Week 7 ACCT 429 Practice Problems

27. LO.5 Eloise contributes $40,000 to MeldCo in exchange for a 30% ownership interest. During the first year of operations, MeldCo earns a profit of $200,000. At the end of that year, MeldCo holds liabilities of $75,000. a. Calculate Eloise's basis for her stock if MeldCo is a C corporation. b. Calculate Eloise's basis for her stock if MeldCo is an S corporation. c. Calculate Eloise's basis for her partnership interest if MeldCo is a partnership.

27. a. Initial basis under § 351 and § 358 $40,000 Effect of corporate earnings -0- Effect of corporate liability -0- Eloise's stock basis: C corporation $40,000 b. Initial basis under § 351 and § 358 $ 40,000 Effect of corporate earnings ($200,000 × 30%) 60,000 Effect of corporate liability -0- Eloise's stock basis: S corporation $100,000 c. Initial basis under § 721 and § 722 $ 40,000 Effect of partnership earnings ($200,000 × 30%) 60,000 Effect of partnership liability ($75,000 × 30%) 22,500 Eloise's basis for partnership interest $122,500

14. LO.4, 5 Assume the same facts as in Problem 13. What income, gains, losses, and deductions does Amy report on her income tax return? Based on the information provided, what other calculations is she required to make?

Amy would report her $200,000 share of the partnership's ordinary income, her $2,000 share of the partnership's interest income, and her $3,000 share of the partnership's net short-term capital gain. She may deduct her $2,000 share of the partnership's charitable contribution. The cash distribution Amy received would not be taxable; nor would the decrease in Amy's share of partnership liabilities. As a general partner, Amy's distributive share of the partnership's ordinary income is subject to selfemployment tax and possibly the additional Medicare tax (0.9%). In 2013 and later years, her net investment income from the partnership (e.g., interest and gains) may be subject to the net investment income tax (3.8%) under § 1411.

1. LO.2 Janda and Kelsey contributed $1 million each to the JKL LLC in exchange for 45% capital and profits interests in the entity. Lilli will contribute no cash, but has agreed to manage the LLC's business operations in exchange for an $80,000 annual salary and a 10% interest in the LLC's capital and profits (valued at $200,000). What are the consequences of the entity formation and Lilli's compensation arrangement to the LLC members? To the LLC itself?

Janda and Kelsey have essentially each given a 5% partnership interest to Lilli in exchange for ongoing management services she will contribute to the LLC. Lilli has received this interest in the LLC's capital and future profits in exchange for services. As Lilli is fully vested in the capital interest, she would pay tax on the liquidation value of the interest, or $200,000. The value of the future profits interest cannot be determined, so it is not currently taxable; Lilli will pay tax on each year's annual allocations. Because Lilli's management services would likely be an ordinary and necessary business expense, JKL can deduct the $200,000; the deduction would probably be allocated to Janda and Kelsey. In addition, JKL has an ongoing requirement to pay Lilli $80,000 per year. This is a guaranteed payment for services and is deductible by JKL and taxable to Lilli as ordinary income.

9. LO.5 The LizMack LLC distributes the following assets to its member, Liz. • $20,000 cash. • Inventory with a $20,000 value and a $10,000 basis to the entity. • A parcel of land with a $30,000 value and a $35,000 basis to the entity. What issues must be considered in determining the Federal income tax treatment of the distribution?

The following issues must be addressed: • Is this a current (i.e., nonliquidating distribution) or a liquidating distribution? No loss can be recognized on a current distribution. In addition, current vs. liquidating status may impact Liz's basis in the assets she receives. • Is the cash distribution greater than Liz's basis in the partnership interest? If so, Liz will recognize gain on the distribution. • Is the distribution disproportionate with respect to the inventory? If so, Liz or the partnership may be required to recognize ordinary income on the distribution. • What is Liz's basis in the land and inventory she receives in the distribution? If this is a liquidating distribution, the assets are allocated a substituted basis equal to Liz's remaining basis in her partnership interest. If this is a current distribution, the assets are allocated the lesser of (1) a carryover basis or (2) a substituted basis equal to Liz's remaining basis in her partnership interest. In either case, ordering rules must be followed in determining Liz's basis in the land and inventory she receives in the distribution.

3. LO.2 Sea Green Enterprises reports the following assets and liabilities on its balance sheet. Net Book Value Fair Market Value Assets $600,000 $925,000 Liabilities 200,000 200,000 Sea Green has just lost a product liability suit with damages of $10 million being awarded to the plaintiff. Although Sea Green will appeal the judgment, legal counsel indicates that the judgment is highly unlikely to be overturned by the appellate court. The product liability insurance carried by Sea Green includes a payout ceiling of $6 million. What is the amount of liability of the entity and its owners if Sea Green is: a. A sole proprietorship? b. A partnership or an LLC? c. A C corporation? d. An S corporation?

a. As a sole proprietorship has unlimited liability, the sole proprietorship and the owner are liable for the remaining $4 million after the $6 million is paid by insurance. Since the net FMV of the net assets is $725,000 ($925,000 - $200,000), the owner is liable for the remaining $3,275,000 ($4,000,000 - $725,000). b. Because a partnership has unlimited liability, the partnership and the partners are liable for the remaining $4 million after the $6 million is paid by insurance. Since the net FMV of the net assets is $725,000 ($925,000 - $200,000), the partners are liable for the remaining $3,275,000 ($4,000,000 - $725,000). c. A C corporation has limited liability (i.e., equal to the FMV of the assets of $925,000). The plaintiff will share with the other creditors (i.e., $200,000) of the entity with respect to claims against the $925,000 of assets. The shareholders of the C corporation have no personal liability for the remaining corporate debts of $3,075,000 ($4,000,000 - $925,000). d. Same response as in (c) for an S corporation.

13. LO.4, 5 Amy and Mitchell are equal partners in the accrual basis AM Partnership. At the beginning of the current tax year, Amy's capital account has a balance of $300,000, and the partnership has recourse debts of $200,000 payable to unrelated parties. All partnership recourse debt is shared equally between the partners. The following information about AM's operations for the current year is obtained from the partnership's records. Ordinary income $400,000 Interest income from P&G bond 4,000 Long-term capital loss 6,000 Short-term capital gain 12,000 Charitable contribution 4,000 Cash distribution to Amy 20,000 Year-end partnership debt payable to unrelated parties is $140,000. If all transactions are reflected in her beginning capital and basis in the same manner: a. What is Amy's basis in the partnership interest at the beginning of the year? b. What is Amy's basis in the partnership interest at the end of the current year?

a. Assuming that Amy's capital account reflects an accurate number for basis purposes, her beginning basis is determined as follows: Capital account balance, beginning of year $300,000 Share of AM's debt ($200,000 × 1/2) 100,000 Amy's basis, beginning of year $400,000 b. Amy's basis at the end of the year is determined as follows: Capital account balance, beginning of year $300,000 Add Amy's share of: Taxable income $200,000 Interest income 2,000 Net short-term capital gain 3,000 205,000 $505,000 Less: Charitable contribution $ 2,000 Cash distribution to Amy 20,000 (22,000) $483,000 Plus: Share of AM's debt ($140,000 × 1/2) 70,000 Amy's basis, end of year $553,000

28. LO.5 In each of the following independent cases in which the partnership owns no hot assets, indicate the following. All of the partners received proportionate distributions. • Whether the partner recognizes gain or loss. • Whether the partnership recognizes gain or loss. • The partner's adjusted basis for the property distributed. • The partner's outside basis in the partnership after the distribution. a. Kim receives $20,000 of cash in partial liquidation of her interest in the partnership. Kim's outside basis for her partnership interest immediately before the distribution is $3,000. b. Kourtni receives $40,000 of cash and land with a $30,000 inside basis to the partnership (value $50,000) in partial liquidation of her interest. Kourtni's outside basis for her partnership interest immediately before the distribution is $80,000. c. Assume the same facts as in (b), except that Kourtni's outside basis for her partnership interest immediately before the distribution is $60,000. d. Klois receives $50,000 of cash and inventory with a basis of $30,000 and a fair market value of $50,000 in partial liquidation of her partnership interest. Her basis was $90,000 before the distribution.

a. Kim recognizes a $17,000 gain on the distribution. Her outside basis for her partnership interest is reduced to $0. The partnership does not recognize any gain or loss on the transaction. b. The $40,000 cash is deemed distributed first and reduces Kourtni's outside basis to $40,000. The land takes a $30,000 carryover basis to Kourtni, and her outside basis for her partnership interest is reduced to $10,000. The partnership recognizes no gain or loss on the transaction. c. Kourtni recognizes no gain or loss on the cash distribution, the land takes a substituted basis of $20,000, and her outside basis for the partnership interest is reduced to $0. d. The $50,000 of cash is deemed distributed first and reduces Klois's basis to $40,000. The inventory is distributed next. The inventory takes a carryover basis of $30,000. Klois has assigned basis in the assets received of $80,000, and her remaining basis in the partnership interest is $10,000. Because this is a nonliquidating distribution, Klois cannot claim a loss. The partnership recognizes no gain or loss on the distribution.

2. LO.5 Using the legend provided, indicate which form of business entity each of the following characteristics describes. Some of the characteristics may apply to more than one form of business entity. Legend: P = Applies to partnership and LLC S = Applies to S corporation C = Applies to C corporation a. Basis for an ownership interest is increased by an investment by the owner. b. Basis for an ownership interest is decreased by a distribution to the owner. c. Basis for an ownership interest is increased by entity profits. d. Basis for an ownership interest is decreased by entity losses. e. Basis for an ownership interest is increased as the entity's liabilities increase. f. Basis for an ownership interest is decreased as the entity's liabilities decrease.

a. Partnership, S corporation, and C corporation (P, S, and C). b. Partnership and S corporation (P and S). c. Partnership and S corporation (P and S). d. Partnership and S corporation (P and S). e. Partnership (P). f. Partnership (P).

1. LO.2, 3, 4, 5, 6, 7 Using the legend provided, indicate which form of business entity each of the following characteristics describes. Some of the characteristics may apply to more than one form of business entity. Legend: SP = Applies to sole proprietorship P = Applies to partnership and LLC S = Applies to S corporation C = Applies to C corporation N = Applies to none a. Has limited liability. b. Greatest ability to raise capital. c. Subject to double taxation. d. Subject to accumulated earnings tax. e. Limit on types and number of shareholders. f. Has unlimited liability. g. Sale of the business can be subject to double taxation. h. Contribution of property to the entity in exchange for an ownership interest can result in the nonrecognition of realized gain. i. Profits and losses affect the basis for an ownership interest. j. Entity liabilities affect the basis for an ownership interest. k. Distributions of earnings are taxed as dividend income to the owners. l. Total invested capital cannot exceed $1 million. m. AAA is an account that relates to this entity.

a. S corporation and C corporation (S and C). b. C corporation (C). c. C corporation (C). d. C corporation (C). e. S corporation (S). f. Sole proprietorship and partnership (SP and P). g. C corporation (C). h. Partnership (P), S corporation (S), and C corporation (C). i. Sole proprietorship, partnership, and S corporation (SP, P, and S). j. Sole proprietorship and partnership (SP and P). k. C corporation (C). l. N m. S corporation (S).

26. LO.5 Agnes, Becky, and Carol form a business entity with each contributing the following. Adjusted Basis Fair Market Value Agnes: Cash $100,000 $100,000 Becky: Land 60,000 120,000 Carol: Services 50,000 Their ownership percentages will be as follows. Agnes 40% Becky 40% Carol 20% Becky's land has a $20,000 mortgage that is assumed by the entity. Carol is an attorney who receives her ownership interest in exchange for legal services. Determine the recognized gain to the owners, the basis for their ownership interests, and the entity's basis for its assets if the entity is organized as: a. A partnership. b. A C corporation. c. An S corporation.

a. Section 721 provides that no gain or loss is recognized by the partners upon the contribution of property to a partnership. Thus, neither Agnes nor Becky has any recognized gain. Since Carol is contributing services rather than property, she has a recognized gain of $50,000. Section 722 provides for a carryover basis for the partners. The $20,000 mortgage assumed by the partnership results in the adjustments indicated below. Thus, the partner's basis for the partnership interest is as follows: Agnes ($100,000 + $8,000) $108,000 Becky ($60,000 - $20,000 + $8,000) 48,000 Carol ($50,000 + $4,000) 54,000 Section 723 provides for a carryover basis to the partnership for the assets received. Cash $100,000 Land 60,000 Organization costs 50,000 b. Section 351 provides that no gain or loss is recognized upon the contribution of property to a corporation if the shareholders control (i.e., at least 80%) the corporation immediately after the transfer. Since the combined ownership of Agnes and Becky (40% + 40% = 80%) satisfies this requirement, neither has any recognized gain. Since Carol is contributing services rather than property, she has a recognized gain of $50,000. Section 358 provides for a carryover basis for the shareholders. Thus, the shareholder's basis for the stock is as follows: Agnes $100,000 Becky ($60,000 - $20,000) 40,000 Carol 50,000 Section 362 provides for a carryover basis to the corporation for the assets received. Cash $100,000 Land 60,000 Organization costs 50,000 c. Same tax consequences as in b. above, since S status involves a corporation.

10. LO.3 On July 1 of the current year, the R&R Partnership was formed to operate a bed-and-breakfast inn. The partnership paid $3,000 in legal fees for drafting the partnership agreement and $5,000 for accounting fees related to organizing the entity. It also paid $10,000 in syndication costs to locate and secure investments from limited partners. In addition, before opening the inn for business, the entity paid $15,500 for advertising and $36,000 in costs related to an open house just before the grand opening of the property. The partnership opened the inn for business on October 1. a. How are these expenses classified? b. How much may the partnership deduct in its initial year of operations? c. How are costs treated that are not deducted currently?

a. The legal and accounting fees totaling $8,000 are organizational costs. The $10,000 to secure limited partnership investments are nonamortizable, nondeductible syndication costs. The $51,500 for advertising and the pre-opening event are startup expenses. b. The partnership may deduct $5,000 of the organizational costs, plus $50 amortization [($8,000 total - $5,000 deducted)/180 months × 3 months], for a total of $5,050. None of the syndication costs is deductible. The partnership may deduct $3,500 of the startup costs [$5,000 maximum permitted - ($51,500 total - $50,000 phaseout)], plus $800 amortization [($51,500 total - $3,500 deducted)/180 months × 3 months] for a total deduction in its initial year of operation of $4,300. c. The organizational and startup costs that are not deducted currently are amortized and deducted over 180 months, beginning with the month in which the partnership begins business. The syndication costs are not deductible.