chapter 2testbank360.eu/sample/solution-manual-west-federal-taxation-31st... · *5 corporate versus...

CHAPTER 2

CORPORATIONS: INTRODUCTION AND OPERATING RULES

SOLUTIONS TO PROBLEM MATERIALS

Question/Problem Topic

Status:PresentEdition

Q/P inPriorEdition

1 Tax and nontax factors in entity selection Unchanged 12 Partnership capital gain and withdrawals Unchanged 23 Corporation versus proprietorship Unchanged 34 Corporate tax versus partnership tax Unchanged 4*5 Corporate versus individual taxation Unchanged 56 Expenses to avoid double taxation Unchanged 67 Unreasonable compensation New8 Taxation of dividends and salary Unchanged 89 Check-the-box rules New

10 Benefits of LLC Unchanged 1011 Fiscal year election for corporation Unchanged 1112 Accrual method of accounting limitations New13 Accrual method required Unchanged 1314 Capital loss treatment of corporation and

individualUnchanged 14

*15 Capital gain treatment for corporations,individuals, and LLC

Unchanged 15

16 LTCL of individuals and corporations Unchanged 1617 Passive loss rules: closely held C corporations

and PSCs contrastedNew

18 Passive loss deduction for closely heldcorporation and personal service corporation

Unchanged 18

19 Tax treatment of charitable contributions forcorporate and noncorporate taxpayers

Unchanged 19

20 Production activities deduction Unchanged 2021 NOL, dividends, LTCL issues New22 Dividends received deduction Unchanged 2223 Organizational expenditures New24 Start-up expenditures Modified 2425 Tax liability of related corporations Unchanged 2526 Differences between taxable income and

accounting incomeUnchanged 27

2-1

Full file at http://testbank360.eu/solution-manual-west-federal-taxation-31st-hoffman

Question/Problem Topic


Q/P inPriorEdition

27 Schedule M-3 Unchanged 2828 Schedule M-3 New29 Compare LTCL treatment for corporations and

for proprietorshipsUnchanged 29

30 Tax treatment of income and distributions frompartnership, S and C corporations

New

31 Corporation net income taxation, cash distribu-tion to owner versus proprietorship with cashdistribution, new rules on dividend taxation

Unchanged 31

32 Taxation of corporation versus proprietorship Unchanged 32*33 Taxation of corporation versus proprietorship New34 Comparison of deduction for casualty loss for

individual and corporate taxpayersNew

*35 Tax liability determination as proprietorship orcorporation

Unchanged 35

36 Salary requirements for use of fiscal year bypersonal service corporation

New

37 Capital loss of corporation New38 Salary deduction under cash and accrual

accountingUnchanged 38

39 Comparison of treatment of capital losses forindividual and corporate taxpayers

Unchanged 39

40 Capital gains and losses of a corporation;carryback/carryover

New

41 Passive loss of closely held corporation; PSC Unchanged 4142 Charitable contributions of corporation

compared with individual taxpayerUnchanged 42

43 Corporate charitable contribution Unchanged 4344 Charitable contributions of corporation;

carryoverNew

45 Timing of charitable contributions deduction ofaccrual basis corporation

Unchanged 45

46 Production activities deduction Modified 46*47 Dividends received deduction New*48 Dividends received deduction Unchanged 4849 Organizational expenses Unchanged 49*50 Organizational expenses Unchanged 50*51 Determine corporate income tax liability Modified 5152 Filing requirements for Form 1120-A Unchanged 52*53 Schedule M-1, Form 1120 Modified 5354 Schedule M-1, Form 1120 Unchanged 5455 Schedule M-3, Form 1120 Unchanged 5556 Schedule M-3, Form 1120 Unchanged 5657 Schedule M-3, Form 1120 Unchanged 5758 Schedule M-3, Form 1120 Unchanged 5859 Tax issues involved in starting a new business

in the corporate formUnchanged 59

2-2 2008 Corporations Volume/Solutions Manual


Tax ReturnProblems Topic


Q/P inPriorEdition

1 Corporation income tax (Form 1120) Modified 12 Corporation income tax (Form 1120) Modified 2

ResearchProblem

1 Dividends received deduction New2 Charitable contribution deduction Unchanged 23 Expenditures incurred on behalf of

corporationNew

4 Internet activity Unchanged 45 Internet activity Unchanged 5

*The solution to this problem is available on a transparency master.

Corporations: Introduction and Operating Rules 2-3


CHECK FIGURES

29.a. Andrew will report profit $20,000and capital loss $5,000.

29.b. Andrew’s income is not increased.30.a. Each partner reports $100,000 net

profit and LTCG of $30,000.30.b. Same as a.30.c. Corporation reports $260,000

income. Shareholder reports$40,000 dividend income.

32.a. Losses not passed through toshareholder.

32.b. Deduct $153,000.33.a. After-tax income $94,739.25.33.b. After-tax income $77,770.33.c. After-tax income $73,103.25.34.a. $50,900.34.b. $67,500.35.a. $36,050.35.b. $29,450.35.c. $23,420.35.d. $33,658.36.a. $75,000.36.b. $52,500.37.a. $75,000.37.b. $93,000.38. $65,000 for Hugh, $60,000 for

Sam.39.a. $8,000 deducted 2007; $7,000

carried forward to 2008.39.b. $5,000 deducted 2007; $10,000 car-

ried back to 2004, then 2005, etc.40.a. Offset short-term capital gain of

$90,000 against net long-term capitalloss of $570,000. The $480,000 netlong-term loss is carried back 3 yearsand forward 5 years.

40.b. Total carryback $420,000.40.c. $60,000; carry forward 2008, etc.40.d. $477,000 carried forward indefi-

nitely.41. Offset $45,000 of passive loss

against active income. No offset ifa PSC.

42.a. $12,000.42.b. $12,500.44.a. $38,700.44.b. Excess $9,300 carried forward.45. 2007.46.a. $36,000.46.b. $37,500.47.a. $54,000.47.b. ($12,000).48. Green $35,000; Orange $210,000;

Yellow $224,000.49.a. $5,072.49.b. $5,092.49.c. $5,072.49.d. $5,092.50. $5,566.51. Purple $7,200; Azul $108,050;

Pink $113,900; Turquoise$2,278,000; Teal $7,910,000.

52. Jay no; Shrike no; Martin yes.53. $120,000.54. $100,000.



DISCUSSION QUESTIONS

1. You should ask questions that will enable you to assess both tax and nontax factors thatwill affect the entity choice. Some relevant questions are addressed in the following table,although there are many additional possibilities.

Question Reason for the question

What type of business are you going tooperate?

This question will provide information thatmay affect the need for limited liability,ability to raise capital, ease of transferringinterests in the business, how long thebusiness will continue, and how thebusiness will be managed.

What amount and type of income (loss) doyou expect from the business?

Income from a business will eventually bereported on the tax returns of the owners.

What is the amount and type of income(loss) that you expect from other sources?

For example, income (loss) from apartnership, S corporation, or LLC will‘‘flow through’’ to the owners. Dividendsfrom a C corporation must be reportedon the tax returns of the shareholders.Any income (loss) from other sourceswill also be reported on the returns ofthe owners. Thus, for planning purposes,it is important to know all sources andtypes of income (loss) that the ownerswill have.

Do you expect to have losses in the earlyyears of the business?

Losses of partnerships, S corporations,and LLCs flow through to the ownersand represent potential deductions ontheir individual returns. Losses of a Ccorporation do not flow through.

Will you withdraw profits from thebusiness or leave them in the business so itcan grow?

Profits from a partnership, S corporation,or LLC will ‘‘flow through’’ to the owners,and will be subject to taxation on theirindividual tax returns. Profits of a Ccorporation must be reported on the taxreturns of the shareholders only if suchprofits are paid out to shareholdersas dividends. Thus, in the case of apartnership, S corporation, or LLC,owners must pay tax on profits beforeplowing funds back into the business.In the case of a C corporation, thecorporation must pay tax on its profits.

pp. 2-2 to 2-7

2. George must report $75,000 income on his tax return, and Mike is not required to reportincome from the corporation on his tax return. Proprietorship profits flow through to theowner and are reported on the owner’s individual income tax return. Shareholders arerequired to report income from a corporation only to the extent of dividends received. Mikedid not receive a dividend. pp. 2-2 and 2-4



3. Art should consider operating the business as a sole proprietorship for the first three years.If he works 15 hours per week in the business, he will exceed the minimum number ofhours required to be a material participant (52 � 15 = 780). Therefore, he will be able todeduct the losses against his other income. When the business becomes profitable, Artshould consider incorporating. If he reinvests the profits in the business, the value of thestock should grow accordingly, and he should be able to sell his stock in the corporation forlong-term capital gain. pp. 2-2 to 2-4

4. Losses of sole proprietorships are passed through to their owners, but losses (operating orcapital) of regular corporations are not. Capital losses of sole proprietorships retain theircharacter when reported by the proprietor.

The capital loss of the sole proprietorship is passed through to Lucille, and she is allowedto report it on her tax return as a capital loss. She can offset the loss against capital gainsor deduct it against ordinary income (up to $3,000) if she has no capital gains for the year.The capital loss of Mabel’s corporation is reported on the tax return of the corporation,which is a separate taxable entity. It has no effect on her taxable income.

The operating loss is passed through to Lucille, and she is allowed to deduct it on her taxreturn (subject to at-risk and passive loss limitations). The operating loss of the corporationhas no effect on Mabel’s tax return.

pp. 2-2 to 2-4, 2-11 and 2-12

5. Conner should report the information on his individual tax return as follows:

If SE is Conner should report

a. A proprietorship $90,000 profit on Schedule C, $3,000 capital losson Schedule D (with a $9,000 carryover). The$45,000 withdrawal would have no impact onConner’s individual tax return.

b. A C corporation $45,000 dividend (profit withdrawn from SE).Neither the $90,000 profit nor the $12,000 capitalloss would flow through.

c. An S corporation $90,000 profit and $12,000 capital loss would flowthrough from SE to Conner and be reported on hisindividual tax return. The capital loss would becombined with any personal capital gains (losses),and would be subject to the $3,000 limit. The$45,000 withdrawal would have no impact onConner’s individual tax return.

6. If Tanesha buys the warehouse and rents it to the corporation, she can charge thecorporation the highest amount of rent that is reasonable. The rental operation can helpher to bail some profits out of the corporation and avoid double taxation on corporateincome. The depreciation and other expenses incurred in connection with the warehousewill be deductible by Tanesha, which should enable her to offset some or all of the rentalincome. If the rental property produces a loss, Tanesha can use the loss to offset any pas-sive income she might have. If Tanesha has the corporation buy the warehouse, the reve-nue and expenses related to the building will be included in the computation of corporateincome. If there is a profit, Tanesha can bail it out as a dividend, which will be taxed at a15% rate. pp. 2-5, 2-6, and 2-32



7. To the extent a salary paid to a shareholder-employee is considered reasonable, thecorporation is allowed a deduction. To the extent a salary payment is consideredunreasonable, the payment is treated as a dividend and is not allowed as a deduction.

a. Vivian reports the $400,000 as salary and pays tax on it at a marginal rate of 35%.The corporation has a $400,000 deduction.

b. Vivian reports the $400,000 as dividend income and pays tax on it at a marginalrate of 15%. The corporation is not allowed to deduct the $400,000 dividend.

c. Since the shareholder-employee is taxed on both salary ($300,000) and dividends($100,000), double taxation on $100,000 has occurred.

p. 2-5

8. Al will be subject to a 15% rate on the $20,000 that ABC pays him as a dividend, but ABCwill not be allowed to deduct the amount in computing corporate taxable income. Jay willreport the additional $20,000 that JKL pays him as salary and will be taxed at his marginalrate of 35%. JKL will be allowed to deduct the salary payment in computing corporatetaxable income. p. 2-5

9. The check-the-box rules permit a qualifying LLC to be taxed either as a partnership or as acorporation. The primary tax reason for choosing to operate as an LLC is to avoid thedouble taxation associated with C corporations. The primary nontax reason for operatingas an LLC is to avoid unlimited liability. pp. 2-7 and 2-8

10. The primary nontax advantage of an LLC is limited liability. The primary tax advantage isthat Erica can elect to have the LLC treated as a partnership rather than a corporation, thusavoiding the problem of double taxation associated with a C corporation. pp. 2-7 and 2-8

11. As owner-employees, Hank and Charlie offer services in the area of performing arts, so HCis a personal service corporation. HC appears to have a business year that ends on January31. Although a PSC is not normally allowed to adopt a fiscal year, HC should be able todemonstrate a business purpose for electing a January 31 fiscal year-end. Example 10

12. A corporation that uses the accrual method cannot claim a deduction for an expenseinvolving a related party until the recipient reports that amount as income. Jeong, a cashbasis taxpayer, must report the rent income in 2008, the year she receives the payment.The corporation may deduct the rent expense in 2008, the year Jeong is required to reportit as income. p. 2-10

13. Businesses that maintain inventory for sale to customers are required to use the accrualmethod of accounting for determining sales and cost of goods sold. Therefore, RoseCorporation would be required to use the accrual method, at least for transactionsinvolving inventory. p. 2-11

14. Kathy may use her $25,000 LTCL to offset any capital gains she has during the year. If shehas losses in excess of gains, she may deduct up to $3,000 of the losses as a deductionfor AGI, and any remaining losses may be carried forward indefinitely.

Eagle Corporation may use the capital loss to offset any capital gains realized during the year.Any excess losses may be carried back three years and forward five years. When carriedback or forward, a long-term capital loss is treated as a short-term loss. pp. 2-11 and 2-12



15. The reporting rules and applicable tax rates are summarized in the following table.

If Alpha is The gain would be reported The tax rate would be

a. A proprietorship By Janice on Sch. D, Form 1040 15%

b. An S corporation By Alpha on Form 1120S; flow-through to Janice on Schedule K-1

15%

c. A C corporation By Alpha on Form 1120 Applicable corporate taxrate

d. An LLC By Janice or Alpha—a onemember LLC can elect to be taxedas a sole proprietorship or as acorporation—see items a. and c.above

See items a. or c. above

16. John may deduct up to $3,000 of his net capital loss in computing taxable income for thecurrent year and may carry the remaining $4,000 forward for an indefinite period. He canuse the capital loss carryover to offset capital gains in the carryforward years, or he candeduct up to $3,000 per year from ordinary income if he has no capital gains. FoxCorporation cannot deduct any of the loss in the year incurred. However, Fox can carry theloss back three years and forward five years until the entire loss is offset against capitalgains in the carryback or carryforward years. Examples 13 and 14

17. a. If Osprey is a personal service corporation, it cannot deduct any of the passive loss.A personal service corporation cannot offset a passive loss against either active orportfolio income.

b. A closely held corporation that is not a personal service corporation can offsetpassive losses against active income but not against portfolio income. Therefore,Osprey can deduct $180,000 of the $270,000 passive loss.

p. 2-12

18. A closely held corporation that is not a personal service corporation can offset a passiveloss against active income, but not against portfolio income. Hummingbird can deduct only$30,000 of the $60,000 passive loss. Example 15

19. Individuals cannot deduct contributions until they are actually made. Therefore, Andreamust wait until 2008 to deduct the contribution. Aqua Corporation, whose board ofdirectors authorized the contribution in 2007, can deduct the contribution in 2007,assuming the pledge is paid on or before March 15, 2008. p. 2-12 and Example 16

20. Presumably the corporation qualified for the production activity deduction. The rate for thededuction, which is 3% for 2006, increases to 6% for 2007 through 2009. See Example 23and related discussion.

It is also possible that the controller expects the corporation’s tax rate to decrease in 2007,which would result in a lower corporate tax on the $200,000 income.

21. Finch Corporation must determine whether it had a net operating loss (NOL) in 2008. Inmaking this determination, consider the operating loss, the dividend received, and thedividends received deduction. The long-term capital loss (LTCL) is not allowed. However,Finch may carry the LTCL back to 2006 and 2007 to offset any capital gain in those years.



An NOL may be carried back two years and forward 20 years to offset taxable income. If Finchhas an NOL for 2008, it must decide whether to carry the NOL back to prior years or forward tofuture years. It should forgo the NOL carryback if tax rates in the two preceding years were lowand if higher rates are expected in the future. Before electing to forgo an NOL carryback,however, a corporation should be able to predict with confidence that future profits will be higher.

p. 2-33 and Example 37

22. Otter Corporation will be allowed to exclude 80% of its $240,000 dividend (subject topossible limitations described in Example 25). It will pay tax at the applicable corporate taxrate on the portion of the dividend not excluded. Gerald must include the entire $240,000dividend and will pay tax at the 15% rate applicable to individuals. Example 3

23. a. Expenditures that qualify for amortization include the following: legal services inci-dent to organization (such as costs of drafting the corporate charter, the bylaws,the minutes, and the terms of original stock certificates); necessary accountingservices; expenses of temporary directors and of organizational meetings of direc-tors or stockholders; and fees paid to the state of incorporation.

b. Expenditures that do not qualify are those connected with the issuing or selling ofshares of stock or other securities (e.g., commissions, professional fees, and print-ing costs) or with the transfer of assets to a corporation.

c. Amortization is over a period of 180 months or more. The period begins with themonth in which the corporation begins business. Amortization is conditioned on anelection. If an election is not made, organizational expenditures cannot bededucted until the corporation ceases to do business and liquidates. However, ifthe corporate charter limits the life of the corporation, the expenditures could beamortized over such life.

d. Expenses must be incurred before the end of the taxable year in which the corpora-tion begins business. Expenses paid by a cash basis corporation in a subsequentyear would still qualify. In this regard, the corporation’s method of accounting is ofno consequence.

e. The special election allows immediate expensing of the first $5,000 of qualifyingorganizational costs. The exception is phased out on a dollar-for-dollar basis whenorganizational costs exceed $50,000.

f. The election is made in a statement attached to the corporation’s return for its firsttaxable year. The return and statements must be filed no later than the due date ofthe return (including any extensions).

pp. 2-17, 2-18, and Example 26

24. Expenses incurred before any revenue is produced by a business are treated as start-upexpenditures under § 195. A taxpayer may elect to expense $5,000 of such expenses andamortize the balance over a period of 180 months or longer, rather than capitalize suchcosts permanently. Therefore, Teal can elect to deduct $5,000 in 2008 and amortize theremainder over 180 months. p. 2-18

25. George’s plan will not reduce corporate income taxes. Palmetto, Poplar, and Spruce wouldbe related corporations and would be subject to special rules for computing the corporateincome tax. Therefore, the total corporate tax liability would remain unchanged. Examples29 and 30 and related discussion



26. The starting point on Schedule M-1 is net income per books. Additions and subtractionsare entered for items that affect net income per books and taxable income differently. Anexample of an addition is Federal income tax expense, which is deducted in computing netincome per books but is disallowed in computing taxable income. An example of asubtraction is a charitable contributions carryover that was deducted for book purposes ina prior year but deducted in the current year for tax purposes.

ADDITIONS

b. Travel and entertainment expenses in excess of deductible limitsc. Book depreciation in excess of allowable tax depreciationd. Federal income tax per bookse. Charitable contributions in excess of deductible limitsf. Premiums paid on life insurance policy on key employeei. Interest incurred to carry tax-exempt bonds

SUBTRACTIONS

a. Charitable contributions carryover from previous yearg. Proceeds of life insurance paid on death of key employeeh. Tax-exempt interest


27. The government’s objectives were (1) to create greater transparency between corporatefinancial statements and tax returns, and (2) to identify corporations that engage inaggressive tax practices. p. 2-23

28. The ordinary income from Fox as well as the short-term capital gain and charitablecontributions flow through to Wolf. Wolf must report book income on its Schedule M-3. Itmust also calculate income per tax return (ordinary income + short-term capital gain �charitable contributions), and show the difference between book income and income pertax return as a permanent difference. See Example 34

PROBLEMS

29. a. Revenues, expenses, gains, and losses of a proprietorship flow through to the pro-prietor. Consequently, Andrew reports the $20,000 net profit and $5,000 capitalloss on his individual tax return.

b. Shareholders are required to report income from a corporation only to the extent ofdividends received. Therefore, Andrew does not report the net profit or capital losson his individual return.

pp. 2-2 and 2-4

30. a. Otter, a partnership, is not a taxpaying entity. Its profit (loss) and separate itemsflow through to the partners. The partnership’s Form 1065 reports net profit of$200,000 ($500,000 income � $300,000 expenses). The partnership also reportsthe $60,000 long-term capital gain as a separately stated item on Form 1065. Ellieand Linda each receive a Schedule K-1 reflecting net profit of $100,000 and sepa-rately stated long-term capital gain of $30,000, which each reports on her ownreturn. The withdrawals do not affect taxable income but decrease their basis in thepartnership. Example 2



b. Otter, an S corporation, is not a taxpaying entity. Its profit (loss) and separate itemsflow through to the shareholders. The S corporation’s Form 1120S reports net profitof $200,000 ($500,000 income � $300,000 expenses). The S corporation alsoshows the $60,000 long-term capital gain as a separately stated item on Form1120S. Ellie and Linda both receive a Schedule K-1 reporting net profit of $100,000and separately stated long-term capital gain of $30,000, which each reports on herown return. The withdrawals do not affect taxable income but decrease their basisin the S corporation. Example 2

c. Otter, a C corporation, is a taxpaying entity. Otter’s Form 1120 reports net operatingprofit of $200,000 ($500,000 income � $300,000 expenses) and the $60,000 long-term capital gain. Ellie and Linda report dividend income of $40,000 each. The divi-dend income is subject to a maximum tax rate of 15%. pp. 2-3 to 2-5, and Example 3

31. If Mesquite Company is a corporation, the $200,000 net profit is taxable at the corporate level,resulting in corporate tax of $61,250 [$22,250 + .39($200,000 � $100,000)]. Sheryl will paytax of $20,812.50 on the dividend income ($138,750 � 15%). Total taxes amount to$82,062.50 ($61,250 + $20,812.50). If Mesquite Company is a proprietorship, Sheryl mustpay tax of $70,000 ($200,000 � 35%). In the case of a corporation, FICA taxes would add tothe tax burden of the corporation and the individual. In the case of the proprietorship, theindividual would be subject to self-employment taxes. pp. 2-2 to 2-5 and Examples 5 and 6

32. Losses of a C corporation are not passed through to the shareholders. The corporationmay carry net operating losses to other years (back two years, forward 20). Capital lossesof corporations are not deductible in the year incurred, but can be carried back three yearsor forward five years.

Operating losses of a proprietorship are deductible if the proprietor is a material participant.Net capital losses are passed through to the proprietor and are subject to the $3,000 limitation.

a. The corporation’s losses are subject to the NOL and capital loss carryback provi-sions. The losses are not passed through to the shareholder.

b. Chris is a material participant in Orange Company. Chris has enough other incometo be in the 35% bracket, so he will not be in a net operating loss situation afterdeducting the loss from Orange Company. He can deduct $153,000 ($150,000operating loss+ $3,000 capital loss).

pp. 2-6 and 2-12

33. Johnson Company has net income of $120,000 ($170,000 revenue � $50,000 expenses).If the company is a proprietorship, Ed must report this amount as income, regardless of theamount he withdraws. If the company is a corporation, it must pay corporate tax on theincome and Ed must report any dividends he receives from the company as income.

a. Ed’s after-tax income is computed below:Income from proprietorship ($170,000� $50,000) $ 120,000Less deductions ($5,350 standard deduction+ $3,400

exemption) (8,750)

Taxable income $ 111,250

Tax on $111,250 (see Appendix A for Tax Rate Schedules) $25,260.75

After-tax income ($120,000� $25,260.75) $94,739.25



b. Tax on corporation’s net income of $120,000:

Tax on $100,000 $22,250Tax on $20,000@ 39% 7,800

Tax liability $30,050

Corporation’s after-tax income ($120,000� $30,050) $89,950

Ed’s taxable income ($89,950 dividend� $5,350standard deduction� $3,400 exemption) $81,200

Ed’s tax on $81,200 at 15% rate applicable todividends $12,180

Ed’s after-tax income ($89,950� $12,180) $77,770

c. The corporation will have $30,050 taxable income ($170,000 revenue � $89,950salary � $50,000 other expenses). Ed will have taxable income of $81,200($89,950 � $5,350 standard deduction � $3,400 exemption). His tax will be$16,846.75, and his after-tax income will be $73,103.25 ($89,950� $16,846.75).

pp. 2-2 to 2-5

34. a. Wilson can deduct $50,900 [$112,500 � $45,000 (insurance recovery) � $100(floor on personal casualty losses)� $16,500 (10% of $165,000 AGI)] if he itemizesdeductions. If Wilson does not itemize, he would not have a deduction.

b. Wilson can deduct $67,500 [$112,500 � $45,000 (insurance recovery)]. Corpora-tions are not subject to the $100 floor or the 10% limitation.

p. 2-9

35. a. Gross income $200,000Ordinary deductions (97,000)

Taxable income (to owner of proprietorship) $103,000

Tax@ 35% $36,050

b. Gross income of corporation $200,000Ordinary deductions (97,000)Salary (70,000)


Corporate tax $ 4,950Gross income of shareholderSalary $ 70,000Tax@ 35% 24,500

Total tax $29,450

c. Gross income of corporation $200,000Ordinary deductions (97,000)

Taxable income $103,000

Corporate tax $23,420



d. Gross income of corporation $200,000Ordinary deductions (97,000)Salary (70,000)


Corporate tax $ 4,950

Tax paid by shareholderOn salary ($70,000� 35%) $ 24,500On dividend [($33,000� $4,950)� 15%] 4,208

28,708

Total tax $33,658

e. Hoffman, Raabe, Smith, and Maloney, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 3, 2007

Mr. Robert Benton1121 Monroe StreetIronton, OH 45638

Dear Mr. Benton:

This letter is in response to your inquiry as to the tax effects of incorporating yourbusiness in 2008. I have analyzed the tax results under both assumptions, proprie-torship and corporation. I cannot give you a recommendation until we discuss thematter further and you provide me with some additional information. My analysisbased on information you have given me to date is presented below.

COMPUTATION 1

Total tax on $103,000 taxable income if you continue as aproprietorship (35% tax rate) $36,050

Total tax if you incorporate:Individual tax on $70,000 salary @ 35% $24,500Corporate tax on $33,000 corporate taxable income 4,950

Total $29,450

Although this analysis appears to favor incorporating, it is important to consider thatthere will be additional tax on the $28,050 of income left in the corporation if youwithdraw that amount as a dividend in the future, as calculated below:

COMPUTATION 2

Income left in corporation ($33,000 taxable income�$4,950 corporate tax) $28,050

Tax on $28,050@ 15% $ 4,208

Total tax paid if you incorporate ($29,450+ $4,208) $33,658



Comparison of computations 1 and 2 appears to support incorporating. If you incor-porate and recover the income left in the corporation as long-term capital gain inthe future, the total tax cost of incorporating will be the same, as shown in computa-tion 3 below.

COMPUTATION 3

Income left in corporation ($33,000 taxable income�$4,950 corporate tax) $28,050

Tax on $28,050@ 15% LTCG rate $ 4,208

Total tax paid if you incorporate ($29,450+ $4,208) $33,658

In summary, incorporation appears to be the most attractive option, whether yourecover income left in the corporation as capital gain or as dividend income. Keepin mind, however, that there are important nontax considerations with respect tothis decision. We can discuss those issues at our next meeting.

Thank you for consulting my firm on this important decision. We are pleased to pro-vide analyses that will help you make the right choice.

Sincerely,

Jon Thomas, CPA

pp. 2-2 to 2-5 and 2-19

36. a. The salary for the deferral period (October through December) must be at least pro-portionate to the employee’s salary received for the fiscal year. The amount thatSwanson Corporation must pay Herbert during the period October 1 throughDecember 31, 2007, to permit the continued use of its fiscal year without negativetax effects is $75,000 ($300,000� 3/12). Example 11

b. Swanson Corporation, a PSC, is subject to a tax rate of 35% on all of its netprofit. The corporation would pay tax of $52,500 ($150,000 � 35%). To illustratethe negative tax impact of classification as a PSC, compare this amount to the$41,750 that a corporation that is not a PSC would pay on taxable income of$150,000. p. 2-19

37. A corporation cannot deduct a net capital loss in the year incurred. The net loss can becarried back for three years and offset against capital gain in the carryback years. If thecapital loss is not used up in the carryback years, the excess can be carried forward for fiveyears. Capital gains of corporations are included in taxable income and are not subject tothe preferential rate applicable to individuals.

a. $600,000 (operating income) � $525,000 (operating expenses) = $75,000 taxableincome. No capital loss deduction is allowed.

b. $600,000 (operating income) � $525,000 (operating expenses) + $18,000 (netcapital gain) = $93,000 taxable income.

p. 2-11



38. Under the accrual method of accounting, Egret would deduct $65,000 ($60,000� $20,000+$25,000) of the salary paid to Hugh, since he did not ownmore than 50% of the corporation’sstock. It would deduct $60,000 of Sam’s salary under the accrual method of accounting,since Sam owned more than 50% of the corporation’s stock. p. 2-11

39. a. Of the $15,000 long-term capital loss, $8,000 can be deducted in 2007. The losswill offset the capital gains of $5,000 first; then, an additional $3,000 of the loss maybe utilized as a deduction against ordinary income. The remaining $7,000 of loss iscarried forward to 2008 and years thereafter until completely deducted.

b. Only $5,000 of the loss may be deducted in 2007. The loss deduction is limited tothe amount of capital gains ($3,000 STCG+ $2,000 LTCG). A corporation may notclaim any capital losses as a deduction against ordinary income. The remaining$10,000 loss can be carried back to the three preceding years to reduce any capitalgains in those years. [The loss is carried back first to the tax year 2004.] Anyremaining loss not offset against capital gains in the three previous years can becarried forward for five years only, to offset capital gains in those years. The long-termcapital loss will be treated as a short-term capital loss as it is carried back and forward.

Examples 13 and 14

40. a. Net short-term capital gain $ 90,000Net long-term capital loss (570,000)

Excess net long-term loss ($480,000)

Gorilla cannot deduct the excess capital loss of $480,000 on its 2007 return, butmust carry it back to the three preceding years, applying it to 2004, 2005, and 2006,in that order. Such long-term capital losses are carried back or forward as short-term capital losses.

b. 2007 excess loss ($480,000)

Offset against2004 (net long-term capital gains) $120,0002005 (net short-term capital gains) 90,0002006 (net long-term capital gains) 210,000

Total carrybacks $420,000

c. $60,000 ($480,000 � $420,000) STCL carryover to 2008, 2009, 2010, 2011, and2012, in that order.

d. Leslie nets these transactions with all other capital transactions for 2007. Assumingthese are her only capital transactions in 2007, she offsets $90,000 of capital gainsagainst the capital losses and deducts an additional $3,000 in capital losses. Theremaining $477,000 ($570,000� $90,000� $3,000) is carried forward indefinitely.

p. 2-11

41. If Condor is a closely held corporation and not a PSC, it may offset $45,000 of the $80,000passive loss against the $45,000 of active business income. However, it may not offset theremaining $35,000 against portfolio income. Example 15

If Condor were a PSC, it could not offset the passive loss against either active or portfolioincome. p. 2-12



42. a. When a corporation contributes inventory that is used in a manner related to theexempt purpose of the charity to which the inventory is donated, the amount of thededuction is equal to basis plus one-half of the appreciation, in this case $12,000[$10,000+ 50%($14,000� $10,000)]. p. 2-14 and Example 20

b. Normally, corporate contributions of long-term capital gain property are measuredby the fair market value of the asset, $14,000. In this case, the deduction will be lim-ited to $12,500, 10% of taxable income. The remaining $1,500 ($14,000 �$12,500) may be carried forward for five years. pp. 2-13 and 2-14

43. Hoffman, Raabe, Smith, and Maloney, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 6, 2007

Mr. Joseph ThompsonJay Corporation1442 Main StreetFreeport, ME 04032

Dear Mr. Thompson:

I have evaluated the proposed alternatives for your 2007 year-end contribution to the Uni-versity of Maine. I recommend that you sell the Brown Corporation stock and donate theproceeds to the University. The four alternatives are discussed below.

Donation of cash, the unimproved land, or the Brown stock each will result in a $120,000charitable contribution deduction. Donation of the Maize Corporation stock will result inonly a $20,000 charitable contribution deduction.

Contribution of the Brown Corporation stock will result in a less desirable outcome from atax perspective. However, you will benefit in two ways if you sell the Brown stock and givethe $120,000 in proceeds to the University. Donation of the proceeds will result ina $120,000 charitable contribution deduction. In addition, sale of the stock will result in a$50,000 long-term capital loss. If Jay Corporation had capital gains of at least $50,000 andpaid corporate income tax in the past three years, the entire loss can be carried back andJay will receive tax refunds for the carryback years. If Jay Corporation had no capital gainsin the carryback years, the capital loss can be carried forward and offset against capitalgains of the corporation for up to five years.

Jay Corporation should make the donation in time for the ownership to change handsbefore the end of the year. Therefore, I recommend that you notify your broker immediatelyso there will be no problem in completing the donation on a timely basis.

I will be pleased to discuss my recommendation in further detail if you wish. Please call meif you have questions. Thank you for consulting my firm on this matter. We look forward toserving you in the future.

Sincerely,

Richard Stinson, CPA

pp. 2-13 and 2-14



44. a. Taxable income for purposes of applying the 10% charitable contributions limitationdoes not include the dividends received deduction or capital loss carryback. Forpurposes of the 10% limitation, taxable income is $387,000 ($600,000� $240,000+$27,000). The maximum charitable contribution allowed for the year, therefore, is$38,700 (10%� $387,000).

b. The excess $9,300 not allowed ($48,000 contribution� $38,700 allowed) is carriedover to the following year.


45. Hoffman, Raabe, Smith, and Maloney, CPAs5191 Natorp Boulevard

Mason, OH 45040

December 6, 2007

Mr. Dan Simms, PresidentSimms Corporation1121 Madison StreetSeattle, WA 98121

Dear Mr. Simms:

On December 3 you asked me to advise you on the timing of a contribution by Simms Cor-poration to the University of Washington. My calculations show that the corporation willmaximize its tax savings by making the contribution in 2007.

If the corporation makes the contribution in 2007, it can deduct $20,000 as a charitablecontribution, which will save $7,800 (39% tax rate � $20,000 deduction) in Federal incometax. However, if the corporation makes the contribution in 2008, the percentage limitationsapplicable to corporations will limit its 2008 deduction to $10,000 ($100,000 projected profit�10% limit). The corporation will save $3,400 (34% tax rate � $10,000 deduction) in taxes asa result of this deduction. The corporation may carry the remaining $10,000 forward anddeduct the amount in 2009. If the corporation continues at the 2008 profit level, it will save anadditional $3,400 in tax in 2009, for a total tax savings of $6,800.

This analysis makes it clear that the corporation will save $1,000 more ($7,800� $6,800) ifit makes the contribution in 2007. In addition, all of the savings will occur in 2007. If the cor-poration makes the contribution in 2008, its tax savings will be split between 2008 and2009. My advice is that the corporation should make the contribution immediately so own-ership of the stock can be transferred by December 31.

Sincerely,

Alicia Gomez, CPA

pp. 2-14 and 2-15

46. a. Cheetah’s production activities deduction for 2007 is 6% of the lesser of

l taxable income of $600,000, or

l qualified production income of $750,000.



The tentative deduction is $36,000 ($600,000 � 6%). Because W-2 wages were$75,000, the wage limitation ($75,000 � 50% = $37,500) does not apply. There-fore, Cheetah’s final production activities deduction for 2007 is $36,000. p. 2-15

b. Cheetah’s production activities deduction for 2010 is 9% of the lesser of

l taxable income of $600,000, or

l qualified production income of $750,000.

The tentative deduction is $54,000 ($600,000 � 9%). Because W-2 wages were$75,000, the wage limitation ($75,000 � 50% = $37,500) applies. Therefore,Cheetah’s final production activities deduction for 2010 is $37,500. p. 2-15

47. a. The key to this question is the relationship between the dividends received deduc-tion and the net operating loss deduction. The dividends received deduction (DRD)is limited to a percentage of taxable income of the corporation (unless taking the fulldividends received deduction would cause or increase an NOL). In this case andwith a 15% stock ownership, the dividends received deduction is limited to 70% oftaxable income.

Gross income from operations $ 660,000Less: Expenses from operations (720,000)Dividends 240,000

Taxable income before the dividends received deduction $ 180,000Dividends received deduction (70%� $240,000)* (126,000)


*Computation of the DRD limitation:

Step 1

Multiply the dividends received by the deduction percentage[$240,000� 70% (based on 15% ownership)] $168,000

Step 2

Multiply the taxable income before the DRD by thededuction percentage ($180,000� 70%) $126,000

Step 3

Lesser of Step 1 or Step 2 unless full DRD generates NOL $126,000

The dividends received deduction is limited to 70% of taxable income becausededucting 70% of the $240,000 dividend received ($168,000) would not create anet operating loss ($180,000� $168,000= $12,000 net income).

b. The dividends received deduction (DRD) is limited to a percentage of taxableincome of the corporation (unless taking the full dividends received deductionwould cause or increase an NOL). With a 70% stock ownership, the full 80% divi-dends received deduction creates an NOL, as shown on the following page.



Gross income from operations $ 660,000Less: Expenses from operations (720,000)Dividends 240,000

Taxable income before the dividends received deduction $ 180,000Dividends received deduction (80%� $240,000)* (192,000)

Taxable income (NOL) ($ 12,000)

*Computation of the DRD limitation:

Step 1

Multiply the dividends received by the deduction percentage[$240,000� 80% (based on 70% ownership)] $ 192,000

Step 2

Multiply the taxable income before the DRD by the deductionpercentage ($180,000� 80%) $ 144,000

Step 3

Lesser of Step 1 or Step 2 unless full DRD generates NOL $ 192,000

The dividends received deduction is not limited to 80% of taxable income becausededucting 80% of the $240,000 dividend received ($192,000) would create a netoperating loss ($180,000� $192,000= $12,000 net loss).

Example 25

48. Following the procedure used in Example 25 in the text, proceed as follows:

GreenCorporation

OrangeCorporation

YellowCorporation

Step 1

70%� $50,000 (dividend received) $35,00070%� $300,000 (dividend received) $210,00070%� $400,000 (dividend received) $280,000

Step 2

70%� $100,000 (taxable income) $70,00070%� $150,000 (taxable income) $105,00070%� $320,000 (taxable income) $224,000

Step 3

Lesser of Step 1 or Step 2 $35,000 $224,000Generates a net operating loss $210,000

Consequently, the dividends received deduction for Green Corporation is $35,000 underthe general rule. Orange Corporation claims a dividends received deduction of $210,000because a net operating loss results when the Step 1 amount ($210,000) is subtracted



from 100% of taxable income ($150,000). Yellow Corporation, however, is subject to thetaxable income limitation and is allowed only $224,000 as a dividends received deduction.


49. a. $5,000 (amount that can be immediately expensed) + [($18,000 � $5,000) ‚ 180months] = $5,072. To qualify for the election, the expenditure must be incurredbefore the end of the taxable year in which the corporation begins business. Amorti-zation does not apply to the $3,600 of expenses that were incurred after the end ofthe taxable year.

b. $5,000 (amount that can be immediately expensed) + [($21,600 � $5,000) ‚ 180months] = $5,092.

c. $5,072 [same as a.]. The corporation’s method of accounting is of no consequencein determining organizational expenditures that qualify for the election to amortize.

d. $5,092. [same as b.]

pp. 2-17, 2-18, and Examples 26 and 38

50. Qualifying organizational expenditures include these items:

Expenses of temporary directors and of organizational meetings $12,000Fee paid to the state of incorporation 3,000Accounting services incident to organization 15,000Legal services for drafting the corporate charter and bylaws 21,000

Total $51,000

Since an appropriate and timely election under § 248 was made, the amount that Hum-mingbird Corporation may write off for the tax year 2007 is determined as follows:

$4,000+ [($51,000� $4,000) ‚ 180 months� 6 (months in tax year)] = $4,000+[$261 (per month amortization)� 6 months] = $5,566.

Only $4,000 of the $5,000 immediate expensing is allowed as the total expenses of$51,000 exceed $50,000 by $1,000. The $4,000 immediately expensed reduces theamount left to be amortized to $47,000 ($51,000� $4,000).

pp. 2-17 and 2-18

51. Purple Corporation:

Tax on $48,000 is $7,200 ($48,000� 15%).

Azul Corporation:

Tax on—$320,000Tax on $100,000 $ 22,250Tax on $220,000� 39% 85,800

Total tax $108,050



Pink Corporation:

Tax on—$335,000Tax on $100,000 $ 22,250Tax on $235,000� 39% 91,650

Total tax $ 113,900

Turquoise Corporation:

Tax on—$6,700,000Tax on $335,000 $ 113,900Tax on $6,365,000� 34% 2,164,100

Total tax $2,278,000

Teal Corporation:

Tax on—$22,600,000Tax on $22,600,000� 35% $7,910,000

p. 2-5 and Examples 27 and 28

52. Corporations Jay and Shrike may not file Form 1120-A. Sales for Jay exceed $500,000; Shrikeis amember of a controlled group. Martin Corporationmay file Form 1120-A. pp. 2-20 and 2-21

53. Net income per books is reconciled to taxable income as follows:

Net income per books (after tax) $ 209,710Plus:Items that decreased net income per books

but did not affect taxable income:+ Federal income tax liability 30,050+ Excess of capital losses over capital gains 5,550+ Interest paid on loan incurred to purchase

tax-exempt bonds 2,650+ Premiums paid on policy on life of president

of the corporation 4,040

Subtotal $ 252,000Minus:Items that increased net income per books

but did not affect taxable income:� Interest income from tax-exempt bonds (32,000)� Life insurance proceeds received as a result

of the death of the corporate president (100,000)


Example 31



54. Net income per books is reconciled to taxable income as follows:

Net income per books (after tax) $172,750Plus:Items that decreased net income per books

but did not affect taxable income:+ Federal income tax liability 22,250+ Excess of capital losses over capital gains 6,000+ Prepaid rent 10,000+ Interest paid on loan incurred to purchase

tax-exempt bonds 3,000+ Premiums paid on policy on life of president

of the corporation 10,000

Subtotal $ 224,000Minus:Items that increased net income per books

but did not affect taxable income:� Interest income from tax-exempt bonds (5,000)� Rent taxed in 2006 (15,000)� Life insurance proceeds received as a result

of the death of the corporate president (100,000)� Excess depreciation (4,000)



55. PGW will enter $120 million on Schedule M-3, Part I, line 4 (worldwide consolidated netincome) and CGW’s net income of $22 million on line 5a (net income from nonincludibleforeign entities). This results in net income per income statement of includible corporations(Part 1, line 11) of $98 million. Example 33

56. PGW must report these items on Schedule M-3, Part II, line 9 [Income (Loss) from U.S.partnerships]. The corporation reports $5,000,000 (book income) on line 9, column (a).PGW reports income per tax return of $3,900,000 ($2,500,000 + $3,500,000 �$2,000,000 � $100,000) in column (d) of line 9, and a permanent difference of $1,100,000in column (c). Example 34

57. PGWmust report the amortization on line 28, Part III as follows: $50,000 book amortizationin column (a), $25,000 temporary difference in column (b), and $75,000 tax returnamortization in column (d). This problem illustrates the Schedule M-3 reporting when bookexpenses are less than tax return deductions. It also illustrates the reporting of temporarydifferences. Example 35

58. These amounts must be reported on line 32, Part III as follows: $100,000 book bad debtexpense in column (a), $75,000 temporary difference in column (b), and $25,000 tax returnbad debt expense in column (d). This problem illustrates reporting procedures when bookexpenses are greater than tax return deductions. It also illustrates the reporting oftemporary differences. Example 36

59. Organizational expenditures and start-up expenditures were incurred in January andFebruary. The corporation can elect to expense the first $5,000 of qualifying expendituresand amortize the remaining balance over a period of 180 months or more. Don and Steveshould identify the organizational expenditures that qualify for this election, and decidewhether to make the election.



The corporation must choose cost recovery methods and decide whether to elect immedi-ate expensing under § 179. It is also necessary to select an accounting method. Theaccrual method will be required for sales and purchases of inventory, but the hybrid methodmay be chosen as the overall method. This would allow use of the cash method for all itemsother than purchases and sales.

The corporation has a great deal of flexibility in selecting a fiscal or calendar year. The golfretail business is generally seasonal in nature, so the corporation should consider electinga November 30, January 31, or February 28 fiscal year.

The accrued bonuses will not be deductible if not paid by the close of the tax year. If thepayment date is not changed, the deduction for bonuses will be disallowed, which couldresult in underpayment of estimated payments, which would result in a penalty.

pp. 2-9, 2-10, and 2-32

TAX RETURN PROBLEMS

1.

2.

The answers to the Research Problems and the Tax Return Problems are incorporated into theInstructor ’s Guide with Lecture Notes to accompany the 2008 Annual Edition of WEST FEDERALTAXATION: CORPORATIONS, PARTNERSHIPS, ESTATES & TRUSTS.



NOTES



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