . 44 Tax on all taxable income. Enter the smaller of line 43 or line 44 here and on Form 1041, Schedule G, Part I, line 1a (or Form 990-T, Part II, line 2) . . . . . . . . . . . . . . . . . . .

Schedule D (Form 1041) 2022

C:14-56 Form

8960

Department of the Treasury Internal Revenue Service

Net Investment Income Tax— Individuals, Estates, and Trusts

OMB No. 1545-2227

Lopez Trust #3

74-1243565

Investment Income

Section 6013(g) election (see instructions) Section 6013(h) election (see instructions) Regulations section 1.1411-10(g) election (see instructions) 1 Taxable interest (see instructions) . . . . . . . . . . . . . . . . . . . . 2 Ordinary dividends (see instructions) . . . . . . . . . . . . . . . . . . . 3 Annuities (see instructions) . . . . . . . . . . . . . . . . . . . . . . 4a Rental real estate, royalties, partnerships, S corporations, trusts, etc. (see 4a instructions) . . . . . . . . . . . . . . . . . . . . . . b Adjustment for net income or loss derived in the ordinary course of a nonsection 1411 trade or business (see instructions) . . . . . . . . . . 4b c Combine lines 4a and 4b . . . . . . . . . . . . . . . . . . . . . . . 5a Net gain or loss from disposition of property (see instructions) . . . . . 5a b Net gain or loss from disposition of property that is not subject to net 5b investment income tax (see instructions) . . . . . . . . . . . . c Adjustment from disposition of partnership interest or S corporation stock (see instructions) . . . . . . . . . . . . . . . . . . . . . . 5c d Combine lines 5a through 5c . . . . . . . . . . . . . . . . . . . . . 6 Adjustments to investment income for certain CFCs and PFICs (see instructions) . . . . 7 Other modifications to investment income (see instructions) . . . . . . . . . . . 8 Total investment income. Combine lines 1, 2, 3, 4c, 5d, 6, and 7 . . . . . . . . . .

Part II 9a b c d 10 11

. . .

1 2 3

. . . .

5d 6 7 8

300

Investment Expenses Allocable to Investment Income and Modifications

. . . . . .

9a 9b 9c . . . . . . . . .

985a

300 9,500

9d 10 11

985

8,515

. . .

Tax Computation

Individuals: 13 14 15 16 17

9,200

. . .

Part III 12

Attachment Sequence No. 72 Your social security number or EIN

Name(s) shown on your tax return

Part I

2022

Attach to your tax return. Go to www.irs.gov/Form8960 for instructions and the latest information.

Estates and Trusts:

8,515 18a Net investment income (line 12 above) . . . . . . . . . . . . . 18a b Deductions for distributions of net investment income and deductions under 4,814b 18b section 642(c) (see instructions) . . . . . . . . . . . . . . . c Undistributed net investment income. Subtract line 18b from 18a (see 3,701 instructions). If zero or less,. enter . .-0-. . . . . . . . . . . . . . . 18c 19a Adjusted gross income (see instructions) . . . . . . . . . . . . 19a 3,601c b Highest tax bracket for estates and trusts for the year (see instructions) . . 19b 14,450d c Subtract line 19b from line 19a. If zero or less, enter -0- . . . . . . . 19c -020 Enter the smaller of line 18c or line 19c . . . . . . . . . . . . . . . . . . . . . 21 Net investment income tax for estates and trusts. Multiply line 20 by 3.8% (0.038). Enter here and include on your tax return (see instructions) . . . . . . . . . . . . . . . . . . . For Paperwork Reduction Act Notice, see your tax return instructions.

Cat. No. 59474M

16 17

20 21

aSee Form 1041, Page 1, Line 16. bSee Form 1041, Schedule B, Line 15. c$8,515 – $4,814 – $100 exemption = $3,601 d$14,450 is the highest tax bracket for estates and trusts for tax years beginning in 2023.

985

-0-0-

Form 8960 (2022)

C:14-56

Schedule K-1 (Form 1041)

Final K-1

Amended K-1

For calendar year 2022, or tax year

Interest income

Ordinary dividends

Beneficiary’s Share of Income, Deductions, 2b See back of form and instructions. Credits, etc.

Qualified dividends

Department of the Treasury Internal Revenue Service

beginning

Part I A

/ 2022

ending

Information About the Estate or Trust

OMB No. 1545-0092

Beneficiary’s Share of Current Year Income, Deductions, Credits, and Other Items

Part III

4,814a

Net short-term capital gain

Net long-term capital gain

28% rate gain

Unrecaptured section 1250 gain

Other portfolio and nonbusiness income

Ordinary business income

Net rental real estate income

Other rental income

Directly apportioned deductions

Final year deductions

Alternative minimum tax adjustment

Credits and credit recapture

Other information

4,814

Estate’s or trust’s employer identification number

74-1243565

Estate’s or trust’s name

Lopez Trust #3 C

Fiduciary's name, address, city, state, and ZIP code

First Bank 125 Seaview Northwest City, WA 98112

Check if Form 1041-T was filed and enter the date it was filed

Check if this is the final Form 1041 for the estate or trust

Part II

Information About the Beneficiary

Beneficiary's identifying number

Beneficiary's name, address, city, state, and ZIP code

Estate tax deduction

3,786b

XXX-XX-XXXX

Loretta Lopez 123 Maple Ave. Northwest City, WA 98115

X Domestic beneficiary

Foreign beneficiary

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

For IRS Use Only

www.irs.gov/Form1041

Cat. No. 11380D

Schedule K-1 (Form 1041) 2022

aForm 1041, Schedule B, Line 13 bForm 1041, Schedule B, Line 12 Note: Total $6,800 distribution is allocated between $4,814 taxable income and $3,786 tax-exempt income.

C:14-56 Page 2

Schedule K-1 (Form 1041) 2022

1. Interest income

Form 1040 or 1040-SR, line 2b

2a. Ordinary dividends

Form 1040 or 1040-SR, line 3b

Code

2b. Qualified dividends

Form 1040 or 1040-SR, line 3a

A Credit for estimated taxes

3. Net short-term capital gain

Schedule D, line 5

B Credit for backup withholding

4a. Net long-term capital gain

Schedule D, line 12

C Low-income housing credit

4b. 28% rate gain

28% Rate Gain Worksheet, line 4 (Schedule D Instructions)

D Rehabilitation credit and energy credit

4c. Unrecaptured section 1250 gain

Unrecaptured Section 1250 Gain Worksheet, line 11 (Schedule D Instructions)

F Work opportunity credit

5. Other portfolio and nonbusiness income

Schedule E, line 33, column (f)

6. Ordinary business income

Schedule E, line 33, column (d) or (f)

7. Net rental real estate income

Schedule E, line 33, column (d) or (f)

M Orphan drug credit

8. Other rental income

Schedule E, line 33, column (d) or (f)

N Credit for employer-provided child care and facilities

L Indian employment credit

O Biodiesel and renewable diesel fuels credit

9. Directly apportioned deductions Code

P Credit to holders of tax credit bonds

A Depreciation

Form 8582 or Schedule E, line 33, column (c) or (e)

Q Credit for employer differential wage payments

B Depletion

Form 8582 or Schedule E, line 33, column (c) or (e)

R Recapture of credits

C Amortization

Form 8582 or Schedule E, line 33, column (c) or (e)

10. Estate tax deduction

Schedule A, line 16

11. Final year deductions A Excess deductions — Section 67(e) expenses

}

K Empowerment zone employment credit

Z Other credits 14. Other information

Report on Form 1040 or 1040-SR, line 26 Form 1040 or 1040-SR, line 25c

See the beneficiary’s instructions

A Tax-exempt interest

Form 1040 or 1040-SR, line 2a

B Foreign taxes

Schedule 3 (Form 1040), line 1 or Sch. A, line 6

Schedule 1 (Form 1040), line 24k (also see the beneficiary’s instructions)

C Reserved for future use

B Excess deductions — Non–miscellaneous See the beneficiary’s instructions itemized deductions

D Reserved for future use

C Short-term capital loss carryover

Schedule D, line 5

E Net investment income

Form 4952, line 4a

D Long-term capital loss carryover

Schedule D, line 12; line 5 of the wksht. for Sch. D, line 18; and line 16 of the wksht. for Sch. D, line 19

F Gross farm and fishing income

Schedule E, line 42

G Foreign trading gross receipts (IRC 942(a))

See the Instructions for Form 8873

H Adjustment for section 1411 net investment income or deductions

Form 8960, line 7 (also see the beneficiary’s instructions)

I Section 199A information

See the beneficiary’s instructions

Z Other information

See the beneficiary’s instructions

E Net operating loss carryover — regular tax

Schedule 1 (Form 1040), line 8a

F Net operating loss carryover — minimum tax

Form 6251, line 2f

}

Form 6251, line 2j

Note: If you are a beneficiary who does not file a Form 1040 or 1040-SR, see instructions for the type of income tax return you are filing.

See the beneficiary’s instructions and the Instructions for Form 6251

2023 Form 8801

Form

C:14-57

1041 U.S. Income Tax Return for Estates and Trusts

2022

Department of the Treasury—Internal Revenue Service

Go to www.irs.gov/Form1041 for instructions and the latest information.

A Check all that apply: Decedent’s estate Simple trust

✓ Complex trust Qualified disability trust ESBT (S portion only) Grantor type trust Bankruptcy estate—Ch. 7 Bankruptcy estate—Ch. 11 Pooled income fund B Number of Schedules K-1 attached (see instructions)

For calendar year 2022 or fiscal year beginning

Income Deductions

, 2022, and ending

, 20

Name of estate or trust (If a grantor type trust, see the instructions.)

C Employer identification number

Name and title of fiduciary

D Date entity created

74-1212121

Stan Meadows Trust

Merchants Bank, Trustee

2014

E Nonexempt charitable and split-interest trusts, check applicable box(es). See instructions.

Number, street, and room or suite no. (If a P.O. box, see the instructions.)

201 Fifth Ave. Northeast City, NY 10000

Described in sec. 4947(a)(1). Check here if not a private foundation . .

City or town, state or province, country, and ZIP or foreign postal code F Check

applicable boxes:

Described in sec. 4947(a)(2)

Initial return

Final return

Amended return

Net operating loss carryback

Change in trust’s name

Change in fiduciary

Change in fiduciary’s name

Change in fiduciary’s address

G Check here if the estate or filing trust made a section 645 election .

Tax and Payments

OMB No. 1545-0092

Trust TIN

1 2a b 3 4 5 6 7 8 9 10 11 12 13 14

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total ordinary dividends . . . . . . . . . . . . . . . . . . . . . . . . . Qualified dividends allocable to: (1) Beneficiaries (2) Estate or trust Business income or (loss). Attach Schedule C (Form 1040) . . . . . . . . . . . . . Capital gain or (loss). Attach Schedule D (Form 1041) . . . . . . . . . . . . . . . Rents, royalties, partnerships, other estates and trusts, etc. Attach Schedule E (Form 1040) . . Farm income or (loss). Attach Schedule F (Form 1040) . . . . . . . . . . . . . . . Ordinary gain or (loss). Attach Form 4797 . . . . . . . . . . . . . . . . . . . Other income. List type and amount Total income. Combine lines 1, 2a, and 3 through 8 . . . . . . . . . . . . . . . Interest. Check if Form 4952 is attached . . . . . . . . . . . . . . . . . . Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fiduciary fees. If only a portion is deductible under section 67(e), see instructions ($2,400 – $343b) Charitable deduction (from Schedule A, line 7) . . . . . . . . . . . . . . . . . Attorney, accountant, and return preparer fees. If only a portion is deductible under section 67(e), see instructions . . . . . . . . . . . . . . . . . . . . . . . . . . .

15a b 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

9,967a

40,033

48,543

4,000 50,000

1 2a 3 4 5 6 7 8 9 10 11 12 13

(3,000)

51,000 2,057 400

14 15a 15b 16

2,457 10,274

18 19 20 21 22 23 24 25 26 27 28 29 30

100 10,374 38,169 7,429 6,000 1,429c

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and

Paid Preparer Firm’s name Use Only Firm’s address

Date

Preparer’s signature

For Paperwork Reduction Act Notice, see the separate instructions.

EIN of fiduciary if a financial institution Date

See instructions.

Yes

Check if PTIN self-employed Firm’s EIN Phone no.

Cat. No. 11370H

Form 1041 (2022)

Note: Problem C:14-57 instructs students to prepare a Form 1041 for 2023. Because the 2023 forms were not yet available as of the time of publication, 2023 figures were used where possible in preparing this 2022 tax return. a($50,000 ordinary dividends/$60,200 DNI) x $12,000 total distribution bTrustee's fee allocable to tax-exempt interest. See calculation on next page. cAssume no estimated tax penalty. Note: Pages related to the AMT are omitted. C:TRP-153 Copyright © 2024 Pearson Education, Inc.

C:14-57 Page 2

Form 1041 (2022)

Schedule A

Charitable Deduction. Don’t complete for a simple trust or a pooled income fund.

1 2 3 4

5 6

Charitable deduction. Subtract line 6 from line 5. Enter here and on page 1, line 13 .

Schedule B

4 5 6 7

Income Distribution Deduction

1 2 3 4 5 6

Adjusted total income. See instructions . . . . . . . . . . . . . . . . . . . . . Adjusted tax-exempt interest . . . . . . . . . . . . . . . . Total net gain from Schedule D (Form 1041), line 19, column (1). See instructions . . . . . . . Enter amount from Schedule A, line 4 (minus any allocable section 1202 exclusion) . . . . . . Capital gains for the tax year included on Schedule A, line 1. See instructions . . . . . . . . Enter any gain from page 1, line 4, as a negative number. If page 1, line 4, is a loss, enter the loss as a positive number . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7 8

9 10 11 12 13 14 15

1 2 3

($9,000 – $343b)

62,600c

1 2 3 4 5

6 7

3,000 60,200

. . . . . . .

9 10 11 12 13 14 15

-012,000 12,000 1,726d 10,274 51,543 10,274

6,528

Schedule G Tax Computation and Payments (see instructions) Part I — Tax Computation 1 a b c d 2a b c d e 3 4 5 6 7 8 9

6,528 .

. . . . . . . .

2e 3 4 5 6 7 8 9

10 11 12 13 14 15 16c 17 18

Part II — Payments 10 11 12 13 14 15 16 17 18 19

48,543a 8,657

6,528 901 7,429 6,000 6,000

6,000

Form 1041 (2022)

aSee Line 17 on Page 1 bTrustee's fee allocable to tax-exempt interest: $9,000/($50,000 + $4,000 + $9,000) x $2,400 = $343 c$4,000 + $50,000 + $9,000 - $400 = $62,600 d($8,657 adjusted tax-exempt income/$60,200 DNI) x $12,000 distribution = $1,726

C:14-57 Page 3 Yes No

Form 1041 (2022)

Other Information 1

9,000

✓ ✓ ✓

✓ ✓

✓ ✓ ✓ ✓ ✓

Form 1041 (2022)

C:14-57 SCHEDULE D (Form 1041) Department of the Treasury Internal Revenue Service

Capital Gains and Losses

OMB No. 1545-0092

Attach to Form 1041, Form 5227, or Form 990-T. Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9 and 10. Go to www.irs.gov/F1041 for instructions and the latest information.

2022

Employer identification number

Name of estate or trust

Stan Meadows Trust

74-1212121

Yes

✓

Note: Form 5227 filers need to complete only Parts I and II.

Part I

Short-Term Capital Gains and Losses—Generally Assets Held 1 Year or Less (see instructions)

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

(d) Proceeds (sales price)

(h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g)

(g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g)

(e) Cost (or other basis)

Short-term capital gain or (loss) from Forms 4684, 6252, 6781, and 8824 .

5 6

Part II

5 6

(

)

Long-Term Capital Gains and Losses—Generally Assets Held More Than 1 Year (see instructions)

See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars.

11 12 13 14 15

(d) Proceeds (sales price)

(e) Cost (or other basis)

18,000

30,000

(g) (h) Gain or (loss) Subtract column (e) Adjustments from column (d) and to gain or loss from Form(s) 8949, Part II, combine the result with column (g) line 2, column (g)

(12,000)

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

Cat. No. 11376V

11 12 13 14 15 ( 16

)

(12,000)

Schedule D (Form 1041) 2022

C:14-57 Page 2

Schedule D (Form 1041) 2022

Part III 17 18 a b c 19

Summary of Parts I and II

(1) Beneficiaries’ (see instr.)

(2) Estate’s or trust’s

(3) Total

(12,000)

17 18a 18b 18c 19

Part IV 20

Capital Loss Limitation

Enter here and enter as a (loss) on Form 1041, line 4 (or Schedule A (Form 990-T), Part I, line 4c, if a trust), the smaller of: a

The loss on line 19, column (3) or b $3,000

20 (

3,000

)

Part V

Tax Computation Using Maximum Capital Gains Rates

21 22 23

24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

38,169

-0-

40,033 40,033 -0-

40,033 -02,800 -0-

38,169 37,233 13,700 2,800 10,900 10,900

38,169 13,700 24,469

2,800

1,635

4,893

6,528

-06,528

12,267

Schedule D (Form 1041) 2022

C:14-57 Form

8960

Department of the Treasury Internal Revenue Service

Net Investment Income Tax— Individuals, Estates, and Trusts

OMB No. 1545-2227

Attachment Sequence No. 72 Your social security number or EIN

Name(s) shown on your tax return

Stan Meadows Trust

Part I

2022

Attach to your tax return. Go to www.irs.gov/Form8960 for instructions and the latest information.

74-1212121

Investment Income

Section 6013(g) election (see instructions) Section 6013(h) election (see instructions) Regulations section 1.1411-10(g) election (see instructions) 1 Taxable interest (see instructions) . . . . . . . . . . . . . . . . . . . . . . . 2 Ordinary dividends (see instructions) . . . . . . . . . . . . . . . . . . . . . . 3 Annuities (see instructions) . . . . . . . . . . . . . . . . . . . . . . . . . 4a Rental real estate, royalties, partnerships, S corporations, trusts, etc. (see 4a instructions) . . . . . . . . . . . . . . . . . . . . . . b Adjustment for net income or loss derived in the ordinary course of a nonsection 1411 trade or business (see instructions) . . . . . . . . . . 4b c Combine lines 4a and 4b . . . . . . . . . . . . . . . . . . . . . . . . . . 5a Net gain or loss from disposition of property (see instructions) . . . . . 5a (3,000) b Net gain or loss from disposition of property that is not subject to net 5b investment income tax (see instructions) . . . . . . . . . . . . c Adjustment from disposition of partnership interest or S corporation stock (see instructions) . . . . . . . . . . . . . . . . . . . . . . 5c d Combine lines 5a through 5c . . . . . . . . . . . . . . . . . . . . . . . . 6 Adjustments to investment income for certain CFCs and PFICs (see instructions) . . . . . . . 7 Other modifications to investment income (see instructions) . . . . . . . . . . . . . . 8 Total investment income. Combine lines 1, 2, 3, 4c, 5d, 6, and 7 . . . . . . . . . . . . .

(3,000)

. . .

9d 10 11

2,457

48,543

Investment Expenses Allocable to Investment Income and Modifications

Part III 12

. . . . . .

9a 9b 9c . . . . . . . . .

. . .

2,457a . . .

. . .

Tax Computation

Individuals: 13 14 15 16 17

4,000 50,000

5d 6 7 8

Part II 9a b c d 10 11

1 2 3

Estates and Trusts:

48,543 18a Net investment income (line 12 above) . . . . . . . . . . . . . 18a b Deductions for distributions of net investment income and deductions under 10,274b 18b section 642(c) (see instructions) . . . . . . . . . . . . . . . c Undistributed net investment income. Subtract line 18b from 18a (see 38,269 instructions). If zero or less,. enter . .-0-. . . . . . . . . . . . . . . 18c 19a Adjusted gross income (see instructions) . . . . . . . . . . . . 19a 38,169c b Highest tax bracket for estates and trusts for the year (see instructions) . . 19b 14,450d c Subtract line 19b from line 19a. If zero or less, enter -0- . . . . . . . 19c 23,719 20 Enter the smaller of line 18c or line 19c . . . . . . . . . . . . . . . . . . . . . 21 Net investment income tax for estates and trusts. Multiply line 20 by 3.8% (0.038). Enter here and include on your tax return (see instructions) . . . . . . . . . . . . . . . . . . . For Paperwork Reduction Act Notice, see your tax return instructions.

Cat. No. 59474M

2,457

16 17

20 21

aSee Form 1041, Page 1, Line 16. bSee Form 1041, Schedule B, Line 15. c$51,000 – $2,457 – $10,274 – $100 exemption = $38,169 d$14,450 is the highest tax bracket for estates and trusts for tax years beginning in 2023

51,000

23,719 901

Form 8960 (2022)

C:14-57

Schedule K-1 (Form 1041)

For calendar year 2022, or tax year

Department of the Treasury Internal Revenue Service

Final K-1

Part III

Amended K-1

Interest income

Ordinary dividends

Beneficiary’s Share of Income, Deductions, 2b See back of form and instructions. Credits, etc.

Qualified dividends

beginning

Part I A

/ 2022

ending

Information About the Estate or Trust

OMB No. 1545-0092

Beneficiary’s Share of Current Year Income, Deductions, Credits, and Other Items

Final year deductions

Alternative minimum tax adjustment

Credits and credit recapture

Other information

2,492 2,492

Net short-term capital gain

Net long-term capital gain

28% rate gain

Unrecaptured section 1250 gain

Other portfolio and nonbusiness income

Ordinary business income

Net rental real estate income

Other rental income

Directly apportioned deductions

Estate’s or trust’s employer identification number

74-1212121

Estate’s or trust’s name

Stan Meadows Trust C

Fiduciary's name, address, city, state, and ZIP code

Merchants Bank 201 Fifth Ave. Northeast City, NY 10000

Check if Form 1041-T was filed and enter the date it was filed

Check if this is the final Form 1041 for the estate or trust

Part II

Information About the Beneficiary

Beneficiary's identifying number

Beneficiary's name, address, city, state, and ZIP code

A 10

Estate tax deduction

431 2,569a

XXX-XX-XXXX

Angela Meadows 3 East 46th St. North City, NY 11000

X Domestic beneficiary

Foreign beneficiary

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

For IRS Use Only

www.irs.gov/Form1041

Cat. No. 11380D

Schedule K-1 (Form 1041) 2022

Note: See allocation summary at the end of the solution. a$77 interest income + $2,492 dividends if the beneficiary elects to tax the dividends at ordinary rates under Sec. 163(d)(4)(B).

C:14-57

Schedule K-1 (Form 1041)

For calendar year 2022, or tax year

Department of the Treasury Internal Revenue Service

Final K-1

Part III

Amended K-1

Interest income

Ordinary dividends

Beneficiary’s Share of Income, Deductions, 2b See back of form and instructions. Credits, etc.

Qualified dividends

beginning

Part I A

/ 2022

ending

Information About the Estate or Trust

OMB No. 1545-0092

Beneficiary’s Share of Current Year Income, Deductions, Credits, and Other Items

230

Final year deductions

Alternative minimum tax adjustment

Credits and credit recapture

Other information

7,475 7,475

Net short-term capital gain

Net long-term capital gain

28% rate gain

Unrecaptured section 1250 gain

Other portfolio and nonbusiness income

Ordinary business income

Net rental real estate income

Other rental income

Directly apportioned deductions

Estate’s or trust’s employer identification number

74-1212121

Estate’s or trust’s name

Stan Meadows Trust C

Fiduciary's name, address, city, state, and ZIP code

Merchants Bank 201 Fifth Ave. Northeast City, NY 10000

Check if Form 1041-T was filed and enter the date it was filed

Check if this is the final Form 1041 for the estate or trust

Part II

Information About the Beneficiary

Beneficiary's identifying number

Beneficiary's name, address, city, state, and ZIP code

A 10

Estate tax deduction

1,295 7,705a

XXX-XX-XXXX

Barry Meadows 3 East 46th St. North City, NY 11000

X Domestic beneficiary

Foreign beneficiary

For Paperwork Reduction Act Notice, see the Instructions for Form 1041.

For IRS Use Only

www.irs.gov/Form1041

Cat. No. 11380D

Note: See allocation summary at the end of the solution. a$230 interest income + $7,475 dividends if the beneficiary elects to tax the dividends at ordinary rates under Sec. 163(d)(4)(B).

Schedule K-1 (Form 1041) 2022

C:14-57 Page 2

Schedule K-1 (Form 1041) 2022

1. Interest income

Form 1040 or 1040-SR, line 2b

2a. Ordinary dividends

Form 1040 or 1040-SR, line 3b

Code

2b. Qualified dividends

Form 1040 or 1040-SR, line 3a

A Credit for estimated taxes

3. Net short-term capital gain

Schedule D, line 5

B Credit for backup withholding

4a. Net long-term capital gain

Schedule D, line 12

C Low-income housing credit

4b. 28% rate gain

28% Rate Gain Worksheet, line 4 (Schedule D Instructions)

D Rehabilitation credit and energy credit

4c. Unrecaptured section 1250 gain

Unrecaptured Section 1250 Gain Worksheet, line 11 (Schedule D Instructions)

F Work opportunity credit

5. Other portfolio and nonbusiness income

Schedule E, line 33, column (f)

6. Ordinary business income

Schedule E, line 33, column (d) or (f)

7. Net rental real estate income

Schedule E, line 33, column (d) or (f)

M Orphan drug credit

8. Other rental income

Schedule E, line 33, column (d) or (f)

N Credit for employer-provided child care and facilities

L Indian employment credit

O Biodiesel and renewable diesel fuels credit

9. Directly apportioned deductions Code

P Credit to holders of tax credit bonds

A Depreciation

Form 8582 or Schedule E, line 33, column (c) or (e)

Q Credit for employer differential wage payments

B Depletion

Form 8582 or Schedule E, line 33, column (c) or (e)

R Recapture of credits

C Amortization

Form 8582 or Schedule E, line 33, column (c) or (e)

10. Estate tax deduction

Schedule A, line 16

11. Final year deductions A Excess deductions — Section 67(e) expenses

}

K Empowerment zone employment credit

Z Other credits 14. Other information

Report on Form 1040 or 1040-SR, line 26 Form 1040 or 1040-SR, line 25c

See the beneficiary’s instructions

A Tax-exempt interest

Form 1040 or 1040-SR, line 2a

B Foreign taxes

Schedule 3 (Form 1040), line 1 or Sch. A, line 6

Schedule 1 (Form 1040), line 24k (also see the beneficiary’s instructions)

C Reserved for future use

B Excess deductions — Non–miscellaneous See the beneficiary’s instructions itemized deductions

D Reserved for future use

C Short-term capital loss carryover

Schedule D, line 5

E Net investment income

Form 4952, line 4a

D Long-term capital loss carryover

Schedule D, line 12; line 5 of the wksht. for Sch. D, line 18; and line 16 of the wksht. for Sch. D, line 19

F Gross farm and fishing income

Schedule E, line 42

G Foreign trading gross receipts (IRC 942(a))

See the Instructions for Form 8873

H Adjustment for section 1411 net investment income or deductions

Form 8960, line 7 (also see the beneficiary’s instructions)

I Section 199A information

See the beneficiary’s instructions

Z Other information

See the beneficiary’s instructions

E Net operating loss carryover — regular tax

Schedule 1 (Form 1040), line 8a

F Net operating loss carryover — minimum tax

Form 6251, line 2f

}

Form 6251, line 2j

Note: If you are a beneficiary who does not file a Form 1040 or 1040-SR, see instructions for the type of income tax return you are filing.

See the beneficiary’s instructions and the Instructions for Form 6251

2023 Form 8801

C:14-57 Stan Meadows Trust 74-1212121 2022 Form 1041 Schedule B, Line 12 (tax exempt distributions) Line 2 ÷ Line 7 = Exempt income as a percent of distributable net income ($8,657 ÷ $60,200) = 14.380% Line 11 times exempt income as a percent of distributable income = distributed exempt income $12,000 total distribution × 0.14380 = $1,726 tax-exempt distributed Schedule K-1, Lines 1, 2a, 2b, and 14 (beneficiary’s share of distributions) Allocate the $2,457 deductible trustee’s and accountant’s fees to taxable interest income, which is taxed at a higher rate than dividends. Compute distributed dividends and distributed taxable interest income: 1. [(dividends – no allocable fees) ÷ distributable net income] × total distributions = distributed dividends ($50,000 ÷ $60,200) × $12,000 = $9,967 2. [(interest - allocable fees) ÷ distributable net income] × total distributions = distributed taxable interest [($4,000 − $2,457) ÷ $60,200] × $12,000 = $307 Allocated distributed income to beneficiaries: Total Dividends Taxable interest Subtotal Exempt interest Total

$ 9,967 307 $10,274 1,726 $12,000

Barry’s 75% $ 7,475 230 $ 7,705 1,295 $ 9,000

Angela’s 25% $ 2,492 77 $ 2,569 431 $ 3,000

Note: Income for alternative minimum tax purposes is the same as for regular tax purposes.

Pearson's Federal Taxation 2024 Corporations, Partnerships, Estates, & Trusts 37th Edition By Mitche