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CHAPTER 22

S CORPORATIONS
SOLUTIONS TO PROBLEM MATERIALS

Question/
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3
4
5
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7
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10
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13
14
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16
17
18
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23
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27

Topic
Tax differences: partnerships versus S corporation
Use of NOL carryovers
S corporations and like-kind exchanges
Nonresident alien
Reelection after termination
Treatment of a LTCG
Schedule M
AAA bypass election
AAA versus stock basis
Stock basis
Built-in gains tax
C corporation NOL and S election
Subchapter S taxable income
Nonseparately computed income
Nonseparately computed income
Income allocation
AAA
Distributions
Distributions
Appreciated property
Shareholder basis: losses and distributions
AAA: losses and distributions
Stock basis/AAA
Distribution
AEP bypass election
Alternative minimum tax
Loss allocation
22-1

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Question/
Problem

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32
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35
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2005 Comprehensive Volume/Solutions Manual

Topic

Loss allocation
Loss allocation
Built-in gains tax
Built-in gains tax
Passive investment income tax
Stock basis
Built-in gains tax
Family S corporation and reallocation of operating
income
Liquidation of S corporation
Reducing salary to owner

Status:
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Edition

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Research
Problem
1
2
3

Bad debt vs. stock redemption


Passive activity losses
Internet activity

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in Prior
Edition

28
30
32
33
34
35
36

S Corporations

22-3

CHECK FIGURES
13.a.
13.b.
14.
15.a.
15.b.
16.a.
16.b.
17.
18.
19.
20.
21.
22.
23.a.
.

$78,000.
$26,000.
$68,000.
Sammys share, $26,000.
$2,400.
Thomas $123,287.85; Estate
$376,712.87; Ralph $500,000.
Ralph $500,000; Thomas $200,000;
Estate $300,000.
$1,185,150.
Tobias $90,000 ordinary income
(salary); Goblins $90,000 deduction.
Tobias $90,000 ordinary income
(dividend); Goblins no deduction.
$60,000 LTCG at S level; $20,000
flow-through to each; Charlenes
basis, $150,000.
Bips ending stock basis $0.
Ending AAA ($30,000); ending AEP
$55,000.
$41,000.
.

23.b
24.
25.
27.
28.
29.
30.a.
30.b.
30.c.
31.
32.
33.
34.
37.

$66,000
Each shareholder has $200,000
dividend income, $250,000 ending
basis.
Each shareholder has $300,000
dividend income.
$12,000.
$21,000.
$19,200 operating loss; $4,800 capital
loss.
$19,600 liability.
$29,750.
$17,500.
$18,550 tax liability.
$10,500.
Andre $6,500; Crum $16,500;
Barbara $22,500.
Corporate tax, $21,070; Farris gain,
$35,718.
$3,060 saved.

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2005 Comprehensive Volume/Solutions Manual

DISCUSSION QUESTIONS
1.

Although the Federal tax treatment of S corporations and partnerships is similar, it is not
identical. For instance, liabilities affect an owners basis differently, and S corporations
may incur a tax liability at the corporate level. Furthermore, an S corporation may not
allocate income like a partnership, and distributions of appreciated property are taxable in
an S corporation situation (see Concept Summary 22-2). In addition, a variety of C
corporation provisions apply to S corporations. For example, the liquidation of C and S
corporations is taxed in the same way. As a rule, where the S corporation provisions are
silent, C corporation rules apply. pp. 22-2 and 22-3

2.

Section 1371(b)(1) states that no carryforward from a C corporation year may be carried
to an S corporation tax year. However, an S corporation can offset built-in gains with
unexpired NOLs or capital losses from C corporation years. pp. 22-4 and 22-31

3.

Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040
May 20, 2004
Bob Roman
8411 Huron Boulevard
West Chester, PA 19382
Dear Mr. Roman:
A qualified Subchapter S subsidiary (QSSS) should be helpful in your situation. The
advent of QSSSs has enhanced your ability to insulate different projects from the liabilities
of other projects and, at the same time, reducing the tax costs previously associated with
such liability insulation.
Create a QSSS and make the 1031 exchange, and the parent S corporation does not
have the potential liability exposure. Thus, by using a QSSS your parent corporation
avoids any potential environmental liabilities.
QSSSs are treated as disregarded entities. They have a separate legal existence for liability
purposes, but exist only as a division of the parent S corporation for tax purposes.
Sincerely,
Gene Crumbley, CPA
Partner
p. 22-6

4.

The two shareholders will have difficulty making the S election effective for 2004.

For the election to be effective as of January 1, 2004, the previous shareholder also
must consent to the election. Under 1362(b)(2)(B)(ii), where any shareholder who
owns stock at the beginning of the tax year for which the election is effective, but not

S Corporations

22-5

on the date of the election, does not consent to the election, the election is effective as
of the next taxable year.

Effective if the previous shareholder does consent, this previous shareholder is not a
qualified shareholder (i.e., a nonresident alien). Thus, the S election is effective for
2005 (but not for 2004).

p. 22-9
5.

TAX FILE MEMORANDUM


Date: September 8, 2004
From: Doreen Lane
Re:

Involuntary termination of two-person S corporationElvis Samford shareholder.

I told Mr. Samford over the phone that, after an election has been terminated, five years
must pass before a new election can be made. Theoretically, Mr. Samford must wait until
the year 2008 before a new election is available. Section 1362(f) does allow the IRS to
make exceptions to this rule and permit an earlier election in two situations.

There is a more-than-50% change in ownership after the first year for which the
termination is applicable.

The event causing the termination was not reasonably within the control of the S
corporation or its majority shareholders.

Thus, Mr. Samford might have a chance of an early election. Reg. 1.1372-5(a) and Rev.
Rul. 78-274, 1978-2 C.B. 220.
p. 22-11
6.

The $120,000 LTCG is treated as a Schedule K item, and 20% of it ($24,000) will appear
on the shareholders Schedule K-1. The shareholders will show the $24,000 LTCG on the
Form 1040. p. 22-14

7.

a.

+ OAA

d.

PTI

g.

AAA

b.

AAA

e.

+ OAA

h.

AAA

c.

+ AAA

f.

OAA

i.

AAA

j.

AAA

Example 25
8.

Collett should consider the following factors.

A bypass election is available to the S corporation. With the consent of all of its
shareholders, an S corporation may elect to have a distribution treated as made from
AEP rather than from AAA. The distribution will be taxable to the shareholder, but
any AEP is eliminated. pp. 22-18 and 22-33

22-6

9.

2005 Comprehensive Volume/Solutions Manual

Absent the bypass election, no adjustments are made to AEP during S years except for
distributions taxed as dividends and adjustments from redemptions, liquidations, and
reorganizations. pp. 22-16 and 22-17

Even without AEP, the S corporation should maintain an AAA. This figure is needed
during the post-termination transition period of approximately one year. A cash
distribution can reduce AAA during this postelection termination period. p. 22-19

The AAA bypass election may be used in the final year of an S election to avoid the
accumulated earnings tax or personal holding company tax. Example 49

TAX MEMORANDUM
Date: November 1, 2004
To:

Caleb Hudson

Re:

Differences between AAA and stock basis of an S corporation.

Stock basis typically opens at a positive amount, and AAA starts out with a zero
balance.

AAA is a corporate account, and stock basis is calculated at the shareholder


level.

AAA can have a negative balance, but stock basis cannot go below zero.

AAA is not adjusted for tax-exempt income or related expenses or for Federal
taxes attributable to a C corporation tax year. Stock basis is adjusted for these
items.

pp. 22-17, 22-18, 22-21, 22-22, and Exhibit 22-1


10.

a.

d.

g.

j.

m.

b.

e.

h.

k.

n.

c.

f.

i.

l.

o.

pp. 22-21 and 22-22


11.

On the conversion date, the S corporation must include the stock value of the subsidiary in
the net unrealized built-in gain, subject to a future built-in gains tax. Later, when the
subsidiary is liquidated, a second net unrealized built-in gain is recognized. Thus, the S
corporation may pay a built-in gains tax twice on the same appreciation. pp. 22-27 and
22-28

12.

Texas, Inc. should remain a C corporation for 2004 and possibly for the next few years.
The $110,000 NOL carryover could not be used if the S election were made (except for
purposes of the built-in gains tax). The projected income for 2004-2007 indicates that
Texas can take advantage of this NOL if it remains a C corporation. pp. 22-24 and 22-31

S Corporations

22-7

PROBLEMS
13.

a.

Book income
Add: Long-term capital loss

$90,000
9,000
$99,000

Deduct:
Dividends received
Tax-exempt interest
1231 gain
Recovery of bad debts
Ordinary income
b.

$9,000
2,000
6,000
4,000

(21,000)
$78,000

$26,000 ($78,000 3)

Example 16
14.

Sales
1250 gain
$142,000
Cost of goods sold
Administrative expenses
Depreciation expense
Nonseparately computed income

$130,000
12,000
$42,000
15,000
17,000

(74,000)
$ 68,000

Example 16
15.

a.

Sales
1250 gain
Less:
Cost of goods sold
$40,000
Administrative expenses
5,000
Depreciation
10,000
Nonseparately computed income
Sammys share

b.

$100,000
20,000
$120,000

55,000
$ 65,000
X 40%
$ 26,000

$6,000 X .40 = $2,400 STCL to Sammy

Example 16
16.

a.

Absent a per-books election, the income is allocated by assigning an equal portion


of the annual income of $1 million to each day (or $2,739.73 per day) and
allocating the daily portion among the two shareholders. Thomas is allocated 50%
of the daily income for 90 days from January 1 through March 31, or $123,287.85
($2,739.73 2 X 90). Thomass estate would be allocated 50% of the income for
the 275 days from April 1 through December 31, or $376,712.87 ($2,739.73 2 X
275). Ralph would be allocated $500,000 for the full year.

b.

If the per-books election is made, the income of $400,000 from January 1 through
March 31 is divided equally between Ralph and Thomas, so that each would be

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2005 Comprehensive Volume/Solutions Manual


allocated $200,000. The income of $600,000 from April 1 through December 31
is divided equally between Ralph and Thomass estate, or $300,000 to each.
Example 20

17.

Beginning AAA
Add:
Operating income
Interest income
Dividend income
Less:
LTCL
Section 179 expenses
Charitable contributions
Cash distributions
Ending AAA

$ 782,000
$472,000
6,500
14,050
$492,550
$ 7,400
6,000
19,000
57,000

89,400

403,150
$1,185,150

Exhibit 22-1
18.

Tobias recognizes $90,000 of ordinary income. The corporation has a $90,000 deduction
which passes through to Tobias. His stock basis is reduced to zero, and he has a $10,000
loss carryover. Figure 22-1 and Concept Summary 22-1

19.

Tobias recognizes $90,000 of dividend income, with no deduction pass through, and has
an $80,000 remaining stock basis. AEP is reduced to zero. Concept Summary 22-1

20.

A capital gain of $60,000 ($170,000 $110,000) is reported at the S corporation level,


and each owner will have a flow through of $20,000 ($60,000/3). Charlenes basis
becomes $150,000 ($300,000 $170,000 + $20,000). Concept Summary 22-2

21.

TAX FILE MEMORANDUM


Date: October 21, 2004
RE:

S corporation losses and distributions

S corporation tax law now provides that distributions are treated as reductions of stock
basis before considering any losses. Thus, Bip Wallace should treat the loss and
distribution as follows.
Bips beginning stock basis
Less: Current year distributions
Basis before loss
Less: Partial loss
Ending stock basis

$100,000
(70,000)
$ 30,000
(30,000)
$
-0-

Suspended loss

$ 25,000

p. 22-23 and Example 35

S Corporations
22.

22-9

There will be a $30,000 negative balance in AAA, and AEP remains at $55,000.
Beginning balance, 1-1-05
Less: Distributions
Less: Loss
Ending Balance

AAA
$100,000
(70,000)
(60,000)
($ 30,000)

AEP
$55,000
-0-0$55,000

In this case, AAA is adjusted first for the distributions and then for the loss. However, the
negative balance must be restored to a positive balance before the shareholders may
receive any distributions that will not be taxed as dividend income.
Exhibit 22-1
23.

a.

Beginning stock basis


Add:
Taxable income
Dividend income
Tax-exempt interest
STCG
Section 1231 gain
Less:

Charitable contributions
Political contributions
STCL
Dividends to Malcolm
Ending stock basis

$22,000
$16,000
6,000
9,000
3,000
3,500
$ 2,500
4,000
6,000
6,000

37,500
$59,500

(18,500)
$41,000

p. 22-21
b.

Beginning AAA
Add:
Taxable income
Dividends received
STCG
Section 1231 gain
Less:
Charitable contributions
Political contributions
STCL
Dividends to Malcolm
Ending AAA

$40,000
$32,000
12,000
6,000
7,000

$ 5,000
8,000
12,000
6,000

57,000
$97,000

(31,000)
$66,000

Exhibit 22-1
24.

On the distribution of the securities, there is a recognized gain of $200,000 to Money, Inc.
($1 million $800,000), which increases AAA by $200,000. This $200,000 of gain flows
through to the two shareholders ($100,000 each), and each shareholder increases his or
her stock basis by $100,000.

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2005 Comprehensive Volume/Solutions Manual


The $100,000 operating income increases the corporate AAA by $100,000. The operating
income flows through to the two shareholders ($50,000 each) and increases each
shareholders stock basis by $50,000. Thus, before the distribution of securities, AAA is
$600,000 ($300,000 + $100,000 + $200,000). The $1 million distribution is treated as
coming first from AAA, to the extent of $600,000, and then from AEP, to the extent of
$400,000. AAA is reduced to zero ($600,000 $600,000), and AEP is reduced to
$200,000 ($600,000 $400,000).
Before the distribution, each shareholders basis is $550,000 ($400,000 + $100,000 +
$50,000). Basis then is reduced by the nontaxable portion of the distribution (i.e.,
$300,000 from AAA) to $250,000 each. Each shareholder has $200,000 of dividend
income resulting from the distribution.
Concept Summaries 22-1, 22-2, and 1367(a)(2)(A)

25.

Most of the results are the same as in 25, except that AEP is reduced to zero. Each
shareholder receives a $300,000 taxable distribution and a $200,000 tax-free distribution
from AAA. The AAA is $200,000 at the end of the year ($600,000 $400,000), and each
shareholders basis is $350,000 ($550,000 $200,000). Concept Summaries 22-1
and 22-2

26.

Section 56(b)(1)(A)(i) denies a deduction for the $400,000 of investment expenses for
purposes of the alternative minimum tax, even though net taxable income is zero
($400,000 $400,000). Thus, $400,000 of investment income flows through to the
shareholder. If an S corporation makes cash distributions to the shareholder in order to
pay any AMT, these distributions will in turn create additional alternative minimum tax
liability. Figure 22-1 and p. 22-13

27.

$12,000 ($60,000 X .50 X 146/365). p. 22-14

28.

($70,000 X .50) X 219/365 = $21,000. p. 22-14

29.

TAX FILE MEMORANDUM


Date: December 3, 2004
RE:

Flow through of Losses

If a shareholders basis is insufficient to allow the full use of the flow-through losses and
there is more than one type of loss, the amount of each deductible flow-through loss is
determined on a pro rata basis.
Ms. Muhammads share of the operating loss is $24,000 ($80,000 X 30%) and of the
capital loss is $6,000 ($20,000 X 30%). Since her basis in the stock is $24,000, only
$24,000 is deductible. Thus, $19,200 of the operating loss [($24,000/$30,000) X
$24,000] and $4,800 of the capital loss [($6,000/$30,000) X $24,000] can be deducted
currently by Ms. Muhammad. The unused losses ($4,800 operating loss; $1,200 capital
loss) are carried forward to future years. pp. 22-23, 22-24, and Figure 22-1
30.

a.

Inventory:
FMV ($90,000 X .80)
Adjusted basis ($70,0000 X .80)

$72,000
(56,000)

S Corporations
Built-in gain realized
Collection of receivables
Built-in gain
Tax rate
Liability

22-11
$16,000
40,000
$56,000
X 35%
$19,600

b.

$195,000 $110,000 = $85,000 X .35 = $29,750.

c.

$270,000 $220,000 = $50,000 X .35 = $17,500.

Concept Summary 22-3, 1374(d)(2), and Reg. 1.1374-3


31.

Taxable income (less than net built-in gain)


Less: NOL
Tax base
Rate
Gross tax due
Less: Business credit
Tax liability

$80,000
(7,000)
$73,000
X 35%
$25,550
(9,000)
$16,550

Example 45 and Concept Summary 22-3


32.

The S corporation incurred net passive investment income of $60,000 [$100,000 (passive
investment income) $40,000 (expenses incurred in connection with earning the passive
investment income)]. Since 25% of $190,000 (gross receipts) = $47,500, passive
investment income (PII) beyond the amount allowed is $52,500 ($100,000 $47,500).
$52,500 (PII in excess of 25% gross receipts) X $60,000 (net PII) = $31,500 ENPI
$100,000 (PII for the year)
Thus, the 1375 penalty tax is $10,500 (35% X $30,000), because taxable income is less
than ENPI.
Example 47

33.

Beginning Bases
STCG
Distribution
Nondeductible fees and penalties
Net tax operating loss
LTCL
Ending stock bases

Andre
$12,000
12,500
(5,000)
(1,000)
(10,000)
(2,000)
$ 6,500

Crum
$22,000
12,500
(5,000)
(1,000)
(10,000)
(2,000)
$16,500

Barbara
$28,000
12,500
(5,000)
(1,000)
(10,000)
(2,000)
$22,500

p. 22-22 and Example 30


34.

Yates Corporation recognizes an $80,600 gain ($130,800 $50,200), of which $60,200


($110,400 $50,200) is subject to the corporate built-in gains tax. The other $20,400
($130,800 $110,400) of the gain is subject to the S corporation pass-through rules and is
not taxed at the corporate level.

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2005 Comprehensive Volume/Solutions Manual


Thus, the corporate tax is $21,070 (0.35 X $60,200). Mark Farris then essentially uses his
60% of this tax ($21,070 X .60 = $12,642) to reduce his flow-through gain of $48,360
($80,600 X .60 = $48,360), resulting in a net taxable gain of $35,718 ($48,360
$12,642).
Example 41

35.

This family may be trying to avoid salaries to obtain employment tax savings. Likewise,
the absence of salaries to the parents shifts income to the daughter, who may be in a lower
tax bracket. Under 1366(e) and Reg. 1.1373-1(a)(2), the IRS agent could require that
reasonable compensation be paid to all three owners. Additional payroll taxes also may be
assessed. In this case, however, the allocation of compensation to the daughter results in
an increase in her earned income and a decrease in her unearned income (i.e., her pro rata
share of S corporation ordinary income). This, in turn, results in a reduction in the kiddie
tax, which applies only to unearned income, and consequently may reduce the overall
income taxes paid by the family members. However, the agent also would impose payroll
taxes upon the salary amounts.
Bonnie
Clyde
Daughter

No Salaries
$60,000
60,000
60,000

With Salaries*
$35,000
35,000
35,000

*$180,000 $30,000 $35,000 $10,000 = $105,000 X 1/3 = $35,000


Example 48
36.

TAX FILE MEMORANDUM


Date: June 18, 2004
From: Judy Hernandez
Re:

Friedman, Inc., liquidation

I told Arnold Schwartz, CFO, over the phone that S corporations are subject to many of
the same liquidation rules applicable to regular corporations. For example, the distribution
of the appreciated land and inventory is treated as if the property were sold to the
shareholders in a taxable transaction.
The S corporation incurs no corporate tax (except for any 1374tax),butthegainsflow
throughtotheshareholders.Anycorporategainincreasestheshareholdersstockbases
bylikeamountsandreduceanygainsrealizedbytheshareholderswhentheyreceivethe
liquidation proceeds. Typically, double tax is avoided, but special tax attributes
disappear(i.e.,AAA).
With respect to the depreciated marketable securities, the S corporation can recognize the
loss.
p. 22-37

S Corporations
37.

22-13

Opal and the corporation save $3,060 in FICA taxes ($20,000 X .153). However, an IRS
agent may argue that a reasonable salary is not being paid and recharacterize the
distribution as a salary. Footnote 68 and pp. 22-33 and 22-34

The answers to the Research Problems are incorporated into the 2005 Comprehensive Volume of
the Instructors Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION:
COMPREHENSIVE VOLUME.

22-14

2005 Comprehensive Volume/Solutions Manual


NOTES