ACCT40610 Lecture Notes - Lecture 6: Internal Revenue Code, Constructive Receipt, Tax Deduction

Question: Reading Federal Income Taxation of Corporations andShareholders Text: Study Chapters 7 & 8 o...

Reading

Federal Income Taxation of Corporations andShareholders

Text: Study Chapters 7 & 8of the Bittker & Eustice text.

Penalty Taxes on Undistributed CorporateIncome, Dividends and Other NonliquidatingDistributions

LESSON 6, PROBLEM #1

In not less than 1,000 words discuss "earnings and profits".Your discussion should include major differences between computingcurrent earnings and profits and current taxable income as well aswhy earnings and profits should be calculated before a corporationdecides to make a distribution to its shareholders.

LESSON 6, PROBLEM #2

Allan owns all of the stock of CadyCo. The stock’s basis is$100,000. CadyCo has a total of current and accumulated earningsand profits of $50,000. CadyCo distributes $200,000 cash to Allan“with respect to his stock” (i.e., as a state law “dividend”). Howis the $200,000 taxed? What is Allan’s stock basis after thedistribution? Alternatively, CadyCo distributes to Allan his noteto CadyCo for $200,000 borrowed from CadyCo.

LESSON 6, PROBLEM #3

Assumptions: The stock of ChadCo is owned equally bytwo shareholders: SecondCo (a corporation) and Arnold (anindividual). ChadCo and SecondCo use the accrual method, Arnolduses the cash method. All use a calendar taxable year. Assume §1059 does not apply. Use a 34 percent corporate tax rate in thisproblem. During the current year, ChadCo accrued income andexpenses as follows:

(1) On December 24 of the preceding year, SecondCo and Arnoldincorporated ChadCo and capitalized ChadCo with cash of $100,000each. On December 31 of that preceding year, SecondCo and Arnoldreceived distributions from ChadCo of $5,000 each; ChadCo did notearn any income for that year. In addition, SecondCo and Arnoldreceived distributions of $5,000 each, in the current year.

Which distributions should be gross income to SecondCo andArnold, in what amounts, and why? What does E&P have to do withthis?

(2) Alternative: Arnold just bought the ChadCo shares onDecember 30 of the current year from another shareholder for FMV of$145,000, before the declaration and payment of a

$5,000 distribution to Arnold on December 31 of the currentyear.

Should the distribution be taxable income to Arnold?Why?

(3) Now assume that SecondCo’s basis in its ChadCo stock is$100,000 and Arnold’s basis in his ChadCo stock is $40,000. OnJanuary 2 of the current taxable year, ChadCo distributes $100,000in cash to SecondCo and $100,000 in cash to Arnold. As of the endof the preceding taxable year, ChadCo’s accumulated E&P waszero.

What are the tax consequences of this distribution toChadCo, SecondCo, and Arnold? [Hint: First compute ChadCo’scurrent-year taxable income and then compute current- year E&Pbefore reducing the E&P for the distribution (“interimE&P”); after reducing for the distribution, compute finalaccumulated E&P.]

(4) Variation: Assume Arnold’s shares were owned by a differentshareholder every quarter and $50,000 was distributed ratably toall shareholders quarterly?

How much dividend would SecondCo and the holders of Arnold’sshares receive?

(5) Suppose under the basic facts in (3) above that ChadCo hadan accumulated de?cit of

$100,000 in its E&P account as of December 31 of thepreceding taxable year.

(6) If, on December 1 of the current year (the declarationdate), ChadCo’s board of directors voted to pay the $200,000distribution by mailing the checks on December 31 of the currenttaxable year (the payment date, the identi?cation of which is apractice generally used only by widely held corporations) toshareholders of record on December l5 of the current taxable year(the record date), such checks actually being received by SecondCoand Arnold in the mail on January 2 of the next year? Assume thatSecondCo and Arnold are the public and that they are the onlyshareholders (as in the basic facts).

How would your answer to (3) above change?

(7) Suppose that SecondCo is an individual and that ChadCo hasalways been an S corporation.

What is ChadCo’s E&P‘? How is each shareholder’spersonal income tax return affected for the current year by the taxitems ofChadCo? How will ChadCo distribution of

$100,000 to each shareholder in the current year affectshareholders?

It is now late May 2018 and you, CPA, have just finished meetingwith your partner, Ms. Wong. Ms. Wong wants your help with someclients of hers.

One client, Garden Supplies Co. (GSC) has had a new shareholderbuy shares. Ms. Wong wants you to tell her if GSC is a resident ofCanada for tax purposes in 2018 and describe the personal taxconsequences that Mrs. Gardiner will have from her 2018 share sale.You can ignore the acquisition of control rules. Also, given thelist of GSC’s 2018 expenditures in Exhibit I, calculate the total2018 expenses that are deductible in 2018 when computing net incomefor tax purposes. GSC is very profitable and wants to claim themaximum amount of deductions possible. You do not need to commenton non-deductible items.

Note: Additional information about GSC is provided in ExhibitI.

Another client, Mr. Rich, who is a non-resident of Canada, hasjust purchased a newly built townhouse in Canada for $1,500,000that he plans to rent out. The home was purchased on May 1, 2018and will be rented out starting on July 1, 2018. What Canadianincome tax obligations will Mr. Rich face in 2018? If you have anyrecommendations that will reduce Mr. Rich’s Canadian income taxobligations (in 2018 or in future years) with respect to his rentalproperty, then you should provide them. Additional informationabout Mr. Rich is provided in Exhibit II.

Ms. Wong wants you to draft a memo to her answering herquestions. She says you can ignore provincial income taxes, ignoreforeign taxes and ignore any income tax treaties. Explain youranswers, show all your detailed calculations and give IncomeTax Act (ITA) section, subsection and paragraph (whereapplicable) references and Income Tax Regulations sectionand subsection references in order to support your answers. Whengiving references you must be specific. Do not just list multiplereferences!

Exhibit I

Garden Supplies Co.

Garden Supplies Co (GSC) is a private company that wasincorporated in Canada in 1963 by Mr. Taft. Mr. Taft subscribed for1,000 common shares in return for $100 (in aggregate). GSC does nothave any other shares outstanding

GSC has a December 31^st year-end and its board ofdirectors meetings are typically held in the United States(U.S.)

GSC operates gardening supply stores in Canada and it startedwith one store in Toronto in 1963. Now it has 10 stores throughoutCanada

In 2005, Mr. Taft sold his shares to Mrs. Gardiner for $1M inaggregate (which was their FMV at the time)

In late January 2018, Mrs. Gardiner sold 600 of her GSC commonshares for $3,000 per share to Marcus Jones, an arm’s length person(she still owns 400 common shares of GSC)

In January 2018, Mrs. Gardiner paid $3,500 to a charteredbusiness valuator to value her GSC shares and paid $2,500 in legalfees related to her sale of GSC shares

The FMV of GSC was determined to be $3M

Mrs. Gardiner incurred $300 of safety deposit box rental fees in2018 and she keeps her GSC share certificates in her safety depositbox

Assume GSC is not a qualified small business corporation

Marcus Jones is a non-resident of Canada

In 2018 GSC incurred the following expenditures:

Income taxes paid of $124,500

Salary and wages expense paid of $390,000

In addition, GSC accrued a bonus payable to Mrs. Gardiner of$70,000 for work performed in 2018. This bonus will not be paiduntil May 31, 2019

Interest expense paid of $5,000 on a bank loan used to financebusiness operations

Dividends paid to shareholders of $55,000

Warranty expense accrued of $25,000 (based on estimated warrantycosts). The actual cost in 2018 of servicing warranties was$20,000

Purchased new shelving units to display merchandise on April 1,2018 for $200,000

Purchased new computer software for $3,000 on January 1,2018

Purchased goodwill for $40,000 as part of a business acquisitionon January 1, 2018

Purchased a patent, with an 18-year legal life remaining onDecember 31, 2018 for $10,000

Accrued office supply expenses of $12,000, for suppliespurchased (and used) in late 2018. Payment of this account payablewas made in early 2019

Paid $7,000 for Toronto Blue Jays (baseball) tickets used totake large customers out to games

Incurred $4,000 of legal fees related to obtaining bankfinancing, and

Incurred lobbying expenses of $1,300 for matters related to thebusiness

Assume all expenditures are reasonable unless otherwiseindicated

Assume the prescribed interest rate is 1% at all times

Exhibit II

Mr. Rich

Mr. Rich’s rental income is property income; i.e., he is notrunning a business

Mr. Rich wants to minimize his Canadian rental income and hedoes not have any other Canadian income

Mr. Rich has prepared the following (assume that all theexpenses below are paid in 2018 and are reasonable):

Mr. Rich’s Canadian Rental Income

For the year-ended December 31, 2018

Gross rental revenue ($4,000 permonth) $24,000

Mortgage interest ($2,200 permonth) $13,200

Property taxes ($610 permonth) $3,660

Maintenance and repairs ($500 permonth) $3,000

Insurance ($200 permonth) $1,200

Total expenses $21,060

Netincome $2,940