Question 1

Mr. Longwood and Mrs. Kennett are the equal shareholders in LK Corporation. Both shareholders have a 37 percent marginal tax rate on ordinary income. LK's financial records show the following:
 $\begin{array}{llr}
  \text {  Gross income from sales} &\$875,000\
 \text { Operating expenses } &(420,000)\
 \text {Interest paid on debt to shareholders  } &(75,000)\
 \text {  Dividend distributions:} &\
 \text { Mr. Longwood } &(50,000)\
 \text {  Mrs. Kennett} &(50,000)\
\end{array}$
 Compute the combined tax cost for LK, Mr. Longwood, and Mrs. Kennett attributable to LK's operations.How would your computation change if the interest on the shareholder debt was $175,000 and LK paid no dividends?

Accepted Answer

The answer of Mr. Longwood and Mrs. Kennett are the...

Question 2

During a recent IRS audit, the revenue agent decided that the Emig family used their closely held corporation, Gamekeeper, to avoid shareholder tax by accumulating earnings beyond the reasonable needs of the business. Gamekeeper's taxable income was $800,000, it paid no dividends, and it had no business need to retain any income. Compute Gamekeeper's accumulated earnings tax assuming that it had accumulated $2 million of after-tax income in prior years.

Accepted Answer

The answer of During a recent IRS audit, the revenue...

Question 3

Which of the following statements regarding the use of a corporation as a tax shelter is false?
A) In years in which the individual tax rates were significantly higher than the corporate rates, individuals could reduce the tax on business income by operating as a regular corporation rather than as a passthrough entity.
B) The combination of deferral of individual tax and conversion of ordinary income into capital gain enhanced the attractiveness of corporations as tax shelters.
C) When the top corporate and individual tax rates are equal, the opportunity for individuals to exploit differences between the individual and corporate rate structures is significant.
D) When the top corporate and individual tax rates are equal, corporations are effective tax shelters only if business income is very small and the owners are willing to forgo dividends for a long period of time.

Accepted Answer

When the top corporate and individual tax rates are equal, there is no significant opportunity for individuals to exploit differences between the individual and corporate rate structures. Therefore, statement C is false. The other statements are true.

Question 4

For the current tax year, Cuddle Corporation's $500,000 of taxable income is all considered to be personal holding company income. The corporation did not pay dividends. Which of the following statements is true?
A) The corporation will owe a personal holding company tax of $105,000.
B) The corporation will owe a regular tax of $100,000.
C) The corporation's total tax liability will be $210,000.
D) The corporation's total tax liability will be $205,000.

Accepted Answer

The answer of For the current tax year, Cuddle Corporation's...

Question 5

Mr. Olsen has a marginal tax rate on ordinary income of 37 percent. He currently earns $100,000 per year through a business operated as a sole proprietorship. If Mr. Olsen does not require current cash from the business, calculate the potential increase or decrease in his annual tax liability if he incorporates and operates the business through a regular corporation.
A) No increase or decrease
B) $16,000 decrease
C) $16,000 increase
D) $3,000 decrease

Accepted Answer

Incorporating and operating the business through a regular corporation could allow Mr. Olsen to benefit from the lower corporate tax rate, which is 21%. If he earns $100,000 and pays tax at the corporate rate instead of his personal marginal rate of 37%, the tax savings would be 16% of $100,000, which equals $16,000. This calculation assumes he leaves the earnings within the corporation and does not take them out as dividends, which would be subject to personal income tax.

Question 6

Which of the following benefits does not occur when owner-shareholders accumulate earnings of their closely-held corporations at the entity level and later sell their stock at an increased value?
A) Deferral of shareholder tax until the year of sale.
B) Conversion of ordinary income into capital gain.
C) Increase in corporate capitalization and reduction in debt-equity ratio.
D) All of these choices occur when owner-shareholders accumulate earnings of the closely-held corporations.

Accepted Answer

All the listed benefits occur when owner-shareholders accumulate earnings at the entity level and later sell their stock at an increased value, including tax deferral, conversion of income type, and improvements in financial ratios.

Question 7

Mrs. Fuente, who has a 37% marginal tax rate on ordinary income, is the sole shareholder and CEO of Furey Inc. She also holds a $1 million interest-bearing note issued by Furey. The corporation's current-year financial records show the following: $\begin{array}{llr}
  \text {Sales revenue  } &\$1,879,000\
 \text {  Mrs. Fuente's salary} &(160,000)\
 \text {  Other operating expenses} &(414,000)&\
 \text {  Interest paid on Mrs. Fuente's note} &(60,000)\
 \text { Dividend distributed to Mrs. Fuente } &(100,000)\
\end{array}$
 Compute Mrs. Fuente's tax on her income from Furey. (Ignore payroll taxes in your calculations.)
A) $64,000
B) $91,200
C) $101,400
D) $118,400

Accepted Answer

First, we need to compute Mrs. Fuente's income from Furey:

Dividends received: $400,000 x 70% = $280,000
Interest income: $60,000
Total income: $340,000

Next, we need to determine the tax on Mrs. Fuente's income from Furey:

Dividend income: $280,000 x 20% = $56,000
Interest income: $60,000 x 37% = $22,200
Total tax: $78,200

However, Mrs. Fuente also has to pay tax on the interest income from the note issued by Furey:

Interest income: $40,000 x 37% = $14,800

Therefore, Mrs. Fuente's total tax is $78,200 + $14,800 = $93,000. However, she also gets a credit for the tax paid by Furey on her behalf on the dividends she received:

Tax paid by Furey: $400,000 x 30% = $120,000
Credit: $120,000 x 20% = $24,000

So the final tax on Mrs. Fuente's income from Furey is $93,000 - $24,000 = $69,000

Adding this to her tax on ordinary income of $32,400 (37% x ($90,000 - $18,200)), her total tax is $101,400 (Option C).

Question 8

Ms. Chou, who is in the 37 percent marginal tax bracket, is the sole shareholder of Liu Corporation. This year, Liu earned $200,000 of taxable income and distributed $50,000 to Ms. Chou. Calculate the combined tax cost for Liu and Ms. Chou.
A) $42,000
B) $60,500
C) $74,000
D) $52,000

Accepted Answer

The answer of Ms. Chou, who is in the 37...

Question 9

Which of the following statements regarding the accumulated earnings tax is true?
A) The accumulated earnings tax is imposed instead of the regular corporate income tax.
B) The accumulated earnings tax is intended to coerce corporations to pay dividends.
C) The accumulated earnings tax is calculated by the corporation and paid on its annual corporate income tax return.
D) All of these choices statements are true.

Accepted Answer

The accumulated earnings tax is intended to discourage corporations from hoarding retained earnings instead of paying dividends, by imposing an additional tax on accumulated earnings beyond a certain limit. It is not imposed instead of the regular corporate income tax, and it is not calculated separately on the annual corporate income tax return.

Question 10

Mrs. Ford, who has a 37% marginal tax rate, is the sole shareholder and CEO of Fast Inc. She also holds a $1 million interest-bearing note issued by Fast. The corporation's current-year financial records show the following: $\begin{array}{llr}
  \text {Sales revenue  } &\$1,879,000\
 \text {  Mrs. Fuente's salary} &(160,000)\
 \text {  Other operating expenses} &(414,000)&\
 \text {  Interest paid on Mrs. Fuente's note} &(60,000)\
 \text { Dividend distributed to Mrs. Fuente } &(100,000)\
\end{array}$

Compute Fast's taxable income.
A) $1,145,000
B) $1,245,000
C) $1,305,000
D) $1,465,000

Accepted Answer

Fast's taxable income is calculated by subtracting the operating expenses, Mrs. Fuente's salary, and the interest paid on her note from the sales revenue. This calculation does not include dividends distributed, as they are not deductible for the corporation. Therefore, the taxable income is $1,879,000 - $160,000 - $414,000 - $60,000 = $1,245,000.

Question 11

Betsy Williams is the sole shareholder of Kurt Corporation. She also owns the office building that serves as corporate headquarters for Kurt. Last year, Kurt paid $200,000 annual rent to Betsy for use of the building. Kurt's marginal tax rate was 21 percent and Betsy's marginal tax rate was 37 percent. The revenue agent who audited Kurt's return concluded that the fair rental value of the office building was $140,000.What effect does this conclusion have on Betsy's personal income tax liability?What effect does this conclusion have on Kurt's corporate income tax liability?

Accepted Answer

The answer of Betsy Williams is the sole shareholder of...

Question 12

Which of the following statements regarding the personal holding company tax is false?
A) The personal holding company tax is imposed in addition to the regular corporate income tax.
B) The personal holding company tax was originally enacted to discourage individuals from incorporating their investment portfolios.
C) The personal holding company tax is calculated by a qualifying corporation and paid on its annual corporate income tax return.
D) The personal holding company tax is assessed on a qualifying corporation's undistributed personal holding company income.

Accepted Answer

The answer of Which of the following statements regarding the...

Question 13

During a recent IRS audit, the revenue agent decided that Roger used his closely-held corporation, Dodger Inc., to avoid shareholder tax by accumulating earnings beyond the reasonable needs of the business. Dodger's taxable income for the year was $500,000, and it paid no dividends. Compute Dodger's accumulated earnings tax, assuming that it had accumulated $2 million after-tax income in prior years.
A) $100,000
B) $400,000
C) $50,000
D) $0

Accepted Answer

The accumulated earnings tax is 20% of the accumulated taxable income. Since Dodger Inc. has $500,000 in taxable income and no dividends were paid, the tax is 20% of $500,000, which is $100,000.

Question 14

Which of the following is not a permissible reason for a regular corporation to accumulate earnings at the entity level and avoid the imposition of the accumulated earnings tax?
A) To construct a new plant facility in connection with expanding the corporation's business into a new geographic region
B) To accumulate a fund of cash with which to pay off long-term debt due in twenty years
C) To fund the development of a new product line
D) To invest in the stock of an unrelated company to take advantage of the dividends received deduction

Accepted Answer

Accumulating earnings to invest in the stock of an unrelated company to take advantage of the dividends received deduction is not a permissible reason for a corporation to avoid the accumulated earnings tax. The IRS deems such investments to be passive activities and not related to the corporation's trade or business.

Quiz 12: The Choice of Business Entity

Which of the following statements regarding the use of a corporation as a tax shelter is false?

For the current tax year, Cuddle Corporation's $500,000 of taxable income is all considered to be personal holding company income. The corporation did not pay dividends. Which of the following statements is true?

Which of the following benefits does not occur when owner-shareholders accumulate earnings of their closely-held corporations at the entity level and later sell their stock at an increased value?

Ms. Chou, who is in the 37 percent marginal tax bracket, is the sole shareholder of Liu Corporation. This year, Liu earned $200,000 of taxable income and distributed $50,000 to Ms. Chou. Calculate the combined tax cost for Liu and Ms. Chou.

Which of the following statements regarding the accumulated earnings tax is true?

Which of the following statements regarding the personal holding company tax is false?

Which of the following is not a permissible reason for a regular corporation to accumulate earnings at the entity level and avoid the imposition of the accumulated earnings tax?