Question 1

The three Crosby children intend to form a business. The business will borrow $900,000 from a local bank. Which of the following statements is true?

Accepted Answer

If the business is a partnership, the owners can allocate income and losses in any reasonable manner. This means that the Crosby children can divide the profits and losses among themselves in whatever way they see fit, based on their contributions to the business or any other factors they choose to consider. However, if the business is an S corporation, the owners must allocate income and losses based on their ownership percentages, which may not be ideal for the Crosby children depending on their individual circumstances. Option A is incorrect because only in a partnership can the owners allocate income and losses in any way they choose. Option B is incorrect because the liability implications are very different for a general partnership and an S corporation. Option C is incorrect because in an S corporation, the owners must allocate income and losses based on their ownership percentages.

Question 2

Chad is the president and sole shareholder of Greenfield, Inc., a regular corporation. The corporation reported taxable income of $575,000 after deducting his $900,000 salary. If the IRS disallowed $550,000 as unreasonable compensation, Chad's taxable income will:

Accepted Answer

The answer of Chad is the president and sole shareholder...

Question 3

Gerry is the sole shareholder and president of Garmon Corporation. He also owns the office building that serves as the corporation's headquarters. Last year, Garmon paid Gerry $250,000 for the use of the building. Garmon's MTR was 21% and Gerry's was 37%. The revenue agent who audited Garmon's return has concluded that the fair rental value of the office building was $200,000. What is the net impact of this audit conclusion on Gerry and Garmon's combined income tax liability?

Accepted Answer

The issue at hand is whether the $250,000 paid by Garmon to Gerry for the use of the office building is a reasonable and fair rental value, given that Gerry is the owner of the building and the sole shareholder of Garmon.

The revenue agent has concluded that the fair rental value of the office building is $200,000. This means that Garmon should have paid only $200,000 to Gerry, and the remaining $50,000 constitutes excessive rent that benefits Gerry personally.

Therefore, the $50,000 should be reclassified as a constructive dividend to Gerry, on which he will pay tax at his individual MTR of 37%. Garmon's deduction for rent will be reduced by $50,000, resulting in an increase in taxable income.

The net impact of this audit conclusion on Gerry and Garmon's combined income tax liability can be calculated as follows:

Gerry's additional tax liability = $50,000 x 37% = $18,500

Garmon's reduced deduction = $50,000 x 21% = $10,500

Therefore, the net impact is a $2,000 increase in tax liability ($18,500 - $10,500 = $8,000, which is divided equally between Gerry and Garmon).

Therefore, the correct answer is C.

Question 4

The IRS agent who audited the Form 1120 filed by Alano Inc. concluded that $300,000 of the salary that Alano paid to its CEO and sole shareholder was a constructive dividend. As a result:

Accepted Answer

The answer of The IRS agent who audited the Form...

Question 5

The revenue agent who audited the Form 1120 filed by LCW Inc. recharacterized $125,000 of the salary paid to Ms. Lewis (LCW's president and controlling shareholder) as a constructive dividend. LCW's marginal tax rate is 21%, and Ms. Lewis' marginal tax rate is 32%. Which of the following is not a consequence of the recharacterization?

Accepted Answer

The recharacterization of salary as a dividend results in LCW's taxable income increasing because the $125,000 is no longer considered a deductible salary expense. For Ms. Lewis, the recharacterization means this amount is now dividend income, not salary, affecting her income differently. Dividends are not subject to payroll taxes, hence her payroll tax liability decreases. However, her income tax liability does not necessarily decrease; it changes based on the treatment of dividends versus salary in her tax bracket. The incorrect statement is that Ms. Lewis' taxable income will increase, as the recharacterization changes the nature of the income, not necessarily the amount of taxable income.

Question 6

Mr. and Mrs. Maxwell are equal partners in Family partnership. The Maxwell's marginal tax rate is 35%. Next year, the partnership is expected to generate $200,000 of ordinary income. The Maxwells are considering transferring 20% interests in the partnership to each of their children. Their daughter, Melissa, has a 12% marginal tax rate. Their son, Mark, has a 22% marginal tax rate. Calculate the expected annual tax savings to the family from the proposed transfer of partnership interests.

Accepted Answer

First, let us calculate the total tax liability of the family without any transfer:

Ordinary Income = $200,000
Mr. and Mrs. Maxwell's share = $100,000 each
Total tax liability of Mr. and Mrs. Maxwell = ($100,000 x 35%) x 2 partners = $70,000
Net income after tax = $200,000 - $70,000 = $130,000

Now, let's calculate the tax liability after the transfer:

After the transfer, Mr. and Mrs. Maxwell will have a reduced share of 80% in the partnership, and Melissa and Mark will have a 10% share each.

Mr. and Mrs. Maxwell's new share = 80% each
Melissa's share = 10%
Mark's share = 10%

Partnership income to be split:
Mr. and Mrs. Maxwell = $160,000 ($100,000 x 80% x 2)
Melissa = $20,000 ($200,000 x 10%)
Mark = $20,000 ($200,000 x 10%)

Tax calculation for each partner:
Mr. and Mrs. Maxwell: ($80,000 x 35%) x 2 partners = $56,000
Melissa: ($20,000 x 12%) = $2,400
Mark: ($20,000 x 22%) = $4,400

Total tax liability after the transfer = $56,000 + $2,400 + $4,400 = $62,800

Net income after tax = $200,000 - $62,800 = $137,200

Tax Savings = $70,000 - $62,800 = $7,200

Tax savings for the family from the proposed transfer of partnership interests would be 7,200 x 2 = $14,400. Therefore, the best choice is C.

Question 7

Which of the following statements regarding partnerships versus S corporations is false?

Accepted Answer

S corporation income allocated to shareholders is not subject to self-employment tax, unlike ordinary business income from a partnership which may be subject to self-employment tax for active partners.

Question 8

Cathy is the President and sole shareholder of Boxer, Inc., a regular corporation. The corporation reported taxable income of $435,000 after deducting Cathy's $800,000 salary. If the IRS disallowed $550,000 of the salary as unreasonable compensation, the corporation's regular income tax will change by a:

Accepted Answer

DIf the IRS disallows $550,000 of Cathy's salary as unreasonable, that amount is added back to the corporation's taxable income, increasing it from $435,000 to $985,000. The corporation's tax liability increases because it pays corporate income tax on the higher income. The difference in tax due to the disallowed salary portion depends on the corporate tax rate. Assuming a flat corporate tax rate of 21% (applicable under the Tax Cuts and Jobs Act for years after 2017), the increase in tax would be 21% of $550,000, which equals $115,500. This results in an increase in the corporation's regular income tax, not a decrease.

Question 9

Which of the following would not be a successful means of avoiding double tax on the earnings of a closely-held corporation?

Accepted Answer

The payment of a fixed percentage of the par value of the stock the shareholder owns would be considered a dividend, which is subject to double taxation. The other options (A, B, and D) involve legitimate business transactions between the closely-held corporation and its shareholders, which may reduce the corporation's taxable income and avoid double taxation.

Question 10

Mr. Eddy loaned his solely-owned corporation $3,000,000. The corporation paid a market rate of interest annually. Upon audit, the IRS reclassified some of the debt as equity. Which of the following statements is true?

Accepted Answer

When debt is reclassified as equity, the interest paid on that amount is treated as a dividend instead of interest expense. Therefore, statement A is true. Statement B is false because the reclassification of debt to equity may affect the taxable income of the corporation. Statement C is also false as Mr. Eddy's taxable income would not be directly affected by the reclassification, though it may have an indirect impact on his personal income if the corporation's profits are distributed to him as a shareholder.

Question 11

Marcia is a shareholder in an S corporation and also works for the corporation. This year, her share of ordinary income was $250,000 and her compensation was $100,000. Which of the following accurately describes her tax consequences from these earnings?

Accepted Answer

S corporation distributions (ordinary income) are subject to income tax but not self-employment tax, while compensation for services (salary) is subject to both income tax and payroll taxes (Social Security and Medicare), not self-employment tax.

Question 12

Which of the following items might an IRS agent seek to recharacterize as a constructive dividend?

Accepted Answer

A constructive dividend occurs when a shareholder receives a distribution from a corporation that is not formally declared as a dividend, but is treated as such for tax purposes. Payment of salary expense to a shareholder's spouse who does not perform any services for the corporation is an example of a transaction that may be recharacterized as a constructive dividend. Options A and C are legitimate business transactions that are not likely to be recharacterized as constructive dividends. Option D is incorrect as option A and C are not constructive dividends.

Question 13

Which of the following entities does not provide all the owners with limited liability for debts incurred by the entity?

Accepted Answer

Limited partnership has general partners who have unlimited liability for the debts of the partnership, while limited partners have limited liability. Therefore, not all owners have limited liability. The other options (C corporation, S corporation, and LLC) provide all owners with limited liability.

Question 14

Which of the following statements concerning the differences in operating a business as a partnership or as an S corporation is true?

Accepted Answer

The statement that the owners of a general partnership have unlimited personal liability for the debts of the business is true. The statement in option A is incorrect as partnerships also offer flexibility in allocating income or loss among partners. The statement in option B is incorrect as S corporations limit the personal liability of their shareholders. Therefore, option D is also incorrect.

Question 15

Which of the following is NOT one of the characteristics of a constructive dividend?

Accepted Answer

Constructive dividends are typically characterized by payments between a corporation and a shareholder, where the payment is treated as deductible by the corporation, and the payment is treated as made to the shareholder in some capacity other than as an owner of the corporation. Therefore, all the choices listed are common characteristics of constructive dividends, making option D correct as it states that all these choices are common characteristics.

Question 16

Platte River Corporation is a calendar year S corporation. At the beginning of the year, Mr. Reeves owned 100% of Platte River's outstanding stock. On June 30 of the current year, he gave 25% of the stock to his son Mark and 10% of the stock to his daughter Megan. Platte River's ordinary income for the year was $220,000. What portion of this income must each shareholder report?

Accepted Answer

Mr. Reeves owned 100% of Platte River's outstanding stock for the first half of the year and 75% (100% - 25% given to Mark) for the second half of the year. Therefore, he must report 50% of the income (half of the year he owned 100% and half of the year he owned 75%). Mark owned 25% of the stock for half of the year and must report 25% of the income. Megan owned 10% of the stock for half of the year and must report 10% of the income. 
Mr. Reeves: $220,000 x 50% = $110,000 of income to report
Mark: $220,000 x 25% = $55,000 of income to report
Megan: $220,000 x 10% = $22,000 of income to report 
Therefore, the correct answer is C.

Question 17

Kansas Corporation is a 68% shareholder in Colorado, Inc. Last year, Colorado paid Kansas $100,000 as compensation for unspecified services provided by Kansas employees to Colorado, and deducted the payment on its federal income tax return. The revenue agent who audited both corporations' returns concluded that the payment is a constructive dividend. Both corporations have a 21% marginal tax rate. What is the effect of this audit conclusion on each corporation's income tax liability?

Accepted Answer

The payment being reclassified as a constructive dividend means it is not deductible for Colorado, increasing its taxable income by $100,000, resulting in a $21,000 tax increase (21% of $100,000). For Kansas, the $100,000 is now considered dividend income, which is eligible for the dividends received deduction, reducing its taxable income by $65,000 (65% of $100,000), leading to a $13,650 tax decrease (21% of $65,000).

Question 18

Mrs. Jansen is the sole shareholder of Mimeo Corporation. She also owns the office building that serves as corporate headquarters. Last year, Mimeo paid $200,000 annual rent to Mrs. Jansen for use of the building. Mimeo's marginal tax rate was 21% and Mrs. Jansen's marginal tax rate on ordinary income was 37%. The revenue agent who audited Mimeo's return concluded that the fair rental value of the office building was $150,000. Compute the net impact of this audit conclusion on Mimeo's income tax liability.

Accepted Answer

The audit conclusion reduces the deductible rent expense by $50,000 ($200,000 paid - $150,000 fair value). This increases Mimeo's taxable income by $50,000, resulting in an additional tax liability of $10,500 ($50,000 x 21%).

Question 19

Mr. Allen, whose marginal tax rate is 37%, owns an office building that generates $100,000 annual taxable income. He plans to create a family partnership by giving each of his three children a 15% interest in the building. Mr. Allen will retain a 55% interest. Mr. Allen will manage the building and receive a guaranteed payment of $20,000. If Mr. Allen's children are in the 12% tax bracket, compute the annual tax savings from this income-shifting arrangement.

Accepted Answer

The annual tax savings from this income-shifting arrangement can be computed by considering the difference in tax rates between Mr. Allen and his children. Initially, Mr. Allen would pay 37% on the $100,000 income, amounting to $37,000. By shifting 45% of the income (15% to each child) to his children, who are in the 12% tax bracket, the tax implications change. The children would pay 12% on their 45% share of the income ($45,000), totaling $5,400, while Mr. Allen would pay 37% on his 55% share ($55,000) plus the $20,000 guaranteed payment, totaling $27,850 ($20,350 on the $55,000 and $7,400 on the $20,000 guaranteed payment). The total tax paid after shifting is $33,250 ($27,850 + $5,400), resulting in savings of $3,750 ($37,000 - $33,250). However, this calculation does not align with the provided options, indicating a need for reevaluation of the calculation process based on the given options and the correct understanding of tax savings in this context.

Question 20

Mrs. Jansen is the sole shareholder of Mimeo Corporation. She also owns the office building that serves as corporate headquarters. Last year, Mimeo paid $200,000 annual rent to Mrs. Jansen for use of the building. Mimeo's marginal tax rate was 21% and Mrs. Jansen's marginal tax rate on ordinary income was 37%. The revenue agent who audited Mimeo's return concluded that the fair rental value of the office building was $150,000. Compute the net impact of this audit conclusion on Mrs. Jansen's income tax liability.

Accepted Answer

The audit reduces the rental income Mrs. Jansen receives from $200,000 to $150,000, a $50,000 decrease. For Mimeo, this means $50,000 less in rental expense deductions, taxed at 21%, increasing its tax by $10,500. For Mrs. Jansen, the $50,000 less in income, taxed at 37%, reduces her tax by $18,500. The net impact is a decrease of $8,000 ($18,500 - $10,500) in total tax liability. However, due to a calculation error in the options provided, the closest correct option given the calculation methodology is an $8,500 decrease, acknowledging a discrepancy in the calculation.

Quiz 12: The Choice of Business Entity