Accounting 331-Lecture Notes2002

Accounting 331
Course OutlineFall 2004

Chapter 2
Introduction to Income Taxation of Corporations
Differences and similarities to individual income taxation. Corporation has no

deduction for itemized deductions (as all of its expenses are business deductions)
plus there is no standard deduction or personal/dependency exemption. Corporate
income tax model is much more straightforward.
Gross Income (generally apply to all business entities)

-Trade or Business Deductions (generally apply to all business entities)
= Taxable Income before NOL and Special (Dividends Received) Deductions
- NOL & Dividends Received Deductions
= Taxable Income
Note: No AGI for Corporations
Accounting Periods and Methods
C Corporations may choose a calendar year or a fiscal year for reporting purposes,
but S corporations and personal service corporations are subject to restrictions on
the choice of a fiscal year. Consequently S & PSC normally choose a calendar
year.
The cash method is often not available to C corporations. S Corporations and

qualified PSCs are excluded from this rule; C corporations with average gross
receipts $ 5 million or less for the past three years are also excluded.
IRS Notice 2001-76 permits qualified service providers with average annual gross
receipts of not more than $ 10 million for the most recent three year period to use
the cash method. This applies even if the taxpayer is buying and selling
inventory.
Do Q 2-13
Comparison of a proprietorship (flow-through entity) with a corporation.

Proprietorship profits subject to SE tax, no salary for the proprietor. C
corporations taxed on the net income and the shareholders taxed on the dividends
received. Shareholders of C corporations can be subject to treatment of part of
their salaries as dividends under the doctrine of unreasonable compensation.
1
267 Related party issuesan accrual basis taxpayer cannot claim a deduction
for an accrual owed to a related party until the recipient reports that amount as
income.
Capital gains and LossesComparison with Individuals
Net capital gains for corporations are not subject to lower rates as are gains for
individuals.
Corporate capital losses may only offset capital gains.
Excess capital losses are carried back three years and forward five years to offset
capital gains, while capital gains for individuals are carried forward indefinitely.
Further for corporations capital loss carry-backs or carryovers become short-
term capital losses. For individuals they retain their original status as short term
and long term.
Do P 2-39, 40
Passive Activity Losses
Passive Loss Limitations apply to closely held C corporations (>50% ownership, 5 or

fewer individuals) and to PSCs, but do not apply to regular C corporations.
Closely held C corporations may offset passive losses against active income.
Do Q 2-18
Charitable Contributions
General ObservationsRules parallel to a large extent those for individuals. For long-
term capital gain property the amount of the deduction is the fair market value on the date
of the donation. A contribution of tangible personal property that is put to an unrelated
use by the charity is limited to the adjusted basis at the date of donation.
For contributions of ordinary income-producing property, the deduction is limited to the
lower of adjusted basis or fair market value. Corporate contributions of ordinary income
property to charities that use the property in a manner related to the exempt purpose and
solely for the care of the ill, needy or infants or where the property is used for research
purposes (under special rules):
1. The deduction is measured by the adjusted basis of the property plus half of the
appreciation of the property.
2. However, the deduction cannot exceed twice the basis of the property.
A corporate taxpayer is limited to 10% or taxable income computed without regard

to the charitable contribution deduction, any net operating loss carry-back, and the
dividends received deduction. Any contribution in excess of the 10% limitation may
be carried forward for five succeeding tax years.
2
For accrual basis corporations there is an exception to the rule that deductions for
charitable contributions are allowed only for the year in which payment is made. A
corporation may deduct a charitable contribution in the year preceding payment if the
contribution is authorized by the board of directors by the end of that year and is paid on
or before the 15th day of the third month of the next year.
Review Problems 2-42, 43, 44
Net Operating Losses
A net operating loss of a corporation is not subject to the adjustments required for
individual taxpayers (capital gains/losses & non-business income)
A corporation is allowed to include a dividends received deduction in computing its
net operating loss (See White Corporation example in P 2-47)
Generally NOLs are carried back 2 years and forward 20 years. The corporation
may also elect to forgo the carry back and simply carry forward.
Deductions Available Only to CorporationsDividends Received Deduction
A corporation is allowed a dividends-received deduction for distributions received from

other domestic corporations.
The amount is limited as follows (page 2-18)
Ownership Level Percentage

Less than 20% 70%
20% or more but less than 80% 80
80% or more 100
The dividends received deduction is limited to a percent of taxable income of the

corporation computed without regard to the net operating loss, the dividends received
deduction and any capital loss carry-back for the current tax year. The percentage of
taxable income corresponds to the deduction percentage. The taxable income limitation
does not apply if the corporate shareholder has a NOL for the current year.
Review Problems 2-46 & 47
Organization and Start Up Expenses
Qualifying expenses under 248:
Legal services incident to organization

Necessary accounting services
Expenses of temporary directors and organizational meetings of directors or shareholders
Fees paid to the state of incorporation
3
Such expenses may be amortized over a 60 month (or greater) period. To qualify for
the election must be incurred before the end of the taxable year in which the
corporation begins business. If a timely election is not made the organizational
expenses cannot be deducted until the corporation ceases to do business and liquidates.
The election is made in a statement attached to the corporations return for its first taxable
year. A cash basis corporation can include cost that incurred (although unpaid) as long as
the liability arises in the first year.
Under 195 start-up costs can also be amortized over a period of 60 months. These
costs include investigation expense involved in entering a new business as well as
operating expenses incurred before the corporation actually begins producing gross
income (e.g. rent, payroll, travel, market surveys, financial audits, legal fees).
Review Problem 2-48, 49
Corporate Income Tax Rates
Corporations compute their Federal income tax liability using the rate structure contained
in 11(b). Tax savings at lower rates, favors small businesses, PSC rate is 35%, we will
use 34% for most illustrations.
Tax Liability of Related Corporations
Related corporations are subject to special rules for computing the income tax, the
accumulated earnings credit, and the AMT exemption. Without these rules the
shareholders of corporations could gain significant tax advantages by splitting a single
corporation into multiple corporations. Hamburgers York Road 41 TC 78 (1964) and
examples 30 & 31 page 2-22 give illustrations.
To preclude the advantages that could be gained by the use of multiple corporations the
tax law requires special treatment for controlled groups of corporations. To eliminate the
advantages of using multiple corporations to achieve lower rates the law limits a
controlled groups taxable income in the tax brackets below 35%. As a group they are
limited to the amount they would have if they were one corporation. The allocation of
the lower brackets is equal unless all members consent to an apportionment.
Controlled Groups
Controlled groups are generally parent-subsidiary or brother-sister groups. A parent-

subsidiary group exists if:
stock possessing at least 80% of the total combined voting power of all classes of stock or
at least 80% of the total value of shares of all classes of stock in each of the corporations,
except the common parent, is owned by one or more of the other corporations and
4
the common parent owns stock possessing at least 80% of the total value of shares of all
classes of stock of at least one of the other corporations.
A brother-sister controlled group exists if:
two or more corporations are owned by five or fewer persons (individuals, estates or
trusts) who possess stock representing at least 80% of the total voting power of all classes
entitled to vote or at least 80% of the total value of shares of all classes of each
corporation and who have a common ownership of more than 50% of the total combined
voting powers of all classes of stock entitled to vote or more than 50% of the total value
of shares of all classes of stock of each corporation.
A combined controlled group (parent-subsidiary and brother-sister) exists when each

corporation is a member of some group and at least one member is a parent and that
parent is also a brother or sister.
See US vs Vogel Fertilizer 102 S. Ct. 821 (1982) for the treatment of the common
ownership test under the 80% rule. Brother-Sister must shareholder must have ownership
in more than 1 corporation.
Review P 2-52,53,54
Filing Requirements
Corporations must file a tax return (Form 1120, Form 1120S or Form 1120A on or before
the 15th day of the 3rd month following the close of the tax year. A corporation is entitled
to an automatic extension of six months provided that it timely and properly files Form
7004 and deposits the full amount of the tax due with Form 8109.
The abbreviated 1120A can only be used in certain circumstances (see pages 2-27 & 28.)
A corporation must make payments of estimated tax liability unless the tax liability less
than $ 500. Payment dates for calendar year corporations are: 4/15, 6/15, 9/15 and
12/15.
Reconciliation of Taxable Income and Financial Net Income
Schedule M-1Reconciliation of Income per Books with Income per Return.

Adjustments will generally be the same as those on the tax trial balance. Note that
taxable income per return will be net income before special deductions. See page 2-
28 for illustration
Schedule M-2 is an analysis of unappropriated retained earnings. Watch for

corrections of errors that have income tax implications.
Review Problem 2-57
5
Review of Form 1120 on pages 2-31 thru 2-35:
Page 1Computation of Taxable Income/Balance Due-Refund

Page 2Cost of Sales, Dividends Received & Special Deductions and Compensation of
Officers
Page 3Tax Computations, Questions
Page4Book Balance Sheets, Schedules M-1 & M-2
6
Chapter 3
I. Organization of a Corporation
Under 351 no gain or loss is recognized upon the transfer by one or more persons
of property to a corporation solely in exchange for stock in that corporation if,
immediately after the exchange, such persons are in control of the corporation to
which the property was transferred.
Property is broadly construed. The term includes unrealized receivables, installment

obligations, secret processes, formulas and patents.
Stock under 351 includes common or preferred stock. It does not include stock
rights, stock warrants, and long-term debt (securities). Mortgages and liabilities related
to business do not taint the transaction.
Control means at least 80% of the total combined voting power of all classes of stock
entitled to vote and at least 80% of the total number of shares of all other classes of
stock.
Control (80%) may apply to a single person or to several individuals, if they are all
parties to an integrated transaction.
The exchange does not necessarily require simultaneous exchanges by two or more
persons, but it does require that the rights of the parties have been previously defined and
that the execution of the agreement proceeds with an expedition consistent with orderly
procedure.
If the property of money, other than stock, is received from the corporation, gain
will be recognized to the extent of the lesser of the gain realized or the boot received.
Note that losses are never recognized.
SEE FIGURES 3-1 & 3-2 on page 3-12. Non recognition of gain or loss is
accomplished by a carryover of basis. 358 provides that the basis of the stock received
in a 351 transfer is the same as the basis taxpayers had in the property transferred
increased by gain recognized and decreased by the boot received.
Services
351 treatment will be lost if the stock is transferred to a person who did not contribute
property, causing those who did to lack control immediately after the exchange. Services
are not considered property under 351. If a person performs services for the
corporation in exchange for stock and also transfers some property (a significant
amount), her or she is treated as a member of the transferring group.
7
Other Points
351 is mandatory. It applies to later transfers to an existing corporation by either new

or former shareholders. This provision commonly prevents new shareholders from
receiving tax-free treatment.
Illustrative Problems:
Q 3-8
P 3-27, 28, 31
Assumption of Liabilities by the Acquiring Corporation
Under 357 (a) the assumption of a liability by the acquiring corporation taking
property will not produce boot to the transferor shareholder in a 351 transaction.
Liabilities assumed by the transferee corporation are treated as other property or
money as far as the basis of the stock received in the transfer is concerned. The
basis of the stock received must be reduced by the amount of liabilities assumed by
the corporation.
Review Q 3-12
Exceptions: 357(b)if the principal purpose of the assumption of liabilities is to avoid

tax or there is no bona fide business purpose behind the exchange, the liabilities in total
will treated as money received and taxed as boot.
357(c)provides that if the sum of the liabilities exceeds the adjusted basis of the
properties transferred, the excess is taxable gain.
Accounts payable for a cash basis taxpayer that give rise to a deduction are not
considered liabilities for the purposes of 357 (c).
The effect of 357 (c) is to generate recognized gain. As to whether such gain is
capital or ordinary, look to the nature of the asset transferred.
357 (b) produces boot, not gain. If both 357 (b) and 357 (c) apply, 357 (b)
prevails.
Review Illustrative Problems 3-37, 40
III. Recapture Provisions
In a pure tax-free transfer under 351 the depreciation recapture rules do not apply.
However, the recapture potential (and holding period) are transferred to the corporation.
8
Review Illustrative Problem 3-43
IV. Capital Structure of a Corporation
Capital contributionsIssuance of stock & contributions of money or property. 118

(a)-- No gain recognized to the corporation. The corporation will have as the basis
of in the property, the transferor-shareholders basis. Shareholder recognizes no
gain or loss on the transfer and the basis in the original shares must be adjusted
accordingly.
Contributions by a non shareholderNo gain is recognized by the

Corporation. Basis of property to the corporation is 0. Review Illustrative Problem
3-44
Debt in the Capital Structure
Advantages of receiving long-term debt to the transferor shareholder. Interest is

deductible to the corporation, while dividends payments are not. Shareholders are not
taxed on loan payments unless they exceed the basis.
In certain instances the IRS will contend that the debt is really an equity interest and will
deny the shareholders the advantages of debt financing. We call this situation a thin
capitalization issue. Page 3-17 identifies the factors to be considered in addressing this
question.
Investor Losses
Under 165(g)(1) the loss is usually classified as a long-term capital loss. No

deduction is permitted unless the investor can prove the investment is entirely worthless.
Ordinary losses of stock will be permitted under the following circumstances: (1)
dealer in securities, (2) purchase induced by fraud, (3) affiliated corporation, (4)
application of 1244.
Business v. Non Business Bad Debtsshareholder loans by non corporate taxpayers are
STCL with no deduction for partial worthlessness.
1244 stock
Applies only to the original holder

Permits ordinary loss treatment up to a maximum of $ 50,000 per year ($ 100,000 if a
joint return is filed) for losses on the sale or the worthlessness of a small business
corporation.
The total amount of stock which can be offered under the plan to issue 1244 stock plus
any other stock issued by the corporation cannot exceed $ 1 million.
9
A corporation must derive more than 50% of its aggregate gross receipts from sources
other than royalties, rents, dividends, interest, annuities, or securities (applies to the most
recent five years)
Losses above limitation for the year ($50,000, $100,000) are capital losses.
The basis of 1244 stock issued by a corporation in exchange for property that has an
adjusted basis above its fair market value immediately before the exchange is reduced to
the fair market value of the property on the date of the exchange.
Review problem 3-47.
Gain From Qualified Small Business Stock 1202
Non-corporate shareholder may exclude 50% of gain on the sale. Must hold for five
years, be part of an original issue. Details on pages 3-21, 22
10
Chapter 4
Earnings & Profits 312
Not defined under the Code; similar to RE; represents the upper limit for the amount of
dividend income that shareholders must recognize. Rules apply to C Corporations.
Computation of E & P shown in Concept Summary 4-1 on page 4-7.

Current E & P = Taxable Income +/- Adjustments.
Illustrative Problems: Q 4-3, P 4-30
Distributions from Earnings & Profits
See Concept Summary 4-2 on page 4-8.
Made first from current E & P, then from accumulated E & P. Note that if current E & P
is negative and accumulated E & P is positive, the accounts are netted at the date of
distribution). Current E & P losses are allocated on a pro-rata basis.
Distributions (1) reduce E & P to 0 (dividend income), then return of capital (tax-
free) to 0, remaining excess is capital gain.
To determine the amount of a distribution that is from current E & P;
Current E & P portion of distribution = Total Current E & P x Each Distribution

Total Distribution
Illustrative Problems 4-28, 32, 43
Property Distributions
Effect on Shareholder;
Amount Distributed = FMV of the property -- related liabilities assumed by

on the date of distribution assumed by the shareholder
11
Effect on the Corporation:
1. For appreciated property, the gain is recognized. Losses are disallowed.

2. Distributions cannot create negative E & P
3. Corporate distributions reduce E & P by
a. the amount of money distributed.
b. (> FMV or adjusted basis of property) related liabilities
c. gains on distributions of appreciated property
4. If the distributed property is subject to a liability in excess of its basis a special
rule applies.
FMV for determining gain is not less than the amount of the liability.
P 3-37, 35, 34
Constructive Dividends
In reality these are disguised dividends, undertaken for tax avoidance purposes. They
usually involve shareholders of closely held C corporations. See pages 4-15-18. Some
examples:
Shareholder use of corporate owned property

Bargain sale of corporate property to a shareholder
Bargain rental of corporate property
Payments for the benefit of a shareholder.
Unreasonable compensation
Loans to shareholders without bona fide business purpose
Loans by shareholders, equity rather than debt.
Illustrative Problem 4-39
Distributions from One Corporation to Another
No new tax concepts, but note the operation of the dividends received deduction and the
effect on E & P.
Illustrative Problems 4-41
12
Stock Dividends 305
IRC generally treats them as non taxable; however there are exceptions
Distributions of stock or property

Distribution of property to some shareholders with a corresponding increase in the
proportionate interest of other shareholders in either assets or E & P of the distributing
corporation.
Distributions of preferred stock to some common shareholders and of common stock to
other common shareholders
In general, distributions of stock to preferred shareholders.
In general distributions of convertible preferred stock.
FMV used to measure value of taxable dividends, Do Illustrative Problem 4-48.
Stock Rights Reg. 1.305-1(b) & 307(b)(1)
Rules for taxability are identical to stock dividends.
The 15% rule. If the FMV of the rights is 15+% of the value of the stock, the holder must
allocate cost basis to the rights. Otherwise the basis of the rights is 0. The owner may
elect to allocate when the value is < 15%, but no allocation is required.
Sale of the rights produces a capital gain.
Do Illustrative Problem 4-49
13
Chapter 5
Redemptions and Liquidations
Observations on Corporate Distributions
Distributions from a C Corporation to its shareholders are ordinarily dividends and are
taxed as ordinary income. However a distribution that is a qualifying stock redemption is
treated in the same manner as a sale of stock to a third party by the shareholder and
capital gain treatment is available.
Shareholders benefit from a qualified stock redemption in that they may offset the
amount received from the corporation by the basis of the stock redeemed, and thus report
less taxable income.
Further classification of the gain as a capital gain provides a benefit to the taxpayer who
has substantial losses since capital losses can be used to offset capital gains. In addition
for individual shareholders net capital gains are taxed at a maximum rate of 15% (10%,
8%).
While a non-corporate shareholder receives more favorable treatment from a qualifying

stock redemption than from a dividend distribution, the reverse is generally true for a
corporate shareholder. Because of the dividends received deduction, a corporate
shareholder would report only a small portion of dividend income as taxable income.
Stock Redemptions in General
Stock redemptions that qualify under 302 (b) and 303 are given capital gain
treatment. To qualify as a stock redemption a distribution must be among the
following types:
Not essentially a dividend 302 (b)(1) Meaningful Reduction

A disproportionate redemption 302(b)(2)
A complete termination of a shareholders interest 302(b)(3)
Partial liquidation 302 (b) (4)
303 Be used to pay a shareholders death taxes and administration expenses

Note that 303 is an independent provisionno attribution rules.
Review Concept Summary 5-1 on page 5-14.
14
Because a qualified stock redemption is treated as a sale or exchange, gain or loss to the
shareholder is measured by the difference between the amount realized and the stocks
adjusted basis. The shareholders basis in any property received in a stock redemption is
the fair market value of the property.
302 (b)(1)Not Essentially Equivalent to a Dividend
Rules established in US v Davis 90 S.Ct. 1041 (USSC, 1970). Redemption must result in
a meaningful reduction in the shareholders interest. Business purpose is irrelevant,
318 attribution rules apply.
302 (b)(2)--Disproportionate Redemptions
Will be substantially disproportionate if the shareholder after the distribution less than
80% of the total interest owned in the corporation before the distribution and owns less
than 50% of the combined voting power of all classes of stock entitled to vote. In
determining stock ownership the constructive ownership rules of 318 apply.
Under 318 a person is treated as owning the stock of his or her spouse, children,
grandchildren, and parents. He/she is also deemed to own a proportionate part of the
stock owned by an estate as beneficiary, or by a corporation, trust or partnership in which
the shareholder has an interest.
302 (b)(3)Complete Terminations
Shareholder receives capital gain treatment if his interest is completely terminated. If the
provisions of 302 (b)(3) are met the family constructive ownership rules of 318 (a) do
not apply.
A shareholder may not retain any interest in the corporation except that of creditor.
The shareholder may not acquire any such interest (except by bequest or inheritance)
within 10 years.
The shareholder must file an agreement to notify the IRS if such an interest is acquired.
Review Illustrative Problem 5-43, 48
15
302(b)(4)Redemptions in Partial Liquidation
Qualified partial liquidations must meet all the following requirements.
Distribution to a non-corporate shareholder

Distribution under a plan; must occur within the taxable year in which the plan is
adopted or within the succeeding taxable year.
Distribution must be essentially equivalent to a dividend. A genuine contraction of the
corporations business must occur.
Must pursuant to the termination of an active business. Corporation must have at least
two trades. Neither of the trades can have been acquired in a taxable transaction within
the last five years. The non terminated trade must continue in business.
303--Redemption to Pay Death Taxes
An executor can redeem stock in a closely held corporation and receive sale or exchange
treatment when the stock represents a substantial amount of the gross estate. If 303
rules are met 302 does not apply.
The value of the stock must be in excess of 35 % of the value of the adjusted gross estate
of the decedent [gross estate [administration + funeral expenses ( 2053) + casualty
losses ( 2054)]
In determining the 35% requirement, stock of two or more corporations is treated as stock
of a single corporation if 20% of the outstanding stock of each is included in the gross
estate.
Applies only to the extent of the sum of the death taxes imposed and funeral and
administration expenses allowable as deductions of the estate.
Result of 303 is essentially to make the redemption tax-free. Review illustrative

problem 5-47.
Effect on Corporation Redeeming Its Stock
Under 311 (b) a distributing corporation must recognize gain if it uses appreciated
property to redeem its stock.
Expenses a corporation incurs in redeeming its stock are non-amortizable capital

expenditures. Payments that are non-deductible include stock purchase premiums,
amounts paid to a stockholder for the shareholders agreement not to reacquire stock in
the corporation for a specified time and legal, accounting, transfer agent, brokerage, and
appraisal fees.
16
The Earnings and Profits account of a corporation is reduced by a qualified stock
redemption in an amount not in excess of the ratable share of the E & P of the
distributing corporation attributable to the stock redeemed.
LiquidationsEffect on the Liquidating Corporation 336
336 provides that with the exception of property distributed to a parent in

complete liquidation of a subsidiary ( 337), gain or loss is recognized to a liquidating
corporation on the distribution of property in complete liquidation. The property is
treated as if it were sold at fair market value.
336(d) imposes restrictions on the deductibility of losses in related party situations

(as defined by 267). Review Figure 5-2 on page 5-23.
General liquidation expenses are deductible to the liquidating corporation. Specific

liquidating expenses relating to the sale or disposition of corporate assets are offset
against the selling price of the asset sold.
LiquidationsEffect on the Shareholder 331
The general rule under 331 provides capital gain or loss treatment to the
shareholder.
The basis of assets received by the shareholder will generally be their fair market
value at the date of the distribution. [ 334(a)]
Review Illustrative Problems 5-60
Liquidation of a Subsidiary-- 332 (Parent) & 337 (Subsidiary)
If a parent corporation liquidates a subsidiary in which it owns at least 80% of the voting
stock and at least 80% of the total value of all other stock and the subsidiary distributes at
least all of its property in complete liquidation within the taxable year or within three
years from the close of the taxable year in which a plan was adopted and the first
distribution occurred, 332 is mandatory.
No gain or loss is recognized on the liquidation (except to the subsidiary if 338 is

elected or as to distributions to the minority interest.)
17
Distribution to a minority shareholder is treated in the same manner as one made
pursuant to a non-liquidating stock redemption. Gain but not loss is recognized to the
subsidiary on property distributed to a minority shareholder. The minority shareholder is
subject to the general rule of 331. The difference between the fair market value of the
asset distributed and the basis of the minority shareholders stock is the amount of gain or
loss recognized. The tax basis of the property received by the minority shareholder is the
propertys fair market value at the date of distribution.
The subsidiary corporation must be solvent and the parent corporation must own at least
80% of the voting power and value of the subsidiarys stock at all stages of the
liquidation.
Under 334(b)(1) Property has the same basis as it had in the hands of the subsidiary.
Parents basis in the stock disappears. Carryover rules under 381 apply.
If the subsidiary transfers appreciated property to its parent to satisfy a debt, it must
recognize gain on the transaction unless 332 applies. However the parent corporation
recognizes gain or loss on the receipt of property in satisfaction of indebtedness, even if
the property is received during the liquidation of the subsidiary.
Basis of Property Received by the Parent CorporationGeneral Rule
Under 334(b)(1) property received in complete liquidation of a subsidiary has the

same basis it had in the hands of the subsidiary. Further the parents basis in the stock
of the liquidated subsidiary disappears and the carryover rules of 381 apply.
Basis of Property Received by the Parent Corporation-- 338 Election
When a corporation acquires a controlling interest (80 percent) in another corporation

over a short time period, the acquisition cost of the stock will reflect the FMV of the
subsidiarys assets (including goodwill). In all but a few unusual situations the parents
basis in the stock will vary greatly from the subsidiarys basis in its assets, often
producing a non-recognized gain. Under 338 the parent may elect to recognize the
gain/loss from the purchase of the stock. The election must be made within 8 months and
15 days of the purchase.
The subsidiary is treated as having sold its assets on the qualified stock purchase date for
a value that is determined with reference to the ;parents basis in the subsidiary stock plus
any liabilities of the subsidiary. The subsidiary is then treated as a new corporation that
purchased those assets for similarly computed amount on the day following the qualified
stock purchase date. The deemed sale results in gain (or loss) recognition to the
subsidiary and the deemed purchase results in a stepped up (or down) basis for the
subsidiarys assets. The subsidiary may, but need not, be liquidated. If the subsidiary is
liquidated, the parent will obtain a carryover of the stepped up (or down) basis in the
subsidiarys assets.
18
Review Concept Summary 5-2 on page 5-29.
19
Chapter 6
Alternative Minimum Tax and Certain Penalty Taxes Imposed on Corporations
The Alternative Minimum Tax
Figure 6-1 on page 6-4 shows how the tax is computed. The purpose of the tax is to
force corporations who have low effective tax rates and take advantage of benefits in the
tax law to pay at least a minimum level of tax.
Some highlights:
Taxable Income before the Net Operating Loss computation is the starting point.
Adjustments (pages 6-4,5,6) may be positive or negative, while preferences (page 6)
are always positive. Do Illustrative Problem 6-37
AMTI is determined before any deduction is made for the exemption amount.
AMT rate is 20% for corporations.
AMT = Tentative AMT Regular Corporate Income Tax
$ 40,000 exemption is phased out between $150,000 and $ 310,000 AMTI
AMT subject to estimated tax rules
AMT tax paid in one tax year may be carried forward against the corporations future
regular tax liability that exceeds its minimum tax.
There is also an exemption from the tax for small corporations with average gross
receipts of $ 5 million or less over the three preceding years.
The ACE Adjustment
Several types of itemsadd income exclusion items considered for E & P purposes
only; 70% dividends received deduction; organization expense deduction, LIFO
inventory adjustments, installment sales; subtract expense related to add items. Review
Concept Summary 6-1 on page 6-8.
AMTI increased by 75% (ACE Adjusted AMTI) AMTI reduced by 75% (negative
adjustments limited to net positive adjustments remaining for prior years.
Review Figure 6-2 on Page 6-7.
Review Illustrative Problem 6-35 & 36
20
The Accumulated Earnings Tax
A penalty tax on unreasonable accumulations; assessed on IRS audit. Normally not an

important issue; tax was adopted in the late 1930s as a way to stimulate investment.
The tax is imposed in addition to the regular tax and the 20% AMT. The tax is 15%
(38.6 % in 2002) of accumulated taxable income.
There is a safety valve for small corporations. Each non service corporation has a $
250,000 potential credit ($ 150,000 for service corporations) even though the company is
accumulating earnings for no worthwhile business purpose.
The accumulated earnings credit is the greater of (1) the current profits for the tax year
retained for the reasonable needs of the business [minus the net long term capital gain for
the year (net of income taxes)] less the accumulated earnings and profits at the close of
the preceding tax year or (2) excess or ($ 250,000 or $ 150,000 less the accumulated
earnings and profits at the close of the preceding tax year.
Additional safety valve. If a corporations funds are invested in the assets essential to the
needs of the business, the IRS will have difficulty taxing the accumulated earnings. The
challenge is in agreeing on what are the reasonable needs of the business. Bardahl
formula often used for this purpose.
Dividend distributions reduce the amount of accumulated taxable income. Dividends

paid during the year + 2 months from following year are deductible.
Mechanics of the penalty tax are shown on page 6-19. Review Illustrative Problem 6-45
Personal Holding Penalty Tax
The purpose of the personal holding penalty tax is to prevent high bracket taxpayers from
sheltering certain passive types of income in corporations that they own and control. The
PHC tax encourages the distribution of corporate earnings to shareholders.
Certain types of corporations are excluded from PHC status: (e.g. tax exempt
organizations, life insurance companies, foreign corporations, small business investment
corporations).
Two tests cause a corporation to fall within the PHC provisionsmust meet both tests:
Was more than 50% of the value of the outstanding stock of the corporation owned
directly or indirectly by five or fewer individuals at any time during the last half of the
tax year? 9 or fewer shareholders automatically meet this test. 544 provides attribution
rules. (see page 6-23)
21
Is a substantial portion (60% or more) of corporate income (AOGI) composed of passive
income (PHCI) such as dividends, interest, rents, royalties, and personal service
contracts? PHCI AOGI 60%
Figure 6-3 on page 6-24 describes the calculation of AOGI
Although rental income is normally PHCI it can be excluded if two tests are met:
Adjusted income from rents 50% + of AOGI

Dividends Paid 10% (Non-rent PHCI 10 % of OGI)
Calculation of the PHC tax: 15% of Undistributed Personal Holding Company Income.
Review Figure 6-4 on page 6-27
Review Illustrative Problem 6-59 (Quail)
22
Chapter 7
Corporations: Reorganizations
Initial Observations
Tax-free reorganizations are a form of nontaxable exchange. No gain or loss is

recognized to the security holders of the various corporations involved in a tax-free
reorganization in exchange for the stock or securities. If they receive other property
(boot), gain is recognized to the extent of the lesser of the gain realized or the boot
received. For stockholders the gain can be dividend income to the extent of earnings
and profits, then capital gain. If the shareholder can show that the redemption
qualifies on 302, all of the gain is capital. Debt holders recognized capital gain to the
extent the principal amount of the securities is greater than the principal amount of the
securities given up.
368 requires the following:
There must be a plan of reorganization.
The reorganization must meet the continuity of interest test. The test requires
shareholders of the target corporation to receive acquiring corporation stock equal to at
least 50% of their prior stock ownership in the target corporation. If the continuity of
interest requirement is met at the time of the reorganization, a sale of stock to an
unrelated party immediately before or after the restructuring will not destroy the
continuity of interest.
The reorganization must also meet the continuity of business enterprise test. The
corporation must either (1) continue in the targets historic business or (2) use a
significant portion of the targets assets in business.
The restructuring must meet the judicial doctrine of having a sound business purpose
economic consequences germane to the business that go beyond the mere avoidance of
Federal taxes. The corporations business purpose should be paramount.
The court-imposed step transaction doctrine should not apply to the reorganization.
Gain or loss generally is not recognized to the corporations involved in reorganization.

Exceptions: (1) A target fails to distribute other property or its own appreciated property
to its shareholders and (2) acquiring corporation recognizes gain or loss when it
transfers non-cash boot to the target shareholders.
The Basis RulesReview Concept Summary 7-1 on page 7-5 and Concept Summary 7-2
on page 7-8. then Concept Summary 7-3 on page 7-9.
23
Types of Tax Free Reorganizations
Each type has an identifying letter.
368 (a)(1)(A)Statutory Merger or Consolidation

368 (a)(1)(B)---Exchange of Voting Stock for Stock
368 (a)(1)(C)---Exchange of Assets for Voting Stock
368 (a)(1)(D)---Divisive Exchange [spin-off, split-off, split-up]
368 (a)(1)(E)---Re-capitalization
368 (a)(1)(F)---Mere Change in Identity, Form, or Place of Organization
368 (a)(1)(G)---Statutory Transfer of Assets in Bankruptcy or Receivership
Proceeding
Type A Mergers and Consolidations (Figure 1, Page 7-10)
There is no need that the consideration be voting stock.
Money or property exchanged will not cause the reorganization to be taxable if the
continuity of interest test is met. [at least 50% of the consideration must be stock].
The money or other property transferred to the target corporation will be boot and be
taxable; but its receipt will not destroy the tax-free treatment of receiving stock as
consideration.
The A reorganization turns on state level requirements; therefore compliance with state
law requiring mergers and consolidations is necessary to perfect the acquisition. This can
cause problems regarding dissenters rights, required shareholders meetings and voting.
In addition the acquiring corporation as a matter of law assumes all liabilities of the
acquired corporation. Review Figure 7-1 on page 7-11
A subsidiary can be the acquiring corporation. The subsidiary will issue its parents stock
to shareholders of the merged corporation to maintain control over the subsidiary.
However the subsidiary will assume the liabilities of the acquired corporation and the
assets of the parent will be protected. Further since the parent is the majority shareholder
of the parent there is no need to secure the approval of the shareholders. No subsidiary
stock can be used in this type of reorganization. .
24
Type B reorganization
Acquisition by one corporation of the controlling stock of another by using voting stock
as the sole consideration. Stock of the target must be acquired from the target
corporation or from its shareholders as long as there is ultimately 80% control after the
reorganization. The acquiring corporation may use no other consideration but voting
stock. If the acquiring corporation is a subsidiary, it must use the voting stock of the
parent. Review Figure 7-2 on page 7-12.
Review Illustrative Problem 7-20 c, d, f, k
Type C reorganization
Acquisition of substantially all of the assets of the acquired corporation in exchange for
the voting stock of the acquiring corporation.
A transaction will not qualify as a C reorganization unless the acquired corporation

distributes the stock, securities, and other properties it receives in the reorganization as
well as any other property it retains. The target must liquidate after the distribution.
Review Figure 7-3 on page 7-14. Review Illustrative Problem 7-20 g, i.
Consideration in the C reorganization normally consists of the acquiring corporations

voting stock. Cash and other property do not disrupt C status if at least 80% of the
FMV of the targets property is obtained with voting stock. When the acquiring
corporation gives solely voting stock for the target corporations assets, the target
corporations liabilities assumed by the acquiring corporation are not considered boot in
the exchange. However, liabilities received by the acquiring corporation are considered
other property if the target corporation receives any property (usually cash) other than
voting stock.
Review Illustrative Problems 7-20 h, 24 & 25
D Reorganizations
Acquisitive D Reorganization Requirements
Substantially all of the property of the acquiring corporation must be transferred to the
target corporation.
The acquiring corporation must obtain control (50%) of the target.
The acquiring corporation must liquidate.
25
Transaction may also meet the C requirement, if so; it is treated as a D
reorganization. Review Figure 7-4 on page 7-16.
Divisive D Reorganization Requirements
The stock received by the original corporation must constitute control (80%) of the new
corporation(s).
The stock of the new corporation must be distributed to shareholders of the original
corporation.
Both the assets transferred and those retained by the original corporation must represent
active businesses that have been owned and conducted by the original corporation for at
least five years before the transfer.
The distributions of stock and securities to the shareholders cannot be a device for
distributing the earnings and profits of either the original corporation or the controlled
corporation.
Spin-Offs, Split-Offs, and Split-Ups
Review Figure 7-5on page 7-18 and Figure 7-6 on page 7-19.
Review Illustrative Problem 7-20 a, l & 7-29, 30
Other Reorganizations
Type E reorganizationa recapitalization, a major change in the character and amount

of stock and paid-in capital of a corporation.
Type F reorganizationA mere change in identity, form, or place of organization.
Type G reorganizationA transfer of substantially all of the assets of a debtor, under

court approved reorganization in bankruptcy, receiverships, and foreclosures, to an
acquiring corporation.
Review Illustrative Problem 7-20 b, j and Problem 7-32 and Concept Summary 7-4 on
page 7-23
381--Carryover of Tax Attributes
381 lists tax features of an acquired corporation which are carried over to the
successor. 381 applies to A,C,F, non-divisive D, and G
reorganizations. The B and E reorganizations were omitted since in both
cases the corporation continues exactly as before only with changed ownership. There is
no need for specific rules for carryovers, since the carryovers occur automatically. The
divisive D was omitted since the transferor stays in existence and continues an active
business. The transferor maintains all carryovers and the controlled corporation are
considered a new entity.
26
NOL carries are subject to limitations under 382. These limits are highly complex
and beyond the scope of this course.
E & P of an acquired corporation carries over to a successor corporation. A deficit

in E & P can only be carried over to offset E & P accumulated after the date of the
transfer. Capital loss carryovers have the same limitations as NOLs.
For depreciationcost recovery methods, installment method of reporting, and

credit carryovers, the acquiring corporation uses the method of accounting used by
the acquired corporation. Review Concept Summary 7-5 on page 7-30. Review
Illustrative Problem 7-38.
27
Chapter 8
Consolidated Return Rules
Context of Consolidated Return Rules
More than 90% of all corporate returns filed in the US are for closely-held corporations,
but the vast majority of assets are hold by corporations eligible to file on a consolidated
basis.
Consolidated returns allow the taxpayer to offset the taxable gains of one member of
the group against the operating income of another. Consolidated returns can result
when a merger or a consolidation is completed. Affiliated groups can be mandated by
regulation of constructed to take advantage of financial or market share considerations.
Congress has delegated to the Treasury most of the details of the consolidated return
rules, so that this area of the Regulations represent some of the longest and most complex
comprehensive rules in the tax law. However, for the most part the underlying
purpose of the rules remains one of organizational neutrality. When a group of
closely related corporations computes its overall tax liability, no tax advantage or
disadvantage should result to those who file separate returns.
Concept Summary 8-1, Page 8-7 provides a helpful summary advantages and
disadvantages of consolidation.
Electing Consolidated Return Status
Only an affiliated group (parent-subsidiary relationship) can file a consolidated tax

return. Multiple tiers and chains of corporations are allowed as long as the group has an
identifiable parent. Note that parent must have 80% of the voting power and value of the
stock of the subsidiary. Review example 7 on page 8-9. Members of an affiliated group
can file tax returns in either of two ways:
File a separate tax return for each member of the group and claim a 100% dividends
received deduction for payments passing among them.
Elect to file income tax returns on a consolidated basis. No 100% dividends received
deduction is allowed for payments among group members. Do Problem 8-26
Table 8-1 on page 8-10 enumerates other tax choices available to the affiliated group.
Study it carefully. Knowing the financial statement consolidated rules is not helpful.
Review Illustrative Questions 8-12, 14, 15, Problem 8-38
28
Eligibility for the Consolidation Election
The most commonly encountered corporations that ineligible to file a consolidated return
include:
Non US corporations
Tax exempt corporations
Insurance companies
Partnerships, Trusts & Estates, and special entities
Compliance Requirements
The initial consolidated return must be filed in lieu of the members separate return. In
addition, Form 1122 must be attached to the consolidated return, carrying the consents of
all of the group members to the consolidated election.
A consolidated election must be made no longer than the extended due date of the
parents return for the year. An application to terminate the consolidation election must
be filed at least ninety days prior to the extended due date of the anticipated consolidated
return. Generally when a corporation leaves a consolidated group it must wait five years
before it can reenter the group.
Each consolidated return must include Form 851, an affiliations schedule, detailing
shareholdings and stock ownership changes that occurred during the year and estimated
tax payments for the group.
Consolidated returns are due on the fifteenth day of the third month following the close
of the groups tax year. Group members are jointly and severally liable for the entire
consolidated tax return liability. Commencing with the third consolidated return year,
estimated tax payments must be made on a consolidated basis.
Benefits accruing from the graduated corporate tax rates are apportioned equally among
the group members, unless all members consent to some other method through an annual
election.
All members of a consolidated group must use the parents tax year. Differences
among group members are allowable with respect to tax accounting methods.
29
Stock Basis of Subsidiary
Basis = Acquisition Price + Positive Adjustments Negative Adjustments
Positive Adjustments
An allocable share of consolidated taxable income for the year

An allocable share of consolidated operating or capital loss of a subsidiary that could not
utilize the loss through a carry-back to prior year.
Negative Adjustments
An allocable share of a consolidated taxable loss for the year.

An allocable share of any carryover operating or capital looses that are deducted on the
consolidated return and have not previously reduced stock basis.
Dividends paid by the subsidiary out of E & P.
Note that the stock basis calculations use an equity method approach. Do Problem 8-32a
Computing Consolidated Taxable Income
Calculate using Figure 8-2 on page 8-20.
Calculate taxable income for each member of the group as if it were a separate
entity.
Isolate group items, and deferral/restoration events for inter-company items and
determine their treatment in consolidation.
Combine the remaining separate income items with the group/restoration items
for each member of the group from step 2. The combined result on the tax return
will reflect that portion of each group item taken into income or available as a
deduction in consolidation. The deferral/restoration items along with the 100%
dividends received deduction for inter-company dividends are treated as
eliminations.
Determine the consolidated taxable income, consolidated income tax, and
consolidated balance due/refund.
Review Assignment D
30
Group ItemsSeveral taxable income items are computed on a consolidated basis. Thus
they are removed from the members separate taxable incomes and computed using
aggregate values. The most commonly encountered of the group items are:
Net capital gain/loss

1231 gain/loss
Casualty/theft loss
Charitable contributions
Dividends received deduction
Net operating loss
AMT liability
For a special class of inter-company transactions, any realized gain/loss is removed from
consolidated taxable income and held in suspense until a restoration event occurs.
Generally the restoration event is a sale of an asset outside the group or termination of the
consolidation election.
Restoration events also include the claiming a cost recovery deduction by the acquiring
member or the write-down of the assets inventory cost. Upon an occurrence of the
restoration event, asset basis and holding period start over.
An election is available to permit immediate recognition of gain/loss. Asset basis and
holding period commence with the date of purchase.
Review Assignment C
Members Net Operating Losses
Limited by 381 and 382 See Figure at bottom of page 8-23 and Figure 8-3, Page 8-24
IRS can reallocate under 269 & 482
Do Problems 8-33, 34
Carry-back 2 years and carry-forward 20 years, with an election to carry-forward.

NOL calculated after removing charitable contributions and capital loss deductions.
When an NOL is carried forward from a separate return year into a consolidated
return year, the SRLY rules apply. The consolidated return can include a NOL carry-
forward from a SRLY period only to the extent of the lesser of its (a) current year or (2)
cumulative positive contribution to current-year consolidated taxable income.
31
Chapter 10
Partnerships: Formation, Operation and Basis
Overview of Partnership Taxation
Generally partnerships are not treated as separate tax entities for Federal income tax
purposes. All items of income, gain or loss, deduction or credit are passed through to the
partners according to the partnership agreement. Each partners distributive share of
partnership income and expense is reported on the partners separate return.
Partnership income is subject to only one level of taxation. The Internal Revenue Code
ensures this result by increasing a partners basis by income allocated to the partner and
decreasing it by losses allocated to the partner.
Two conflicting concepts govern partnerships:
Under the entity concept a partnership is considered to be an independent entity, separate

and apart from the aggregate of its partners. Examples of its influence can be found in
the fact that the partnership makes most tax accounting elections.
Under the aggregate or conduit concept, a partnership is a common pool to which each
partner contributes capital or services in the pursuit of profit. As such it is a channel
through which income, deductions, gains, losses, and credits flow through to the partners.
For example partnerships are generally not subject to Federal income taxation.
Formation of a Partnership
721 provide that a partnership and partners do not recognize gain or loss from the
contribution of property in exchange for a partnership interest. The basis of a
partnership interest acquired in exchange for money and other property equals the
cash exchanged plus the partners adjusted basis in the other property contributed.
The non-recognition provision of 721 is a deferral rather than a tax reduction provision.
The partner takes a substituted basis in his partnership interest, and the partnership takes
a carryover basis in the assets it receives. Any built in gain or loss is deferred until later
disposal of the property or the eventual termination of the partnership.
If a partnership interest is received for services, the non-recognition rule of 721

does not apply. Instead the partner receiving the interest is required to recognize its
fair market value as ordinary income (compensation for services).
32
Recognition of attributable gain upon contribution also occurs:
when recourse liabilities associated with the contributed assets that are
assumed by other partners, exceed the contributing partners basis in those
assets.
when partnership assets are distributed to other partners as an exchange.
when contributed appreciated assets are distributed to other partners within five
years of the contribution date.
when other assets are distributed to the contributing partner within five years of
the contribution date and certain other conditions apply.
when a contribution followed by a distribution is viewed as a disguised sale.
Review Illustrative Problem 10-18 (omit f), 19
The holding period for the contributed property carries over to the partnership. If
depreciable property is contributed, the partnership is usually required to use the
same recovery method and life used by the partner.
Inside and Outside Basis
Two important definitions in partnership taxation. Inside basis refers to the

adjusted basis of each partnership asset, as determined from the partnership tax
accounts. Outside basis represents each partners basis in the partnership interest
the tax basis on the individual partners books.
Tax Accounting Elections
Most partnership elections are made by the partnership entity. Examples include
choosing the partnerships method of accounting, taxable year, inventory methods, cost
recovery methods, amortization periods, optional basis adjustments ( 754 election), and
179 elections.
A partnership can elect to amortize partnership organization and start-up costs over sixty
months beginning with the month that the partnership began business.
Intangible assets may be categorized as 197 assets amortizable over 15 years or non
197 assets (syndication costs, see page 10-17) which usually are not amortizable.
To be amortizable the cost must be paid or incurred by the due date of the tax return for
the first year. Cash method partnerships must amortize costs incurred but not paid
beginning in the second tax year (2 tax years amortization)
33
Partnership Operations
Measuring and Reporting Income
Form 1065 measures and reports the transactions for the tax
year. Schedule K reports each of the partnerships tax items
first, a non-separate amount (netted as ordinary income), then
the separate amounts. Page 10-21 shows a list of these separate
items, but it is easier to think of them as items that special treatment
on the partners income tax return. Note: 1231 gain is a separately
stated item, while 1245 gain is ordinary income.
Withdrawals do not normally affect the Schedule K items and are reported at the
end of the tax year. They are usually non-taxable, but can be taxable if they are in
excess of the partners tax basis (see Chapter 11). The withdrawals are treated as
distributions as of the last day of the tax year.
Partnership Allocations
The partnership agreement can provide that any partner may share capital, profits, and
losses in different ratios. The economic effect test is designed to prevent manipulation of
the allocations. The principal features are as follows:
An allocation of income or gain must increase a partners capital account, and an

allocation of deduction or loss must decrease the partners capital account.
When the partners interest is liquidated, the partner must receive assets that have a
fair market value equal to the positive balance in the capital account.
A partner with a negative capital balance must restore that account upon
liquidation of the interest. Restoration of a negative capital account can best be
envisioned as a contribution of cash to the partnership equal to the negative
balance.
Pre-contribution gain or loss must be allocated among the partners to take into account
the variation between the basis of the property and its fair market value at the date of the
contribution. For non-depreciable property the built in gain or loss allocated to the
contributing partner upon disposal of the asset or termination of the partnership.
For depreciable property specific allocation rules describe how the depreciation is to be
allocated among the partners. (We review these in Acc 432)
34
Basis of Partnership Interest
Figure 10-3, page 10-33 illustrates the calculation of outside and inside partnership
basis. Note that for determining the overall limit of losses, a partners basis is
determined at the end of the partnership taxable year. It is adjusted for
distributions and any partnership gains but not consider any losses during the year.
Under the at-risk rules, the partners loss is limited to the partners basis. The loss
may also be limited by the passive activity rules. At risk amounts include recourse
and qualified non-recourse debt. Calculation of the loss limit takes the following
pattern: Outside basis, then at risk amounts, then passive activity amounts.
Review Illustrative Problem 10-25, 29, 30 (omit e), 34, 35, 36
Transactions Between Partner & Partnership
Guaranteed Paymentspayments for services performed by the partner or for the use
of the partners capital. The payment may not be determined by reference to partnership
income. The nature of the payment determines whether the payment is a deduction or a
capital expenditure. The recipients must report guaranteed payments separately. They do
not increase the partners basis.
Sales of PropertyNo loss is recognized on a sale of property between a person and a

partnership when the person owns directly or indirectly more than 50% of the
partnership property or capital; any gain is ordinary income unless the asset is a capital
asset to both seller and purchaser.
35
Chapter 11
Partnerships: Distributions, Transfer of Interests, and Terminations
Distributions From a Partnership
Liquidating Distribution(1) when a partnership itself liquidates and distributes all of

its property to its partners or (2) when an ongoing partnership redeems the interest of one
of its partners (retirement or death of a partner).
Non-liquidating distributionany distribution from a continuing partnership to a

continuing partner. Two typesdraws (distribution of partners share of current or
accumulated partnership profits that have been taxed to the partner in current or prior
taxable years of the partnership) and partial liquidation (distribution that reduces the
partners interest in partnership capital but does not liquidate the partners entire interest
in the partnership). Basic tax treatment of both types is the same.
Proportionate DistributionsA partner receives an appropriate share of certain

ordinary income producing assets of the partnership. A disproportionate distribution
occurs when the distribution increases or decreases the distributee partners interest in
certain ordinary income producing assets.
Proportionate Non-liquidating Distribution
Under 731 (a)(1) neither the partner nor the partnership recognized gain or loss when a
proportionate non-liquidating distribution occurs. However, a partner recognizes gain
from a non-liquidating distribution to the extent that the cash received exceeds the
outside basis of the partners interest in the partnership. The nature of the gain is
determined by whether or not the partnership owns hot ( 751) assets. The partner
usually takes a carryover basis for the assets distributed [ 732 (a)(1)]. Review Concept
Summary 11-1 on page 11-10. Note the treatment of losses and the ordering rules. The
calculations begin with the partners outside basis.
Cash
Unrealized receivables and inventory
All other assets
Review Illustrative Problems 11-15 & 17
36
Property Distributions
In general a distributee partner does not recognize gain from a property distribution. If
the basis of property distributed by a partnership exceeds the basis in the partnership
interest, the distributed asset takes a substituted basis. When more than one asset in a
particular class is distributed special rules apply. Discuss the three step process on page
11-8. Review Illustrative Problem 11-19.
Proportionate Liquidating Distributions
736--Proportionate liquidating distributions consist of a single distribution or a series of

distributions that result in the termination of the partners entire interest in the
partnership. Partnership does not recognize gain or loss. Concept Summary 11-2 on page
11-13 summarizes the rules for allocation of basis and possible gain/loss recognition by
the partners. Note: (1) partners entire basis is allocated to the assets received unless the
partner is required to recognize a loss. A loss may be recognized when only cash,
unrealized receivables or inventory is received in the distribution. (2) The calculations
begin the partners outside basis. Under the ordering rules, the basis of some assets may
be adjusted upwards or downwards to absorb the partners remaining outside basis.
Unrealized receivables and inventory are never stepped up although they may be
stepped down.
The ordering rules are as follows:
Cash (capital gain on any excess over basis)

Unrealized receivables and inventory (apply to remaining basis)
Other Assets
The distributee partner may recognize loss on the liquidation if (1) the partner receives
only cash, unrealized receivables or inventory and (2) the partners outside basis exceeds
the partnerships inside basis for the assets distributed.
Review Illustrative Problems 11-24, 25, 26 & 27
Property Distributions with Special Tax Treatment
Disguised SalesTaxable sale or exchange rules apply.

Marketable Securitiesgenerally treated as a cash distribution at
FMV. However, not cash if contributed by the partner who now receives the
distribution or (in general) the property has appreciated in value.
Precontribution gainrecognized by the contributing partner if the property is
distributed within 7 years to a non-contributing partner. Also if the
partnership distributes any property other than cash to a partner within seven
years after that partner contributes appreciated property to the partnership.
37
Disproportionate Distributions
Partnership makes a distribution of cash or property to a partner and that distribution

increases or decreases the distributee partners proportionate interest in certain of the
partnerships ordinary income producing assets ( 751 assets or hot assets). 751
assets include unrealized receivables and substantially appreciated inventory (i.e. all
assets that are not cash, capital or 1231 assets). Substantially appreciated inventory is
inventory that has a FMV is excess of 120% of the partnerships adjusted basis in the
inventory. Substantially appreciated inventory also includes depreciation recapture.
751 (b) maintains each partners proportionate share of ordinary income by recasting
any transaction in which a disproportionate distribution of hot assets is made. If the
distributee partner receives less than a proportionate share of hot assets, the transaction
is treated as two separate events occurred: (1) the partnership made a distribution of
some of the hot assets to the distributee partner, and (2) that partner immediately sold
these hot assets back to the partnership. The partner recognizes ordinary income on the
sale of the hot assets, and the partnership takes a cost basis for the hot assets purchased.
Liquidating Distributions to Retiring or Deceased Partners
736 classifies payments made by an ongoing partnership in complete liquidation of a

retiring or deceased partners interest as either income [ 736 (a)]going concern value
or property [ 736 (b)] paymentsasset value.
736 (a) payments are treated as a partners distributive share of partnership income or
alternatively as a guaranteed payment to the retiring partner. If the amount is (1) a
distributive share, the remaining partners report a lesser share of partnership income; if
the amount is a guaranteed payment, the partnership deducts the guaranteed payment.
Property payments (normally covered by 736 (b)) by a service oriented partnership to a
general partner are 736 (a) payments and are ordinary income.
All payments not categorized as 736 (b) property payments are categorized as 736 (a)
income payments. Payments that are determined by reference to partnership income are
treated as distributive shares of that income (i.e., an allocation of partnership income for
the year). They are taxed to the distributee partner according to their character to the
partnership. Payments that are not determined by reference to partnership income are
treated as guaranteed payments.
736 (b) payments are cash distributions paid by the partnership to the partner in
exchange for the partners interest in the partnership assets. The partnership may not
deduct these amounts. If the partnership no hot assets, the normal distribution rules apply
(Concept Summary 11-2). If the partnership owns 751 assets, property payments to the
38
partner are allocated between cash payments for the partners share of (1) hot (ordinary
income) assets and other (capital gain/loss) assets.
736 (b) payments for non hot assets are treated first as a return of the partners
outside basis in the partnership. Once the entire basis is returned any additional amounts
are taxed as capital gains.
If part of the property payment is for the partners share of hot assets, the 736 (b)
payment is allocated between the portion related to hot assets (treatment described
below) and the portion related to other assets (described in the preceding )
First, the partners proportionate share of hot assets is deemed to be distributed. A

partner cannot step up the basis in hot assets, so on the distribution, the hot assets take the
lesser of the partnerships inside basis for the hot assets or the partners outside basis in
the interest.
Second, these hot assets are deemed to be sold back to the partnership at FMV. A
portion of the 736 (b) payment is allocated to the partnerships deemed purchase of the
hot assets.
Review Illustrative Problem 11-32, 34
Sale of a Partnership Interest
Generally the sale or exchange of a partnership interest results in gain or loss, measured
by the difference between the amount realized and the selling partners adjusted basis the
partnership interest.
LiabilitiesMust consider the selling partners share of the liabilities in computing the
amount realized and the adjusted basis.
When a partner sells the entire interest in the partnership: (1) income for the partnership
interest for the tax year is allocated between the buying partner and the selling partner.
The partners tax year closes with respect to the selling partner.
There are two acceptable methods of determining the partners share of the income: (1)
pro-ration of annual income, (2) interim closing of the books.
The partnership is not required to issue a Schedule K-1 to the selling partner until the
normal filing of the return. Partners who sell or exchange a partnership interest must
promptly notify the partnership of the transfers. After notification the partnership may be
required to file an information statement with the IRS for the calendar year in which the
transfers took place.
39
Effect of Hot Assets on the Sale
Amount realized from the sale of a partnership interest attributable to unrealized

receivables or inventory is being treated as being a sale of a non-capital (i.e.
ordinary) asset. Unrealized receivables include 0- basis receivables and
depreciation recapture. Inventory includes all partnership property except money,
capital assets and 1231 assets. (e.g. A/R for an accrual basis partnership is
inventory. Review Concept Summary 11-4 on page 11-27.
Review Illustrative Problem 11-33 (a thru d)
Other Dispositions of Partnership Interests
Review list on page 11-27
Optional Adjustments to Property Basis
Because the value of assets sold can differ from their inside basis. In such cases a
discrepancy exists between the purchasing partners outside basis and that partners share
of the inside basis of partnership assets. If the partnership makes an optional basis
adjustment election ( 754 election), the inside basis of the partnership property can be
adjusted to reflect the price paid by the partner. If the election is not made the results
may be inequitable. The nature of the adjustment depends on whether it is a sale or
exchange of an interest or a partnership distribution.
Under 743 (b)Sale or Exchange Treatment
Transferees outside basis in the partnership $ xxx

Less: Transferee share of the inside basis of all
partnership property (xxx)
Adjustment $ xxx
Review Illustrative Problem 11-33 e
Under 734 (b)Property Distributions
The basis is increased by: (1) any gain recognized by the distributee partner and (2) the
excess of the partnerships adjusted basis for any distributed property over the adjusted
basis of that property in the hands of the distributee partner.
The basis is decreased by: (1) any loss recognized by the distributee partner and
(2) in the case of a liquidating distribution, the excess of the distributee partners
adjusted basis of any distributed property over the basis of that property to the
partnership.
40
Termination of a Partnership
A partnerships final tax year ends when:
No part of the business to be carried on by any of the partners in the partnership.

Within a 12 month period, there is a sale or exchange of 50% or more of the
partnerships capital and profits.
41
Chapter 12
S Corporations
Qualifications for S Corporation Status
Domestic Corporation
Eligible Corporationnot foreign, banks, insurance companies, Puerto Rico
& possession corporations. 100% ownership of C Corporations is ok, as are
qualified S Corporation subsidiaries.
One Class of Stock
Maximum of 75 shareholders
Shareholders must be individuals, estates and certain trusts
No non resident aliens
Making the Election
Must file on a timely basis (all shareholders consent) a Form 2553. For S corporation
status to apply to the current tax year, the election must be filed either in the previous
year or before the fifteenth day of the third month of the current year. The shareholder
consent must be in writing, and it must generally be filed by the election deadline.
Loss of the Election
Shareholders owning a majority of share voluntarily revoke the election.

A new shareholder owning more than one-half of the stock affirmatively refuses to
consent to the election.]
The corporation no longer qualifies as a small business corporation.
The corporation does not meet the PII limitation. (see page 12-12)
Voluntary revocation requires the consent of shareholders owning a majority of shares on

the day that revocation is to been made. (2 mo. 15 day rule applies). Failure to qualify at
any time immediately revokes the election.
Corporation must generally wait five years before re-electing S Status.
Operational Rules
Computation of Taxable IncomeReview Figure 12-1 on page 12-12 and list of

separately stated items on page 12-13. Note the ordinary income is not subject to SE tax.
Allocation of Income and LossReview diagram on page 12-14.
42
The Short-Year Election; first year ends with the termination of a shareholders interest,
second year with the close of the normal tax year.
Tax Treatment of Distributions to Shareholders
Distributions--No Accumulated Earnings and Profits from C Corporation
The usual situationDistributions are a tax-free recovery of capital to the extent that it
does not exceed the shareholders adjusted basis in the stock of the S corporation. Any
excess is capital gain.
Accumulated Earnings and Profits from C Corporation YearsSpecial account

(called the accumulated adjustments account or AAA) keeps track of undistributed
earnings that have been previously taxed to the shareholders since 1982. A similar
account (called the other adjustments account or OAA) tracks untaxed earnings and
related disallowed deductions. Review Exhibit 12-1 on page 12-17.
Distributions of C corporation Earnings and Profits--taxed as dividends while S

corporation earnings are tax free to the extent of the shareholders adjusted basis in the S
corporation stock. Note that AAA and OAA can have negative balances.
Concept Summary 12-1 describes the ordering rules where (1) No E & P exists [right
column] and (2) E & P exists. Note the By-pass election which permits the corporation to
by pass AAA and pay E & P first.
Schedule M-2
Schedule M-2 reports changes in AAA and in OAAA. Review Question 12-7
Tax Treatment of Property Distributions by an S Corporation
An S corporation recognizes a gain on any distribution of appreciated property (other

than reorganization) in the same manner as if the asset had been sold to the shareholder at
its fair market value. The corporations gain is passed through to the shareholder.
The S corporation does not recognize a loss when distributing assets that are worth less
than their basis. As with gain property the shareholders basis is equal to the assets fair
market value. Review the general rules for S corporations, C corporations and
partnerships shown in Concept Summary 12-2 on page 12-20.
43
Fringe Benefit Rules [Not Discussed in Hoffman Text]
The S Corporation is not treated as a corporate taxpayer with respect to many fringe
benefits paid to any >2% shareholder. Instead the S Corporation is treated the same as a
partnership and the >2% shareholder is treated as a partner in such partnership. Because
of this restriction many fringe benefits paid to >2% shareholders are treated as
compensation to the shareholder are deductible by the corporation if the benefit is not
excludable from the shareholders gross income. Shareholders owning 2% or less of the
S corporation stock are treated as ordinary employees.
The special fringe benefit rules apply only to statutory fringe benefits:
79 group term life insurance premiums

105 & 106 accident and health benefit plan insurance premiums and payments
119 meals and lodging furnished by the employer
125 cafeteria benefit plans
132 employer-provided parking
Fringe benefits excluded from compensation income include:
104 compensation for injuries and sickness

127 educational assistance program benefits
129 dependent care assistance program benefits
132 no-additional cost benefits, qualified employee discounts, working condition fringe
benefits, de-minimis fringe benefits and on-premises athletic facilities.
For purposes of 162 (l) [deduction for AGI for self-employed taxpayers health
insurance premiums], a >2% shareholder is considered self-employed.
Shareholder Basis
Initial basis follow 351 concepts.
Upward basis adjustments include:
further stock purchases.

non-separately stated computed income. Line 1, Schedule K
separately stated income
depletion in excess of basis
Downward basis adjustments include:
non-deductible expenses
non-separately state loss. Line 1, Schedule K
separately stated loss and deduction items.
distributions not reported as income.
44
The basis rules for an S corporation are similar to the rules for determining a partners
interest basis in a partnership. Except for loans from a shareholder to an S corporation,
corporate borrowing has no effect on shareholder basis. These shareholder loans have a
tax basis only for the shareholder making the loan.
If a loans basis has been reduced and is not restored, income is recognized to the
shareholder when the S corporation repays that shareholder.
Review Illustrative Question 12-10 Problems 12-21, 24, 25, 26
Treatment of Losses
Net Operating LossDeductions for an S corporations NOL-pass through cannot exceed

a shareholders adjusted basis in the stock plus the basis of any loans made by the
shareholder to the corporation.
A shareholders share of an NOL may be greater than both stock basis and loan basis. A
shareholder is entitled to carry forward a loss to the extent that the loss for the year
exceeds basis. Any loss carried forward may be deducted only by the same shareholder if
and when the basis in the stock of or loans to the corporation is restored.
Review Illustrative Problem 12-35 Note the order in which income, distributions
and losses appear).
At Risk RulesA shareholder is usually considered at risk with respect to an activity to

the extent of cash and the adjusted basis of other property contributed to the S
corporation, any amount borrowed for use in the activity for which the taxpayer has
personal liability for payment from personal assets, and the net FMV of personal assets
that secure non-recourse borrowing.
Passive Losses and Credits-- 469 provides that net passive losses and credits are not
deductible when incurred and must be carried over to a year when there is passive
income. A shareholders stock basis is reduced by passive losses that flow through to the
shareholder, even though the shareholder may not be entitled to a current deduction due
to the passive loss limitations.
Tax on Pre-Election Built in Gain ( 1374 tax)
The built in gains tax is applied at the highest corporate rate (35%) for C corporation
unrealized gains attributed to appreciated assets contributed to an S corporation. The tax
is applied to the lesser of recognized built in gains or taxable income computed as a C
corporation. Any remaining built-in gain is carried forward. Built-in gains can be offset
by C corporation NOLs and capital losses. Note that the tax only arises if an S
corporation has previously been a C corporation. The 1374 tax relates to recognized
45
gains for a ten period after conversion. Recognized built in losses can offset built in
gains in certain circumstances.
Review Illustrative Problem 12-31 a
Passive Investment Income Penalty Tax ( 1375)
The tax is imposed on the excess passive investment income of S corporations that have
(1) previously been C corporations and (2) have earnings and profits. The tax is applied at
the highest corporate rate (35%). The rate is applied to excess net passive income
(ENPI) and is limited to C corporation taxable income before special deduction.
ENPI = [passive investment income 25% gross receipts] passive investment

income
Other Rules
S corporation taxed as a C corporation in some states; many states require withholding

for non-resident shareholders. Composite returns are often available for non-resident
shareholders.
Any family members who render services or furnish capital must be paid reasonable
amounts. Otherwise the IRS can make adjustments to clearly reflect the value of the
services or capital.
46
Chapter 14
Exempt Entities
Subchapter F ( 501-529, [ 401]) of the Internal Revenue Code deals with these
entities. An organization qualifies for exempt status only if it fits one of the categories
provided by the Code. Exhibit 14-1, page 14-4
describes the various types of exempt organizations. We will emphasize only a few
major categories: 501 (c)(1), (c)(3), (c)(4), (c)(6), (c)(7), & (d).
Note that contributions to certain specified organizations [e.g. 501 (c)(1), (c)(3), (d)]
qualify as a deduction.
These entities share common characteristics:
Serve some type of common good.

Not for profit [governmental] entity.
Net earnings do not benefit members/management of the organization.
Organization does not exert political influence. Lobbying prohibited.
Tax consequences of exempt status are discussed in Concept Summary 14-2 on page 14-
10.
Private Foundations
Those without broad public support can be subject to punitive taxes. Also there are limits
on deductions to private non-operating foundations.
Unrelated Business Income Tax (UBIT)
A major consideration in managing not for profit organizations; contingent liabilities can
be substantial. UBIT rates are those applied to a C corporation taxpayer. The tax is
applied against net income from activities not related to the organizations exempt
purpose. If the organization regularly conducts a trade or business, not substantially
related to the exempt purpose could be subject to UBIT.
Review Concept Summary 14-4, page 14-25. The exceptions to the tax are particularly
important. Note the special rules for corporate sponsorship payments and bingo games.
A payment qualifies as a exempt sponsorship payment if meets the following

requirements:
No arrangement or expectation that the trade or business making the payment will receive
any substantial benefit other than the use or acknowledgment of its name, logo, or
product lines in connection with the activities of the exempt organization.
47
Such use or acknowledgement does not include advertising the payors products or
services.
The payment does not include any payment for which the amount is contingent upon the
level of attendance at one or more events, broadcast ratings, or other factors indicating
the degree of exposure to one or more events.
Qualified bingo games are not a related trade or business if (1) the bingo game is legal
under both state and local law and (2) commercial bingo games are not normally
permitted in the jurisdiction. Review Illustrative Problem 14-49
The Tax Formula for Unrelated Business Taxable Income
Gross unrelated business income

Deductions
= Net unrelated business income
Modifications
= Net unrelated business taxable income
Review Illustrative Problem 14-44 (omit a), 45
Positive Adjustments: (1) charitable contributions > 10%, (2) net unrelated debt financed
income and (3) interest, annuity, royalty and rent income from a controlled organization.
Negative Adjustments: (1) net income from dividends, annuities, and rents, (2) net
royalty income (3) net rent income from real property and certain personal property
[leased with rental property & incidental], (4) gains and losses from the sale exchange or
other disposition of property except for inventory, (5) Net qualified research income (6)
charitable contribution deduction without regard to the unrelated trade or business and (7)
a specific deduction of $ 1,000.
Review Illustrative Problems 14-51, 53, 54
Reporting Requirements
Must have IRS approval for exempt status [Form 1023] for 501(c)(3) organizations,
Form 1024 for others.
File Form 990, 990A, or 990PF. Federal agencies, churches, organization with gross
receipts <= $25,000 do not have to file. Due date is 4 mos. and 15 days, with a 6 mo.
extension. Information from forms 990 and 1023 are available for public inspection.
Review Illustrative Questions 14-29, 30 & 32
48
Chapter 16
Tax Administration and Practice
Interest on Federal Tax Underpayments (Overpayments)
Congress sets the interest rates applicable to Federal tax underpayments (deficiencies)
and overpayments (refunds) close to the rates available in financial markets. The Code
provides for rates to be determined quarterly. IR interest is based on Federal Short- term
rates as published in Revenue Rulings (maturity 3 years or less).
For non corporate taxpayers the interest rate applicable to both overpayments and
underpayments is 4% for the first quarter of 2004. For most corporate taxpayers the
rate is 3% for overpayments and 4% for underpayments.
If an overpayment is refunded to the taxpayer within 45 days after the date the return is
filed or is due, no interest is allowed. When the taxpayer files an amended return or
makes a claim for refund of a prior years tax, interest is authorized from the original due
date of the return through the date when the amended return is filed.
Taxpayer Penalties
Failure to file by the due date (including extensions)--5% per month up to a

maximum of 25%, with a minimum penalty of $ 100. Note that application for an
automatic extension does not extend the due date for paying the estimated amount
of tax owed.
Failure to pay the tax due as shown on the return1/2% per month up to a
maximum of 25%. Obtaining an extension for filing a tax return does not by itself
extend the date by which the taxes due must be paid.
In all cases a fraction of a month counts as a full month. The failure to file and failure to
pay penalties relate to the net amount due. During any month in which both penalties
apply the failure to file penalty is reduced by the amount of the failure to pay penalty.
Review Illustrative Problem 16-27.
Accuracy Related Penalties (20 %)
Negligence or disregard of rules and regulations

Can be avoided if the taxpayer shows reasonable cause and acted in good faith. The
penalty applies to all taxes. Review Illustrative Problem 16-30
49
Substantial understatement of tax liability
Penalty applies when the understatement exceeds the larger of 10 percent of the tax
due or $ 5,000. Penalty can be avoided if that taxpayer has substantial authority;
has a reasonable basis for his/her position; has adequately disclosed his/her position
on Form 8275 or IRS has not borne its burden of proof.
Penalty for overvaluationinflated value of charitable contributions.

Penalty applies only when the valuation (basis) used is 200% or more of the correct
valuation (basis) and is doubled if the valuation (basis) is 400% or more. Penalty
applies only to the extent that the resulting income tax underpayment exceeds $ 5,000
($10,000 for C corporations). Rate is 20% of the additional tax that would have been
paid had the correct valuation (or basis) been used.
Penalty can be avoided if the taxpayer can show reasonable cause and good faith. For
charitable deduction property taxpayer must rely on valuation of qualified appraiser and
make good faith investigation of the value.)
Review Illustrative Problem 32-e
Penalty for undervaluationestate and gift taxes
Penalty applies only if the value of the property claimed on the return is 50% or less than
the amount determined to be correct. The penalty is doubled if the reported value is 25%
or less than the correct determination. Applies only to an additional transfer tax liability
in excess of $ 5,000. Review Illustrative Problem 33-c
Other Penalties
Civil fraudmanipulation of books, substantial omissions from income and erroneous

deductions. Penalty is 75% of any understatement
Criminal Penaltieswillfulness on the part of the taxpayer. Differs from civil fraud
penalties in degree. Fine of $100,000 or up to five years in prison.
Failure to pay estimated taxes
Based on the rate of interest in effect for deficiency assessments.

Not imposed if the net tax due for the year is less than $ 500 for corporations and $ 1,000
for individuals.
50
Underpayment of estimated tax = difference between estimated that were paid and
the least of (1) 90% of the current year tax, (2) 100 % of the prior-year tax and (3)
90% of the annualized income through each quarter. Prior year income test (2)
increases to 112% if AGI is greater than $ 150,000. Corporate rules are similar in
most cases to individuals except that prior year tax must be greater than 0.
False Information with Respect to Withholding-Civil Penalty of $ 500, criminal fine $

1,000 and/or up to one year in prison
Failure to Make Deposits of Taxes or Overstatements of Deposits
Penalty of up to 15% of any under-deposited amount not paid, various criminal

penalties, 100% penalty for willful behavior, and required remittance of all
withholdings and matching social security or unemployment taxes.
Statute of Limitations
No return or fraudulent return, the statute is unlimited.

Omission of gross income in excess of 25% of gross income stated on the return, the
statute is increased to six years.
Bad debtsseven years
Normally any assessment of tax must occur within three years of the filing of the
return (or, if later, the due date of the return).
Refund Claims and the Statute of Limitations
File claim on form 1040X or 1120X. There must be a separate claim filed for each
tax period, and the statement of facts and grounds for the claim must be stated in
sufficient detail.
The refund claim must be filed within three years of filing the tax return or within
two years following the payment of the tax is this period expires on a later date.
51
Tax Practice
Rules Governing Tax PracticeCircular 230, Preparer Penalties under 6701 and
6695. (Pages 16-26, 27) Review Illustrative Problem 16-43
AICPA Statement of Standards for Tax Practice
SSTS comprise part of AICPAs Code of Professional Conduct. Review Statements on

Pages 16-29, 30
52
Chapter 17
The Federal Estate and Gift Taxes
Formula For the Gift Tax
Review Figure 1-1 on page 17-6.
Important Features:
Deductions and Exclusions may be allowed to arrive at taxable gifts. The gifts are
valued at the fair market value at the date of the transfer.
For a gift to be complete under state law the following elements must be present.
1. Donor competent to make a gift.

2. Donee capable of receiving and possessing the property.
3. Donative intent on behalf of the donor.
4. Actual or constructive delivery of the property to the donee or the donees
representative.
5. Acceptance of the gift by the donee.
The federal gift tax applies to all gratuitous transfers of property made be U.S.
citizens or residents. In this regard, it does not matter where the property is
located.
Property settlements can escape the gift tax if a divorce occurs within a prescribed
period of time. ( 1045).
To split gifts the spouses must be legally married to each other at the time of the
gift. They both must indicate on their separate gift tax returns their consent to
have all gifts made during that calendar year split between them.
Prior taxable gifts must be added to arrive at the tax base to which the unified
transfer tax is applied.
Deductions are available for charitable contributions and marital transfers.
The annual exclusion for 2004 is $ 11,000. the annual exclusion applied to all
gifts of a present interest made during the calendar year in the order in which they
are made until the $ 11,000 exclusion per donee is exhausted. A present interest is
an unrestricted right to right to the immediate use, possession or enjoyment of
property or of the income.
The unified credit for gifts for 2004 is $ 345,800 based on an exclusion amount of
$ 1,000,000.
53
A form 709 (U.S. gift tax return) must be filed whenever the gifts for any one
calendar year exceed the annual exclusion or involve a gift a future interest. The
return is due on April 15 following the year of the gift.
Do Problems 17-34, 38
Key Property Concepts
Joint Tenancy or tenants by the entirety. The right of survivorship exists and the last
tenant to survive receives the property.
If the property holders are tenants in common, death does not defeat an owners interest.
Partial Interests. Interests in assets can be divided in terms of rights to income and to
principal. Particularly when property is placed in trust, it is not uncommon to carve out
various income interests that must be accounted for separately from the ultimate
disposition of the property itself.
The Federal Estate Tax Return
Review the diagram on page 17-20 (components of the gross estate)
Gross Estate
Includes all property (at fmv at date of death or alternate valuation date)
subject to Federal Estate Tax. This includes:
1. Property Owned by the Decedent ( 2033)

2. Dower and Curtesy Interests ( 2034)
3. Adjustments for Gifts Made within Three Years of Death ( 2035)
4. Transfers with a Retained Life Estate ( 2036)
Estate taxes can be avoided on lifetime transfers only if the decedent does
not retain control over the property. Under 2036 the value of any
property transferred by the deceased during lifetime for less than adequate
consideration must be included if either of the following was retained:
The possession or enjoyment of, or the right to the income from

the property.
The right, either alone or in conjunction with any person, to
designate the persons who shall possess or enjoy the property or
the income.
54
5. Revocable Transfers ( 2038)
The gross estate includes the value of property interests transferred by the
decedent (except to the extent that the transfer was made for full
consideration) if the enjoyment of the property transferred was subject, at
the date of decedents death, to any power of the decedent to alter, amend,
revoke or terminate the transfer.
6. Annuities ( 2039)
7. Joint Interests ( 2040, 2511)
The Federal estate tax treatment of tenancies in common and community

property follows the logical approach of taxing only the portion of the
property included in the deceased owners probate estate. (The probate
estate consists of all of a decedents property subject to administration by
the executor or administrator of the estate. The administration is
supervised by a local court of appropriate jurisdiction.)
Unless the parties have provided otherwise, each tenant is deemed to own
an interest equal to the portion of the original consideration he or she
furnished.
For certain joint tenancies the tax consequences are different. All of the
property is included in the deceased co-owners gross estate unless it can
be proved that the surviving co-owners contributed to the cost of the
property. If a contribution can be shown, the amount to be excluded is
calculated by the following formulae:
Surviving co-owners contribution x Fair Market Value of the Property

Total cost of the property
8. Powers of Appointment ( 2041, 2514)
A power of appointment is a power to determine who shall own or enjoy at

the present or in the future the property subject to the power. It must be
created by another and does not include a power created or retained by the
decedent when he or she transferred his or her own property. The exercise,
lapse, or release of a general power of appointment during the life of the
holder is subject to the gift tax. If the exercise, lapse, or release occurs at
death, the property subject to the power is included in the holders gross
estate. If, however, a special power of appointment is involved, no gift or
estate tax consequences result.
9. Life Insurance ( 2042)
55
Do Illustrative Problems 17-32, 40, 48
Taxable Estate
The gross estate less the following:
Expenses, Indebtedness and Taxes ( 2053)

Losses ( 2054) [Casualty or Theft less anticipated insurance recovery]
Transfers to Charity ( 2055, 2522)
Marital Deduction (2056, 2056A, 2523)
Computing the Estate Tax
Review Figure 17-2 on page 17-6.
Taxable Estate + Post 1976 taxable gifts ( 2001 (b)) = Tax Base
Tax Base Tentative Tax on Base ( 2001 (c))
Subtract: Gift Taxes Paid or Deemed Paid

Tax Credits (Including Unified Credit, State Death Tax Credit & Credit
for Tax on Prior Transfers)
Equals Estate Tax Due
Do Illustrative Problems 17-54(c), 57 (Kirk)
Procedural Matters:
Form 706 due nine months after the decedents death. Automatic extension is
available for six months (Form 4768).
Generation SkippingTransfer Tax
Designed to prevent bypass of generation of transfer taxes. GSTT is the highest rate
under the gift and estate schedule. The total transfer tax may exceed what the donee
receives. GST exemption is equal the exclusion applicable to the federal estate tax.
56
Chapter 19
Income Taxation of Trusts & Estates
Subchapter J
More common to see taxable events related to income taxes than estate and gift taxes.
Review Figure 19-1, page 19-4 than discusses terminology. Note the two tax
elementscorpus (a separate taxable entity) and income (a flow through entity)
Taxpayers file forms 1041 & 1041 K-1. Review Illustrative Problems 19-20, 21
Important IssuesIRD (income in respect to a decedent) and ERD. Included on both

form 706 & 1041. Note that the executor can elect to include administrative expenses
on either Form 706 or Form 1041. Review Illustrative Problems 19-22, 31
Common types of entities
Simple trust ($ 300 personal exemption)accounting income is distributed currently

to beneficiary. Note that the tax law treats the trust somewhat similar to an
individual. Income tax brackets for trusts & estates are much narrower than for
individuals.
Complex trust ($ 100 usually personal exemption)all other trusts. Beneficiaries

may be subject to two-tier approach in determining their share of taxable income.
Estates ($ 600) personal exemptionIncome tax treatment follows the rules for
Complex trusts. Note that specific bequests from the estate are not subject to income
tax.
Grantor trust an example is a living trust, taxed to the individuals who created
the trust. These are revocable trusts. The individuals include their income on Form
1040.
Calculating Entity Taxable Income and Income Assigned to the Beneficiaries.
Figure 19-2, Page 19-9 A five step process
Notes: Step 1 Accounting Income is determined by the trust agreement or will and
determines that actual amounts of cash/other assets distributed to the beneficiaries.
Step 2: Entity taxable income includes taxable income of both the entity and the
beneficiaries. It is not necessarily equal to accounting income because some of the
expenses (such as fiduciary fees & depreciation) may be assigned to income
regardless of their treatment in the trust agreement or will.
57
Step 3: Lesser of DNI or the amounts distributed to the beneficiaries is the amount
deducted in step 3. DNI = Taxable Income before the Distribution Deduction +
personal exemption + Net tax-exempt interest + Net capital losses Net capital gains
allocated to corpus. Deductible DNI is DNI net tax exempt income
Distribution Deduction is the taxable amount of the amount actually distributed to the
beneficiaries.
Step 4: Compute Entity Taxable Income (Step 2 less Step 3).
Step 5: Allocate DNI to the beneficiaries based on the tax character of the individual
components. Use the tier system, if necessary.
Figure 19-3 page 19-10 provides a worksheet for the calculations.
Illustrative Problems 19-25, 28, 29, 30, 33
58
59
60
61
62
63
64

Accounting 331-Lecture Notes2002

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Accounting 331-Lecture Notes2002

Uploaded by

Copyright:

Available Formats

Accounting 331

Course OutlineFall 2004

Introduction to Income Taxation of Corporations

Differences and similarities to individual income taxation. Corporation has no

Gross Income (generally apply to all business entities)

= Taxable Income before NOL and Special (Dividends Received) Deductions

- NOL & Dividends Received Deductions

Note: No AGI for Corporations

Accounting Periods and Methods

The cash method is often not available to C corporations. S Corporations and

Comparison of a proprietorship (flow-through entity) with a corporation.

Capital gains and LossesComparison with Individuals

Passive Activity Losses

Passive Loss Limitations apply to closely held C corporations (>50% ownership, 5 or

A corporate taxpayer is limited to 10% or taxable income computed without regard

Review Problems 2-42, 43, 44

Net Operating Losses

Deductions Available Only to CorporationsDividends Received Deduction

A corporation is allowed a dividends-received deduction for distributions received from

Ownership Level Percentage

The dividends received deduction is limited to a percent of taxable income of the

Review Problems 2-46 & 47

Organization and Start Up Expenses

Qualifying expenses under 248:

Legal services incident to organization

Review Problem 2-48, 49

Corporate Income Tax Rates

Tax Liability of Related Corporations

Controlled groups are generally parent-subsidiary or brother-sister groups. A parent-

A brother-sister controlled group exists if:

A combined controlled group (parent-subsidiary and brother-sister) exists when each

Reconciliation of Taxable Income and Financial Net Income

Schedule M-1Reconciliation of Income per Books with Income per Return.

Schedule M-2 is an analysis of unappropriated retained earnings. Watch for

Review Problem 2-57

Page 1Computation of Taxable Income/Balance Due-Refund

Property is broadly construed. The term includes unrealized receivables, installment

351 is mandatory. It applies to later transfers to an existing corporation by either new

Assumption of Liabilities by the Acquiring Corporation

Exceptions: 357(b)if the principal purpose of the assumption of liabilities is to avoid

Review Illustrative Problems 3-37, 40

III. Recapture Provisions

IV. Capital Structure of a Corporation

Capital contributionsIssuance of stock & contributions of money or property. 118

Contributions by a non shareholderNo gain is recognized by the

Debt in the Capital Structure

Advantages of receiving long-term debt to the transferor shareholder. Interest is

Under 165(g)(1) the loss is usually classified as a long-term capital loss. No

Applies only to the original holder

Review problem 3-47.

Gain From Qualified Small Business Stock 1202

Earnings & Profits 312

Computation of E & P shown in Concept Summary 4-1 on page 4-7.

Illustrative Problems: Q 4-3, P 4-30

Distributions from Earnings & Profits

See Concept Summary 4-2 on page 4-8.

To determine the amount of a distribution that is from current E & P;

Current E & P portion of distribution = Total Current E & P x Each Distribution

Illustrative Problems 4-28, 32, 43

Amount Distributed = FMV of the property -- related liabilities assumed by

1. For appreciated property, the gain is recognized. Losses are disallowed.

Shareholder use of corporate owned property

Illustrative Problem 4-39

Distributions from One Corporation to Another