Question & Answer

Does this mean that the value of manufacturing output in 2007 was 1.3 per cent higher than 2018 in money terms?

P.1 If a bank paid its depositors 3 per cent interest and inflation was 5 per cent, what would be the real rate of interest?

P.2 Has your real income gone up or down this last year?

2. What are the advantages and disadvantages of presenting data graphically with the axes starting from zero?

If the vertical scale for Figure A1.2 ran from 0 to 5 million, how would this alter your impression of the degree to which unemployment had changed?

Could bar charts or pie charts be used for representing time-series data?

How would it be possible to show three different lines on the same diagram?

What was the level of unemployment mid-way between quarter 2 and quarter 3 of 2020?

The table in Box 1.2 shows time-series data for four different variables for four different countries. Would there have been any advantage in giving the figures for each separate year? Would there have been any disadvantage?

What else is the diagram telling us?

Suppose you asked your favorite AI query tool “How long is the carryover period for NOLs incurred in 2024?” and the AI tool responded as follows:

The carryover period for a net operating loss (NOL) incurred in 2024 would typically be up to 20 years. This means that the corporation or individual with the NOL can carry the loss forward and use it to offset taxable income in future tax years for up to 20 years from the year in which the NOL was generated.

Is the AI answer to the question correct?  Explain.

Suppose you asked your favorite AI query tool “Can a single member LLC with one owner who is an individual elect to be taxed as an S corporation?” and the AI tool responded as follows:

Amy is evaluating the cash flow consequences of organizing her business entity SHO as an LLC (taxed as a sole proprietorship), an S corporation, or a C corporation. Amy used the following assumptions to make her calculations:

a)      For all entity types, the business reports $22,000 of business income before deducting compensation paid to Amy and payroll taxes SHO pays on Amy’s behalf.

b)      All entities would use the cash method of accounting.

c)      If Amy organizes SHO as an S corporation or a C corporation, SHO will pay Amy a $5,000 annual salary (assume the salary is reasonable for purposes of this problem). For both the S and C corporations, Amy will pay 7.65% FICA tax on her salary and SHO will also pay 7.65% FICA tax on Amy’s salary (the FICA tax paid by the entity is deductible by the entity).

d)     Amy’s marginal ordinary income tax rate is 35 percent and her income tax rate on qualified dividends and net capital gains is 15 percent.

e)      Amy’s marginal self-employment tax rate 15.3 percent.

f)       Amy pays a .9 percent additional Medicare tax on salary and net earnings from self-employment (i.e., her salary and net earnings from self-employment income are over the threshold for the tax).

g)      Amy pays a 3.8 percent net investment income tax on dividends and net capital gains (i.e., AGI on joint tax return is over threshold by more than any net investment income she receives).

h)      Assume that for purposes of the qualified business income deduction, the business income is not from a specified service and neither the wage-based limitation nor the taxable income limitation applies to limit the deduction.

i)        If SHO is formed as an S corporation or a C corporation, SHO will distribute all of its earnings after paying entity level taxes and after deducting salary and related FICA taxes paid to Amy.

Required:

a. Fill in the cells in the table below to identify cash flows associated with the income from the business if the business is formed as an LLC (sole proprietorship), S corporation, or C corporation for tax purposes. Enter cash outflows as negative numbers.

*Remember to consider account flow-through income, qualified dividends, the self-employment tax deduction, and the qualified business income deduction in thecalculation.

b. At a high level, describe the factors causing differences in the after-tax cash flows from each entity, given that the before-tax cash flows are the same (don’t use dollar amounts in explanation).

Cool Touch Cookware (CTC) has been in business for about 10 years now. Daisy and Kesha are each 50 percent owners of the business. They initially established the business with cash contributions. CTC manufactures unique cookware that remains cool to the touch when in use. CTC has been fairly profitable over the years. Daisy and Kesha have both been actively involved in managing the business. They have developed very good personal relationships with many customers (both wholesale and retail) that, Daisy and Kesha believe, keep the customers coming back.

On September 30 of the current year, CTC had all of its assets appraised. Below is CTC’s balance sheet, as of September 30, with the corresponding appraisals of the fair market value of all of its assets. Note that CTC has several depreciated assets. CTC uses the hybrid method of accounting. It accounts for its gross margin-related items under the accrual method, and it accounts for everything else using the cash method of accounting.

Assets Adjusted 

Tax Basis

FMV

Cash $150,000 $150,000

Accounts receivable 20,000 15,000

Inventory* 90,000 300,000

Equipment 120,000 100,000

Investment in XYZ stock 40,000 120,000

Land (used in the business) 80,000 70,000

Building 200,000 180,000

 Total Assets $700,000 $935,000**

Liabilities

Accounts payable $ 40,000

Bank loan60,000

Mortgage on building100,000

Equity 500,000

 Total liabilities and equity$700,000

*CTC uses the LIFO method for determining the adjusted basis of its inventory. Its basis in the inventory under the FIFO method would have been $110,000.

**In addition, Daisy and Kesha had the entire business appraised at $1,135,000, which is $200,000 more than the value of the identifiable assets.

From January 1 of the current year through September 30, CTC reported the following income:

Ordinary business income    $530,000

Dividends from XYZ stock    $12,000

Long-term capital losses $15,000

Interest income $ 3,000

Daisy and Kesha are considering changing the business form of CTC.

Required:

a. Assume CTC is organized as a C corporation. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an S corporation. [Hint: see §§1374 and 1363(d).]

b. Assume CTC is organized as a C corporation. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an LLC. Assume CTC converts to an LLC (taxed as a partnership) by distributing its assets to its shareholders, who then contribute the assets to a new LLC. [Hint: see §§331, 336, and 721(a).]

c. Assume that CTC is a C corporation with a net operating loss carryforward as of the beginning of the year in the amount of $500,000 and that the NOL originated in 2019. Identify significant tax and nontax issues associated with converting CTC from a C corporation to an LLC (taxed as a partnership). Assume CTC converts to an LLC by distributing its assets to its shareholders, who then contribute the assets to a new LLC. [Hint: see §§172(a), 331, 336, and 721(a).]

Daisy Taylor has developed a viable new business idea. Her idea is to design and manufacture cookware that remains cool to the touch when in use. She has had several family members and friends try out her prototype cookware, and they have consistently given the cookware rave reviews. With this encouragement, Daisy started giving serious thought to starting up a business called “Cool Touch Cookware” (CTC).

Daisy understands that it will take a few years for the business to become profitable.  She would like to grow her business and perhaps at some point “go public” or sell the business to a large retailer.

Daisy, who is single, decided to quit her full-time job so that she could focus all of her efforts on the new business. Daisy had some savings to support her for a while, but she did not have any other source of income. She was able to recruit Kesha and Aryan to join her as initial equity investors in CTC. Kesha has an MBA and a law degree. She was employed as a business consultant when she decided to leave that job to work with Daisy and Aryan. Aryan owns a very profitable used car business. Because buying and selling used cars takes all his time, he is interested in becoming only a passive investor in CTC. He wanted to get in on the ground floor because he really likes the product and believes CTC will be wildly successful. While CTC originally has three investors, Daisy and Kesha have plans to grow the business and seek more owners and capital in the future.

The three owners agreed that Daisy would contribute land and cash for a 30 percent interest in CTC, Kesha would contribute services (legal and business advisory) for the first two years for a 30 percent interest, and Aryan would contribute cash for a 40 percent interest. The plan called for Daisy and Kesha to be actively involved in managing the business, while Aryan would not be. The three equity owners’ contributions are summarized as follows:

Daisy Contributed

FMV Adjusted 

Basis Ownership

Interest

Land (held as investment) $120,000 $70,000 30%

Cash$30,000

Kesha Contributed

Services $150,000 30%

Aryan Contributed

Cash $200,000 40%

Working together, Daisy and Kesha made the following five-year income and loss projections for CTC. They anticipate the business will be profitable and that it will continue to grow after the first five years.

Cool Touch Cookware

5-Year Income and Loss Projections

Year Income

(Loss)

1 ($200,000)

2 ($80,000)

3 ($20,000)

4 $60,000

5 $180,000

With plans for Daisy and Kesha to spend a considerable amount of their time working for and managing CTC, the owners would like to develop a compensation plan that works for all parties. Down the road, they plan to have two business locations (in different cities). Daisy would take responsibility for the activities of one location and Kesha would take responsibility for the other. Finally, they would like to arrange for some performance-based financial incentives for each location. 

To get the business activities started, Daisy and Kesha determined CTC would need to borrow $800,000 to purchase a building to house its manufacturing facilities and its administrative offices (at least for now). Also, in need of additional cash, Daisy and Kesha arranged to have CTC borrow $300,000 from a local bank and to borrow $200,000 cash from Aryan. CTC would pay Aryan a market rate of interest on the loan, but there was no fixed date for principal repayment.

Required:

Identify significant tax and nontax issues or concerns that may differ across entity types and discuss how they are relevant to the choice of entity decision for CTC.

Several issues or concerns exist in forming a new business and choosing an entity. Some of the non-tax issues are:

Haruki and Bob have owned and operated SOA as a C corporation for a number of years. When they formed the entity, Haruki and Bob each contributed $100,000 to SOA. Each has a current basis of $100,000 in his SOA ownership interest. Information on SOA’s assets at the end of year 5 is as follows (SOA does not have any liabilities): 

Assets FMV Adjusted Basis Built-in Gain

Cash $200,000 $200,000 $0

Inventory 80,000 40,000 40,000

Land and building 220,000 170,000 50,000

 Total$500,000

At the end of year 5, SOA liquidated and distributed half of the land and building, half of the inventory, and half of the cash remaining after paying taxes (if any) to each owner. Assume that, excluding the effects of the liquidating distribution, SOA’s taxable income for year 5 is $0. 

a. What are the amount and character of gain or loss SOA will recognize on the liquidating distribution?

b. What are the amount and character of gain or loss Haruki will recognize when he receives the liquidating distribution of cash and property? Recall that his stock basis is $100,000 and he is treated as having sold his stock for the liquidation proceeds.

Rondo and his business associate, Larry, are considering forming a business entity called R&L, but they are unsure about whether to form it as a C corporation, an S corporation, or an LLC taxed as a partnership for tax purposes. Rondo and Larry would each invest $50,000 in the business. Thus, each owner would take an initial basis in his ownership interest of $50,000 no matter which entity type is formed. Shortly after the formation of the entity, the business borrowed $30,000 from the bank. If applicable, this debt will be shared equally between the two owners.

a. After taking the loan into account, what is Rondo’s tax basis in his R&L stock if R&L is formed as a C corporation?

b. After taking the loan into account, what is Rondo’s tax basis in his R&L stock if R&L is formed as an S corporation?

c. After taking the loan into account, what is Rondo’s tax basis in his R&L ownership interest if R&L is formed as an LLC and taxed as a partnership?

Dave and his friend Stewart each owns 50 percent of KBS. During the year, Dave received $75,000 compensation for services he performed for KBS during the year. He performed a significant amount of work for the entity, and he was heavily involved in management decisions for the entity (he was not a passive investor in KBS). After deducting Dave’s compensation, KBS reported taxable income of $30,000. How much FICA and/or self-employment tax is Dave required to pay on his compensation and his share of the KBS income if KBS is formed as a C corporation, an S corporation, or a limited liability company (taxed as a partnership) (ignore the .9 percent additional Medicare tax)? How much FICA tax would the entity be required to pay on the compensation paid to Dave?

Mustafa, Mickayla, and Taylor are starting a new business (MMT). To get the business started, Mustafa is contributing $200,000 for a 40 percent ownership interest, Mickayla is contributing a building with a value of $200,000 and a tax basis of $150,000 for a 40 percent ownership interest, and Taylor is contributing legal services for a 20 percent ownership interest. What amount of gain or income is each owner required to recognize under each of the following alterative situations? [Hint: Look at §§351 and 721.]

a. MMT is formed as a C corporation.

b. MMT is formed as an S corporation.

c. MMT is formed as an LLC (taxed as a partnership).

Danni is a single 30 percent owner of Kolt (a business entity). In the current year, Kolt reported a $1,000,000 business loss. Answer the following questions associated with each of the following alternative scenarios:

Damarcus is a 50 percent owner of Rockit (a business entity). In the current year, Rockit reported a $100,000 business loss. Answer the following questions associated with each of the following alternative scenarios.

Willow Corp. (a calendar-year C corporation) reported taxable income before the net operating loss deduction (NOL) in the amount of $100,000 in 2024. Willow had an NOL carryover of $90,000 to 2024 How much tax will Willow Corp. pay for 2024, what is its NOL carryover to 2025, and when will the NOL expire under the following assumptions?

SCC corporation (a calendar-year C corporation) has a net operating loss (NOL) carryover to 2024 in the amount of $30,000.  How much tax will SCC pay for 2024 if it reports taxable income from operations of $20,000 before considering loss carryovers under the following assumptions?

a. The NOL originated in 2017.

Mackenzie is considering conducting her business, Mac561, as either a single member LLC or an S corporation. Assume her marginal ordinary income tax rate is 37 percent, her marginal FICA rate on employee compensation is 1.45 percent, her marginal self-employment tax rate is 2.9 percent (her other self-employment income and/or salary exceeds the wage base limit for the 12.4 percent Social Security tax portion of the self-employment tax), and any employee compensation or self-employment income she receives is subject to the .9 percent additional Medicare tax. Also, assume Mac561 generated $200,000 of business income before considering the deduction for compensation Mac561 pays to Mackenzie and Mackenzie can claim the full qualified business income deduction on Mac561’s business income allocated to her. Determine Mackenzie’s after-tax cash flow from the entity’s business income and any compensation she receives from the business under the following assumptions:

a. Mackenzie conducted Mac561 as a single-member LLC.

b.      Mackenzie conducted Mac561 as an S corporation and she received a salary of $100,000. All business income allocated to her is also distributed to her.

c.       Mackenzie conducted Mac561 as an S corporation and she received a salary of $20,000. All business income allocated to her is also distributed to her.

d.  Which entity/compensation combination generated the most after-tax cash flow for Mackenzie? What are the primary contributing factors favoring this combination?

After several years of profitable operations, Javell, the sole shareholder of JBD Inc., a C corporation, sold 22 percent of her JBD stock to ZNO Inc., a C corporation in a similar industry. During the current year, JBD reports $1,000,000 of after-tax income. JBD distributes all of its after-tax earnings to its two shareholders in proportion to their shareholdings.  How much tax will ZNO pay on the dividend it receives from JBD? What is ZNO’s tax rate on the dividend income (after considering the DRD)? [Hint: see §243.]

Marathon Inc. (a C corporation) reported $1,000,000 of taxable income in the current year. During the year, it distributed $100,000 as dividends to its shareholders as follows:

• $5,000 to Guy, a 5 percent individual shareholder.

• $15,000 to Little Rock Corp., a 15 percent shareholder (C corporation). 

• $80,000 to other shareholders.

a. How much of the dividend payment did Marathon deduct in determining its taxable income?

b. Assuming Guy’s marginal ordinary tax rate is 37 percent, how much tax will he pay on the $5,000 dividend he received from Marathon Inc. (including the net investment income tax)? 

c. What amount of tax will Little Rock Corp. pay on the $15,000 dividend it received from Marathon Inc. (50 percent dividends-received deduction)?

d. Complete Form 1120 Schedule C for Little Rock Corp. to reflect its dividends-received deduction (use the most recent Form 1120 Schedule C available).

e. On what line on page 1 of Little Rock Corp.’s Form 1120 is the dividend from Marathon Inc. reported, and on what line of Little Rock Corp.’s Form 1120 is its dividends-received deduction reported?