Corporations: Introduction and Operating Rules2-1
CHAPTER 2
Corporations: Introduction AND Operating RULES
Instructor: The test items in both the print Test Bank and ExamView test-creation software are numbered by question type within each chapter. Thus, users of ExamView can more easily preview their selections using the printed Test Bank in the same numbering system.
Status: / Q/PQuestion/ / Present / in Prior
Problem /
Topic
/ Edition / EditionTRUE OR FALSE
1Sole proprietorship taxationNew
2Partnership taxationUnchanged2
3S corporation taxationUnchanged3
4Corporate tax versus partnership taxModified4
5C corporation taxation: double taxation effectModified5
6S corporation: capital loss pass throughUnchanged6
7C corporation reasonable compensationUnchanged7
8Unreasonable compensationUnchanged8
9Salary versus dividendUnchanged9
10Corporate tax computationModified10
11Corporate tax rates versus individual ratesNew
12Nontax considerations in entity selectionNew
13Classification for Federal taxation: single-memberNew
LLC
14Accounting periods: fiscal year limitation for PSCNew
15Accounting methods: inventoriesUnchanged14
16Accounting methods: accrual basis corporationUnchanged15
and cash basis related party
17Corporate tax on LTCGModified16
18Corporation’s capital lossModified17
19Passive loss rules: closely held C corporations andUnchanged19
PSCs contrasted
20Passive loss rules: closely held corporation Modified20
21Charitable contributions: accrual corporationUnchanged21
exception
22Charitable contributions: capital gain propertyModified23
23Charitable contributions: corporate inventoryModified22
exception
Status: / Q/PQuestion/ / Present / in Prior
Problem /
Topic
/ Edition / Edition24Charitable contributions: limitation with carryoverUnchanged24
applied
25Domestic production activities deductionNew
26NOL carryoverUnchanged26
27Dividends received deductionUnchanged27
28Dividends received deductionModified29
29Dividends received deduction: holding periodNew
requirement
30Organizational expenditures:cash basis corporationUnchanged30
31Personal service corporation ratesModified31
32Tax liability of related corporationsUnchanged32
33Form 1120: requirementsNew
34Schedule M-1Unchanged33
35Schedule M-1: tax-exempt incomeModified37
36Schedule M-1: nondeductible expenseModified38
37Schedule M-1: tax-exempt incomeUnchanged39
38Schedule M-1: net capital lossUnchanged40
39Schedule M-1: interest on loan to purchaseModified41
tax-exempt bonds
40Schedule M-3: voluntary filingUnchanged34
41Financial accounting considerations: FAS 109New
deferred asset defined
42Financial accounting considerations: FIN 48New
MULTIPLE CHOICE
1Corporate tax versus proprietorship taxNew
2Corporate tax versus S corporation taxUnchanged2
3S corporation tax versus proprietorship taxUnchanged3
4Proprietorship tax: LTCLUnchanged4
5Corporate versus proprietorship: LTCG ratesUnchanged5
6Partnership tax: ordinary income and LTCGModified7
7Corporate taxable income: net capital lossUnchanged9
8Taxation of dividendsModified10
9LLC taxationModified11
10Accounting periods: PSC, fiscal year salary requiredModified13
11Accounting periods: PSC, fiscal year salary requiredUnchanged14
12Accounting methods: cash method limitation forModified12
corporations
13Accounting methods: accrual method corporationUnchanged22
and cash method related party
14Capital gains and losses: corporate loss carryoverModified16
15Capital gains and losses: corporate taxable incomeUnchanged17
16Passive losses: personal service corporationUnchanged18
17Passive losses: personal service corporationModified19
18Passive losses: closely held corporationModified20
19Passive losses: personal service corporationUnchanged21
Status: / Q/PQuestion/ / Present / in Prior
Problem /
Topic
/ Edition / Edition20Charitable contributions: inventory, loss property,Modified23
capital gain property
21Charitable contributions: limitationModified24
22Domestic production activities deductionUnchanged25
23Net operating loss: when to forgo carrybackUnchanged26
24Dividends received deduction: percentage of Modified27
ownership
25Dividends received deduction: computationModified28
26Dividends received deduction: percentage of Modified29
ownership
27Dividends received deduction: percentage of Unchanged30
ownership
28Organizational expenses Modified31
29Corporate tax liability: computing with net capitalNew
gain
30Corporate tax provisions: miscellaneous rulesNew
31Corporate tax provisions: miscellaneous rulesNew
32Schedule M-1 additionsUnchanged32
33Schedule M-1 subtractionsUnchanged33
PROBLEMS
1Compare tax treatment for corporation,Unchanged1
S corporation, and partnership
2Compare tax treatment for corporationandModified2
proprietorship: dividends versus salary
3Compare tax treatment for corporationandUnchanged3
proprietorship: dividends versus withdrawals
4Net capital loss: corporation versus proprietorshipModified4
5PSC: fiscal year required salary payments;tax liabilityModified6
6Corporate charitable deduction: effect ofUnchanged9
dividends received deduction
7Corporate charitable deduction: limitationwithNew
carryover from prior year
8Corporate NOL: applicability of dividendsreceivedUnchanged10
deduction
9Dividends received deduction: taxable incomeUnchanged11
limitation and NOL exception
10Dividends received deduction: taxable incomeUnchanged12
limitation and NOL exception
11Corporate tax computationUnchanged14
12Schedule M-1Modified13
13FIN 48: determining tax positionsNew
ESSAY
1Entity choice: tax and nontax factorsUnchanged1
2Proprietorship net income Unchanged2
Status: / Q/PQuestion/ / Present / in Prior
Problem /
Topic
/ Edition / Edition3Unreasonable compensationUnchanged4
4Salary versus dividend to shareholder-employeeUnchanged5
5Corporation versus proprietorship: tax and nontaxNew
differences
6LLC versus proprietorship: advantages and “check-New
the-box” regulations
7Fiscal year election for corporation and PSCUnchanged6
8Fiscal year of PSC: reason for limitationUnchanged7
9Accounting methods: accrual method corporationUnchanged9
and cash basis related party
10Incorporating a proprietorship: identifying Unchanged11
relevant issues
11Accounting methods: cash method small Modified13
corporation exception
12Corporate contribution deduction: accrual ofUnchanged14
13Dividends received deduction: relatedUnchanged18
corporations
14Corporate organizational expenditures and start-upUnchanged16
expenditures
15Tax liability of related corporationsUnchanged17
16Schedule M-1 reconciliationUnchanged15
17Financial accounting considerations: FAS 109New
TRUE/FALSE
1.An individual who owns a proprietorship must report profit from the proprietorship on his/her Federal income tax return.
ANS:T
A sole proprietorship is not a taxable entity separate from the individual who owns the proprietorship. The owner of a proprietorship reports transactions of the business on Schedule C of his or her individual tax return.
PTS:1REF:Example 1
2.Herman and Henry are equal partners in Badger Enterprises, a calendar year partnership. During the year, Badger Enterprises had $305,000 gross income and $230,000 operating expenses. Badger distributed $20,000 to each of the partners. Herman and Henry each must report $37,500 of income from the partnership.
ANS:T
The partnership is not a taxpaying entity. Its profit (loss) and separate items flow through to the partners. The partnership’s Form 1065 reports net profit of $75,000 ($305,000 income – $230,000 expenses). Herman and Henry both receive a Schedule K-1 reporting net profit of $37,500. Each partner reports net profit of $37,500 on his own return.
PTS:1REF:Example 2
3.Robin is a 50% shareholder in Robin-Wren, an S corporation. Robin-Wren earned net income of $100,000 during the year, and Robin received a distribution of $35,000 from the corporation. Robin must report a $35,000 dividend on his individual Federal income tax return (Form 1040).
ANS:F
The shareholders of an S corporation report their shares of the entity’s net income or loss, regardless of how much of the income was withdrawn from the corporation. Robin must report income of $50,000.
PTS:1REF:p. 2-3
4.Jeff owns a 30% interest in a partnership that earned $100,000 in the current year. He also owns 30% of the stock in a C corporation that earned $100,000 during the year. The corporation did not make any distributions, and the partnership distributed $20,000 to him. Jeff must report $30,000 of income on his individual tax return.
ANS:T
Jeff must report his $30,000 (30% $100,000) share of the partnership’s income on his individual tax return. The C corporation’s income is not taxed to Jeff until it is distributed to him. The $20,000 partnership distribution does not affect his income.
PTS:1REF:p. 2-3 | p. 2-4
5.Quail Corporation is a C corporation with net income of $500,000 during 2008. If Quail paid dividends of $70,000 to its shareholders, the corporation must pay tax on $430,000 of net income. Shareholders must report the $70,000 of dividends as income.
ANS:F
Quail Corporation must pay tax on the $500,000 of corporate net income. Dividends paid are not deductible by the corporation. Shareholders must pay tax on the $70,000 of dividends received from the corporation. This is commonly referred to as double taxation.
PTS:1REF:Example 3
6.Coyote Enterprises, an S corporation, had a capital loss of $50,000 during the year. Gerald, who owns 40% of Coyote’s stock, may report $20,000 of Coyote’s capital loss on his individual Federal income tax return (Form 1040).
ANS:T
Capital losses of an S corporation pass through from the entity to the shareholders.
PTS:1REF:p. 2-3
7.Emma, the sole shareholder of Quail Corporation (a C corporation), has the corporation pay her a salary of $300,000 in 2008. The Tax Court has held that $80,000 represents unreasonable compensation. Assuming Emma is in the 35% bracket in 2008, the Tax Court’s holding will reduce the total tax she pays in 2008.
ANS:T
To the extent a salary payment is not considered reasonable, the payment is treated as a dividend, which is generally taxed at a maximum rate of 15%. The Tax Court’s holding saves Emma $16,000 [$80,000 (35% – 15%)].
PTS:1REF:p. 2-4
8.Compensation that is determined to be unreasonable is usually treated as a constructive dividend to the shareholder and is not deductible by the corporation.
ANS:T
Unreasonable compensation is treated as a constructive dividend to the shareholder and is not deductible by the corporation.
PTS:1REF:p. 2-4
9.Lou, an employee and sole shareholder of Amarillo Corporation, a C corporation, has the corporation pay him $175,000. Lou is in the 35% tax bracket. His income tax will be the same, regardless of whether Amarillo treats the payments as a dividend or as salary.
ANS:F
Lou must pay tax on his salary at his marginal rate of 35%, while dividends are generally taxed at a 15% rate.
PTS:1REF:p. 2-4
10.Thrush Corporation files Form 1120, which reports taxable income of $200,000. The corporation’s tax is $56,250.
ANS:F
The tax is equal to $61,250 [($50,000 × 15%) + ($25,000 × 25%) + ($25,000 × 34%) + ($100,000 × 39%)].
PTS:1REF:Exhibit 2-1
11.The corporate marginal tax rates range from 10% to 35%, while the individual marginal tax rates range from 15% to 39%.
ANS:F
The opposite is the case: the corporate marginal tax rates range from 15% to 39%, and the individual marginal tax rates range from 10% to 35%.
PTS:1REF:p. 2-5
12.Nontax considerations in the selection of business form include limited liability, free transferability of ownership interests, continuity of life, and centralized management.
ANS:TPTS:1REF:p. 2-6
13.Under the “check-the-box” Regulations, a single-member LLC that fails to elect to be to treated as a corporation will be taxed as a partnership.
ANS:F
Sole proprietorship, not corporation, is the default classification for a single-member LLC that does not elect to be treated as a corporation under the “check-the-box” Regulations.
PTS:1REF:p. 2-8
14.All corporations are allowed to choose a calendar year or a fiscal year for Federal tax reporting purposes.
ANS:F
There are limitations on the use of a fiscal year in the case of personal service corporations and S corporations. Such entities generally must use the calendar year as their reporting period, but several exceptions to this rule apply (e.g., business purpose for fiscal year).
PTS:1REF:p. 2-9 | p. 2-10
15.In general, corporations that maintain inventory for sale to customers may use either the cash or accrual method of accounting for determining sales and cost of goods sold.
ANS:F
As a general rule, corporations that maintain inventory for sale to customers are required to use the accrual method of accounting for determining sales and cost of goods sold. The cash method may be used for other income and expense items.
PTS:1REF:p. 2-11
16.On December 31, 2008, Lavender, Inc., an accrual basis C corporation, accrues a $90,000 bonus to Barry, its vice president and a 40% shareholder. Lavender pays the bonus to Barry, who is a cash basis taxpayer, on March 15, 2009. Lavender can deduct the bonus in 2008.
ANS:T
Lavender is allowed a deduction in 2008 because Barry is not a related party (more than 50% shareholder).
PTS:1REF:Example 12
17.In 2008, Fox Corporation had taxable income of $100,000, which included a long-term capital gain of $30,000. The maximum amount of tax applicable to the capital gain is $4,500 ($30,000 15%).
ANS:F
While the maximum rate on long-term capital gains of individuals is limited to 15%, there is no maximum rate applicable to long-term capital gains of C corporations.
PTS:1REF:p. 2-12
18.Albatross, a C corporation, had $200,000 net income from operations and a $25,000 short-term capital loss in 2008. Albatross Corporation’s taxable income is $200,000.
ANS:T
A corporation cannot deduct a net capital loss in the year incurred. For corporations, a net capital loss must be carried back three years or forward five years and be offset against capital gains in the carryback/forward years.
PTS:1REF:p. 2-12
19.The passive loss rules apply more favorably to closely held C corporations than to personal service corporations (PSCs).
ANS:T
The passive loss rules prohibit PSCs from offsetting passive losses against either active or portfolio income. Closely held corporations, however, may offset passive losses against active income.
A corporation is closely held if, at any time during the taxable year, more than 50% of the value of the corporation’s outstanding stock is owned, directly or indirectly, by or for not more than five individuals.
PTS:1REF:Example 15
20.Peach Corporation had $135,000 of active income, $180,000 of portfolio income, and a $155,000 passive loss during the year. If Peach is a closely held C corporation that is not a PSC, it can deduct the $155,000 passive loss.
ANS:F
If Peach is a closely held corporation, the passive loss is deductible to the extent of the corporation’s active income, or $135,000.
PTS:1REF:Example 15
21.On December 30, 2008, Debbie, a sole proprietor, pledged to make a $10,000 charitable contribution on or before January 15, 2009. Green Corporation, an accrual basis corporation, made a similar pledge on the same date, and the contribution was authorized by Green’s board of directors. Debbie and Green Corporation, both calendar year taxpayers, can deduct these contributions in 2008.
ANS:F
Individuals cannot deduct contributions until they are actually made. Therefore, Debbie must wait until 2009 to deduct the contribution, assuming she honors the pledge. Green Corporation, whose board of directors authorized the contribution in 2008, can deduct the contribution in 2008, assuming the pledge is paid on or before March 15, 2008.
PTS:1REF:Example 16
22.On April 8, 2008, Oriole Corporation donated a painting worth $150,000 to the TexasArt Museum, a qualified public charity. The museum included the painting in its permanent collection. Oriole Corporation purchased the painting 5 years ago for $75,000. Oriole’s charitable contribution deduction is $150,000 (ignoring the taxable income limitation).
ANS:T
The painting is capital gain property which the museum puts to a use that is related to its exempt function. Thus, the amount of the deduction is equal to the fair market value of the painting, or $150,000.
PTS:1REF:Example 17
23.Zircon Corporation donated scientific property worth $350,000 to CityUniversity (a qualified charitable organization) to be used in research. The basis of the property was $100,000, and Zircon had held it for ten months as inventory. Zircon Corporation may deduct $225,000 as a charitable contribution (ignoring the taxable income limitation).
ANS:F
The scientific property is ordinary income property but it qualifies for the increased deduction amount available for certain corporate contributions of inventory. As such, the amount of the deduction is equal to the lesser of (1) the sum of inventory’s basis plus 50% of the appreciation on the property [$225,000 = $100,000 + 50%($350,000 – $100,000)] or (2) twice the basis [$200,000 = $100,000 × 2]. In this case, the ceiling applies, and the deduction amount is $200,000.
PTS:1REF:Example 20
24.Egret Corporation, a calendar year taxpayer, had an excess charitable contribution for 2007 of $10,000. In 2008, it made a further charitable contribution of $14,000. Its 2008 deduction is limited to $16,000. In applying the 10% limitation, the $10,000 carryover must be used after the current year contribution.
ANS:T
The current (2008) contribution must be used first and the carryover (2007) used last.
PTS:1REF:Example 22
25.For a corporation, the domestic production activities deduction is equal to 6% of the lower of (1) qualified production activities income or (2) taxable income. However, the deduction cannot exceed the W-2 wages related to qualified production activities income.
ANS:F
The deduction cannot exceed 50% of the W-2 wages related to qualified production activities income.
PTS:1REF:Example 23
26.A corporate net operating loss can be carried back 3 years and forward 5 years to offset taxable income for those years.
ANS:F
A corporate net operating loss can be carried back 2 years and forward 20 years to offset taxable income for those years.
PTS:1REF:p. 2-16
27.Bass Corporation received a dividend of $80,000 from Trout Corporation. Bass owns 15% of the Trout Corporation stock. Assuming it is not subject to the taxable income limitation, Bass’s dividends received deduction is $64,000.
ANS:F
The deduction percentage for less than 20% ownership is 70%. The dividends received deduction would be $56,000 ($80,000 70%).
PTS:1REF:p. 2-17
28.Bluebird Corporation received a $200,000 dividend from Canary Corporation. Bluebird, which owns 80% of Canary Corporation, may take a dividends received deduction of $200,000.
ANS:T
The allowable dividends received deduction for a corporation that owns 80% or more of the dividend-paying corporation is 100%. Therefore, Bluebird can take a dividends received deduction of $200,000.
PTS:1REF:p. 2-17
29.No dividends received deduction is allowed unless the corporation has held the stock for more than 60 days.
ANS:F
The corporation must hold the stock for more than 45 days in order to qualify for the dividends received deduction.
PTS:1REF:Example 26
30.A cash basis corporation that incurs (but does not pay) qualifying organizational expenditures in its first year of operations may include such expenses in the 180-month amortization period.
ANS:T
As long as they are incurred, such expenses do not have to be paid in the first year.
PTS:1REF:p. 2-19
31.A personal service corporation with taxable income of $100,000 will have a tax liability of $22,250.
ANS:F
A personal service corporation is subject to the 35% rate on all taxable income; thus, the tax liability is $35,000.
PTS:1REF:p. 2-20
32.Ed, an individual, incorporates two separate businesses that he owns by establishing two new corporations. Each corporation generates taxable income of $50,000. Each corporation will have a tax liability of $7,500.
ANS:F
Since the corporations would be a controlled group, their taxable income would be combined in applying the corporate income tax rates. The tax on $100,000 would be $22,250, or $11,125 tax for each corporation.
PTS:1REF:p. 2-21
33.A corporation with no taxable income need not file a Form 1120.
ANS:F
No such exemption exists.
PTS:1REF:p. 2-22
34.Schedule M-1 is used to reconcile net income as computed for financial accounting purposes with taxable income reported on the corporation’s income tax return.
ANS:TPTS:1REF:p. 2-23
35.Income that is included in net income per books but not included in taxable income is a subtraction item on Schedule M-1.
ANS:TPTS:1REF:p. 2-23
36.An expense that is deducted in computing net income per books but not deductible in computing taxable income is a subtraction item on Schedule M-1.
ANS:F
An expense that is deducted in computing net income per books but not deductible in computing taxable income is an addition item on Schedule M-1.
PTS:1REF:p. 2-23
37.Macayo, Inc., received $800,000 life insurance proceeds on the death of its president. The $800,000 will be an addition item on Macayo’s Schedule M-1.
ANS:F
The $800,000 is treated as a subtraction.
PTS:1REF:Example 32
38.Canary Corporation, which sustained a $5,000 net short-term capital loss during the year, will enter $5,000 as an addition on Schedule M-1.
ANS:T
A net short-term capital loss is entered as an addition on Schedule M-1. The loss is deductible for book purposes but not for tax purposes. Therefore, the $5,000 capital loss must be added in reconciling from book income to taxable income.
PTS:1REF:p. 2-23
39.Aqua, Inc., paid $15,000 interest on a loan to purchase tax-exempt bonds. The $15,000 is a subtraction on Aqua’s Schedule M-1.
ANS:F
The interest is deductible for book purposes but not for tax purposes; thus, an addition on Schecule M-1 is required.
PTS:1REF:Example 32
40.A corporation that is not required to file Schedule M-3 is permitted to file a Schedule M-3 voluntarily.