TAXATION NOTES

CHAPTER 2 – CORPORATE FORMATIONS AND CAPITAL STRUCTURE  Explain the tax advantages and disadvantages of alternative business forms: Businesses can be organized in: Sole proprietorships, partnerships, corporations, limited liability companies (LLC), limited liability partnerships (LLP). SOLE PROPRIETORSHIPS: Owned by one individual and it is not a separate entity. The owner reports business’ income and expenses on schedule C of form 1040 (individual tax return). Advantages include: taxed at the individual level which can sometimes be lower than corporations, owner can contribute or withdraw cash without tax consequences; and business losses may offset nonbusiness income. Disadvantages include: a sole proprietor must pay the full amount of social security taxes, owner may not deduct compensation, there are no tax-exempt benefits, and owner cannot choose their fiscal year.

PARTNERSHIPS: Owned by two or more individuals, a partnership is a tax reporting, but NOT taxpaying, entity. Each year a partnership must file a tax return (form 1065) to report the results of their operations. When the partnership return is filed, the preparer must send each partner a statement (schedule K) that reports partner’s allocable share of partnership income and expenses. A partnership can be general or limited. In a general partnership, the liability of each partner is unlimited. In a limited partnership, at least one partner must be a general partner, and at least one partner must be a limited partner. Advantages include: taxed at the individual level which can sometimes be lower than corporations, owners can contribute or withdraw cash without tax consequences; and business losses may offset non-business income. Disadvantages include: must pay the full amount of social security taxes, owners may not deduct compensation, there are no tax-exempt benefits, and owners cannot choose their fiscal year.

Corporations: Corporations fall into two categories: C Corps and S Corps. C Corps are subject to double taxation and S Corps are taxed at the individual level. C Corporations C corps must report all income and expenses on form 1120. Shareholders are NOT taxed on the corporation’s earnings unless these earnings are distributed as dividends. Advantages include: Shareholders are considered employees, so they only pay half of their social security tax. There are tax-free fringe benefits. The corporation must deduct ordinary and necessary business expenses. They can choose their fiscal year. Shareholder can exclude 50% of the gain realized on the sale or exchange of stock if held for more than 5 years. Disadvantages include: Double taxation, distribution of cash or property to a shareholder is considered a dividend in which the shareholder will have to pay taxes on it. NOLs have no tax benefits/savings in the year the corporation incurs them, it can only be carried back or forward. Capital losses cannot be offset by ordinary income. S Corporations S corps are pass-through entities. The number and type of shareholders are limited, but owners do enjoy limited liability. To obtain S corporation status, owners must make an election and each report their operations on form 1120S. Advantages include: Taxed at the individual level, gains can be offset again losses from other sources. Shareholders generally can contribute money to or withdraw money without recognizing gain. Disadvantages include: nontaxable benefits are not available, cannot choose their fiscal year. Limited liability companies (LLCs): Offers owners the limited liability of a corporation, but an LLC with more than one owner generally is treated like a partnership. LLCs can have unlimited number of owners. LLC may choose to be taxed like a corporation or a partnership (default). Limited liability partnerships (LLPs): Offers owners limited liability. Partners are liable for their own acts and the acts of individuals under their direction. LLP may choose to be taxed like a corporation or a partnership (default).

 Apply the check-the-box regulations to partnerships, corporations, and trusts: According to these regulations, a business with two or more owners is treated by default as a partnership for tax purposes unless it elects to be taxed as a corporation. A business with one owner is disregarded as a separate entity and thus treated as a sole proprietorship by default unless it elects to be taxed as a corporation.

 Determine the legal requirements for forming a corporation: The legal requirements for forming a corporation depend on state law. These requirements generally include: - Investing a minimum amount of capital - Filing articles of incorporation - Issuing stock - Paying state incorporation fees Transfers of money, property or services to the corporation may have tax consequences for both the transferor investor and the transferee corporation. For example, the sale of property for stock usually is taxable to the transferor. HOWEVER, if Sec. 351 applies, any gain or loss realized on the exchange may be deferred.

 Explain the requirements for deferring gain or loss upon incorporation: SECTION 351  transferors recognize no gain or loss when they transfer property to a corporation solely in exchange for the corporation’s stock provided that, immediately after the exchange, the transferors are in control of the corporation. If the transferors of property receive other consideration in addition to stock, such as cash, they will have to pay taxes and recognize some or all of their realized gain. The transferors realized gain or loss is not exempt from taxation, it is only DEFERRED until the shareholder sells or exchanges the stock received in sec. 351. Stock basis = FMV of stock received – deferred gain (or + deferred loss) The holding period of stock received in exchange for capital assets or sec. 1231 property included the holding period of the transferred property. Holding period for boot property begins on the day after the exchange.

Specific requirements are: - The transferors must transfer property to the corporation. It does not apply to an exchange of services for stock. -

They must receive stock of the transferee corporation in exchange Nonqualified stock is considered boot. If a transferor receives any money or property other than stock in the transferee corporation, the additional money or property is BOOT. The transferor recognized gain to the extent of the lesser of the transferor’s realized gain or the FMV of the boot received. A transferor never recognizes a loss under sec. 351 Sec. 1231 property is considered a ordinary gain

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They must be in control of the corporation immediately after the exchange, means that all the exchanges must be agreed to beforehand. (Control of 80% voting power and total number of shares) Because services are not property, stock received by a person that only performs services does NOT count toward the 80% control threshold. If below the 80%, then basis for stock is the FMV and any gain or loss should be recognized. If a person transfers both services and property to a corporation in exchange for the corporation’s stock, all the stock received is counted toward the 80% control threshold. Cash in conjunction with the service offered should be at least 10% of the FMV of the service to count.

If the exchange qualifies as Sec 351 exchange, then the basis of property exchange for the corporation is the same as the base for the transferor. If the exchange does NOT qualify, then the basis is the FMV of the property. If the basis exceeds the FMV (there is a loss) then the basis for the corporation is limited by the lower number (the FMV). The loss on each item must be allocated proportionately. In a like-kind exchange, if a transferee assumes a transferor’s liability, the transferor is treated as though he or she received a cash payment equal to the amount of liability assumed. HOWEVER, if a transaction satisfies the sec. 357 requirements, sec 357 provides relief from this. Recapture of depreciation  If a sec 351 exchange is completely nontaxable, no depreciation for the transferor is recaptured. The corporation inherits the entire amount of the transferor’s recapture amount. Assignment of income doctrine  The IRS has ruled that the doctrine that income is taxable to the person who earned it does NOT apply in sec 351 exchange. The accounts receivable takes a zero basis in the corporation’s hands, and the corporation included their value in its income when they collect the receivables.

SECTION 357 a) General rule  The transferee corporation’s assumption of liabilities in a property transfer qualifying under Sec. 351 is NOT considered equivalent to the transferor’s receipt of money. To get the transferor’s stock basis, the assumption of liabilities by the corporation is treated as money received and decreases the transferor’s stock basis. b) Exception 1  All liabilities assumed by a transferee corporation are considered to be money/boot received by the transferor if the principal purpose of the transfer of any of the liabilities is tax avoidance or if no bona fide business purpose exists c) Exception 2  if the total amount of liabilities assumed by a transferee corporation exceeds the total basis of property transferred, the transferor recognizes the excess as gain.

 Determine the tax consequences of worthless stock or debt obligations: A debt or equity security that becomes worthless results in a capital loss for the investor as of the last day of the tax year in which the security becomes worthless. Ordinary loss treatment is available in the following circumstances: - Securities that are noncapital assets - Affiliated corporations - Section 1244 stock Limited to $50,000 for single person and $100,000 for married couple Non-business bad debts are short term capital losses Business bad debts are deductible as ordinary losses without limitation The IRS treats a loan made by a shareholder to a corporation in connection to his stock investment as non-business bad debt

CHAPTER 3 – THE CORPORATE INCOME TAX  Apply the requirements for selecting tax years and accounting methods to various types of C corporations: Once a corporation is formed, it must select its tax year and accounting methods in the first tax return. S corporations have to use a calendar year Personal Service corporations (PSC) have to use a calendar year. PSC are defined as a corporation whose principal activity is the performance of personal services by its employee-owners who own more than 10% of the stock. PSCs are taxed at a flat 35%. A corporation that desires to change its annual accounting period must obtain the approval of the IRS. A corporation has to use the accrual method of accounting unless: - They qualify as a family farming corporation - They qualify as a PSC - Meets a $5 Million gross receipts test for all prior tax years - They have elected to be a S corp Cash method may not be used if inventories are a material income-producing factor.

 Compute a corporation’s taxable income: Deductions  Corporations do not compute AGI, and their deductions are presumed to be ordinary and necessary business expenses. No deductions are allowed for: - Interest on amounts borrowed to purchase tax-exempt securities - Illegal bribes or kickbacks - Fines and penalties - Insurance premiums incurred to ensure the lives of officers and employees when the corp is the beneficiary. Organizational expenditures  Under Sec 248, a corporation may elect to deduct the first $10,000, however, the corporation must reduce the $10,000 by the amount by which cumulative organizational expenditures exceed $60,000. The corporation amortizes the remaining over a 180 month period beginning in the month that the business begins. Organizational expenditures include: -legal expenses to draft charter and bylaws, minutes of organizational meetings, and terms or original stock certificates - Accounting fees and fees paid to the state of incorporation - Temporary director’s fees

Start-up expenditures  Ordinary and necessary business expenses that includes: - Costs for a survey of potential markets - Analysis of available facilities - Advertisements relating to opening the business - Training of employees - Travel and other expenses for securing distributors - Hiring of management and outside consultants The corporation can elect to deduct the first $10,000, however, the corporation must reduce the $10,000 by the amount by which cumulative start-up expenditures exceed $60,000. The corporation amortizes the remaining over a 180 month period beginning in the month that the business begins. Accrued compensation  If a corporation accrues an obligation to pay compensation, the corporation must make the payment within 2 and half months after the close of its tax year. Otherwise, the deduction cannot be taken until the year of payment. Corp must make the payment by March 15. Charitable contributions  Corporations are limited to 10% of taxable income. Accrual basis corporations may deduct contributions in the year of accrual if the board of directors authorizes the contribution by year-end, AND the corporations pay it by March 15th. Depreciation on Sec 1250 property  Straight line applies to real property. Corporations must recapture as ordinary income an additional amount equal to 20% of the excess of the amount Net Capital gains  Corporate capital gains are taxed at the regular corporate tax rates Capital Losses  Corporations CANNOT offset any ordinary income with capital losses. However, capital losses carry back 3 years and forward 5 years and offset capital gains. Capital losses are treated as short term. Any unused capital losses remaining at the end of the carryover period expire. Dividends-received deductions  Corporations that own less than 20% of the distributing corporation’s stock may deduct 70% of the dividends received. If the corporations own more than 20% but less than 80%, it may deduct 80% of the dividends received. If the corporation owns more than 80%, It may deduct 100% of the dividends received. NOLs  A corporation NOL is simply the excess of its deductions over its income for the year. The NOL carries back 2 years and forward 20 years. Passive Losses  does NOT apply to C Corporations. Sequencing of the deduction calculations  All deductions – charitable contributions – dividends received deduction – NOL deduction – U.S production activities deduction

 Understand what a controlled group is and the tax consequences of being a controlled group: A controlled group is comprised of two or more corporations owned directly or indirectly by the same shareholder or group of shareholders. In a parent-subsidiary controlled group, one corporation (the parent) must directly own at least 80% of voting power OR 80% of total stock value.

 Understand how compensation planning can reduce taxes for corporations and their shareholders: Compensation paid to shareholder-employee in the form of salary has the advantage of single taxation. Dividends payments are taxed twice. Corporations CANNOT deduct dividend payments. Salary or fringe benefit payments (deducted by the corporation) have to be reasonable in amount and be paid for services rendered by the employee. Corporations cannot pay salaries that exceed 1 million. Fringe benefits provide two types of tax advantages: a tax deferral or an exclusion.

 Determine the requirements for paying corporate income taxes and filing a corporate return: Corporations must file their tax returns by the fifteenth day of the third month following the close of their tax year. Schedule L  balance sheet The IRS requires the reconciliation of the corporation’s financial accounting income and its taxable income. The reconciliation must be provided on schedule M-1. Corporations with total assets of $10 million or more must complete schedule M-3 Permanent differences: -

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Some book income is never taxed: tax exempt interest, proceeds of life insurance carried by the corporation on the lives of key officers Some book expenses are never deductible for tax purposes: Expenses incurred in earning taxexempt interest, premiums paid for life insurance, fines and expenses resulting from the violation of law, disallowed travel and entertainment costs, political contributions, federal income taxes per books. Some tax deductions are never taken for book purposes: dividends received deduction, the U.S production activities deductions, and percentage depletions in excess of their cost.

Temporary differences: -

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Some revenues or gains are recognized for book purposes in the current year but not reported for tax purposes until later years. Some revenues or gains are taxable before they are reported for book purposes. These items are included in taxable income when received but are included in book income as they accrue. (prepaids) Some expenses or losses are deductible for tax purposes after they are recognized for book purposes. Some expenses or losses are deductible for tax purposes before they are recognized for book purposes.

 Determine the financial statement implications of federal income taxes: ASC (accounting standards codification) 740 establishes principles of accounting for current income taxes and for deferred taxes arising from temporary differences. ASC 740 addresses the financial statement consequences of the following events: - Revenues, expenses, gains, losses recognized for tax purposes in an earlier or later year than recognized for financial statement purposes - Other events that create differences between book and tax bases of assets and liabilities - Operating loss and tax credit carrybacks or carryforwards

Accounting for Uncertain tax positions ASC 740 also prescribes that for tax purposes, a firm may take a position in claiming a tax benefit that might not be sustained under IRS scrutiny. The FASB believes that for determining the financial statement tax provision, such uncertain tax positions either should not be recognized or should be recognized only partially. Two step approach: 1. The firm determines whether the tax position has a more likely than not (greater than 50%) probability of being sustained upon IRS examination. If the tax provision does not exceed this threshold, the firm cannot recognize the tax benefit for financial reporting purposes until the position subsequently meets the more likely than not threshold, OR the firm favorably settles the tax issue with the IRS or in court, OR the statute of limitations on the transaction expires

CHAPTER 4 – CORPORATE NONLIQUIDATING DISTRIBUTIONS  Calculate corporate current E&P: E&P is the economic ability to pay dividends. Distributions are deemed to be made out of current E&P first, and then out of accumulated E&P to the extent that current E&P is insufficient. The starting point for computing E&P is taxable income or NOL ADDED BACK: - Tax exempt interest - Proceeds from a life insurance that the corporation is the beneficiary - Recoveries of bad debts - Federal income tax refunds - Deferred gains on installment sales - Dividends received deduction - NOL carryovers, capital loss carryover - Charitable contributions - U.S production activities deduction SUBTRACT: - Federal income taxes - Premiums on life insurance that the corporation is the beneficiary - Excess capital losses - Excess charitable contributions - Expenses related to tax-exempt income - Losses on sales to related parties - Penalties and fines - Political contributions and lobbying expenses

 Distinguish between current and accumulated E&P: Current E&P is computed as of the last day of the tax year without reduction for distributions during the year. If the corporation generates both a current E&P deficit and an accumulated E&P deficit, none of the distributions is treated as a dividend. Instead, all distributions are treated as a return of capital to the extent of the shareholder’s basis. Distributions exceeding this amount are taxed as capital gain.

If the corporation has a current E&P deficit and a positive accumulated E&P balance, it must net the two accounts at the time of the distribution to determine the dividend amount. If the balance remaining after the netting is positive, the distribution is treated as dividend to the extent of the lesser of the distribution amount or the E&P balance. If the E&P is zero or negative, the distribution is treated as return of capital.

 Determine the tax consequences of nonliquidating distributions: CONSEQUENCES TO THE SHAREHOLDER Property includes money, securities, and any other property EXCEPT stock in the corporation making the distribution. 3 questions need to be answered: - What is the amount of the distribution? - To what extent is the amount treated as a dividend? - What is the basis of the property to the shareholder, and when does its holding period begin? When the property is distributed, the distribution amount is equal to its FMV on the distribution date plus any money received. The amount of any liability related to the property reduces the distribution amount. The shareholder takes the FMV basis in any property received and the basis is NOT reduced by any liabilities. The holding period begins the day after the distribution date CONSEQUENCES TO THE DISTRIBUTING CORPORATION 2 questions need to be answered: - What amount and character of gain or loss must the distributing corporation recognize? - What effect does the distribution have on the corporation’s E&P? When a corporation distributes property that has appreciated in value, it MUST recognize gain. The corporation DOES NOT recognizes losses when it distributes property. If the distributed property is subject to a liability or the shareholder assumes a liability, the property’s FMV is deemed to be no less than the amount of the liability. A corporation’s E&P is increased by any E&P gain resulting from a distribution of appreciated property. A corporation’s E&P is reduced by {(a) the amount of money distributes, plus (b) the greater of FMV or E&P basis of any noncash property distribution, minus (c) liabilities assumed by the shareholder}.

CONSTRUCTIVE DIVIDENS: Excessive corporate payment to a shareholder to reflect the true economic benefit awarded to the shareholder. Includes: -

Loans to a shareholder Excessive compensation paid to shareholder-employees Excessive compensation paid to shareholders for the use of shareholder property Corporate payments that is personal to the shareholder If shareholder buys a corporate property at a discount Shareholder use of corporate property without paying rent

 Determine the tax consequences of stock dividends and the issuance of stock rights: NONTAXABLE STOCK DIVIDEND: If a stock dividend is nontaxable, the basis of the stock with respect to which the distribution was made must be allocated between the old and new shares. If the old and new shares are identical, the basis of each share is determined by dividing the basis of the old shares by the total number of shares after the distribution. If the old and new shares are not identical, the basis of the old shares is allocated according to the relative FMVs of the old and new shares on the distribution date.

NONTAXABLE STOCK RIGHTS: If the value of the stock rights is less than 15% of the value of the stock with respect to which the rights were distributed, the basis of the rights is zero unless the shareholder elects to allocate stock basis to the rights. If the value of the stock rights is 15% or more of the value of the underlying stock, the shareholder must allocate the basis of the underlying stock between the stock and the stock rights.

The distributing corporation recognizes no gain or loss on the stock dividend, whether it is taxable or nontaxable. Nontaxable distributions of stock or stock rights have NO tax effect on the distributing corporation.

 Discern when a stock redemption should be treated as a sale and when it should be treated as a dividend: A stock redemption is a corporation’s acquiring its own stock in exchange for corporate property. In general, if the shareholder’s proportionate interest has been substantially reduced, the redemption is treated as a sale. On the other hand, if this interest remains the same or increases, the redemption is treated as dividend.

 Avoiding unreasonable compensation: Hedge agreement  this agreement obligates the shareholder-employee to repay any portion of salary the IRS disallows as a corporate deduction. The shareholder can then deduct this amount in the year he or she repays it

 Bootstrap acquisitions:

CHAPTER 9 – PARTNERSHIP FORMATION AND OPERATION  Differentiate between general and limited partnerships General Partnerships: Each partner has the right to participate in the management of the partnership. Only one (or a few) may exercise management responsibilities. Unlimited liability for all partners. Limited partnerships: Must have at least one general partner, and at least one limited partner. The limited partner cannot be active in management. LLLC: General partners have limited liability. Large Partnerships: At least 100 partners and cannot be a service partnership and not engaged in commodity trading. A Partnership is NOT a taxpaying entity, and income is passed to partners on SCHEDULE K. However, the partnership must file FORM 1065 that informs the IRS about the partnerships earnings and allocation of income. The partner’s basis Beginning basis + share of liabilities + share of partnership income – share of partnership losses CANNOT HAVE NEGATIVE BASIS! Partnership distributions Nonliquidating distributions are NOT taxable to the partners and are considered return of capital and reduce partner’s basis. If the distribution is so large and exceeds the basis, partner then recognizes gain. Liquidating distributions causes the partner to recognize gains only is the distribution exceeds the basis. The partner recognizes losses only if the distribution is cash, inventory, and unrealized receivables.

 Explain the tax results of a contribution of property or services in exchange for a partnership interest Sec 721  no gain or loss on the exchange of property for partnership interest. Basis is the same as the property’s. Property includes cash, tangible and intangible property. NOT SERVICES Gain or loss is only recognized if it is considered an investment property, a sale or assumption of liability by the partnership exceeds the basis of the property exchanged. Liability relief is considered a cash distribution. Sec 752  partner’s basis is increased by his share of partnerships liability and reduced by the partnership’s assumption of their share of the liability that was relieved. Partner’s basis in the partnership’s interest (OUTSIDE BASIS) Sum of money contributed plus basis of property, beginning basis also includes share of liabilities at the time of contribution. Holding period: Sec 1231 property includes the transferor’s basis Ordinary property basis begins the day after the distribution Partnership’s basis in the property: Sec 723. Same as the property’s basis in the hands of the contributing partner. Unrealized receivables  If a partner contributes an unrealized receivable to his or her partnership, any gain or loss recognized on the partnership’s later disposition or collection of the receivable is treated as ORDINARY GAIN OR LOSS. Inventory  ORDINARY for 5 years. Capitol loss property  Capital Loss within 5 years Contribution of services: A partner who receives partnership interest in exchange for services has been compensated as if he or she receives cash and thus MUST recognize ordinary income. Payments by the partnership for services are either deductible as an expense or capitalized. Organizational and Syndication expenditures: Sec 709.

 Differentiate between items included in partnership ordinary income, gain, loss, deduction, or credit items Separately stated items  Sec 702 Partnership ordinary income All taxable items of income, gain, loss, or deduction that do not have to be separately stated are combined into a total called partnership ordinary income or loss. Included are items like: -

Gross profit on sales Administrative expenses Employee salaries Sec 1245 depreciation recapture

 Calculate a partner’s distributive share of partnership income, gain, loss, deduction, or credit items Partner’s distributive share: Sec 704  partner’s distributive share is the portion of partnership taxable and nontaxable income that the partner has agreed to report for tax purposes.

 Explain the requirements for a special partnership allocation Allocations related to contributed property: Sec 704c

 Calculate a partner’s basis in a partnership interest Contribution – Substitutes basis from contributes property Purchase – cost basis Inheritance – FMV Gift – donor’s basis

Partner’s basis + increase in share of partnership liability – decrease in share of partnership liability + Partnership liability assumed by this partner – this partner’s liabilities assumed by the partnership

Recourse loan  the usual kind of loan for which the borrower remains liable until the loan is paid. Nonrecourse loan  one in which the lender may sell property used as a security if the loan is not paid, but no partner is liable for any deficiency.

Sec 705  basis is increased by tax-exempt income and decreased by expenses that are not tax deductible

 Determine the limitations on a partner’s deduction of partnership losses The partner always reports income or gain items in his or her current tax year, and these increase the partner’s basis. Sec 704 limits a partner’s loss deduction to the amount of his or her basis in the partnership interest before the loss. The remaining loss that exceeds the basis is carry forward. AT RISK LOSS LIMITATION Congress established the at-risk rules, which limit loss deductions to the partner’s at-risk basis. The at-risk basis is essentially the same amount as the regular partnership basis with the exception that liabilities increase the at risk basis only if the partner is at risk for such as an amount. At-risk rules do not apply to nonrecourse debt if it is qualified real estate financial.

 Determine the tax consequences of a guaranteed payment A partner who provides services to the partnership in an ongoing relationship might be compensated like any other employee. Sec 707 labels this payment as a GUARANTEED PAYMENT. Guaranteed payments are ordinary income to the recipient. The guaranteed payment must be included in income for the recipient partner’s tax year during which the partnership year ends and the partnership deducts or capitalizes the payment.

Self-employment income: Include: guaranteed payments, partnership ordinary income and loss and some separately stated items. Exclude: capital gains and losses, sec 1231 gains and losses, interests, dividends and rentals Limited partners only include guaranteed payments.