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SM Ch02 SWFT2013

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SM Ch02 SWFT2013SM C

    CHAPTER 2

    CORPORATIONS: INTRODUCTION AND OPERATING RULES

    SOLUTIONS TO PROBLEM MATERIALS

     Status: Q/P

    Question/ Learning Present in Prior

    Problem Objective Topic Edition Edition

     1 LO 1 Choice of entity: tax and nontax factors Unchanged 1

     in entity selection

     2 LO 1 Corporation versus S corporation: treatment New

     of operating income and tax-exempt

     income; no distributions

     3 LO 1, 7 Corporation versus proprietorship: treatment Unchanged 3

     of losses

     4 LO 1, 2 Corporation versus partnership: treatment of Unchanged 4

     operating losses and LTCG

     5 LO 1, 2 Corporation versus LLC and S corporation Unchanged 5

     6 LO 1, 7 Closely held corporations: shareholder Unchanged 6

     transactions

     7 LO 1 Corporate and individual tax rates compared Unchanged 7

     8 LO 1 LLCs: tax treatment of Unchanged 8

     9 LO 1 LLCs: multi-owner default rule New

     10 LO 2 Accounting periods: general rule and fiscal New

     year limitation

     11 LO 2 Accounting periods: PSC fiscal year New

     limitation

     12 LO 2 Accounting methods: limitation on cash New

     method

     13 LO 2 Accounting methods: limitation on accrual Unchanged 13

     of expenses to cash basis related party

     14 LO 2 Net capital gain: corporate and individual Unchanged 14

     tax rates contrasted

     15 LO 2 Net capital loss: corporation and Unchanged 15

     individual contrasted

     16 LO 2 Recapture of depreciation: ? 291 adjustment New

     17 LO 2 Passive loss rules: closely held C Unchanged 17

     corporations and PSCs contrasted

     18 LO 2 Passive loss rules: closely held C Modified 18

     corporation

    2-1

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2-2 2013 Corporations Volume/Solutions Manual

     Status: Q/P

    Question/ Learning Present in Prior

    Problem Objective Topic Edition Edition

     19 LO 2 Charitable contributions: year of deduction Unchanged 19

     for accrual basis corporation

     20 LO 2 Charitable contributions: amount of New

     contributions

     21 LO 2, 7 Charitable contributions: year-end planning Unchanged 21

     issues with carryover

     22 LO 2 Domestic production activities deduction: New

     computation

     23 LO 2, 3, 7 NOL carryover issues Unchanged 23

     24 LO 1, 3 Dividends received deduction: corporate Modified 24

     versus individual treatment

     25 LO 3 Dividends received deduction: reduced Unchanged 25

     ownership interest

    6 LO 3 Dividends received deduction: holding New 2

     period requirement

     27 LO 3 Organizational and startup expenditures Unchanged 27

     contrasted

     28 LO 4 Corporate income tax rates: highest Unchanged 28

     marginal rate

     29 LO 5 Tax liability of related corporations New

     30 LO 6 Estimated tax payments: required annual Unchanged 30

     payment

     31 LO 6 Schedule M-1: adjustments Unchanged 31

     32 LO 6 Schedule M-3: reconciliation of expense Modified 32

     item

     33 LO 1 Compare LTCG treatment for regular Unchanged 33

     corporations and proprietorships

     34 LO 1 Tax treatment of income and distributions Unchanged 34

     from partnership, S and C corporations

     35 LO 1, 2 Corporation versus proprietorship: salary Modified 35

     versus dividends; tax-exempt interest

     36 LO 1, 2 Corporations versus S corporation: ordinary New

     income and LTCG

     *37 LO 1 Corporation versus proprietorship: after- Updated 37

     tax comparison

     38 LO 2 Comparison of deduction for casualty loss Modified 38

     for individual and corporate taxpayers

     *39 LO 1, 4, 7 Tax liability determination as proprietorship Unchanged 39

     or corporation

     40 LO 2, 4 Personal service corporation: salary New

     requirements for use of fiscal year and

     tax rate

     41 LO 2 Accounting methods: related party expense; New

     cash versus accrual

     42 LO 2, 4 Capital gains and losses: tax rate on LTCG Unchanged 42

     for corporation versus individual

     43 LO 2 Net capital loss of corporation Unchanged 43

     44 LO 2 Comparison of treatment of net capital losses Unchanged 44

     for individual and corporate taxpayers

    ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

     Corporations: Introduction and Operating Rules 2-3

     Status: Q/P

    Question/ Learning Present in Prior

    Problem Objective Topic Edition Edition

     45 LO 2 Capital gains and losses of a corporation; Unchanged 45

     carryback/carryover

     46 LO 2 Recapture of depreciation on ? 1250 Modified 46

     property: corporation versus individual

     47 LO 2 Passive loss of closely held corporation; Unchanged 47

     PSC

     48 LO 2 Corporate charitable contributions: amount New

     of contributions

     49 LO 2, 7 Corporate charitable contributions: tax Unchanged 49

     planning

     50 LO 2, 7 Corporate charitable contributions: Unchanged 50

     carryover; tax planning

     51 LO 2, 7 Corporate charitable contributions: timing Unchanged 51

     of deduction; taxable income limit

     52 LO 2 Domestic production activities deduction New

     *53 LO 2, 3 Net operating loss: computed with New

     dividends received deduction

     *54 LO 3 Dividends received deduction Unchanged 54

     55 LO 3 Organizational expenditures Unchanged 55

     *56 LO 3 Startup expenditures Modified 56

     *57 LO 4 Determine corporate income tax liability Unchanged 57

     58 LO 5 Tax liability of related corporations Modified 58

     59 LO 6 Estimated tax payments: large corporation New

     *60 LO 6 Schedule M-1, Form 1120 Unchanged 60

     61 LO 6 Schedule M-1, Form 1120 Modified 61

     62 LO 6 Schedule M-2, Form 1120 Unchanged 62

     63 LO 6 Schedule M-3, Form 1120 Unchanged 63

     64 LO 6 Schedule M-3, Form 1120 Unchanged 64

     65 LO 6 Schedule M-3, Form 1120 Modified 65

     66 LO 2, 3, 7 Tax issues involved in starting a new Unchanged 66

     business in the corporate form

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

     Status: Q/P

     Tax Return Present in Prior

    Problem Topic Edition Edition

     1 Corporation income tax (Form 1120 with Sch. M-3) Modified 1

     2 Corporation income tax (Form 1120) Unchanged 2

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2-4 2013 Corporations Volume/Solutions Manual

     Status: Q/P

    Research Present in Prior

    Problem Topic Edition Edition

     1 Limitation on fiscal year-end for PSC: business New

     purpose exception

     2 Charitable contribution of inventory: enhanced Unchanged 1

     deduction

     3 Personal service corporation: application to Unchanged 2

     surveying business

     4 Internet activity Unchanged 4

     5 Internet activity New

     6 Internet activity Unchanged 6

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     Corporations: Introduction and Operating Rules 2-5

    CHECK FIGURES

    33.a. Juanita will report profit $50,000 and 44.b. $16,000 deducted 2012; $15,000

    long-term capital gain $20,000. carried back to 2009, then 2010, etc. 334.b. Juanita‘s income is not increased. 5.a. Offset short-term capital gain of 34.a. Each partner reports $55,000 net profit $70,000 against net long-term capital

    and short-term capital loss $7,500. loss of $195,000. The $125,000 net 34.b. Same as a. capital loss is carried back 3 years and 34.c. Corporation reports $110,000 income. forward 5 years.

    Shareholders each report $25,000 45.b. Total carryback $110,000.

    dividend income. 45.c. $15,000; carry forward to 2013, etc. 35.a. Azure tax of $119,000; Sasha $0 tax. 45.d. Deduct $73,000 in 2012, $122,000 35.b. Azure tax of $119,000; Sasha $11,250 carried forward indefinitely.

    tax. 46.a. Ordinary income of $57,498 and 35.c. Azure tax of $90,500; Sasha $26,250 ? 1231 gain of $429,994.

    tax. 46.b. Section 1231 gain of $487,492. 35.d. Azure tax of $0; Sasha $122,500 tax. 47. Offset $225,000 of passive loss against 35.e. Azure tax of $0; Sasha $122,500 tax. active income. No offset if a PSC. 36.a. Taupe tax of $0; Charlene tax of 48. $118,500.

    $151,500. 50. Gift land in 2013.

    36.b. Taupe tax of $153,000; Charlene $0 51. 2012.

    tax. 52.a. $81,000.

    37.a. After-tax income $152,689. 52.b. $75,000.

    37.b. After-tax income $124,702. 53.a. $54,000.

    37.c. After-tax income $109,169. 53.b. ($12,000).

    38.a. $17,400 itemized deduction. 54. Green $140,000; Orange $105,000; 38.b. $40,000. Yellow $140,000.

    39.a. $56,000. 55.a. $6,317.

    39.b. $43,350. 55.b. $2,300.

    39.c. $45,650. 56. $6,217.

    39.d. $54,023. 57. Purple $6,750; Azul $104,150; Pink 40.a. $84,000. $799,000; Turquoise $7,350,000; Teal 40.b. $33,250. $28,000.

    41.a. $440,000. 58. Red $42,325; White $69,625. 41.b. $460,000. 59. April 15, $59,500; June 15, $212,500; 42.a. $17,150. September 15, $136,000; December 15, 42.b. $12,750. $136,000.

    43.a. $60,000 taxable income; $10,000 tax. 60. Taxable income of $120,000. 43.b. $68,000 taxable income; $12,000 tax. 61. Taxable income of $265,000. 44.a. $19,000 deducted 2012; $12,000

    carried forward to 2013.

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    2-6 2013 Corporations Volume/Solutions Manual

    DISCUSSION QUESTIONS

     1. You should ask questions that will enable you to assess both tax and nontax factors that will

    affect the entity choice. Some relevant questions are addressed in the following table,

    although there are many additional possibilities.

    Question Reason for the question

    This question will provide information that What type of business are you

    going to operate? may affect the need for limited liability,

    ability to raise capital, ease of transferring

    interests in the business, how long the

    business will continue, and how the business

    will be managed.

    What amount and type of income Income from a business will eventually be (loss) do you expect from the reported on the tax returns of the owners.

    business?

    What is the amount and type of For example, income (loss) from a partnership, income (loss) that you expect from S corporation, or LLC will ‗‗flow through‖ to other sources? the owners. Dividends from a C corporation

    must be reported on the tax returns of the

    shareholders. Any income (loss) from other

    sources will also be reported on the returns of

    the owners. Thus, for planning purposes, it is

    important to know all sources and types of

    income (loss) that the owners will have.

    Do you expect to have losses in the Losses of partnerships, S corporations, and early years of the business? LLCs flow through to the owners and

    represent potential deductions on their

    individual returns. Losses of a C corporation

    do not flow through.

    Will you withdraw profits from the Profits from a partnership, S corporation, or business or leave them in the LLC will ‗‗flow through‖ to the owners, and business so it can grow? will be subject to taxation on their individual

    tax returns. Profits of a C corporation must be

    reported on the tax returns of the shareholders

    only if such profits are paid out to shareholders

    as dividends. Thus, in the case of a partnership,

    S corporation, or LLC, owners must pay tax on

    profits before plowing funds back into the

    business. In the case of a C corporation, the

    corporation must pay tax on its profits.

    In what state(s) will the business States assess business taxes (e.g., corporate be formed? income tax, franchise tax) on various forms

    of entities, including some that apply to S

    corporations, partnerships, and/or LLCs.

     pp. 2-2 to 2-8

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     Corporations: Introduction and Operating Rules 2-7

     2. C corporations are separate taxable entities. Cassowary Corporation will report the operating

    income and tax-exempt income on its return (Form 1120), resulting in taxable income of

    $120,000 for the year. Shareholders are required to report income from a C corporation only

    to the extent of dividends received; thus, Barbara reports no income from Cassowary for 2012.

    An S corporation is a tax reporting entity but (generally) not a taxable entity. Instead, its

    profit (loss) and separately stated items flow through to the shareholders. Emu Corporation

    will report ordinary business income of $120,000 and separately stated tax-exempt interest

    income of $8,000 on its return (Form 1120S), with 40% of these amounts allocated to Barbara

    (Schedule K-1). Barbara will report ordinary business income of $48,000 and tax-exempt

    interest income of $3,200 on her individual return (Form 1040). The absence of dividend

    distributions from Emu Corporation does not affect Barbara‘s treatment of the income. pp. 2-3

    and 2-5

     3. Art should consider operating the business as a sole proprietorship (or a single-member LLC)

    for the first three years. If he works 15 hours per week in the business, he will exceed the

    minimum number of hours required to be a material participant (52 × 15 = 780) under the

    passive loss rules. Therefore, he will be able to deduct the losses against his other income.

    When the business becomes profitable, Art should consider incorporating. If he reinvests the

    profits in the business, the value of the stock should grow accordingly, and he should be able

    to sell his stock in the corporation for long-term capital gain. pp. 2-2 to 2-8, 2-38, and 2-39

     4. A C corporation is a separate taxable entity, and its taxable income has no effect on the

    shareholders until such time a dividend is paid. When dividends are paid, shareholders must

    report dividend income on their tax returns. Thus, Plover Corporation will have a net

    operating loss of $60,000 (operating loss of $80,000 + long-term capital gain of $20,000), and

    the NOL does not pass through to the shareholders. Since no dividends were distributed, the

    shareholders have no tax consequences in the current year with respect to Plover Corporation.

     Partnerships are tax reporting entities, and the income, gains, deductions, and losses of a

    partnership are passed through to and reported by the partners on their tax returns. Long-term

    capital gains of a partnership retain their character when reported by the partners.

    Distributions (or the lack thereof) typically do not affect the tax treatment of partnership

    activities. Thus, each partner of Vireo will report an operating loss of $20,000 ($80,000 ? 4

    partners) and a LTCG of $5,000 ($20,000 ? 4 partners). Various loss limitation rules

    (e.g., partnership loss limitation, at-risk rules, and passive loss rules) may limit a partner‘s

    ability to currently deduct some or all of the operating loss.

     pp. 2-2, 2-3, and 2-5

     5. If Blue Company is an LLC: A single-member LLC is taxed as a proprietorship. Thus,

    Samantha will report the $200,000 operating income (Schedule C), $10,000 short-term capital

    loss (Schedule D), and $3,000 tax-exempt interest (Form 1040, page 1) on her tax return. The

    $50,000 withdrawal would have no effect on Samantha‘s individual tax return.

     If Blue Company is an S corporation: An S corporation is a tax reporting entity (Form 1120S),

    and its income, gains, deductions, and losses are passed through to and reported by the

    shareholders on their tax returns. Separately stated items, e.g., tax-exempt income and capital

    losses, retain their character at the shareholder level. Consequently, Samantha will report the

    $200,000 operating income (Schedule E), $10,000 short-term capital loss (Schedule D), and

    $3,000 tax-exempt interest (Form 1040, page 1) on her tax return. The $50,000 withdrawal

    would have no effect on Samantha‘s individual tax return.

    If Blue Company is a C corporation: A C corporation is a separate taxable entity, and its

    taxable income has no effect on the shareholders until such time a dividend is paid. When ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

    2-8 2013 Corporations Volume/Solutions Manual

    dividends are paid, shareholders must report dividend income on their tax returns. Thus, Blue Company will report taxable income of $200,000 on its Form 1120. Corporations can deduct capital losses only to the extent of capital gains. The $10,000 net capital loss (STCL) will be carried back 3 years and forward 5 years. The tax-exempt interest income is excluded from Blue‘s gross income. Samantha will report dividend income of $50,000 (Schedule B) on her individual tax return.

    pp. 2-2 to 2-8

    6. Shareholder employment by the corporation.

     Compensation paid to shareholder must be reasonable (i.e., not in excess of arms-

    length amount).

     Shareholder rents or leases property to corporation.

     Rent/lease payment to shareholder must be reasonable (i.e., not in excess of fair rental

    value).

     Shareholder loans money to corporation.

     Interest payment (rate) to shareholder must be reasonable (i.e., not in excess of market

    rate).

     Shareholder sells property to corporation.

     Sale price to corporation must be reasonable (i.e., not in excess of fair market value).

     Corporation rents or leases property to shareholder.

     Rent/lease payment to corporation must be reasonable (i.e., not less than fair rental

    value).

     Corporation loans money to shareholder.

     Interest payment (rate) to corporation must be reasonable (i.e., not less than market

    rate).

     Corporation sells property to shareholder.

     Sale price to shareholder must be reasonable (i.e., not less than fair market value).

     pp. 2-4, 2-39, and 2-40

    7. The marginal tax rates for C corporations are: 15%, 25%, 34%, 35%, 38%, and 39%. The marginal tax rates for individuals are 10%, 15%, 25%, 28%, 33%, and 35%. p. 2-4 and Exhibit 2.1

    8. Under the check-the-box Regulations, LLCs are be taxed as follows. A single-member LLC is taxed as a proprietorship unless an election is made on Form 8832 to be taxed as a corporation. An LLC with more than one owner is taxed as a partnership unless an election is made on Form 8832 to be taxed as corporation. Entities that are incorporated under state law or required to be taxed as corporations under Federal law (e.g., certain publicly traded partnerships) cannot make an election under the check-the-box Regulations. p. 2-8 ? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

     Corporations: Introduction and Operating Rules 2-9

     9. The statement is correct. Because no Form 8832 was filed, the LLC will be taxed as a

    partnership, the default classification for multi-member LLCs under the check-the-box

    Regulations. A Form 8832 is required to be filed only if the taxpayer wants to elect to have

    the entity classified as a corporation for Federal tax purposes. p. 2-8

    10. In general, the statement is correct. That is, corporate taxpayers generally may choose a

    calendar year or a fiscal year for reporting purposes. However, the use of a fiscal year is

    restricted for personal service corporations and S corporations. For such corporations, the

    calendar year is the required reporting period, subject to a few limited exceptions (e.g.,

    business purpose for fiscal year can be demonstrated, deferral under a ? 444 election). p. 2-10 11. A C corporation is relatively unrestricted as to the choice of accounting periods, and generally

    may choose either a fiscal year or a calendar year. It is not necessary for a new C corporation

    to obtain consent of the IRS with regard to its choice of an accounting period. Personal

    service corporations, however, can elect a fiscal year only under one of the following

    circumstances:

     A business purpose for the year can be demonstrated.

     The year results in a deferral of not more than three months‘ income. An election under

    ? 444 is required, and the PSC will be subject to the deduction limitations of ? 280H.

     The PSC retained the same year that was used for its fiscal year ending 1987, provided an

    election was made under ? 444 and subject to the deduction limitations of ? 280H.

    Thus, Salmon Corporation can elect a March 31 fiscal year-end, but Scarlet Corporation

    would need to satisfy the business purpose exception to qualify for a March 31 fiscal year-end.

    p. 2-10

    12. In general, a corporation is not allowed to use the cash method of accounting for Federal tax

    purposes. However, S corporations, qualified personal service corporations, and

    C corporations engaged in the trade or business of farming or timber are exceptions to this

    rule. Further, a C corporation with $5 million or less of average gross receipts over the past

    three years is allowed to use the cash method.

     a. Jade Corporation has $4.8 million of average gross receipts over the 2009-2011 period.

    Thus, Jade satisfies the gross receipts exception and may use the cash method of

    accounting.

     b. Lime Corporation, a PSC, may use the cash method of accounting without regard to its

    gross receipts.

     pp. 2-10 and 2-11

    13. A corporation that uses the accrual method cannot claim a deduction for an expense involving

    a related party (e.g., a more than 50% shareholder) until the recipient reports that amount as

    income. Wang, a cash basis taxpayer, must report the $35,000 interest income in 2013, the

    year she receives the payment. The corporation may deduct the $35,000 interest expense in

    2013, the year Wang is required to report it as income. p. 2-11 and Example 12 14. Both corporations and individuals include recognized capital gains in their taxable income.

    For a corporate taxpayer, there is no preferential tax rate applicable to long-term capital gains.

    Instead, the capital gain is taxed at Parrot‘s normal tax rate of 35%. The preferential tax rate

    of 15% would apply to Jeanette‘s long-term capital gain. p. 2-11

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2-10 2013 Corporations Volume/Solutions Manual

    15. John and Eagle Corporation each net the $6,000 STCG against the $8,000 LTCL, resulting in

    a $2,000 net capital loss. John reports the capital transactions on his individual tax return, and

    deducts the $2,000 net capital loss in the current year. Eagle reports the capital transactions

    on its the corporate tax return, but none of the $2,000 net capital loss is deductible in the

    current year. Instead, Eagle carries back a $2,000 STCL three years and, if necessary,

    forward 5 years, to be offset against capital gains in such years. pp. 2-11 and 2-12 16. For an individual taxpayer, there is no deprecation recapture under ? 1250 with respect to

    realty placed in service after 1986 and depreciated under the straight-line method. However,

    under ? 291, a C corporation must treat a portion of gain recognized on the disposition of

    ? 1250 property as depreciation recapture (ordinary income). The ? 291 ordinary income

    amount is equal to 20% of the excess of the amount of depreciation recapture that would arise

    if the property was ? 1245 property over the amount of depreciation recapture computed

    under ? 1250 (without regard to ? 291). As a result, some of the gain recognized by a C

    corporation on the sale of the warehouse will be ordinary income (and not ? 1231 gain).

    p. 2-12 and Example 15

    17. a. If Osprey is a personal service corporation, it cannot deduct any of the passive loss in

    the current year. A personal service corporation cannot offset a passive loss against

    either active or portfolio income.

     b. A closely held corporation that is not a personal service corporation can offset passive

    losses against active income but not against portfolio income. Therefore, Osprey can

    deduct the entire $60,000 passive loss.

     p. 2-13

    18. A closely held C corporation that is not a personal service corporation can offset a passive

    loss against active income, but not against portfolio income. Hummingbird can deduct only

    $40,000 of the $45,000 passive loss. Thus, Hummingbird‘s taxable income is $15,000

    ($40,000 + $15,000 $40,000). Example 16

    19. In order to be deductible by an accrual basis corporation in the year authorized by its board of

    directors, a charitable contribution must be paid within 2 1/2 months of the end of the year of

    authorization (March 15, 2013, in this case). Because payment was made within the required

    time period, the charitable contribution is deductible in 2012. p. 2-14

    20. The rules for determining the amount of a charitable contribution of property by a

    C corporation are:

     Loss property (fair market value less than basis) = fair market value.

     Ordinary income property (property that, if sold, would not result in a long-term capital

    gain or ? 1231 gain) = basis.

     Certain contributions of inventory qualifying for increased contribution amount (e.g.,

    contribution of inventory that is related to organization‘s exempt function and such

    use is solely for the care of the ill, needy, or infants) = lesser of (1) the sum of the

    property‘s basis plus 50% of the appreciation on the property or (2) twice the

    property‘s basis.

     Capital gain property (property that, if sold, would result in a long-term capital gain or

    ? 1231 gain) = fair market value.

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