Tax Chp 4 Answers

8/12/2019 Tax Chp 4 Answers

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Chapter 04 - Entities Overview

Chapter 4Entities Overview

SOLUTIONS MANUAL

Discussion Questions

1. [LO 1] What are the most common legal entities used or operating a !usiness" #ow arethese entities treated similarl$ and dierentl$ or state law purposes"

Answer:

Corporations, limited liability companies (LLCs), general and limited partnerships,

and sole proprietorships. These entities differ in terms of the formalities that must be

observed to create them, the legal rights and responsibilities conferred on them and

their owners, and the ta rules that determine how they and their owners will be

taed.

%. [LO 1] #ow do !usiness owners create legal entities" &s the process the same or all entities"& not' what are the dierences"

Answer:

The process of creating legal entities differs by entity type. !usiness owners legally

form corporations by filing articles of incorporation in the state of incorporation while

business owners create limited liability companies by filing articles of organi"ation in

the state of organi"ation. #eneral partnerships may be formed either with or without

written partnership agreements, and they typically can be formed without filing

documents with the state. $owever, limited partnerships are usually organi"ed bywritten agreement and must typically file a certificate of limited partnership to be

recogni"ed by the state.

(. [LO 1] What is an operating agreement or an LLC" )re operating agreements re*uired orlimited lia!ilit$ companies" & not' wh$ might it !e important to have one"

Answer:

An operating agreement is a written document among the owners of an LLC specifying

the owners% legal rights and responsibilities for dealing with each other.#enerally,operating agreements are not re&uired by law for limited liability companies' however,

it might be important to have one to spell out the management practices of the new

entity as well as the rights and responsibilities of the owners.

4. [LO 1] E+plain how legal entities dier in terms o the lia!ilit$ protection the$ aord theirowners.

4-1, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in

an$ manner. /his document ma$ not !e copied' scanned' duplicated' orwarded' distri!uted' or posted on a we!site' in whole or part.


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Answer:

Corporations and LLCs offer owners limited liability. #eneral partners and sole

proprietors may be held personally responsible for the debts of the general partnership

and sole proprietorship. $owever, limited partners are not responsible for the

partnership%s liabilities.

2. [LO 1] Wh$ are C corporations still popular despite the dou!le ta+ on their income"

Answer:

Corporations have an advantage in liability protection compared to sole

proprietorships and partnerships. n addition, corporations have an advantage if

owners ever want to tae a business public. As a result, corporations remain desirable

legal entities despite their ta disadvantages.

3. [LO 1] Wh$ is it a nonta+ advantage or corporations to !e a!le to trade their stoc on thestoc maret"

Answer:

$aving the ability to issue stoc in the stoc maret provides corporations with a

source of capital typically not available to other types of entities. n addition, going

public provides a mechanism for shareholders of successful closely*held corporations

to sell their stoc on an established echange.

5. [LO 1] #ow do corporations protect shareholders rom lia!ilit$" & $ou ormed a smallcorporation' would $ou !e a!le to avoid repa$ing a !an loan rom $our communit$ !an ithe corporation went !anrupt" E+plain.

Answer:

A corporation is solely responsible for its liabilities. +ne eception to this is for payroll

ta liabilities. hareholders of closely*held corporations may be held responsible for

these liabilities. f a corporation were to go banrupt, the ban may have priority in

the corporation%s assets but it could not come to the shareholders to satisfy the

outstanding ban loan. The shareholders may lose their investment in the corporation

but their personal assets would be safe from the ban.

6. [LO 1' LO %] Other than corporations' are there other legal entities that oer lia!ilit$protection" )re an$ o them ta+ed as low-through entities" E+plain.

Answer: -es. Limited liability companies provide their members with liability protection

similar to that provided by corporations to their shareholders. Limited partnerships

protect limited partners, but not general partners, from partnership liabilities. All of

these alternatives to corporations are taed as flow*through entities. Limited liability

companies are either taed as partnerships (if there are at least two members), sole

proprietorships (if there is only one individual member), or as disregarded entities (if

there is only one corporate member). Limited partnerships are generally taed as

partnerships.

4-%, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in



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7. [LO %] &n general' how are unincorporated entities classiied or ta+ purposes"

Answer:

nincorporated entities are taxed aseither partnerships, sole proprietorships, or

disregarded entities (an entity that is considered to be the same entity as the owner).nincorporated entities (including LLCs) with more than one owner are taed as

partnerships. nincorporated entities (including LLCs) with only one individualowner

such as sole proprietorships and single*member LLCs are taed as sole

proprietorships.

10. [LO %] Can unincorporated legal entities ever !e treated as corporations or ta+ purposes"Can corporations ever !e treated as low-through entities or ta+ purposes" E+plain.

Answer:

Treasury regulations permit owners of unincorporated legal entities to elect to have

them treated as C corporations. +n the other hand, shareholders of certain eligiblecorporations may elect to have them receive flow*through ta treatment as

corporations.

11. [LO %] What are the dierences' i an$' !etween the legal and ta+ classiication o !usinessentities"

Answer:

A business entity may be legally classified as a corporation, limited liability company

(LLC), a general partnership (#/), a limited partnership (L/), or a sole proprietorship

under state law. $owever, for ta purposes a business entity can be classified as either

a separate tapaying entity or as a flow*through entity. eparate tapaying entities pay

ta on their own income. n contrast, flow*through entities generally don%t pay taes

because income from these entities flows through to their business owners who are

responsible for paying ta on the income. C corporations are separate tapaying

entities and if elected some flow*through entities may be treated as separate tapaying

entities. 0low*through entities are usually taed as either partnerships, sole

proprietorships, or disregarded entities.

1%. [LO %] What t$pes o !usiness entities does our ta+ s$stem recognie"

Answer:

Although there are more types of legal entities, there are really only four categories of

business entities recogni"ed by our ta system: C corporations, treated as separate

tapaying entities, corporations, partnerships, and sole proprietorships, treated as

flow*through entities.

1(. [LO (] Who pa$s the irst level o ta+ on a C corporation8s income" What is the ta+ rateapplica!le to the irst level o ta+"

4-(, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in



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Answer:

The C corporation files a ta return and pays taes on its taable income. The

marginal ta rate depends on the amount of the corporation%s taable income. The

current marginal ta rates range from a low of 12 percent to a maimum of 34 percent.

The most profitable corporations are taed at a flat 32 percent rate.

14. [LO (] Who pa$s the second level o ta+ on a C corporation8s income" What is the ta+ rateapplica!le to the second level o ta+ and when is it levied"

Answer:

A corporation%s shareholders are responsible for the second level of ta on corporate

income. The applicable rate for the second level of ta depends on whether

corporations retain their after*ta earnings and on the type of shareholder(s). The

shareholders pay ta either when they receive dividends at the dividend ta rate or

when they sell their stoc at the capital gains ta rate (either long* or short*term,

depending on how long they held the stoc). ndividual shareholders may also bere&uired to pay a 5edicare Contribution Ta of 3.67 on capital gains and dividends,

depending on their income level. Corporate shareholders may be eligible for a

dividends received deduction on dividends received from stoc ownership. This

deduction reduces the dividend ta rate for corporate shareholders. nstitutional and

ta*eempt shareholders also have special rules on the taation of dividends and

capital gains.

12. [LO (] &s it possi!le or shareholders to deer or avoid the second level o ta+ on corporateincome" 9riel$ e+plain.

Answer:

-es. The second level of ta can be avoided entirely to the etent shareholder

payments such as salary, rents, interest, and fringe benefits are ta deductible. The

second level of ta is deferred to the etent corporations don%t pay dividends and

shareholders defer selling their shares.$owever, if a corporation retains earnings withno business purpose for doing so, it may be sub8ect to the accumulated earnings ta.

This is a penalty ta that eliminates the ta incentive for retaining earnings to avoid

the double ta

13. [LO (] #ow does a corporation8s decision to pa$ dividends aect its overall ta+ rate[:corporate level ta+ ; shareholder level ta+


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15. [LO (] &s it possi!le or the overall ta+ rate on corporate ta+a!le income to !e lower than theta+ rate on low-through entit$ ta+a!le income" & so' under what conditions would $oue+pect the overall corporate ta+ rate to !e lower"

Answer:-es, it is possible for the overall corporate ta rate to be lower than the ta rate on

flow*through entity income under certain conditions. 9hen corporate marginal rates

are substantially lower than individual shareholder marginal rates and dividends are

taed at preferential rates, the combined effect of low corporate marginal rates and

preferential dividend rates can produce an overall ta rate less than the individual

shareholder%s marginal rate.

16. [LO (] )ssume Congress increases individual ta+ rates on ordinar$ income while leaving allother ta+ rates constant. #ow would this change aect the overall ta+ rate on corporate

ta+a!le income" #ow would this change aect overall ta+ rates or owners o low-throughentities"

Answer:

The overall ta rate on corporate taable income would remain constant because

Congress did not change the corporate rate, dividend rate, or capital gains rate. The

ta rate for flow*through entities would increase because their individual owners

would have a higher ta liability on the business income.

17. [LO (] )ssume Congress increases the dividend ta+ rate to the ordinar$ income rate whileleaving all other ta+ rates constant. #ow would this change aect the overall ta+ rate oncorporate ta+a!le income"

Answer:

The overall corporate income ta rate would increase because the second level ta to

shareholders on the dividend distributions would increase. The overall ta rate would

also increase because individual shareholders would be taed at a higher rate due to

the increase in the dividend rate.

%0. [LO (] Evaluate the ollowing statement> ?When dividends and long-term capital gains areta+ed at the same rate' the overall ta+ rate on corporate income is the same whether thecorporation distri!utes its ater-ta+ earnings as a dividend or whether it reinvests the ater-ta+ earnings to increase the value o the corporation.@

Answer:

This statement is incorrect because it ignores the time value of money. Although

dividends and long*term capital gains are currently taed at the same rate for

individual shareholders, this does not mean the present value of capital gains taes

paid when shares are sold will e&ual dividends taes paid when dividends are received.

As shareholders increase the holding period of their shares, capital gains taes on




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share appreciation attributable to reinvested dividends are deferred, and the present

value of these capital gains% taes will decline relative to taes paid currently on

dividends.

%1. [LO (] & AB corporation is a shareholder o 9CD corporation' how man$ levels o ta+ is

9CD8s !eore-ta+ income potentiall$ su!ect to" #as Congress provided an$ ta+ relie orthis result" E+plain.

Answer:

Taes are paid first by !C and then by ;-< when it receives !C%s dividends. ;-,3GG (1) M (=)

(>) +wner ta E,EGG (3) 327 =,1>2 (3) 127

(2) After*ta earnings K1>,3GG (3) M (>) K1=,122 (3) M (>)

b. LLC Corp.

+verall ta rate 327 (>)?(1) >>.E27 N(=) O (>)P?(1)

2(. [LO (] Evon would lie to organie G#O as either an G corporation or as a C corporationgenerating a 7 percent annual !eore-ta+ return on a J%00'000 investment. )ssumeindividual and corporate ta+ rates are !oth (2 percent and individual capital gains anddividend ta+ rates are %0 percent. G#O will pa$ out its ater-ta+ earnings ever$ $ear as a

dividend i it is ormed as a C corporation. )ssume Evon is the sole owner o the entit$ andignore sel-emplo$ment ta+es. inall$' assume Evon is activel$ involved in the !usiness.

a. #ow much would Evon eep ater ta+es i G#O is organied as either an G corporationor as a C corporation"

!. What are the overall ta+ rates i G#O is organied as either an G Corporation or as a Ccorporation"




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Answer:

a. Corp. escription C Corp. escription

(1) /reta earnings K16,GGG 47 K=GG,GGG K16,GGG 47 K=GG,GGG

(=) Intity level ta *G* D,3GG 327 (1)(3) After*ta entity

earnings

K16,GGG (1) M (=) K11,EGG (1) M (=)

(>) +wner ta D,3GG (3) 327 1,E22 (3) 127

(2) After*ta earnings K11,EGG (3) M (>) K4,4>2 (3) M (>)

b. LLC Corp.

+verall ta rate 327 (>)?(1) >>.E27 N(=) O (>)P?(1)

24. [LO(] Nac would lie to organie G as either an LLC or as a C corporation generating an11 percent annual !eore-ta+ return on a J100'000 investment. )ssume individual ordinar$rates are (2 percent' corporate rates are 12 percent' and individual capital gains anddividends ta+ rates are %0 percent. G will distri!ute its ater-ta+ earnings ever$ $ear as adividend i is ormed as a C corporation. )ssume Nac is the sole owner o the entit$ and isactivel$ involved in the !usiness. &gnore sel-emplo$ment ta+es.

a. #ow much would Nac eep ater ta+es i G is organied as either an LLC or as a Ccorporation"

!. What are the overall ta+ rates i G is organied as either an LLC or as a C corporation"

Answer:

a. LLC escription C Corp. escription

(1) /reta earnings K11,GGG 117 K1GG,GGG K11,GGG 117 K1GG,GGG

(=) Intity level ta *G* 1,D2G 127 (1)

(3) After*ta entity

earnings

K11,GGG (1) M (=) K4,32G (1) M (=)

(>) +wner ta 3,62G (3) 327 1,6EG (3) =G7

(2) After*ta earnings KE,12G (3) M (>) KE,>6G (3) M (>)

b. LLC Corp.

+verall ta rate 327 (>)?(1) 3=7 N(=) O (>)P?(1)




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22. [LO (] HFesearchI Psing the We! as a research tool' determine which countries lev$ adou!le-ta+ on corporate income. 9ased on $our research' what seem to !e the pros and conso the dou!le-ta+"

Answer:5any countries levy a double ta on corporate income' however, several have

developed various techni&ues to offset or mitigate the double ta. 0or eample, an

imputation system (Australia, Few


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K1,23G ta. K12,GGG dividend M K1G,2GG dividends received deduction R K>,2GG taable

portion of dividend 3>7 marginal ta rate R K1,23G.

d. Complete orm 11%0 Gchedule C or Little Foc Corp. to relect its dividends receiveddeduction.

e. On what line o Little Foc Corp.8s orm 11%0 page 1 is the dividend rom arathon &nc.reported and on what line o Little Foc Corp.8s orm 11%0 is its dividends receiveddeduction reported.

Little Boc Corp will report the K12,GGG dividend on 0orm 11=G, page 1, line >.

Little Boc Corp. will report its K1G,2GG dividend on 0orm 11=G, page 1, line =4b.

25. [LO (] HFesearchI )ter several $ears o proita!le operations' Navell' the sole shareholdero N9D &nc.' a C corporation' sold 16 percent o her N9D stoc to O &nc.' a C corporationin a similar industr$. During the current $ear N9D reports J1'000'000 o ater-ta+ income.N9D distri!utes all o its ater-ta+ earnings to its two shareholders in proportion to theirstocholdings. )ssume O8s marginal ta+ rate is (2 percent. #ow much ta+ will Opa$ on the dividend it receives rom N9D" What is O8s overall ta+ rate on its dividendincome" [Hint: see IRC 243(a)]




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Answer:

According to BC =>3(a), corporations are generally entitled to a EG percent

dividends received deduction. ubsections (b) and (c) go on to provide for a larger

dividends received deduction if a corporation owns =G percent or more of the dividend*

paying corporation. n this situation,


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Answer:

a. 9ithout

alary

escription b. 9ith

alary

escription

(1) Taable income beforesalary

K =GG,GGG K =GG,GGG

(=) alary G 12G,GGG

(3) Taable income K =GG,GGG (1) M (=) K 2G,GGG (1) M (=)

(>) Intity ta EG,GGG (3) 327 1E,2GG (3) 327

(2) After*ta entity

earnings

K13G,GGG (3) M (>) K 3=,2GG (3) M (>)

(D) Saron%s ta on

dividends and salary

14,2GG (2) 127 2E,3E2 N(=) 327P O

N(2) 127P

Combined ta K 64,2GG (>) O (D) K E>,6E2 (>) O (D)

c. The combined taes are lower under part b because the ma8ority of the corporation%s

earnings are only sub8ect to one level of ta (the individual ta on the salary). n part a

the taable income after salary is K=GG,GGG but in part b it is K2G,GGG since the

deduction of K12G,GGG is taen and this leads to only K2G,GGG that is taed twice in part

b.

27. [LO (] or the current $ear' aple Corporation' a C corporation' reports ta+a!le income oJ%00'000 !eore pa$ing salar$ to its sole shareholder Diane. Diane8s marginal ta+ rate onordinar$ income is (2 percent and 12 percent on dividend income. & aple pa$s Diane asalar$ o J120'000 !ut the &FG determines that Diane8s salar$ in e+cess o J60'000 isunreasona!le compensation' what is the amount o the overall ta+ :corporate level ;shareholder level< on aple8s J%00'000 pre-salar$ income" )ssume aple8s ta+ rate is (2percent and it distri!utes all ater-ta+ earnings to Diane.

Answer: K61,EGG overall ta (combined ta for corporation and shareholder) computed as

follows:

9ith K6G,GGG

alary

escription

(1) Taable income before

salary

K =GG,GGG

(=) alary 6G,GGG

(3) Taable income K 1=G,GGG (1) M (=)

(>) Intity ta K>=,GGG (3) 327

(2) After*ta entity

earnings

KE6,GGG (3) M (>)

(D) iane%s ta on

dividends

K11,EGG (2) 127

(E) iane%s ta on salary K=6,GGG (=) 327

4-%0, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in



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c.

9ith non*&ualified

fringe benefits

escription

(1) Taable income before fringes K 12G,GGG

(=) 0ringe benefits 1G,GGG(3) Taable income K 1>G,GGG (1) M (=)

(>) Intity ta >4,GGG (3) 327

(2) After*ta entity earnings K 41,GGG (3) M (>)

(D) Haren%s ta on dividends 13,D2G (2) 127

(E) Haren%s ta on fringe benefit 3,2GG (=) 327

+verall ta K DD,12G (>) O (D) O (E)

31. [LO (] Na!ar Corporation' a C corporation' proects that it will have ta+a!le income o

J(00'000 !eore incurring an$ lease e+penses. Na!ar8s ta+ rate is (2 percent. )!dul' Na!ar8ssole shareholder' has a marginal ta+ rate o (7.3 percent on ordinar$ income and %0 percenton dividend income. Na!ar alwa$s distri!utes all o its ater-ta+ earnings to )!dul.

a. What is the amount o the overall ta+ :corporate level ; shareholder level< on Na!arCorp.8s J(00'000 pre-lease e+pense income i Na!ar Corp. distri!utes all o its ater-ta+earnings to its sole shareholder )!dul :include the edicare Contri!ution /a+ ondividend rental income


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(2) After*ta entity

earnings

K142,GGG K 1E2,2GG 1E6,E2G (3) M (>)

(D) Abdul%s ta on

dividends

K>D,>1G K>1,ED4 K>=,2>3 (2) (=G7 O

3.67)

(E) Abdul%s ta on

lease payment

G K13,G=G K1G,62G (=) (34.D7 O

3.67)+verall ta K 121,>1G K 1>4,=64 K 1>4,D>3 (>) O (D) O (E)

3%. [LO (] utt Corporation proects that it will have ta+a!le income or the $ear o J400'000!eore incurring an$ interest e+pense. )ssume utt8s ta+ rate is (2 percent.

a. What is the amount o the overall ta+ :corporate level ; shareholder level< on theJ400'000 o pre-interest e+pense earnings i #ael' utt8s sole shareholder' lends uttCorporation J(0'000 at the !eginning o the $ear' utt pa$s #ael J6'000 o interest onthe loan :interest is considered to !e reasona!le12 (2) 127

(E) $a"el%s ta on

interest

=,6GG =,1GG (=) 327

(6) ouble ta K 1E6,==G K 1E6,>12 (>) O (D) O (E)

+verall ta rate >>.2D7 >>.D7 (6)?(1)

4-%(, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in



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3(. [LO (] HFesearchI Pltimate Comort 9lanets &nc. has had a great couple o $ears andwants to distri!ute its earnings while avoiding dou!le ta+ation on its income. &t decides togive its sole shareholder' Laura' a salar$ o J1'200'000 in the current $ear. What actorswould the courts e+amine to determine i LauraRs salar$ is reasona!le" [#int> Gee Elliotts'

&nc. v. Commissioner' 513 .%d 1%41 :7th Cir. 176(1 (4th Cir. 1463) indicates that

unreasonable salary payments to Laura will be treated as constructive dividends

payments to Laura.

34. [LO (] )lice' the sole shareholder o SL' decided that she would purchase a !uilding andthen lease it to SL. Ghe leased the !uilding to SL or J1'620 per month. #owever' the&FG determined that the air maret value o the lease pa$ment should onl$ !e J1'300 permonth. #ow would the lease pa$ment !e treated with respect to !oth )lice and SL"

Answer:

+f the total K1,62G lease payment to Alice, K1,DGG would be treated as a deductible rent

epense to L/ and as ordinary income to Alice. The remaining K=2G would be treated

as a non*deductible dividend to L/ and a taable dividend to Alice.

32. [LO (] &n its irst $ear o e+istence :$ear 1


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Answer: K>,2GG.

escription

(1) -ear 3 taable income K1GG,GGG

(=) -ear 1 F+L carryforward (K3G,GGG)(3) -ear = F+L carryforward (K>G,GGG)

(>) Taable income reported 3G,GGG (1) M (=) M (3)

(2) Ta rate 127 ee corporate

ta rate table

Taes paid in year 3 K>,2GG (>) (2)

35. [LO (] H /a+ ormsI HlanningI &n its irst $ear o e+istence :$ear 1< WCC corporation :a Ccorporation< reported ta+a!le income o J150'000 and paid J47'220 o ederal income ta+.

&n $ear %' WCC reported a net operating loss o J40'000. WCC proects that it will reportJ600'000 o ta+a!le income rom its $ear ( activities.

a. 9ased on its proections' how much will WCC corporation save in ta+es i it elects toorgo the OL carr$!ac and carries its $ear % OL orward to $ear ("

9CC should carrybac the year = loss to year 1. f it carries bac the loss, the loss will

offset income that was taed a 347 marginal rate. n contrast, if it carries the loss

forward, the loss will offset income that would be taed at a 3>7 rate. Thus 9CC will

save K=,GGG more in taes if it carries the loss bac. 0urther, it will get the ta savings

immediately.

!. HormsI )ssuming WCC corporation carries !ac its $ear % OL to $ear 1' prepare aorm 11(7 ?Corporation )pplication or /entative Feund@ or WCC corporation to relectthe OL carr$!ac. Pse reasona!le assumptions to ill in missing inormation.




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36. [LO (] Damarcus is a 20Q owner o #oop :a !usiness entit$


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K2G,GGG. amarcus had ade&uate basis and at ris amounts to absorb the loss

and the passive activity limits do not apply because he is not a passive investor

in $oop. Conse&uently, amarcus can deduct all of the loss allocated to him.

e. #oop is organied as an LLC. it$ percent o #oop8s loss is allocated to Damarcus.Damarcus does not wor or #oop at all :he is a passive investor in #oop


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!. / is ormed as an G corporation.

ame answer as part a. nder 321, 5icey and 5icalya do not recogni"e any

gain. $owever, because Taylor is contributing services (and services are not

property) Taylor must recogni"e K1GG,GGG of ordinary income on the receipt ofthe K1GG,GGG worth of stoc she receives from 55T.

c. / is ormed as an LLC.

nder E=1, neither 5icy nor 5icayla recogni"e any gain on the transfer.

$owever, because Taylor has a twenty percent interest in 55T, she recogni"es

K1GG,GGG of ordinary income on the transaction.

50. [LO (] HFesearchI Dave and his riend Gtewart each own 20 percent o K9G. During the

$ear' Dave receives J52'000 compensation or services he perorms or K9G during the$ear. #e perormed a signiicant amount o wor or the entit$ and he was heavil$ involvedin management decisions or the entit$ :he was not a passive investor in K9G


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!orrowed J(0'000 rom the !an. & applica!le' this de!t is shared e*uall$ !etween thetwo owners.

a. )ter taing the loan into account' what is Fondo8s ta+ !asis in his FUL stoc i FULis ormed as a C corporation"

K2G,GGG. C corporation shareholders do not include entity debt in the ta basis of

their stoc in the corporation.

!. )ter taing the loan into account' what is Fondo8s ta+ !asis in his FUL stoc i FULis ormed as an G corporation"

K2G,GGG. corporation shareholders do not include entity debt in the ta basis of

their stoc in the corporation.

c. )ter taing the loan into account' what is Fondo8s ta+ !asis in his FUL ownership

interest i FUL is ormed as an LLC"

KD2,GGG (K2G,GGG O K12,GGG). The owner of an LLC includes his share of the LLC%s

liabilities in his ownership interest. $ere Bondo includes K12,GGG in his basis (his

share of the K3G,GGG LLC debt).

5%. [LO (] HFesearchI Kevin and 9o! have owned and operated GO) as a C corporation or anum!er o $ears. When the$ ormed the entit$' Kevin and 9o! each contri!uted J100'000 toGO). /he$ each have a current !asis o J100'000 in their GO) ownership interest.&normation on GO)8s assets at the end o $ear 2 is as ollows :GO) does not have an$lia!ilities

Assets 05U Ad8usted !asis !uilt*in #ain

Cash J%00'000 J%00'000 J0

&nventor$ 60'000 40'000 40'000

Land and !uilding %%0'000 150'000 20'000

/otal J200'000

)t the end o $ear 2' GO) li*uidated and distri!uted hal o the land' hal o the inventor$' andhal o the cash remaining ater pa$ing ta+es :i an$< to each owner. )ssume that' e+cluding theeects o the li*uidating distri!ution' GO)8s ta+a!le income or $ear 2 is J0. )lso' assume thati GO) is re*uired to pa$ ta+' it pa$s at a lat (0Q ta+ rate.

a. What is the amount and character o gain or loss GO) will recognie on theli*uidating distri!ution"

!. What is the amount and character o gain or loss Kevin will recognie when hereceives the li*uidating distri!ution o cash and propert$" Fecall that his stoc !asis isJ100'000 and he is treated as having sold his stoc or the li*uidation proceeds.

4-(0, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in



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Answer:

a. !y maing a li&uidating distribution, +A is treated as though it sold its assets for their

fair maret value. +n the distribution, +A will recogni"e ordinary income of K>G,GGG on

the distribution of the inventory (the built in gain) and K2G,GGG of ec. 1=31 gain?ordinaryincome (depending on accumulated depreciation) on the distribution of the land and

building.

b. K13D,2GG long*term capital gain. +A must pay ta on the K4G,GGG of income it

recogni"es in the distribution. !ecause its marginal rate is 3G7 it pays K=E,GGG ta on the

distribution. The ta payment reduces +A%s cash to K1E3,GGG (K=GG,GGG * K=E,GGG). The

fair maret value of the assets +A distributes to its shareholders is K>E3,GGG (K2GG,GGG

total value minus K=E,GGG taes). +ne*half of the K>E3,GGG (K=3D,2GG) is distributed to

Hevin. Conse&uently, Hevin%s long*term capital gain on the distribution is K13D,2GG

(K=3D,2GG received minus K1GG,GGG basis in his stoc). The gain is long*term capital gain

because the stoc is a capital asset and Hevin held the stoc for more than a year beforethe li&uidating distribution.

C+5/BI$IFUI /B+!LI5

5(. HFesearchV lanningI Dawn /a$lor is currentl$ emplo$ed !$ the state Cham!er oCommerce. While she eno$s the relativel$ short worwees' she eventuall$ would lie towor or hersel rather than or an emplo$er. &n her current position' she deals with a lot osuccessul entrepreneurs who have !ecome role models or her. Dawn has also developed ane+tensive list o contacts that should serve her well when she starts her own !usiness.

&t has taen a while !ut Dawn !elieves she has inall$ developed a via!le new !usiness idea.

#er idea is to design and manuacture cooware that remains cool to the touch when in use.Ghe has had several riends tr$ out her protot$pe cooware and the$ have consistentl$ giventhe cooware rave reviews. With this encouragement' Dawn started giving serious thoughtsto maing ?Cool /ouch Cooware@ :C/C< a mone$maing enterprise.

Dawn had enough !usiness !acground to realie that she is em!aring on a ris$ path' !utone' she hopes' with signiicant potential rewards down the road. )ter creating some initialincome proections' Dawn realied that it will tae a ew $ears or the !usiness to !ecomeproita!le. )ter that' she hopes the s$8s the limit. Ghe would lie to grow her !usiness andperhaps at some point ?go pu!lic@ or sell the !usiness to a large retailer. /his could !e herticet to the rich and amous.

Dawn' who is single' decided to *uit her o! with the state Cham!er o Commerce so thatshe could ocus all o her eorts on the new !usiness. Dawn had some savings to supporther or a while !ut she did not have an$ other source o income. Dawn was a!le to recruitLinda and ie to oin her as initial e*uit$ investors in C/C. Linda has an 9) and a lawdegree. Ghe was emplo$ed as a !usiness consultant when she decided to leave that o! andwor with Dawn and ie. Linda8s hus!and earns around J(00'000 a $ear as an engineer

4-(1, %014 !$ craw-#ill Education. /his is proprietar$ material solel$ or authoried instructor use. ot authoried or sale or distri!ution in



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:emplo$ee

awn Contributed 05U

Ad8usted

!asis

+wnership

nterest

Land :held as investment< J1%0'000 J50'000 (0Q

Cash J(0'000

Linda Contributed

Gervices J120'000 (0Q

5ie Contributed

Cash J%00'000 40Q

Woring together' Dawn and Linda made the ollowing ive-$ear income and lossproections or C/C. /he$ anticipate the !usiness will !e proita!le and that it will continueto grow ater the irst ive $ears.

Cool Touch Cooware

2*-ear ncome and Loss /ro8ections

-ear

ncome

(Loss)

1 :J%00'000

Tax Chp 4 Answers

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