Tax Accounting 2 Exam 1

Mark owns an unincorporated business and has $20,000 of Section 1231 gains and $22,000 of Section 1231 losses. He must report a capital loss of $2,000 on his tax return.

False

A net Sec. 1231 gain is treated as ordinary income to the extent of any nonrecaptured net Sec. 1231 losses for the preceding five years.

True

1231 property must satisfy a holding period of more than one year.

True

Gains and losses resulting from condemnations of Sec. 1231 property and capital assets held more than one year are classified as ordinary gains and losses.

False

The purpose of Sec. 1245 is to eliminate the advantage taxpayers would have if they were able to reduce ordinary income by depreciation deductions and also receive favorable Sec. 1231 treatment when the asset was sold.

True

If a taxpayer has gains on Sec. 1231 assets, Secs. 1245 and 1250 must be applied first to determine any amounts recaptured as ordinary income, and any excess gain may then be netted with Sec. 1231 losses for possible long-term capital gain treatment.

True

The amount recaptured as ordinary income under either Sec. 1245 or Sec. 1250 can never exceed the realized gain.

True

Jeremy has $18,000 of Section 1231 gains and $23,000 of Section 1231 losses. The gains and losses are characterized as

Ordinary Income: $18,000

Ordinary Loss: $23,000

During the current year, Danika recognizes a $30,000 Section 1231 gain and a $22,000 Section 1231 loss. Prior to this, Danika's only Section 1231 item was a $15,000 loss two years ago. Danika must report a(n)

$8,000 ordinary income

Terry has sold equipment used in her business. She acquired three years ago for $50,000 and has recognized $30,000 of depreciation across the years in use. In order to recognize any Sec. 1231 (capital) gain, she must sell the equipment for more than

$50,000

Explain how the gain on the sale or exchange of land could be classified as either ordinary income, a Sec. 1231 gain, or a LTCG, depending on the facts and circumstances.

- Held as inventory: Ordinary

- Used in a business <=1 year: Ordinary

- Used in a business >1 year: Sec. 1231

- Held as investment: LTCG

- Held for personal use: LTCG

When is a net Sec. 1231 gain treated as ordinary income?

Net Sec. 1231 gain is treated as ordinary income to the extent of any nonrecaptured net Sec. 1231 losses for the five most recent preceding years.

Carlie who is single has a Sec. 1231 gain of $10,000 and no Sec. 1231 losses during the current year. Explain why the gain might be taxed at 15%

LT Cap Gains $40,401 - $445,850

- LTCG treatment: Sec 1231 gains exceeding Sec 1231 losses with no unrecaptured losses

- Ordinary income between $40,400 and $435,850

Carlie who is single has a Sec. 1231 gain of $10,000 and no Sec. 1231 losses during the current year. Explain why the gain might be taxed at 37%

Ordinary $523,601+

- Ordinary treatment: She had at least $10,000 of unrecaptured 1231 losses.

- Ordinary income is greater than $523,600

Carlie who is single has a Sec. 1231 gain of $10,000 and no Sec. 1231 losses during the current year. Explain why the gain might be taxed at 25%

Sec 1250 unrecapture rate

- Gain is from the sale of a building with depreciation of at least $10,000

Carlie who is single has a Sec. 1231 gain of $10,000 and no Sec. 1231 losses during the current year. Explain why the gain might be taxed at 20%

LT Cap Gains $445,850+

- LTCG treatment: Sec 1231 gains exceeding Sec 1231 losses with no unrecaptured losses

- Ordinary income is greater than $445,850

Carlie who is single has a Sec. 1231 gain of $10,000 and no Sec. 1231 losses during the current year. Explain why the gain might be taxed at zero

LT Cap Gains $0 - $40,400

- LTCG treatment: Sec 1231 gains exceeding Sec 1231 losses with no unrecaptured losses

- Ordinary income is less than $30,400

Why is it unlikely that gain due to the sale of equipment will be treated as Sec. 1231 gains?

Equipment is Sec. 1245 property and gain to the extent of total depreciation is ordinary income. Generally, the amount of depreciation is greater than the gain realized. Taxpayers must sell the equipment for more than the original basis to have any of the gain treated as Sec. 1231 gain.

Hank sells equipment used in a trade or business for $25,000. The equipment cost $30,000 and has an adjusted basis of $25,500. Why is it important to know the holding period?

- If the holding period is one year or less, the $500 loss is ordinary

- If the holding period is more than one year, the loss is a Sec. 1231 loss

- A Sec. 1231 loss may offset Sec. 1231 gains which would otherwise be treated as a LTCG

Karen purchase a computer three years ago for $15,300 to use exclusively for her business. She expensed the entire cost of her computer under section 179. If she sells the computer during the current year for $3,721, what is the amount character of her recognized gain?

The entire gain is ordinary income (Sec . 1245 - depreciation recapture).

Which of the following assets (assume all assets have a holding period of more than one year) do not qualify as Sec. 1231 property:

- Inventory

- A pig held for breeding

- Land used as a parking lot for customers

- Marketable securities

- The inventory and marketable securities do not qualify as Sec. 1231 property.

When is an office building subject to the depreciation recapture rules of Sec. 1245:

An office building is subject to the depreciation recapture rules of Sec. 1245 if the building is placed in service after 1980 and before 1987 and the ACRS statutory rates are used to determine the cost recovery deductions.

Rashad owns a duplex used 100% as residential rental property. Under what conditions, if any, will any gain that he recognizes be Sec 1245 ordinary income?

Rashad would never have to recognize any Sec. 1245 ordinary income as a result of selling residential rental property even if the property is placed in service after 1980 and before 1987.

Why may a corporation recognize a greater amount of ordinary income due to the sale of Sec. 1250 property than a noncorporate taxpayer?

A corporate taxpayer must apply the recapture rules of Sec. 291(a). If a corporate taxpayer disposes of Sec. 1250 property, 20% of the excess of the amount that would be recaptured if the property was Sec. 1245 property over the amount recaptured as ordinary income under Sec. 1250 is ordinary income

Dale owns business equipment with a $100,000 FMV and an adjusted basis of $60,000. The property was originally acquired for $150,000. Which one of the following transactions would result in recognition of $40,000 ordinary income by Dale due to the depreciation recapture rules of Sec. 1245?

C. He disposes of the equipment in an installment sale and receives $10,000 cash in the year of the sale. Dale must recognize $40,000 of ordinary income

A sole proprietor is required to use the same reporting period for both business and individual tax information

True

Corporations are legally better suited for taking a business public compared with LLCs and general partnerships.

True

Section 351 applies to an exchange if the contributing shareholders own more than 50% of a corporation's stock after the transfer.

False

Which of the following is an advantage of a sole proprietorship over other business forms?

Ease of formation

Which of the following statements is correct?

S shareholders are taxed on their proportionate share of earnings whether or not distributed.

Demarcus is a 50% partner in the DJ partnership. DJ has taxable income for the year of $200,000. Demarcus received a $75,000 distribution from the partnership. What amount of income related to DJ must Demarcus recognize?

$100,000

Jeremy transfers Sec. 351 property acquired three years earlier having a $100,000 basis and a $160,000 FMV to Morton Corporation. Jeremy receives all 200 shares of Morton stock having a $140,000 FMV, and a $20,000 cash. What is Jeremy's recognized gain?

$20,000

For Sec. 351 purposes, the term "property" does not include

Services rendered

Carolyn transfers property with an adjusted basis of $50,000 and an FMV of $60,000 in exchange for Prime Corporation stock in a Sec. 351 transaction. Carolyn's basis in the stock is

$50,000

Jermaine owns all 200 shares of Peach Corporation stock valued at $50,000. Kenya, a new shareholder, receives 200 newly issued shares from Peach Corporation in exchange for a delivery van with an adjusted basis of $40,000 and an FMV of $50,000 which he bought for personal use. Which of the following statements is correct?

The transaction results in $10,000 income for Kenya and his basis in the stock is $50,000.

What entities or business forms are available for a new enterprise? Explain the advantage and disadvantage of each.

- Sole Proprietorship

- Partnership

- C Corporation

- S Corporation

- Limited Liability Company (LLC)

- Limited Liability Partnership (LLP)

Alice and Bill plan to go into business together. For the first two or three years of operations, they anticipate losses, which they would like to use to offset income from other sources. They are also concerned about exposing their personal assets to business liabilities. Advice Alice and Bill as to what business form would best meet their needs.

- Tax -> Conduit

- Liability -> Entity

- S Corporation or a LLC

Bruce and Bob organize Black LLC on May 10 of the current year. What is the entities default tax classification? Are any alternative classifications available? If so, (1) how do Bruce and Bob elect the alternative classifications and (2) what are the tax consequences of doing so?

- Default tax classification is as a partnership (pass-through)

- It can elect to be treated as a separate entity (C corporation) for tax purposes. Form 8832

John and Wilbur form White Corporation on May 3 of the current year. What is the entity's default tax classifications? Are any alternative classifications available? If so, (1) how do Bruce and Bob elect the alternative classifications and (2) what are the tax consequences of doing so?

- Default tax classification is as a separate entity (C corporation)

- It can elect to be treated as an S Corporation and be treated as a pass-through entity (Form 2553).

Debate the following proposition: All corporate formation transactions should be taxable events.

PRO:

- There is a change in ownership

- Tax revenue would go up

- Simpler, no special cases

- Do not need to structure around Sec. 351

CON: (no change in current law)

- Hurts start-up by reducing capital available

- No economic gains or losses are realized (only a transfer of ownership)

- Current system prevents recognition of losses (increasing tax revenue)

- Discourages incorporation of businesses

What are the tax consequences for the transferor and transferee when property is transferred to a newly created corporation in an exchange qualifying as nontaxable under Sec. 351?

- Neither recognizes a gain or loss when property is exchanged for stock (if no boot)

- The transferor's realized gain or loss is deferred until the stock is sold.

- The transferor's realized gain when the asset is sold.

What items are considered to be property for purposes of Sec. 351(a)?

- Money and almost any other kind of tangible or intangible property, including installment obligations, accounts receivable, inventory, equipment, patents, trademarks, trade names, and computer software.

- Services

- an indebtedness of the transferee corporation that is not evidenced by a security

- interest on an indebtedness that accrued on or after the beginning of the transferor's holding period for the debt

John and Mary each exchange property worth $50,000 for 100 shares of New Corp stock. Peter exchanges services for 98 shares of New stock and $1,000 in cash for 2 shares of New stock. Are the Sec. 351 requirements met? Why or why not?

What advice would you give the shareholders?

- No. Peter is not considered a transfer of property. His property is less than 10% of the value of the stock he received.

- John + Mary = 2/3 ownership (< 80%)

- Peter needs to raise his cash contribution to equal at least 10% of the value of the stock received.

- Increase his contribution to $5,000 and lower the value of his services to $45,000.

Does Sec. 351 require shareholders to receive stock equal in value to the property transferred? Suppose Fred and Susan each transfer property worth $50,000 to Spade Corp. In Exchange, Fred received 25 shares of Spade stock and Susan receives 75 shares. Are the Sec. 351 requirements met?

Explain the tax consequences of the exchange.

Sec. 351 is satisfied as together they control 100% of the shares.

The exchange is treated as a proportional exchange followed by a gift:

- Fred receives 50 shares for his $50,000 contribution

- Susan receives 50 shares for his $50,000 contribution

- Fred gives 25 shares to Susan

- Gift tax may apply

- Basis in gift will be based upon Fred's basis

How are a transferor's basis and holding period determined for stock and other property (boot) received in a Sec. 351 exchange? How does the transferee corp's assumption of liabilities affect the transferor's basis in the stock ...and holding period

Adjusted basis in property transferred

+ Any gain recognized in the transfer

- FMV of boot

--------------------------------------------

= Basis of stock received

Gain = lessor of realized gain and FMV of boot

Basis of stock =

- Basis of property transferred (if a capital or Sec. 1231 property)

- Day after the exchange date (if other assets)Basis of boot = day after the exchange date Assumption of debts is treated identically as payment of other property (boot).

What are the advantages and disadvantages of using debt in a firm's capital structure?

PRO: (benefits of debt)

- Interest is deductible (dividends) by payor

- Repayment is treated as a return of capital

CON:

- Dividends may be eligible for dividends-received deduction

- Debt treated as boot in corp. formation

- Stock dividend is not taxable

- Worthless stock is ordinary loss (capital loss for debt)

Why might shareholders avoid Sec. 351 treatment? Explain three ways they can accomplish this end.

They will want to avoid Sec. 351 if they want to recognize a gain or loss

1. Selling the property to the corp

2. Selling it to a third party who contributes the property

3. Receiving sufficient boot to recognize the gain

Compare the tax treatment of capital gains and losses by a corporation and by an individual.

Treatment is identical except corporations...

o can't deduct capital losses from ordinary income

o Can carry losses back 3 yrs and forward 5 yrs

What are organizational expenditures? How are they treated for tax purposes?

Organizational expenditures for the creation of a corporation

o Legal expense, accounting fees, temporary directors

First $5,000 is expensed (total less than $50,000) and the remainder is amortized over 180 months.

What are start-up expenditures? How are they treated for tax purposes?

Ordinary and necessary business expenses paid or incurred to investigate the creation or acquisition of a business

o before business becomes active

First $5,000 is expensed (total less than $50,000) and the remainder is amortized over 180 months.

What limitations apply to a corporation's deduction for business interest?

The deductibility of business interest in a given year is limited to the sum of the following amounts:

o business interest income

o 30% of adjusted taxable income

o floor plan financing interest for motor vehicles

Zero Corp contributes inventory (computers) to State University for use in its mathematics program. The computers have a $1,225 cost basis and a $2,800 FMV. How much is Zero's charitable contribution deduction for the computers? (ignore the 10% limit on non-cash contributions).

If qualifies as scientific research...

o $2,012 [1,225 + 50% (2,800 - 1,225)] **

Otherwise, $1,225 [basis]

** remember that the deduction must be less than twice the property basis

Deer Corp. is a C corporation. Its taxable income for the year is $200,000. What is Deer Corp's income tax liability for the year?

- $42,000

- In tax years beginning after 2017, the corporation is subject to a flat 21% tax rate.

Why is the dividends-received deduction disallowed if the stock on which the corporation pays the dividend is debt financed?

The dividends-received deduction on debt-financed stock is disallowed to prevent a corporation from deducting interest paid on money borrowed to purchase the stock, while paying little or no tax on the dividends received on the stock. Otherwise, the corporation could gain an arbitrage advantage by acquiring debt-financed stock.

What are the tax advantages of substituting fringe benefits for salary paid to a shareholder-employee?

Fringe benefits:

• Deductible from net income for corporation

• Not taxable for employee

Salary:

• Taxable for employee

List for types of differences that can cause a corporation's book income to differ from its taxable income.

1. Book income is not taxable

2. Book income and tax income recognized in different periods

3. Book expense is not tax deductible

4. Book expense and tax deduction recognized in different periods

Describe the three types of controlled groups.

- Brother-sister controlled groups

• Two or more corporations

• Five or fewer individuals, trusts, or estates

• > 80% of the voting power each corp

• > 50% of the voting power (combined the lowest ownership for each party)

- Parent-subsidiary controlled groups

• One Corp owns 80% (voting or value)

• Parent + Sub owns 80% of another

- Combined controlled groups