Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations

Chapter 10
Questions and Problems for Discussion
1.

A sole proprietorship is not a legal entity but merely a business activity carried on by an individual.
The proprietor is personally liable to the business creditors. The net profit or loss from the activity is
part of the proprietors taxable income. Because a sole proprietorship has no separate identity from
its proprietor, it cant be described as a passthrough entity.

2.

Mrs. Liu should use the marginal rate applying to the next dollar of taxable income on Form 1040.

3.

If the $17,000 business loss exceeds the total of Mr. Pitts other income items for the year (salary,
dividends, interest, etc.), the excess qualifies as a net operating loss, which he can carryback as a
deduction to his two prior taxable years.

4.

Firm Q remitted $13,400 employer payroll tax (which it deducted as a business expense) and
$13,400 employee payroll tax withheld from the compensation paid to its employees during the year.

5.

The employee payroll tax is extremely convenient because the responsibility for computing and
paying the tax is on the employer, not the employee. However, the payroll tax rate structure is
regressive: 7.65 percent on a base amount of annual compensation + 1.45 percent on compensation
in excess of the base. In 2007, the employee payroll tax on $50,000 compensation is $3,825 for an
average rate of 7.65 percent. The employee payroll tax on $200,000 compensation is $8,945 for an
average rate of 4.47 percent. Thus, the employee payroll tax is often criticized as vertically
inequitable.

6.

The self-employment tax is based on net earnings from self-employment, which is essentially the
profit that sole proprietors earn from their business. Individuals pay their self-employment tax at the
same time and in the same manner as they pay income tax.

7.

The income tax deduction for one-half of self-employment tax corresponds to the employers
deduction for employer payroll tax. The nondeductible one-half of self-employment tax corresponds
to the nondeductible employee payroll tax.

8.

a. General partners have unlimited personal liability for all recourse debts of their partnership.
b. Limited partners have no personal liability for the debts of their partnership. However, Tom,
Angela, and Peter all cannot be limited partners because a limited partnership must have at
least one general partner.
c.

The members of an LLC have no personal liability for the debts of their company.

d. The shareholders of an S corporation have no personal liability for the debts of their corporation.
9.

Any item recognized by a passthrough entity that is subject to a special rule, limitation, or treatment
in the computation of individual or corporate taxable income or tax liability must be separately stated.
This separate accounting allows each owner to apply the special rule, limitation, or treatment to that
owners share of the item.

10. Each partner in Soya Partnership must combine its share of Soyas Section 1231 loss with all other
Section 1231 gains and losses realized during the year to determine that partners net Section 1231
gain or loss. The rule that a net Section 1231 loss is deductible as an ordinary loss and a net Section
1231 gain is treated as a capital gain can be applied only at the partner (rather than the partnership)
level.

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
11. The different uses of cash have no effect on the federal income tax liabilities of Mr. A and Mr. Z. Both
will pay tax on the income generated by their sole proprietorships, regardless of the amount of cash
flow generated or the use to which the owners put such cash flow.
12. a. As a shareholder, Mr. Bates has limited liability for creditor claims against UPF. In other words,
the creditor cannot demand repayment of the corporate debt from Mr. Bates.
b. The creditor can demand repayment of the entire $120,000 debt from Mr. Bates. If Mr. Bates
pays the debt, he can seek restitution from the other general partners for their proportionate
shares.
c.

As a limited partner, Mr. Bates has limited liability for creditor claims against UPF.

d. As a member of a LLC, Mr. Bates has limited liability for creditor claims against UPF.
13. a. Mr. Yangs basis in his sole proprietorship is the aggregate basis of the tangible and intangible
assets used in the business activity.
b. Mr. Yangs basis is his adjusted basis in his intangible partnership interest, which equals his
initial basis (contributed cash and property or cost basis of a purchased interest) adjusted for
increases and decreases in his investment over time.
c.

Mr. Yangs basis is his adjusted basis in his corporate stock, which equals his initial basis
(contributed cash and property or cost basis of purchased stock) adjusted for increases and
decreases in his investment over time.

14. Corporation ABC must compute its adjusted basis in its interest in KK Partnership as of the date of
sale. This adjusted basis must include ABCs share of partnership items attributable to the portion of
KKs taxable year during which ABC was a partner (January 1 through October 9). The partnership
may not be able to compute such share until after the closing of the year on December 31.

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations

Application Problems
1.

a. Schedule C would reflect net profit of $26,800 as shown on the following Schedule C:

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
b. Schedule SE would reflect $3,787 of SE tax, as shown on the following Schedule SE:

2.

a. Rheas home office deduction is computed as follows.

Annual rent
Housekeeping service
Renters insurance
Total apartment expense
Percentage of square footage used as office
Expenses allocated to office

$48,000
5,200
2,000
$55,200
.15
$8,280

Rheas home office deduction is $8,280.

b. Rheas home office deduction is limited to $4,000 (net profit before the deduction).
3.

a. Colins home office deduction is computed as follows.

Annual housing expenses
Percentage of square footage used as office
Expenses allocated to office
MACRS depreciation (10% [$185,000 39 years])
Home office deduction

$19,055
.10
1,905
474
$2,379

Net profit before home office deduction

Home office deduction
Net profit

$75,000
(2,379)
$72,621

b. Net profit before home office deduction

Home office deduction (limited to profit before deduction)
Net profit
4.

$1,800
(1,800)
-0-

a. BDFs 2007 payroll tax is $4,590 ($60,000 7.65%).

b. BDFs 2007 payroll tax is $8,945 ([$97,500 6.2%] + [$200,000 1.45%]).

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
5.

a. BDFs 2008 payroll tax would be $4,590 (no change from 2007).
b. BDFs 2008 payroll tax would be $9,224 ([$102,000 6.2%] + [$200,000 1.45%]).

6.

a. Mrs. Singers 2006 self-employment tax is $7,271, and her income tax deduction is $3,635

b. Mrs. Singers 2006 self-employment tax is $6,859, and her income tax deduction is $3,430.

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
c.

7.

Mrs. Singers 2006 self-employment tax is $340, and her income tax deduction is $170.

a. Only the $120,000 profit from operations is subject to self-employment tax.

b. Self-employment tax = $14,895 = $94,200 * 12.4% + $120,000 * 92.35% * 2.9%
c.

Net profit from operations

Ordinary gain on asset sale
Interest income on working capital
Before-tax income from bookstore activities
One-half self-employment tax
Taxable income from bookstore activity

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$120,000
17,000
960
$137,960
(7,448)
$130,512

Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
8.

a. Net profit from JCs practice

One-half self-employment tax
Taxable income from practice
Tax rate
Income tax
Before-tax income
Self-employment tax
Income tax
After-tax income

$32,000
(2,261)
$29,739
.25
$7,435
$32,000
(4,522)
(7,435)
$20,043

b. JCs self-employment tax is 38 percent of the federal tax burden on her business income
($4,522 SE tax $11,957 total tax).
9.

a. Social Security tax ($33,000 6.2%)

Medicare tax ($33,000 1.45%)
Employer payroll tax on Bens salary

$2,046
479
$2,525

b. Salary payment to Ben

$33,000
Employer payroll tax on salary
2,525
Unemployment tax
400
Janes before-tax cost of salary/tax payments
$35,925
Income tax savings from deduction ($35,925 35%)
Reduction in Janes SE tax
Income tax cost of reduced deduction for 50% SE tax
($481 35%)
Net tax savings from SE tax reduction

$35,925
(12,574)

$962
(168)
(794)

Janes after-tax cost of hiring Ben

$22,557

10. a. As equal general partners, AB and YZ each include half the partnerships recourse debt in their
initial bases.
ABs contributed cash
ABs share of recourse debt
ABs initial basis in its partnership interest

$500,000
125,000
$625,000

YZs basis in contributed land

YZs share of recourse debt
YZs initial basis in its partnership interest

$430,000
125,000
$555,000

b. Because YZ is a limited partner, it is not responsible for any of the partnerships recourse debt.
As the general partner, AB is responsible for repayment (i.e. has unlimited liability) and
consequently can include the entire partnership debt in basis.
ABs contributed cash
ABs share of recourse debt
ABs initial basis in its partnership interest

$500,000
250,000
$750,000

YZs basis in contributed land

YZs share of recourse debt
YZs initial basis in its partnership interest

$430,000
-0$430,000

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
11. FGH Partnerships $600,000 ordinary business income is allocated equally to Triad LLC and Beta.
However, since these two partners are both passthrough entities, the $300,000 allocated to each is
passed through and reported by the following taxpayers.
Mr. T (40% $300,000)
Mrs. U (35% $300,000)
V Inc. (25% $300,000)
Ms. B

$120,000
105,000
75,000
300,000
$600,000

12. a. Rochelles taxable income will increase by the $25,000 of ordinary income. Rochelle will
combine the $3,000 Section 1231 loss with any Section 1231 gains or losses from other
sources. Ultimately, the loss will reduce her taxable income by $3,000. The nondeductible
expenses and cash distribution will have no impact on her taxable income. Thus, the net impact
of the partnership activity on Rochelles taxable income is an increase of $22,000.
b. Tax cost = $22,000 * 35% = $7,700 cash outflow. Cash distribution of $5,000 is a cash inflow.
Net cash outflow of $2,700 ($5,000 - $7,700).
13. Gross receipts from sales
Cost of goods sold
Operating expenses
50% meals and entertainment
KLMNs ordinary business income

$670,000
(460,000)
(96,800)
(3,120)
$110,080

KLMNs Section 1231 loss on the equipment sale and charitable contribution are separately stated
items.
14. a. Mr. T has the following shares.
Ordinary business income
Separately stated items: Section 1231 loss
Charitable contribution
Nondeductible expense
b. Mr. Ts adjusted basis at beginning of year
Increased by ordinary business income
Decreased by: Cash distribution
Section 1231 loss
Charitable contribution
Nondeductible expense
Mr. Ts adjusted basis at end of year
c.

$11,008
(1,350)
(150)
(312)
$45,000
11,008
(1,000)
(1,350)
(150)
(312)
$53,196

Mr. Ts adjusted basis would increase to $55,996 ($53,196 + 10% [$28,000 increase in
partnership debt]).

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
15. a. Ordinary income = $270,000 = $500,000 - $200,000 - $30,000
Separately stated items:
Long-term capital gain
$9,000
Nondeductible expenses
2,000
Distributions
100,000
b. Ordinary income, $135,000; Long-term capital gain, $4,500; Nondeductible expenses, $1,000;
Distributions, $50,000
c.

$139,500 = $135,000 ordinary income + $4,500 capital gain

d. $123,500 = $25,000 beginning basis + $135,000 ordinary income +$4,500 capital gain - $1,000
nondeductible expenses - $50,000 distribution +$10,000 share of debt increase
16. Schedule K:

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b. Jayanthis Schedule K-1:

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17.

Partner X
Initial basis in partnership interest
Deduction for $21,000 share of loss
Adjusted basis at beginning of next year

Partner Y

$50,000
(21,000)
$29,000

$10,000*
(10,000)
-0-

* Adjusted basis of contributed business assets

18. AVs net Section 1231 loss is computed as follows.
Section 1231 loss on sale of equipment
Share of LLC Section 1231 gain
Net Section 1231 loss

$(17,000)
4,000
$(13,000)

AVs net capital loss is computed as follows.

Capital loss on sale of securities
Share of LLC capital loss
Net capital loss

$(5,000)
(1,200)
$(6,200)

Without the items from the LLC, AV has a $17,000 deductible Section 1231 loss and a $5,000
nondeductible capital loss. With the items from the LLC, it has a $13,000 deductible Section 1231
loss and a $6,200 nondeductible capital loss. Thus, the LLC items increased AVs taxable income by
$4,000.
19. a. Ordinary income before guaranteed payments
Deduction for guaranteed payments
Ordinary business income

$95,000
(48,000)
$47,000

Bonnies and Georges 50% share

$23,500

b. Bonnies self-employment income is $71,500 ($48,000 guaranteed payment + $23,500 share of

ordinary business income). Georges self-employment income equals her $23,500 share of
ordinary business income.
c.

Ordinary income before guaranteed payments

Deduction for guaranteed payments
Ordinary business loss

$32,000
(48,000)
$(16,000)

Bonnies and Georges 50% share

$(8,000)

Bonnies self-employment income is $40,000 ($48,000 guaranteed payment $8,000 share of

business loss), while George has no self-employment income.
20.

Zeldas adjusted basis at beginning of 2006

Increased by: 60% share of dividends and interest
60% share of capital gain
Basis before loss deduction
a. Decreased by limited deduction for
60% share of business loss
b. Zeldas adjusted basis at end of 2006
c.

$95,000
8,760
3,720
$107,480
(107,480)
-0-

If Zelda received a $5,000 cash distribution from the partnership, her basis before the loss
deduction would be only $102,480, and the deduction for her share of the business loss is
limited to $102,480.

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
21. a. Zelda can deduct her $18,520 loss carryforward from 2006. Consequently, she will report a
$14,320 business loss ($4,200 2007 income - $18,250 loss carryforward) and $10,800 dividend
and interest income on her 2007 Form 1040.
Zeldas adjusted basis at beginning of 2007
Increased by: 60% share of business income
60% share of dividends and interest
60% share of partnership debt
Basis before loss deduction
Decreased by deduction for 2006 loss carryforward
($126,000 $107,480)
b. Zeldas adjusted basis at end of 2007
22. a. Ms. Ps initial cost basis in her partnership interest
Increased by share of partnership debt
Decreased by share of ordinary loss
Ms. Ps adjusted basis on January 1, 2008

-04,200
10,800
12,600
$27,600
(18,520)
$9,080
$20,000
12,000
(28,000)
$4,000

Ms. P can deduct her entire $28,000 share of loss on her 2007 return.
b. Amount realized on sale ($2,000 cash + $12,000 debt relief)
Adjusted basis
Gain recognized on sale of partnership interest

$14,000
(4,000)
$10,000

23. a. Leo can deduct $23,000 of his $30,000 allocated share of BLSs 2005 operating loss.
Leos initial basis
Decreased by limited loss deduction
b. Adjusted basis at end of 2005

BLS Stock

BLS Note

$15,000
(15,000)
-0-

$8,000
(8,000)
-0-

24. a. Leo is allocated $20,400 of 2006 income from BLS, so he can deduct his $7,000 loss
carryforward from 2005. Consequently, he will include $13,400 S corporation income in 2006
taxable income.
BLS Stock
BLS Note
Leos basis at beginning of 2006
Increased by 2006 income allocation
Decreased by 2005 loss carryforward
b. Adjusted basis at end of 2006
c.

-012,400
(7,000)
$5,400

-08,000
_____
$8,000

In this case, Leo is allocated $11,000 of 2006 income from BLS, only $4,000 of which is included
in his 2006 taxable income.
BLS Stock
BLS Note

Leos basis at beginning of 2006

Increased by 2006 income allocation
Decreased by 2005 loss carryforward
d. Adjusted basis at end of 2006

-03,000
(3,000)
-0-

-08,000
(4,000)
$4,000

25. Because his adjusted basis in the note surrendered in only $4,000, Leo must recognize a $4,000
capital gain on the receipt of the $8,000 repayment.

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
26. a. Evans cash withdrawal from the S corporation is not taxable to him, nor it the payment
deductible by the S corporation.
b. If the payments are recharacterized as salary, the S corporation is permitted a deduction,
lowering its taxable income. Evan must report salary income. The net effect on Evans taxable
income and income tax liability should be zero, since he is the sole shareholder of the S
corporation.
c.

If the $50,000 per year is treated as salary, both the S corporation and Evan have unpaid payroll
tax of $3,825 per year, for a total potential underpayment of $22,950 ($3,825 * 2 * 3 years).

Issue Recognition Problems

1.

Will the marginal tax rate on Ellie and her husbands joint return for next year (and the rate applying
to Ellies business profits) increase because Ellies husband will earn a salary?

2.

Does Javier owe employee payroll tax on his entire salary plus self-employment tax on his entire net
earnings from self-employment? Does Javier have an annual base amount of compensation subject
to either Social Security tax or self-employment tax (but not both), or does he have an annual base
amount subject to both Social Security and self-employment tax?

3.

Is Mrs. Chou also considered to be self-employed so that some of the net profit from the business
should be attributed to her for self-employment tax purposes?

4.

Does Travis use of his home office to house the family library violate the exclusive use test for a
home office deduction?

5.

Should AF Partnership allocate a portion of its capital gain to Lola, even though she was not a
partner on the date the gain was realized? How does AF Partnership allocate 15 percent of its
income between Lola and R Corporation? What is Lolas adjusted basis in her partnership interest
on April 12?

6.

Did Fred adjust his basis in the limited partnership interest for his share of annual partnership
income? Has Fred received cash distributions equaling the total partnership income on which he
paid tax for the last nine years?

7.

Is the exchange of a partnership interest for an interest in a newly formed LLC a taxable or
nontaxable exchange?

8.

Does the state of incorporation (and every other state in which the corporation will conduct business)
treat an S corporation as a nontaxable passthrough entity for state income tax purposes?

9.

What happens to Mr. Yangs carryforward of his DK loss when he sells his entire interest in the
partnership? Can Mr. Yang deduct $7,500 of his loss carryforward because he recognized a $7,500
gain on the sale of the partnership interest? Does the loss carryforward transfer to the purchaser of
the partnership interest?

10. Which share of loss (ordinary or capital) does Paula deduct first? Because Paula can deduct only
$6,200 of her partnership losses, how does she allocate the deduction between her shares of
ordinary loss and capital loss?
11. Does Marcus recognize his final monthly 2007 guaranteed payment as taxable income in 2007 or
2008? Does the partnership deduction for the payment depend on the year in which Marcus
recognizes the payment as income?

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
12. Can David increase the basis in his DES stock by his $8,900 allocation of tax-exempt interest so that
he can deduct his entire $4,700 ordinary loss allocation?
13. How should WW account for the $21,000 payment made on its shareholders personal behalf?
Should Mr. and Mrs. West treat the corporate payment on their personal behalf as taxable
compensation from WW or as a nontaxable cash distribution that reduces the basis in their WW
stock?
14. Can the other six individuals prevent a termination of NSs S corporation election? Is the NS stock
subject to a buy-sell agreement or similar restriction that prevents the individual from giving shares
to a nonqualifying shareholder?
15. Can BR recognize the $125,000 loss realized on the sale of land to a partnership in which it is a
partner? Are BR and the limited partnership related parties for purposes of the loss disallowance
rule? Does BR indirectly own a 100 percent interest in the partnership because all other partners are
BR shareholders?
16. In which taxable year does Corporation L report its $100,000 share of JKL Partnerships 2006
business income? Is Corporation Ls $100,000 share allocated between the corporations fiscal year
ending on June 30, 2006, and its fiscal year ending on June 30, 2007?
17. Can FG deduct a $15,500 ordinary abandonment loss because it relinquished its equity interest in
the limited partnership?
Research Problems
1.

Rev. Rul. 66-95, 1966-1 CB 169, provides the authority for the solution to this research problem. The
first step is the computation of Don Ferriss guaranteed payment, which the partnership can deduct
in the computation of taxable income.
Taxable income before deduction of guaranteed payment

$107,200
.50
$53,600

Don Ferriss share before guarantee

Minimum guarantee
Share
Guaranteed payment

$75,000
(53,600)
$21,400

The second step is the computation of F&Ls taxable income.

Taxable income before deduction of guaranteed payment
Guaranteed payment
Taxable income

$107,200
(21,400)
$85,800

The last step is the computation of Don and Lous shares of taxable income.
Taxable income

Don Ferris

Lou Lindberg

Total

$53,600

$32,200

$85,800

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2.

This research problem is based on the facts in Tracy Lee Milian v. Commissioner, TC Memo 1999366, in which the court held that a police officer was liable for self-employment tax on his earnings as
an off-duty security guard. The police officer was acting as an independent contractor rather than a
police department employee, even though he wore his police uniform and used police equipment. As
a security guard, he was not under policy department control, even though the policy department
approved his off-duty work. Because the facts of Max Coens situation so closely resemble the facts
in the Milian case, the IRS would certainly conclude that Maxs $4,100 wages from the school district
are net earnings from self-employment.

3.

According to Section 1362(d)(2), Herolds S election terminated on October 10, 2006. Per Section
1362(e)(1), the corporation must file its final Form 1120S for the period January 1-October 9 (S short
year) and its first Form 1120 for the period October 10-December 31 (C short year). Section 1362(e)
(2) requires that Herolds 2006 taxable income be pro rated between the two returns based on the
number of days in each short year. Here is the pro ration.
(282 days [Jan. 1-Oct. 9] 365) $592,030 = $457,404 income on Form 1120S
(83 days [Oct. 10-Dec. 31] 365) $592,030 = $134,626 income on Form 1120
Section 1362(e)(5) requires that the corporate tax on Herolds C short year income be computed on
an annualized basis. Thus, the corporate tax rates are applied to $592,030 annual income to result
in a full years tax of $201,290. This amount is then multiplied by the ratio of the number of days in
the C short year to the number of days in the full year. Based on this annualization, Herolds tax for
its C short year is $45,773 ([83 365] $201,290.

4.

Because Sandy has a zero adjusted basis in her worthless note, Section 166(b) provides that her
bad debt deduction is zero. Because she also has a zero adjusted basis in her worthless stock,
Section 166(g)(1) provides that her capital loss realized on the deemed sale of this stock is also
zero. Reg. Sec. 1.1366-2(a)(5) provides that if an S corporation shareholder disposes of all of her
stock, any loss carryforward attributable to the Section 1366(d) basis limitation is permanently
disallowed. Thus, Sandy can never deduct her $7,400 ordinary loss carryforward. In summary,
Sandy has no 2006 tax consequences from the worthlessness of her investment in Lindlee Inc.

Tax Planning Cases

1.

Mr. and Mrs. Janus should clearly document that they used the $80,000 borrowed funds (plus
$5,000 from their savings account) to buy the new equipment for their restaurant. By doing so, the
interest on the debt is a fully deductible business expense on their Schedule C. If they used
borrowed funds to buy the two automobiles, the interest paid on such funds would be a
nondeductible personal expense.

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2.

Eve and Frank should not withdraw any funds from the partnership in 2007 because they need to
keep their initial investments intact to deduct the partnerships operating loss on their 2007 Form
1040s.
Eves Basis
Franks Basis
Initial cash invested in the partnership
Partnership debt included in basis
Basis before loss deduction
Share of 2007 operating loss
Basis at end of 2007

$30,000
25,000
$55,000
(50,000)
$5,000

$30,000
25,000
$55,000
(50,000)
$5,000

If the partners withdraw their initial cash contributions in December 2007, they can deduct only
$25,000 of their share of loss. The $25,000 nondeductible loss would carry forward as a deduction
against 2008 income. However, the deferral of a $25,000 ordinary deduction for one year decreases
the tax savings from the deduction in NPV terms. For example, at a 7 percent discount rate, the
deferral of the deduction for one year reduces the tax savings from $8,750 ($25,000 35%) to
$8,181 ($8,750 .935 discount factor). Of course, Eve and Frank must weigh the tax savings
against the opportunity cost of delaying their cash withdrawals from December to January.
3. a. In each case, Amishas net cash flow from the loan in year 0 is ($26,000).
Cash loaned to Sultan
Tax savings from deduction of loss
against debt basis ($40,000 35%)
Net cash flow in year 0

($40,000)
14,000
($26,000)

The $49,000 share of undistributed corporate income in years 1 and 2 increased Amishas basis
in her Sultan note to $40,000 and her stock basis to $9,000. The repayment of the loan in year 2
resulted in $42,470 net cash flow ($40,000 repayment + $3,800 interest - $1,330 tax cost [$3,800
interest income 35%]).
PV of year 0 net cash flow
PV of year 2 net cash flow
($42,470 .890 discount factor)
NPV of cash flows

($26,000)
37,798
$11,798

b. The $19,100 share of undistributed corporate income in years 1 and 2 increased Amishas basis
in her Sultan note to $19,100. The repayment of the loan in year 2 triggered a $20,900 capital
gain taxed at 15%. Consequently, the repayment resulted in $39,335 net cash flow ($40,000
repayment - $3,135 capital gain tax + $3,800 interest - $1,330 tax cost [$3,800 interest income
35%]).
PV of year 0 net cash flow
PV of year 2 net cash flow
($39,335 .890 discount factor)
NPV of cash flows
c.

($26,000)
35,008
$9,008

Amishas share of corporate losses in years 1 and 2 had no effect on the zero basis in her Sultan
note. Consequently, when Sultan defaulted on repayment, Mrs. NG did not realize any tax loss on
the worthlessness of the note. The NPV of the cash flows associated with her loan is ($26,000).

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Chapter10SoleProprietorships,Partnerships,LLCs,andSCorporations
4. Investment A:
Purchase/Sale
Dividends
Tax on dividends
Tax on gain
Net cash flow

Year 0
$(50,000)

$(50,000)

Year 1

Year 2

$4,000
(600)

$4,000
(600)

$3,600

$3,600

Year 1

Year 2

$(3,500)

$(3,500)

$(3,500)

$(3,500)

Year 3
$60,000
4,000
(600)
(1,500)
$61,900

NPV at 4% = $11,819
Investment B:
Year 0
Purchase/Sale
$(50,000)
Tax on annual income
Tax on gain
Net cash flow
$(50,000)

Year 3
$90,000
(3,500)
(1,500)
$85,000

NPV at 4% = $18,963
Note: tax basis of S corporation stock prior to sale is $80,000 ($50,000 +$30,000 earnings)
Based on these projections, Marla should choose Investment B, the S corporation stock.

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