Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S

Corporations
Chapter10

QuestionsandProblemsforDiscussion

1. Asoleproprietorshipisnotalegalentitybutmerelyabusinessactivitycarriedonbyanindividual.
Theproprietorispersonallyliabletothebusinesscreditors.Thenetprofitorlossfromtheactivityis
partoftheproprietorstaxableincome.Becauseasoleproprietorshiphasnoseparateidentityfrom
itsproprietor,itcantbedescribedasapassthroughentity.

2. Mrs.LiushouldusethemarginalrateapplyingtothenextdollaroftaxableincomeonForm1040.

3. Ifthe$17,000businesslossexceedsthetotalofMr.Pittsotherincomeitemsfortheyear(salary,
dividends,interest,etc.),theexcessqualifiesasanetoperatingloss,whichhecancarrybackasa
deductiontohistwopriortaxableyears.

4. FirmQremitted$13,400employerpayrolltax(whichitdeductedasabusinessexpense)and
$13,400employeepayrolltaxwithheldfromthecompensationpaidtoitsemployeesduringtheyear.

5. Theemployeepayrolltaxisextremelyconvenientbecausetheresponsibilityforcomputingand
payingthetaxisontheemployer,nottheemployee.However,thepayrolltaxratestructureis
regressive:7.65percentonabaseamountofannualcompensation+1.45percentoncompensation
inexcessofthebase.In2007,theemployeepayrolltaxon$50,000compensationis$3,825foran
averagerateof7.65percent.Theemployeepayrolltaxon$200,000compensationis$8,945foran
averagerateof4.47percent.Thus,theemployeepayrolltaxisoftencriticizedasvertically
inequitable.

6. Theselfemploymenttaxisbasedonnetearningsfromselfemployment,whichisessentiallythe
profitthatsoleproprietorsearnfromtheirbusiness.Individualspaytheirselfemploymenttaxatthe
sametimeandinthesamemannerastheypayincometax.

7. Theincometaxdeductionforonehalfofselfemploymenttaxcorrespondstotheemployers
deductionforemployerpayrolltax.Thenondeductibleonehalfofselfemploymenttaxcorresponds
tothenondeductibleemployeepayrolltax.

8. a. Generalpartnershaveunlimitedpersonalliabilityforallrecoursedebtsoftheirpartnership.

b. Limitedpartnershavenopersonalliabilityforthedebtsoftheirpartnership.However,Tom,
Angela,andPeterallcannotbelimitedpartnersbecausealimitedpartnershipmusthaveat
leastonegeneralpartner.

c. ThemembersofanLLChavenopersonalliabilityforthedebtsoftheircompany.

d. TheshareholdersofanScorporationhavenopersonalliabilityforthedebtsoftheircorporation.

9. Anyitemrecognizedbyapassthroughentitythatissubjecttoaspecialrule,limitation,ortreatment
inthecomputationofindividualorcorporatetaxableincomeortaxliabilitymustbeseparatelystated.
Thisseparateaccountingallowseachownertoapplythespecialrule,limitation,ortreatmenttothat
ownersshareoftheitem.

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10. EachpartnerinSoyaPartnershipmustcombineitsshareofSoyasSection1231losswithallother
Section1231gainsandlossesrealizedduringtheyeartodeterminethatpartnersnetSection1231
gainorloss.TherulethatanetSection1231lossisdeductibleasanordinarylossandanetSection
1231gainistreatedasacapitalgaincanbeappliedonlyatthepartner(ratherthanthepartnership)
level.

11. ThedifferentusesofcashhavenoeffectonthefederalincometaxliabilitiesofMr.AandMr.Z.
Bothwillpaytaxontheincomegeneratedbytheirsoleproprietorships,regardlessoftheamountof
cashflowgeneratedortheusetowhichtheownersputsuchcashflow.

12. a. Asashareholder,Mr.BateshaslimitedliabilityforcreditorclaimsagainstUPF.Inotherwords,
thecreditorcannotdemandrepaymentofthecorporatedebtfromMr.Bates.

b. Thecreditorcandemandrepaymentoftheentire$120,000debtfromMr.Bates.IfMr.Bates
paysthedebt,hecanseekrestitutionfromtheothergeneralpartnersfortheirproportionate
shares.

c. Asalimitedpartner,Mr.BateshaslimitedliabilityforcreditorclaimsagainstUPF.

d. AsamemberofaLLC,Mr.BateshaslimitedliabilityforcreditorclaimsagainstUPF.

13. a. Mr.Yangsbasisinhissoleproprietorshipistheaggregatebasisofthetangibleandintangible
assetsusedinthebusinessactivity.

b. Mr.Yangsbasisishisadjustedbasisinhisintangiblepartnershipinterest,whichequalshis
initialbasis(contributedcashandpropertyorcostbasisofapurchasedinterest)adjustedfor
increasesanddecreasesinhisinvestmentovertime.

c. Mr.Yangsbasisishisadjustedbasisinhiscorporatestock,whichequalshisinitialbasis
(contributedcashandpropertyorcostbasisofpurchasedstock)adjustedforincreasesand
decreasesinhisinvestmentovertime.

14. CorporationABCmustcomputeitsadjustedbasisinitsinterestinKKPartnershipasofthedateof
sale.ThisadjustedbasismustincludeABCsshareofpartnershipitemsattributabletotheportionof
KKstaxableyearduringwhichABCwasapartner(January1throughOctober9).Thepartnership
maynotbeabletocomputesuchshareuntilaftertheclosingoftheyearonDecember31.

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ApplicationProblems

1. a. ScheduleCwouldreflectnetprofitof$26,800asshownonthefollowingScheduleC:

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b. ScheduleSEwouldreflect$3,787ofSEtax,asshownonthefollowingScheduleSE:

2. a. Rheashomeofficedeductioniscomputedasfollows.
Annualrent $48,000
Housekeepingservice 5,200
Rentersinsurance 2,000
Totalapartmentexpense $55,200
Percentageofsquarefootageusedasoffice .15
Expensesallocatedtooffice $8,280

Rheashomeofficedeductionis$8,280.

b. Rheashomeofficedeductionislimitedto$4,000(netprofitbeforethededuction).

3. a. Colinshomeofficedeductioniscomputedasfollows.
Annualhousingexpenses $19,055
Percentageofsquarefootageusedasoffice .10
Expensesallocatedtooffice 1,905
MACRSdepreciation(10%[$185,000 39years]) 474
Homeofficededuction $2,379

Netprofitbeforehomeofficededuction $75,000
Homeofficededuction (2,379)
Netprofit $72,621

b. Netprofitbeforehomeofficededuction $1,800
Homeofficededuction(limitedtoprofitbeforededuction) (1,800)
Netprofit 0

4. a. BDFs2007payrolltaxis$4,590($60,0007.65%).

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b. BDFs2007payrolltaxis$8,945([$97,5006.2%]+[$200,0001.45%]).

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5. a. BDFs2008payrolltaxwouldbe$4,590(nochangefrom2007).

b. BDFs2008payrolltaxwouldbe$9,224([$102,0006.2%]+[$200,0001.45%]).

6. a. Mrs.Singers2006selfemploymenttaxis$7,271,andherincometaxdeductionis$3,635

b. Mrs.Singers2006selfemploymenttaxis$6,859,andherincometaxdeductionis$3,430.

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c. Mrs.Singers2006selfemploymenttaxis$340,andherincometaxdeductionis$170.

7. a. Onlythe$120,000profitfromoperationsissubjecttoselfemploymenttax.

b. Selfemploymenttax=$14,895=$94,200*12.4%+$120,000*92.35%*2.9%

c. Netprofitfromoperations $120,000
Ordinarygainonassetsale 17,000
Interestincomeonworkingcapital 960
Beforetaxincomefrombookstoreactivities $137,960
Onehalfselfemploymenttax (7,448)
Taxableincomefrombookstoreactivity $130,512

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8. a. NetprofitfromJCspractice $32,000
Onehalfselfemploymenttax (2,261)
Taxableincomefrompractice $29,739
Taxrate .25
Incometax $7,435

Beforetaxincome $32,000
Selfemploymenttax (4,522)
Incometax (7,435)
Aftertaxincome $20,043

b. JCsselfemploymenttaxis38percentofthefederaltaxburdenonherbusinessincome
($4,522SEtax $11,957totaltax).

9. a. SocialSecuritytax($33,000 6.2%) $2,046

Medicaretax($33,000 1.45%) 479
EmployerpayrolltaxonBenssalary $2,525

b. SalarypaymenttoBen $33,000
Employerpayrolltaxonsalary 2,525
Unemploymenttax 400
Janesbeforetaxcostofsalary/taxpayments $35,925 $35,925
Incometaxsavingsfromdeduction($35,92535%) (12,574)

ReductioninJanesSEtax $962
Incometaxcostofreduceddeductionfor50%SEtax
($48135%) (168)
NettaxsavingsfromSEtaxreduction (794)

JanesaftertaxcostofhiringBen $22,557

10. a. Asequalgeneralpartners,ABandYZeachincludehalfthepartnershipsrecoursedebtintheir
initialbases.
ABscontributedcash $500,000
ABsshareofrecoursedebt 125,000
ABsinitialbasisinitspartnershipinterest $625,000

YZsbasisincontributedland $430,000
YZsshareofrecoursedebt 125,000
YZsinitialbasisinitspartnershipinterest $555,000

b. BecauseYZisalimitedpartner,itisnotresponsibleforanyofthepartnershipsrecoursedebt.
Asthegeneralpartner,ABisresponsibleforrepayment(i.e.hasunlimitedliability)and
consequentlycanincludetheentirepartnershipdebtinbasis.
ABscontributedcash $500,000
ABsshareofrecoursedebt 250,000
ABsinitialbasisinitspartnershipinterest $750,000

YZsbasisincontributedland $430,000
YZsshareofrecoursedebt 0

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YZsinitialbasisinitspartnershipinterest $430,000

11. FGHPartnerships$600,000ordinarybusinessincomeisallocatedequallytoTriadLLCandBeta.
However,sincethesetwopartnersarebothpassthroughentities,the$300,000allocatedtoeachis
passedthroughandreportedbythefollowingtaxpayers.
Mr.T(40%$300,000) $120,000
Mrs.U(35%$300,000) 105,000
VInc.(25%$300,000) 75,000
Ms.B 300,000
$600,000

12. a. Rochellestaxableincomewillincreasebythe$25,000ofordinaryincome.Rochellewill
combinethe$3,000Section1231losswithanySection1231gainsorlossesfromother
sources.Ultimately,thelosswillreducehertaxableincomeby$3,000.Thenondeductible
expensesandcashdistributionwillhavenoimpactonhertaxableincome.Thus,thenetimpact
ofthepartnershipactivityonRochellestaxableincomeisanincreaseof$22,000.

b. Taxcost=$22,000*35%=$7,700cashoutflow.Cashdistributionof$5,000isacashinflow.
Netcashoutflowof$2,700($5,000$7,700).

13. Grossreceiptsfromsales $670,000

Costofgoodssold (460,000)
Operatingexpenses (96,800)
50%mealsandentertainment (3,120)
KLMNsordinarybusinessincome $110,080

KLMNsSection1231lossontheequipmentsaleandcharitablecontributionareseparatelystated
items.

14. a. Mr.Thasthefollowingshares.
Ordinarybusinessincome $11,008
Separatelystateditems: Section1231loss (1,350)
Charitablecontribution (150)
Nondeductibleexpense (312)

b. Mr.Tsadjustedbasisatbeginningofyear $45,000
Increasedbyordinarybusinessincome 11,008
Decreasedby: Cashdistribution (1,000)
Section1231loss (1,350)
Charitablecontribution (150)
Nondeductibleexpense (312)
Mr.Tsadjustedbasisatendofyear $53,196

c. Mr.Tsadjustedbasiswouldincreaseto$55,996($53,196+10%[$28,000increasein
partnershipdebt]).

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15. a. Ordinaryincome=$270,000=$500,000$200,000$30,000
Separatelystateditems:
Longtermcapitalgain $9,000
Nondeductibleexpenses 2,000
Distributions 100,000

b. Ordinaryincome,$135,000;Longtermcapitalgain,$4,500;Nondeductibleexpenses,$1,000;
Distributions,$50,000

c. $139,500=$135,000ordinaryincome+$4,500capitalgain

d. $123,500=$25,000beginningbasis+$135,000ordinaryincome+$4,500capitalgain$1,000
nondeductibleexpenses$50,000distribution+$10,000shareofdebtincrease

16. ScheduleK:

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b. JayanthisScheduleK1:

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17. PartnerX PartnerY

Initialbasisinpartnershipinterest $50,000 $10,000*
Deductionfor$21,000shareofloss (21,000) (10,000)
Adjustedbasisatbeginningofnextyear $29,000 0

*Adjustedbasisofcontributedbusinessassets

18. AVsnetSection1231lossiscomputedasfollows.
Section1231lossonsaleofequipment $(17,000)
ShareofLLCSection1231gain 4,000
NetSection1231loss $(13,000)

AVsnetcapitallossiscomputedasfollows.
Capitallossonsaleofsecurities $(5,000)
ShareofLLCcapitalloss (1,200)
Netcapitalloss $(6,200)

WithouttheitemsfromtheLLC,AVhasa$17,000deductibleSection1231lossanda$5,000
nondeductiblecapitalloss.WiththeitemsfromtheLLC,ithasa$13,000deductibleSection1231
lossanda$6,200nondeductiblecapitalloss.Thus,theLLCitemsincreasedAVstaxableincomeby
$4,000.

19. a. Ordinaryincomebeforeguaranteedpayments $95,000

Deductionforguaranteedpayments (48,000)
Ordinarybusinessincome $47,000

BonniesandGeorges50%share $23,500

b. Bonniesselfemploymentincomeis$71,500($48,000guaranteedpayment+$23,500shareof
ordinarybusinessincome).Georgesselfemploymentincomeequalsher$23,500shareof
ordinarybusinessincome.

c. Ordinaryincomebeforeguaranteedpayments $32,000
Deductionforguaranteedpayments (48,000)
Ordinarybusinessloss $(16,000)

BonniesandGeorges50%share $(8,000)

Bonniesselfemploymentincomeis$40,000($48,000guaranteedpayment$8,000shareof
businessloss),whileGeorgehasnoselfemploymentincome.

20. Zeldasadjustedbasisatbeginningof2006 $95,000

Increasedby: 60%shareofdividendsandinterest 8,760
60%shareofcapitalgain 3,720
Basisbeforelossdeduction $107,480
a. Decreasedbylimiteddeductionfor
60%shareofbusinessloss (107,480)
b. Zeldasadjustedbasisatendof2006 0

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c. IfZeldareceiveda$5,000cashdistributionfromthepartnership,herbasisbeforetheloss
deductionwouldbeonly$102,480,andthedeductionforhershareofthebusinesslossis
limitedto$102,480.

21. a. Zeldacandeducther$18,520losscarryforwardfrom2006.Consequently,shewillreporta
$14,320businessloss($4,2002007income$18,250losscarryforward)and$10,800dividend
andinterestincomeonher2007Form1040.

Zeldasadjustedbasisatbeginningof2007 0
Increasedby: 60%shareofbusinessincome 4,200
60%shareofdividendsandinterest 10,800
60%shareofpartnershipdebt 12,600
Basisbeforelossdeduction $27,600
Decreasedbydeductionfor2006losscarryforward
($126,000$107,480) (18,520)
b. Zeldasadjustedbasisatendof2007 $9,080

22. a. Ms.Psinitialcostbasisinherpartnershipinterest $20,000

Increasedbyshareofpartnershipdebt 12,000
Decreasedbyshareofordinaryloss (28,000)
Ms.PsadjustedbasisonJanuary1,2008 $4,000

Ms.Pcandeductherentire$28,000shareoflossonher2007return.

b. Amountrealizedonsale($2,000cash+$12,000debtrelief) $14,000
Adjustedbasis (4,000)
Gainrecognizedonsaleofpartnershipinterest $10,000

23. a. Leocandeduct$23,000ofhis$30,000allocatedshareofBLSs2005operatingloss.
BLSStock BLSNote
Leosinitialbasis $15,000 $8,000
Decreasedbylimitedlossdeduction (15,000) (8,000)
b. Adjustedbasisatendof2005 0 0

24. a. Leoisallocated$20,400of2006incomefromBLS,sohecandeducthis$7,000loss
carryforwardfrom2005.Consequently,hewillinclude$13,400Scorporationincomein2006
taxableincome.
BLSStock BLSNote
Leosbasisatbeginningof2006 0 0
Increasedby2006incomeallocation 12,400 8,000
Decreasedby2005losscarryforward (7,000) _____
b. Adjustedbasisatendof2006 $5,400 $8,000

c. Inthiscase,Leoisallocated$11,000of2006incomefromBLS,only$4,000ofwhichisincluded
inhis2006taxableincome.
BLSStock BLSNote
Leosbasisatbeginningof2006 0 0
Increasedby2006incomeallocation 3,000 8,000
Decreasedby2005losscarryforward (3,000) (4,000)
d. Adjustedbasisatendof2006 0 $4,000

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25. Becausehisadjustedbasisinthenotesurrenderedinonly$4,000,Leomustrecognizea$4,000
capitalgainonthereceiptofthe$8,000repayment.

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26. a. EvanscashwithdrawalfromtheScorporationisnottaxabletohim,noritthepayment
deductiblebytheScorporation.

b. Ifthepaymentsarerecharacterizedassalary,theScorporationispermittedadeduction,
loweringitstaxableincome.Evanmustreportsalaryincome.TheneteffectonEvanstaxable
incomeandincometaxliabilityshouldbezero,sinceheisthesoleshareholderoftheS
corporation.

c. Ifthe$50,000peryearistreatedassalary,boththeScorporationandEvanhaveunpaidpayroll
taxof$3,825peryear,foratotalpotentialunderpaymentof$22,950($3,825*2*3years).

IssueRecognitionProblems

1. WillthemarginaltaxrateonEllieandherhusbandsjointreturnfornextyear(andtherateapplying
toElliesbusinessprofits)increasebecauseEllieshusbandwillearnasalary?

2. DoesJavieroweemployeepayrolltaxonhisentiresalaryplusselfemploymenttaxonhisentirenet
earningsfromselfemployment?DoesJavierhaveanannualbaseamountofcompensationsubject
toeitherSocialSecuritytaxorselfemploymenttax(butnotboth),ordoeshehaveanannualbase
amountsubjecttobothSocialSecurityandselfemploymenttax?

3. IsMrs.Choualsoconsideredtobeselfemployedsothatsomeofthenetprofitfromthebusiness
shouldbeattributedtoherforselfemploymenttaxpurposes?

4. DoesTravisuseofhishomeofficetohousethefamilylibraryviolatetheexclusiveusetestfora
homeofficededuction?

5. ShouldAFPartnershipallocateaportionofitscapitalgaintoLola,eventhoughshewasnota
partneronthedatethegainwasrealized?HowdoesAFPartnershipallocate15percentofits
incomebetweenLolaandRCorporation?WhatisLolasadjustedbasisinherpartnershipinterest
onApril12?

6. DidFredadjusthisbasisinthelimitedpartnershipinterestforhisshareofannualpartnership
income?HasFredreceivedcashdistributionsequalingthetotalpartnershipincomeonwhichhe
paidtaxforthelastnineyears?

7. IstheexchangeofapartnershipinterestforaninterestinanewlyformedLLCataxableor
nontaxableexchange?

8. Doesthestateofincorporation(andeveryotherstateinwhichthecorporationwillconductbusiness)
treatanScorporationasanontaxablepassthroughentityforstateincometaxpurposes?

9. WhathappenstoMr.YangscarryforwardofhisDKlosswhenhesellshisentireinterestinthe
partnership?CanMr.Yangdeduct$7,500ofhislosscarryforwardbecauseherecognizeda$7,500
gainonthesaleofthepartnershipinterest?Doesthelosscarryforwardtransfertothepurchaserof
thepartnershipinterest?

10. Whichshareofloss(ordinaryorcapital)doesPauladeductfirst?BecausePaulacandeductonly
$6,200ofherpartnershiplosses,howdoessheallocatethedeductionbetweenhersharesof
ordinarylossandcapitalloss?

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11. DoesMarcusrecognizehisfinalmonthly2007guaranteedpaymentastaxableincomein2007or
2008?DoesthepartnershipdeductionforthepaymentdependontheyearinwhichMarcus
recognizesthepaymentasincome?

12. CanDavidincreasethebasisinhisDESstockbyhis$8,900allocationoftaxexemptinterestsothat
hecandeducthisentire$4,700ordinarylossallocation?

13. HowshouldWWaccountforthe$21,000paymentmadeonitsshareholderspersonalbehalf?
ShouldMr.andMrs.Westtreatthecorporatepaymentontheirpersonalbehalfastaxable
compensationfromWWorasanontaxablecashdistributionthatreducesthebasisintheirWW
stock?

14. CantheothersixindividualspreventaterminationofNSsScorporationelection?IstheNSstock
subjecttoabuysellagreementorsimilarrestrictionthatpreventstheindividualfromgivingshares
toanonqualifyingshareholder?

15. CanBRrecognizethe$125,000lossrealizedonthesaleoflandtoapartnershipinwhichitisa
partner?AreBRandthelimitedpartnershiprelatedpartiesforpurposesofthelossdisallowance
rule?DoesBRindirectlyowna100percentinterestinthepartnershipbecauseallotherpartnersare
BRshareholders?

16. InwhichtaxableyeardoesCorporationLreportits$100,000shareofJKLPartnerships2006
businessincome?IsCorporationLs$100,000shareallocatedbetweenthecorporationsfiscalyear
endingonJune30,2006,anditsfiscalyearendingonJune30,2007?

17. CanFGdeducta$15,500ordinaryabandonmentlossbecauseitrelinquisheditsequityinterestin
thelimitedpartnership?

ResearchProblems

1. Rev.Rul.6695,19661CB169,providestheauthorityforthesolutiontothisresearchproblem.The
firststepisthecomputationofDonFerrissguaranteedpayment,whichthepartnershipcandeduct
inthecomputationoftaxableincome.
Taxableincomebeforedeductionofguaranteedpayment $107,200
.50
DonFerrisssharebeforeguarantee $53,600
Minimumguarantee $75,000
Share (53,600)
Guaranteedpayment $21,400

ThesecondstepisthecomputationofF&Lstaxableincome.
Taxableincomebeforedeductionofguaranteedpayment $107,200
Guaranteedpayment (21,400)
Taxableincome $85,800

ThelaststepisthecomputationofDonandLoussharesoftaxableincome.
DonFerris LouLindberg Total
Taxableincome $53,600 $32,200 $85,800

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2. ThisresearchproblemisbasedonthefactsinTracyLeeMilianv.Commissioner,TCMemo
1999366,inwhichthecourtheldthatapoliceofficerwasliableforselfemploymenttaxonhis
earningsasanoffdutysecurityguard.Thepoliceofficerwasactingasanindependentcontractor
ratherthanapolicedepartmentemployee,eventhoughheworehispoliceuniformandusedpolice
equipment.Asasecurityguard,hewasnotunderpolicydepartmentcontrol,eventhoughthepolicy
departmentapprovedhisoffdutywork.BecausethefactsofMaxCoenssituationsoclosely
resemblethefactsintheMiliancase,theIRSwouldcertainlyconcludethatMaxs$4,100wages
fromtheschooldistrictarenetearningsfromselfemployment.

3. AccordingtoSection1362(d)(2),HeroldsSelectionterminatedonOctober10,2006.PerSection
1362(e)(1),thecorporationmustfileitsfinalForm1120SfortheperiodJanuary1October9(Sshort
year)anditsfirstForm1120fortheperiodOctober10December31(Cshortyear).Section1362(e)
(2)requiresthatHerolds2006taxableincomebeproratedbetweenthetworeturnsbasedonthe
numberofdaysineachshortyear.Hereistheproration.
(282days[Jan.1Oct.9]365)$592,030=$457,404incomeonForm1120S
(83days[Oct.10Dec.31]365)$592,030=$134,626incomeonForm1120

Section1362(e)(5)requiresthatthecorporatetaxonHeroldsCshortyearincomebecomputedon
anannualizedbasis.Thus,thecorporatetaxratesareappliedto$592,030annualincometoresult
inafullyearstaxof$201,290.Thisamountisthenmultipliedbytheratioofthenumberofdaysin
theCshortyeartothenumberofdaysinthefullyear.Basedonthisannualization,Heroldstaxfor
itsCshortyearis$45,773([83365]$201,290.

4. BecauseSandyhasazeroadjustedbasisinherworthlessnote,Section166(b)providesthather
baddebtdeductioniszero.Becauseshealsohasazeroadjustedbasisinherworthlessstock,
Section166(g)(1)providesthathercapitallossrealizedonthedeemedsaleofthisstockisalso
zero.Reg.Sec.1.13662(a)(5)providesthatifanScorporationshareholderdisposesofallofher
stock,anylosscarryforwardattributabletotheSection1366(d)basislimitationispermanently
disallowed.Thus,Sandycanneverdeducther$7,400ordinarylosscarryforward.Insummary,
Sandyhasno2006taxconsequencesfromtheworthlessnessofherinvestmentinLindleeInc.

TaxPlanningCases

1. Mr.andMrs.Janusshouldclearlydocumentthattheyusedthe$80,000borrowedfunds(plus
$5,000fromtheirsavingsaccount)tobuythenewequipmentfortheirrestaurant.Bydoingso,the
interestonthedebtisafullydeductiblebusinessexpenseontheirScheduleC.Iftheyused
borrowedfundstobuythetwoautomobiles,theinterestpaidonsuchfundswouldbea
nondeductiblepersonalexpense.

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2. EveandFrankshouldnotwithdrawanyfundsfromthepartnershipin2007becausetheyneedto
keeptheirinitialinvestmentsintacttodeductthepartnershipsoperatinglossontheir2007Form
1040s.
EvesBasis FranksBasis
Initialcashinvestedinthepartnership $30,000 $30,000
Partnershipdebtincludedinbasis 25,000 25,000
Basisbeforelossdeduction $55,000 $55,000
Shareof2007operatingloss (50,000) (50,000)
Basisatendof2007 $5,000 $5,000

IfthepartnerswithdrawtheirinitialcashcontributionsinDecember2007,theycandeductonly
$25,000oftheirshareofloss.The$25,000nondeductiblelosswouldcarryforwardasadeduction
against2008income.However,thedeferralofa$25,000ordinarydeductionforoneyeardecreases
thetaxsavingsfromthedeductioninNPVterms.Forexample,ata7percentdiscountrate,the
deferralofthedeductionforoneyearreducesthetaxsavingsfrom$8,750($25,000 35%)to
$8,181($8,750 .935discountfactor).Ofcourse,EveandFrankmustweighthetaxsavings
againsttheopportunitycostofdelayingtheircashwithdrawalsfromDecembertoJanuary.

3. a. Ineachcase,Amishasnetcashflowfromtheloaninyear0is($26,000).
CashloanedtoSultan ($40,000)
Taxsavingsfromdeductionofloss
againstdebtbasis($40,00035%) 14,000
Netcashflowinyear0 ($26,000)
The$49,000shareofundistributedcorporateincomeinyears1and2increasedAmishasbasis
inherSultannoteto$40,000andherstockbasisto$9,000.Therepaymentoftheloaninyear2
resultedin$42,470netcashflow($40,000repayment+$3,800interest$1,330taxcost[$3,800
interestincome35%]).
PVofyear0netcashflow ($26,000)
PVofyear2netcashflow
($42,470.890discountfactor) 37,798
NPVofcashflows $11,798

b. The$19,100shareofundistributedcorporateincomeinyears1and2increasedAmishasbasis
inherSultannoteto$19,100.Therepaymentoftheloaninyear2triggereda$20,900capital
gaintaxedat15%.Consequently,therepaymentresultedin$39,335netcashflow($40,000
repayment$3,135capitalgaintax+$3,800interest$1,330taxcost[$3,800interestincome
35%]).
PVofyear0netcashflow ($26,000)
PVofyear2netcashflow
($39,335.890discountfactor) 35,008
NPVofcashflows $9,008

c. Amishasshareofcorporatelossesinyears1and2hadnoeffectonthezerobasisinherSultan
note.Consequently,whenSultandefaultedonrepayment,Mrs.NGdidnotrealizeanytaxlosson
theworthlessnessofthenote.TheNPVofthecashflowsassociatedwithherloanis($26,000).

1021
 Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S
Corporations

4. InvestmentA:

Year0 Year1 Year2 Year3

Purchase/Sale $(50,000) $60,000
Dividends $4,000 $4,000 4,000
Taxondividends (600) (600) (600)
Taxongain (1,500)
Netcashflow $(50,000) $3,600 $3,600 $61,900

NPVat4%=$11,819

InvestmentB:
Year0 Year1 Year2 Year3
Purchase/Sale $(50,000) $90,000
Taxonannualincome $(3,500) $(3,500) (3,500)
Taxongain (1,500)
Netcashflow $(50,000) $(3,500) $(3,500) $85,000

NPVat4%=$18,963

Note:taxbasisofScorporationstockpriortosaleis$80,000($50,000+$30,000earnings)

Basedontheseprojections,MarlashouldchooseInvestmentB,theScorporationstock.

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