1 Chapter 14 Entity Operations and Distributions-2010 Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2010, Dr. Howard Godfrey Edited October 30, T10-Chp-14-1-Entity-Choice-Operations-and-Dist-2010

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Taxation of Operations The general formula for computing income tax is: Gross Income less:Deductions Taxable Income times: Tax rate (for entity) Income tax less:Tax prepayments and Tax credits Tax (refund) due with return

Let’s concentrate on the exceptions to the general formula common to each entity.

Sole Proprietorship Many items are reported elsewhere on the owner’s return and not reported as part of the proprietorship’s income – Investment income and expense – Capital gains and losses – Section 1231 gains and losses – Passive activity items – Charitable contributions – Owner’s personal expenses – Tax credits – Net operating losses

Partnership Income & expenses are reported by the partners according to their ownership interests Items which would receive special treatment on a partner’s return are reported separately – All items listed separately for sole proprietorships – Amounts expensed under Section 179 – Alternative minimum tax items – Nondeductible expenses

Partnership Income-1 John Mason and his brother Bennie are equal partners in Mason Enterprises, which operates as a partnership. How would they report the income and loss items from partnership operations? John and Bennie each invested $50,000 to start Mason Enterprises. Each has a 50% interest in the partnership. During the first year, the business had the income and expenses from operations shown on the next slide:

Partnership Losses are deductible subject to three limitations – Limited to the amount of a partner’s basis (capital recovery concept) – Limited to the partner’s at-risk amount – Limited by passive activity rules

Partnership Partner’s basis is adjusted to reflect partnership income and losses reported – Increased for income or gains Designed to prevent double taxation – Decreased for losses Designed to prevent double benefit and reflect capital recovery

Problem. In computing the ordinary business income of a partnership, a deduction is allowed for: a. Net operating loss deduction. b. Depreciation Expense c. Short-term capital losses. d. Gifts to qualified charities.

Gil and Bill partnership had book income of $37,000 this year which included the following: Dividend income $ 1,000 Short ‑ term capital loss(4,000) Section 1231 gain7,000 Ordinary income (sec recapture) 1,500 Interest income 1,000 They share profits and losses equally. What amount of partnership income (excluding all separately reported items) should each partner report on his individual income tax return for the year? a. $19,625 b. $18,500 c. $ 16,000 d. $7,313

Andrew invested $10,000 for a 25% interest in XYZ Partnership on of Year-1. In Year-2, XYZ had taxable income of $20,000. Partnership had nontaxable income of $8,000. XYZ Partnership made a cash distribution to Andrew of $12,000. Assuming no other transaction occurred, how much income is included on Andrew's tax return for Year-2? a. $-0 b. $5,000 c. $10,000 d. $17,000IRS-1994

Andrew invested $10,000 for a 25% interest in XYZ Partnership on of Year-1. In Year-2, XYZ had taxable income of $20,000. It also had nontaxable income of $8,000. XYZ Partnership made a cash distribution to Andrew of $12,000. Assuming no other transactions occurred, what is Andrew's basis in the partnership at the end of Year-2? a. $-0 b. $5,000 c. $10,000 d. $17,000IRS-1994

Partnership Transactions between a partner and partnership are subject to related-party rules – Partner who has > 50% interest in a partnership is a related party – Losses on sales are disallowed

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26  Corporate Tax Rates  15% on first $50,000  25% on $50,001 - $75,000  34% on $75,001 - $100,000  39% (34% + 5% surtax) on $100,001 - $335,000  34% on $335,001 - $10,000,000  35% on $10,000,001 - $15,000,000  38% (35% + 3%) on $15,000,001 - $18,333,333  35% on over $18,333,333

27 PSC Personal service corporation is a corporation – that provides service in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, or performing arts and – is substantially owned by its employees A flat 35% tax rate applies to its entire taxable income The PSC provisions encourage owner- employees to take earnings out as salary

Corporation Taxable income is determined at the corporate level under the general formula Exceptions: – Net capital losses are not deductible – Corporations must recapture additional depreciation for Sec property = 20% of straight-line depreciation taken

Corporation – Passive activity losses Corporations are not subject to the passive activity rules – Personal service corporations must follow them – Closely-held corporations may use passive losses to offset active income but not portfolio income – Charitable contributions are limited to 10% of taxable income Before dividend-received deductions and any carryovers Excess contributions may be carried forward 5 years

Corporation – Net operating loss cannot be used in the current year or distributed to shareholders May be carried back 2 years and forward 20 until used May elect to forego the carry back

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32 Capital Losses- Baker Baker Corp., had taxable income of $36,000 business operations in Year 1. Baker also had the following: Short term capital gain$8,600 Short term capital loss(9,600) Long term capital gain1,500 Long term capital loss(3,500) What is taxable income for Year 1? a. $35,000 b. $33,000 c. $36,000 d. $35,500 CPA - Nov. 1995

33 Capital Losses-Baker Baker Corp., had taxable income of $36,000 business operations in Year-1. Baker also had the following: Short term capital gain$8,600 Short term capital loss(9,600) Long term capital gain1,500 Long term capital loss(3,500) What is taxable income for Year-1? $36,000

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35 Corporate Income Tax – Problem - 2

36 Corporate Income Tax – Solution-3

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38 Grant, Inc. acquired 30% of South Co.’s voting stock for $200,000 on January 1, Grant’s 30% interest in South gave Grant the ability to exercise significant influence over South’s operating and financial policies. During 2010, South earned $80,000 and paid dividends of $50,000. What amount of income should Grant include in its 2010 Federal income tax return as a result of the investment? a. $15,000 b. $24,000 c. $35,000 d. $50,000 e. $80,000 CPA Nov

39 Grant, Inc. acquired 30% of South Co.’s voting stock for $200,000 on January 1, Grant’s 30% interest in South gave Grant the ability to exercise significant influence over South’s operating and financial policies. During 2010, South earned $80,000 and paid dividends of $50,000. What amount of income should Grant include in its 2010 Federal income tax return as a result of the investment? This company will use equity method for GAAP and cost method for Tax Return.

40 Div. Received- Green - 1 Green Corp. owns 25% of Cande Corp. This year, Green received $10,000 dividends on the Cande stock. Assuming no other limit applies, Green’s dividends-received deduction is: a. $7,000. b. $8,000. c. $2,000. d. $ (IRS-2003)

41 Div. Received- Green – 1 2 Green Corp. owns 25% of Cande Corp. This year, Green received $10,000 dividends on the Cande stock. Assuming no other limit applies, Green’s dividends-received deduction is: a. $7,000. b. $8,000. c. $2,000. d. $ (IRS-2003)

51 Spring Corp’s has income from business of $500,000 & expenses of $750,000. Spring also received dividends from the Acme Corp. of $100,000. Spring owns 25% Acme. What is Spring’s NOL for the year? a. ($150,000) b. ($0). c. ($220,000) d. ($230,000). (IRS Exam 2003)

54 Spring Corp’s has income from business of $500,000 & expenses of $750,000. Spring also received dividends from the Acme Corp. of $100,000. Spring owns 25% Acme. What is Spring’s NOL for the year? ($230,000)

55 This year, Pack Corp. had gross income from operations of $350,000 and operating expenses of $400,000. Pack received dividends of $100,000 from Smith Inc., of which Pack is a 20% owner. The NOL carryover from last year is $20,000. What is Pack's NOL for the current year? a. $50,000 b. $30,000 c. $20,000 d. $10,000 IRS-1995

56 This year, Pack Corp. had gross income from operations of $350,000 and operating expenses of $400,000. Pack received dividends of $100,000 from Smith Inc., of which Pack is a 20% owner. The NOL carryover from last year is $20,000. What is Pack's NOL for the current year? $30,000

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S Corporation Income and expenses are reported by the shareholders according to their ownership interest – Items which would receive special treatment on a shareholder’s return are reported separately – Losses are deductible subject to the three limitations faced by partnerships S corporations are also subject to the corporate depreciation recapture rules for Section 1250 property

S Corporation May not use take the dividend- received deduction NOLs are subject to three limitations – Basis limitation – At-risk limitation – Passive activity loss limitation

Section 1363(b)

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Entity Distributions The tax treatment of distributions to an owner depends on the amount and kind of the distribution and the entity making the distribution. Distributions are either – Liquidating – Nonliquidating

What are the effects of nonliquidating distributions made by each entity?

Sole Proprietorship Distribute cash – No tax consequences to owner / entity Distribute property – No gain or loss recognized until owner sells the property

Partnership Distribute cash – Partner recognizes no gain unless amount exceeds partner’s basis; excess is capital gain – No tax consequences to partnership Distribute property – Partner recognizes no gain or loss; Basis is the lesser of carryover basis or partner's basis – No tax consequences to the entity

81 The adjusted basis of Jody's partnership interest was $50,000 immediately before Jody received a current distribution of $20,000 cash and land with an adjusted basis to the partnership of $40,000 and a FMV of $35,000. What amount of taxable gain must Jody report as a result of this distribution? a. $0 b. $5,000 c. $10,000 d. $20,000 CPA 11-93

82 The adjusted basis of Jody's partnership interest was $50,000 immediately before Jody received a current distribution of $20,000 cash and land with an adjusted basis to the partnership of $40,000 and a FMV of $35,000. What is Jody's basis in the land ? a. $0 b. $30,000 c. $35,000 d. $40,000 CPA 11-93

83 The adjusted basis of Jody's partnership interest was $50,000 immediately before Jody received a current distribution of $20,000 cash and land with an adjusted basis to the partnership of $40,000 and a FMV of $35,000. What is Jody's basis in her partnership interest after this distribution? a. $0 b. $30,000 c. $35,000 d. $40,000 CPA 11-93

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Ben is a partner in the Success Partnership. The adjusted basis of Ben's partnership interest was $25,000 immediately before Ben received a liquidating distribution of $20,000 cash and land with an adjusted basis to the partnership of $40,000 and a fair market value of $50,000. What is Ben’s basis in the land received in this distribution? a. $0 b. $5,000 c. $10,000 d. $15,000 CPA 11-93

C Corporation Distribute cash – Shareholder reports Dividend income to the extent of earnings and profits or corporation, then Return of capital to the extent of basis, then Capital gain – No tax consequences to corporation Distribute property – Shareholder reports same as cash (FMV of Prop.) – Corporation reports gain “as if the property was sold” for its FMV. No loss allowed.

Dahl Corp. (Slide 1) Accum. E&P at $120,000 E&P for ,000 Cash distributions to individual stockholders during ,000 What is the amount of dividend income taxable to Dahl's stockholders in 2009? a. $0 b. $160,000 c. $280,000 d. $360,000 CPANov1995

Dahl Corp. (Slide 2) Accum. E&P at $120,000 E&P for ,000 Cash distributions to individual stockholders during ,000 What is the amount of dividend income taxable to Dahl's stockholders in 2009? a. $0 b. $160,000 c. $280,000 d. $360,000 CPANov1995

Cole Corp.-1 Cole Corp. distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. E&P is not a limiting factor. What is the amount of dividend income recognized by shareholder? a. $75,000. b. $125,000. c. $ 135,000. d. $ - 0 –.

Cole Corp.-2 Cole Corp. distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. E&P is not a limiting factor. What is the amount of dividend income recognized by shareholder? a. $75,000. b. $125,000. c. $ 135,000. d. $ - 0 –.

Cole Corp.-3 Cole Corp. distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. What is the shareholder’s basis in the non-cash property? a. $0. b. $50,000. c. $60,000. d. $125,000.

Cole Corp.-4 Cole Corp. distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. What is the shareholder’s basis in the non-cash property? a. $0. b. $50,000. c. $60,000. d. $125,000.

Property Distributions Property distributions – corporation recognizes gain on distribution of appreciated property (but not loss) – Value of distribution is net FMV (net of any liabilities assumed) and basis to shareholder is FMV – Like cash dividends, property dividends taxable only to extent of E&P

Cole Corp.-5 Cole Corp. distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. What gain must Cole Corp. recognize? a. $10,000. b. $75,000. c. $ 25,000. d. $ - 0 –. (IRS Exam 2003)

Cole Corp.-6 Cole Corp. distributes $75,000 in cash along with land having a $50,000 adjusted basis and a $60,000 FMV to its shareholder. What gain must Cole Corp. recognize? a. $10,000. b. $75,000. c. $ 25,000. d. $ - 0 –. (IRS Exam 2003)

S Corporation Distribute cash – Shareholder recognizes no gain unless amount exceeds basis; excess is capital gain – No tax consequences to corporation Distribute property – Same as for cash – Corporation reports gain “as if the property was sold” for its FMV. No loss allowed. If corporation has been a C corporation and has earnings and profits, the computations are more complicated.

102 Beth invested $25,000 in a new Corp on January 1, Beth does not borrow from the Corp or make loans to the Corp. The Corp elected S Status on January 1, The Corp had net income of $50,000 in On December 31, 2010 the Corp distributes $80,000 to Beth. How much income does Beth recognize as a result of the cash distribution? a. $0 b. $5,000 c. $25,000 d. $80,000

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105 Repeat preceding slide. What is Beth’s basis at the end of the year? $0

What are the effects of liquidating distributions made by each entity?

Sole Proprietorship Distribute cash – No tax consequences to owner / entity Distribute property – When property is sold; gain or loss = FMV less basis

Partnership Distribute cash – Partner recognizes No gain unless amount exceeds partner’s basis; excess is capital gain If only cash is distributed, loss may be recognized – No tax consequences to partnership Distribute property – Partner recognizes no gain or loss; Basis is the lesser of carryover basis or partner's basis – No tax consequences to the entity

Brody is a partner in the Success Partnership. The adjusted basis of Brody's partnership interest was $25,000 immediately before Brody received a liquidating distribution of $20,000 cash and land with an adjusted basis to partnership of $40,000 and a fair market value of $50,000. What is Brody’s basis in the land received this distribution? a. $0 b. $5,000 c. $10,000 d. $15,000 CPA 11-93

C Corporation vDistribute cash FShareholder reports capital gain or loss = amount less basis FNo tax consequences to corporation vDistribute property FShareholder reports same as cash FCorporation reports gain or loss “as if the property was sold” for its FMV

L Corp. adopted a plan of liquidation on Jan. 31. L sold its property, paid its income taxes and distributed cash of $900,000 to its only stockholder in complete liquidation. E & P before the distribution were $600,000. Stockholder’s adjusted basis in L Corp. stock was $700,000. Tax effects of the liquidation to stockholder? [Sec. 331(a)] Dividend income? ____________ Capital gain of? ____________

L Corp. adopted a plan of liquidation on Jan. 31. L sold its property, paid its income taxes and distributed cash of $900,000 to its only stockholder in complete liquidation. E & P before the distribution were $600,000. Stockholder’s adjusted basis in L Corp. stock was $700,000. Tax effects of the liquidation to stockholder? [Sec. 331(a)] Dividend income? 0 Capital gain of? $200,000 E&P not relevant for liquidation.

Sue owns all of the stock in Big Corp. Sue has a basis of $5,000 in the stock. Big adopts a plan of liquidation, pays all tax liabilities for the year, and distributes two assets to Sue: (1) Cash of $10,000 and (2) Land: Basis of $30,000 & FMV of $70,000. Income or gain recognized by Sue? [Sec. 331(a), 1001] Dividend income? ____________ Capital gain of? ____________

Sue owns all of the stock in Big Corp. Sue has a basis of $5,000 in the stock. Big adopts a plan of liquidation, pays all tax liabilities for the year, and distributes two assets to Sue: (1) Cash of $10,000 and (2) Land: Basis of $30,000. FMV of $70,000. Income or gain recognized by Sue? [Sec. 331(a), 1001] Dividend income? 0 Capital gain of? $75,000

S Corporation vDistribute cash FShareholder recognizes capital gain or loss equal to distribution amount less basis FNo tax consequences to corporation vDistribute property FShareholder reports same as for cash FCorporation reports gain or loss “as if the property was sold” for its FMV

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Tax Planning With proper tax planning, owners of entities can minimize their overall tax liability by taking full advantage of the progressive tax rate structure. – Income splitting – Children as employees – Family entities

The End