Solution manual SW federal taxation corporations partnerships estates and trusts 35e by hoffman chapter 13

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CHAPTER 13
COMPARATIVE FORMS OF DOING BUSINESS
SOLUTIONS TO PROBLEM MATERIALS

Question/
Problem

Learning
Objective

1
2

LO 1
LO 1, 3

3
4
5
6
7
8
9
10
11
12
13
14
15

16
17
18
19
20
21
22
23
24

Topic

Legal and tax forms
Taxation of C corporation versus S
corporation
LO 1
Limited liability company
LO 3
Tax rates: corporation versus individual
LO 2, 3
Limited liability partnership
LO 2
Limited liability: corporate general partner
LO 2
Nontax factors and tax factors in choosing a
business entity
LO 1, 2, 3 Limited liability and loss pass-throughs
LO 3, 4, 7 S corporation versus C corporation status
LO 3
Distribution policy: C corporation and S

corporation
LO 3
Alternative minimum tax: ACE adjustment
LO 3
Alternative minimum tax: shifting income
and deductions
LO 3
S corporation and limited liability company:
state income tax treatment
LO 4
Fringe benefits and tax treatment
LO 4
Double taxation and reasonable compensation
LO 4
Avoiding double taxation: techniques
LO 4
Avoiding double taxation: interest payments
LO 4
Avoiding double taxation: no distributions
LO 4
Accumulated earnings tax
LO 4, 5
S corporation versus C corporation status
LO 4
S corporation: qualification
LO 5
Contribution of personal use assets to a
corporation or a sole proprietorship
LO 5
Recognition under § 351 and § 721

LO 5
Special allocations

Status:
Present
Edition

Q/P
in Prior
Edition

Unchanged
New

1

New
Updated
Unchanged
Unchanged
Modified

4
5
6
7

Unchanged
Unchanged
Modified

8
9
10

Unchanged
New

11

Unchanged

13

New
New
New
New
Unchanged
Unchanged
Unchanged
Modified
Unchanged

18
19
20
21
22

Modified
Unchanged

23
24

Instructor: For difficulty, timing, and assessment information about each item, see p. 13-4.

13-1
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13-2

Question/
Problem

2012 Corporations Volume/Solutions Manual

Learning
Objective

25

LO 5

26
27

28
29

LO 5
LO 5
LO 5
LO 5

30

LO 6

31
32
33
34
35
36
37

LO 6
LO 2, 3,
4, 5, 6, 7
LO 5
LO 5, 6
LO 2
LO 3
LO 1, 2, 3

38

LO 2, 3

39
*40
*41
*42
43
44
*45
46
*47
*48
*49
50

LO 3
LO 3
LO 3
LO 3
LO 4
LO 4
LO 4
LO 4
LO 4
LO 3, 4
LO 4
LO 4

51

LO 5

*52

LO 5

*53

LO 5

*54
55
*56
57
58
*59

LO 5
LO 5
LO 5
LO 5
LO 5
LO 6

Topic
Basis for ownership interest: effect of entity
liabilities
Basis for ownership interest
S corporation as a taxpayer

Partnership and C corporation: distributions
Partnership: § 465 at-risk and § 469 passive
activity loss
Sale of an ownership interest: sole
proprietorship
Sale of an ownership interest: C corporation
Entity attributes
Entity attributes
Special allocations: § 754 election
Liability exposure
Corporate tax rates: marginal and effective
Choice of business entity: tax and nontax
factors
Choice of business entity: tax and nontax
factors
Choice of business entity
Single versus double taxation
Alternative minimum tax
Alternative minimum tax: installment sale
Fringe benefits
Fringe benefits
Reasonable compensation
Shareholder loans to corporation
Shareholder leasing property to corporation
Accumulated earnings tax
Stock redemption versus sale to outsiders
S corporation: maintaining or revoking
status
Recognition under § 351, basis, and allocation
of gain

Recognition at time of contribution and
basis
Effects of contributions, profits, and
distributions on basis: different types
of entity
Transactions affecting different entity types
Distributions to owners
Passive activity losses
Basis and at-risk rules: partnership
Special allocations
Asset sale versus stock sale

Status:
Present
Edition

Q/P
in Prior
Edition

New
Unchanged
Unchanged
New
Modified

26
27
29

Modified

30

Modified
Unchanged

31
32

Unchanged
Unchanged
Modified
New
Unchanged

33
34
35

Modified

38

Unchanged
Modified
New
New
Modified
Unchanged

Unchanged
New
Unchanged
Modified
Modified
Unchanged

39
40

37

43
44
45
47
48
49
50

New
Unchanged

52

New
Unchanged
Modified
New
Modified

Unchanged
Unchanged

54
55
57
58
59

Instructor: For difficulty, timing, and assessment information about each item, see p. 13-4.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Comparative Forms of Doing Business

Question/
Problem

Learning
Objective

*60

LO 6

61
62

LO 6
LO 6

Topic
Sale of partnership interests: tax
consequences
Sale of a business: partnership
Purchase of a business: C corporation

13-3
Status:
Present
Edition

Q/P
in Prior
Edition

Modified

60

Unchanged
New

61

*The solution to this problem is available on a transparency master.
Instructor: For difficulty, timing, and assessment information about each item, see p. 13-4.

Research
Problem
1
2
3
4
5
6
7
8

Topic
Stock redemption versus dividend
S corporation shareholder and payroll taxes
S corporation debt basis
Partnership: share of profits
Internet activity
Internet activity
Internet activity
Internet activity

Status
Present
Edition

Q/P
in Prior
Edition

Unchanged
Unchanged
Unchanged
Unchanged
Unchanged
Unchanged
Unchanged
Unchanged

1
2
3
4
5
6
7
8

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13-4

2012 Corporations Volume/Solutions Manual

Question/
Problem

Est’d
completion
time

Difficulty

Assessment Information
AICPA*
AACSB*
Core Comp
Core Comp

1
2
3
4
5
6
7
8

Easy
Easy
Easy
Easy
Easy
Easy
Easy
Medium

5
5
5
10
10
5
5
10

FN-Reporting
FN-Reporting
FN-Reporting
FN-Measurement
FN-Reporting
FN-Reporting
FN-Reporting
FN-Reporting

9

Medium

10

FN-Reporting

10

Medium

10

FN-Reporting

11
12

Easy
Easy

13

Medium

14

Easy

15

Medium

16

Easy

17

Medium

18

Easy

19
20

Easy
Medium

10
10

21
22

Medium
Easy

10
5

23
24
25

Easy
Medium
Easy

5
10
5

26
27

Easy
Easy

10
5

28

Easy

10

29

Easy

5

5
5
10
5
10

Analytic | Reflective
Thinking

*Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB
core competencies in assessment.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

To download more slides, ebook, solutions and test bank, visit

Comparative Forms of Doing Business

Question/
Problem

Difficulty

Est’d
completion
time

30

Easy

10

31

Medium

10

32
33

Medium
Easy

10
10

34

Medium

10

35
36

Medium
Medium

10
10

37
38

Medium
Medium

15
15

39

Medium

10

40

Medium

15

41

Hard

15

42

Hard

15

43

Easy

10

44

Medium

15

45

Medium

10

46

Easy

10

47

Medium

10

48
49

Medium
Hard

10
15

50

Medium

10

51

Hard

20

52

Medium

15

53

Analytic
Analytic
Analytic
Analytic
Analytic
Analytic | Reflective
Thinking
Analytic | Reflective
Thinking
Analytic
Analytic
Analytic
Analytic | Reflective
Thinking

*Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB
core competencies in assessment.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

To download more slides, ebook, solutions and test bank, visit

13-6

2012 Corporations Volume/Solutions Manual

Question/
Problem

Est’d
completion
time

Difficulty

55

Medium

15

56

Easy

10

57
58
59

Medium
Easy
Hard

10
10
20

60

Hard

10

61

Hard

15

62

Hard

20

Assessment Information
AICPA*
AACSB*
Core Comp
Core Comp
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement
FN-Reporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting
FN-Measurement | FNReporting

FN-Measurement | FNReporting

Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Analytic
Communication | Analytic

*Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB
core competencies in assessment.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Comparative Forms of Doing Business

13-7

CHECK FIGURES
35.a.
35.b.
35.c.
35.d.
36.a.
36.b.

39.a.
39.b.
40.a.
40.b.
40.c.
41.a.
42.
43.a.
43.b.
44.a.
46.a.

46.b.

48.a.
48.b.
48.c.
49.a.
49.b.
50.
52.a.

$4 million.
$4 million.
$975,000.
Same as c.
Red 34%, 19.67%; White 39%,
33.51%; Blue 34%, 34%; Magenta
35%, 35%.
Phaseout benefits of lower brackets.

C corporation results in tax savings of
$10,850.
C corporation results in tax savings of
$177.
$0 for Mabel and Alan.
$78,750 each.
$275,500; $280,000.
$2,125,000.
Select the cash option.
$78,000 excludible.
$78,000 gross income.
Partnership $165,000; C Corporation
$95,000; S Corporation $165,000.
Parrott deducts interest expense
$54,000; Abner reports interest income
$32,400; Freda reports interest income
of $21,600 each year.
Parrott not allowed deduction; Abner
reports dividend income $32,400 each
year; Freda reports dividend income of
$21,600 each year.
$79,200 accumulated earnings tax and
$272,000 regular tax liability for
Flower.
$272,000 regular tax liability for
Flower.
$0 regular tax liability for Flower.
Grace yes; Frank no.
Grace yes; Frank yes.
S election should be maintained.

$0 recognized gain for Agnes and
Becky, $50,000 recognized gain for
Carol; outside basis: Agnes $108,000,
Becky $48,000, Carol $54,000.

52.b.

52.c.
53.a.
53.b.
53.c.
55.a.
55.b.
56.a.
56.b.
56.c.
57.a.
57.b.
58.a.
58.b.
58.c.
59.a.
59.b.

59.c.
60.a.
60.b.
61.a.
61.b.
62.

$0 recognized gain for Agnes and
Becky, $50,000 recognized gain for
Carol; stock basis: Agnes $100,000,
Becky $40,000, Carol $50,000.
Same as b.
$88,000 partnership basis.
$103,500 stock basis.
$114,750 stock basis.
Sam $95,000 gain; Allison $240,000
dividend income; Swift $65,000 gain.
Sam $95,000 gain; Allison $240,000
basis reduction; Swift $65,000 gain
passthrough.
$374,000.
$49,000.
$54,000.
Abby $500,000; Velma $275,000.
Abby $450,000; Velma $225,000.
Megan $10,000; Vern $90,000.
$100,000 loss to corporation.
Megan $60,000; Vern $40,000.
Emily and Freda stock basis $908,000;
George recognized capital gain
$348,000.
Emily and Freda have basis for listed
assets $750,000 and goodwill
$158,000; George recognized capital
gain on liquidation $229,680.
Emily and Freda stock basis $550,000;

George recognized capital loss
$10,000.
Tom’s outside basis $325,000; Walt’s
outside basis $325,000.
Copper Partnership terminates; basis
for partnership assets $650,000.
Gail $207,000 LTCG; Harry $157,000
LTCG.
Acquire the assets.
Acquire the assets.

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13-8

2012 Corporations Volume/Solutions Manual

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. p. 13-3

2.

A corporation is a separate legal entity, apart from its owners. If it is a C (regular) corporation
for Federal income tax purposes, the corporation is taxed on its earnings. If the corporate
earnings are distributed to the shareholders as dividends, the earnings are subject to a second
layer of taxation. A corporation that elects S corporation status receives tax treatment similar
to that of a partnership with the corporate earnings being taxed only at the shareholder level.
The tax law provides for S status to allow entities to choose the corporate form and avoid
double taxation. pp. 13-3 and 13-6 to 13-8

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. 13-3, 13-5, 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 2011 income between $137,300 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 2011
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. pp. 13-7 and
13-18

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 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.
p. 13-5 and Tax in the News on p. 13-4

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 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. So this prior
pitfall no longer exists. pp. 13-5, 13-6, and Figure 13.1

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Comparative Forms of Doing Business

7.

13-9

a.

Nontax factors are important to Samuel in selecting the business entity form for his
lawn-servicing business. The ability of the entity to raise capital as well as the
advantages of limited liability should be considered when selecting the form of
business entity. Additional factors which should be taken into account include: (1) the
estimated life of the business, (2) the number of owners and their roles in
the management of the business, (3) the ease of transfer of ownership interests, and (4)
the organizational formality required to establish the entity.

b.

Tax factors are also important to Samuel. However, one cannot conclude which are
more significant to Samuel. Above all, business decisions should make economic
sense.

pp. 13-4 to 13-8
8.

Abe 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 Abe’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 Abe is subject
to taxation). pp. 13-6 to 13-8

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.
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. 13-6, 13-11, and Concept Summary 13.2

10.

a.

A C corporation is taxed on its earnings. A dividend is a distribution of some or all of
the after-tax earnings of the C corporation. Therefore, the shareholder is taxed on the
full amount of the dividend distribution. If a distribution is entirely a return of capital,
then the shareholder is not taxed on the distribution. If the distribution is partially a
return of capital (e.g., a stock redemption), the shareholder is taxed only on the portion
that does not qualify for return of capital treatment (i.e., the excess of the amount

realized over the basis).

b.

Return of capital treatment applies for an S corporation which has never been
a C corporation. A distribution that does not exceed a shareholder’s basis for stock

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13-10

2012 Corporations Volume/Solutions Manual
merely reduces the basis. If a distribution exceeds a shareholder’s basis for stock, the
excess is classified as a capital gain.
pp. 13-6 to 13-8 and 13-13

11.

The adjusted current earnings (ACE) modification applies only to C corporations. The
amount of the adjustment is 75% of the excess of ACE over unadjusted alternative minimum
taxable income. If unadjusted alternative minimum taxable income exceeds ACE for the tax
year, the adjustment is negative. pp. 13-8 and 13-9

12.

Violet’s acceleration of income and deferral of deductions for a tax year in which it is subject
to the AMT can be beneficial. Since Violet is subject to the AMT for the current year, any

increase in net income is taxed at the 20% AMT rate. If such income were taxed next year, it
would be subject to a 34% regular corporate tax rate. p. 13-9

13.

Both the S corporation and the limited liability company forms will permit Mary and Richert
to pass the entity losses through to their Federal individual income tax returns. For state
income tax purposes, the limited liability company form also will accomplish this result.
However, not all states permit S corporation treatment. Thus, Mary and Richert need to
ascertain if such treatment is available in the southeastern state. If S corporation treatment is
not available, then they should select the limited liability company form. If S corporation
treatment is available, they probably still should select the limited liability company form
because of the statutory restrictions that exist with S corporations (e.g., number and types of
owners and the capital structure). p. 13-9

14.

For a taxpayer to receive favorable tax treatment for certain fringe benefits, the taxpayer must
be an employee. The IRS defines the term employee restrictively. For the owner of a
business entity to be treated as an employee, the entity must be a corporation. For this
purpose, an S corporation is treated as a partnership, and a greater-than-2 percent shareholder
is treated as a partner. pp. 13-10 and 13-11

15.

a.

b.

Since David and Tan, Inc.’s objective is to avoid double taxation, the following need

to be addressed:
•

Tan’s taxable income can be reduced through reasonable compensation payments.
Is the $400,000 annual salary for David reasonable? It might be possible to
increase this amount and still be reasonable!

•

Based on the data, it appears that Tan is not distributing dividends to David.
While such a technique can be used to avoid or defer double taxation, is the
retention defensible in terms of the accumulated earnings tax?

•

Would an S corporation election be advisable?

Yes, avoiding double taxation associated with Tan should be a goal of David and Tan.
This is consistent with the general goal of minimizing taxation.

pp. 13-11 to 13-14
16.

The following payments to shareholders are deductible in calculating corporate taxable
income.
•

Salary payments to shareholder-employees.

•

Lease rental payments to shareholder-lessors.

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Comparative Forms of Doing Business
•

13-11

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.
pp. 13-11, 13-12, and Examples 11 and 12
17.

The second approach (i.e., a combined capital contribution of $500,000 and loan of $300,000)
has two potential advantages. First, the annual interest payment of $18,000 ($300,000 × 6%)
on the loan is deductible by the corporation. Second, the repayment of the loan by the
corporation does not result in 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 dividends (making them nondeductible
by the corporation). Furthermore, the loan repayment will be treated as a dividend to the
shareholder.
pp. 13-11, 13-12, and Example 12

18.

Perhaps. In theory, this approach represents sound tax planning. However, it may not be
feasible for several reasons. First, the shareholders may not be willing to forgo distributions
from the corporation. Second, such a distribution policy could result in the imposition of an
accumulated earnings tax. pp. 13-12 and 13-13

19.

Both Orange and Rust are closely held corporations (i.e., 14 shareholders). Such corporations may
have accumulated earnings tax problems unless the reasonable needs of the business requirement is
satisfied. Evidently, Orange may encounter an accumulated earnings tax problem because it cannot
justify all of the earnings retained. One possible reason why Rust may not have this problem is that
it can justify all of its undistributed earnings (e.g., a growth company considering expansion).
Another possible reason is that Rust has been an S corporation throughout its 9-year life. pp. 13-12,
13-13, Chapter 3, 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. 13-13 and 13-14

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13-12
21.

2012 Corporations Volume/Solutions Manual
a.

S corporations can have a maximum of 100 shareholders. For this limitation, married
shareholders and certain family members are counted as one shareholder. Divorced
taxpayers are still counted as one shareholder. So after the divorce, there still are only
100 shareholders. 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.

b.

The qualification requirements for S status must be maintained. That is, if any of
these requirements are not kept, the entity loses its S status and becomes a
C corporation. Therefore, if Tammy or Arnold transfer some of the S corporation
stock to an unrelated person, Roadrunner becomes a C corporation since the 100
unrelated shareholder limitation is exceeded.

p. 13-14, Chapter 12, and Concept Summary 13.2
22.

The tax consequences to Sabrina and to the entities will be the same. The fair market value of
the SUV of $40,000 is less than Sabrina’s adjusted basis (i.e., cost) of $58,000 for the SUV.
Therefore, the adjusted basis of the SUV to the S corporation or to the C corporation is the
lower fair market value of $40,000. Sabrina’s realized loss of $18,000 (i. e, the value decline
while she held the SUV for personal use) is disallowed. The contribution of the SUV to
Sabrina’s sole proprietorship produces the same tax consequences as the contribution to her
wholly owned corporation. p. 13-15 and Concept Summary 13.2

23.

a.

Sections 721, 722, and 723 provide for the nonrecognition of realized gain or loss,
a carryover basis for the partner’s partnership basis, and a carryover basis for the
partnership’s basis for its assets contributed. Sections 351, 358, and 362 provide for
the same tax consequences on the contribution of property by a shareholder to a
corporation but only if the 80% control requirement is satisfied. If the 80% control
requirement is not satisfied, the shareholder’s realized gain or loss is recognized and
the basis for his or her stock is the fair market value at the date of the contribution.
The corporation’s basis for the contributed assets is the fair market value at the date of
the contribution.

b.

Except as noted in part a., the same nonrecognition rules that apply for a C corporation
apply for an S corporation.

p. 13-15 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. 13-15, 13-16, 13-21, and Concept Summary 13.2

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Comparative Forms of Doing Business
25.

13-13

Changes in partnership liabilities increase or decrease a partner’s basis in the partnership
interest. This is appropriate because generally partners are liable for the entity liabilities if not
paid by the partnership.
Corporate liability changes do not have any effect on the shareholder’s basis in the stock. This
is appropriate because the shareholder has limited liability and is not liable for the debts of the
entity.
p. 13-16, 13-17, and Example 17

26.

Item

Effect on Basis
Shareholder in
C Corporation
no effect

Shareholder in

S Corporation
+

Profits

Partner
+

Losses

–

no effect

–

Liability increase

+

no effect

no effect

Liability decrease

–

no effect

no effect

Contribution of assets

+

Distribution of assets

–

p. 13-17 and Example 17

+
no effect if
classified as
a dividend

+
–

–
if classified
as a return
of capital

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.

a.

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 their
respective shares of the earnings of the partnership rather than on the receipt of
distributions of earnings. Thus, Dexter has already been taxed on his share of the
partnership earnings.

b.

If Warbler is a C corporation, the answer does change. If E & P is adequate,
distributions of earnings are dividend income to Dexter.

pp. 13-17 and 13-18

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13-14
29.

2012 Corporations Volume/Solutions Manual
A partner’s basis for the partnership interest is increased by his or her share of increases in

partnership liabilities.
a.

The § 465 at-risk rules limit the impact of partnership liability increases only to the
amount for which a partner is at-risk. Thus, nonrecourse debt will have no effect on
the at-risk basis of either the general partner or the limited partner.

b.

The passive activity loss rules of § 469 subject the loss deduction to an additional
hurdle. As far as the partner is concerned, if the activity that generated the loss is a
passive activity, the partnership loss pass-through can be offset only against passive
activity income. Thus, it cannot be offset against either active income or portfolio
income of the partner.

c.

While both § 465 and § 469 limit a partner’s ability to deduct his or her share of
partnership losses, § 469 has the potential to be more restrictive. This conclusion is
based on the fact that unless there is offsetting passive activity income, passive
activity losses cannot be deducted. Section 465 will produce this result only if a
partner’s at-risk basis is zero.

pp. 13-19 and 13-20
30.

a.

No. Regardless of the legal form of transaction selected, it is treated as a sale of the
individual assets for tax purposes. Classification of gain or loss as capital or ordinary

depends on the nature and holding period of the individual assets.

b.

Since the transaction is treated as the sale of the individual assets regardless of the
legal form of the transfer, it is not relevant to Bruce whether the assets have
appreciated or declined in value.

p. 13-23, Example 22, and Concept Summary 13.1
31.

From Vladimir’s perspective, the sale of Ruby, Inc. should be structured to avoid double
taxation. A sale of the stock of Ruby to the investor group achieves this objective. The sale of
the assets by the corporation (or the distribution of the assets to Vladimir to make the sale)
followed by the liquidation of the corporation results in double taxation. Thus, Vladimir needs
to recognize this difference in tax consequences in order to effectively conclude the
negotiations. pp. 13-26 and 13-27

32.

a.

S corporation and C corporation (S and C). p. 13-5

b.

C corporation (C). pp. 13-4 and 13-5

c.

C corporation (C). pp. 13-6 to 13-8

d.

Sole proprietorship, partnership, and S corporation (SP, P, and S). p. 13-6

e.

C corporation (C). p. 13-13

f.

S corporation (S). Concept Summary 13.2

g.

Sole proprietorship and partnership (SP and P). p. 13-5

h.

C corporation (C). p. 13-26 and Concept Summary 13.1

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Comparative Forms of Doing Business

33.

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. 13-18

l.

N.

m.

S. p. 13-19

a.
b.

Partnership, S corporation, and C corporation (P, S, and C).
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).

13-15

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. pp. 13-21,
13-25, and Example 23

PROBLEMS
35.

a.

As a sole proprietorship has unlimited liability, the sole proprietorship and the owner
are liable for the remaining $4 million after the $3 million is paid by insurance. Since
the net FMV of the net assets is $725,000 ($975,000 – $250,000), the owner is liable
for the remaining $3,275,000 ($4,000,000 – $725,000).

b.

Because a partnership has unlimited liability, the partnership and the partners are
liable for the remaining $4 million after the $3 million is paid by insurance. Since the
net FMV of the net assets is $725,000 ($975,000 – $250,000), the partners are liable
for the remaining $3,275,000 ($4,000,000 – $725,000).

c.

A C corporation has limited liability (i.e., equal to the FMV of the assets of $975,000).
The plaintiff will share with the other creditors (i.e., $250,000) of the entity with
respect to claims against the $975,000 of assets. The shareholders of the C corporation
have no personal liability for the remaining corporate debts of $3,025,000 ($4,000,000
– $975,000).

d.

Same response as in c. for an S corporation.

p. 13-5

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13-16
36.

2012 Corporations Volume/Solutions Manual
a.

The tax liability of each of the corporations is as follows:
Red Corporation
15%
25%
34%

×
×
×

$ 50,000
25,000
7,000

=
=
=

$ 7,500
6,250
2,380
$16,130

×
×
×
×

$ 50,000
25,000
230,000
205,000

=
=
=
=

$

15%
25%
34%
5%

×
×
×
×

$ 50,000
25,000

625,000
235,000

=
=
=
=

$

or 34%

×

$700,000

=

$238,000

34%
35%
3%

×
×
×

$10,000,000
30,000,000

3,333,333

=
=
=

$ 3,400,000
10,500,000
100,000
$14,000,000

or 35%

×

$40,000,000

=

$14,000,000

White Corporation
15%
25%
34%
5%

7,500
6,250
78,200

10,250
$102,200

Blue Corporation
7,500
6,250
212,500
11,750
$238,000

Magenta Corporation

The effective tax rate for each of the corporations is as follows:
Red Corporation
$16,130
$82,000

=

19.67%

=

33.51%

=

34%

White Corporation

$102,200
$305,000
Blue Corporation
$238,000
$700,000

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13-17

Magenta Corporation
$14,000,000
$40,000,000

=

35%

The marginal tax rate for each of the corporations is as follows:
Red
White
Blue
Magenta
b.

34%
39%
34%
35%

The marginal tax rate can be 39% (34% + 5%) or 38% (35% + 3%) as the result of the
phaseout 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 11, 2011
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 (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

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13-18

2012 Corporations Volume/Solutions Manual
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 13-6

38.

The three forms of business entity available to Jack and his spouse are the partnership, C
corporation, and S corporation. The sole proprietorship is not a viable option, since Jack and
his spouse are to be the owners. 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 and his spouse this does not appear to be an advantage, when
compared with an unincorporated entity (i.e., partnership), because he and his spouse are to be
the only owners. The corporate form does however, in this case, offer the advantage of limited
liability.
If Jack and his spouse select the partnership form, the profits of the entity will be taxed to the
two owners. Since Jack and his spouse will be in the 35% tax bracket, the tax liability on the
projected earnings of $250,000 for the initial year would be $87,500 ($250,000 × 35%).
If Jack and his spouse select the corporate form, the earnings of the business will be taxed to
the corporation. The tax liability on the projected earnings of $250,000 for the initial year
would be $80,750 [($50,000 × 15%) + ($25,000 × 25%) + ($25,000 × 34%) + ($150,000 ×
39%)]. In addition, to the extent that the corporation distributes part or all of the after-tax
earnings to Jack and his spouse as a dividend, double taxation would result. On the other
hand, if the corporation pays salaries to Jack and his spouse, they will be able to receive cash
from the corporation without double taxation. The total income tax would increase, however,
as amounts received by Jack and his spouse 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 and his spouse rather than at the corporate level. While the initial year,
their tax liability of $87,500 would be higher than the C corporation tax liability of $80,750,
the potential for being subject to double taxation would be avoided. Finally, the advantage of
limited liability would be achieved.
pp. 13-3 to 13-6

39.

a.

If Clay is a C corporation, the corporate tax liability is:
15%
25%
34%

×
×
×

$50,000
25,000
15,000

=
=
=

$ 7,500
6,250
5,100
$18,850

Since Clay will not distribute any dividends, the shareholders will have no tax liability
associated with it.

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13-19

If Clay is an S corporation, the corporate tax liability will be $0 and the shareholders’
tax liability will be $29,700 ($90,000 × 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 × 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. 13-6, 13-7, and Example 8
40.

a.

The corporate tax liability on taxable income of $450,000 is $153,000 for the
C corporation.

$ 50,000
25,000
25,000
235,000
115,000

×
×
×
×
×

15%
25%
34%
39%
34%

=
=
=
=
=

$

7,500
6,250
8,500
91,650

39,100
$153,000

Since the tax benefits of the 15% and 25% brackets have been phased out, the tax
liability could be calculated as follows:
$450,000 × 34% = $153,000
Since the tax liability on the $450,000 is assessed at the corporate level, there will be
no dividend distribution to Mabel and Alan. They will each receive a salary of
$175,000.
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 $78,750
($225,000 × 35%) associated with their respective shares of the corporate taxable
income of $450,000. Therefore, the corporation will need to distribute $78,750 each to
Mabel and Alan to pay their tax liability. They also will receive their salary of
$175,000 each.

c.

The combined entity/owner tax liability in a. will be as follows:
C corporation
Shareholders on distribution
Shareholders on salaries ($350,000 × 35%)
Combined tax liability

$153,000
–0–
122,500
$275,500

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13-20

2012 Corporations Volume/Solutions Manual
The combined entity/owner tax liability in b. will be as follows:
S corporation
Shareholders taxed on S corporation earnings
($450,000 × 35%)
Shareholders on salaries ($350,000 × 35%)
Combined tax liability

$

–0–

157,500
122,500
$280,000

p. 13-6 and Example 7
41.

a.

Owl’s regular income tax liability on taxable income of $6,250,000 is calculated as

follows:
15%
25%
34%
39%
34%

×
×
×
×
×

$

50,000
25,000
25,000
235,000
5,915,000

=
=
=
=
=

$

7,500

6,250
8,500
91,650
2,011,100
$2,125,000

Since the tax benefits of the 15% and 25% brackets have been phased out, the tax liability
could be calculated as follows:
$6.25 million × 34% = $2,125,000
The AMT of the corporation is calculated as follows:
Taxable income
+ Positive AMT adjustments including ACE adjustment
($600,000 + $750,000)
– Negative AMT adjustments
+ Tax preferences
= Alternative minimum taxable income (AMTI)
– Exemption [$40,000 – 25%($12,570,000 – $150,000)]
= AMT base
× Rate
= Tentative AMT
– Regular income tax liability
= AMT

$ 6,250,000
1,350,000
(30,000)
5,000,000
$12,570,000
(–0–)
$12,570,000

20%
$ 2,514,000
(2,125,000)
$ 389,000

Thus, if Owl is a C corporation, its tax liability is $2,514,000 ($2,125,000 regular
income tax + $389,000 AMT).
b.

An S corporation is a tax reporter rather than a taxpayer. Thus, Owl 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. 13-8 and 13-9

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Comparative Forms of Doing Business
42.

13-21

Falcon’s tax liability for 2011 and 2012 is as follows if the cash option is selected.
Regular Income Tax Liability
Taxable income before sale
Gain from sale ($500,000 – $400,000)
Taxable income

2011
$400,000
100,000
$500,000

2012
$400,000
–0–
$400,000

Tax liability (34% rate)

$170,000

$136,000

Taxable income before sale
AMT gain from sale ($500,000 – $425,000)
Other AMT adjustments and tax preferences
AMTI
Exemption amount
AMT base

Rate
Tentative AMT

2011
$400,000
75,000
425,000
$900,000
(–0–)
$900,000
× 20%
$180,000

2012
$400,000
–0–
–0–
$400,000
(–0–)
$400,000
× 20%
$ 80,000

AMT

$ 10,000

$

AMT

–0–

Falcon’s tax liability for 2011 and 2012 is as follows if the installment option is selected.
Regular Income Tax Liability
Taxable income before sale
Gain from sale ($500,000 – $400,000)
Taxable income

2011
$400,000
–0–
$400,000

2012
$400,000
100,000
$500,000

Tax liability (34% rate)

$136,000

$170,000

Taxable income before sale
AMT gain from sale ($500,000 – $425,000)
Other AMT adjustments and tax preferences
AMTI
Exemption amount

AMT base
Rate
Tentative AMT

2011
$400,000
–0–
425,000
$825,000
(–0–)
$825,000
× 20%
$165,000

2012
$400,000
75,000
–0–
$475,000
(–0–)
$475,000
× 20%
$ 95,000

AMT

$ 29,000

$

AMT

–0–

If the cash option is selected, the combined tax liability for the two years is $316,000
($180,000 in 2011 and $136,000 in 2012). If the installment option is selected, the combined
tax liability for the two years is $335,000 ($165,000 in 2011 and $170,000 in 2012). Thus,
Falcon saves $19,000 ($335,000 – $316,000) by selecting the cash option.
pp. 13-8, 13-9, and Chapter 3

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13-22
43.

2012 Corporations Volume/Solutions Manual
a.

If the farm is incorporated as a C (regular) corporation, then the sisters and the brother
as shareholder-employees can qualify as employees. Thus, the $78,000 ($50,000 for
lodging and $28,000 for meals) is excludible to the sisters and the brother under the
§ 119 meals and lodging exclusion. If the farm is an S corporation, the sisters and the
brother are treated as partners (see part b.).

b.

If the farm is not incorporated (i.e., a partnership), the IRS position is that the sisters

and the brother do not satisfy the definition of an employee. Therefore, they are not
eligible for the §119 exclusion and the $78,000 must be included in their gross
income.

pp. 13-10, 13-11, and Example 10
44.

a.

Taxable income before cost of
certain fringe benefits
– Deductible fringe benefits
Taxable income

Partnership
$400,000
(235,000)
$165,000

C Corporation
$400,000
(305,000)
$ 95,000

S Corporation
$400,000
(235,000)
$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.
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. 13-10 and 13-11
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Comparative Forms of Doing Business
45.

a.

13-23

Under option 1, Turtle can deduct salaries of $600,000. Thus, Turtle’s taxable income
will be $0 ($600,000 – $600,000). No dividends will be distributed since there are no
after-tax earnings. Britney will include $270,000 of salary in her gross income, Shania
will include $180,000 of salary in her gross income, and Alan will include $150,000 of
salary in his gross income.
Under option 2, Turtle can deduct salaries of $300,000. Thus, Turtle’s taxable income
will be $300,000 ($600,000 – $300,000) and Turtle’s tax liability will be $100,250.
15%
25%
34%
5%

×
×
×

×

$ 50,000
25,000
225,000
200,000

=
=
=
=

$

7,500
6,250
76,500
10,000
$100,250

Britney will include $135,000 of salary and $66,583 [($300,000 – $100,250) × 1/3] of
dividend income in her gross income. Shania will include $90,000 of salary and
$66,583 ($199,750 × 1/3) of dividend income in her gross income. Alan will include
$75,000 of salary and $66,583 ($199,750 × 1/3) of dividend income in his gross
income.
b.

Under option 1, the salary payments reduce Turtle taxable income to $0. Thus, Turtle
should be aware of the possibility of the unreasonable compensation issue being raised
by the IRS.

pp. 13-11 and 13-12
46.

a.

Parrott will deduct interest expense each year of $54,000 ($900,000 × 6%). Abner will
report interest income of $32,400 ($540,000 × 6%) each year and Freda will report
interest income of $21,600 ($360,000 × 6%) each year.

b.

Parrott will not be allowed a deduction each year for the interest payments of $54,000.
Instead, the payments will be labeled as dividends. Abner will report dividend income
of $32,400 each year and Freda will report dividend income of $21,600 each year.
When the loan is repaid in 5 years, assuming adequate earnings and profits, Abner will
report dividend income of $540,000 and Freda will report dividend income of
$360,000.

p. 13-12 and Example 12
47.

If Lavender acquires the shopping mall, its tax liability would increase as follows:
Additional liability ($500,000 net rental income × 34%)

$170,000

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
– Depreciation
= Increase in their taxable incomes

$300,000
(37,000)
$263,000

Additional tax liability ($263,000 × 35%)

$ 92,050

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13-24

2012 Corporations Volume/Solutions Manual
At the corporate level, the corporate taxable income would increase as follows:
Net rental income
– Rental payments to Marci and Jennifer
= Additional taxable income

$500,000
(300,000)
$200,000

Additional tax liability ($200,000 × 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% × $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. 13-11
48.

a.

Flower, Inc.’s corporate tax liability is calculated as follows:
15%
25%
34%
5%

×
×
×
×

$ 50,000
25,000
725,000
235,000

=
=
=
=

$

7,500
6,250
246,500
11,750
$272,000

In addition, Flower may be subject to the accumulated earnings tax. This tax liability
could be as high as $79,200 ($528,000 × 15%). The $528,000 represents the after-tax
earnings of the corporation ($800,000 – $272,000).
b.

In this case, Flower would not be subject to the accumulated earnings tax. Thus, the
total corporate tax liability would be $272,000. The shareholders of Flower would be
taxed on their dividend income of $528,000 ($800,000 – $272,000).

c.

Flower’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 $800,000
is passed through to the shareholders’ tax returns. The accumulated earnings tax does
not apply to S corporations.

pp. 13-6, 13-7, and 13-13

49.

a.

Grace’s redemption qualifies as substantially disproportionate under $ 302(b)(2).
Before the redemption, Grace owned 25% of the stock and after the redemption, she
owns only 11.1%. Therefore, she has had a greater than 20% reduction in her
proportionate stock ownership. As a result, she qualifies for return of capital treatment.
Amount realized
Basis [$150,000 × (125 shares ÷ 175 shares)]
Recognized long-term capital gain

$175,000
(107,143)
$ 67,857

Frank’s redemption does not qualify as substantially disproportionate—after the
redemption, he does not own less than 50% of the stock. Therefore, he has dividend
income of $175,000 which is eligible for the beneficial 15% tax rate. His total stock
basis will not change (i.e., $350,000), but his basis per share will increase from $667
($350,000 ÷ 525 shares) to $875 ($350,000 ÷ 400 shares).

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Comparative Forms of Doing Business
b.

The tax consequences to Grace of selling 125 shares to Chuck would be the same as in
a. above. However, Frank would now receive return of capital treatment rather than
dividend treatment. His recognized gain on selling 125 shares to Chuck is calculated
as follows:
Amount realized
Basis [($350,000 × (125 shares ÷ 525 shares)]
Recognized long-term capital gain

c.

13-25

$175,000
(83,333)
$ 91,667

Factors that would influence the form of the transaction (i.e., stock redemption versus
sale of stock to an outsider) include the following:
•

External market for the stock.

•

Willingness of Frank and Grace to permit an outsider to purchase stock in the
corporation.

•

Frank’s preference for capital gain treatment (e.g., other capital losses available)

rather than dividend results.

•

Frank’s preference for increasing gross income by only $91,667 instead of
$175,000.

p. 13-13 and Example 14
50.

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 × 33%). If the S election is revoked effective for 2011, 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) × 15%].
Therefore, the total corporate and shareholder tax liability would be as follows:
Corporate tax liability
Shareholder tax liability

S Corporation
$ –0–
49,500
$49,500

C Corporation

$41,750
16,238
$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. 13-14 and Example 15
51.

a.

No gain or loss is recognized on the contribution of property to a partnership.
Therefore, Evans’ realized gain of $275,000 ($400,000 amount realized – $125,000
adjusted basis) is not recognized. Basis in the partnership interest is $400,000 for
Andrew and $125,000 for Evans. The recognized gain on the sale of the land is

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Solution manual SW federal taxation corporations partnerships estates and trusts 35e by hoffman chapter 13

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