TAX 655: Final Exam

Notes

Complete the problems as presented in this document. You may create a new document and/or spreadsheet as needed. Any memo should be no more than 3 pages in length. Please state any assumptions used if problems are not clear.

Problem 1

Your client, a physician, recently purchased a yacht on which he flies a pennant with a medical emblem on it. He recently informed you that he purchased the yacht and flies the pennant to advertise his occupation and thus attract new patients. He has asked you if he may deduct as ordinary and necessary business expenses the costs of insuring and maintaining the yacht. In search of an answer, consult RIA’s CHECKPOINT TAXavailable on-line through the SNHU Shapiro Library. Explain the steps taken to find your answer.

To find this answer using the RIA Checkpoint I searched ordinary and necessary business expenses. Multiple results showed up in my search which led to reading through some headlines. In that search I found Sec 162 trade or business expense.

According to IRC Section 162 business expenses must be both ordinary and necessary. An ordinary expense is an expense that is common and accepted in your trade or business. A necessary expense is an expense that is helpful and appropriate for your trade or business. Although there is a pennant with a medical emblem on it flying from the yacht, this is not an ordinary or necessary expense. The yacht is considered a personal expense as it does not bring recognition or patients to the client. I found information on a very similar case (Henry v. CIR, 36 TC 879 (1961).)
Problem 2

Stacey Small has a small salon that she has run for a few years as a sole proprietorship. The proprietorship uses the cash method of accounting and the calendar year as its tax year. Stacey needs additional capital for expansion and knows two people who might be interested in investing. One would like to practice hairdressing in the salon. The other would only invest.

Stacey wants to know the tax consequences of incorporating the business. Her business assets include a building, equipment, accounts receivable and cash. Liabilities include a mortgage on the building and a few accounts payable, which are deductible when paid.

Write a memo to Stacey explaining the tax consequences of the incorporation. As part of your memo examine the possibility of having the corporation issue common and preferred stock and debt for the shareholders’ property and money.

Problem 3

Five years ago, Lacey, Kaylee, and Doug organized a software corporation, DLK, which develops and sells Online Meetings software for businesses. DLK is a C corporation. Each individual contributed $10,000 to the company in exchange for 1,000 shares of DLK stock (for a total of 3,000 shares). The corporation also borrowed $250,000 from ACME Venture Capital to finance operating costs and capital expenditures.

Because of intense competition, DLK struggled for the first few years of operation and the corporation sustained chronic losses. This year, Lacey, DLK’s president, decided to seek additional funds to finance DLK’s working capital.

CME declined to extend additional funds because of the money already invested in DLK. High Tech Venture Capital Inc. proposed to lend DLK $100,000, but at a 10% premium over the prime rate. (Other software manufacturers in the same market can borrow at a 3% premium.) First Round Capital proposed to invest $50,000 of equity capital into DLK, but on the condition that the investment firm be granted the right to elect five members to DLK’s board of directors. Discouraged by the “high cost” of external borrowing, Lacey decides to approach Kaylee and Doug.

Lacey suggests to Kaylee and Doug that each of the three original investors contribute an additional $25,000 to DLK in exchange for five 20-year debentures. The debentures will be unsecured and subordinate to ACME’s debt. Annual interest on the debentures will accrue at a floating 5% premium over the prime rate. The right to receive interest payments will be cumulative; that is each debenture holder is entitled to past and current interest payments before DLK’s board can declare a common stock dividend. The debentures would be both nontransferable and noncallable. Lacey, Kaylee and Doug have asked you, their tax accountant, to advise them on the tax implications of the proposed financing agreement. After researching the issue, issue your advice in a tax research memo. At a minimum, you should consult the following authorities:

IRC. Sec 385
Rudolph A. Hardman, 60 AFTR 2d 87-5651, 82-7 USTC ¶9523 (9th Cir., 1987)
Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC ¶9438 (5th Cir., 1967)

Problem 4

Which of the following groups constitute a controlled group? (Any stock not listed below is held by unrelated individuals each owning less than 1% of the outstanding stock.) For brother-sister corporations, which definition applies?

Mark owns 90% of the single classes of stock of Hot and Ice Corporations.
Johnson and Carey Corporations each have only a single class of stock outstanding. The two controlling individual shareholders own the stock as follows:

Stock Ownership Percentages
Shareholder / Johnson Corp. / Carey Corp
David / 60% / 80%
Kelly / 30% / 0%

Red, Blue and ABC Corporations each have a single class of stock outstanding. The stock is owned as follows:

Stock Ownership Percentages
Shareholder / Blue Corp. / ABC Corp
Red / 80% / 50%
Blue / 40%

Red Corporation’s stock is widely held by over 1,000 shareholders, none of whom owns directly or indirectly more than 1% of Red’s stock.

Helm, Oak, Walnut and Zinnia Corporations each have a single class of stock outstanding. The stock is owned as follows:

Stock Ownership Percentages
Shareholder / Helm Corp. / Oak Corp / Walnut Corp / Zinnia Corp
James / 100% / 90%
Helm / 80% / 30%
Walnut / 60%

Problem 5

Eric and Denise are partners in ED Partnership. Eric owns a 60% capital, profits and loss interest. Denise owns the remaining interest. Both materially participate in the partnership activities. At the beginning of the current year, ED’s only liabilities are $50,000 in accounts payable, which remain outstanding at year-end. In August, ED borrowed $120,000 on a nonrecourse basis from Delta Bank. The loan is secured by property with a $230,000 FMV. These are ED’s only liabilities at year-end. Basis for the partnership interest at the beginning of the year is $40,000 for Denise and $60,000 for Eric before considering the impact of liabilities and operations. ED has a $200,000 ordinary loss during the current year. How much loss can Eric and Denise recognize?

Problem 6

Linda pays $100,000 cash for Jerry’s ¼ interest in the JILL Partnership. The partnership has a Sec. 754 election effect. Just before the sale of Jerry’s interest, JILL’s balance sheet appears as follows:

Partnership’s Basis / FMV
Assets:
Cash / $75,000 / $75,000
Land / $225,000 / $325,000
Total / $300,000 / $400,000
Partners' capital
Jerry / $75,000 / $100,000
Instrument Corp / $75,000 / $100,000
Logo Corp / $75,000 / $100,000
Lighthouse Corp / $75,000 / $100,000
Total / $300,000 / $400,000

What is Linda’s total optional basis adjustment?
If JILL Partnership sells the land for its $325,000 FMV immediately after Linda purchases her interest, how much gain or loss will the partnership recognize?
How much gain will Linda report as a result of the sale?

Problem 7

Monte and Allie each own 50% of Raider Corporation, an S corporation. Both individuals actively participate in Raider’s business. On January 1, Monte and Allie have adjusted bases for their Raider stock of $80,000 and $90,000 respectively. During the current year, Raider reports the following results:

Ordinary loss / $175,000
Tax-exempt interest income / 20,000
Long-term capital loss / 32,000

Raider’s balance sheet at year-end shows the following liabilities: accounts payable, $90,000; mortgage payable, $30,000; and note payable to Allie, $10,000.

What income and deductions will Monte and Allie report from Raider’s current year activities?

MonteAllie

Ordinary Loss($175,000/50%)$87,500$87,500

Tax exempt interest

Income

Long term capital loss ($32,000/50%) $16,000$16,000

What is Monte’s stock basis on December 31?

Beginning Basis$80,000

Less: Ordinary Loss($87,500)

Less: Long term capital loss($16,000)

Basis on December 310

Monte’s stock basis is 0 because the basis cannot be negative.

What are Allie’s stock basis and debt basis on December 31?

Beginning Basis$80,000

Less: Ordinary Loss($87,500)

Less: Long term capital loss($16,000)

Basis on December 31

Allie’s basis is 0 because the basis cannot be negative.

What loss carryovers are available for Monte and Allie?

Ordinary loss carried over for Monte and Allie is $87,500. The long term capital loss carryover is $13,000 for both Monte and Allie. This is calculated by subtracting maximum current year deduction ($3,000) from the long term capital loss ($16,000).

Explain how the use of the losses in Part a would change if instead Raider were a partnership and Monte and Allie were partners who shared profits, losses and liabilities equally.

A partnership does not pay taxes. If Raider were partnership then Monte and Allie would report their share of the losses and deductions on their individual tax return. The business would still have to file a form 1065 and Monte and Allie would each receive a schedule K-1.

Problem 8

Tom Hughes died in 2009 with a gross estate of $3.9 million and debt of $30,000. He made post-1976 taxable gifts of $100,000, valued at $80,000 when he died. His estate paid state death taxes of $110,200. What is his estate tax base?

Gross Estate$3,900,000

Less: Debt($30,000)

Less: State Estate taxes paid($110,200)

Taxable Estate$3,759,800 Gifts, Post 1976 $100,000

Estate Tax Base$3,859,800

TAX 655: Final Exam1