Federal Taxation of Entities

Penalty Taxes

Accumulated Earnings Tax—Corporations are sometimes used to avoid high individual tax rates. This use of the corporate form to reduce tax rates only works if the income remains in the corporation. If the income is distributed as dividends, then it is subject to the individual tax and no tax savings is realized. The accumulated earnings tax is designed to mitigate this use of the corporate form. Unnecessarily high levels of accumulated taxable income trigger this penalty tax, and it operates by imposing a penalty tax on any undistributed income. Hence, the accumulated earnings tax can be avoided either by documenting business reasons for accumulating income, or by distributing income as dividends. A. An accumulated earnings tax of 20% is imposed on undistributed accumulated taxable income. 1. Accumulated taxable income is computed by adjusting taxable income to reflect retained economic income. 2. Dividend distributions reduce accumulated taxable income because income is not accumulated if dividends are paid out to shareholders. 3. For purposes of the accumulated earnings tax, dividends include consent dividends and dividends paid within three-and-a-half months of year-end. Definition Consent Dividends: Hypothetical dividends that are treated as if they were paid on the last day of the corporation's taxable year. Since they are not actually distributed, shareholders increase their stock basis by the amount of consent dividends included in their gross income. 4. Finally, an accumulated earnings credit is subtracted from any accumulation to represent the "reasonable" accumulation of earnings for business purposes. B. Adjustments—There are six modifications made to taxable income to reflect economic accumulations of income. 1. Taxable income is reduced by (1) accrued income taxes, (2) excess charitable contributions, (3) net capital loss, (4) net capital gain after tax. Definition Excess Charitable Contributions: The amount of contributions to charity in excess of the corporate deduction limit (10% of taxable income). a. Shortcut—The adjustments for net capital loss and net capital gain are mutually exclusive in that only one can occur in any given year. That is, either the corporation will have capital losses in excess of gains (a net capital loss) or vice versa (a net capital gain). 2. Taxable income is increased by adding back (5) the dividends-received deduction and (6) any net operating loss or capital loss carryovers. C. Accumulated Earnings Credit—The accumulated earnings credit is the greater of two numbers related to earnings and profits. 1. One number is the amount of the current earnings and profits needed for the "reasonable needs" of the business. Definition Reasonable Needs of a Business: A question of fact, but they have been found to include amounts necessary to finance business expansion (actual or planned), to provide working capital, or to retire liabilities. Reasonable needs, however, do not include amounts retained for unrealistic needs or for loans to shareholders. 2. The second number is a flat $250,000 ($150,000 for service (e.g., health, law, accounting, engineering) corporations) less the accumulated earnings and profits at the close of preceding year. Note Since the credit is the greater of these two items, there is no maximum on the credit as long as reasonable business needs support it. Note A corporation that passes the tests as a personal holding company may be subject to the PHC tax only if it also has undistributed PHC income. Personal Holding Company (PHC) Tax—Corporations are sometimes used to hold investments because corporations are entitled to deduct a portion of dividends received. Hence, taxable income will be less if dividends are received by a corporation rather than an individual. The personal holding company tax is designed to mitigate this use of the corporate form. This penalty tax is triggered by relatively high levels of investment income in a corporation and it operates by imposing a penalty tax on any undistributed income. Hence, the personal holding company tax can be avoided either by keeping investment income levels relatively low, or by distributing income as dividends. A. A PHC tax of 20% is imposed only on corporations qualifying as personal holding companies. 1. Banks, insurance, and finance companies are exempt from the tax because their business purpose is to manage investments. 2. The tax base for the PHC tax is taxable income adjusted to reflect retained economic income. 3. Like the accumulated earnings tax, the PHC tax can be avoided by paying dividends. B. Income and Ownership Tests—A corporation is a personal holding company if it "passes" two tests: the income test and the ownership test. 1. The income test is met if personal holding company income constitutes 60% of adjusted ordinary gross income (AOGI). Definitions Personal Holding Company Income: This income includes taxable dividends, interest, and sometimes, rents, royalties, and personal service contracts. If more than 50% of the corporation's gross income is from rents, then the rental income is not included as PHC income. Adjusted Ordinary Gross Income (AOGI): Gross income excluding capital and 1231 gains and reduced by expenses associated with the production of rent and royalty income. 2. The ownership test is met if more than 50% of the value of the stock is owned directly or indirectly by five or fewer individuals at any time during the last half of the year. Definition Indirect Ownership: Determined by stock "attribution" rules. These rules define ownership to include the stock held by an entity (the portion relating to a corporation, partnership, trust, or estate) or by family members (brothers and sisters, spouse, ancestors, and lineal descendants). An individual will not be considered to be the constructive owner of the stock owned by nephews, cousins, uncles, aunts, and any of his/her spouse's relatives. a. Shortcut—A corporation with 10 or more equal and unrelated shareholders would not be a PHC because it will not pass the ownership test. C. Adjustments—PHC income is taxable income modified by five adjustments. The adjustments to taxable income are designed so that the tax base (undistributed PHC income) reflects retained economic income. 1. Taxable income is reduced by (1) accrued income tax, (2) excess charitable contributions, and (3) net capital gain (after tax). 2. Taxable income is increased by adding back (4) the dividends-received deduction and (5) the carryover for net operating losses from year prior to the previous year. a. Shortcut—The adjustments for the PHC are similar to those used for the accumulated earnings tax except that there is no adjustment for net capital losses and the adjustment for net operating loss carryovers does not include an NOL from the previous year. D. PHC Tax—The PHC tax is imposed on undistributed PHC income. 1. To reduce PHC income, dividends must be pro rata. (The dividends cannot be paid disproportionately.) 2. For purposes of the PHC tax, dividends include dividends paid during the year, consent dividends, and dividends paid within 3½; months of year-end (limited to 20% of dividends actually paid during year). 3. A deficiency dividend can also be paid to avoid the PHC tax. Definition Deficiency Dividend: A dividend expressly declared to avoid the tax and is paid within 90 days of tax imposition (the finding of a deficiency due to the PHC tax). Look at this section for formulas The accumulated earnings tax is a tax imposed on corporations that accumulate earnings beyond reasonable amount. This tax was imposed to prevent corporations from accumulating earnings and profits with the purpose of avoiding income tax on its shareholders. Any corporation accumulating earnings beyond the point of reasonable needs of the business is considered to have accumulated the earnings for the tax benefit of its shareholders, unless a preponderance of the evidence indicates otherwise. Only the shareholders of closely-held corporations would tend to have the power to retain corporate earnings for their benefit. As a result, the accumulated earnings tax tends to be applied more often to closely-held corporations. However, the number of shareholders in a corporation is not a determining factor in imposing the tax. Hence, the accumulated earnings tax may be applied regardless of the number of shareholders in a corporation. Domestic and foreign corporations satisfying the personal holding company stock ownership and income tests are personal holding companies. The stock ownership test is satisfied if, at some time during the corporation's tax year, 50% or more of the corporation's stock was directly or indirectly owned by five or fewer individuals. Acme Corp. only has two shareholders, satisfying the stock ownership test. The income test is satisfied if 60% or more of the corporation's adjusted ordinary gross income is personal holding company income. Personal holding company income consists of: dividends; interest; annuities; rents; mineral, oil and gas royalties; copyright and patent royalties; produced film rents; compensation for more than 25% use of corporate property by shareholders; amounts received under personal services contracts; and amounts received from estates and trusts. Since all of Acme Corp.'s income comes from investments, all of the corporation's income is considered personal holding company income and, as a result, the corporation satisfies the income test. Since Acme Corp. satisfies the stock ownership and income tests, it is a personal holding company. The accumulated earnings tax is a penalty tax imposed on corporations that accumulates earnings and profits for the purpose of avoiding income tax for its shareholders. The accumulated earnings tax is equivalent to 20% of the corporation's accumulated taxable income. Accumulated taxable income is composed of taxable income adjusted downward for federal income and excess profits taxes, charitable deduction in excess of the ceiling, net capital gains and losses, and taxes of foreign countries and U.S. possessions and upward for certain corporate deductions, net operating loss deduction and capital loss carryback or carryover. When calculating the accumulated earnings tax, corporations are given a credit, the accumulated earnings credit, of $250,000 ($150,000 for certain service corporations) plus dividends paid within the first 3 1/2 months of the corporation's tax year less accumulated earnings and profits at the end of the preceding tax year. Hence, the maximum amount of accumulated taxable income that may be subject to the accumulated earnings tax for Year 9 if Kari Corp. takes only the minimum accumulated earnings credit is $66,000. This amount is composed of $400,000 in taxable income less both a downward adjustment of $84,000 for federal income taxes and the $250,000 accumulated earnings credit. Domestic and foreign corporations satisfying the personal holding company stock ownership and income tests are personal holding companies. As such, the corporation will be subject a 20% penalty tax on undistributed personal holding company income. The stock ownership test is satisfied if, at some time during the corporation's tax year, 50% or more of the corporation's stock was directly or indirectly owned by five or fewer individuals. An individual indirectly owns stock if it is owned by the individual's family or partner. Family includes the individual's brothers, sisters, spouse and lineal descendants and ancestors. An individual will not be considered to be the constructive owner of the stock owned by nephews, cousins, uncles, aunts, and any of his/hers spouses relatives. Constructive ownership also may exist if the individual is a partner in a partnership or the beneficiary of an estate that is a shareholder. The income test is satisfied if 60% or more of the corporation's adjusted ordinary gross income is personal holding company income. With 450 shares, Edwards already directly owns 45% of Zero Corp.'s outstanding stock. If an estate where Edwards is the beneficiary owns the remainder of the corporation's 200 shares of stock, Edwards would directly or indirectly own more than 50% of the corporation. An ownership exceeding the 50% direct or indirect ownership percentage is needed to satisfy the stock ownership test. Hence, Zero Corp. could be a personal holding company if the remaining 200 shares were owned by an estate where Edwards is the beneficiary. Each response given to this question satisfies the stock ownership test for a personal holding company because, in each response, five or fewer individuals would own more than 50% of the corporation's stock. However, this response is the best as it concentrates over 50% ownership under the control of one individual. For the personal holding company (PHC) tests, interest earned on tax-exempt obligations is excluded from PHC income. PHC income consists of: dividends; interest; annuities; rents; mineral, oil and gas royalties; copyright and patent royalties; produced film rents; compensation for more than 25% use of corporate property by shareholders; amounts received under personal services contracts; and amounts received from estates and trusts. Since only the dividends should be included, this response is correct. Personal holding companies are required to pay taxes on their undistributed personal holding company income. Personal holding company income and undistributed personal holding company income differ. Undistributed personal holding company income is computed by adjusting taxable income, then subtracting the dividends paid deduction. Deductions are made from taxable income for federal and foreign taxes; charitable contributions (based on a higher percentage limitation than the 10% of income limitation imposed on corporations); and excess capital gains (i.e., any excess net long-term capital gain over net short-term capital loss for the tax year). Corporate deductions for dividends received and any net operating loss deduction must be added back, and business expenses and depreciation exceeding rental income may have to be added back. Hence, both the federal income taxes and the net long-term capital gain should be deducted from taxable income by Kane in determining undistributed personal holding company income prior to the dividend-paid deduction.

Corporate Reorganizations

Acquisitions and Reorganizations—Mergers, stock acquisitions, and asset acquisitions can all qualify for reorganization status if the shareholders of the acquired corporation receive sufficient equity from the acquiring corporations. A. Type A Reorganization Definition Type A Reorganization: A merger or consolidation under state law (called a statutory merger). Note that Target is exchanging its assets for Acquiring's stock. Once Target dissolves, the shareholders of Target own Acquiring stock. 1. In a merger, the acquired corporation (target) dissolves into another corporation (the acquiring corporation). 2. In a consolidation, both the acquired and the acquiring corporations dissolve into a new (surviving) corporation. 3. At least 50% of the consideration provided to Target by Acquiring must be stock in Acquiring. 4. The shareholders of the acquired firm can only defer gains and losses to the extent they receive equity of the acquiring corporation. Note, that both voting and/or nonvoting stock can be used in Type A reorganization. 5. Forms of payment that do not qualify as equity, are considered boot. 6. Acquiring must assume all of the liabilities of Target. DefinitionBoot: Property that does not qualify for nonrecognition. Boot triggers the recognition of gain, but not the recognition of losses. B. Type B Reorganization DefinitionType B Reorganization: An acquisition of the stock of the target solely in exchange for voting stock of the acquiring firm. Acquiring exchanges its own stock for stock in Target. Target remains in existence, but it is now owned at least 80% by Acquiring. The former Target shareholders now own stock in Acquiring. 1. The acquiring firm must exchange its own voting stock (or that of its parent company) for the stock of the target. Note that the use of nonvoting stock will disqualify the transaction from being a tax-free B reorganization. 2. The acquiring firm must own at least 80% of the stock of the target firm (voting and all other classes of stock) after the most recent acquisition of stock. Note that 80% does not need to be acquired during this acquisition; rather, total ownership must be 80% after the transaction. 3. Any consideration other than voting shares in the acquiring corporation, will violate the requirements of the reorganization. C. Type C Reorganization Definition Type C Reorganization: An acquisition of "substantially all" of the assets of the target solely in exchange for voting stock of the acquiring firm. Note, that Target is exchanging its assets for Acquiring's stock. The shareholders of Target own Acquiring stock after the reorganization. 1. The target firm then distributes the stock and other assets to its shareholders. 2. Substantially all of the assets is defined by the IRS as 90% of net asset value and 70% of gross asset value. 3. The stock that Acquiring transfers to Target can be only voting stock and must be at least 80% of the consideration provided. Other consideration provided (i.e., boot) cannot exceed 20% of the total consideration provided by Acquiring. a. If liabilities attached to Target's assets are assumed by Acquiring, this liability relief is not considered as boot (and therefore not subject to the 20% test) unless other boot is also given. If other boot is also given, then the total amount of boot and liability relief cannot exceed 20% of the consideration. D. Type D Reorganization Definition Type D Reorganization: A divisive reorganization (not acquisitive) in that a corporation (the parent) divides by transferring assets to a subsidiary in exchange for subsidiary shares. 1. The parent then distributes the subsidiary shares to its shareholders (spin-off) or redeems P stock with the S stock (split-off). Alternatively, the parent could be liquidated into two new corporations (a split-up). 2. In all events, the parent corporation must receive and distribute control of the subsidiary in the exchange (80% of the voting and other classes of stock). E. Other Reorganizations—Exist to defer gains and losses on specialized transactions. 1. E and F reorganizations are recapitalizations and nominal changes (such as changes in the name of the corporation or the state of incorporation). 2. G reorganizations are related to bankruptcy recapitalizations. F. In addition to meeting the specific reorganization rules described above, tax-free reorganizations must meet the following judicial principles: 1. The transaction must be motivated by a valid business purpose. 2. The continuity of business enterprise test requires that the acquiring corporation must (1) continue the historic business of the target corporation, or (2) use a significant portion of target's assets in the continuing business of acquiring corporation. 3. A merger only qualifies as a reorganization if the continuity of interest requirement is met. This test requires that a substantial amount of the consideration that Acquiring gives to Target must be stock in Acquiring. If at least 50% of the consideration is Acquiring stock then this test is definitely met, but the IRS has ruled that 40% can be sufficient also. 4. The step transaction doctrine permits multiple steps to be collapsed into a single step when the steps are so interdependent on one another that one would not have occurred without the other(s). Collapsing these steps may lead to a tax result other than that desired by the taxpayer. Deferral of Gains/Losses and Basis Issues—Generally, a reorganization does not require income recognition at the corporate level (by either the target or the acquiring corporation). A. Acquiring Corporation—In a reorganization, the acquiring corporation does not recognize gain or loss on the transfer of its stock for the acquired corporation. 1. An exception to this rule occurs if the acquiring corporation distributes appreciated property (in addition to stock). The appreciated property will trigger gain recognition to the acquiring corporation just as if the acquiring firm sold the assets. 2. The basis that the acquiring corporation takes in the assets received is: Basis in property to Target + Gain recognized by Target B. Acquired Corporation—In a reorganization, the acquired corporation does not generally recognize gain or loss. 1. A distribution of appreciated property to shareholders in connection with the acquisition will trigger gain recognition by the acquired corporation. 2. Shortcut—Whenever a corporation distributes appreciated property (property with a value in excess of adjusted basis), the corporation will recognize the gain. This applies regardless of whether the distribution is related to a reorganization, a redemption, or a liquidation. C. Shareholders—No gain or loss is recognized to the shareholders of the corporations involved in a tax-free reorganization if they receive only stock in exchange for property of the acquiring organization. 1. If shareholders receive other property in addition to stock, it is treated as boot and gain is recognized equal to the lower of: a. Boot received or b. Realized gain. i. Any gain recognized will be dividend income to the extent of the shareholder's proportionate share of Target's E&P. Any remaining gain is capital gain. 2. The basis to the shareholder in the stock received is: Basis in stock surrendered + Gain recognized − Boot received Tax Attributes—The tax attributes of the target firm (such as net operating loss carryovers) survive in reorganizations. Definition Tax Attributes: The tax characteristics of the firm. The most common attributes are the adjusted basis of assets, the earnings and profits of the corporation, carryovers (including net operating loss, capital loss, and excess charitable contributions), accounting methods (including depreciation methods), and tax credit carryovers. A. If the target firm disappears (in a merger or asset acquisition), then the acquiring corporation is entitled to the target's tax attributes. B. If the target survives as a subsidiary (e.g., after a stock acquisition), then the tax attributes stay with the target corporation. The acquiring firm can avail itself of a limited amount of the target's attributes through a consolidation with the target. The use of tax attributes by a surviving corporation or a parent is strictly limited through the application of complex provisions designed to limit tax incentives for corporate acquisitions. C. Specific Limitations 1. Earnings and profit of the target firm carries over to Acquiring. However, if Target has a deficit in E&P, that deficit can be used to offset only future earnings of the combined companies (not past E&P of Acquiring). 2. An NOL of Target is limited as follows for Acquiring's first tax return after the reorganization: (Income of Acquiring × # of days in year after transfer) / 365 days 3. Additionally, if there is a significant change in the ownership of Target (generally > 50% over a three-year period) the amount of Target's NOL that can be used annually in all future years is strictly limited (Section 382 limitation) to: FMV of Target's stock before the change × Long-term tax-exempt rate Other Types of Acquisitions—The corporate tax consequences of a taxable acquisition (not a reorganization) depend upon the form of the acquisition. A. Subsidiaries—If the acquiring firm purchases the stock of the target and operates the target as a subsidiary, then neither firm recognizes any gain or loss. 1. The tax attributes of the target survive, albeit trapped in the target firm. 2. The acquiring firm uses the purchase price of the target's shares as the adjusted basis of the subsidiary. 3. The adjusted basis of the target's assets does not change. B. Section 338 Elections—Under certain conditions in a taxable stock purchase, the acquiring firm can elect to step up the basis of the target's asset to FMV. 1. This election, referred to as a 338 election, requires the recognition of any gain generated by the difference between the adjusted basis of the target's assets and the fair market value of the stock. 2. The benefit of the election (step up in the basis of the acquired assets) is generally less than the tax cost triggered by gain recognition. Hence, the election is rarely invoked. C. Taxable Mergers—If the acquiring firm merges the target or acquires the assets of the target, then the target corporation recognizes gains and losses on the transfer of its assets. 1. The adjusted basis of the target's assets is their fair market value. Any excess purchase price is allocated to goodwill and amortized over 15 years. Tax attributes of the subsidiary transfer to the parent after a tax-free liquidation of the subsidiary into the parent. The 80% control test is met since 90% of ABC's voting stock is being acquired. XYZ is using its voting stock as required for B reorganizations. If taxpayer receives stocks or securities under a plan of reorganization from a corporation included in the reorganization, the taxpayer does not recognize a gain or loss from the transaction. However, if the taxpayer receives boot, the transaction is taxable up to the amount of the boot. Since Gow received the Rook Corp. stock solely in exchange for his Lad Corp. stock under a plan of reorganization and did not receive any boot, the transaction would be tax-free for Gow. Corporate reorganizations generally are tax-free for both shareholders and the corporation. In this case, the reorganization would be viewed as a Type A: Merger or Consolidation, which qualifies for tax-free treatment for both shareholders and the corporation. This response correctly indicates that the transaction would be tax-free for both shareholders and the corporation and, therefore, it is correct.

Distributions and Special Taxes

Distributions—Distributions may trigger corporate gain, but normally represent a return of capital to shareholders. A. Corporate Gain—The corporation generates gains by distributing appreciated property. 1. The gain is passed through to shareholders like other income. B. Shareholder Income if Corporation Has No E&P—A distribution creates a gain to the shareholder if the distribution exceeds the shareholder's adjusted basis in the stock. 1. The amount of a distribution is the amount of cash plus the value of any property distributed (less any debt on the property assumed by the shareholder). 2. Distributions in excess of adjusted basis are taxed as gains from the sale of stock. 3. Shortcut—Distributions in excess of adjusted basis will most likely be taxed as capital gains because stock will most likely be a capital asset in the hands of the shareholder (an asset held for investment). C. Shareholder Income if S Corporation Has E&P—Shareholders of S corporations with accumulated earnings and profits (E&P) from a previous status as a C corporation are subject to a complex distribution system. 1. Shortcut—An S corporation that has always been an S electing corporation will not need to use an accumulated adjustments account unless and until the S election is terminated. In addition, an S corporation, that was previously a C corporation, will not need to use an accumulated adjustments account unless the corporation had earnings and profits from this prior period. 2. Accumulated undistributed income generated during S status is recorded at the corporate level in the accumulated adjustments account (AAA). 3. AAA is adjusted in the same way as stock basis except (1) no adjustment is made for tax exempt income (and related expenses) and (2) AAA can be negative (only losses can reduce AAA below zero; distributions cannot create a deficit in AAA). 4. OAA is the other adjustments account that tracks tax-exempt income earned by the corporation. 5. Order of distributions a. Distributions follow this order: i. First tax-free from AAA (nontaxable; note that distributions from AAA also reduce stock basis) ii. Then from E&P (dividend income) iii. Next from stock basis, which is a tax-free return of capital iv. The remaining distribution is a capital gain b. An S corporation can make a bypass election, which allows the distribution to first come from E&P and then AAA. 6. Distributions from AAA reduce the balance of AAA (but distributions never reduce AAA below zero—only losses can accomplish this feat). 7. Distributions from AAA reduce the adjusted basis of the shareholder's stock. D. Distributions of cash during a minimum one-year period following termination of an S corporation election receive special treatment. 1. Treated as a tax-free recovery of stock basis to the extent it does not exceed AAA balance. 2. Since only cash distributions receive this special treatment, the corporation should not distribute property during this post-termination transition period. Built-in Gains Tax—An S corporation can be subject to tax if the corporation sells property that contained a built-in gain at the time of the S election. Definition Built-in Gain Property: For purposes of a tax on an S corporation, appreciated property (value in excess of adjusted basis) as of the beginning of the first year of the S status. A. Shortcut—A built-in gains tax is not imposed on a corporation that has always been an S electing corporation. B. The tax is imposed at the highest corporate rate (21%) and is limited to the net amount of built-in gain at the time of election. C. The tax can only be imposed for a period of 5 years after the S election is made. D. In the year of the sell, if property is also sold that had built-in losses at the date of the S election, these built-in losses can offset the built-in gains. E. The total built-in gain subject to this tax in any given year is also limited to the S corporation's taxable income for that year. F. The amount of built-in gains tax paid passes through on the S corporation tax return as an expense. To the extent the tax is due to built-in gains on capital assets, the tax passes through as a capital loss. Passive Investment Income Tax—An S corporation can be subject to the top corporate tax rate if the corporation reports excessive passive investment income and the corporation has E&P from prior status as a C corporation. Definition Passive Income: For purposes of the exam includes interest, dividends (except dividends from a subsidiary to the extent the subsidiary is conducting an active trade or business), royalties, and rents (unless substantial extra services are provided). A. Excessive passive income is passive income over 25% of gross receipts. B. The IRS may waive this tax if the corporation establishes that it made distributions within a reasonable time of discovering that E&P existed from a prior year. C. Shortcut—A corporation that has never been a regular C corporation or does not have E&P from a prior period as a C corporation cannot be subject to the corporate tax on excessive net passive income. LIFO Recapture—A C corporation using LIFO that converts to S status must recapture the excess of the inventory's value using a FIFO cost flow assumption over its LIFO tax basis as of the close of its last tax year as a C corporation. 1. The LIFO recapture is included in the C corporation's gross income, and the tax attributable to its inclusion is payable in four equal installments. 2. The first installment must be paid by the due date of the tax return for the last C corporation year, with the three remaining installments due by the due dates of the tax returns for the three succeeding taxable years. The built-in gains tax is levied on the appreciation in assets that occurred while the corporation was a C corporation (i.e., before the S election). The tax is triggered if the asset is sold during the first five years the entity is an S corporation. Calculate basis in an S corporation as follows: The current basis of $25,000 is increased by the $1,000 of income to $26,000, then reduced for the distribution of $30,000 which would reduce the basis to $0 and produce a $4,000 gain. The $3,000 loss is suspended until there is more basis in the future. If the amount of the distribution exceeds the adjusted basis of the stock, such excess shall be treated as gain from the sale or exchange of property. Correct! A C corporation that makes an S election and has unrealized built-in gains in its assets as of the election day must pay a built-in gains tax on this appreciation if it is recognized within the next 5 years. When Prail makes the S election it has appreciation in the land of $50,000 ($150,000 - $100,000). Since the land was sold within 5 years of the election day, the first $50,000 of gain is taxed to the corporation at the rate of 21%. Therefore, Prail must pay a tax of $10,500 ($50,000 × 21%). An S corporation shareholder increases/decreases her basis in the S corporation stock by her share of the corporation's income (taxable and nontaxable) and expenses (deductible and nondeductible). Distributions also reduce the stock basis. Sandy's basis is reduced to $40,000 for the distribution ($60,000 - $20,000) and is increased for all three income items for an ending basis of $85,000 ($40,000 + $30,000 + $5,000 + $10,000). The built-in gains tax applies only when an existing C corporation makes an S corporation election. The built-in gains tax does not apply when a sole proprietorship makes an S election, so the correct answer is $0. A distribution from an S corporation that has no accumulated earnings and profits reduces the basis of a shareholder's stock. If the payment exceeds the shareholder's basis in the stock, it is viewed as a payment in exchange for stock.

Distributions from a Corporation

Earnings and Profits—To properly classify distributions from a corporation, one must know the corporation's earnings and profits (E&P). To determine earnings and profits, taxable income must be adjusted to represent economic income. Hence, many of the adjustments will be very similar to the reconciling items used to adjust taxable income with book (accounting) income, except the direction of the change will be reversed. A. Additions to Taxable Income—Are made for exempt income or deductions that do not represent an economic outlay. 1. Municipal interest and life insurance proceeds are added to taxable income because they are economic inflows excluded from taxable income. 2. The dividends-received deduction does not represent an economic outlay, so it is added back to taxable income in computing E&P. 3. Deductions claimed for carryovers from previous years (carryforwards) are added back to taxable income. 4. Proceeds from corporate life insurance policy (less cash surrender value) B. Some Expenditures are Not Deductible—But represent economic outlays. These expenditures reduce taxable income in computing E&P. 1. The amount of federal income tax (net of credits) reduces taxable income in computing E&P because it represents an economic outlay. 2. Related party losses 3. Penalties, fines, lobbying expenses, life insurance premiums for a "key" man, entertainment expenses, and the disallowed portion of business meals. C. Some Modifications to Taxable Income—Modifications are timing differences and can be positive or negative. 1. The deferred portion of a gain from a current installment sale (but not other deferrals) is also added to taxable income because it represents an economic inflow. When the gain is recognized in later years, it reduces taxable income because it has already been included in E&P in the year of the sale. 2. The amount of depreciation deducted in excess of straight-line is viewed as a form of deferral and it is added back to taxable income (like the installment gain, this is a timing adjustment that will reverse in later years). The Alternate Depreciation System (ADS) is used to compute depreciation for earnings and profits. See the "Section 1231 Assets—Cost Recovery" lesson for more details on ADS. 3. The amount deducted under Section 179 for regular tax must be deducted ratably over five years for computing E&P. Bonus depreciation is not allowed for computing E&P. 4. Net capital loss and the excess amount of charitable contributions D. Distributions generally reduce E&P 1. Cash distributions reduce E&P. Note Distributions cannot create a deficit in E&P, but E&P can have a negative balance due to net operating losses (negative taxable income). 2. Distributions of property reduce E&P by the greater of the value of the property or the adjusted basis and this amount is then reduced by any liabilities that are assumed by the shareholder. 3. A distribution of appreciated property will first increase E&P by the amount of the gain recognized on the distribution. 4. Distributions cannot create a deficit in E&P—only losses can create a deficit. Dividend Treatment—The taxation of distributions as dividend income to shareholders depends upon the earnings and profits (E&P) accumulated in the corporation prior to distribution. Distributions are: A. Taxable as dividend income to extent of the shareholder's pro-rata share of E&P; B. Excess is tax-free to extent of shareholder's basis in stock (and reduces the basis); C. Remaining distribution amount is taxed as a capital gain; D. Both current and accumulated E&P are used to determine whether a distribution is a dividend. There are four possible scenarios. Definitions Current E&P: That which is generated during the year (up to the year-end). Accumulated E&P: The amount on the first day of the year (ignoring current E&P). 1. Scenario #1—If both current and accumulated E&P are negative, then distributions are a return of capital (tax-free up to adjusted basis—and then capital gain).Exam TipQuestions about distributions from E&P will typically use year-end distributions or describe income as earned ratably throughout the year. This language simplifies the calculation of the E&P balance on the date of the distribution (necessary to determine whether the distribution is from current or accumulated E&P). 2. Scenario #2—If both current and accumulated E&P are positive, then the distribution is taxed as a dividend. Distributions are first taken from current E&P by allocating E&P to each distribution, based on the amount of the distributions. If there is only one distribution during the year, then all of the current E&P is allocated to that distribution. Once current E&P is depleted, then distributions reduce accumulated E&P. 3. Scenario #3—If current E&P is positive but accumulated E&P is negative, then a distribution is a dividend only to the extent of the current E&P. 4. Scenario #4—If accumulated E&P is positive but current E&P is negative, then a distribution is a dividend to the extent of net E&P (accumulated E&P less an allocated portion of the deficit in current E&P) on the date of the distribution. E. A deficit in current E&P is allocated ratably during the year based on time, even if there is only one distribution for the year. F. If more than one distribution is made during the year a positive current E&P balance is prorated among the distributions based on the amount of the distributions. G. Accumulated E&P is allocated in chronological order. Property Distribution—Distributions of property (in-kind distributions). A. The value of the property distributed (net of any debt assumed by the shareholder) is the amount eligible for dividend treatment. B. The distribution of appreciated property causes the corporation to recognize gains (not losses) like a sale of the property. C. If the liability on the property exceeds the property's fair market value, the FMV is treated as being equal to the liability. D. Amount distributed = FMV − Liabilities on property E. Basis of the property to the shareholder is the fair market value. F. Constructive dividends are also treated as distributions. Definition Constructive Dividend: A payment to a shareholder that, although not formally declared as a dividend, is regarded as a dividend. Property distributions to shareholders will often be treated as a constructive dividend. For a shareholder who also is an employee at the corporation, any disallowed salary will be treated as a dividend. Dividends are taxable to the shareholder and are not deductible for the corporation. A distribution to a C corporation is: 1. Taxable as dividend income to extent of the shareholder's pro rata share of earnings and profits. 2. Excess is tax-free to extent of shareholder's basis in stock (and reduces the basis). 3. Remaining distribution amount is taxed as a capital gain. Capital losses are not included as an option. For dividends, the amount distributed is the fair market value of the property received less any liabilities assumed by the shareholder, or $35,000 ($38,000 − $3,000). Fox would have $35,000 of dividend income since earnings and profits is at least this amount. However, the basis in the property received as a taxable dividend is always the fair market value of the property, or $38,000. Dividend income must be reported for the distribution to the extent of Webster's current and accumulated earnings and profits ($70,000). The amount of the distribution is the cash of $20,000 plus the fair market value ($60,000) of the property distributed, or $80,000. This distribution is taxed as $70,000 of dividend income with the remaining $10,000 treated as a return of the shareholders' bases in their stock. When both accumulated and current E&P are positive, distributions are taxed as dividends to the extent of the sum of these amounts, or $50,000 ($30,000 + $20,000). The remaining $30,000 of the $80,000 distributions is treated as a return of capital. When accumulated E&P is negative and current E&P is positive, distributions are treated as dividends to the extent of current E&P. Thus, $10,000 is reported as dividend income and the other $5,000 is a return of capital. Correct! Depreciation for E&P purposes is straight line, so if the tax depreciation is straight line, then no adjustment is necessary. When a corporation distributes property to a shareholder in a nonliquidating distribution, gains are recognized to the corporation, but not losses. A $50,000 gain is recognized for the land ($100,000 - $50,000) and a $25,000 gain for the patent ($25,000 - 0) for a total gain of $75,000. The loss on the building is not recognized.

Business Tax Credits

Foreign Tax Credit—The U.S. taxes income from all sources, including income from foreign countries. The purpose of this credit is to prevent double taxation of foreign income that is subject to income tax in the foreign jurisdiction. A. The credit is limited to the lower of the foreign tax paid, or the proportion of U.S. tax allocable to foreign sourced income (known as the foreign tax credit limitation). 1. The proportion of U.S. tax allocable to foreign sourced income (foreign tax credit limitation) is determined by multiplying U.S. tax times the ratio of foreign taxable income to total taxable income. 2. Excess foreign tax credits carryback one year and forward 10 years. The excess amount is the foreign taxes paid or accrued for a tax year that exceeds the foreign tax credit limitation. B. In lieu of a credit, a taxpayer can elect to mitigate foreign taxes in two other ways. 1. Taxpayers can claim the foreign tax as an itemized deduction. 2. Taxpayers can elect to exclude income earned (in excess of housing costs) while a bona fide resident in a foreign country. The exclusion is a maximum of $108,700 (2021; adjusted for inflation) if the taxpayer is physically present in the foreign country for at least 330 days in any 12 consecutive months. General Business Credit—The general business credit consists of a combination of credits designed to subsidize certain activities. While each credit is calculated independently, the combination of credits is subject to an overall limit. A. The general business credit is limited to the taxpayer's net income tax reduced by 25% of net regular tax liability that exceeds $25,000. B. Net income tax is the sum of the regular tax liability and the AMT, reduced by certain nonrefundable tax credits (e.g., foreign tax credit). Net regular tax liability equals the net income tax less the AMT. C. Unused credits are carried back one year and then forward 20 years. D. The upshot of the credit is that the business credit cannot offset all of the regular tax if the liability exceeds $25,000. The Rehabilitation Credit—A credit is allowed for the rehabilitation of certain buildings. A. The rehabilitation credit percentage depends upon the type of expenditure. 1. Expenditures to rehabilitate property placed in service before 1936 were eligible for a 10% credit for tax years before 2018. 2. Expenditures to rehabilitate certified historic structure are eligible for a 20% credit. Beginning in 2018, the credit is claimed evenly over a 5-year period. 3. The adjusted basis of the property is reduced by the amount of credit. 4. To qualify for the credit, straight-line depreciation or ADS must be used for the building. 5. Before 2018 the rehabilitation credit was all taken in the first year and was recaptured if the building was held less than five years (the recapture rate is 20% per year). Small Employer Health Insurance Credit A. An eligible small employer (ESE) can claim a credit equal to 50% of its nonelective contributions for health insurance for its employees (25% for small tax-exempt employers). B. To be eligible for the credit, an ESE has to contribute at least 50% of the cost of the employee's insurance premiums under a contribution arrangement. C. The full amount of the credit is available only to an ESE with 10 or fewer full-time equivalent employees and whose employees have average annual full-time equivalent wages of less than $27,800 (2021). The credit is fully phased out once the number of full-time employees reaches 25 and/or the average wages reach $55,600 (2021). D. For purposes of the credit, the owner of a business and specified relatives are not treated as employees (and thus, no credit is allowed for the employer contributions for the health insurance of those employees). E. Any unused credits may be able to be carried back or carried forward. Work Opportunity Tax Credit (WOTC) A. This credit is calculated on the amount of wages paid per eligible employee during the first year of employment. The credit is 40% of qualified wages, with a maximum credit of $2,400. B. The credit is elective. C. The credit is targeted at certain employee groups, such as veterans and long-term unemployment recipients. D. The WOTC reduces the deduction for wages. Research Credit A. Incremental research expenditures are eligible for a 20% credit. The research must be conducted within the U.S. and does not apply to research for commercial production, surveys, or social science research. B. Taxpayers may elect to use an alternative simplified research credit. This is equal to 14% of the excess of qualified research expenses over 50% of the average research expenses for the last three years. C. An eligible small business (ESB) can also reduce its AMT liability by the research credit. An ESB's average gross receipts for the previous three years must not exceed $50 million. D. No deduction is allowed for research expenditures used to compute the research credit. Low-Income Housing Credit A. The amount of credit for owners of low-income housing projects depends on (1) whether the taxpayer acquires existing housing or whether the housing is newly constructed or rehabilitated, and (2) whether or not the housing project is financed by tax-exempt bonds or other federally subsidized financing. The applicable credit rates are the appropriate percentages issued by the IRS for the month in which the building is placed in service. B. The amount on which the credit is computed is the portion of the total depreciable basis of a qualified housing project that reflects the portion of the housing units within the project that are occupied by qualified low-income individuals. C. The credit is claimed each year (for a 10-year period) beginning with the year that the property is placed in service. The first-year credit is prorated to reflect the date placed in service. Disabled Access Credit A. A tax credit is available to an eligible small business for expenditures incurred to make the business accessible to disabled individuals. The amount of this credit is equal to 50% of the amount of the eligible access expenditures for a year that exceed $250 but do not exceed $10,250. B. An eligible small business is one that either (1) had gross receipts for the preceding tax year that did not exceed $1 million, or (2) had no more than 30 full-time employees during the preceding tax year and (3) elects to have this credit apply. C. Eligible access expenditures are amounts incurred to comply with the requirements of the Americans with Disabilities Act of 1990 and include amounts incurred for the purpose of removing architectural, communication, physical, or transportation barriers that prevent a business from being accessible to, or usable by, disabled individuals; amounts incurred to provide qualified readers to visually impaired individuals; and amounts incurred to acquire or modify equipment or devices for disabled individuals. Expenses incurred in connection with new construction are not eligible for the credit. D. This credit is included as part of the general business credit; no deduction or credit is allowed under any other Code provision for any amount for which a disabled access credit is allowed. Empowerment Zone Employment Credit A. The credit is generally equal to 20% of the first $15,000 of wages paid to each employee who is a resident of a designated empowerment zone and performs substantially all services within the zone in an employer's trade or business. B. The deduction for wages must be reduced by the amount of credit. Employer Social Security Credit A. Credit allowed to food and beverage establishments for the employer's portion of FICA tax (7.65%) attributable to reported tips in excess of those tips treated as wages for purposes of satisfying the minimum wage provisions of the Fair Labor Standards Act. B. No deduction is allowed for any amount taken into account in determining the credit. Employer-Provided Child Care Credit A. Employers who provide child care facilities to their employees during normal working hours are eligible for a credit equal to 25% of qualified child care expenditures and 10% of qualified child care resource and referral expenditures. The maximum credit is $150,000 per year and is subject to a 10n-year recapture rule. B. Qualified child care expenditures include amounts paid to acquire, construct, and rehabilitate property that is to be used as a qualified child care facility (e.g., training costs of employees, scholarship programs, compensation for employees with high levels of child care training). 1. To prevent a double benefit, the basis of qualifying property is reduced by the amount of credit, and the amount of qualifying expenditures that would otherwise be deductible must be reduced by the amount of credit. Employer-Paid Medical and Family Leave Credit A. Businesses can claim a general business tax credit equal to 12.5% of wages paid to qualifying employees while on family and medical leave. B. The employee must receive at least 50% of the wages normally paid to an employee. C. All qualifying employees must receive at least two weeks of annual paid family and medical leave. D. The 12.5% is increased by .25 percentage points for each percentage point by which the wages paid exceed 50%. E. Credit percentage can never exceed 25%. Small employers receive a credit to offset the costs of setting up a new retirement plan. A. The credit is the greater of (1) $500 or (2) the lesser of (a) $250 multiplied by the number of nonhighly compensated employees of the eligible employer who are eligible to participate in the plan, or (b) $5,000. B. The credit applies for up to three years. C. In general, small employers are those with 100 or fewer employees who received at least $5,000 in compensation for the preceding year. D. In addition to the above credit, a credit of $500 per year is allowed to employers to defray startup costs for new section 401(k) plans and SIMPLE IRA plans that include automatic enrollment. Correct! Businesses can claim a general business tax credit equal to 12.5% of wages paid to qualifying employees while on family and medical leave. The credit percentage can never exceed 25%. The foreign tax credit is the lower of: 1) foreign tax paid ($39,000), or 2) U.S. tax x foreign taxable income / worldwide taxable income $96,000 x $120,000 / $300,000 = $38,400 Correct! The work opportunity tax credit is 40% of the first $6,000 of wages per employee, so the maximum credit is $2,400 Foreign income taxes paid by a corporation may be claimed either as a deduction or as a credit, at the option of the corporation. To minimize a corporation's tax liability, it is better to claim the credit for the foreign income taxes than to deduct the taxes. The foreign tax credit allows for a dollar-for-dollar deduction from the corporation's tax liability, whereas the deduction is from taxable income. The general business credit is a combination of several tax credits that are computed separately under each under its own set of rules. The purpose of the general business credit is to combine these credits into a single amount to provide uniform rules for the current credits that may be taken to offset a taxpayer's tax liability. In addition, the credit provides uniform rules for carryback-carryover years. The general business credit may be carried back for 1 year, then forward for 20 years. The general business credits are composed of the: investment credit; work opportunity credit; alcohol fuel credit; incremental research credit; low-income housing credit; disabled access credit; credit for producing electricity from specified renewable resources; enhanced oil recovery credit; Indian employment credit; employer Social Security credit; empowerment zone employment credit; orphan drug credit; and excise tax payments to the Trans-Alaska Pipeline Liability Fund credit.

Partnership Distributions

Gain/Loss Deferral—Partnerships generally do not recognize gains or losses on distributions. A. Partners can recognize gains on nonliquidating or liquidating distributions of cash. Cash distributed in excess of outside basis causes gain recognition. B. Nonliquidating distributions of property never trigger loss recognition, but losses may be recognized on a liquidating distribution. Nonliquidating (or Current) Distributions Definition Nonliquidating Distribution: A distribution to a continuing partner, including a draw by the partner. A. Arm's-length sales to partners are not distributions. B. Basis Effects—For partners, nonliquidating distributions are a return of capital that reduces outside basis (in a specific order). 1. First, the partner's adjusted basis is allocated to cash distributions and cash deemed distributed (reductions in liabilities). 2. Second, the partner's adjusted basis is allocated to distributions of unrealized receivables and inventory in an amount equal to the partnership's basis in these assets. 3. Finally, the partner's adjusted basis is allocated to other assets distributed. Any deficiency in the partner's adjusted basis is allocated to properties with unrealized losses, and any excess basis is allocated to properties with unrealized gains. 4. Distributed property retains its inside basis (in the hands of the partner) unless the partner runs out of outside basis, then the inside basis of the property is reduced to the outside basis. 5. If the distributed property consists of multiple assets, then the allocation of basis can be quite complex. A simple approach is to allocate the outside basis by the amount of the inside basis. Liquidating Distributions—A liquidating distribution may result in gain or loss, and it requires the partner to transfer his or her outside basis to assets received from the partnership. A. A liquidating distribution occurs when the entire partnership is liquidated or the interest of one partner is redeemed. 1. The distribution can be a series of transfers. 2. The partnership, generally, does not recognize any gains or losses. B. Basis Effect—Liquidating distributions are treated as a return of capital and the partner's outside basis is substituted for the inside basis of distributed property. 1. Like nonliquidating distributions, distributions of cash (and deemed distributions) trigger gain to the extent cash exceeds outside basis. 2. Distributed property retains its inside basis, but this amount is adjusted (up or down) depending upon the outside basis of the partner. The calculation of this adjustment is complex and unlikely to be tested. 3. Inventory and receivables must be distributed pro-rata (a non-pro-rata distribution will be disproportionate). C. Loss Recognition—Unlike nonliquidating distributions, partners can recognize losses on liquidating distributions, but only if two conditions are met: 1. First, the distribution must consist only of cash, inventory, and unrealized receivables. 2. Second, the outside basis of the partner's interest exceeds the sum of cash plus the inside basis of the receivables and inventory. Retirement Distributions A. Payments made in liquidation of the interest of a retiring or deceased partner are generally treated as partnership distributions made in exchange for the partner's interest in partnership property. Such payments generally result in capital gain or loss to the retiring or deceased partner. B. However, payments made to a retiring or deceased general partner in a partnership in which capital is not a material income-producing factor must be reported as ordinary income by the partner to the extent such payments are for the partner's share of unrealized receivables or goodwill (unless the partnership agreement provides for a payment with respect to goodwill). 1. Amounts treated as ordinary income by the retiring or deceased partner are either deductible by the partnership (treated as guaranteed payments) or reduce the income allocated to remaining partners (treated as a distributive share of partnership income). 2. Capital is not a material income-producing factor if substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services (e.g., accountants, doctors, dentists, lawyers). Special Issues—Complications are created by built-in gains, deemed distributions, and disproportionate distributions. A. Deemed distributions (reductions in liabilities) are treated as cash distributions. B. Distributions of marketable securities (up to the value of the securities less the partner's share of appreciation inherent in the securities) are treated as deemed distributions. C. Distributions of built-in gain property to other partners (other than the partner who originally contributed the property) within seven years of the original contribution cause gain recognition. "Disproportionate" distributions of hot assets can also trigger income recognition. Definitions Hot Assets: Generate ordinary income or loss because the partner has not yet been taxed on accrued, but unrealized, income. Disproportionate Distributions: Occur when ordinary income assets (inventory and receivables) are distributed to partners without regard to their proportionate ownership interests. Therefore, if a 12% partner receives 12% of the hot assets, then no special rules need to be applied because it is a proportionate distribution. Most CPA Exam questions on this topic will be proportionate distributions. A. A distribution is disproportionate as to a partner's share of unrealized receivables or substantially appreciated inventory. Inventory is substantially appreciated if its FMV exceeds 120% of its basis. 1. Hot assets are inventory and unrealized receivables. For distributions, inventory has to be substantially appreciated (FMV > 120% × adjusted basis) for it to be classified as a hot asset. a. Unrealized receivables generally are receivables of cash basis taxpayers. Potential Section 1245 and Section 1250 recapture are also included as an unrealized receivable. b. Inventory is defined as any asset other than cash, capital assets, or Section 1231 assets. 2. The partner may receive more than the partner's share of these assets, or 3. The partner may receive more than the partner's share of other assets, in effect giving up a share of unrealized receivables or substantially appreciated inventory. 4. The partner may recognize gain or loss. The gain or loss is the difference between the FMV of what is received and the basis of what is given up. The gain or loss is limited to the disproportionate amount of unrealized receivables or substantially appreciated inventory that is received or given up. The character of the gain or loss depends on the character of the property given up. B. The partnership may similarly recognize gain or loss when there is a disproportionate distribution with respect to substantially appreciated inventory or unrealized receivables. Optional Section 754 Adjustment to Basis of Partnership Property A. On a distribution of property to a partner or on a sale by a partner of a partnership interest, the partnership may elect to adjust the basis of its assets to prevent any inequities that otherwise might occur. Once an election is made, it applies to all similar transactions unless the IRS approves revocation of the election. B. Upon the distribution of partnership property, the basis of remaining partnership property will be adjusted for all partners. 1. Increased by a. The amount of gain recognized to a distributee partner, and b. The excess of the partnership's basis in the property distributed over the basis of that property in the hands of distributee partner. 2. Decreased by a. The amount of loss recognized to a distributee partner, and b. The excess of basis of property in hands of distributee over the prior basis of that property in the partnership. Integrated Review Problem—A, B, and C formed ABC partnership with the following contributions: Look at image A. The land was a capital asset to B and subject to a mortgage of $5,000, assumed by the partnership. Assume that this year the partnership breaks even, but decides to make distributions to each partner. 1. What is B's initial basis? $8,000 (12,000 − 5,000 + (20% × 5,000)). 2. What is C's initial basis? $25,500 (24,000 + (30% × 5,000)). 3. A nonliquidating cash distribution may reduce the recipient partner's basis below zero. False. 4. A nonliquidating distribution of unappreciated inventory reduces the recipient partner's basis in the partnership. True. 5. In a liquidating distribution of property other than money, where the partnership's basis of the distributed property exceeds the basis of the partner's interest, the partner's basis in the distributed property is limited to his or her predistribution basis in the partnership interest. True. 6. Gain is recognized by the partner who receives a nonliquidating distribution of property, where the adjusted basis of the property exceeds his basis in the partnership interest before the distribution. False. 7. In a nonliquidating distribution of inventory, where the partnership has no unrealized receivables or appreciated inventory, the basis of inventory that is distributed to a partner cannot exceed the inventory's adjusted basis to the partnership. True. 8. The partnership's nonliquidating distribution of encumbered property to a partner who assumes the mortgage does not affect the other partners' bases in their partnership interests. False. A partner's basis in property received in a nonliquidating distribution is the same as the partnership's basis immediately before the distribution. However, the partner's basis in the property may not exceed his/her basis in the partnership less any cash received in the distribution. Hart received property with a basis of $12,000 ($5,000 in cash plus the partnership's basis in the land of $7,000). However, his basis in the partnership interest is $9,000, so the basis in the property distributed must be limited to this amount. Since the distribution included $5,000 in cash, Hart's basis in the land is $4,000 ($9,000 - 5,000). Gain is recognized on a partnership distribution ONLY if the cash distributed exceeds the basis in the partnership interest. In this case there was no cash distributed, so no gain is recognized. A partner receiving a distribution from a partnership usually does not recognize a gain or loss. Gains are recognized only to the extent the partner receives an amount of cash exceeding his/her adjusted basis in the partnership interest. Gains from property distributions other than cash are not recognized until the partner sells or disposes of the property. Therefore, Stone does not recognize any gain or loss from the distribution. The partner must report $25,000 of ordinary income and the $10,000 guaranteed payment. The distribution does not generate additional income since the partner has sufficient basis to absorb it Gain is recognized from a partnership distribution if the cash distributed to the partner exceeds her basis in her partnership interest. Morse's basis of $4,000 is increased by her share of the partnership's ordinary income, or $5,000 ($10,000 × 50%), increasing her basis to $9,000. The cash distribution of $11,000 exceeds her basis of $9,000 by $2,000. So Morse has a $2,000 capital gain. Tucker must first reduce his basis in the partnership interest of $10,000 by the cash distribution of $20,000 (but not below zero). Tucker recognizes a gain of $10,000 due to the cash distribution and his basis in the partnership interest is reduced to zero. Tucker's basis in the building is the lower of (1) the partnership's basis in the building ($30,000), or (2) Tucker's basis in the partnership interest after the cash distribution ($0). Thus, Tucker's basis in the building is zero.

Taxation of Foreign Income

General Rules A. Treaties between the United States and other countries generally override the tax provisions in the U.S. tax law or foreign tax law. B. Foreign taxpayers are usually taxed only on U.S. source income. C. Before 2018, U.S. persons were taxed on all income earned anywhere in the world. 1. A U.S. person includes a citizen or resident of the U.S., a domestic partnership or corporation, and any estate or trust other than a foreign estate or trust 2. Before 2018, a U.S. corporation was subject to tax on its worldwide income, including the income of a foreign branch. In contrast, a U.S. corporation is generally not taxed on the net income of a foreign subsidiary corporation until the income is repatriated in the form of dividends to the parent corporation. 3. Beginning in 2018, the taxation of foreign-source income to U.S. persons begins to transition toward a territorial tax system. a. The previous worldwide taxation framework does not completely cease to exist. Rather, the new rules overlay the historical worldwide taxation structure. b. U.S. businesses that sell goods and services abroad must continue to report that income immediately in the United States. c. Profits and losses from branch operations in foreign jurisdictions are also reported immediately. d. A reduced tax rate of 13.125% applies to income from intangible assets that the U.S. entity employs in foreign countries. Sourcing of Income and Deductions—Determining whether income is U.S. source or foreign source is critical for computing the federal income tax. A. Earned income is foreign source if earned in a foreign country and U.S. source if earned domestically. This also includes employee benefits. B. Unearned income is foreign source if received from a foreign resident or for property that is used in a foreign country. C. Income from the sale of personalty is determined based on the residence of the seller, except: 1. Inventory is sourced based on the location of the property. 2. In the case of depreciable property, recapture is sourced where depreciation was claimed. Remaining gain is sourced where title transfers. D. Income from the sale of intangibles is sourced where the amortization was claimed. Source of income from the use of intangible property is determined by the country in which the property is used. E. Income from the sale or exchange of real property is sourced based on the location of the property. Source of income from the use of tangible real property is determined by the country in which the property is located. F. Interest income is U.S. source if received from: 1. U.S. government 2. Noncorporate U.S. residents 3. Domestic corporations G. If a U.S. corporation receives 80% or more of its active business income from foreign sources over the previous three years then interest received from that corporation is foreign source. H. Dividends from U.S. corporations are U.S. source and from foreign corporations are foreign source. I. If a foreign corporation receives 25% or more of gross income from income connected with a U.S. business for the three previous tax years then dividends from that foreign corporation are U.S. source. J. Deductions must also be allocated or apportioned as U.S. source or foreign source. K. The IRS has the authority to change the allocation of income and deductions if it determines that the taxpayer's methods do not clearly reflect income. Taxation of Inbound versus Outbound Transactions Beginning in 2018 A. Definitions 1. "Outbound transactions" refer to the taxation of foreign-source income by U.S. taxpayers. 2. "Inbound taxation" refers to the taxation of U.S.-source income by non-U.S. taxpayers. B. U.S. Source Income 1. U.S. persons are always taxed on U.S.-source income. 2. Non-U.S. persons are potentially taxed on U.S.-source income. C. Foreign-Source Income from Outbound Transactions 1. Generally, this income is taxed only in the foreign jurisdiction. 2. If it is taxed in the United States and the foreign jurisdiction, then a foreign tax credit is allowed. 3. The transfer of assets from the United States to a foreign country may trigger income (depreciation recapture applies). 4. If assets are used in a trade or business outside the United States, gain is deferred unless the property is: a. Inventory or unrealized receivables b. Installment obligations c. Foreign currency Territorial Tax System Beginning in 2018 A. In prior years, if foreign-source income was not Subpart F income or not taxed immediately under another provision, it was not taxed until the U.S. business repatriated the profits back to the United States. B. The new system provides a 100% deduction by U.S. corporations for the foreign-source portion of dividends received from the earnings and profits of 10%-owned foreign affiliates. This deduction completely offsets the income from the foreign subsidiary. C. The U.S. business must have owned stock in the foreign affiliate for at least one year. D. No foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to a dividend that qualifies for the deduction. E. As part of the transition to a territorial tax system, U.S. shareholders must pay a tax on previously unrepatriated earnings. 1. U.S. shareholders owning at least 10% of a foreign subsidiary must include in income the shareholder's share of post-1986 Earnings & Profits if not previously taxed in the United States. This is included for the subsidiary's last tax year beginning before 2018. 2. The E&P is taxed at 8% except for the portion due to cash, which is taxed at 15.5%. 3. The balance can be paid immediately or over 8 years. If installment payments are elected, the payments for the first five years each equal 8% of the net tax liability; the Year 6 installment equals 15% of the net tax liability; the Year 7 installment equals 20%; and the Year 8 installment of the remaining balance equals 25% of the net tax liability. Controlled Foreign Corporations (CFC) A. A CFC is a foreign corporation for which more than 50% of the voting power or value of stock is owned by U.S. shareholders (limited to those who own, directly and indirectly, 10% or more of the foreign corporation) on any day of the tax year of the foreign corporation. B. Certain types of income from a CFC are taxed to a U.S. shareholder as a constructive dividend, even if no actual distribution has occurred. This income is referred to as Subpart F income. The main types of income subject to this rule include: 1. Income that is not connected economically to the country in which the corporation is organized 2. Income from insuring the risk of loss from outside the county in which the corporation is organized C. A 10.5% tax applies on intangible income that is foreign-sourced. This income is not classified as Subpart F income. The foreign tax credit is allowed against this tax, but only to the extent of 80% of the foreign taxes paid, and without any carryover allowed to another tax year. Worldwide Income—Potential Double Taxation A. Outbound income that is taxed in the United States and in a foreign jurisdiction is potentially subject to double taxation. B. Three provisions mitigate the potential double taxation of this income: 1. Foreign income taxes paid are an itemized deduction for individuals. 2. Alternatively, a credit may be claimed for foreign taxes paid. 3. Certain individuals can elect to exclude foreign-earned income. C. The credit for foreign taxes paid is limited if the U.S. effective tax rate exceeds the foreign effective rate. Limit = U.S. tax on worldwide income × (Foreign source taxable income / Worldwide taxable income) 1. Excess foreign tax credits can be carried back one year and carried forward 10 years. 2. Individuals who have only passive foreign income that does not exceed $300 ($600 for joint returns) can elect to be exempt from the foreign tax credit limitation. 3. A foreign tax credit usually provides a greater benefit than a deduction. The deduction may be preferable when the foreign effective tax rate is high and foreign income, as compared to worldwide income, is small. D. Qualifying individuals must meet one of two tests to benefit from the foreign-earned income exclusion: 1. During a continuous period that includes an entire tax year, the individual must be a bona fide resident of at least one foreign country. 2. The individual must have a tax home in a foreign country and must have been present in one or more foreign countries for at least 330 days during any 12 consecutive months. 3. Qualifying individuals can exclude: a. Foreign-earned income from personal services, limited to $108,700 in 2021. b. Employer-provided foreign housing income, limited to $15,218 (14% of the $108,700) for 2021. This exclusion is allowed only to the extent it exceeds 16% × $108,700, or $17,392. c. Taxpayers must file an election to take the exclusion, which is binding for future years until revoked. d. If a taxpayer was present in a foreign country for at least 330 days but less than the entire year, the exclusion is prorated on a daily basis (365-day year). Base Erosion Anti-Abuse Tax A. This tax applies when large C corporations attempt to shift too much taxable income to countries with lower tax rates. B. This tax applies to C corporations: -with average annual gross receipts of at least $500 million for the prior three tax years, and -whose "excessive" deductible royalties, management fees, and similar payments are made to a related non-U.S. person. "Excessive" means that base erosion items total at least 3% of total deductible payments for the year. C. A related non-U.S. partner is owned at least 25% by the U.S. corporation. A 25% owner is any taxpayer who owns at least 25% of the total voting power or value of all classes of stock of a corporation. D. If these conditions are met, the entity pays an income tax equal to the greater of: -the corporation's regular tax liability, or -10% × (Taxable income + Base erosion items) E. For 2020 to 2025, the tax rate is 10%. F. Base erosion items do not include those related to cost of goods sold and other active trade or business expenses, like salaries, or those where a withholding tax already applies. Foreign Currency Gains and Losses A. Foreign currency exchange gains and losses resulting from the normal course of business operations are ordinary. B. Foreign currency exchange gains and losses resulting from investment or personal transactions are capital. Transfer Taxes A. Taxpayers may use transfer pricing to manipulate the amount of income earned in the United States. Assume that BIG Corporation has manufacturing operations in the United States and in a foreign country, and that the U.S. entity sells its product to the foreign entity for the foreign entity to then use in its operations. Clearly, the sales price that BIG sets for the product will determine the amount of gain generated in the United States. B. If the IRS determines that the price set by BIG does not clearly reflect income, the IRS has broad powers under Section 482 to reallocate income to insure that income is clearly stated. C. Because it may be difficult for a taxpayer to determine what price might be used by unrelated taxpayers dealing at arm's length, the IRS permits taxpayers to enter into an Advance Pricing Agreement (APA) with the IRS on the best method for determining arm's length prices for transfers between taxpayers owned or controlled by the same interests. Pursuant to an APA, a taxpayer and the IRS agree as to the transfer pricing method to be used to determine the transfer prices for specified transactions. U.S. Taxation of Foreign Persons A. Nonresident foreign persons generally are subject to U.S. tax on two categories of income: (1) income that is effectively connected with a U.S. trade or business (ECI), and (2) certain passive types of U.S. source income commonly referred to as fixed and determinable annual or periodical income (FDAP). 1. A foreign person's income that is effectively connected with a U.S. trade or business (ECI) is subject to tax at regular graduated income tax rates and deductions are allowed in computing the amount subject to tax. A trade or business generally is defined by case law as profit-oriented activities that are regular, substantial, and continuous. Effectively connected with a U.S. trade or business means that (1) the income is derived from assets held for use in the conduct of a U.S. business, and (2) the activity of the U.S. business was a material factor in the realization of the income. Under an income tax treaty, the U.S. may instead agree to tax business profits of a treaty resident only if the profits are attributable to a permanent establishment (PE) in the U.S. A PE is a fixed place of business through which business is wholly or partially carried on. Simply maintaining storage facilities within the U.S. generally does not by itself amount to a PE. 2. Generally, a nonresident alien who performs personal services within the U.S. is considered to be engaged in a U.S. trade or business. However, the performance of personal services will not constitute a U.S. trade or business if (1) the nonresident alien is present in the U.S. for 90 days or less during the tax year, (2) the amount of compensation received for U.S. services is $3,000 or less, and (3) the nonresident alien works for either a foreign person who is not engaged in a U.S. trade or business, or the foreign office of a U.S. person. 3. Fixed and determinable annual or periodical income (FDAP) is generally subject to a 30% withholding tax that is applied to the gross amount of income with no deductions allowed. Withholding of tax occurs at the source of payment (i.e., the person paying the income is required to withhold the tax and remit it to the IRS). FDAP primarily is from passive, nonbusiness activities including such items as interest, dividends, rents, royalties, and annuities. FDAP generally excludes gain from the sale or exchange of real or personal property, and income that is excluded from gross income by U.S. persons. The 30% withholding tax rate may be reduced or even eliminated by an applicable income tax treaty. Transfers of Property to Foreign Corporations A. Gain (but not loss) is generally recognized on the transfer of property by a U.S. person to a foreign corporation notwithstanding the deferral provision of Subchapter C that otherwise would apply. This prevents gains from escaping U.S. taxation and is accomplished by providing that a "foreign corporation" shall not be considered a corporation for purposes of the Subchapter C provisions (e.g., Sec. 351 transfer to a controlled corporation, Sec. 332 liquidation of a subsidiary, Sec. 361 transfer of property pursuant to a corporate reorganization). B. The above recognition rule does not apply to any property transferred to a foreign corporation for use by such foreign corporation in the active conduct of a trade or business outside of the U.S.. Exceptions requiring gain recognition apply to transfers of certain types of property that are likely to be promptly resold or are highly fungible such as receivables, copyrights, inventory, installment obligations, foreign currency or foreign-currency-denominated investments, and interests in leased property. Global Intangible Low-Taxed Income A. The Global Intangible Low-Taxed Income (GILTI) applies broadly to certain income generated by a controlled foreign corporation (CFC). U.S shareholders must include in income the aggregate amount of certain income generated by its CFC(s), even if not actually repatriated. B. This provision taxes the U.S. shareholder on its allocable share of CFC earnings to the extent the earnings exceed a 10% return on the shareholder's allocable share of tangible assets held by CFCs. This tax applies to C corporations and flow-through taxpayers. C. If the U.S. shareholder is a domestic C corporation, it is eligible for up to an 80% deemed paid foreign tax credit (FTC) and a 50% deduction of the current-year inclusion. D. The GILTI will have its greatest impact on a foreign business that has a high level of profit in relation to the amount of fixed assets owned. Foreign-Derived Intangible Income Deduction A. The Foreign-Derived Intangible Income (FDII) deduction is a deduction for domestic C corporations that generate certain types of foreign income. B. The deduction applies to U.S. taxpayers that generate income from export sales or services. The deduction is a percentage of eligible income and reduces a taxpayer's effective tax rate on this income. C. U.S. taxpayers that generate gross receipts from the following activities may qualify for the deduction: - Sale, lease, license, exchange or other disposition of property by a taxpayer to a non-U.S. taxpayer for foreign use. - Services provided by taxpayer to any person or with respect to property, not located in the U.S. D. The provision assumes a corporation earns a fixed rate of return on its tangible assets. Any remaining income is assumed generated by intangible assets, even if that is not actually the case. So a corporation can receive an FDII deduction even if no intangible assets are owned. Summary of Current Framework for Taxation of Foreign Income A. 100% deduction for foreign-source dividends received by domestic corporations from 10%-owned foreign corporations. A foreign tax credit is not available for this income. B. Foreign earnings in excess of a deemed return (10% of certain business assets) are taxed currently as another type of controlled foreign corporation (CFC) income (GILTI). A 10.5% effective tax rate and 80% FTC is available. C. An incentive is provided to produce intangible income in the U.S. with an effective tax rate of 13.125%. This incentive applies to inbound income also (FDII). An 80% FTC is available. D. A base erosion tax (BEAT) of 10% is imposed on deemed base erosion payments such as royalties and interest. Cost-of-goods-sold payments are not subject to BEAT. Correct! A 100% dividend received deduction may be claimed for a dividend received from a foreign corporation in which ownership exceeds 10% and the stock was owned for more than 365 days. Americano may claim a DRD for Soleil only because ownership exceeded 365 days and Americano owns at least 10%. The $90,000 of salary is completely excluded. Foreign-earned income from personal services is excluded up to $108,700 in 2021. The housing is excludable to the extent it exceeds 16% × $108,700, or $17,392. This excess is $22,608 ($40,000 − $17,392). However, the housing exclusion may never exceed $15,218 in 2021, so the includible housing income is $24,782 ($40,000 − $15,218). The interest income is fully includible as is the U.S.-source earned income of $60,000. Therefore, includible income is $24,782 + $20,000 + $60,000, or $104,782. $25,000, but not to exceed the foreign tax credit limitation of $80,000/($120,000 + $80,000) × $61,250 = $24,500.

Transactions with Partners

Guaranteed Payments—Guaranteed payments are those made to partners without regard to partnership income. A. Partners are not employees of the partnership, but might receive guaranteed payments for services or capital investment. B. Guaranteed payments are ordinary income to the recipients at the partnership year-end. C. Guaranteed payments (for deduction purposes) reduce partnership income and thereby reduce each partner's distributive share of such income. D. Guaranteed payments are deemed to be paid to the partner on the last day of the partnership's tax year, regardless of when payment was actually made. Precontribution (Built-In) Gains and Losses—These are allocated back to the original contributing partners when the property is sold. Definition Built-In Gain (or Loss) Property: Property that has appreciated (declined) in value at the time of its contribution to the partnership (the value of gain property is greater than its adjusted basis, whereas the value of loss property is less than its adjusted basis). Misconception There is no time limit on the allocation of the amount of built-in gains and losses from sales of property. A time limit (five years) applies to the characterization of these gains and losses as ordinary or capital. Another time limit (seven years) applies to the distribution of built-in gain property (to partners). A. The built-in gain or loss is allocated to the contributing partner up to the gain or loss realized on the sale. B. The character of the built-in gains and losses is generally determined by the use of the property by the partnership, with two exceptions. 1. Sales of contributed ordinary income or loss property (e.g., inventory and accounts receivable) generate ordinary income or loss to the contributing partner. The characterization of income or loss as ordinary from a sale of inventory is limited to five years (five years after the property was contributed to the partnership). There is no time limit for the ordinary income characterization for accounts receivables. a. Note that all gain or loss on the sale is treated as ordinary if the above rule is met. It is not limited to the built-in gain or loss at the time of contribution. 2. Sales of contributed capital assets with built-in capital losses generate capital losses to contributing partners (again only for five years after the contribution). However, for built-in capital losses, the amount of loss that can be recharacterized as capital is limited to the built-in loss at the time the asset was contributed. Related Party Rules A. If a person engages in a transaction with a partnership other than as a member of such partnership, any resulting gain or loss is generally recognized. However, if the transaction involves a more than 50% owned partnership, one of three special rules may apply. Constructive ownership rules apply in determining whether a transaction involves a more than 50% owned partnership. For this purpose, an individual's family includes brothers and sisters, spouse, ancestors, and lineal descendants. 1. No losses are deductible from sales or exchanges of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership, or between two partnerships in which the same persons own (directly or indirectly) more than 50% of the capital or profits interests. A gain later realized on a subsequent sale by the transferee will not be recognized to the extent of the disallowed loss. 2. A gain recognized on a sale or exchange of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership, or between two partnerships in which the same persons own (directly or indirectly) more than 50% of the capital or profits interests, will be treated as ordinary income if the property is not a capital asset in the hands of the transferee. 3. No deduction for a payment to a partner can be claimed by an accrual partnership until the cash basis partner includes the payment in income. Note that this applies to all partners (not just those owning more than 50%). Partners are generally not considered to be employees for purposes of employee fringe benefits (e.g., cost of $50,000 of group-term life insurance, exclusion of premiums or benefits under an employer accident or health plan, etc.). The value of a partner's fringe benefits are deductible by the partnership as guaranteed payments and must be included in a partner's gross income. The realized gain on the sale of the assets is $3,000 ($18,000 - $15,000 basis in assets). Abe's built in gain on the contribution is $5,000. The amount of gain allocated to Abe is the lower of the realized gain or built-in gain, so $3,000 is the allocation. Under the Internal Revenue Code sections pertaining to partnerships, guaranteed payments are payments to partners for services or the use of capital without regard to partnership income. Thus, guaranteed payments are treated similarly to salary payments to the partner, not as partnership distributions. Certain items are separately stated on a partnership's income tax return and, as a result, are not included in the ordinary income of a partnership. These items are directly passed through to the partners and included on the partners' income tax return. The separately stated items are composed of: charitable contributions; dividends; short-term capital gains and losses; long-term capital gains and losses; Code Section 1231 gains and losses; income, gains, losses, deductions and credits specially allocated under the partnership agreement; nonbusiness production of income expenses; income, gains and losses from the sale of unrealized receivables and appreciated inventory; bad debt, prior taxes and delinquency amounts recovered; taxes of foreign nations and U.S. possessions eligible for the foreign tax credit; intangible drilling and development expenses; mining exploration expenses; and soil and water conservation expenses. Guaranteed payments to partners are treated as salary payments. Thus, the payments are deductible from the partnership's ordinary income. Guaranteed payments from a partnership for the services of a partner are treated as salary payments and, as a result, receive similar treatment under the Internal Revenue Code. Therefore, in contrast to provisions applying to other withdrawals of assets from partnerships by partners, guaranteed payments are deductible by the partnership. The deduction for guaranteed payments may create an ordinary loss for the partnership. Guaranteed payments are required to be reported separately from the partner's share of the partnership's income on the partner's K-1. Thus, guaranteed payments made by a partnership to partners for services rendered to the partnership, that are deductible business expenses under the Internal Revenue Code, are deductible expenses on the U.S. Partnership Return of Income, Form 1065, in order to arrive at partnership income (loss) and included on schedules K-1 to be taxed as ordinary income to the partners. Guaranteed payments to partners from their partnership for partnership services or capital are not treated as partnership distributions. Instead, the payments are treated as salary payments to employees or interest payments. Hence, White would have to include the $3,000 guaranteed payment on his Year 7 tax return. In addition, since partnerships are pass-through for tax purposes, White must include his share of the partnership's income on his tax return. White share of the partnership's income would be $10,000 (= $30,000 in partnership income multiplied by White's 1/3 share in profits and losses). Therefore, the total amount that White must include from Rapid Partnership as taxable income in his Year 7 tax return is $13,000, the sum of the $3,000 in guaranteed payments made to White and White's share of the partnership's income. Guaranteed payments from a partnership for the services of a partner are treated as salary payments and, as a result, are made without regard to the partner's share of the partnership's income. Thus, a guaranteed payment by a partnership to a partner for services rendered may include an agreement to pay a salary of $5,000 monthly without regard to partnership income and may not include an agreement to pay 25% interest in partnership profits. Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only.

Formation of a Corporation

Recognition of Gain or Loss—The recognition of gain or loss on a contribution of property in exchange for stock is determined by the ownership levels of the contributing shareholders. Deferral—Deferral of gain and loss is required for members of the control club. Definition Control Club: The group of individuals who participate in a transfer of property to a corporation and are in control of the corporation immediately after the transfer. A. To be eligible for membership in the control club, property must be contributed (services rendered to the corporation is not property). B. The property must be transferred in exchange for stock. Definition Stock: Any equity interest (common and preferred) except that "nonqualified" preferred stock (NPS) is treated as boot. NPS is preferred stock that is expected to be redeemed within 20 years. 1. Immediately after the transfer, the transferor(s) are in control, and control is defined as owning at least 80% of the voting and nonvoting stock. 2. The receipt of boot (e.g., cash, short-term notes, securities, etc.) triggers gain but not loss. 3. Note: In order to meet the 80% control test, shareholders who contributed services for their stock may also contribute a small amount of property so their stock ownership can contribute to meeting the 80% requirement. However, the IRS has ruled that the value of the property must be equal to at least 10% of the value of the services for the shareholder's stock ownership to be included. 4. Existing shareholder contributes property so that the group will meet the 80% test. The value of the property contributed by the existing shareholder must be equal to at least 10% of the value of the stock owned by the existing shareholder before the new contribution can be included in the group. 5. Any depreciation recapture potential transfers to corporation with the property. Definitions Boot: Property received other than stock. Sec. 351 Exchange: A corporate formation that qualifies to defer the gain or loss is known as a Section 351 Exchange. C. If boot is received, the gain recognized to the shareholder is the lower of: 1. Realized gain or 2. The fair market value of the boot received D. If stock is received in exchange for services: 1. The transferor has wage income equal to the fair market value of the stock received (and basis in the stock equal to that amount). 2. The corporation has a salary expense deduction (unless the services rendered were an organizational expense). E. Reminder: The corporation does not realize any gain or loss on issuing stock. Basis Issues—The adjusted basis for qualifying property is a carryover basis. A. The corporation takes an adjusted basis in the property from the transferor plus any gain recognized by the transferor. B. The corporation's basis in the property received is: Shareholder's basis in property + Gain recognized by shareholder C. The shareholder's stock takes the adjusted basis of the transferred property plus any gain recognized less any boot received. D. The shareholder's basis in the stock received from the corporation is: Basis of all property transferred to the corporation + Gain recognized by shareholder − Boot received by shareholder − Liabilities assumed by corporations 1. Shortcut—A carryover basis is the fair value of the property less the gain deferred (or plus any loss deferred). This shortcut works only if the value of the property is known. E. Debt Assumption—A contribution of encumbered property requires that the transferor reduce the basis of the stock by the amount of debt assumed by the corporation. F. Basis Adjustment for Loss Property 1. If the total basis of the property transferred by a shareholder is greater than the fair market value of the property, a basis adjustment is required to prevent the shareholders and the corporation from both benefiting from this unrealized loss. The downward basis adjustment is allocated proportionately among all assets contributed by the shareholder that had a built-in loss. 2. Note: If the shareholder and corporation elect, the shareholder's stock basis can be reduced rather than the corporation's assets. Debt Assumptions—Gain may be recognized in two circumstances if the corporation assumes the shareholders' debt. A. If the total liabilities assumed by the corporation exceed the total adjusted basis of property transferred by the shareholder, then gain must be recognized as follows: Gain recognized = Liabilities assumed − Basis of property transferred B. If the debt was not incurred by the shareholder for valid business reasons, then the corporate assumption will cause ALL of the debt relief to be treated as boot. This will cause gain to be recognized, but only to the extent of the realized gain. Holding Period A. The Shareholder's Holding Period—For the stock may or may not include the amount of time the shareholder held the property just given to the corporation. 1. Capital asset or Section 1231—Asset transferred to corporation—property holding period is tacked on to stock holding period. 2. All other property—Holding period of property does not tack on. Holding period for stock begins on day after the transfer. B. The Corporation's Holding Period—In the property received always includes the period that the transferor held the property before the exchange. Debt vs. Equity—Corporate debt can be reclassified as equity, but this is a question of fact. A. Debt characteristics are important (instrument, collateral, interest, etc.). B. The corporation is not thinly capitalized (debt equity ratio too high). C. No gain or loss is recognized on the issuance of debt. Capital Contributions and Corporation's Basis A. Definition—Capital contributions include money or property received by a corporation with nothing being given in return. B. Property Contributions 1. By shareholders—There is no gain or loss to a corporation when shareholders contribute property. Shareholder's basis in stock is increased by basis of property contributed. 2. By nonshareholders—Corporation recognizes gain equal to the fair market value of the property received. Its basis in the received property is its fair market value. On a corporate formation, gain is recognized to the extent that the liabilities assumed by the corporation exceed the basis in the assets contributed by the shareholder. The gain for this shareholder is $6,000 ($12,000 debt less $6,000 basis). Immediately after the exchange, Jones must control at least 80 percent of the corporation's voting stock and 80 percent of all the other classes of stock issued by the corporation for the incorporation to be tax-free. The transaction would qualify as a tax-free event for Carr because it would be considered to be a Section 351 transfer. Under Section 351, no gain or loss is recognized if the property is transferred solely for the exchange of stock of the corporation, if immediately after the transfer the transferring taxpayer or taxpayers have control over the corporation. Control is defined as owning at least 80% of corporation's voting stock and at least 80% of the corporation's other classes of stock. Since Beck and Carr together own 90% of the corporation immediately after the transfer, the transaction would be a tax-free event for both taxpayers.

Corporate Redemptions and Liquidations

Redemptions—A redemption of stock occurs when a corporation repurchases stock from a shareholder. The redemption is generally treated by the shareholder as a sale of the stock that will trigger recognition of gain or loss. However, a redemption of stock can also be structured to have the identical effect of a dividend distribution. Hence, the tax rules are constructed to assure that redemptions, which have the effect of a dividend, are taxed as dividends rather than sales of stock. A. There are two advantages of redemption treatment. First, the shareholder is able to offset stock basis against the redemption proceeds. Second, any resulting gain is treated as capital gain, which is often advantageous as compared to dividend income. Three Methods to Qualify—In order for a redemption to be taxed as a sale, it must qualify under one of three circumstances: A. First—A redemption will be treated as a sale, if the distribution is not essentially equivalent to a dividend (NEED). Definition Not Essentially Equivalent to a Dividend (NEED): This phrase has been interpreted to mean that there is a "meaningful" reduction in the shareholder's rights, including voting rights and rights to earnings. 1. Shortcut—NEED is a question of fact that is very ambiguous. B. Second—A substantially disproportionate redemption will also qualify as a sale if the shareholder passes two tests: the control test and the reduced interest test. Definitions Control Test: The shareholder must own less than 50% of the voting shares after the redemption. Reduced Interest Test: The shareholder must own less than 80% of the shares that were owned prior to the redemption. C. Third—A complete termination of the shareholder's interest in the corporation qualifies as a sale. Definition Complete Termination: The shareholder must surrender the stock owned directly. 1. For complete terminations, family attribution (but not entity attribution) can be waived with the execution of an agreement by the taxpayer to notify the IRS of any subsequent acquisitions of stock for the next 10 years. 2. In the agreement the taxpayer must agree to not acquire any stock interest in the corporation during the next 10 years. The taxpayer also cannot exercise managerial control over the corporation in any manner. 3. If this agreement is violated at any time during the 10 years then the waiver of the family attribution rules in the year of the sale is voided. 4. An inheritance of stock in the corporation will not violate the 10-year agreement. Note The scope of attribution rules is not uniform across various tax topics. For example, the attribution rules applying to redemptions is narrower than the attribution rules applying to the personal holding companies. The latter rules include siblings (brothers and sisters) who are not included for the redemption rules. Attribution—For purposes of the redemption tests, the shareholder's interest includes stock owned directly and indirectly. Indirect or constructive ownership is determined through stock attribution rules. A. Family Attribution Definition Family Attribution: Stock is owned by family members. It is defined to include spouse, children, grandchildren, and parents. B. Entity Attribution—Corporations Definitions Stock Attribution: A taxpayer is deemed to own stock held by other related taxpayers. There are two forms of attribution: attribution to/from an entity and attribution to/from family. Entity Attribution: Stock owned by a corporation, partnership, trust, or estate is deemed to be owned by a taxpayer who is an owner or beneficiary of the entity. Additionally, stock owned by the owner or beneficiary may be deemed to be owned by the entity. 1. Entity to owner—A shareholder is only subject to entity attribution if the corporation is controlled by the shareholder (owning 50% or more of the value of the stock). In this case, the shareholder is deemed to own a proportionate interest (equal to the ownership interest) of the stock held by the corporation. If the shareholder owns less than 50% of the corporation, then none of the stock owned by the corporation is attributed to the shareholder. 2. Owner to entity—Stock owned by a 50% or greater shareholder is deemed to be owned in full (100%) by the corporation. If the shareholder owns less than 50% of the corporation, there is no attribution from the shareholder to the entity. C. Entity Attribution—Partnerships 1. Entity to owner—Stock owned by a partnership is deemed to be owned by the partner based on her ownership interest in the partnership. Note this attribution applies to all partners, not just partners who own 50% or more. 2. Owner to entity—Stock owned by a partner is deemed to be owned in full by the partnership. Note that this attribution applies to stock owned by all partners, not just partners who own 50% or more. D. Entity Attribution—Estates and Trusts. The attribution rules for estates and trusts are similar to the rules for partnerships. Consequences to Corporation A. If the corporation distributes appreciated property as part of the redemption, the appreciation is recognized by the corporation. However, the loss in distributed assets that have declined in value is not recognized. If the property has been depreciated, the corporation may have to recognize Section 1245 or Section 1250 recapture. B. The corporation must reduce its earnings and profits for redemptions. The reduction is the lower of 1) the redeemed stock's proportionate share of E&P, or 2) the amount of the redemption. 1. If the redemption is actually treated as a dividend, E&P is reduced by the greater of the FMV or adjusted basis of the property distributed, reduced by any liabilities attached to the property. Partial Liquidations A. A partial liquidation is treated as a sale by noncorporate shareholders, so it is a fourth method to qualify for redemption treatment. There are two tests for partial liquidations, one objective and one subjective. Definition Partial Liquidation: A contraction of the corporate business. Hence, the determination for sale treatment is made by looking for a contraction at the corporate level. B. The objective test requires that the corporation must completely terminate a qualifying business and must continue to operate at least one qualifying business. Definition Qualifying Business: A trade conducted for five years prior to the determination. C. To meet the subjective test, the distribution must qualify as not essentially equivalent to a dividend in that it results from a genuine contraction of the corporate business, and not just from the sale of excess inventory. Note Not essentially equivalent to a dividend for purposes of a partial liquidation is different from the definition of NEED for redemptions. The former focuses on the source of the distribution at the corporate level, while the latter examines the effect of the distribution at the shareholder level. However, both definitions are similar in that they are very subjective tests. Redemption Used to Pay Death Taxes A. A redemption used to pay death taxes may also be treated as a sale under two conditions. B. The death of a shareholder in a valuable closely-held corporation may result in significant death taxes. However, if the corporate stock is the primary asset of the estate, then a redemption may be necessary in order to pay the estate tax. If the stock held by the estate is treated as a sale, no additional tax is usually due because adjusted basis of stock is increased to FMV on date of death. 1. The stock held by the decedent must be a large portion of the estate (35% of adjusted gross estate). 2. The redemption is limited to the amount of federal and state death taxes and funeral and administrative expenses. Stock Distributions A. Stock distributions are not taxable to the shareholder if there is no option to receive property in lieu of stock and there is no change in proportionate interests of the shareholders. B. A stock bailout is treated as a dividend to the shareholder to the extent of earnings and profits at the time of the sale or redemption. Definition Stock Bailout: A distribution of nonvoting stock followed by sale (or redemption) of the stock by the corporation. Complete Liquidations—A distribution in complete liquidation occurs with the dissolution of a corporation and the distribution of remaining assets. A complete liquidation is similar to a redemption in that the shareholders receive assets in exchange for canceling the shares of stock. A. Shareholders Recognize Gain or Loss—On the Liquidating Distribution 1. The gain or loss is determined by subtracting the adjusted basis of the stock from the fair market value of the distribution, reduced by any taxes paid by the corporation for the liquidation. 2. Any gain or loss recognized by the shareholder will generally be a capital gain or loss (depending on whether the stock is a capital asset). The related party rule that disallows losses on sales of assets between related parties does not apply. 3. If the distributed property is subject to a liability, then the shareholder reduces the fair market value of the property by the amount of liabilities. 4. The adjusted basis of the property received in the distribution is its fair market value on the date of distribution, reduced by any taxes paid by the corporation for the liquidation. B. A Corporation Will Recognize Gain or Loss—When It Makes a Liquidating Distribution. 1. The computation of the gain or loss is computed by subtracting the adjusted basis from the fair market value of the property distributed on the date of distribution. 2. The nature of the gain or loss depends on the nature of the asset distributed (ordinary, capital, or Section 1231). 3. If the distributed property is subject to a liability, then the fair market value of the property cannot be less than the amount of liabilities. 4. Expenses incurred in the liquidation are deducted on the last corporate return. 5. If the corporation realizes a loss on the distribution of property in complete liquidation to a shareholder owning more than 50% (including constructive ownership) in value of the corporation's stock, then the loss is not recognized if: a. The distribution of each asset is not pro-rata or b. The property distributed is disqualified property (i.e., property acquired by the liquidating corporation in a tax-free incorporation or as a contribution to capital during a five-year period ending on the date of the distribution). 6. Built-in losses will be disallowed on distributions of some disqualified property to any shareholder, if the principal purpose was to recognize loss by the corporation in connection with the liquidation. Note Under the related-party rule, all losses are disallowed. Under the non-related-party rule, only built-in losses are disallowed. a. Such a purpose is presumed, if the transfer occurs within two years of the adoption of the plan of liquidation, unless a business purpose can be established. b. Any decline in value for the property after its contribution to the corporation results in a deductible loss to the liquidating corporation. Only the built-in loss at the time of contribution is disallowed. C. Subsidiaries—No Gain or Loss Is Recognized—On the liquidation of a subsidiary by the parent under two conditions. When a controlled subsidiary is liquidated, no real disposition of the assets has occurred. The assets have merely been transferred from one corporate pocket to another. The key to deferring gain and loss is the establishment of control and the timing of the liquidation. 1. First, the parent must own 80% of the voting stock and other stock of the subsidiary. 2. Second, the subsidiary must distribute its assets within the tax year (or within three years of the close of the tax year of the first distribution). 3. The parent corporation takes a carryover basis in the distributed assets and inherits the subsidiary's tax attributes. 4. The subsidiary recognizes gains (but not losses) on distribution of assets to minority shareholders. The inventory is not a capital asset so it is not included in computing the capital gain or loss. The $40,000 capital gain from the sale of the land is offset by the $50,000 capital loss from the sale of the marketable securities. The net capital loss is $10,000, which is recognized since this is a complete liquidation. If stock of a subsidiary is liquidated by its parent company, any realized gain on the transaction is, in general, not recognized. The realized gain to parent is $150 ($250 property received - $100 basis). The recognized gain is zero. Noncorporate shareholders treat the gain on a redemption of stock that qualifies as a partial liquidation of the distributing corporation as a capital gain, just as if they had sold their stock. Corporate shareholders receive dividend treatment on a partial liquidation.

Sales and Terminations

Sales of Partnership Interests—A sale of a partnership interest results in a gain or loss calculated in the manner used for other assets, using outside basis to compute the gain or loss. The portion of any gain or loss due to hot assets is not eligible for capital gain treatment. A. Sales 1. The sale, exchange, or liquidation of a partner's entire interest closes the partnership's tax year for that partner, but not for other partners or for the partnership as a whole. The income for a partner that dies during the year passes to the partner for the portion of the year that he or she was alive. 2. The selling partner's amount realized includes the buyer's assumption of the selling partner's share of the partnership liabilities. B. Hot Assets 1. If the partnership has hot assets at the time a partnership interest is sold, the selling partner must allocate a portion of the sale proceeds to these assets and recognize ordinary income. 2. Hot assets are a) unrealized receivables (receivables of a cash basis taxpayer; includes depreciation recapture), and b) inventory. Definition Inventory: All assets other than cash, capital assets, and Section 1231 assets. 3. The remaining sale proceeds are allocable to the selling partner's capital asset interest and result in a capital gain or loss. C. Look-Through Rules. In addition to hot assets, other rules can also cause gain to be recharacterized. 1. If the partnership owns collectibles, the selling partners gain will be taxed at 28% to the extent it is due to collectibles (see the "Capital Gains and Losses" lesson for more detail). 2. If the partnership has Section 1250 assets, any unrecaptured Section 1250 gain will be taxed at 25% (see the"Capital Gains and Losses" lesson for more detail). 3. The look-through rules also impact the character of gain for the sale of a partnership interest by a foreign person if the partnership is engaged in a U.S. trade or business. a. Gain from the sale is "effectively connected" with a U.S. trade or business to the extent the foreign partner would have had effectively connected gain or loss had the partnership sold all of its assets at FMV on the dates of the sale. b. Such gain or loss is allocated to partners in the same manner as non-separately stated income and loss. D. If a Section 754 election is in effect, then basis adjustments to partnership property may be needed. These basis adjustments benefit the new partner who purchased the partnership interest. 1. Upon the sale or exchange of a partnership interest, the basis of partnership property to the transferee (not other partners) will be a. Increased by the excess of the basis of the transferee's partnership interest over the transferee's share of the adjusted basis of partnership property; or b. Decreased by the excess of transferee's share of adjusted basis of partnership property over the basis for the transferee's partnership interest. E. The adjustment allowed under Section 754 is required if a substantial built-in loss occurs because of the transfer of the partnership interest. A substantial built-in loss exists if the partnership's adjusted basis in its property exceeds its fair market value by more than $250,000. Terminations—The termination of a partnership requires the closing of the partnership books. A. Termination requires a closing of the partnership 1. Termination requires a closing of the partnership tax year. 2. Termination results in a deemed distribution of assets to the partners. B. A partnership terminates for tax purposes if no part of the business continues to be carried on by any partner in the partnership form. Note Generally, partnerships are contracts between the partners that are terminated with the death or withdrawal of any partner. However, the death or withdrawal of a partner doesn't necessarily terminate partnerships for tax purposes. The partnership only determines the share for the decedent partner. C. Mergers and Divisions—Partnerships can merge with or divide from the original partnership continuing as the reporting entity. 1. In a merger of partnerships, the resulting partnership is a continuation of the merging partnership whose partners have a more than 50% interest in the resulting partnership. 2. In a division of a partnership, a resulting partnership is a continuation of the prior partnership if the resulting partnership's partners had a more than 50% interest in the prior partnership. Integrated Review Problem—A, B, and C formed ABC partnership with the following contributions: Look at image A. The land was a capital asset to B and subject to a mortgage of $5,000, assumed by the partnership. Assume that this year the partnership breaks even but decides to make distributions to each partner. 1. What is B's initial basis? $8,000 (12,000 − 5,000 + (20% × 5,000)). 2. What is C's initial basis? $25,500 (24,000 + (30% × 5,000)). 3. A nonliquidating cash distribution may reduce the recipient partner's basis below zero. False. 4. A nonliquidating distribution of unappreciated inventory reduces the recipient partner's basis in the partnership. True. 5. In a liquidating distribution of property other than money, where the partnership's basis of the distributed property exceeds the basis of the partner's interest, the partner's basis in the distributed property is limited to his predistribution basis in the partnership interest. True. 6. Gain is recognized by the partner who receives a nonliquidating distribution of property, where the adjusted basis of the property exceeds his basis in the partnership interest before the distribution. False. 7. In a nonliquidating distribution of inventory, where the partnership has no unrealized receivables or appreciated inventory, the basis of inventory that is distributed to a partner cannot exceed the inventory's adjusted basis to the partnership. True. 8. The partnership's nonliquidating distribution of encumbered property to a partner who assumes the mortgage does not affect the other partners' bases in their partnership interests. False. "Hot assets" for a partnership include ONLY inventory and unrealized receivables. When a partnership divides into two or more partnerships, the original partnership is continued in each of the new partnerships which contain partners that controlled 50% or more of the partnership interest in the original partnership. Since Abel and Benz own 40% and 20% interests, respectively, in the capital and profits of Partnership Abel, Benz, Clark and Day, the new Partnership Abel and Benz is considered a continuation of Partnership Abel, Benz, Clark and Day. However, Clark and Day only own a combined 40% interest in the capital and profits of Partnership Abel, Benz, Clark and Day. Hence, the Partnership Clark and Day is not considered a continuation of Partnership Abel, Benz, Clark and Day. If a partner sells or exchanges his/her partnership interest and the partnership has either unrealized receivables or substantially appreciated inventory, the partner recognizes an ordinary gain to the extent that the amount realized by the partner due to the unrealized receivables or substantially appreciated inventory is greater than the partner's basis in the items. When Carr sold his partnership interest in Allen, Baker and Carr, the partnership had unrealized receivables. The amount realized by Carr due to the unrealized receivables was $140,000, the partnership's total unrealized receivables of $420,000 multiplied by Carr's one-third ownership interest. Carr does not have any basis in the unrealized receivables (indicating that none of the receivables have been collected). Hence, Carr must report an ordinary gain of $140,000, the $140,000 realized by Carr due to the unrealized receivables less Carr's basis in the receivables, which is zero. If a partner sells his/her interest in the partnership, the partner recognizes a capital gain equal to the amount that the payment exceeds the partner's adjusted basis in the partnership. Clark's adjusted basis in the partnership is $40,000 immediately before the sale. His amount realized is $55,000 ($30,000 cash received + $25,000 debt relief). Hence, Clark must recognize a capital gain of $15,000 ($55,000 − $40,000). For tax purposes, a partnership terminates when it stops doing business as a partnership. When the partnership's business and financial operations are continued by other members, there is a deemed distribution of assets to the remaining partners and the purchaser and a hypothetical recontribution of assets to a new partnership.

Corporate Income

Tax Form for This Lesson: Form 1120 and Schedule M-3 (available for download and printing from the lesson overview of your software). Corporate Tax Formula The Corporate Income Tax Formula Realized Income (Nonrecognition of Income: Deferrals and Exclusions) =Gross Income (Cost of Goods Sold) (Other Deductions) =Taxable Income x Tax Rates =Gross Tax (Credits and Payments) + Other Taxes =Net Tax A. The corporate tax calculation is very similar to the formula used to calculate individual taxes. The general income and deduction rules for corporations are the same as those for individuals. For example, the NOL rules for individuals and corporations are generally the same. C Corporation: A corporation subject to the corporate income tax is often referred to as a C corporation because the rules governing the corporate tax are contained in Subchapter C of the Internal Revenue Code. B. The Corporate Formula—Is analogous to the individual formula. 1. Expenses are generally deductible as business deductions (subject to the limits placed on business deductions, such as reasonable, ordinary, etc.). 2. There are categories of special deductions subject to special limitations (see the lesson "Special Corporate Deductions" for more details). 3. Deductible capital losses are offset against recognized capital gains, but there is no deduction for a net capital loss. Rather, a net capital loss is carried over (back three years/forward five years) to offset against capital gains in other years. C. Special Rules 1. Corporations can choose a fiscal year unless the corporation makes an "S" election or qualifies as a personal service corporation. Personal service corporations generally must use a calendar year-end. Personal Service Corporation: A corporation whose principal activity is the performance of personal services performed by employees who own substantially all of the stock; for example, a medical corporation whose owners are also the doctors providing the medical services. 2. Accrual accounting is required except for small corporations (gross receipts less than $26 million [2021]), certain personal service corporations, and S corporations. Recurring expenses, however, must be paid within 8 1/2 months of the fiscal year-end to be deducted. 3. Multiple tax brackets are not available for members of a "controlled group" (see the "Taxation of Related Corporations" lesson) or for personal service corporations (a flat 21% tax rate is employed). 4. Passive loss rules a. Passive loss limits do not apply to corporations (except personal service corporations and certain "close" corporations). b. Closely held corporations can use passive losses to offset active corporate income but not portfolio income. c. Personal service corporations cannot offset passive losses against either active income or portfolio income. Closely Held Corporation: A corporation is a closely held corporation if at any time during the last half of the taxable year more than 50% in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals. 5. Corporations are subject to a flat 21% tax rate. 6. Personal service corporations are taxed at a flat 21% rate. Book Income versus Taxable Income—Schedule M-1 is a reconciliation of book income to taxable income before the dividends received deduction. Schedule M-1 reconciles to taxable income before the dividends received and net operating loss deductions. Corporations with total assets of $10 million or more are required to file schedule M-3, which provides much more detail than Schedule M-1. A. Nondeductible expenses are added to book income (federal tax expense, net capital loss, expenses in excess of limits, etc.). B. Income that is taxable but not included in book income is added to book income (e.g., prepaid income included in taxable income). C. Nontaxable income that is included in book income is subtracted from book income (municipal interest, life insurance proceeds, etc.). D. Deductions not expensed in book income are subtracted from book income (election to expense, etc.). E. Schedule M-3 is divided into three sections. 1. Part I provides certain financial information and reconciles worldwide consolidated net income on the book financial statements to book income for the entities included on the corporate tax return. 2. Part II reconciles the book income computed in Part I to the taxable income shown on the Form 1120. For each reconciling item the effect due to permanent differences and timing differences must be shown. 3. Part III provides a breakdown of the expense/deduction items that affect the reconciliation of book income to taxable income in Part II. This total is carried to Part II and combined with the income items listed in Part II. 4. Certain large S corporations and partnerships must also file Schedule M-3. Net Operating Loss—A net operating loss (NOL) is negative taxable income carried from other tax years. A. NOLS incurred after 2017 and before 2021 can be carried back to the five preceding tax years and can be carried forward indefinitely. For NOLS carried forward to 2020 from previous years, those NOLs can offset 100% of the taxable income in 2020. NOLs incurred in 2021 cannot be carried back and can be carried forward indefinitely. NOLs that are carried forward to 2021 from the past can offset only 80% of taxable income in 2021. B. Any carryover from a previous or prior year is not included in calculating the current year NOL (specific for each year). C. The current year carryover ignores carryovers created in other years. Multiple carryovers to one year are used in a FIFO order. D. Charitable contributions are not allowed in computing the NOL. E. NOL carrybacks from years before 2018 can be reported on an amended return (Form 1120X), or Form 1139, Corporation Application for Tentative Refund, can be filed by the end of the tax year following the year of loss. Schedule M-2 of Form 1120 analyzes changes in a corporation's Unappropriated Retained Earnings per books between the beginning and end of the year. Balance at beginning of year Add: Net income per books Other increases Less: Dividends to shareholders Other decreases (e.g., addition to reserve for contingencies) =Balance at end of year Correct! The beginning point for the computation is book income before federal taxes of $250,000. The $46,000 of municipal interest income is not taxable so it must be removed from book income ($250,000 − $46,000 = $204,000). The $4,000 of expenses do not reduce taxable income since they were incurred to produce tax-exempt income, but they did reduce book income, so they must be added back to book income. $204,000 + $4,000 = $208,000. Taxable income is $208,000. The purpose of Schedule M-1 of Form 1120 U.S. Corporation Income Tax Return is to reconcile book income (loss) with income per the return. Federal income tax is not deductible for tax purposes so it must be added back to book income, giving $349,300 ($239,200 + $110,100). The goodwill is amortized over 15 years for tax purposes, or $20,000 per year ($300,000/15 years). Thus, the book goodwill amortization is added back and the tax goodwill is deducted. This results in taxable income of $336,800 ($349,300 + $7,500 − $20,000). Taxable income is computed as follows: Pretax book income. $543,000 Excess depreciation (20,000) Prepaid rental income 36,000 Fines 10,000 Municipal interest income (25,000) Taxable income. $544,000 The purpose of Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return is to reconcile book income (loss) with income per the return. Certain items need to be added to and subtracted from book income to reconcile with income per the tax return. Federal income taxes; excess capital losses over capital gains; income subject to tax not recorded on the books; and expenses recorded on the books not deducted on the return must be added to book income. Income recorded on the books but not included on the return, including tax-exempt interest, and deductions on the return not charged against the books must be subtracted from book income. Both the interest incurred on loan to carry U.S. obligations and the provision for state corporation income tax are deductible for GAAP and for income tax purposes. Hence, since both of the expenses would be included in book income and in income per the return, there is no difference to reconcile and, as a result, neither expense would appear on the Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return. Correct! The tax deduction for bad debts is limited to the amount allowed under the direct write-off method. Under the allowance method for bad debts (used for book purposes), Filler-Up recorded $15,000 in bad debt expenses for accounts estimated to be uncollectible. Filler-Up can deduct only $5,000 as bad debt expense for tax purposes. Therefore, Filler-Up must add $10,000 ($15,000 - $5,000) to book income as an M−1 adjustment.

Tax-Exempt Organizations

Tax Form for This Lesson: Form 990 (available for download and printing from the lesson overview of your software). Tax-Exempt Organizations—Tax-exempt organizations include corporations, community chests, funds, charities, labor organizations, social clubs, pension and profit-sharing trusts, and private foundations. Partnerships cannot be treated as tax-exempt. A. Exemption 1. An exempt organization (EO) may be in the form of a corporation or trust, and it must apply for and receive an exemption from taxation (Form 1023 or Form 1024). 2. Most organizations must apply for exemption using Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the IRC. However, a shorter application Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the IRC, can be used by organizations with assets of $250,000 or less and annual gross receipts of $50,000 or less. An organization utilizing Form 1023-EZ must submit the form and applicable user fee online. Form 1023-EZ cannot be used by foreign organizations, churches, schools, hospitals, and private foundations. B. Filing Requirements 1. EO must file an information return (Form 990) if gross receipts exceed $50,000. a. This form reports income, expenses, and substantial contributors. It also must include total lobbying and political expenditures. b. Churches do not have to file Form 990. c. Form 990 must be filed on or before the 15th day of the fifth month after the close of the tax year. An automatic six-month extension is available. d. Form 990-EZ can be used unless gross receipts exceed $200,000 (or if total assets exceed $500,000). 2. Most EOs that are not required to file an information return must file an annual electronic notice with the IRS (Form 990-N). a. This notice includes demographic information and justifies the continuing basis for tax-exempt status. The EO must also confirm that annual gross receipts are usually $50,000 or less. b. The groups that are exempt from the electronic notice requirement include churches, state institutions, and governmental units. 3. EOs that do not meet these filing requirements for three consecutive years will lose their tax-exempt status. 4. Most EOs must make their last three years' tax returns and their tax-exempt application available to interested parties. C. Private Foundations Definition Private Foundations: Tax-exempt organizations that receive less than one-third of their annual support from their members and the general public. 1. Private foundations file Form 990-PF. 2. Private foundations are Sec. 501(c)(3) organizations other than churches, educational organizations, hospitals or medical research organizations operated in conjunction with hospitals, endowment funds operated for the benefit of certain state and municipal colleges and universities, governmental units, and publicly supported organizations. a. An organization is publicly supported if it normally receives at least one-third of its total support from governmental units and the general public (e.g., support received in the form of gifts, grants, contributions, membership fees, gross receipts from admissions, sales of merchandise, etc.) b. Private foundations may be subject to taxes based on investment income, self-dealing, failure to distribute income, excess business holdings, investments that jeopardize charitable purposes, and taxable expenditures. The initial taxes (with the exception of the tax on investment income) are imposed because the organization engages in prohibited transactions. Additional taxes are imposed if the prohibited transactions are not corrected with a specified period. Qualification—To qualify as an EO the organization must operate exclusively for a tax-exempt purpose. A. Many EOs are organized for religious, charitable, scientific, literary, or educational purposes; prevention of cruelty to children or animals; or promoting amateur sports activities. B. Influencing legislation or political parties is not an acceptable purpose. Unrelated Business Income—An EO is taxed on its unrelated business income (UBI). A. To be UBI, income must: 1. Be from a business regularly carried on, and 2. Be unrelated to the EO exempt purposes. B. A business is substantially related only if the activity contributes importantly to the accomplishment of the exempt purposes of the organization. C. Beginning in 2018, unrelated business taxable income must be computed separately for each trade or business activity. D. Related income (meaning that the income is not subject to tax) includes: 1. An activity where substantially all work is performed for no compensation 2. A business carried on for the convenience of students or members of a charitable, religious, or scientific organization 3. Sale of merchandise/stock received as contributions 4. In general, investment income 5. Rents received from real property E. Income from debt-financed property unrelated to the exempt function of the EO is UBI. F. Income from advertising in journals of the EO is UBI. G. UBI is taxed (only if it exceeds $1,000) at regular corporate rates if the organization is a corporation; at trust rates if it is a trust. H. Exempt organizations with unrelated business income must file Form 990-T, Exempt Organization Business Income Tax Return, if the organization has gross income of at least $1,000 from an unrelated trade or business. The obligation to file Form 990-T is in addition to the obligation to file Form 990. Additionally, Form 990-T may be required even though Form 990 is not required to be filed. I. An organization must make estimated tax payments if it expects its tax for the year to be more than $500. Engaging in insubstantial nonexempt activities will not cause an exempt organization to lose its exempt status. However, exempt organizations are strictly prohibited from engaging in political campaigns and activities. A private foundation is a tax-exempt organization which receives less than one-third of its annual support from its members and the general public. Therefore, public charities that solicit broad public support do not meet this definition. Corporations, community chests, funds, or foundations having religious, charitable, scientific, testing for public safety, literary, or educational purposes or organized for prevention of cruelty to children or animals, or to foster national or international amateur sports competition are tax-exempt. Partnerships are not included on this list.

Flow-Through of Income and Losses

Tax Form for this Lesson: Form 1065 and 1065K-1 (available for download and printing from the lesson overview of your software). Allocations of Income A. Items of income and expense are allocated from the partnership to partners. Partners include these items (known as their distributive share) on the return that includes the year-end of the partnership. Partners modify their adjusted basis in the partnership for these allocations. B. Allocations—Partners receive a share of income or a (potentially different) share of loss, according to the partnership agreement. 1. Any special allocation must pass a judgmental substantial economic effect test that ensures that partners with special allocations bear the economic burden or receive the economic benefit of the special allocation. 2. If no special allocation is provided in the partnership agreement, then separately stated items are distributed in the same proportions as income and loss. Distributive Share A. Partnerships report a share of items of income and expense to each partner. 1. Partnerships are not subject to tax, but report taxable income on Form 1065. 2. Profits and losses are allocated to each partner based on each partner's profit and loss sharing ratio. 3. Measuring and reporting partnership income involves a two-step process. a. All items of income, gain, deduction, loss, or credit that are required to be separately stated, or that are specially allocated, are removed from the partnership's ordinary income or loss determination process. Each partner's proportionate share of these items is reported on Schedule K-1. b. The remaining items are lumped together to produce the net ordinary income or loss, which is also proportionately reported to each partner. 4. Partnerships report taxable income (ordinary income) and separately stated items to each partner on Schedule K-1. Definition Separately Stated Items: Any tax items (deductions, income, preferences, etc.), that might affect partners differently—these items retain their character to the owners. a. Some common examples of separately stated items include: i. Capital gains and losses ii. Section 1231 gains and losses iii. Charitable contributions iv. Foreign income taxes v. Section 179 expense deduction vi. Interest, dividend, and royalty income vii. Interest expense on investment indebtedness viii. Net income (loss) from rental real estate activity ix. Net income (loss) from other rental activity x. Tax-exempt income b. Frequently encountered ordinary income and deductions (non-separately stated items) include i. Sales less cost of goods sold ii. Business expenses such as wages, rents, bad debts, and repairs iii. Deduction for guaranteed payments to partners iv. Depreciation v. Amortization (over 180 months) of partnership organization and start-up expenditures vi. Section 1245 and 1250, recapture 5. Capital withdrawals do not affect income. 6. The character of any gain or loss recognized on the disposition of property is generally determined by the nature of the property in the hands of the partnership. However, for contributed property, the character may be based on the nature of the property to the contributing partner before contribution. a. If a partner contributes unrealized receivables, the partnership will recognize ordinary income or loss on the subsequent disposition of the unrealized receivables. b. If the property contributed was inventory property to the contributing partner, any gain or loss recognized by the partnership on the disposition of the property within five years will be treated as ordinary income or loss. c. If the contributed property was a capital asset, any loss later recognized by the partnership on the disposition of the property within five years will be treated as a capital loss to the extent of the contributing partner's unrecognized capital loss at the time of contribution. This rule applies to losses only, not to gains. 7. Partnerships may use the cash basis of accounting unless the partnership is a "tax shelter" or at least one partner is a C corporation. Exceptions allow the cash method for farming and where the partnership (or corporate partner) is a small business (average annual gross receipts of $25 million or less for the three prior years ending with the current tax year). 8. Partnerships may elect to amortize organization and start-up costs. a. Definition: Organization costs relate to organizing the business so they will benefit the business for its entire life, the length of which cannot be estimated. Start-up costs are expenditures of a nature that would usually be deducted in the year incurred, but cannot be deducted since they were incurred before the business began operations (e.g., training costs for employees). Organizational expenses in the amount of $5,000 may be deducted, but the $5,000 is reduced by the amount of expenditures incurred that exceed $50,000. b. Start-up expenses in the amount of $5,000 may be deducted, but the $5,000 is reduced by the amount of expenditures incurred that exceed $50,000. c. Expenses not deducted must be capitalized and amortized over 180 months, beginning with the month that the corporation begins its business operations. An election can be made to not deduct or amortize the expenses. d. Syndication expenditures (cost of selling partnership interests) are capitalized and cannot be amortized. 9. General partners' distributive shares are subject to the self-employment tax, whereas limited partners' shares usually are not. However, guaranteed payments for both general and limited partners are subject to the self-employment tax. 10. Partners may be able to receive a deduction equal to 20% of the income that flows through to them from a partnership as a qualified business income deduction (QBI). See the Taxation of Income from Business Entities lesson for more detail. B. Family Partnerships 1. If the business is primarily service oriented (capital is not a material income-producing factor), a family member will be considered a partner only if the family member shares in the management or performs needed services. 2. Capital is not a material income-producing factor if substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services (e.g., accountants, architects, lawyers). 3. A family member is generally considered a partner if the family member actually owns a capital interest in a business in which capital is a material income-producing factor. 4. Where a capital interest in a partnership in which capital is a material income-producing factor is treated as created by gift, the distributive shares of partnership income of the donor and donee are determined by first making a reasonable allowance for services rendered to the partnership, and then allocating the remainder according to the relative capital interests of the donor and donee. Example Dad is a half partner in a partnership where capital is a material income producing factor. Dad gives a 20% interest to his son. This year, the partnership earns $100 of income and Dad provides services worth $10. The son is allocated a partnership income of $18. C. Loss Limitations 1. Partners can only deduct losses if all three of the following hurdles are passed (in this order): a. Partners must have enough basis to deduct the loss. b. Partners can deduct losses only to the extent of their at-risk amount. Generally, at-risk equals the partners' basis less the partner's share of nonrecourse debt. Qualified nonrecourse real estate financing is included in at-risk basis. c. If the loss is a passive loss, the partner can deduct the loss only to the extent of passive income. Limited partners' losses are passive by definition (for more information see the lesson "Limitations on Business Deductions"). 2. Disallowed losses are carried over and used in future years when the remaining criteria are met. 3. Excess Business Losses a. No deduction is allowed for: i. A noncorporate taxpayer's (including sole proprietors and owners of partnerships, S corporations, and limited liability companies) ii. Excess business loss iii. That exceeds $524,000/$262,000 (2021) (married filing joint/other). b. The disallowed amount is added to the taxpayer's NOL carryforward. c. This limitation applies after application of the passive loss rules. d. The limit applies to the aggregate net loss from all the taxpayer's trades or businesses. e. For partnerships and Scorporations, the limitation applies at the owner level. Correct! In the preceding year, Gavin is allocated $6,000 of the loss. He uses $4,000 of the loss and reduces his basis in his partnership interest to zero, and he has $2,000 of loss suspended. In the current year, the ordering rule for basis must be followed for computing basis (income, distributions, losses). Gavin is allocated $3,500 of the income, which increases his basis to $3,500. He receives $500 of the distribution, which reduces his basis to $3,000. He then uses the $2,000 suspended loss from the previous year to reduce his basis to $1,000. Correct. Ordinary income for a partnership is the non-separately stated income as reported on page 1 of Form 1065. The charitable contributions and long-term capital gain are separately stated and not included. assive activity losses are the amount that total losses from passive activities exceed total gains from passive activities. The characterization of a partner's share of the partnership's income as passive or nonpassive depends on the partner's participation in the partnership's income earning activities. Since Wolf did not materially participate in the partnership business, his share of the partnership's operating loss, $5,000, is considered a loss from a passive activity. Passive income does not include portfolio income. As a result, Wolf's share of the $20,000 in interest income would not be passive. Therefore, since Wolf had no gains from passive activities to offset the loss from his share of the partnership's operating loss, Wolf would have a passive loss of $5,000, equal to his share of the partnership's operating loss. At-risk rules limit the amount of loss deductions from investment activities to the amount the taxpayer had at-risk. The amount that a taxpayer had at risk is the amount of cash and basis of property contributed to an activity. Borrowed amounts are considered to be at risk to the extent that the taxpayer is personally liable for repayment. At-risk rules do not apply to partnerships, but the rules do apply to the individual partners. Passive activity rules prevent the offsetting of nonpassive income with passive losses and credits from passive activities. Passive activity rules do not apply to partnerships, but the rules do apply to the individual partners. This response correctly indicates that at-risk and passive activity rules apply in determining a partner's deduction for that partner's share of partnership losses. $5,000 of organizational expenses may be deducted, but the $5,000 is reduced by the amount of expenditures incurred that exceed $50,000. Expenses not deducted must be capitalized and amortized over 180 months, beginning with the month that the corporation begins its business operations. Deductions are not allowed to the partnership or any partner for expenses incurred to sell partnership interests. Hence, $5,000 of the legal fees to prepare the partnership agreement may be deducted. However, the accounting fees to prepare the representations in offering materials may not be expensed or amortized because these expenses are related to selling partnership interests.

Income and Basis

Tax Forms for This Lesson: Form 1120S and Form 1120SK-1 (available for download and printing from the lesson overview of your software). Operating Rules A. Required Year-End—Rather than pay the corporate tax, S corporations report income to shareholders on a year-end consistent with that of the shareholders. B. A Calendar Year-End—This is generally the default for S corporations. 1. S corporations can elect a fiscal year-end (with IRS permission) if there is a business purpose to the extension. The most common business purpose is to elect a natural business year. Definition Natural Business Year: A year in which 25% or more of the gross receipts occur in the last two months of the year (three consecutive years). 2. S corporations may elect a year-end under Section 444 with no more than three months of deferral (a deposit with the IRS is required to compensate the government for the deferral benefits to the shareholders if the benefits exceed $500). Reporting Operations—S corporations calculate taxable income (reported on Form 1120S) in a manner similar to partnerships (e.g., no personal deductions). A. S corporations may use the cash basis of accounting unless the corporation is a tax shelter. B. An S corporation reports taxable income (ordinary income) and separately stated items for each shareholder on Schedule K-1 whether or not any dividends were declared. Definition Separately Stated Items: Any tax items (deductions, income, preferences, etc.,) that might affect owners differently. These items retain their character to the owners and must, therefore, be reported separately for each owner. C. S corporations are not entitled to most special corporate deductions, such as the dividends- received deduction. D. S corporations do not pay alternative minimum tax, personal holding company tax, or accumulated earnings tax. E. S corporations make most of the tax elections (not shareholders), including the election to amortize organization and start-up costs. F. An S corporation that fails to file a timely return is liable for a monthly penalty equal to $200 (2017) times the number of persons who were shareholders during any part of the tax year, for each month (or partial month) that the return is not filed. G. Health and accident insurance premiums and other fringe benefits paid by an S corporation on behalf of a more than 2% shareholder-employee are deductible by the S corporation as compensation and includible in the shareholder-employee's gross income on Form W-2. H. Expenses and interest owed to any cash-method shareholder are deductible by an accrual-method S corporation only when paid. Flow-Through to Shareholders—Each shareholder reports income consistent with the period in which the corporate stock was held. A. Each shareholder reports income and separately stated items according to pro-rata share of stock ownership. 1. If relative interests change during the year, each shareholder calculates the share of income on a daily basis. 2. To calculate the daily share of income prior to (or after) the change in shares, divide annual income (and separately stated items) by the number of days in the year. Next, multiply this amount by (1) number of days prior to (after) the change and (2) the percentage ownership interest. 3. If a shareholder's interest is completely terminated (death or sale), then the share can be calculated by closing the books as of the termination date (an interim close). However, all shareholders, including the departing shareholder, must agree to this treatment. 4. Shareholders may be able to receive a deduction equal to 20% of the income that flows through to them from an S corporation as a qualified business income deduction (QBI). See the "Taxation of Income from Business Entities" lesson for more detail. Adjusted Stock Basis—Each shareholder has an adjusted basis in his S stock that must be modified by contributions, income, distributions, and expenses. A. First, contributions to capital increase the shareholder's adjusted basis. B. Second, the shareholder's share of income (including exempt income) increases the shareholder's adjusted basis. C. Third, distributions to the shareholder decrease the shareholder's adjusted basis. D. Fourth, the shareholder's share of loss (including nondeductible expenses) decreases the shareholder's adjusted basis. Calculation of S Shareholder's Basis Initial Basis Plus: Additional Contributions Shareholder's share of: Corporate Income Exempt Income Less: Distributions from AAA/OAA (in following order): Cash Inventory and receivables Other property Nondeductible Expenses Corporate Losses E. Stock basis is adjusted in the following order: 1. Increased for all income items 2. Decreased for distributions that are excluded from gross income 3. Decreased for nondeductible, noncapital items 4. Decreased for deductible expenses and losses Loss Limitations—Loss deductions are limited in four ways. A. First, the adjusted basis of the stock limits loss deductions because a shareholder's basis cannot be reduced below zero. B. Second, the adjusted basis of loans to the corporation by the shareholder can be used for loss deductions once the adjusted basis of the stock is exhausted. However, later increases in basis are used to restore the basis of the debt before basis of the stock. 1. Debt basis is created when the shareholder loans his or her own funds to the S corporation. 2. Once reduced, the basis of debt is later increased (but not above its original basis) by net undistributed income. C. Third, shareholders may only deduct losses to the extent they are "at risk" for investments in the corporation. D. Fourth, passive loss limits may also limit loss deductions depending upon the nature of the corporate business and the shareholders' participation in management activities. E. Unused losses (due to inadequate basis) are carried forward indefinitely (until the adjusted basis of the stock increases or the S election is revoked). F. Excess Business Losses 1. No deduction is allowed for: -A noncorporate taxpayer's (including sole proprietors and owners of partnerships, S corporations, and limited liability companies) -Excess business loss -That exceeds $519,000/$258,000 (married filing joint/other). 2. The disallowed amount is added to the taxpayer's NOL carryforward. 3. This limitation applies after application of the passive loss rules. 4. The limit applies to the aggregate net loss from all the taxpayer's trades or businesses. 5. For partnerships and S corporations, the limitation applies at the owner level. G. If an S corporation contributes appreciated property to a charitable organization, the corporation can deduct the fair market value of the property. However, S corporation shareholders can reduce their basis by only the contributed property's basis. 65,000 − 10,000 + 6,000 + 4,000 − 9,000 = 56,000. The question is asking how the municipal interest income effects basis as well as the effect of the net capital losses. Beginning basis = $65,000 Basis is increased by: Stock purchases Capital contributions Nonseparately stated income items Separately stated income items Basis is decreased by: Nonseparately stated computed loss ($10,000) Separately stated loss and deduction items Distributions not reported as income by shareholder Nondeductible expenses of corporation Basis is increased or decreased by the following separately stated item: Tax-exempt income $6,000 Capital gains and losses $4,000 (LTCG); ($9,000) (STCL) Section 1231 gains and losses Charitable contributions Passive gains, losses, and credits Portfolio income Foreign income Investment income and expense Depletion Section 179 expense The entire premium payment must be included in income since SH owns 2% or more of the L's stock. If SH owned less than 2% of the stock, the entire premium payment could be excluded from income.. S1's beginning basis is $12. It is increased by 50% of the taxable and tax-exempt income (($81 + $10) × 50% = $45.50) and decreased by the $51 distribution.$12 + $45.50 − $51 = $6.50 Once the S corporation completes the steps necessary to become a C corporation, it will be allowed to retain its June 30 year-end since C corporations are not subject to the tax-year limitations to which partnerships and S corporations are. However, C corporations cannot use the cash method of accounting unless their average annual gross receipts for the previous three years do not exceed $26,000,000 (2021). Once the $26,000,000 (2021) test is failed the accrual method must be used for all future tax years. Since this corporation has had revenues of more than $30 million it must use the accrual method of accounting. Collectible gain is taxed at a maximum rate of 28% and can be offset with collectible losses, so it needs to be separately stated. Meyer's share of Bern Corp.'s 2019 loss should be Meyer's pro rata share of the corporation's income. Since Meyer owned 50% of Bern Corp. for the first 40 days of Bern Corp.'s tax year, Meyer's portion of the loss would be $2,000 (= 50% ownership × (40 days/365 days) × $36,500 ordinary loss). Meyer's share of the corporation's loss is dependent on his/her ownership percentage, It is unaffected by Meyer's being an employee of the corporation. Correct! The amount of the nonseparately stated income from Manning Corp. that should be reported on Kane's Year 2 tax return should be Kane's pro rata share of the corporation's income. Since Kane owned 100% of Manning and sold a 25% share on the 40th day of Manning's tax year, Kane's portion of the income would be calculated with respect to 100% ownership for the first 40 days of the corporation's tax year and 75% ownership for the remainder of the tax year. Kane's share of Manning's income from the first 40 days of the corporation's tax year would be $8,000 = 100% ownership × (40 days/365 days) × $73,000 in income. Kane's share of the corporation's income for the remainder of the year would be $48,750 = 75% ownership × (325 days/365 days) × $73,000 in income). Hence, the amount of the nonseparately stated income from Manning Corp. that should be reported on Kane's Year 2 tax return is $56,750 − the sum of $8,000 from the first 40 days and $48,750 from the remainder of the tax year.

State and Local Taxation

Types of State and Local Taxes—State and local governments levy many different types of taxes. The most common are as follows: A. Sales Taxes 1. Levied on tangible personal property and some services. 2. Exemptions vary by state but usually include items bought for resale and that are used in manufacturing. B. Use Taxes—Levied on the use of tangible personal property that was not purchased in the state. C. Property Taxes 1. Ad valorem taxes based on the value of real property (realty taxes) and personal property (personalty taxes). 2. There are usually exemptions for certain types of property, including those for inventory. 3. A few states also tax intangible property. 4. Usually levied for property owned at a specific date. D. Franchise Tax 1. Levied on the privilege of doing business in a state. 2. Based on the value of the capital used in the jurisdiction (common stock, paid-in capital, and retained earnings). E. Excise Tax 1. Levied on the quantity of an item or sales price. a. Examples include tax on gasoline, cigarettes, and alcohol. 2. Can be charged to a manufacturer or consumer. F. Unemployment Tax 1. Levied on taxable wages with a limit per employee (usually $7,000). 2. Rate varies based on experience of employer. G. Incorporation fees are charged for incorporating in a state or registering to do business in a state. Jurisdiction to Tax—Because many businesses conduct operations in more than one state, a significant issue is determining which states have the authority to levy a tax on a particular business. Definitions Domestic Corporations: Entities incorporated under the laws of a particular state. Foreign Corporations: Corporations incorporated in another state. A. Difficult to determine the degree of power to tax foreign corporations. B. Supreme Court developed four tests to determine jurisdiction to tax (Complete Auto Transit v. Brady): 1. Business activity must have substantial nexus with state. 2. The tax must be fairly apportioned. 3. The tax cannot discriminate against interstate commerce. 4. The tax must be fairly related to services that the state provides. C. South Dakota v. Wayfair, Inc. 1. In the Wayfair decision, the Supreme Court held that states can assert nexus for sales and use tax purposes without requiring a seller's physical presence in the state. This overturns the Supreme Court's decision in Quill Corp. v. North Dakota from 1992. 2. The Supreme Court found that the ruling in Quill banning sales tax collection when businesses lack "physical presence" in a state was incorrect. 3. The Court reasoned that Quill was "a judicially created tax shelter for businesses that decide to limit their physical presence and still sell goods and services" to a state's residents. D. Nexus for taxing a corporation's income does not exist if activity in the state is limited to: 1. Advertising 2. Determining reorder needs of customers 3. Furnishing autos to sales staff Definition Nexus: The degree of the relationship that must exist between a state and a foreign corporation for the state to have the right to impose a tax. The application of nexus to state taxation is governed by Public Law 86-272. This law applies to sales of tangible personal property and does not apply to the sale of services or to the leasing or renting of property. Nexus is determined on a year by year basis. E. The following types of activities are usually sufficient to establish nexus with a state (if these activities occur in the state): 1. Approving/accepting orders 2. Hiring/supervising employees other than sales staff 3. Installation 4. Maintaining an office or warehouse (an office maintained by an independent contractor does not establish nexus) 5. Providing maintenance or engineering services 6. Making repairs 7. Investigating creditworthiness or collecting delinquent accounts 8. Providing training for employees other than sales staff State Income Tax Computation—A model law known as the Uniform Division of Income for Tax Purposes Act (UDIPTA) helps to minimize differences among state tax laws. A. The starting point for computing state income taxes is federal taxable income, increased by adjustments such as (specific rules depend on state): 1. Dividends received deduction 2. Expenses related to interest earned on U.S. bonds 3. State income taxes 4. Depreciation in excess of that allowed for state 5. Municipal interest taxed for state purposes B. Decreased by: 1. Federal income taxes paid 2. Expenses related to municipal interest income 3. Interest on U.S. bonds 4. Depreciation in addition to that allowed for federal purposes C. Business versus Nonbusiness Income—If more than one state has nexus to tax the income of a business entity then the income must be apportioned among the states. Designating income as business or nonbusiness is very required for this computation. 1. Business income is apportioned among all the states in which the corporation does business. 2. Business income—Is generally:Generated from business's regular operations (transactional test), orFrom the sale of property that is an integral part of the business (functional test). 3. Nonbusiness income—Generally includes investment income and income from transactions not part of regular operations. Nonbusiness income is generally allocated to the state of incorporation. 4. If investment income is generated by regular business operations it is business income. D. Apportionment 1. Business income is apportioned among the states in which it is earned based on apportionment factors such as sales, property, and payroll. 2. In general, states have discretion to apply different tax rules to different types of income. The U.S. Supreme Court has allowed states great flexibility to choose an apportioning formula and to tax income of an interstate business. 3. Some states use only one apportionment factor. Others vary in how they weight the factors. Different types of factors are used for financial institutions and service businesses. 5. Sales factor is computed as: Total sales in state / Total sales a. The state of sale is determined based on the point of delivery. b. If the business does not have nexus in the state of delivery then the sale is apportioned to the state where the sale originated. 6. Property factor is computed as: Average value of property in state / Value of all property a. Property is limited to real property and tangible personal property, but does not include cash. It is valued at cost or book value depending on the state. b. Property also includes leased property (usually valued at the annual lease times eight). c. Property is included only if used in the production of business income. 7. Payroll factor is computed as: Compensation paid or accrued in state / Total compensation paid or accrued a. Compensation includes fringe benefits if taxable under federal law. b. Payments to independent contractors and paid into Section 401(k) plans are usually not included. c. Compensation is included only if related to the production of business income. 8. The Uniform Division of Income for Tax Purposes Act (UDITPA) is a model act adopted by the National Conference of Commissioners on Uniform State Laws (NCCUSL) and the American Bar Association to promote uniformity in state allocation and apportionment rules. Not all states have adopted this Act. a. The Act provides that if income-producing activity occurs in more than one state, the receipts are assigned to the state where the greatest cost of performance was incurred. b. Intangible assets are excluded from the property factor under the standard formula. c. To promote fairness across states the Act provides the following: If the allocation and apportionment provisions of UDITPA do not fairly represent the extent of the taxpayer's business activity in the state, the taxpayer may petition for, or the tax administrator may require, with respect to all or any part of the taxpayer's activity, if reasonable: a. Separate accounting b. The exclusion of any one or more of the factors c. The inclusion of one or more additional factors that will fairly represent the taxpayer's business activity in this state d. The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer's income Filing Requirements for State Income Taxes A. Filing approaches vary across states, including: 1. Each entity reports separately. 2. Affiliated corporations file a consolidated return. 3. Members of a unitary group combine their transactions on one return. B. Unitary groups meet the definitional requirements of a specific state. Generally three requirement are evaluated to determine if entities should be combined, including unity of: 1. Ownership-more than 50% 2. Operations 3. Use-centralized management C. Partnerships may be included in a unitary group. D. Businesses may be included in a unitary group even if there is not nexus with a state. E. Note that some states do not recognize the federal S Corporation election. F. Some states also tax partnerships at the entity level. If property is purchased in one state but used in a different state, the state of use is likely to impose a use tax for the use of the property in its jurisdiction.

Business Entity Choice

Legal Forms—There are various legal forms that owners can choose for their business, each with certain tax and nontax advantages and disadvantages. A. Most common legal forms include: 1. Sole proprietorships (not a separate entity) 2. Corporations 3. General partnerships 4. Limited partnerships 5. Limited liability companies 6. Limited liability partnerships 7. Business trusts B. These legal forms fall into one of the following tax classifications: 1. Corporations (C and S) 2. Partnerships 3. Trusts 4. Sole proprietorship (individual files on Schedule C) C. Types of Partnerships 1. General partnerships exist when two or more partners join together and do not specifically provide that one or more partners is a limited partner. Since each general partner has unlimited liability, creditors can reach the personal assets of a general partner to satisfy partnership debts, including a malpractice judgment against the partnership even though the partner was not personally involved in the malpractice. 2. Limited partnerships have two classes of partners, with at least one general partner (who has the same rights and responsibilities as a partner in a general partnership) and at least one limited partner. A limited partner generally cannot participate in the active management of the partnership and, in the event of losses, generally can lose no more than his or her own capital contribution. A limited partnership is often the preferred entity of choice for real estate ventures requiring significant capital contributions. 3. Limited liability partnerships differ from general partnerships in that with an LLP, a partner is not liable for damages resulting from the negligence, malpractice, or fraud committed by other partners. However, each partner is personally liable for his or her own negligence, malpractice, or fraud. LLPs are often used by service providers such as architects, accountants, attorneys, and physicians. 4. Limited liability companies that do not elect to be treated as an association taxable as a corporation are subject to the rules applicable to partnerships (a single-member LLC would be disregarded as an entity separate from its owner). An LLC combines the nontax advantage of limited liability for each and every owner of the entity with the tax advantage of pass-through treatment and the flexibility of partnership taxation. The LLC structure is generally available to both nonprofessional service providers and capital-intensive companies. 5. Electing large partnerships are partnerships that have elected to be taxed under a simplified reporting system that does not require as much separate reporting to partners as does a regular partnership. For example, charitable contributions are deductible by the partnership (subject to a 10% of taxable income limitation), and the Section 179 expense election is deducted in computing partnership ordinary income and not separately passed through to partners. To qualify, the partnership must not be a service partnership or engaged in commodity trading, must have at least 100 partners, and must file an election to be taxed as an electing large partnership. A partnership will cease to be an electing large partnership if it has fewer than 100 partners for a taxable year. Check-the-Box Regulations—Under the check-the-box regulations, unincorporated entities may elect to be taxed as an association (corporation) or a partnership. A. Some associations are automatically taxed as corporations and are not eligible to make an election. These per se corporations include business entities formed under statutes that refer to the entities as incorporated. These entities are taxed as either S corporations or C Corporations. 1. Per se corporations include: a. Entities incorporated under state law b. Insurance companies c. State-chartered banks, if deposits are insured by FDIC d. Publicly-traded partnerships e. Specified foreign entities 2. Certain other entities (such as REITs, tax-exempt organizations, etc.) are also classified as corporations. B. For entities not listed as per se corporations, the default options for the entity is a partnership when the business has two or more owners. This default rule typically applies to partnerships and limited liability companies. If an entity does not prefer the default classification, it can elect to be taxed as a corporation. C. If an entity has only one owner, then the default classification is that the entity is "disregarded" for federal income tax purposes. These entities can also elect to be taxed as a corporation. 1. Disregarded means that the entity, while clearly a distinct entity for legal purposes, is ignored for federal income tax purposes. 2. An LLC owned 100% by an individual is treated as a sole proprietorship. 3. An LLC owned 100% by a corporation is treated as a division of the corporation on Form 1120. D. An election under the check-the-box regulations is effective if filed within the first 75 days of the tax year. E. An election can be changed after five years or with IRS permission. F. A business trust is taxed as a trust on Form 1041. Tax Entities Can be Compared and Contrasted on the Following Characteristics—(Note: Refer to the chart at the end of this lesson for a summary of this material.) A. Limited Liability—Corporate shareholders and LLC members have limited liability, as do limited partners. B. Double Taxation—The only entity subject to double taxation is C corporations. Income is taxed to the corporation and then a second time when paid to shareholders as a dividend. C. Retain Income at Lower Current Tax Cost—The entity that may be able to retain income at a lower tax cost is the C corporation (this depends on the level of current tax rates for corporations and individuals). This is not possible with flow-through entities since income flows to the owners even if not distributed. D. Tax-Deferred Contributions—While both corporations and partnerships can be formed in such a manner that realized gains/losses are deferred, the rules are much more favorable for partnerships (and LLCs) since there is no 80% control test requirement for deferrals for partnerships. E. Distributions—The distributions rules favor partnerships (and LLCs). Gain is recognized on partnership distributions only if the cash distributed exceeds the partner's basis in his or her partnership interest. If a corporation distributes appreciated property as a dividend, redemption, or liquidation, gain will be recognized to the corporation (for the appreciation) and potentially to the shareholder (double taxation) as well. F. Owner Basis for Entity Level Debt—Only partners in a partnership and LLC members can increase their basis in their ownership interest for entity level debt. This benefits the partner/member since losses can be deducted on the owner's tax return only to the extent of basis in the ownership interest. This is the reason that partnerships are often used for tax shelters. G. Fringe Benefits—Partners in a partnership are not eligible to benefit from many fringe benefit exclusions because partners who work for the partnership are not considered to be employees. This same rule applies to S corporation shareholders who own 2% or more of the S corporation. Characteristics of Partnerships A. Advantages 1. Single taxation 2. Flexibility—Partners can allocate income, expenses, credits, and all other tax items in any manner as long as the allocation has substantial economic effect. 3. Basis increase for debt 4. Tax-deferred contributions/admissions 5. Distributions/withdrawals rarely produce gain to the partners B. Disadvantages 1. Unlimited liability for general partners 2. Limited partners have limited management rights. Comparison of Partnerships and S Corporations A. Key Similarities 1. Both are flow-through entities with single taxation. 2. LLC members, limited partners, and S corporation shareholders have limited liability (but general partners do not), 3. Both have restrictions on the year-end that must be used for the entity. B. Key Differences 1. Partners have flexibility with profit and loss sharing ratios. S corporations must allocate all tax items according to the percentage of stock owned by each shareholder. 2. The built-in gain rules that apply to partnerships do not apply to S corporations. 3. Income allocations from partnerships to general partners are subject to the self-employment tax. Income allocations from S corporations are not subject to the self- employment tax. 4. Partners receive a basis increase for partnership debt whereas S corporation shareholders do not. The owner's basis is increased for her distributive share of profits and losses for S corporations, partnerships, and limited liability companies. However, owner's basis is not affected by the debt of S corporations, while it is for partnerships and limited liability companies. Correct! For tax year 2020, the C corporation can deduct all of the projected $20,000 in charitable contributions (limited to 25% of taxable income) and none of the capital losses since net capital losses are not deductible. Net income is $100,000 ordinary income less $20,000 equals $80,000. (Note: 2020 tax law will be tested on the CPA exam from 7/1/20 through 6/30/21.)

Eligibility, Elections, Terminations

Legal Status—The S election can only be made by a corporation, and the corporation retains its legal corporate status after the election. A. S corporations retain corporate status and their corporate characteristics when: 1. Shareholders are not liable for corporate debt. 2. Shares can be freely transferred. 3. Shareholders can be employees (separation of ownership and management). B. Tax Characteristics—Unlike C corporations, S corporations act as conduits for taxable income. 1. Like partners, S shareholders are taxed on portion of income or loss, regardless of distributions. 2. There is no imposition of the corporate AMT, PHC, or accumulated earnings taxes. Individual (not corporate) tax preferences are allocated to shareholders. 3. The adjusted basis of shareholders' stock is generally adjusted at year end. 4. Shareholders recognize gains when the value of distributions (cash or property) exceeds the adjusted basis in the stock. 5. Partners in a partnership are not eligible to benefit from many fringe benefit exclusions because partners who work for the partnership are not considered to be employees. This same rule applies to S corporation shareholders who own 2% or more of the S corporation. 6. A 2% or greater S corporation shareholder can deduct premiums paid on health insurance policies issued in his or her own name as a deduction for AGI as long as the shareholder has earned income from the S corporation that exceeds the total of all premiums paid. 7. Shareholders who work for the S corporation are employees who are subject to payroll taxes (social security and Medicare). However, the distributive share to shareholders is not subject to self-employment taxes. C. Default Rules for S Corporations are the C Corporation Rules—Despite conceptual similarity to partnerships, corporate rules serve as default rules for S corporations. 1. There is no special provision for contributions of property to an S corporation. Hence, the "control club" rule prevails for nonrecognition. 2. S corporations can elect to amortize organizational expenses. 3. Distributions of property take an outside basis of FMV (rather than inside basis). 4. Distributions of built-in gain or loss property do not have any special implications for the contributing shareholder. 5. Distribution of appreciated property causes recognition of gain at the corporate level (passed through to shareholders). 6. There is no earnings and profits calculation because all earnings are taxed to shareholders, but a special calculation is necessary to distinguish Subchapter S earnings (called accumulated adjustments) from earnings and profits accumulated previously under Chapter C status. Eligibility Rules—To qualify for an S election, a corporation must have the requisite ownership structure and be an eligible entity. A. Eligibility Entity—The corporation must be an eligible entity. 1. Foreign corporations are not eligible. 2. Certain members of affiliated groups, parents of subsidiaries, financial institutions, and DISCs are not eligible. Banks are ineligible if they use the reserve method of accounting for bad debts. 3. S corporations may own an 80% or more equity interest in a C corporation. 4. S corporations may own a qualified Subchapter S subsidiary. Definition Qualified Subchapter S Subsidiary: A corporation that meets all requirements for Subchapter S status and is owned 100% by a parent S corporation. B. Shareholder Requirements—Shareholders must be eligible. 1. Nonresident aliens, C corporations, and partnerships are not eligible. a. Shortcut—An S corporation can be a parent corporation, but it cannot be a subsidiary of any corporation except another subchapter S corporation. 2. Estates (bankruptcy or testamentary) can be shareholders. 3. Trusts can be shareholders, if grantor or testamentary (two-year limit after transfer). 4. Special stock voting trusts and qualified S trusts can be shareholders (all beneficiaries are qualified and electing shareholders). 5. Small business electing trusts and exempt entities are allowed as shareholders. C. Shareholder Limit—An eligible corporation can have no more than 100 shareholders. 1. All members of a family and their estates are treated as a single shareholder. 2. Each beneficiary of a shareholding trust is counted as a separate shareholder. 3. Co-owners of stock each count as one shareholder. D. Stock Requirements—Only one class of stock is outstanding. 1. Shares that vary solely in voting rights are not considered two classes of stock. 2. Convertible debt does not violate the requirement unless and until it is converted into a second class of stock. 3. Unissued treasury stock does not violate the requirement. 4. A safe harbor exists for shareholder debt to prevent these securities from being interpreted as a second class of equity. The debt must be evidenced by a written promise that is not contingent or convertible. Short-term unwritten loans are sanctioned in amounts under $10,000. Election Requirements—The shareholders of the corporation must make a qualifying election to obtain or revoke S status. A. Unanimous consent of shareholders is required for election. 1. The election is valid for the current year, if it is made on or before the 15th day of the third month (Form 2553). 2. An election that is ineligible for the current year is still valid for the next year (if the circumstance causing ineligibility is corrected). 3. All current shareholders (and past shareholders for the current year, up to date of election) must consent to election. 4. Both spouses must consent, if the stock is jointly owned. Note In its initial year, a corporation must make the S election on or before the 15th day of the third month after commencing business. B. Termination Requirements—Termination of the election can occur through three circumstances. 1. A voluntary termination occurs through a majority vote (a majority of all shareholders) specifying a prospective year or made before the 15th day of the third month for the current year. a. Also note, that if there is a greater than 50% change in the ownership of the S corporation, the new owners must affirm that they wish to continue to S election. Note All shareholders (voting and nonvoting) are entitled to a vote in a voluntary termination of an S election. 2. An involuntary termination occurs through a violation of an eligibility requirement, and this termination is effective on the date of the violation. Note An involuntary termination caused by a violation of an eligibility requirement will generally create a short S year and a short C year. a. Reminder—The IRS can waive an inadvertent termination. Definition Short Year: A tax year consisting of less than 12 months. 3. An involuntary termination can occur due to a violation of the limit on passive investment income exceeding 25% of gross receipts for three consecutive years (see discussion of S corporate taxes in the "Income and Basis" and "Distributions and Special Taxes" lessons). This termination is effective on the first day of the fourth consecutive year. This provision only applies if the S corporation has earnings and profits (from previous C corporation years) on its balance sheet. Note Once terminated, S status cannot be elected without IRS permission for five years. The S election does not terminate if an S corporation acquires another corporation. Note that if the C corporation purchased any stock in the S corporation, the S election would terminate. The shareholder limit is 100 and members of the same family count as one shareholder. S corporations have both passive and nonpassive income. However, if an S corporation has excessive net passive income, a tax at the highest corporate rate is imposed on the excessive passive income. Excessive passive income is the amount that passive investment income exceeds 25% of the corporation's gross receipts. An S corporation may have shareholders that are individuals, decedent's estates, bankruptcy estates, or trusts (charitable organizations and qualified plan trusts are included for post-'97 tax years). This response correctly states that an S corporation, from its inception, may have both passive and nonpassive income and a shareholder that is a bankruptcy estate. A corporation's S election may be revoked voluntarily with the consent of the shareholders holding a majority of the corporation's issued and outstanding stock, including nonvoting stock. Since, in this case, the S corporation has 30,000 shares of voting common stock and 20,000 shares of nonvoting common stock issued and outstanding, shareholders holding at least 25,001 shares of stock would be needed to have a majority and, as a result, the ability to revoke the corporation's S election. This response correctly indicates that shareholders controlling 26,000 shares of stock (10,000 shares of voting and 16,000 shares of nonvoting) would have the ability to voluntarily revoke the corporation's S election despite their not having a majority of the voting shares. Ace Corp.'s S election would be recognized as of January 1, Year 9. An S election made by the 15th day of the 3rd month of the tax year is effective for that year. To be retroactive, the corporation had to be eligible on all days in the tax year prior to the day of the election and all persons that were shareholders before that day, but not on that day, must consent to the election. An S Corporation election is effective for the current tax year, if made by the 15th day of the third month of the tax year. Since the election is after to March 15, Year 8, it is effective for Year 9.

Accounting Methods and Periods—Corporations

Accounting Periods A. The term taxable year refers to a taxpayer's annual accounting period. Annual accounting period means the annual period that the taxpayer uses to compute income in keeping his books. 1. Calendar year is a period of 12 months ending on December 31. 2. Fiscal year is a period of 12 months ending on the last day of a month other than December. 3. 52-53-week year is an annual period always ending on the same day of the week (e.g., last Sunday of a month, or the Sunday closest to the end of a month). B. A business establishes an accounting period by filing its first tax return. C. Rules for Adoption of Taxable Year 1. Corporation that is a C corporation (other than a personal service corporation) may adopt any taxable year that it chooses. A personal service corporation generally must adopt a calendar year. 2. Partnership is a pass-through entity and generally must use the same tax year as that used by its partners owning more than 50% of partnership income and capital. A different taxable year may be permitted if there is a substantial business purpose. 3. S corporation is a pass-through entity and generally must adopt a calendar year. A different taxable year may be permitted if there is a substantial business purpose. 4. Estate may adopt any taxable year for its income tax return that it chooses. 5. Trust (other than charitable and tax-exempt trusts) must adopt a calendar year. D. Substantial business purpose and IRS approval are generally required to change a taxable year. Taxpayers can request permission to change a year by filing Form 1128, Application for Change in Accounting Period, by the 15th day of the second month after the close of a short period. 1. The business purpose requirement may be satisfied if the taxpayer is requesting a change to a natural business year. The business purpose test will be met if the taxpayer receives at least 25% of its gross receipts in the last two months of the selected year, and this 25% test has been satisfied for three consecutive years. 2. The IRS may require that certain conditions be met before it approves a request for change (e.g., the IRS may require partners to switch to the same year as is being requested by the partnership). E. Some changes in tax years require no approval. 1. A corporation (other than an S Corporation) may change its year if its taxable year has not changed within the past 10 years ending with the calendar year of change; the resulting short period does not have an NOL; the corporation's annualized taxable income for the short period is at least 90% of its taxable income for the preceding year; and the corporation's status (e.g., personal holding company) for the short period is the same as the preceding year. 2. A newly acquired subsidiary that will be included in a consolidated return must change its taxable year to the same year as used by its parent. F. Taxable Periods of Less than 12 Months 1. If due to beginning or ending of taxpayer's existence, tax is computed in normal way (e.g., corporation is formed, or individual dies). The taxpayer's exemptions and credits are not prorated. In the case of a decedent, the income tax return can be filed as if the decedent lived throughout the entire tax year. 2. If the short period is due to a change in taxable year, taxable income generally must be annualized. However, a new subsidiary that has a short year because of being included in a consolidated return is not required to annualize. a. When annualizing, an individual cannot use the tax tables and must itemize deductions. Personal exemptions must be prorated. b. Taxable income is multiplied by 12 and divided by the number of months in short period. c. The tax is computed and multiplied by the number of months in the short period, then divided by 12. Tax Accounting Methods A. Cash versus Accrual Accounting—In general, the following entities cannot use the cash method of accounting: 1. Regular C corporations 2. Partnerships that have regular C corporations as partners 3. Tax shelters (Note: The exceptions listed in item "4" below do not apply to tax shelters.) Definition Tax Shelter: An entity other than a C corporation for which ownership interests have been offered for sale in an offering required to be registered with Federal or State security agencies. 4. Notwithstanding the above, the following entities can use the cash method: 1. Any corporation (or partnership with C corporation partners) whose annual gross receipts do not exceed $26 million (2021). The test is satisfied for a prior year if the average annual gross receipts for the previous three-year period do not exceed $26 million. Once the test is failed, the entity must use the accrual method for all future tax years. 2. Certain farming businesses 3. Qualified personal service corporations Definition Qualified Personal Service Corporation: A corporation that exists if (1) substantially all of the activities of the business consist of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and (2) at least 95% of its stock is owned by the employees performing the services. Long-Term Contracts A. Special rules apply to recognize income for production projects that generally take more than one year to complete (e.g., aircraft, ships). B. The general rule is that the percentage of completion method must be used to recognize income, so that the gross profit from the project is recognized over the time period that it takes to complete the project. C. The completed contract method allows the gross profit from the project to be deferred until the year that the production process is complete. For contracts entered into after December 31, 2017, in tax years ending after that date, small construction contracts can use the completed contract method. A small construction project is a contract for the construction or improvement of real property if the contract: 1. Is expected to be completed within two years of commencement of the contract, and 2. Is performed by a taxpayer that meets the $26 million (2021) gross receipts test. Correct! C corporations cannot use the cash method of accounting unless their average annual gross receipts for the previous three years do not exceed $26,000,000 (2021). Once the $26,000,000 test is failed, the accrual method must be used for all future tax years. Since Dart has had revenues of more than $30 million for the last three years, it must use the accrual method of accounting. For accrual-based taxpayers, items generally are included in gross income for the year in which the income is earned. However, for tax purposes, income is earned when(1) all the events have occurred to attach the taxpayer's right to receive the income and(2) the amount of income can be determined with reasonable accuracy. Cash-based taxpayers report income when it is actually received or constructively received (i.e., in the taxpayer's control). Since all the events have occurred to attach Ral Corp.'s right to receive the income and the amount of income can be determined with reasonable accuracy, the corporation must report $27,000 in rental revenue for Year 8. It is irrelevant that the rental revenue covers the following years.

Formation and Basis

Introduction—A business operated as a partnership is not recognized as a taxable entity under the income tax laws. Instead, the partners divide the income and expenses of the business and report their share on individual returns. The income is taxed to the owners regardless of distributions. Distributions are, in turn, treated as a return of capital. The distinction between partnerships and corporations is important because no tax is imposed on partnerships. Partnership Definition Definition Partnership: An association of two or more taxpayers to operate a business that is not taxed as a corporation. A. An entity may be exempt from partnership rules if organized for investment purposes. B. A partnership must be an association of two or more taxpayers with the objective of making a profit. The existence of a partnership is a question of fact, but co-ownership and/or joint use of property does not necessarily constitute a partnership. There must be an active conduct of a business with the intent to share profits. C. Certain publicly traded partnerships (i.e., master limited partnerships) are taxed as corporations. Check-the-Box—Under the "check-the-box" regulations, unincorporated entities may elect to be taxed as an association (corporation) or a partnership. A. Some associations are automatically taxed as corporations and are not eligible to make an election. These per se corporations include business entities formed under statutes that refer to the entities as incorporated. B. The default entity is a partnership when the business has two or more owners. This default rule typically applies to partnerships and limited liability companies. If an entity does not prefer the default rule, it can elect to be taxed as a corporation. C. If an entity has only one owner, then the default classification is that the entity is disregarded for federal income tax purposes. These entities can also elect to be taxed as a corporation. D. An election under the check-the-box regulations is effective if filed within the first 75 days of the tax year. General/Limited Partners Definitions General partners: Can participate in management and have joint and several liability for the partnership's debts. All partnerships must have at least one general partner. Limited partners: Are only liable up to their investment, but they cannot participate in management without losing their limited status. A. A partnership loss will be a passive loss to a limited partner. Note Without specific information (e.g., number of hours of activity for the partner), partnerships engaging in rental activities are most likely passive. See the "Limitations on Business Deductions" lesson for more detail. B. A partnership loss may be a passive loss to a general partner depending upon whether the partner meets the material participation test. See the "Limitations on Business Deductions" lesson for more detail. C. Note that owners of limited liability companies are known as members and they also have limited liability. D. Limited liability partnerships also usually filed as partnerships for federal tax purposes, unless the partners elect differently. Partner Interests—Each partner owns a capital interest and a profits interest. A. The capital-sharing ratio represents each partner's share of partnership capital. B. Profit and loss (P&L) sharing ratios are each partner's share of profits and losses, respectively. Formations—The formation of a partnership does not trigger income, but requires that both the partners and the partnership calculate adjusted basis. A. Contributions to a partnership are not taxable events, but require partners to calculate a substituted basis for their partnership interest. B. Deferred Gain or Loss—Partners and partnerships recognize no gain or loss on contributions in exchange for a partnership interest. 1. The control club used for corporate contributions is not relevant for partnerships since partnerships are taxed as conduits. a. Reminder—The control club is the 80% control requirement necessary to provide shareholders with deferral for contributions to a corporation. 2. No distinction is made between an initial contribution and later additional contributions. 3. No deferral is available for contributions to a partnership in exchange for property—deferral is only available for exchanges of property for a partnership interest. C. Exceptions Exist for Nonrecognition 1. Services contributed for a partnership interest create income in the amount of the value of the partnership interest (which also becomes the adjusted basis of the partnership interest). 2. There is no deferral for contributions that are essentially disguised sales or attempts to diversify stock holdings. 3. Profits Interest. a. A taxpayer may receive a profits interest only in return for services. In that case, the partner's interest in the capital of the partnership is zero. Generally, the receipt of a profits interest is not taxable; rather, the partner has income when profits flowthrough to him or her at the end of each tax year. b. Partnership interests that are profits interests received in return for services that hold investments or real estate have special rules. The profits allocated to the profits-interest partners must be from assets held for more than three years to produce long-term capital gain. Additionally, the partnership interest itself must be held for more than three years when it is sold for any resulting gain to be long-term. Basis Issues at Formation—Each partner calculates his or her personal adjusted basis (outside basis) in the partnership, and the partnership calculates the adjusted basis of the assets (inside basis) held by the partnership. A. Partnership—A partnership takes a carryover basis (the adjusted basis of the property in the hands of the partners) for contributed property. Definition Inside Basis of Property: The aggregate basis of assets in the hands of the partnership. 1. Since the adjusted basis of contributed property carries over from the partners to the partnership, the holding periods and depreciation methods also continue unabated. B. Partner—Each partner takes a substituted basis in the partnership interest from the assets contributed to the partnership. Definition Outside Basis of Property: The adjusted basis of each partners' interest in the partnership. Holding Period A. The holding period in the partnership interest includes the holding period of the contributed asset for contributions of capital assets and Section 1231 assets. For other assets, the holding period starts when the contribution is received by the partnership. B. The holding period that the partner has in the asset before contributed always transfers to the partnership, regardless of the type of asset contributed. C. The adjusted basis for contributions of services is the value included in the income of the partner. D. The adjusted basis for partnership interests purchased from existing partners or interests received as gifts or inheritances are determined like other assets (cost or carryover basis, respectively). Computation of Basis of Partnership Interest—Partners continually adjust their outside basis for partnership transactions, including the deduction of their share of partnership losses. A. Increases—A partner's basis is increased by contributions of property, income, and increases in liabilities. 1. A partner's proportionate share of income includes gains and exempt income. 2. A partner's proportionate share includes increases in liabilities (treated like a contribution). B. Decreases—A partner's basis is decreased by distributions, expenses, and deemed distributions. 1.A partner's proportionate share of expenses, including deductions, losses, and nondeductible expenses (not capital expenditures) 2. A partner's proportionate share of decreases in liabilities (deemed distributions) Definition Deemed Distribution: Occurs with any decrease in the partnership liabilities. 3. Reminder—A partner's basis in the partnership cannot be reduced below zero. If the net change in basis in the partnership interest due to debt being assumed by the partnership exceeds the total basis of the assets contributed, the partner must recognize gain equal to that excess to prevent negative basis from occurring. C. Debt Allocations—Changes in Liabilities Affect a Partner's Basis. 1. An increase in the partnership's liabilities (e.g., loan from a bank, increase in accounts payable) increases each partner's basis in the partnership by each partner's share of the increase. 2. Any decrease in the partnership's liabilities is considered to be a distribution of money to each partner and reduces each partner's basis in the partnership by each partner's share of the decrease. 3. Any decrease in a partner's individual liability by reason of the assumption by the partnership of such individual liabilities is considered to be a distribution of money to the partner by the partnership (i.e., partner's basis is reduced). 4. Any increase in a partner's individual liability by reason of the assumption by the partner of partnership liabilities is considered to be a contribution of money to the partnership by the partner. Thus, the partner's basis is increased. 5. In the example above, we assumed that debt was allocated based on ownership percentage. This is usually a reasonable assumption for the CPA Exam. However, the debt allocation rules are actually much more complex than this. a. Recourse debt—For recourse debt, each partner's share of debt is measured by his or her economic risk of loss assuming a constructive liquidation scenario occurred. While this material is likely too complex for the exam, you should be aware that limited partners are not allocated any share of recourse debt. b. Nonrecourse debt—This is debt for which the lender's only recourse, in the event of default, is to take back the property. As above, the allocation of nonrecourse debt is likely too complex for the exam. However, you should be aware that nonrecourse debt is often allocated based on the partners' profit sharing ratios. Also, contrasted with recourse debt, both general and limited partners are allocated nonrecourse debt. D. A partner's basis for the partnership is adjusted in the following order: (1) increased for all income items (including tax-exempt income); (2) decreased for distributions; and (3) decreased by deductions and losses (including nondeductible items not charged to capital). Capital Account A. While basis represents one's investment in a partnership for tax purposes, capital account represents the amount a partner should receive when the partnership is liquidated. B. Basis and capital account are computed in a similar fashion, except: 1. Liabilities of the partnership do not affect the capital account. 2. The fair market value of contributions and distributions impact the capital account, rather than the tax basis. Permitted Tax Years—Partners report income in the year that the partnership tax yearends. A. Since the partnership and the partners may not have the same year-ends, the partners only report income once the partnership closes its books at the partnership year-end. B. Required Tax Year: The required tax year for the partnership is determined as follows: 1. Partnerships use the same year-end as its majority interest partner(s) (more than 50% capital and P&L). 2. If the partnership has no single year for the majority, then the partnership uses same year-end as all of its principal partners (5% P&L interest or more). 3. If neither the majority interest nor principal partner test is met, the required tax year is determined by using the least aggregate deferral method. This method is computationally intensive, but determines the year-end which will provide the least amount of deferral for the entire partnership group. C. If a partnership does not want to use the required tax year, the partners can elect a fiscal year-end (with IRS permission) if there is a business purpose; a natural business year can also be used. Definition Natural Business Year: A year in which 25% or more of the gross receipts occur in the last two months of the year (three consecutive years). D. A second exception to the required tax year is that under Section 444 partnerships may elect a year-end with no more than three months of deferral, but a deposit with the IRS is required to compensate the government for the deferral benefits to the partners (only if the deferral benefit exceeds $500). E. The taxable year of a partnership ordinarily will not close as a result of the death or entry of a partner, or the liquidation or sale of a partner's interest. But the partnership's taxable year closes as to the partner whose entire interest is sold or liquidated. Additionally, the partnership tax year closes with respect to a deceased partner as of date of death. Compliance Rules A. Any partnership that fails to file a timely return is liable for a monthly penalty equal to $210 (2020) times the number of persons who were partners during any part of the tax year, for each month (or partial month) that the return is not filed. B. Partnership Audit Rules 1. Simplified audit procedures apply to partnerships. Partnerships with less than 100 partners that do not have a partnership as a partner can elect out of these rules. 2. Each partnership designates one partner to represent the partnership before the IRS. 3. Audit adjustments are assessed and paid at the partnership level, using the highest marginal tax rate that applies to individuals or corporations. If the partnership decides to issue revised K-1s to the partners, then the additional tax will not be paid at the partnership level. The partner received a partnership interest in return for property and services. His basis in his partnership for the property contributed is equal to the basis of the property he contributed, or $30,000 ($20,000 + $10,000). For the services rendered he must recognize $5,000 of income for the interest received, so he has a $5,000 basis in that portion of his partnership interest. His total basis in the partnership interest is $35,000 ($30,000 + $5,000). The profits allocated to a profits-interest partner in an investment partnership must be from assets held for more than three years to produce long-term capital gain. Upon a partnership formation the partnership's basis in the assets received from the contributing partners is the basis in the hands of the partner. Thus, Apple's basis is $5,000. 50% of the loss and income impacts George's basis. George's share of the partnership debt decreased by $8,000 ($40,000 - ($64,000 / 2)) during the year, so George's basis is decreased by 50% of the reduction, or $8,000. Ending basis is computed as follows: Beginning basis. $32,500 Operating loss(15,000) Interest and dividend income4,000 Partnership debt change( 8,000) Ending basis$13,500 A partnership may elect to have a tax year other than the generally required tax year if the deferral period for the tax year elected does not exceed three months. In addition, the adoption of a tax year other than that generally required may be claimed, if there is a valid business purpose. Thus, this response meets the first requirement and, therefore, is correct. A partner's basis in the partnership interest is increased by: 1. additional contributions; 2. additional interests purchased or inherited; 3. the partner's share of the partnership's income (including tax-exempt income); and 4. any increases in the partner's share of partnership liabilities. A partner's basis in the partnership interest is decreased by: 1. cash and the partnership's adjusted basis of property received by the partner in a nonliquidating distribution; 2. the adjusted basis allocable to any part of the partner's interest sold or transferred; 3. the partner's share of the partnership's losses; and 4. any decreases in the partner's share of partnership liabilities. This response correctly states that the transferee's share of the partnership liabilities should be used in computing the basis of a partner's interest acquired from another partner. This response also correctly states that cash paid by transferee to transferor should be included in the computation. The holding period of a partnership interest acquired in exchange for a contributed capital asset begins on the date the partner's holding period of the capital asset began.

Special Corporate Deductions

Organizational, Start-Up, and Syndication Expenditures A. Expenses incurred in connection with the organization of a corporation are organizational expenses. $5,000 of these expenses may be deducted, but the $5,000 is reduced by the amount of expenditures incurred that exceed $50,000. Expenses not deducted must be capitalized, and amortized over 180 months, beginning with the month that the corporation begins its business operations, unless an election is filed not to do so. 1. Typical organizational expenses are legal services incident to organization, accounting services, organizational meetings of directors and shareholders, and fees paid to incorporate. They must be incurred before the end of the taxable year that business begins (but they do not have to be paid, even if on the cash basis). B. An additional deduction is allowed using the same rules as above for start-up costs. Start-up costs are expenditures that would be deductible as regular operating expenses, except that the corporation has not yet started its trade or business operation so they do not meet the criteria for deductibility. For example, if a new restaurant pays waitresses while they are being trained, but before it opens for business, these salary payments are start-up costs. C. Costs of issuing and selling stock are syndication expenses. They must also be capitalized, but cannot be amortized. Charitable Contributions—Can be deducted after the amortization of organizational expenditures. A. Charitable Contribution Rules—Are the same as for individuals, with the following exceptions: 1. A corporation's contribution of inventory or depreciables or real property used in its trade or business to charities that use the property in a manner related to the exempt purpose and solely for the care of the ill, needy, or infants, or where the property is used for research purposes under specified conditions, is subject to special rules. 2. The deduction is the lower of: AB of property + 50% × (FMV − AB), or 2 × AB 3. This rule applies for contributions of "wholesome" food inventory by corporations and other businesses to charities that use the food in an appropriate manner. These contributions can be deducted up to 15% of taxable income from the food operations. For 2020 and 2021, the 15% is increased to 25%. Note that the food inventory rule applies to all businesses, not just corporations. B. The corporation can elect to deduct accrued contributions if the contributions are actually paid in the first three-and-a-half months following the year-end. (For corporations with a June 30 year-end the deadline is two-and-a-half months following year-end [September 15]). C. The limit on the deduction is 10% of taxable income (before special deductions for charity and carryovers). For 2020 and 2021, cash contributions by corporations can be deducted up to 25% of taxable income. D. Any excess charitable contribution (above the 10%, or 25%, limit) carries forward for five years (there is no carryback). Dividends-Received Deduction—The dividends-received deduction (DRD) is a percentage (%) of domestic dividends. A. To be eligible, the stock must be of a domestic corporation held over a 45-day window (90 days for preferred stock). This prevents dividend stripping. The DRD cannot be claimed by S corporations, personal service corporations, and personal holding companies. B. A DRD is allowed for foreign-source dividends received from a foreign corporation if the U.S. corporate shareholder owns at least 10% of the voting power or value of the stock. C. The DRD percentage depends on the level of stock owned by the corporation. 1. Shortcut—If the corporation owns less than 20% of the stock of another corporation, then the dividends-received deduction (DRD) is 50% of the dividends received. If the corporation owns 80% or more, then the DRD is 100% of the dividends received. All ownership levels between these two extremes are entitled to an 65% DRD. Note If a consolidated tax return is filed when a parent owns at least 80% of the subsiduary, intercompany dividends are eliminated in the consolidation process and not included in consolidated gross income. Ownership percentage. Deduction percentage Less than 20% 50% 20% or more, but less than 80% 65% 80% or more 100% Note If a problem does not mention the amount of stock ownership, assume it is less than 20%. D. The DRD is limited by taxable income (before the DRD), unless the DRD creates or adds to a net operating loss. For this limitation, calculate the corporation's taxable income before any net operating losses, any capital loss carrybacks, and the dividends-received deduction. E. The following steps are required to compute the DRD: 1. Multiply dividends received by the deduction percentage. 2. Multiply taxable income before dividends-received deduction as calculated previously by the deduction percentage. 3. Subtract Step 1 from taxable income before dividends-received deduction. 4. If Step 3 yields a negative amount (i.e., loss), Step 1 is the dividends-received deduction. 5. If Step 3 yields a positive amount, the dividends-received deduction is the lower of Step 1 or Step 2. Note The dividends-received deduction is not limited by taxable income if the full dividends-received deduction creates or adds to a net operating loss. For example, suppose ABC corporation received $100 in dividends from a domestic corporation (ABC owned less than 20% of the stock). If ABC has taxable income (before the DRD) of $10, then the DRD is $50 because it exceeds taxable income and thereby creates a net operating loss (an NOL of $40). F. Additional limits are imposed on the DRD if debt is used to finance the investment in stock (DRD is limited to the proportion of dividends that are not financed by debt). G. The reduction in the DRD cannot exceed the interest deduction allocable to the portfolio stock indebtedness. Domestic Production Deduction (DPD)—The DPD has been repealed. Casualty Losses—Treated the same as for an individual except A. There is no $100 floor. B. If property is completely destroyed, the amount of loss is the property's adjusted basis. C. A partial loss is measured the same as for an individual's nonbusiness loss (i.e., the lesser of the decrease in FMV, or the property's adjusted basis). Research and Development Expenditures of a Corporation (or Individual)— May be treated under one of three alternatives: A. Currently expensed in year paid or incurred B. Amortized over a period of 60 months or more if life not determinable C. Capitalized and depreciated over 10 years Insurance Premiums A. A corporation may deduct insurance premiums paid for casualty insurance, employee health or accident insurance, and life insurance coverage for its employees and their beneficiaries. B. Premiums paid on life insurance policies in which the corporation itself is the beneficiary are not deductible. Ordering Rules for Corporate Deductions—The following expenses are deducted in a specific order because each one is limited to the amount of income after reducing taxable income by the prior deduction. Look at image Correct! Ignoring the dividend, Brown has a net operating loss (NOL) of $200,000. Brown must also include the $100,000 of dividends in income, reducing the NOL to $100,000. Brown also is permitted to take the dividends received deduction. Since the dividend is received from a Fortune 500 corporation it is reasonable to assume that Brown owns less than 20% of the corporation, so the dividends received deduction is 50% of the dividends received, or $50,000. This increases the NOL to $150,000. Note that the dividends received deduction is not limited to the taxable income of Brown since Brown has a loss before the dividends received deduction. While cash-based taxpayers deduct deferred compensation in the tax year that the compensation is actually paid to employees, accrual basis taxpayers deduct deferred compensation in the tax year that the liability to pay the compensation becomes fixed. The liability to pay the deferred compensation becomes fixed when: (1) all events have occurred to establish the liability to pay the compensation; (2) economic performance has occurred with respect to the liability; and (3) the amount can be determined with reasonable accuracy. In addition, accrual-basis taxpayers must pay the deferred compensation within the first 2 1/2 months of a tax year to deduct the compensation in the preceding year. Assuming Soma Corp. fixed the liability to pay the compensation in Year 7, the corporation may deduct all of the nonshareholder bonuses ($60,000) on its Year 7 tax return because the bonuses were paid within the first 2 1/2 months of the end of its Year 8 tax year. Since an additional $10,000 more of bonuses were paid than accrued, this amount may be added to the corporation's compensation expense, putting that expense at $610,000. Correct! If a C corporation owns less than 20% of a domestic corporation, 50% of dividends received or accrued from corporation may be deducted. A C corporation owning 20% or more but less than 80% of a domestic corporation may deduct 65% of the dividends received or accrued from the corporation. Similarly, C corporation owning 80% or more of a domestic corporation may deduct 100% of the dividends received or accrued from the corporation. However, the dividend received deduction is limited to a percentage of the taxable income of the corporation, unless the corporation sustains a net operating loss. If the corporation has a net operating loss, the dividend received deduction may be taken without limiting the deduction to a percentage of the corporation's taxable income. Since it is not otherwise noted, it is assumed that Kisco Corp. owns less than 20% of the domestic corporation. Hence, Kisco may deduct 50% (or $5,000) of the dividends received, giving taxable income of $65,000. Kisco's income tax on that amount of income is $13,650. Correct! If a C corporation owns less than 20% of a domestic corporation, 50% of dividends received or accrued from corporation may be deducted. A C corporation owning 20% or more but less than 80% of a domestic corporation may deduct 65% of the dividends received or accrued from the corporation. Similarly, C corporation owning 80% or more of a domestic corporation may deduct 100% of the dividends received or accrued from the corporation. However, the dividend received deduction is limited to a percentage of the taxable income of the corporation, unless the corporation sustains a net operating loss. If the corporation has a net operating loss, the dividend received deduction may be taken without limiting the deduction to a percentage of the corporation's taxable income. Since Kelly Corp. is not affiliated with the corporation paying the dividends, it owns less than 20% of the corporation paying the dividends and, as a result, may take a 50% (or $25,000) dividend received deduction. Bad debts are deductible with no percentage limitation. However, Kelly Corp. cannot take a deduction for its bad debt expense because no bad debt was actually incurred. Instead, the expense represents an increase in allowances for doubtful accounts. The corporation's bad debt expense must be added back to net income. Hence, Kelly Corp.'s taxable income is $355,000—net income of $300,000 minus dividend received deduction of $25,000 and plus the bad debts expense of $80,000. This response correctly adds back bad debt expense and correctly deducts the dividend received deduction. orrect! If a C corporation owns less than 20% of a domestic corporation, 50% of dividends received or accrued from the corporation may be deducted. A C corporation owning 20% or more but less than 80% of a domestic corporation may deduct 65% of the dividends received or accrued from the corporation. Similarly, C corporation owning 80% or more of a domestic corporation may deduct 100% of the dividends received or accrued from the corporation. However, the dividend received deduction is limited to a percentage of the taxable income of the corporation, unless the corporation sustains a net operating loss. For this question, the taxable income limitation rule comes into effect: When ownership is less than 80%, the dividends received deduction (DRD) equals the lesser of 50% or 65% of the dividends received (whichever applies), or 50% or 65% of taxable income computed (whichever applies) without regard to the DRD, any net operating loss (NOL) deduction, or capital loss carry back. The taxable income limitation rule does not apply however if the DRD creates or adds to a NOL. If the corporation has a net operating loss, the dividend received deduction may be taken without limiting the deduction to a percentage of the corporation's taxable income. This response uses the correct deduction percentage for Best Corp.'s ownership percentage and correctly limits the dividend received deduction to a percentage of the corporation's taxable income. The limit is calculated by multiplying taxable income (before the dividend received deduction), i.e., $90,000, by the correct dividend received deduction percentage, i.e., 50%. This answer is correct. The requirement is to determine the NOL for 2021, given that deductions in the tax return exceed gross income by $75,000. In computing the NOL for 2021, the DRD of $6,600 would be fully allowed, but the $13,400 NOL deduction (carryover from 2020) would not be allowed. $75,000 - $13,400 = $61,600.

Taxation of Related Corporations

Overview—Corporations can be directly related through inter-corporate ownership or indirectly related through common shareholders. Affiliated Groups—An "affiliated group" exists when one corporation owns at least 80% of the voting power of another corporation and holds shares representing at least 80% of its value. This test must be met on every day of the year. Elect to File—Eligible affiliated corporations can elect to file a consolidated return. A. Consolidating permits the corporations to eliminate intercompany profits and losses, allows the profitable corporation to offset its income against losses of another corporation, and permits net capital losses of one corporation to offset capital gains of another. Note Ownership of a corporation is determined by examining the amount of voting stock, as well as other classes of stock. To qualify as a parent, a corporation must own 80% or more of each class. Once a parent and subsidiary exist, then related corporations can be included in the affiliated group if the total ownership (including all corporations within the group) rises to 80% or more. B. Gains and losses on intercompany sales are deferred until disposition outside the group. These gains and losses will be recognized at the time of the eventual disposition outside the consolidated firm but the nature of the gain or loss is determined by the use of the property at the time of the intercompany sale. C. Foreign corporations, exempt corporations, regulated investment companies, S corporations, and insurance companies are not eligible to consolidate. D. The election to consolidate must be unanimous and it is binding on future returns (irrevocable) and creates a joint and several tax liability. E. The members of the group must conform their tax year to the parent's tax year. F. Intercompany dividends are eliminated from consolidated taxable income. G. The parent adjusts the basis of the stock of a consolidated subsidiary for allocable portion of income, losses, and dividends. Controlled Groups—Controlled groups are parent-subsidiary corporations, brother-sister groups, and certain insurance companies. A. A controlled group of corporations is entitled to one $250,000 accumulated earnings tax credit. A controlled group also receives only one Section 179 expense deduction. B. The following tests are applied on the last day of the year. C. Parent-Subsidiary—The focus here is on corporate ownership. A parent-subsidiary controlled group exists if: 1. Stock possessing at least 80% of the voting power of all classes of stock entitled to vote, or at least 80% of the total value of shares of all classes of stock of each of the corporations, except the common parent, is owned by one or more of the other corporations, and 2. The common parent owns stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote, or at least 80% of the total value of shares of all classes of stock of at least one of the other corporations. D. Brother-Sister—The focus here is on individual ownership. A brother-sister controlled group exists if: 1. Two or more corporations are owned by five or fewer persons (individuals, estates, or trusts): a. Who have a common ownership of more than 50% of the total combined voting powers of all classes of stock entitled to vote, or more than 50% of the total value of shares of all classes of stock of each corporation, and b. Who possess stock representing at least 80% of the total combined voting power of all classes of stock entitled to vote, or at least 80% of the total value of shares of all classes of each corporation. c. The 80% test does not apply for determining brother-sister corporations in some circumstances, such as limiting the accumulated earnings credit. A and C are an affiliated group because A owns at least 80% of C and A is the parent company. B and D may not file a consolidated return because S corporations are not eligible to be in an affiliated group. By definition, members of an affiliated group are eligible to elect to file a consolidated tax return. In general, an affiliated group contains a parent corporation and other corporations that are owned at least 80% by other members of the affiliated group. Correct! When filing a consolidated return, the intercompany dividends between the parent and its subsidiaries are not taxable. To be permitted to file a consolidated return, the parent and its subsidiaries must be members of an affiliated group. Corporations qualify as members of an affiliated group by having a common parent that directly owns at least 80% of the total voting stock and at least 80% of the total value of the stock in at least one other includible corporation. In addition, a minimum of one of the other includible corporations must own at least 80% in each of the remaining includible corporations. The primary advantages of filing a consolidated return are that: (1) intercompany dividends are excludable from taxable income; (2) losses of one affiliated member offset gains of another member; and (3) intercompany profits are deferred until realized. Hence, the dividends are fully deductible and this response is, therefore, correct. The primary advantages of filing a consolidated return are that:(1) losses of one affiliated member offset gains of another member;(2) intercompany dividends are excludable from taxable income; and(3) intercompany profits are deferred until realized. Since this response indicates that the operating losses of one group member may be used to offset operating profits of the other members, it is correct.

Tax Planning Strategies for Business Entities

Tax Planning for Charitable Contributions A. Contributions of Inventory 1. A corporation's contribution of inventory or depreciables or real property used in its trade or business to charities that use the property in a manner related to the exempt purpose and solely for the care of the ill, needy, or infants, or where the property is used for research purposes under specified conditions, is subject to special rules. 2. The deduction is the lower of:AB of property + 50% × (FMV − AB), or 2 × AB 3. This rule applies for contributions of "wholesome" food inventory by corporations and other businesses to charities that use the food in an appropriate manner. These contributions can also be deducted up to 15% (25% in 2020 and 2021) of taxable income (instead of the regular 10% limit). Note that this rule applies to all businesses, not just corporations. B. The corporation can elect to deduct accrued contributions if the contributions are actually paid in the first three and a half months months following the year-end. Consideration of Nontax Factors in Tax Planning A. Tax effects should never be the only factors considered for a decision. B. Nontax factors must also be considered. C. It is possible that the alternative with the best tax outcome increases costs in other areas for the company. D. The goal is to maximize after-tax income, not minimize taxes. Other Tax Planning Strategies A. Consider hiring children as employees as their wages will be taxed at a lower tax rate. Make sure that compensation is reasonable. B. When forming a business entity, make sure that the rules are met to defer gains and losses. C. For partnerships, increase basis in partnership interest with partnership debt so that additional losses can be used by partners on their tax returns. D. For regular corporation, use tax-free fringe benefits to maximize benefits to employees/owners and their family members. E. Note that since the corporate tax rate is now a flat rate of 21%, there are no tax potential savings from shifting income among related entities.