Comparative Forms of Doing Business 13-XXX - DocsLib

Comparative Forms of Doing Business 13-XXX

2006

CHAPTER 13 COMPARATIVE FORMS OF DOING BUSINESS SOLUTIONS TO PROBLEM MATERIALS

DISCUSSION QUESTIONS 1. The principal legal forms for conducting a business entity are the sole proprietorship, partnership, limited liability company, and corporation. The principal Federal income tax forms are the same, except that the corporation is divided into the C corporation and the S corporation. pp. 13-3 and 13-4 2. The legal and tax forms of a business entity usually are the same, but differences can develop. If the corporate entity lacks substance, the IRS may ignore the corporate legal form and tax the owners directly. Likewise, the IRS may attempt to treat a partnership as if it were a corporation. This latter likelihood has been reduced due to the issuance of the check-the-box Regulations. pp. 13-3 and 13-4 3. The business advantage of a limited liability company is limited liability. The tax advantage is that the entity can be taxed under the conduit concept available to partnerships. Thus, only single taxation, rather than double taxation, applies. Also, losses can be passed through from the entity to the owners. pp. 13-4, 13-6, and 13-7 4. The maximum statutory rate for a C corporation and for an individual is 35%. However, at certain levels of income the individual rates are lower than the corporate rates. For example, in 2005 income between $100,000 and $250,000 is taxed at 28% or 33% for a married taxpayer filing a joint return, whereas for a corporation the rate is 39%. In addition, at certain levels of income, the individual rates are higher than the corporate rates. For example, in 2005 income between $500,000 and $10,000,000 is taxed to a corporation at 34%, whereas for a married taxpayer filing a joint return, the rate is 35%. So what is relevant is the actual rates that apply in a particular situation and not the maximum statutory rates. Also double taxation may apply with corporations if dividend distributions are made to shareholders. p. 13-8 and Example 7 5. The motivation for the change in legal form is to limit liability. Under the general partnership form, there is unlimited liability with the personal assets of each of the firm partners being subject to the claims of the partnership creditors. Under the limited liability partnership form, the personal assets of a particular partner are subject to the 13-1 13-2 2006 Annual Edition/Solutions Manual

claims of the partnership creditors for his or her actions. (Note in some states that even this amount is limited.) However, the personal assets of a particular partner are not subject to the claims of partnership creditors for the actions of other partners. The income tax consequences associated with the general partnership form and the limited liability form are the same. That is, the entity is not subject to taxation (i.e., the partnership is a tax reporter and the partners are the taxpayers). Both profits and losses are passed through to the partners. pp. 13-4, 13-5, and Tax in the News on p. 13-5 6. The limited liability objective can be achieved by forming a limited partnership whose general partner is a corporation. The liability of the limited partners is limited by the statute. The owners of the corporation have effectively limited their liability by having the corporation be the general partner. Prior to the issuance of the check-the-box Regulations, it was necessary to structure the entity carefully in order to avoid the limited partnership being classified as an association and taxed as a corporation. Under the check-the-box Regulations, the limited partnership cannot be reclassified as an association and taxed as a corporation. Figure 13-1 7. a. and b. The ability to raise capital and the shelter of limited liability are advantages of the corporate form. While the limited partnership form enables the limited partners to limit their liability to the amount invested, the general partner or partners have unlimited liability. Both corporate shareholders and limited partners could forfeit this protection to the extent they guarantee corporate or partnership debts. c. There is no limit on the life of a corporation. Changes in the owners of a partnership can result in its termination. d. There is no limit on the number of owners for a corporation; a partnership must have at least two. Centralized management is a characteristic of a corporation. While the typical general partnership lacks centralized management, it exists in the usual limited partnership. pp. 13-5 to 13-7 and Concept Summary 13-2 8. Gary can benefit by passing the losses through and offsetting them against his other income. Since he is the sole owner, the three business forms available that will permit this are the sole proprietorship, limited liability company (LLC), and the S corporation. A benefit of the S corporation and the limited liability company when compared with the sole proprietorship is limited liability. Once Gary’s business starts producing a profit, each of these three business forms will result in single taxation (i.e., the entity is not subject to taxation and Gary is subject to taxation). pp. 13-7 to 13-9 9. The S corporation and its owners are subject to single taxation and the C corporation and its owners are subject to double taxation. As Sue suggests, one way to avoid double taxation is to reduce the corporate taxable income to zero. However, one must be aware of the possibility of the IRS raising the unreasonable compensation issue. To the extent that the IRS is successful, the salary is reclassified as a dividend and double taxation is produced. Comparative Forms of Doing Business 13-3

Sam is correct that being an S corporation does provide certain constraints in that the requirements that must be satisfied in order to elect S status (e.g., number and types of shareholders, only one class of stock) become maintenance requirements. For example, issuing preferred stock would result in termination of the S election. One approach would be for Sam to elect S corporation status presently. If at some time in the future he cannot continue to satisfy the maintenance requirements, he would then become a C corporation. During the period that the S corporation election is in effect, he would not have to be concerned about double taxation.

Note that a tax advisor should not limit his or her analysis to the options provided by the client. Sam should also consider the limited liability company (LLC). pp. 13-8, 13-12, 13-13, and Concept Summary 13-2 10. A C corporation is subject to double taxation only if it makes distributions to the shareholders. Since Paul’s corporation currently pays no dividends and does not intend to do so in the future, double taxation is not present. In addition, the $60,000 salary paid to Paul was deductible by the corporation in calculating its taxable income of $100,000. By making the S election, Paul may have created a wherewithal to pay problem for himself. He is taxed on the $100,000 even though he is receiving no dividends from the corporation. Thus, he may have generated a cash flow problem. In addition, by making the S election, he has increased the entity/owner tax liability for a C corporation from $22,250 [($50,000 X 15%) + ($25,000 X 25%) + ($25,000 X 34%)] to that for an S corporation of $33,000 ($100,000 X 33%). However, as the entity earnings increase each year, this $10,750 ($33,000 – $22,250) difference will decrease. Ultimately the C corporation tax could be greater than the S corporation tax at the shareholder level. pp. 13-8, 13-12, 13-13, and Example 7 11. All four of the entities, either directly or indirectly, are subject to the AMT. For the sole proprietorship and the C corporation, the impact is direct (i.e., the AMT is calculated on the sole proprietorship’s Form 1040 and on the C corporation’s Form 1120). For the partnership and S corporation, the impact is indirect (i.e., the entities are conduits and the AMT is calculated on the owners’ tax returns). pp. 13-9 and 13-10

12. Violet’s acceleration of income and deferral of deductions for a year in which it is subject to the AMT can be beneficial. Since Violet is subject to the AMT for the current year, any net income increases are taxed at the 20% AMT rate. If such income were taxed next year, it would be subject to a 34% regular corporate tax rate. pp. 13-9 and 13-10 13. If Nell chooses the partnership form, the losses can be deducted on both her Federal and state income tax returns (assuming the three states each have a state income tax). However, if she chooses the corporate form, not all states permit the S corporation election for state income tax purposes. In such case, Nell would not be able to deduct the corporate losses on her state income tax return. Thus, Nell needs to inquire whether the states permit the S election. p. 13-11

14. The statement describes the most favorable type of fringe benefit available taxwise. For example, meals and lodging which qualify under § 119 receive this tax treatment. However, many fringe benefits (e.g., pension and profit sharing plans) provide an 13-4 2006 Annual Edition/Solutions Manual

immediate deduction for the employer, but only tax deferral for the employee. Thus, the employee is taxed in the future when he or she actually receives the benefit. While not as favorable as a complete exclusion, deferral treatment is a positive tax advantage. pp. 13-11 and 13-12 15. The relevant issue for Oscar and Lavender, Inc., is the long-term effect of the dividend policy. Assuming there is no immediate accumulated earnings tax problem, the present dividend policy avoids double taxation. But do reasonable needs exist for keeping the earnings in the corporation rather than distributing them as dividends? If not, then the corporation is vulnerable to the imposition of the accumulated earnings tax. Oscar may also want to consider having his salary increased as a way of insulating additional funds from being subject to double taxation. pp. 13-13 and 13-14 16. The following payments to shareholders are deductible in calculating corporate taxable income.

 Salary payments to shareholder-employees.  Lease or rental payments to shareholder-lessors.  Interest payments to shareholder-creditors. Because of the tax benefit that results, the IRS scrutinizes these types of transactions carefully in terms of reasonableness. In addition, the interest payments may result in the IRS raising the § 385 thin capitalization issue. p. 13-13 and Examples 11 and 12 17. One of the issues that Liane needs to be concerned about is avoiding double taxation. Once she incorporates her sole proprietorship as a C corporation, the C corporation is subject to taxation on its taxable income. Then, Liane is taxed on any after-tax earnings distributed to her as dividends. One way to avoid or reduce the effect of double taxation is to reduce corporate taxable income. If Liane leases the land and building to the corporation, the lease rental payments (assuming they are reasonable) made by the corporation to Liane are deductible in calculating corporate taxable income. p. 13-13 18. The second approach (i.e., a combined capital contribution of $500,000 and loan of $300,000) has two potential advantages. First, the interest payments of $18,000 ($300,000 X 6%) on the loan are deductible by the corporation. Second, the repayment of the loan by the corporation does not produce income to Teresa. The potential pitfall is that the IRS may consider the corporation to be thinly capitalized. This could result in interest payments being reclassified as dividend payments (making them not deductible by the corporation). The loan repayment will be treated as a dividend to the shareholder. p. 13-13 19. The absence of dividends may result in the IRS assessing the accumulated earnings tax. If this should occur, accumulated taxable income would be taxed at a 15% rate in 2005. Comparative Forms of Doing Business 13-5

The penalty tax will not be assessed if Martin has reasonable needs for its accumulated earnings (e.g., is investing in the expansion of the business). If Martin is not a closely held corporation, it is unlikely that the accumulated earnings tax will be assessed. While the accumulated earning tax does apply to corporations that are not closely held, it is assessed only if the corporate earnings are retained for the purpose of avoiding double taxation. Finally, the accumulated earnings tax does not apply to S corporations. Thus, if Martin has been an S corporation since inception, the penalty tax would not apply. pp. 13-13, 13-14, Chapter 6, and Concept Summary 13-2 20. Operating as a C corporation would provide Arnold with greater flexibility in that he would not have to be concerned with satisfying the qualification requirements under § 1361 in order to elect S corporation status. Once the election is made, the qualification requirements become maintenance requirements. The principal negative attribute of being a C corporation is the potential for double taxation. Factors to consider in making the S election include the following:

 Are all the shareholders willing to consent to the election?  Can the qualification requirements under § 1361 be satisfied at the time of the election?

 Since the qualification requirements become maintenance requirements, can these requirements continue to be satisfied?

 For what period will the conditions that make the election beneficial continue to prevail?

 Will the corporate distribution policy create wherewithal to pay problems at the shareholder level? pp. 13-14 and 13-15 21. S corporations can have a maximum of 100 shareholders. For this limitation, married shareholders and certain family members are counted as one shareholder. Therefore, Tammy and Arnold need to structure the property settlement so that this requirement is not violated (i.e., only one of them will remain a shareholder). When there are enough shareholders that there may eventually be a problem with this requirement, a sound tax strategy would include a right of first refusal provision on the part of the corporation or other shareholders with regard to transferring stock outside the extant shareholder group. p. 13-15, Chapter 12, and Concept Summary 13-2 22. The tax consequences to Sadie and to the entities will be the same. The fair market value of the truck of $15,000 is less than Sadie’s adjusted basis (i.e., cost) of $37,000 for the truck. Therefore, the adjusted basis of the truck to the S corporation or to the C corporation is the lower fair market value of $15,000. Sadie’s realized loss of $22,000 (i.e., the value decline while she held the truck for personal use) is disallowed. p. 13-16 and Concept Summary 13-2 23. Section 721 applies the conduit concept with respect to partnership contributions, and realized gains and losses are not recognized. Since the corporation generally is governed by the entity concept, realized gains and losses associated with shareholder contributions 13-6 2006 Annual Edition/Solutions Manual

of assets to the corporation would be recognized. If the requirements of § 351 are satisfied, however, the conduit concept is substituted for the entity concept and any realized gains and losses are not recognized. Paramount to the application of § 351 is the 80% control requirement. pp. 13-16, 13-17, and Concept Summary 13-2 24. Section 704(c) provides for a mandatory special allocation if a partner contributes an asset to a partnership whose basis is not equal to the fair market value. The amount of the special allocation for the contributing partner is the difference between the partner’s adjusted basis for the asset and the fair market value. The purpose for the special allocation is to provide for the eventual taxation of the value increment or decrement to the contributing partner, rather than to have it shared among all the partners. Other elective special allocations are available if they have substantial economic effect. The concept of special allocations does not apply for the corporate form because of the entity concept. The recognition of gains or losses and the taking of deductions occurs at the corporate rather than at the shareholder level. S corporations use the per share and per day allocation method. pp. 13-16, 13-17, 13-21, and Concept Summary 13-2 25. Increases in partnership liabilities increase a partner’s basis for his or her partnership interest, and decreases in partnership liabilities decrease such basis. This is appropriate because the general partners are liable for the liabilities if not paid by the partnership. Corporate liability increases and decreases do not have any effect on the shareholder’s basis for his or her stock. This is appropriate because the shareholder has limited liability. p. 13-17 and Example 17

26. Item Effect on Basis Shareholder in Shareholder in Partner C corporation S corporation Profits + no effect + Losses – no effect –

Liability increase + no effect no effect Liability decrease – no effect no effect Contribution of + + + Assets Distribution of assets – no effect – if classified as a dividend – if classified as a return of Comparative Forms of Doing Business 13-7

capital p. 13-17 and Example 17 27. The conduit concept generally applies to the S corporation. Therefore, the S corporation is a tax reporter rather than a taxpayer, with the taxation occurring at the shareholder level. However, there are several instances in which the S corporation is the taxpayer. Included are the tax on built-in gains and the tax on certain passive investment income. p. 13-18 and Concept Summary 13-2 28. The conduit concept applies in the case of a partnership. Therefore, the partnership is merely a tax reporter and the partners are the taxpayers. The partners are taxed on the earnings of the partnership rather than on the receipt of distributions. Thus, Dexter has already been taxed on his share of the partnership earnings. p. 13-19 29. The C corporation is treated as a separate taxable entity and is subject to double taxation. The benefit of the S election is that the corporation generally is not subject to taxation. Similar to the partnership, the earnings of an S corporation are passed through and taxed at the owner level. Therefore, if the S corporation shareholder later receives a distribution, such earnings have already been taxed. p. 13-19 30. If Sandra and Reese each sell their stock of Olive, they will be taxed on the recognized gain (i.e., excess of amount realized over the adjusted basis for the stock). Olive Corporation is not affected by the sale. If Olive sells the assets, pays its liabilities, and distributes the net assets to the shareholders, the recognized gain is passed through to the shareholders. The shareholders’ adjusted basis for their stock is increased by the amount of the gain they recognized. The shareholders are also taxed on the excess of the amount distributed to them by Olive over the adjusted basis of their stock. Both the stock sale and the asset sale will produce the same total amount of recognized gain to Sandra and Reese. However, there may be a difference in its classification. All of the recognized gain on the stock sale is a long-term capital gain (the stock is a capital asset). On the asset sale, some of the gain could be ordinary income because the assets may not be capital assets. Another factor favoring the stock sale is that it is less complex and costly to consummate than the asset sale. pp. 13-25, 13-26, and Concept Summary 13-1 31. The complete liquidation of a C corporation subjects the corporation/shareholders to double taxation. First, the C corporation is taxed on any gain on the sale of its assets. Second, the shareholders are taxed on the difference between their stock basis and the value of the assets distributed to them by the corporation. If the form of the transaction is a stock sale by the shareholders, then only the shareholders are subject to taxation. They are taxed on the difference between their stock basis and the sales proceeds received. Consequently, the seller benefits from structuring the disposition as a stock sale rather than as a liquidation. 13-8 2006 Annual Edition/Solutions Manual

p. 13-25 and Concept Summary 13-1 32. a. S corporation and C corporation (S and C). p. 13-6 b. C corporation (C). pp. 13-5 and 13-6 c. C corporation (C). pp. 13-7 to 13-9 d. Sole proprietorship, partnership, and S corporation (SP, P, and S). pp. 13-7 and 13-8 e. C corporation (C). p. 13-13 and Concept Summary 13-2 f. S corporation (S). Concept Summary 13-2 g. Sole proprietorship and partnership (SP and P). p. 13-6 h. C corporation (C). p. 13-25 and Concept Summary 13-1 i. Sole proprietorship, partnership, and S corporation (SP, P, and S). p. 13-17 j. Sole proprietorship and partnership (SP and P). p. 13-17 k. C corporation (C). p. 13-19 33. a. Partnership, S corporation and C corporation (P, S, and C). b. Partnership and S corporation (P and S). c. Partnership and S corporation (P and S). d. Partnership and S corporation (P and S). e. Partnership (P). f. Partnership (P). p. 13-17 and Concept Summary 13-2 34. At least four factors should be considered when evaluating whether to make the election under § 754 which will activate the operational provisions of § 743. These four factors are: (1) the partnership must make the election, (2) the election could produce negative basis adjustments if the adjusted basis exceeds the fair market value of the partnership assets at the acquisition date, (3) the election also activates the optional adjustment to basis under § 734 that results from partnership distributions, and (4) the complexity of recordkeeping. p. 13-24 and Example 23

PROBLEMS 35. a. Since a sole proprietorship has unlimited liability, the sole proprietorship and the owner is liable for the remaining $2 million after the $3 million is paid by Comparative Forms of Doing Business 13-9

insurance. Since the net FMV of the net assets is $850,000 ($950,000 – $100,000), the owner is liable for the remaining $1,150,000 ($2,000,000 – $850,000). b. Since a partnership has unlimited liability, the partnership and the partners are liable for the remaining $2 million after the $3 million is paid by insurance. Since the net FMV of the net assets is $850,000 ($950,000 – $100,000), the partners are liable for the remaining $1,150,000 ($2,000,000 – $850,000). c. A C corporation has limited liability (i.e., equal to the FMV of the assets of $950,000). The plaintiff will share with the other creditors (i.e., $100,000) of the entity with respect to claims against the $950,000 of assets. The shareholders of the C corporation have no personal liability for the remaining corporate debts of $1,150,000 ($2,000,000 + $100,000 – $950,000). d. Same response as in c. for an S corporation. p. 13-6 13-10 2006 Annual Edition/Solutions Manual

36. a. The tax liability of each of the corporations is as follows: Red Corporation 15% X $50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 17,000 = 5,780 $19,530 White Corporation 15% X $ 50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 250,000 = 85,000 5% X 225,000 = 11,250 $110,000 Blue Corporation 15% X $ 50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 725,000 = 246,500 5% X 235,000 = 11,750 $272,000 or 34% X $800,000 = $272,000 Orange Corporation 34% X $10,000,000 = $ 3,400,000 35% X 30,000,000 = 10,500,000 3% X 3,333,333 = 100,000 $14,000,000 or 35% X $40,000,000 = $14,000,000 The effective tax rate for each of the corporations is as follows: Red Corporation

$19,530 = 21.23% $92,000 White Corporation

$110,000 = 33.85% $325,000 Blue Corporation

$272,000 = 34% $800,000 Comparative Forms of Doing Business 13-11

Orange Corporation

$14,000,000 = 35% $40,000,000 The marginal tax rate for each of the corporations is as follows: Red 34% White 39% Blue 34% Orange 35% b. The marginal tax rate can be 39% (34% + 5%) or 38% (35% + 3%) as the result of the phase-out of the benefits of the lower brackets. The effective tax rate will never exceed the statutory rate of 35%. Chapter 2 37. Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 March 15, 2005 Amy and Jeff Barnes 5700 Redmont Highway Washington, D.C. 20024 Dear Amy and Jeff: I am responding to your request for advice on the business entity form to be selected for operating the florist shop. In our conversation, the inclination was to conduct the business as a partnership or as an S corporation. After paying salaries of $45,000 to each of you, the profits of the business will be about $60,000. The intent is to invest the earnings in the growth of the business rather than make distributions. In selecting an entity form, consideration should be given to both tax and nontax factors. The tax consequences for the partnership form versus the S corporation form would be the same. The salary of $45,000 is included in your gross income, and the partnership or S corporation would deduct the $90,000 in calculating its taxable income. In addition, regardless of whether the entity is a partnership or an S corporation, each of you would include one-half of the $60,000 projected floral earnings in gross income. A substantial difference does exist, however, with respect to the nontax factors. If the floral shop is conducted as a general partnership, there is unlimited liability. Conversely, if the floral shop is conducted as an S corporation, limited liability results. Although in many cases shareholders of small businesses operating as S corporations are required to guarantee corporate debts, the corporate form still provides protection against contingent liabilities. In choosing between the partnership and the S corporation form, I recommend the S corporation form. However, you may want to consider the limited liability company 13-12 2006 Annual Edition/Solutions Manual

(LLC) form. This legal form provides limited liability, the same tax consequences as those of the partnership form, and greater flexibility than the S corporation form. Call me at your convenience. I look forward to resolving any questions you have regarding the business entity form for your floral shop. Sincerely, Carlene Sims, CPA pp. 13-3 to 13-7 38. The three forms of business entity available to Jack are the sole proprietorship, corporation, and S corporation. The partnership is not a viable option, since Jack is to be the sole owner. In selecting the business form, Jack should consider both tax and nontax factors. Nontax factors to consider include the ability to raise capital and limited liability. The corporate form normally provides the greatest ease and potential for obtaining owner financing. However, for Jack this does not appear to be an advantage, when compared with an unincorporated entity (i.e., sole proprietorship), because he is to be the only owner. The corporate form does however, in this case, offer the advantage of limited liability. If Jack selects the sole proprietorship form, the profits of the entity will be taxed to him. Since Jack will be in the 35% tax bracket, the tax liability on the projected earnings of $200,000 for the initial year would be $70,000 ($200,000 X 35%). If Jack selects the corporate form, the earnings of the business will be taxed to the corporation. The tax liability on the projected earnings of $200,000 for the initial year would be $61,250 [($50,000 X 15%) + ($25,000 X 25%) + ($25,000 X 34%) + ($100,000 X 39%)]. In addition, to the extent that the corporation distributes part or all of the after- tax earnings to Jack as a dividend, double taxation would result. On the other hand, if the corporation pays Jack a salary, Jack will be able to receive cash from the corporation without double taxation. The total income tax would increase, however, as amounts received by Jack as salary will be taxed at 35%. This may be the best solution. Another solution would be to elect S corporation status. The earnings of the corporation would be taxed to Jack rather than at the corporate level. While the initial year, the tax liability of $70,000 would be higher than the C corporation tax liability of $61,250, the potential for being subject to double taxation would be avoided. Finally, the advantage of limited liability would be achieved. pp. 13-5 to 13-8 39. a. If Clay is a C corporation, the corporate tax liability is: 15% X $50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 15,000 = 5,100 $18,850 Since Clay will not distribute any dividends, the shareholders will have no tax liability associated with it. Comparative Forms of Doing Business 13-13

If Clay is an S corporation, the corporate tax liability will be $0 and the shareholders’ tax liability will be $29,700 ($90,000 X 33%). Viewed from an entity-owner perspective, operating as a C corporation will result in tax savings of $10,850 ($29,700 – $18,850). Note that these savings are based on the assumption that the after-tax earnings are reinvested in the growth (i.e., reasonable needs for purposes of accumulated earnings tax) of the business and that no distributions are made to the shareholders. b. If Clay is a C corporation, the corporate tax liability is $18,850. The tax at the shareholder level on the distribution of after-tax earnings of $71,150 is $10,673 ($71,150 X 15%) assuming the dividends are qualified dividends. Therefore, the combined corporation and shareholder tax is $29,523 ($18,850 + $10,673). If Clay is an S corporation, the corporate tax liability will be $0 and the shareholder tax liability will be $29,700. The $90,000 will be a distribution out of AAA and thus will be tax-free to the shareholders. Viewed from an entity-owner perspective, operating as a C corporation will result in tax savings of $177 ($29,700 – $29,523). pp. 13-8, 13-9, and Example 8 40. a. The corporate tax liability on taxable income of $300,000 is $100,250 for the C corporation. $ 50,000 X 15% = $ 7,500 25,000 X 25% = 6,250 25,000 X 34% = 8,500 200,000 X 39%= 78,000 $100,250 Since the tax liability on the $300,000 is assessed at the corporate level, there will be no dividend distribution to Mabel and Alan. They will each receive a salary of $100,000. b. The tax liability is assessed at the shareholder level rather than at the corporate level for the S corporation. Mabel and Alan will each have a tax liability of $52,500 ($150,000 X 35%) associated with their respective shares of the corporate taxable income of $300,000. Therefore, the corporation will need to distribute $52,500 each to Mabel and Alan to pay their tax liability. They also will receive their salary of $100,000 each. c. The combined entity/owner tax liability in a. will be as follows: C corporation $100,250 Shareholders on distribution -0- Shareholders on salaries ($200,000 X 35%) 70,000 Combined tax liability $170,250 The combined entity/owner tax liability in b. will be as follows: 13-14 2006 Annual Edition/Solutions Manual

S corporation $ -0- Shareholders taxed on S corporation earnings ($300,000 X 35%) 105,000 Shareholders on salaries ($200,000 X 35%) 70,000 Combined tax liability $175,000 p. 13-8 and Example 7 41. a. Parrott’s regular income tax liability on taxable income of $5,000,000 is calculated as follows: 15% X $ 50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 25,000 = 8,500 39% X 235,000 = 91,650 34% X 4,915,000 = 1,671,100 $1,785,000 The AMT of the corporation is calculated as follows: Taxable income $ 5,250,000 + Positive AMT adjustments including ACE adjustment ($425,000 + $720,000) 1,145,000 – Negative AMT adjustments (30,000) + Tax preferences 6,000,000 = Alternative minimum taxable income (AMTI) $12,365,000 – Exemption [$40,000 – 25%($12,365,000 – $150,000)] (-0-) = AMT base $12,365,000 X Rate 20% = Tentative AMT $ 2,473,000 – Regular income tax liability (1,785,000) = AMT $ 688,000 Thus, if Parrott is a C corporation, its tax liability is $2,473,000 ($1,785,000 regular income tax + $688,000 AMT). b. An S corporation is a tax reporter rather than a taxpayer. Thus, Parrott will pass the regular taxable income, the separately stated items, and AMT attributes through to its shareholders who will make the regular tax liability calculation and the AMT calculation on their individual income tax returns. c. The results in a. will be the same. Whether the C corporation is closely-held is not relevant. An S corporation, however, cannot have 5,000 shareholders. It would be taxed as a C corporation. The answer to b. then would be the same as the result in a. pp. 13-9 and 13-10 42. Falcon’s tax liability for 2005 and 2006 is as follows if the cash option is selected. Comparative Forms of Doing Business 13-15

Regular Income Tax Liability 2005 2006 Taxable income before sale $400,000 $400,000 Gain from sale ($500,000 – $400,000) 100,000 -0- Taxable income $500,000 $400,000 Tax liability (34% rate) $170,000 $136,000 AMT 2005 2006 Taxable income before sale $400,000 $400,000 AMT gain from sale ($500,000 – $425,000) 75,000 -0- Other AMT adjustments and tax preferences 425,000 -0- AMTI $900,000 $400,000 Exemption amount (-0-) (-0-) AMT base $900,000 $400,000 Rate X 20% X 20% Tentative AMT $180,000 $ 80,000 AMT $ 10,000 $ -0- Falcon’s tax liability for 2005 and 2006 is as follows if the installment option is selected. Regular Income Tax Liability 2005 2006 Taxable income before sale $400,000 $400,000 Gain from sale ($500,000 – $400,000) -0- 100,000 Taxable income $400,000 $500,000 Tax liability (34% rate) $136,000 $170,000 AMT 2005 2006 Taxable income before sale $400,000 $400,000 AMT gain from sale ($500,000 – $425,000) -0- 75,000 Other AMT adjustments and tax preferences 425,000 -0- AMTI $825,000 $475,000 Exemption amount (-0-) (-0-) AMT base $825,000 $475,000 Rate X 20% X 20% Tentative AMT $165,000 $ 95,000 AMT $ 29,000 $ -0- 13-16 2006 Annual Edition/Solutions Manual

If the cash option is selected, the combined tax liability for the two years is $316,000 ($180,000 in 2005 and $136,000 in 2006). If the installment option is selected, the combined tax liability for the two years is $335,000 ($165,000 in 2005 and $170,000 in 2006). Thus, Falcon saves $19,000 ($335,000 – $316,000) by selecting the cash option. pp. 13-9, 13-10, and Chapter 6 43. a. If the farm is incorporated as a C (regular) corporation, then the sisters as shareholder-employees can qualify as employees. Thus, the $48,000 ($30,000 for lodging and $18,000 for meals) is excludible to the sisters under the § 119 meals and lodging exclusion. If the farm is an S corporation, the sisters are treated as are partners (see part b.). b. If the farm is not incorporated (i.e., a partnership), the IRS position is that the sisters do not satisfy the definition of an employee. Therefore, they are not eligible for the § 119 exclusion and the $48,000 must be included in their gross income. pp. 13-11, 13-12, and Example 10 44. a. Partnership C Corporation S Corporation Taxable income before cost of certain fringe benefits $400,000 $400,000 $400,000 – Deductible fringe benefits (235,000) (305,000) (235,000) Taxable income $165,000 $ 95,000 $165,000 Assuming that the fringe benefit plans are not discriminatory, the potential exists for the employer business entity to deduct the amounts paid for fringe benefits. Thus, regardless of the entity form, the amounts paid to a qualified pension plan (H.R. 10 plan for owner/employees of a partnership or an S corporation) are deductible by the business entity. For the partners and S corporation shareholders, the pension amount is included in their gross income and then is eligible for deduction as a contribution to an H.R. 10 plan. Group-term life insurance and meals and lodging are only deductible by the C corporation (see part b.). For beneficial fringe benefit treatment for group-term life insurance and meals and lodging to be received, the individual must be an employee. Partners do not qualify as employees, and greater than 2% shareholders of an S corporation are treated the same as partners in a partnership for fringe benefit purposes. b. For beneficial fringe benefit treatment for group-term life insurance and meals and lodging to be received, the individual must be an employee. Partners do not qualify as employees, and greater than 2% shareholders of an S corporation are treated the same as partners in a partnership for fringe benefit purposes. Since partners and greater than 2% S corporation shareholders do not qualify as employees, they do not qualify for either § 79 exclusion treatment for group-term life insurance or § 119 exclusion treatment for meals and lodging. Therefore, the amounts paid by the business entity for these fringe benefits are included in the gross income of the partners and S corporation shareholders. For the corporate shareholders, the amounts paid are deductible by the corporation and excludible by the employee-shareholders. Comparative Forms of Doing Business 13-17

The pension plan contributions made for employees are excludible by the covered employees. Income will not be recognized by the employees until they receive payments from the pension plan. For the owner/employees of a partnership or an S corporation who have contributions made to their H.R. 10 plans by the business entity, the amounts paid must be included in their gross income. However, this inclusion can be offset by a corresponding deduction for adjusted gross income on the individual’s tax return. When benefits are paid from the H.R. 10 plan, the recipient includes the amount in his or her gross income. pp. 13-11 and 13-12 45. a. Under option 1, Beaver can deduct salaries of $300,000. Thus, Beaver’s taxable income will be $0 ($300,000 – $300,000). No dividends will be distributed since there are no after-tax earnings. Gerald will include $180,000 of salary in his gross income, and Joanie will include $120,000 of salary in her gross income. Under option 2, Beaver can deduct salaries of $100,000. Thus, Beaver’s taxable income will be $200,000 ($300,000 – $100,000) and Beaver’s tax liability will be $61,250. 15% X $50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 125,000 = 42,500 5% X 100,000 = 5,000 $61,250 Gerald include $60,000 of salary and $69,375 [($200,000 – $61,250) X 50%] of dividend income in his gross income. Joanie will include $40,000 of salary and $69,375 ($138,750 X 50%) of dividend income in her gross income. b. Under option 1, the salary payments reduce Beaver’s taxable income to $0. Thus, Beaver should be aware of the possibility of the unreasonable compensation issue being raised by the IRS. pp. 13-12 and 13-13 46. a. Swallow will deduct interest expense each year of $36,000 ($600,000 X 6%). Sandra and Fran will each report interest income of $18,000 ($300,000 X 6%) each year. b. Swallow will not be allowed a deduction each year for the interest payments of $36,000. Instead, the payments will be labeled as dividends. Sandra and Fran will each report dividend income of $18,000 each year. When the loan is repaid in 5 years, assuming adequate earnings and profits, Sandra and Fran will each report dividend income of $300,000. p. 13-13 and Example 12 47. If Lavender acquires the shopping mall, its tax liability would increase as follows: Additional liability ($500,000 net rental income X 34%) $170,000 13-18 2006 Annual Edition/Solutions Manual

The individual tax liabilities of Marci and Jennifer would not be affected by the shopping mall acquisition by the corporation. If Marci and Jennifer acquire the shopping mall and lease it to the corporation, their combined tax liabilities would increase as follows: Net rental income $300,000 –Depreciation (37,000) =Increase in their taxable incomes $263,000 Additional tax liability ($263,000 X 35%) $ 92,050 At the corporate level, the corporate taxable income would increase as follows: Net rental income $500,000 –Rental payments to Marci and Jennifer (300,000) =Additional taxable income $200,000 Additional tax liability ($200,000 X 34%) $ 68,000 Thus, under the option recommended by the CPA, the combined tax liability of $160,050 ($92,050 + $68,000) is slightly less than the $170,000 tax liability under the corporate acquisition option (34% X $500,000). In addition, Lavender has been able to channel $300,000 to Marci and Jennifer with the amount being deductible in calculating Lavender’s taxable income. p. 13-13 48. a. Petal, Inc.’s corporate tax liability is calculated as follows: 15% X $ 50,000 = $ 7,500 25% X 25,000 = 6,250 34% X 550,000 = 187,000 5% X 235,000 = 11,750 $212,500 In addition, Petal may be subject to the accumulated earnings tax. This tax liability could be as high as $61,875 ($412,500 X 15%). The $412,500 represents the after-tax earnings of the corporation ($625,000 – $212,500). b. In this case, Petal would not be subject to the accumulated earnings tax. Thus, the total corporate tax liability would be $212,500. The shareholders of Petal would be taxed on their dividend income of $412,500 ($625,000 – $212,500). c. Petal’s regular income tax liability is $0 because the S election results in the corporation not being subject to Federal income tax. The taxable income of $625,000 is passed through to the shareholders’ tax returns. The accumulated earnings tax does not apply to S corporations. pp. 13-8, 13-9, 13-13, and 13-14 Comparative Forms of Doing Business 13-19

49. If the S election is voluntarily terminated, another election for Eagle Corporation cannot be made for a five-year period. Therefore, the decision regarding revoking the S election should be considered a long-run, rather than a short-run, one. The revocation of the election can be made only if a majority of the shareholders consent. Thus, Nell will need one of the other shareholders to agree with her in order to voluntarily revoke the election. Assuming that the S election is maintained and the earnings of $150,000 are distributed to the shareholders, the tax liability associated with the distribution for all the shareholders is $49,500 ($150,000 X 33%). If the S election is revoked effective for 2005, the corporate tax liability is $41,750. The tax liability for all of the shareholders on the dividend distribution, assuming the dividends are qualified dividends, is $16,238 [($150,000 – $41,750) X 15%]. Therefore, the total corporate and shareholder tax liability would be as follows: S Corporation C Corporation Corporate tax liability $ -0- $41,750 Shareholder tax liability 49,500 16,238 $49,500 $57,988 Revocation of the S election combined with a policy of distributing all the earnings to the three shareholders will result in a greater combined corporation/shareholder tax liability of $8,488 ($57,988 – $49,500). Thus, if all of the earnings are going to be distributed, the S election should be maintained. p. 13-15 and Example 15 50. a. No gain or loss is recognized on the contribution of property by Bob and Carl to the corporation. For Bob, there is no realized gain or loss. Carl’s realized gain of $115,000 [$240,000 (amount realized) – $125,000 (adjusted basis)] is not recognized because the § 351 requirements are satisfied. Therefore, the realized gain is deferred, and Carl has a carryover basis for his stock of $85,000 [$125,000 (adjusted basis) – $40,000 (mortgage assumed)]. Bob’s basis for his stock is $200,000. Deer, Inc.’s basis for the land is a carryover basis of $125,000. Each shareholder has a basis for his loan of $75,000. In addition, each shareholder has interest income each year of $6,000 ($75,000 X 8%) and Deer, Inc. deducts $12,000 of interest expense each year. b. The asset contributions will be treated the same as in part a. If all of the debt is reclassified as equity, Bob’s and Carl’s basis for their stock will each increase by $75,000. The interest payments of $12,000 annually will be reclassified as dividends and will not be deductible by Deer, Inc. c. TAX FILE MEMORANDUM DATE: January 6, 2005 FROM: Seth Addison SUBJECT: Contributions and Loans to Deer, Inc. 13-20 2006 Annual Edition/Solutions Manual

Today I met at lunch with Bob Bentz to discuss the tax consequences of the capital contributions and loans to Deer made by him and Carl Pierce. Capital contributions Asset Basis FMV Bob: Cash $200,000 $200,000 Carl: Land* 125,000 240,000 * Mortgage of $40,000 assumed by Deer, Inc. Loans to Deer, Inc. Bob $75,000 Carl $75,000 Maturity date: 10 years Interest rate: 8% (same as Federal rate). I reviewed with Bob the following tax consequences:  Recognition of gain: Since Bob and Carl own all of the stock, the realized gain of $115,000 ($240,000 – $125,000) to Carl is not recognized under § 351.  Basis for stock: Bob’s is $200,000 and Carl’s is $85,000 ($125,000 – $40,000).  Basis for assets: Deer’s basis for its assets is as follows: Cash $200,000 Land $125,000  Assuming the loans made by Bob and Carl to Deer are classified as loans, Deer can deduct $12,000 of interest expense each year and Bob and Carl must each include $6,000 of interest income in their gross income each year for the 10-year period. Each has a basis for their loan of $75,000.  If the IRS should reclassify the loans as equity (i.e., thin capitalization issue), the interest payments would be treated as dividends. Thus, Deer would lose its $12,000 interest deduction and Bob and Carl each would be receiving dividend income each year rather than interest income. If E & P is at least $150,000 at the time of the loan repayment, Bob and Carl would each be required to report $75,000 of dividend income rather than treating the repayment as a return of capital. pp. 13-13, 13-16, and 13-17 51. a. Section 721 provides that no gain or loss is recognized by the partners upon the contribution of property to a partnership. Thus, neither Agnes nor Becky has any recognized gain. Since Carol is contributing services rather than property, she has a recognized gain of $50,000. Comparative Forms of Doing Business 13-21

Section 722 provides for a carryover basis for the partners. The $20,000 mortgage assumed by the partnership results in the adjustments indicated below. Thus, the partner’s basis for the partnership interest is as follows: Agnes ($100,000 + $8,000) $108,000 Becky ($60,000 – $20,000 + $8,000) 48,000 Carol ($50,000 + $4,000) 54,000 Section 723 provides for a carryover basis to the partnership for the assets received. Cash $100,000 Land 60,000 Organization costs 50,000 b. Section 351 provides that no gain or loss is recognized upon the contribution of property to a corporation if the shareholders control (i.e., at least 80%) the corporation immediately after the transfer. Since the combined ownership of Agnes and Becky (40% + 40% = 80%) satisfies this requirement, neither has any recognized gain. Since Carol is contributing services rather than property, she has a recognized gain of $50,000. Section 358 provides for a carryover basis for the shareholders. Thus, the shareholder’s basis for the stock is as follows: Agnes $100,000 Becky ($60,000 – $20,000) 40,000 Carol 50,000 Section 362 provides for a carryover basis to the corporation for the assets received. Cash $100,000 Land 60,000 Organization costs 50,000 c. Same tax consequences as in (b.), since S status involves a corporation. pp. 13-16 and 13-17 52. a. Initial basis under § 351 $25,000 Effect of corporate earnings -0- Effect of corporate liability -0- Alicia’s stock basis: regular corporation $25,000 b. Initial basis under § 351 $25,000 Effect of corporate earnings ($150,000 X 20%) 30,000 Effect of corporate liability -0- Alicia’s stock basis: S corporation $55,000 13-22 2006 Annual Edition/Solutions Manual

c. Initial basis under § 731 $25,000 Effect of corporate earnings ($150,000 X 20%) 30,000 Effect of corporate liability ($60,000 X 20%) 12,000 Alicia’s basis for partnership interest $67,000 pp. 13-17 and 13-18 53. a. (1) Operations $ 92,000 Tax-exempt interest income (excludable) -0- Long-term capital gain 60,000 Taxable income for C corporation $152,000 (2) Operations $92,000 Taxable income for S corporation $92,000 Each shareholder reports his or her share of the taxable income from operations of $92,000 and the long-term capital gain of $60,000. The tax-exempt interest of $19,000 passes through to the shareholders but is excludible from gross income. b. (1) For C corporation shareholders, the $200,000 distribution is a dividend because it is paid out of earnings and profits. The earnings and profits of the corporation at the end of the year is arrived at as follows: Beginning balance $900,000 + Taxable income 152,000 + Tax-exempt interest 19,000 – Tax liability (42,530)* – Dividend distribution (200,000) = Ending E & P $828,470 *The corporate tax liability is $42,530 [($50,000 X 15%) + ($25,000 X 25%) + ($25,000 X 34%) + ($52,000 X 39%)]. (2) For the S corporation shareholders, the $200,000 distribution is treated as a return of capital and reduces the shareholders’ stock basis. pp. 13-17 and 13-18

54. a. James reduces the basis for his partnership interest by $50,000 to $10,000. Karen reduces the basis for her partnership interest by $60,000 to $20,000. Neither James nor Karen recognizes any gain since the outside basis of each partner prior to the distribution exceeds the amount of the cash received. JK has no recognition and reduces the basis of partnership assets by $110,000 ($50,000 + $60,000). b. James has dividend income of $50,000, and Karen has dividend income of $60,000. JK reduces its earnings and profits account by $110,000 ($50,000 + $60,000). James’ stock basis remains at $60,000 and Karen’s stock basis remains at $80,000. p. 13-19 55. a. Beige’s taxable income is calculated as follows: Comparative Forms of Doing Business 13-23

Active income $212,000 Portfolio income 20,000 Passive activity losses (-0-)* Taxable income $232,000 *The assumption is made that Beige satisfies the three requirements for being labeled a personal service corporation for § 469 purposes. Therefore, none of the passive activity losses can be offset against either the active income or the portfolio income. b. Beige’s taxable income is calculated as follows: Active income $212,000 Portfolio income 20,000 Passive activity losses (212,000)* Taxable income $ 20,000 *The passive activity losses can be offset against the active income of a closely held corporation if the corporation does not meet the stock ownership requirements under the personal holding company provisions. If the corporation does meet the PHC provisions requirements, the answer is the same as in a. pp. 13-19 and 13-20 56. a. Rosa’s basis for her partnership interest prior to consideration of the loss is $120,000 [$50,000 + 10% of $700,000 (partnership debt)]. However, the loss pass-through which Rosa can deduct is limited to her at-risk basis of $65,000 [$50,000 + 10% of $150,000 (recourse debt)]. At the end of 2005, Rosa’s basis for her partnership interest is $55,000 [$50,000 + 10% of $700,000 (partnership debt) – $65,000 (at-risk amount of loss passed through)]. Although Rosa’s share of the partnership loss is $90,000 (10% X $900,000), her basis is reduced only by the $65,000 which produces a tax benefit. The $25,000 ($90,000 – $65,000) which Rosa cannot deduct can be used in future taxable years, once her at-risk basis is adequate to absorb it. b. Since the entity concept applies, none of the C corporation’s loss can be deducted on Rosa’s tax return. The basis for Rosa’s stock at the end of 2005 is $50,000, the amount of her initial contribution. pp. 13-17, 13-18, and 13-20 57. a. Since the 80% control requirement of § 351 is not satisfied at the time Sanford contributes the land to the C corporation, the basis of the land to the corporation is the fair market value of $120,000. Therefore, the sale of the land by the corporation for $140,000 produces a recognized gain of $20,000 [$140,000 (amount realized) – $120,000 (adjusted basis)]. The sale has no effect at the shareholder level. b. The 80% control requirement of § 351 is again not satisfied. As in part a., therefore, the sale of the land for $140,000 produces a recognized gain of $20,000. Since the entity is an S corporation, the recognized gain is passed through to the three shareholders based on their stock ownership. Thus, $7,000 13-24 2006 Annual Edition/Solutions Manual

($20,000 X 35%) is reported on Sanford’s return and the balance of $13,000 is reported on the returns of the other two shareholders. c. The nonrecognition requirements of § 721 are satisfied at the time Sanford contributes the land to the partnership. Therefore, the partnership has a carryover basis in the land of $83,000, and its recognized gain is $57,000 [$140,000 (amount realized) – $83,000 (adjusted basis)]. Section 704(c) requires that the precontribution appreciation of $37,000 be allocated to Sanford. The balance of the recognized gain ($20,000) is allocated among all three partners based on the profit and loss sharing ratio. pp. 13-16, 13-17, and 13-21 58. a. The basis for the stock purchased by Emily and Freda would be its cost of $908,000. The basis of the assets to the corporation would not be affected, since the corporation is not involved in the purchase/sale transaction. George would have a recognized gain of $348,000 from the stock sale and the gain would be classified as a capital gain. Amount realized $908,000 – Basis for stock (560,000) Recognized gain $348,000 b. Emily and Freda would have a basis for each of the assets purchased equal to the cost (i.e., FMV). Since the FMV of the listed assets is $750,000, the $158,000 excess of the purchase price over $750,000 will be assigned to goodwill. Goodwill is amortized over a period of 15 years for tax purposes. If Emily and Freda desire to conduct the business in corporate form, they can contribute the assets to a corporation in a tax-free transaction under § 351. The basis of the contributed assets to the corporation will be a carryover basis (i.e., total basis of $908,000). Pelican will be assigned the following recognized gain from the sale of the assets to Emily and Freda for $908,000: Recognized Classification Asset Gain Capital Ordinary Cash $ -0- $ -0- $ -0- Accounts receivable -0- -0- -0- Inventory 10,000 -0- 10,000 Furniture and fixtures 20,000 -0- 20,000* Building 50,000 50,000** -0- Land 110,000 110,000** -0- Goodwill 158,000 158,000 -0- $348,000 $318,000 $30,000 * § 1245 recapture ** § 1231 gain. Comparative Forms of Doing Business 13-25

George, as the shareholder, is not involved in the purchase/sale transaction. Thus, this transaction will produce no tax consequences for George. Logically, however, the corporation would liquidate and distribute the available cash to George. Since Pelican is in the 34% tax bracket, the corporate tax liability associated with the asset sale would be $118,320 ($348,000 X 34%). Therefore, when George receives a liquidating distribution of $789,680 ($908,000 – $118,320), he will recognize a capital gain of $229,680 ($789,680 amount realized – $560,000 adjusted basis for stock). c. The basis for the stock purchased by Emily and Freda is its cost of $550,000. The basis of the assets to the corporation would not be affected, since the corporation is not involved in the purchase/sale transaction. George would receive a recognized loss of $10,000 from the stock sale and the loss would be classified as a capital loss. Amount realized $550,000 – Basis for stock (560,000) Recognized loss ($ 10,000) p. 13-25 and Concept Summary 13-1 59. a. Amount realized $260,000 Less: adjusted basis (160,000) Realized gain $100,000 Recognized gain $100,000 Even though Linda sold her business, the transaction is treated as the sale of the individual assets. This is necessary to classify the recognized gain as capital or ordinary. Asset Ordinary Capital and § 1231 Accounts receivable $25,000 $ -0- Office furniture and fixtures 2,000 -0- Building 15,000 Land 20,000 Goodwill 38,000 Since the sales price exceeds the fair market value of the listed assets by $38,000 ($260,000 – $222,000), the excess is treated as paid for goodwill. b. Juan has a basis for each of the assets of fair market value, and a basis for goodwill of $38,000. c. Under existing rules, both goodwill and a covenant not to compete are amortized and deducted over a 15-year statutory period. Thus, from Juan’s perspective, the tax consequences of assigning the $38,000 excess payment to goodwill or to a covenant are the same. However, the tax consequences to Linda differ. That is, gain on the covenant is classified as ordinary income, whereas gain on the goodwill is classified as a capital gain. Thus, if the covenant has no legal relevance to Juan, he should negotiate with Linda for a price reduction which 13-26 2006 Annual Edition/Solutions Manual

reflects the tax benefit of the alternative tax on capital gains to Linda (assuming there is a benefit to Linda). Conversely, if a covenant would have legal relevance to Juan, then at least part of the $38,000 should be assigned to a covenant. Example 22 and Concept Summary 13-1 60. a. The sales are treated as the sales of ownership interests. Thus, each partner calculates his or her recognized gain as follows: Gail Harry Amount realized $307,000 $307,000 – Basis(100,000) (150,000) Recognized gain $207,000 $157,000 The recognized gain is classified as long-term capital gain under § 741 subject to any ordinary income recognition under § 751 for “hot” assets. Since GH Partnership has no unrealized receivables or substantially appreciated inventory, all of the gain is classified as long-term capital gain. The sale of the partnership interests by Gail and Harry results in the termination of GH Partnership. Under § 708(b)(1)(B), there is a sale or exchange of at least 50% of the total interest in partnership capital and profits within a 12-month period, b. If the assets are appreciated, an individual purchasing an interest in a partnership normally would prefer to purchase the assets rather than an ownership interest. This preference occurs because the basis of the assets will be equal to the amount paid for them (i.e., FMV). With the purchase of a partnership interest, however, a carryover basis results. This negative result associated with the purchase of a partnership interest can be offset if the partnership makes the § 754 election. This activates the special basis provisions under § 743 for the acquiring partner. However, there are a variety of reasons why the partnership may be unwilling to make this election. In the case at hand, the usual choices do not apply because the GH Partnership is terminated. Regardless of the method of purchase, the assets of the new partnership (i.e., KL Partnership) will have a basis equal to the amount paid by Keith and Liz (i.e., FMV).

pp. 13-23, 13-24, and Concept Summary 13-1

61. Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 August 16, 2005 Mr. Bill Evans 100 Village Green Chattanooga, TN 37403 Dear Mr. Evans: Comparative Forms of Doing Business 13-27

I am responding to the inquiry regarding whether you should negotiate to purchase the stock or the assets of Dane Corporation. From a tax perspective, you should acquire the assets of Dane Corporation rather than the stock. By purchasing the assets, the basis for the assets will be the purchase price of $750,000. Then contribute the assets to a new corporation under § 351 without any recognition. The basis of the assets to the corporation will be $750,000. If the stock of Dane Corporation is purchased instead, the basis for the stock is the purchase price of $750,000. However, the corporation’s basis for its assets would remain at $410,000. A nontax advantage of the asset purchase is the avoidance of legal responsibility for any liabilities of Dane Corporation. Although Dane has no recorded liabilities, there is the possibility of unrecorded or contingent liabilities. If I can be of further assistance, please let me know. Sincerely, Robert Ames, CPA Partner TAX FILE MEMORANDUM DATE: August 12, 2005 FROM: Robert Ames SUBJECT: Purchase of Dane Corporation by Bill Evans Bill Evans is going to purchase either the stock of Dane Corporation or its assets. Bill has agreed with the seller that Dane has a fair market value of $750,000. Dane’s adjusted basis for its assets is $410,000. Bill has requested our advice on whether he should negotiate to purchase the stock of Dane or its assets. If Bill purchases the assets of Dane, his basis for the assets would be the purchase price of $750,000. He then could contribute the assets to a new corporation without any recognition under § 351. The corporation’s adjusted basis for the assets would be $750,000. If Bill purchases the stock of Dane, his basis for the stock would be $750,000. However, since Dane is not involved in the transaction, the corporation’s basis for its assets would remain at $410,000. Thus, from a tax perspective, Bill should purchase the assets rather than the stock of Dane. In addition, the asset purchase will avoid any potential unrecorded or contingent liability problem. p. 13-25

The answers to the Research Problems are incorporated into the 2006 Annual Edition of the Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATES & TRUSTS. 13-28 2006 Annual Edition/Solutions Manual

NOTES

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