business entities taxation

8/10/2019 business entities taxation

1/102

Interactive Self-Study CPE/CE Cour

2013 Tax Yea

BusinessEntities

CPE/CE4 Credit Hour

Corporations, Partnerships,&LLCs


2/102TheTaxReview Business Entities Overview

Business Entities Self-Study CPE/CE

Copyright 2013 Tax Materials, Inc.

All Rights Reserved

Course Overview

Program Content: This course provides continuing professional education (CPE/CE) for tax professionals to address taxatiobasis, and reporting issues for C corporations, S corporations, partnerships, and exempt organizations. Pro

lems with organization and administration of these business entities are examined by use of court decisio

that illustrate how tax rules apply in real-life situations, with focus on distributions from the business ent

to individuals with an ownership interest.

Publication Date: September 2013. Expiration Date: The Final Exam must be completed online withinone year from your date of purchase or shipment. See

the Final Examination Instructions on the next page for information regarding final exam completion.

Field of Study: Taxes.

Program Level: Overview.This course provides a general overview of the subject area from a broad perspective. It isappropriate for tax professionals at all organization levels.

Recommended Participants: Tax professionals who prepare individual income tax returns are encouraged to participate in this cours

Prerequisites: Individuals who have prepared Form 1040 tax returns.

Advance Preparation: No advanced preparation is needed to complete this course.

Type of Delivery Method: Interactive self-study.

CPE/CE Credit Hours: 4 Credit Hours. One 50-minute period equals one CPE/CE Credit Hour. Passing Grade: Participants who answer a minimum of 70% correct on the final exam will receive a Certificate of Completi

See the Final Examination Instructions on the next page for further information regarding passing requi

ments and acquiring the Certificate of Completion.

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Tax Materials, Inc. has been approved by the California Tax Education Council to offer the Business EntitieSelf-Study CPE/CE Course 6193-CE-0010, which provides 4 hours of federal credit and 0 hours of state cred

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ditional requirements to register as a tax preparer may be obtained by contacting CTEC at P.O. Box 289

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CTEC Course ID Number 6193-CE-00


3/102ii Overview TheTaxReview Business Entities

Business Entities Self-Study CPE/CE

Helpful Hint:Attempt to relate your tax preparation experience with the information you are studying. By doing

so, you will increase retention and maximize your results. Also, utilize the Notes sections to jot down reminders

and information that will be helpful to you in your tax practice.

Follow the instructions below:

1) Start each chapter by reading the Learning Objectives.

2) Read the course materials in the chapter. Pay close attention to:a) Key Facts:Information that is particularly pertinent to the Learning Objective.

b) Examples:Review the examples to associate the information to real-world application.

c) Notes:Many of the main points of the chapter are highlighted. Review the notes and try to relate the

content with your experience.

3) Complete the Self-Quiz at the end of the chapter. The questions are broken out by Learning Objective. Review

the Learning Objectives before completing each set of questions. Determine your progress by comparing your

answers to the correct ones on the pages that follow.

4) After all chapters have been studied, and each Self-Quiz has been taken, complete the Final Exam located

at the back of this instruction booklet.

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4/102TheTaxReview Business Entities Table of Contents

Learning Objectives / Table of Contents

Chapter

1 C Corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-A Define requirements for nontaxable transfers to corporations under IRC section 351.

1-B Determine how recent court decisions affect treatment of loan disbursements and repayments to

C corporations.

1-C Determine whether distributions from C corporations are taxable or nontaxable.

2 S Corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2-A File Form 2553, Election by a Small Business Corporation,and apply the proper Revenue Procedure

to request relief for a late election.

2-B Compute taxable income from S corporation distributions and determine the effect on a

shareholders stock basis.

2-C Recognize the potential of S corporation termination because of shareholder revocation, failure of

qualification, or violation of passive income restrictions.

3 Partnerships and LLCs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 3-A Identify separately stated items of partnership income or loss and report those items properly on

Schedule K-1, Form 1065, U.S. Return of Partnership Income.

3-B Identify recourse and nonrecourse liabilities and determine the effect on a partner or LLC

members ownership basis.

3-C Determine gain or loss on current distributions or liquidating distributions made to a partner or LLC

member.

4 Exempt Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 4-A Determine whether an entity qualifies as a tax-exempt organization under Internal Revenue Code

section 501(c)(3), based on organizational structure, operation, and purpose. 4-B Identify the filing requirements and required disclosures for a tax-exempt organization.

4-C Identify unrelated business income and requirements for filing Form 990-T, Exempt Organization

Business Tax Return.

Final Exam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9


5/102iv Table of Contents TheTaxReview Business Entities


6/102TheTaxReview Business Entities Chapter 1

CPE/CE

Learning Objectives

Successful completion of this course will enable the participant to:

1-A Define requirements for nontaxable transfers to corporations under IRC

section 351.

1-B Determine how recent court decisions affect treatment of loan disburse-

ments and repayments to C corporations.

1-C Determine whether distributions from C corporations are taxable or

nontaxable.

Glossary Terms

Section 351.If the conditions of IRC section 351 are met, no gain or loss results

when a person transfers property, including cash, to a C corporation.

Bona fide loan.A loan involving a business entity and one of its owners must

have characteristics of an arms-length transaction, including a true debtor/creditor relationship, to be recognized as a bona fide loan for tax purposes.

Earnings and profits.An accounting concept used to determine the amounts

available for dividend distribution to shareholders of a C corporation. Distri-

butions up to the amount of a C corporations earnings and profits are gener-

ally taxable to the shareholders. Distributions in excess of earnings and profits

are treated as a return of capital.

Learning Objective 1-A

Define requirements for nontaxable transfers to corporations under IRCsection 351.

General Rule for Contributions of Capital to a CorporationContributions to the capital of a corporation are paid-in capital. The contri-

butions, whether cash or property, are not taxable to the corporation. The na-

ture of the contribution will determine the basis for the corporation and the

shareholder.

Contributions of cash.A shareholder does not recognize gain or loss upon a

cash contribution in exchange for stock. The shareholders basis in stock is the

amount of cash contributed.

Contributions of property.The basis of property contributed to the capital of

a corporation is the same as the basis the shareholder had in the property,

increased by any gain the shareholder recognized on the exchange. This

amount is also the shareholders basis in the corporations stock. Exception:

See Nontaxable TransfersSection 351,page 2.

KEY FACT

1 C Corporations


7/1022 Chapter 1 TheTaxReview Business Entities

NOTES Services in exchange for stock.The fair market value of services rendered

in exchange for corporate stock is taxable to the service provider. The taxable

amount is the shareholders basis in the stock.

Contributions by non-shareholders.Contributions to capital made by non-

shareholders (such as land contributed by a municipality) have a basis to the

corporation of zero. If a corporation receives a cash contribution from a person

other than a shareholder, the corporation must reduce the basis of any prop-

erty acquired with that contribution during the 12-month period following the

date of the contribution by the amount of the contribution (not below zero).

Nontaxable TransfersSection 351General rule.No gain or loss shall be recognized if property is transferred

to a corporation by one or more persons solely in exchange for stock in such

corporation, and immediately after the exchange such person or persons are in

control of the corporation.

Alex transfers property worth $35,000 and renders services valued at $3,000

to a corporation in exchange for stock valued at $38,000. Right after the ex-change, he owns 85% of the outstanding stock. No gain is recognized on the

exchange of the property under section 351. However, Alex recognizes ordi-

nary income of $3,000 as payment for services he rendered to the corporation.

Control defined.The term control means the ownership of stock possessing

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

of the corporation.

Notes:

The term one or more persons may include individuals, trusts, estates, part-nerships, associations, or corporations.

Money is treated as property for purposes of section 351.

Services do not qualify as property for purposes of section 351.

Technical know-how, such as trade secrets or processes, may be considered

property for purposes of section 351, depending on the importance of the

underlying services.

Bill and Gary buy property for $100,000, each contributing $50,000. Years later,

they organize a corporation and transfer the property to the corporation. The

property is the only capital contributed to the corporation. The fair marketvalue of the property at the time of the transfer was $300,000. Under section

351, no gain is realized on the transfer by Bill, Gary, or the corporation. Bill

and Gary each have a basis in the corporation of $50,000.

T a mak valu vcndd n chang cpack axal h vcpvd.

EXAMPLE

T m cnl man hwnhp ck pssng a la80% h al cmnd vngpw all clas ck nld v and a la 80% h alnum ha all h clas

ck h cpan.

EXAMPLE



NOTES

Bill and Gary transfer property with a basis of $100,000 ($50,000 each) to a

corporation in exchange for stock with a fair market value of $300,000. This

represents 75% of each class of stock of the corporation, as the other 25% was

already issued to someone else. Because they did not meet the 80% owner-

ship threshold immediately after the exchange, Bill and Gary each recognize

a taxable gain of $100,000 (FMV of stock for each of $150,000 minus $50,000

basis of each).

Nonqualified transactions.Section 351 treatment does not apply to the fol-

lowing situations.

Transfers to investment companies.

Transfers in a bankruptcy or similar proceeding in exchange for stock used to

pay creditors.

Stock is received in exchange for the corporations debt or security interest in

the corporations debt.

Immediately after the exchange.Simultaneous exchanges are not necessary

to meet the qualifications for purposes of section 351. Control of the corpora-tion immediately after the exchange includes agreements where the rights

of the parties have been previously defined, and execution of the agreement

proceeds in a timely manner consistent with the agreement.

Transfer must be solely in exchange for stock.If the transferor receives prop-

erty other than stock in the exchange (referred to as boot), gain is realized

to the extent of the money or other property received. Boot includes debt

obligations issued by the corporation.

Nonqualified preferred stock. Transfer of nonqualified preferred stock istreated as boot and does not count for purposes of the 80% control qualifica-

tion for a section 351 transfer. The term nonqualified preferred stock means

preferred stock if:

The holder of the stock has the right to require the issuer or a related person

to redeem or purchase the stock,

The issuer or a related person is required to redeem or purchase the stock,

The issuer or a related person has the right to redeem or purchase the stock

and, as of the issue date, it is more likely than not that such right will be exer-

cised, or

The dividend rate on such stock varies in whole or in part (directly or indi-rectly) with reference to interest rates, commodity prices, or other similar

indices.

Group control. A group of investors can combine to meet the 80% control

requirement. However, minimal transfers of property by shareholders do not

qualify if the reason is merely to qualify other individuals for a section 351

transfer. Regulations refer to property which is of relatively small value in

comparison to the value of the stock. Revenue Procedure 77-37 explains that

the property transferred will not be considered of relatively small value if the

EXAMPLE

KEY FACT



NOTES fair market value of the property transferred is equal to, or in excess of, 10%

of the fair market value of the stock and securities already owned (or to be re-

ceived for service) by such person.

Assumption of liabilities in a section 351 exchange.In most areas of tax law,

liability relief is treated the same as if cash had changed hands. However, in a

section 351 transfer, a corporation can assume liability without triggering gain

if the liability is less than the contributors adjusted basis. The shareholders

basis in stock is reduced by the amount of liability transferred.

If the liability assumed by the corporation is more than the contributing share-

holders adjusted basis, the excess is treated as gain.

BasisSection 351 Transfer

Shareholders Basis in Stock Corporations Basis in Property

Adjusted basis of property

+ Gain recognized

+ Cash paid

Cash received

FMV of property received

Liabilities transferred

Adjusted basis of property in hands of

the shareholder

+ Gain recognized by the shareholder on

the transfer

Alan transferred property to a corporation in a section 351 exchange. The

propertys FMV was $20,000, and Alans adjusted basis in the property was

$8,000. The property was subject to a liability of $6,000, which was transferred

to the corporation. Alans basis in the stock received is $2,000 ($8,000 adjusted

basis of property contributed minus $6,000 liability transferred).

Assume the same facts as Example #1, above, except the property was subjectto a liability of $10,000. Because Alans adjusted basis in the property was

$8,000, he would report a gain of $2,000 on the transaction. Alans basis in the

stock received would be $0.

Relief of liability not required to trigger gain.Assumption of liability by

the corporation does not necessarily mean the shareholder must be relieved

of liability. In Seggerman, the corporation assumed liabilities associated with

contributed assets. However, the taxpayers remained personally liable for the

debts as secondarily liable guarantors. The liability was greater than the ba-

sis of property contributed. Therefore, even though the taxpayers were not re-lieved of liability, the amount was subtracted from basis and gain was recog-

nized. (Seggerman,7th Cir., October 24, 2002)

Holding period.The holding period for stock received in a section 351 transfer

includes the time the shareholder held the property before the exchange. The

corporations holding period for the contributed property includes the time the

property was held by the shareholder.

EXAMPLE #1

EXAMPLE #2

T hldng pd ck cvdn a cn 351 an ncludh m h hahld hld hppy h chang.



NOTES

In Slota vs. Commissioner,taxpayers set up a corporation for their farming op-

eration. The taxpayers received income from crop sales and USDA payments

and deposited those elements of income into their personal account. They sub-

sequently transferred the income amounts to their corporate account. When

filing their tax return, the taxpayers assigned the income to their corporate

return, which, because of corporate expenses, resulted in zero taxable income

for the corporation. The taxpayers asserted they contributed the crops and

the USDA payments to the corporation and, therefore, the corporation earned

the income. The IRS contended the amounts transferred to the corporation

were income from personal business and not property and, therefore, should

be taxed as personal income instead of corporate income. The court agreed

with the IRS, stating the taxpayers failed to show they transferred the crops or

underlying land to the corporation. The taxpayers may not avoid paying tax on

income by transferring income to a newly organized corporation in a section

351 transaction. (Slota,T.C. Summary 2010-152).

Reporting a Section 351 TransferBoth the corporation and every significant transferor (stockholder who owns

either 5% or more of a public company or 1% or more of a privately held com-

pany) involved in a section 351 transfer must attach a statement to their income

tax returns.

Significant transferor.A significant transferor is anyone who transfers prop-

erty to a corporation under section 351, and if immediately after the exchange

owns at least 5% (by vote or value) of the total outstanding stock of a publicly

traded company, or at least 1% (by vote or value) of the total outstanding stock

of a privately held company.

Required statement.Every significant transferor receiving stock in a section351 exchange must attach to his or her tax return for the taxable year of the

exchange a statement detailing certain information regarding the exchange.

Corporations transferring stock must also attach a similar statement to their

tax return.

Filed with the shareholders return.Shareholders must attach a statement

to the income tax return for the taxable year of the exchange that contains the

following information.

1) Description of the property transferred in exchange for stock and the cost or

other basis of the property transferred.

2) With respect to stock received in the exchange, information on:

The kind of stock and preferences, if any,

The number of shares of each class received, and

The fair market value per share of each class at the date of the exchange.

3) With respect to securities received in the exchange, information on:

The principal amount and terms, and

The fair market value at the date of exchange.

4) The amount of money received, if any.

COURT CASE

Evy gnfican an cvck n a cn 351 changmu atach h h ax u h axal ya h changa amn dalng cannman gadng h changCpan anrng ck mual atach a mla amn h ax un.



NOTES 5) With respect to other property received:

A complete description of each separate item,

The fair market value of each separate item at the date of exchange, and

In the case of a corporate shareholder, the adjusted basis of the other prop-

erty in the hands of the controlled corporation immediately before the dis-

tribution of such other property to the corporate shareholder in connec-

tion with the exchange.

6) With respect to liabilities assumed by the corporation, information on:

The nature of the liabilities, When and under what circumstances created,

The corporate business reason for assumption by the corporation, and

Whether such assumption eliminates the transferors primary liability.

Filed with the corporations return.Every corporation distributing stock in

a section 351 exchange must attach a statement to its income tax return for the

taxable year of the exchange that contains the following information.

1) A complete description of all property received from the transferors.

2) The basis of the exchanged property in the hands of the transferors on the

date of the exchange.

3) The following information with respect to the capital stock of the corporation: The total issued and outstanding capital stock immediately prior to and

immediately after the exchange, with a complete description of each class

of stock,

The classes of stock and number of shares issued to each transferor in the

exchange, and the number of shares of each class of stock owned by each

transferor immediately prior to and immediately after the exchange, and

The fair market value of the capital stock as of the date of exchange which

was issued to each transferor.

4) The following information with respect to securities of the corporation:

The principal amount and terms of all securities outstanding immediatelyprior to and immediately after the exchange,

The principal amount and terms of securities issued to each transferor in

the exchange, with information showing each transferors holdings of se-

curities of the corporation immediately prior to and immediately after the

exchange,

The FMV of the securities issued to the transferors on the date of the ex-

change, and

Information as to whether the securities issued in the exchange are subor-

dinated in any way to other claims against the corporation.

5) The amount of money, if any, which passed to each of the transferors in con-nection with the transaction.

6) With respect to other property which passed to each transferor:

A complete description of each separate item,

The FMV of each separate item at the date of exchange, and

In the case of a corporate transferor, the adjusted basis of each separate

item in the hands of the corporation immediately before the distribution

of such other property to the corporate transferor in connection with the

exchange.



NOTES7) The following information as to the transferors liabilities assumed by the

corporation in the exchange:

The amount and a description of each liability,

When and under what circumstances created, and

The corporate business reasons for assumption by the corporation.

Learning Objective 1-B

Determine how recent court decisions affect treatment of loandisbursements and repayments to C corporations.

C Corporation Loans to ShareholdersIn many cases, little thought is given to tax consequences when a C corporation

advances or loans funds to a shareholder. Even when the transaction is intend-

ed as a loan, documentation is quite often lacking. Lack of proper documenta-

tion opens the door for the IRS to assert that the payment to the shareholder

was actually a disguised dividend or compensation, rather than a loan.

Even with clear documentation that the transaction is a loan, there can still be

unfavorable tax consequences when the terms of the loan are not followed or

too little or no interest is charged.

Shareholder Loans to C CorporationWhen a shareholder invests in a C corporation, the investment is usually char-

acterized as a contribution to capital, which is not taxable to the corporation

nor deductible by the shareholder. Later withdrawals from the corporation are

typically treated as a dividend, taxable to the shareholder and not deductible

to the C corporation.

When a shareholder makes a loan to a C corporation, instead of a contributionto capital, the following tax advantages are gained.

Repayment of the loan principal to the shareholder is nontaxable, as opposed

to a taxable dividend distribution. The shareholder pays no tax on the re-

payment received and the payment by the C corporation is not a deductible

expense. The shareholder is able to recover part of their investment in the

C corporation without triggering any taxes.

The interest payments to the shareholder are deductible by the C corpora-

tion. This allows a shareholder to withdraw cash from the corporation with-

out double taxation. The shareholder will pay income tax on the interest pay-

ments; however, the interest payment is not subject to payroll taxes.

IRS Market Segment Specialization Program Audit TechniqueGuideShareholder LoansThe IRS issued Market Segment Specialization Program Audit Technique

GuideShareholder Loans to assist its examiners in auditing corporations to

determine whether a bona fide shareholder loan exists. Although the guide

focuses on corporate loans to shareholders, many of the factors it considers in

determining whether an actual loan exists apply equally to shareholder loans

to corporations.

Evn wh cla dcumnan hh anacn a lan, h canll unaval ax cnquncwhn h m h lan a nllwd ltl n n chagd.



NOTES The guide directs the examiner to ask the question: is there a bona fide debt?

The primary determination as to whether or not debt is a bona fide debt hinges

on the question: When the loan was made, was there a genuine intent that

the borrowed funds be repaid? Over many years, a set of common law factors

has evolved. The guide recommends the following key determining factors be

considered.

The extent to which the shareholder controls the corporation.

Whether security was given.

Is the shareholder in a position to repay the loan? Adequate earnings and profits.

Certificate of indebtedness is given to the corporation.

Is there a repayment schedule or an attempt to repay?

Is there a set maturity date?

Whether the corporation charges interest.

Whether the corporation has made systematic efforts to obtain repayment.

Magnitude of the advances.

Whether a ceiling exists to limit the amount the corporation can advance.

Dividend history of the company.

The guide instructs the reader to view the above factors as a whole. Any fac-tor on its own is not determinative and the list is not all inclusive. The purpose

for analyzing the above factors is to determine the parties intent at the time of

distribution.

Is There a Debtor/Creditor Relationship?The courts also focus on whether the parties to the transaction intended to cre-

ate a bona fide debtor/creditor relationship. The courts have noted that wheth-

er the transfer of funds between a shareholder and a C corporation constitute

bona fide debt is a question of fact which must be decided on the basis of all

relevant facts and circumstances in each case.

Shareholder loan to a C corporation. When presented with the issue of

whether a purported loan from a shareholder to a C corporation is debt or eq-

uity, the courts have generally weighed the following factors and provided the

following explanations:

Names given to the documents.The issuance of a stock certificate indicates a capi-

tal contribution. The issuance of a note is indicative of bona fide debt. However,

in a closely held corporation, labels attached to transfers through bookkeeping

entries have limited significance unless the labels are supported by objective

evidence.

Presence or absence of fixed maturity date.The presence of a fixed maturity date

indicates a fixed obligation to repay, a characteristic of a debt obligation. The

absence of the same on the other hand would indicate that the repayment was

somehow tied to the fortunes of the business, indicative of an equity advance.

Source of repayments.If it is impossible to estimate when a monetary transfer

will be repaid because the repayment is contingent upon future profits, a cap-

ital investment is indicated. When a debtors repayment is contingent upon

earnings, the lender is acting more like a capital investor hoping to make a

T pmay dmnan a whh n d a na fidd hng n h qun: Whnh lan wa mad, wa h agnun nn ha h rwdund pad?

In a clly hld cpan, lalatachd an hughkkpng n hav lmdgnficanc unls h lal auppd y bcv vdnc.



NOTESprofit, not as a creditor expecting to be repaid regardless of the companys suc-

cess or failure.

The right to enforce repayment.An essential element in determining whether a

shareholder intended to enforce repayment of the advance is whether a good-

faith intent on the part of the recipient of the funds to make repayment and

good-faith intent on the part of the shareholder to enforce payment exists.

Increase in management participation.If a shareholder makes a monetary transfer

to a corporation, and as a result receives an increased right to participate in themanagement of the corporation, such participation tends to demonstrate that

the advance was not a bona fide debt, but rather a capital investment.

Status equal to or inferior to other creditors. Whether a monetary transfer is sub-

ordinated to an outside creditor bears on whether a shareholder was acting as

a creditor or an investor. In addition, failure to demand timely repayment ef-

fectively subordinates the shareholder-corporation debt to the rights of other

creditors who receive payment in the interim.

Intent of the parties.The inquiry of a court in resolving the debt-equity issue is

primarily directed at ascertaining the intent of the parties.

Thin or adequate capitalization.A monetary transfer to a corporation appearsto be a capital contribution if the corporation is thinly capitalized. When look-

ing at a corporations debt to equity ratio, the courts typically look to industry

averages as a guide.

The identity of interest between creditor and shareholder.This factor generally com-

pares the equity ownership of stockholders with their position as creditors in

order to determine whether there is an identity of interest between the two

positions. This factor does not apply in sole shareholder situations.

Source of interest payments.This factor is essentially the same as the third factor,

the source of repayments. The focus, however, is on how the parties treated theinterest. A true lender is concerned with interest. When shareholders transfer

sums to a corporation and do not insist that the corporation make interest pay-

ments, it indicates that the shareholders expect to be paid out of future earn-

ings or through increased market value of their equity interest.

Ability to obtain loans from outside lending institutions.Would an outside lender

have loaned the funds in the same form and on the same terms? However, the

mere fact that a loan could not be obtained from an unrelated source does not

preclude the existence of a bona fide loan.

Use of the funds by the corporation.Generally, the fact that an advance is used to

satisfy the daily operating needs of a corporation indicates a bona fide indebt-edness, whereas a monetary transfer resembles equity if it is used to acquire

capital assets.

Failure to repay on the due date.A true lender is also concerned with the repay-

ment of the loan. When a shareholder transfers funds to a corporation and

does not receive repayment on the due date, it indicates that the shareholder is

acting as an equity investor, not a lender.



NOTES

C corporation loan to a shareholder.When presented with the issue of wheth-

er a disbursement to a shareholder was a loan, a distribution, or compensa-

tion, the courts weigh many of the same factors listed on page 8. The critical

question is the same. What was the intent of the parties? Was there a genuine

intent that the borrowed funds would be repaid? Key factors the court consid-

ers include:

Whether the promise to repay is evidenced by a note or other instrument,

Whether interest was charged,

Whether a fixed schedule for repayments was established,

Whether collateral was given to secure the loan,

Whether repayments were made,

Whether the shareholder had a reasonable prospect of repaying the loan

and whether the corporation had sufficient funds to advance the loan, and

Whether the parties conducted themselves as if the transaction were a loan.

Ernie is a shareholder of Power Wash, Inc., a C corporation. Ernie borrowed

$5,000 from Power Wash, Inc. and executed a promissory note for $5,000 with

5% interest. The note did not specify a maturity date or repayment amount.

Ernie and Power Wash, Inc. initiated bi-weekly payroll deductions of $100

per pay period that will pay off the loan within a couple of years. The lack of

maturity date or repayment schedule has generally not been held against a

taxpayer by the courts. The pattern of systematic payroll deductions and that

the loan will be repaid within a couple of years is evidence that the $5,000 is

a bona fide debt.

Marcus is a shareholder of Painters, Inc., a C corporation. On December 1,

2013 Marcus borrowed $5,000 from Painters, Inc. and executed a promissory

note for $5,000 with 5% interest due on December 1, 2014. Marcus made no

interest or principal payments and on December 1, 2014 renewed the note

with Painters, Inc. for $5,000 plus the accrued interest of $250. The terms of

the renewed note are $5,250 principal, 5% interest, and due date of December

1, 2015. On December 1, 2015, Marcus again renewed the note, plus accrued

interest, for $5,512.50 principal, 5% interest, and due date of December 1, 2016.

The courts have viewed the pattern of setting a maturity date and annually

renewing the note, but never repaying the loan, indicative of a disguised divi-

dend and not a bona fide debt.

KEY FACT

EXAMPLE

EXAMPLE



NOTES

The taxpayers husband, who was deceased at the time of the court case,

was the sole shareholder of a C corporation. The taxpayers husband was the

key employee and responsible for managing the business. The taxpayer was

also employed by the corporation. The corporation had a line of credit from

an outside lender which was secured by all the companys assets, in addition

to property owned by the taxpayer and her husband. When the corporation

started having cash flow problems, it tried to obtain additional loans from the

outside lender. The outside lender declined to loan any additional funds until

the previous loans were repaid. The taxpayers husband then decided to use

personal funds to help his corporation and was advised by his CPA to treat

the advances as loans instead of capital investments. The taxpayers husband

also asked the taxpayer to loan funds to his corporation. The taxpayer was

hesitant as she knew the corporation was struggling financially; however, she

believed, if necessary, her husband would repay the loans so she decided to

loan funds to the corporation.

The taxpayer and her husband made a number of loans to the corporation with

varying amounts of documentation. The in-house accountant was instructedto record all advances from the personal accounts of the taxpayers husband

as shareholder loans on the corporate books, and the CPA also reported those

transactions as shareholder loans on the corporate income tax returns. Formal

loan documents were not executed for most of the transactions. The corpora-

tion did not make any payments on any of the funds advanced. No interest was

charged and no security was given for the shareholder loans. Also, prior to

the taxpayers husbands death, he did not seek repayment of the shareholder

loans. After the taxpayers husband died, the corporation ceased its opera-

tions. On the corporations final tax return, it reported $218,489 as income from

forgiveness. The taxpayer filed an amended tax return reporting a business

bad debt loss of $218,489 from the shareholder loans made. The IRS disallowed

the taxpayers ordinary loss treatment of the $218,489 business bad debt de-

duction and instead allowed the taxpayer a $218,489 capital loss.

The issue for the court to decide was whether the monetary transfers made

by the taxpayer and her husband to the corporation were capital contributions

or bona fide debts. The court applied the factors listed in Shareholder loan to

a C corporation,page 8. The court noted a number of items that indicated the

advances were capital contributions and not bona fide debt. No fixed maturity

date existed and there was no fixed repayment schedule. Despite knowing

the corporation was struggling, and that there was not sufficient cash flow to

repay them, the taxpayer and her husband advanced funds to the corporation.

Even though the notes were demand notes, the court found clear evidence

that the taxpayer and her deceased husband would not have demanded pay-

ment if it would have imperiled the financial condition of the corporation, and

a demand for repayment or interest was never made. The court further noted

that the taxpayer and her deceased husband knew the extent of the corpora-

tions financial problems and knew that transferring funds to the corporation

Continued on next page

COURT CASE



NOTES

Court Case continued

was risky. Knowing this, the taxpayer and her deceased husband still chose to

make the transfers. Although the transfers were treated as debt on the corpo-

rate books, the court did not believe the taxpayer and her husband intended,

or could have intended, the transfers to be bona fide debt. The court held that

the transfers did not constitute bona fide debt and should be treated as capital

contributions. (Tedford,T.C. Summary 2004-132)

The taxpayer was the sole shareholder and president of a C corporation. Dur-

ing the year, the taxpayer received a salary from the corporation. The taxpayer

also received miscellaneous checks totaling $72,000 from the corporation that

he did not report as income. The taxpayer treated the miscellaneous checks as

repayments of loans previously advanced to the corporation. The IRS argued

that the $72,000 of disbursements were dividend distributions and taxable to

the taxpayer.

The corporations tax return shows a zero balance on its balance sheet under

the item loans from shareholders. The corporation does maintain a handwrit-

ten ledger entitled shareholder cash loans to corporation which lists several

loans at various interest rates. None of the loans in the ledger are corroborated

by a formal promissory note with principal and interest rates corresponding

to the amounts recorded in the ledger.

The taxpayer presented, as evidence of his shareholder loans to the corpo-

ration, two promissory notes. A line of credit promissory note (first note) for

$1,000,000, dated September 1, 1995, bearing interest at 5% and payable on

demand. This note lists the taxpayer as the borrower and the corporation as

the lender. The second promissory note (second note) dated March 22, 1996was for $337,500, payable on demand, bearing interest at 9.5%, or 12% if pay-

ment is not made upon demand. The second note is unsecured and is not

listed in the corporations handwritten ledger of shareholder loans. Attached

to the second note is a copy of a personal note between the taxpayer and a

bank. The taxpayers bank loan is for the principal sum of $337,500, charges

interest identical to the second note but has a stated maturity of April 1, 1999,

and is secured by real estate owned by the taxpayer. The taxpayer stated

that he borrowed the funds from the bank to loan to the corporation since his

personal funds were depleted.

The court was not persuaded that the promissory notes presented by thetaxpayer represent true indebtedness of the corporation. The first note clearly

states that the borrower is the taxpayer and the lender is the corporation.

The taxpayer argued that the names of the parties are reversed but there is

no record that links the first note explicitly to any actual monetary advance

by the taxpayer to the corporation. Neither the corporation nor the taxpayer

presented any record for any alleged advancements, repayment or accruals

of interest regarding funds lent pursuant to the first or second note. The notes

Continued on next page

COURT CASE



NOTES

Court Case continued

are not listed in the corporations handwritten ledger or listed on the corpora-

tions balance sheet. The taxpayer was unable to substantiate the claim that

the $72,000 of miscellaneous checks received were repayments of loans or

that any loans existed from the taxpayer to the corporation.

Even if the taxpayer had presented consistent and credible evidence that the

cash repayments were repayments of prior loans to the corporation, the court

stated it would have concluded, based on the facts and circumstances of this

case, that those prior loans were in reality equity contributions and not debt.

The court applied the factors listed in Shareholder loan to a C corporation,

page 8. The court found the factors weighed in favor of reclassifying any al-

leged loans from the taxpayer to the corporation as equity investments. Also,

when comparing the second note to the taxpayers note with the bank, the

second note had no stated maturity date and was not secured, which put the

taxpayer in a riskier position than the bank. The court viewed this as further

supporting the argument of a capital contribution. The court concluded that

any alleged loans from the taxpayer to the corporation were equity contribu-

tions to risk capital rather than true debt. Thus the disbursements totaling

$72,000 were dividend distributions taxable to the taxpayer. (HJ Builders, Inc.,

T.C. Memo 2006-278)

The taxpayers were sole shareholders of two C corporations. Each corporate

balance sheet reported outstanding shareholder loans for the years in ques-

tion. When requested under audit, the taxpayers did not produce any written

agreements or promissory notes evidencing any of the amounts reported as

loans to or by the corporations. Neither taxpayer charged interest on any

amount lent to his or her separate corporation. None of the amounts reported

as loans were collateralized, and the amounts reported as repayments were

not made pursuant to a schedule or any other specific term. The taxpayers

and the corporations did not record the amount of any loan between them,

or otherwise keep track of it accurately. During the years under audit, the

taxpayers received distributions from their corporations which they recorded

as loan repayments. The IRS disagreed with the characterization, arguing that

all the distributions were actually constructive dividends.

The court agreed with the IRS. The court recognized that closely held corpo-

rations may sometimes be lax in formalizing their dealings with each other;

however, the court rejected the taxpayers claims as unsupported. The court

found the taxpayers did not establish their intent at the time of any of the dis-

tributions to be that the distribution was a repayment of a shareholder loan or

the making of a loan to a shareholder. At the time of any of the distributions,

the taxpayers failed to establish that the requisite bona fide debtor/creditor

relationship existed. (Knutsen-Rowell, Inc. et al,T.C. Memo 2011-65)

COURT CASE



NOTES Learning Objective 1-C

Determine whether distributions from C corporations are taxable or

nontaxable.

General Rules for Taxation of Non-Liquidating DistributionsC corporations may distribute money, stock, or other property to shareholders.

The following general rules hold for non-liquidating distributions.

Distributions of earnings and profits (E&P) are taxable to the recipient asdividends.

Distributions in excess of E&P are nontaxable up to the amount of a share-

holders basis in the C corporation stock.

Distributions in excess of E&P, and in excess of a shareholders stock basis,

represent gain from the sale or exchange of property (capital gain). The hold-

ing period for long- or short-term treatment is determined by how long the

shareholder owned the stock.

The C corporation, not the shareholder, determines whether the distribution is

a dividend. The corporation files Form 5452, Corporate Report of Nondividend

Distributions,as part of making this determination. The corporation does not

deduct dividends paid to shareholders.

Earnings and Profits (E&P)E&P is an accounting concept used for purposes of properly determining:

Taxable dividends.

Taxable distributions when a C corporation converts to an S corporation.

Taxable liquidation proceeds.

E&P is used to identify distributions that represent return on a shareholders

investment. Distributions in excess of E&P represent a return of capital.

Earnings and profits are composed of current-year E&P and accumulated E&P.

Note:E&P represents the amount that can be distributed to shareholders with-

out depleting capital. E&P is not the same as net income.

Current-year E&P.A worksheet for computing current-year E&P is provided

as part of Form 5452, Corporate Report of Nondividend Distributions.The general

idea is to determine how much money and property might be available for

distribution, without totally ignoring the effects of depreciation. Current-year

E&P can be computed using the following steps.

1) Compute current-year taxable income using the normal rules for income

and deductions, but without any Section 179 expense or depreciation deduc-

tions that may have been claimed on the tax return.

2) If the Section 179 expense was claimed on the tax return, compute deprecia-

tion on the affected asset over five years using the straight-line method.

3) Compute all other depreciation using ADS life and straight-line method.

KEY FACT

KEY FACT



NOTES4) Add the following items to income.

Refunds of federal income tax received during the year.

Tax-exempt income, including nontaxable life insurance proceeds paid to

the C corporation.

Dividends received deductions used to compute taxable income.

Any carryovers used to compute current-year taxable income (such as NOL

deductions, excess charitable contributions, and capital losses).

Deferred gains on current-year installment sales.

Cancelled debt not included in current-year taxable income.5) Subtract the following items from income.

Federal income taxes paid or accrued in the current year.

Expenses of producing tax-exempt income in the current year.

Any other current-year nondeductible items, such as fines, penalties, politi-

cal contributions and lobbying expenses, certain life insurance premiums,

including interest on debt, current excess capital losses, current excess

charitable contributions, and meals and entertainment expenses.

Note:The lists of additions and subtractions in the Internal Revenue Code and

Treasury Regulations are not comprehensive.

Accumulated E&P.Current-year E&P, if not distributed to shareholders, be-

comes accumulated E&P. Since distributions can be made in excess of current

E&P, it is possible for current E&P to be negative. Accumulated E&P is deter-

mined by the C corporation at the beginning of each tax year.

Nontaxable income earned by a C corporation increases E&P since it repre-

sents a shareholders return on investment.

Jill is the sole shareholder in Pail Corporation, a C corporation that manu-factures buckets. Jills basis in her Pail Corporation stock is $55,000. In 2013,

Pail Corporation had E&P of $40,000 available for distribution, which includes

$2,400 in nontaxable municipal bond interest. Any 2013 distribution to Jill of

$40,000 or less will be fully taxable to her as dividends, even though the dis-

tribution could include E&P attributable to nontaxable bond interest.

Distributions less than current-year E&P.If total distributions during the

year do not exceed current-year E&P (calculated at the close of the year with-

out subtracting distributions made during the year), then all distributions

made during the year are treated as distributions of current-year E&P. Suchdistributions are taxable to the shareholder as dividends.

Distributions in excess of current-year E&P. If total distributions for the

year exceed current-year E&P (calculated at the close of the year without sub-

tracting distributions made during the year), then part or all of each distribu-

tion is treated as a distribution of accumulated E&P. The portion attributable

to E&P is taxable to the shareholder as dividends. The calculation depends on

whether the C corporation has current-year E&P.

KEY FACT

EXAMPLE



NOTES

The corporation has current-year E&P.Allocate distributions for the year as

follows:

1) Divide current-year E&P by total distributions for the year. Since total

distributions exceed E&P, the result is a fraction less than one but greater

than zero.

2) Multiply each distribution made during the year by the fraction from the first

step. The result is the amount of the distribution to be treated as having

come from current-year E&P. Starting with the first distribution made during

the year, the remainder of each distribution will be treated as having come

from accumulated E&P.

The corporation does not have current-year E&P. Allocate distributions for

the year as follows:

1) If current-year E&P is less than zero, prorate the negative balance to the

date of each distribution made during the year. Skip this step if current E&P

is exactly zero.

2) Determine the available accumulated E&P for each distribution date during

the year by subtracting the amounts obtained in the first step, if any. Treat

each distribution as a distribution from these adjusted accumulated E&P

amounts.

If the second step in either case reduces accumulated E&P to zero, then the

remaining part of each distribution reduces the adjusted basis of the stock

held by the shareholders. To the extent that the balance exceeds the adjusted

basis of the stock, it is treated as gain from the sale or exchange of property.

Jack is the sole shareholder in Pumper Corporation, a C corporation that makes

water pumps. At the beginning of 2013, Pumper Corporations accumulated

E&P is $20,000. During the year, the corporation made an $8,000 distribution to

Jack on June 30 and again on December 31. The treatment of the $16,000 total

2013 distributions depends on whether Pumper Corporation had E&P in 2013.

Case #1:Suppose Pumper Corporations 2013 E&P is $10,000.

1) Current-year E&P divided by distributions is $10,000 $16,000, or 0.625.

2) Each $8,000 distribution consists of $5,000 ($8,000 0.625) in current-year

E&P and $3,000 in accumulated E&P.

Pumper Corporation has distributed all of its current-year E&P and $6,000 ofits accumulated E&P. The remaining $14,000 of accumulated E&P is available

for distribution in future years. Continued on next page

CASE #1

CASE #2

EXAMPLE



NOTES

Example continued

Case #2:Suppose Pumper Corporations 2013 E&P is ($14,000), that is, negative

$14,000.

1) ($14,000) is prorated by assigning ($7,000) to each distribution date.

2) Determine the available accumulated E&P on each distribution date as

follows:

June 30, 2013 Distribution:

Accumulated E&P . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . .$ 20,000

Prorated current-year E&P . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . (7,000)

Accumulated E&P available . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . .$ 13,000

Amount of distribution treated as dividend . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . (8,000)

December 31, 2013 Distribution:

Accumulated E&P . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . .$ 5,000

Prorated current-year E&P . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . (7,000)

Accumulated E&P available . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . (2,000)

Amount of distribution treated as dividend . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . $ 0

Nondividend amount. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . $ 8,000 2013 year-end accumulated E&P . . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . (2,000)

The nondividend amount paid on December 31 is nontaxable to the extent that

it does not exceed Jacks basis in Pumper Corporations stock. The amount

in excess of his basis, if any, is treated as gain from the sale or exchange of

property.

In Case #2 of the example, above, suppose Jacks basis in Pumper Corpora-

tions stock is $5,500. The $16,000 distributed to Jack in 2013 consists of an

$8,000 dividend, $5,500 return of capital, and $2,500 gain from the sale or ex-change of property. Jacks stock basis is reduced to zero.

Constructive DividendsThe IRS may examine C corporations with E&P and reclassify distributions

to shareholders as constructive dividends. Often the IRS must first determine

that amounts paid by the corporation (or not paid by a shareholder) are actu-

ally distributions instead of corporate expenses. The corporation does not de-

duct constructive dividends.

If distributions made to a shareholder have previously been reported as non-

taxable to the shareholder, amounts reclassified as constructive dividends

become taxable to the shareholder.

The following examples illustrate how constructive dividends can occur.

Below-market loans.The corporation lends money to a shareholder but charg-

es interest below the applicable federal rate, or no interest at all. The amount

of interest that should have been charged may be treated as a distribution to

the shareholder.

EXAMPLE

KEY FACT



NOTES Cancellation of shareholder debt.The corporation cancels a debt owed to the

corporation by a shareholder. The amount cancelled is treated as a distribu-

tion to the shareholder.

Transfers of property for less than fair market value.The corporation sells, ex-

changes, or otherwise transfers property to a shareholder, but the sharehold-

er pays less than the FMV of the property. If the shareholder is not a corpora-

tion, the excess of FMV over price paid may be treated as a distribution to the

shareholder.

Unreasonable rents.The corporation rents property from a shareholder, butthe amount of rent is unreasonably more than the shareholder would charge

an unrelated party. The excessive part of the rent may be treated as a distribu-

tion to the shareholder.

Unreasonable salaries.The corporation pays an employee who is also a share-

holder a salary that is unreasonably high in relation to the services actually

performed by the shareholder-employee. The excessive part of the wages

may be treated as a distribution to the shareholder.

Personal expenses.The corporation pays a shareholders personal expenses or

otherwise fails to meet the requirements for deducting expenses paid in be-

half of a shareholder. The amount paid may be treated as a distribution to theshareholder.

During the tax years 2003 2005, a C corporation paid and deducted all the

expenses and reported the income from an activity that the Tax Court deter-

mined was the sole shareholders hobby. The hobby activity existed before the

corporation was formed and was unrelated to the business of the corporation.

Not only were the hobby expenses disallowed as an expense to the corpora-

tion, but the amounts paid by the corporation were reclassified by the IRS as

constructive dividends to the shareholder.

The Court also determined that the corporations profit-sharing plan did not

constitute a qualified profit-sharing plan under IRC section 401(a). Contribu-

tions made by the corporation to the plan during the years in question were not

deductible by the corporation, but were reclassified as constructive dividends

to the shareholder.

In each of the years under examination, the corporation paid wages to a friend

of the shareholder in connection with the hobby activity. Those wages became

part of the constructive dividends. The potential existed for the wage amounts

to be taxed three times: to the corporation (since the deduction for the wages

was disallowed), to the shareholder (as constructive dividends), and to the

friend (as wages). The Court did not address this possibility. (DKD Enterprises,

T.C. Memo 2011-29)

General Rule for Distributions of Stock and Stock RightsDistributions by a C corporation of its own stock (stock dividends) and rights

to acquire corporate stock (stock options) are generally not taxable to the

recipient and are not reported on the recipients tax return.

COURT CASE


24/102



NOTES Chapter 1 Self-Quiz

InstructionsTest your knowledge and comprehension of information presented in Chapter 1.

True/False1) Mark transferred property to a corporation and immediately after the ex-

change his percentage of stock ownership was exactly 80%. Marks owner-ship percentage meets the control test for purposes of section 351.

True False

2) When a shareholder makes a loan to a C corporation instead of an equity

contribution, certain tax advantages are gained.

True False

3) A shareholder files Form 5452, Corporate Report of Nondividend Distributions,

in order to determine how a distribution from a C corporation is to be taxed

on his or her personal return.

True False

Multiple Choice1) For each of the following scenarios, the transfer qualifies under section 351.

Which of the following statements about transfers to a corporation is true?

a) Fred transfers property with a FMV of $50,000 and a basis of $20,000.

Freds basis in the stock is $50,000.

b) Wilma transfers cash in the amount of $100,000 and services valued at

$20,000 in exchange for stock valued at $120,000. Wilmas basis in the stock

is $100,000.c) Barney transfers property with a FMV of $50,000, basis of $20,000, and debt

on the property of $15,000 to a corporation. Barneys basis in the stock is

$35,000.

d) Betty transfers property with a FMV of $40,000, basis of $30,000, and debt

on the property of $10,000 to a corporation. In addition, she transfers

$10,000 cash. Bettys basis in the stock is $30,000.

2) All the following factors are considered when evaluating whether a share-

holder loan to a C corporation has the characteristics of a bona fide debt or

an equity contribution except:

a) Intent of the parties.

b) Absence of a fixed maturity date.

c) Failure to pay on the due date.

d) The management position of the shareholder.



NOTES3) Stan is the sole shareholder in QRS Corporation, a C corporation that does

plumbing repairs. His basis in company stock is $21,500. In June 2013, Stan

received a distribution of $10,000 from QRS Corporation. In December 2013,

the corporation forgave a loan of $15,000 made to Stan so he could buy a boat.

QRS Corporation had $17,000 E&P available for distribution in 2013. What

does Stan report on his individual tax return? What are his basis in QRS

Corporation stock and QRS Corporations E&P at the beginning of 2014?

a) Stan reports $17,000 in dividends and reduces his basis in QRS Corpora-

tion stock to $13,500. QRS Corporations E&P at the beginning of 2014 is $0.

b) Stan reports $10,000 in dividends and reduces his basis in QRS Corpora-

tion stock to $6,500. QRS Corporations E&P at the beginning of 2014 is

$7,000.

c) Stan reports $25,000 in dividends and increases his basis in QRS Corpora-

tion stock to $29,500. QRS Corporations E&P at the beginning of 2014 is $0.

d) Stan reports $21,500 in dividends and reduces his basis in QRS Corpo-

ration stock to $0. QRS Corporations E&P at the beginning of 2014 is

$13,500.



NOTES Chapter 1 Self-Quiz Answers

True/False1) Mark transferred property to a corporation and immediately after the ex-

change his percentage of stock ownership was exactly 80%. Marks owner-

ship percentage meets the control test for purposes of section 351.

True Correct.Under section 351, control means ownership of 80%

or more of the corporations stock. False Incorrect.Under section 351, control means ownership of 80%

or more of the corporations stock. The percentage of ownership

does not need to be greater than 80%.

2) When a shareholder makes a loan to a C corporation instead of an equity

contribution, certain tax advantages are gained.

True Correct.The repayment of loan principal is a nontaxable event.

The shareholder pays no tax on the repayment of loan princi-

pal, and the payment by the C corporation is not a deductible

expense. Making a loan instead of an equity contribution allows

the shareholder to recover part of their funds advanced to the

C corporation without triggering any taxes.

False Incorrect.Withdrawals from a C corporation are typically treat-

ed as dividends, taxable to the shareholder and not deductible

by the C corporation. When funds advanced to a C corporation

are treated as a loan instead of an equity contribution, the prin-

cipal repayments are tax-free and the payment of interest is a

means to withdraw cash from the C corporation without double

taxation.

3) A shareholder files Form 5452, Corporate Report of Nondividend Distributions,in order to determine how a distribution from a C corporation is to be taxed

on his or her personal return.

True Incorrect.Form 5452 includes the corporations calculation of earn-

ings and profits. This form is filed by the C corporation, not by

shareholders.

False Correct.The classification of distributions is done at the corpo-

rate level, not at the individual level.

Multiple Choice1) For each of the following scenarios, the transfer qualifies under section 351.Which of the following statements about transfers to a corporation is true?

a) Fred transfers property with a FMV of $50,000 and a basis of $20,000. Freds

basis in the stock is $50,000.

Incorrect. Freds basis in the stock is the same basis he had in the property

transferred. Freds basis is $20,000.



NOTESb) Wilma transfers cash in the amount of $100,000 and services valued at

$20,000 in exchange for stock valued at $120,000. Wilmas basis in the stock

is $100,000.

Incorrect.The fair market value of services Wilma provides in exchange

for stock is taxable to Wilma. The taxable amount is included in

the basis of the stock. Her basis is $120,000 ($100,000 cash plus

$20,000 services).

c) Barney transfers property with a FMV of $50,000, basis of $20,000, and debt

on the property of $15,000 to a corporation. Barneys basis in the stock is

$35,000.

Incorrect. Liabilities transferred reduce the basis of the stock. Barneys ba-

sis is $5,000 ($20,000 basis in the property minus $15,000 debt).

d) Betty transfers property with a FMV of $40,000, basis of $30,000, and debt on

the property of $10,000 to a corporation. In addition, she transfers $10,000

cash. Bettys basis in the stock is $30,000.

Correct.Bettys basis is the original basis of the property minus the lia-

bility transferred plus the cash transferred. ($30,000 basis minus

$10,000 debt = $20,000 plus $10,000 cash).2) All the following factors are considered when evaluating whether a share-

holder loan to a C corporation has the characteristics of a bona fide debt or

an equity contribution except:

a) Intent of the parties.

Incorrect. The intent of the shareholder and the C corporation at the time

the loan is made is one of the primary factors in determining

whether or not the debt is a bona fide debt.

b) Absence of a fixed maturity date.

Incorrect. The absence or presence of a fixed maturity date is a factor that

is considered. The presence of a fixed maturity date is a charac-

teristic of debt obligations, while the absence of a fixed maturity

date is indicative of an equity contribution.

c) Failure to pay on the due date.

Incorrect.One of the factors considered is whether the loan is repaid on

the due date. A true lender is concerned with the repayment of

the loan. When a shareholder does not receive repayment on

the due date, it indicates the shareholder is acting as an equity

investor, not a lender.

d) The management position of the shareholder. Correct.The management position of a shareholder is not a factor con-

sidered in evaluating shareholder loans. However, increased

management rights given to a shareholder as a result of a loan is

one of the factors. The increased right to participate in manage-

ment tends to demonstrate that the advance was not a bona fide

debt but an equity contribution.


29/102



CPE/CE2 S CorporationsLearning Objectives

Successful completion of this course will enable the participant to:

2-A File Form 2553, Election by a Small Business Corporation, and apply the

proper Revenue Procedure to request relief for a late election.

2-B Compute taxable income from S corporation distributions and determine

the effect on a shareholders stock basis.

2-C Recognize the potential of S corporation termination because of share-

holder revocation, failure of qualification, or violation of passive income

restrictions.

Glossary Terms

One-class-of-stock rule.To qualify for S corporation status, the corporation

may have only one class of stock with regard to rights to dividends and liquida-

tion proceeds.Accumulated adjustments account (AAA). An S corporation account that

represents the accumulation of undistributed S corporation income.

Other adjustments account.An S corporation account that tracks tax-exempt

income and related expenses, and federal taxes.

Learning Objective 2-A

File Form 2553, Election by a Small Business Corporation, and apply the

proper Revenue Procedure to request relief for a late election.

General Rules for Filing Form 2553 An eligible corporation makes the election to be taxed as an S corporation by

filing Form 2553, Election by a Small Business Corporation.The effective date of

the election is indicated on line E, Form 2553.

Form 2553 must be completed and filed no later than two months and 15 days

after the first day of the tax year the election is to take effect (March 15 for a

calendar year corporation).

An existing corporation may file Form 2553 at any time during the tax year

immediately preceding the date the election is to take effect.

Each shareholder who owns stock on the date the election is filed must con-sent to the election and sign Form 2553 or separate consent statement. If Form

2553 is filed on or after the effective date, all shareholders who owned stock at

any time between the effective date and date of filing must consent and sign.

There are special signature rules for shareholders who are minor children,

estates or trusts, and those with community, joint, or other shared interest.



NOTES

Cue Corporation has been in existence for ten years and qualifies to make the

S corporation election. Cue Corporation has a window of 14 months and 15

days in which to make the election. (12 months preceding the effective date

and the two months and 15 days after the effective date).

Exceptions to General Rules for Filing Form 2553An eligible non-corporate entity (such as a partnership or LLC) may elect to be

taxed as an S corporation. Such an entity that files Form 2553 is deemed also to

have made the election to be taxed as a corporation. This eliminates the need to

file Form 8832, Entity Classification Election.

IRS procedures may allow a late election when a corporation (or non-corporate

entity electing to be taxed as a corporation) misses the deadline for filing Form

2553.

Who May File Form 2553 and Elect S Corporation Status?A corporation (or other eligible entity) may file Form 2553 to elect be an S cor-

poration only if it meets all the following tests.

It is a domestic corporation (or a domestic entity eligible to elect treatment as

a corporation). Individual shareholders may not be resident aliens.

It has no more than 100 shareholders, limited to individuals, estates, and cer-

tain tax-exempt organizations and trusts. All members of a family and their

estates may be treated as one shareholder. A family is defined as a common

ancestor and all lineal descendents, together with current and former spous-

es of the common ancestor and the lineal descendents.

It has only one class of stock, disregarding differences in voting rights. Gener-

ally this requirement is met if all outstanding shares of corporate stock con-

fer to all the shareholders identical rights to any distribution and liquidation

proceeds.

It is not one of the following ineligible corporations.

1) An insurance company.

2) A financial institution that uses the reserve method of accounting for bad

debts.

3) A DISC or former DISC (domestic international sales corporation).

4) A corporation claiming the Puerto Rico and possessions tax credit.

Examples of eligible shareholders. The following may be S corporation

shareholders: individuals who are U.S. citizens or residents, decedents es-

tates, bankruptcy estates, 501(c)(3) organizations, employee stock option plans,

qualified pension plans and qualified profit-sharing plans, qualified subchap-

ter S trusts (QSSTs), and electing small business trusts (ESBTs).

Examples of ineligible shareholders.The following may not be S corpora-

tion shareholders: partnerships, corporations (including single-member LLCs

electing to be taxed as corporations), charitable remainder trusts, IRAs, SEPs,

SIMPLE plans, and state and local governments.

EXAMPLE

An lgl nn-cpa ny(uch a a panhp LLC) maylc axd a an S cpan.



NOTES

A timely-filed Form 2553 is generally mailed or faxed directly to the IRS. Ad-

dresses and fax numbers are provided in the instructions for Form 2553. Proof

of mailing or fax should be retained. The IRS will notify the corporation whether

the election has been accepted and when it will take effect.

Relief for Late S Corporation ElectionsIf Form 2553 is filed more than two months and 15 days after the first day of the

tax year, it is late and the election generally will be effective for the following

tax year. Relief for a late S corporation election (and entity classification elec-

tion, if applicable) may be available if the corporation can show that failure to

file on time was due to a reasonable cause. Form 2553 includes a section for

describing the reasonable cause. If an otherwise eligible corporation fails to

meet any requirements discussed, below, relief for a late S corporation election

may be available under other Revenue Procedures or through a Private Letter

Ruling.

No Form 2553; Form 1120S Not Filed (Rev. Proc. 2007-62)This simplified method applies only for elections effective for tax years ending

on or after December 31, 2007, and when no more than six months have passed

since the unextended due date for the initial Form 1120S.

Revenue Procedure 2007-62 allows a qualifying corporation (or other eligible

entity) to request simultaneous relief for a late S corporation election and for a

late entity classification election, if applicable, when the elections are intended

to be effective on the same date.

All the following requirements must be met.

1) The corporation (or other eligible entity) has not yet filed a tax return for thetax year beginning on the date indicated on Form 2553.

2) The corporation (or other eligible entity) fails to qualify for S corporation

election and, if applicable, for election to be taxed as a corporation solely

because Form 2553 was not timely filed.

3) The corporation (or other eligible entity) has reasonable cause for its failure

to timely make the election.

4) No taxpayer whose liability would be affected by the S corporation election

has reported inconsistently with the S corporation election.

5) No more than six months have passed since the unextended due date of

Form 1120S for the tax year beginning on the date indicated on Form 2553.

Requesting relief and making the election.The request for relief is made by

filing a completed Form 2553 as an attachment to the corporations (or other

eligible entitys) initial Form 1120S.

This must be done no later than six months after the due date of the initial

Form 1120S (excluding extensions).

Form 2553 includes space for an explanation of the reasonable cause. No ad-

ditional statements or attachments are required.

KEY FACT

I Fm 2553 fild m han wmnh and 15 day a h fiday h ax ya, la and hlcn gnally wll ffcv h llwng ax ya.



NOTES

Tar-Dee LLC uses a calendar year and wants to be taxed as an S corporation.

Tar-Dee LLC meets all the requirements for electing to be taxed as a corpora-

tion and for electing S corporation status, and has selected March 1, 2013 as

the date the election is to take effect. Tar-Dee LLC fails to file Form 2553 by

the due date of May 15, 2013 because the members thought their lawyer was

filing the form. In thinking the lawyer had filed Form 2553, Tar-Dee LLC has

reasonable cause for its failure to timely file Form 2553. Tar-Dee LLC may use

the procedures of Revenue Procedure 2007-62 by filing its initial Form 1120S

and Form 2553 no later than September 15, 2014. If Tar-Dee LLC files these

forms after March 15, 2014 without first obtaining an extension of time to file

Form 1120S, the usual late-filing penalties will apply.

Late Election Relief: No Form 2553, but Form 1120S FiledIf Form 1120S has been filed without an S corporation election, relief for a late

election may be available. Two cases are described here. The procedures for re-

questing relief and making the election are the same for both situations.

Form 1120S Filed, No IRS Complaints (Rev. Proc. 97-48)An otherwise eligible corporation that has not filed Form 2553, but has been

filing Form 1120S without IRS complaint, can receive automatic relief under

Revenue Procedure 97-48. All the following requirements must be met.

1) The corporation has filed Form 1120S consistent with the intent to be an

S corporation.

2) The corporation fails to qualify as an S corporation solely because Form 2553

was not timely filed.

3) The corporation has reasonable cause for its failure to timely make the

election.4) No taxpayer whose liability would be affected by the S corporation election

has ever reported inconsistently with the S corporation election.

5) Neither the corporation nor any of its shareholders received notification

from the IRS regarding any problem with S corporation status within six

months of the date on which the initial Form 1120S was timely filed.

Form 1120S Filed, IRS Notice Received (Rev. Proc. 2003-43)An otherwise eligible corporation that has not filed Form 2553, but has filed

Form 1120S, may be able to request relief under Revenue Procedure 2003-43

even if an IRS notice regarding S corporation status has been received. All thefollowing requirements must be met.

1) The initial form 1120S was filed within six months of the original unextended

due date.

2) The corporation fails to qualify as an S corporation solely because Form 2553

was not timely filed.

3) The corporation has reasonable cause for its failure to timely make the

election.

EXAMPLE

I Fm 1120S ha n fild whuan S cpan lcn, l ala lcn may avalal.



NOTES4) No taxpayer whose liability would be affected by the S corporation election

has ever reported inconsistently with the S corporation election.

5) Less than 24 months have passed since the original due date of Form 2553.

Requesting relief and making the election.In both cases, the request for re-

lief is made by filing a completed Form 2553 at any time during the period that

the corporation intended to be an S corporation (Rev. Proc. 97-48), or within 24

months of the original due date for Form 2553 (Rev. Proc. 2003-43).

As applicable, write at the top of Form 2553 Filed Pursuant to Rev. Proc.

97-48 or Filed Pursuant to Rev. Proc. 2003-43.

Describe the reasonable cause in the space provided on Form 2553.

Fo

business entities taxation

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