(PDF) Taxation of Individuals and Business Entities - McGraw Hill

McGraw-Hill’s

Taxation of Individuals and Business Entities

Brian C. SpilkerBrigham Young University

Editor

Benjamin C. AyersThe University of Georgia

Edmund OutslayMichigan State University

Connie D. WeaverTexas A&M University

John A. BarrickBrigham Young University

John R. RobinsonTexas A&M University

Ron G. WorshamBrigham Young University

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McGRAW-HILL’S TAXATION OF INDIVIDUALS AND BUSINESS ENTITIES, 2020 EDITION, ELEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2020 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2019, 2018, and 2017. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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DedicationsWe dedicate this book to:

My family and to Professor Dave Stewart for his great example and friendship.Brian Spilker

My wife, Marilyn, daughters Margaret Lindley and Georgia, son Benjamin, and parents Bill and Linda.Ben Ayers

My wife, Jill, and my children Annika, Corinne, Lina, Mitch, and Connor.John Barrick

My family, Jane, Mark, Sarah, Chloe, Lily, Jeff, and Nicole, and to Professor James E. Wheeler, my mentor and friend.Ed Outslay

JES, Tommy, and Laura.John Robinson

My family: Dan, Travis, Alix, Alan, and Anna.Connie Weaver

My wife, Anne, sons Matthew and Daniel, and daughters Whitney and Hayley.Ron Worsham

https://mheducation.com/highered

iii

About the Authors

Brian C. Spilker (PhD, University of Texas at Austin, 1993) is the Robert Call/Deloitte Profes-sor in the School of Accountancy at Brigham Young University. He teaches taxation atBrigham Young University. He received both BS (Summa Cum Laude) and MAcc (tax em-phasis) degrees from Brigham Young University before working as a tax consultant for Arthur Young & Co. (now Ernst & Young). After his professional work experience, Brian earned his PhD at the University of Texas at Austin. He received the Price Waterhouse Fellowship in Tax Award and the American Taxation Association and Arthur Andersen Teaching InnovationAward for his work in the classroom. Brian has also been awarded for his use of technology in the classroom at Brigham Young University. Brian researches issues relating to tax informa-tion search and professional tax judgment. His research has been published in journals such as The Accounting Review, Organizational Behavior and Human Decision Processes, Journal of the American Taxation Association, Behavioral Research in Accounting, Journal of Account-ing Education, Journal of Corporate Taxation, and Journal of Accountancy.

CourtesyBrian Spilker

Ben Ayers (PhD, University of Texas at Austin, 1996) holds the Earl Davis Chair in Taxation and is the dean of the Terry College of Business at the University of Georgia. He received a PhD from the University of Texas at Austin and an MTA and BS from the University of Alabama. Prior to entering the PhD program at the University of Texas, Ben was a tax manager at KPMG in Tampa, Florida, and a contract manager with Complete Health, Inc., in Birmingham, Alabama. He is the recipient of 11 teaching awards at the school, college, and university levels, including the Richard B. Russell Undergraduate Teaching Award, the highest teaching honor for University of Georgia junior faculty members. His research interests include the effects of taxation on firm structure, mergers and acquisitions, and capital markets and the effects of accounting information on security returns. He has published articles in journals such as The Accounting Review, Journal of Finance, Journal of Accounting and Economics, Contemporary Accounting Research, Review of Accounting Studies, Journal of Law and Economics, Journal of the American Taxation Association, and National Tax Journal. Ben was the 1997 recipient of the American Accounting Association’s Competitive Manuscript Award, the 2003 and 2008 recipient of the American Taxation Association’s Outstanding Manuscript Award, and the 2016 recipient of the American Taxation Association’s Ray M. Sommerfeld Outstanding Tax Educator Award.

Courtesy Ben Ayers

John Barrick (PhD, University of Nebraska at Lincoln, 1998) is currently an associate profes-sor in the Marriott School at Brigham Young University. He served as an accountant at the United States Congress Joint Committee on Taxation during the 110th and 111th Congresses. He teaches taxation in the graduate and undergraduate programs at Brigham Young Univer-sity. He received both BS and MAcc (tax emphasis) degrees from Brigham Young University before working as a tax consultant for Price Waterhouse (now PricewaterhouseCoopers). Af-ter his professional work experience, John earned his PhD at the University of Nebraska at Lincoln. He was the 1998 recipient of the American Accounting Association, Accounting, Behavior, and Organization Section’s Outstanding Dissertation Award. John researches issues relating to tax corporate political activity. His research has been published in journals such as Organizational Behavior and Human Decision Processes, Contemporary Accounting Research, and Journal of the American Taxation Association. Courtesy John Barrick

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Ed Outslay (PhD, University of Michigan, 1981) is a professor of accounting and the Deloitte/Michael Licata Endowed Professor of Taxation in the Department of Accounting and Information Systems at Michigan State University, where he has taught since 1981. He received a BA from Furman University in 1974 and an MBA and PhD from the University of Michigan in 1977 and 1981. Ed currently teaches graduate classes in corporate taxation, multiunit enterprises, accounting for income taxes, and international taxation. In February 2003, Ed testified before the Senate Finance Committee on the Joint Committee on Taxation’s Report on Enron Corporation. MSU has honored Ed with the Presidential Award for Out-standing Community Service, the Distinguished Faculty Award, the John D. Withrow Teacher-Scholar Award, the Roland H. Salmonson Outstanding Teaching Award, the Senior Class Council Distinguished Faculty Award, the MSU Teacher-Scholar Award, and MSU’s 1st Annual Curricular Service-Learning and Civic Engagement Award in 2008. Ed received the Ray M. Sommerfeld Outstanding Tax Educator Award in 2004 and the Life-time Service Award in 2013 from the American Taxation Association. He has also received the ATA Outstanding Manuscript Award twice, the ATA/Deloitte Teaching Innovations Award, and the 2004 Distinguished Achievement in Accounting Education Award from the Michigan Association of CPAs.In 2017, Ed received the American Accounting Association / J. Michael and Mary Ann Cook Prize given in “foremost recog-nition of an individual who consistently demonstrates the attributes of a superior teacher in the discipline of accounting.” Ed has been recognized for his community service by the Greater Lansing Chapter of the Association of Government Accountants, the City of East Lansing (Crystal Award), and the East Lansing Education Foundation. He received a National Assistant Coach of the Year Award in 2003 from AFLAC and was named an Assistant High School Baseball Coach of the Year in 2002 by the Michigan High School Baseball Coaches Association.

Courtesy Ed Outslay

John Robinson (PhD, University of Michigan, 1981) is the Patricia ’77 and Grant E. Sims ’77 Eminent Scholar Chair in Business. Prior to joining the faculty at Texas A&M, John was the C. Aubrey Smith Professor of Accounting at the University of Texas at Austin, Texas, and he taught at the University of Kansas where he was the Arthur Young Faculty Scholar. In 2009–2010 John served as the Academic Fellow in the Division of Corporation Finance at the Securities and Exchange Commission. He has been the recipient of the Henry A. Bubb Award for outstanding teaching, the Texas Blazer’s Faculty Excellence Award, and the MPA Council Outstanding Professor Award. John also received the 2012 Outstanding Service Award from the American Taxation Association (ATA) and in 2017 was named the Ernst & Young and ATA Ray Sommerfeld Outstanding Educator. John served as the 2014–2015 president (elect) of the ATA and was the ATA’s president for 2015–2016. John conducts research in a broad variety of topics involving financial accounting, mergers and acquisitions, and the influence of taxes on financial structures and performance. His scholarly articles have appeared in The Accounting Review, The Journal of Accounting and Economics, Journal of Finance, National Tax Journal, Journal of Law and Economics, Journal of the American Taxation Association, The Journal of the American Bar Association, and The Journal of Taxation. John’s research was honored with the 2003 and 2008 ATA Outstanding Manuscript Awards. In addition, John was the editor of The Journal of the American Taxation Association from 2002–2005. Professor Robinson received his J.D. (Cum Laude) from the University of Michigan in 1979, and he teaches courses on individual and corporate taxation and advanced accounting.

Courtesy John Robinson

About the Authors

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Connie Weaver(PhD, Arizona State University, 1997) is the KPMG Professor of Accounting at Texas A&M University. She received a PhD from Arizona State University, an MPA from the University of Texas at Arlington, and a BS (chemical engineering) from the University of Texas at Austin. Prior to entering the PhD Program, Connie was a tax manager at Ernst & Young in Dallas, Texas, where she became licensed to practice as a CPA. She teaches taxation in the Professional Program in Accounting and the Executive MBA program at Texas A&M University. She has also taught undergraduate and graduate students at the University of Wisconsin–Madison and the University of Texas at Austin. She is the recipient of several teaching awards, including the 2006 American Taxation Association/Deloitte Teaching Innovations award, the David and Denise Baggett Teaching award, and the college and university level Association of Former Students Distinguished Achievement award in teaching. Connie’s current research interests include the effects of tax and financial incentives on corporate decisions and reporting. She has published articles in journals such as The Accounting Review, Contemporary Accounting Research, Journal of the American Taxation Association, National Tax Journal, Accounting Horizons, Journal of Corporate Finance, and Tax Notes. Connie is the senior editor of The Journal of the American Taxation Association and she serves on the editorial board of Contemporary Accounting Research.

Courtesy Connie Weaver

Ron Worsham (PhD, University of Florida, 1994) is an associate professor in the School of Accountancy at Brigham Young University. He teaches taxation in the graduate, undergradu-ate, MBA, and Executive MBA programs at Brigham Young University. He has also taught as a visiting professor at the University of Chicago. He received both BS and MAcc (tax empha-sis) degrees from Brigham Young University before working as a tax consultant for Arthur Young & Co. (now Ernst & Young) in Dallas, Texas. While in Texas, he became licensed to practice as a CPA. After his professional work experience, Ron earned his PhD at the Univer-sity of Florida. He has been honored for outstanding innovation in the classroom at Brigham Young University. Ron has published academic research in the areas of taxpayer compliance and professional tax judgment. He has also published legal research in a variety of areas. His work has been published in journals such as Journal of the American Taxation Association, The Journal of International Taxation, The Tax Executive,Tax Notes, The Journal of Accoun-tancy, and Practical Tax Strategies. Courtesy Ron Worsham

About the Authors

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TEACHING THE CODE IN CONTEXT

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The bold innovative approach used by McGraw-Hill’s Taxation series is quickly becoming the most popular choice of course materials among in-structors and students. It’s apparent why the clear, organized, and engaging delivery of content, paired with the most current and robust tax code updates, has been adopted by more than 650 schools across the country.

McGraw-Hill’s Taxation is designed to provide a unique, innovative, and engaging learning ex-perience for students studying taxation. The breadth of the topical coverage, the storyline approach to presenting the material, the em-phasis on the tax and nontax consequences of multiple parties involved in transactions, and the integration of financial and tax accounting topics make this book ideal for the modern tax curriculum.

“Do you want the best tax text? This is the one to use. It has a storyline in each chapter that can relate to real life issues.”

Leslie A. Mostow – University of Maryland, College Park

“This text provides broad coverage of important topics and does so in a manner that is easy for students to understand. The material is very accessible for students.”

Kyle Post – Tarleton State University

Since the first manuscript was written in 2005, 450 professors have contributed 500 book reviews, in addition to 30 focus groups and symposia. Throughout this preface, their comments on the book’s organization, pedagogy, and unique features are a testament to the market-driven nature of Taxation’s development.

“I think this is the best book available for introductory and intermediate courses in taxation.”

Shane Stinson – University of Alabama

vii

A MODERN APPROACH FOR TODAY’S STUDENTMcGraw-Hill’s Taxation series was built around the following five core precepts:

1 Storyline Approach: Each chapter begins with a storyline that introduces a set of characters or a business entity facing specific tax-related situations. Each chapter’s examples are related to the storyline, providing students with opportunities to learn the code in context.

2 Integrated Examples: In addition to providing examples in-context, we provide “What if” scenarios within many examples to illustrate how variations in the facts might or might not change the answers.

3 Conversational Writing Style: The authors took special care to write McGraw-Hill’s Taxationin a way that fosters a friendly dialogue between the content and each individual student. The tone of the presentation is intentionally conversational—creating the impression of speaking with the student, as opposed to lecturing to the student.

4 Superior Organization of Related Topics: McGraw-Hill’s Taxationprovides two alternative topic sequences. In the McGraw-Hill’s Taxation of Individuals and Business Entities volume, the individual topics generally follow the tax form sequence, with an individual overview chapter and then chapters on income, deductions, investment-related issues, and the tax liability computation. The topics then transition into business-related topics that apply to individuals. This volume then provides a group of specialty chapters dealing with topics of particular interest to individuals (including students), including separate chapters on home ownership, compensation, and retirement savings and deferred compen-sation. This volume concludes with a chapter covering the taxation of business entities. Alternatively, in the Essentials of Federal Taxation volume, the topics follow a more traditional sequence, with topics streamlined (no specialty chapters) and presented in more of a life-cycle approach.

5 Real-World Focus: Students learn best when they see how concepts are applied in the real world. For that reason, real-world examples and articles are included in “Taxes in the Real World” boxes throughout the book. These vignettes demonstrate current issues in taxation and show the relevance of tax issues in all areas of business.

“The in-text examples of how to complete tax returns (is a strength of this text). These help students improve their overall understanding of the material as it moves from something abstract to something tangible the student can produce.”

Christine Cheng – Louisiana State University

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A STORYLINE APPROACH THAT RESONATES WITH STUDENTS

8-1

Storyline Summary

Taxpayers: Courtney Wilson, age 40, and Courtney’s mother Dorothy “Gram” Weiss, age 70

Family Courtney is divorced with a son, Deron, description: age 10, and a daughter, Ellen, age 20.

Gram is currently residing with Courtney.

Location: Kansas City, Missouri

Employment Courtney works as an architect for EWD. status: Gram is retired.

Filing status: Courtney is head of household. Gram is single.

Current Courtney and Gram have computed their situation: taxable income. Now they are trying to

determine their tax liability, tax refund, or additional taxes due and whether they owe any payment-related penalties.

©Drazen_/E+/Getty Images

She’s planning on filing her tax return and paying her taxes on time.

Gram’s tax situation is much more straightfor-ward. She needs to determine the regular income tax on her taxable income. Her income is so low she knows she need not worry about the alternative mini-mum tax, and she believes she doesn’t owe any self-employment tax. Gram didn’t prepay any taxes this year, so she is concerned that she might be required to pay an underpayment penalty. She plans to file her tax return and pay her taxes by the looming due date.

to be continued . . .

Courtney has already determined her taxable income. Now she’s working on computing her tax liability. She

knows she owes a significant amount of regu-lar income tax on her employment and busi-ness activities. However, she’s not sure how to compute the tax on the qualified dividends she re-ceived from General Electric and is worried that she may be subject to the alternative minimum tax this year. Finally, Courtney knows she owes some self-employment taxes on her business income. Courtney would like to determine whether she is eligible to claim any tax credits, such as the child tax credit for her two children and education credits, because she paid for a portion of her daughter Ellen’s tuition at the University of Missouri–Kansas City this year. Courtney is hoping that she has paid enough in taxes during the year to avoid underpayment penalties.

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Each chapter begins with a storyline that introduces a set of characters facing specific tax-related situations. This rev-olutionary approach to teaching tax emphasizes real people facing real tax dilemmas. Students learn to apply practical tax information to specific business and personal situations. As their situations evolve, the characters are brought further to life.

“Excellent text! Very readable, easy for students to read and understand. Storyline approach and integrated examples make it easy for students to relate to taxpayers and their tax situations.”

Sandra Owen – Indiana State University, Bloomington

ExamplesExamples are the cornerstone of any textbook covering taxation. For this reason, McGraw-Hill’s Taxation authors took special care to create clear and helpful exam-ples that relate to the storyline of the chapter. Students learn to refer to the facts presented in the storyline and apply them to other scenarios—in this way, they build a greater base of knowledge through application. Many exam-ples also include “What if?” sce-narios that add more complexity to the example or explore related tax concepts.

2-4 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities

The statute of limitations for IRS assessment can be extended in certain circ*mstances. For example,the original three-year statute of limitations for IRS assessments is extended to six yearsif the taxpayer omits items of gross income that exceed 25 percent of the gross income reported on the tax return. For fraudulent returns, or if the taxpayer fails to file a tax return, the news is understandably worse. The statute of limitations remains open indefi-nitely in these cases. The statute of limitations can also be voluntarily extended by the taxpayer at the request of the IRS to allow both sides sufficient time to resolve issues.

BillandMercedesfiletheir2015federaltaxreturnonSeptember6,2016,afterreceivinganauto-maticextensiontofiletheirreturnbyOctober15,2016.In2019,theIRSselectstheir2015taxreturnforaudit.WhendoesthestatuteoflimitationsendforBillandMercedes’s2015taxreturn?

Answer: Assumingthesix-yearand“unlimited”statuteoflimitationrulesdonotapply,thestatuteoflimitationsendsonSeptember6,2019(threeyearsafterthelateroftheactualfilingdateandtheoriginalduedate).

What if: WhenwouldthestatuteoflimitationsendforBillandMercedesfortheir2015taxreturnifthecouplefiledthereturnonMarch22,2016(beforetheoriginalduedateofApril15,2016)?

Answer: InthisscenariothestatuteoflimitationswouldendonApril15,2019,becausethelateroftheactualfilingdateandtheoriginalduedateisApril15,2016.

Example 2-1

Taxpayers should prepare for the possibility of an audit by retaining all supporting documents (receipts, canceled checks, etc.) for a tax return until the statute of limitations expires. After the statute of limitations expires, taxpayers can discard the majority of sup-porting documents but should still keep a copy of the tax return itself, as well as any docu-ments that may have ongoing significance, such as those establishing the taxpayer’s basis or original investment in existing assets like personal residences and long-term investments.

IRS AUDIT SELECTIONWhy me? This is a recurring question in life and definitely a common taxpayer question after receiving an IRS audit notice. The answer, in general, is that a taxpayer’s return is selected for audit because the IRS has data suggesting the taxpayer’s tax return has a high probability of a significant understated tax liability. Budget constraints limit the IRS’s ability to audit a majority or even a large minority of tax returns. Currently, fewer than 1 percent of all tax returns are audited. Thus, the IRS must be strategic in selecting returns for audit in an effort to promote the highest level of voluntary taxpayer compliance and increase tax revenues.

Specifically, how does the IRS select tax returns for audit? The IRS uses a number of computer programs and outside data sources (newspapers, financial statement disclosures, informants, and other public and private sources) to identify tax returns that may have an un-derstated tax liability. Common computer initiatives include the DIF (Discriminant Func-tion) system,thedocument perfection program, and theinformation matching program. The most important of these initiatives is the DIF system. The DIF system assigns a score to each tax return that represents the probability the tax liability on the return has been underre-ported (a higher score = a higher likelihood of underreporting). The IRS derives the weights assigned to specific tax return attributes from historical IRS audit adjustment data from the National Research Program.7 The DIF system then uses these (undisclosed) weights to score each tax return based on the tax return’s characteristics. Returns with higher DIF scores are reviewed to determine whether an audit is the best course of action.

LO 2-2

7Similar to its predecessor, the Taxpayer Compliance Measurement Program, the National Research Program (NRP) analyzes a large sample of tax returns that are randomly selected for audit. From these randomly selected returns, the IRS identifies tax return characteristics (e.g., deductions for a home office, unusually high tax deductions relative to a taxpayer’s income) associated with underreported liabilities, weights these characteristics, and then incorporates them into the DIF system. The NRP analyzes randomly selected returns to ensure that the DIF scorings are representative of the population of tax returns.

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“I enjoy teaching from the McGraw-Hill Spilker taxation textbook. Students too have commented that they prefer it over other texts they have learned taxation from. The ancillaries, LearnSmart and Connect help in my mission to present the material in a logical, reader-friendly manner.”

Cheryl Crespi – Central Connecticut State University

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THE PEDAGOGY YOUR STUDENTS NEED TO PUT THE CODE IN CONTEXT

CHAPTER 6 Individual Deductions 6-15

InterestThere are two itemized deductions for interest expense.26 First, subject to limitations described in more detail in the Tax Consequences of Home Ownership chapter, individu-als can deduct interest paid on acquisition indebtedness secured by a qualified residence (the taxpayer’s principal residence and one other residence).27 Acquisition indebtedness is any debt secured by a qualified residence that is incurred in acquiring, constructing, or substantially improving the residence.28

The home mortgage interest deduction is limited by a cap on acquisition indebted-ness that varies based upon when the indebtedness originated. For acquisition indebt-edness incurred after December 15, 2017, taxpayers may only deduct mortgage interest

Answer: $8,620 ($6,700 withholding + $420 overpayment applied to 2019 + $1,500 real estate taxes). The treatment of the overpayment is the same as if Courtney had received the refund in 2019 and then remitted it to the state as payment of 2019 taxes. Because she paid the tax in 2019, she is allowed to deduct the tax in 2019. Recall that under the tax benefit rule (see the Gross Income and Exclusions chapter), Courtney was required to include the $420 in her 2019 gross income.

Taxes in the Real WorldTaxes in the Real World are short boxes used throughout the book to demonstrate the real-world use of tax concepts. Current articles on tax issues, the real-world application of chapter-specific tax rules, and short vignettes on popular news about tax are some of the issues covered in Taxes in the Real World boxes.

TAXES IN THE REAL WORLD Is It a Deductible State Tax Payment, Charitable Contribution, or Neither?

In recent years, it has become popular for state and local governments to provide state or local tax credits for contributions to certain qualified charities (for example, local hospitals, certain scholarship funds, etc.). While there was no “of-ficial” IRS guidance on the federal tax treatment of these contributions, in “unofficial” guidance, the IRS Office of Chief Counsel (see Chief Counsel Advice Memorandum 201105010) advised that a payment to a state agency or charitable organization in return for a tax credit might be characterized as either a deductible charitable contribution or a deductible state tax payment. The 2010 CCA advised that taxpay-ers could take a charitable deduction for the full amount of the contribution without subtract-ing the value of the state tax credit received. Hence, for federal tax purposes, the taxpayer could take a charitable contribution deduction for an amount that otherwise was used to re-duce the taxpayer’s state tax liability. Because individuals deduct both state taxes and chari-table contributions as itemized deductions, the IRS was not too concerned with these types of state tax credit programs.

As you might expect, the IRS’s laissez-faire stance changed in 2018 with the enactment of the $10,000 limit on the itemized deduction for state, local, and foreign taxes. Specifically, the IRS revis-ited the federal tax consequences of state and lo-cal tax credit programs out of concern that taxpayers may use these programs to bypass the $10,000 limit on state, local, and foreign tax de-ductions. After further review, the news was not favorable for taxpayers. In Prop. Reg. §1.170A-1(h)(3), the IRS stated that, effective for contributions after August 27, 2018, taxpayers making pay-ments or transferring property to an entity eligible to receive tax-deductible contributions will have to reduce theircharitablecontributiondeductions by the amount of anystateor localtaxcreditreceived (or expected to be received). Thus, after August 27, 2018, if a taxpayer receives a dollar-for-dollar state tax credit for a contribution to a qualified charity, the charitable contribution deduction is reduced to zero for federal tax purposes (i.e., the contribution is neither a deductible state tax payment or deductible charitable contribution).

Sources: Prop. Reg. §1.170A-1(h)(3); REG-112176-18.

26Interest paid on loans where the proceeds are used in a trade or business is fully deductible as a business expense deduction for AGI.27Prior to 2018, taxpayers could also deduct premiums paid or accrued on mortgage insurance (insurance premiums paid by the borrower to protect the lender against the borrower defaulting on the loan) as qualified residence interest expense. At press time, the deduction for mortgage insurance premiums has not been extended beyond 2017.28Subject to rules discussed in the Tax Consequences of Home Ownership chapter, points paid on indebtedness incurred in acquiring a home are also generally deductible as mortgage interest expense in the year the loan originates and points to refinance a home mortgage are typically amortized and deducted over the life of the loan (but see research memo in the Tax Compliance, the IRS, and Tax Authorities chapter for an exception).

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“This is the best text I have found for both my students and myself. Easier to read than other textbooks I have looked at, good examples, and, as mentioned before, I appreciate the instructor resources.”

– Esther Ehrlich, CPA, The University of Texas at El Paso

The Key FactsThe Key Facts pro-vide quick synopses of the critical pieces of information pre-sented throughouteach chapter.

CHAPTER 1 An Introduction to Tax 1-5

HOW TO CALCULATE A TAXIn its simplest form, the amount of tax equals the tax base multiplied by the tax rate:

Eq. 1-1 Tax = Tax Base × Tax Rate

The tax base defines what is actually taxed and is usually expressed in monetary terms, whereas the tax rate determines the level of taxes imposed on the tax base and is usually expressed as a percentage. For example, a sales tax rate of 6 percent on a purchase of $30 yields a tax of $1.80 ($1.80 = $30 × .06).

Federal, state, and local jurisdictions use a large variety of tax bases to collect tax. Some common tax bases (and related taxes) include taxable income (federal and state income taxes), purchases (sales tax), real estate values (real estate tax), and personal property values (personal property tax).

Different portions of a tax base may be taxed at different rates. A single tax applied to an entire base constitutes a flat tax. In the case of graduated taxes, the base is divided into a series of monetary amounts, or brackets, and each successive bracket is taxed at a different (gradually higher or gradually lower) percentage rate.

Calculating some taxes—income taxes for individuals or corporations, for example—can be quite complex. Advocates of flat taxes argue that the process should be simpler. But as we’ll see throughout the text, most of the difficulty in calculating a tax rests in determining the tax base, not the tax rate. Indeed, there are only three basic tax rate struc-tures (proportional, progressive, and regressive), and each can be mastered without much difficulty.

DIFFERENT WAYS TO MEASURE TAX RATESBefore we discuss the alternative tax rate structures, let’s first define three different tax rates that will be useful in contrasting the different tax rate structures: the marginal, aver-age, and effective tax rates.

The marginal tax rate is the tax rate that applies to the next additional increment of a taxpayer’s taxable income (or deductions). Specifically,

Marginal Tax Rate =

Eq. 1-2 ΔTax*

ΔTaxable Income=

(New Total Tax − Old Total Tax)(New Taxable Income − Old Taxable Income)

*Δ means change in.

where “old” refers to the current tax and “new” refers to the revised tax after incorporat-ing the additional income (or deductions) in question. In graduated income tax systems, additional income (deductions) can push a taxpayer into a higher (lower) tax bracket, thus changing the marginal tax rate.

LO 1-3

THE KEY FACTS

How to Calculate a Tax

• Tax = Tax base × Tax rate• The tax base defines

what is actually taxed and is usually expressed in monetary terms.

• The tax rate determines the level of taxes imposed on the tax base and is usually expressed as a percentage.

• Different portions of a tax base may be taxed at different rates.

4The tax rate schedules for single, married filing jointly, married filing separately, and head of household are included in Appendix D.

Example 1-3

Margaret’s parents, Bill and Mercedes, file a joint tax return. They have $160,000 of taxable income this year (after all tax deductions). Assuming the following federal tax rate schedule applies, how much federal income tax will they owe this year?4

(continued on page 1-6)

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CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-7

to interpret and rule differently on the same basic tax issue. Given a choice of courts, the taxpayer should prefer the court most likely to rule favorably on his or her particular is-sues. The courts also differ in other ways. For example, the U.S. District Court is the only court that provides for a jury trial; the U.S. Tax Court is the only court that allows tax cases to be heard before the taxpayer pays the disputed liability and the only court with a small claims division (hearing claims involving disputed liabilities of $50,000 or less); and the U.S. Tax Court judges are tax experts, whereas the U.S. District Court and U.S. Court of Federal Claims judges are generalists. The taxpayer should consider each of these factors in choosing a trial court. For example, if the taxpayer feels very confident in her tax return position but does not have sufficient funds to pay the disputed liability, she will prefer the U.S. Tax Court. If, instead, the taxpayer is litigating a tax return position that is low on technical merit but high on emotional appeal, a jury trial in the local U.S. District Court may be the best option.

What happens after the taxpayer’s case has been decided in a trial court? The process may not be quite finished. After the trial court’s verdict, the losing party has the right to request one of the 13 U.S. Circuit Courts of Appealsto hear the case. Exhibit 2-3 de-picts the specific appellant courts for each lower-level court. Both the U.S. Tax Court and local U.S. District Court cases are appealed to the specific U.S. Circuit Court of Appeals based on the taxpayer’s residence.9 Cases litigated in Alabama, Florida, and Georgia, for

ExhibitsToday’s students are visual learners, and McGraw-Hill’s Taxation understands this student need by making use of clear and engaging charts, diagrams, and tabular demonstrations of key material.

EXHIBIT 2-2 IRS Appeals/Litigation Process

1a. Agree with proposed adjustment

1b. Disagree with proposed adjustment

3a. Agree with proposed adjustment

2a. Request appeals

5. IRS denies refund claim

3b. Disagree with proposed adjustment

4b. Pay tax

4a. Do not pay tax; Petition Tax Court

2b. No taxpayer response

Tax Court

90-Day Letter

30-Day Letter

Appeals Conference

IRS Exam

Pay Taxes Due

File Claim forRefund with the IRS

File Suit in U.S. DistrictCourt or U.S. Court of

Federal Claims

(IRS Exam): ©Imageroller/Alamy Stock Photo; (Supreme Court): ©McGraw-Hill Education/Jill Braaten, photographer

9Decisions rendered by the U.S. Tax Court Small Claims Division cannot be appealed by the taxpayer or the IRS.

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“It is easily accessible to students as it is written in easy-to-understand language, and contains sufficient examples to illustrate complicated tax concepts and calculations.”

Machiavelli Chao – University of California, Irvine: The Paul Merage School of Business

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PRACTICE MAKES PERFECT WITH A WIDESummaryA unique feature of McGraw-Hill’s Taxation is the end-of-chapter sum-mary organized around learning ob-jectives. Each objective has a brief, bullet-point summary that covers the major topics and concepts for that chapter, including references to critical exhibits and examples. All end-of-chapter material is tied to learning objectives.

2-30 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities

30-day letter (2-6)90-day letter (2-6)acquiescence (2-17)action on decision (2-17)annotated tax service (2-18)Circular 230 (2-24)citator (2-21)civil penalties (2-26)correspondence examination (2-5)criminal penalties (2-26)determination letters (2-16)DIF (Discriminant Function)

system (2-4)document perfection

program (2-4)field examination (2-6)final regulations (2-15)Golsen rule (2-15)

information matching program (2-4)

Internal Revenue Code of 1986 (2-11)

interpretative regulations (2-16)legislative regulations (2-16)nonacquiescence (2-17)office examination (2-6)primary authorities (2-9)private letter rulings (2-16)procedural regulations (2-16)proposed regulations (2-15)question of fact (2-19)question of law (2-19)regulations (2-15)revenue procedures (2-16)revenue rulings (2-16)secondary authorities (2-9)

stare decisis (2-15)Statements on Standards for Tax

Services (SSTS) (2-23)statute of limitations (2-3)substantial authority (2-24)tax treaties (2-14)technical advice memorandum (2-16)temporary regulations (2-15)topical tax service (2-19)U.S. Circuit Courts

of Appeals(2-7)U.S. Constitution (2-11)U.S. Court of Federal Claims (2-6)U.S. District Court (2-6)U.S. Supreme Court (2-8)U.S. Tax Court (2-6)writ of certiorari (2-8)

KEY TERMS

DISCUSSION QUESTIONS

Discussion Questions are available in Connect®.

1. Name three factors that determine whether a taxpayer is required to file a tax return. 2. Benita is concerned that she will not be able to complete her tax return by April 15.

Can she request an extension to file her return? By what date must she do so? Assuming she requests an extension, what is the latest date that she could file her return this year without penalty?

3. Agua Linda Inc. is a calendar-year corporation. What is the original due date for the corporate tax return? What happens if the original due date falls on a Saturday?

4. Approximately what percentage of tax returns does the IRS audit? What are the implications of this number for the IRS’s strategy in selecting returns for audit?

5. Explain the difference between the DIF system and the National Research Program. How do they relate to each other?

6. Describe the differences between the three types of audits in terms of their scope and taxpayer type.

7. Simon just received a 30-day letter from the IRS indicating a proposed assessment. Does he have to pay the additional tax? What are his options?

8. Compare and contrast the three trial-level courts. 9. Compare and contrast the three types of tax law sources and give examples of each.10. The U.S. Constitution is the highest tax authority but provides very little in the way

of tax laws. What are the next highest tax authorities beneath the U.S. Constitution?11. Jackie has just opened her copy of the Code for the first time. She looks at the table

of contents and wonders why it is organized the way it is. She questions whether it makes sense to try and understand the Code’s organization. What are some reasons why understanding the organization of the Internal Revenue Code may prove useful?

12. Laura Li, a U.S. resident, worked for three months this summer in China. What type of tax authority may be especially useful in determining the tax consequences of her foreign income?

LO 2-1

LO 2-2

LO 2-3

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2-28 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities

As we explained in Example 2-6, Bill and Mercedes’s CPA met her professional stan-dards (as defined currently in SSTS No. 1) by recommending a tax return position that meets the “Substantial Authority” standard. Likewise, because substantial tax authority supports the tax return position, Bill and Mercedes’s CPA should also not have penalty exposure under IRC Sec. 6694.

CONCLUSIONNow that we have a full understanding of the issue under audit for Bill and Mercedes, what is their likely outcome? Another good question. The IRS has stated that it will continue to disallow a current deduction for points incurred for refinanced mortgages. Nonetheless, the courts appear to follow J.R. Huntsman v. Comm., and therefore, the IRS stands a strong possibility of losing this case if litigated. In an IRS appeals con-ference, the appeals officer may consider the hazards of litigation. Accordingly, Bill and Mercedes have a good likelihood of a favorable resolution at the appeals conference.

In this chapter we discussed several of the fundamentals of tax practice and proce-dure: taxpayer filing requirements, the statute of limitations, the IRS audit process, the primary tax authorities, tax research, tax professional standards, and taxpayer and tax practitioner penalties. For the tax accountant, these fundamentals form the basis for much of her work. Likewise, tax research forms the basis of much of a tax professional’s com-pliance and planning services. Even for the accountant who doesn’t specialize in tax accounting, gaining a basic understanding of tax practice and procedure is important. Assisting clients with the IRS audit process is a valued service that accountants provide, and clients expect all accountants to understand basic tax procedure issues and how to research basic tax issues.

Summary

Identify the filing requirements for income tax returns and the statute of limitations forassessment.

• Allcorporationsmustfileataxreturnannuallyregardlessoftheirtaxableincome.Estatesandtrustsarerequiredtofileannualincometaxreturnsiftheirgrossincomeexceeds$600.Thefilingrequirementsforindividualtaxpayersdependonthetaxpayer’sfilingstatus,age,andgrossincome.

• IndividualandCcorporationtaxreturns(exceptforCcorporationswithaJune30year-end)aredueonthefifteenthdayofthefourthmonthfollowingyear-end.ForCcorporationswithaJune30year-end,partnerships,andScorporations,taxreturnsmustbefiledbythefifteenthdayofthethirdmonthfollowingtheentity’sfiscalyear-end.Anytaxpayerunabletofileataxreturnbytheoriginalduedatecanrequestanextensiontofile.

• ForbothamendedtaxreturnsfiledbyataxpayerandproposedtaxassessmentsbytheIRS,thestatuteoflimitationsgenerallyendsthreeyearsfromthelaterof(1)thedatethetaxreturnwasactuallyfiledor(2)thetaxreturn’soriginalduedate.

OutlinetheIRSauditprocess,howreturnsareselected,thedifferenttypesofaudits,andwhathappensaftertheaudit.

• TheIRSusesanumberofcomputerprogramsandoutsidedatasourcestoidentifytaxreturnsthatmayhaveanunderstatedtaxliability.CommoncomputerinitiativesincludetheDIF(DiscriminantFunction)system,thedocumentperfectionprogram,andtheinformationmatchingprogram.

• ThethreetypesofIRSauditsconsistofcorrespondence,office,andfieldexaminations.

LO 2-1

LO 2-2

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Tax Compliance, the IRS, and Tax Authorities

chapter

Learning Objectives

Upon completing this chapter, you should be able to:

LO 2-1 Identify the filing requirements for income tax returns and the statute of limitations for assessment.

LO 2-2 Outline the IRS audit process, how returns are selected, the different types of audits, and what happens after the audit.

LO 2-3 Evaluate the relative weights of the various tax law sources.

LO 2-4 Describe the legislative process as it pertains to taxation.

LO 2-5 Perform the basic steps in tax research.

LO 2-6 Describe tax professional responsibilities in providing tax advice.

LO 2-7 Identify taxpayer and tax professional penalties.

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Discussion QuestionsDiscussion questions, now available in Con-nect, are provided for each of the major con-cepts in each chapter, providing students with an opportunity to review key parts of the chapter and answer evocative questions about what they have learned.

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6-36 CHAPTER 6 Individual Deductions

money. Penny reported the following income and expenses from her nights at the track:

Prize money $2,500Expenses:Transportation from her home to the races 1,000Depreciation on the dirt-track car 4,000Entry fees 3,500Oil, gas, supplies, repairs for the dirt-track car 2,050

What are the tax effects of Penny’s racing income and expenses assuming that the racing activity is a hobby for Penny?

34. Simpson, age 45, is a single individual who is employed full-time by Duff Corpora-tion. This year Simpson reports AGI of $50,000 and has incurred the following medical expenses:Dentist charges $ 900Physician charges 1,800Optical charges 500Cost of eyeglasses 300Hospital charges 2,100Prescription drugs 250Over-the-counter drugs 450Medical insurance premiums (not through an exchange) 775

a) Calculate the amount of medical expenses that will be included with Simpson’s itemized deductions after any applicable limitations.

b) Suppose that Simpson was reimbursed for $250 of the physician’s charges and $1,200 for the hospital costs. Calculate the amount of medical expenses that will be included with Simpson’s itemized deductions after any applicable limitations.

35. This year Tim is age 45 and is considering enrolling in an insurance program that provides for long-term care insurance. He is curious about whether the insurance premiums are deductible as a medical expense and, if so, what the maximum amount is that can be deducted in any year.

36. Doctor Bones prescribed physical therapy in a pool to treat Jack’s broken back. In response to this advice (and for no other reason), Jack built a swimming pool in his backyard and strictly limited use of the pool to physical therapy. Jack paid $25,000 to build the pool, but he wondered if this amount could be deducted as a medical expense. Determine if a capital expenditure such as the cost of a swimming pool qualifies for the medical expense deduction.

37. Charles has AGI of $50,000 and has made the following payments related to (1) land he inherited from his deceased aunt and (2) a personal vacation taken last year. Calculate the amount of taxes Charles may include in his itemized deductions for the year under the following circ*mstances:State inheritance tax on the land $1,200County real estate tax on the land 1,500School district tax on the land 690City special assessment on the land (new curbs and gutters) 700State tax on airline tickets (paid on vacation) 125Local hotel tax (paid during vacation) 195

a) Suppose that Charles holds the land for appreciation.b) Suppose that Charles holds the land for rent.c) Suppose that Charles holds the land for appreciation and that the vacation was

actually a business trip.

LO 6-2

research

LO 6-2

research

LO 6-2LO 6-1

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6-34 CHAPTER 6 Individual Deductions

allocable to Don Juan as the sole shareholder. Assume that the $600,000 loss is not limited by the basis, at-risk, or passive loss rules, and that Don Juan has no other business income or business losses. How much of the $600,000 loss will Don Juan be able to deduct this year? What happens to any loss not deducted this year?

26. Smithers is a self-employed individual who earns $30,000 per year in self- employment income. Smithers pays $2,200 in annual health insurance premiums (not through an exchange) for his own medical care. In each of the following situations, determine the amount of the deductible health insurance premium for Smithers before any AGI limitation.a) Smithers is single and the self-employment income is his only source of

income.b) Smithers is single, but besides being self-employed, Smithers is also employed

part-time by SF Power Corporation. This year Smithers elected not to participate in SF’s health plan.

c) Smithers is self-employed and he is also married. Smithers’s spouse, Samantha, is employed full-time by SF Power Corporation and is covered by SF’s health plan. Smithers is not eligible to participate in SF’s health plan.

d) Smithers is self-employed and he is also married. Smithers’s spouse, Samantha, is employed full-time by SF Power Corporation and is covered by SF’s health plan. Smithers elected not to participate in SF’s health plan.

27. Hardaway earned $100,000 of compensation this year. He also paid (or had paid for him) $3,000 of health insurance (not through an exchange). What is Hardaway’s AGI in each of the following situations? (Ignore the effects of Social Security and self-employment taxes.)a) Hardaway is an employee and his employer paid Hardaway’s $3,000 of health in-

surance for him as a nontaxable fringe benefit. Consequently, Hardaway received $97,000 of taxable compensation and $3,000 of nontaxable compensation.

b) Hardaway is a self-employed taxpayer, and he paid $3,000 of health insurance himself. He is not eligible to participate in an employer-sponsored plan.

28. Betty operates a beauty salon as a sole proprietorship. Betty also owns and rents an apartment building. This year Betty had the following income and expenses. Deter-mine Betty’s AGI and complete page 2 (through line 7) and Schedule 1 of Form 1040 for Betty. You may assume that Betty will owe $2,502 in self-employment tax on her salon income, with $1,251 representing the employer portion of the self-employment tax.You may also assume that her divorce from Rocky was finalized in 2016.

Interest income $11,255Salon sales and revenue 86,360Salaries paid to beauticians 45,250Beauty salon supplies 23,400Alimony paid to her ex-husband, Rocky 6,000Rental revenue from apartment building 31,220Depreciation on apartment building 12,900Real estate taxes paid on apartment building 11,100Real estate taxes paid on personal residence 6,241Contributions to charity 4,237

29. Lionel is an unmarried law student at State University Law School, a qualified educational institution. This year Lionel borrowed $24,000 from County Bank

LO 6-1

tax forms

LO 6-1

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2-32 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities

39. What are the basic differences between civil and criminal tax penalties?40. What are some of the most common civil penalties imposed on taxpayers?41. What are the taxpayer’s standards to avoid the substantial understatement of tax

penalty?42. What are the tax practitioner’s standards to avoid a penalty for recommending a tax

return position?

PROBLEMS

Select problems are available in Connect®.

43. Ahmed does not have enough cash on hand to pay his taxes. He was excited to hear that he can request an extension to file his tax return. Does this solve his problem? What are the ramifications if he doesn’t pay his tax liability by April 15?

44. Molto Stancha Corporation had zero earnings this fiscal year; in fact, it lost money. Must the corporation file a tax return?

45. The estate of Monique Chablis earned $450 of income this year. Is the estate required to file an income tax return?

46. Jamarcus, a full-time student, earned $2,500 this year from a summer job. He had no other income this year and will have zero federal income tax liability this year. His employer withheld $300 of federal income tax from his summer pay. Is Jamarcus required to file a tax return? Should Jamarcus file a tax return?

47. Shane has never filed a tax return despite earning excessive sums of money as a gambler. When does the statute of limitations expire for the years in which Shane has not filed a tax return?

48. Latoya filed her tax return on February 10 this year. When will the statute of limitations expire for this tax return?

49. Using the facts from the previous problem, how would your answer change if Latoya understated her income by 40 percent? How would your answer change if Latoya intentionally failed to report as taxable income any cash payments she received from her clients?

50. Paula could not reach an agreement with the IRS at her appeals conference and has just received a 90-day letter. If she wants to litigate the issue but does not have sufficient cash to pay the proposed deficiency, what is her best court choice?

51. In choosing a trial-level court, how should a court’s previous rulings influence the choice? How should circuit court rulings influence the taxpayer’s choice of a trial-level court?

52. Sophia recently won a tax case litigated in the 7th Circuit. She has just heard that the Supreme Court denied the writ of certiorari. Should she be happy or not, and why?

53. Campbell’s tax return was audited because she failed to report interest she earned on her tax return. What IRS audit selection method identified her tax return?

54. Yong’s tax return was audited because he calculated his tax liability incorrectly. What IRS audit procedure identified his tax return for audit?

55. Randy deducted a high level of itemized deductions two years ago relative to his income level. He recently received an IRS notice requesting documentation for his itemized deductions. What audit procedure likely identified his tax return for audit?

56. Jackie has a corporate client that has recently received a 30-day notice from the IRS with a $100,000 tax assessment. Her client is considering requesting an appeals conference to contest the assessment. What factors should Jackie advise her client to consider before requesting an appeals conference?

LO 2-7

LO 2-1

LO 2-2

planning

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CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-33

57. The IRS recently completed an audit of Shea’s tax return and assessed $15,000 ad-ditional tax. Shea requested an appeals conference but was unable to settle the case at the conference. She is contemplating which trial court to choose to hear her case. Provide a recommendation based on the following alternative facts:a) Shea resides in the 2nd Circuit, and the 2nd Circuit has recently ruled against the

position Shea is litigating.b) The Federal Circuit Court of Appeals has recently ruled in favor of Shea’s

position.c) The issue being litigated involves a question of fact. Shea has a very appealing

story to tell but little favorable case law to support her position.d) The issue being litigated is highly technical, and Shea believes strongly in her

interpretation of the law.e) Shea is a local elected official and would prefer to minimize any local publicity

regarding the case.58. Juanita, a Texas resident (5th Circuit), is researching a tax question and finds a 5th

Circuit case ruling that is favorable and a 9th Circuit case that is unfavorable. Which circuit case has more “authoritative weight” and why? How would your answer change if Juanita were a Kentucky resident (6th Circuit)?

59. Faith, a resident of Florida (11th Circuit), recently found a circuit court case that is favorable to her research question. Which two circuits would she prefer to have issued the opinion?

60. Robert has found a “favorable” authority directly on point for his tax question. If the authority is a court case, which court would he prefer to have issued the opinion? Which court would he least prefer to have issued the opinion?

61. Jamareo has found a “favorable” authority directly on point for his tax question. If the authority is an administrative authority, which specific type of authority would he prefer to answer his question? Which administrative authority would he least prefer to answer his question?

62. For each of the following citations, identify the type of authority (statutory, admin-istrative, or judicial) and explain the citation.a) Reg. Sec. 1.111-1(b)b) IRC Sec. 469(c)(7)(B)(i)c) Rev. Rul. 82-204, 1982-2 C.B. 192d) Amdahl Corp., 108 TC 507 (1997)e) PLR 9727004f) Hills v. Comm., 50 AFTR2d 82-6070 (11th Cir., 1982)

63. For each of the following citations, identify the type of authority (statutory, admin-istrative, or judicial) and explain the citation.a) IRC Sec. 280A(c)(5)b) Rev. Proc. 2004-34, 2004-1 C.B. 911c) Lakewood Associates, RIA TC Memo 95-3566d) TAM 200427004e) U.S. v. Muncy, 2008-2 USTC par. 50,449 (E.D., AR, 2008)

64. Justine would like to clarify her understanding of a code section recently enacted by Congress. What tax law sources are available to assist Justine?

65. Aldina has identified conflicting authorities that address her research question. How should she evaluate these authorities to make a conclusion?

66. Georgette has identified a 1983 court case that appears to answer her research question. What must she do to determine if the case still represents “current” law?

67. Sandy has determined that her research question depends upon the interpretation of the phrase “not compensated by insurance.” What type of research question is this?

LO 2-2

planning

LO 2-3

LO 2-4

LO 2-5

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4-38 CHAPTER 4 Individual Income Tax Overview, Dependents, and Filing Status

separate status. By changing his filing status, Doug sought a refund for an overpay-ment for the tax year 2019 (he paid more tax in the original joint return than he owed on a separate return). Is Doug allowed to change his filing status for the 2019 tax year and receive a tax refund with his amended return?

COMPREHENSIVE PROBLEMSSelect problems are available in Connect®.

54. Marc and Michelle are married and earned salaries this year of $64,000 and $12,000, respectively. In addition to their salaries, they received interest of $350 from municipal bonds and $500 from corporate bonds. Marc contributed $2,500 to an individual retirement account, and Marc paid alimony to a prior spouse in the amount of $1,500. Marc and Michelle have a 10-year-old son, Matthew, who lived with them throughout the entire year. Thus, Marc and Michelle are allowed to claim a $2,000 child tax credit for Matthew. Marc and Michelle paid $6,000 of expendi-tures that qualify as itemized deductions and they had a total of $3,500 in federal income taxes withheld from their paychecks during the course of the year.a) What is Marc and Michelle’s gross income?b) What is Marc and Michelle’s adjusted gross income?c) What is the total amount of Marc and Michelle’s deductions from AGI?d) What is Marc and Michelle’s taxable income?e) What is Marc and Michelle’s taxes payable or refund due for the year? (Use the

tax rate schedules.)f) Complete Marc and Michelle’s Form 1040 pages 1 and 2, and Schedule 1 (use

the most recent form available).55. Demarco and Janine Jackson have been married for 20 years and have four children

who qualify as their dependents (Damarcus, Janine, Michael, and Candice). The couple received salary income of $100,000 and qualified business income of $10,000 from an investment in a partnership, and they sold their home this year. They initially purchased the home three years ago for $200,000 and they sold it for $250,000. The gain on the sale qualified for the exclusion from the sale of a princi-pal residence. The Jacksons incurred $16,500 of itemized deductions, and they had $3,550 withheld from their paychecks for federal taxes. They are also allowed to claim a child tax credit for each of their children. However, because Candice is 18years of age, the Jacksons may claim a child tax credit for other qualifying dependents for Candice.a) What is the Jacksons’ taxable income, and what is their tax liability or (refund)?b) Complete page 1, page 2, and Schedule 1 of the Jacksons’ Form 1040 (use the

most recent form available).c) What would their taxable income be if their itemized deductions totaled $28,000

instead of $16,500?d) What would their taxable income be if they had $0 itemized deductions and

$6,000 of for AGI deductions?e) Assume the original facts but now suppose the Jacksons also incurred a loss of

$5,000 on the sale of some of their investment assets. What effect does the $5,000 loss have on their taxable income?

f) Assume the original facts but now suppose the Jacksons own investments that appreciated by $10,000 during the year. The Jacksons believe the investments will continue to appreciate, so they did not sell the investments during this year. What is the Jacksons’ taxable income?

tax forms

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VARIETY OF ASSIGNMENT MATERIAL

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ProblemsProblems are designed to test the comprehension of more complex topics. Each problem at the end of the chapter is tied to one of that chapter’s learning objectives, with multiple problems for critical topics.

Tax Forms ProblemsTax forms problems are a set of require-ments included in the end-of-chapter material of the 2020 edition. These problems require students to complete a tax form (or part of a tax form), provid-ing students with valuable experience and practice with filling out these forms. These requirements—and their relevant forms—are also included in Connect. Each tax form problem includes an icon to differentiate it from regular problems.

Research ProblemsResearch problems are special problems throughout the end-of-chapter assignment mate-rial. These require students to do both basic and more complex research on topics outside of the scope of the book. Each research problem includes an icon to differentiate it from regular problems.

Planning ProblemsPlanning problems are another unique set of problems included in the end-of-chapter assignment material. These re-quire students to test their tax planning skills after covering the chapter topics. Each planning problem includes an icon to differentiate it from regular problems.

Comprehensive and Tax Return ProblemsComprehensive and tax return problems address multiple concepts in a single problem. Comprehensive problems are ideal for cumulative topics; for this rea-son, they are located at the end of all chapters. In the end-of-book Appendix C, we include tax return problems that cover multiple chapters. Additional tax return problems are also available inConnectand Instructor Resource Center.These problems range from simple to complex and cover individual taxation, corporate taxation, partnership taxation, and S corporation taxation.

Students—study more efficiently, retain more and achieve better outcomes. Instructors—focus on what you love—teaching.

SUCCESSFUL SEMESTERS INCLUDE CONNECT

For Instructors

You’re in the driver’s seat.Want to build your own course? No problem. Prefer to use our turnkey, prebuilt course? Easy. Want to make changes throughout the semester? Sure. And you’ll save time with Connect’s auto-grading too.

65%Less Time Grading

spi69614_fm_i-xxxv.indd 12 2/22/19 8:49 PM

They’ll thank you for it.Adaptive study resources like SmartBook® help your students be better prepared in less time. You can transform your class time from dull definitions to dynamic debates. Hear from your peers about the benefits of Connect at www.mheducation.com/highered/connect

Make it simple, make it affordable. Connect makes it easy with seamless integration using any of the major Learning Management Systems—Blackboard®, Canvas, and D2L, among others—to let you organize your course in one convenient location. Give your students access to digital materials at a discount with our inclusive access program. Ask your McGraw-Hill representative for more information.

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Solutions for your challenges.A product isn’t a solution. Real solutions are affordable, reliable, and come with training and ongoing support when you need it and how you want it. Our Customer Experience Group can also help you troubleshoot tech problems—although Connect’s 99% uptime means you might not need to call them. See for yourself at status.mheducation.com

https://www.mheducation.com/highered/connect

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”

Chapter 12 Quiz Chapter 11 Quiz

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Chapter 13 Evidence of Evolution Chapter 11 DNA Technology

Chapter 7 DNA Structure and Gene...

and 7 more...

13 14

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For Students

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Effective, efficient studying.Connect helps you be more productive with your study time and get better grades using tools like SmartBook, which highlights key concepts and creates a personalized study plan. Connect sets you up for success, so you walk into class with confidence and walk out with better grades.

made it easy to study when “I really liked this app—it

you don't have your text-book in front of you.

- Jordan Cunningham, Eastern Washington University

Study anytime, anywhere.Download the free ReadAnywhere app and access your online eBook when it’s convenient, even if you’re offline. And since the app automatically syncs with your eBook in Connect, all of your notes are available every time you open it. Find out more at www.mheducation.com/readanywhere

No surprises. The Connect Calendar and Reports tools keep you on track with the work you need to get done and your assignment scores. Life gets busy; Connect tools help you keep learning through it all.

Learning for everyone. McGraw-Hill works directly with Accessibility Services Departments and faculty to meet the learning needs of all students. Please contact your Accessibility Services office and ask them to email [emailprotected], or visit www.mheducation.com/about/accessibility.html for more information.

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xiv

DIGITAL LEARNING ASSETS TO IMPROVE STUDENT OUTCOMES

“The quality of the online materials in Connect and Learnsmart are market-leading and unmatched in the tax arena.”

Jason W. Stanfield– Ball State University

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Connect helps students learn more effi-ciently by providing feedback and practice material when they need it, where they need it. Connect grades homework auto-matically and gives immediate feedback on any questions students may have missed. The extensive assignable, gradable end-of-chapter content includes problems, comprehensive problems (available as auto-graded tax forms), and discussion questions. Also, select questions have been redesigned to test students’ knowledge more fully. They now include tables for students to work through rather than requiring that all calculations be done offline.

Auto-Graded Tax FormsThe auto-graded Tax Formsin Connect provide a much-improved student experience when solving the tax-form based problems. The tax form simulation allows students to apply tax concepts by completing the actual tax forms online with automatic feedback and grading for both students and instructors.

Guided ExamplesThe Guided Examples, or “hint”videos, in Connect provide anarrated, animated, step-by-stepwalk-through of select problemssimilar to those assigned. Theseshort presentations can be turnedon or off by instructors and pro-vide reinforcement when studentsneed it most.

TaxACT®M c G ra w - H i l l ’s Taxation can be

packaged with tax software from TaxACT, one of the leading prep-aration software companies in the market today. The 2018 edition in-cludes availability of both Individuals and Business Entities software, including the 1040 Forms and TaxACT Preparer’s Business 3-Pack (with Forms 1065, 1120, and 1120S). Please note, TaxACT is only compatible with PCs and not Macs. However, we offer easy-to-complete licensing agreement templates that are accessible within Connect and the Instructor Resources Center to enable school computer labs to download the software onto campus hardware for free.

Roger’s CPAMcGraw-Hill Education has partnered with Roger CPA Review, a global leader in CPA Exam preparation, to provide students a smooth

transition from the accounting classroom to successful completion of the CPA Exam. While many aspiring accountants wait until they have completed their academic studies to begin preparing for the CPA Exam, research shows that those who become familiar with exam content earlier in the process have a stronger chance of successfully passing the CPA Exam. Accordingly, students using these McGraw-Hill materials will have access to sample CPA Exam multiple-choice questions and Task-based Simulations from Roger CPA Review, with expert-written explanations and solutions. All questions are either directly from the AICPA or are modeled on AICPA questions that appear in the exam. Task-based Simulations are delivered via the Roger CPA Review platform, which mirrors the look, feel, and functionality of the actual exam. McGraw-Hill Education and Roger CPA Review are dedicated to supporting every accounting student along their journey, ultimately helping them achieve career success in the accounting profes-sion. For more information about the full Roger CPA Review program, exam requirements, and exam content, visit www.rogercpareview.com.

McGraw-Hill Customer Experience Group Contact InformationAt McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can contact our Product Specialists 24 hours a day to get product training online. Or you can search the knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094, or visit www.mhhe.com/support. One of our Technical Support Analysts will be able to assist you in a timely fashion.

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xvi

Four Volumes to Fit

McGraw-Hill’s Taxation of Individuals is organized to empha-size topics that are most important to undergraduates taking their first tax course. The first three chapters provide an introduction to taxation and then carefully guide students through tax research and tax planning. Part II discusses the fundamental elements of individual income tax, starting with the tax formula in Chapter 4 and then proceeding to more discussion on income, deductions, investments, and computing tax liabilities in Chapters 5–8. Part III then discusses tax issues associated with business-related activities. Specifically, this part addresses business income and deductions, accounting methods, and tax consequences associated with purchasing assets and property dispositions (sales, trades, or other dispositions). Part IV is unique among tax textbooks; this section combines related tax issues for compensation, retirement savings, and home ownership.Part I: Introduction to Taxation 1. An Introduction to Tax2. Tax Compliance, the IRS, and Tax Authorities

3. Tax Planning Strategies and Related LimitationsPart II: Basic Individual Taxation 4. Individual Income Tax Overview, Dependents, and Filing

Status 5. Gross Income and Exclusions 6. Individual Deductions 7. Investments 8. Individual Income Tax Computation and Tax CreditsPart III: Business-Related Transactions 9. Business Income, Deductions, and Accounting Methods10. Property Acquisition and Cost Recovery11. Property DispositionsPart IV: Specialized Topics12. Compensation13. Retirement Savings and Deferred Compensation14. Tax Consequences of Home Ownership

McGraw-Hill’s Taxation of Business Entities begins with the process for determining gross income and deductions for businesses, and the tax consequences associated with purchasing assets and property dispositions (sales, trades, or other disposi-tions). Part II provides a comprehensive overview of entities and the formation, reorganization, and liquidation of corporations. Unique to this series is a complete chapter on accounting for income taxes, which provides a primer on the basics of calculating the income tax provision. Included in the narrative is a discussion of temporary and permanent differences and their impact on a company’s book “effective tax rate.” Part III provides a detailed discussion of partnerships and S corporations. The last part of the book covers state and local taxation, multinational taxation, and transfer taxes and wealth planning.Part I: Business-Related Transactions

Business Income, Deductions, and Accounting Methods2. Property Acquisition and Cost Recovery3. Property Dispositions

Part II: Entity Overview and Taxation of C Corporations4.

Entities Overview5. Corporate Operations6. Accounting for Income Taxes7. Corporate Taxation: Nonliquidating Distributions8. Corporate Formation, Reorganization, and Liquidation

Part III: Taxation of Flow-Through Entities 9.

Forming and Operating Partnerships10. Dispositions of Partnership Interests and Partnership

Distributions11. S CorporationsPart IV: Multijurisdictional Taxation and Transfer Taxes12.

State and Local Taxes13. The U.S. Taxation of Multinational Transactions14. Transfer Taxes and Wealth Planning

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xvii

Four Course Approaches

McGraw-Hill’s Taxation of Individuals and Business Entities covers all chapters included

in the two split volumes in one convenient volume.See Table of Contents.

Part I: Introduction to Taxation

An Introduction to Tax2. Tax Compliance, the IRS, and Tax Authorities3. Tax Planning Strategies and Related Limitations

Part II: Basic Individual Taxation

Individual Income Tax Overview, Dependents, and Filing Status

5. Gross Income and Exclusions6. Individual Deductions7. Investments8. Individual Income Tax Computation and Tax Credits

Part III: Business-Related Transactions 9.

Business Income, Deductions, and Accounting Methods10. Property Acquisition and Cost Recovery11. Property DispositionsPart IV: Specialized Topics12.

Compensation13. Retirement Savings and Deferred Compensation14. Tax Consequences of Home OwnershipPart V: Entity Overview and Taxation of C Corporations15.

Entities Overview16. Corporate Operations17. Accounting for Income Taxes18. Corporate Taxation: Nonliquidating Distributions19. Corporate Formation, Reorganization, and LiquidationPart VI: Taxation of Flow-Through Entities20.

Forming and Operating Partnerships

21. Dispositions of Partnership Interests and Partnership Distributions

22. S CorporationsPart VII: Multijurisdictional Taxation and Transfer Taxes23.

State and Local Taxes24. The U.S. Taxation of Multinational Transactions25. Transfer Taxes and Wealth Planning

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McGraw-Hill’s Essentials of Federal Taxation is designed for a one-semester course, covering the basics of taxation of individu-als and business entities. To facilitate a one-semester course, McGraw-Hill’s Essentials of Federal Taxation folds the key top-ics from the investments, compensation, retirement savings, and home ownership chapters in Taxation of Individuals into three individual taxation chapters that discuss gross income and exclu-sions, for AGI deductions, and from AGI deductions, respec-tively. The essentials volume also includes a two-chapter C corporation sequence that uses a life-cycle approach covering corporate formations and then corporate operations in the first chapter and nonliquidating and liquidating corporate distribu-tions in the second chapter. This volume is perfect for those teaching a one-semester course and for those who struggle to get through the 25-chapter comprehensive volume.Part I: Introduction to Taxation

An Introduction to Tax2. Tax Compliance, the IRS, and Tax Authorities3. Tax Planning Strategies and Related Limitations

Part II: Individual Taxation4.

Individual Income Tax Overview, Dependents, and Filing Status

5. Gross Income and Exclusions6. Individual For AGI Deductions7. Individual From AGI Deductions8. Individual Income Tax Computation and Tax Credits

Part III: Business-Related Transactions 9.

Business Income, Deductions, and Accounting Methods10. Property Acquisition and Cost Recovery11. Property DispositionsPart IV: Entity Overview and Taxation of C Corporations12.

Entities Overview13. Corporate Formations and Operations14. Corporate Nonliquidating and Liquidating DistributionsPart V: Taxation of Flow-Through Entities15.

Forming and Operating Partnerships16. Dispositions of Partnership Interests and Partnership

Distributions17. S Corporations

xviii

SUPPLEMENTS FOR INSTRUCTORSAssurance of Learning ReadyMany educational institutions today are focused on the notion of assurance of learning, an im-portant element of many accreditation stan-dards. McGraw-Hill’s Taxation is designedspecifically to support your assurance of learn-ing initiatives with a simple, yet powerful, solution.

Each chapter in the book begins with a list of numbered learning objectives, which appear throughout the chapter as well as in the end-of-chapter assignments. Every test bank question for McGraw-Hill’s Taxation maps to a specific chapter learning objective in the textbook. Each test bank question also identifies topic area, level of difficulty, Bloom’s Taxonomy level, and AICPA and AACSB skill area.

AACSB StatementMcGraw-Hill Education is a proud corporate member of AACSB International. Understand-ing the importance and value of AACSB ac-creditation, McGraw-Hill’s Taxation recognizes the curricula guidelines detailed in the AACSB standards for business accreditation by connect-ing selected questions in the text and the test bank to the general knowledge and skill guide-lines in the revised AACSB standards.

The statements contained in McGraw-Hill’s Taxation are provided only as a guide for the users of this textbook. The AACSB leaves con-tent coverage and assessment within the pur-view of individual schools, the mission of the school, and the faculty. While McGraw-Hill’s Taxation and the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within the text and test bank, labeled selected questions according to the eight general knowledge and skill areas.

TestGenTestGen is a complete, state-of-the-art test gen-erator and editing application software that al-lows instructors to quickly and easily select test items from McGraw Hill’s TestGen testbank content and to organize, edit, and customize the questions and answers to rapidly generate paper tests. Questions can include stylized text, sym-bols, graphics, and equations that are inserted directly into questions using built-in mathemat-ical templates. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a test generator system for today’s educators.

A HEARTFELT THANKS TO THE MANY COLLEAGUES WHO SHAPED THIS BOOKThe version of the book you are reading would not be the same book without the valuable suggestions, keen insights, and constructive criticisms of the list of reviewers below. Each professor listed here contributed in substantive ways to the organization of chapters, coverage of topics, and use of pedagogy. We are grateful to them for taking the time to read chapters or attend reviewer conferences, focus groups, and symposia in support of the development for the book:

Previous Edition ReviewersDonna Abelli, Mount Ida CollegeJoseph Assalone,Rowan College at Gloucester CountyDr. Valeriya Avdeev,William Paterson UniversityRobyn Barrett,St. Louis Community CollegeKevin Baugess, ICDC CollegeChristopher Becker, Coastal Carolina UniversityJeanne Bedell, Keiser UniversityMarcia Behrens,Nichols CollegeMichael Belleman,St. Clair County Community College David Berman,Community College of PhiladelphiaTim Biggart, Berry College

Cynthia Bird,Tidewater Community CollegeLisa Blum, University of LouisvilleRick Blumenfeld,Sierra CollegeCindy Bortman Boggess, Babson CollegeCathalene Bowler, University of Northern IowaJustin Breidenbach,Ohio Wesleyan UniversitySuzon Bridges, Houston Community CollegeStephen Bukowy, UNC PembrokeEsther Bunn,Stephen F. Austin State UniversityHolly Caldwell, Bridgewater CollegeJames Campbell,Thomas CollegeAlisa Carini,UCSD Extension

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xix

Ronald Carter, Patrick Henry Community CollegeCynthia Caruso, Endicott CollegePaul Caselton,University of Illinois–SpringfieldAmy Chataginer,Mississippi Gulf Coast Community CollegeMachiavelli Chao,University of California–IrvineMax Chao, University of California–IrvineChristine Cheng,Louisiana State UniversityLisa Church,Rhode Island CollegeMarilyn Ciolino,Delgado Community CollegeWayne Clark,Southwest Baptist UniversityAnn Cohen,University at Buffalo, SUNYSharon Cox, University of Illinois–Urbana-ChampaignTerry Crain, University of Oklahoma–NormanRoger Crane, Indiana University EastCheryl Crespi, Central Connecticut State UniversityBrad Cripe, Northern Illinois UniversityCurtis J. Crocker, Southern Crescent Technical CollegeRichard Cummings, University of Wisconsin–WhitewaterJoshua Cutler, University of HoustonWilliam Dams, Lenoir Community CollegeNichole Dauenhauer,Lakeland Community CollegeSusan Snow Davis, Green River CollegeJim Desimpelare, University of Michigan–Ann ArborJulie Dilling,Moraine Park Technical CollegeSteve Dombrock,Carroll UniversityDr. Vicky C. Dominguez, College of Southern NevadaMichael P. Donohoe, University of Illinois–Urbana-ChampaignJohn Dorocak, California State University–San BerdinadoAmy Dunbar, University of Connecticut–StorrsJohn Eagan, Morehouse CollegeReed Easton,Seton Hall UniversityEsther Ehrlich, CPA, The University of Texas at El PasoElizabeth Ekmekjian, William Paterson UniversityAnn Esarco, Columbia College ColumbiaFrank Faber,St. Joseph’s CollegeMichael fa*gan,Raritan Valley Community CollegeFrank Farina, Catawba CollegeAndrew Finley,Claremont McKennaTim Fogarty,Case Western Reserve UniversityMimi Ford,Middle Georgia State UniversityWilhelmina Ford,Middle Georgia State UniversityGeorge Frankel,San Francisco State UniversityLawrence Friedken,Penn State UniversityStephen Gara, Drake UniversityRobert Gary, University of New MexicoGreg Geisler, Indiana UniversityEarl Godfrey, Gardner Webb UniversityThomas Godwin, Purdue UniversityDavid Golub, Northeastern UniversityMarina Grau,Houston Community CollegeBrian Greenstein, University of DelawarePatrick Griffin,Lewis UniversityLillian Grose,University of Holy CrossRosie Hagen,Virginia Western Community CollegeMarcye Hampton, University of Central FloridaCass Hausserman, Portland State UniversityRebecca Helms,Ivy Tech Community CollegeMelanie Hicks, Liberty UniversityMary Ann Hofmann, Appalachian State UniversityRobert Joseph Holdren,Muskingum University

Bambi Hora,University of Central OklahomaCarol Hughes,Asheville Buncombe Technical Community CollegeHelen Hurwitz, Saint Louis UniversityRik Ichiho,Dixie State UniversityKerry Inger, Auburn UniversityPaul Johnson,Mississippi Gulf Coast CC–JD CampusAthena Jones, University of Maryland University CollegeAndrew Junikiewicz, Temple UniversitySusan Jurney, University of Arkansas–FayettevilleSandra Kemper, Regis UniversityJon Kerr,Baruch College–CUNYLara Kessler,Grand Valley State UniversityJanice Klimek,University of Central MissouriPamela Knight,Columbus Technical CollegeSatoshi Kojima, East Los Angeles CollegeDawn Konicek,Idaho State UniversityJack Lachman, Brooklyn CollegeBrandon Lanciloti,Freed-Hardeman UniversityStacie Laplante, University of Wisconsin–MadisonSuzanne Laudadio,Durham TechStephanie Lewis, Ohio State University–ColumbusTroy Lewis, Brigham Young UniversityTeresa Lightner, University of North TexasRobert Lin, California State University–East BayChris Loiselle, Cornerstone UniversityBruce Lubich,Penn State–HarrisburgElizabeth Lyon, California State University–SacramentoNarelle Mackenzie, San Diego State University, National UniversityMichael Malmfeldt,Shenandoah UniversityKate Mantzke, Northern Illinois UniversityRobert Martin, Kennesaw State UniversityAnthony Masino, East Tennessee State UniversityPaul Mason, Baylor UniversityLisa McKinney, University of Alabama at Birmingham Allison McLeod, University of North TexasLois McWhorter,Somerset Community CollegeJanet Meade, University of HoustonMichele Meckfessel, University of Missouri–St. LouisFrank Messina, University of Alabama at BirminghamR Miedaner, Lee UniversityKen Milani,University of Notre DameKaren Morris,Northeast Iowa Community CollegeStephanie Morris, Mercer UniversityMichelle Moshier, University at AlbanyLeslie Mostow, University of Maryland–College ParkJames Motter, Indiana University-Purdue University IndianapolisJackie Myers, Sinclair Community CollegeMichael Nee, Cape Cod Community CollegeLiz Ott, Casper CollegeSandra Owen, Indiana State University–BloomingtonEdwin Pagan,Passaic County Community CollegeJeff Paterson, Florida State UniversityRonald Pearson, Bay CollegeMartina Peng,Franklin University Michael Watne Penn, Jr, The University of IllinoisJames Pierson, Franklin UniversitySonja Pippin,University of Nevada–RenoJonathan David Pittard, University of California–RiversideAnthony Pochesci, Rutgers University

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Kyle Post, Tarleton State UniversityChristopher Proschko, Texas State UniversityJoshua Racca, University of AlabamaFrancisco Rangel, Riverside City CollegePauline Ash Ray, Thomas UniversityLuke Richardson, University of South FloridaRodney Ridenour,Montana State University NorthernJohn Robertson,Arkansas State UniversitySusan Robinson,Georgia Southwestern State UniversityMorgan Rockett,Moberly Area Community CollegeMiles Romney, Michigan State UniversityAnanth Seetharaman, Saint Louis UniversityAlisa Shapiro,Raritan Valley Community CollegeDeanna Sharpe, University of MissouriWayne Shaw,Southern Methodist UniversitySonia Singh,University of FloridaGeorgi Smatrakalev, Florida Atlantic UniversityLucia Smeal, Georgia State UniversityPamela Smith, University of Texas at San AntonioAdam Spoolstra,Johnson County Community CollegeJoe Standridge,Sonoma State Jason Stanfield, Ball State UniversityGeorge Starbuck,McMurry UniversityJames Stekelberg, University of Arizona

Shane Stinson, University of AlabamaTerrie Stolte, Columbus State Community CollegeGloria Jean Stuart, Georgia Southern UniversityKenton Swift, University of MontanaMaryBeth Tobin, Bridgewater State UniversityErin Towery, The University of GeorgiaRonald Unger,Temple UniversityKaren Wallace, Ramapo CollegeNatasha Ware,Southeastern UniversityLuke Watson, University of FloridaSarah Webber, University of DaytonCassandra Weitzenkamp, Peru State CollegeMarvin Williams, University of Houston–DowntownChris Woehrle, American CollegeJennifer Wright, Drexel UniversityMassood Yahya-Zadeh, George Mason UniversityJames Yang, Montclair State UniversityScott Yetmar, Cleveland State UniversityCharlie Yuan, Elizabeth City State UniversityXiaoli Yuan,Elizabeth City State UniversityZhen Zhang, Towson UniversityMingjun Zhou, DePaul University

AcknowledgmentsWe would like to thank the many talented people who made valuable contributions to the creation of this eleventh edition. William A. Padley of Madison Area Technical College, Deanna Sharpe of the University of Missouri–Columbia, Troy Lewis of Brigham Young University, and Dr. Jason Stanfield of Ball State University checked the page proofs and solutions manual for accuracy; we greatly appreciate the hours they spent checking tax forms and double-checking our calculations throughout the book. Teressa Farough, Troy Lewis, and David Chamberlain ofCal Poly–Orfalea accuracy checked the test bank. Thank you to Troy Lewis,Monika Turek, and Jason Stanfield for your contributions to the Smartbook revision for this edition. Special thanks to Troy Lewis for his sharp eye and valuable feedback throughout the revision process. Thanks as well to Helena Hunt from Agate Publishing for managing the supplement process. Finally, Jason Stanfield, Deanna Sharpe, and Vivian Paige of Old Dominion University greatly contributed to the accuracy of McGraw-Hill’s Connect for the 2020 edition.

We also appreciate the expert attention given to this project by the staff at McGraw-Hill Education, especially Tim Vertovec, Managing Director; Kathleen Klehr, Executive Portfolio Manager; Danielle McLimore, Assessment Product Developer; Erin Quinones, Core Product Developer; Lori Koetters, Brian Nacik, and Jill Eccher, Content Project Managers; Jessica Cuevas, Designer; Natalie King, Marketing Director; Zach Rudin, Marketing Manager; and Sue Culbertson, Senior Buyer.

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Changes in Taxation of Individuals and Business Entities, 2020 EditionFor the 2020 edition of McGraw-Hill’s Taxation of Individuals and Business Entities, many changes were made in response to feedback from reviewers and focus group participants:

∙ All tax forms have been updated for the latest available tax form as of March 2019. In addition, chapter content throughout the text has been updated to reflect tax law changes through March 2019.

Other notable changes in the 2019 edition include:

Chapter 1

∙

Updated tax rates for 2019 and Examples 1-3 through 1-7.

∙ Updated Social Security Wage base for 2019.∙ Updated unified Tax Credit for 2019.∙ Updated Taxes in the Real World: National Debt for

current debt limit.

Chapter 2

∙

Updated gross income thresholds by filing status for 2019.

∙ Enhanced discussion of statute of limitations. ∙ Updated penalty amounts for failure to file a tax

return and failure to pay tax owed.

Chapter 3

∙

Updated tax rates for 2019.∙ Updated Exhibit 3-3 for new tax rates post-TCJA.∙ Modified Example 3-4 to clarify the solution.

Chapter 4

∙

Edited discussion of Form 1040 to match up with revised tax forms.

∙ Updated Exhibit 4-7 to reflect standard deduction amounts for 2019.

∙ Updated tax rates for 2019 rates.∙ Clarified discussion on tiebreaker rules for qualifying

child. ∙ Revised discussion question 11.∙ Updated tax forms from 2017 to 2018.

Chapter 5

∙

Updated for 2019 amounts for qualified transporta-tion benefits.

∙ Updated for 2019 flexible spending account contributions.

∙ Updated for 2019 foreign income exclusion amounts.∙ Updated for annual gift tax exclusion and unified tax

credit for 2019.

∙

Updated U.S. Series EE Bond interest income exclusion for 2019.

∙ Updated tax forms from 2017 to 2018.

Chapter 6

∙

Updated excess business loss limitation for 2019.∙ Updated discussion of deduction for interest on

qualified education loan for 2019.∙ Updated AGI floor for medical expense itemized

deduction for 2019.∙ Updated mileage rate for medical expense itemized

deduction for 2019.∙ Added a Taxes in the Real World on state and local

tax credits and charitable contributions.∙ Revised discussion of casualty and theft losses on

personal-use assets.∙ Updated standard deduction amounts for 2019

amounts.∙ Expanded discussion for deduction for qualified

business income and updated for 2019.∙ Updated tax forms from 2017 to 2018.

Chapter 7

∙

Updated tax rates in all examples and problems for 2019.

∙ Updated Exhibit 7-3.∙ Updated examples for changes in capital gains tax

rate thresholds.∙ Revised the discussion of capital gains netting

process to illustrate a simpler process for taxpayers that only have 0/15/20 percent long-term capital gains.

∙ Updated tax forms from 2017 to 2018.

Chapter 8

∙

Updated tax rate schedules for 2019.∙ Moved discussion of net investment income tax to

additional tax section.∙ Updated discussion of kiddie tax for 2019.∙ Updated AMT exemption and tax rate schedule

for 2019. ∙ Updated Social Security tax wage base and

self- employment tax base for 2019.∙ Updated lifetime learning credit phase-out

for 2019.

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xxii

∙ Updated earned income credit amounts for 2019.∙ Updated tax forms from 2017 to 2018.

Chapter 9

∙ Updated tax forms from 2017 to 2018. ∙ Updated definition of interest for the business

interest limitation to conform with proposed regulations.

∙ Added a new Taxes in the Real World on the all-events test for rebate payments.

∙ Added two new research problems.∙ Added a description of the latest IRS position on the

deduction of business meals in conjunction with nondeductible entertainment.

∙ Added example and homework problems on the deduction of business meals.

∙ Revised examples and text discussion for updated 2018 mileage rates.

∙ Expanded description of accounting exceptions for small businesses (average annual gross receipts of $26 million or less in prior three years).

Chapter 10

∙

Updated Exhibit 10-2 for Weyerhaueser’s 2017 assets.

∙ Updated tax rates for 2019.∙ Revised section on §179 amounts to reflect the

inflation adjustments for 2019.∙ Updated examples for 2019 §179 amounts.∙ Clarified treatment of bonus depreciation for AMT

purposes.∙ Updated discussion and Exhibit 10-10 relating to

automobile depreciation limits.∙ Updated §179 amount for SUVs for 2019 inflation

amount changes.∙ Updated tax forms from 2017 to 2018.∙ Updated and revised end-of-chapter problems for

§179 amounts and bonus depreciation rules.

Chapter 11

∙

Updated tax rates for 2019.∙ Updated Exhibit 11-6 for changes to recapture.∙ Clarified discussion of §1250 recapture as it applies

to qualified improvement property placed in service prior to 2018.

∙ Modified discussion of §1239 gains.∙ Modified discussion on like-kind exchanges to

clarify purpose of a third-party deferred like-kind exchange.

∙ Updated discussion of boot given in like-kind exchange.

∙ Added definition of condemnation.

∙

Added clarification of amortization of foreign R&E expenditures post-December 31, 2021.

∙ Updated tax forms from 2017 to 2018 forms.

Chapter 12

∙

Substantially revised discussion of salary and wages.∙ Substantially revised discussion of equity-based

compensation.∙ Updated qualified transportation fringe benefit

amounts for 2019.∙ Updated tax forms to 2018.∙ Updated Taxes in the Real World for 2018 proxy

statement information.

Chapter 13

∙

Updated footnote 1 to reflect the 2018 OASDI Trustees report.

∙ Updated inflation adjusted limits for defined benefit plans, defined contribution plans, and individually managed plans.

∙ Removed old Exhibit from Coca-Cola proxy state-ment (old Exhibit 13-6) and integrated a summary description in the text.

∙ Inserted new footnote providing citation to authority for exceptions to 10 percent early distribution penalty.

∙ Expanded discussion about making IRA contributions for the prior year after year-end.

∙ Added discussion to footnote dealing with rollovers from traditional IRAs to Roth IRAs.

∙ Updated modified AGI phase-out thresholds for deductible contributions to traditional IRAs and contributions to Roth IRAs.

∙ Updated calculations for limits on self-employed retirement accounts to reflect updated 2019 Social Security wage base limitation.

∙ Updated saver’s credit information for 2019.

Chapter 14

∙

Updated Taxes in the Real World dealing with online rental communities such as Airbnb.

∙ Added discussion and an example describing and illustrating when a loan called a “home equity loan” by a bank is considered to be acquisition debt for tax purposes.

∙ Revised LO 14-3 to emphasize home mortgage interest deduction.

∙ Revised discussion of the IRS method and the Tax Court method to reflect the circ*mstances in which each is more favorable given the new tax law.

∙ Clarified discussion about home office expense requirements.

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xxiii

∙

Revised discussion questions 12, 14, 25, and 32.∙ Revised problems 46, 47, 48, and 68.∙ Updated solutions to reflect 2019 inflation-adjusted

numbers.∙ Updated tax forms from 2017 to 2018.∙ Updated settlement statement in Appendix A to

reflect 2019 information.

Chapter 15

∙

Revised section describing the self-employment tax and the additional Medicare tax.

∙ Updated the discussion on specified service trades or businesses for purposes of the deduction for qualified business income and included reference to new regu-lation dealing with what constitutes a specified trade or business.

∙ Updated Social Security wage base limitation for 2019, including related calculations.

∙ Revised numbers in Example 15-4.∙ Eliminated detailed discussion about pre-2018

individual and corporate tax rates.∙ Eliminated discussion about pre-2018 dividends

received deduction percentages.∙ Included more discussion relating to the dividends

received deduction.∙ Replaced discussion question 5.

Chapter 16

∙

Updated the discussion on stock option compensation.∙ Revised Taxes in the Real World for Facebook stock

options.∙ Updated the compliance section for new year-end

filing.

Chapter 17

∙

Updated the Taxes in the Real World saga of Weatherford.

∙ Updated chapter material to incorporate the new FASB rules on disclosures of deferred tax assets and liabilities.

∙ Updated the Microsoft uncertain tax benefit footnote disclosure.

∙ Updated the FASB’s projects involving accounting for income taxes.

Chapter 18

∙

Condensed the facts of the story.∙ Clarified explanation of the ordering of E&P

distributions.∙ Introduced a research problem illustrating the

calculation of E&P when distributions include both dividends and stock redemptions.

Chapter 19

∙

Clarified some definitions and terms throughout the chapter.

∙ Revised explanation of basis calculation when share-holders receive boot in a §351 transaction.

∙ Revised illustration of a gain or loss calculation for a §351 transaction with boot.

∙ Added two problems illustrating basis and gain and loss calculation for §351 transactions.

Chapter 20

∙

Updated discussion on the new rule dealing with the availability of the cash method of accounting for partnerships to reflect inflation adjustment.

∙ Updated discussion on new excess business loss limi-tation and how it interacts with other loss limitation rules to reflect inflation adjustments.

∙ Updated tax forms from 2017 to 2018.∙ Revised Taxes in the Real World example.∙ Revised end of chapter problems to reflect inflation

adjustments.

Chapter 21

∙

Revised Taxes in the Real World example.∙ Added new end of chapter problem on Section 754

basis step-ups.

Chapter 22

∙

Updated excess business loss limitation for 2019.∙ Updated Social Security tax wage base for 2018.∙ Updated tax forms from 2017 to 2018.

Chapter 23

∙

Substantially revised sales and use tax discussion.∙ Updated sales tax nexus for Wayfair vs. South

Dakota.∙ Substantially revised the discussion of income tax

nexus.∙ Substantially revised the discussion of Public Law

86-272.

Chapter 24

∙

Updated the discussion on the OECD base erosion and profit-shifting project.

∙ Updated the proposals for international tax reform.∙ Updated the discussion on inversions.

Chapter 25

∙

Revised text and Exhibit 25-2 for changes in the ex-emption equivalent.

∙ Revised calculations, text descriptions, and examples to reflect inflation changes.

∙ Added new problem illustrating incomplete gifts.∙ Replaced Exhibit 25-5 with 2018 Form 709.

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xxiv

∙

Replaced Exhibit 25-8 with 2019 Form 706.∙ Included a new Taxes in the Real World discussing

the role of wills in the estate tax.

∙

Added illustration reconciling the gift and estate tax formulas.

∙ Clarified the description and illustration of retained estates.

As We Go to Press

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The 2020 Edition is current through March, 2019. You can visit the Connect Library for updates that occur after this date.

xxv

Table of Contents

1 An Introduction to TaxWho Cares about Taxes and Why? 1-2

What Qualifies as a Tax? 1-4

How to Calculate a Tax 1-5

Different Ways to Measure Tax Rates 1-5

Tax Rate Structures 1-8Proportional Tax Rate Structure 1-9Progressive Tax Rate Structure 1-9Regressive Tax Rate Structure 1-10

Types of Taxes 1-11Federal Taxes 1-11

Income Tax 1-12

Employment and Unemployment Taxes 1-12

Excise Taxes 1-13

Transfer Taxes 1-13

State and Local Taxes 1-14Income Taxes 1-14

Sales and Use Taxes 1-14

Property Taxes 1-15

Excise Taxes 1-15

Implicit Taxes 1-16

Evaluating Alternative Tax Systems 1-17Sufficiency 1-18

Static versus Dynamic Forecasting 1-18

Income versus Substitution Effects 1-19

Equity 1-20Horizontal versus Vertical Equity 1-21

Certainty 1-22Convenience 1-22Economy 1-22Evaluating Tax Systems—The Trade-Offs 1-23

Conclusion 1-23

2 Tax Compliance, the IRS, and Tax AuthoritiesTaxpayer Filing Requirements 2-2

Tax Return Due Date and Extensions 2-3Statute of Limitations 2-3

IRS Audit Selection 2-4Types of Audits 2-5

After the Audit 2-6

Tax Law Sources 2-9Legislative Sources: Congress and the

Constitution 2-11Internal Revenue Code 2-11

The Legislative Process for Tax Laws 2-12

Basic Organization of the Code 2-13

Tax Treaties 2-14

Judicial Sources: The Courts 2-14Administrative Sources: The U.S. Treasury 2-15

Regulations, Revenue Rulings, and Revenue Procedures 2-15

Letter Rulings 2-16

Tax Research 2-17Step 1: Understand Facts 2-17Step 2: Identify Issues 2-17Step 3: Locate Relevant Authorities 2-18Step 4: Analyze Tax Authorities 2-19Step 5: Document and Communicate the

Results 2-21Facts 2-21

Issues 2-21

Authorities 2-22

Conclusion 2-22

Analysis 2-22

Client Letters 2-22

Tax Professional Responsibilities 2-23

Taxpayer and Tax Practitioner Penalties 2-26

Conclusion 2-28

3 Tax Planning Strategies and Related LimitationsBasic Tax Planning Overview 3-2

Timing Strategies 3-2Present Value of Money 3-3The Timing Strategy When Tax Rates Are

Constant 3-4The Timing Strategy When Tax Rates

Change 3-7Limitations to Timing Strategies 3-10

Income-Shifting Strategies 3-11Transactions between Family Members

and Limitations 3-12

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xxvi Table of Contents

Transactions between Owners and Their Businesses and Limitations 3-12

Income Shifting across Jurisdictions and Limitations 3-15

Conversion Strategies 3-15Limitations of Conversion Strategies 3-18

Additional Limitations to Tax Planning Strategies: Judicially Based Doctrines 3-18

Tax Avoidance versus Tax Evasion 3-19

Conclusion 3-20

4 Individual Income Tax Overview, Dependents, and Filing StatusThe Individual Income Tax Formula 4-2

Gross Income 4-2Character of Income 4-3

Deductions 4-7For AGI Deductions 4-7

From AGI Deductions 4-7

Income Tax Calculation 4-9Other Taxes 4-10Tax Credits 4-10Tax Prepayments 4-10

Dependents of the Taxpayer 4-11Dependency Requirements 4-11

Qualifying Child 4-11

Qualifying Relative 4-13

Filing Status 4-17Married Filing Jointly and Married Filing

Separately 4-18Qualifying Widow or Widower (Surviving

Spouse) 4-19Single 4-19Head of Household 4-19

Married Individuals Treated as Unmarried (Abandoned Spouse) 4-21

Summary of Income Tax Formula 4-22

Conclusion 4-24

Appendix A: Dependency Exemption Flowchart (Part I) 4-25

Appendix A: (Part II) 4-26

Appendix B: Qualifying Person for Head of Household Filing Status Flowchart 4-27

Appendix C: Determination of Filing Status Flowchart 4-28

5 Gross Income and ExclusionsRealization and Recognition of Income 5-2

What Is Included in Gross Income? 5-2Economic Benefit 5-3

spi69614_fm_i-xxxv.indd 26 2/22/19 8:49 PM

Realization Principle 5-3

Recognition 5-4

Other Income Concepts 5-4Form of Receipt 5-4

Return of Capital Principle 5-4

Recovery of Amounts Previously Deducted 5-5

When Do Taxpayers Recognize Income? 5-6Accounting Methods 5-6

Constructive Receipt 5-7

Claim of Right 5-7

Who Recognizes the Income? 5-8Assignment of Income 5-8

Community Property Systems 5-8

Types of Income 5-9Income from Services 5-10Income from Property 5-10

Annuities 5-11

Property Dispositions 5-13

Other Sources of Gross Income 5-14Income from Flow-Through Entities 5-14

Alimony 5-14

Prizes, Awards, and Gambling Winnings 5-16

Social Security Benefits 5-17

Imputed Income 5-19

Discharge of Indebtedness 5-20

Exclusion Provisions 5-21Common Exclusions 5-21

Municipal Bond Interest 5-21

Gains on the Sale of Personal Residence 5-22

Fringe Benefits 5-23

Education-Related Exclusions 5-25Scholarships 5-25

Other Educational Subsidies 5-26

U.S. Series EE Bonds 5-26

Exclusions That Mitigate Double Taxation 5-27Gifts and Inheritances 5-27

Life Insurance Proceeds 5-27

Foreign-Earned Income 5-28

Sickness and Injury-Related Exclusions 5-29Workers’ Compensation 5-29

Payments Associated with Personal Injury 5-29

Health Care Reimbursem*nt 5-30

Disability Insurance 5-30

Deferral Provisions 5-31

Income Summary 5-31

Table of Contents xxvii

Conclusion 5-32

Appendix: 2018 Social Security Worksheet from Form 1040 Instructions 5-33

6 Individual DeductionsDeductions for AGI 6-2

Deductions Directly Related to Business Activities 6-2Trade or Business Expenses 6-3

Rental and Royalty Expenses 6-5

Losses on Dispositions 6-6

Flow-Through Entities 6-6

Excess Business Loss Limitation 6-6

Deductions Indirectly Related to Business Activities 6-7Moving Expenses 6-7

Health Insurance Deduction by Self-Employed Taxpayers 6-7

Self-Employment Tax Deduction 6-7

Penalty for Early Withdrawal of Savings 6-8

Deductions Subsidizing Specific ActivitiesDeduction for Interest on Qualified Edu

Loans 6-9

Summary: Deductions for AGI 6-10

Deductions from AGI: Itemized Deductions Medical Expenses 6-11

Transportation and Travel for Medical Purposes 6-13

Hospitals and Long-Term Care Facilities

Medical Expense Deduction Limitation

Taxes 6-14Interest 6-15Charitable Contributions 6-16

Contributions of Money 6-17

Contributions of Property Other Than Money 6-17

Charitable Contribution Deduction Limitations 6-19

Casualty and Theft Losses on Personal-Use Assets 6-21

Other Itemized Deductions 6-21Summary of Itemized Deductions 6-22

The Standard Deduction 6-24Standard Deduction 6-24

Bunching Itemized Deductions 6-26

Deduction for Qualified Business Income 6-26Deduction for Qualified Business

Income 6-26Limitations 6-28Taxable Income Summary 6-30

Conclusion 6-31

6-8catio

6-11

6-1

6-13

7 InvestmentsInvestments Overview 7-2

Portfolio Income: Interest and Dividends 7-2Interest 7-3

Corporate and U.S. Treasury Bonds 7-3

U.S. Savings Bonds 7-4

Dividends 7-6

Portfolio Income: Capital Gains and Losses 7-7Types of Capital Gains and Losses 7-10

25 Percent Gains 7-10

28 Percent Gains 7-11

Netting Process for Gains and Losses 7-12

Calculating Tax Liability on Net Capital Gains 7-16

Limits for Capital Loss Deductions 7-21Losses on the Sale of Personal-Use

Assets 7-21

Capital Losses on Sales to Related Persons 7-22

Wash Sales 7-22

Balancing Tax Planning Strategies for Capital Assets with Other Goals 7-23

Portfolio Income Summary 7-24

Investment Interest Expense 7-25Net Investment Income Tax 7-27

Passive Activity Income and Losses 7-28Passive Activity Definition 7-29Income and Loss Categories 7-29Rental Real Estate Exception to the Passive

Activity Loss Rules 7-32Net Investment Income Tax on Net Passive

Income 7-32

Conclusion 7-33

8 Individual Income Tax Computation and Tax CreditsRegular Federal Income Tax Computation 8-2

Tax Rate Schedules 8-2Marriage Penalty or Benefit 8-3Exceptions to the Basic Tax Computation 8-3

Preferential Tax Rates for Capital Gains and Dividends 8-4

Kiddie Tax 8-5

Alternative Minimum Tax 8-7Alternative Minimum Tax Formula 8-8

Alternative Minimum Taxable Income 8-8

AMT Exemption 8-11

Tentative Minimum Tax and AMT Computation 8-11

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xxviii Ta

ble of Contents

ditional Taxes 8-13Net Investment Income Tax 8-13

Employment and Self-Employment Taxes 8-Employee FICA Taxes Payable 8-14

Self-Employment Taxes 8-16

Employee vs. Self-Employed (Independent Contractor) 8-21

Tax Credits 8-23Nonrefundable Personal Credits 8-24

Child Tax Credit 8-24

Child and Dependent Care Credit 8-25

Education Credits 8-27

Refundable Personal Credits 8-29Earned Income Credit 8-29

Other Refundable Personal Credits 8-31

Business Tax Credits 8-31Foreign Tax Credit 8-31

Tax Credit Summary 8-32Credit Application Sequence 8-32

Taxpayer Prepayments and Filing Requirements 8-34Prepayments 8-34

Underpayment Penalties 8-35

Filing Requirements 8-36Late Filing Penalty 8-37

Late Payment Penalty 8-37

Tax Summary 8-37

usion 8-39

ness Income, Deductions, aounting Methods

Business Gross Income 9-2

Business Deductions 9-2Ordinary and Necessary 9-3Reasonable in Amount 9-4

Limitations on Business Deductions 9-5Expenditures against Public Policy 9-5Political Contributions and Lobbying CosCapital Expenditures 9-6Expenses Associated with the Production

Tax-Exempt Income 9-6Personal Expenditures 9-7Mixed-Motive Expenditures 9-7

Meals 9-8

Travel and Transportation 9-8

Property Use 9-10

Record Keeping and Other Requirements 9-11

Limitation on Business Interest Deductions 9-11

ts 9

f o

-6

Concl

ProRecCost

RecBa

DeprPe

0 1

Concl

BusiAcc

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Specific Business Deductions 9-12Losses on Dispositions of Business

Property 9-12Business Casualty Losses 9-13

Accounting Periods 9-13

Accounting Methods 9-14Financial and Tax Accounting Methods 9-15Overall Accounting Method 9-15

Cash Method 9-15

Accrual Method 9-16

Accrual Income 9-17All-Events Test for Income 9-17

Taxation of Advance Payments of Income (Unearned Income) 9-17Advance Payments for Goods and

Services 9-18

Inventories 9-18Uniform Capitalization 9-19

Inventory Cost-Flow Methods 9-19

Accrual Deductions 9-20All-Events Test for Deductions 9-21

Economic Performance 9-22

Bad Debt Expense 9-25

Limitations on Accruals to Related Persons 9-25

Comparison of Accrual and Cash Methods 9-26

Adopting an Accounting Method 9-27Changing Accounting Methods 9-28

Tax Consequences of Changing Accounting Methods 9-30

usion 9-31

perty Acquisition and Cost overyRecovery and Tax Basis for Cost overy 10-2sis for Cost Recovery 10-3

eciation 10-6rsonal Property Depreciation 10-7Depreciation Method 10-8

Depreciation Recovery Period 10-8

Depreciation Conventions 10-9

Calculating Depreciation for Personal Property 10-10

Applying the Half-Year Convention 10-11

Applying the Mid-Quarter Convention 10-13

Real Property 10-14Applicable Method 10-15

Applicable Convention 10-15

Depreciation Tables 10-15

Table of Contents xxix

Special Rules Relating to Cost Recovery 10-17

Immediate Expensing (§179) 10-17

Bonus Depreciation 10-21

Listed Property 10-23

Luxury Automobiles 10-26

Depreciation for the Alternative Minimum Tax 10-30

Depreciation Summary 10-30

Amortization 10-32Section 197 Intangibles 10-32Organizational Expenditures and Start-Up

Costs 10-33Research and Experimentation

Expenditures 10-36Patents and Copyrights 10-36Amortizable Intangible Asset Summary 10-37

Depletion 10-38

Conclusion 10-41

Appendix A: MACRS Tables 10-41

11 Property DispositionsDispositions 11-2

Amount Realized 11-2Determination of Adjusted Basis 11-2

Gifts 11-3

Inherited Property 11-3

Property Converted from Personal Use to Business Use 11-3

Realized Gain or Loss on Disposition 11-5Recognized Gain or Loss on

Disposition 11-6

Character of Gain or Loss 11-6Ordinary Assets 11-7Capital Assets 11-7Section 1231 Assets 11-8

Depreciation Recapture 11-9Section 1245 Property 11-10

Scenario 1: Gain Created Solely through Cost Recovery Deductions 11-11

Scenario 2: Gain Due to Both Cost Recovery Deductions and Asset Appreciation 11-11

Scenario 3: Asset Sold at a Loss 11-12

Section 1250 Depreciation Recapture for Real Property 11-13

Other Provisions Affecting the Rate at Which Gains Are Taxed 11-14Unrecaptured §1250 Gain for

Individuals 11-14

Characterizing Gains on the Sale of Depreciable Property to Related Persons 11-16

Calculating Net §1231 Gains or Losses 11-16Section 1231 Look-Back Rule 11-18

Gain or Loss Summary 11-20

Nonrecognition Transactions 11-20Like-Kind Exchanges 11-20

Definition of Like-Kind Property 11-24

Property Use 11-24

Timing Requirements for a Like-Kind Exchange 11-25

Tax Consequences When Like-Kind Property Is Exchanged Solely for Like-Kind Property 11-26

Tax Consequences of Transfers Involving Like-Kind and Non-Like-Kind Property (Boot) 11-26

Reporting Like-Kind Exchanges 11-28Involuntary Conversions 11-28Installment Sales 11-31Gains Ineligible for Installment

Reporting 11-33Other Nonrecognition Provisions 11-33Related-Person Loss Disallowance

Rules 11-34

Conclusion 11-35

12 CompensationSalary and Wages 12-2

Employee Considerations for Salary and Wages 12-2Tax Withholding 12-2

Employer Considerations for Salary and Wages 12-2Deductibility of Salary and Wage

Payments 12-2

Equity-Based Compensation 12-7Stock Options 12-9

Employee Tax Considerations for Stock Options 12-10

Employer Tax Considerations for Stock Options 12-13

Restricted Stock 12-15Employee Tax Considerations for Restricted

Stock 12-16

Employer Tax Considerations for Restricted Stock 12-18

Qualified Equity Grants 12-19

Equity-Based Compensation Summary 12-20

Fringe Benefits 12-20

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xxx Table of Contents

Taxable Fringe Benefits 12-20Employee Considerations for Taxable Fringe

Benefits 12-21

Employer Considerations for Taxable Fringe Benefits 12-23

Nontaxable Fringe Benefits 12-24Group-Term Life Insurance 12-24

Health and Accident Insurance and Benefits 12-24

Meals and Lodging for the Convenience of the Employer 12-26

Employee Educational Assistance 12-26

Dependent Care Benefits 12-26

No-Additional-Cost Services 12-26

Qualified Employee Discounts 12-27

Working Condition Fringe Benefits 12-28

De Minimis Fringe Benefits 12-29

Qualified Transportation Fringe Benefits 12-29

Cafeteria Plans and Flexible Spending Accounts 12-29

Employee and Employer Considerations for Nontaxable Fringe Benefits 12-30

Tax Planning with Fringe Benefits 12-30Fringe Benefits Summary 12-32

Conclusion 12-33

13 Retirement Savings and Deferred CompensationEmployer-Provided Qualified Plans 13-3

Defined Benefit Plans 13-3Vesting 13-4Distributions 13-5Nontax Considerations 13-5

Defined Contribution Plans 13-6Employer Matching 13-6Contribution Limits 13-7Vesting 13-7After-Tax Cost of Contributions to Traditional

(non-Roth) Defined Contribution Plans 13-8Distributions from Traditional Defined

Contribution Plans 13-9After-Tax Rates of Return for Traditional Defined

Contribution Plans 13-11Roth 401(k) Plans 13-11Comparing Traditional Defined Contribution

Plans and Roth 401(k) Plans 13-14

Nonqualified Deferred Compensation Plans 13-15Nonqualified Plans versus Qualified Defined

Contribution Plans 13-15

Employee Considerations 13-16Employer Considerations 13-18

Individually Managed Qualified Retirement Plans 13-19

Individual Retirement Accounts 13-19Traditional IRAs 13-19

Contributions 13-19

Nondeductible Contributions 13-22

Distributions 13-22

Roth IRAs 13-23Contributions 13-23

Distributions 13-23

Rollover from Traditional to Roth IRA 13-25Comparing Traditional and Roth IRAs 13-26

Self-Employed Retirement Accounts 13-27Simplified Employee Pension

(SEP) IRA 13-28Nontax Considerations 13-28

Individual 401(k) Plans 13-28Nontax Considerations 13-30

Saver’s Credit 13-30

Conclusion 13-31

Appendix A: Traditional IRA Deduction Limitations 13-32

Appendix B: Roth IRA Contribution Limits 13-34

14 Tax Consequences of Home OwnershipIs a Dwelling Unit a Principal Residence, Residence,

or Nonresidence? 14-2

Personal Use of the Home 14-3Exclusion of Gain on Sale of Personal

Residence 14-4Requirements 14-5

Home Mortgage Interest Deduction 14-8Limitation on Acquisition Indebtedness 14-9

Points 14-11

Real Property Taxes 14-13

Rental Use of the Home 14-15Residence with Minimal Rental Use 14-15Residence with Significant Rental Use (Vacation

Home) 14-16Nonresidence (Rental Property) 14-21

Losses on Rental Property 14-21

Business Use of the Home 14-23Direct versus Indirect Expenses 14-25Limitations on Deductibility of Expenses 14-26

Conclusion 14-28

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Table of Contents xxxi

Appendix A: Sample Settlement Statement for the Jeffersons 14-30

Appendix B: Flowchart of Tax Rules Relating to Home Used for Rental Purposes 14-32

15 Entities OverviewEntity Legal Classification and Nontax

Characteristics 15-2Legal Classification 15-2Nontax Characteristics 15-2

Responsibility for Liabilities 15-3

Rights, Responsibilities, and Legal Arrangements among Owners 15-3

Entity Tax Classification 15-5

Entity Tax Characteristics 15-7Taxation of Business Entity Income 15-7

The Taxation of Flow-Through Entity Business Income 15-7

Overall Tax Rate of C Corporation Income 15-11

Owner Compensation 15-15

Deductibility of Entity Losses 15-16

Other Tax Characteristics 15-19Converting to Other Entity Types 15-19

Conclusion 15-23

16 Corporate OperationsCorporate Taxable Income Formula 16-2

Accounting Periods and Methods 16-2

Computing Corporate Taxable Income 16-3Book–Tax Differences 16-3

Common Permanent Book–Tax Differences 16-4

Common Temporary Book–Tax Differences 16-6

Corporate-Specific Deductions and Associated Book–Tax Differences 16-9Stock Options 16-9

Net Capital Losses 16-12

Net Operating Losses 16-13

Charitable Contributions 16-14

Dividends Received Deduction 16-17

Taxable Income Summary 16-21Corporate Income Tax Liability 16-21

Compliance 16-21Consolidated Tax Returns 16-25

Corporate Tax Return Due Dates and Estimated Taxes 16-26

Conclusion 16-29

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17 Accounting for Income TaxesAccounting for Income Taxes and the Income Tax

Provision Process 17-2Why Is Accounting for Income Taxes So

Complex? 17-3Objectives of ASC 740 17-4The Income Tax Provision Process 17-6

Calculating a Company’s Income Tax Provision 17-6Step 1: Adjust Pretax Net Income for All

Permanent Differences 17-6Step 2: Identify All Temporary Differences and

Tax Carryforward Amounts 17-8Revenues or Gains That Are Taxable after

They Are Recognized in Financial Income 17-8

Expenses or Losses That Are Deductible after They Are Recognized in Financial Income 17-8

Revenues or Gains That Are Taxable before They Are Recognized in Financial Income 17-9

Expenses or Losses That Are Deductible before They Are Recognized in Financial Income 17-9

Identifying Taxable and Deductible Temporary Differences 17-9Taxable Temporary Difference 17-9

Deductible Temporary Difference 17-9

Step 3: Compute the Current Income Tax Expense or Benefit 17-11

Step 4: Determine the Ending Balances in the Balance Sheet Deferred Tax Asset and Liability Accounts 17-12

Determining Whether a Valuation Allowance Is Needed 17-16Step 5: Evaluate the Need for a Valuation

Allowance for Gross Deferred Tax Assets 17-16

Determining the Need for a Valuation Allowance 17-16Future Reversals of Existing Taxable

Temporary Differences 17-17

Taxable Income in Prior Carryback Year(s) 17-17

Expected Future Taxable Income Exclusive of Reversing Temporary Differences and Carryforwards 17-17

Tax Planning Strategies 17-17

Negative Evidence That a Valuation Allowance Is Needed 17-17

Step 6: Calculate the Deferred Income Tax Expense or Benefit 17-20

xxxii Table of Contents

Distributions of Noncash Property to Shareholders 18-11The Tax Consequences to a Corporation

Paying Noncash Property as a Dividend 18-12

Liabilities 18-12

Effect of Noncash Property Distributions on E&P 18-13

Stock Distributions 18-15Tax Consequences to Shareholders Receiving a

Stock Distribution 18-15Nontaxable Stock Distributions 18-15

Taxable Stock Distributions 18-16

Stock Redemptions 18-16The Form of a Stock Redemption 18-17Redemptions That Reduce a Shareholder’s

Ownership Interest 18-18Redemptions That Are Substantially

Disproportionate 18-18

Complete Redemption of the Stock Owned by a Shareholder 18-21

Redemptions That Are Not Essentially Equivalent to a Dividend 18-22

Tax Consequences to the Distributing Corporation 18-24

Trends in Stock Redemptions by Publicly Traded Corporations 18-24

Partial Liquidations 18-25

Conclusion 18-26

19 Corporate Formation, Reorganization, and LiquidationReview of the Taxation of Property

Dispositions 19-2

Tax-Deferred Transfers of Property to a Corporation 19-3Transactions Subject to Tax Deferral 19-5Meeting the Section 351 Tax Deferral

Requirements 19-5Section 351 Applies Only to the Transfer of

Property to the Corporation 19-5

The Property Transferred to the Corporation Must Be Exchanged for Stock of the Corporation 19-6

The Transferor(s) of Property to the Corporation Must Be in Control of the Corporation, in the Aggregate, Immediately after the Transfer 19-6

Tax Consequences to Shareholders 19-8Tax Consequences When a Shareholder

Receives Boot 19-9Assumption of Shareholder Liabilities by the

Corporation 19-11

Accounting for Uncertainty in Income Tax Positions 17-21Application of ASC 740 to Uncertain Tax

Positions 17-21Step 1: Recognition 17-22

Step 2: Measurement 17-22

Subsequent Events 17-23Interest and Penalties 17-24Disclosures of Uncertain Tax Positions 17-24Schedule UTP (Uncertain Tax Position)

Statement 17-25

Financial Statement Disclosure and Computing a Corporation’s Effective Tax Rate 17-25Balance Sheet Classification 17-25Income Tax Footnote Disclosure 17-25

Computation and Reconciliation of the Income Tax Provision with a Company’s Hypothetical Tax Provision 17-27

Importance of a Corporation’s Effective Tax Rate 17-28

Interim Period Effective Tax Rates 17-29Accounting for the Tax Cuts and Jobs

Act 17-29

FASB Projects Related to Accounting for Income Taxes 17-29

Conclusion 17-29

18 Corporate Taxation: Nonliquidating DistributionsTaxation of Property Distributions 18-2

Determining the Dividend Amount from Earnings and Profits 18-3Overview 18-3Dividends Defined 18-3Computing Earnings and Profits 18-4

Nontaxable Income Included in Current E&P 18-4

Deductible Expenses That Do Not Reduce Current E&P 18-5

Nondeductible Expenses That Reduce Current E&P 18-5

Items Requiring Separate Accounting Methods for E&P Purposes 18-5

Ordering of E&P Distributions 18-8Positive Current E&P and Positive

Accumulated E&P 18-8

Positive Current E&P and Negative Accumulated E&P 18-9

Negative Current E&P and Positive Accumulated E&P 18-9

Negative Current E&P and Negative Accumulated E&P 18-10

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Table of Contents xxxiii

Accounting Periods 20-14Required Year-Ends 20-14

Accounting Methods 20-16

Reporting the Results of Partnership Operations 20-17Ordinary Business Income (Loss) and Separately

Stated Items 20-17Guaranteed Payments 20-19

Self-Employment Tax 20-20

Limitation on Business Interest Expense 20-22

Deduction for Qualified Business Income 20-22

Net Investment Income Tax 20-23Allocating Partners’ Shares of Income and

Loss 20-23Partnership Compliance Issues 20-24

Partner’s Adjusted Tax Basis in Partnership Interest 20-28Cash Distributions in Operating

Partnerships 20-30

Loss Limitations 20-30Tax-Basis Limitation 20-30At-Risk Amount Limitation 20-31Passive Activity Loss Limitation 20-32

Passive Activity Defined 20-33

Income and Loss Baskets 20-34

Excess Business Loss Limitation 20-35

Conclusion 20-36

21 Dispositions of Partnership Interests and Partnership DistributionsBasics of Sales of Partnership Interests 21-2

Seller Issues 21-2Hot Assets 21-3

Buyer and Partnership Issues 21-7Varying Interest Rule 21-8

Basics of Partnership Distributions 21-9Operating Distributions 21-9

Operating Distributions of Money Only 21-9

Operating Distributions That Include Property Other Than Money 21-10

Liquidating Distributions 21-12Gain or Loss Recognition in Liquidating

Distributions 21-13

Basis in Distributed Property 21-13

Partner’s Outside Basis Is Greater Than Inside Bases of Distributed Assets 21-14

Partner’s Outside Basis Is Less Than Inside Bases of Distributed Assets 21-17

Tax-Avoidance Transactions 19-12

Liabilities in Excess of Basis 19-12

Tax Consequences to the Transferee Corporation 19-14

Other Issues Related to Incorporating an Ongoing Business 19-16Depreciable Assets Transferred to a

Corporation 19-16

Contributions to Capital 19-17Section 1244 Stock 19-18

Taxable and Tax-Deferred Corporate Acquisitions 19-19The Acquisition Tax Model 19-19

Tax Consequences to a Corporate Acquisition 19-21Taxable Acquisitions 19-22Tax-Deferred Acquisitions 19-24Judicial Principles That Underlie All Tax-Deferred

Reorganizations 19-25Continuity of Interest 19-25

Continuity of Business Enterprise 19-25

Business Purpose Test 19-25

Type A Asset Acquisitions 19-25Forward Triangular Type A Merger 19-27

Reverse Triangular Type A Merger 19-28

Type B Stock-for-Stock Reorganizations 19-29

Complete Liquidation of a Corporation 19-30Tax Consequences to the Shareholders in a

Complete Liquidation 19-32Tax Consequences to the Liquidating

Corporation in a Complete Liquidation 19-34Taxable Liquidating Distributions 19-34

Nontaxable Liquidating Distributions 19-36

Conclusion 19-37

20 Forming and Operating PartnershipsFlow-Through Entities Overview 20-2

Aggregate and Entity Concepts 20-3

Partnership Formations and Acquisitions of Partnership Interests 20-3Acquiring Partnership Interests When

Partnerships Are Formed 20-3Contributions of Property 20-3

Contribution of Services 20-9

Organizational Expenditures, Start-Up Costs, and Syndication Costs 20-12

Acquisitions of Partnership Interests 20-13

Partnership Accounting: Tax Elections, Accounting Periods, and Accounting Methods 20-13Tax Elections 20-14

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xxxiv Table of Contents

S Corporation Taxes and Filing Requirements 22-22Built-in Gains Tax 22-22Excess Net Passive Income Tax 22-24LIFO Recapture Tax 22-26Estimated Taxes 22-28Filing Requirements 22-28

Comparing C and S Corporations and Partnerships 22-30

Conclusion 22-31

23 State and Local TaxesState and Local Taxes 23-2

Sales and Use Taxes 23-5Sales Tax Nexus 23-5Sales Tax Liability 23-8

Income Taxes 23-10Income Tax Nexus 23-10

Protection under Public Law 86-272 23-11

Economic Income Tax Nexus 23-13

Entities Included on Income Tax Return 23-15Separate Tax Returns 23-15

Unitary Tax Returns 23-15

State Taxable Income 23-16Dividing State Tax Base among States 23-18

Business Income 23-18

Nonbusiness Income 23-24

State Income Tax Liability 23-24Nonincome-Based Taxes 23-25

Conclusion 23-26

24 The U.S. Taxation of Multinational TransactionsThe U.S. Framework for Taxing Multinational

Transactions 24-2U.S. Taxation of a Nonresident 24-3Definition of a Resident for U.S. Tax

Purposes 24-4Overview of the U.S. Foreign Tax Credit

System 24-5

U.S. Source Rules for Gross Income and Deductions 24-6Source of Income Rules 24-7

Interest 24-7

Dividends 24-8

Compensation for Services 24-8

Rents and Royalties 24-10

Gain or Loss from Sale of Real Property 24-10

Character and Holding Period of Distributed Assets 21-21

Disproportionate Distributions 21-24

Special Basis Adjustments 21-26Special Basis Adjustments for

Dispositions 21-27Special Basis Adjustments for

Distributions 21-28

Conclusion 21-29

22 S CorporationsS Corporation Elections 22-2

Formations 22-2S Corporation Qualification Requirements 22-2S Corporation Election 22-3

S Corporation Terminations 22-5Voluntary Terminations 22-5Involuntary Terminations 22-5

Failure to Meet Requirements 22-5

Excess of Passive Investment Income 22-6

Short Tax Years 22-6S Corporation Reelections 22-7

Operating Issues 22-8Accounting Methods and Periods 22-8Income and Loss Allocations 22-8Separately Stated Items 22-9

Shareholder’s Basis 22-11Initial Basis 22-11

Annual Basis Adjustments 22-12

Loss Limitations 22-13Tax-Basis Limitation 22-13

At-Risk Amount Limitation 22-14

Post-Termination Transition Period Loss Limitation 22-14

Passive Activity Loss Limitation 22-15

Excess Business Loss Limitation 22-15

Self-Employment Income 22-15Net Investment Income Tax 22-16Fringe Benefits 22-16

Distributions 22-17Operating Distributions 22-17

S Corporation with No C Corporation Accumulated Earnings and Profits 22-17

S Corporation with C Corporation Accumulated Earnings and Profits 22-18

Property Distributions 22-20

Post-Termination Transition Period Distributions 22-21

Liquidating Distributions 22-21

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Table of Contents xxxv

Taxable Gifts 25-9Gift-Splitting Election 25-10

Marital Deduction 25-10

Charitable Deduction 25-12

Computation of the Gift Tax 25-12Tax on Current Taxable Gifts 25-13

Applicable Credit 25-14

The Federal Estate Tax 25-17The Gross Estate 25-17

Specific Inclusions 25-18

Valuation 25-21

Gross Estate Summary 25-22

The Taxable Estate 25-22Administrative Expenses, Debts, Losses, and

State Death Taxes 25-23

Marital and Charitable Deductions 25-23

Computation of the Estate Tax 25-25Adjusted Taxable Gifts 25-25

Applicable Credit 25-26

Wealth Planning Concepts 25-29The Generation-Skipping Tax 25-29Income Tax Considerations 25-29Transfer Tax Planning Techniques 25-30

Serial Gifts 25-30

The Step-Up in Tax Basis 25-31

Integrated Wealth Plans 25-32

Conclusion 25-33

Appendix A Tax Forms A-1

Appendix B Tax Terms Glossary B-1

Appendix C Comprehensive Tax Return Problems C-1

Appendix D Tax Rates D

Code Index CI

Subject Index SI-1

Gain or Loss from Sale of Purchased Personal Property 24-10

Gain or Loss from Sale of Manufactured Inventory 24-10

Source of Deduction Rules 24-11General Principles of Allocation and

Apportionment 24-11

Special Apportionment Rules 24-12

Operating Abroad through a Foreign Corporation 24-17

Foreign-Derived Intangible Income 24-18

Treaties 24-19

Foreign Tax Credits 24-21FTC Limitation Categories of Taxable

Income 24-21Passive Category Income 24-21

Foreign Branch Income 24-22

General Category Income 24-22

Creditable Foreign Taxes 24-22Direct Taxes 24-23

In Lieu of Taxes 24-23

Planning for International Operations 24-23Check-the-Box Hybrid Entities 24-24

U.S. Anti-Deferral Rules 24-25Definition of a Controlled Foreign

Corporation 24-26Definition of Subpart F Income 24-27Planning to Avoid Subpart F Income 24-29

Base Erosion and Profit Shifting Initiatives around the World 24-31

Conclusion 24-31

25 Transfer Taxes and Wealth PlanningIntroduction to Federal Transfer Taxes 25-2

Beginnings 25-2Common Features of Integrated Transfer

Taxes 25-2

The Federal Gift Tax 25-4Transfers Subject to Gift Tax 25-5

Valuation 25-6

The Annual Exclusion 25-8

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chapter

3 Tax Planning Strategies and Related Limitations

Learning Objectives

Upon completing this chapter, you should be able to:

LO 3-1 Identify the objectives of basic tax planning strategies.

LO 3-2 Apply the timing strategy.

LO 3-3 Apply the concept of present value to tax planning.

LO 3-4 Apply the income-shifting strategy.

LO 3-5 Apply the conversion strategy.

LO 3-6 Describe basic judicial doctrines that limit tax planning strategies.

LO 3-7 Contrast tax avoidance and tax evasion.

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3-1

©michaeljung/Shutterstock

Storyline Summary

Taxpayers: Bill and Mercedes

Family description:

Bill and Mercedes are married with onedaughter, Margaret.

Employment status:

Bill is an economics professor; Mercedes isa small business owner.

Filing status: Married, filing jointly

Current situation:

Bill and Mercedes want to engage inlow-risk tax planning strategies.

While working with their CPA during their audit, Bill and Mercedes decide to inquire about low-risk tax planning

opportunities. Specifically, they would like to gain a better understanding of how to maximize their after-tax income without increasing their potential for another audit. (Although it was fun and educational,

spi69614_ch03_000-029.indd 1 1/23/19 10:00 PM

one audit is enough!) Mercedes is convinced that, as a small business owner (Lavish Interior Designs Inc.), she pays more than her fair share of taxes. Likewise, Bill, an avid investor, wonders whether he is missing the mark by not considering taxes in his investment decisions. ■

3-2 CHAPTER 3 Tax Planning Strategies and Related Limitations

Bill and Mercedes have come to the right place. This chapter describes the basic tax planning concepts that form the basis of the simplest to most complex tax planning transactions. In the process we also discuss the judicial doctrines that serve as basic limits on tax planning.

LO 3-1LO 3-1 BASIC TAX PLANNING OVERVIEWEffective tax planning requires a basic understanding of the roles that tax and nontax fac-tors play in structuring business, investment, and personal decisions. Although tax factors may not be the sole or even the primary determinant of a transaction or its structure, taxes can significantly affect the costs or benefits associated with business, investment, and personal transactions. Thus, the tax implications of competing transactions warrant care-ful consideration. Likewise, nontax factors, such as the taxpayer’s financial goals or legal constraints, are an integral part of every transaction.

In general terms, effective tax planning maximizes the taxpayer’s after-tax wealth while achieving the taxpayer’s nontax goals. Maximizing after-tax wealth is not necessar-ily the same as minimizing taxes. Specifically, maximizing after-tax wealth requires us to consider both the tax and nontax costs and benefits of alternative transactions, whereas tax minimization focuses solely on a single cost—taxes. Indeed, if the goal of tax plan-ning were simply to minimize taxes, the simplest way to achieve it would be to earn no income at all. Obviously, this strategy has potential limitations—most notably, the un-attractive nontax consequence of poverty. Thus, it is necessary to consider the nontax ramifications of any planning strategy.

THE KEY FACTS

The Basics of Tax Planning

• Effective tax planning maximizes the taxpayer’s after-tax wealth while achieving the taxpayer’s nontax goals.

• Virtually every transaction includes three parties: the taxpayer, the other trans-acting party, and the uninvited silent party that specifies the tax conse-quences of the transaction—the government.

• Astute tax planning requiresan understanding of the tax and nontax costs from the perspectives of both the taxpayer and the other parties.

Virtually every transaction includes three parties: the taxpayer, the other trans-acting party, and the uninvited silent party that specifies the tax consequences of thetransaction—the government. Astute tax planning requires an understanding of the tax and nontax costs from the perspectives of both the taxpayerand the other parties. For example, as discussed in the Compensation chapter, it would be impos-sible for an employer to develop an effective compensation plan without considering the tax and nontax costs associated with different compensation arrangements from both the employer’s and the employees’ perspectives. With sound tax planning, the employer can design a compensation package that generates value for employees while reducing costs for the employer. (One way to achieve this goal is through the use of nontaxable fringe benefits, such as health insurance, which are deductible expenses to the employer but not taxable income to employees.) Throughout the text, we highlight situations where this multilateral approach to tax planning is especially important.

In this chapter we discuss three basic tax planning strategies that represent the build-ing blocks of tax planning:

1. Timing (deferring or accelerating taxable income and tax deductions).2. Income shifting (shifting income from high- to low-tax-rate taxpayers).3. Conversion (converting income from high- to low-tax-rate activities).

LO 3-2 LO 3-3

LO 3-6

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TIMING STRATEGIESOne of the cornerstones of basic tax planning is the idea of timing. When income is taxed or an expense is deducted affects the associated “real” tax costs or savings. This is true for two reasons. First, the time when income is taxed or an expense is deducted affects the present value of the taxes paid on income or the tax savings on deductions. Second, the tax costs of income and tax savings of deductions vary as tax rates change. The tax costs on income are higher when tax rates are higher and lower when tax rates are lower. Likewise, the tax savings on deductions are higher when tax rates are higher

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-3

and lower when tax rates are lower. Let’s look at the effects of present value and tax rates on the timing strategy.

Present Value of MoneyThe concept of present value—also known as the time value of money—basically states that $1 received today is worth more than $1 received in the future. Is this true, or is this some type of new math?

It’s true. Assuming an investor can earn a positive after-tax rate of return such as 5percent, $1 invested today should be worth $1.05 in one year.1 Specifically,

Eq. 3-1

where $1 is the present value, r is the after-tax rate of return (5 percent), and n is the investment period (1 year). Hence, $1 today is equivalent to $1.05 in one year. The impli-cation of the time value of money for tax planning is that the timing of a cash inflow or a cash outflow affects the present value of the income or expense.

Example 3-1

Billisgiventhechoiceofreceivinga$1,000nontaxablegifttodayora$1,000nontaxablegiftinoneyear.WhichwouldBillprefer?AssumeBillcouldinvest$1,000todayandearnan8percentreturnaf-tertaxesinoneyear.Ifhereceivesthegifttoday,howmuchwouldthe$1,000beworthinoneyear?

Answer: The$1,000gifttodaywouldbeworth$1,080inoneyear,andthusBillshouldprefertore-ceivethegifttoday.Specifically,

nFutureValue=PresentValue×(1+r ) =$1,000×(1+.08)1=$1,080

In terms of future value, the choice in the above example between receiving $1,000 today and $1,000 in one year simplifies to a choice between $1,080 and $1,000. For even the least materialistic individual, choosing $1,080—that is, $1,000 today—should be straightforward.

THE KEY FACTS

Present Value of Money• The concept of present

value—also known as the time value of money—states that $1 received today is worth more than $1 received in the future.

• The implication of the time value of money for tax planning is that the timing of a cash inflow or a cash outflow affects the present value of the income or expense.

• Present Value = Future Value/(1 + r )n.

• When we are considering cash inflows, higher pres-ent values are preferred; when we are considering cash outflows, lower pres-ent values are preferred.

Often tax planners find it useful to consider sums not in terms of future value, but rather in terms of present value. How would we restate the choice in Example 3-1 in terms of present value? Obviously, the present value of receiving $1,000 today is $1,000, but what is the present value of $1,000 received in one year? The answer depends on the discount factor, which we derive from the taxpayer’s expected after-tax rate of return. The discount factor is very useful for calculating the present value of future inflows or outflows of cash. We can derive the discount factor for a given rate of return simply by rearranging the future value equation (Eq. 3-1) from above:

Eq. 3-2 Present Value = Future Value/(1 + r)n

= $1/(1 + .08)1 = $0.926 Therefore, the discount factor = 0.926

Future Value = Present Value × (1 + r)n

= $1 × (1 + .05)1 = $1.05

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Eq. 3-1

1Assuming a constant marginal tax rate (t), after-tax rate of return (r) may be calculated as follows: r = R × (1 − t), where R is the taxpayer’s before-tax rate of return.

3-4 CHAPTER 3 Tax Planning Strategies and Related Limitations

EXHIBIT 3-1 Present Value of a Single Payment at Various Annual Rates of Return

Year 4% 5% 6% 7% 8% 9% 10% 11% 12%

1 .962 .952 .943 .935 .926 .917 .909 .901 .893 2 .925 .907 .890 .873 .857 .842 .826 .812 .797 3 .889 .864 .840 .816 .794 .772 .751 .731 .712 4 .855 .823 .792 .763 .735 .708 .683 .659 .636 5 .822 .784 .747 .713 .681 .650 .621 .593 .567 6 .790 .746 .705 .666 .630 .596 .564 .535 .507 7 .760 .711 .665 .623 .583 .547 .513 .482 .452 8 .731 .677 .627 .582 .540 .502 .467 .434 .404 9 .703 .645 .592 .544 .500 .460 .424 .391 .361 10 .676 .614 .558 .508 .463 .422 .386 .352 .322 11 .650 .585 .527 .475 .429 .388 .350 .317 .287 12 .625 .557 .497 .444 .397 .356 .319 .286 .257 13 .601 .530 .469 .415 .368 .326 .290 .258 .229 14 .577 .505 .442 .388 .340 .299 .263 .232 .205 15 .555 .481 .417 .362 .315 .275 .239 .209 .183

Applying the discount factor, we can see that $1,000 received in one year is worth $926 in today’s dollars. Thus, in terms of present value, Bill’s choice in Example 3-1 simplifies to a choice between a cash inflow of $1,000 today and a cash inflow worth $926 today. Again, choosing $1,000 today is pretty straightforward.

Exhibit 3-1 provides the discount factors for a lump sum (single payment) received in n periods using various rates of return. Tax planners frequently utilize such tables for quick reference in calculating present value for sums under consideration.

Example 3-2

Atarecentholidaysale,BillandMercedespurchased$1,000worthoffurniturewith“nomoneydownandnopaymentsforoneyear!”Howmuchmoneyisthisdealreallyworth?(Assumetheirafter-taxrateofreturnoninvestmentsis10percent.)

Answer: Thediscount factorof .909(Exhibit3-1,10%RateofReturncolumn,Year1row)meansthe present value of $1,000 is $909 ($1,000× .909= $909)—soBill andMercedes save$91 ($1,000−$909=$91).

While Example 3-1 considers a $1,000 cash inflow, Example 3-2 addresses a $1,000 cash outflow. In terms of present value, choosing between paying $1,000 today and pay-ing $1,000 in a year simplifies to choosing a cash outflow of either $1,000 (by paying today) or $909 (by paying in one year). Most people would prefer to pay $909. Indeed, financial planners always keep the following general rule of thumb in mind: When con-sidering cash inflows, prefer higher present values; when considering cash outflows, pre-fer lower present values.

The Timing Strategy When Tax Rates Are ConstantIn terms of tax planning, remember that taxes paid represent cash outflows, while tax sav-ings generated from tax deductions are cash inflows. This perspective leads us to two basic tax-related timing strategies when tax rates are constant (not changing):

1. Accelerate tax deductions (deduct in an earlier period).

2. Defer recognizing taxable income (recognize in a later period).

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CHAPTER 3 Tax Planning Strategies and Related Limitations 3-5

Accelerating tax deductions to an earlier period increases the present value of the tax savings from the deduction. That is, tax savings received now have a higher present value than the same amount received a year from now.

Deferring income to a later period decreases the present value of the tax cost of the income. That is, taxes paid a year from now have a lower present value than taxes paid today. These two strategies are summarized in Exhibit 3-2.

EXHIBIT 3-2 The Timing Tax Strategy When Tax Rates Are Constant

Item Recommendation Why?

Tax deductions Accelerate tax deductions into earlier years.

Maximizes the present value of tax savings from deductions.

Taxable income Defer taxable income into

later tax years. Minimizes the present value of taxes paid.

Example 3-3

Mercedes,acalendar-yeartaxpayer,usesthecashmethodofaccountingforhersmallbusiness.2OnDecember28,shereceivesa$10,000billfromheraccountantforconsultingservicesrelatedtohersmallbusiness.Shecanavoidlatepaymentchargesbypayingthe$10,000billbeforeJanuary10ofnextyear.Let’sassumethatMercedes’smarginaltaxrateis32percentthis year and nextandthatshecanearnanafter-tax rateof returnof10percentonher investments.Whenshouldshepay the$10,000bill—thisyearornext?

Answer: IfMercedespaysthebillthisyear,shewillreceiveataxdeductiononthisyear’staxreturn.3IfshepaysthebillinJanuary,shewillreceiveataxdeductiononnextyear’staxreturn(oneyearlater).Sheneedstocomparetheafter-taxcostsoftheaccountingservice,usingthepresentvalueofthetaxsavingsforeachscenario:

Present Value Comparison

Description

Option 1: Pay $10,000 bill this year

Option 2: Pay $10,000 bill next year

Taxdeduction $10,000 $10,000Marginaltaxrate ×32% ×32%Taxsavings $ 3,200 $3,200Discountfactor ×1 ×.909Presentvaluetaxsavings $ 3,200 $2,909

After-tax cost of accounting services:Before-taxcost $10,000 $10,000Less:Presentvaluetaxsavings −3,200 −2,909After-taxcostofaccountingservices $6,800 $7,091

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SinceMercedeswouldsurelyratherspend$6,800than$7,091foraccountingservices,payingthebillinDecemberistheclearwinner.

2In the Business Income, Deductions, and Accounting Methods chapter, we discuss the basic accounting methods (e.g., cash vs. the accrual method), which influence the timing of when income and deductions are recognized for tax purposes.3Accelerating her payment from January 10 to December 31 will increase the present value of the $10,000 cash outflow by 10 days. Thus, there is a minor present value cost associated with accelerating her payment.

3-6 CHAPTER 3 Tax Planning Strategies and Related Limitations

In terms of accelerating deductions, the intent of the timing strategy is to acceler-ate the tax deduction significantly without accelerating the actual cash outflow that generates the expense. Indeed, if we assume a marginal rate of 32 percent and an after-tax return of 8 percent, accelerating a $1,000 cash outflow by one year to real-ize $320 in tax savings actually increases the after-tax cost of the expense from $629.68 to $680.

Present Value Comparison

Description

Present value of net cash

outflow today

Present value of net cash outflow

in one year

Cashoutflow $1,000 $1,000.00Less:Taxsavings(outflow×32%taxrate) −320 −320.00Netcashoutflow $ 680 $680.00Presentvaluefactor ×1 ×.926Presentvalueofnetcashoutflowtoday $ 680 $ 629.68

Generally speaking, whenever a taxpayer can accelerate a deduction without also substantially accelerating the cash outflow, the timing strategy will be more beneficial.

Is the accelerating deductions strategy utilized in the real world? Yes. While it is particularly effective for cash-method taxpayers, who can often control the year in which they pay their expenses, all taxpayers have some latitude in timing deductions. Common examples of the timing strategy include accelerating depreciation deductions for depre-ciable assets, using LIFO instead of FIFO for inventory, and accelerating the deduction of certain prepaid expenses.4 For large corporations, the benefits associated with this timing strategy can be quite substantial. Thus, tax planners spend considerable time identifying the proper period in which to recognize expenses and evaluating opportunities to acceler-ate deductions.

Are there certain taxpayer or transaction attributes that enhance the advantages of accelerating deductions? Absolutely. Higher tax rates, higher rates of return, larger trans-action amounts, and the ability to accelerate deductions by two or more years all increase the benefits of accelerating deductions. To demonstrate this for yourself, simply rework Example 3-3 and substitute any of the following: 50 percent tax rate, 12 percent after-tax rate of return, $100,000 expense, or a five-year period difference in the timing of the ex-pense deduction. The benefits of accelerating deductions become much more prominent with these changes.

Deferring income recognition is an equally beneficial timing strategy, especially when the taxpayer can defer the recognition of income significantly without deferring the actual receipt of income very much. Consider the following example.

Example 3-4

InearlyDecember,Billdecideshewould like to sell$100,000ofhisDell Inc. stock,whichcost$20,00010yearsago.AssumeBill’staxrateonthe$80,000gainwillbe15percentandhistypicalafter-taxrateofreturnoninvestmentsis7percent.WhateffectwoulddeferringthesaletoJanuaryhaveonBill’safter-taxcashflowonthesale?

4See the discussion of accounting methods in the Business Income, Deductions, and Accounting Methods chapter.

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Example 3-4

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-7

Answer:

Present Value Comparison

Description

Option 1: Sell the $100,000 stock in

December5

Option 2: Sell the $100,000 stock in

January5

Salesprice $100,000 $100,000Less:Costofstock −20,000 −20,000Gainonsale $ 80,000 $ 80,000MarginaltaxrateTaxongain

×15%$ 12,000

× 15%$ 12,000

DiscountfactorPresentvaluetaxcost

×1$ 12,000

× .935$ 11,220

After-tax cash flow from sale:Salesprice $100,000 $100,000Less:Presentvaluetaxcost −12,000 −11,220After-taxcashflowfromsale $ 88,000 $ 88,780

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Billwoulddoubtlesslyprefer toearn$88,780 to$88,000, so froma taxperspective, selling theDellInc.stockinJanuaryispreferable.AnimportantnontaxissueforBilltoconsideristhepossibilitythatthestockpricemayfluctuatebetweenDecemberandJanuary.

Income deferral represents an important aspect of investment planning, retirement planning, and certain property transactions. Income-related timing considerations also affect tax planning for everyday business operations, such as determining the appropriate period in which to recognize income (e.g., cash or accrual accounting method for income and deduction recognition, and depreciation methods).

THE KEY FACTS

The Timing Strategy

• The time at which income s taxed or an expense is deducted affects the pres-ent value of the taxes paid on income or tax savings on deductions.

• The tax costs of income and tax savings of deduc-tions vary as tax rates change.

• When tax rates are constant, tax planners prefer to defer income and accelerate deductions.

• When tax rates are increas-ing, the taxpayer must calculate the optimal tax strategies for deductions and income.

• When tax rates are de-creasing, taxpayers should accelerate tax deductions into earlier years and defer taxable income to later years.

Do certain taxpayer or transaction attributes enhance the advantages of deferring in-come? Yes. The list is very similar to that for accelerating deductions: Higher tax rates, higher rates of return, larger transaction amounts, and the ability to defer revenue recog-nition for longer periods of time increase the benefits of deferral. To demonstrate this for yourself, simply rework Example 3-4 using any of the following: 50 percent tax rate, 12percent after-tax rate of return on investments, or $200,000 gain.6

The Timing Strategy When Tax Rates ChangeWhen tax rates change, the timing strategy requires a little more consideration because the tax costs of income and the tax savings from deductions will now vary. The higher the tax rate, the higher the tax savings for a tax deduction. The lower the tax rate, the lower

5This will require Bill to pay the tax on the gain no later than April 15 of the following year (i.e., 3 months after the sale for option 1 and 15 months after the sale for option 2). If Bill and Mercedes’s current-year withholding and estimated payments do not equal or exceed 110 percent of their previous year’s tax liability, they will have to make an estimated payment by January 15 to avoid the failure to make estimated tax payment penalty (discussed later in the Individual Income Tax Computation and Tax Credits chapter). This example assumes that Bill and Mercedes can avoid the underpayment of estimated tax penalty discussed in the Individual Income Tax Compu-tation and Tax Credits chapter by paying 110 percent of their previous year’s tax liability in both options 1 and 2. Thus, they can defer paying the tax on the gain until April 15 of the year following the sale.6In Example 3-4, increasing the deferral period (e.g., from one to five years) also increases the benefits of tax deferral but requires additional assumptions regarding the expected five-year return of the Dell Inc. stock (as-suming he does not sell the stock for five years) and his new investment (assuming he sells the Dell Inc. stock and immediately reinvests the after-tax proceeds).

3-8 CHAPTER 3 Tax Planning Strategies and Related Limitations

EXHIBIT 3-3 Historical Maximum Ordinary and Capital Gains Tax Rates for Individuals Since 1982

Ordinary tax rate

Capital gains tax rate

10%

20%

30%

40%

50%

60%

1982 1985 1988 1991 1994 1997 2000 2003 2006 2012 2015 2018 20192009Year

Tax

Rate

the tax costs for taxable income. All other things being equal, taxpayers should prefer to recognize deductions during high-tax-rate years and income during low-tax-rate years. The implication is that before a taxpayer implements the timing strategies suggested above (accelerate deductions, defer income), she should consider whether her tax rates are likely to change. In fact, as we discuss below, increasing tax rates may even suggest the taxpayer should accelerate income and defer deductions.

What would cause a taxpayer’s marginal tax rate to change? The taxpayer’s taxable income can change for a variety of reasons, such as changing jobs, retiring, or starting a new business. Indeed, in theIntroduction to Tax chapter, we demonstrated how a tax-payer’s marginal tax rate changes as income or deductions change. Marginal tax rates can also change because of tax legislation. We discussed the tax legislative process in the Tax Compliance, the IRS, and Tax Authorities chapter and noted that Congress frequently enacts tax legislation because lawmakers use taxes to raise revenue, stimulate the econ-omy, and so on.For example, the Tax Cuts and Jobs Act enacted on December 22, 2017, lowered the top ordinary tax rate from 39.6 percent to 37 percent. In the last 35 years, Congress has changed the maximum statutory tax rates that apply to ordinary income, such as wages and business income, or capital gains, such as gains from the sale of stock, for individual taxpayers no fewer than 11 times (see Exhibit 3-3).

Let’s take a look at how changing tax rates affect the timing strategy recommenda-tions. Exhibit 3-4 presents recommendations for when tax rates are increasing. The tax-payer must actually calculate the optimal tax strategies for deductions and income when tax rates are increasing. Specifically, because accelerating deductions causes them to be

EXHIBIT 3-4 The Timing Tax Strategy When Tax Rates Are Increasing

Item Recommendation Why?

Tax deductions Requires calculation to determine optimal strategy.

The taxpayer must calculate whether the benefit of accelerating deductions outweighs the disadvantage of recognizing deductions in a lower-tax-rate year.

Taxable income Requires calculation to determine optimal strategy.

The taxpayer must calculate whether the benefit of deferring income outweighs the disadvantage of recognizing income in a higher-tax-rate year.

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C 3-9HAPTER 3 Tax Planning Strategies and Related Limitations

recognized in a lower-tax-rate year, the taxpayer must calculate whether the benefit of accelerating the deduction outweighs the disadvantage. Likewise, because deferring in-come causes income to be recognized in a higher-tax-rate year, the taxpayer must calcu-late whether the benefit of deferring income outweighs the disadvantage.

Example 3-5

Havingdecidedsheneedsnewequipmentforherbusiness,Mercedesisnowconsideringwhethertomakethepurchaseandclaimacorresponding$10,000deductionatyear-endornextyear.Mercedesanticipatesthat,withthenewmachinery,herbusinessincomewillrisesuchthathermarginalratewillincreasefrom24percentthisyearto32percentnextyear.Assumingherafter-taxrateofreturnis8percent,whatshouldMercedesdo?

Answer: Givenrisingtaxrates,Mercedesmustcalculatetheafter-taxcostoftheequipmentforbothoptionsandcomparepresentvalues.

Present Value Comparison

Description

Option 1: Pay $10,000 bill this year

Option 2: Pay $10,000 bill next year

Taxdeduction $10,000 $10,000Marginaltaxrate ×24% × 32%Taxsavings $ 2,400 $ 3,200Discountfactor ×1 ×.926Presentvaluetaxsavings $ 2,400 $ 2,963

After-tax cost of equipment:Before-taxcost $10,000 $10,000Less:Presentvaluetaxsavings −2,400 −2,963After-taxcostofequipment $ 7,600 $ 7,037

spi69614_ch03_000-029.indd 9 1/23/19 10:00 PM

Payingthe$10,000nextyearistheclearwinner.

In the above example, if the choice were either to recognize $10,000 of income this year or next, the amounts would be exactly the same but the conclusion would be different, and Mercedes would prefer to receive $7,600 of after-tax income this year instead of $7,037. (Remember, when considering cash inflows, we prefer the higher present value.) Are these always the answers when tax rates are increasing? No, the answer will depend on both the taxpayer’s after-tax rate of return and the magnitude of the tax rate increase.

Now let’s consider the recommendations when tax rates are decreasing—a common scenario when an individual reaches retirement. Exhibit 3-5 presents the timing strategy

EXHIBIT 3-5 The Timing Tax Strategy When Tax Rates Are Decreasing

Item Recommendation Why?

Tax deductions Accelerate tax deductionsinto earlier years.

Maximizes the present value of tax savings from deductions due to the acceleration of thedeductions into earlier years with a

higher tax rate.

Taxable income Defer taxable income into later tax years.

Minimizes the present value of taxes paid due to the deferral of the income to later years with a lower tax rate.

3-10 CHAPTER 3 Tax Planning Strategies and Related Limitations

TAXES IN THE REAL WORLD Tax Reform and Tax Planning

How does tax reform affect taxpayers’ tax plan-ning? It depends! There is little debate that tax reform affects taxpayers’ decisions, but how it af-fects their decisions is a function of the enacted tax laws and taxpayers’ circ*mstances. Provi-sions to reduce the tax rate, eliminate the interest deduction on corporate debt, and change the tax treatment of capital expenditures affect the after-tax cost of investments, making them more diffi-cult to appropriately value. As a result, it is more difficult for taxpayers to determine the appropri-ate tax planning strategy.

For companies in the business of investing, such as private equity firms and real estate in-vestment companies, the various tax provisions can have a big and potentially negative impact. For example, it is fairly common for private eq-uity firms to use leveraged buyouts to acquire portfolio companies. Eliminating interest deduc-tions reduces the value of the portfolio compa-nies and, consequently, reduces the profitability

of private equity firms. Therefore, this provision might encourage taxpayers to reduce debt us-age on investment purchases (an example of the conversion strategy). Capital intensive busi-nesses will see tax benefits from a tax provision that allows full expensing of capital investments, leading to their use of the timing strategy to pur-chase assets in the time period when these as-sets can be immediately expensed rather than depreciated. Similarly, a reduction in tax rates can generate additional tax benefits by encour-aging taxpayers to accelerate deductions in a year with higher tax rates or to defer income so it is realized in a year with lower tax rates, a ba-sic tax timing strategy.

With tax reform, it is certain that taxpayersare assessing how their tax strategies might change.

Source: Based on: “Tax reform uncertainty testing alternative investors,” http://www.pionline.com/article/ 20170417/PRINT/304179983/tax-reform-uncertainty-testing-alternative-investors, April 17, 2017.

recommendations in this case. The recommendations are clear. Taxpayers should acceler-ate tax deductions into earlier years to reap the tax savings from accelerating deductions to higher-tax-rate years. Likewise, taxpayers should defer taxable income to later years to enjoy the tax benefits of deferring taxable income to lower-tax-rate years.

THE KEY FACTS

Limitations to the Timing Strategy

Timing strategies contain several inherent limitations.• Whenever a taxpayer is

unable to accelerate a deduction without also accelerating the cash out-flow, the timing strategy will be less beneficial.

• Tax law generally requires taxpayers to continue their investment in an asset in order to defer income rec-ognition for tax purposes.

• A deferral strategy may not be optimal if the tax-payer has severe cash flow needs, if continuing the investment would generate a low rate of return compared to other investments, if the current investment would subject the taxpayer to unneces-sary risk, and soon.

• The constructive receipt doctrine, which provides that a taxpayer must recognize income when itisactually or construc-tively received, also restricts income deferral for cash-method taxpayers.

Limitations to Timing Strategies Timing strategies contain certain inherent limita-tions. First, tax laws generally require taxpayers to continue their investment in an asset in order to defer income recognition for tax purposes. In other words, deferral is generally not an option if a taxpayer has “cashed out” of an investment.7 For example, Bill could not sell his Dell stock in December and then choose not to recognize the income until January. A deferral strategy may not be optimal if (1) the taxpayer has severe cash flow needs, (2) continuing the investment would generate a low rate of return compared to other investments, or (3) the current i nvestment would subject the taxpayer to unneces-sary risk. For example, the risk that thevalue of Bill’s investment in Dell Inc. will decline from December to January in Example 3-4 may lead Bill to forgo deferring his stock sale until January. Again, the astute taxpayer considers both the tax and nontax ramifications of deferring income.

A second limitation results from the constructive receipt doctrine, which also re-stricts income deferral for cash-method taxpayers.8 Unlike accrual-method taxpayers, cash-method taxpayers report income for tax purposes when the income is received, whether it is in the form of cash, property, or services.9 The cash method affords taxpayers

7See the discussions of like-kind exchanges in the Property Dispositions chapter.8Later in this chapter we discuss other judicial doctrines that apply to all planning strategies.9Accrual-method taxpayers report income when it is earned. In general, income is deemed earned when all events have occurred that fix the taxpayer’s right to the income and the income can be estimated with reason-able accuracy. Thus, income recognition for accrual-method taxpayers generally is not tied to payment. The constructive receipt doctrine may apply in situations in which no cash, property, or services have been received but the taxpayer has a right to the income.

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CHAPTER 3 Tax Planning Strategies and Related Limitations 3-11

some leeway in determining when to recognize income, because such taxpayers can control when they bill their clients. However, the constructive receipt doctrine provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has been credited to the taxpayer’s account or if the income is unconditionally available to the taxpayer, the tax-payer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income.

Example 3-6

Mercedes’sbrother-in-law,Carlos,worksforKingAcura,whichrecentlyinstitutedabonusplanthatpaysyear-endbonuseseachDecembertoemployeesratedaboveaveragefortheircustomerser-vice.Carlosisexpectinga$10,000bonusthisyearthatwillbepaidonDecember31.Thinkinghe’dprefertodeferthisincomeuntilnextyear,CarlosplanstotakeavacationonDecember30sothathewillnotreceivehisbonuscheckuntilJanuary.WillCarlos’sstrategywork?

Answer: No,theconstructivereceiptdoctrineapplieshere.BecauseCarlos’scheckwasuncondition-allyavailabletohimonDecember31,hewasawareofitsavailability,andtherewerenorestrictionsonhiscontrolovertheincomeonthatdate,Carlosmustreporttheincomeinthecurrentyear.

What could taxpayers do to avoid Carlos’s problem in the future? They could request that their employer institute a company policy of paying bonuses on January 1, which would allow all employees to report the bonus income in that year. However, if the em-ployer is a cash-method taxpayer, this creates a potential conflict with its employees. Such an employer would most likely prefer to deduct the bonus in the current year, which requires the bonuses to be paid in December. This conflict would not exist if the employer were an accrual-method taxpayer, because paying the bonuses in January would not affect its ability to deduct the bonuses in the previous year.10

LO 3-4 LO 3-6INCOME-SHIFTING STRATEGIESWe’ve seen that the value of a tax deduction, or the tax cost of income, varies with the marginal tax rate. We’ve also seen that tax rates can vary across time, which leads to ba-sic tax planning strategies regarding when to recognize deductions and income. Tax rates can also vary across taxpayers or jurisdictions (states, countries), which leads to still other tax planning strategies—for example, shifting income from high-tax-rate taxpayers to low-tax-rate taxpayers or shifting deductions from low-tax-rate taxpayers to high-tax-rate taxpayers.

The type of taxpayers who benefit most from this strategy are (1) related parties, such as family members or businesses and their owners, who have varying marginal tax rates and are willing to shift income for the benefit of the group; and (2) taxpayers operating in multiple jurisdictions with different marginal tax rates. In any case, tax planners should seek only legitimate methods of shifting income that will withstand IRS scrutiny. In the following section we discuss transactions between family members, followed by a discus-sion of transactions between owners and their businesses, and finally a discussion of in-come shifting across jurisdictions.

10§267(a)(2). When an employee/shareholder and an employer/corporation are related (i.e., the employee/shareholder owns more than 50 percent of the value of the employer corporation), the corporation cannot deduct the compensation expense until the employee/shareholder includes the payment in income.

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LO 3-4 LO 3-6

3-12 CHAPTER 3 Tax Planning Strategies and Related Limitations

Transactions between Family Members and LimitationsOne of the most common examples of income shifting is high-tax-rate parents shifting in-come to low-tax-rate children. For example, Bill and Mercedes have a 32 percent marginal tax rate, whereas their daughter, Margaret, has a 10 percent marginal tax rate. Assuming their marginal tax rates remain constant with relatively modest changes in income, every $1 of income that Bill and Mercedes shift to Margaret reduces the family’s tax liability by 22 cents [$1 × (32% − 10%)]. Thus, if Bill and Mercedes shift $10,000 of taxable income to Margaret, the family’s after-tax income will increase by $2,200. Can taxpayers legally do this? Yes and no. As you might expect, there are limitations on this type of income shifting.

The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns it.11 Merely attributing your paycheck or dividend to another taxpayer does not transfer the tax liability associated with the income. The assignment of income doctrine im-plies that, in order to shift income to a taxpayer, that taxpayer must actually earn the income. For example, if Mercedes would like to shift some of her business income to Margaret, Margaret must actually earn it. One way to accomplish this would be for Mer cedes to employ Margaret in her business and pay her a $10,000 salary. The effects of this transaction are to decrease Mercedes’s taxable income by $10,000 because of tax-deductible salary expense, and to increase Margaret’s income by the $10,000 taxable salary. What if Margaret is paid $10,000 to answer Mercedes’s business phone one Saturday afternoon every month? Does this seem reasonable? Not likely. The IRS frowns upon this type of aggressive strategy.

Indeed, the IRS closely scrutinizes such related-party transactions—that is, finan-cial activities among family members (also among owners and their businesses, or among businesses owned by the same owners). Unlike arm’s length transactions, in which each transacting party negotiates for his or her own benefit, related-party transactions are use-ful for taxpayers who are much more willing to negotiate for their own common good to the detriment of the IRS. For example, would Mercedes pay an unrelated party $10,000 to answer the phone once a month? Doubtful.12

Are there other ways to shift income to children? For example, could Bill shift some of his investment income to Margaret? Yes, but there’s a catch. The assignment of income ap-plies what is referred to as the “fruit and the tree” analogy [Lucas v. Earl (S. Ct., 1930), 8AFTR 10287]. For the owner to avoid being taxed on the fruit from the tree (the income), the owner must transfer the tree. Thus, to shift investment income, Bill would also have to transfer ownership in the underlying investment assets to Margaret.13 Is there a problem with this requirement? Not for Margaret. However, Bill would likely prefer to maintain his wealth. The nontax disadvantages of transferring wealth to implement the income-shifting strategy often outweigh the tax benefits of the transfer. For example, most parents either could not afford to or would have serious reservations about transferring significant wealth to their children—a prime example of how nontax costs may override tax considerations.

Transactions between Owners and Their Businesses and LimitationsIncome shifting is not limited to transactions within a family unit. One of the most com-mon examples occurs between owners and their businesses. Let’s consider Mercedes’s interior design business. Currently, Mercedes operates her business as a sole proprietorship. A sole proprietorship (unlike a C corporation) is not a separate reporting entity, and thus, Mercedes reports her business income and deductions on her individual tax return. Shifting

11Later in this chapter we discuss other judicial doctrines that apply to all planning strategies.12The Internal Revenue Code also contains specific provisions to curtail benefits from related-person transac-tions. For example, §267 disallows a tax deduction for losses on sales to related persons (even if the sale was consummated at the asset’s fair market value).13Further, the “kiddie tax” may apply when parents shift too much investment income to children. The kiddie tax restricts the amount of a child’s investment income that can be taxed at the child’s (lower) tax rate and subjects the rest to trust (higher) tax rates.

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CHAPTER 3 Tax Planning Strategies and Related Limitations 3-13

income to or from her sole proprietorship offers no benefit because all of her sole propri-etorship income is reported on her tax return, regardless of whether it is attributed to her personally or to her business. On the other hand, if Mercedes operated her interior design business as a C corporation, shifting income to or from the C corporation may make good financial sense because the corporation would be a separate entity with tax rates distinct from Mercedes’s individual tax rate. Shifting income to herselffrom the C corporation may allow Mercedes to decrease the tax on her business profits, thereby increasing her after-tax income.This strategy may become more common with the recent significant drop in the corporate tax rates compared to the small decrease in individual tax rates. Example 3-7 illustrates the savings obtainable from this strategy.

Example 3-7

Mercedesisconsideringincorporatingherinteriordesignbusiness.Sheprojects$200,000ofbusinessprofitnextyear.Excludingthisprofit,BillandMercedesexpect$70,000oftaxableincomenextyear.IfMer-cedeswouldliketominimizehercurrent-yeartaxliability,shouldsheincorporateherbusiness?(UsethemarriedfilingjointlytaxratescheduleandthecorporatetaxrateinAppendixDtoanswerthisquestion.)

Answer: IfMercedesdoesnotincorporateherbusiness,thefirst$8,950ofherbusinessprofitswillbetaxedat12percent(from$70,000to$78,950oftaxableincome,themarginaltaxrateis12percent.Thenext$89,450(from$78,950to$168,400oftaxableincome)wouldbetaxedat22percent.Theremain-ing$101,600(from$168,400to$270,000oftaxableincome)wouldbetaxedat24percent.Uponre-viewingthecorporatetaxrateschedule,youshouldnotethatthecorporatetaxrateisaflat21percent,andislowerthanBillandMercedes’scurrentmarginaltaxrateof24percent.Thus,thereappearstobesomeopportunityforMercedestoreducehercurrent-yeartaxliabilitybyincorporatingherbusiness.14

In order to shift income from the corporation to the owner, the corporation must create a tax deduction for itself in the process. Compensation paid to employee–owners is the most common method of shifting income from corporations to their owners. Compensation ex-pense is deductible by the corporation and is generally taxable to the employee. (Seethe Com-pensation chapterfor a broader discussion of nontaxable compensation benefits.) Having the business owner rent property to the corporation or loan money to the corporation are also ef-fective income-shifting methods, because both transactions generate tax deductions for the corporation and income for the shareholder. Because corporations don’t get a tax deduction for dividends paid, paying dividends is not an effective way to shift income. Having a corporation pay dividends actually results in “double taxation”—the profits generating the dividends are taxed first at the corporate level, and then at the shareholder level. Depending on the taxpayer’s tax rate and their dividend tax rate, this strategy may be a good onethough under the new tax law it can be quite complicated, and recommending this tax planning strategy without analyz-ing the taxpayer’s situation may not be a good way to keep your job as a tax consultant.

After a taxpayer identifies the opportunity and appropriate method to shift income (compensation paid to a related party), he or she can easily determine the optimal amount to shift depending on the taxpayers’ marginal tax rates.

Example 3-8

AssumingMercedes’sgoalistominimizehercurrent-yearfederalincometaxliability,howmuchofthe$200,000businessincomeshouldhercorporationreport?

Answer: Itshouldreport$191,050.Comparingthetwotaxrateschedulesrevealshowtocalculatethisnumber.

(continued on page 3-14)

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14Note that this is a simplified discussion of one of many tax issues associated with incorporating a business and assumes Mercedes’s business does not qualify for the deduction for qualified business income discussed in the Individual Deductions chapter. In addition, as discussed later in this chapter, Mercedes must consider the judicial doctrines (economic substance, business purpose, etc.) in making this decision. She also needs to consider further tax planning opportunities described in the following example.

3-14 CHAPTER 3 Tax Planning Strategies and Related Limitations

Step 1:WouldMercedesratherhaveincometaxedat21percent(thecorporation’staxrate)or12per-cent(BillandMercedes’smarginaltaxratebeforerecognizinganyprofitfromMercedes’sbusiness)?Theobviousansweris12percent.TotakeadvantageofBillandMercedes’s12percenttaxbracket,Mercedesshouldshift$8,950oftheexpected$200,000inprofitstoherselfandBill—viaasalarypaidtoMercedes.

Step 2:AssumingBillandMercedesreport$78,950ofincome,theirmarginaltaxratewillnowbe22percent,andthusMercedes’schoiceistohaveadditionalincometaxedat22percent(BillandMercedes’smarginaltaxrate)orat21percent(thecorporation’staxrate).Theclearanswerinthiscaseis21percent.Totakeadvantageofthe21percentcorporatetaxrate,thecorporationshouldretaintheremaining$191,050oftheexpected$200,000inprofits.

HowmuchcurrentfederalincometaxdoesthisstrategysaveBillandMercedes?Thecorporation’sandBillandMercedes’scombinedfederalincometaxliabilitywillbe$49,207($40,121forthecorpo-rationplus$9,086forBillandMercedes)comparedto$53,149forBillandMercedesifthebusinessisoperatedasasoleproprietorship.Thus,theywillsave$3,942.15

Are there nontax disadvantages of the income-shifting-via-incorporating strategy? Yes. For example, one nontax disadvantage for Mercedes is that her new corporation now has $150,929 of her after-tax profits ($191,050 profits less $40,121 of corporate tax). If Mercedes has personal cash-flow needs that require use of the $150,929, this is not a viable strategy. Indeed, it’s advantageous only if the business owner intends to reinvest the business profits into the business. Furthermore, any subsequent transactions between Mercedes and the corporation would clearly be related-party transactions. Thus, Mercedes should be prepared for IRS scrutiny.16

As the above example illustrates, tax-avoiding strategies can be quite beneficial and as Bill and Mercedes’s personal (nonbusiness) income increases (i.e., their tax bracket increases on personal income), the strategies will produce even greater tax savings. With the decrease in the corporate tax rate from 35 percent to 21 percent due to recent tax law changes, we are likely to see an increasing preference for businesses to operate as corpo-rations. However, tax planning strategies also entail some financial risks if they fail to pass muster with the IRS.

ETHICS

AgnesMeheristheownerofLuPat,aprofitableconstruction company that she operates as asoleproprietorship.Asasoleproprietor,AgnesreportsthebusinessincomefromLuPatonherindividualtaxreturn.Agnesexpectsthebusinessto generate $400,000 of taxable income thisyear.Combinedwithherother income, thiswillputherinthetoptaxbracket(37percent).AgneshastwochildrennamedEllieMaeandSpencer,

ages9and11,respectively,whodonotcurrentlyhaveany taxable income.Agneswould like toshiftsomeofherincomefromLuPattoEllieMaeandSpencer to reduce theoverall taxburdenfrom thebusiness income.Toshift the income,AgneshiredEllieMaeandSpencer toperformsome janitorial and clerical services for LuPat,payingeachchild$20,000.Whatdoyouthinkofa*gnes’sstrategy?

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15This strategy will result in the eventual double taxation of the income retained in Mercedes’s corporation. Specifically, Mercedes will eventually have to pay tax on the income retained by the corporation, either in the form of taxable dividends from the corporation or a taxable gain when she sells or liquidates the corpora-tion. The present value of this additional layer of tax reduces the tax savings from this strategy. The longer that the second layer of tax is deferred, the more advantageous this strategy will be. In addition, the example ignores employment-related taxes. These calculations are beyond the scope of this chapter.16The taxpayer should maintain documentation for related-party transactions (e.g., notes for related-party loans and contemporaneous documentation of reasonable compensation paid to related parties).

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-15

Income Shifting across Jurisdictions and LimitationsTaxpayers that operate in multiple jurisdictions (states, countries) also apply the income-shifting strategy. Specifically, income earned in different jurisdictions—whether in the United States or abroad, and for state income tax purposes, income earned in different states—is often taxed very differently. With a proper understanding of the differences in tax laws across jurisdictions, taxpayers can use these differences to maximize their after-tax wealth.

Example 3-9

Carlos’semployer,KingAcura,hastwolocations. Itsmainlocationis inSouthDakota(astatewithnocorporatetax),withasecondarylocationinNorthDakota(maximumcorporatestatetaxrateof4.31percent).WhattaxplanningstrategymaysavemoneyforKingAcura?

Answer: ThemostobviousstrategyistoshiftincomefromtheNorthDakotalocationtotheSouthDakotalocation,therebyreducingKingAcura’sstateincometaxliabilitybyabout4.31centsforeverydollarofincomeshifted.17

A number of possibilities exist to execute a strategy such as King Acura’s in Example 3-9. Assuming that the North Dakota and South Dakota locations exchange cars, the firm could shift income via transfer pricing (using the price the South Dakota location charges the North Dakota location for cars transferred to North Dakota). Likewise, if the South Dakota location (the corporate headquarters) provides a legitimate support function for the North Dakota location, the firm should allocate a portion of theoverhead and administrative expenses from the South Dakota location to the North Dakota location.

THE KEY FACTS

The Income-Shifting Strategy

• Income shifting exploits thedifferences in tax rates across taxpayers or jurisdictions.

• Common examples of income shifting include high-tax-rate parents shift-ing income to low-tax-rate children, businesses shift-ing income to their owners, and taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions. The assign-ment of income doctrine requires income to be taxed to the taxpayer who actually earns the income.

• The IRS closely monitors income-shifting strategies that involve related-party transactions.

What are some of the limitations of income shifting across jurisdictions? First, taxing authorities are fully aware of the tax benefits of strategically structuring trans-actions across tax borders (across countries or states). Thus, the IRS closely examines transfer pricing on international transactions. Similarly, state tax authorities scrutinize interstate transactions between related taxpayers. Second, when taxpayers locate in low-tax-rate jurisdictions to, in effect, shift income to a tax-advantaged jurisdiction, they may bear implicit taxes (i.e., additional costs attributable to the jurisdiction’s tax advantage). For example, the demand for workers, services, or property in low-tax-rate jurisdictions, whether a foreign country or a low-tax state, may increase the non-tax costs associated with operating a business there enough to offset the tax advantages. Finally, negative publicity from moving operations (and jobs) from the United States to a lower-tax jurisdiction may more than offset any tax benefits associated with these strategies.

CONVERSION STRATEGIES LO 3-5

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We’ve now seen how tax rates can vary across time and taxpayers. They can also vary across different activities. For example, ordinary income such as salary, interest income, and business income received by individual taxpayers is taxed at their ordinary marginal tax rates. Long-term capital gains, which are gains from the sale of investment assets held

17Because state taxes are deductible for federal tax purposes, every dollar of state taxes reduced with this strategy will increase King Acura’s federal income tax liability by its federal marginal tax rate (e.g., 21 percent). Thus, the net tax savings for every dollar of income shifted from North Dakota to South Dakota will be 3.4 percent, which equals the state tax savings (4.31 percent) less the federal tax increase resulting from the lost state tax deduction (4.31% × 21%).

3-16 CHAPTER 3 Tax Planning Strategies and Related Limitations

longer than one year, and dividends are taxed at lower tax rates (currently a maximum of 20 percent), and still other forms of income like nontaxable compensation benefits and municipal bond interest are tax-exempt. Expenses from different types of activities may also be treated very differently for tax purposes. Business expenses are generally fully tax deductible, whereas tax deductions for investments may be limited, and tax deductions for personal expenses may be completely disallowed. In sum, the tax law does not treat all types of income or deductions the same. This understanding forms the basis for the conversion strategy—recasting income and expenses to receive the most favorable tax treatment.

THE KEY FACTS

The Conversion Strategy• The conversion strategy is

based on the understand-ing that the tax law does not treat all types of income or deductions the same.

• To implement the conver-sion strategy, taxpayers should be aware of the underlying differences in tax treatment across vari-ous types of income, ex-penses, and activities and have some ability to alter the nature of the income orexpense to receive the more advantageous tax treatment.

• The Internal Revenue Code contains specific provisions that prevent the taxpayer from changing the nature ofexpenses, income, or activities to a more tax- advantaged status.

• Implicit taxes may reduce or eliminate the advantages of conversion strategies.

To implement the conversion strategy, the taxpayer must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities and have some ability to alter the nature of the income or expense to receive the more advan-tageous tax treatment. What are some common examples of the conversion strategy? In-come and deductions with differing character, investments generating income subject to differing tax rates, expenses with differing deductibility, and compensation resulting in taxable versus nontaxable income are all examples of items to which the conversion strat-egy can apply.

To analyze the benefits of the conversion strategy, you often compare the after-tax rates of return of alternative investments rather than the before-tax rates of return. Given a stationary marginal tax rate, you can calculate an investment’s after-tax rate of return as follows:

Eq. 3-3 After-Tax Rate of Return = Before-Tax Rate of Return

− (Before-Tax Rate of Return × Marginal Tax Rate)

which simplifies to

After-Tax Rate of Return = Before-Tax Rate of Return Eq. 3-4

× (1 − Marginal Tax Rate)

Example 3-10

Billiscontemplatingthreedifferentinvestments,eachwiththesameamountofrisk:

Ahigh-dividendstockthatpays8.5percentdividendsannuallybuthasnoappreciationpotential.2. Taxablecorporatebondsthatpay9.7percentinterestannually.3. Tax-exemptmunicipalbondsthatpay6percentinterestannually.

Assumingthatdividendsaretaxedat20percentandthatBill’smarginaltaxrateonordinaryincomeis37percent,whichinvestmentshouldBillchoose?

Answer: Toanswerthisquestion,wemustcomputeBill’safter-taxrateofreturnforeachinvestment.Theafter-taxratesofreturnforthethreeinvestmentsare

Investment Choice Computation After-Tax Rate of Return

High-dividendstock 8.5%×(1−20%)= 6.8%Corporatebond 9.7%×(1−37%)= 6.1Municipalbond 6%×(1−0%)= 6.0

Accordingly,Billshouldchoosethedividend-yieldingstock. Whatmarginal tax rateonordinary incomewouldmakeBill indifferentbetween thedividend-yieldingstockandthecorporatebond?

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After-Tax Rate of Return = Before-Tax Rate of Return × (1 − Marginal Tax Rate)

Example 3-10

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-17

Answer: Thedividend-yieldingstockhasanafter-taxratereturnof6.8percent.ForBilltobeindifferentbetweenthisstockandthecorporatebond,thecorporatebondwouldneeda6.8percentafter-taxrateofreturn.WecanuseEquation3-4tosolveforthemarginaltaxrate.

After-TaxRateofReturn=Before-TaxRateofReturn×(1−MarginalTaxRate)6.8%=9.7%×(1−MarginalTaxRate)

MarginalTaxRate=29.90%

Let’scheckthisanswer:

After-TaxRateofReturn 9.7% (1 29.90%) 6.8%= × − =

Example 3-10 shows how taxpayers may compare investments when the investment period is one year. However, when taxpayers hold investments for more than a year they potentially receive benefits from combining the timing strategy and the conversion strategy. First, they may be able to defer recognizing gains on the assets until they sell them—the longer the deferral period, the lower the present value of the tax when taxpayers ultimately sell the assets. Second, they may pay taxes on the gains at preferential rates. For example, taxpayers who invest in a corporate stock (capital asset) that does not pay dividends will defer gain on any stock appreciation until they sell the stock, and because it is a capital asset held longer than one year, their gains will be taxed at the lower preferential tax rate for long-term capital gains. These tax advantages provide taxpayers with a greater after-tax rate of return on these investments than they would obtain from less tax-favored assets that earn equivalent before-tax rates of return. Investors who quickly sell investments pay taxes on gains at higher, ordinary rates and incur significantly greater transaction costs. Neverthe-less, taxpayers should balance the tax benefits available for holding assets with the risk that the asset values will have declined by the time they want to sell the assets.

To compare investments with differing time horizons, taxpayers use the annualized after-tax rate of return. In general, the after-tax rate of return on any investment is (FV/I)1/n – 1 where FV is the future value after taxes, I is the investment (in after-tax dollars), and n is the number of investment periods.18

Example 3-11

What if: AssumeBilldecidestopurchaseIntelstockfor$50,000andholdthesharesforfiveyears.IftheIntelstockgrowsataconstant8percentbefore-taxrateanddoesnotpayanydividends,howmuchcashwillBillaccumulateaftertaxesafterfiveyears,assumingalong-termcapitalgainstaxrateof20percent?

Answer: $68,773,computedasfollows:

Description Amount Explanation

(1)Proceedsfromsale $73,466 [$50,000×(1+0.08)5](2)Basisinshares 50,000 Thisistheinvestmentintheshares.(3)Gainrealizedonsale $23,466 (1)−(2)(4)Taxrateongain ×20% Lowrateforlong-termcapitalgain*(5)Taxongain $ 4,693 (3)×(4)After-tax cash after 5 years $68,773 (1)−(5)

(continued on page 3-18)

*AssumesBilldoesn’thaveanycapitallosses.

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18Financial calculators designate this calculation as the IRR or internal rate of return.

3-18 CHAPTER 3 Tax Planning Strategies and Related Limitations

Whatannualafter-taxrateofreturnwillBillearnonthemoneyinvested?

Answer: 6.58percent[($68,773/$50,000)1/5−1].

What if: Whatwouldbetheafter-taxrateofreturnifBillheldthestockfor18years?

Answer: 7.03percent,computedasfollows:

Description Amount Explanation

(1)Proceedsfromsale $199,801 [$50,000×(1+0.08)18](2)Basisinshares 50,000 Thisistheinvestmentintheshares.(3)Gainrealizedonsale $149,801 (1)−(2)(4)Taxrateongain(5)Taxongain

× 20%$ 29,960

Lowrateforlong-termcapitalgain*(3)×(4)

After-taxcashafter18years $169,841 (1)−(5)

After-tax rate of return after18 years

7.03% [($169,841/$50,000)1/18−1]

*AssumesBilldoesn’thaveanycapitallosses.

What if: HowdoesBill’srateofreturnontheIntelstockheldforfiveyearscomparetoataxablecor-poratebondthatpays9percentinterestannuallyandisheldforfiveyears?

Answer: Theannualizedrateofreturnonthestockheldforfiveyears is6.58percent,asshownabove.Becausethe interestonthetaxablecorporatebondis taxedannually, theannualafter-taxrateofreturndoesnotchangewiththeinvestmenthorizonandwillequal6.1percent,asshowninExample3-10[9.7%×(1−37%)].Inthissituation,thecombinedtaxbenefitsfromthetimingandcon-versionstrategiescausethestockinvestmenttogenerateahigherannualizedafter-taxreturnthanthetaxablecorporatebondeventhoughitspretaxreturnislower.

Limitations of Conversion StrategiesLike other tax planning strategies, conversion strategies face potential limitations. The Internal Revenue Code itself also contains several specific provisions that prevent the tax-payer from changing the nature of expenses, income, or activities to a more tax-advantaged status, including (among many others) the depreciation recapture rules discussed in the Property Dispositions chapter and the luxury auto depreciation rules discussed in theProperty Acquisition and Cost Recovery chapter. In addition, as discussed in the Introduction to Tax chapter, implicit taxes may reduce or eliminate the advantages of tax-preferred investments (such as municipal bonds or any investment taxed at preferential tax rates) by decreasing their before-tax rate of returns. Thus, implicit taxes may reduce the advantages of the conversion strategy.

LO 3-6

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ADDITIONAL LIMITATIONS TO TAX PLANNING STRATEGIES: JUDICIALLY BASED DOCTRINESThe IRS has several other doctrines at its disposal for situations in which it expects tax-payer abuse. These doctrines have developed from court decisions and apply across a wide variety of transactions and planning strategies (timing, income shifting, and conver-sion). The business purpose doctrine, for instance, allows the IRS to challenge and dis-allow business expenses for transactions with no underlying business motivation, such as the travel cost of a spouse accompanying a taxpayer on a business trip. The step-transac-tion doctrine allows the IRS to collapse a series of related transactions into one transac-tion to determine the tax consequences of the transaction. The substance-over-form doctrine allows the IRS to consider the transaction’s substance regardless of its form and, where appropriate, to reclassify the transaction according to its substance. Finally, the

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-19

economic substance doctrine requires transactions to meet two criteria to obtain tax benefits. First, a transaction must meaningfully change a taxpayer’s economic position (ex-cluding any federal income tax effects). Second, the taxpayer must have a substantial pur-pose (other than tax avoidance) for the transaction. Economic substance is clearly related to several other doctrines such as the business purpose, step-transaction, and substance- over-form doctrines; however, the economic substance doctrine was incorporated into the Internal Revenue Code as §7701(o). This codification standardizes the requirement for transactions to meet both tests.None of the other doctrines have yet been codified.

THE KEY FACTS

Additional Limitations to Tax Planning Strategies:

Judicial Doctrines• Certain judicial doctrines

restrict the common tax planning strategies (timing, income shifting, and conversion).• The business purpose

doctrine allows the IRS to challenge and disal-low business expenses for transactions with no underlying business motivation.

• The step-transaction doctrine allows the IRS to collapse a series of related transactions intoone transaction todetermine the tax consequences of the transaction.

• The substance-over-form doctrine allows the IRS to reclassify a trans-action according to its substance.

• The economic substance doctrine requires trans-actions to have both an economic effect (aside from the tax effect) and a substantial purpose (aside from reduction oftax liability).

The courts have been inconsistent with the application of the tests, with some requir-ing the transaction to meet either the business purpose or the economic substance require-ments and others requiring that it meet both tests. A key part of the codificationof the economic substance doctrine is a stiff penalty of 40 percent of the underpayment for failing to meet the requirements—reduced to 20 percent if the taxpayer makes adequate disclosure. In the Tax Compliance, the IRS, and Tax Authorities chapter, we noted that the Internal Revenue Code is the ultimate tax authority. The business purpose, step- transaction, substance-over-form, and economic substance doctrines allow the IRS to state the tax consequences of transactions that follow only the form of the Internal Revenue Code and not the spirit.

You can often assess whether the business purpose, step-transaction, or substance-over-form doctrines apply by using the “smell test.” If the transaction “smells bad,” one of these doctrines likely applies. (Transactions usually “smell bad” when the primary purpose is to avoid taxes and not to accomplish an independent business objective.) For example, using the substance-over-form doctrine, the IRS would likely reclassify most of the $10,000 paid to Margaret for answering the phone one Saturday afternoon a month as a gift from Mercedes to Margaret (see the earlier discussion of income shifting and trans-actions between family members), even though the transaction was structured as compen-sation and Margaret did do some work for her mother. This recharacterization would unwind the income-shifting benefits for the amount considered to be a gift, because gifts to family members are not tax deductible. In sum, the substance of the transaction must be justifiable, not just the form.

TAX AVOIDANCE VERSUS TAX EVASIONEach of thegeneral tax planning strategies discussed in this book falls within the confines of legal tax avoidance. Tax avoidance has long been endorsed by the courts and even Congress. Recall, for example, that Congress specifically encourages tax avoidance by excluding municipal bond income from taxation, preferentially taxing dividend and capi-tal gain income, and enacting other provisions. Likewise, the courts have often made it quite clear that taxpayers are under no moral obligation to pay more taxes than required by law. As an example, in Commissioner v. Newman, 159 F.2d 848 (2 Cir., 1947), which considered a taxpayer’s ability to shift income to his children using trusts, Judge Learned Hand included the following statement in his dissenting opinion:

LO 3-7

THE KEY FACTS

Tax Evasion versus Tax Avoidance

• Tax avoidance is the legal act of arranging your transactions to minimize taxes paid.

• Tax evasion is the willful attempt to defraud the government by not paying taxes legally owed.

• Tax evasion falls outside the confines of legal tax avoidance.

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not volun-tary contributions. To demand more in the name of morals is mere cant.

In contrast to tax avoidance, tax evasion—that is, the willful attempt to defraud the government—falls outside the confines of legal tax avoidance and thus may land the per-petrator within the confines of a federal prison. (Recall from the Tax Compliance, the IRS, and Tax Authorities chapter that the rewards of tax evasion include stiff monetary penalties and imprisonment.) When does tax avoidance become tax evasion? Very good question. In many cases a clear distinction exists between avoidance (such as not paying tax on municipal bond interest) and evasion (not paying tax on a $1,000,000 game show

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3-20 CHAPTER 3 Tax Planning Strategies and Related Limitations

prize). In other cases, the line is less clear. In these situations, professional judgment, the use of a smell test, and consideration of the business purpose, step-transaction, substance-over-form, and economic substance doctrines may prove useful.

TAXES IN THE REAL WORLD Cheating the IRS

Fewpeopleliketopaytaxes,butmostofusdoso.Some,however,trytocheattheIRS,includingtherichandfamous(amongthem,Mike“TheSit-uation” Sorrentino, Chris Tucker, and rapperDMX).FolkswhoaretryingtoescapethereachoftheIRSmayfailtofiletaxreturns,claimdeduc-tionstowhichthey’renotentitled,makeupfakebusinessexpenses,orotherwisetrytodisguisehowmuchmoney they reallymade.These taxevaderscostthegovernmentalotofmoney.Theaverage annual “tax gap” for 2008–2010, themost recentperiod forwhich the IRShasesti-mated the amount of owed taxes thatweren’tpaidontime,is$458billion(seehttps://www.irs.gov/newsroom/the-tax-gap).

Themaincauseofthetaxgapisunderreport-ing income, accounting for $376billionof theIRS’smissingmoney.Notfilingreturnsandunder-payingtaxesowedweretwoothercauses.Someofthatmoneyfails tomakeit intothehandsofthe government through innocent accounting

mistakesortheinabilityoftaxpayerstopayeventhoughtheywantto.Butsomeofitgoesmissingduetodeliberatefraud.

Infiscalyear(FY)2016,theIRSinitiated3,395criminal investigationsrelatedto taxcodeviola-tions(thesearen’tthesameasaudits,whicharemuch more common—1.03 million individualswereauditedinFY2016).Thenumberofcriminalinvestigationsisrelativelysmall,especiallyconsid-eringthemillionsoftaxpayersintheUnitedStates.ButoncetheIRSstartsaninvestigation,there’sagoodchanceitwillleadtoaconvictionandprisontimefortheoffender.TheIRSboastsofa79.5per-centconvictionrate (2,699sentenced/3,395in-vestigations)onthesecriminaltaxcases.

Source: “AvoidanAudit:6TaxLessonsfromCelebrities,”http://www.cheatsheet.com/personal-finance/5-lessons-from-celebrity-tax-cheats.html/?a=viewallApril4,2016;andtheIRSCriminalDivisions2016AnnualReport,https://www.irs.gov/pub/foia/ig/ci/2016_annual_report_02092017.pdf.

As you might expect, tax evasion is a major problem for the IRS that vigorous pros-ecution alone has not been able to solve. Is tax evasion a victimless crime? No. Because the federal government must replace lost tax revenues by imposing higher taxes on oth-ers, honest taxpayers are the true victims of tax evasion. Currently, themost recent fed-eral government estimatesindicate that tax evasion costs the federal government more than $450 billion annually in lost tax revenues. As citizens and residents of the United States, each of us must recognize our obligation to support our country. As future ac-countants and business professionals, we also must recognize the inherent value of high ethical standards, which call for us to do the right thing in all situations. Business pro-fessionals have learned over and over that the costs of doing otherwise far exceed any short-term gains.

CONCLUSIONIn this chapter we discussed three basic tax planning strategies—timing, income shifting, and conversion—and their related limitations. Each of these strategies exploits the varia-tion in taxation across different dimensions. The timing strategy exploits the variation in taxation across time: The real tax costs of income decrease as taxation is deferred; the real tax savings associated with tax deductions increase as tax deductions are accelerated. However, because tax rates may change over time and the tax costs of income and tax savings of deductions vary with tax rates, tax planning should consider the effects of such changes on the timing strategy. The income-shifting strategy exploits the variation in taxation across taxpayers or jurisdictions. The assignment of income doctrine limits ag-gressive attempts to shift income across taxpayers. In addition, related-party transactions

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https://www.irs.gov/newsroom/the-tax-gap

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-21

receive close IRS attention given the increased likelihood of taxpayer abuses in these transactions. Finally, the conversion strategy exploits the variation in taxation rates across activities, although implicit taxes may reduce the advantages of this strategy. In addition to limitations specific to each planning strategy, the judicial doctrines of business pur-pose, step-transaction, and substance-over-form broadly apply to a wide range of transac-tions and planning strategies.

The timing, income-shifting, and conversion strategies represent the building blocks for the more sophisticated tax strategies that tax professionals employ on a daily basis. Combining an understanding of these basic tax planning strategies with knowledge of our tax law will provide you with the tools necessary to identify, evaluate, and implement tax planning strategies. Throughout the remainder of the text, we will discuss how these strat-egies can be applied to different transactions.

Summary

Identifytheobjectivesofbasictaxplanningstrategies. LO 3-1

• Effectivetaxplanningmaximizesthetaxpayer’safter-taxwealthwhileachievingthetaxpayer’snontaxgoals.Maximizingafter-taxwealthisnotnecessarilythesameastaxminimization.Maximizingafter-taxwealthrequiresonetoconsiderboththetaxandnontaxcostsandbenefitsofalternativetransactions,whereastaxminimizationfocusessolelyonasinglecost(i.e.,taxes).

• Virtuallyeverytransactioninvolvesthreeparties:thetaxpayer,theothertransactingparty,andtheuninvitedsilentpartythatspecifiesthetaxconsequencesofthetransaction(i.e.,thegovernment).Astutetaxplanningrequiresanunderstandingofthetaxandnontaxcostsfromthetaxpayer’sandtheotherparties’perspectives.

Applythetimingstrategy. LO 3-2

•

Oneofthecornerstonesofbasictaxplanninginvolvestheideaoftiming—thatis,whenincome istaxedoranexpenseisdeductedaffectstheassociated“real”taxcostsorsav-ings.Thisistruefortworeasons.First,thetimingofwhenincomeistaxedoranexpenseisdeductedaffectsthepresent valueofthetaxespaidonincomeorthetaxsavingsondeductions.Second,thetaxcostsofincomeandthetaxsavingsfromdeductionsvaryastax rateschange.

• Whentaxratesareconstant,taxplannersprefertodeferincome(i.e.,toreducethepresentvalueoftaxespaid)andacceleratedeductions(i.e.,toincreasethepresentvalueoftaxsavings).Highertaxrates,higherratesofreturn,largertransactionamounts,andtheabilitytoacceleratedeductionsordeferincomebytwoormoreyearsincreasethebenefitsofthetimingstrategy.

• Whentaxrateschange,thetimingstrategyrequiresalittlemoreconsiderationbecausethetaxcostsofincomeandthetaxsavingsfromdeductionsvaryastax rateschange.Whentaxratesareincreasing,thetaxpayermustcalculatetheoptimaltaxstrategiesfordeductionsandincome.Whentaxratesaredecreasing,therecommendationsareclear.Taxpayersshouldacceleratetaxdeductionsintoearlieryearsanddefertaxableincometolateryears.

• Timingstrategiescontainseveralinherentlimitations.Generallyspeaking,wheneverataxpayermustaccelerateacashoutflowtoaccelerateadeduction,thetimingstrategywillbelessbeneficial.Taxlawgenerallyrequirestaxpayerstocontinuetheirinvestmentinanassetinordertodeferincomerecognitionfortaxpurposes.Adeferralstrategymaynotbeoptimalifthetaxpayerhasseverecashflowneeds,ifcontinuingtheinvest-mentwouldgeneratealowrateofreturncomparedtootherinvestments,ifthecurrentinvestmentwouldsubjectthetaxpayertounnecessaryrisk,andsoon.Theconstructivereceiptdoctrine,whichprovidesthatataxpayermustrecognizeincomewhenitisactuallyorconstructivelyreceived,alsorestrictsincomedeferralforcash-methodtaxpayers.

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LO 3-1

LO 3-2

3-22 CHAPTER 3 Tax Planning Strategies and Related Limitations

LO 3-3 Applytheconceptofpresentvaluetotaxplanning.

• Theconceptofpresentvalue—alsoknownasthetimevalueofmoney—basicallystatesthat$1todayisworthmorethan$1inthefuture.Forexample,assuminganinvestorcanearnapositivereturn(e.g.,5percentaftertaxes),$1investedtodayshouldbeworth$1.05inoneyear.Hence,$1todayisequivalentto$1.05inoneyear.

• Theimplicationofthetimevalueofmoneyfortaxplanningisthatthetimingofacashinflow oracashoutflowaffectsthepresentvalueoftheincomeorexpense.

LO 3-4 Applytheincome-shiftingstrategy.

• Theincome-shiftingstrategyexploitsthedifferencesintaxratesacrosstaxpayersorjuris-dictions.Threeofthemostcommonexamplesofincomeshiftingarehigh-tax-rateparentsshiftingincometolow-tax-ratechildren,businessesshiftingincometotheirowners,andtaxpayersshiftingincomefromhigh-taxjurisdictionstolow-taxjurisdictions.

• Theassignmentofincomedoctrinerequiresincometobetaxedtothetaxpayerwhoactu-allyearnstheincome.Inaddition,theIRScloselymonitorssuchrelated-partytransactions—thatis,financialactivitiesamongfamilymembers,amongownersandtheirbusinesses,oramongbusinessesownedbythesameowners.Implicittaxesmayalsolimitthebenefitsofincomeshiftingvialocatingintax-advantagedjurisdictions.

LO 3-5 Applytheconversionstrategy.

• Taxlawdoesnottreatalltypesofincomeordeductionsthesame.Thisunderstandingformsthebasisfortheconversionstrategy—recastingincomeandexpensestoreceivethemostfavorabletaxtreatment.Toimplementtheconversionstrategy,onemustbeawareoftheunderlyingdifferencesintaxtreatmentacrossvarioustypesofincome,expenses,andactivitiesandhavesomeabilitytoalterthenatureoftheincomeorexpensetoreceivethemoreadvantageoustaxtreatment.

• Commonexamplesoftheconversionstrategyincludeinvestmentplanningtoinvestinassetsthatgeneratepreferentiallytaxedincome;compensationplanningtorestructureemployeecompensationfromcurrentlytaxablecompensationtonontaxableortax-deferredformsofcompensation;andcorporatedistributionplanningtostructurecorporatedistributionstoreceivethemostadvantageoustaxtreatment.

• TheInternalRevenueCodecontainsspecificprovisionsthatpreventthetaxpayerfromchangingthenatureofexpenses,income,oractivitiestoamoretax-advantagedstatus.Implicittaxesmayalsoreduceoreliminatetheadvantagesofconversionstrategies.

LO 3-6

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Describebasicjudicialdoctrinesthatlimittaxplanningstrategies.

• Theconstructivereceiptdoctrine,whichmaylimitthetimingstrategy,providesthatataxpayermustrecognizeincomewhenitisactuallyorconstructivelyreceived.Constructivereceiptisdeemedtohaveoccurrediftheincomehasbeencreditedtothetaxpayer’saccountoriftheincomeisunconditionallyavailabletothetaxpayer,thetaxpayerisawareoftheincome’savailability,andtherearenorestrictionsonthetaxpayer’scontrolovertheincome.

• Theassignmentofincomedoctrinerequiresincometobetaxedtothetaxpayerwhoactuallyearnstheincome.Theassignmentofincomedoctrineimpliesthat,inordertoshiftincometoataxpayer,thattaxpayermustactuallyearntheincome.

• Thebusinesspurpose,step-transaction,andsubstance-over-formdoctrinesapplyacrossawidevarietyoftransactionsandplanningstrategies(timing,incomeshifting,andconversion).

• ThebusinesspurposedoctrineallowstheIRStochallengeanddisallowbusinessexpensesfortransactionswithnounderlyingbusinessmotivation,suchasthetravelcostofaspouseaccompanyingataxpayeronabusinesstrip.

• Thestep-transactiondoctrineallowstheIRStocollapseaseriesofrelatedtransactionsintoonetransactiontodeterminethetaxconsequencesofthetransaction.

• Thesubstance-over-formdoctrineallowstheIRStoconsiderthetransaction’ssubstanceregardlessofitsformand,whereappropriate,reclassifythetransactionaccordingtoitssubstance.

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-23

• Thecodifiedeconomicsubstancedoctrinerequirestransactionstohaveasubstantialpur-poseandtomeaningfullychangeataxpayer’seconomicpositioninorderforataxpayertoobtaintaxbenefits.

Contrasttaxavoidanceandtaxevasion.

LO 3-7

• Taxavoidanceisthelegalactofarrangingone’stransactions,andsoon,tominimizetaxespaid.Taxevasionisthewillfulattempttodefraudthegovernment(i.e.,bynotpayingtaxeslegallyowed).Taxevasionfallsoutsidetheconfinesoflegaltaxavoidance.

• Inmanycasesacleardistinctionexistsbetweenavoidance(e.g.,notpayingtaxonmunici-palbondinterest)andevasion(e.g.,notpayingtaxona$1,000,000gameshowprize).Inothercases,thelinebetweentaxavoidanceandevasionislessclear.Inthesesituations,professionaljudgment,theuseofa“smelltest,”andconsiderationofthebusinesspurpose,step-transaction,andsubstance-over-formdoctrinesmayproveuseful.

KEY TERMS

after-tax rate of return (3-3)arm’s length transactions(3-12)assignment of income doctrine (3-12)before-tax rate of return (3-16)business purpose doctrine (3-18)

constructive receipt doctrine (3-10)discount factor (3-3)economic substance doctrine (3-19)implicit tax (3-15)present value (3-3)

related-party transaction (3-12)step-transaction doctrine (3-18)substance-over-form doctrine (3-18)tax avoidance (3-19)tax evasion (3-19)

DISCUSSION QUESTIONSDiscussion Questions are available in Connect®.

1. “The goal of tax planning is to minimize taxes.” Explain why this statement is not true.

LO 3-1

2. Describe the three parties engaged in every business transaction and how under-standing taxes may aid in structuring transactions.

LO 3-1

3. In this chapter we discussed three basic tax planning strategies. What different fea-tures of taxation does each of these strategies exploit?

LO 3-1

4. What are the two basic timing strategies? What is the intent of each? LO 3-2

5. Why is the timing strategy particularly effective for cash-method taxpayers? LO 3-2

6. What are some common examples of the timing strategy? LO 3-2

7. What factors increase the benefits of accelerating deductions or deferring income? LO 3-2

8. How do changing tax rates affect the timing strategy? What information do you need to determine the appropriate timing strategy when tax rates change?

LO 3-2 LO 3-3

9. Describe the ways in which the timing strategy has limitations. LO 3-2 LO 3-6

10. The concept of the time value of money suggests that $1 today is not equal to $1 in the future. Explain why this is true.

LO 3-3

11. Why is understanding the time value of money important for tax planning? LO 3-3

12. What two factors increase the difference between present and future values? LO 3-3

13. What factors have to be present for income shifting to be a viable strategy? LO 3-4

14. Name three common types of income shifting. LO 3-4

15. What are some ways that a parent could effectively shift income to a child? What are some of the disadvantages of these methods?

LO 3-4

16. What is the key factor in shifting income from a business to its owners? What are some methods of shifting income in this context?

LO 3-4

17. Explain why paying dividends is not an effective way to shift income from a corpo-ration to its owners.

LO 3-4

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LO 3-2

3-24 CHAPTER 3 Tax Planning Strategies and Related Limitations

LO 3-5 18. What are some of the common examples of the conversion strategy?LO 3-5 19. What is needed to implement the conversion strategy?LO 3-5 20. Explain how implicit taxes may limit the benefits of the conversion strategy.

planning

LO 3-5 LO 3-6 21. Clark owns stock in BCS Corporation that he purchased in January of the current year. The stock has appreciated significantly during the year. It is now December of the current year, and Clark is deciding whether or not he should sell the stock. What tax and nontax factors should Clark consider before making the decision on whether to sell the stock now?

LO 3-5 22. Do after-tax rates of return for investments in either interest- or dividend-paying securities increase with the length of the investment? Why or why not?

LO 3-5 23. Cameron purchases stock in both Corporation X and Corporation Y. Neither corpo-ration pays dividends. The stocks both earn an identical before-tax rate of return. Cameron sells stock in Corporation X after three years and he sells the stock in Corporation Y after five years. Which investment likely earned a greater after-tax return? Why?

LO 3-5 24. Under what circ*mstances would you expect the after-tax return from an investment in a capital asset to approach that of tax-exempt assets (assuming equal before-tax rates of return)?

planning

LO 3-5 25. Laurie is thinking about investing in one or several of the following investment options:

Corporate bonds (ordinary interest paid annually)Dividend-paying stock (qualified dividends)Life insurance (tax-exempt)Savings accountGrowth stock

a) Assuming all of the options earn similar returns before taxes, rank Laurie’s in-vestment options from highest to lowest according to their after-tax returns.

b) Which of the investments employ the deferral and/or conversion tax planning strategies?

c) How does the time period of the investment affect the returns from these alternatives?

d) How do these alternative investments differ in terms of their nontax characteristics?

LO 3-5 26. What is an “implicit tax” and how does it affect a taxpayer’s decision to purchase municipal bonds?

LO 3-6 27. Several judicial doctrines limit basic tax planning strategies. What are they? Which planning strategies do they limit?

LO 3-6 28. What is the constructive receipt doctrine? What types of taxpayers does this doc-trine generally affect? For what tax planning strategy is the constructive receipt doc-trine a potential limitation?

LO 3-6 29. Explain the assignment of income doctrine. In what situations would this doctrine potentially apply?

LO 3-6 30. Relative to arm’s length transactions, why do related-party transactions receive more IRS scrutiny?

LO 3-6 31. Describe the business purpose, step-transaction, and substance-over-form doctrines. What types of tax planning strategies may these doctrines inhibit?

LO 3-7 32. What is the difference between tax avoidance and tax evasion?LO 3-7 33. What are the rewards of tax avoidance? What are the rewards of tax evasion?LO 3-7

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34. “Tax avoidance is discouraged by the courts and Congress.” Is this statement true or false? Please explain.

LO 3-5

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-25

PROBLEMSSelect problems are available in Connect®.

35. Yong recently paid his accountant $10,000 for elaborate tax planning strategies that exploit the timing strategy. Assuming this is an election year and there could be a power shift in the White House and Congress, what is a potential risk associated with Yong’s strategies?

LO 3-2

planning

36. Billups, a physician and cash-method taxpayer, is new to the concept of tax plan-ning and recently learned of the timing strategy. To implement the timing strategy, Billups plans to establish a new policy that allows all his clients to wait two years to pay their co-pays. Assume that Billups does not expect his marginal tax rates to change. What is wrong with his strategy?

LO 3-2 LO 3-3

planning

37. Tesha works for a company that pays a year-end bonus in January of each year (instead of December of the preceding year) to allow employees to defer the bonus income. Assume Congress recently passed tax legislation that decreases individual tax rates as of next year. Does this increase or decrease the benefits of the bonus deferral this year? What if Congress passed legislation that increased tax rates next year? Should Tesha ask the company to change its policy this year? What additional information do you need to answer this question?

LO 3-2 LO 3-3

planning

38. Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole pro-prietorship. In late December she received a $20,000 bill from her accountant for con-sulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next?

LO 3-2 LO 3-3

planning

39. Using the facts from the previous problem, how would your answer change if Isabel’s after-tax rate of return were 8 percent?

LO 3-2 LO 3-3

planning

40. Manny, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $20,000 of legal services for a client. Manny typically requires his clients to pay his bills immediately upon receipt. Assume Manny’s marginal tax rate is 37 percent this year and next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Manny send his client the bill in December or January?

LO 3-2 LO 3-3

planning

41. Using the facts from the previous problem, how would your answer change if Manny’s after-tax rate of return were 8 percent?

LO 3-2 LO 3-3

planning

42. Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December, she received a $20,000 bill from her accountant for consulting services related to her small business. Reese can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume Reese’s marginal tax rate is 32 percent this year and will be 37 percent next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next?

LO 3-2 LO 3-3

planning

43. Using the facts from the previous problem, when should Reese pay the bill if she expects her marginal tax rate to be 35 percent next year? 24 percent next year?

LO 3-2 LO 3-3

planning

44. Hank, a calendar-year taxpayer, uses the cash method of accounting for his sole pro-prietorship. In late December, he performed $20,000 of legal services for a client. Hank typically requires his clients to pay his bills immediately upon receipt. As-sume his marginal tax rate is 32 percent this year and will be 37 percent next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Hank send his client the bill in December or January?

LO 3-2 LO 3-3

planning

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3-26 CHAPTER 3 Tax Planning Strategies and Related Limitations

LO 3-2 LO 3-3

planning45. Using the facts from the previous problem, when should Hank send the bill if he ex-

pects his marginal tax rate to be 35 percent next year? 24 percent next year?LO 3-3 46. Geraldo recently won a lottery and chose to receive $100,000 today instead of an

equivalent amount in 10 years, computed using an 8 percent rate of return. Today, he learned that interest rates are expected to increase in the future. Is this good news for Geraldo given his decision?

LO 3-3 47. Assume Rafael can earn an 8 percent after-tax rate of return. Would he prefer $1,000 today or $1,500 in five years?planning

LO 3-3 48. Assume Ellina earns a 10 percent after-tax rate of return and that she owes a friend $1,200. Would she prefer to pay the friend $1,200 today or $1,750 in four years?planning

LO 3-3 49. Jonah has the choice of paying Rita $10,000 today or $40,000 in 10 years. Assume Jonah can earn a 12 percent after-tax rate of return. Which should he choose?planning

LO 3-3

planning50. Bob’s Lottery Inc. has decided to offer winners a choice of $100,000 in 10 years or

some amount currently. Assume that Bob’s Lottery Inc. earns a 10 percent after-tax rate of return. What amount should Bob’s offer lottery winners currently, in order to be indifferent between the two choices?

LO 3-4

planning51. Tawana owns and operates a sole proprietorship and has a 37 percent marginal

tax rate. She provides her son, Jonathon, $8,000 a year for college expenses. Jonathon works as a pizza delivery person every fall and has a marginal tax rate of 15 percent.a) What could Tawana do to reduce her family tax burden?b) How much pretax income does it currently take Tawana to generate the $8,000

(after taxes) given to Jonathon?c) If Jonathon worked for his mother’s sole proprietorship, what salary would she

have to pay him to generate $8,000 after taxes (ignoring any Social Security, Medicare, or self-employment tax issues)?

d) How much money would the strategy in part (c) save?LO 3-4

planning52. Moana is a single taxpayer who operates a sole proprietorship. She expects her tax-

able income next year to be $250,000, of which $200,000 is attributed to her sole proprietorship. Moana is contemplating incorporating her sole proprietorship. Using the single individual tax brackets and the corporate tax rate in Tax Rates at the end of the book, find out how much current tax this strategy could save Moana (ignore any Social Security, Medicare, or self-employment tax issues). How much income should be left in the corporation?

LO 3-4

planning53. Orie and Jane, husband and wife, operate a sole proprietorship. They expect their

taxable income next year to be $450,000, of which $250,000is attributed to the sole proprietorship. Orie and Jane are contemplating incorporating their sole proprietor-ship. Using the married-joint tax brackets and the corporate tax rate in Tax Rates at the end of the book, find out how much current tax this strategy could save Orie and Jane. How much income should be left in the corporation?

LO 3-4

planning54. Hyundai is considering opening a plant in two neighboring states. One state has a

corporate tax rate of 10 percent. If operated in this state, the plant is expected to generate $1,000,000 pretax profit. The other state has a corporate tax rate of 2 per-cent. If operated in this state, the plant is expected to generate $930,000 of pretax profit. Which state should Hyundai choose? Why do you think the plant in the state with a lower tax rate would produce a lower before-tax income?

LO 3-4 LO 3-6

planning

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55. Bendetta, a high-tax-rate taxpayer, owns several rental properties and would like to shift some income to her daughter, Jenine. Bendetta instructs her tenants to send their rent checks to Jenine so Jenine can report the rental income. Will this shift the income from Bendetta to Jenine? Why, or why not?

LO 3-4

CHAPTER 3 Tax Planning Strategies and Related Limitations 3-27

56. Using the facts in the previous problem, what are some ways that Bendetta could shift some of the rental income to Jenine? What are the disadvantages associated with these income-shifting strategies?

LO 3-4 LO 3-6

planning

57. Daniel is considering selling two stocks that have not fared well over recent years. A friend recently informed Daniel that one of his stocks has a special designation, which allows him to treat a loss up to $50,000 on this stock as an ordinary loss rather than the typical capital loss. Daniel figures that he has a loss of $60,000 on each stock. If Daniel’s marginal tax rate is 35 percent and he has $120,000 of other capital gains (taxed at 15 percent), what is the tax savings from the special tax treatment?

LO 3-5

planning

58. Dennis is currently considering investing in municipal bonds that earn 6 percent interest, or in taxable bonds issued by the Coca-Cola Company that pay 8 percent. If Dennis’s tax rate is 22 percent, which bond should he choose? Which bond should he choose if his tax rate is 32 percent? At what tax rate would he be indifferent between the bonds? What strategy is this decision based upon?

LO 3-5

planning

59. Helen holds 1,000 shares of Fizbo Inc. stock that she purchased 11 months ago. The stock has done very well and has appreciated $20/share since Helen bought the stock. When sold, the stock will be taxed at capital gains rates (the long-term rate is 15 percent and the short-term rate is the taxpayer’s marginal tax rate). If Helen’s marginal tax rate is 35 percent, how much would she save by holding the stock an additional month before selling? What might prevent Helen from waiting to sell?

LO 3-5

planning

60. Anne’s marginal income tax rate is 32 percent. She purchases a corporate bond for $10,000 and the maturity, or face value, of the bond is $10,000. If the bond pays 5percent per year before taxes, what is Anne’s annual after-tax rate of return from the bond if the bond matures in 1 year? What is her annual after-tax rate of return ifthe bond matures in 10 years?

LO 3-5

61. Irene is saving for a new car she hopes to purchase either four or six years from now. Irene invests $10,000 in a growth stock that does not pay dividends and expects a 6 percent annual before-tax return (the investment is tax deferred). When she cashes in the investment after either four or six years, she expects the applicable marginal tax rate on long-term capital gains to be 25 percent.

planningLO 3-5

a) What will be the value of this investment four years from now? Six years from now?

b) When Irene sells the investment, how much cash will she have after taxes to purchase the new car (four and six years from now)?

62. Komiko Tanaka invests $12,000 in LymaBean, Inc. LymaBean does not pay any dividends. Komiko projects that her investment will generate a 10 percent before-tax rate of return. She plans to invest for the long term.

planningLO 3-5

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a) How much cash will Komiko retain, after taxes, if she holds the investment for five years and then sells it when the long-term capital gains rate is 15 percent?

b) What is Komiko’s after-tax rate of return on her investment in part (a)?c) How much cash will Komiko retain, after taxes, if she holds the investment

for five years and then sells when the long-term capital gains rate is 25 percent?

d) What is Komiko’s after-tax rate of return on her investment in part (c)?e) How much cash will Komiko retain, after taxes, if she holds the investment

for 15 years and then sells when the long-term capital gains rate is 15 percent?

f) What is Komiko’s after-tax rate of return on her investment in part (e)?

3-28 CHAPTER 3 Tax Planning Strategies and Related Limitations

LO 3-5

planning

63. Alan inherited $100,000 with the stipulation that he “invest it to financially benefit his family.” Alan and his wife Alice decided they would invest the inheritance to help them accomplish two financial goals: purchasing a Park City vacation home and saving for their son Cooper’s education.

Vacation Home Cooper’s Education

Initialinvestment $50,000 $50,000Investmenthorizon 5years 18years

Alan and Alice have a marginal income tax rate of 32 percent (capital gains rate of 15 percent) and have decided to investigate the following investment opportunities.

5 Years Annual After-Tax Rate of Return

18 Years

Annual After-Tax Rate of Return

Corporatebonds(ordinaryinteresttaxedannually)

5.75% 4.75%

Dividend-payingstock(noappreciationanddividendsaretaxedat15%)

3.50% 3.50%

Growthstock FV=$65,000 FV=$140,000Municipalbond(tax-exempt) 3.20% 3.10%

Complete the two annual after-tax rate of return columns for each investment and provide investment recommendations for Alan and Alice.

LO 3-7 64. Duff is really interested in decreasing his tax liability, and by his very nature he is somewhat aggressive. A friend of a friend told him that cash transactions are more difficult for the IRS to identify and, thus, tax. Duff is contemplating using this “strategy” of not reporting cash collected in his business to minimize his tax liability. Is this tax planning? What are the risks with this strategy?

LO 3-7 65. Using the facts from the previous problem, how would your answer change if, instead, Duff adopted the cash method of accounting to allow him to better control the timing of his cash receipts and disbursem*nts?

LO 3-2 LO 3-4 LO 3-5

planning

research

66. Using an available tax service or the Internet, identify three basic tax planning ideas or tax tips suggested for year-end tax planning. Which basic tax strategy from this chapter does each planning idea employ?

LO 3-7

research

67. Jayanna, an advertising consultant, is contemplating instructing some of her clients to pay her in cash so that she does not have to report the income on her tax return. Use an available tax service to identify the three basic elements of tax evasion and penalties associated with tax evasion. Write a memo to Jayanna explaining tax evasion and the risks associated with her actions.

LO 3-7

research

68. Using the IRS website (https://www.irs.gov/uac/The-Tax-Gap), how large is the current estimated “tax gap” (i.e., the amount of tax underpaid by taxpayers annually)? What group of taxpayers represents the largest “contributors” to the tax gap?

Source: Roger CPA Review

Sample CPA Exam questions from Roger CPA Review are available in Connect as support for the topics in this text. These Multiple Choice Questions and Task-Based Simulations include expert-written explanations and solutions and provide a starting point for students to become familiar with the content and functionality of the actual CPA Exam.

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LO 3-5

(https://www.irs.gov/uac/The-Tax-Gap

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15chapter

Entities Overview

Learning Objectives

Upon completing this chapter, you should be able to:

LO15-1

Discuss the legal and nontax characteristics of different types of legal entities.

LO 15-2 Describe the different types of entities for tax purposes.

LO 15-3 Identify fundamental differences in tax characteristics across entity types.

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15-1

Storyline Summary

Taxpayer: Nicole Johnson

Location: Salt Lake City, Utah

Employment State government employee with status: entrepreneurial ambitions

©Gyorgy Barna/Shutterstock

Nicole Johnson is currently employed by the Utah Chamber of Commerce in Salt Lake City, Utah. While she enjoys the relatively

short workweeks, she eventually would like to work for herself. In her current position, she deals with a lot of successful entrepreneurs who have become role models for her. Nicole has also developed an exten-sive list of contacts that should serve her well when she starts her own business. It has taken a while, but Nicole believes she has finally developed a viable new business idea. Her idea is to design and manufacture bed sheets that have various colored patterns and are made of unique fabric blends. The sheets look great and are extremely comfortable whether the bedroom is warm or cool. She has had several friends try out her prototype sheets and they have consistently given the sheets rave reviews. With this encouragement, Nicole started giving serious thought to making “Color Comfort Sheets” a moneymaking enterprise.

Nicole has enough business background to real-ize that she is embarking on a risky path, but one, she hopes, with significant potential rewards. After creating some initial income projections, Nicole realized that it will take a few years for the business to become profitable.

While Nicole’s original plan was to start the business by herself, she is considering seeking out another equity owner so that she can add financial resources and business experience to the venture. Nicole feels like she has a grasp on her business plan, but she still needs to determine how to organize the business for tax purposes. After doing some research, Nicole learned that she should con-sider many factors in order to determine the “best” entity type for her business. Each type of entity has advantages and disadvantages from both tax and nontax perspectives, and the best entity for a busi-ness depends on the goals, outlook, and strategy for that particular business and its owners. She under-stands that she has more work to do to make an informed decision.

to be continued . . .

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CHAPTER 15 Entities Overview15-2

This chapter explores various types of legal entities and then discusses entities available for tax purposes. We outline some of the pros and cons of each entity type from both nontax and tax perspectives, as we help Nicole determine how she will organize her busi-ness to best accomplish her goals. Subsequent chapters provide additional detail concern-ing the tax characteristics of each entity type.

LO 15-1 ENTITY LEGAL CLASSIFICATION AND NONTAX CHARACTERISTICSWhen forming new business ventures, entrepreneurs can choose to house their operations under one of several basic entity types. These entities differ in terms of their legal and tax considerations. In fact, as we discuss in more depth below, the legal classification of a business may be different from its tax classification. These entities differ in terms of the formalities that entrepreneurs must follow to create them, the legal rights and responsi-bilities conferred on the entities and their owners, and the tax rules that determine how the entities and owners will be taxed on income generated by the entities. CPAs are fre-quently asked to help clients choose the best entity choice for their businesses.CPAs can help clients navigate recent tax legislation that has significantly changed the tax land-scape for entity choice.

Legal ClassificationGenerally, a business entity legally may be classified as a corporation, a limited liability company (LLC), a general partnership (GP), a limited partnership (LP), or a sole proprietorship (not formed as an LLC).1 Under state law, corporations are recognized as legal entities separate from their owners (shareholders). Business owners legally form corporations by filing articles of incorporation with the state in which they organize the business. State laws also recognize limited liability companies (LLCs) as legal entities separate from their owners (members). Business owners create limited liability compa-nies by filingeither a certificate of organization or articles of organization with the state in which they are organizing the business (depending on the state).

Partnerships are formed under state partnership statutes and the degree of formality required depends on the type of partnership being formed. General partnerships may be formed by written agreement among the partners, called a partnership agreement, or they may be formed informally without a written agreement when two or more owners join together in an activity to generate profits. Although general partners are not required to file partnership agreements with the state, general partnerships are still considered to be legal entities separate from their owners under state laws. Unlike general partnerships, limited partnerships are usually organized by written agreement and typically must file a certificate of limited partnership to be recognized by the state.2

Finally, for state law purposes, sole proprietorships (not formed as single member LLCs) are not treated as legal entities separate from their individual owners. As a re-sult, sole proprietors are not required to formally organize their businesses with the state, and they hold title to business assets in their own names rather than in the name of their businesses.

Nontax CharacteristicsRather than identify and discuss all possible nontax entity characteristics, we compare and contrast several prominent characteristics across the different legal entity types.

1Variations of these entities include limited liability partnerships (LLPs), limited liability limited partnerships (LLLPs), professional limited liability companies (PLLCs), and professional corporations (PCs).2Similar to limited partnerships, LLPs, LLLPs, PLLCs, and PCs must register with the state to receive formal recognition.

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CHAPTER 15 Entities Overview 15-3

Responsibility for Liabilities Whether the entity or the owner(s) is ultimately re-sponsible for paying the liabilities of the business depends on the type of entity. Under state law, a corporation is solely responsible for its liabilities.3 Similarly, LLCs and not their members are responsible for the liabilities of the business.4 For entities formed as partnerships, all general partners are ultimately responsible for the liabilities of the partnership. In contrast, limited partners are not responsible for the partnership’s liabil-ities.5 However, limited partners are not allowed to actively participate in the activities of the business.

Finally, if a business is conducted as a sole proprietorship, the individual owner is responsible for the liabilities of the business. However, individual business owners may organize their businesses as single-member LLCs. In exchange for observing the formali-ties of organizing as an LLC, they receive the liability protection afforded LLC members.6

Rights, Responsibilities, and Legal Arrangements among Owners State cor-poration laws specify the rights and responsibilities of corporations and their sharehold-ers. For example, to retain limited liability protection for shareholders, corporations must create, regularly update, and comply with a set of bylaws (internal rules governing how the corporation is run). They must have a board of directors. They must have regular board meetings and regular (at least annual) shareholder meetings, and they must keep minutes of these meetings. They must also issue shares of stock to owners (shareholders) and maintain a stock ledger reflecting stock ownership. They must comply with annual filing requirements specified by the state of incorporation, pay required filing fees, and pay required corporate taxes, if any. Consequently, shareholders have no flexibility to alter their legal treatment with respect to one another(rights are determined solely by stock ownership not by agreements), with respect to the corporation, or with respect to outsiders. In contrast, while state laws provide default provisions specifying rights and responsibilities of LLCs and their members, members have the flexibility to alter their arrangement by spelling out, through an operating agreement, the management practices of the entity and the rights and responsibilities of the members consistent with their wishes. Thus, LLCs allow more flexible business arrangements than do corporations.

THE KEY FACTS

Legal Classification and Nontax Characteristics

of Entities• State law generally classi-

fies entities as either cor-porations, limited liability companies, general part-nerships, limited partner-ships, or sole proprietorships.

• Corporations and limited liability companies shield all their owners against the entity’s liabilities.

• Corporations are less flex-ible than other entities but are generally better suited to going public.

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Like LLC statutes, state partnership laws provide default provisions specifying the partners’ legal rights and responsibilities for dealing with each other absent an agreement to the contrary. Because partners have the flexibility to depart from the default provi-sions, they frequently craft partnership agreements that are consistent with their preferences.

Although in many instances having the flexibility to customize business arrange-ments is desirable, sometimes inflexible governance rules mandated by state statute are needed to limit the participation of owners in management when their participation be-comes impractical. For example, when businesses decide to “go public” with an initial public offering (IPO)on one of the public securities exchanges, they usually solicit a

3Payroll tax liabilities are an important exception to this general rule. Shareholders of closely held corporations may be held responsible for these liabilities.4When closely held corporations and LLCs borrow from banks or other lenders, shareholders or members are commonly asked to personally guarantee the debt. To the extent they do this, they become personally liable to repay the loan in the event the corporation or LLC is unable to repay it.5Limited liability limited partnerships (LLLPs) are limited partnerships in which general and limited partners are protected from the liabilities of the entity. Also, professional service businesses such as accounting firms and law firms are generally not allowed to operate as corporations, LLCs, or limited partnerships. These businesses are frequently organized as limited liability partnerships (LLPs), professional limited liability companies (PLLCs), or professional corporations (PCs). Owners of a PLLC or a PC are protected from liabilities of the entity other than liabilities stemming from their own negligence. LLPs do not provide protection against liabilities stemming from a partner’s own negligence or from the LLP’s contractual liabilities.6Shareholders of corporations and LLC members are responsible for liabilities stemming from their own negligence.

15-4 CHAPTER 15 Entities Overview

vast pool of potential investors to become corporate shareholders.7 State corporation laws prohibit shareholders from directly amending corporate governance rules and from di-rectly participating in management—they have only the right to vote for corporate direc-tors or officers. In comparison, LLC members generally have the right to amend the LLC operating agreement, provide input, and manage LLCs. Obviously, managing a publicly traded business would be next to impossible if thousands of owners had the legal right to change operating rules and directly participate in managing the enterprise.

Exhibit 15-1 summarizes several nontax characteristics of different types of legal entities.

EXHIBIT 15-1 Business Types: Legal Entities and Nontax Characteristics

Nontax Characteristics

Corporation LLC

General Partnership

Limited Partnership

Sole Proprietorship

Must formally organize with state

Yes Yes No Yes No*

Responsibility for liabilities of business

Entity Entity General partner(s)

General partner(s)

Owner†

Legal arrangement among owners

Not flexible

Flexible Flexible Flexible Not applicable

Suitable for initial public offering

Yes No No No^ No

*A sole proprietor must organize with the state if she forms a single-member LLC.†The owner is not responsible for the liabilities of the business if the sole proprietorship is organized as an LLC. However, the owner is responsible for liabilities stemming from her own negligence and for any liabilities the owner personally guarantees.^While it is uncommon, certain limited partnerships are eligible for IPOs.

As summarized in Exhibit 15-1, corporations and LLCs have the advantage in lia-bility protection, LLCs and partnerships have an advantage over other entities in terms of legal flexibility, and corporations have the advantage when owners want to take a business public.

continued from page 15-1 . . .As an initial step in the process of selecting the type of legal entity to house Color Comfort Sheets (CCS), Nicole began to research nontax issues that might be relevant to her decision. Early in her research she realized that the nontax benefits unique to traditional corporations were relevant primarily to large, publicly traded corporations. Although Nicole was very optimistic about CCS’s prospects, she knew it would likely be a long time, if ever, before it went public. However, she remained interested in limiting her own and other potential investors’ liability in the new venture, so she began to dig a little deeper. As she perused the state of Utah website, she learned that corporations and LLCs are the only legal entities that can completely shield investors from liabilities. Although Nicole doesn’t anticipate any trouble from her future creditors, she decides to limit her choice of legal entity to either a corporation or LLC.

At this point in her information-gathering process, Nicole is leaning toward the LLC option because she is not sure she wants to deal with board meetings and all the other formalities of operating a corporation; however, she decides to assemble a five-year forecast of CCS’s expected operating results and to learn a little more about the way corporations and LLCs are taxed before making a final decision.

to be continued . . .

7The vast majority of IPOs involve corporate shares; however, limited partnership interests are occasionally sold in IPOs. Like shareholders, limited partners are typically not allowed to participate in management. Limited partnerships are used for public offerings in lieu of corporations when they qualify for favorable partnership tax treatment available to some publicly traded partnerships.

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CHAPTER 15 Entities Overview 15-5

ENTITY TAX CLASSIFICATION LO 15-2

A business’s legal form may be different from its tax form. We discussed the legal form of business entities above. We now discuss the tax form of business entities. In general terms, for tax purposes business entities can be classified as either separate taxpaying entities orflow-through entities.Separate taxpaying entities pay tax on their own income. In con-trast, flow-through entities generally don’t pay taxes because income from these entities flows through to their business owners, who are responsible for paying tax on the income.

THE KEY FACTS

Tax Classification of Legal Entities

• Corporations are C corporations unless they make a valid S election.

• Unincorporated entities are taxed as partnerships if they have more than one owner.

• Unincorporated entities are taxed as sole propri-etorships if held by a single individual or as disregarded entities if held by a single entity.

• Unincorporated entities may elect to be treated as C corporations. They then may make an S election if eligible.

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How do we determine whether a particular business entity is treated as a separate tax-paying entity or as a flow-through entity for tax purposes? According to Treasury Regula-tions, commonly referred to as the “check-the-box” regulations, entities that are legal corporations under state law are, by default, treated as C corporations for tax purposes. These corporations and their shareholders are subject to tax provisions in Subchapter C (and not Subchapter S) of the Internal Revenue Code.8 C corporations report their taxable income to the IRS on Form 1120. However, shareholders of legal corporations may qualify to make a special tax election known as an “S” election, thus permitting the corporation to be taxed as a flow-through entity called an S corporation.9 S corporations and their share-holders are subject to tax provisions in Subchapter S of the Internal Revenue Code. S cor-porations report the results of their operations to the IRS on Form 1120S.

Also under the check-the-box regulations, unincorporated entities are, by default, treated as flow-through entities.10 However, owners of an unincorporated entity can still elect to have their business taxed as a C corporation instead of as the default flow-through entity.11 In fact, the owner(s) of an unincorporated entity could elect to have the business taxed as a C corporation and then make a second election to have the “C corporation” taxed as an S corporation (provided that it meets the S corporation eligibility require-ments).12Before making such elections, however, the business owner(s) would need to be convinced that the move makes sense from a tax perspective.13 The nontax considerations do not change because these elections do not affect the legal classification of the entity.

Finally, unincorporated flow-through entities (all flow-through entities except S cor-porations) are treated for tax purposes as either partnerships, sole proprietorships, or disregarded entities (considered to be the same entity as the owner).14 Unincorporated entities (including LLCs) with more than one owner are treated as partnerships.15Part-nerships report their operating results to the IRS on Form 1065. Unincorporated entities (including LLCs) with only one individual owner such as sole proprietorships and single-member LLCs are treated as sole proprietorships.16 Income from businesses taxed as sole proprietorships is reported on Schedule C of Form 1040. Similarly, unincorporated entities with only one corporate owner, typically a single-member LLC, are disregarded for tax purposes. Thus, income and losses from this single, corporate-member LLC is reported as if it had originated from a division of the corporation and is reported directly on the single-member corporation’s return. Exhibit 15-2 provides a flowchart for deter-mining the tax form of a business entity under the check-the-box regulations. Taxpayers check the box by filing Form 8832.

8Reg. §301.7701-3(a).9§1362(a). Because §1361 limits the number and type of shareholders of corporations qualifying to make an S election, some corporations are ineligible to become S corporations.10Reg. §301.7701-3(b). However, §7704 mandates that unincorporated publicly traded entities be taxed as corporations unless their income predominately consists of certain types of passive income.11Reg. §301.7701-3(a).12In general, a noncorporate entity that is eligible to elect to be treated as a corporation can elect to be treated as a corporation for tax purposes and as an S corporation in one step by filing a timely S corporation election.13As presented in Exhibit 15-3, compared to corporations, unincorporated entities taxed as partnerships have more favorable ownership requirements and more favorable tax treatment on nonliquidating and liquidating distributions of noncash property.14Reg. §301.7701-3(a).15Reg. §301.7701-3(b)(i).16Reg. §301.7701-3(b)(ii).

15-6 CHAPTER 15 Entities Overview

EXHIBIT 15-2 Determining the tax form of a business entity under check-the-box regulations

To summarize, although there are other types of legal entities, there are really only four categories of business entities recognized by the U.S. tax system, as follows:

1. C corporation (separate taxpaying entity; income reported on Form 1120).2. S corporation (flow-through entity; income reported on Form 1120S).3. Partnership (flow-through entity; income reported on Form 1065).4. Sole proprietorship (flow-through entity; income reported on Form 1040,

Schedule C).

S corporation fortax purposes.

Files Form 1120S

C corporation fortax purposes.

Files Form 1120

YesNo

Treated the same as the owner(not a separate entity from the

owner). Income or loss is includedon the owner’s tax return.

Sole proprietor for tax purposes.Files Form 1040, Schedule C

NoYes

Is the owner anIndividual?

Partnership fortax purposes.

Files Form 1065

NoYes

Does the entity havemore than one

owner?

Yes

Is the entity a legalcorporation?

Does the entity qualify forand elect

S corporation status?Election made on Form 2553.

Does the entity elect to betreated as a C corporation

for tax purposes?

YesNo

Example 15-1

What if: Assume Nicole legally forms CCS as a corporation (with only common stock) by filing articles of incorporation with the state. What are her options for classifying CCS for tax purposes if she is the only shareholder of CCS?

Answer: Nicole may treat CCS as either a C corporation or an S corporation. The default tax classifica-tion is a C corporation for tax purposes. However, given the facts provided, CCS is eligible to make an election to be taxed as an S corporation.17

17§1361(b).

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CHAPTER 15 Entities Overview 15-7

What if: Assume Nicole legally forms CCS as an LLC (with only one class of ownership rights) by filing articles of organization with the state. What are her options for classifying CCS for tax purposes if she is the only member of CCS?

Answer: The default classification for CCS is a sole proprietorship because CCS is unincorporated with one individual member. However, Nicole may elect to have CCS taxed as a C corporation or as an S corporation. CCS can be treated as a C corporation because unincorporated entities may elect to be taxed as corporations. Further, eligible entities taxed as corporations can elect to be treated as S corporations.

What if: Assume Nicole legally forms CCS as an LLC and allows other individuals or business entities to become members in return for contributing their cash, property, or services to CCS. What is the default tax classification of CCS under these assumptions?

Answer: Partnership. The default tax classification for unincorporated entities with more than one owner is a partnership.

It might seem at this point that owners of businesses classified as flow-through enti-ties would be treated the same for tax purposes; however, that is true only in a general sense. We see in this and other chapters that there are subtle and not-so-subtle differences in ways the owners of ventures classified as S corporations, partnerships, and sole propri-etorships are taxed.18

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ENTITY TAX CHARACTERISTICS LO 15-3

In choosing among the available options for the tax form of business entities, owners and their advisers must carefully consider whether tax rules that apply to a particular tax clas-sification would be either more or less favorable than tax rules under alternative tax clas-sifications. The specific tax rules they must compare and contrast are unique to their situations; however, certain key differences in the tax rules tend to be relevant in many scenarios. We turn our attention to the taxation of business entity income, owner compen-sation, and the tax treatment of entity losses, because these are a few of the most impor-tant tax characteristics to consider when selecting the tax form of the entity. Later in the chapter we preview other tax factors that differ between entities, and we identify the chapter where each factor is discussed in more detail.

Taxation of Business Entity IncomeThe taxation of a business entity’s income depends on whether the entity is a flow-through entity or a C corporation. Flow-through entity income is taxed once to the owner when the income “flows through” or is allocated (on paper) to entity owners at the end of the year, whether or not the income is distributed to them. The income is included on the owners’ tax returns as if they had earned the income themselves. Flow-through entity owners are not, however, taxed when the income is actually distributed to them. C corpo-ration income is taxed twice. The income is first taxed to the corporation at the corporate tax rate. A C corporation’s income is taxed again to the shareholders when the corpora-tion distributes the income as a dividend or when shareholders sell their stock.19

The Taxation of Flow-Through Entity Business Income The tax that flow-through entity owners pay on the entity’s business income depends in large part on the owner’s marginal income tax rate. For 2019, the top marginal individual tax rate is 37percent. Nevertheless, flow-through entity owners’ tax burden on the flow-through

18The Business Income, Deductions, and Accounting Methods chapter explains how sole proprietors are taxed, and the Forming and Operating Partnerships, Dispositions of Partnership Interests and Partnership Distributions, and the S Corporations chapters explain how partners and S corporation shareholders are taxed.19Distributions to C corporation shareholders are taxed as dividends to the extent they come from the “earnings and profits” (similar to economic income) of corporations.

15-8 CHAPTER 15 Entities Overview

income also depends on whether the income is eligible for the deduction for qualified busi-ness income, whether it is subject to the net investment income tax, whether it is subject to self-em ployment tax and/or it is subject to the additional Medicare tax. Below, we discuss the deduction for qualified business income, the net investment income tax, the self- employment tax, the additional Medicare tax, and the overall tax rate on flow-through entity income (assuming the owners are individuals).

Deduction for qualified business income. This deduction applies to individuals with qualified business income (QBI) from flow-through entities, including partnerships, Scorporations, or sole proprietorships.20 That is, this is a deduction for individuals and not for business entities. The deduction is a from AGI deduction but is not an itemized deduction. Therefore, individuals can claim the deduction even though they claim the standard deduction instead of itemized deductions. In general, a taxpayer can deduct 20percent of the amount of qualified business income allocated to them from the entity, subject to certain limitations.21 Qualified business income is the net business income from a qualified trade or business conducted in the United States. To qualify, the business income must be from a business other than a specified service trade or business. In general, a specified service trade or business includes certain service businesses such as services in the fields of health, law, accounting, actuarial science, performing arts, con-sulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or which involves the performance of services that consist of investing and investment management trading or dealing in securities, partnership interests, or com-modities.22 Business income does not include income earned as an employee or invest-ment type income such as capital gains, dividends, and investment interest income.

Net investment income tax. When an owner of an entity taxed as a partnership or a shareholder of an S corporation does not work for the entity (that is, the owner is a pas-sive owner or investor in the entity), the business income allocated to the taxpayer is considered to be “passive” income.23 Because passive income is considered to be invest-ment income for purposes of the net investment income tax, passive owners of flow-through entities may be required to pay net investment income tax on income allocated to them from the business. The net investment income tax rate is 3.8 percent and it applies only when a taxpayer’s (modified) AGI exceeds the threshold amount. The threshold amount is $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers.24

Self-employment tax. Business owners who receive and/or are allocated self-employment income from their business are subject to self-employment tax on the income. Whether a flow-through entity’s business income allocated to an owner is considered to be self-employment income to the owner depends on the type of entity and the owner’s involvement in the entity’s business activities. An S corporation’s business income allocated to a shareholder is not self-employment income to the shareholder. In contrast, a sole propri-etorship’s income is self-employment income to the sole proprietor. The determination isn’t as clear for the business income allocated to owners of entities taxed as a partnership.

20§199A.21Under §199A(b)(2)(B), the deduction cannot exceed the greater of 50 percent of the wages paid with respect to the qualified trade or business, or the sum of 25 percent of the wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property in the qualified trade or business. This limit does not apply to taxpayers with taxable income (before the deduction) below a certain threshold and the limitation phases in over a range of taxable income above the threshold [see §199A(b)(3)]. The limit is applied at the individual owner level and is beyond the scope of this chapter.22§199A(d)(2). See Reg. §1.199A-5 for discussion of what constitutes a specified trade or business in each of the fields referenced in §199A(d)(2). The specified service trade or business requirement does not apply to taxpayers with taxable income (before the deduction) below a certain threshold and the requirement phases in over a range of taxable income above the threshold [see §199A(d)(3)].23See §469. We discuss specific tests for determining when an owner is a passive investor in the Forming and Operating Partnerships chapter.24See §1411.

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CHAPTER 15 Entities Overview 15-9

For these entities, whether business income is self-employment income to an owner depends on the owner’s involvement in the entity’s business activities.25

The tax base for the self-employment tax is the taxpayer’s net earnings from self-employment. Net earnings from self-employment is 92.35 percent of the taxpayer’s self-employment income (from all sources).26 For 2019, the first $132,900 of net earnings from self-employment is taxed at 15.3 percent and net earnings from self-employment above $132,900 is taxed at 2.9 percent. The $132,900 cutoff is reduced by the amount of the employee compensation the taxpayer received during the year. Thus, for example, a taxpayer who was allocated $170,000 of self-employment income (assuming no other self-employment income and no employee compensation) would report $156,995 of net earnings from self-employment ($170,000× .9235) and owe $21,032 of self-employment tax ($132,900 × .153 + ($156,995 minus $132,900) × .029). Taxpayers can deduct 50per-cent of the self-employment tax they pay as a for AGI deduction. Consequently, a taxpayer who paid $21,032 of self-employment tax would deduct $10,516 of the tax as a for AGI deduction ($21,032 × .50). Finally, it is important to note that the self-employment tax is computed separately for each spouse even if a married couple files a joint return (the com-putation of the self-employment tax is not a joint computation).

Additional Medicare tax. In addition to the self-employment tax, business owners who receive or are allocated self-employment income from their business potentially must pay the additional Medicare tax on the income. The tax rate for the additional Medicare tax is .9 percent and the tax base is the sum of the taxpayer’s net earnings from self-employment (from all sources) plus compensation earned as an employee in excess of a threshold amount. The threshold amount is $250,000 for married taxpayers filing jointly and sur-viving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers.27 Thus, for example, a single taxpayer who was allocated $240,000 of self-employment income (assuming no other self-employment income and no employee compensation) and who reported $270,000 of AGI would have $221,640 of net earnings from self-employment ($240,000 × .9235) and would owe $195 of additional Medicare tax [($221,640 minus $200,000) × .009].

The additional Medicare tax is computed jointly for married couples filing a joint re-turn. Thus, net earnings from self-employment from both spouses (and compensation earned as employees, if any) is combined to determine the excess of net earnings from self-employment over the $250,000 threshold amount for married taxpayers filing a joint tax return. Taxpayers are not allowed to deduct any of the additional Medicare tax they pay.

Example 15-2

What if: Assume that Nicole chooses to form CCS as an S corporation. She makes the following assumptions:• CCS’staxableincomeis$500,000andalloftheincomeisbusinessincome.• Hermarginalordinarytaxrateis37percent.• Nicoleiseligibleforthefulldeductionforqualifiedbusinessincomeontheflow-throughincome

from CCS.• Theincomeisnotpassiveincomeandisthereforenotsubjecttothenetinvestmentincometax.• BecauseCCSisanScorporation,theflow-throughbusinessincomefromCCSisnotself-employment

income to Nicole.WhatistheoveralltaxrateonCCS’sbusinessincome?

(continued on page 15-10)

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25We discuss more details of determining whether business income allocated to partners is self-employment income in the Forming and Operating Partnerships chapter.26See §1402. Taxing 92.35 percent of self-employment income for self-employment tax and additional Medicare tax purposes provides the taxpayer with an implicit 7.65 percent deduction for the employer’s portion of the 15.3 percent self-employment tax.27The additional Medicare tax applies to combined earned income of both spouses if married filing jointly.

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Answer: 29.6 percent, computed as follows:

Description Amount Explanation

(1)BusinessincomeallocatedtoNicole $500,000

(2)Deductionforqualifiedbusinessincome (100,000) (1)×20percent

(3)NettaxableincometoNicolefromCCS 400,000 (1)+ (2)

(4) Earnings after entity-level tax 37% Marginal tax rate

(5)Owner-levelincometax 148,000 (3)× (4)

Overall tax rate on business income allocation 29.6% (5)/(1)

What if: Assume the original facts except that the income from CCS is not eligible for the deduction forqualifiedbusinessincome.WhatistheoveralltaxrateonCCS’sbusinessincome?

Answer: 37percent.Theentire$500,000businessincomeistaxedtoNicoleathermarginalordinarytax rate of 37 percent.

What if: Assume the original facts except the income from CCS is not eligible for the deduction for qualifiedbusinessincomeandNicoleisapassiveinvestorinCCSandmustpaythe3.8percentnetinvestment income tax on the income. What is the overall tax rate on the income of CCS?

Answer: 40.8percent.The full$500,000ofbusiness income is taxed toNicoleathermarginalordinarytaxrateof37percentplusthenetinvestmentincometaxrateof3.8percent.

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Example 15-3

What if: Assume that Nicole forms CCS as an LLC with another investor so that CCS is taxed as a partnership. Nicole makes the following assumptions:• CCSearnsbusinessincomeof$1,000,000andNicole’sshareofthebusinessincomeis$500,000.• Nicole’smarginalordinarytaxrateis37percent.• Nicoleisentitledtothefulldeductionforqualifiedbusinessincomeontheflow-throughincome

from CCS.• Because Nicole works full-time for the entity, the business income allocated to her is self-

employment income.• Nicole’s marginal self-employment tax rate is 2.9 percent (she has other sources of self-

employmentincomethatputhernetearningsfromself-employmentoverthe$132,900cutoffforthe15.3percentrate).

• Theentirenetearningsfromself-employmentfromtheincomeallocationissubjecttothe.9percentadditional Medicare tax (her AGI and her net earnings from self-employment are over the threshold amount before considering the the CCS business income allocation).

What is the overall tax rate on the CCS business income allocated to Nicole?

Answer: 32.61 percent, computed as follows:

Description Amount Explanation

(1)BusinessincomeallocatedtoNicole $500,000

(2)Deductionfor50percentofself-employmenttax(for AGI deduction)

(6,695) (1)×.9235×.029×.5

(3)Deductionforqualifiedbusinessincome(from AGI deduction)

(100,000) (1)×20percent

(4)IncomenetofNicole’sdeductions 393,305 (1)− (2) − (3)

(5)Owner-levelincometax 145,523 (4)× 37%

(6) Self-employment tax 13,391 (1) ×.9235×.029(7)AdditionalMedicaretax 4,156 (1)×.9235×.009(8)TotaltaxpaidonCCSbusinessincomeallocations $163,070 (5)+ (6) + (7)

Overall tax rate on business income allocation 32.61% (8)/(1)

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What if: Assumetheoriginalfactsexceptthatthebusinessincomeallocationisnotqualifiedbusinessincome (QBI). What is the overall tax rate on the CCS business income allocated to Nicole?

Answer: 40.01percent.Theonlydifferencebetweentheoriginalandnewfactsinthiswhat-ifexampleisthatNicolewouldpayanadditional$37,000inincometax($100,000QBIdeduction× 37 percent taxrate).Consequently,theoveralltaxesdueonthebusinessincomeallocationwouldbe$200,070($163,070+$37,000)andtheoveralltaxratewouldbe40.01percent($200,070/$500,000).What if: AssumetheoriginalfactsexceptthatthebusinessincomeallocationisNicole’sonlysourceofself-employmentincomefortheyear.Further,assumethatNicole’shusbandreceived$800,000ofsalary. What is the overall tax rate on the CCS business income allocated to Nicole?

Answer: 35.30percent,computedasfollows:

Description Amount Explanation

(1)BusinessincomeallocatedtoNicole $500,000

(2)Netearningsfromself-employment 461,750 (1)×.9235

(3)Deductionfor50percentofself-employmenttax (for AGI deduction)

(14,935) (7)×.5

(4)Deductionforqualifiedbusinessincome(from AGI deduction)

(100,000) (1)×20%

(5)IncomenetofNicole’sdeductions 385,065 (1) (3) (4)− −

(6)Owner-levelincometax 142,474 (5)×37%

(7)Self-employmenttax 29,870 $132,900×.153+ [(2) − $132,900]×.029

(8)AdditionalMedicaretax 4,156 (2)×.009[couple’sAGIandemployee compensation incomeexceeds$250,000threshold amount before including(2)]

(9)TotaltaxpaidonCCSbusinessincomeallocations

$176,500 (6)+ (7) +(8)

Overall tax rate on business income allocation 35.30% (9)/(1)

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What if: Assume the original facts except the income from CCS is not eligible for the QBI deduction andNicoleisapassiveinvestorinCCS.Consequently,shemustpaythenetinvestmentincometaxonthe entire income allocation but not the self-employment tax or the additional Medicare tax. What is the overall tax rate on the CCS business income allocated to Nicole?

Answer: 40.8percent.Theentire$500,000business incomeallocation is taxedtoNicoleathermarginalordinarytaxrateof37percentplusthenetinvestmentincometaxrateof3.8percent.

In summary, while income from a flow-through entity is taxed only once, the overall tax rate on the entity’s business income depends on whether the income (and the owner) qualifies for the deduction for qualified business income and whether the income is sub-ject to the net investment tax or is considered to be self-employment income.

Overall Tax Rate of C Corporation Income C corporations are taxed on their taxable income at a flat 21 percent rate. The tax rate on the second level of tax on a Ccor-poration’s income depends on whether the shareholder is an individual, a C corporation, an institutional shareholder, a tax-exempt entity, or a foreign entity.

Individual shareholders. The tax rate on dividends to individual taxpayers depends on the individual’s taxable income. High-income taxpayers are taxed on dividends at a 20percent rate, low-income taxpayers are taxed at a 0 percent rate, and others are taxed on dividends at

15-12 CHAPTER 15 Entities Overview

a 15 percent rate.28 Also, as discussed above, taxpayers with (modified) AGI in excess of a threshold amount pay an additional 3.8 percent net investment income tax on dividends.

Example 15-4

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What if: Assume that Nicole forms CCS as a C corporation and she makes the following assumptions:• CCSearnstaxableincomeof$500,000.• CSSwilldistributeallofitsafter-taxearningsannuallyasadividend.• Nicole’smarginalordinarytaxrateis37percentandherdividendtaxrateis23.8percent(including

the net investment income tax).WhatistheoveralltaxrateonCCS’staxableincome?

Answer: 39.8percent,computedasfollows:

Description Amount Explanation

(1)Taxableincome $500,000

(2) Corporate tax rate 21% Flat corporate tax rate

(3)Corporate-leveltax $105,000 (1)×(2)[firstleveloftax](4)Incomeremainingaftertaxesandamount

distributed as a dividend$395,000 (1)− (3)

(5)Dividendtaxrate 23.8% 20%dividendrate+3.8%netinvestment income tax rate

(6)Shareholder-leveltaxondividend $94,010 (4)×(5)[secondleveloftax](7)Totaltaxpaidoncorporatetaxableincome $199,010 (3)+ (6)

Overall tax rate on corporate taxable income 39.8% (7)/(1)

Notethattheoverallrateisnot44.8percent(21percentcorporaterate+23.8percentshareholderrate)becausetheamountofcorporate-leveltax($105,000)isincomethatisnottaxedtwice(itispaidto the government, not to the shareholders).

What if: Assume that Nicole forms CCS as a C corporation and she makes the following assumptions:• CCSearnstaxableincomeof$500,000.• CCSdistributes25percentofitsafter-taxearningsasadividendandretainstheresttogrowthe

business.• Nicole’smarginalordinarytaxrateis37percentandherdividendtaxrateis23.8percent(including

the net investment income tax).WhatistheoveralltaxrateonCCS’staxableincome?

Answer: 25.7percent,computedasfollows:

Description Amount Explanation

(1)Taxableincome $500,000

(2) Corporate tax rate 21% Flat corporate tax rate

(3)Corporate-leveltax $105,000 (1)×(2)[firstleveloftax](4)Incomeremainingaftertaxesandamount

distributed as a dividend$395,000 (1)− (3)

(5)Dividend $98,750 (4)×25%distributed(6)Taxrateondividend 23.8% 20%dividendrate+3.8%net

investment income tax rate

(7)Shareholder-leveltaxondividend $23,503 (5) (6)[secondleveloftax]

(8)Totaltaxpaidoncorporatetaxableincome $128,503 (3)+ (7)

Overall tax rate on corporate taxable income 25.7% (8)/(1)

28To the extent the dividend income increases a taxpayer’s taxable income beyond specific “breakpoints” the div-idend is taxed at a higher rate. For 2019, the breakpoint between the 0 and 15 percent rate is $78,750 for married taxpayers filing jointly, $52,750 for head of household filers, and $39,375 for all other taxpayers. The breakpoint between the 15 percent and 20 percent rate is $488,850 for married taxpayers filing jointly, $244,425 for married taxpayers filing separately, $434,500 for single taxpayers, and $461,700 for head of household filers.

CHAPTER 15 Entities Overview 15-13

The overall tax rate is lower in this situation because CCS retains most of its after-tax income and thus protects that portion of its income from immediate double taxation. If CCS retained all of its after-tax earnings, the current overall tax rate on its income would have been 21 percent (the corporate tax rate). Also, note that while the overall tax rate is lower when CCS distributes less of its income, Nicole also receives less cash from the business.

Shareholders that are C corporations. Shareholders that are C corporations are taxed on dividends at 21 percent, the same rate as they are taxed on ordinary income. In addition, divi-dends received by a corporation are potentially subject to another (third) level of tax when the corporation receiving the dividend distributes its earnings as dividends to its shareholders. This potential for more than two levels of tax on the same before-tax earnings prompted Congress to allow corporations to claim the dividends received deduction (DRD). In the next chapter, we discuss the DRD in detail, but the underlying concept is that a corporation receiving a dividend is allowed to deduct a certain percentage of the dividend from its taxable income to offset the potential for additional layers of taxation on the dividend when it distrib-utes the dividend to its shareholders. The dividends-received deduction percentage is 50, 65, or 100 percent of the dividend received, depending on the level of the recipient corporation’s ownership in the dividend-paying corporation’s stock. The DRD is 50 percent if the share-holder corporation owns less than 20 percent of the distributing corporation; 65 percent if it owns at least 20 percent but less than 80 percent of the distributing corporation; and 100 percent if the shareholder corporation owns at least 80 percent of the distributing corporation. Thus, a corporation’s net tax rate on a dividend received is 10.5 percent if it claims a 50 percent DRD [.21 tax rate × (1 − .5 DRD)], 7.35 percent if it claims a 65 percent DRD [.21 tax rate × (1 − .65 DRD)], and 0 percent if it claims a 100 percent DRD [.21 × (1 − 1.0 DRD)].

Example 15-5

What if: AssumethatNicoleinvitesacorporationtoinvestinCCSinexchangefora10percentsharein the company. Nicole makes the following assumptions as part of her calculations:• CCSisaCcorporation.• CCSearnstaxableincomeof$500,000.• CCSwillpayoutallofitsafter-taxearningsannuallyasadividend.Giventheseassumptions,whatwouldbetheoverall taxrateonthecorporate investor’sshareofCCS’sincomegiventhattheshareholdercorporationwouldbeeligibleforthe50percentdividendsreceived deduction?

Answer: 29.3 percent, computed as follows:

Description Amount Explanation

(1)Taxableincome $500,000

(2)Corporatetaxrate 21% $105,000

(3) Entity-level tax (1) ×(2)[firstleveloftax](4)After-taxincome $395,000 (1)− (3)

(5)Corporateinvestor’sdividend $39,500 (4)×10%(6)Taxabledividend $19,750 (5)× (1 −50%DRD)(7)Corporateinvestor’sshare

of entity-level tax$10,500 (3)×10%investor’sshare

(8)Corporateinvestor’staxondividend $4,148 (6)× 21% corporate tax rate

(9)Totaltaxpaidoncorporatetaxable income

$14,648 (7)+(8)

Overall tax rate on corporate taxable income

29.3% (9)/[(1) ×10%investor’sshare]

Note: The income of the corporate shareholder will be taxed again when the corporate shareholder distributes it to its own shareholders.

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15-14 CHAPTER 15 Entities Overview

Institutional shareholders. Pension and retirement funds are some of the largest insti-tutional shareholders of corporations. However, these entities do not pay shareholder-level tax on the dividends they receive. Ultimately, retirees pay the second tax on this income when they receive retirement distributions from these funds. While retirees pay the second tax at ordinary rates, not the reduced dividend rates, they are able to defer the tax until they receive fund distributions.

Tax-exempt and foreign shareholders. Tax-exempt organizations such as churches and universities are exempt from tax on their investment income, including dividend income from investments in corporate stock. Similarly, foreign investors may be eligible for re-duced rates on dividend income depending on the tax treaty, if any, their country of resi-dence has signed with the United States.

As we discuss and illustrate above, C corporation income is subject to double taxation. The first tax is paid by the corporation when it earns the income and the second tax is paid by the shareholders when the shareholders receive distributions of the corpora-tion’s earnings in the form of dividends. Can C corporations avoid the second level of tax entirely by not paying dividends? The answer is generally no. Even when corporations retain after-tax income, their shareholders pay the second level of tax at capital gains rates on the undistributed income when they sell their stock because the undistributed income indirectly increases the value of their stock and thus increases shareholders’ gains when they sell the stock. Assuming the shareholder is an individual and the shareholder owns stock in a corporation for more than a year, the gain is taxed at the same rates as the tax rates on qualified dividends discussed above (0, 15, or 20 percent plus 3.8 percent net investment income tax for higher income taxpayers). Because this second level of tax is deferred until taxpayers sell their stock, the longer they hold the stock, the less the tax cost is on a present value basis. In the extreme, taxpayers can avoid the second level of income tax completely on their stock appreciation by holding the stock until death. At death, gain built into the stock is eliminated because the stock takes basis equal to the value of the stock on the date of death.29

Shareholders other than individuals face different tax consequences when they sell their shares. When shareholders that are C corporations eventually sell the stock, they are taxed on capital gains at a flat 21 percent tax rate. Consequently, income from stock appreciation may expose income to more than two levels of taxation because capital gains from selling stock do not qualify for the dividends received deduction. Also, institutional shareholders don’t pay tax when they sell their stock and recognize capital gains. However, retirees generally pay tax on the gains at ordinary rates when they receive dis-tributions from their retirement accounts. Finally, tax-exempt shareholders do not pay tax on capital gains from selling stock, and foreign investors are generally not subject to U.S. tax on their capital gains from selling corporate stock.

Finally, the tax law provides incentives for C corporations to distribute income rather than to retain it for the purpose of avoiding the second level of tax. First, personal holding companies (closely held corporations generating primarily investment income) are subject to a 20 percent personal holding company tax on their undistributed income.30 Second, corporations that retain earnings for the purpose of avoiding the sec-ond level of tax are subject to a 20 percent accumulated earnings tax on the retained earnings.31 Corporations are not considered to be retaining earnings for tax avoidance purposes and are not subject to the accumulated earnings tax to the extent they (1) rein-vest the earnings in assets necessary for their business or (2) retain liquid assets for rea-sonable planned needs of the business.

Under the tax rate system prior to 2018, flow-through entities were generally consid-ered to be superior to corporations for tax purposes because they generated income that was taxed only once while corporations produced income that was taxed twice, with the 29See §1014.30§541.31See §§531–533.

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CHAPTER 15 Entities Overview 15-15

first level of tax imposed at a rate comparable to the individual tax rate. However, for years after 2017, the corporate tax rate is significantly lower than the maximum individual tax rate. Further, as described above, tax law effective beginning in 2018 provides a deduction for qualified business income (QBI) for individuals who are owners of flow-through entities. This tax legislation makes the optimal choice of entity based on overall tax rates of the entity’s business income less clear than it was under prior law. It is important to note, however, that the corporate tax rate reduction is a permanent change, while the QBI deduction is scheduled to expire in 2026. The overall tax rate on a flow-through entity’s business income depends on whether the flow-through entity’s business income is eligible for the QBI deduction and whether the income is subject to the net investment income tax or the self-employment tax and the additional Medicare tax. For C corporations, the overall tax rate depends in large part on the extent to which the corporation distributes its after-tax earnings as a dividend to its shareholders. As we saw in Example 15-2, the overall tax rate on CCS’s taxable income as a flow-through entity ranged from 29.6 percent to 40.8 percent, depending on whether the QBI deduction and the net investment income tax applied. In Example 15-4, the overall tax rate on CCS’s taxable income as a C corporation ranged from 21 percent, when CCS retained all of its after-tax income, to 39.8 percent, when it distributed all of its after-tax income.

Owner Compensation Entity owners who work for the entity are compensated in different ways, depending on the entity type. Owners of S corporations and C corpora-tions receive compensation as employees. Owners of flow-through entities taxed as partnerships receive compensation in the form of guaranteed payments. Sole proprietors don’t receive a separate compensation payment because a sole proprietorship is the same taxable entity as the individual sole proprietor.

S corporations and C corporations deduct the wages paid to employees (including shareholders who are employees) to calculate the entity’s business income. They also pay (and deduct) the employer’s portion of the FICA tax (Social Security tax plus Medicare tax) on the employee’s behalf. The employer’s portion of the tax is 7.65 percent of the employee’s first $132,900 of employee compensation plus 1.45 percent of employee compensation above $132,900. The shareholder-employee is taxed on the wages received at ordinary rates and is required to pay the employee’s portion of the FICA tax, which is generally the same as the employer’s portion. When considering both the employer’s and the employee’s portions of the FICA tax, the overall FICA rate is 15.3 percent of the first $132,900 of wages and 2.9 percent of the rest. This is the same rate as the self-employment tax rate. Also, similar to self- employment income, employee compensation is subject to the additional Medicare tax when the taxpayer’s AGI is over the threshold amount (discussed above).

Entities taxed as partnerships deduct guaranteed payments made to owners working for the entity. However, the entity is not required to pay FICA tax on the owner-worker’s behalf because guaranteed payments are self-employment income and self-employment taxes are the sole responsibility of the owner-worker.32 The owner-worker is taxed on the amount of the guaranteed payment at ordinary rates and is required to pay self-employment tax and potentially additional Medicare tax on the income, depending on their income level (see prior discussion on computing the self-employment and additional Medicare tax). A sole proprietorship does not pay deductible compensation to the sole proprietor. All of the income of a sole pr oprietorship is self-employment income and, consequently, is subject to self-em ployment tax and the additional Medicare tax.

Owner compensation provides potential tax planning opportunities, depending on the type of entity. For S corporations, business income allocations to owners are not subject to FICA or self-employment tax. However, wages paid to owner-employees are subject to FICA tax. (Recall that the combined employer/employee FICA rate is the same as the self-employment tax rate.) Consequently, as we discuss in the S Corporations chapter,

32Taxpayers pay self-employment tax on self-employment income and FICA taxes on employee compensation.

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15-16 CHAPTER 15 Entities Overview

Scorporations have a tax incentive to pay lower salary/wages to shareholder-employees that is subject to FICA tax so there is more business income to allocate to shareholder-employees that is not subject to FICA tax (lower deductible wages means higher business income allocations). Further, S corporations have an incentive to reduce wages to share-holder-employees in order to increase business income because employee compensation is not eligible for the deduction for qualified business income, but business income allo-cations to shareholders are eligible. In the extreme, S corporations may prefer to pay zero wages to shareholder-employees in order to maximize business income allocations to them. However, to the extent an S corporation shareholder receives an unreasonably low salary for services provided, the IRS may reclassify some of the shareholder’s business income allocation as salary.

In contrast to S corporations, entities taxed as partnerships don’t have an incentive to decrease guaranteed payments in order to increase business income allocations in an at-tempt to save self-employment taxes to owners. This is because both guaranteed pay-ments and business income allocations are self-employment income to the owner-worker. However, similar to S corporations, entities taxed as partnerships have an incentive to reduce guaranteed payments to owner-workers in order to increase business income al-locations to them because guaranteed payments are not eligible for the qualified business income but allocations of business income are eligible. Finally, relative to both S corpora-tions and entities taxed as partnerships, sole proprietorships may be the most advanta-geous for purposes of maximizing the qualified business income deduction in certain situations. This is because the sole proprietorship’s qualifying business income is not re-duced by a deduction for compensation paid to the owner/sole proprietor.

For C corporations, tax planning opportunities have potentially shifted with the steep reduction in the corporate tax rate relative to individual rates, effective beginning in 2018. Prior to the rate reduction, corporations could avoid double taxation of their income by paying deductible salaries to shareholder-employees. This income would be taxed once to the employee at ordinary rates similar to the corporate rate. The IRS could evaluate compensation to an employee-shareholder to determine if the compensation was unreasonably high for the work the employee-shareholder was doing and, to the extent it was, reclassify the excess compensation as nondeductible dividends. Currently, however, with the corporate rate significantly lower than the maximum individual rate, corporations have an incentive to pay lower salaries to shareholder-employees in order to have more of their income taxed at the lower corporate rate. By reducing deductible salaries, more of the corporate income is subject to tax at the lower 21 percent tax rate. If the income is paid in the form of salaries, it is subject to the individual rate (the top rate is 37 percent) and subject to both the employer’s and the employee’s portion of the FICA tax. This type of strategy is more likely to be useful for closely held corporations where all of the owners work for the corporation. It remains to be seen how the IRS will respond to such strategies.

While the overall tax rate of an entity’s income and the tax treatment of owner com-pensation are important entity choice factors, it is also important to consider the tax treat-ment of the entity’s losses and other tax characteristics when choosing a tax entity for a new business.

Deductibility of Entity Losses When a C corporation’s tax deductions exceed its income for the year, the excess is called a net operating loss (NOL). While NOLs provide no tax benefit to C corporations for the year they incur them, corporations may use NOLs to offset corporate taxable income and reduce corporate taxes in other years. The specific tax treatment for an NOL depends on when the NOL was generated. For NOLs generated in tax years ending before 2018, corporations could carry NOLs back and offset up to 100percent of taxable income (before the NOL deduction) reported in the two preceding years and carry NOLs forward to offset up to 100 percent of taxable income for up to 20years. However, for NOLs generated in tax years ending after 2017, corporations can carry NOLs forward indefinitely but they are not allowed to carry them back. Further, the

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CHAPTER 15 Entities Overview 15-17

deduction for post 2017 NOLs is limited to 80 percent of taxable income (before the NOL deduction) for a given year.33 In any event, losses from C corporations are not available to offset shareholders’ personal income.

THE KEY FACTS

Taxation of Entity Income

• Flow-through entity income is taxed at the owner’s tax rate. Individuals are taxed at a top marginal income rate of 37 percent on busi-ness income allocated to them from a flow-through entity.

• Flow-through entity owners who receive qualified busi-ness income from a flow-through entity are allowed to claim a qualified busi-ness income deduction equal to 20 percent of the qualified business income allocated to them (subject to certain limitations).

• Business income alloca-tions to passive owners of flow-through entities may be subject to the 3.8 per-cent net investment income tax.

• Business income allocated to S corporation sharehold-ers is not subject to self-employment tax.

• Owners of entities taxed as a partnership may be subject to self-employment tax on business income allocations, depending on the owner’s involvement in the business activities.

• Sole proprietors are sub-ject to self-employment tax on the sole proprietorship’s income.

• C corporation taxable income is subject to a flat 21 percent tax rate.

• Individuals who are C corporation shareholders are generally taxed at a maximum rate of 20 per-cent on dividends received. Further, certain taxpayers may be charged a 3.8 per-cent net investment in-come tax on dividends and capital gains.

• C corporation share holders that are themselves C corporations are generally eligible to receive a 50 per cent or greater dividends received deduction (DRD).

(continued )

In contrast to losses generated by C corporations, losses generated by sole propri-etorships and other flow-through entities are generally available to offset the owners’ personal income, subject to certain restrictions. For example, the owner of an entity taxed as a partnership or an S corporation shareholder may deduct losses from the en-tity only to the extent of the owner’s basis in her ownership interest in the flow-through entity. In addition, deductibility of losses from flow-through entities may be further limited by the at-risk limitation and/or the passive activity loss limitation. The at-risk limitation is similar to the basis limitation but is slightly more restrictive. The passive activity loss limitation typically applies to individual investors who are passive inves-tors in the flow-through entity. For passive investors, the business activities of the en-tity are called passive activities. In these circ*mstances, taxpayers can deduct losses from passive activities only to the extent they have income from other passive activities (or when they sell their interest in the activity). Due to the complex nature of these limitations, we defer a detailed discussion of these limitations until the Forming and Operating Partnerships chapter.

Individual taxpayers are also not allowed to deduct an “excess business loss”for the year. An excess business loss is the excess of aggregate business deductions for the year over the sum of aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for 2019 is $510,000 for married taxpay-ers filing jointly and $255,000 for other taxpayers. The amounts are indexed for infla-tion. Excess business losses include business losses from sole proprietorships, entities taxed as partnerships, and S corporations. In the case of an S corporation or an entity taxed as a partnership, the provision applies at the owner level. Excess busi-ness losses are carried forward and used in subsequent years. The excess business loss limitation applies to losses that are otherwise deductible after applying the basis, at-risk, and passive loss rules. See the Forming and Operating Partnerships chapter for more details.

The ability to deduct flow-through losses against other sources of income can be a significant issue for owners of new businesses because new businesses tend to report losses early on as the businesses get established. If owners form a new business as a C corporation, the corporate-level losses provide no current tax benefit to the shareholders. The fact that C corporation losses are trapped at the corporate level can impose a higher tax cost for shareholders initially doing business as a C corporation relative to a flow-through entity such as an S corporation or an entity taxed as a partnership.

TAXES IN THE REAL WORLD Will Entity Selection Be Affected by the Recent Tax Law Changes?

InitsStatisticsofIncomeTaxReport,theInternalRevenueServicereportedthefollowinginforma-tion relating to tax entity selection by business owners as of 2013 (the most recent year re-ported). Sole proprietorships were the most com-mon, followed by S corporations, entities taxed as partnerships, and then C corporations. Never-theless, C corporations by far generated the most business entity receipts and net income.

Under recent tax legislation, the C corporation taxratehasbeenreducedfrom35percentto21percent and owners of flow-through entities are allowedanewdeductionforqualifiedbusinessincome generated by the entity. Going forward, how do you expect the percentage of each entity type to change, if at all, under the new tax sys-tem? Is it likely we will see a shift toward C corpo-rations as the entity of choice?

(continued )

33We discuss the net operating loss deduction in more detail in the Corporate Operations chapter.

spi69614_ch15_000-035.indd 17 1/18/19 6:49 PM

15-18 CHAPTER 15 Entities Overview

• C corporation shareholders who are individuals gener-ally pay capital gainstaxes when shares aresold at a gain.

• S corporation and C corpo-ration shareholders receive employee compensation for work they do for the entity.

• Owner-workers for entities taxed as a partnershipreceive compensation in the form of guaranteed payments. Guaranteedpayments are self- employment income.

Number of Entities

Business Receipts

Net Income (including deficits)

Totalsforallentities 33,423,187 $33,260,092,484 $3,065,208,464

Entity Type Percentage Percentage Percentage

Ccorporations 4.82 61.24 46.64

Scorporations 12.74 20.55 17.93

Generalpartnerships 1.69 1.22 3.56

Limitedpartnerships 1.25 3.89 10.00

LLCs(taxedaspartnerships) 6.84 9.02 9.72

Soleproprietorships(nonfarm) 72.03 4.09 12.15

Other* .63 0 0

*OtherincludesRealEstateInvestmentTrusts(REITs)andRegulatedInvestmentCompanies(RICs).Neithertypeofentity has business receipts or net income.

Source: https://www.irs.gov/statistics/soi-tax-stats-integrated-business-data, Tax Year2013.

ETHICS

Troy is thesoleshareholderandCEOofBQT.BQT is a very profitable S corporation. Until re-cently,Troy’ssalarywasinlinewiththesalariesof comparable CEOs. However, Troy recentlylearned that he could reduce his tax burden if he were to reduce his salary. In particular, by lowering his salary, Troy would receive less em-ployeecompensationthatissubjecttoFICAtax

andisnoteligibleforthequalifiedbusinessin-come deduction, and he would be allocated more business income that is not subject toFICAtaxandqualifiesforthequalifiedbusinessincome deduction. After considering the poten-tial benefits, Troy decided to cut his salary in half.DoyouthinkTroy’sdecisionisethical?Whyor why not?

Example 15-6

spi69614_ch15_000-035.indd 18 1/18/19 6:49 PM

What if: Assume that Nicole organizes CCS as a C corporation and that, in spite of her best efforts as CEOofthecompany,CCSreportsataxlossof$50,000initsfirstyearofoperation(year1).AlsoassumethatNicole’smarginaltaxrateis37percentandherhusband’ssalaryforyear1is$500,000.Nicolefilesajointtaxreturnwithherhusband.HowmuchtaxwillCCSpayinyear1andhowmuchtaxwillNicole(andherhusband)payonthe$500,000ofothertaxableincomeifCCSisorganizedasaCcorporation?

Answer: CCSwillpay$0intaxesbecauseitreportsalossfortaxpurposes.However,CCScancarrythelossforwardtofutureyearsandcanusethelosstooffsetupto80percentofitstaxableincomeinagivenyear.BecauseNicolemaynotusetheCCSlosstooffsetherhusband’ssalary,she(andherhusband)mustpay$185,000intaxes.Seethecomputationsinthetablebelow.

What if: SupposeCCSisorganizedasanScorporationandNicole’sstockbasisinCCSbeforetheyear1lossis$100,000.HowmuchtaxwillCCSpayinyear1,andhowmuchtaxwillNicole(andherhusband)payonthe$500,000salary?

Answer: CCSwill pay $0 taxes (S corporations are not tax-paying entities) andNicolewill pay$166,500intaxes.Seethecomputationsinthetablebelow.

DescriptionC

CorporationS Corporation (flow-through) Explanation

(1)Taxableincome(loss) $(50,000) $(50,000)

(2) CCS corporate-level tax $ 0 $ 0 No taxable income

(3)Nicole’sotherincome $500,000 $500,000

(4)CCSlossavailableto offsetNicole’sotherincome

$0 $(50,000) $0ifCcorporation;(1)ifS corporation(flow-throughentity)

(5)Nicole’sotherincomereduced by entity loss

$500,000 $450,000 (3) (4)

(6)Nicole’smarginalordinarytax rate

37% 37%

Nicole’s tax on other income $185,000 $166,500 (5)× (6)

CHAPTER 15 Entities Overview 15-19

What if: SupposeCCSisorganizedasanScorporationandNicole’sstockbasisbeforethe$50,000year1lossis$100,000.Further,assumethatNicoledoesnotparticipateinCCS’sbusinessactivities;that is, assume she is a passive investor in the business entity. How much tax will Nicole (and her hus-band)payonthe$500,000ofotherincome?

Answer: $185,000.BecauseNicoleisapassiveinvestor,sheisnotallowedtodeductthelossallo-cated to her this year. She must carry it over and use it in future years (this assumes neither Nicole nor her husband have income from other investments in which they are passive investors).

As the example above illustrates, owners’ ability to immediately use start-up losses from flow-through entities to offset income from other sources is a tax advantage of flow-through entities over C corporations.

OTHER TAX CHARACTERISTICSThere are many tax factors that differ across entities and can influence the entity selection decision. Exhibit 15-3 provides an overview of these tax characteristics. The exhibit de-scribes the general rules for each tax characteristic as it relates to C corporations, S cor-porations, entities taxed as partnerships, and sole proprietorships, and it ranks the entities on each characteristic (1 is most tax favorable). Finally, it identifies the chapters where detail on these tax characteristics can be found.

Converting to Other Entity TypesWith the significant reduction in corporate tax rates from tax legislation effective beginning in 2018, owners of existing flow-through entities may reevaluate their entity status and determine whether they prefer to have their entity taxed as a C corporation rather than as a flow-through entity. Fortunately for flow-through entity owners wanting to change entity type, it is easy and inexpensive to convert flow-through entities, including sole proprietor-ships, into C corporations. Owners of S corporations can revoke their election to be taxed as an S corporation and be taxed as a C corporation (see the S Corporations chapter for details on this process). As we discussed in the Entity Tax Classification section of this chapter, owners of entities taxed as partnerships and sole proprietors doing business as an LLC can retain the same legal entity type but make a check-the-box election to be taxed as a C corporation. Alternatively, owners of partnerships and sole proprietors can contribute the assets of the business entity to a newly formed corporation in a tax-deferred transaction without any special tax elections.34 However, because this alternative involves creating a new legal entity, nontax factors (e.g., the cost of creating a new entity, changing the asset title to a new entity, etc.) may make this option less desirable than the check-the-box elec-tion to be taxed as a C corporation.

Conversely, with recent tax law changes providing a deduction for qualified business income and slightly lower individual tax rates, C corporation shareholders may prefer to have their business taxed as a flow-through entity rather than as a C corporation. Share-holders of existing corporations really have only two options for converting into flow-through entities. First, shareholders of C corporations could make an election to treat the corporation as an S corporation (flow-through entity), if they are eligible to do so. This option is not available for many corporations due to the tax rule restrictions prohibiting certain corporations from operating as S corporations.35 The only other option is for the shareholders t o liquidate the corporation and form the business as an entity taxed as a partnership or sole proprietorship for tax purposes. This may not be a viable option, how-ever, because the taxes imposed on liquidating corporations with appreciated assets can be punitive, even with the significantly lower corporate tax rate provided by recent tax

34§351 and Rev. Rul. 84-111 1984-2 CB 88.35See the S Corporations chapter for details on making the S corporation election.

spi69614_ch15_000-035.indd 19 1/18/19 6:49 PM

15-20

HIB

IT 1

5-3

Com

pari

son

of T

ax C

hara

cter

istic

s ac

ross

Ent

ities

Tax

Cha

ract

erist

icC

Cor

pora

tion

Entit

y Ta

xed

Part

ners

hip

S C

orpo

ratio

nSo

Prop

riet

orsh

ipSu

ary

ner l

imits

At l

east

one

shar

ehol

der.

At l

east

two

owne

rs.

Not

mor

e th

an 1

00;

no c

orpo

ratio

ns,

partn

ersh

ips,

nres

iden

t alie

ns,

or c

erta

in tr

usts

N/A

Lim

itatio

ns a

r e le

ast s

trict

for C

cor

pora

tions

and

mos

t stri

ct fo

r S c

orpo

ratio

ns. S

rpor

atio

ns a

re th

e on

ly e

ntity

with

sign

ifica

nt o

wne

r lim

itatio

ns. M

ore

deta

il fo

r thi

s fa

ctor

is d

iscu

ssed

in th

e S

Cor

pora

tions

cha

pter

Ran

k11

N/A

ner

cont

ribut

ions

appr

ecia

ted

prop

erty

entit

Tax

defe

rred

shar

ehol

der i

f ce

rtain

requ

irem

ents

are

met

Tax

defe

rred

to o

wne

r.Ta

x de

ferr

ed to

areh

olde

r if c

erta

requ

irem

ents

are

met

N/A

This

fact

or fa

vors

ent

ities

taxe

d as

par

tner

ship

s bec

ause

par

tner

s are

not

requ

ired

mee

t spe

cial

requ

irem

ents

in o

rder

to a

void

reco

gniz

ing

gain

the

cont

ribut

ion

appr

ecia

ted

prop

erty

to th

e pa

rtner

ship

, but

shar

ehol

ders

of b

oth

C a

nd S

cor

pora

tions

e re

quire

d to

mee

t cer

tain

requ

irem

ents

to a

void

reco

gniz

ing

gain

such

ntrib

utio

ns to

the

corp

orat

ion.

Mor

e de

tail

for t

his f

acto

r is p

rovi

ded

in th

Cor

pora

te F

orm

atio

n, R

eorg

aniz

atio

n, a

nd L

iqui

datio

n, th

e Fo

rmin

g an

d O

pera

ting

Partn

ersh

ips,

and

the

S C

orpo

ratio

ns c

hapt

ers.

Ran

N/A

Acc

ount

ing

perio

dsG

ener

ally

, any

tax

year

that

end

s on

the

last

day

of a

mon

th.2

Gen

eral

ly, m

ust u

se ta

x ye

ar th

at m

atch

es ta

x ye

ar o

f ow

ners

(spe

cial

les w

hen

not a

ll ow

ners

hav

e sa

tax

year

-end

Cal

enda

r yea

r.G

ener

ally

cale

ndar

yea

r.C

cor

pora

tions

gen

eral

ly h

ave

the

mos

t fle

xibi

lity

to se

lect

thei

r yea

r-end

. But

bec

ause

cor

pora

tions

are

not

flow

-thro

ugh

entit

ies,

this

is n

ot a

real

adv

anta

ge o

r dis

adva

ntag

e fro

m a

tax

pers

pect

ive.

Par

tner

ship

s gen

eral

ly a

re n

ot fr

ee to

cho

ose

thei

r yea

r-end

but

ey c

an h

ave

a ye

ar-e

nd th

at is

a d

iffer

ent y

ear-e

nd fr

om so

of th

e ow

ners

. Bec

ause

is a

llow

s som

e pa

rtner

s to

defe

r rep

ortin

g in

com

e, th

is fa

ctor

favo

rs p

artn

ersh

ips o

ver

S co

rpor

atio

ns. S

cor

pora

tions

gen

eral

ly h

ave

the

sam

e ca

lend

ar y

ear-e

nd a

s the

ir sh

areh

olde

rs. M

ore

deta

il fo

r thi

s fac

tor i

s pro

vide

d in

the

Bus

ines

s Inc

ome,

educ

tions

, and

Acc

ount

ing

Met

hods

, the

For

min

g an

d O

pera

ting

Partn

ersh

ips,

d th

e S

Cor

pora

tions

cha

pter

s.R

ank

N/A

Ove

rall

acco

untin

g m

etho

Mus

t use

acc

rual

etho

d un

less

erag

e an

nual

oss r

ecei

pts a

$26

mill

ion

less

.3,4

Gen

eral

ly, a

llow

ed to

e ca

sh o

r acc

rual

etho

Gen

eral

ly, a

llow

ed to

e ca

sh o

r acc

rual

etho

Cas

h or

acc

rual

etho

d.En

titie

s tax

ed a

s par

tner

ship

s, S

corp

orat

ions

, and

sole

pro

prie

tors

hips

gen

eral

ly h

ave

mor

e fle

xibi

lity

to c

hoos

e th

eir o

vera

ll ac

coun

ting

met

hod

than

C c

orpo

ratio

ns w

ith

aver

age

annu

al g

ross

rece

ipts

ove

r $26

mill

ion.

The

cas

h m

etho

d m

akes

it e

asie

r for

thes

e en

titie

s to

plan

the

timin

g of

inco

and

expe

nses

than

doe

s the

acc

rual

met

hod.

Mor

e de

tail

for t

his f

acto

r is p

rovi

ded

in th

e B

usin

ess I

ncom

e, D

educ

tions

, and

Acc

ount

ing

Met

hods

, the

Cor

pora

te O

pera

tions

, the

For

min

g an

d O

pera

ting

Partn

ersh

ips,

and

the

Cor

pora

tions

cha

pter

s.R

ank

Allo

catio

of in

com

e or

ss it

ems

to o

wne

N/A

Allo

catio

ns b

ased

par

tner

ship

reem

ent (

can

ffer f

rom

ners

hip

perc

enta

ges)

Allo

catio

ns b

ased

stock

ners

hip

perc

enta

ges.

N/A

This

fact

or a

pplie

s to

partn

ersh

ips a

nd S

cor

pora

tions

onl

y. P

artn

ersh

ips h

ave

mor

e fle

xibi

lity

than

S c

orpo

ratio

ns to

det

erm

ine

how

t o a

lloca

te in

com

e an

d lo

ss it

ems t

o en

tity

owne

rs. M

ore

deta

il fo

r thi

s fac

tor i

s pro

vide

d in

the

Form

ing

and

Ope

ratin

g Pa

rtner

ship

sand

the

S C

orpo

ratio

ns c

hapt

ers.

Ran

N/A

spi69614_ch15_000-035.indd 20 1/18/19 6:49 PM

15-21

Shar

e of

flow

- th

roug

h en

tity

debt

incl

uded

bas

is o

f ow

ner’s

equ

ity

inte

rest

N/A

Incr

ease

bas

is in

ners

hip

inte

rest

owne

r’s sh

are

entit

y’s d

ebt.

incr

ease

in st

ock

basi

s for

deb

t of e

ntity

peci

al ru

les i

f sh

areh

olde

r len

mon

ey to

S c

orpo

ratio

n).

N/A

Partn

ers a

re a

llow

ed to

incr

ease

the

basi

s in

thei

r ow

ners

hip

inte

rest

thei

r sha

re o

f the

par

tner

ship

’s d

ebt;

S co

rpor

atio

n sh

areh

olde

rs g

ener

ally

e no

t. Th

is fa

ctor

favo

rs p

artn

ersh

ips o

ver S

cor

pora

tions

. Mor

e de

tail

for

this

fact

or is

pro

vide

d in

the

Form

ing

and

Ope

ratin

g Pa

rtner

ship

sand

e S

Cor

pora

tions

cha

pter

Ran

/A1

Non

liqui

datin

g di

strib

utio

ns o

f no

ncas

h pr

oper

Gai

ns re

cogn

ized

dist

ribut

ions

appr

ecia

ted

prop

erty

and

loss

disa

llow

ed o

n di

strib

utio

ns o

f de

prec

iate

d pr

oper

ty.

Gen

eral

ly n

o ga

in o

r lo

ss re

cogn

ized

nonc

ash

prop

erty

strib

utio

ns.

Sam

e as

C c

orpo

ratio

n.N

/ATh

is fa

ctor

favo

rs p

artn

ersh

ips f

or d

istrib

utio

ns o

f app

reci

ated

and

prec

iate

d pr

oper

ty.M

ore

deta

il fo

r thi

s fac

tor i

s pro

vide

d in

the

Cor

pora

te T

axat

ion:

Non

liqui

datin

g D

istrib

utio

ns, t

heD

ispo

sitio

ns o

f Pa

rtner

ship

Inte

rests

and

Par

tner

ship

Dist

ribut

ions

, and

the

S C

orpo

ratio

chap

ters

Ran

N/A

Liqu

idat

ing

distr

ibut

ions

Gai

n an

d lo

reco

gniz

ed (c

erta

loss

es d

isal

low

ed).

Gen

eral

ly n

o ga

in o

r lo

ss re

cogn

ized

ain

and

loss

reco

gniz

(cer

tain

loss

disa

llow

ed).

N/A

This

fact

or te

nds t

o fa

vor p

artn

ersh

ips i

f the

liqu

idat

ing

entit

ies h

ave

gain

sets

, and

it te

nds t

o fa

vor c

orpo

ratio

ns if

the

entit

ies h

ave

loss

ass

ets.

Mor

e de

tail

for t

his f

acto

r is p

rovi

ded

in th

e C

orpo

rate

For

mat

ion,

orga

niza

tion,

and

Liq

uida

tion,

the

Dis

posi

tions

of P

artn

ersh

ip In

tere

sts

and

Partn

ersh

ip D

istrib

utio

ns, a

nd th

e S

Cor

pora

tions

cha

pter

Ran

N/A

1 “R

ank”

ord

ers t

he e

ntiti

es b

ased

the

parti

cula

r cha

ract

erist

ic (1

is m

ost f

avor

able

).2 C

cor

pora

tions

that

qua

lify

as p

erso

nal s

ervi

ce c

orpo

ratio

ns (P

SCs)

are

gen

eral

ly re

quire

d to

use

a c

alen

dar y

ear.

In g

ener

al, a

per

sona

l ser

vice

cor

pora

tion

is a

cor

pora

tion

who

se sh

areh

olde

rs p

erfo

prof

essi

onal

serv

ices

such

as l

aw, e

ngin

eerin

g, a

nd a

ccou

ntin

g. S

ee §

448(

d)(2

) for

mor

e de

tail.

3 The

$26

mill

ion

thre

shol

d ap

plie

s for

tax

year

s beg

inni

ng in

201

9. F

or ta

x ye

ars b

egin

ning

in 2

018,

the

thre

shol

d w

as $

25 m

illio

n.4 C

cor

pora

tions

that

are

qua

lifie

d pe

rson

al se

rvic

e co

rpor

atio

ns a

re re

quire

d to

use

the

cash

met

hod.

Tax

Cha

ract

erist

C C

orpo

ratio

nEn

tity

Taxe

d as

rtne

rshi

Cor

pora

tion

Sole

opri

etor

ship

Sum

mar

spi69614_ch15_000-035.indd 21 1/18/19 6:49 PM

15-22 CHAPTER 15 Entities Overview

law changes. As described in Exhibit 15-3, liquidating corporations are taxed on the ap-preciation in the assets they distribute to their shareholders in liquidation. Further, share-holders of liquidating cor porations are also taxed on the difference between the fair market value of the assets they receive from the liquidating corporation and the tax basis in their stock. Effectiv ely, the total double-tax cost of liquidating a corporation can swamp expected tax savings from operating as a flow-through entity. The tax cost of liquidating an entity is a factor to consider when making the tax entity choice for a business.

Example 15-7

What if: Assume we are years down the road and that Nicole is the sole shareholder of CCS (aCcorporation).CCS’sassetshavea fairmarketvalueof$10millionandadjusted taxbasisof $6million($4millionbuilt-ingain).Furtherassumethatthecorporatetaxrateis21percent,Nicole’sstockbasisinCCSis$2million,andhermarginaltaxrateonlong-termcapitalgainsis23.8percent(20percentcapitalgainsrate+3.8percentnetinvestmentincometax).HowmuchtaxwouldCCSandNicoleberequiredtopayifCCSweretoliquidateinordertoformanLLC?

Answer: $2,544,080.ThiswouldbeasteeptaxpricetopayforchangingfromaCcorporationto an LLC.

Description Amount Explanation

(1)FMVofCCSassets $10,000,000

(2)AdjustedbasisofCCSassets 6,000,000

(3)CCStaxableincomeonliquidation 4,000,000 (1)− (2)

(4) Corporate tax rate 21%

(5)Entity-leveltax 840,000 (3)× (4)

(6)After-taxassetsdistributedtoNicole 9,160,000 (1)−(5)

(7)Nicole’sstockbasis 2,000,000

(8)Nicole’slong-termcapitalgainondistribution 7,160,000 (6)–(7)

(9)Nicole’smarginaltaxrateongain 23.8%

(10)Shareholder-leveltax 1,704,080 (8)× (9)

Total entity and shareholder-level tax on liquidation $2,544,080 (5)+(10)

continued from page 15-4 . . .Nicole quickly determined she would legally form CCS as an LLC in Utah. This would provide her with limited liability and allow her complete flexibility for determining the tax entity type of CCS. If at some point she wanted to convert CCS into a corporation in Utah, she was advised that she could make the conversion simply by filing some paperwork.

Nicole’s five-year forecast of CCS’s expected operating results showed that CCS would generate losses for the first three years and then become very profitable thereafter. With these projections in hand, Nicole first considered forming CCS as a partnership for tax purposes (she was planning on bringing in another investor) or electing to become an S corporation. Nicole determined that income allocated to her from CCS would be eligible for the deduction for qualified business income whether she operated CCS as a partnership or an S corporation. She then compared the specific tax rules applicable to partnerships and S corporations before deciding her preference between the two tax entity types. She identified some differences that could sway her decision one way or the other. Supporting a decision to select a partnership, Nicole learned she would likely be able to deduct the projected start-up losses from CCS more quickly with a partnership compared with an S corporation because she could include a share of the partnership’s debt in her

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CHAPTER 15 Entities Overview 15-23

tax basis in her ownership interest (whereas she would not be able to include a share of the S corporation’s debt in the tax basis of her ownership interest). Nicole also hoped to attract corporate investors, and she discovered that a partnership can have corporate partners but that S corporations are not permitted to have corporate shareholders. Supporting a decision to select an S corporation, Nicole learned that S corporations appear to have a compelling advantage over partnerships in reducing the self-employment tax of owners active in managing their businesses. Nicole decided that she preferred a partnership over an S corporation because she would be willing to potentially incur additional self-employment taxes with a partnership in exchange for the ability to deduct her losses sooner and for the freedom to solicit corporate investors.

Nicole then turned her attention to whether she preferred to operate CCS as a Ccorporation or a partnership for tax purposes. Favoring the partnership tax entity choice was the fact that Nicole would be able to immediately deduct initial losses of the business against her personal income. Favoring the C corporation choice was the overall tax rate on the CCS income when it becomes profitable. She reasoned that the corporate tax rate is significantly lower than her marginal individual tax rate and she planned to grow CCS by having CCS retain rather than distribute its income and subject it to a second level of tax. Consequently, Nicole determined that the overall tax rate to CCS income would be significantly lower if she operated CCS as a C corporation. Further, as a C corporation she would be able to solicit corporate owners and eventually take CCS public if the opportunity were to present itself (to do this she would have to convert to a legal corporation). After much thought and analysis, Nicole chose to make the election necessary to have CCS taxed as a C corporation. With this big decision out of the way, Nicole could focus on applying for a small business loan from her local bank and on having her attorney take the necessary steps to formally organize CCS as a limited liability company. ■

CONCLUSIONAny time a new business is formed, and periodically thereafter as circ*mstances change (such as relevant tax law), business owners must carefully evaluate what type of business entity will maximize the after-tax profits from their business ventures. Many of the key factors to consider in the entity selection decision-making process are outlined in this chapter. When making the entity selection decision, owners must carefully balance the tax and nontax characteristics unique to the entities available to them. This chapter explains how various legal entities are treated for tax purposes and how certain tax characteristics differ between entity types. Moreover, it also identifies some of the more important nontax issues that come to bear on the choice of entity decision. With this understanding, taxpay-ers and their advisers will be better prepared to face this frequently encountered business decision. In the Forming and Operating Partnerships chapter, we return to Nicole and Color Comfort Sheets LLC to examine the tax rules that apply to Nicole and other mem-bers in CCS as they form the entity for tax purposes and begin business operations.

Summary

Discuss the legal and nontax characteristics of different types of legal entities. LO 15-1

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• Entities that differ in terms of their legal characteristics include corporations, limited liabilitycompanies, general partnerships, limited partnerships, and sole proprietorships.

• Corporations are formally organized by filing articles of incorporation with the state. Theyare legally separate entities and protect their shareholders from the liabilities of the corpo-ration. State corporation laws dictate interactions between corporations and shareholders.

15-24 CHAPTER 15 Entities Overview

As a result, shareholders have limited flexibility to customize their business arrangements with the corporation and other shareholders. State corporate governance rules do, how-ever, facilitate initial public offerings.

• Limited liability companies are formally organized by filing articles of organization with the state. Like corporations, they are separate legal entities that shield their members from liabilities. In contrast to corporations, state LLC statutes give members a great deal of latitude in customizing their business arrangements with the LLC and other members.

• General partnerships may be organized informally without state approval, but limited part-nerships must file a certificate of limited partnership with the state to organize. Although they are considered to be legally separate entities, they provide either limited or no liability protection for partners. While limited partners in limited partnerships have liability protec-tion, general partners are fully exposed to the liabilities of the partnership. General and limited partnerships are given a great deal of latitude in customizing their partnership agreements.

• Sole proprietorships are businesses legally indistinguishable from their sole individual owners. As such, they are very flexible but provide no liability protection. Sole proprietors can obtain liability protection by converting to a single-member LLC.

LO 15-2 Describe the different types of entities for tax purposes.

• The four categories of business entities recognized by our tax system include: C corporations, S corporations, partnerships, and sole proprietorships.

• Legalcorporationsthatdon’tmaketheSelectionaretreatedasCcorporationsandthere-fore pay taxes. All other entities recognized for tax purposes are flow-through entities.

• LegalcorporationsthatqualifyforandmaketheSelectionaretreatedasScorporations.• Unincorporated entities with more than one owner are treated as partnerships unless they

elect to be taxed as a corporation. If the entity elects to be taxed as a corporation, it can furtherelecttobetaxedasanScorporationifitmeetstheScorporationrequirements.

• Unincorporated entities with one owner are treated as sole proprietorships, where the sole owner is an individual, or as disregarded entities otherwise. If a sole proprietor converts to a single member LLC, the LLC can elect to be taxed as a corporation. It can further elect to be taxed as an S corporation.

LO 15-3

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Identify fundamental differences in tax characteristics across entity types.

• Flow-through entity income is taxed once at the owner level. For individual owners, the top rateis37percent.Flow-throughincomemayalsobesubjecttothenetinvestmentincometax for passive investors or the self-employment tax for those involved in the business activities of a partnership or sole proprietorship.

• Flow-throughbusinessownersareeligibletodeduct20percentoftheirqualifiedbusinessincome as a fromAGIdeductionthatisnotanitemizeddeduction.Thedeductionissubjectto certain limitations determined at the individual level.

• Qualified business income is generally nonservice business income generated in the United States.

• Flow-throughentitybusinessincomeallocatedtopassiveownersissubjecttothe3.8percentnet investment income tax for taxpayers with AGI over a threshold dependent on filing status.

• Self-employmentincomeissubjecttoself-employmenttaxandadditionalMedicaretax.• S corporation business income allocated to shareholders is not self-employment income.• Sole proprietorship income is self-employment income to the sole proprietor.• Whether business income of entities taxed as a partnership is self-employment income to

anownerdependsontheowner’sinvolvementintheentity’sbusinessactivities.• Corporate taxable income is taxed at the corporate level and again at the shareholder

level. The corporate tax rate is a flat 21 percent. The second level of tax is paid at the shareholder level when the corporation distributes after-tax earnings as a dividend or when the shareholder sells the stock. The tax rate for the second level of tax depends on the type of shareholder.

• Dividendsandlong-termcapitalgainsaretaxedatatoprateof23.8percent(20percentdividendplus3.8percentnetinvestmentincometax).Corporateshareholdersaretaxedon

CHAPTER 15 Entities Overview 15-25

dividends and capital gains at the corporate tax rate. However, corporations are entitled to deduct 50, 65, or 100 percent of dividends received based on the extent of their ownership in the distributing corporation.

• Corporations can defer the second level of tax by not distributing their after-tax income. However, corporations that retain earnings for tax avoidance rather than business purposes may be subject to the accumulated earnings tax or the personal holding company tax. These taxes reduce the incentive for corporations to retain earnings in order to avoid the second level of tax. Corporations are allowed to retain earnings to invest in their business.

• Business entity owners who work for the entity are compensated in different ways, depending on the type of entity.

• S corporation and C corporation shareholders who work for the entity receive employee compensation.

• Owners who work for entities taxed as partnerships receive guaranteed payments that are self-employment income to the owner-worker.

• Sole proprietors don’t receive compensation from the business because the sole propri-etorship and the sole proprietor are the same entity for tax purposes.

• Operating losses from S corporations and entities taxed as partnerships flow through to the owners. Owners may deduct these losses only to the extent of the basis in their ownership interest. The losses must also clear “at-risk” limitations and passive activity loss limitations in order for the owners to deduct the loss.

• The at-risk limitation is similar to the basis limitation. The passive activity loss limitations typi-cally apply to individual investors who do little, if any, work relating to the business activities of the flow-through entity (referred to as passive activities to the individual investors). In these circ*mstances, taxpayers can deduct such losses only to the extent they have income from other passive activities.

• Flow-through entity individual owners are not allowed to deduct an excess business loss for the year ($510,000 for married couples filing jointly; $255,000 for other taxpayers). This provision potentially limits losses that would otherwise be deductible after applying the at-risk and passive activity loss limitations.

• Shareholders can mitigate the double tax by increasing the time they hold shares before selling.

• C corporation losses are referred to as net operating losses (NOLs).• C corporations incurring NOLs before 2018 can carry the losses back two years and

forward up to 20 years to offset up to 100 percent of taxable income in those years. C corporations incurring losses after 2017 can carry the losses forward indefinitely but may not carry the losses back. Further, the NOL deduction is limited to 80 percent of taxable income without the deduction in those years.

• C corporations may have one or many shareholders. S corporations may have one share-holder and as many as 100 unrelated shareholders; but corporations, nonresident aliens, partnerships, and certain trusts may not be S corporation shareholders. Partnerships must have at least two partners but are not restricted to a maximum number of partners. Sole proprietorships may have only one owner.

• Gains and income from contributing appreciated property to business entities are more easily deferred with partnerships compared to C and S corporations.

• S corporations, partnerships, and sole proprietorships are generally required to use tax year-ends conforming to the tax year-ends of their owners. C corporations may use any tax year-end.

• C corporations generally must use the accrual method unless they are a smaller corporation (average gross receipts of $26 million or less in the prior three years). S corporations may use either the cash or accrual method of accounting. Partnerships generally may use either the cash or accrual method. Sole proprietorships may use either the cash or accrual method.

• Income and losses may be specially allocated to partners based on the partnership agreement. This gives partnerships a great deal of flexibility in determining how the risks and rewards of the enterprise are shared among partners. In contrast, income and losses must be allocated pro rata to S corporation shareholders consistent with their ownership percentages.

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15-26 CHAPTER 15 Entities Overview

• Partners, but not S corporation shareholders, may add their share of entity debt to the basis in their ownership interest.

• Generally, distributions of appreciated property trigger gain at both the corporate and shareholderlevelwhenmadetoshareholdersofCcorporations;triggergainatthecorpo-ratelevelwhenmadetoScorporationshareholders;anddon’ttriggeranygainatallwhenmade to partners.

• Onliquidation,CandScorporationswillgenerallyrecognizegainsandlossesondistrib-uted assets. In contrast, partnerships and their partners generally do not recognize gains or lossesonliquidatingdistributions.

• Converting a flow-through entity into a C corporation for tax purposes is generally fairly easy and inexpensive to do. S corporation shareholders can revoke the S corporation election;partnerships(andsoleproprietorshipsformedasLLCs)canchecktheboxtobetaxedasacorporation;andpartnershipsandsoleproprietorscancontributeassetstoacorporate entity in tax-deferred transactions.

• C corporations wanting to convert to a flow-through entity have two options. They may electtobecomeanScorporationifeligible,ortheymayliquidatethecorporationandorganizeasanewentity.TaxesfromliquidatingCcorporationscanbesignificantwhen C corporations have appreciated assets.

KEY TERMS

accumulated earnings tax (15-14)articles of incorporation (15-2)articles of organization (15-2)C corporation (15-5)certificate of limited

partnership (15-2)certificate of organization (15-2)corporation (15-2)disregarded entities (15-5)dividends received deduction

(DRD)(15-13)

double taxation (15-14)excess business loss (15-17)flow-through entities (15-5)general partnership (GP)(15-2)initial public offering (IPO)(15-3)institutional shareholders (15-11)limited liability company

(LLC)(15-2)limited partnership (LP)(15-2)net earnings from

self-employment(15-9)

net operating loss (NOL) (15-16)partnership agreement (15-2)personal holding companies(15-14)personal holding company

tax (15-14)qualified business income (QBI) (15-8)S corporation (15-5)single-member LLCs (15-5)sole proprietorship (15-2)specified service trade or

business (15-8)

DISCUSSION QUESTIONS

Discussion Questions are available in Connect®.

LO 15-1 1. What are the most common legal entities used for operating a business? How are these entities treated similarly and differently for state law purposes?

LO 15-1 2. How do business owners create legal entities? Is the process the same for all entities? If not, what are the differences?

LO 15-1 3. What is an operating agreement for an LLC? Are operating agreements required for limited liability companies? If not, why might it be important to have one?

LO 15-1 4. Explain how legal entities differ in terms of the liability protection they afford their owners.

LO 15-1 5. Have recent tax law changes increased or decreased the double tax on C corporation income? Explain.

LO 15-1 6. Why is it a nontax advantage for corporations to be able to trade their stock on the stock market?

LO 15-1

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7. How do legal corporations protect shareholders from liability? If you formed a small corporation, would you be able to avoid repaying a bank loan from your community bank if the corporation went bankrupt? Explain.

CHAPTER 15 Entities Overview 15-27

8. Other than corporations, are there other legal entities that offer liability protection? Are any of them taxed as flow-through entities? Explain.

LO 15-1 LO 15-2

9. In general, how are unincorporated entities classified for tax purposes? LO 15-2

10. Can unincorporated legal entities ever be treated as corporations for tax purposes? Can legal corporations ever be treated as flow-through entities for tax purposes? Explain.

LO 15-2

11. What are the differences, if any, between the legal and tax classifications of business entities?

LO 15-2

12. What types of business entities does the U.S. tax system recognize? LO 15-2

13. For flow-through entities with individual owners, how many times is flow-through entity income taxed, who pays the tax, and what is the tax rate?

LO 15-3

14. What is the qualified business income deduction and how does it affect the tax rate on flow-through entity income?

LO 15-3

15. Doug is considering investing in one of two partnerships that will build, own, and operate a hotel. One is located in Canada and one is located in Arizona. Assuming both investments will generate the same before-tax rate of return, which entity should Doug invest in when considering the after-tax consequences of the invest-ment? Assume Doug’s marginal rate is 37 percent, he will be a passive investor in the business, and he will report the flow-through income from either entity on his tax return. Explain (ignore any foreign tax credit issues).

LO 15-3

16. Is business income allocated from a flow-through entity to its owner’s self- employment income? Explain.

LO 15-3

17. Who pays the first level of tax on a C corporation’s income? What is the tax rate applicable to the first level of tax?

LO 15-3

18. Who pays the second level of tax on a C corporation’s income? What is the tax rate applicable to the second level of tax and when is it levied?

LO 15-3

19. Is it possible for shareholders to defer or avoid the second level of tax on corporate income? Briefly explain.

LO 15-3

20. How does a corporation’s decision to pay dividends affect its overall tax rate? LO 15-3

21. Is it possible for the overall tax rate on corporate taxable income to be lower than the tax rate on flow-through entity taxable income? If so, under what conditions would you expect the overall corporate tax rate to be lower?

LO 15-3

22. Assume Congress increases individual tax rates on ordinary income while leaving all other tax rates unchanged. How would this change affect the overall tax rate on corporate taxable income? How would this change affect overall tax rates for owners of flow-through entities?

LO 15-3

23. Assume Congress increases the dividend tax rate to the ordinary tax rate while leaving all other tax rates unchanged. How would this change affect the overall tax rate on corporate taxable income?

LO 15-3

24. Evaluate the following statement: “When dividends and long-term capital gains are taxed at the same rate, the overall tax rate on corporate income is the same whether the corporation distributes its after-tax earnings as a dividend or whether it reinvests the after-tax earnings to increase the value of the corporation.”

LO 15-3

25. If XYZ Corporation is a shareholder of BCD Corporation, how many levels of tax is BCD’s before-tax income potentially subject to? Has Congress provided any tax relief for this result? Explain.

LO 15-3

26. How many times is income from a C corporation taxed if a retirement fund is the owner of the corporation’s stock? Explain.

LO 15-3

27. For tax purposes, how is the compensation paid to an S corporation shareholder similar to compensation paid to an owner of an entity taxed as a partnership? How is it different?

LO 15-3

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15-28 CHAPTER 15 Entities Overview

LO 15-3 28. Why might it be a good tax planning strategy for an S corporation with one share-holder to pay a salary to the shareholder on the low end of what the services are potentially worth?

LO 15-3 29. When a C corporation reports a loss for the year, can shareholders use the loss to offset their personal income? Why or why not?

LO 15-3 30. Is a current-year net operating loss of a C corporation available to offset income from the corporation in other years? Explain.

LO 15-3 31. Would a corporation with a small amount of current-year taxable income (before the net operating loss deduction) and a large net operating loss carryover have a tax liability for the current year? Explain.

LO 15-3 32. In its first year of existence, SMS, an S corporation, reported a business loss of $10,000. Michelle, SMS’s sole shareholder, reports $50,000 of taxable income from sources other than SMS. What must you know to determine whether she can deduct the $10,000 loss against her other income? Explain.

LO 15-3 33. ELS, an S corporation, reported a business loss of $1,000,000. Ethan, ELS’s sole shareholder, is involved in ELS’s daily business activities and he reports $1,200,000 of taxable income from sources other than ELS. What must you know in order to determine how much, if any, of the $1,000,000 loss Ethan may deduct in the current year? Explain.

LO 15-3 34. Why are S corporations less favorable than C corporations and entities taxed as partnerships in terms of owner-related limitations?

LO 15-3 35. Are C corporations or flow-through entities (S corporations and entities taxed as partnerships) more flexible in terms of selecting a tax year-end? Why are the tax rules in this area different for C corporations and flow-through entities?

LO 15-3 36. Which tax entity types are generally allowed to use the cash method of accounting?LO 15-3 37. According to the tax rules, how are profits and losses allocated to owners of entities

taxed as partnerships (partners or LLC members)? How are they allocated to S cor-poration shareholders? Which entity permits greater flexibility in allocating profits and losses?

LO 15-3 38. Compare and contrast the FICA tax burden of S corporation shareholder-employees and LLC members(assume the LLC is taxed as a partnership) receiving compensa-tion for working for the entity (guaranteed payments) and business income alloca-tions to S corporation shareholders and LLC members assuming the owners are actively involved in the entity’s business activities. How does your analysis change if the owners are not actively involved in the entity’s business activities?

LO 15-3 39. Explain how liabilities of an LLC(taxed as a partnership) or an S corporation affect the amount of tax losses from the entity that limited liability company members and S corporation shareholders may deduct. Do the tax rules favor LLCs or S corporations?

LO 15-3 40. Compare the entity-level tax consequences for C corporations, S corporations, andentities taxed as partnerships for both nonliquidating and liquidating distribu-tions of noncash property. Do the tax rules tend to favor one entity type more than the others? Explain.

LO 15-3 41. If entities taxed as partnerships and S corporations are both flow-through entities for tax purposes, why might an owner prefer one form over the other for tax purposes? List separately the tax factors supporting the decision to operate as either an entity taxed as a partnership or as an S corporation.

LO 15-3

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42. What are the tax advantages and disadvantages of converting a C corporation into an LLC taxed as a partnership?

CHAPTER 15 Entities Overview 15-29

PROBLEMSSelect problems are available inConnect®.

43. Visit your state’s official website and review the information there related to forming and operating business entities in your state. Write a short report explainingthe steps for organizing a business in your state and summarizing any tax-related information you found.

LO 15-1

research

44. Andrea would like to organize SHO as either an LLC (taxed as a sole proprietor-ship) or a C corporation. In either form, the entity is expected to generate an 11 per-cent annual before-tax return on a $200,000 investment. Andrea’s marginal income tax rate is 35 percent and her tax rate on dividends and capital gains is 15 percent. Andrea will also pay a 3.8 percent net investment income tax on dividends and capital gains she recognizes. If Andrea organizes SHO as an LLC, Andrea will be required to pay an additional 2.9 percent for self-employment tax and an additional .9 percent for the additional Medicare tax. Further, she is eligible to claim the full deduction for qualified business income. Assume that SHO will pay out all of its after-tax earnings every year as a dividend if it is formed as a C corporation.

LO 15-3

a) How much cash after taxes would Andrea receive from her investment in the first year if SHO is organized as either an LLC or a C corporation?

b) What is the overall tax rate on SHO’s income in the first year if SHO is organized as an LLC or as a C corporation?

45. Jacob is a member of WCC (an LLC taxed as a partnership). Jacob was allocated $100,000 of business income from WCC for the year. Jacob’s marginal income tax rate is 37 percent. The business allocation is subject to 2.9 percent of self-employment tax and .9 percent additional Medicare tax.

LO 15-3

a) What is the amount of tax Jacob will owe on the income allocation if the income is not qualified business income?

b) What is the amount of tax Jacob will owe on the income allocation if the income is qualified business income (QBI) and Jacob qualifies for the full QBI deduction?

46. Amanda would like to organize BAL as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Amanda’s marginal income tax rate is 37 percent and her tax rate on dividends and capital gains is 23.8 percent (including the 3.8 percent net investment income tax). If Amanda organizes BAL as an LLC, she will be required to pay an additional 2.9 percent for self-employment tax and an additional .9 percent for the additional Medicare tax. Also, she is eligible to claim a full deduction for qualified business income on BAL’s income. Assume that BAL will distribute half of its after-tax earnings every year as a dividend if it is formed as a C corporation.

LO 15-3

a) How much cash after taxes would Amanda receive from her investment in the first year if BAL is organized as either an LLC or a C corporation?

b) What is the overall tax rate on BAL’s income in the first year if BAL is organized as an LLC or as a C corporation?

47. Sandra would like to organize BAL as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Sandra’s marginal income tax rate is 37 percent and her tax rate on dividends and capital gains is 23.8 percent (including the 3.8 percent net investment income tax). If Sandra organizes BAL as an LLC, she will be required to pay an additional 2.9 percent for self-employment tax and an additional .9 percent for the additional Medicare tax. BAL’s income is not qualified business income (QBI) so Sandra is not allowed to claim the QBI

LO 15-3

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15-30 CHAPTER 15 Entities Overview

deduction. Assume that BAL will distribute all of its after-tax earnings every year as a dividend if it is formed as a C corporation. a) How much cash after taxes would Sandra receive from her investment in the first

year if BAL is organized as either an LLC or a C corporation? b) What is the overall tax rate on BAL’s income in the first year if BAL is organized

as an LLC or as a C corporation?

LO 15-3 48. Tremaine would like to organize UTA as either an S Corporation or a C corpora-tion. In either form, the entity will generate a 9 percent annual before-tax return on a $1,000,000 investment. Tremaine’s marginal income tax rate is 37 percent and his tax rate on dividends and capital gains is 23.8 percent (including the net investment income tax). If Tremaine organizes UTA as an S corporation he will be allowed to claim the deduction for qualified business income. Also, because Tremaine will participate in UTA’s business activities, the income from UTA will not be subject to the net investment income tax. Assume that UTA will pay out 25 percent of its after-tax earnings every year as a dividend if it is formed as a C corporation.

research

a) How much cash after taxes would Tremaine receive from his investment in the first year if UTA is organized as either an S corporation or a C corporation?

b) What is the overall tax rate on UTA’s income in the first year if UTA is organized as an S corporation or as a C corporation?

c) What is the overall tax rate on UTA’s income in the first year if it is organized as an S corporation but UTA’s income is not qualified business income?

d) What is the overall tax rate on UTA’s income if UTA’s income is not qualified business income and Tremaine is a passive investor in UTA?

LO 15-3 49. Marathon Inc. (a C corporation) reported $1,000,000 of taxable income in the current year. During the year, it distributed $100,000 as dividends to its shareholders as follows:

tax forms ∙ $5,000 to Guy, a 5 percent individual shareholder.∙ $15,000 to Little Rock Corp., a 15 percent shareholder (C corporation).∙ $80,000 to other shareholders.a) How much of the dividend payment did Marathon deduct in determining its

taxable income?b) Assuming Guy’s marginal ordinary tax rate is 37 percent, how much tax will he

pay on the $5,000 dividend he received from Marathon Inc. (including the net investment income tax)?

c) What amount of tax will Little Rock Corp. pay on the $15,000 dividend it received from Marathon Inc. (50 percent dividends received deduction)?

d) Complete Form 1120 Schedule C for Little Rock Corp. to reflect its dividends received deduction (use the most recent Form 1120, Schedule C available).

e) On what line on page 1 of Little Rock Corp.’s Form 1120 is the dividend from Marathon Inc. reported, and on what line of Little Rock Corp.’s Form 1120 is its dividends received deduction reported?

LO 15-3 50. After several years of profitable operations, Javell, the sole shareholder of JBD Inc., a C corporation, sold 22 percent of her JBD stock to ZNO Inc., a C corporation in a similar industry. During the current year JBD reports $1,000,000 of after-tax in-come. JBD distributes all of its after-tax earnings to its two shareholders in propor-tion to their shareholdings. How much tax will ZNO pay on the dividend it receives from JBD? What is ZNO’s tax rate on the dividend income (after considering the DRD)? [Hint: See IRC §243.]

research

LO 15-3

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51. Mackenzie is considering conducting her business, Mac561, as either a single- member LLC or as an S corporation. Assume her marginal ordinary income tax rate is 37 percent, her marginal FICA rate on employee compensation is 1.45 percent, her marginal self-employment tax rate is 2.9 percent, and any employee compensation or

CHAPTER 15 Entities Overview 15-31

self-employment income she receives is subject to the .9 percent additional Medicare tax. Also assume Mac561 generated $200,000 of business income before considering the deduction for compensation Mac561 pays to Mackenzie and Mackenzie can claim the full qualified business income deduction on Mac561’s business income. Determine Mackenzie’s after-tax cash flow from the entity’s business income and any compensation she receives from the business under the following assumptions:a) Mackenzie conducted Mac561 as a single-member LLC.b) Mackenzie conducted Mac561 as an S corporation and she received a salary

of $100,000. All business income allocated to her is also distributed to her.c) Mackenzie conducted Mac561 as an S corporation and she received a salary

of $20,000. All business income allocated to her is also distributed to her.d) Which entity/compensation combination generated the most after-cash flow for

Mackenzie? What are the primary contributing factors favoring this combination?

52. In its first year of existence (year 1), SCC corporation (a C corporation) reported a loss for tax purposes of $30,000. How much tax will SCC pay in year 2 if it reports taxable income from operations of $20,000 before considering loss carryovers under the following assumptions?

LO 15-3

a) Year 1 is 2017.b) Year 1 is 2018.

53. In its first year of existence (year 1), Willow Corp. (a C corporation) reports a loss for tax purposes of $50,000. In year 2 it reports a $40,000 loss. For year 3, it reports taxable income from operations of $100,000 before any loss carryovers. How much tax will Willow Corp. pay in year 3, what is its NOL carryover to year 4, and when will the NOL expire under the following assumptions?

LO 15-3

a) Year 1 is 2017.b) Year 1 is 2018.

54. Damarcus is a 50 percent owner of Hoop (a business entity). In the current year, Hoop reported a $100,000 business loss. Answer the following questions associated with each of the following alternative scenarios.

LO 15-3

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a) Hoop is organized as a C corporation and Damarcus works full-time as an employee for Hoop. Damarcus has a $20,000 basis in his Hoop stock. How much of Hoop’s loss is Damarcus allowed to deduct against his other income?

b) Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus works full-time for Hoop (he is not consid-ered to be a passive investor in Hoop). Damarcus has a $20,000 basis in his Hoop ownership interest and he also has a $20,000 at-risk amount in his investment in Hoop. Damarcus does not report income or loss from any other business activity investments. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year?

c) Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus does not work for Hoop at all (he is a passive in-vestor in Hoop). Damarcus has a $20,000 basis in his Hoop ownership inter est and he also has a $20,000 at-risk amount in his investment in Hoop. Damarcus does not report income or loss from any other business activity investments. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year?

d) Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus works full-time for Hoop (he is not considered to be a passive investor in Hoop). Damarcus has a $70,000 basis in his Hoop ownership interest and he also has a $70,000 at-risk amount in his investment in Hoop. Damarcus does not report income or loss from any other business activity investments. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year?

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e) Hoop is organized as an LLC taxed as a partnership. Fifty percent of Hoop’s loss is allocated to Damarcus. Damarcus does not work for Hoop at all (he is a pas-sive investor in Hoop). Damarcus has a $20,000 basis in his Hoop ownership interest and he also has a $20,000 at-risk amount in his investment in Hoop. Damarcus reports $10,000 of income from a business activity in which he is a passive investor. How much of the $50,000 loss allocated to him by Hoop is Damarcus allowed to deduct this year?

LO 15-3 55. Danni is a single 30 percent owner of Kolt (a business entity). In the current year, Kolt reported a $1,000,000 business loss. Answer the following questions associ-ated with each of the following alternative scenarios:a) Kolt is organized as a C corporation and Danni works 20 hours a week as an

employee for Kolt. Danni has a $200,000 basis in her Kolt stock. How much of Kolt’s loss is Danni allowed to deduct this year against her other income?

b) Kolt is organized as an LLC taxed as a partnership. Thirty percent of Kolt’s loss is allocated to Danni. Danni works 20 hours a week on Kolt business activities (she is not considered to be a passive investor in Kolt). Danni has a $400,000 basis in her Kolt ownership interest and she also has a $400,000 at-risk amount in her investment in Kolt. Danni does not report income or loss from any other business activity investments. How much of the $300,000 loss allocated to her from Kolt is Danni allowed to deduct this year?

c) Kolt is organized as an LLC taxed as a partnership. Thirty percent of Kolt’s loss is allocated to Danni. Danni is not involved in Kolt business activities. Consequently, she is considered to be a passive investor in Kolt. Danni has a $400,000 basis in her Kolt ownership interest and she also has a $400,000 at-risk amount in her investment in Kolt. Danni does not report income or loss from any other business activity investments. How much of the $300,000 loss allocated to her from Kolt is Danni allowed to deduct this year?

LO 15-3 56. Mickey, Mickayla, and Taylor are starting a new business (MMT). To get the busi-ness started, Mickey is contributing $200,000 for a 40 percent ownership interest, Mickayla is contributing a building with a value of $200,000 and a tax basis of $150,000 for a 40 percent ownership interest, and Taylor is contributing legal services for a 20 percent ownership interest. What amount of gain is each owner required to recognize under each of the following alternative situations? [Hint: Look at§351 and §721.]

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a) MMT is formed as a C corporation.b) MMT is formed as an S corporation.c) MMT is formed as an LLC.

LO 15-3 57. Dave and his friend Stewart each own 50 percent of KBS. During the year, Dave receives $75,000 compensation for services he performs for KBS during the year. He performed a significant amount of work for the entity and he was heavily involved in management decisionsfor the entity (he was not a passive investor in KBS). After deducting Dave’s compensation, KBS reports taxable income of $30,000. How much FICA and/or self-employment tax is Dave required to pay on his compensation and his share of the KBS income if KBS is formed as a C corporation, an S corporation, or a limited liability company (ignore the .9 percent additional Medicare tax)?

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LO 15-3 58. Rondo and his business associate, Larry, are considering forming a business entity called R&L but they are unsure about whether to form it as a C corporation, an Scorporation, or an LLC taxed as a partnership. Rondo and Larry would each invest $50,000 in the business. Thus, each owner would take an initial basis in his ownership interest of $50,000 no matter which entity type is formed. Shortly after the formation of the entity, the business borrowed $30,000 from the bank. If applicable, this debt will be shared equally between the two owners.

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a) After taking the loan into account, what is Rondo’s tax basis in his R&L stock if R&L is formed as a C corporation?

b) After taking the loan into account, what is Rondo’s tax basis in his R&L stock if R&L is formed as an S corporation?

c) After taking the loan into account, what is Rondo’s tax basis in his R&L ownership interest if R&L is formed as an LLC and taxed as a partnership?

59. Kevin and Bob have owned and operated SOA as a C corporation for a number of years. When they formed the entity, Kevin and Bob each contributed $100,000 to SOA. They each have a current basis of $100,000 in their SOA ownership interest. Information on SOA’s assets at the end of year 5 is as follows (SOA does not have any liabilities):

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Assets FMV Adjusted Basis Built-in Gain

Cash $200,000 $200,000 $0Inventory 80,000 40,000 40,000Landandbuilding 220,000 170,000 50,000Total $500,000

At the end of year 5, SOA liquidated and distributed half of the land, half of the inventory, and half of the cash remaining after paying taxes (if any) to each owner. Assume that, excluding the effects of the liquidating distribution, SOA’s taxable income for year 5 is $0.a) What is the amount and character of gain or loss SOA will recognize on the

liquidating distribution?b) What is the amount and character of gain or loss Kevin will recognize when he

receives the liquidating distribution of cash and property? Recall that his stock basis is $100,000 and he is treated as having sold his stock for the liquidation proceeds.

COMPREHENSIVE PROBLEMSSelect problems are available with Connect®.

60. Daisy Taylor has developed a viable new business idea. Her idea is to design and manufacture cookware that remains cool to the touch when in use. She has had several friends try out her prototype cookware and they have consistently given the cookware rave reviews. With this encouragement, Daisy started giving serious thought to starting up a business called “Cool Touch Cookware” (CTC).

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Daisy understands that it will take a few years for the business to become profit-able. She would like to grow her business and perhaps at some point “go public” or sell the business to a large retailer. Daisy, who is single, decided to quit her full-time job so that she could focus all of her efforts on the new business. Daisy had some savings to support her for a while but she did not have any other source of income. She was able to recruit Kesha and Aryan to join her as initial equity investors in CTC. Kesha has an MBA and a law degree. Kesha was employed as a business consultant when she decided to leave that job and work with Daisy and Aryan. Kesha’s husband earns close to $300,000 a year as an engineer (employee). Aryan owns a very profitable used car business. Because buying and selling used cars takes all his time, he is interested in becoming only a passive investor in CTC. He wanted to get in on the ground floor because he really likes the product and believes CTC will be wildly successful. While CTC originally has three investors, Daisy and Kesha have plans to grow the business and seek more owners and capital in the future.

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The three owners agreed that Daisy would contribute land and cash for a 30percent interest in CTC, Kesha would contribute services (legal and business advisory) for the first two years for a 30 percent interest, and Aryan would contribute cash for a 40 percent interest. The plan called for Daisy and Kesha to be actively involved in managing the business while Aryan would not be. The three equity owners’ contributions are summarized as follows:

Daisy Contributed FMV Adjusted Basis Ownership Interest

Land(heldasinvestment) $120,000 $70,000 30%Cash 30,000

Kesha Contributed

Services 150,000 30

Aryan Contributed

Cash 200,000 40

Working together, Daisy and Kesha made the following five-year income and loss projections for CTC. They anticipate the business will be profitable and that it will continue to grow after the first five years.

Cool Touch Cookware 5-Year Income and Loss Projections

Year Income (Loss)

1 $(200,000)2 (80,000)3 (20,000)4 60,0005 180,000

With plans for Daisy and Kesha to spend a considerable amount of their time working for and managing CTC, the owners would like to develop a compensation plan that works for all parties. Down the road, they plan to have two business loca-tions (in different cities). Daisy would take responsibility for the activities of one location and Kesha would take responsibility for the other. Finally, they would like to arrange for some performance-based financial incentives for each location. To get the business activities started, Daisy and Kesha determined CTC would need to borrow $800,000 to purchase a building to house its manufacturing facilities and its administrative offices (at least for now). Also, in need of additional cash, Daisy and Kesha arranged to have CTC borrow $300,000 from a local bank and to borrow $200,000 cash from Aryan. CTC would pay Aryan a market rate of interest on the loan but there was no fixed date for principal repayment.

Required:Identify significant tax and nontax issues or concerns that may differ across entity types and discuss how they are relevant to the choice of entity decision for CTC.

research61. Cool Touch Cookware (CTC) has been in business for about 10 years now. Daisy

and Kesha are each 50 percent owners of the business. They initially established the business with cash contributions. CTC manufactures unique cookware that remains cool to the touch when in use. CTC has been fairly profitable over the years. Daisy and Kesha have both been actively involved in managing the business. They have developed very good personal relationships with many customers (both wholesale and retail) that, Daisy and Kesha believe, keep the customers coming back. On September 30 of the current year, CTC had all of its assets appraised. Below is CTC’s balance sheet, as of September 30, with the corresponding appraisals of the fair market value of all of its assets. Note that CTC has several depreciated assets. CTC uses the hybrid method of accounting. It accounts for its

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gross margin-related items under the accrual method and it accounts for everything else using the cash method of accounting.

Assets Adjusted Tax Basis FMV

Cash $150,000 $150,000 Accounts receivable 20,000 15,000 Inventory* 90,000 300,000 Equipment 120,000 100,000 Investment in XYZ stock 40,000 120,000 Land (used in the business) 80,000 70,000 Building 200,000 180,000Total assets $700,000 $935,000†

Liabilities

Accounts payable $ 40,000Bank loan 60,000 Mortgage on building 100,000Equity 500,000Total liabilities and equity $700,000

*CTC uses the LIFO method for determining the adjusted basis of its inventory. Its basis in the inventory under the FIFO method would have been $110,000.

†In addition, Daisy and Kesha had the entire business appraised at $1,135,000, which is $200,000 more than the value of the identifiable assets.

From January 1 of the current year through September 30, CTC reported the following income:

Ordinary business income $530,000 Dividends from XYZ stock 12,000 Long-term capital losses 15,000 Interest income 3,000

Daisy and Kesha are considering changing the business form of CTC.

Required:

a) Assume CTC is organized as a C corporation. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an S corporation. [Hint: See IRC §1374 and §1363(d).]

b) Assume CTC is organized as a C corporation. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an LLC. Assume CTC converts to an LLC(taxed as a partnership) by distributing its assets to its shareholders, who then contribute the assets to a new LLC. [Hint: See IRC §§331, 336, and 721(a).]

c) Assume that CTC is a C corporation with a net operating loss carryforward as of the beginning of the year in the amount of $2,000,000. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an LLC (taxed as a partnership). Assume CTC converts to an LLC by distributing its assets to its shareholders, who then contribute the assets to a new LLC. [Hint: See IRC §§172(a), 331, 336, and 721(a).]

Source: Roger CPA Review

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(PDF) Taxation of Individuals and Business Entities - McGraw Hill - DOKUMEN.TIPS (2024)

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