CH 16

Chapter I:16
Corporations
Discussion Questions
I:16-1 a.
C corporation. Under the check-the-box regulations Sales, Inc. must be taxed as a
C corporation.
b.
No. Elective treatment is not available to Sales, Inc. under the check-the-box
regulations. However, a corporations owner(s) can make an S corporation election under IRC
Sec. 1361 to be taxed as an S corporation. The S corporation rules permit Sales, Inc. to be
exempt from the federal corporate income tax and to be treated as a conduit entity.
c.
If William Bonney were the sole shareholder of Sales, Inc. he could elect under
the check-the-box regulations to have the corporate entity disregarded. As such, income earned
by the entity would be taxed under the rules for a sole proprietorship. All income earned by
the proprietorship flows through to Bonney. The income is reported on Bonneys Form 1040,
Schedule C. Alternatively, he could make an S corporation election and have the corporation
taxed under the Subchapter S rules and reported on Form 1120S. pp. I:16-2 and I:16-3.
I:16-2 For reasons relating to the essential features of a corporate entity. The C corporation may be
desirable for several reasons. First, it provides limited liability protection to its owners (although
some flow-through tax entities, such as limited liability companies and S corporations, provide the
same benefit). Second, C corporations have free transferability of ownership. This advantage is
important particularly to large publicly held corporations. That is, selling corporate shares is easier
than transferring partnership interests, LLC memberships, or S corporation stock. Thus, the C
corporation entity form may make it easier to raise equity capital, particularly if the corporation's
stock is traded on an established stock exchange. Third, the corporate form has continuity of life. For
example, the death of an owner or the sale of stock does not terminate the corporation. Fourth, if the
corporation retains its earnings for growth (for example, reasonable current and future business
needs), the second layer of tax is deferred until the shareholder sells his or her stock. If the corporate
stock is sold, the gain is taxed at capital gains rates. If this deferral is long enough, the additional tax
cost for the second layer of tax may be minimal on a present-value basis.
Fifth, the tax rate on qualified dividends paid to shareholders has been reduced to a
maximum rate of 20% (before considering the additional 3.8% net investment income tax that
applies to higher income taxpayers). Corporate dividends paid to individual shareholders were
taxed at ordinary income rates (up to almost a 40% marginal tax rate) before 2003. Now
qualified dividend income is taxed at the same rate as net capital gains. As a result of this
change in treatment, the top federal tax rate for qualified dividends received by an individual is
20% (0% for individuals whose income is in the 10% or 15% marginal tax bracket; 15% for
taxpayers in the 25%, 28%, 33% and 35% marginal tax brackets). As a result, C corporation
income is still taxed twice, but at a reduced rate from the tax imposed on an individual
shareholder in prior years. Dividend income may also be taxed to the shareholders under state
income tax rules. Sixth, conducting multistate and international business may be easier with C
corporations or groups of C corporations than with partnerships or other flow-through business
forms. Seventh, acquisitions and mergers may be easier to accomplish with a C corporation than
with the other entity forms. p. I:16-2.
Copyright 2015 Pearson Education, Inc.
I:16-1
I:16-3 Through various transactions. Tax analysts argue that besides being able to shift the tax
burden to consumers in the form of higher prices, some corporations are able to shift the burden
to (a) employees in the form of lower salaries and wages, (b) tenants in the form of higher rents,
and/or (c) shareholders in the form of lower dividends and stock values. p. I:16-2.
I:16-4 Where the investor has also realized long-term capital losses. In this situation, the
investor can offset the losses against the gains, thereby reducing his or her overall tax liability.
pp. I:16-4 and I:16-5.
I:16-5 a.
Yes, resulting in a $4,000 NLTCL in the current year.
b.
No, net long-term and net short-term capital losses are not deductible in the
current year but are eligible for a 3-year carryback and a 5-year carryover and can be used as an
offset against capital gains recognized in those years.
c.
The corporate carryback and carryover loss rules. All $4,000 of the capital loss
recognized in the current year is carried back to the prior year. $3,000 of the loss offsets the
$3,000 NLTCG reported in that year. Since only the one capital gain is reported, $1,000 of the
NLTCL carries forward as a STCL to the next five tax years and can provide a tax benefit if
sufficient capital gains are recognized in the five-year period to offset this capital loss. pp. I:16-4
and I:16-5.
I:16-6 a.
To mitigate the possible triple taxation of income earned by a corporation. For
example, without the dividends received deduction (DRD), corporate income would be taxed
once when earned, again when distributed to a corporate shareholder, and a third time when
distributed to the shareholders of the second corporation. The DRD reduces the taxation to the
second corporation, but not the taxation to the corporation earning the income or its shareholders.
b.
Yes. A corporation receives a full dividends-received deduction (DRD) when it
has sufficient taxable income to avoid the limitation or when it has losses such that the full
dividends-received deduction creates or increases an NOL. However, for a certain range of
taxable income, the DRD is limited to a percentage of taxable income. Congress may have
enacted this limitation to prevent corporations from manipulating taxable income or the
dividends that they receive to zero out taxable income. However, given the NOL exception, the
limitation may have little or no substantive rationale. Moreover, the limitation adds unnecessary
complexity to the tax law. Corporations need to plan carefully to be able to claim the full DRD
to which they are entitled. DRDs that are not used because of the limitation cannot be used as a
carryback or carryover. The common tax planning utilized involves the deferral of income to a
later tax year or the acceleration of deductions to an earlier tax year to create an NOL situation.
c.
Different tax liabilities, depending on percentage ownership. A C corporation
that receives $10,000 of dividend income from a 10%-owned corporation can claim a 70%
dividends-received deduction. The $7,000 of dividends-received deduction leaves $3,000
($10,000 - $7,000) in taxable income. Using a 34% marginal tax rate, $1,020 in tax is owed on
the dividend income. If the C corporation were instead 25% owned, then an 80% dividendsreceived deduction can be claimed. The deduction leaves $2,000 ($10,000 - $8,000) in taxable
income and a $680 tax liability on the dividend income. If the C corporation were instead 80%
or more owned by another corporation, then a 100% dividends-received deduction can be
claimed. The 100% dividends-received deduction permits the dividend to be received tax-free.
I:16-2
d.
Different effective tax rates, depending on different percentage ownerships. An
effective tax rate for the incremental dividend income is determined by dividing the additional
taxes that are owed by the additional amount of dividend income received. The dividend from
the 10%-owned corporation is taxed at a 10.2% ($1,020 divided by $10,000) effective tax rate.
The dividend from the 25%-owned corporation is taxed at a 6.8% ($680 divided by $10,000)
effective tax rate. The dividend from the 80% or more owned C corporation is taxed at a 0.0%
effective tax rate. pp. I:16-5 and I:16-6.
I:16-7 Where the corporation has taxable income below $75,000. The NOL carryback is least
advantageous in years where the marginal tax rate is at a low level (15 or 25%). The NOL may
produce greater tax savings by being carried forward to where the 34% tax rate might apply.
Note that carrying back an NOL produces current tax savings while carrying over an NOL
produces deferred tax savings. The tax savings from a NOL carryforward are usually claimed as
a reduction in estimated tax payments. Note also that if the election is made, it applies to both
carryback years. pp. I:16-6 and I:16-7.
I:16-8 If the payment is authorized by the board of directors prior to the end of the tax year and
if the contribution is actually made within 2 months following the end of the tax year. The
accrual election for charitable contributions is not available to an S corporation.
p. I:16-7.
I:16-9 a.
The $200,000 increase in Carl's salary is not deductible even though it is fully
taxable to Carl because it exceeds the $1 million ceiling for certain key executives in publiclyheld corporations (IRC, Sec. 162(m)). The $1 million ceiling is a fixed amount and is not
adjusted annually for inflation.
b.
Instead of increasing Carl's fixed salary above $1 million, several alternatives
should be considered including:
Paying Carl a commission if he is engaged in selling.
Providing $200,000 in performance-based compensation (for example, a bonus).
Increasing (subject to limits) deductible payments to retirement plans and tax-free
fringe benefits that do not trigger current taxation. p. I:16-8.
I:16-10 Possibly retained: Students might argue that the $1,000,000 compensation limitation is
justified to deter payment of excessively large fixed compensation packages. The limit might be
justified by encouraging firms to pay performance-based compensation. Possibly repealed:
Conversely, students may argue that the limitations are easy to circumvent and therefore useless,
or students may argue that the marketplace should set compensation levels without interference
from government intervention. However, some companies find it easier to pay nondeductible
compensation instead of having to negotiate a new employment contract with a high-level
executive. Some thought should be given to legislating annual inflation adjustments to the
$1,000,000 deduction ceiling to take into account the changing value of a dollar due to inflation.
p. I:16-8.
I:16-3
I:16-11 The corporate tax structure basically has four statutory marginal tax rates: 15%, 25%, 34%,
and 35%. Phase-outs, however, add two "bubbles" to the marginal tax rate structure. Between
taxable incomes of $100,000 and $335,000, a 5-percentage point surtax phases-out the tax savings
from the 15% and 25% brackets, thereby creating a 39% marginal tax rate for taxpayers in this
range. Between taxable incomes of $15 million and $18,333,333, the 3-percentage point surtax
phases-out the tax savings from the 34% bracket that starts at $10,000,000 of taxable income,
thereby creating a 38% marginal tax rate for taxpayers in this range.
Average corporate tax rates (tax liability/taxable income) have three flat brackets and two
increasing levels. Between taxable incomes of $0 and $50,000, the average tax rate is a flat
15%; between taxable incomes of $50,000 and $335,000, the average tax rate increases from
15% to 34%; between taxable incomes of $335,000 and $10 million, the average tax rate is a flat
34%; between taxable incomes of $10 million and $18,333,333, the average tax rate increases
from 34% to 35%; and for taxable income over $18,333,333, the average tax rate is a flat 35%.
Students can argue that such a structure is desirable because it taxes large corporations at
a high flat rate (35%) while providing small corporations the benefits of using the low tax
brackets (15% or 25%). Conversely, students can argue that this system is unnecessarily
complex and unfair because it imposes high marginal tax rates (39% and 38%) at arbitrary points
and does so indirectly rather than through a straightforward tax rate schedule where marginal tax
rates increase as taxable income increases. pp. I:16-8 through I:16-11.
I:16-12 Possible explanation: For the first $10,000,000 earned by a C corporation in any tax
year the corporate income tax is levied at a 34% average tax rate. However, if one looks at the
marginal tax rates in excess of $10,000,000, the rates are 35% and 38%. These marginal tax
rates increase the average tax rate to 34.333% when taxable income is $15,000,000 and 35%
when taxable income is $18,333,333. The average tax rate remains at 35% when taxable income
exceeds $18,333,333.
pp. I:16-10 and I:16-11.
I:16-13 To provide an incentive for U.S. corporations to produce goods in the U.S. by lowering
the effective tax rates on income earned from the goods. The U.S. production activities
deduction was enacted for two principal purposes; (1) to reduce the tax disadvantage for
U.S. corporations in the international marketplace, and (2) to replace the extraterritorial income
exclusion (ETI). Passed in October of the 2004 election year, this provision was certainly
influenced by election concerns. The Republicans had come under fire for U.S. corporations
moving jobs abroad with what the public perceived as little penalty. pp. I:16-8 and I:16-9.
I:16-14 a.
Yes. Spurrier Corporation is subject to the corporate alternative minimum tax
because (1) the corporation does not qualify for the exemption based on prior year gross receipts,
and (2) the corporations AMTI exceeds $40,000. In the case of Spurrier, AMTI equals taxable
income ($50,000) plus tax preference items and positive adjustments ($100,000), or $150,000,
minus a $40,000 statutory exemption, or $110,000. The tentative minimum tax amount equals
$22,000 ($110,000 x 0.20) minus the federal income tax ($13,750), or $8,250.
b.
Spurrier reports its alternative minimum tax liability on Form 4626 that is
included with its Form 1120 (corporate income tax return) filing. Timely payment of the
alternative minimum tax occurs on or before the due date of March 15 for calendar year
taxpayers.
I:16-4
c.
No. Spurrier cannot avoid the AMT by paying dividends to one or more of its
shareholders. Dividend payments only can reduce a corporations liability for the accumulated
earnings tax and the personal holding company tax. pp. I:16-12 and I:16-13.
I:16-15 To ensure that C corporations with significant economic income pay at least some taxes.
Congress was concerned that individual and corporate taxpayers could use incentives, such as
exclusions, deductions, and credits to eliminate most or all of their tax liabilities, thereby
reducing the actual or perceived fairness of the tax system. Arguably, this dual system is
unnecessarily complex, especially because the minimum tax credit makes the AMT a mere
prepayment system. Consequently, one could argue that, if Congress is uncomfortable with tax
incentives (tax preferences), Congress should attack them directly in the regular tax system and
then after eliminating most or all of the tax incentives go ahead and eliminate the dual system.
pp. I:16-12 and I:16-13.
I:16-16 In the current year, none. The alternative minimum tax payment represents the excess of
the alternative minimum tax liability over the regular tax liability for the current year. The
amount of the AMT payment made in the current year ($30,000) is available as a tax credit. No
tax benefit is available for the tax payment.
In previous tax years, none. The AMT credit cannot be carried back to an earlier tax year.
In future tax years, significant benefits. The AMT credit can be carried forward
indefinitely and used to offset the amount of the regular tax liability that is owed in excess of the
tentative minimum tax liability. Taxpayers need to be selective in their use of the minimum tax
credit and the general business tax credit. The minimum tax credit carries over indefinitely. The
general business credit, on the other hand, carries back one year and forward 20 years.
pp. I:16-12 and I:16-13.
I:16-17 a.
To discourage corporations from retaining excess earnings for purposes unrelated
to the corporations business. Congress enacted the penalty tax at a time when corporate tax
rates were significantly lower than individual tax rates, a situation that gave individuals the
incentive to shelter earnings in a corporate entity. With the American Taxpayer Relief Act of
2012, the current top corporate tax rate (35%) is once again slightly lower than the top individual
tax rate (39.6%), providing some incentive to potentially retain earnings in the corporation. This
act increased the accumulated earnings tax rate to 20%, the same rate that high income
shareholders are taxed on dividend income if the corporation distributes its accumulated
earnings. The accumulated earnings tax decreases the attractiveness of retaining excess earnings
for tax avoidance purposes. The penalized earnings could be subject to triple taxation: once
when earned by the corporation, a second time when penalized under the accumulated earnings
tax, and a third time when the earnings ultimately are distributed to the shareholder.
b.
Because this type of accumulation does not circumvent Congress's purpose for
enacting the penalty tax. Thus, the corporation is allowed to reduce accumulated taxable income
by amounts retained for its reasonable business needs. In many cases, this adjustment either
reduces or eliminates entirely the accumulated earnings tax. pp. I:16-14 and I:16-15.
I:16-5
I:16-18 Not necessarily. To avoid an attack by the IRS, the corporation must use the $1 million
of retained earnings for reasonable needs of the business and not for unrelated business needs.
Dividend payments are not required if the earnings are reinvested in operating assets or the funds
are retained to meet the reasonable needs of the business. Reasonable business needs include
business expansion, plant replacement, acquiring assets or stock of another business, retiring
debt, and making investments in or loans to suppliers or customers. To avoid the accumulated
earnings tax, all business and expansion plans must be definite as opposed to being vague. The
business and expansion plans need to be documented by the corporation and made available to
the IRS should a question about the need to reinvest earnings ever arise. Because the E&P has
been reinvested in operating assets for expansion purposes, Acme Corporation is not likely
subject to the accumulated earnings tax. pp. I:16-14 and I:16-15.
I:16-19 a.
To discourage individuals from using a corporation to shelter earnings generated
by passive- or investment-type assets. Usually, such corporations were closely held. Congress
enacted the penalty tax at a time when corporate tax rates were significantly lower than the top
individual tax rates (30 percentage points or more), a situation that gave individuals a substantial
incentive to shelter passive or investment earnings in the corporate form. The personal holding
company tax rate is 20%, the same rate most shareholders will pay on qualified dividend income.
Prior to the 2003 tax legislation, dividends and undistributed personal holding company income
were both taxed at the ordinary income tax rate. Today, individuals have less of an incentive to
shelter passive or investment earnings in the corporate form because of the lower tax rate on
dividend income.
b.
The 50% stock ownership test and the 60% of adjusted ordinary gross income
test. Closely held corporations with high levels of passive or investment income are the target of
the PHC tax. The two tests (closely-held stock and predominately earning passive income)
identify such corporations for possible assessment of the tax. The 50% stock ownership test
identifies closely held corporations, and the 60% of adjusted ordinary gross income test identifies
corporations with too much passive or investment income. pp. I:16-16 and I:16-17.
I:16-20 The difference is this: a corporations incurring liability for the personal holding
company tax does not require a tax avoidance motive. Rather, it requires mechanical application
of an objective test. By contrast, a corporations incurring liability for the accumulated earnings
tax does require such a motive; specifically, an intent to avoid the tax on dividends. p. I:16-16.
I:16-21 Because a substantial tax advantage could be derived from operating a single business as
two or more separate corporations controlled by the same shareholders. This advantage
primarily results from the possibility of claiming the benefit of the lower corporate tax rates that
apply to taxable income up to $75,000 for each new corporation that is created. Thus, each new
corporation could provide an annual $11,750 ($34,000 taxes at 34% rate - $22,250 on first
$100,000 of taxable income actual tax) tax savings. pp. I:16-17 through I:16-20.
I:16-6
I:16-22 The underlying rationale is this: Section 351 allows shareholders to defer recognition of
gain or loss on the transfer of assets to a controlled corporation. Without Sec. 351, a sole
proprietorship would have difficulty adopting the corporate form of organization because the
transfer of appreciated property would constitute a taxable transaction resulting in gain (but
perhaps not a loss due to the Sec. 267 related party rules) being recognized by the transferor.
Under a Sec. 351 transfer, only the form of business changes (e.g., a sole proprietorship or
partnership becomes a corporation) while the assets remain under the control of the transferor.
In addition, shareholders that receive only stock, as opposed to cash and liquid assets on the
transfer, would not have the wherewithal to pay tax on the gains that otherwise would be
recognized. pp. I:16-21 and I:16-22.
I:16-23 Debate: The following points are provided in favor or against the proposition that all
corporate formation transactions should be treated as taxable events.
PRO
1.
2.
3.
4.
5.
6.
7.
Corporate formations are exchange transactions and therefore should be taxable.

The transfer is a change from direct ownership to indirect ownership and, therefore,
should be taxable.
Reduces the need for tax planning; taxpayers will not have to restructure a transaction to
be able to recognize gains and losses.
Ease of administrationbrings tax basis up to correct value. No need to worry about
carryover rules (e.g., basis, Sec. 1245/1250 recapture, holding periods).
Eliminate difference between financial accounting and tax reporting of the transaction.
Typically financial accounting rules require booking the assets at their FMV.
Eliminates a contingent tax liability payable in the future for the corporation.
Government revenues will increase because gains are recognized.
CON
1.
2.
3.
4.
5.
6.
7.
May prevent taxpayers from using the corporate form if they already have been a
proprietorship/partnership since they will need to have funds to pay the taxes on the
gains. The capital of the proprietorship/partnership will be impaired.
Will hurt start-up corporations who will need to raise additional capital to offset the
capital lost to taxes.
Prevents transferor from recognizing losses.
Transfer is only a change from direct ownership to indirect ownership and, therefore,
should be tax-free.
Taxpayer has continued his or her equity interest in the assets.
Taxpayers do not have a wherewithal to pay if only stock (or stock and debt obligations)
is received.
Government revenues will decrease because losses are recognized.
I:16-7
I:16-24 a.
Disadvantages: the building transfer is tax-free to Brett Nelson under Sec. 351.
His $45,000 ($75,000 FMV of stock received - $30,000 adjusted basis of building) realized gain
is not recognized for tax purposes. Brett Nelson can defer his realized gain until he sells his
stock in a taxable transaction. The buildings basis in Gator Corporations hands is its $30,000
basis in Brett Nelsons hands. Gators depreciation deduction is based on the buildings $30,000
carryover basis instead of its $75,000 FMV. This basis difference causes Gator to deduct
approximately $1,500 less depreciation per tax year (based on an assumed 30-year remaining
recovery period for nonresidential real property and straight-line depreciation) than would be
available if the building had been purchased for cash. If the building is later sold in a taxable
transaction, using the carryover basis for the building may cause part or all of the $45,000
difference between the buildings FMV and its tax basis that existed on Gators acquisition date
to be recognized as an increased gain by Gator.
b.
Disadvantages: the building transfer is tax-free to Brett Nelson under Sec. 351.
His $45,000 ($30,000 FMV of stock received - $75,000 adjusted basis of building) realized loss
is not recognized for tax purposes. Brett Nelson must defer his $45,000 realized loss until he
sells his stock in a taxable transaction. Nelson may have been better off to sell the building for
cash so he could immediately recognize his tax loss. Such a sale may be subject to the
limitations found in the Sec. 267(a) related party loss rules. The buildings basis in Gators
hands generally is its $30,000 basis in Brett Nelsons hands. Gators depreciation deduction is
based on the buildings $30,000, if the building is subsequently sold in a taxable transaction.
pp. I:16-20 through I:16-24.
c.
The basis of property that is contributed to a corporation in a Sec. 351 transaction
is not increased to the propertys FMV because recognition of the gain on the transaction is
deferred until the property is sold or exchanged by the transferee corporation. A step-up in the
propertys basis occurs if the transferor recognizes part or all of the gain realized on the asset
transfer. A step-down in basis occurs if the propertys FMV is less than its adjusted basis.
d.
Gator would still recognize no gain on the transfer of the building from Brett
Nelson to Gator in exchange for Gator stock. The buildings adjusted basis in the hands of Gator
is $30,000. Brett Nelsons basis in the Gator stock is reduced from $30,000 to $5,000 by the
$25,000 amount of his liabilities that are acquired by Gator (IRC Sec. 358(a)). pp. I:16-20
through I:16-24.
I:16-25 a.
The likely tax consequences are as follows: because Carmen mortgaged the
property immediately prior to the Sec. 351 exchange and transferred the property and the liability
to the corporation, the transaction probably lacks a bona fide business purpose because
the mortgaged funds were used for a personal purpose (remodeling her home). Under Sec. 357(b),
the $50,000 liability is reported as boot received by Carmen. Carmens $40,000 recognized gain is
the lesser of her realized gain of $40,000 ($100,000 - $60,000) or the boot of $50,000 received.
b.
Rationale: if the shareholder borrows money just before the incorporation and has
the corporation assume the loan, the shareholder in effect gets money out of the corporation
without incurring an income tax liability as would happen if a $40,000 dividend were instead
paid. Without the special rule for tax avoidance or failure to have a bona fide business purpose,
the shareholder could engage in this maneuver without boot being triggered because of the
general rule that the assumption of a liability does not constitute boot. pp. I:16-22 through
I:16-24.
I:16-8
I:16-26 a.
Principal advantages: from the corporations perspective, the principal advantage
of capitalizing with debt as opposed to equity is that interest on debt is deductible, whereas
dividends on equity are nondeductible. From the shareholders perspective, the principal
advantage is that debt retirement is not a taxable event, whereas stock (i.e., equity) redemption is
a taxable event.
b.
Tax consequences: if the property transfer meets the requirements of Sec. 351, it
is tax-free to Sato, Jose, and Satish. Expressed differently, gain realized on the transfer of
appreciated property is not recognized for tax purposes.
c.
Ensuing tax consequences: if the IRS recharacterizes the debt as equity, the
following tax consequences would result, (i) interest on the debt would be nondeductible by the
corporation and taxed to Jose and Satish as a dividend; (ii) future debt retirement would be taxed
to Jose and Satish as a stock redemption; (iii) the contribution of cash would likely be tax-free
under Sec. 351 pp. I:16-20-21, I:16-24.
I:16-27 (1) The S corporation, and (2) the limited liability company. With respect to both
forms, taxable items reported at the entity level flow through to the separate returns of the
entitys owners. In this specific case, the start-up losses generated at the entity level during the
first two years of operation would flow through to Chang and Georges separate returns. There,
each owner could offset a pro rata share of the losses against his or her income. In addition, both
an S corporation and a limited liability company afford all of their owners limited liability
(unlike the case of a limited partnership, in which at least one general partner incurs unlimited
liability). Given the extraordinary risks associated with an explosives business, such a feature
would be advantageous. p. I:16-2.
I:16-28 A bias of a corporation's capital structure in favor of debt over equity. Such a bias
would be economically inefficient if the debt-to-equity ratio differs from that which would occur
without the tax influence. Moreover, too much debt may cause a corporation to be excessively
leveraged and to be capitalized too thinly, thereby increasing the corporations interest rate,
creating potential financial difficulties or incurring IRS challenges to the interest deduction. The
preferential tax rate on qualifying dividends of 20% (or lower) reduces the disincentive for
the shareholder who receives the dividend or interest payments, and may result in the
shareholder/creditor to prefer dividend payments. Nevertheless, since interest is deductible to
the corporation and dividends are not, the disincentive to pay dividends instead of interest
remains for the paying corporation. Students should form their own opinions as to whether the
tax law should be changed. p. I:16-24.
I:16-29 Because the meaning of the language, "not essentially equivalent," is somewhat unclear.
Originally, the courts held that exchange treatment would apply under Sec. 302(b)(1) if a
business purpose existed and if the transaction had no tax avoidance motive. The Supreme
Court, however, decided in the Maclin P. Davis case that business purpose is irrelevant in
determining dividend equivalency and that the redemption must result in a meaningful reduction
in the shareholder's interest in the corporations assets at liquidation, interest in the corporations
current and accumulated earnings, and right to vote his or her stock. The IRS has generally held
that a meaningful reduction has occurred when the shareholder goes from a majority stock
position to a minority stock position or from one minority stock position to a smaller minority
stock position. Due to the uncertainty regarding the application of Sec. 302(b)(1), a safer course
I:16-9
to follow is the mechanical tests in Secs. 302(b)(2) [substantially disproportionate] and 302(b)(3)
[complete termination of a stock interest]. The Sec. 302(b)(4) rules are also an option. However
they generally are not used since they require a change to the corporations operations such as
discontinuing a line of business.
pp. I:16-29 through I:16-32.
I:16-30
Substantially
disproportionate
a. Often permissible,
even where stock
ownership does not
decrease by more
than 80%
b. Constructive
ownership rules may
be waived
Not permissible
Not waivable
Not essentially
equivalent to a
dividend
Permissible, so long
as there is a
meaningful
reduction in
shareholder interest
Not waivable
Complete
termination of
shareholder interest
Not permissible
c. Treated as an
exchange taxed as
capital gain or loss
d. Stock not
surrendered in
exchange for
corporate
distribution
Yes
Yes
Waivable, if
shareholder agrees
not to acquire
corporate interest for
10 years
Yes
Not the case
Not the case
Not the case
pp. I:16-29 through I:16-30.

I:16-31 Not necessarily. The major difference between the complete termination of a
shareholder's interest under Sec. 302(b)(3) and the substantially disproportionate test under Sec.
302(b)(2) is that the family constructive ownership rules can be waived only when Sec.
302(b)(3) is used. For the family constructive ownership rules not to apply, the former
shareholder must file an agreement with the IRS stating that he or she will have no interest in the
corporation, other than that of a creditor, for a 10-year period. p. I:16-30.
I:16-32 In terms of taxability. Liquidation of a controlled subsidiary corporation is a tax-free
transaction under Code Sec. 332(a) assuming that there are no minority shareholders. Neither
the parent corporation nor the subsidiary corporation recognizes gain or loss on the liquidation.
The bases of the subsidiary's assets carry over to the parent along with other tax attributes (IRC.,
Sec. 381(a)). [If there are minority shareholders, their tax treatment is the same as for a regular
liquidation.] The parent's basis in the subsidiary's stock disappears.
I:16-10
The liquidation of a corporation that does not qualify as a controlled subsidiary (for
example, a less than 80%-owned subsidiary), on the other hand, is a taxable event. The
liquidated corporation recognizes gains and losses on the distribution or sale of its noncash
assets, and the shareholders recognize gain or loss on the receipt of cash or noncash property in
exchange for their stock interest. The shareholders' gains and losses equal the difference between
the FMV of the assets distributed (minus the amount of any liabilities distributed) and the basis
of their stock. The shareholders take a FMV basis in the noncash assets distributed. Corporate
tax attributes disappear in a taxable liquidation.
When a controlled subsidiary is liquidated, the business stays within the corporate form,
and the tax law generally deems such transactions as nontaxable (IRC 332(a)). When an
individual liquidates his or her corporation, however, the corporate form disappears. Moreover,
the individual receiving the liquidating distribution may decide not to continue the trade or
business in a noncorporate form. pp. I:16-32 and I:16-33.
I:16-33 For the following reasons: the cost of a corporate formation transaction usually is quite
low because Sec. 351 permits appreciated property to be transferred to a corporation with no gain
being recognized except to the extent that excess liabilities are transferred to the corporation that
are taxable under IRC Sec. 357(c) or the shareholder receives boot property. The shareholders
generally recognize no loss on a corporate formation transaction even if they receive boot property.
On the other hand, a liquidating corporation recognizes gain or loss on its noncash property
distributions unless certain exceptions apply. The shareholders also recognize gain or loss upon
receiving liquidating distributions in exchange for their stock. One common exception to the gain
recognition requirement occurs when a corporation forms a controlled subsidiary corporation and
then subsequently liquidates the corporation. IRC Secs. 332 and 337 permit both the liquidating
corporation and its parent corporation to avoid recognizing gain or loss on the liquidation.
pp. I:16-31 and I:16-33.
I:16-34 To facilitate investments in small corporations. If an individual invests in a sole
proprietorship or a partnership, the invested amounts, if used for operations, are deductible against
the individual's ordinary income even if the business fails. However, if the individual invests in a
C corporation and the corporation fails, the losses would not be deductible because the corporation
has no income against which to offset the losses. Moreover, without Sec. 1244, an individual
shareholder could not deduct the investment in the worthless stock against ordinary income. Such
losses would be a capital loss deductible only against capital gains or deductible annually up to
$3,000 against ordinary income. This disparate treatment could raise an impediment to incorporating
businesses. To reduce this disparity, Sec. 1244 allows ordinary loss treatment within specified dollar
limits, thereby removing potential roadblocks to business incorporations. Section 1244 stock is often
called a no cost advantage for shareholders of a small business corporation. There is no downside
risk and only a small extra cost to make a Sec. 1244 election. The difference between capital loss
and ordinary loss treatment, however, can be substantial. pp. I:16-33 and I:16-34.
I:16-35 For reasons of corporate deductibility. Dividends are fully taxable to the shareholders if
the corporation has sufficient E&P, but dividends are not deductible by the corporation.
Payment of additional salary, interest, or rent, while taxable to the shareholders, is deductible by
the corporation as long as the amounts are reasonable. The additional salary is subject to a FICA
tax levy unless the employee has already earned the maximum amount of FICA wages for the
year. p. I:16-34.
I:16-11
I:16-36 One advantage of having a corporation treated as a C corporation is that the corporate
entity is not limited by the number of shareholders. An S corporation, on the other hand, is
limited to 100 shareholders (with all family members being treated as a single shareholder). For
a newly-formed business this may not be an issue until a number of years after its creation. Once
the corporation goes beyond the S corporation shareholder limit the S corporation election is lost
and a corporation is taxed as a C corporation.
A second advantage is that the S corporations profits are taxed ratably to each
shareholder and taxed at his or her marginal individual income tax rate with no second level of
taxation occurring when a dividend distribution is paid by the corporation to its shareholders.
In the case of both a C corporation and an S corporation, a tax is imposed at capital gains rates
on the profit reported on the sale or other disposition of part or all of a shareholders stock
investment.
A third advantage is that the ordinary income (profits) and capital gains reported by the
S corporation are allocated to each shareholder and increases the shareholders basis in his or her
S corporations stock investment. Ordinary losses and capital losses of the S corporation are
allocated to each shareholder and decrease the shareholders basis (but not below zero) in his or
her S corporation stock investment.
I:16-37 Because the IRS will find these differences useful in determining whether and what
items to audit. The schedule Form M-3 requires that large and mid-size C corporations provide a
reconciliation to the IRS of their financial accounting financial statements and their tax financial
statements. Generally, corporations with total assets of $10 million or more are required to file
Schedule M-3 with their Form 1120. p. I:16-37.
I:16-38 Besides M-1 and M-2, the following schedules, with their respective reporting functions,
are incorporated in Form 1120:
Schedule
C
J
K
L
Reporting Function
Reports dividends received by the corporation
Reports computation of corporate tax
Reports other information, such as accounting method, business
activity, corporate affiliates
Reports balance sheet, per the corporations books
Issue Identification Questions

I:16-39 The following tax issues: In the short-run, the primary issue is the imposition of penalty
taxes (i.e., the accumulated earnings tax or the personal holding tax) if future earnings are
reinvested in nonoperating assets. A secondary issue in the long run involves the tax
consequences arising from the acquisition of investment securities (e.g., the availability of the
dividends-received deduction). Rather than reinvesting the monies in the business, Helen might
consider increasing her salary and fringe benefits. Helen also needs to consider the tax
consequences arising from the eventual liquidation of the corporation, a sale of the business
assets followed by a liquidation of the corporation, or a sale of the corporate stock when she
retires. pp. I:16-14 through I:16-17.
I:16-12
I:16-40 The primary tax issue is the tax consequences arising from the formation of the
corporation. If Sec. 351 is applicable, will gain or loss be recognized by Helga and Hugo? Does
the transfer of liabilities in excess of the basis of the assets trigger the recognition of gain by Hugo?
If so, what is the character of the gain? What is Hugos basis in his stock? Does Hugos stock
qualify as Sec. 1244 stock? What is the corporations basis in the assets it receives from Hugo?
Should Helga attempt to avoid the operation of Sec. 351 so as to recognize losses on the transfer of
her assets? Should Helga attempt to sell her assets to an unrelated third party so as to recognize the
loss and invest the proceeds in the corporation? Do the related party loss rules of Sec. 267(b) apply
to a sale of Helgas assets to the corporation? If Helga recognizes a loss, what is its character?
What is Helgas basis for her stock? Does Helgas stock qualify as Sec. 1244 stock? What is the
corporations basis in the assets it receives from Helga? Should Hugo and Helga make an
S corporation election for their new entity? What accounting period and other tax elections should
be made in the initial year? pp. I:16-20 through I:16-24, I:16-33 and I:16-34.
I:16-41 The primary tax issue is whether Sec. 385 debt-equity rules will apply to recharacterize
the debt as equity under the first alternative. What impact will the loss of the interest deduction
have on the corporations tax position? If the interest deduction creates a loss, then would an
S corporation election or an alternative business form (for example, partnership or limited
liability company) be desirable? A secondary consideration is the effect of the issuance of debt
upon the need for recognition of gain by John and Joy on the asset transfer under Sec. 351(b). A
third consideration is the ability of the stock (and debt?) to qualify as Sec. 1244 stock. The
organizational costs should be amortizable over 60 months or longer under Sec. 248.
pp. I:16-24, I:16-33 and I:16-34.
Problems
I:16-42 a.
$12,000 NSTCL, computed as follows:

NLTCG of $12,000 ($20,000 LTCG - $8,000 LTCL)
NSTCL of $24,000 ($16,000 STCG - $40,000 STCL)
Netting the above two amounts produces:
NSTCL of $12,000 ($24,000 NSTCL - $12,000 NLTCG)
b.
$60,000 because the NSTCL cannot offset ordinary income.
c.
Net long- and short-term capital losses are not deductible in the year incurred.
Instead, they are subject to a three-year carryback and a five-year carryover rule as an offset to
capital gains recognized in the eight-year loss utilization period. If the corporation is in its first
taxable year (or had no prior capital gains and losses), the losses can only be used as a carryover.
pp. I:16-4 and I:16-5.
I:16-43 a.
$200,000 of capital losses are carried back and used to offset $100,000 ($20,000 +
$20,000 + $60,000) of NLTCGs for 2011 through 2013. The character of the carryback for
corporations is short-term capital loss for both the NSTCL and NLTCL.
I:16-13
b.
Unused capital losses of $100,000 ($80,000 + $120,000 - $100,000 used as a
carryback) are carried over for five years.
c.
The character of unused capital loss carryovers also is short-term.
pp. I:16-4 and I:16-5.
I:16-44 Able Corporation is taxed in the following manner for the four situations.
Situation 1:
LTCG = $10,000
STCG = $5,000
Net Sec. 1231 gain = $10,000 - $5,000 = $5,000
LTCG = $15,000 = $10,000 LTCG + $5,000 Sec. 1231 gain
Tax owed if a corporation = $20,000 x 0.35 = $7,000
Tax owed if an individual = $5,000 STCG x 0.396 = $1,980
$15,000 LTCG x 0.20 = $3,000
Total corporate taxes owed on the property transactions are $2,020
higher [$7,000 ($1,980 + $3,000)] than those for an individual. This
result is due to the lower individual tax rate for long-term capital gains.
Situation 2:
LTCG = $10,000
STCG = $15,000
Net Sec. 1231 gain = $20,000 - $5,000 = $15,000
LTCG = $25,000 = $10,000 LTCG + $15,000 Sec. 1231 gain.
Corporate tax = ($25,000 + $15,000) x 0.35 = $14,000
Individual tax = ($15,000 x 0.396) + ($25,000 x 0.20) = $10,940
Total corporate taxes owed on the property transaction are $3,060
higher ($14,000 - $10,940) than those for individuals.
Situation 3:
LTCG = $10,000
STCL = $15,000
Sec. 1231 gains = $0
Sec. 1231 losses = $15,000
NSTCL = $5,000 ($10,000 LTCG - $15,000 STCL)
The corporation can use the $5,000 NSTCL only to offset net
capital gains or net Sec. 1231 gains. None exist in the current year so the
$5,000 STCL is carried back three years or forward five years. The
$15,000 Sec. 1231 loss is deductible as an ordinary loss and provides a
$5,250 ($15,000 x 0.35) current year tax savings. No tax benefit is
provided by the current year NSTCL unless it can be carried back or
forward.
An individual can deduct $3,000 of the $5,000 NSTCL in the
current year and the $15,000 Sec. 1231 loss as an ordinary loss. The tax
savings is $1,188 ($3,000 x 0.396) from the NSTCL and $5,940 (0.396 x
$15,000) from the Sec. 1231 loss. The total tax savings is $7,128 ($1,188
+ $5,940).
I:16-14
Situation 4:
LTCG = $20,000
STCG = $5,000
Sec. 1231 gains = $10,000
Sec. 1231 losses = $15,000
Net Sec. 1231 loss = $5,000
For an individual, the $20,000 LTCG is taxed at a 20% rate. The
tax is $4,000. The $5,000 of STCG is taxed at a 39.6% rate. The tax is
$1,980. The $5,000 net Sec 1231 loss is deductible as an ordinary loss.
The tax savings from deducting the loss is $1,980 (0.396 x $5,000).
The total tax due is $4,000 ($4,000 + $1,980 - $1,980) for an individual.
For a corporation, the $20,000 LTCG and $5,000 STCG are
taxed at a 35% rate resulting in $8,750 ($25,000 x 0.35) in taxes. The
net Sec. 1231 loss produces a $1,750 ($5,000 x 0.35) tax savings. The
net corporate tax liability is $7,000 ($8,750 - $1,750). The corporate tax
is $3,000 ($7,000 - $4,000) higher than the individual tax liability.
pp. I:16-4 and I:16-5.
I:16-45 a.
$160,000 (0.80 x $200,000 dividend received). The dividends-received deduction
is 80% instead of the standard 70% because Florida owns 20% of the stock of the distributing
corporation. The $240,000 dividends-received deduction limitation ($300,000 x 0.80) does not
reduce the deduction amount.
b.
A $20,000 loss from operations would result in a dividends-received deduction
limitation of $144,000 [0.80 x ($200,000 dividends-received - $20,000 NOL)] if an NOL does
not result after deducting the full amount of the 80% dividends-received deduction computed
under the general rule as follows:
Net loss from operations
Plus: Dividends received
Minus: Dividends-received deduction
Taxable income
$( 20,000)
200,000
(160,000)*
$ 20,000
*$200,000 x 0.80 = $160,000

Since a NOL does not result, the dividends-received deduction is limited to $144,000 [($20,000)
+ $200,000) x 0.80 = $144,000], and taxable income for the year is $36,000 ($180,000 $144,000).
c.
A tentative dividends-received deduction of $140,000 (0.70 x $200,000) because
the ownership percentage is less than 20%. Using the basic facts, the dividends-received
deduction would be $140,000 ($200,000 x 0.70). When a $70,000 operating loss is incurred, the
full $140,000 dividends-received deduction is allowed because a NOL is created. Taxable
income for the year is ($10,000) [($70,000) + $200,000 - $140,000]. pp. I:16-5 and I:16-6.
I:16-15
I:16-46 a.
$160,000 deduction and $130,000 of taxable income. With 25% ownership of
Blue stock, Purple Corporation qualifies for an 80% dividends-received deduction. The
deduction is $160,000 (80% of the lesser of the $200,000 dividend or the $290,000 income
before DRD.) Taxable income is $130,000 ($290,000 - $160,000 dividend received deduction).
b.
$140,000 deduction and $60,000 of taxable income. Yellows dividends-received
deduction under the general computation rule is $154,000 (70% of $220,000). Under the
limitation, the dividends-received deduction is limited to $140,000 (70% of taxable income of
$200,000 {$20,000 operating loss plus $220,000 dividend income}). Taxable income for the
year is
Operating loss
$( 20,000)
220,000
Dividend income
Dividend received deduction (140,000)
Taxable income
$ 60,000
pp. I:16-5 and I:16-6.
I:16-47 $25,000 (before special deductions), calculated as follows:
$500,000
Income from business activities
150,000
Dividend income
Deductible expenses
( 625,000)
Taxable income before special deductions $ 25,000
(120,000)
Special deductions
Taxable income (positive or negative)
$ (95,000)
pp. I:16-6 and I:16-7.
I:16-48 a.
$25,000 (0.10 x $250,000). The dividends-received deduction does not reduce
the charitable contribution limitation calculation.
b.
$15,000 of unused contributions are carried forward for up to five years.
c.
No change. NOL carrybacks to the current year are disregarded when calculating
the charitable contribution limitation. The NOL incurred in the following year likely will cause
the charitable contribution limitation to be zero, thereby preventing any of the $15,000 carryover
from the current year being used. pp. I:16-7 and I:16-8.
I:16-49 a.
b.
c.
$13,750 + 0.34 x ($90,000 - $75,000) = $18,850.

$22,250 + 0.39 x ($300,000 - $100,000) = $100,250.
$113,900 + 0.34 x ($5,000,000 - $335,000) = $1,700,000
or: 0.34 x $5,000,000 = $1,700,000.
d.
$3,400,000 + 0.35 x ($12,000,000 - $10,000,000) = $4,100,000.
e.
$5,150,000 + 0.38 x ($17,000,000 - $15,000,000) = $5,910,000.
f.
$6,416,667 + 0.35 x ($20,000,000 - $18,333,333) = $7,000,000.
or: 0.35 x $20,000,000 = $7,000,000.
g.
If Ajax were a personal service company, its taxable income would be subject to
a flat 35% tax rate regardless of the level of income. Thus, the tax would be $31,500 ($90,000
x 0.35) in Part a, $105,000 ($300,000 x 0.35) in Part b, and $1,750,000 ($5,000,000 x 0.35) in
Part c. pp. I:16-10 through I:16-12.
I:16-16
I:16-50
a.
Current Year
Taxable income before LTCG

LTCG
Taxable income
Tax liability
$ 60,000
50,000
$110,000
$ 26,150a
Following Year
$200,000
-0$200,000
$ 61,250b
Two-Year Total
$87,400
$22,250 + 0.39 x ($110,000 - $100,000) = $26,150

$22,250 + 0.39 x ($200,000 - $100,000) = $61,250
b.
Taxable income before LTCG
LTCG
Taxable income
Tax liability
Current Year
$60,000
-0$60,000
$10,000a
Following Year
$200,000
50,000
$250,000
$ 80,750b
Two-Year Total
$90,750
$7,500 + 0.25 x ($60,000 - $50,000) = $10,000

$22,250 + 0.39 x ($250,000 - $100,000) = $80,750
c.
Current Year. Colorado should sell the assets in the current year because less
taxable income is expected in the current year, and therefore the gain on the sale would be taxed
at lower marginal rates. The entire $50,000 capital gain would be taxed at a 39% rate in the
following year. In the current year, $15,000 of the gain would be taxed at a 25% tax rate,
$25,000 would be taxed at a 34% rate, and $10,000 would be taxed at a 39% rate. Also, the
total tax liability for two years is $87,400 if the asset is sold in the current year and $90,750 if
the asset is sold in the following year, thereby confirming the decision to sell in the current year.
Selling the assets in the current year permits an extra $33,850 [($110,000 - $26,150) ($60,000
- $10,000)] to be invested for an additional year and earn extra investment income. pp. I:16-10
through I:16-12.
I:16-51 a.
Control Corporation will have AMT adjustments for depreciation and ACE.
Control Corporation's AMT adjustment for depreciation is $29,000 ($100,000 tax depreciation
for property placed in service after 1986 minus $71,000 straight-line depreciation under ADS for
the same property). The AMT adjustment for 75% of the excess of adjusted current earnings
over AMTI (before the adjusted current earnings) is $143,250 [0.75 x ($370,000 - $179,000)].
I:16-17
b.
$150,000
Regular taxable income

AMT adjustments:
Depreciation
ACE adjustment
AMTI
Times: Rate
Tentative minimum tax
Minus: Regular tax liability
AMT
Regular tax liability
Plus: AMT liability
Total tax liability
29,000
143,250*
$ 322,250**
x 0.20
$ 64,450
( 41,750)***
$ 22,700
$ 41,750
22,700
$ 64,450
* ($370,000 - $179,000) x 0.75 = $143,250.

** The exemption is eliminated because Controls AMTI exceeds $310,000.
***$22,250 tax on first $100,000 + 0.39 x ($150,000 - $100,000) = $41,750.
pp. I:16-12 and I:16-13.
I:16-52 a.
$93,250, computed as follows:

Taxable income
Adjustments:
Plus: Dividends-received deduction
Minus: Federal income taxes paid
Dividends paid
Accumulated earnings credit
Accumulated taxable income
$150,000
85,000
( 41,750)
( 20,000)
( 80,000)*
$ 93,250
* The greater of:

1.
Remaining statutory exemption: $70,000 ($250,000 - $180,000) E&P at

beginning of year, or
2.
Current earnings retained for business needs: $80,000 (reasonable needs

of $260,000 at end of year - $180,000 accumulated E&P at the beginning
of the year retained for reasonable needs).
b.
$18,650. The accumulated earnings tax rate is 20%. Crane's accumulated earnings
tax liability is $18,650 ($93,250 x 0.20).
c.
Through the following options: One option for Crane is to distribute cash to the
shareholders to eliminate the unreasonable portion of the accumulated earnings. A second
option is to determine logical reasons for accumulating the earnings (for example, working
capital needs, new capital investments, expansion of the business, etc.). A third option can be an
expansion of the number of shareholders so that the entity is no longer a closely-held
corporation. One needs to remember that payment of the accumulated earnings tax in one tax
I:16-18
year does not provide protection against being cited for having an unreasonable earnings
accumulation in a later year.
pp. I:16-14 and I:16-15.
I:16-53 a.
Disagree. George is not correct that the payment of dividends will insulate the
corporation from the personal holding company tax. In particular, for the year in question,
Delta Corporation paid only $6,000 of dividends, which is substantially less than the personal
holding company tax base.
b.
Taxable income
Adjustments:
Plus: Dividends-received deduction
Minus: Federal income tax liability ($50,000 x 0.15)
Dividends-paid deduction
Undistributed personal holding company income
Times: PHC tax rate
PHC tax
$ 50,000
80,000
( 7,500)
( 6,000)
$116,500
x 0.20
$ 23,300
The personal holding company tax rate is 20%. This rate is the same rate most
shareholders will pay on dividend income. Prior to the 2003 Act, dividends and undistributed
personal holding company income were both taxed at ordinary income tax rates. Today,
individuals have less of an incentive to shelter passive or investment earnings in the corporate
form, because of the lower tax rate on dividend income.
c.
Through (1) the payment of significant dividends to reduce or eliminate the
$116,500 tax base, (2) failing to meet the stock ownership test by making changes in
shareholder ownership amounts (for example, by selling stock to people unrelated to the three
current shareholders), or (3) failing to meet the 60% of adjusted ordinary gross income test by
reducing the amount of personal holding company income (e.g., dividends and interest), or by
(4) reinvesting its earnings in operating assets producing nonpassive income. pp. I:16-16
through I:16-17.
I:16-19
I:16-54 a.
$11,125 for East and $20,875 for Eagle. These amounts are computed as follows:
Corporation
Tax Brackets
Total
East
Eagle
Tax on initial $50,000 of taxable income

apportioned equally to East and Eagle (0.15 x
$25,000)
$ 7,500
$ 3,750
$ 3,750
Tax on next $25,000 of taxable income apportioned

equally to East and Eagle (0.25 x $12,500)
6,250
3,125
3,125
Tax on next $25,000 of taxable income apportioned

equally to East and Eagle (0.34 x $12,500)
8,500
4,250
4,250
Tax on taxable income from $50,000 to $75,000 for

East (0.39 x $25,000)
9,750
______
9,750
$32,000
$11,125
$20,875
Total tax liability
Note that the total tax is $32,000, the same tax amount that one corporation with $125,000 of
taxable income would pay [$22,250 on first $100,000 in taxable income + 0.39 ($125,000 $100,000) = $32,000].
b.
$7,500 for East and $13,750 for Eagle, or a total of $21,250. The tax difference
between the two answers is $10,750 ($32,000 - $21,250).
Corporation
Tax Brackets
Total
Tax on initial $50,000 of taxable income

(0.15 x $50,000) for each corporation
$15,000
Tax on next $25,000 for Eagle (0.25 x $25,000)
6,250
Total tax for East and Eagle if not a controlled $21,250

group
pp. I:16-8 through I:16-11, I:16-17 through I:16-20.
I:16-20
East
$7,500
-0$7,500
Eagle
$ 7,500
6,250
$13,750
I:16-55 None. If all three corporations are tested together, they fail to be a brother-sister
controlled group under the 80%-50% test because Cathy owns stock in only two of the
corporations and the 80% common ownership requirement is failed.
Individuals
Alfred
Barbara
Total
First
Second
Third
Identical
Interest
40%
30
70%
40%
60
100%
40%
30
70%
40%
30
70%
Although, the shareholders meet the 50% test, they fail the 80% test because together they do not
own at least 80% of each and every one of the three corporations. As illustrated below, if First
and Third Corporations are tested without Second Corporation, Cathy's ownership is included
and First and Third are brother-sister corporations. Second Corporation, however, is not a
member of the controlled group.
Individuals
Alfred
Barbara
Cathy
Total
First
40%
30
30
100%
Third
Identical
Interest
40%
30
30
100%
40%
30
30
100%
pp. I:16-17 through I:16-20.

I:16-56 a.
Jack recognizes $20,000 of Sec. 1231 gain (the lesser of Jack's realized gain of
$40,000 [$100,000 FMV - $60,000 adjusted basis] or $20,000 FMV of boot securities received).
Jack's basis in the Giant stock is $60,000 ($60,000 adjusted basis + $20,000 gain recognized $20,000 of marketable securities). Jack's basis in the marketable securities is $20,000, their
FMV. Giant's basis in the land is $80,000 (Jack's $60,000 adjusted basis in the property +
$20,000 gain recognized by Jack).
b.
Karen recognizes none of her $20,000 realized loss [($80,000 FMV of stock +
$20,000 FMV of note) - $120,000 basis of equipment] even though the 20-year note is treated as
nonqualifying property (boot). Karen's basis in the stock is $100,000 ($120,000 adjusted basis
for equipment - $20,000 note received), and her basis in the note is $20,000. Giant's basis in the
equipment is its FMV of $100,000 pursuant to the 2004 Jobs Act.
Latoya recognizes $20,000 of ordinary income [the lesser of her $30,000 realized
c.
gain ($100,000 FMV - $70,000 adjusted basis) or $20,000 boot received]. Latoya's basis in the
stock is $70,000 ($70,000 adjusted basis + $20,000 gain recognized - $20,000 boot received).
Latoyas basis in the boot property is $20,000. Giant's basis in the inventory is $90,000
(Latoya's $70,000 adjusted basis in the property + $20,000 gain recognized by Latoya).
I:16-21
d.
Marc recognizes no gain or loss due to Sec. 351. However, Sec. 357 triggers gain
recognition since the assumption of a debt, the amount of which is in excess of his basis in the
land is treated as boot property under Sec. 357(c)(3). Marc's gain is $10,000 ($40,000 mortgage
- $30,000 basis in the land). Marcs basis in the stock is $0 ($30,000 adjusted basis - $40,000
mortgage assumed by the corporation + $10,000 gain recognized). Giant's basis in the land is its
$30,000 carryover basis plus the $10,000 recognized gain, or $40,000.
e.
Giant Corporation recognizes a $5,000 ($20,000 - $15,000) gain under Secs.
311(b) and 351(f) from the distribution of appreciated marketable securities (boot property) to
Jack. pp. I:16-20 through I:16-24 and I:16-27 and I:16-28.
I:16-57 a.
b.
Basis = $35,000; gain recognized = $0

Because the transfer qualifies under Sec 351, the shareholders generally will not
recognize gain or loss on the transaction. With the corporation assuming the
liability, Lindas basis is $35,000 ($45,000 adjusted basis - $10,000 liability
assumed by the corporation). Because the liability is less than her basis, she does
not need to recognize any gain on the transfer.
Basis = $32,000; gain recognized = $0
Because the transfer qualifies under Sec. 351, Cynthia will not need to recognize
any gain or loss on the transaction, and her basis will $32,000 (the same as her
basis in the land).
I:16-58 a.
A $200,000 gain ($800,000 liability assumed - $600,000 adjusted basis) under
Sec. 357(c)(3). The character of the gain is determined by the nature of the asset and how it
was used by the transferor. The gain is Sec. 1231 gain because the asset transferred was land
used in Matts business. The gain would have been capital gain if the land was held by Matt as
an investment.
b.
Zero ($600,000 + $200,000 gain recognized - $800,000 liabilities transferred).
The liabilities assumed by the corporation exceeded the adjusted basis of the property
transferred.
c.
$800,000 ($600,000 adjusted basis in transferors hands + $200,000 gain
recognized). pp. I:16-20 through I:16-24.
I:16-59 a.
Taxable income
$ 30,000
Plus: MACRS depreciation exceeding ADS depreciation
30,000
U.S. production activities deduction
10,000
Dividends-received deduction
60,000
Minus: Federal income tax liability
( 4,500)
Excess charitable contributions
( 9,000)
Current E&P
$116,500
b.
The full $100,000. Before the 2003 Tax Act, dividend income was subject to
the shareholders ordinary income tax rates (the top tax rate was 39.6% for high-income
individuals). Now dividend income of individuals is taxed at capital gains rates. The top tax
rate for dividends is 20%.
I:16-22
$16,500. This amount will be added to the accumulated E&P account and will
c.
reduce the deficit account from its current $300,000 level to a deficit of $283,500. pp. I:16-25
through I:16-27.
I:16-60 a.
$79,750 ($100,000 + $10,000 + $7,000 + $12,000 - $22,250 - $27,000).
$279,750 ($79,750 current E&P + $200,000 accumulated E&P) is taxable as a
b.
dividend. $20,250 ($300,000 - $279,750) is a tax-free return of capital that reduces the
shareholders stock basis. The top tax rate for qualifying dividend income is 20%.
c.
$0. pp. I:16-25 through I:16-27.
$15,200. The accumulated E&P of $40,000 and $24,800 of current E&P deficit
I:16-61 a.
(124 days x $200/day E&P deficit) are netted on the April 30 distribution date. The $73,000
E&P deficit is allocated on a daily basis as $200 per day ($73,000 365). The 124 days (from
the January 1 through May 4 in a non-leap year) are used to determine the $15,200 ($40,000 $24,800) E&P reduction in the current year up to the distribution date. The top tax rate for
qualifying dividends is 20%.
b.
$44,800 is a tax-free return of capital, reducing the stock basis to $280,200.
c.
The accumulated E&P deficit is $48,200 ($73,000 - $24,800 used to offset
accumulated E&P). pp. I:16-25 through I:16-27.
I:16-62 a.
$50,000 for each. For Nancy, the amount distributed equals $50,000 [0.50
(percentage share of the property) x $100,000 (the FMV of the property)]. This amount is
treated as a taxable dividend because the corporation has sufficient E&P. For Palm Corporation,
the tax consequences are the same as for Nancy. Palm also is eligible for a dividends-received
deduction of $40,000 (0.80 x $50,000) because Palm owns 20% or more of the Old Corporation
stock.
b.
For each: $50,000 FMV of each shareholders interest in the land.
Old must recognize any realized gain because the appreciated property is treated
c.
as if the corporation sold the property to the shareholders immediately before its distribution
for its FMV (Sec. 311(b)). Thus, Old recognizes a $70,000 gain ($100,000 FMV - $30,000
adjusted basis). pp. I:16-27 and I:16-28.
I:16-63 a.
A $10,000 gain ($80,000 FMV - $70,000 adjusted basis) that increases taxable
income and E&P. E&P is reduced by the federal income taxes imposed on the gain.
b.
$55,000 ($80,000 FMV - $25,000 liability).
c.
The $80,000 FMV.
pp. I:16-27 and I:16-28.
I:16-23
I:16-64 Galadriel Corporations pre-tax earnings are $500,000. The $100,000 salary is
deductible by the corporation when calculating the corporations income tax liability. The
salary is taxable as ordinary income to Galadriel. In a real-life situation for the year 2014, both
the corporation and Galadriel would pay FICA taxes in the amount of 7.65% on the first
$117,000 of earned income. The employer will also owe state employment taxes on a similar
dollar amount. The employee would not be able to deduct the amount of the FICA taxes that
she pays. The corporation would be able to deduct the amount of the FICA taxes and state
employment taxes that it pays as a business expense.
After considering the salary (but ignoring FICA and state unemployment taxes),
Galadriel Corporation has taxable income calculated as follows:
Pre-salary income
$500,000
Less: Salary
100,000
Taxable income
$400,000
Galadriel corporate income taxes due are $136,000. After tax earnings, for the corporation are
$264,000 ($400,000 taxable income $136,000 taxes). Using the assumption stated in the
problem that this income is all taxed at the highest marginal tax rate for individuals, Gabbys
income tax on the salary is $39,600 ($100,000 x 39.6%) for a total income tax bill for Gabby and
the corporation of $175,600.
Note that the real world addition of FICA and unemployment taxes on the salary option
would add almost $15,000 in taxes to this total tax bill.
If the $100,000 payment to Gabby is a dividend, Galadriel would be denied a deduction
for the payment amount. No employment taxes would be owed on the dividend payment. With
a dividend payment to Gabby, Federal corporate income taxes on the $500,000 taxable income
are $170,000 ($500,000 x 34%). Galadriels after-tax earnings are $330,000 ($500,000 $170,000). Because the dividend is a qualifying dividend, Gabby pays taxes of $20,000
($100,000 x 20%). Total income tax bill for Gabby and the corporation is $190,000. The
reduction in tax rate on dividends has made the two alternatives much closer in total tax due.
The $600,000 is treated as a dividend under Sec. 301 because the redemption
I:16-65 a.
does not qualify as a complete termination under Sec. 302(b)(3) nor a substantially
disproportionate reduction of Jane's interest under Sec. 302(b)(2). Before the redemption Jane
owns 90 of the 100 shares (50 directly and 40 indirectly) or 90%. After the redemption Jane
owns 50 of the 60 shares outstanding (10 directly and 40 indirectly) or 83.3%. To meet the
substantially disproportionate test, Jane's ownership interest needs to be reduced below 50% of
the total combined voting power entitled to vote to meet the 50% test. Under the 80% test, the
ownership percentage must be reduced below 72% (0.80 x 90%). Jane meets neither the 50%
nor 80% test needed to qualify for Sec. 302(b)(2) treatment. Janes redemption is not eligible
for not essentially equivalent to a dividend treatment under Sec. 302(b)(1) since she is still
the controlling shareholder in Private Corporation after the redemption.
b.
$250,000 ($50,000 + $200,000 basis of the redeemed stock).
c.
The redemption would qualify for capital gain treatment under Sec. 302(b)(2).
Jane owned 50% (50 out of 100 shares) of the Private stock prior to the redemption. Jane owns
16.67% (10 out of 60 shares) of the Private stock following the redemption. Jane satisfies the
Sec. 302(b)(2) substantially disproportionate redemption exception to the dividend income
treatment since she owns less than 50% of Privates stock following the redemption. In
addition, her ownership interest after the redemption (16.67%) is less than 80% of her
I:16-24
ownership interest prior to the redemption (50% x 80% = 40%). As a result, Jane recognizes a
$400,000 ($600,000 distribution - $200,000 adjusted basis) long-term capital gain on the
redemption. The basis of Janes remaining 10 shares is $50,000. pp. I:16-28 through I:16-30.
I:16-66 a.
Sam (Son) recognizes a capital gain of $70,000 ($100,000 - $30,000) because
his interest is completely terminated under Sec. 302(b)(3) if a waiver agreement is filed
with the IRS. Frank (Father) recognizes dividend income of $50,000 because his redemption
fails the substantially disproportionate test. To qualify, the shareholder must own less than
80% of the former percentage interest in the voting stock. Before the distribution, Frank
owned 70% (50% directly + 20% from Sam) of the common stock. After the distribution,
Frank must own less than 56% (0.80 x 70%) to meet the 80% test and less than 50% to meet
the 50% test. However, after the distribution, Frank owns 57.1% (40/70 remaining shares). He
fails both the 50% and 80% tests. Franks redemption is not eligible for not essentially
equivalent to a dividend treatment under Sec. 302(b)(1) since he still owns more than 50% of
Primes stock following the redemption.
b.
If Sam does not file an agreement with the IRS to waive the family attribution
rules or if he violates the agreement during the 10-year post-redemption period, the distribution
will be taxed as a $100,000 dividend. The $30,000 basis for Sam's stock would be reallocated
to Frank. pp. I:16-28 through I:16-30.
I:16-67 a.
Liquidating corporations must recognize gains and losses on sales or distributions
of property. Queen Corporation recognizes $1 million ($3 million proceeds - $2 million basis) of
gain from the sale of the fixed assets. Of the $1 million gain on the sale of fixed assets, $800,000 is
ordinary income due to Sec. 1245 recapture, and the remaining $200,000 is Sec. 1231 gain. Queen
also recognizes $1 million ($5 million proceeds - $4 million basis) of capital gain from the sale of
the land. Queen must report the $400,000 ($1,000,000 proceeds - $600,000 basis) gross profit
from the sale of the inventory to customers as ordinary income. All of the gain is taxed at a 34% or
35% rate.
b.
Ahmed recognizes $800,000 ($1,200,000 - $400,000) of capital gain. The
shareholder is deemed to have sold his stock to the corporation in exchange for money or other
property.
Since all three assets have appreciated in value, the tax consequences of
c.
distributing the assets in liquidation to Ahmed would be no different than having Queen
Corporation sell the assets directly to third parties. In each case, Sec. 336 requires Queen to
recognize the gain realized on distributing the assets to Ahmed. Queen recognizes $400,000 of
ordinary income when the inventory is distributed, $1 million of gain ($800,000 of Sec. 1245
gain and $200,000 of Sec. 1231 gain) when the depreciable fixed assets are distributed, and $1
million of capital gain when the land is distributed. Because of the loss disallowance rules found
in Sec. 336, the results might be different to Queen if one or more properties had an unrealized
loss at the time of the distribution to Ahmed. pp. I:16-31 through I:16-33.
I:16-68 a.
Zero. Union Corporation recognizes none of the $1.8 million ($2,500,000 FMV
of assets -$700,000 basis) realized gain as a result of the liquidation per Sec. 332.
b.
$700,000. The basis of the subsidiary's assets carries over to the corporation, and
the adjusted basis of the parent's interest in the subsidiarys stock disappears. Tampa also
assumes the $100,000 in liabilities.
I:16-25
c.
Tampa Corporation inherits Unions $125,000 E&P balance. In addition, Unions
depreciation recapture potential under Secs. 1245 and 1250 carries over to Tampa along with the
assets. pp. I:16-31 through I:16-33.
Tax Strategy Problems

I:16-69 Several suggestions. Alpha and Beta Corporations are a brother-sister controlled group.
The two shareholders (Sandra and John) own all of the stock of Alpha and Beta corporations.
The two corporations are 100% owned by the two shareholders, and there is 80% common
ownership between the two corporations by Sandra and John. The common ownership prevents
each corporation from taking advantage of the $11,750 tax liability on the first $100,000 of
taxable income for each Alpha and Beta.
Alpha has a $100,000 net operating loss. The loss incurred by one member of a brothersister controlled group cannot be used to reduce the tax liability of other members of the
controlled group. As separate entities, the loss incurred by Alpha can be used only to reduce
Alphas tax liability in future tax years. As such, the use of Alphas $100,000 loss is dependent
on Alpha earning a profit in future tax years.
Beta is in much the same situation as Alpha. Beta has incurred $200,000 of NOLs. As
stated in the case, the pricing arrangement between Alpha and Beta appears to limit Betas
profitability to at best operating at break-even. One suggestion that might be made to Sandra and
John is to change the transfer pricing arrangement between the two corporations so that Beta
pays a lower than normal price for the products purchased from Alpha. The lower than
normal pricing arrangement may permit Beta to report a profit on its sales that can be used to
offset $200,000 in prior-year NOLs.
Another alternative is to have Beta merged into Alpha. Alpha could then assume Betas
$200,000 NOL under the rules of Sec. 381(a). Alpha then could avoid the payment of some of
its income taxes by using Betas NOL carryover to reduce its taxable income. The use of Betas
NOL carryovers by Alpha are limited under the rules of Sec. 382. The Sec. 382 rules limit the
use of the NOL to the value of Beta acquired times the Sec. 382 rate at the time of the
acquisition.
If the two parties do not want to merge Beta into Alpha, then the structure could be
changed so that Alpha owns more than 80% of the stock of Beta, thereby permitting a
consolidated tax return to be filed. Prior year losses of Beta that were in existence at the time of
the structure change could be used to offset taxable income earned by Alpha subject to the
limitations imposed by the SRLY rules and/or Sec. 382(a).
I:16-70 Several strategies. The first issue you should explain to the couple is that there are
various business forms that will limit the couples riskthese include limited liability companies
(LLCs), limited partnerships, C corporations, and S corporations. The nontax advantages and
disadvantages of each entity form should be discussed with the couple. After covering these
items in detail, the couple should be told how the various entity forms are taxedthe flowthrough method for limited liability companies, limited partnerships, and S corporations. The
two levels of taxation required with a C corporation should also be discussed. The tax rates
should be discussed including the possibility that the top corporate tax rate could be lower than
the top individual tax rate that applies to LLCs, limited partnerships, and S corporations. Penny
I:16-26
and Rick, however, may be taxed at a marginal personal tax rate that is less than the marginal
corporate tax rate. The fact that there is a second layer of taxation for a C corporation will need
to be considered in addition to the marginal corporate tax rate.
Second, you should cover the tax consequences of the business incurring losses, and that
the LLC, limited partnership, and S corporation forms of doing business permit the losses to be
passed through to the owners of the business. A C corporation, on the other hand, only can use
the losses to offset profits earned by the corporate entity in prior or subsequent years.
Third, you should discuss with the clients that the transaction cost of creating any of these
entity alternatives to a proprietorship is not large. Because an LLC and limited partnership are
taxed under the partnership taxation rules, the creation of an LLC and a limited partnership are
tax-free under the Sec. 721 partnership taxation rules. Similarly, creation of a C or an
S corporation is tax-free under the Sec. 351 corporate taxation rules.
Fourth, you should mention that liquidation of the two entity forms will be different.
Liquidation of a C corporation or an S corporation requires gains and losses to be recognized by
the entity on the distribution of the entitys assets to the shareholders. A second tax will be
imposed on the gain realized by the shareholder(s) on receiving the assets. Generally, liquidation
of a partnership is a tax-free event. The shareholders will take a carryover basis in the assets
from the books of the partnership.
There is no one right answer in terms of selection of a business entity form. For example,
if the owners want to use a flow-through business entity form, there are a series of alternatives
partnership, limited partnership, LLC, or S corporationall with different advantages and
disadvantages.
I:16-71 The following advice: Peter Martin appears to have set himself up pretty well for his
retirement years in Florida. He is apparently worried about whether his pension plan from Martin
Corporation will provide sufficient income for he and his wife to live comfortably. Peter would
like to keep the Martin stock in the family because he is thinking about having Martin
Corporation redeem their shares at some future date. Unfortunately, all of the Martin shares are
owned by family members. The Sec. 318 attribution rules will pose a problem for making a
stock redemption under Secs. 302(b)(1) or (2) that permits the couples basis in the stock to be
recovered tax-free when less than 100% of their stock holdings are redeemed. Redemption of
100% of their stock holdings will qualify for capital gains treatment under the Sec. 302(b)(3)
complete termination rules because the Martins can waive the family attribution rules. The
Martins may want to consider selling their stock to other family members to produce capital gain
treatment, or living off other assets that have been accumulated over the years and keep their
entire Martin Corporation stock holdings.
Depending on the age and health condition of the family members, Sec. 303 (redemption
of stock to pay death taxes) may prove to be a valuable tax-planning device. Sec. 303 permits
part or all of the Martin stock to be redeemed at capital gains rates following the death of either
the husband or wife. Coupled with the step-up in basis that occurs at death, the capital gains tax
incurred when a Sec. 303 stock redemption takes place may be small or nonexistent.
I:16-27
I:16-72 Alternative one: sell the land to ABC.

If Gertrude sells the land, she will recognize long-term capital gain of $1,490,000 and
will pay income tax on the gain of $298,000 ($1,490,000 x 20% capital gains tax). ABC will
then have a purchase price basis in the land of $1,500,000. ABC can expect the following
income from the lot sales:
Sales proceeds
$ 3,000,000
1,500,000
Purchase price for land
Development costs
300,000
Sales commissions (5% of proceeds)
150,000
Taxable income
$ 1,050,000
Tax (34%)
$ 357,000
Total of Gertrudes and ABCs tax related to sales of this land: $655,000. Note that Gertrudes
tax will be due in the tax year in which the sale to ABC takes place, while the corporate income
tax will come due over the time period when the lots are sold.
Alternative two: transfer the land to ABC in exchange for stock.
The transfer of land to Gertrudes wholly owned corporation would qualify as tax free to
both Gertrude and ABC Corporation under Sec. 351. The corporation takes a carryover basis in
the land ($10,000) and Gertrude has a $10,000 basis in her new shares of ABC stock. Under
this alternative, ABC would have the following income and tax expenses:
$3,000,000
Sales proceeds
Carryover basis for land
10,000
Development costs
300,000
Sales commissions (5% of proceeds)
150,000
Taxable income
$2,540,000
Tax (34%)
$ 863,600
This tax will be due over the time period when the lots are sold. It is possible that this tax bill
could be spread over several years.
Note that under this alternative, Gertrude still has no cash from this transfer. If Gertrude wants
cash, she would need to sell some of her ABC shares (and pay the 20% capital gains tax on her
gain on the sale of shares) or take a dividend from ABC (with a 20% tax rate on qualifying
dividends). Either of these alternatives makes the tax cost of this transaction even larger.
I:16-28
Tax Form/Return Preparation Problems

I:16-73 (See Instructors Resource Manual)
I:16-74 (See Instructors Resource Manual)
Case Study Problems

I:16-75 The following points should be made in the memo for the clients:
1.
The transaction should qualify under Sec. 351 although the boot rules should
result in some gain recognition by Paul, and the services rendered by Sam do not constitute Sec.
351 property. Sam will be treated as having received compensation (ordinary income) for his
legal services. Although some stock is issued to Sam in exchange for services, and some
property is received from Paul in exchange for boot property, the total amount of stock issued
by the corporation for property is sufficient to permit the remainder of the transaction to be taxfree under Sec. 351.
2.
The recharacterization of debt to equity under Sec. 385 does not appear to be a
problem because the total debt of $50,000 is small relative to the total capital of $300,000, and
the debt will not be owned proportionately by the shareholders.
Frank recognizes no gain or loss because he receives only FPS stock. His basis
3.
in the stock is $50,000, and FPS's basis in the land and building is $50,000. His holding period
in the stock carries over from the assets transferred. Franks holding period for the building and
land carries over to the corporation.
4.
Paul's realized and recognized gain on the transfer of inventory is $40,000 (the
smaller of the $40,000 realized gain or the $50,000 boot) because FPS debt is not qualifying
property and constitutes boot received. Paul's basis in the FPS stock is $50,000 ($60,000 basis
for the property + $40,000 recognized gain - $50,000 boot received) and is $50,000 for the notes.
FPS's basis in the inventory is $100,000 ($60,000 carryover basis + $40,000 gain recognized by
Paul).
5.
Sam does not recognize the $20,000 loss ($60,000 FMV stock - $80,000 basis) on
the transfer of equipment due to the operation of Sec. 351. However, he must report $40,000 of
compensation income for rendering services. Section 351 continues to apply to Sams asset
transfer because the transfer of equipment for FPS stock is significant relative to the FMV of the
services. Sam's basis in the stock is $120,000 ($80,000 basis of equipment transferred + $40,000
FMV of compensatory stock) even though its FMV is only $100,000. FPS's basis in the
equipment is $60,000, and it must capitalize the $40,000 in legal fees (eligible for 60-month
amortization under Sec. 248). pp. I:16-18 through I:16-22.
6.
The corporation recognizes no gain when issuing the stock for cash or noncash
property. (Sec. 1032).
I:16-29
I:16-76 The memo to Beth should include the following points. The points contain references to
IRC sections for reference purposes, but the memo to Beth should minimize such citations.
1.
The contribution of cash in exchange for stock will be a nontaxable transaction
under Sec. 351. Also, the cash is not appreciated property, so it would not trigger gain in any
case. The basis of the new stock will be $50,000. Finally, the corporation recognizes no gain or
loss under Sec. 1032 when it issues stock for cash.
2.
The loan to the corporation is a nontaxable event for both Beth and the
corporation, and Beth has a $50,000 basis in the debt instrument.
3.
A key issue is whether the loan will be reclassified as equity. To be treated as
debt, the instrument must have the proper legal form, specifically, a stated reasonable interest
rate, currently paid interest, a definite maturity date, and repayment when due. In addition, the
debt-equity ratio must not be excessive, the debt should not be proportional to stock ownership,
and the debt should not be convertible into stock.
In this case, the debt cannot escape proportionality since Beth is the sole
4.
shareholder, which endangers its status as debt. However, the courts have deemed
proportionality irrelevant for sole shareholders. See J.S. Biritz Construction Co. v. CIR, 20
AFTR 2d 68-5891, 68-1 USTC 9118 (8th Cir., 1968).
5.
Although debt is beneficial because interest payments are deductible while
dividends are not, debt may not be the best choice in Beth's situation. To qualify as debt, the
corporation must make regular interest payments, which may put a cash drain on the corporation.
Thus, if the corporation needs its cash for expansion and operations, it may prefer equity because
it can retain its earnings for business needs. The corporation does not have to pay dividends to
avoid possible imposition of the accumulated earnings tax if it can show it retains earnings for
the reasonable needs of the business (Sec. 531). On the other hand, if Beth wants the
contribution returned to her in the near future, debt would be the better option because repayment
would be a tax-free return of capital rather than a potential dividend involving the redemption of
some of her stock holdings.
Tax Research Problems

I:16-77 a.
b.
c.
The State of Florida permits four types of business forms to operate in Florida.
The business forms are: sole proprietorships, corporations, partnerships, and
limited liability companies (LLCs).
Corporations, partnerships, and LLCs created or organized in Florida must
register with the State of Florida. The appropriate state agency is the Florida
Division of Corporations.
Corporations, partnerships, and LLCs that are created or organized outside of
Florida, and operate inside of Florida, also must register with the State of Florida.
I:16-30
d.
The State of Florida imposes a corporate income tax.

1. Corporations and other entities, including those located in other states that
are partners in a partnership or members of a joint venture doing business in
Florida must file Florida Form F-1120 (Corporate Income/Franchise and
Emergency Excise Tax Return).
2. The Florida corporate income tax is calculated using the federal taxable
income modified by certain Florida adjustments, to determine adjusted
federal income.
I:16-78 Consider the following response. Prior to the acquisition Charlie and Delta
corporations have been filing separate corporate tax returns. Each corporation reports its own
income and expenses, pays its own federal income taxes, and files its own corporate income tax
return. Both corporations presumably used the accrual method of accounting because
inventories were one of the major assets for each firm on its balance sheet. Similarly, cost of
goods sold were a major part of each corporations expenses. Sales between the two
corporations were reported for financial accounting and federal income tax purposes using the
accrual method.
Charlies 100% ownership of Deltas stock now permits the two corporations to elect to
file a consolidated tax return. The 80% minimum ownership requirement has been satisfied.
Delta is a major supplier of raw materials and components used in Charlie Corporations
production of plastic toys. Sales between Delta and Charlie prior to the acquisition were fully
taxable to each company. Prior to the acquisition Delta recognized its profits from its sales to
Charlie when the sale took place. In this situation Deltas federal income tax liability reported
sales to Charlie in the tax return for the year in which the sale took place. Under the
consolidated tax return rules, Deltas profit or loss on an inter-company transaction involving
goods can be deferred until the goods are sold by the purchasing corporation (Charlie) to a third
party that is not a member of the affiliated group. The consolidated tax return rules permit a tax
deferral on the inter-company inventory sale from the actual sale date until the goods are used in
a product produced by Charlie that is subsequently sold to a customer. Generally such
accountings are made at the end of the affiliated groups tax year. Before one encourages the
creation of an affiliated group of corporations (rather groups of brother-sister corporations) one
needs to look at the amount of tax savings that are likely to accrue each year and compare it with
the increased cost of filing a single consolidated tax return instead of two (or more) separate
corporate tax returns for each member of the member of the affiliated group. The two firms need
to remember that, once a consolidated tax return election is made, the two firms cannot elect to
file separate tax returns instead of filing a consolidated return when the tax savings become
smaller than the additional cost of complying with the consolidated return rules.
The filing of a consolidated tax return involves additional work over the filing of two
separate corporate tax returns. The tax benefits accruing when a federal consolidated tax return
filing is planned needs to be weighed against the additional costs involved with filing separate
federal corporate tax returns for each individual corporation. In addition, a similar comparison
needs to be made with respect to the state corporation rules for each state in which the company
operates or plans to operate.
I:16-31
I:16-79 Arguably yes. Section 302(b)(3) grants exchange treatment to a shareholder of a

corporation when he has a complete termination of his interest. Section 302(c)(2) states that the
attribution rules of Sec. 318(a)(1) shall not apply if, after the distribution, the distributee has no
interest in the corporation "including an interest as an officer, director, or employee." The only
interest the distributee may have is that of a creditor. In William M. Lynch [83 T.C. 597 (1984)],
the Tax Court held that the redemption of the shareholder's stock constitutes a complete
redemption of his interest under Section 302(b)(3). The specific facts of the Lynch case closely
parallel the facts in the research problem.
In the Lynch case, the taxpayer originally was a sole shareholder of a corporation.
Later, he transferred some of his stock to his son, and thereafter the corporation redeemed the
balance of his stock. After the redemption, the shareholder, Lynch, performed some services for
the corporation pursuant to a consulting agreement. The shareholder was compensated under the
consulting agreement.
In the Lynch case, the Tax Court concluded that tax avoidance was not a principal
purpose for the transfer of the stock to his son within the meaning of Sec. 302(c)(2)(B). The
Court held that the petitioner did not hold a financial stake in the corporation after the
redemption. "The payments which the petitioner received pursuant to the consulting agreement
were in no sense contingent on the profitability or the future operations of the corporation."
However, the Lynch case was reversed upon appeal by the U.S. Court of Appeals. See
William M. Lynch v. CIR, 58 AFTR2d 86-5970, 86-2 USTC 9731 (CA-9, 1986). The Court of
Appeals found that the taxpayer had failed to sever all noncreditor interests in the corporation.
He had an office in the corporation and was covered by medical insurance in addition to acting
as an independent contractor for the corporation. By providing these services, he held a
prohibited interest, and the family attribution rules of Sec. 318 were held to apply. The taxpayer
was disqualified for a complete termination under IRC Sec. 302(b)(3), and the redemption was
treated as a dividend.
Ted cannot hope to avoid the tax problem by claiming that the three-year limitations
period has expired. Sec. 302(c)(2) extends the limitations period to ten years starting with the
date of the redemption distribution.
The consulting agreement in the case study is different from the one used in Lynch.
The consulting agreement found in this research question specifies a $375 hourly rate and
reimbursement for expenses. No guaranteed number of hours of work is mentioned in the
agreement. In addition, unlike the Lynch case, office space is not being made available to Ted
during time periods when consulting services are not being provided.
Teds scenario appears to be different from the Lynch case in a number of ways. These
differences should permit a tax practitioner to develop a stronger case for qualifying under Sec.
302(b)(3). Teds situation is more like the facts in the Estate of Milton S. Lennard v. CIR case
(61 T.C. 554 [1974]). In Lennard, the taxpayers interest was completely terminated following
the redemption of all of his stock under Sec. 302(b)(3). Similar to Lynch, Ted performed
services for his former employer following his retirement. Unlike Lynch, Ted is serving in the
I:16-32
traditional role of an independent contractor. Being an independent contractor leaves Ted with
only a creditor interest in the corporation. In addition, no mention is made of Ted receiving a
pension from his former employer. The lack of a pension being paid to Ted is a positive factor
towards Ted terminating his interest.
The facts in our scenario appear to be more closely aligned to the Lennard case than
the Lynch case. These differences should make it easier to show that Ted should be taxed on
his profit at capital gains rates under the Sec. 302(b)(3) safe haven and not be required to
recognize dividend income under Sec. 301.
One thing that is not mentioned in the facts of the case is the number of hours that Ted
will be working for his former employer. If Ted performed substantial duties that required fulltime (or close to full-time) employment as a consultant by his former employer, then the IRS
would have the possibility of saying that the original relationship between employer and
employee-shareholder Ted had not in fact changed.
If your client is entertaining the possibility of engaging in a similar type of transaction,
he or she should examine the cases that have been decided in the taxpayers favor in similar
types of Sec. 302(b)(3) transactions to see what makes them different from the Lynch case.
I:16-80 Yes. A contribution to capital qualifies for nontaxable treatment under IRC Sec. 351
even though the corporation does not issue additional stock. Sol Lessinger v. CIR, 63 AFTR 2d
89-1055, 89-1 USTC 9254 (2nd Cir., 1989) held that additional stock issued to a sole
shareholder would be a meaningless gesture. If Beth made a contribution to capital, the basis
of her existing stock would increase by $50,000. In addition, the corporation would recognize no
gain or income from the contribution under Sec. 118.
However, various authorities [See Sec. 1244(d)(1)(B), Reg. Secs. 1.1244(c)-1(b) and
1.1244(d)-2(a), and James D. Pierce, 1989 PH T.C. Memo 89,647, 58 TCM 865] hold that an
increase in basis resulting from a contribution to capital will not be treated as part of the basis
when determining the amount of the Sec. 1244 stock loss. Section 1244 treatment is important
because Beth would be allowed an ordinary loss if the stock became worthless. Without Sec.
1244 treatment for the capital contribution, upon worthlessness she would incur a $40,000
ordinary loss (her original basis) and a $50,000 capital loss. The capital loss would be deductible
only to the extent of capital gains recognized in a tax year plus $3,000. On the other hand, if the
corporation issues stock to Beth in exchange for the $50,000, the stock will qualify as Sec. 1244
stock, thereby allowing her a $90,000 ordinary loss if the stock becomes worthless. The
limitation on ordinary loss treatment is $100,000 for a married taxpayer filing a joint tax return.
Thus, to maximize her Sec. 1244 stock benefits, Beth should have the corporation issue
additional shares in exchange for the $50,000.
I:16-81 The following advice: under the general rules of Sec. 1001(a), Peter will realize and
recognize a gain equal to the difference between his sales proceeds and the basis of the shares
that he sells. If he sells all of his shares, $300,000 of gain will be recognized. In general, this
I:16-33
gain is taxed as a long-term capital gain under Sec. 1201(a). Such capital gain ordinarily will be
taxed at a maximum rate of 20%. There are three exceptions to this general rule.
IRC Sec. 1202(a) permits 50% of the gain realized from the sale or exchange of
qualified small business stock held for more than five years to be excluded from taxation. Peter
does not meet the requirement of having held the stock for more than five years. Able
Corporation satisfies the requirements of being a C corporation, and maintaining an active
business. Peters profit will not exceed the $10 million ceiling on excludable gain.
IRC Sec. 1044(a) permits the taxpayer to elect to rollover the gain realized on the
sale of publicly traded securities to the extent that the proceeds are invested in a specialized
small business investment company within 60 days of the date on which the publicly traded
securities were sold. Publicly traded securities are securities traded on an established securities
market. Based on the small number of shareholders, the stock may not be considered to be
publicly traded. More information would be needed about the stock to make a final
determination. The annual limit on the excluded gain is the smaller of $50,000, or $500,000
reduced by the amount of gain excluded under this provision in prior years. The amount of gain
excluded on the sale reduces the basis of the stock acquired in the reinvestment.
IRC Sec. 1045 permits a rollover of gain realized from a qualified small business
stock sale to another qualified small business stock investment. A qualified small business stock
is defined in Sec. 1202(a). The stock that is sold must have been held for more than six months,
and the stock that is purchased must have been acquired within 60 days of the sale date. The
realized gain that goes unrecognized reduces the basis of the newly purchased stock.
The three alternatives give Peter an opportunity to exempt from current taxation part or
all of the currently realized gain. Two of the three alternatives (Secs. 1044 and 1045) require
reinvestment of the sales proceeds. The third alternative (Sec. 1202) exempts the gain from
current taxation even though no reinvestment takes place. The choice of which alternative to use
is up to the investor, and the decision-making should involve the investors need for current cash
as well as an examination of the remainder of Peters stock portfolio. If Peter is to use the first
alternative, he must hold the stock longer.
I:16-82 As a sale of capital asset, because the transaction qualifies as a complete termination of
Erins interest. The easy part of this problem is the analysis of the sale to Evan and the two
employees. The gain on the sale of this 10% of her stock is $245,000 ($250,000 - $5,000 basis
in 10% of the stock).
The more difficult analysis is the determination of the tax result on the redemption of
90% of her shares. This transaction cannot qualify as a substantially disproportionate
redemption of stock under Sec. 302(b)(2) since she still owns 60% indirectly through her son
Evan. To qualify as a sale, she needs to meet the requirements of Sec. 302(b)(3) minus a
complete termination of her interest. She qualifies for a complete termination only if the
constructive ownership rules can be waived under Sec. 302(c). According to that IRC section,
the constructive ownership rules can be waived if, among other things, the distributee (Erin) has
no interest in the corporation other than an interest as a creditor. (Section 302(c)(2)(A)(i)). Reg.
Sec. 1.302-4(d) outlines relationships that are not acceptable for a creditor such as having the
interest rate dependent on earnings. None of these appear to be a problem for this debt.
I:16-34
The only remaining issue appears to be whether the status as landlord will be a problem.
In Rev. Rul. 77-467, the service held that an arms length lease between a corporation and the
redeemed shareholder does not prevent the transaction being treated as a redemption.
In spite of the straightforward look of this research problem, a Tax Court decision
suggests that the IRS was trying to cloud this issue (thankfully, with no success). In the Hurst
case, the IRS maintained that having several relationships with the firm each relationship one
that has been found to be acceptable could be found to be too much together. In this case
decided by the Tax Court, the taxpayer received notes for his redeemed shares, was the landlord
for the corporation, and had a spouse who continued to work for the corporation as an employee.
The IRS contended that the totality of the circumstances gave the taxpayer a financial stake in
the corporation. The Tax Court rejected this argument and held that the redemption qualified as
a complete termination.
What Would You Do In This Situation? Solution

Ch. I:16, p. I:16-15.
a.
The accumulated earnings tax is not a self-assessed tax. (See Prentice Halls
Federal Taxation of Corporation, Partnerships, Estates, and Trusts, 2015 Edition, Chapter C:5.)
The IRS has the responsibility to audit the taxpayer's return and to allege that the company is
subject to the accumulated earnings tax if warranted by the facts. In this case, although the making
of loans to the shareholders is not a reasonable business need for the retention of earnings and the
nonpayment of dividends to the shareholders is a potential indicator that an accumulated earnings
problem exists, the fact that the corporation has reinvested its earnings in operating assets (with the
possible exception of the marketable securities) is a very positive indicator that the earnings have
been reinvested in reasonable business needs. In this situation, the failure to inform the IRS of the
potential problem or to pay the tax is not an error, and the CPA has no responsibility to inform the
IRS or to instruct the client to do so. (See AICPA Statements on Standards for Tax Services No. 6.)
The CPA should inform the client of the potential problem and offer advice so as to prevent the
problem from occurring in the future. Some thought should be given to annually documenting the
firms business needs for the retention of earnings. The two penalty taxes, the accumulated
earnings tax and the personal holding company tax, remain part of the IRC. For 2014, dividend
income is taxed at a 20% maximum marginal tax rate. This rate is the same as the marginal tax
rate applying to capital gains. Scott, Steve, and Sean should be advised to consider making an
S corporation election. There may be an income tax savings to have the corporations income
divided up among the three individuals and taxed on their personal income tax returns. We do not
have enough information to compare the corporations tax liability when operating as a
C corporation versus its tax liability as an S corporation. In addition, the three individuals might
obtain a second tax savings by avoiding the double taxation that is encountered when a
C corporations earnings are distributed to the shareholders as a dividend. Operating as an
S corporation can eliminate exposure to accumulated earnings tax problems that the firm may be
facing in the future. The S corporation election cannot eliminate possible problems that the firm
may encounter when the IRS examines the firms pre-S corporation election tax years.
I:16-35
The personal holding company tax status is based on a mechanical formula.

b.
Once the PHC tests are met, the tax is self-assessed, and a Schedule PH should be filed with
Form 1120 in the year the determination is made. Any penalty tax due should be paid upon the
filing of the corporate income tax return. Interest and penalties on the PHC tax will be owed
from the due date of the income tax return until the tax is paid. Failure to file the Schedule PH
will extend the statute of limitations for a personal holding company from the normal threeyear period to six years even if the corporation owes no additional taxes [Reg. Sec. 301.
6501(f)-1]. The three owners may want to determine whether the PHC penalty tax problem is
a short-run (one-year) phenomenon or represents a long-term multi-year problem. If it is a
long-term problem, the owners may want to consider making an S corporation election. Again,
like with the accumulated earnings tax, earnings from S corporation tax years are passed
through to the owners and no personal holding company tax can be imposed.
I:16-36

CH 16

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CH 16

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Chapter I:16

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Corporate formations are exchange transactions and therefore should be taxable.

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Not the case

Not the case

Not the case

pp. I:16-29 through I:16-30.

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Issue Identification Questions

$12,000 NSTCL, computed as follows:

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*$200,000 x 0.80 = $160,000

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$13,750 + 0.34 x ($90,000 - $75,000) = $18,850.

Taxable income before LTCG

$22,250 + 0.39 x ($110,000 - $100,000) = $26,150

$7,500 + 0.25 x ($60,000 - $50,000) = $10,000

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Regular taxable income

* ($370,000 - $179,000) x 0.75 = $143,250.

$93,250, computed as follows:

* The greater of:

Remaining statutory exemption: $70,000 ($250,000 - $180,000) E&P at

Current earnings retained for business needs: $80,000 (reasonable needs

$15,000, computed as follows:

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Tax on initial $50,000 of taxable income

Tax on next $25,000 of taxable income apportioned

Tax on next $25,000 of taxable income apportioned

Tax on taxable income from $50,000 to $75,000 for

Total tax liability

Tax on initial $50,000 of taxable income

Tax on next $25,000 for Eagle (0.25 x $25,000)

Total tax for East and Eagle if not a controlled $21,250

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pp. I:16-17 through I:16-20.

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Basis = $35,000; gain recognized = $0

$116,500, computed as follows:

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Tax Strategy Problems

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I:16-72 Alternative one: sell the land to ABC.

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Tax Form/Return Preparation Problems

Case Study Problems

Tax Research Problems

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The State of Florida imposes a corporate income tax.

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I:16-79 Arguably yes. Section 302(b)(3) grants exchange treatment to a shareholder of a

Copyright 2015 Pearson Education, Inc.

What Would You Do In This Situation? Solution

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The personal holding company tax status is based on a mechanical formula.

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