Federal Tax Review

CHAPTER 22

S CORPORATIONS

TRUE/FALSE

1. S corporations are treated as partnerships under state laws.

ANS: F REF: p. 22-2

2. Liabilities affect the owner’s basis differently in an S corporation versus a partnership.

ANS: T REF: p. 22-2

3. An S corporation cannot incur a tax liability at the corporation level.

ANS: F REF: p. 22-2

4. Distributions of appreciated property by an S corporation are not taxable to the entity.

ANS: F REF: p. 22-3

5. Where the S corporation rules are silent, C corporation provisions apply.

ANS: T REF: p. 22-3

6. More S corporation returns are filed than C corporation returns.

ANS: T REF: p. 22-3

7. S corporation status allows shareholders to realize tax benefits from corporate losses immediately (assuming sufficient stock basis).

ANS: T REF: p. 22-4

8. NOL carryovers for C years can be used in an S corporation year.

ANS: F REF: p. 22-4

22-1

S Corporations 22-2

9. Tax-exempt income at the S level loses its special tax treatment for the shareholder.

ANS: F REF: p. 22-4

10. An estate may be a shareholder of an S corporation.

ANS: T REF: p. 22-5

11. Most limited liability partnerships can own stock in an S corporation.

ANS: F REF: p. 22-7

12. Most IRAs can own stock in an S corporation.

ANS: F REF: p. 22-7

13. An S corporation can be a shareholder in another corporation.

ANS: T REF: p. 22-7

14. If a resident alien shareholder moves outside the U.S., the S election is terminated.

ANS: T REF: p. 22-7

15. An S election is made on Form 2550.

ANS: F REF: p. 22-8

16. An S election made before becoming a corporation is valid the next 22-month tax year.

ANS: F REF: p. 22-8

17. For a new corporation, a premature S election may not be effective.

ANS: T REF: p. 22-8

18. Only 51% of the shareholders must consent to an S election.

ANS: F REF: p. 22-9

19. Persons who were shareholders during any part of the year before the election date, but were not shareholders when the elction was made, also must consent to the election.

ANS: T REF: p. 22-9

S Corporations 22-3

20. The termination of an S election occurs on the day after a corporation ceases to be a small business corporation.

ANS: FTermination occurs on that day.

PTS: 1 REF: p. 22-10

21. Passive investment income includes gains from the sale of securities.

ANS: T REF: p. 22-11

22. An S corporation may not amortize organization expenses.

ANS: F REF: p. 22-11

23. Tax-exempt income at the corporate level does flow through to the shareholders.

ANS: T REF: Figure 22-1

24. The pro rata method assigns an equal amount of each of the S corporation items (e.g., LTCG) to each day of the year.


25. An S corporation’s AAA cannot have a negative balance.


26. An S corporation with earnings and profits can make a taxable dividend distribution by making a AAA bypass election.

ANS: TBy making the election, distributions will come first from earnings and profits, until that balance is exhausted.

PTS: 1 REF: Concept Summary 22-1

27. Any distribution of cash or property by a corporation with respect to the stock during a post-termination transition period of approximately one year is applied against and reduces the adjusted basis of the stock.

ANS: FOnly cash distributions qualify for this treatment.

PTS: 1 REF: p. 22-19

28. All tax preference items flow through the S corporation, to be included in the shareholders’ AMT calculations.

ANS: T REF: p. 22-31 | p. 22-36 | Figure 22-1

S Corporations 22-4

29. An S shareholder who dies during the corporate tax year must report his or her share of the pro rata income (or loss) up to the date of death on the final individual tax return.

ANS: T§ 1366(a)(1)

PTS: 1 REF: p. 22-14 | Example 20

30. A capital loss allocated to a shareholder always reduces the accumulated adjustments account.

ANS: T REF: Exhibit 22-1

31. Tax-exempt income is not separately stated on Schedule K of Form 1120S.


32. A distribution from previously taxed income is not taxable.


33. An item that appears in the “Other Adjustments Account” affects basis, but not AAA, such as tax-exempt life insurance proceeds.


34. An S corporation does not recognize gain on a distribution of appreciated property.


35. Distributions are made from OAA after AEP and AAA reach zero.


36. Post-termination distributions that are charged against OAA get tax-free treatment.


37. An S corporation recognizes a loss when distributing assets that are worth less than their basis.


38. On distribution of loss property, an S corporation receives a step-down in basis.


39. An S corporation does not recognize a loss when distributing assets that are worth less than their basis.


S Corporations 22-5

40. Payment of an illegal kickback would increase a shareholder’s stock basis.

ANS: FA decrease.

PTS: 1 REF: p. 22-21

41. In certain circumstances, an S shareholder’s basis in her S stock can be reduced below zero.

ANS: FNever below zero.

PTS: 1 REF: p. 22-21

42. Any excess of losses or deductions over both stock and debt basis is lost forever.

ANS: FExcess is suspended.

PTS: 1 REF: p. 22-24

43. A shareholder’s basis is decreased by stock purchases.


44. Depletion in excess of basis in the property will cause an upward adjustment to an S shareholder’s basis.


45. Stock basis is first increased by income items, then decreased by losses, and then decreased by distributions.

ANS: FLosses come last.

PTS: 1 REF: p. 22-21

46. The debt basis always is adjusted back to the original amount before any increase is made in the stock basis.


47. A shareholder may irrevocably elect to have deductible items pass through before any noncapital, nondeductible items.


48. Deductions for an S corporation’s NOL pass-through can never exceed a shareholder’s adjusted basis in his or her stock basis.

ANS: FPlus the basis of any loans made by the shareholder to the corporation.

PTS: 1 REF: p. 22-23

S Corporations 22-6

49. For purpose of the passive investment income test, gross receipts is not the same as gross income.


50. An S corporation may not have a C corporation shareholder.


51. An S corporation is subject to the 10% of taxable income limitation applicable to charitable contributions.


52. The S corporation election is recognized by all states.


53. An S corporation may not issue § 1244 stock.


54. When AEP is present, a negative AAA may cause double taxation of S corporation income.


55. Maximizing shareholder-employee compensation may be beneficial if an S corporation is trying to reduce payroll taxes.


56. The AAA bypass election may be useful to avoid or reduce exposure to the accumulated earnings or personal holding company tax.


57. Unreasonable compensation traditionally has been a problem for S corporations.


58. Distributions from AEP are taxed at the 5/15% rate.

ANS: T REF: p. 22-15 | p. 22-35

MULTIPLE CHOICE

S Corporations 22-7

1. An S corporation is subject to the following tax.a. Corporate income tax (§ 11).b. Built-in gains tax.c. Personal holding company tax.d. Alternative minimum tax.e. None of the above apply to S corporations.

ANS: B REF: p. 22-2

2. Which statement is incorrect?a. S corporations are treated as corporations under state law.b. S corporations for tax purposes are treated as partnerships.c. Distributions of appreciated property are taxable to the S corporation.d. The accumulated earnings tax does not apply to an S corporation.e. None of the above.

ANS: B REF: p. 22-2

3. An S corporation must possess the following characteristics.a. No more than one class of stock.b. Corporation organized in the U.S.c. Only one class of stock.d. All of the above are required of an S corporation.e. None of the above is required of an S corporation.

ANS: D REF: p. 22-2 to 22-8

4. Which corporation is eligible to make the S election?a. Foreign corporation.b. 100% owned corporation.c. An insurance company.d. A U.S. bank.e. None of the above can elect S status.

ANS: B REF: p. 22-5

5. Which could constitute a second class of stock?a. Treasury stock.b. Phantom stock.c. Unexercised stock options.d. Warrants.e. None of the above.

ANS: E REF: p. 22-5

S Corporations 22-8

6. What statement is correct with respect to an S corporation?a. There are now more LLCs than S corporations.b. S corporation status allows shareholders to realize tax benefits from corporate losses

immediately.c. An S corporation is prohibited from being a member of an affiliated group.d. An LLP may own stock in an S corporation.e. None of the above.

ANS: B REF: p. 22-3 to 22-7

7. What statement is correct with respect to an S corporation?a. There is no advantage also to elect § 1244 stock.b. An S corporation can own 85% of an insurance company.c. An estate may be a shareholder.d. A voting trust arrangement is not available.e. None of the above statements is true.

ANS: C REF: p. 22-5

8. Identify a disadvantage of an S corporation.a. Estates can be shareholders.b. Losses flow through to the shareholders.c. The AMT on corporations is avoided.d. Tax-exempt income flows through to the shareholders.e. None of the above is a disadvantage of the S election.

ANS: E REF: p. 22-2 | p. 22-5

9. Which, if any, of the following can be eligible shareholders of an S corporation?a. A resident alien.b. Partnership.c. A foreign corporation.d. A nonqualifying trust.e. None of the above can own stock.

ANS: A REF: p. 22-5 | p. 22-7

10. Which, if any, of the following can be eligible shareholders of an S corporation?a. A child, age 10.b. A resident alien.c. A voting trust.d. An estate of a deceased shareholder.e. All of the above can own stock.

ANS: E REF: p. 22-7

S Corporations 22-9

11. Which statement is incorrect with respect to filing for an S election?a. Form 2553 must be filed.b. All shareholders must consent.c. The election may be filed in the previous year.d. An extension of time is available for filing Form 2553.e. None of the above are incorrect.

ANS: E REF: p. 22-8 | p. 22-9

12. Several individuals acquire assets on behalf of Skip Corporation on May 29, 2007, purchased assets on June 3, and begin doing business on June 11, 2007. They subscribe to shares of stock, file articles of incorporation for Skip, and become shareholders on June 21, 2007. The S election must be filed no later than 2 1/2 months after:a. May 29, 2007.b. June 3, 2007.c. June 11, 2007.d. June 21, 2007.e. December 31, 2007.

ANS: A REF: p. 22-8

13. The maximum number of S shareholders is:a. 75.b. 100.c. 200.d. Indeterminable.e. Some other amount.

ANS: D REF: p. 22-6

14. Which statement is incorrect with respect to an S shareholder’s consent?a. An S election requires a consent from all corporate shareholders.b. Both husband and wife must consent if one owns the stock as community property.c. A consent extension is available only if Form 2553 is filed on a timely basis, reasonable

cause is given, and the interests of the government are not jeopardized.d. A consent must be in writing.e. None of the above statements is incorrect.

ANS: E REF: p. 22-9

15. Which type of distribution from an S corporation is taxed at the 5/15% rate?a. AAA.b. PTI.c. OAA.d. AEP.e. None of the above.

ANS: D REF: p. 22-15

S Corporations 22-10

16. Which transaction affects the Other Adjustments Account on an S corporation’s Schedule M-2?a. Taxable dividends.b. Stock dividend (taxable).c. Section 1250 gain.d. Tax-exempt income.e. None of the above.

ANS: D REF: p. 22-18

17. Which transaction affects the Other Adjustments Account on an S corporation’s Schedule M-2?a. Charitable contributions.b. Unreasonable compensation.c. Payroll tax penalty assessed.d. Section 1245 income.e. None of the above.

ANS: E REF: p. 22-18

18. If the beginning balance in OAA is zero, and the following transactions occur, what is the ending OAA balance?

Section 1245 gain $21,000Payroll tax penalty 4,200Tax-exempt interest 5,300Nontaxable life insurance proceeds 4,100Insurance premiums paid (nondeductible) 2,900

a. $1,300.b. $6,500.c. $23,300.d. $27,500.e. None of the above.

ANS: B$5,300 + $4,100 – $2,900 = $6,500.

PTS: 1 REF: p. 22-18

19. Which transaction affects the Other Adjustments Account on an S corporation’s Schedule M-2?a. Payroll penalty.b. Unreasonable compensation.c. Life insurance proceeds (nontaxable to the recipient S corporation).d. Taxable interest.e. None of the above affects the OAA.

ANS: C REF: p. 22-18


20. Which, if any, of the following items decreases an S corporation’s AAA?a. Section 1231 loss.b. Expenses related to tax-exempt income.c. Depletion in excess of basis.d. Distribution from earnings and profits.e. None of the above.

ANS: AOptions b. and d. have no effect on AAA, and option c. increases AAA.

PTS: 1 REF: Exhibit 22-1

21. During 2007, Houston Nutt, the sole shareholder of a calendar year S corporation, received a distribution of $16,000. On December 31, 2006, his stock basis was $4,000. The corporation earned $11,000 ordinary income during the year. It has no accumulated E & P. Which statement is correct?a. Nutt recognizes a $1,000 LTCG.b. Nutt’s stock basis will be $2,000.c. Nutt’s ordinary income is $15,000.d. Nutt’s return of capital is $11,000.e. None of the above.

ANS: A$11,000 ordinary income; $15,000 return of capital, $1,000 capital gain. Nutt’s stock basis is increased by the $11,000 ordinary income allocable to him, giving a basis of $15,000 before the distribution. The first $15,000 of the distribution is a return of capital, reducing the stock basis to zero. The remaining $1,000 constitutes capital gain (the excess over stock basis).

PTS: 1 REF: Example 22


22. Beginning in 2007, the AAA of Amit, Inc., an S corporation, has a balance of $782,000. During the year, the following items occur.

Operating income $472,000 Interest income 6,500 Dividend income 14,050 Municipal bond interest income 6,000 Long-term capital loss from sale of land 7,400 Section 179 expense 6,000 Charitable contributions 19,000 Cash distributions 57,000

Amit’s ending AAA balance is:a. $1,171,100.b. $1,185,150.c. $1,191,150.d. $1,242,150.e. Some other amount.

ANS: BBeginning AAA $ 782,000 Add:

Operating income $472,000 Interest income 6,500 Dividend income 14,050

$492,550 Less:

LTCL $ 7,400Section 179 expenses 6,000Charitable contributions 19,000Cash distributions 57,000 (89,400) 403,150

Ending AAA $1,185,150

PTS: 1 REF: Exhibit 22-1


23. On January 1, 2007, Kinney, Inc., an electing S corporation, has $4,000 of AEP and a balance of $10,000 in AAA. Kinney has two shareholders, Erin and Maine, each of whom owns 500 shares of Kinney’s stock. Kinney’s 2007 taxable income is $5,000. Kinney distributes $6,000 to each shareholder on February 1, 2007, and distributes another $3,000 to each shareholder on September 1. How is Erin taxed on this distribution?a. $500 dividend income.b. $1,000 dividend income.c. $1,500 dividend income.d. $3,000 dividend income.e. None of the above.

ANS: CAAA is $15,000 ($10,000 + $5,000) as of December 31, 2007, before taking into account the two distributions. Thus, the sum of the distributions ($18,000) exceeds Kinney’s AAA by $3,000. A portion of the $15,000 AAA balance is allocated to each of the February 1 and September 1 distributions, based upon the respective sizes of the distributions, as follows.

February 1:$12,000

$15,000 = $10,000$18,000

September 1:$ 6,000

$15,000 = $5,000$18,000

Thus, Erin and Maine must both report dividend income of $1,000 for the February 1 distribution and $500 each for the September 1 distribution. Assuming that the shareholders have sufficient basis in their stock, both Erin and Maine each have a $7,500 return of capital from AAA.

§ 1368(c), Reg. § 1.1368-2(b)PTS: 1 REF: Concept Summary 22-1

24. Fred is the sole shareholder of an S corporation in Fort Deposit, Alabama. At a time when his stock basis is $10,000, the corporation distributes appreciated property worth $100,000 (basis of $10,000). There is no built-in gain. Fred’s taxable gain is:a. $0.b. $10,000.c. $90,000.d. $100,000.e. None of the above.

ANS: CThere is a $90,000 corporate gain ($100,000 - $10,000) which passes through to Fred and increases his stock basis to $100,000 ($10,000 + $90,000). Then the distribution reduces his stock basis to zero ($100,000 – $100,000). Fred recognizes a taxable gain of $90,000 and takes a $100,000 basis in the property.

PTS: 1 REF: p. 22-19 | p. 22-20


25. Which, if any, of the following items has no effect on the stock basis of an S corporation shareholder?a. Operating income.b. Long-term capital gain.c. Cost of goods sold.d. Short-term capital loss.e. All of the above affect stock basis.

ANS: EOptions a. and b. increase stock basis, and options c. and d. are stock basis decreases.

PTS: 1 REF: p. 22-20 | p. 22-21

26. You are given the following facts about a solely owned S corporation, and you are asked to prepare the shareholder’s ending stock basis.

Increase in AAA $32,000Increase in OAA 6,300Payroll tax penalty 2,140Beginning stock basis 39,800Stock purchases 22,000Tax-exempt insurance proceeds 4,800Insurance premiums paid (nondeductible) 2,700

a. $61,800.b. $68,100.c. $100,060.d. $100,100.e. Some other amount.

ANS: D$39,800 + $32,000 + $6,300 + $22,000 = $100,100.

PTS: 1 REF: p. 22-18 | p. 22-20 | p. 22-21

27. Which of the following reduces a shareholder’s S corporation stock basis?a. Depletion in excess of basis of property.b. Illegal kickbacks.c. Nontaxable income.d. Sales.e. None of the above.

ANS: B REF: p. 22-21


28. You are given the following facts about a 50% owner of an S corporation, and you are asked to prepare his ending stock basis.

Increase in AAA $32,000Increase in OAA 6,300Payroll tax penalty 2,140Ending PTI 6,125Beginning stock basis 39,800Tax-exempt interest income 4,800Insurance premiums paid (nondeductible) 2,700Stock purchases 22,000

a. $80,950.b. $85,750.c. $100,100.d. $106,225.e. Some other amount.

ANS: A$39,800 + .50($32,000) + .50($6,300) + $22,000 = $80,950.

PTS: 1 REF: p. 22-18 | p. 22-20 | p. 22-21

29. On January 2, 2006, David loans his S corporation $10,000, and by the end of 2006 David’s stock basis is zero and the basis in his note has been reduced to $8,000. During 2007, the company’s operating income is $10,000. The company also makes distributions to David of $11,000. Which statement is correct?a. $1,000 LTCG.b. $3,000 LTCG.c. $11,000 LTCG.d. Loan basis is $10,000.e. None of the above statements is correct.

ANS: AThe $11,000 distribution reduced the $10,000 income, so there is no “net increase” to be applied to the loan basis. Thus, the $11,000 distribution reduces the new $10,000 stock basis to zero, with a $1,000 LTCG.


30. On January 2, 2006, David loans his S corporation $10,000. By the end of 2006, David’s stock basis is zero, and the basis in his note has been reduced to $8,000. During 2007, the company’s operating income is $10,000. The company also makes distributions to David of $8,000. Which statement is correct?a. Loan basis is now $10,000.b. $8,000 LTCG.c. Stock basis is $2,000.d. $2,000 LTCG.e. None of the above statements is correct.

ANS: AThe “net increase” of $2,000 ($10,000 – $8,000) is first used to increase loan basis back to $10,000. Stock basis is zero, and there is no long-term capital gain.



31. Nicole is a shareholder in Shaquille, Inc., an S corporation in Tazewell, Tennessee. She has a $15,000 stock basis and a $10,000 basis in debt owed to her by Shaquille, Inc. For 2007, Nicole’s pro rata share of the S corporation’s nonseparately computed loss was $30,000, and a separately stated capital loss was $10,000. What statement is false?a. Nicole may recognize only $18,750 of the nonseparately computed loss.b. She may recognize only $6,250 of the capital loss.c. Nicole may carry forward $11,250 of the disallowed nonseparately computed loss.d. She may carry forward only $4,350 of the disallowed capital loss.e. None of the above.

ANS: DNicole may carry forward only $3,750 of the disallowed capital loss. The sum of the losses attributable to Shaquille, Inc. ($40,000) exceeds the sum of Nicole’s stock and debt bases ($25,000). Thus, the basis limitation must be allocated between her pro rata share of the nonseparately computed loss and the capital loss. Nicole can recognize $18,750 of the nonseparately computed loss ($25,000 $30,000/$40,000) and $6,250 of the capital loss ($25,000 $10,000/$40,000). She can carry forward the $11,250 disallowed nonseparately computed loss and the $3,750 disallowed capital loss.

PTS: 1 REF: p. 22-22 to 22-24 | Figure 22-1

32. During 2007, an S corporation in Gainesville, Florida, incurs the following transactions.

Net income from operations $110,000Interest income from savings account 8,000Long-term capital gain from sale of securities 11,000Short-term capital loss from sale of securities 4,000

The corporation’s passive investment income for 2007 is:a. $3,000.b. $11,000.c. $8,000.d. $19,000.e. None of the above.

ANS: DFor purposes of applying the passive investment income limitation, gains from the sale of securities are not netted against any such losses. Passive investment income, therefore, is $19,000 [$8,000 (interest income) + $11,000 (long-term capital gain from the sale of securities)].

PTS: 1 REF: p. 22-30 | § 1362(d)(3)(D)(i)


33. During 2007, Lion Corporation incurs the following transactions.

Net income from operations $100,000Interest income from savings account 3,000Long-term capital gain from sale of securities 10,000Short-term capital loss from sale of securities 4,000

Lion maintains a valid S election and does not distribute any dividends to its sole shareholder, Penny. As a result, Penny must recognize:a. Ordinary income of $103,000 and long-term capital gain of $5,000.b. Ordinary income of $103,000, long-term capital gain of $10,000, and $4,000 short-term

capital loss.c. Ordinary income of $108,000.d. None of the above.

ANS: B REF: Figure 22-1

34. On January 1, Bobby and Alice own equally all of the stock of an electing S corporation called Prairie Dirt Delight. The dirt company has a $60,000 loss for a non-leap year. On the 219th day of the year, Bobby sells his one-half of the stock to his son, Paul. How much of the $60,000 loss, if any, is allocated to Bobby?a. $0.b. $18,000.c. $36,000.d. $60,000.e. None of the above.

ANS: B$18,000 ($60,000 .50 219/365).

PTS: 1 REF: p. 22-13

35. On January 1, Bobby and Alice own equally all of the stock of an electing S corporation called Prairie Dirt Delight. The soil company has a $90,000 loss for a non-leap year. On the 219th day of the year, Bobby sells his one-half of the stock to his son, Naresh. How much of the $90,000 loss is allocated to Alice?a. $0.b. $18,000.c. $27,000.d. $45,000.e. None of the above.

ANS: D$45,000 ($90,000 .50).

PTS: 1 REF: p. 22-14


36. During the year, an S corporation incurs a net operating loss of $22,000 and a § 1231 gain of $4,000. Marie, the entity’s sole shareholder, has a $15,000 stock basis, and the corporation has a $21,000 balance in AAA at the beginning of the year. What amount, if any, of the NOL may Marie deduct on her personal return?a. $0.b. $18,000.c. $19,000.d. $22,000.e. Some other amount.

ANS: CMarie may deduct $19,000 of the NOL, the amount of her stock basis before considering the NOL. The stock basis is then reduced to zero, and she has an NOL carryforward of $3,000.

Stock basis, beginning of year $15,000§ 1231 gain 4,000Ending basis before NOL $19,000

PTS: 1 REF: p. 22-20 to 22-24

37. An S corporation in Lawrence, Kansas has a recognized built-in gain of $110,000 and taxable income of $90,000. The company has an $8,000 NOL carryforward from a C corporation year, and a $9,000 business credit carryforward from a C corporation year. The built-in gains tax liability is:a. $0.b. $19,700.c. $26,700.d. $28,700.e. None of the above.

ANS: BTaxable income (less than built-in gain) $90,000 Less: NOL (8,000) Tax base $82,000 Rate 35% Gross tax due $28,700 Less: Business credit (9,000) Tax liability $19,700

PTS: 1 REF: Example 45 | Concept Summary 22-3


38. A C corporation elects S status. The corporation may be subject to a built-in gains tax on which of the following assets?a. Securities held for investment.b. Goodwill.c. Accounts receivables.d. Investment land.e. All of the above.

ANS: EThe built-in gains tax can be applied to gains recognized from any type of asset.

PTS: 1 REF: p. 22-27 to 22-29

39. A cash basis calendar year C corporation in Athens, Georgia, has $100,000 of accounts receivable on the date of its conversion to an S corporation on February 14. By the end of the year, $60,000 of these receivables are collected. Calculate any built-in gains tax, assuming that there is sufficient taxable income.a. $0.b. $21,000.c. $28,000.d. $35,000.e. Some other amount.

ANS: B$60,000 35% = $21,000.

PTS: 1 REF: p. 22-27 to 22-29 | Concept Summary 22-3

40. Lott Corporation in Macon, Georgia converts to S corporation status in 2007. Lott used the LIFO inventory method in 2006 and had a LIFO inventory of $420,000 (FIFO value of $550,000). How much tax must be added to the 2006 corporate tax liability, assuming that Lott is subject to a 35% tax rate.a. $0.b. $11,375.c. $45,500.d. $130,000.e. None of the above.

ANS: B$11,375. $550,000 (FIFO basis) – $420,000 (LIFO basis) = $130,000 35% = $45,500/4 = $11,375. The remaining three installments of $11,375 each are paid with Lott’s next three tax returns.



41. In 2007, Ravi Corporation converts to S corporation status. At the end of 2006, the company had an ending LIFO inventory of $310,000 (FIFO value of $400,000). What amount is added to Ravi’s tax liability for 2006?a. $0.b. $7,875.c. $8,750.d. $31,500.e. Some other amount.

ANS: B$7,875 is added to the tax liability in 2006. 35%[$400,000 (FIFO basis) – $310,000 (LIFO basis)] = $31,500 25% = $7,875. This same amount is paid in the next three years.


42. Which of the following is not passive investment income?a. Dividends.b. Interest.c. Gross receipts from sale of stock.d. Annuities.e. All of the above constitute passive investment income.

ANS: E REF: p. 22-30

43. Excess net passive income of an S corporation is $40,000 and taxable income is $32,000. Assuming that there is $50,000 of accumulated earnings and profits from a C corporation year, calculate any passive income penalty tax.a. $0.b. $4,500.c. $10,500.d. $11,200.e. Some other amount.

ANS: DLesser of taxable income or excess net passive income: $32,000 35% = $11,200.

PTS: 1 REF: p. 22-30 | Example 47

44. An S corporation may lose its S tax status:a. Only at the option of the IRS.b. If the corporation has a passive loss during the year.c. If any one of the shareholders dies and the estate owns the stock.d. If any one of the shareholders transfers some of the stock to a nonqualified trust.e. None of the above terminates an S election.

ANS: D§ 1362

PTS: 1 REF: p. 22-10


45. Edwards, an S corporation, distributes a machine to Skip, a majority shareholder. This asset has an adjusted basis of $30,000, but a fair market value of $80,000. Accumulated cost recovery deductions amount to $25,000. Edwards recognizes a gain of:a. $0.b. $25,000.c. $30,000.d. $50,000.e. Some other amount.

ANS: DUnder § 1363(d), gain is recognized to the distributing corporation to the extent of any appreciation in the asset or $50,000 ($80,000 – $30,000).

PTS: 1 REF: Concept Summary 22-2 | Chapter 19

46. An S corporation in Polly Beach, South Carolina, reports a recognized built-in gain of $95,000 and taxable income of $80,000. It holds a $7,000 NOL carryforward and a $9,000 business credit carryforward from a C corporation year. There are no earnings and profits from C corporation years. The built-in gains tax liability is:a. $0.b. $16,550.c. $25,550.d. $28,000.e. None of the above.

ANS: BTaxable income (less than net built-in gain) $80,000 Less: NOL (7,000)Tax base $73,000 Rate 35% Gross tax due $25,550 Less: Business credit (9,000)Tax liability $16,550

PTS: 1 REF: Example 45 | Concept Summary 22-3


47. An S corporation with substantial AEP has operating revenues of $410,000, taxable interest income of $390,000, operating expenses of $260,000, and deductions attributable to the interest of $150,000. The possible investment income penalty tax payable is:a. $0.b. $40,923.c. $116,923.d. $136,500.e. None of the above.

ANS: BENPI = (Net Passive Income/PII) (PII – 25% GR)ENPI = [($390,000 – $150,000)/$390,000] [$390,000 – (25% $800,000)]ENPI = ($240,000/$390,000) $190,000ENPI = $116,923

Since taxable income of $390,000 is more than ENPI, the § 1375 tax is $116,923 35%, or $40,923.PTS: 1 REF: Example 47

48. At the end of 2007, Newt, an S corporation, has gross receipts of $190,000 and gross income of $170,000. Newt has AEP of $22,000 and taxable income of $30,000. There is passive investment income of $100,000, with $40,000 of expenses directly related to the production of passive investment income. Newt’s PII (§ 1375) penalty tax is:a. $0.b. $10,500.c. $11,025.d. $31,500.e. None of the above.

ANS: BTaxable income is less than ENPI, so 35% $30,000 = $10,500.



49. When Gail dies, she owns 100% of the stock of an S corporation, with an adjusted basis of $10,000 and FMV of $100,000. The AB and FMV of the assets inside the S corporation are the same amounts. Gail’s son Phil inherits all of the stock, but does not wish to continue the business. Therefore, the S corporation sells the assets, resulting in a $90,000 capital gain, and liquidates. Assuming that Phil is subject to a marginal tax rate of 30%, what taxes are due?a. $0.b. $25,000.c. $27,000.d. $30,000.e. None of the above.

ANS: APhil obtains a step-up in basis in the stock to $100,000. When the assets are sold, the $90,000 gain flows through to increase his stock basis to $190,000. Then, when the $100,000 cash proceeds are distributed upon liquidation, Phil reports a $90,000 capital loss ($190,000 – $100,000), which can be offset against the $90,000 flow-through gain. Thus, Phil gets a step-up in basis with no tax liability.

PTS: 1 REF: p. 22-38 | §§ 331 and 1014

50. When an S corporation liquidates, which of its tax attributes disappear?a. PTI.b. AAA.c. AEP.d. Suspended losses.e. All of the above.

ANS: EAll attributes disappear.

PTS: 1 REF: p. 22-38

51. An S corporation reports $10,000 DPGR and $7,500 of wages, and the S corporation’s QPAI is $2,500. Shelly has a 50% interest in the S corporation. All expenses that reduce DPGR are from wages, and all wages paid relate to DPGR. How much QPAI and wages are allocated to Shelly?a. $1,250 QPAI and $3,750 wages.b. $2,500 QPAI and $7,500 wages.c. $1,250 QPAI and $1,875 wages.d. $2,500 QPAI and $1,875 wages.e. None of the above.

ANS: A REF: p. 22-37


MATCHING

Match the term with the proper response. There may be more than one responses for each term.a. Includes gross receipts derived from royalties, passive rents, dividends, interest, etc.b. Penalty tax to stop an S corporation from avoiding the corporate tax on disposition of

appreciated property.c. Cumulative total of undistributed non-separately stated items.d. Tax-free distribution.e. Generated under old S corporation rules (pre-1983).f. Items that affect basis but not AAA go here.g. Taxed as a dividend.

1. AAA2. PTI3. OAA4. Built-in gain tax5. Passive investment income tax

1. ANS: A NOTE: C and D are also correct.2. ANS: A NOTE: C, D, and E are also correct.3. ANS: C NOTE: D and F are also correct.4. ANS: B5. ANS: A


COMPLETION

1. The maximum individual tax rate is ______________ (higher, lower, the same) as the corporate income rate.

ANS: Same.PTS: 1 REF: p. 22-3

2. _________________ taxation rules do not apply to an S corporation.

ANS: PartnershipPTS: 1 REF: p. 22-3

3. If shareholders have high marginal rates relative to C corporation rates, it may be desirable to ________________ S corporation status.

ANS: avoid.PTS: 1 REF: p. 22-4

4. The _______________ and ______________ limitations apply to losses generated by an S Corporation.

ANS: at-risk and passive activity.PTS: 1 REF: p. 22-4

5. If any entity electing S status is currently a C corporation, NOL carryovers from prior years ________________ be used in an S corporation year.

ANS: cannot.PTS: 1 REF: p. 22-4

6. An S corporation is limited to a theoretical maximum of ______________ shareholders.

ANS: 100.PTS: 1 REF: p. 22-5

7. The “member of the ________________ election” may be terminated.

ANS: family.PTS: 1 REF: p. 22-7

8. Arizona is a ________________ property state.

ANS: community.PTS: 1 REF: p. 22-7

9. A corporation that does not yet exist ________________ make an S Corporation election.

ANS: cannot.PTS: 1 REF: p. 22-8


10. ____________________ husband and wife must consent if they own their stock jointly.

ANS: BothPTS: 1 REF: p. 22-9

11. Shareholders owning a(n) ____________________ of shares (voting and nonvoting) may _________________________ revoke an election.

ANS: majority, voluntarilyPTS: 1 REF: p. 22-10

12. A termination occurs on the day that a corporation ____________________ to be an S corporation.

ANS: ceasesPTS: 1 REF: p. 22-10

13. S corporation losses are allocated on a ____________________ basis.

ANS: dailyPTS: 1 REF: p. 22-13

14. AAA is the _________________________ total of undistributed non-separately and separately stated items for S corporation taxable years beginning after 1982.

ANS: cumulativePTS: 1 REF: p. 22-16

15. A shareholder has a _________________________ interest in the AAA, regardless of the size of his or her stock basis.

ANS: proportionatePTS: 1 REF: p. 22-16

16. The benefits of the AAA can be ____________________ from one shareholder to another _________________________.

ANS: shifted, shareholderPTS: 1 REF: p. 22-16

17. _________________________ may not make the AAA negative or increase a negative balance.

ANS: DistributionsPTS: 1 REF: p. 22-16

18. Life insurance proceeds received and insurance premiums paid are traced through ____________________.

ANS: OAAPTS: 1 REF: p. 22-18


19. Since only ____________________ distributions reduce AAA during the post-election termination period, a corporation should not make ____________________ distributions during this time.

ANS: cash, propertyPTS: 1 REF: p. 22-19

20. Post-termination distributions that are charged against ____________________ do not get tax-free treatment.

ANS: OAAPTS: 1 REF: p. 22-19

21. Since loss property receives a ____________________ - ____________________ in basis without any loss recognition, distributions of loss property should be ____________________.

ANS: step-down, avoidedPTS: 1 REF: p. 22-20

22. Realized gain is ____________________ by an S corporation on its distribution of appreciated property.

ANS: recognizedPTS: 1 REF: Concept Summary 22-2

23. Non-separately computed loss ____________________ a S shareholder’s stock basis.

ANS: reducesPTS: 1 REF: p. 22-21

24. Net operating losses from C corporation years cannot be utilized at the corporate level, except with respect to ____________________-____________________ ____________________.

ANS: built-in gainsPTS: 1 REF: p. 22-28

25. The built-in gains tax is calculated using the highest ____________________ rate.

ANS: corporatePTS: 1 REF: p. 22-26

26. The taxable LIFO recapture amount equals the excess of the inventory’s value under ____________________ over the ____________________ value.

ANS: FIFO, LIFOPTS: 1 REF: p. 22-29


27. The LIFO recapture tax is payable in ____________________ equal installments.

ANS:Four4PTS: 1 REF: p. 22-29

28. The excess net passive income cannot ____________________ the C corporate taxable income for the year in calculating the passive income penalty tax.

ANS: exceedPTS: 1 REF: p. 22-30

29. The flow-through of S items to a shareholder does not create ____________________-____________________ income.

ANS: self-employmentPTS: 1 REF: p. 22-30

30. It is _________________________ for an S corporation to issue § 1244 stock.

ANS:beneficialadvantageousPTS: 1 REF: p. 22-32

ESSAY

1. Discuss two ways that an S election may be terminated.

ANS:Broadly, there are two ways of terminating the S election-voluntary termination and involuntary termination. If shareholders owning a majority of shares consent, an election can be voluntarily terminated. If the revocation is filed by the fifteenth day of the third month of the tax year, the revocation is effective for the entire tax year (unless a prospective effective date is specified).

An S election may be involuntarily terminated if a disqualifying event occurs (i.e., second class of stock, too many shareholders, etc.). The loss of the election applies as of the date on which the disqualifying event occurs. Shareholders may intentionally cause a disqualifying event to terminate the election.

PTS: 1 REF: p. 22-10 | p. 22-11


2. Advise your client how income, expenses, gains and losses are allocated to shareholders.

ANS:In general, S corporation items are divided into (1) nonseparately computed income or losses, and (2) separately stated income, losses, deductions, and credits that could uniquely effect the tax liability of any shareholder. Each shareholder is allocated a pro rata portion of nonseparately computed income or loss. Separately stated items (e.g., LTCG, charitable contributions) also are allocated on a pro rata share method.

PTS: 1 REF: p. 22-12 to 22-15 | Example 16 to 20

3. Explain the OAA concept.

ANS:S corporations report changes in the AAA on Schedule M-2 of Form 1120S. Schedule M-2 contains a column labeled Other Adjustments Account (OAA). This account includes items that affect basis but not the AAA, such as tax exempt income and any related nondeductible expenses. For example, life insurance proceeds received and insurance premiums paid are traced through the OAA.

Distributions are made from the OAA after AEP and the AAA are depleted to zero. Distributions from the OAA are generally tax-free.

PTS: 1 REF: p. 22-18

4. Compare the distribution of property rules for an S corporation with the corresponding partnership rules.

ANS:The major difference involves distributions of appreciated property. Under the S corporation rules, realized gain on distributed appreciated property is recognized to the corporation, which passes through to the shareholders with no corporate-level tax (other than the built-in gains tax). The gain increases the shareholder’s stock basis. A realized loss, however, is not recognized for an S corporation distribution. The shareholder takes a market value basis in the property.

On the distribution, the shareholder’s stock basis is reduced by the fair market value of the property (but not below zero).

No gain or loss is recognized to a partnership or partners on the distribution of property. Basis to the partner in the asset is the lesser of the partner’s basis in the partnership or the entity’s basis in the asset.

PTS: 1 REF: Concept Summary 22-2


5. Your client is a C corporation that wishes to convert to S status. Advise this corporation with respect to minimizing any § 1374 built-in gains tax.

ANS:The C corporation should obtain sound appraisals of all assets immediately prior to electing S status. The built-in gains tax applies to gains recognized with respect to all types of assets-goodwill, real estate, securities, inventory, cash basis account receivables, etc. Accurate recordkeeping is essential to reduce the future built-in gains tax, because, during the 10-year period, the S corporation must prove that any asset disposed of was not owned on the date of conversion. A loss asset is not subject to this tax, but any such loss can be used to offset built-in gains.

The S corporation could defer disposing of built-in gain assets beyond the 10-year period. Use of like-kind exchanges or reorganizations can be used to postpone recognition of built-in gains.

PTS: 1 REF: pp. 22-26 to 22-28 | p. 22-35 | Example 53 | Example 54

6. How may an S corporation manage its liability for the built-in gains tax?

ANS:A taxable income limitation encourages an S corporation to create or accelerate deductions in the years that built-in gains are recognized. Although the postponed built-in gain is carried forward to future years, the time value of money makes the postponement beneficial. For example, the payment of compensation, rather than a shareholder distribution, creates a deduction that reduces taxable income and postpones the built-in gains tax. Any gain deferred beyond the 10-year recognition period is avoided entirely.

Giving built-in gain property to a charitable organization does not trigger the built-in gains tax. Built-in loss property may be sold in the same year that built-in gain property is sold, to reduce or eliminate the built-in gains tax. Generally, the taxpayer should sell built-in loss property in a year when at least as much built-in gain property is sold. Otherwise, the built-in loss could be wasted.

PTS: 1 REF: p. 22-35 | Example 53 | Example 54

7. Explain how the domestic production activities deduction is used for an S corporation.

ANS:The § 199 deduction is determined at the shareholder level. Domestic production gross receipts (DPGR), attributable cost of goods sold (CGS), and allocable deductions earned by the S corporation are passed through to the shareholders. These corporate-level DPGR, CGS, and allocable deductions are combined with any DPGR, CGS, and allocable deductions that the shareholder has from other sources.

An allocable portion of W-2 wages of the S corporation is passed through to the shareholder, but only those wages properly allocable to DPGR. Thus, a shareholder is treated as having been paid wages equal to the shareholder’s distributable share of wages from the S corporation.

PTS: 1 REF: p. 22-37

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