CHAPTER 12

ANSWERS TO HOMEWORK
SPRING 2013
Lecture.. If shareholders have high marginal rates relative to C corporation rates, it may be
desirable to avoid S corporation status. Although C corporation earnings can be subject to double
taxation, good tax planning mitigates this result (e.g., hen the oners ta!e profits out as salary".
Li!eise, profits of the corporation may be ta!en out by the shareholders as capital gain income
through stoc! redemptions, li#uidations, or sales of stoc! paid to others. Alternatively, C
corporation profits may be paid out as dividends, subject to a $%& maximum tax rate. Any
distribution of profits or sale of stoc! can be deferred to a later year, thereby reducing the present
value of shareholder taxes. 'inally, potential shareholder(level tax on corporate profits can be
eliminated by a step(up in the basis of the stoc! upon the shareholder)s death.
*. An entity must meet these re#uirements to elect S corporation status+
Is a domestic corporation (incorporated and organi,ed in the -nited States".
Is an eligible corporation.
Issues only one class of stoc!.
Is limited to a theoretical maximum of $.. shareholders.
/as only individuals, estates, and certain trusts and exempt organi,ations as shareholders.
/as no nonresident alien shareholders.
$.. a. 0o.
b. 0o.
c. 0o.
$$. a. 1es.
b. 0o.
c. 0o.
$
d. 0o.
e. 1es.
f. 1es.
Lecture. S corporations are limited to a total of $.. shareholders, but family members may
be treated as one shareholder. 23embers of the family4 is defined as the common ancestor,
the lineal descendants of the common ancestor, and the spouses (or former spouses" of the
lineal descendants or common ancestor.

$5. a. 6 7AA d. 6 7AA g. 8 AAA
b. 8 AAA e. 8 7AA h. 8 AAA
c. 6 AAA f. 8 AAA i. 8 AAA
$9. :A; 'IL< 3<37=A0>-3
>ate+ 0ovember $, ?.$?
:o+ Scott :yrney
=e+ >ifferences beteen AAA and stoc! basis of an S corporation
Stoc! basis typically opens at a positive amount, and AAA starts out ith a ,ero balance.
AAA is a corporate account, and stoc! basis is calculated at the shareholder level.
AAA can have a negative balance, but stoc! basis cannot go belo ,ero.
AAA is not adjusted for tax(exempt income or related expenses or for 'ederal taxes
attributable to a C corporation tax year. Stoc! basis is adjusted for these items.
Lecture+ AAA @yAass <lection. :he AAA bypass election allos an S corporation to pay out A<A
before AAA, e.g., to simplify the boo!s. Bith no A<A, the S corporation uses the simple
approach to distributions. Bhen A<A is present, a negative AAA may cause double
taxation. :he AAA bypass election also may enable the S corporation to avoid the passive
investment income penalty tax.
?
$C. 7A:I70AL.
a. 8 d. 6 g. 8 j. 6 m. 6
b. 6 e. 8 h. 8 !. 6 n. 8
c. 8 f. 6 i. 8 l. 8 o. 8
7A:I70AL.
$D. :he to shareholders ill have difficulty ma!ing the S election effective for ?.$?.
'or the election to be effective as of Eanuary $, ?.$?, the previous shareholder also must
consent to the election. -nder F $D5?(b"(?"(@"(ii", here any shareholder ho ons stoc!
at the beginning of the tax year for hich the election is effective, but not on the date of
the election, does not consent to the election, the election is effective as of the next taxable
year.
<ffective if the previous shareholder does consent, this previous shareholder is not a #ualified
shareholder (i.e., a nonresident alien". :hus, the S election is effective for ?.$D (but not for ?.$?".
?.. Aertinent tax issues include the folloing.
Can the shareholder prove the year)s ending basis in the S corporation stoc!G
Bhat is the basis of the shareholder)s stoc!G
Bhat is the basis of loans that the shareholder has made to the S corporationG
In hat order should the shareholder apply the year)s adjustments to the S corporation
stoc! basisG
Is there more than one type of loss (e.g., capital, passive, F $?D$, etc." that passes through
to the shareholder for the yearG
>oes the shareholder have at(ris! amounts so that the pass(through passive loss can be
deductedG
>oes the shareholder have passive income amounts so that the pass(through passive loss
can be deductedG
PROBLEMS.
?H. a. @oo! income IC.,...
Add+ Short(term capital loss 5,...
IC5,...
>educt+
>ividends received IC,...
D
:ax(exempt interest ?,...
Section $?D$ gain 5,...
=ecovery of bad debts H,... (?$,..."
Subchapter S taxable income I *%,...
b. I?%,... (I*%,... J D".
?*. AAA Stock Basis AEP
@eginning balance I?,... I$.,... I5,...
L:CK ?,... ?,... 8.8
@alance IH,... I$?,... I5,...
>istribution (I5,..." (H,..." (H,..." (?,..."L
@alance I 8.8 I 9,... IH,...
Loss (IC,..." (C,..." (9,..." 0o effect
<nding balance (IC,..." I 8.8 LL IH,...
L:axable dividend
LLI$,... suspended loss, cannot have negative stoc! basis
D.. A capital gain of I9.,... (I?H.,... 8 I$5.,..." is reported at the corporate level and each
shareholder includes a flo through of I?.,... (I9.,... J H". >avid)s stoc! basis drops to
I%.,... (I?*.,... 8 ?H.,... 6 ?.,...".
D?. :A; 'IL< 3<37=A0>-3
>ate+ 7ctober D, ?.$?
=e+ S corporation losses and distributions
S corporation tax la no provides that distributions are treated as reductions of stoc! basis
before considering any losses. :hus, Storm 0elson, the sole shareholder, should treat the loss
and distribution as follos.
0elson)s beginning stoc! basis I?..,...
Less+ Current year distributions ($H.,..."
@asis before loss I 5.,...
Less+ Aartial loss (5.,..."
<nding stoc! basis I 8.8
Suspended loss I %.,...
DD. :here ill be a I5.,... negative balance in AAA, and A<A remains at I$$.,....
AAA A<A
@eginning balance, $($($? I?..,... I$$.,...
H
Less+ >istributions ($H.,..." (8.8"
Less+ Loss ($?.,..." (8.8"
<nding @alance (I 5.,..." I$$.,...
/ere AAA is adjusted first for the distributions and then for the loss. /oever, the negative balance
must be restored to a positive balance before the shareholders may receive any distributions
that ill not be taxed as dividend income.
D%. a. @eginning AAA I*5*,.%.
Add+
Sales income I?.5,...
>ividend income $*,...
Interest income D,...
I??5,...
Less+
=eal estate loss I %,...
Charitable contributions $C,...
F $*C expense ?,%..
Administrative expenses H?,... (59,%.." $%*,%..
IC?H,%%.
Less distributions (*$,D.."
<nding AAA I9%D,?%.
H.. Section $D5*(b"(?"(@" indicates that only the MMnet increase4 is applied to restore any
reduction in loan basis. /ere there is no net increase (I$$,... 8 I$%,...". Since stoc! basis
has been increased by I$$,..., there is I$$,... tax(free income and a IH,... capital gain.
L<C:-=<. 7nce the basis of any debt is reduced, it is later increased (only up to the original
amount" by the subse#uent net increase resulting from all positive and negative basis
adjustments. :he debt basis is adjusted bac! to the original amount by any 2net increase4
before any increase is made in the stoc! basis. 20et increase4 for a year is computed after
ta!ing distributions (other than those from A<A" into consideration. A distribution in excess of
stoc! basis does not reduce any debt basis.
H*. And! C"# Ba$aa
@eginning basis I$?,... I??,... ID$,...
S:CK $?,%.. $?,%.. $?,%..
>istribution (5,..." (5,..." (5,..."
0ondeductible fees and penalties ($,..." ($,..." ($,..."
0et tax operating loss ($.,..." ($.,..." ($.,..."
L:CL (?,..." (?,..." (?,..."
<nding stoc! basis I %,%.. I$%,%.. I?H,%..
%
%D. =uby and the corporation save I5,$?. in 'ICA taxes (IH.,... N .$%D". /oever, an I=S
agent may argue that a reasonable salary is not being paid and recharacteri,e the distribution as a
salary.
7A:I70AL. H$ and H?.
H$. 0one, since the loan basis is bac! to the original I$.,....
H?. /ere the loan basis is only bac! to I9,..., so Eeff has a I?,... capital gain (I$.,... 8
I9,..." ith a corporate note. If no corporate note exists, Eeff reports I?,... ordinary
income.
Lecture.
:he AAA bypass election allos an S corporation to pay out A<A before AAA, e.g., to
simplify the boo!s. Bith no A<A, the S corporation uses the simple approach to
distributions. Bhen A<A is present, a negative AAA may cause double taxation. :he AA
A bypass election also may enable the S corporation to avoid the passive investment
income penalty tax.
PROBLEMS%OPTIONAL
?C. a. :obias recogni,es IC.,... of ordinary income. :he corporation has a IC.,... deduction
hich passes through to :obias. /is stoc! basis is reduced to ,ero, and he has a I$.,... loss
carryover.
b. :obias recogni,es IC.,... of dividend income, ith no deduction pass(through, and has an
I9.,... remaining stoc! basis. A<A is reduced to ,ero.
L7SS <;A3AL<
=<+ S corporation losses and distributions
S corporation tax la no provides that distributions are treated as reductions of stoc! basis
before considering any losses. :hus, the shareholder (@ip" should treat the loss and
distribution as follos.
@ip)s beginning stoc! basis I$..,...
Less+ Current year distributions (*.,..."
@asis before loss I D.,...
Less+ Aartial loss (D.,..."
5
<nding stoc! basis I 8.8
Suspended loss I ?%,...
H9. I?.5,%... :he net unreali,ed built(in gain on the conversion date is I59%,... (I$.%,... 8
I$.,... 6 I*..,... 8 I$$.,...", the maximum amount subject to the F$D*H tax. :he
recogni,ed built(in gains and loss are+
Accounts receivable collected I$.%,...
Accounts payable ($$.,..."
Kain on the land (limited to the built(in gain" *..,...
:otal $695,0
00
:axable income is I%C.,... and the built(in gains tax is assessed on the smaller amount
(I%C.,... D%& O I?.5,%..". /oever, there is a carryforard of the net built(in
gains amount that escapes taxation due to the taxable income limitation, to be taxed in
subse#uent years hen taxable income is sufficient. :herefore, IC%,... is carried into
?.$D and treated as a recogni,ed built(in gain then.
%$. :A; 'IL< 3<37=A0>-3
>ate+ Eune $%, ?.$?
'rom+ Eudy /ernande,
=e+ 'riedman, Inc., li#uidation
I told Arnold Schart,, C'7, over the phone that S corporations are subject to many of the
same li#uidation rules applicable to regular corporations. 'or example, the distribution of the
appreciated land and inventory is treated as if the property ere sold to the shareholders in a
taxable transaction.
:he S corporation incurs no corporate tax (except for any F $D*H tax", but the gains flo
through to the shareholders. Any corporate gain increases the shareholders) stoc! basis by li!e
amounts and reduces any gains reali,ed by the shareholders hen they receive the li#uidation
proceeds. :ypically, double tax is avoided, but special tax attributes disappear (i.e., AAA".
Bith respect to the depreciated mar!etable securities, the S corporation can recogni,e the
loss.
%H. :otal gain is I*.,... (I$?.,... 8 I%.,...", and the net unreali,ed built(in gain as of Eanuary
?.$. is IH%,... (I5.,... 8 I$%,...". :he net amount of gains and losses sets the upper limit
on the tax base for the built(in gains tax. :hus, IH%,... of the I*.,... is subject to the
corporate built(in gains tax. :he other I?%,... of gain is subject to the S corporation pass(
through rules and bypasses the corporate income tax
*
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