Tax 2 Study guide
Describe the tax impact of non-liquidating distributions to shareholders.
1. The amount of a distribution equals cash received plus the FMV of any noncash property received reduced by any liabilities assumed or acquired by the shareholder. 2. The distribution is treated as a dividend to the extent of the distributing corporation's current and accumulated E&P. Any distribution amount exceeding E&P is treated as a return of capital that reduces the shareholder's stock basis (but not below zero). Any additional excess is treated as a capital gain. 3. The shareholder's basis in the property received is its FMV. 4. The shareholder's holding period for the property begins on the day after the distribution date.
Taxable income
=cap gain -exemption
Distribution ded
=taxable income -trustees fee
Chapter 11 - Explain the tax advantages and disadvantages of an S corporation.
A number of advantages are available to a corporation that makes an S election. ▶ The corporation's income is exempt from the corporate income tax. An S corporation's income is taxed only to its shareholders, whose tax bracket may be lower than a C corporation's tax bracket. ▶ The corporation's losses pass through to its shareholders and can be used to reduce the taxes owed on other types of income. This feature can be especially important for new businesses. The corporation can make an S election, pass through the start-up losses to the owners, and terminate the election once a C corporation becomes advantageous. ▶ Undistributed income taxed to the shareholder is not taxed again when subsequently distributed unless the distribution exceeds the shareholder's basis for his or her stock. ▶ Capital gains, dividends, and tax-exempt income are separately stated and retain their character when passed through to the shareholders. Such amounts become commingled with other corporate ear
Chapter 11 - Explain the tax advantages and disadvantages of an S corporation.
A number of tax disadvantages also exist for a corporation that makes an S election. ▶ A C corporation is treated as a separate tax entity from its shareholders, thereby permitting its first $50,000 of income to be taxed at a 15% marginal rate instead of the shareholder's marginal rate. ▶ The S corporation's earnings are taxed to the shareholders even though they are not distributed. This treatment may require the corporation to make distributions or salary payments so the shareholder can pay taxes owed on the S corporation's earnings. ▶ S corporations are subject to an excess net passive income tax and a built-in gains tax. Partnerships are not subject to either of these taxes. ▶ Dividends received by the S corporation are not eligible for the dividends-received deduction, as is the case for a C corporation. ▶ Allocation of ordinary income or loss and the separately stated items is based on the stock owned on each day of the tax year. Special allocations of particular items
Analyze a corporation to determine if it is a personal holding company.
A personal holding company is any corporation that (1) has five or fewer individual shareholders who own more than 50% of the corporation's outstanding stock at any time during the last half of its tax year and (2) has personal holding company income that is at least 60% of its adjusted ordinary gross income for the tax year. Personal holding company income includes dividends, interest, annuities, adjusted income from rents, royalties, produced film rents, income from personal service contracts involving a 25% or more shareholder, rental income from corporate property used by a 25% or more shareholder, and distributions from estates or trusts. PHCI is determined according to the following general rules: ▶ Dividends: Includes only distributions out of E&P. Any amounts that are tax exempt (e.g., return of capital distributions) or eligible for capital gain treatment (e.g., liquidating distributions) are excluded from PHCI.32 ▶ Interest income: Includes interest included in gross inc
Describe tax planning strategies that are associated with AMT and PHC.
AMT • Personal property generally is depreciated using the 200% declining balance method for regular tax purposes but using the 150% declining balance method for AMT purposes. For regular tax purposes, a taxpayer can elect to use the same depreciation method used for AMT purposes.75 Such an election can reduce a taxpayer's AMT compliance burden by eliminating the need to keep an additional set of depreciation records to determine the AMT depreciation adjustment, as well as the AMT adjustment that arises when the taxpayer sells depreciable property. This election usually will reduce a taxpayer's AMT but also increase its regular tax. The reduced AMT and increased regular tax often will exactly offset each other. • A corporation pays any AMT in addition to its regular tax, which increases its current tax liability. However, its AMT also generates the same amount of minimum tax credit, which can reduce its future regular tax liabilities. A corporation's tax planning with respect to th
Tax Advantages and Disadvantages of Using Equity in a Corporation's Capital Structure
Advantages: 1. A 70%, 80%, or 100% dividends-received deduction is available to a corporate shareholder who receives dividends. A similar deduction is not available for the receipt of interest (see Chapter C:3). 2. A shareholder can receive common and preferred stock in a tax-free corporate formation under Sec. 351 or a nontaxable reorganization under Sec. 368 without recognizing gain (see Chapters C:2 and C:7, respectively). Receipt of debt securities in each of these two types of transactions generally results in the shareholder's recognizing gain. 3. Common and preferred stock can be distributed tax-free to the corporation's shareholders as a stock dividend. Some common and preferred stock distributions, however, may be taxable as dividends under Sec. 305(b). Distributions of debt obligations generally are taxable as a dividend (see Chapter C:4). 4. Under Sec. 1244, common or preferred stock that the shareholder sells or exchanges or that becomes worthless is eligible for ordinary l
Tax Advantages and Disadvantages of Using Debt in a Corporation's Capital Structure
Advantages: 1. A corporation can deduct interest paid on a debt obligation. 2. Shareholders do not recognize income in a debt retirement as they would in a stock redemption. Disadvantages: 1. If at the time the corporation is formed or later when a shareholder makes a capital contribution, the shareholder receives a debt instrument in exchange for property, the debt is treated as boot, and the shareholder recognizes gain to the extent of the lesser of the boot's FMV or the realized gain. 2. If debt becomes worthless or is sold at less than its face value, the loss generally is a nonbusiness bad debt (treated as a short-term capital loss) or a capital loss. Section 1244 ordinary loss treatment applies only to stock (see pages C:2-32 and C:2-33).
Describe the taxation of shareholders of S corporations.
An S corporation's shareholders must report their pro rata share of the ordinary income or loss and separately stated items for the S corporation's tax year that ends with or within the shareholder's tax year.37 Each shareholder's pro rata share of these items is determined by 1. Allocating an equal portion to each day in the tax year (by dividing the amount of the item by the number of days in the S corporation's tax year) 2. Allocating an equal portion of the daily amount to each share of stock outstanding on each day (by dividing the daily amount for the item by the number of shares of stock outstanding on a particular day) 3. Totaling the daily allocations for each share of stock 4. Totaling the amounts allocated for each share of stock held by the shareholder
Determine the tax treatment for stock dividends and stock rights.
DISTRIBUTING CORPORATION: 1. The distributing corporation recognizes no gain or loss on the stock dividend, whether it is nontaxable or taxable. 2. If the stock dividend is nontaxable, the distributing corporation does not reduce its E&P. 3. If the stock dividend is taxable, the distributing corporation reduces its E&P to the extent the distribution is treated as a taxable dividend.
Determine the tax treatment for stock redemptions.
DISTRIBUTING CORPORATION: Gain/Loss Recognition: Under either the general rule or sale exception, the corporation recognizes gain (but not loss) as though it had sold distributed noncash property for its FMV immediately before the redemption. Earnings and Profits Adjustment: For a redemption treated as a dividend, E&P is reduced in the same manner as for a regular dividend (e.g., by the amount of any money or the FMV of any property distributed). For a redemption treated as a sale, E&P is reduced by the portion of current and accumulated E&P attributable to the redeemed stock. Any distribution amount exceeding this portion reduces the corporation's paid-in capital.
Describe the tax treatment of ordinary income and separately stated items on a partnership return.
Each partner must report his or her distributive share of partnership income. However, Sec. 702, related Treasury Regulations, and tax return instructions require that certain items be separately stated at the partnership level so their character can remain intact at the partner reporting level. For example, the following items must be separately stated: ▶ Net short-term capital gains and losses ▶ Net long-term capital gains and losses ▶ Sec. 1231 gains and losses ▶ Unrecaptured Sec. 1250 gains ▶ Sec. 179 expense ▶ Charitable contributions ▶ Dividends and interest income ▶ Taxes paid or accrued to a foreign country or to a U.S. possession ▶ Tax-exempt or partially tax-exempt interest ▶ Investment income and expenses ▶ Any items subject to special allocations (discussed below) ▶ Any other item provided by Treasury Regulations and tax form instructions As a general rule, an item must be separately stated if the income tax liability of any partner that would result
Define an estate.
Estates originate only upon the death of the person whose assets are being administered. The estate continues in existence until the executor2 (i.e., the person(s) named in the will to manage the property and distribute the assets) or administrator (where the decedent died without a will) completes his or her duties. An executor's or administrator's duties include collecting the assets, paying the debts and taxes, and distributing the property. The time needed to perform the duties may vary from a year or two to over a decade, depending on many factors (e.g., whether anyone contests the will). Because the estate is a separate tax entity, continuing the estate's existence results in an additional personal exemption and achieves having some income taxed to yet another taxpayer, but the estate's income tax rates are very compressed. Nevertheless, the decedent's survivors sometimes can reduce their personal income taxes by preserving the estate's existence as a separate taxpayer. Treasury
Explain the rules that must be followed for corporate liquidations.
GENERAL CORPORATE LIQUIDATION RULES 1. The shareholder's recognized gain or loss equals the amount of cash plus the FMV of the other property received minus the adjusted basis of stock surrendered. Corporate liabilities assumed or acquired by the shareholder reduce the amount realized. 2. The gain or loss is capital if the stock investment is a capital asset. If the shareholder recognizes a loss on the liquidation, Sec. 1244 permits ordinary loss treatment (within limits) for qualifying individual shareholders. 3. The adjusted basis of the property received is its FMV on the distribution date. 4. The shareholder's holding period for the property begins the day after the distribution date. 5. With certain limited exceptions, the distributing corporation recognizes gain or loss when making the distribution. The amount and character of the gain or loss are determined as if the corporation sold the property for its FMV immediately before the distribution. Special rules apply when the share
Chapter 14 - Describe trusts, including inter vivos trusts and testamentary trusts
Often a very wealthy person (one concerned with gift and/or estate taxes) will create trusts for tax and/or other reasons (e.g., conserving assets). A person may create a trust at any point in time by transferring property to the trust. A trustee (named by the transferor) administers the trust property for the benefit of the beneficiary. The trustee may be either an individual or an institution, such as a bank, and there can be more than one trustee. If the transfer occurs during the transferor's lifetime, the trust is called an inter vivos trust, meaning among the living. The transferor is known as the grantor or the trustor. A trust created under the direction of a decedent's will is called a testamentary trust and contains assets formerly held by the decedent's estate. A trust may continue to exist for whatever time the trust instrument or the will specifies, subject to the constraints of the Rule Against Perpetuities.
Describe the tax treatment of ordinary income and separately stated items on an S corporation return.
S corporations are treated much like partnerships and thus report both an ordinary income or loss amount and a series of separately stated items. Ordinary income or loss is the net of income and deductions other than the separately stated items described in the next paragraph. The S corporation's separately stated items are the same ones that apply in partnership taxation under Sec. 702(a), related Treasury Regulations, and tax return instructions.28 For example, the following items must be separately stated: ▶ Net short-term capital gains and losses ▶ Net long-term capital gains and losses ▶ Sec. 1231 gains and losses ▶ Unrecaptured Sec. 1250 gains ▶ Sec. 179 expense ▶ Charitable contributions ▶ Dividends and interest income29 ▶ Taxes paid or accrued to a foreign country or to a U.S. possession ▶ Tax-exempt or partially tax-exempt interest ▶ Investment income and expenses ▶ Any other item provided by Treasury Regulations and tax form instructions Section 1366(b)
Determine the tax treatment for stock dividends and stock rights.
SHAREHOLDERS: 1. A stock dividend is nontaxable except where (1) a shareholder can elect to receive other property in lieu of the stock dividend; (2) some shareholders receive property and other shareholders increase their proportionate equity interest; (3) some common shareholders receive preferred and others receive common stock; (4) the underlying stock is preferred stock, unless the conversion ratio, if any, is adjusted to account for a common stock split or dividend; or (5) the distributed stock is convertible preferred, and the distribution has a disproportionate effect. 2. If the stock dividend meets one of the exceptions to nontaxable treatment, the stock dividend is treated as a property distribution under Sec. 301, where the FMV of the distribution is a taxable dividend to the extent of the distributing corporation's E&P. 3. If the stock dividend is nontaxable, (1) the basis of the underlying stock (old shares) is allocated among the old and new shares according to relative F
Determine the tax treatment for stock redemptions.
SHAREHOLDERS: General Rule: The distribution amount received by a shareholder in exchange for his or her stock is treated as a dividend to the extent of the distributing corporation's E&P. The basis of the surrendered stock is added to the basis of the shareholder's remaining stock. Sale Exception: If the redemption meets specific requirements, the distribution amount received by the shareholder is offset by the adjusted basis of the shares surrendered. The difference generally is treated as a capital gain or loss. No basis adjustment occurs.
Explain the process of establishing a tax year for a partnership.
Section 706 requires that a partnership select the highest ranked tax year-end from the ranking that follows: 1. The tax year-end used by the partners who own a majority interest in the partnership capital and profits. 2. The tax year-end used by all principal partners (i.e., partners who each owns an interest in at least 5% of the partnership capital or profits). 3. The tax year-end determined by the least aggregate deferral test. The IRS may grant permission for the partnership to use a fiscal year-end if the partnership has a natural business year. If the partnership does not have a natural business year, it must either ▶ Use the tax year-end required by Sec. 706 or ▶ Elect a fiscal year-end under Sec. 444 and make a required payment that approximates the tax due on the deferred income.
Describe the process for requesting a private letter ruling.
The IRS charges a user fee for issuing a ruling. All ruling requests must contain a statement of all the relevant facts, including the following: ▶ Names, addresses, telephone numbers, and taxpayer identification numbers of all interested parties ▶ The taxpayer's annual accounting period and method ▶ A description of the taxpayer's business operations ▶ A complete statement of the business reasons for the transaction ▶ A detailed description of the transaction • The taxpayer also should submit copies of the contracts, agreements, deeds, wills, instruments, and other documents that pertain to the transaction. The taxpayer must provide an explicit statement of all the relevant facts and not merely incorporate by reference language from the documents. The taxpayer also should indicate what confidential data should be deleted from the ruling before its release to the public. • If the taxpayer takes a position, he or she must disclose the basis for this position and the author
Scorp passive income
The S corporation can earn an unlimited amount of passive income each year without incurring any penalty provided it has no E&P accumulated in a C corporation tax year (known as Subchapter C E&P) at the end of its tax year. Thus, a corporation can make an S election to avoid the personal holding company tax that otherwise might apply to a C corporation's passive income.
DNI
taxable income exclusive of distribution ded +personal exemption -cap gains +taxfree income
Describe the tax treatment of partnership income.
• A partnership is not a taxpaying entity, and income earned by a partnership is not subject to two layers of federal income taxes. Instead, each partner reports a share of the partnership's income, gain, loss, deduction, and credit items in his or her income tax return. The partnership, however, must file Form 1065 (U.S. Partnership Return of Income), an information return that provides the IRS with information about partnership earnings as well as how the earnings are allocated among the partners. The partnership must elect a tax year and accounting methods to calculate its earnings. • A partner's basis in his or her partnership interest is a crucial element in partnership taxation. When a partner makes a contribution to a partnership or purchases a partnership interest, he or she establishes a beginning basis. Because partners can be personally liable for partnership debts, a partner's basis in his or her partnership interest is increased by his or her share of any partnership l
Explain the criteria that make a corporation liable for alternative minimum tax.
• A qualifying small corporation is exempt from the AMT. To qualify, the corporation's average gross receipts generally must be $7.5 million or less for all three-taxable-year periods before the taxable year for which the corporation is determining qualification. • Additional rules determine whether a corporation is exempt from the AMT: ▶ Gross receipts include total sales and amounts received for services. Gross receipts are not reduced for cost of goods sold and expenses. Gross receipts differ from gross income, gross profit, and taxable income. Thus, even though a corporation may have low gross profit or taxable income, it still may not qualify for exemption if it has high gross receipts. ▶ For any short taxable year (e.g., a corporation's initial year of existence), gross receipts are annualized. ▶ Gross receipts of a controlled group of corporations are aggregated. For example, if two corporations each have $4 million of average gross receipts and comprise a controlled g
Chapter 15 - Identify the steps of the auditing process.
• Generally, the first step in the audit process is a meeting between the IRS agent and the taxpayer or the taxpayer's advisor. • Should the taxpayer agree after this meeting and the agent's supervisor concur in the amount owed, the taxpayer must sign Form 870. (If the taxpayer agrees that he or she owes additional tax and pays the tax upon signing the Form 870 waiver, interest accrues on the tax deficiency from the due date of the return through the payment date. Interest also ceases to accrue 30 days after the taxpayer signs the Form 870 waiver but begins to accrue again when the IRS issues a notice and demand for payment. However, the IRS charges no additional interest if the taxpayer pays the tax due within 21 days of the notice and demand (ten days for $100,000 or more).THE END • If the taxpayer does not sign the Form 870 waiver, the IRS will send the taxpayer a 30-day letter, detailing the proposed changes in the tax-payer's liability and advising the taxpayer of his or her
Describe the tax consequences to a partnership of property or service contributions.
• In most cases, a partner who contributes property in exchange for a partnership interest recognizes no gain or loss on the transaction. Likewise, the partnership recognizes no gain or loss on the contribution of property. The partner's basis for his or her partnership interest and the partnership's basis for the property are both the same as basis of the property transferred.5 Nonrecognition treatment is limited to transactions in which a partner receives a partnership interest in exchange for a contribution of property. As in the corporate formation area, the term property includes cash, tangible property (e.g., buildings and land), and intangible property (e.g., franchise rights, trademarks, and leases).6 Services are specifically excluded from the definition of property, so a contribution of services for a partnership interest is a taxable transaction. • Three exceptions to this general rule may require a partner to recognize a gain upon the contribution of property to a partn
List the due dates for tax returns and tax payments (including extensions).
• Returns for individuals, fiduciaries, and partnerships are due on or before the fifteenth day of the fourth month following the year-end of the individual or entity.31 C corporation and S corporation tax returns are due no later than the fifteenth day of the third month after the corporation's year-end. • Unless the taxpayer is abroad, the extension period cannot exceed six months. • By filing Form 4868, an individual taxpayer may request an automatic six-month extension of time to file the tax return. The extension is automatic in the sense that the taxpayer need not convince the IRS that an extension is necessary. • Corporations request an automatic extension by filing Form 7004 by the original due date for the return. Although the IRC specifies an automatic extension period of three months, Treasury Regulations and the Form 7004 instructions specify six months. • The granting of an extension merely postpones the due date for filing the return. It does not extend the due
Describe the tax treatment for accumulated earnings.
• Section 532(a) states that the accumulated earnings tax applies "to every corporation . . . formed or availed of for the purpose of avoiding the income tax with respect to its shareholders . . . by permitting earnings and profits to accumulate instead of being divided or distributed." Certain corporate forms are excluded from the accumulated earnings tax, including the following: ▶ Personal holding companies ▶ Corporations exempt from tax under Secs. 501 through 530 ▶ S corporations • The Treasury Regulations and the courts have identified several circumstances for which accumulations of earnings are likely to be for reasonable needs:61 ▶ Expansion of business or replacement of plant. ▶ Acquiring a business enterprise. This activity might involve extending the corporation's current business or expanding into a new business, and it could occur through purchasing the stock or the assets of the enterprise conducting the acquired business. The corporation should be careful
Identify the items that must be reconciled in the schedules M-2 and M-3.
• The left side of Schedule M-1 contains items the corporation adds back to book income. These items include the following categories: ▶ Federal income tax expense (per books) ▶ Excess of capital losses over capital gains ▶ Income subject to tax but not recorded on the books in the current year ▶ Expenses recorded on the books but not deductible for tax purposes in the current year • The right side of the schedule contains items the corporation deducts from book income. These items include the following categories: ▶ Income recorded on the books in the current year that is not taxable in the current year ▶ Deductions or losses claimed in the tax return that do not reduce book income in the current year These categorizations, however, do not distinguish between permanent and temporary differences as does Schedule M-3 discussed below. Schedule M-3 requires extensive detail in its reconciliation. Moreover, the schedule has the corporation distinguish between its permanent
Explain when the statute of limitations applies for tax returns.
• Under the general rule of Sec. 6501(a), the limitations period is three years after the date on which the return is filed, regardless of whether the return is timely filed. A return filed before its due date is treated as filed on the due date. • Income Tax Returns. In the case of substantial omissions, the limitations period is six years after the later of the date the return is filed or the return's due date. For income tax purposes, the six-year period is applicable if the taxpayer omits from gross income an amount exceeding 25% of the gross income shown on the return. Note that the six-year rule applies only to omitted income. Thus, claiming excessive deductions will not result in a six-year limitations period. • No limitations period exists if the taxpayer does not file a return. Thus, the government may assess the tax or initiate a court proceeding for collection at any time. • If the government successfully proves that a taxpayer filed a false or fraudulent return "wit
Chapter 9 - Describe the types of partnerships.
• With the advent of LLCs, businesses have the opportunity to be treated as a partnership for tax purposes while having limited liability protection for every owner. State law provides this limited liability. Unique tax rules for LLCs have not been developed. Instead, the check-the-box regulations (discussed in Chapter C:2) permit each LLC to choose whether to be treated as a partnership or taxed as a corporation. If an LLC is considered a partnership for tax purposes, the same tax rules apply to the LLC that apply to a traditional partnership.
Identify which events trigger the termination of an S corporation.
▶ Exceeding the 100-shareholder limit ▶ Having an ineligible shareholder own some of the stock ▶ Creating a second class of stock ▶ Attaining a prohibited tax status ▶ Selecting an improper tax year ▶ Failing the passive investment income test for three consecutive years
A corporation must use the accrual method unless it qualifies under one of the following exceptions (pretest):
▶ It qualifies as a family farming corporation.11 ▶ It qualifies as a personal service corporation, which is a corporation substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and substantially all of whose stock is held by current (or retired) employees performing the services listed above, their estates, or (for two years only) persons who inherited their stock from such employees.12 ▶ It meets a $5 million gross receipts test for all prior tax years beginning after December 31, 1985. A corporation meets this test for any prior tax year if its average gross receipts for the three-year period ending with that prior tax year do not exceed $5 million. If the corporation was not in existence for the entire three-year period, the period during which the corporation was in existence may be used. ▶ It has elected S corporation status.
Describe the requirements for being eligible to elect S corporation status.
▶ The corporation must not have more than 100 shareholders. • members of a family (and their estates) count as one shareholder ▶ All shareholders must be individuals, estates, certain tax-exempt organizations, or certain kinds of trusts. • C corporations and partnerships cannot own S corporation stock. • Seven types of trusts can own S corporation stock: grantor trusts, voting trusts,4 testamentary trusts, qualified Subchapter S trusts (QSSTs),5 qualified retirement plan trusts, small business trusts, and beneficiary-controlled trusts • Small business trusts can own S corporation stock. • A testamentary trust (i.e., a trust created under the terms of a will) that receives S corporation stock can hold the stock and continue to be an eligible shareholder for a two-year period, beginning on the date the stock transfers to the trust. ▶ None of the individual shareholders can be classified as a nonresident alien. • Individuals who are not U.S. citizens (i.e., alien indivi
