Question & Answer

While James Craig and his former classmate Paul Dolittle both studied accounting at school, they ended up pursuing careers in professional cake decorating. Their company, Good to Eat (GTE), specializes in custom-sculpted cakes for weddings, birthdays, and other celebrations.  James and Paul formed the business at the beginning of 2024, and each contributed $50,000 in exchange for a 50 percent ownership interest.  GTE also borrowed $200,000 from a local bank.  Both James and Paul had to personally guarantee the loan.  Both owners provide significant services for the business. The following information pertains to GTE’s 2024 activities.

• GTE uses the cash method of accounting (for both book and tax purposes) and reports income on a calendar-year basis.  

• GTE received $450,000 of sales revenue and reported $210,000 of cost of goods sold (it did not have any ending inventory).

• GTE paid $30,000 compensation to James, $30,000 compensation to Paul, and $40,000 of compensation to other employees (assume these amounts include applicable payroll taxes, if any).

• GTE paid $15,000 of rent for a building and equipment, $20,000 for advertising, $14,000 in interest expense, $4,000 for utilities, and $2,000 for supplies.

• GTE contributed $5,000 to charity.

• GTE received a $1,000 qualified dividend from a great stock investment (it owned 2 percent of the corporation distributing the dividend), and it recognized $1,500 in short-term capital gain when it sold some of the stock.

• On December 1, 2024, GTE distributed $20,000 to James and $20,000 to Paul.

• GTE has qualified property of $300,000 (unadjusted basis).

Required:

a. Assume James and Paul formed GTE as an S corporation.  

• Complete GTE’s Form 1120-S page 1; Form 1120-S, Schedule K; and Paul’s Form 1120-S Schedule K-1 (note that you should use 2023 tax forms). 

• Compute the tax basis of Paul’s stock in GTE at the end of 2024.

• What amount of Paul’s income from GTE is subject to FICA or self-employment taxes?

• What amount of income, including its character, will Paul recognize on the $20,000 distribution he receives on December 1?

• What amount of tax does GTE pay on the $1,000 qualified dividend it received?

Agustina, Bobby, and Claudia are equal owners in Lafter, an S corporation that was a C corporation several years ago. While Agustina and Bobby actively participate in running the company, Claudia has a separate day job and is a passive owner. Consider the following information for 2024: 

• As of January 1, 2024, Agustina, Bobby, and Claudia each have a basis in Lafter stock of $15,000 and a debt basis of $0.  On January 1, the stock basis is also the at-risk amount for each shareholder.

• Bobby and Claudia also are passive owners in Aggressive LLC, which allocated business income of $14,000 to each of them in 2024. Neither has any other source of passive income (besides Lafter, for Claudia). 

• On March 31, 2024, Agustina lends $5,000 of her own money to Lafter.

• Anticipating the need for basis to deduct a loss, on April 4, 2024, Bobby takes out a $10,000 loan to make a $10,000 capital contribution to Lafter. Bobby uses his automobile ($12,000 fair market value) as the sole collateral for his loan (nonrecourse). 

• Lafter has an accumulated adjustments account balance of $45,000 as of January 1, 2024.

• Lafter has C corporation earnings and profits of $15,000 as of January 1, 2024.

• During 2024, Lafter reports a business loss of $75,000, computed as follows:

Sales revenue $90,000

Cost of goods sold (85,000)

Salary to Agustina (40,000)

Salary to Bobby (40,000)

Business (loss)($75,000)

• Lafter also reported $12,000 of tax-exempt interest income.

a. What amount of Lafter’s 2024 business loss of $75,000 are Agustina, Bobby, and Claudia allowed to deduct on their individual tax returns?  What are each owner’s stock basis and debt basis (if applicable) and each owner’s at-risk amount with respect to the investment in Lafter at the end of 2024?

Barry Porter and Winnie Weeks are considering making an S election on March 1, 2024, for their C corporation, Omniocular. However, first they want to consider the implications of the following information:

• Winnie is a U.S. citizen and resident.

• Barry is a citizen of the United Kingdom but a resident of the United States.

• Barry and Winnie each own 50 percent of the voting power in Omniocular.  However, Barry’s stock provides him with a claim on 60 percent of the Omniocular assets in liquidation.

• Omniocular was formed under Arizona state law, but it plans on eventually conducting some business in Mexico.

a) Is Omniocular eligible to elect S corporation status?  If so, when is the election effective?

Knowshon, sole owner of Moreno Inc., is contemplating electing S status for the corporation (Moreno Inc. is currently taxed as a C corporation). Provide recommendations related to Knowshon’s election under the following alternative scenarios:

a. At the end of the current year, Moreno Inc. has a net operating loss of $800,000 carryover from 2023.  Beginning next year, the company expects to return to profitability.  Knowshon projects that Moreno will report profits of $400,000, $500,000, and $600,000 over the next three years.  What suggestions do you have regarding the timing of the S election?  Explain.

Until the end of year 0, Magic Carpets (MC) was a C corporation with a calendar year-end.  At the beginning of year 1, it elected to be taxed as an S corporation.  MC uses the LIFO method to value its inventory.  At the end of year 0, under the LIFO method, its inventory of rugs was valued at $150,000. Under the FIFO method, the rugs would have been valued at $170,000.  How much LIFO recapture tax must MC pay, and what is the due date of the first payment under the following alternative scenarios?

Farve Inc. recently elected S corporation status.  At the time of the election, the company had $10,000 of accumulated earnings and profits and a net unrealized gain of $1,000,000 associated with land it had invested in (although some parcels had an unrealized loss).  In the next couple of years, most of the income the company expects to generate will be in the form of interest and dividends (approximately $200,000 per year).  However, in the future, the company will want to liquidate some of its current holdings in land and possibly reinvest in other parcels.  What strategies can you recommend for Farve Inc. to help reduce its potential tax liability as an S corporation?  

Inuk is the sole shareholder of Tex Corporation.  Inuk first formed Tex as a C corporation.  However, in an attempt to avoid having Tex’s income double-taxed, Inuk elected S corporation status for Tex several years ago.  On December 31, 2024, Tex reports $5,000 of earnings and profits from its years as a C corporation and $50,000 in its accumulated adjustments account from its activities as an S corporation (including its 2024 activities).  Inuk discovered that for the first time Tex was going to have to pay the excess net passive income tax.  Inuk wanted to avoid having to pay the tax, but he determined the only way to avoid the tax was to eliminate Tex’s E&P by the end of 2024.  He determined that, because of the distribution ordering rules (AAA first), he would need to have Tex immediately (in 2024) distribute $55,000 to him.  This would clear out Tex’s accumulated adjustments account first and then eliminate Tex’s C corporation earnings and profits in time to avoid the excess net passive income tax.  Inuk was not sure Tex could come up with $55,000 of cash or property in time to accomplish his objective.  Does Inuk have any other options to eliminate Tex’s earnings and profits without first distributing the balance in Tex’s accumulated adjustments account?

Wood Corporation was a C corporation in 2023 but elected to be taxed as an S corporation in 2024.  At the end of 2023, its earnings and profits were $15,500.  The following table reports Wood Corp.’s (taxable) income for 2024 (its first year as an S corporation).

What is Wood Corporation’s excess net passive income tax for 2024?

Tempe Corporation is a calendar-year corporation.  At the beginning of 2024, its election to be taxed as an S corporation became effective.  Tempe Corp.’s balance sheet at the end of 2023 reflected the following assets (it did not have any earnings and profits from its prior years as a C corporation):

Asset Adjusted basis FMV

Cash $20,000 $20,000

Accounts receivable 40,000 40,000

Inventory 160,000 200,000

Land 150,000 120,000

  Totals $370,000 $380,000

Tempe Corp.’s business income for the year was $40,000 (this would have been its taxable income if it were a C corporation).  During 2024, Tempe Corp. sold all of the inventory it owned at the beginning of the year for $210,000.  

a. What is its built-in gains tax in 2024?

Virginia Corporation is a calendar-year corporation.  At the beginning of 2024, its election to be taxed as an S corporation became effective.  Virginia Corp.’s balance sheet at the end of 2023 reflected the following assets (it did not have any earnings and profits from its prior years as a C corporation).

In 2024, Virginia Corp. reported business income of $50,000 (this would have been its taxable income if it were still a C corporation). What is Virginia’s built-in gains tax in each of the following alternative scenarios?

] Rivendell Corporation uses the accrual method of accounting and has the following assets as of the end of 2023. Rivendell converted to an S corporation on January 1, 2024.  

Asset Adjusted basis FMV

Cash $40,000 $40,000

Accounts receivable 30,000 30,000

Inventory 130,000 60,000

Land 100,000 125,000

  Totals $300,000 $255,000

a. What is Rivendell’s net unrealized built-in gain at the time it converted to an S corporation?

Alabama Corporation, an S corporation, liquidates this year by distributing a parcel of land to its sole shareholder, Mark Ingram. The fair market value of the parcel is $50,000, and its tax basis is $30,000. Mark’s basis in his stock is $25,000.  

Miley decided to terminate the S corporation election of her solely owned corporation on October 17, 2023 (effective immediately), in preparation for taking it public.  Miley had previously elected S corporation status on January 1, 2022.  At the time of the election, the corporation had an accumulated adjustments account balance of $150,000 and $450,000 of accumulated E&P from prior C corporation years, and Miley had a basis in her S corporation stock of $135,000.  During 2024, Miley’s corporation reported $0 taxable income or loss.  Also, during 2024 the corporation made distributions to Miley of $80,000 and $60,000.  How are these distributions taxed to Miley assuming the following?

Carolina Corporation, an S corporation, has no corporate E&P from its years as a C corporation.  At the end of the year, it distributes a small parcel of land to its sole shareholder Shadiya. The fair market value of the parcel is $70,000, and its tax basis is $40,000. Shadiya’s basis in her stock is $14,000.  Assume Carolina Corporation reported $0 taxable income before considering the tax consequences of the distribution.

Pine Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, Alejandro, who has always operated it as a C corporation.  However, at the beginning of this year, Alejandro made a qualifying S election for Pine Corp., effective January 1.  Pine Corp. reported $70,000 of C corporation earnings and profits on the effective date of the S election.  This year (its first S corporation year), Pine Corp. reported business income of $50,000.  Alejandro’s basis in his Pine Corp. stock at the beginning of the year was $15,000.  What are the amount and character of income or gain Alejandro must recognize on the following alternative distributions, and what is his basis in his Pine Corp. stock at the end of the year?

At the end of the year, before distributions, Bombay (an S corporation) has an accumulated adjustments account balance of $15,000 and accumulated E&P of $20,000 from a previous year as a C corporation. During the year, Nicolette (a 40 percent shareholder) received a $20,000 distribution (the remaining shareholders received $30,000 in distributions).  What are the amount and character of income or gain Nicolette must recognize from the distribution? What is her basis in her Bombay stock at the end of the year?  (Assume her stock basis is $40,000 after considering her share of Bombay’s income for the year but before considering the effects of the distribution.)

Assume the following year 2 income statement for Johnstone Corporation, which was a C corporation in year 1 and elected to be taxed as an S corporation beginning in year 2.  Johnstone’s earnings and profits at the end of year 1 were $10,000.  Marcus is Johnstone’s sole shareholder, and he has a stock basis of $40,000 at the end of year 1.  What is Johnstone’s accumulated adjustments account at the end of year 2, and what amount of dividend income does Marcus recognize on the year 2 distribution in each of the following alternative scenarios?  

Johnstone Corporation

Income Statement

December 31, Year 2

Year 2

(S corporation)

Sales revenue $150,000

Cost of goods sold (35,000)

Salary to owners (60,000)

Employee wages (50,000)

Depreciation expense (4,000)

Miscellaneous expenses (4,000)

Interest income 10,000

Overall net income $7,000

On January 1, 2024, Janna has a tax basis of $15,000 in her Mimikaki stock (Mimikaki has been an S corporation since inception). In 2024, Janna was allocated $20,000 of ordinary income from Mimikaki. What are the amount and character of gain she recognizes from end-of-the-year distributions in each of the following alternative scenarios, and what is her stock basis following each distribution?

Oak Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, Glover, and has always operated as a C corporation.  However, at the beginning of this year, Glover made a qualifying S election for Oak Corp., effective January 1.  Oak Corp. did not have any C corporation earnings and profits on that date.  On June 1, Oak Corp. distributed $15,000 to Glover.  What are the amount and character of gain Glover must recognize on the distribution, and what is his basis in his Oak Corp. stock in each of the following alternate scenarios?

Maple Corp., a calendar-year corporation, was formed three years ago by its sole shareholder, Jian, who immediately elected S corporation status.  On December 31 of the current year, Maple distributed $30,000 cash to Jian.  What are the amount and character of gain Jian must recognize on the distribution in each of the following alternative scenarios?

Five friends, Jackie (0.5 percent owner), Jermaine (1 percent owner), Marlon (2 percent owner), Janet (86 percent owner), and Tito (10.5 percent owner) are shareholders in Jackson 5 Inc. (an S corporation).  As employees of the company, each receives health insurance ($10,000 per year benefit), dental insurance ($2,000 per year benefit), and free access to a workout facility located at company headquarters ($500 per year benefit).  What are the tax consequences of these benefits for each shareholder and for Jackson 5 Inc.? 

This year, Justin B.’s share of S corporation income includes $4,000 of interest income, $5,000 of dividend income, and $40,000 of net income from the corporation’s professional service business activity. 

a) Assume that Justin B. materially participates in the S corporation. How much of his S corporation income is potentially subject to the net investment income tax?

Using the facts in problem 62, could Adam and Tom lower their payroll tax exposure if they operated their business as a partnership?  Why or why not?  

Adam Fleeman, a skilled carpenter, started a home improvement business with Tom Collins, a master plumber.  Adam and Tom are concerned about the payroll taxes they will have to pay.  Assume they form an S corporation, and each earns a salary of $80,000 from the corporation; in addition, they expect their share of business profits to be $60,000 each.  How much Social Security tax and Medicare tax (or self-employment tax) will Adam, Tom, and their corporation have to pay on their salary and profits? 

In the past several years, Shakira had loaned money to Shakira Inc. (an S corporation) to help the corporation keep afloat in a downturn.  Her stock basis in the S corporation is now $0, and she has deducted $40,000 in losses, reducing her debt basis from $100,000 to $60,000.  Things appear to be turning around this year, and Shakira Inc. repaid Shakira $20,000 of the $100,000 outstanding loan.  What is Shakira’s income, if any, on the partial loan repayment?