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Chapter 15

Entities Overview

True / False Questions

1. Corporations are legally formed by filing articles of organization with the state in which the

corporation will be created.

True False

2. General partnerships are legally formed by filing a partnership agreement with the state in which

the partnership will be formed.

True False

3. Limited partnerships are legally formed by filing a certificate of limited partnership with the state in

which the partnership will be organized.

True False

4. Sole proprietorships are not treated as legal entities separate from their individual owners.

True False

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5. S corporation shareholders are legally responsible for paying the S corporation's debts because S

corporations are treated as flow-through entities for tax purposes.

True False

6. LLC members have more flexibility than corporate shareholders to alter their legal arrangements

with respect to one another, the entity, and with outsiders.

True False

7. Corporations are legally better suited for taking a business public compared with LLCs and general

partnerships.

True False

8. Both tax and nontax objectives should be considered when choosing an appropriate business

entity.

True False

9. Tax rules require that entities be classified the same way for tax purposes as they are classified for

legal purposes.

True False

10. C corporations and S corporations are separate taxpaying entities that pay tax on their own

income.

True False

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11. All unincorporated entities are generally treated as flow-through entities for tax purposes.

True False

12. In certain circumstances, C corporations can elect to be treated as flow-through entities.

True False

13. An unincorporated entity with more than one owner is, by default, taxed as a partnership.

True False

14. A single-member LLC is taxed as a partnership.

True False

15. For tax purposes, only unincorporated entities can be considered to be disregarded entities.

True False

16. Unincorporated entities with only one individual owner are taxed as sole proprietorships.

True False

17. S corporations have more restrictive ownership requirements than other entities.

True False

18. Entities taxed as partnerships can use special allocations to reward owners based on their

responsibilities, contributions, and individual needs.

True False

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19. Sole proprietors are subject to self-employment taxes on net income from their sole

proprietorships.

True False

20. Shareholders of C corporations receiving property distributions must recognize dividend income

equal to the fair market value of the distributed property if the distributing corporation has

sufficient earnings and profits.

True False

21. Losses from C corporations are never available to offset a shareholder's personal income.

True False

Multiple Choice Questions

22. Which of the following legal entities file documents with the state to be formally recognized by the

state?

A. Limited Liability Company

B. General Partnership

C. Sole Proprietorship

D. None of these

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23. If an individual forms a sole proprietorship, which nontax factor will be of greatest benefit to the

sole proprietor?

A. Liability protection

B. Legal flexibility in defining rights and responsibilities of owners

C. Facilitates initial public offerings

D. Minimal time and cost to organize

24. Which legal entity is correctly paired with the party that bears the ultimate responsibility for paying

the legal entity's liabilities?

A. LLC - LLC members

B. Corporation - Corporation

C. General Partnership - Partnership

D. Limited Partnership - General partner

E. Both Corporation - Corporation and Limited Partnership - General partner.

25. Which legal entity provides the least flexible legal arrangement for owners?

A. Corporation

B. LLC

C. Partnership

D. Sole Proprietorship

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26. Which legal entity is generally best suited for going public?

A. Corporation

B. LLC

C. Limited Liability Partnership

D. General Partnership

E. All of these entities are equally suited for going public.

27. What document must LLCs file with the state to organize their business?

A. Articles of incorporation

B. Certificate of LLC

C. Articles of organization

D. Partnership agreement

E. None of these. LLCs do not have to file with the state to organize their business.

28. Which of the following entity characteristics are generally key drivers for small business owners in

deciding which entity to choose?

A. Double taxation

B. Required accounting period

C. Liability protection

D. Double taxation and required accounting period

E. Double taxation and liability protection

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29. On which form is income from a single member LLC with one corporate (C corporation) owner

reported?

A. Form 1120 used by C corporations to report their income

B. Form 1120S used by S corporations to report their income

C. Form 1065 used by partnerships to report their income

D. Form 1040, Schedule C used by sole proprietorships to report their income

E. None of these.

30. On which tax form does a single member LLCs with one individual owner report its income and

losses?

A. Form 1120

B. Form 1120S

C. Form 1065

D. Form 1040, Schedule C

31. On which tax form do LLCs with more than one owner report their income and losses?

A. Form 1120

B. Form 1120S

C. Form 1065


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32. Which tax classifications can potentially apply to LLCs?

A. S corporation

B. Partnership

C. Sole proprietorship

D. S corporation and Partnership

E. S corporation and Sole proprietorship

F. Partnership and Sole proprietorship

G. All of these

33. Generally, which of the following flow-through entities can elect to be treated as a C corporation?

A. Limited partnership

B. Limited Liability Company

C. General partnership

D. All of these.

34. Which of the following legal entities are classified as C corporations for tax purposes?


B. S corporations

C. Limited partnerships

D. Sole proprietorship

E. None of these

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35. If PST Corporation is a shareholder of MNO Corporation, how many levels of tax is MNO's pre-tax

income potentially exposed to?

A. No taxation

B. Single taxation

C. Double taxation

D. Triple taxation

36. Crocker and Company, Inc. had taxable income of $550,000. At the end of the year, it distributes

all its after-tax earnings to Jimmy, the company's sole shareholder. Jimmy's marginal ordinary tax

rate is 34 percent and his marginal tax rate on dividends is 15 percent. What is the overall tax rate

on Crocker and Company's pre-tax income?

A. 9.9%

B. 15.0%

C. 35.0%

D. 43.9%

E. 66.7%

37. If C corporations retain their after-tax earnings, when will their shareholders be taxed on the

retained earnings?

A. Shareholders will be taxed when they sell their shares at a gain

B. Shareholders will be taxed in the year they elect to be taxed on undistributed retained earnings

C. Shareholders will be taxed on undistributed retained earnings in the year the corporation files its

tax return

D. None of these

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38. Which of the following is most effective in mitigating the double tax?

A. Shift income from high tax rate shareholders to low tax rate corporations

B. Shift income from low tax rate shareholders to high tax rate corporations

C. Shift income from high tax rate corporations to low tax rate shareholders

D. Shift income from low tax rate corporations to high tax rate shareholders

39. While a C corporation's losses cannot be used by their shareholders to offset personal income, a C

corporation may carry back and carry forward losses to help offset the taxable income a

corporation had or will have. How are these net operating losses carried back and carried

forward?

A. Carried back two years, carried forward indefinitely

B. Carried back indefinitely, carried forward two years

C. Carried back two years, carried forward five years

D. Carried back two years, carried forward twenty years

E. None of these.

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40. Logan, a 50 percent shareholder in Military Gear Inc., is comparing the tax consequences of losses

from C corporations with losses from S corporations. Assume Military Gear Inc has a $100,000 loss

for the year, Logan's tax basis in his Military Gear Inc. stock was $150,000 at the beginning of the

year, and he received $75,000 ordinary income from other sources during the year. Assuming

Logan's marginal income tax rate is 15%, how much more tax will Logan pay currently if Military

Gear Inc. is a C corporation compared to the tax he would pay if it were an S corporation?

A. $0

B. $3,750

C. $7,500

D. $11,250

41. Which of the following is not an effective strategy for mitigating double taxation in a C

corporation?

A. C corporations can shift income to shareholders via deductible payments

B. C corporations can make an S election

C. C corporations can pay dividends to their shareholders

D. None of these. All of these statements are effective strategies to mitigate or avoid double

taxation.

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42. Robert is seeking additional capital to expand ABC Inc. In order to qualify ABC as an S corporation,

which type of investor group could Robert obtain capital from?

A. 30 different partnerships

B. 10 different C corporations

C. 90 nonresident individuals

D. 120 unrelated resident individuals

E. None of these.

43. What tax year-end must unincorporated entities with only one owner adopt?

A. The entity is free to adopt any tax year-end

B. The entity must adopt the same year-end as its owner

C. The entity must adopt a calendar year-end

D. The entity may adopt any year-end except for a calendar year-end

44. Roberto and Reagan are both 25 percent owner/managers for Bright Light Inc. Roberto runs the

retail store in Sacramento, CA, and Reagan runs the retail store in San Francisco, CA. Bright Light

Inc. generated a $125,000 profit companywide made up of a $75,000 profit from the Sacramento

store, a ($25,000) loss from the San Francisco store, and a combined $75,000 profit from the

remaining stores. If Bright Light Inc. is an S corporation, how much income will be allocated to

Roberto?

A. $31,250

B. $62,500

C. $75,000

D. $125,000

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45. Roberto and Reagan are both 25 percent owner/managers for Bright Light Enterprises. Roberto

runs the retail store in Sacramento, CA, and Reagan runs the retail store in San Francisco, CA.

Bright Light generated a $125,000 profit companywide made up of a $75,000 profit from the

Sacramento store, a ($25,000) loss from the San Francisco store, and a combined $75,000 profit

from the remaining stores. If Bright Light is taxed as a partnership and decides that Roberto and

Reagan will be allocated 70 percent of his own store's profit with the remaining profits allocated

pro rata among all the owners, how much income will be allocated to Reagan?

A. ($25,000)

B. ($17,500)

C. $5,000

D. $20,000

46. When an employee/shareholder receives an income allocation from an S corporation, what taxes

apply to the income allocation?

A. FICA tax only.

B. Self-employment tax only.

C. FICA and self-employment tax.

D. None of these. This income will never be taxed.

E. None of these. This income will be taxed, but another type of tax will apply.

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47. What is the tax impact to a C corporation or an S corporation when it makes a property

distribution to a shareholder?

A. Recognizes either gain or loss

B. Does not recognize gain or loss

C. Recognizes gain but not loss

D. Recognizes loss only

48. Assume you plan to start a new enterprise; you know the probability of having losses for the first

three years of operations is almost 90 percent, and you know you will report a substantial amount

of income from other sources during those same three years. From a tax perspective, which of the

following entity choices would be least favorable?

A. C corporation

B. LLC


D. S corporation

49. From a tax perspective, which entity choice is preferred when a liquidating distribution occurs and

the entity has assets that have declined in value?

A. Partnership

B. S corporation

C. LLC

D. Partnership and S corporation

E. S corporation and LLC

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50. From a tax perspective, which entity choice is preferred when a liquidating distribution occurs and

the entity has appreciated assets?

A. Partnership

B. S corporation

C. LLC

D. Partnership and LLC


51. If you were seeking an entity with the most favorable tax treatment regarding (1) the number of

owners allowed, (2) the flexibility to select your accounting period, and (3) the availability of

preferential capital gains rates when selling your ownership interest, which entity should you

decide to use?

A. C corporation

B. S corporation

C. Partnership


52. Which of the following is not an effective strategy for mitigating the double tax associated with C

corporations?

A. Paying a salary to a shareholder-employee

B. Leasing property from a shareholder

C. Borrowing money from a shareholder

D. Paying fringe benefits to a shareholder-employee

E. All of these are effective strategies for mitigating double taxation

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53. What is the maximum number of unrelated shareholders a C corporation can have, the maximum

number of unrelated shareholders an S corporation can have, and the maximum number of

partners a partnership may have?

A. 100; no limit; no limit

B. no limit; 100; 2

C. no limit; 100; no limit

D. 100; 100; no limit

Essay Questions

54. David would like to organize HOS as either an LLC or as a corporation generating a 12 percent

annual before-tax return on a $300,000 investment. Individual and corporate tax rates are both 30

percent and individual capital gains and dividend tax rates are 15 percent. HOS will pay out its

after-tax earnings every year to either its members or its shareholders.

a. Ignoring self-employment taxes, how much would David keep after taxes if HOS is organized as

either an LLC or a corporation?

b. Ignoring self-employment taxes, what are the overall tax rates (combined owner and entity

level) if HOS is organized as either an LLC or a corporation?

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55. Jaron would like to organize TMZ as either an LLC or as a C corporation generating a 6 percent

annual before-tax rate of return on a $200,000 investment. Individual and corporate tax rates are

both 40 percent and individual capital gains and dividends tax rates are 10 percent. TMZ will

distribute its earnings annually to either its members or shareholders.

a. Ignoring self-employment taxes (and the additional Medicare Tax), how much would Jaron keep

after taxes if TMZ is organized as either an LLC or a C corporation?

b. Ignoring self-employment taxes (and the additional Medicare Tax), what are the overall tax rates

(combined overall and entity level) if TMZ is organized as either an LLC or as a C corporation?

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56. Emmy would like to organize PRK as either an LLC or as a C corporation generating a 15 percent

annual before-tax rate of return on a $100,000 investment. Individual ordinary rates are 25 percent,

corporate rates are 15 percent, and individual capital gains and dividends tax rates are 5 percent.

PRK will distribute its earnings annually to either its members or shareholders.

a. Ignoring self-employment taxes, how much would Emmy keep after taxes if PRK is organized as

either an LLC or as a C corporation?

b. Ignoring self-employment taxes, what are the overall tax rates (combined entity and owner

level) if PRK is organized as either an LLC or a corporation?

15-19


57. Jerry would like to organize FBC as either an LLC or as a C corporation generating an 8 percent


both 35 percent and individual capital gains and dividends tax rates are 15 percent. FBC will pay

out its after-tax earnings every year to either its members or its shareholders.

a. How much would Jerry keep after taxes if FBC is organized as either an LLC or as a C

corporation (ignore self-employment taxes)?


level) tax rates if FBC is organized as either an LLC or as a C corporation?

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58. Taylor would like to organize DRK as either an LLC or as a C corporation generating a 13 percent


both 30 percent and individual capital gains and dividends tax rates are 5 percent. DRK will


a. Ignoring self-employment taxes, how much would Taylor keep after taxes if DRK is organized as

either an LLC or as a C corporation?

b. Ignoring self-employment taxes, what are the overall (combined owner and entity level) tax

rates if DRK is organized as either an LLC or as a C corporation?

15-21


59. Becca would like to organize BMI as either an LLC or as a C corporation generating a 4 percent

annual before-tax rate of return on a $450,000 investment. Individual ordinary rates are 28

percent, corporate rates are 15 percent, and individual capital gains and dividends tax rates are 15

percent. BMI will distribute its earnings annually to either its members or shareholders.

a. Ignoring self-employment taxes, how much would Becca keep after taxes if BMI is organized as

either a LLC or as a C corporation?


rates if BMI is organized as either an LLC or as a C corporation?

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60. SNL corporation, a C corporation, reports $400,000 of taxable income in the current year. SNL's tax

rate is 35 percent. Answer the following questions, assuming Keegan, SNL's sole shareholder, has a

marginal tax rate of 39.6 percent on ordinary income and 20 percent on dividend income.

a. Compute the first level of tax on SNL's taxable income for the year.

b. Compute the second level of tax on SNL's income assuming that SNL currently distributes all of

its after-tax earnings to Keegan. What is the overall (combined owner and entity level) tax rate on

SNL's taxable income for the year?

61. In the current year, DNS (a C corporation) had taxable income of $600,000 and distributed all of its

after-tax earnings to Daniel, its sole shareholder. DNS's tax rate is 38 percent. Assuming Daniels's

marginal tax rate on ordinary income is 28 percent and his dividend rate is 15 percent (he is not

subject to the net investment income tax), what is the overall tax rate (combined corporate level

and shareholder level) on DNS's $600,000 of taxable income?

15-23


62. In its first year of existence, BYC Corporation (a C corporation) reported a loss for tax purposes of

($40,000). How much tax will BYC pay in year 2 if it reports taxable income from operations of

$35,000 in year 2 before any loss carryovers?

63. In its first year of existence Aspen Corp. (a C corporation) reported a loss for tax purposes of

$50,000. In year 2, it reports a $30,000 loss. For year 3, it reports taxable income from operations

of $120,000. How much tax will Aspen Corp. pay for year 3? Consult the corporate tax rate table

provided to calculate your answer.

15-24


64. For the current year, Creative Designs Inc., a C corporation, reports taxable income of $300,000

before paying salary to Ben the sole shareholder of Creative Designs Inc. (CD). Ben's marginal tax

rate on ordinary income is 28 percent and 15 percent on dividend income. Assume CD's tax rate is

39 percent.

a. How much total income tax will Creative Designs and Ben pay on the $300,000 taxable income

for the year if CD doesn't pay any salary to Ben and instead distributes all of its after-tax income to

Ben as a dividend?

b. How much total income tax will Creative Designs and Ben pay on the $300,000 of income if CD

pays Ben a salary of $100,000 and distributes its remaining after-tax earnings to Ben as a dividend?

c. Compare your answer in part a. with your answer to part b. Explain why these numbers are

different.

15-25


65. For the current year, Birch Corporation, a C corporation, reports taxable income of $400,000

before paying salary to its sole shareholder Elaine. Elaine's marginal tax rate on ordinary income is

33 percent and 15 percent on dividend income. If Birch pays Elaine a salary of $200,000 but the IRS

determines that Elaine's salary in excess of $100,000 is unreasonable compensation, what is the

overall income tax rate on Birch's $400,000 pre-salary income? Assume Birch's tax rate is 35

percent and it always distributes all after-tax earnings to Elaine.

15-26


66. Cali Corp. (a C corporation) projects that it will have taxable income of $250,000 for the year

before paying any fringe benefits. Stacey, Cali's sole shareholder, has a marginal tax rate of 33

percent on ordinary income and 15 percent on dividend income. Assume Cali's tax rate is 34

percent.

a. What is the amount of the combined corporate and shareholder level income tax on Cali's

$250,000 of pre-benefit income if Cali Corp. does not pay out any fringe benefits and distributes

all of its after-tax earnings to Stacey?

b. What is the amount of the combined corporate and shareholder level income tax on Cali's

$250,000 of pre-benefit income if Cali Corp. pays Stacey's adoption expenses of $50,000 and the

payment is considered to be a qualified fringe benefit? Cali Corp. distributes all of its after-tax

earnings to Stacey.

c. What is the amount of the combined corporate and shareholder level income tax on Cali's

$250,000 of pre-benefit income if Cali Corp. pays Stacey's adoption expenses of $50,000 and the

payment is considered to be a nonqualified fringe benefit? Cali Corp. distributes all of its after-tax

earnings to Stacey.

15-27


67. Jamal Corporation, a C corporation, projects that it will have taxable income of $500,000 before

incurring any lease expenses. Jamal's tax rate is 34 percent. Ali, Jamal's sole shareholder, has a

marginal tax rate of 33 percent on ordinary income and 15 percent on dividend income. Jamal

always distributes all of its after-tax earnings to Ali.

a. What is the amount of the combined corporate and shareholder level tax on Jamal Corp.'s

$500,000 pre-lease expense income if Jamal Corp. distributes all of its after-tax earnings to its sole

shareholder Ali (ignore the 3.8% net investment income tax)?

b. What is the amount of the combined corporate and shareholder level tax on Jamal Corp.'s

$500,000 pre-lease expense income if Jamal leases equipment from Ali at a cost of $120,000 for

the year (ignore the 3.8% net investment income tax)?

c. What is the amount of the combined corporate and shareholder level tax on Jamal Corp.'s

$500,000 pre-lease expense income if Jamal Corp. leases equipment from Ali at a cost of $120,000

for the year but the IRS determines that the fair market value of the lease payments is $80,000

(ignore the 3.8% net investment income tax)?

15-28


68. Tuttle Corporation (a C corporation) projects that it will have taxable income for the year of

$300,000 before incurring any interest expense. Assume Tuttle's tax rate is 35 percent.

a. What is the amount of the combined corporate and shareholder level tax on the $300,000 of

pre-interest expense earnings if Ruth, Tuttle's sole shareholder, lends Tuttle Corporation $100,000

at the beginning of the year, Tuttle pays Ruth $10,000 of interest on the loan (interest is considered

to be reasonable), and Tuttle distributes all of its after-tax earnings to Ruth? Assume her ordinary

marginal rate is 33 percent and dividend tax rate is 15 percent.

b. Assume the same facts as in part a except that the IRS determines that the fair market value of

the interest should be $8,000. What is the amount of the combined corporate and shareholder

level tax on Tuttle Corporation's pre-interest expense earnings?

69. Nancy purchased a building and then leased the building to ZML. Nancy is the sole shareholder of

ZML. She leased the building to ZML for $2,500 per month. However, the IRS determined that the

fair market value of the lease payment should only be $1,500 per month. How would the lease

payment be treated with respect to both Nancy and ZML?

15-29


70. Rodger owns 100% of the shares in Trevor Inc., a C corporation. Assume the following for the

current year:

Trevor Inc.’s pre-tax income = $16,000

Trevor Corp’s marginal tax rate = 35%

Percentage of after-tax earnings retained

by Trevor Corp = 0% (i.e. all after-tax

earnings distributed)

Rodger’s dividend tax rate = 5%

Given these assumptions, how much cash does Rodger have from the dividend after all taxes have

been paid?

15-30


71. Corporation A owns 10% of Corporation C. The marginal tax rate on non-dividend income for both

A and C is 34%. Corporation C earns a total of $200 million before taxes in the current year, pays

corporate tax on this income and distributes the remainder proportionately to its shareholders as a

dividend. In addition, Corporation A owns 20% of partnership P that earns $500 million in the

current year. Given this fact pattern, answer the following questions:

a. How much cash from the Corporation C dividend remains after Corporation A pays the tax on

the dividend assuming Corporation A is eligible for the 70 percent dividends received deduction?

b. If partnership P distributes all of its current year earnings in proportion to the partner's

ownership percentages, how much cash from Partnership P does Corporation A have after paying

taxes on its share of income from the partnership?

c. If you were to replace corporation A with individual A [her marginal tax rate on ordinary income

is 28% and on qualified dividends is 15% (the net investment tax does not apply)] in the original

fact pattern above, how much cash does individual A have from the Corporation C dividend after

all taxes assuming the dividends are qualified dividends? Consistent with the original facts, assume

that Corporation C distributes all of its after-tax income to its shareholders.

15-31


Chapter 15 Entities Overview Answer Key

True / False Questions

1. Corporations are legally formed by filing articles of organization with the state in which the

corporation will be created.

FALSE

Corporations file articles of incorporation.

AACSB: Reflective Thinking

AICPA BB: Critical Thinking

Accessibility: Keyboard Navigation

Blooms: Understand

Learning Objective: 15-01 Discuss the legal and nontax characteristics of different types of legal entities.

Level of Difficulty: 2 Medium

Topic: Entity Legal Classification and Nontax Characteristics

2. General partnerships are legally formed by filing a partnership agreement with the state in

which the partnership will be formed.

FALSE

General partnerships may be formed by written agreement among the partners, called a

partnership agreement, or may be formed informally without a written agreement when two or

more owners join together in an activity to generate profits.



15-32



Blooms: Understand




3. Limited partnerships are legally formed by filing a certificate of limited partnership with the

state in which the partnership will be organized.

TRUE




Blooms: Remember


Level of Difficulty: 1 Easy


4. Sole proprietorships are not treated as legal entities separate from their individual owners.

TRUE




Blooms: Remember




5. S corporation shareholders are legally responsible for paying the S corporation's debts because

S corporations are treated as flow-through entities for tax purposes.

FALSE


15-33




Blooms: Understand




6. LLC members have more flexibility than corporate shareholders to alter their legal

arrangements with respect to one another, the entity, and with outsiders.

TRUE




Blooms: Remember




7. Corporations are legally better suited for taking a business public compared with LLCs and

general partnerships.

TRUE




Blooms: Remember




15-34


8. Both tax and nontax objectives should be considered when choosing an appropriate business

entity.

TRUE




Blooms: Understand




9. Tax rules require that entities be classified the same way for tax purposes as they are classified

for legal purposes.

FALSE




Blooms: Remember

Learning Objective: 15-02 Describe the different types of entities for tax purposes.


Topic: Entity Tax Classification

10. C corporations and S corporations are separate taxpaying entities that pay tax on their own

income.

FALSE

S corporations are flow-through entities whose income "flows through" to their owners who are

responsible for paying tax on the income.


15-35




Blooms: Understand




11. All unincorporated entities are generally treated as flow-through entities for tax purposes.

TRUE




Blooms: Understand




12. In certain circumstances, C corporations can elect to be treated as flow-through entities.

TRUE

An S-Corporation election achieves this purpose.




Blooms: Understand




15-36


13. An unincorporated entity with more than one owner is, by default, taxed as a partnership.

TRUE




Blooms: Remember




14. A single-member LLC is taxed as a partnership.

FALSE

Single-member LLCs are taxed as sole proprietorships.




Blooms: Understand




15. For tax purposes, only unincorporated entities can be considered to be disregarded entities.

TRUE

If an entity is incorporated it is a corporate entity for tax purposes and cannot be a disregarded

entity.



15-37



Blooms: Understand




16. Unincorporated entities with only one individual owner are taxed as sole proprietorships.

TRUE




Blooms: Understand




17. S corporations have more restrictive ownership requirements than other entities.

TRUE




Blooms: Understand

Learning Objective: 15-03 Identify fundamental differences in tax characteristics across entity types.


Topic: Entity Tax Characteristics

18. Entities taxed as partnerships can use special allocations to reward owners based on their

responsibilities, contributions, and individual needs.

TRUE



15-38



Blooms: Understand




19. Sole proprietors are subject to self-employment taxes on net income from their sole

proprietorships.

TRUE




Blooms: Understand




20. Shareholders of C corporations receiving property distributions must recognize dividend

income equal to the fair market value of the distributed property if the distributing corporation

has sufficient earnings and profits.

TRUE




Blooms: Understand




15-39


21. Losses from C corporations are never available to offset a shareholder's personal income.

TRUE




Blooms: Remember




Multiple Choice Questions

22. Which of the following legal entities file documents with the state to be formally recognized by

the state?


B. General Partnership

C. Sole Proprietorship

D. None of these

LLCs file articles of organization with the state to receive formal recognition from the state, but

general partnerships typically don't file their partnership agreements. Because sole

proprietorships are not treated as legal entities separate from their owners, sole proprietors

don't need to do anything to receive legal recognition from the state.




15-40


Blooms: Understand




23. If an individual forms a sole proprietorship, which nontax factor will be of greatest benefit to the

sole proprietor?

A. Liability protection

B. Legal flexibility in defining rights and responsibilities of owners

C. Facilitates initial public offerings

D. Minimal time and cost to organize

While a sole proprietorship can be organized with minimal time and cost, sole proprietorships

don't provide a shield for the individual owner. Legal flexibility to define the rights and

responsibilities of owners and the ability to go public are irrelevant because they are not

characteristics that pertain to sole proprietorships.




Blooms: Understand




15-41


24. Which legal entity is correctly paired with the party that bears the ultimate responsibility for

paying the legal entity's liabilities?

A. LLC - LLC members

B. Corporation - Corporation

C. General Partnership - Partnership

D. Limited Partnership - General partner

E. Both Corporation - Corporation and Limited Partnership - General partner.

Corporations and LLCs, rather than their owners, are responsible for their debts. General

partners are responsible for debts of general and limited partnerships.




Blooms: Understand




25. Which legal entity provides the least flexible legal arrangement for owners?

A. Corporation

B. LLC

C. Partnership

D. Sole Proprietorship

State partnership and LLC statutes provide members and partners with a great deal of flexibility.

In contrast, corporate governance rules limit the flexibility of shareholders.


15-42




Blooms: Remember




26. Which legal entity is generally best suited for going public?

A. Corporation

B. LLC

C. Limited Liability Partnership

D. General Partnership

E. All of these entities are equally suited for going public.

Corporations have the governance structure to successfully achieve an initial public offering.

The other entities would have to restructure to make this possible.




Blooms: Remember




15-43


27. What document must LLCs file with the state to organize their business?

A. Articles of incorporation

B. Certificate of LLC

C. Articles of organization

D. Partnership agreement

E. None of these. LLCs do not have to file with the state to organize their business.

LLCs must file articles of organization with the state the LLC desires to organize its business in.




Blooms: Understand




28. Which of the following entity characteristics are generally key drivers for small business owners

in deciding which entity to choose?

A. Double taxation

B. Required accounting period

C. Liability protection

D. Double taxation and required accounting period

E. Double taxation and liability protection

While each circumstance is different, small business owners typically seek liability protection

while avoiding double taxation.


15-44




Blooms: Understand






29. On which form is income from a single member LLC with one corporate (C corporation) owner

reported?

A. Form 1120 used by C corporations to report their income

B. Form 1120S used by S corporations to report their income

C. Form 1065 used by partnerships to report their income

D. Form 1040, Schedule C used by sole proprietorships to report their income

E. None of these.

A single member LLC with one corporate owner is considered to be a disregarded entity. In

essence, the entity is treated like a division of its parent company. Thus, its income will be

reported on the Form 1120 of its parent corporation.




Blooms: Apply


Level of Difficulty: 3 Hard


15-45


30. On which tax form does a single member LLCs with one individual owner report its income and

losses?

A. Form 1120

B. Form 1120S

C. Form 1065


Single member LLCs, with one individual owner, follow the same filing guidelines as sole

proprietorships. Thus, their income is reported on Form 1040, Schedule C.




Blooms: Understand




31. On which tax form do LLCs with more than one owner report their income and losses?

A. Form 1120

B. Form 1120S

C. Form 1065


LLCs with more than one owner are taxed as partnerships and report their income on Form

1065.




15-46


Blooms: Understand




32. Which tax classifications can potentially apply to LLCs?

A. S corporation

B. Partnership

C. Sole proprietorship

D. S corporation and Partnership

E. S corporation and Sole proprietorship

F. Partnership and Sole proprietorship

G. All of these

LLCs can elect to be taxed as corporations and then make an S election if they satisfy the

requirements for number and type of shareholder. The default tax status for LLCs with more

than one member is partnership, and the default tax status for single-member LLCs with an

individual owner is sole proprietorship.




Blooms: Understand




15-47


33. Generally, which of the following flow-through entities can elect to be treated as a C

corporation?

A. Limited partnership

B. Limited Liability Company


D. All of these.

Owners of unincorporated entities may elect to have them treated as C corporations.




Blooms: Understand




15-48


34. Which of the following legal entities are classified as C corporations for tax purposes?


B. S corporations

C. Limited partnerships


E. None of these

Limited liability companies and limited partnerships are generally taxed as partnerships. S

corporations are taxed under a separate set of rules applicable to S corporations (an S

corporation is not a legal entity). Sole proprietorships are not taxed separately from their

owners.




Blooms: Understand




15-49


35. If PST Corporation is a shareholder of MNO Corporation, how many levels of tax is MNO's pre-

tax income potentially exposed to?

A. No taxation

B. Single taxation

C. Double taxation

D. Triple taxation

MNO will have to pay taxes on the amount of pre-tax income it earns. Then, if MNO pays a

dividend to PST, the income will be taxed a second time. If PST pays a dividend to its

shareholders, the income will be taxed a third time.




Blooms: Understand




15-50


36. Crocker and Company, Inc. had taxable income of $550,000. At the end of the year, it

distributes all its after-tax earnings to Jimmy, the company's sole shareholder. Jimmy's marginal

ordinary tax rate is 34 percent and his marginal tax rate on dividends is 15 percent. What is the

overall tax rate on Crocker and Company's pre-tax income?

A. 9.9%

B. 15.0%

C. 35.0%

D. 43.9%

E. 66.7%

Crocker and Company pays taxes of $187,000 ($550,000 × .34). Therefore $363,000 ($550,000 -

$187,000) will be distributed to the shareholder as a dividend. The shareholder pays taxes of

$54,450 ($363,000 × .15). The total taxes paid on Crocker and Company's pre-tax income are

$241,450 ($187,000 + $54,450), and the overall tax rate will be 43.9 percent

($241,450/$550,000).

AACSB: Analytical Thinking



Blooms: Analyze




15-51


37. If C corporations retain their after-tax earnings, when will their shareholders be taxed on the

retained earnings?

A. Shareholders will be taxed when they sell their shares at a gain

B. Shareholders will be taxed in the year they elect to be taxed on undistributed retained

earnings

C. Shareholders will be taxed on undistributed retained earnings in the year the corporation

files its tax return

D. None of these

Corporate shareholders generally pay taxes on corporate earnings when they sell their shares

or when they receive dividends.




Blooms: Understand




15-52


38. Which of the following is most effective in mitigating the double tax?

A. Shift income from high tax rate shareholders to low tax rate corporations

B. Shift income from low tax rate shareholders to high tax rate corporations

C. Shift income from high tax rate corporations to low tax rate shareholders

D. Shift income from low tax rate corporations to high tax rate shareholders

When income is shifted from a high tax rate corporation to a low rate shareholder, the double

tax is avoided and the income is taxed at a lower rate.




Blooms: Understand




15-53


39. While a C corporation's losses cannot be used by their shareholders to offset personal income,

a C corporation may carry back and carry forward losses to help offset the taxable income a

corporation had or will have. How are these net operating losses carried back and carried

forward?

A. Carried back two years, carried forward indefinitely

B. Carried back indefinitely, carried forward two years

C. Carried back two years, carried forward five years

D. Carried back two years, carried forward twenty years

E. None of these.

A C corporation may carry back an NOL two years and carry forward an NOL 20 years.




Blooms: Remember




15-54


40. Logan, a 50 percent shareholder in Military Gear Inc., is comparing the tax consequences of

losses from C corporations with losses from S corporations. Assume Military Gear Inc has a

$100,000 loss for the year, Logan's tax basis in his Military Gear Inc. stock was $150,000 at the

beginning of the year, and he received $75,000 ordinary income from other sources during the

year. Assuming Logan's marginal income tax rate is 15%, how much more tax will Logan pay

currently if Military Gear Inc. is a C corporation compared to the tax he would pay if it were an S

corporation?

A. $0

B. $3,750

C. $7,500

D. $11,250

Logan would pay $11,250 in taxes if Military Gear Inc. is a C corporation ($75,000 × 15 percent).

If it were an S corporation, he would have to pay $3,750 in taxes [($75,000 - $50,000) × 15

percent]. Thus, he has to pay $7,500 more in taxes ($11,250 - $3,750) currently if Military Gear,

Inc. is a C corporation.




Blooms: Understand




15-55


41. Which of the following is not an effective strategy for mitigating double taxation in a C

corporation?

A. C corporations can shift income to shareholders via deductible payments

B. C corporations can make an S election

C. C corporations can pay dividends to their shareholders

D. None of these. All of these statements are effective strategies to mitigate or avoid double

taxation.

Paying dividends actually triggers the double tax rather than avoid it.




Blooms: Understand




15-56


42. Robert is seeking additional capital to expand ABC Inc. In order to qualify ABC as an S

corporation, which type of investor group could Robert obtain capital from?

A. 30 different partnerships

B. 10 different C corporations

C. 90 nonresident individuals

D. 120 unrelated resident individuals

E. None of these.

S corporations have strict rules regarding the number and type of owners they may have. An S

corporation cannot have more than 100 unrelated shareholders. Furthermore, shareholders may

not be corporations, partnerships, nonresident aliens, or certain types of trusts.




Blooms: Remember




15-57


43. What tax year-end must unincorporated entities with only one owner adopt?

A. The entity is free to adopt any tax year-end

B. The entity must adopt the same year-end as its owner

C. The entity must adopt a calendar year-end

D. The entity may adopt any year-end except for a calendar year-end

Owners of unincorporated entities can be either individuals or corporations. In either case, the

tax year-end of the entity must match the tax year-end of the owner.




Blooms: Remember




15-58


44. Roberto and Reagan are both 25 percent owner/managers for Bright Light Inc. Roberto runs

the retail store in Sacramento, CA, and Reagan runs the retail store in San Francisco, CA. Bright

Light Inc. generated a $125,000 profit companywide made up of a $75,000 profit from the


from the remaining stores. If Bright Light Inc. is an S corporation, how much income will be

allocated to Roberto?

A. $31,250

B. $62,500

C. $75,000

D. $125,000

S corporations may not specially allocate income to shareholders; thus, the $125,000

companywide profit must be allocated to Roberto based on his ownership percentage in Bright

Light, Inc. Roberto would receive 25 percent of the total profits, or $31,250 ($125,000 × .25).




Blooms: Analyze




15-59


45. Roberto and Reagan are both 25 percent owner/managers for Bright Light Enterprises. Roberto

runs the retail store in Sacramento, CA, and Reagan runs the retail store in San Francisco, CA.

Bright Light generated a $125,000 profit companywide made up of a $75,000 profit from the


from the remaining stores. If Bright Light is taxed as a partnership and decides that Roberto and

Reagan will be allocated 70 percent of his own store's profit with the remaining profits allocated

pro rata among all the owners, how much income will be allocated to Reagan?

A. ($25,000)

B. ($17,500)

C. $5,000

D. $20,000

Because Bright Lights Enterprises is a partnership, the special allocation described is permissible.

Reagan would receive 70 percent of the loss from his store, or ($17,500) ($25,000 × 70 percent).

Additionally, Reagan will receive 25 percent of the remaining profits not specially allocated, or

$22,500 [.25 × (125,000 + 17,500 - ($75,000 × .7))] Thus, Reagan will be allocated a total of

$5,000 of income.




Blooms: Analyze




15-60


46. When an employee/shareholder receives an income allocation from an S corporation, what

taxes apply to the income allocation?

A. FICA tax only.

B. Self-employment tax only.

C. FICA and self-employment tax.

D. None of these. This income will never be taxed.

E. None of these. This income will be taxed, but another type of tax will apply.

An S corporation employee/shareholder must pay FICA tax on any salary received from an S

corporation; however, any S corporation ordinary business income allocated to them is not

subject to either FICA or self-employment tax. Rather, it will only be subject to the marginal

ordinary income tax rate of the shareholder.




Blooms: Understand




15-61


47. What is the tax impact to a C corporation or an S corporation when it makes a property

distribution to a shareholder?

A. Recognizes either gain or loss

B. Does not recognize gain or loss

C. Recognizes gain but not loss

D. Recognizes loss only

Gains must be recognized on distributed appreciated property for both taxable corporations

and S corporations. However, losses are not allowed if the distributed property has depreciated

in value.




Blooms: Understand




15-62


48. Assume you plan to start a new enterprise; you know the probability of having losses for the

first three years of operations is almost 90 percent, and you know you will report a substantial

amount of income from other sources during those same three years. From a tax perspective,

which of the following entity choices would be least favorable?

A. C corporation

B. LLC


D. S corporation

A C corporation is the least favorable entity choice because the losses from the first three years

of operations will not flow-through to you and be available to offset income from other

sources.




Blooms: Understand




15-63


49. From a tax perspective, which entity choice is preferred when a liquidating distribution occurs

and the entity has assets that have declined in value?

A. Partnership

B. S corporation

C. LLC

D. Partnership and S corporation


When assets that have declined in value are distributed in liquidation, S corporations may

immediately deduct losses from the assets whereas these losses are typically deferred if the

distributing entity is taxed as a partnership.




Blooms: Understand




15-64


50. From a tax perspective, which entity choice is preferred when a liquidating distribution occurs

and the entity has appreciated assets?

A. Partnership

B. S corporation

C. LLC

D. Partnership and LLC


Partnerships and their owners generally don't recognize any gain during a liquidating

distribution. Conversely, S corporations and their shareholders must recognize gain when

appreciated assets are distributed in a liquidating distribution.




Blooms: Understand




15-65


51. If you were seeking an entity with the most favorable tax treatment regarding (1) the number of

owners allowed, (2) the flexibility to select your accounting period, and (3) the availability of

preferential capital gains rates when selling your ownership interest, which entity should you

decide to use?

A. C corporation

B. S corporation

C. Partnership


These three tax considerations are most favorable for a company that chooses to be taxed as a

taxable corporation. There is no limit to the number of owners allowed, no restrictions on what

accounting period to use, and all of the gains from selling shares in a C corporation are capital

gains.




Blooms: Understand




15-66


52. Which of the following is not an effective strategy for mitigating the double tax associated with

C corporations?

A. Paying a salary to a shareholder-employee

B. Leasing property from a shareholder

C. Borrowing money from a shareholder

D. Paying fringe benefits to a shareholder-employee

E. All of these are effective strategies for mitigating double taxation

All of the strategies will reduce the amount of double taxation because they all shift income

from C corporations to their shareholders with payments that are deductible at the corporate

level.




Blooms: Remember




15-67


53. What is the maximum number of unrelated shareholders a C corporation can have, the

maximum number of unrelated shareholders an S corporation can have, and the maximum

number of partners a partnership may have?

A. 100; no limit; no limit

B. no limit; 100; 2

C. no limit; 100; no limit

D. 100; 100; no limit

An S corporation is the only type of entity that has a limit on the maximum number of owners it

may have. S corporations may have up to 100 unrelated shareholders.




Blooms: Remember




Essay Questions

15-68


54. David would like to organize HOS as either an LLC or as a corporation generating a 12 percent

annual before-tax return on a $300,000 investment. Individual and corporate tax rates are both

30 percent and individual capital gains and dividend tax rates are 15 percent. HOS will pay out

its after-tax earnings every year to either its members or its shareholders.

a. Ignoring self-employment taxes, how much would David keep after taxes if HOS is organized

as either an LLC or a corporation?


level) if HOS is organized as either an LLC or a corporation?

Answer to parts a and b:

a. LLC Description Corp. Description

(1) Pretax earnings $36,000 12% × $300,00 $36,000 12% × $300,000

(2) Entity level tax -0- 10,800 30% × (1)

(3) After-tax entity earnings $36,000 (1) – (2) $25,200 (1) –(2)

(4) Owner tax 10,800 (3) × 30% 3,780 (3) × 15%

(5) After-tax earnings $25,200 (3) – (4) $21,420 (3) – (4)

b. LLC Corp.

Overall tax rate 30% (4)/(1) 40.50% [(2) + (4)]/(1)



Blooms: Apply




15-69


55. Jaron would like to organize TMZ as either an LLC or as a C corporation generating a 6 percent

annual before-tax rate of return on a $200,000 investment. Individual and corporate tax rates

are both 40 percent and individual capital gains and dividends tax rates are 10 percent. TMZ will


a. Ignoring self-employment taxes (and the additional Medicare Tax), how much would Jaron

keep after taxes if TMZ is organized as either an LLC or a C corporation?

b. Ignoring self-employment taxes (and the additional Medicare Tax), what are the overall tax

rates (combined overall and entity level) if TMZ is organized as either an LLC or as a C

corporation?



(1) Pretax earnings $12,000 6% × $200,000 $12,000 6% × $200,000

(2) Entity level tax -0- 4,800 40% × (1)

(3) After-tax entity earnings $12,000 (1) – (2) $7,200 (1) – (2)

(4) Owner tax $4,800 (3) × 40% $720 (3) × 10%

(5) After-tax earnings $7,200 (3) – (4) $6480 (3) – (4)

b. LLC Corp.

Overall tax rate 40% (4)/(1) 46% [(2) + (4)]/(1)



Blooms: Apply




15-70


56. Emmy would like to organize PRK as either an LLC or as a C corporation generating a 15

percent annual before-tax rate of return on a $100,000 investment. Individual ordinary rates are

25 percent, corporate rates are 15 percent, and individual capital gains and dividends tax rates

are 5 percent. PRK will distribute its earnings annually to either its members or shareholders.

a. Ignoring self-employment taxes, how much would Emmy keep after taxes if PRK is organized

as either an LLC or as a C corporation?

b. Ignoring self-employment taxes, what are the overall tax rates (combined entity and owner

level) if PRK is organized as either an LLC or a corporation?



(1) Pretax earnings $15,000 15% ×

$100,000 $15,000

15% ×

$100,000

(2) Entity level tax -0- 2,250 15% × (1)

(3) After-tax entity

earnings $15,000 (1) – (2) $12,750 (1) – (2)

(4) Owner tax 3,750 (3) × 25% $637.50 (3) × 5%

(5) After-tax earnings $11,250 (3) – (4) 12,112.50 (3) – (4)

b. LLC Corp.

Overall tax rate 25% (4)/(1) 19.25% [(2) + (4)]/(1)



Blooms: Apply




15-71


57. Jerry would like to organize FBC as either an LLC or as a C corporation generating an 8 percent

annual before-tax rate of return on a $400,000 investment. Individual and corporate tax rates

are both 35 percent and individual capital gains and dividends tax rates are 15 percent. FBC will

pay out its after-tax earnings every year to either its members or its shareholders.

a. How much would Jerry keep after taxes if FBC is organized as either an LLC or as a C

corporation (ignore self-employment taxes)?


level) tax rates if FBC is organized as either an LLC or as a C corporation?


(1) Pretax earnings $32,000 8% × $400,000 $32,000 8% × $400,000

(2) Entity level tax -0- 11,200 35% × (1)


(4) Owner tax 11,200 (3) × 35% 3,120 (3) × 15%


b. LLC Corp.

Overall tax rate 35% (4)/(1) 44.75% [(2) + (4)]/(1)



Blooms: Apply




15-72


58. Taylor would like to organize DRK as either an LLC or as a C corporation generating a 13

percent annual before-tax rate of return on a $250,000 investment. Individual and corporate tax

rates are both 30 percent and individual capital gains and dividends tax rates are 5 percent.

DRK will distribute its earnings annually to either its members or shareholders.

a. Ignoring self-employment taxes, how much would Taylor keep after taxes if DRK is organized

as either an LLC or as a C corporation?


rates if DRK is organized as either an LLC or as a C corporation?



(1) Pretax earnings $32,500 13% ×

$250,000 $32,500

13% ×

$250,000

(2) Entity level tax -0- 9,750 30% × (1)


earnings $32,500 (1) – (2) $22,750 (1) – (2)

(4) Owner tax 9,750 (3) × 30% 1,137.50 (3) × 5%

(5) After-tax earnings $22,750 (3) – (4) $21,612.50 (3) – (4)

b. LLC Corp.

Overall tax rate 30% (4)/(1) 33.50% [(2) + (4)]/(1)



Blooms: Apply




15-73


59. Becca would like to organize BMI as either an LLC or as a C corporation generating a 4 percent

annual before-tax rate of return on a $450,000 investment. Individual ordinary rates are 28

percent, corporate rates are 15 percent, and individual capital gains and dividends tax rates are

15 percent. BMI will distribute its earnings annually to either its members or shareholders.

a. Ignoring self-employment taxes, how much would Becca keep after taxes if BMI is organized

as either a LLC or as a C corporation?


rates if BMI is organized as either an LLC or as a C corporation?



(1) Pretax earnings $18,000 4% × $450,000 $18,000 4% × $450,000

(2) Entity level tax -0- 2,700 15% × (1)


(4) Owner tax 5,040 (3) × 28% 2,295 (3) × 15%


b. LLC Corp.

Overall tax rate 28% (4)/(1) 27.75% [(2) + (4)]/(1)



Blooms: Apply




15-74


60. SNL corporation, a C corporation, reports $400,000 of taxable income in the current year. SNL's

tax rate is 35 percent. Answer the following questions, assuming Keegan, SNL's sole

shareholder, has a marginal tax rate of 39.6 percent on ordinary income and 20 percent on

dividend income.

a. Compute the first level of tax on SNL's taxable income for the year.

b. Compute the second level of tax on SNL's income assuming that SNL currently distributes all

of its after-tax earnings to Keegan. What is the overall (combined owner and entity level) tax

rate on SNL's taxable income for the year?


a. Description

(1) SNL taxable

income $400,000

(2) SNL level tax $140,000 35% × (1)

(3) After SNL-

level tax

earnings

available for

dividends

$260,000 (1) – (2)

b.

(4) Keegan's tax $61,880 (3) × (20% +

3.8%)

(5) After-tax

earnings $198,120 (3) – (4)

(6) Combined

taxes $201,880 (2) + (4)

Overall tax rate 50.47% (6)/(1)

15-75


Because Keegan is in the 39.6% marginal tax bracket, his capital gains rate is 20%. He also is

subject to the additional 3.8% Net Investment Income Tax because his dividend income was

over the threshold amount.



Blooms: Apply




15-76


61. In the current year, DNS (a C corporation) had taxable income of $600,000 and distributed all of

its after-tax earnings to Daniel, its sole shareholder. DNS's tax rate is 38 percent. Assuming

Daniels's marginal tax rate on ordinary income is 28 percent and his dividend rate is 15 percent

(he is not subject to the net investment income tax), what is the overall tax rate (combined

corporate level and shareholder level) on DNS's $600,000 of taxable income?

Description

(1) DNS

taxable

income

$600,000

(2) DNS

level tax 228,000 38% × (1)

(3) After

DNS-level

tax earnings

available for

dividends

$372,000 (1) – (2)

(4) Daniels’s

tax 55,800 (3) × 15%

(5) After-tax

earnings $316,200 (3) – (4)

(6)

Combined

taxes

$283,800 (2) + (4)

Overall tax

rate 47.3% (6)/(1)



Blooms: Apply


15-77




62. In its first year of existence, BYC Corporation (a C corporation) reported a loss for tax purposes

of ($40,000). How much tax will BYC pay in year 2 if it reports taxable income from operations

of $35,000 in year 2 before any loss carryovers?

None. BYC's loss in year 1 of ($40,000) will be available to offset income generated by BYC in

year 2. Since BYC earned $35,000 of taxable income in year 2 before any loss carryovers, it can

use ($35,000) of the loss carryover from year 1 to offset its entire taxable income. BYC will have

a ($5,000) loss carryover available for year 3 and beyond.



Blooms: Apply




15-78


63. In its first year of existence Aspen Corp. (a C corporation) reported a loss for tax purposes of

$50,000. In year 2, it reports a $30,000 loss. For year 3, it reports taxable income from

operations of $120,000. How much tax will Aspen Corp. pay for year 3? Consult the corporate

tax rate table provided to calculate your answer.

Description

(1) Year 3

taxable

income

$120,000

(2) Year 1

NOL

carryforward

($50,000)

(3) Year 2

NOL

carryforward

($30,000)

(4) Taxable

income

reported

40,000 (1) – (2) –

(3)

(5) Tax Rate 15%

See

corporate

tax rate

table

(6) Taxes

Paid $6,000 (4) × (5)



Blooms: Apply




15-79


64. For the current year, Creative Designs Inc., a C corporation, reports taxable income of $300,000

before paying salary to Ben the sole shareholder of Creative Designs Inc. (CD). Ben's marginal

tax rate on ordinary income is 28 percent and 15 percent on dividend income. Assume CD's tax

rate is 39 percent.

a. How much total income tax will Creative Designs and Ben pay on the $300,000 taxable

income for the year if CD doesn't pay any salary to Ben and instead distributes all of its after-tax

income to Ben as a dividend?

b. How much total income tax will Creative Designs and Ben pay on the $300,000 of income if

CD pays Ben a salary of $100,000 and distributes its remaining after-tax earnings to Ben as a

dividend?

c. Compare your answer in part a. with your answer to part b. Explain why these numbers are

different.


Part a: $144,450 total taxes

Part b: $124,300 total taxes

a. Without

Salary Description

b. With

Salary Description

(1) Taxable income

before salary $300,000 $300,000

(2) Salary -0- (100,000)

(3) Taxable income $300,000 (1) – (2) $200,000 (1) – (2)

(4) Entity tax 117,000 (3) × 39% 78,000 (3) × 39%


earnings $183,000 (3) – (4) $122,000 (3) – (4)

(6) Ben’s tax on

dividends 27,450 (5) × 15% 18,300 (5) × 15%

15-80


(7) Ben’s tax on salary Not applicable 28,000 (2) × 28%

(8) Combined tax $144,450 (4) + (6) $124,300 (4) + (6) +

(7)

Overall tax rate 48.15% (8)/(1) 41.43% (8)/(1)

Answer to part c: The combined taxes are lower under part b because $100,000 of the

corporation's earnings is only subject to one level of tax (the individual tax on the salary).

Conversely, total taxes paid are greater in part a than in part b because a greater share of

corporate pre-tax earnings is subject to the double tax.



Blooms: Apply




15-81


65. For the current year, Birch Corporation, a C corporation, reports taxable income of $400,000

before paying salary to its sole shareholder Elaine. Elaine's marginal tax rate on ordinary income

is 33 percent and 15 percent on dividend income. If Birch pays Elaine a salary of $200,000 but

the IRS determines that Elaine's salary in excess of $100,000 is unreasonable compensation,

what is the overall income tax rate on Birch's $400,000 pre-salary income? Assume Birch's tax

rate is 35 percent and it always distributes all after-tax earnings to Elaine.

With $100,000 Salary Description

(1) Taxable income before

salary $400,000

(2) Salary 100,000

(3) Taxable income $300,000 (1) – (2)

(4) Entity tax $105,000 (3) × 35%

(5) After-tax entity earnings $195,000 (3) – (4)

(6) Elaine’s tax on

dividends $29,250 (5) × 15%

(7) Elaine’s tax on salary $33,000 (2) × 33%

(8) Combined tax $167,250 (4) + (6) + (7)

Overall tax rate 41.81% (8)/(1)

Feedback: In calculating the double-tax on Birch Corp.'s pre-salary taxable income, the

$100,000 amount the IRS will allow Birch to deduct is taken into account rather than the

$200,000 amount it would prefer to deduct.



Blooms: Apply




15-82


15-83


66. Cali Corp. (a C corporation) projects that it will have taxable income of $250,000 for the year

before paying any fringe benefits. Stacey, Cali's sole shareholder, has a marginal tax rate of 33

percent on ordinary income and 15 percent on dividend income. Assume Cali's tax rate is 34

percent.

a. What is the amount of the combined corporate and shareholder level income tax on Cali's

$250,000 of pre-benefit income if Cali Corp. does not pay out any fringe benefits and

distributes all of its after-tax earnings to Stacey?

b. What is the amount of the combined corporate and shareholder level income tax on Cali's

$250,000 of pre-benefit income if Cali Corp. pays Stacey's adoption expenses of $50,000 and

the payment is considered to be a qualified fringe benefit? Cali Corp. distributes all of its after-

tax earnings to Stacey.

c. What is the amount of the combined corporate and shareholder level income tax on Cali's

$250,000 of pre-benefit income if Cali Corp. pays Stacey's adoption expenses of $50,000 and

the payment is considered to be a nonqualified fringe benefit? Cali Corp. distributes all of its

after-tax earnings to Stacey.


a.

Without

fringe

benefits

Description

b. With

fringe

benefits

Description

(1) Taxable

income before

fringes

$250,000 $250,000

(2) Fringe

benefits 0 (50,000)

(3) Taxable

income $250,000 (1) – (2) $200,000 (1) – (2)

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(4) Entity tax 85,000 (3) × 34% 68,000 (3) × 34%

(5) After-tax

entity

earnings

$165,000 (3) – (4) $132,000 (3) – (4)

(6) Stacey’s

tax on

dividends

24,750 (5) × 15% 19,800 (5) × 15%

(7) Combined

tax $109,750 (4) + (6) $87,800 (4) + (6)

Overall tax

rate 43.9% (7)/(1) 35.12% (7)/(1)

Stacey is not taxed on the $50,000 payout of adoption expenses because this is considered a

qualified fringe benefit.

Answer to part c:

With non-

qualified

fringe

benefits

Description

(1) Taxable

income

before

fringes

$250,000

(2) Fringe

benefits (50,000)

(3) Taxable

income $200,000 (1) – (2)

(4) Entity

tax 68,000 (3) × 34%

(5) After-tax

entity $132,000 (3) – (4)

15-85


earnings

(6) Stacey’s

tax on

dividends

19,800 (5) × 15%

(7) Stacey’s

tax on fringe

benefit

16,500 (2) × 33%

(8)

Combined

tax

$104,300 (4) + (6) +

(7)

Overall tax

rate 41.72% (8)/(1)



Blooms: Apply




15-86


67. Jamal Corporation, a C corporation, projects that it will have taxable income of $500,000 before

incurring any lease expenses. Jamal's tax rate is 34 percent. Ali, Jamal's sole shareholder, has a

marginal tax rate of 33 percent on ordinary income and 15 percent on dividend income. Jamal

always distributes all of its after-tax earnings to Ali.

a. What is the amount of the combined corporate and shareholder level tax on Jamal Corp.'s

$500,000 pre-lease expense income if Jamal Corp. distributes all of its after-tax earnings to its

sole shareholder Ali (ignore the 3.8% net investment income tax)?

b. What is the amount of the combined corporate and shareholder level tax on Jamal Corp.'s

$500,000 pre-lease expense income if Jamal leases equipment from Ali at a cost of $120,000 for

the year (ignore the 3.8% net investment income tax)?

c. What is the amount of the combined corporate and shareholder level tax on Jamal Corp.'s

$500,000 pre-lease expense income if Jamal Corp. leases equipment from Ali at a cost of

$120,000 for the year but the IRS determines that the fair market value of the lease payments is

$80,000 (ignore the 3.8% net investment income tax)?

Answer to parts a, b, and c:

a. No Lease

Payment

b. $120,000 Lease

Deduction

c. $80,000 Lease

Deduction Description

(1) Taxable income

before lease payment $500,000 $500,000 $500,000

(2) Lease payment 0 (120,000) (80,000)

(3) Taxable income $500,000 $380,000 $420,000 (1) – (2)

(4) Entity tax 170,000 $129,200 $142,800 (3) × 34%


earnings $330,000 $250,800 277,200 (3) – (4)

(6) Ali’s tax on dividends $49,500 $37,620 $41,580 (5) × 15%

(7) Ali’s tax on lease 0 $39,600 $26,400 (2) × 33%

15-87


payment

(8) Combined tax $219,500 $206,420 210,780 (4) + (6) +

(7)

Overall tax rate 43.9% 41.28% 42.16% (8)/(1)



Blooms: Apply




15-88


68. Tuttle Corporation (a C corporation) projects that it will have taxable income for the year of

$300,000 before incurring any interest expense. Assume Tuttle's tax rate is 35 percent.

a. What is the amount of the combined corporate and shareholder level tax on the $300,000 of

pre-interest expense earnings if Ruth, Tuttle's sole shareholder, lends Tuttle Corporation

$100,000 at the beginning of the year, Tuttle pays Ruth $10,000 of interest on the loan (interest

is considered to be reasonable), and Tuttle distributes all of its after-tax earnings to Ruth?

Assume her ordinary marginal rate is 33 percent and dividend tax rate is 15 percent.

b. Assume the same facts as in part a except that the IRS determines that the fair market value

of the interest should be $8,000. What is the amount of the combined corporate and

shareholder level tax on Tuttle Corporation's pre-interest expense earnings?


a. With

unreasonable

interest

Description

b. With

reasonable

interest

Description

(1)

Taxable

income

before

interest

$300,000 $300,000

(2)

Reasonable

interest

(10,000) (8,000)

(3)

Taxable

income

$290,000 (1) – (2) $292,000 (1) – (2)

(4) Entity

tax 101,500 (3) × 35% 102,200 (3) × 35%

15-89


(5) After-tax

entity earnings $188,500 (3) – (4) $189,800 (3) – (4)

(6) Ruth’s tax

on dividends 28,275 (5) × 15% 28,470 (5) × 15%

(7) Ruth’s tax

on Interest 3,300 (2) × 33% 2,640 (2) × 33%

(8)

Combined

tax

$133,075 (4) × (6) +

(7) $133,310

(4) + (6) +

(7)

Overall tax

rate 44.36% (8)/(1) 44.44% (8)/(1)



Blooms: Apply




69. Nancy purchased a building and then leased the building to ZML. Nancy is the sole shareholder

of ZML. She leased the building to ZML for $2,500 per month. However, the IRS determined

that the fair market value of the lease payment should only be $1,500 per month. How would

the lease payment be treated with respect to both Nancy and ZML?

Of the total $2,500 lease payment to Nancy, $1,500 would be treated as a deductible rent

expense to ZML and as ordinary income to Nancy. The remaining $1,000 would be treated as a

non-deductible dividend to ZML and a taxable dividend to Nancy.



Blooms: Apply



15-90



70. Rodger owns 100% of the shares in Trevor Inc., a C corporation. Assume the following for the

current year:

Trevor Inc.’s pre-tax income =

$16,000

Trevor Corp’s marginal tax rate = 35%

Percentage of after-tax earnings

retained by Trevor Corp = 0% (i.e. all

after-tax earnings distributed)

Rodger’s dividend tax rate = 5%

Given these assumptions, how much cash does Rodger have from the dividend after all taxes

have been paid?

Description Amount Explanation

(1) Trevor Inc.’s pre-

tax income $16,000

(2) Dividend to

Rodger $10,400

(1) × (1 –

.35)

(3) Rodger’s tax on

dividend $520 (2) × .05

(4) Cash remaining

after tax on dividend $9,880 (2) – (3)



Blooms: Apply



15-91



15-92


71. Corporation A owns 10% of Corporation C. The marginal tax rate on non-dividend income for

both A and C is 34%. Corporation C earns a total of $200 million before taxes in the current

year, pays corporate tax on this income and distributes the remainder proportionately to its

shareholders as a dividend. In addition, Corporation A owns 20% of partnership P that earns

$500 million in the current year. Given this fact pattern, answer the following questions:

a. How much cash from the Corporation C dividend remains after Corporation A pays the tax

on the dividend assuming Corporation A is eligible for the 70 percent dividends received

deduction?

b. If partnership P distributes all of its current year earnings in proportion to the partner's

ownership percentages, how much cash from Partnership P does Corporation A have after

paying taxes on its share of income from the partnership?

c. If you were to replace corporation A with individual A [her marginal tax rate on ordinary

income is 28% and on qualified dividends is 15% (the net investment tax does not apply)] in the

original fact pattern above, how much cash does individual A have from the Corporation C

dividend after all taxes assuming the dividends are qualified dividends? Consistent with the

original facts, assume that Corporation C distributes all of its after-tax income to its

shareholders.

Answer to part a:


(1) Dividend

from

Corporation C

$13,200,000 $200,000,000 ×

(1 – .34) × 10%

(2) Tax on

dividend from

Corporation C

$1,346,400 (1) × 34% ×

30%

(3) Cash

remaining after $11,853,600 (1) – (2)

15-93


tax on dividend

Answer to part b:


(1) Cash

received from

Partnership P

$100,000,000 $500,000,000

× 20%

(2) Tax on share

of income

from

partnership P

$34,000,000 (1) × 34%

(3) Cash

remaining from

distribution

after taxes

$66,000,000 (1) – (2)

Answer to part c:


(1) Dividend

from

Corporation C

$13,200,000 $200,000,000 ×

(1 – .34) × 10%

(2) Tax on

dividend from

Corporation C

$1,980,000 (1) × 15%

(3) Cash

remaining after

tax on dividend

$11,220,000 (1) – (2)



Blooms: Apply

15-94





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